Archive for June, 2012

Both Sraffa and Hayek Were Right and Wrong About the Natural Rate of Interest

Last September, after Robert Murphy and Lord Keynes wrote about the Sraffa-Hayek debate of 1932 about the natural rate of interest, I wrote a post about that controversy in which I took an intermediate position defending Hayek against Sraffa’s charge that his use of the natural-rate concept was incoherent, while observing as well that the natural rate of interest in nominal terms is not unique, because any real intertemporal equilibrium is consistent with any choice of price level and any rate of inflation. The condition for a real intertemporal equilibrium with money is simply that the level and rate of change of prices be foreseen correctly.  In such an equilibrium, own rates could differ, but by no more than necessary to compensate for different real service flows and different costs of storage associated with different assets, inasmuch as the expected net real return from holding every asset must be equal in equilibrium. But while expected real returns from holding assets must be equal, that unique real return is consistent with any nominal return reflecting any arbitrary rate of price change.  It is not by choosing a particular nominal rate of interest — a rate that equals the natural rate — that the monetary authority brings about intertemporal equilibrium.  Rather, it is the consistency between whatever nominal interest rate the monetary authority has chosen and the expectations by economic agents of future prices that is the necessary and sufficient condition for intertemporal equilibrium. Any nominal interest rate can become the natural rate if it is supported by an equilibrium set of price expectations. Hayek almost, but not quite, understood this point. His incomplete understanding seems to have prevented him from responding effectively to Sraffa’s charge that his concept of a natural rate of interest was incoherent based on the potential existence of many different own rates of interest in a barter equilibrium.

As a result of last September’s post about Sraffa and Hayek, my colleague Paul Zimmerman and I wrote a paper about the Sraffa-Hayek debate and Keynes’s role in the debate and his later discussion of own rates in chapter 17 of the General Theory. I gave a talk about this paper at Brock University in St. Catherines, Ontario on Sunday at the annual meeting of the History of Economics Society. At some point in the near future, I hope the paper will be ready to circulate on the internet and to submit for publication. When it is I will provide a link to it on the blog. So it was an interesting coincidence that two days after the conference, the Sraffa-Hayek debate about the natural rate and about own rates was the subject of renewed interest in the blogosphere.

The latest round was started by Andrew Laiton who wrote about multiple own rates of interest. Laiton apparently thinks that there could be multiple real own rates, but seems to me to overlook the market forces that tend to equalize own rates, market forces wonderfully described by Keynes in chapter 17. Nick Rowe followed up with a post in which he seems to accept that real own rates could differ across commodities, but doesn’t think that that matters. All that matters is that the monetary authority choose a particular own rate and sets its nominal rate to match the chosen own rate. (Daniel Kuehn agrees with Nick here.)

Nick is right that there is no natural rate that can be defined apart from a particular choice of a nominal price path for at least one commodity over time. But in an economy with n commodities and t time periods, there are nt possible choices (actually many more possible choices if we take into account all possible baskets of commodities and all possible rates of price change). The job of the monetary authority is to pin down a path of nominal prices.  Given that nominal choice, the natural rate consistent with intertemporal equilibrium would find expression in a particular nominal term structure of interest rates consistent with the equilibrium price expectations of agents. Hayek himself proposed constant NGDP as a possible monetary rule. What Hayek failed to see is that it was the choice of a particular value or time path of nominal GDP that would determine a particular nominal value of the natural rate, not, as Hayek believed, that by choosing a nominal interest rate equal to the natural rate, the monetary authority would ensure that NGDP remained constant over time.

Justice Scalia Is Overruled by Judge Posner

Justice Antonin Scalia’s over-the-top outburst in the form of an oral reading of his dissent in Arizona et al. v. United States elicited a stinging rebuke from Judge Richard Posner of the Court of Appeals for the Seventh Circuit. Judge Posner’s rebuke of Justice Scalia is properly receiving a lot of attention, but the attention has been focused chiefly on Judge Posner’s comments on the unseemly political character of Justice Scalia’s outburst. But Judge Posner’s comments on the substantive issues involved in illegal immigration are also worthy of note.

