Archive for February, 2013

That Oh So Elusive Natural Rate of Interest

Last week, I did a short post linking to the new draft of my paper with Paul Zimmerman about the Sraffa-Hayek exchange on the natural rate of interest. In the paper, we attempt to assess Sraffa’s criticism in his 1932 review of Prices and Production of Hayek’s use of the idea of a natural rate of interest as well as Hayek’s response, or, perhaps, his lack of response, to Sraffa’s criticism. The issues raised by Sraffa are devilishly tricky, especially because he introduced the unfamiliar terminology of own-rates of interest, later adopted Keynes in chapter 17 of the General Theory in order to express his criticism. The consensus about this debate is that Sraffa got the best of Hayek in this exchange – the natural rate of interest was just one of the issues Sraffa raised, and, in the process, he took Hayek down a peg or two after the startling success that Hayek enjoyed upon his arrival in England, and publication of Prices and Production. In a comment to my post, Greg Ransom questions this conventional version of the exchange, but that’s my story and I’m sticking to it.

What Paul and I do in the paper is to try to understand Sraffa’s criticism of Hayek. It seems to us that the stridency of Sraffa’s attack on Hayek suggests that Sraffa was arguing that Hayek’s conception of a natural rate of interest was somehow incoherent in a barter economy in which there is growth and investment and, thus, changes in relative prices over time, implying that commodity own rates of interest would have differ. If, in a barter economy with growth and savings and investment, there are many own-rates, Sraffa seemed to be saying, it is impossible to identify any one of them as the natural rate of interest. In a later account of the exchange between Sraffa and Hayek, Ludwig Lachmann, a pupil of Hayek, pointed out that, even if there are many own rates in a barter economy, the own rates must, in an intertemporal equilibrium, stand in a unique relationship to each other: the expected net return from holding any asset cannot differ from the expected net return on holding any other asset. That is a condition of equilibrium. If so, it is possible, at least conceptually, to infer a unique real interest rate. That unique real interest rate could be identified with Hayek’s natural rate of interest.

In fact, as we point out in our paper, Irving Fisher in his classic Appreciation and Interest (1896) had demonstrated precisely this point, theoretically extracting the real rate from the different nominal rates of interest corresponding to loans contracted in terms of different assets with different expected rates of price appreciation. Thus, Sraffa did not demonstrate that there was no natural rate of interest. There is a unique real rate of interest in intertemporal equilibrium which corresponds to the Hayekian natural rate. However, what Sraffa could have demonstrated — though had he done so, he would still have been 35 years behind Irving Fisher – is that the unique real rate is consistent with an infinite number of nominal rates provided that those nominal rates reflected corresponding anticipated rate of price appreciation. But, instead, Sraffa argued that there is no unique real rate in intertemporal equilibrium. That was a mistake.

Another interesting (at least to us) point in our paper is that Keynes who, as editor of the Economic Journal, asked Sraffa to review Prices and Production, borrowed Sraffa’s own-rate terminology in chapter 17 of the General Theory, but, instead of following Sraffa’s analysis and arguing that there is no natural rate of interest, Keynes proceeded to derive, using (without acknowledgment) a generalized version of Fisher’s argument of 1896, a unique relationship between commodity own rates, adjusted for expected price changes, and net service yields, such that the expected net returns on all assets would be equalized. From this, Keynes did not conclude, as had Sraffa, that there is no natural rate of interest. Rather, he made a very different argument: that the natural rate of interest is a useless concept, because there are many natural rates each corresponding to a different the level of income and employment, a consideration that Hayek, and presumably Fisher, had avoided by assuming full intertemporal equilibrium. But Keynes never disputed that for any given level of income and employment, there would be a unique real rate to which all commodity own rates had to correspond. Thus, Keynes turned Sraffa’s analysis on its head. And the final point of interest is that even though Keynes, in chapter 17, presented essentially the same analysis of own rates, though in more general terms, that Fisher had presented 40 years earlier, Keynes in chapter 13 explicitly rejected Fisher’s distinction between the real and nominal rates of interest. Go figure.

