Update: Mark Thornton, Joe Salerno, and Peter Klein take down Krugman here, here, and here, much better than I did.

On Sunday in Paul Krugman’s blogs he references a blog post by Brad DeLong about Paul Ryan’s response to QE3 in which Ryan references Ron Paul and “Honest money” all so he can ask the question:

How do the Austrians propose dealing with money market funds?

I mean, it has always been a peculiarity of that school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government. This is historically wrong, but maybe the actual history of banking is deep enough in the past for that wrongness to get missed.

But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.

So are such funds illegitimate?

First of all, the title of his post is ridiculous. No where is Ron Paul quoted in the post as having a position on money market funds. Krugman links the term “honest money” with Ron Paul and then implies that Austrian economics is opposed to money market funds because according to him they are money “created out of thin air by financial institutions”.

Now there is a debate within Austrian economics as to whether money market funds actually do increase the money supply or not and therefore whether they should be considered fractional-reserve banking. Rothbard thought that there were good arguments both ways.

The problem here is that obviously Krugman knows nothing about Austrian economics and worse yet, doesn’t bother to research anything before blurting out the first thing that pops into his head.

Let’s assume he’s right and MMFs are fractional-reserve banking.

Rothbard states the following in chapter eight, “FREE BANKING AND THE LIMITS
ON BANK CREDIT INFLATION”, of The Mystery of Banking.

Let us also define a system of free banking as one where banks are treated like any other business on the free market. Hence, they are not subjected to any government control or regulation, and entry into the banking business is completely free. There is one and only one government “regulation”: that they, like any other business, must pay their debts promptly or else be declared insolvent and be put out of business. In short, under free banking, banks are totally free, even to engage in fractional reserve banking, but they must redeem their notes or demand deposits on demand, promptly and without cavil, or otherwise be forced to close their doors and liquidate their assets.

(emphasis mine)

The conclusion here is exactly the opposite of what Krugman claims the Austrian (and by association I assume he means libertarian) position on MMFs should be.

I challenge him to find an Austrian or libertarian who would ask the government to regulate free banking to force them to keep 100% reserves. There’s simply no need. In a free banking system the market would take care of those who didn’t.

Rothbard concluded that:

…contrary to propaganda and myth, free
banking would lead to hard money and allow very little bank
credit expansion and fractional reserve banking. The hard rigor
of redemption by one bank upon another will keep any one
bank’s expansion severely limited.

However, in chapter nine he goes on to explain what happens when you introduce a central bank and remove the free-market influence on banking. Now you need a requirement to maintain 100% reserves or you get what we have today, AKA Paul Krugman’s paradise.

Nice try, Paul. You may want to try sitting on your hands before hitting the ‘Publish’ button from now on.