Illegal immigration is a polarizing political and social issue. Many people hate illegal immigrants. Others regard them as an indispensable part of the American labor force. There are 10 million to 11 million illegal immigrants (for rather obvious reasons no one knows the exact number), and illegal immigrants are thought to amount to about 5 percent of the total labor force. Because they tend to do jobs that few Americans want, and because their wages are below average, many (though by no means all) economists believe that the illegal immigrants actually increase the wages of Americans (including legal immigrants). The reason is that the existence of a large body of low-wage workers increases the demand for goods and services both by reducing the cost of production and by their own purchases as consumers, and increased demand for goods and services translates into increased demand for labor and hence higher wages. This is not a certainty but seems a good guess of the effect of illegal immigrants. Illegal immigrants do receive some social services, but fewer than citizens do. It is unclear whether they commit more crimes on average than citizens; they may commit fewer. Of course, some illegal immigrants are criminals, and the Obama administration has decided to focus the very limited resources of the federal immigration enforcement authorities on catching and deporting the criminals. Focusing on them and leaving the law-abiding (law-abiding except for the immigration law itself!) illegal immigrants seems a defensible policy. And certainly state and local law enforcement can assist the feds in apprehending illegal immigrants who commit crimes (being in this country without legal authorization is unlawful, but, with some exceptions, it is not criminal); nothing in the Arizona decision prevents that.

In his peroration, Justice Scalia says that “Arizona bears the brunt of the country’s illegal immigration problem. Its citizens feel themselves under siege by large numbers of illegal immigrant who invade their property, strain their social services, and even place their lives in jeopardy.” Arizona bears the brunt? Arizona is only one of the states that border Mexico, and if it succeeds in excluding illegal immigrants, these other states will bear the brunt, so it is unclear what the net gain to society would have been from Arizona’s efforts, now partially invalidated by the Supreme Court. But the suggestion that illegal immigrants in Arizona are invading Americans’ property, straining their social services, and even placing their lives in jeopardy is sufficiently inflammatory to call for a citation to some reputable source of such hyperbole. Justice Scalia cites nothing to support it.

As of last year there were estimated to be 360,000 illegal immigrants in Arizona, which is less than 6 percent of the Arizona population—below the estimated average illegal immigrant population of the United States. (So much for Arizona’s bearing the brunt of illegal immigration.) Maybe Arizona’s illegal immigrants are more violent, less respectful of property, worse spongers off social services, and otherwise more obnoxious than the illegal immigrants in other states, but one would like to see some evidence of that.

PS I notice that one blogger points out that Judge Posner’s arithmetic is off.  If the total number of illegal immigrants is 10-11 million, then illegal immigrants are approximately 3% of the US population, so that Arizona has a significantly higher ratio of illegal immigrants to its population than does the US as a whole.  Still, if the number of illegal immigrants in Arizona were equal to only 3% of Arizona’s population, there would be about 200,000 illegal immigrants in Arizona.  That Arizona may have an extra 160,000 illegal immigrants compared to the national average is not quite the same as “bear[ing] the brunt of the illegal immigration problem.”

The Bank for International Settlements Falls into a Hayekian Trap

On April 9, 1975, F. A. Hayek, having recently received the Nobel Prize in economics, was invited to give a talk to a group of distinguished economists at the American Enterprise Institute in Washington DC. He was introduced by his old friend and colleague from Vienna, Gottfried Haberler. During his talk, Hayek pointed out that although a downturn can be triggered by microeconomic factors causing a lack of correspondence between the distribution of demand across products and industries and the distribution of labor across products and industries.

These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due ot some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices.

Lacking such price readjustment and resource reallocation, the original unemployment may then spread by means of the mechanism I have discussed before, the “secondary contraction,” as I used to call it. In this way, unemployment may eventually become general.

In the subsequent discussion, Haberler asked Hayek to elaborate on the concept of a “secondary contraction,” and the appropriate policy response to such a phenomenon. Haberler asked:

I was very glad you said that you find some justification in the view that depressions are aggravated by a cumulative spiral and that there is such a thing as a secondary deflation. Don’t you think that it is possible to do something about that aggravation without recreating the fundamental maladjustments which, in your opinion, caused the depression.

Hayek replied:

I hope I implied this. The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose.