Bob Murphy wrote a nice paper on the Sraffa-Hayek debate, which I have referred to before on this blog. However, I disagree with him that Sraffa’s criticism of Hayek was correct. In a post earlier this week, he infers, from our statement that, as long as price expectations are correct, any nominal rate is consistent with the unique real natural rate, that we must agree with him that Sraffa was right and Hayek was wrong about the natural rate. I think that Bob is in error on the pure theory here. There is a unique real natural rate in intertemporal equilibrium, and, in principle, the monetary authority could set a money rate equal to that real rate, provided that that nominal rate was consistent with the price expectations held by the public. However, intertemporal equilibrium could be achieved by any nominal interest rate selected by the monetary authority, again provided that the nominal rate chosen was consistent with the price expectations held by the public. In practice, either formulation is very damaging to Hayek’s policy criterion of setting the nominal interest rate equal to the real natural rate. But contrary to Sraffa’s charge, the policy criterion is not incoherent. It is just unworkable, as Hayek formulated it, and, on Hayek’s own theory, the criterion is unnecessary to avoid distorting malinvestments.

Armen Alchian, The Economists’ Economist

The first time that I ever heard of Armen Alchian was when I took introductory economics at UCLA as a freshman, and his book (co-authored with his colleague William R. Allen who was probably responsible for the macro and international chapters) University Economics (the greatest economics textbook ever written) was the required text. I had only just started to get interested in economics, and was still more interested in political philosophy than in economics, but I found myself captivated by what I was reading in Alchian’s textbook, even though I didn’t find the professor teaching the course very exciting. And after 10 weeks (the University of California had switched to a quarter system) of introductory micro, I changed my major to economics. So there is no doubt that I became an economist because the textbook that I was taught from was written by Alchian.

In my four years as an undergraduate at UCLA, I took three classes from Axel Leijonhufvud, two from Ben Klein, two from Bill Allen, and one each from Robert Rooney, Nicos Devletoglou, James Buchanan, Jack Hirshleifer, George Murphy, and Jean Balbach. But Alchian, who in those days was not teaching undergrads, was a looming presence. It became obvious that Alchian was the central figure in the department, the leader and the role model that everyone else looked up to. I would see him occasionally on campus, but was too shy or too much in awe of him to introduce myself to him. One incident that I particularly recall is when, in my junior year, F. A. Hayek visited UCLA in the fall and winter quarters (in the department of philosophy!) teaching an undergraduate course in the philosophy of the social sciences and a graduate seminar on the first draft of Law, Legislation and Liberty. I took Hayek’s course on the philosophy of the social sciences, and audited his graduate seminar, and I occasionally used to visit his office to ask him some questions. I once asked his advice about which graduate programs he would suggest that I apply to. He mentioned two schools, Chicago, of course, and Princeton where his friends Fritz Machlup and Jacob Viner were still teaching, before asking, “but why would you think of going to graduate school anywhere else than UCLA? You will get the best training in economics in the world from Alchian, Hirshleifer and Leijonhufvud.” And so it was, I applied to, and was accepted at, Chicago, but stayed at UCLA.

As a first year graduate student, I took the (three-quarter) microeconomics sequence from Jack Hirshleifer (who in the scholarly hierarachy at UCLA ranked only slightly below Alchian) and the two-quarter macroeconomics sequence from Leijonhufvud. Hirshleifer taught a great course. He was totally prepared, very organized and his lectures were always clear and easy to follow. To do well, you had to sit back listen, review the lecture notes, read through the reading assignments, and do the homework problems. For me at least, with the benefit of four years of UCLA undergraduate training, it was a breeze.

Great as Hirshleifer was as a teacher, I still felt that I was missing out by not having been taught by Alchian. Perhaps Alchian felt that the students who took the microeconomics sequence from Hirshleifer should get some training from him as well, so the next year he taught a graduate seminar in topics in price theory, to give us an opportunity to learn from him how to do economics. You could also see how Alchian operated if you went to a workshop or lecture by a visiting scholar, when Alchian would start to ask questions. He would smile, put his head on his forehead, and say something like, “I just don’t understand that,” and force whoever it was to try to explain the logic by which he had arrived at some conclusion. And Alchian would just keep smiling, explain what the problem was with the answer he got, and ask more questions. Alchian didn’t shout or rant or rave, but if Alchian was questioning you, you were not in a very comfortable position.

