Here is Kurt Schuler over at freebanking.org:

“During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.”

Kurt is of course very right – the way to see whether monetary policy is tight or loose is to look at the money supply relative to the money demand. Since, we can not observe the difference between the money supply and the money demand directly Market Monetarists recommend to look at asset prices. We know that tight money (stronger money demand growth than the money supply growth) leads to a drop in equity prices, lower bond yields (due to lower inflation expectations), a stronger currency and for large economies like the US or China lower commodity prices.

One thing Kurt did not mention – and I a bit puzzled about that as it is a very important argument for Free Banking – is that in a world with Free Banking the total privatisation of the money supply means that the money supply (ideally?) is perfectly elastic and that any increase in money demand is meet by a equally large increase in the money supply. The same will be the case in a world with central banks targeting the NGDP level. With a perfectly elastic money supply crisis like the Great Depression and the Great Recession is likely to be much more unlikely.

PS I am writing this while I am in Lithuania – a country where Kurt’s (and George Selgin’s) work played a key role nearly 20 years ago in the introduction of the country’s currency board system. See more on this here.