Later in the discussion, Haberler again pressed Hayek on his position regarding a downward deflationary spiral such as occurred in the 1930s. Hayek responded to Haberler as follows:

You ask whether I have changed my opinion about combatting secondary deflation. I do not have to change my theoretical views. As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market.

In a terrific commentary on the recent annual report of the Bank for International Settlements, Ryan Avent disposes of the arguments offered by the BIS for tightening current monetary policies.

I was especially struck by the following passage, quoted by Avent, from the report.

Although central banks in many advanced economies may have no choice but to keep monetary policy relatively accommodative for now, they should use every opportunity to raise the pressure for deleveraging, balance sheet repair and structural adjustment by other means.

Here, in another, slightly less ferocious, guise, is the deflationary argument that Hayek himself disavowed nearly 40 years ago:  that secondary deflation could be used to “break the growing rigidity of wage rates,” or in updated BIS terminology could “raise the pressure for deleveraging, balance sheet repair and structural adjustment.”

Plus ca change, plus c’est la meme chose.

Money Wages and Money Illusion

A couple of weeks ago, in the first of three posts about Armen Alchian’s discussion of the microeconomic underpinnings for Keynesian involuntary unemployment, I quoted the following passage from a footnote in Alchian’s classic paper, “Information Costs, Pricing, and Resource Unemployment.”

[C]onsider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference.

Saturos made the following comment on that post:

“The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen.”

But that is money illusion. If my money wage rises by less than inflation, that says nothing about whether other money wages have risen by less than inflation. There is no explanation for a separate behavioral response to a cut in one’s observed real wage through nominal wages or prices – unless workers are observing their nominal wages instead of their real wages, i.e. money illusion.

I gave only a cursory response to Saturos’s comment, though I did come back to it in the third of my series of posts on Alchian’s discussion of Keynesian unemployment. But my focus was primarily on Alchian’s discussion of the validity of the inflation-induced-wage-lag hypothesis, a hypothesis disputed by Alchian and attributed by him to Keynes. I discussed my own reservations about Alchian’s position on the wage lag in that post, but here I want to go back and discuss Saturos’s objection directly. My claim is that there is a difference between the assumption that workers observe only nominal, not real, wages, in the process of making decisions about whether to accept or reject wage offers and the assumption of money illusion.

Here is how to think about the difference. In any period, some workers are searching for employment, and presumably they (or at least some of them) can search more efficiently (i.e., collect more wage offers) while unemployed than employed.  In obtaining wage offers, workers can only observe a nominal wage offer for their services; they can’t observe a real wage, because it is too costly and time-consuming for any individual to collect observations for all the goods and services that enter into a reasonably comprehensive price index, and then compute a price level from those price observations. However, based on experience and other sources of information, workers, like other economic agents, form expectations about what prices they will observe (i.e., the prices that will clear markets). In any period, workers’ wage expectations are determined, in part, by their expectations of movements in the general price level. The higher the expected rate of inflation, the higher the expected wage. The absence of money illusion means that workers change their expectations of wage offers (given expectations about changes in real wages) in line with their expectations of inflation. However, within any period, workers’ expectations are fixed. (Actually, the period can be defined as the length of time during which expectations are held fixed.) This is simply the temporary-equilibrium construct introduced by Hicks in Value and Capital and again in Capital and Growth.

With expectations fixed during a given period, workers, observing wage offers, either accept or reject those offers by comparing a given nominal nominal wage offer with the nominal reservation wage settled upon at the beginning of the period, a reservation wage conditional on the expectation of inflation for that period formed at the beginning of the period. Thus, the distinction made by Alchian between the information conveyed by a nominal-wage cut at a constant price level versus the information conveyed by a constant money wage at an unexpectedly high price level is perfectly valid, and entails no money illusion. The only assumption is that, over some finite period of time, inflation or price-level expectations are held constant instead of being revised continuously and instantaneously. Another way of saying this is that the actual rate of inflation does not always equal the expected rate of inflation. But to repeat, there is no assumption of money illusion. I am pretty sure that I heard Earl Thompson explain this in his graduate macrotheory class at UCLA around 1972-73, but I had to work through the argument again for myself before remembering that I had heard it all from Earl about 40 years earlier.