So I was more than a bit apprehensive going into Alchian’s seminar. There were all kinds of stories told by graduate students about how tough Alchian could be on his students if they weren’t able to respond adequately when subjected to his questioning in the Socratic style. But the seminar could not have been more enjoyable. There was give and take, but I don’t remember seeing any blood spilled. Perhaps by the time I got to his seminar, Alchian, then about 57, had mellowed a bit, or, maybe, because we had all gone through the graduate microeconomics sequence, he felt that we didn’t require such an intense learning environment. At any rate, the seminar, which met twice a week for an hour and a quarter for 10 weeks, usually involved Alchian picking a story from the newspaper and asking us how to analyze the economics underlying the story. Armed with nothing but a chalkboard and piece of chalk, Alchian would lead us relatively painlessly from confusion to clarity, from obscurity to enlightenment. The key concepts with which to approach any problem were to understand the choices available to those involved, to define the relevant costs, and to understand the constraints under which choices are made, the constraints being determined largely by the delimitation of the property rights under which the resources can be used or exchanged, or, to be more precise, the property rights to use those resources can be exchanged.

Ultimately, the lesson that I learned from Alchian is that, at its best, economic theory is a tool for solving actual real problems, and the nature of the problem ought to dictate the way in which the theory (verbal, numerical, graphical, higher mathematical) is deployed, not the other way around. The goal is not to reach any particular conclusion, but to apply the tools in the best and most authentic way that they can be applied. Alchian did not wear his politics on his sleeve, though it wasn’t too hard to figure out that he was politically conservative with libertarian tendencies. But you never got the feeling that his politics dictated his economic analysis. In many respects, Alchian’s closest disciple was Earl Thompson, who studied under Alchian as an undergraduate, and then, after playing minor-league baseball for a couple of years, going to Harvard for graduate school, eventually coming back to UCLA as an assistant professor where he remained for his entire career. Earl, discarding his youthful libertarianism early on, developed many completely original, often eccentric, theories about the optimality of all kinds of government interventions – even protectionism – opposed by most economists, but Alchian took them all in stride. Mere policy disagreements never affected their close personal bond, and Alchian wrote the forward to Earl’s book with Charles Hickson, Ideology and the Evolution of Vital Economics Institutions. If Alchian was friendly with and an admirer of Milton Friedman, he just as friendly with, and just as admiring of, Paul Samuelson and Kenneth Arrow, with whom he collaborated on several projects in the 1950s when they consulted for the Rand Corporation. Alchian cared less about the policy conclusion than he did about the quality of the underlying economic analysis.

As I have pointed out on several prior occasions, it is simply scandalous that Alchian was not awarded the Noble Prize. His published output was not as voluminous as that of some other luminaries, but there is a remarkably high proportion of classics among his publications. So many important ideas came from him, especially thinking about economic competition as an evolutionary process, the distinction between the functional relationship between cost and volume of output and cost and rate of output, the effect of incomplete information on economic action, the economics of property rights, the effects of inflation on economic activity. (Two volumes of his Collected Works, a must for anyone really serious about economics, contain a number of previously unpublished or hard to find papers, and are available here.) Perhaps in the future I will discuss some of my favorites among his articles.

Although Alchian did not win the Nobel Prize, in 1990 the Nobel Prize was awarded to Harry Markowitz, Merton Miller, and William F. Sharpe for their work on financial economics. Sharp, went to UCLA, writing his Ph.D. dissertation on securities prices under Alchian, and worked at the Rand Corporation in the 1950s and 1960s with Markowitz.  Here’s what Sharpe wrote about Alchian:

Armen Alchian, a professor of economics, was my role model at UCLA. He taught his students to question everything; to always begin an analysis with first principles; to concentrate on essential elements and abstract from secondary ones; and to play devil’s advocate with one’s own ideas. In his classes we were able to watch a first-rate mind work on a host of fascinating problems. I have attempted to emulate his approach to research ever since.

