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.


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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