Anna Schwartz, RIP

Last Thursday night, I was in Niagra Falls en route to the History of Economics Society Conference at Brock University in St. Catharines, Ontario to present a paper on the Sraffa-Hayek debate (co-authored with my FTC colleague Paul Zimmerman) when I saw the news that Anna Schwartz had passed away a few hours earlier. The news brought back memories of how I first got to know Anna in 1985, thanks to our mutual friend Harvey Segal, formerly chief economist at Citibank, who had recently joined the Manhattan Institute where I was a Senior Fellow and had just started writing my book Free Banking and Monetary Reform. When Harvey suggested that it would be a good idea for me to meet and get to know Anna, I was not so sure that it was such a good idea, because I knew that I was going to be writing critically about Friedman and Monetarism, and about the explanation for the Great Depression given by Friedman and Schwartz in their Monetary History of the US. Nevertheless, Harvey was insistent, dismissing my misgivings and assuring me that Anna was not only a great scholar, but a wonderful and kind-hearted person, and that she would not take offense at a sincerely held difference of opinion. Taking Harvey’s word, I went to visit Anna at her office at the NBER on the NYU campus at Washington Square, but not without some residual trepidation at what was in store for me. But when I arrived at her office, I was immediately put at ease by her genuine warmth and interest in my work, based on what Harvey had told her about me and what I was doing. About a year later when my first draft was complete and submitted to Cambridge University Press, I was truly gratified when I received the report that Anna had written to the editors at Cambridge about my manuscript, praising the book as an important contribution to monetary economics even while registering her own disagreement with certain positions I had taken that were at odds with what she and Friedman had written.

Over the next couple of years Anna and I actually became even closer when, after finishing Free Banking and Monetary Reform, I accepted an offer to edit a proposed encyclopedia of business cycles and depressions, an assignment that I later bitterly regretted accepting when the enormity of the project that I had undertaken became all too clear to me.  After taking the assignment, I think that Anna was probably the first person that I contacted, and she agreed to serve as a consulting editor, and immediately put me in touch with two of her colleagues at the National Bureau, Victor Zarnowitz, and Geoffrey Moore. During my decade-long struggle to plan, execute, and see to conclusion this project, it was in no small part thanks to the generous and unstinting assistance of my three original consulting editors, Anna, Victor Zarnowitz, and Geof Moore. Over time, they were soon joined by other distinguished economists (Tom Cooley, Barry Eichengreen, Harald Hagemann, Phil Klein, Roger Kormendi, David Laidler, Phil Mirowski, Ed Nell, Lionello Punzo and Alesandro Vercelli) whose interest in and enthusiasm for the project kept me going when I wanted nothing more than to rid myself of this troublesome project. But without the help I received at the very start from Anna, and from Victor Zarnowitz and Geof Moore, the project would have never gotten off the ground. Sadly, with Anna gone, none of my original three consulting editors is still with us. Nor is another dear friend, Harvey Segal. I shall miss, but will not forget, them.

In a small tribute to Anna’s memory, I reproduce below (in part) the entry, written by Michael Bordo, on Anna Jacobsen Schwartz (1915 – 2012), from Business Cycles and Depressions: An Encyclopedia.

Anna Schwartz has contributed significantly to our understanding of the role of money in propagating and exacerbating business-cycle disturbances. Schwartz’s collaboration with Milton Friedman in the highly acclaimed money and business-cycle project of the National Bureau of Economic Research (NBER) helped establish the modern quantity theory of money (or Monetarism) as a dominant explanation for macroeconomic instability. Her contributions lie in the four related areas of monetary statistics, monetary history, monetary theory and policy, and international arrangements.

Born in New York City, she received a B. A. from Barnard College in 1934, an M.A. from Columbia in 1936, and a Ph.D. from Columbia in 1964. Most of Schwartz’s career has been spent in active research. After a year at the United States Department of Agriculture in 1936, she spent five years at Columbia University’s Social Science Research Council. She joined the NBER in 1941, where she has remained ever since. In 1981-82, Schwartz served as staff director of the United States Gold Commission and was responsible for writing the Gold Commission Report.

Schwartz’s early research was focused mainly on economic history and statistics. A collaboration with A. D. Gayer and W. W. Rostow from 1936 to 1941 produced a massive and important study of cycles and trends in the British economy during the Industrial Revolution, The Growth and Fluctuation of the British Economy, 1790-1850. The authors adopted NBER techniques to isolate cycles and trends in key time series of economic performance. Historical analysis was then interwoven with descriptive statistics to present an anatomy of the development of the British economy in this important period.