And if you go to the Amazon page for University Economics and look at the comments you will see a comment from none other than Harry Markowitz:

I am about to order this book. I have just read its quite favorable reviews, and I am not a bit surprised at their being impressed by Armen Alchian’s writings. I was a colleague of Armen’s, at the Rand Corporation “think tank,” during the 1950s, and hold no economist in higher regard. When I sat down at my keyboard just now it was to find out what happened to Armen’s works. One Google response was someone saying that Armen should get a Nobel Prize. I concur. My own Nobel Prize in Economics was awarded in 1990 along with the prize for Wm. Sharpe. I see in Wikipedia that Armen “influenced” Bill, and that Armen is still alive and is 96 years old. I’ll see if I can contact him, but first I’ll buy this book.

I will always remember Alchian’s air of amused, philosophical detachment, occasionally bemused (though, perhaps only apparently so, as he tried to guide his students and colleagues with question to figure out a point that he already grasped), always curious, always eager for the intellectual challenge of discovery and problem solving. Has there ever been a greater teacher of economics than Alchian? Perhaps, but I don’t know who. I close with one more quotation, this one from Axel Leijonhufvud written about Alchian 25 years ago.  It still rings true.

[Alchian’s] unique brand of price theory is what gave UCLA Economics its own intellectual profile and achieved for us international recognition as an independent school of some importance—as a group of scholars who did not always take their leads from MIT, Chicago or wherever. When I came here (in 1964) the Department had Armen’s intellectual stamp on it (and he remained the obvious leader until just a couple of years ago ….). Even people outside Armen’s fields, like myself, learned to do Armen’s brand of economic analysis and a strong esprit de corps among both faculty and graduate students sprang from the consciousness that this ‘New Institutional Economics’ was one of the waves of the future and that we, at UCLA, were surfing it way ahead of the rest. But Armen’s true importance to the UCLA school did not stem just from the new ideas he taught or the outwardly recognized “brandname” that he created for us. For many of his young colleagues he embodied qualities of mind and character that seemed the more important to seek to emulate the more closely you got to know him.

My Paper (co-authored with Paul Zimmerman) on Hayek and Sraffa

I have just uploaded to the SSRN website a new draft of the paper (co-authored with Paul Zimmerman) on Hayek and Sraffa and the natural rate of interest, presented last June at the History of Economics Society conference at Brock University. The paper evolved from an early post on this blog in September 2011. I also wrote about the Hayek-Sraffa controversy in a post in June 2012 just after the HES conference.

One interesting wrinkle that occurred to me just as I was making revisions in the paper this week is that Keynes’s treatment of own rates in chapter 17 of the General Theory, which was in an important sense inspired by Sraffa, but, in my view, came to a very different conclusion from Sraffa’s, was actually nothing more than a generalization of Irving Fisher’s analysis of the real and nominal rates of interest, first presented in Fisher’s 1896 book Appreciation and Interest. In his Tract on Monetary Reform, Keynes extended Fisher’s analysis into his theory of covered interest rate arbitrage. What is really surprising is that, despite his reliance on Fisher’s analysis in the Tract and also in the Treatise on Money, Keynes sharply criticized Fisher’s analysis of the nominal and real rates of interest in chapter 13 of the General Theory. (I discussed that difficult passage in the General Theory in this post).  That is certainly surprising. But what is astonishing to me is that, after trashing Fisher in chapter 13 of the GT, Keynes goes back to Fisher in chapter 17, giving a generalized restatement of Fisher’s analysis in his discussion of own rates. Am I the first person to have noticed Keynes’s schizophrenic treatment of Fisher in the General Theory?

PS: My revered teacher, the great Armen Alchian passed away yesterday at the age of 98. There have been many tributes to him, such as this one by David Henderson, also a student of Alchian’s, in the Wall Street Journal. I have written about Alchian in the past (here, here, here, here, and here), and I hope to write about Alchian again in the near future. There was none like him; he will be missed terribly.

Robert Waldmann, WADR, Maybe You Really Should Calm Down

Responding to this recent post of mine, Robert Waldmann wrote a post of his own with a title alluding to an earlier post of mine responding to a previous post of his. Just to recapitulate briefly, the point of the post which seems to have provoked Professor Waldmann was to refute the allegation that the Fed and the Bank of Japan are starting a currency war by following a policy of monetary ease in which they are raising (at least temporarily) their inflation target. I focused my attention on a piece written by Irwin Stelzer for the Weekly Standard, entitled not so coincidentally, “Currency Wars.” I also went on to point out that Stelzer, in warning of the supposedly dire consequences of starting a currency war, very misleadingly suggested that Hitler’s rise to power was the result of an inflationary policy followed by Germany in the 1930s.

Here is how Waldmann responds:

I do not find any reference to the zero lower bound in this post.  Your analysis of monetary expansion does not distinguish between the cases when the ZLB holds and when it doesn’t.  You assume that the effect of an expansion of the money supply on domestic demand can be analyzed ignoring that detail. I think it is clear that the association between the money supply and domestic demand has been different in the USA since oh September 2008 than it was before.  This doesn’t seem to me to be a detail which can be entirely overlooked in any discussion of current policy.

Actually, I don’t think that, in principle, I disagree with any of this. I agree that the zero lower bound is relevant to the analysis of the current situation. I prefer to couch the analysis in terms of the Fisher equation making use of the equilibrium condition that the nominal rate of interest must equal the real rate plus expected inflation. If the expected rate of deflation is greater than the real rate, equilibrium is impossible and the result is a crash of asset prices, which is what happened in 2008. But as long as the real rate of interest is negative (presumably because of pessimistic entrepreneurial expectations), the rate of inflation has to be sufficiently above real rate of interest for nominal rates to be comfortably above zero. As long as nominal rates are close to zero and real rates are negative, the economy cannot be operating in the neighborhood of full-employment equilibrium. I developed the basic theory in my paper “The Fisher Effect Under Deflationary Expectations” available on SSRN, and provided some empirical evidence (which I am hoping to update soon) that asset prices (as reflected in the S&P 500) since 2008 have been strongly correlated with expected inflation (as approximated by the TIPS spread) even though there is no strong theoretical reason for asset prices to be correlated with expected inflation, and no evidence of correlation before 2008. Although I think that this is a better way than the Keynesian model to think about why the US economy has been underperforming so badly since 2008, I don’t think that the models are contradictory or inconsistent, so I don’t deny that fiscal policy could have some stimulative effect. But apparently that is not good enough for Professor Waldmann.

Also, I note that prior to his [Stelzer’s] “jejune dismissal of monetary policy,” Stelzer jenunely dismissed fiscal policy.  You don’t mention this at all.  Your omission is striking, since the evidence that Stelzer is wrong to dismiss fiscal policy is overwhelming (not overwhelming enough to overwhelm John Taylor but then mere evidence couldn’t do that).  In contrast, the dismissal of monetary policy when an economy is in a liquidity trap is consistent with the available evidence.

It seems to me that Waldmann is being a tad oversensitive. Stelzer’s line was “stimulus packages don’t work very well, and monetary policy produces lots of fiat money but not very many jobs.” What was jejune was not the conclusion that fiscal policy and monetary policy aren’t effective; it was his formulation that monetary expansion produces lots of fiat money but not many jobs, a formulation which, I believe, was intended to be clever, but struck me as being not clever, but, well, jejune. So I did not mean to deny that fiscal policy could be effective at the zero lower bound, but I disagree that the available evidence is consistent with the proposition that monetary policy is ineffective in a liquidity trap. In 1933, for example, monetary policy triggered the fastest economic expansion in US history, when FDR devalued the dollar shortly after taking office, an expansion unfortunately prematurely terminated by the enactment of FDR’s misguided National Industrial Recovery Act. The strong correlation between inflation expectations and stock prices since 2008, it seems to me, also qualifies as evidence that monetary policy is not ineffective at the zero lower bound. But if Professor Waldmann has a different interpretation of the significance of that correlation, I would be very interested in hearing about it.