Schwartz collaborated with Milton Friedman on the NBER’s money and business-cycle project over a period of thirty years. This research resulted in three volumes: A Monetary History of the United States, 1867-1960, Monetary Statistics of the United States, and Monetary Trends in the United States and the United Kingdom, 1875-1975. . . .

The overwhelming historical evidence gathered by Schwartz linking economic instability to erratic monetary behavior, in turn a product of discretionary monetary policy, has convinced her of the desirability of stable money brought about through a constant money-growth rule. The evidence of particular interest to the student of cyclical phenomena is the banking panics in the United States between 1873 and 1933, especially from 1930 to 1933. Banking panics were a key ingredient in virtually every severe cyclical downturn and were critical in converting a serious, but not unusual, downturn beginning in 19329 into the “Great Contraction.” According to Schwartz’s research, each of the panics could have been allayed by timely and appropriate lender-of-last-resort intervention by the monetary authorities. Moreover, the likelihood of panics ever occurring would be remote in a stable monetary environment.

Yikes! Inflation Expectations Turned Negative Yesterday

In the wake of the FOMC’s decision Wednesday to ignore reality (and its own forecasts), the stock market dove yesterday. Inflation expectations, as approximated by the breakeven TIPS spread, also dove. And for the first time since March 2009, when the S&P 500 fell below 700, the implied breakeven TIPS spread on a one-year Treasury turned negative. I point this out just to illustrate the gravity of the current situation, not because there is a huge difference between the expectation of slightly positive inflation and slightly negative deflation.

Check out this chart for the one-year breakeven TIPS spread, this one for the 2-year, this one for the 5-year, and this one for the 10-year.

Chairman Bernanke has been reduced to defending the indefensible. Paul Krugman properly castigated the FOMC’s abdication of responsibility this week. Scott Sumner believes that Bernanke’s heart is in the right place, but his hands are tied, and is therefore unable to do what he knows in his heart ought to be done. If Scott is right, then Bernanke has only one honorable course of action: to resign and to explain that he cannot continue to serve as Fed Chairman, presiding over, and complicit in, a policy that he knows is mistaken and leading us to disaster.

The FOMC Kicks the Can Down the Road

At its meeting today, the Federal Open Market Committee (FOMC) decided . . . , well, decided not to decide. Faced with a feeble US economic recovery showing clear signs of getting weaker still, and a perilous economic situation in Europe poised to spin out of control into a full-blown financial crisis, the FOMC opted to continue the status quo, prolonging its so-called Operation Twist in which the Fed is liquidating its holdings of short-dated Treasuries and replacing them with longer-dated Treasuries, on the theory that changing the maturity structure of the Fed’s balance sheet will reduce long-term interest rates, thereby providing some further incentive for long-term borrowing, as if the problem holding back a recovery were long-term nominal interest rates that are not low enough.

What I found most interesting in today’s statement was the FOMC’s assessment of inflation. In the opening paragraph of its statement, the FOMC states:

Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

What is the basis for the FOMC’s statement that inflation expectations are stable?  Does the FOMC not take seriously the estimate of inflation expectations just published by the Cleveland Fed showing that inflation expectations over a 10-year time horizon are at an all-time low of 1.19% and the expectation for the next 12 months is 0.6%, the lowest since March 2009 when the stock market reached its post-crisis low?  And the FOMC’s April projection for PCE inflation in 2012 was in a range 1.9 to 2.0%; its current projection is now 1.2 to 1.7%.  In contrast to 2008, when the FOMC was in a tizzy about inflation expectations becoming unanchored because of rapidly rising food and energy prices, the FOMC seems remarkably calm and unperturbed about a 0.3% fall in headline inflation in May.

Then in the next paragraph the FOMC makes another — shall we say, puzzling — statement:

The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

So the FOMC admits that inflation is likely to be less than its own inflation target. Let’s be sure that we understand this. The economy is weakening, growth is slowing, unemployment, after nearly four years above 8 percent, is once again rising, and the Fed’s own expectation of the inflation rate for 2012 is well below the FOMC target. And what is the FOMC response?  Steady as you go.