Instead of looking at the relationship between inflation expectations and stock prices, Waldmann wants to look at the relationship between job growth and monetary policy:

I hereby challenge you to show data on US “growth”  meaning (I agree with your guess) mostly employment growth since 2007 to someone unfamiliar with the debate and ask that person to find the dates of shifts in monetary policy.  I am willing to bet actual money (not much I don’t have much) that the person will not pick out QEIII or operation twist.    I also guess that this person will not detect forward guidance looking at day to day changes in asset prices.

I claim that the null that nothing special happened the day QEIV was announced or any of the 4 plausible dates of announcement of QE2 (starting with a FOMC meeting, then Bernanke’s Jackson Hole speech then 2 more) can’t be rejected by the data. This is based on analysis by two SF FED economists who look at the sum of changes over three of the days (not including the Jackson Hole day when the sign was wrong) and get a change (of the sign they want) whose square is less than 6 times the variance of daily changes (of the 10 year rate IIRC).  IIRC 4.5 times.  Cherry picking and not rejecting the null one wants to reject is a sign that one’s favored (alternative) hypothesis is not strongly supported by the data.

I think that the way to pick out changes in monetary policy is to look at changes in inflation expectations, and I think that you can find some correlation between changes in monetary policy, so identified, and employment, though it is probably not nearly as striking as the relationship between asset prices and inflation expectations. I also don’t think that operation twist had any positive effect, but QE3 does seem to have had some. I am not familiar with the study by the San Francisco Fed economists, but I will try to find it and see what I can make out of it. In the meantime, even if Waldmann is correct about the relationship between monetary policy and employment since 2008, there are all kinds of good reasons for not rushing to reject a null hypothesis on the basis of a handful of ambiguous observations. That wouldn’t necessarily be the calm and reasonable thing to do.

Ronald Dworkin, RIP

I never met Ronald Dworkin, and I have not studied his work on legal philosophy carefully, but one essay that he wrote many years ago made a deep impression on me when I read it over 40 years ago as an undergraduate, and I still consider it just about the most profound discussion of law that I ever read. The essay, “Is Law a System of Rules?” (reprinted in The Philosophy of Law)  is a refutation of the philosophy of legal positivism, which holds that law is simply the command of a duly authorized sovereign law giver, an idea that was powerfully articulated by Thomas Hobbes and later by Jeremy Bentham.

Legal positivism was developed largely in reaction to theories of natural law, reflected in the work of legal philosophers like Hugo Grotius and Samuel Pufendorf, and in William Blackstone’s famous Commentaries on the Laws of England. The validity of law and the obligation to obey law were derived from the correspondence, even if only imperfect, of positive law to natural law. Blackstone’s Commentaries were largely a form of apologetics aimed at showing how well English law corresponded to the natural law. Jeremy Bentham would have none of this, calling “natural rights” (i.e., the rights derived from natural law) simple nonsense, and “natural and imprescriptible rights” nonsense on stilts.

Legal positivism was first given a systematic exposition by Bentham’s younger contemporary, John Austin, who described law as those commands of a sovereign for which one would be punished if one failed to obey them, the sovereign being he who is habitually obeyed. The twentieth century legal philosopher H. L. A. Hart further refined the doctrine in a definitive treatise, The Concept of Law, in which he argued that law must have a systematic and non-arbitrary structure. Laws are more than commands, but they remain disconnected from any moral principles. Law is not just a set of commands; it is a system of rules, but the rules have no necessary moral content.

As a Rhodes Scholar, Dworkin studied under Hart at Oxford, but he rejected Hart’s view of law. In his paper “Is Law a System of Rules?” Dworkin subjected legal positivism, in the sophisticated version (law as a system of rules) articulated by Hart, to a searching philosophical analysis. When I read Dworkin’s essay, I had already read Hayek’s great work, The Constitution of Liberty, and, while Hayek was visiting UCLA in the 1968-69 academic year, the first draft of his Law, Legislation and Liberty. In both of these works, Hayek had also criticized legal positivism, which he viewed as diametrically opposed to his cherished ideal of the rule of law as a necessary condition of liberty. But his criticism seemed to me not nearly as effective or as interesting as Dworkin’s. Despite disagreeing with Dworkin on a lot of issues, I have, ever since, admired Dworkin as a pre-eminent legal and political philosopher.