In a news story about the FOMC decision, Marketwatch reporter Steve Goldstein writes:

The Federal Reserve on Wednesday softened its growth and inflation forecasts over the next three years, as the central bank said the unemployment rate will hold above 8% through the end of 2012. The Fed also cut its inflation forecast down aggressively, to between 1.2% and 1.7% this year, as opposed to its forecast in April between 1.9% and 2%. The central bank targets 2% inflation over the medium term, so the reduced inflation forecast is likely to ratchet up expectations of additional central bank easing, possibly as soon as August. The Fed’s forecast for growth this year is down to a range of 1.9% to 2.4%, down from 2.4% to 2.9% in April — and its April 2011 forecast that 2012 growth would range between 3.5% and 4.2%. Also of note, it appears that the two newest voters, Jerome Powell and Jeremy Stein, are among the most dovish; the most recent breakdown of when the right time to raise hikes shows the only change is in 2015, which now has six members in that camp, up from four in April. Powell and Stein were recently sworn in as Fed governors.

So the optimistic take on all this is that the FOMC has set the stage for taking aggressive action at its next meeting. Since bottoming out last week, stock prices recovered, apparently in expectation of easing by the Fed. Today’s announcement is not what the market was hoping for, but there are at least signs that the FOMC will take action soon. In our desperation, we have been reduced to grasping at straws.

Money Is Always* and Everywhere* Non-Neutral

Via Scott Sumner I found another of Nick Rowe’s remarkably thoughtful and thought-provoking posts about the foundations of monetary theory. The object – at least as I read him – of Nick’s post is to explain how and why money can (or must) be neutral. And Nick performs this little (or maybe not so little) feat by juxtaposing two giants in the history of monetary theory, David Hume from the eighteenth century and Don Patinkin from the twentieth. Both, it seems, were convinced of the theoretical, indeed logical, necessity of monetary neutrality, but both felt constrained by observational experience to acknowledge that money has real effects, which is just another of saying that money is not (or at least not always) neutral.

I am not going to discuss Nick’s post in detail. Instead, I want to question what I take to be an underlying premise of his post, that there is a theoretical presumption that money is neutral, at least in the long run. In questioning the neutrality of money, I do not mean that one cannot easily write down a model in which it is possible to derive the conclusion that a change in the quantity of money changes the equilibrium in that model by changing all money prices proportionately, leaving all relative prices and all real quantities of goods produced and consumed unchanged. What I assert is that the real world conditions under which this result would obtain do not exist, with the possible exception of a currency reform in which a new currency unit is introduced to replace the old unit at a defined rate between the new and old units. In such a case, but only in such a case, it is likely that the results of the change would be confined to money prices, with no effect on real quantities. (It is because of this trivial exception that I inserted asterisks after “always” and “everywhere” in the title of this post.)

Let me give a few, certainly not all, of the reasons why money is never neutral. First, most agree as David Hume explained over 250 years ago that changes in the quantity of money do have short-term real effects. The neutrality of money is thus usually presented as a proposition valid only in the long-run. But there is clearly no compelling reason to think that it is valid in the long run either, because, as Keynes recognized, the long run is a succession of short runs. But each short-run involves a variety of irreversible investments and irrevocable commitments, so that any deviation from the long-run equilibrium path one might have embarked on at time 0 will render it practically impossible to ever revert back to the long-run path from which one started. If money has real short-term effects, in an economy characterized by path dependence, money must have long-term effects. Real irreversible investments are just one example of such path dependencies. There are also path dependencies associated with investments in human capital or employment decisions. Indeed, path dependencies are inherent in any economy in which trading is allowed at disequilibrium prices, which is to say every economy that exists or ever existed.

If workers’ chances of being employed depend on their previous employment history, short-term increases in employment necessarily have long-term effects on the future employability of workers. Chronic high employment now degrades the quality of the labor force in the future. If arguments that potential GDP has fallen since 2008 have any validity, a powerful reason why potential GDP has fallen is surely the increase in chronic unemployment since 2008.

Another way to make this point is that the proposition of long-run neutrality presupposes that there is one and only one equilibrium time path for the economy. The economy is in equilibrium if and only if it is on that unique time path. Under long-run neutrality, you can deviate from that equilibrium time path for a while, but sooner or later you must get back on it. When you’re back on it, monetary neutrality has been restored. But if there is no single equilibrium time path, there is no presumption of neutrality in the short run or the long run.