Dworkin’s main criticism of the theory that law is a system of rules was that the theory cannot account for the role played by legal principles in informing and guiding judges in deciding actual cases whose outcome is not obvious. Here is how Dworkin, in his essay, described the role of one such principle.

In 1889 a New York court, in the famous case of Riggs v. Palmer had to decide whether an heir named in the will of his grandfather could inherit under that will, even though he had murdered his grandfather to do so. The court began its reasoning with this admission: “It is quite true that statutes regulating the making, proof and effect of wills, and the devolution of property, if literally construed, and if their force and effect can in no way and under no circumstances be controlled or modified, give this property to the murderer.” But the court continued in to note that “all laws as well as all contracts may be controlled in their operation and effect by general, fundamental maxims of the common law. No one shall be permitted to profit by his own fraud, or to take advantage of his own wrong, or to found any claim upon his own iniquity, or acquire property by his own crime.” The murder did not receive his inheritance.

From here Dworkin went on to conduct a rigorous philosophical analysis of the way in which the principle that no one may profit from his own wrong could be understood within the conceptual framework of legal positivism that law is nothing more than a system of rules. In fact, Dworkin argued, rules cannot be applied in a vacuum, there must be principles and standards that provide judges with the resources by which to arrive at judicial decisions in cases where there is not an exact match between the given facts and an applicable rule, cases in which, in the terminology of legal positivism, judges must exercise discretion, as if discretion meant no more than freedom to reach an arbitrary unprincipled decision. Principles govern judicial decisions, but not in the same way that rules do. Rules are binary, on or off; principles are flexible, they have weight, their application requires judgment.

If we take baseball rules as a model, we find that rules of law, like the rule that a will is invalid unless signed by three witnesses, fit the model well. If the requirement of three witnesses is a valid legal rule, then it cannot be that a will has signed by only two witnesses and is valid. . . .

But this is not the way the sample principles in the quotations operated. Even those which look most like rules do not set out legal consequences that follow automatically when the conditions provided are met. We say that our law respects the principle that no man may profit from his own wrong, but we do not mean that the law never permits a man to profit from wrongs he commits. In fact, people most often profit, perfectly legally, from their legal wrongs. . . .

We do not treat these . . . counter-instances . . . as showing that the principle about profiting from one’s own wrongs is not a principle of our legal system, or that it is incomplete and needs qualifying exceptions. We not treat counter-instances as exceptions (at least not exceptions in the way in which a catcher’s dropping the third strike is an exception) because we could not hope to capture these counter-instances simply by a more extended statement of the principle. . . . Listing some of these might sharpen our sense of the principle’s weight, but it would not make for a more accurate or complete statement of the principle. . . .

All that is meant, when we way that a particular principle is a principle of our law, is that the principle is one which officials must take into account, if it is relevant, as a consideration inclining in one direction or another.

Just as an aside, I will observe that this passage and others in Dworkin’s essay make it clear that when Chief Justice Roberts appeared before the Senate Judiciary Committee in 2005 and stated that in his view the job of a judge is calling balls and strikes but not pitching or batting, he was using a distinctly inappropriate, and perhaps misleading, metaphor to describe what it is that a judge, especially an appellate judge, is called upon to do. See Dworkin’s essay on the Roberts hearing in the New York Review of Books.

Although I never met Dworkin, I did correspond with him on a few occasions, once many years ago and more recently exchanging emails with him about various issues — the last time when I sent him a link to this post commenting on the oral argument before the Supreme Court about the Affordable Health Care Act. His responses to me were always cordial and unfailingly polite; I now regret not having saved the letters and the emails. Here are links to obituaries in the New York Times, The Guardian and The Financial Times.