Let me also mention another reason besides time dependence and irreversibility why it is a mistake to conceive of an economy as having a unique equilibrium time path. As I have observed in previous posts on this blog, every economic equilibrium is dependent on the expectations held by the agents. A change in expectations changes the equilibrium. Or, as I have expressed it previously, expectations are fundamental. If a change in monetary policy induces, or is associated with, a change in expectations, the economic equilibrium changes. So money can’t be neutral. Ever.

PS Let me just mention that I have drawn in this post on an unpublished paper by Richard Lipsey “The Neutrality of Money,” which he was kind enough to share with me. Lipsey particularly emphasized path dependence as a reason why money, as he put, “is an artifact of economic models,” not a universally correct prediction about the world. Lipsey developed the idea of path dependence more fully in another much longer paper co-athored with Kenneth Carlaw that he shared with me, “Does History Matter? Empirical Analysis of Evolutionary versus New Classical Views of the Economy” forthcoming in the Journal of Evolutionary Economics. Perhaps in a future post, I will discuss the Carlaw Lipsey paper at greater length.

1970s Stagflation

Karl Smith, Scott Sumner, and Yichuan Wang have been discussing whether the experience of the 1970s qualifies as “stagflation.” The term stagflation seems to have been coined in the 1973-74 recession, which was characterized by a rising inflation rate and a rising unemployment rate, a paradoxical conjunction of events for which economic theory did not seem to have a ready explanation. Scott observed that inasmuch as average real GDP growth over the decade was a quite respectable 3.2%, applying the term “stagflation” to the decade seems to be misplaced. Karl Smith says that although real GDP growth was fairly strong unemployment rates were much higher after the early 1970s than they had been in the 1960s and even in the lackluster 1950s (a decade of low inflation and low growth). Yichuan Wang weighs in with the observation that high growth in GDP produced almost no measurable effect on real GDP growth even though a simple Phillips Curve or AD/AS framework would suggest that all that extra growth in nominal GDP should have produced some payoff in added real GDP growth.

Here are some further observations on what happened in the 1970s. Inflation expectations began increasing in the late 1960s, so that a very modest tightening of monetary policy in 1969-70 produced a minor recession, but an almost imperceptible reduction in inflation. Nixon, not wanting to run for reelection with a stagnating economy — the memory of running unsuccessfully for President in 1960 during a recession having seared in his consciousness — forced an unwilling Fed to increase money growth rapidly while cynically imposing wage and price controls to keep a lid on inflation. The political strategy was a smashing success, but the stage was set for a ratcheting up of inflation and inflation expectations, though markets were actually slow to anticipate the rapid rise in inflation that followed.

Thus, the early part of the decade fits in well with Scott’s interpretation. Rising aggregate demand produced rising inflation and rising real GDP growth. Unfortunately, wage and price control quickly began to have harmful economic effects, producing shortages and other disruptions in economic activity that may have shaved a few percentage points off real GDP growth over the next few years. More serious was the first big oil-price shock in late 1973 in the wake of the Yom Kippur war, causing a quadrupling of oil prices over a period of a few months as well as horrific gasoline shortages attributable to the effects of remaining price controls on the petroleum sector, controls that, for political reasons, could not be removed even though other price controls had mercifully been allowed to expire. So in 1974, there was a rapid increase in inflation expectations fueled both by a tardy realization of the inflationary implications of the Nixon/Burns policy monetary of 1971-73, and a presumption that increases in oil prices would be accommodated in output prices rather than forcing down prices of complementary inputs. But because of general anti-inflation sentiment, monetary policy was tightened at precisely the moment when aggregate supply was contracting as a result of rising inflation expectations and an exogenous oil price shock. That meant that read GDP began to fall sharply even though output-price inflation was accelerating. It was that temporary conjunction of falling real GDP, rising unemployment, and rising inflation in 1974 that gave rise to the term “stagflation.” After initially focusing on inflation, the newly installed Ford administration quickly pivoted and provided economic stimulus to generate a recovery and the temporary inflationary bulge worked its way through the system. The recovery was robust enough to have enabled Ford to have been re-elected had it not been for Ford’s monumental gaffe in his debate against Jimmy Carter denying that Poland was under Soviet domination or for lingering resentment against Ford for having pre-emptively pardoned Richard Nixon for any crimes that he committed during his Presidency.

By the time that Jimmy Carter took office, the US economy was well into a cyclical expansion, but Carter, after replacing Arthur Burns as Fed chairman with the clueless G. William Miller, encouraged Miller to continue a policy of rapid monetary expansion, producing rising inflation in 1977 and 1978. Once again, unnecessary monetary stimulus produced rising inflation and rising inflation expectations just before a second oil-price shock, precipitated by the Iranian Revolution, began in 1979. The combination of rising inflation expectations and rapidly rising oil prices (exacerbated by the continuing controls on petroleum pricing causing renewed shortages of gasoline and other refined products) caused a leftward shift in aggregate supply, causing inflation to rise while output fell. Hence the second episode of stagflation.

So what does this all mean? Well, if one looks at the periods of rapid increases in aggregate demand in which oil price shocks were absent, we observe very high rates of real GDP growth. In the 1960s from the third quarter of 1961 to the third quarter of 1969, real GDP growth averaged 4.8%. Over the same period, the average annual rate of increase in the GDP price deflator was 2.6%. For the 10 quarters from the first quarter of 1971 through the second quarter of 1973, real GDP growth averaged 5.9%, and for 15 quarters rom the second quarter of 1975 to the fourth quarter of 1978, real GDP growth averaged 5.1%. The average annual rate of increase in the GDP deflator in the 1971-73 period was 5.2% and in the 1975-78 period, the rate of increase in prices was 6.4%. In the periods of recession or slow growth associated with the oil-price shocks (i.e, 1973-74 and 1979, the rate of increase in the GDP deflator was 9.3% in the former period, and 8.4% in the latter. Thus inflation was higher in recession or slow growth periods than in rapid growth periods. That was stagflation.  Although economic expansions were about as fast in the 1970s as the 1960s, it would not be outlandish to suggest that rapid increases in nominal GDP in the 1970s did produce faster real GDP growth than would have occurred otherwise, though one might also argue that those temporary increases in real GDP growth had a non-trivial downside.

Why was unemployment so much higher in the 1970s than in the 1960s even though the rate of labor force participation was higher? I think that the obvious answer is that there was an influx of women and baby boomers into the work force without much previous work experience. Typically, new entrants into the labor force spend more time searching for employment than workers with previous experience, so it would not be surprising to observe a higher measured unemployment rate in the 1970s than in the 1960s even though jobs were not harder to find for most of the 1970s than they were in the 1960s.

The Cleveland Fed Reports Inflation Expectations Are Dropping Fast; Bernanke Doesn’t Seem to Care

Coinciding with the latest report on the consumer price index, showing the largest one month drop in the CPI since 2008, the Cleveland Fed issued its monthly update on inflation expectations.

News Release: June 14, 2012

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.19 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

As the attached chart shows, the current expected rate of inflation over a 10-year time horizon is at an all-time low, dropping 30 basis points in the last two months. But in his testimony to Congress this week, Chairman Bernanke did not seem to think there was any problem with monetary policy. It’s all those other guys’ fault.  Well, who exactly is responsible for falling inflation expectations, Mr. Bernanke, if not the FOMC? Does a sharp drop in inflation expectations, the sharpest since the horrific summer of 2008 give you any cause for concern? If so, is there any change in policy that the FOMC plans to undertake at its next meeting? Or is the FOMC only concerned about inflation expectations when they show signs of becoming unanchored on the upside, not the downside?

UPDATE (3:44 PM EDST):  A quick look at the excel file showing the Cleveland Fed’s estimates of inflation expectations at maturities from 1 to 30 years shows that one-year expectation fell last month to 0.6% from 1.4% the previous month.  That is the lowest one-year inflation expectation since March of 2009 (-.0.3%) when the S&P 500 fell to 676, 10% below the previous trough of 752, in November 2008.  We are treading on very thin ice, and the only thing that may be keeping us afloat is the market’s expectation that the FOMC has no alternative but to adopt another round of Quantitative Easing.  Let’s see if the confidence of the market is justified.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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