It Ain’t What People Don’t Know that Gets Them into Trouble; It’s What They Know That Ain’t So

I start with a short autobiographical introduction. In the interlude between my brief academic career and my 25 years at the FTC, one of my jobs was as an antitrust economist at a consulting firm called NERA (National Economic Research Associates). The President (and founder) of the firm was then Irwin Stelzer who, after selling the business for a tidy sum to Marsh & McLennan, eventually relinquished day-to-day management of the firm. When I was at NERA, it actually had a reputation of being a Democratic-leaning, pro-enforcement, non-Chicago-School, firm, but, at some point after Stelzer left NERA, I began seeing articles and op-eds by him promoting a pro-Republican, pro-deregulation, agenda. He became Director of Regulatory Policy Studies at the American Enterprise Institute and subsequently Director of Economic Policy Studies at the Hudson Institute. Stelzer developed a relationship with Rupert Murdoch, writing regular columns on economic policy for a number of Murdoch publications, such as the Sunday Times and the Weekly Standard. The relationship with Murdoch has apparently made Stelzer a somewhat controversial figure in Britain, where he maintains a residence, but all details about that relationship are unknown to me. After not seeing Irwin for almost 30 years, I have recently chanced to meet him twice at concerts at the Kennedy Center in Washington, enjoying a very pleasant conversation with him, possibly even mentioning to him my new career as a blogger, and later exchanging a few emails.

I mention all this, because last night I happened to see Stelzer’s latest economic commentary in the Weekly Standard on the subject of currency wars. Given my past, and recently resumed, relationship with Stelzer, I do feel a little funny now that I am about to write somewhat critically about him, but, hey, a blogger’s gotta do what a blogger’s gotta do.

Stelzer’s first paragraph sets the tone:

Growth is the summum bonum of economic policy. Tough to arrange at home: stimulus packages don’t work very well, and monetary policy produces lots of fiat money but not very many jobs. The solution: export-led growth—the other guy will buy so much of your goods and services that your economy will grow. There are two ways to make this sort of growth happen. Lower the international value of your currency so that your output is cheaper overseas, or increase productivity at home by lowering labor and other costs and therefore the prices you need to charge foreigners. The first is painless, or so it seems initially. The second requires a politically difficult assault on benefits and union created labor market rigidities.

What we have here is a confusion of concepts and meanings. Starting with a facile identification of the highest good of economic policy with growth, where growth seems to denote growth in employment, Stelzer offers up a jejune dismissal of monetary policy, and concludes that exports are the answer. How are exports to be increased? The easy, but disreputable, way is to depreciate your currency, the hard, but virtuous, way is to cut your costs. The underlying confusion here is that between the nominal and the real exchange rate.  Let me try to sort things out.

A nominal exchange rate tells you how much of one currency can be exchanged for a unit of another currency. The exchange rate between the dollar and the euro is now about $1.33 per euro. If the euro depreciated against the dollar, the exchange rate might fall to something like, say, $1.25 per euro. For given euro prices of stuff made in Europe, a depreciated euro would mean that the prices, measured in dollars, of European stuff would fall, presumably causing European exports to the US to rise. The reduced exchange rate would work in favor of European exports. However, prices do change, and a falling euro would tend to raise the euro prices of the stuff made in Europe. If the US and European economies were in (foreign-trade) equilibrium before the euro depreciated against the dollar, prices of European stuff would keep going up until the European export advantage was eliminated. So even as the nominal euro exchange rate depreciated against the dollar, price adjustments would tend to restore the real euro exchange rate back to its original equilibrium level, thereby eliminating the temporary advantage enjoyed by European exports immediately after the fall in the nominal euro exchange rate.

That’s not to say that monetary policy cannot affect the real exchange rate, just that doing so requires more than reducing the nominal exchange rate. I discussed this a while back in a couple of posts (here and here) on currency manipulation and the Chinese central bank. The upshot of those posts was that to prevent domestic prices from rising in response to a depreciated nominal exchange rate, thereby offsetting the reduction in the nominal exchange rate and restoring the real exchange rate to its original level, a country (or its central bank) would have to follow a tight-money policy aimed at sterilizing the inflows of foreign cash corresponding to the increased outflow of exports.

Apparently Stelzer did not read my posts on the subject (tsk, tsk). Otherwise, he could not have written the following:

Until now, China has been the world’s devaluer par excellence, keeping the yuan low so that its export-led economy could continue to provide jobs for the millions of Chinese moving off the farms and into the cities.

Well, to begin with, China has not been keeping the nominal yuan low. For a long time, the yuan was pegged at a fixed exchange rate against the dollar. More recently, the yuan has been appreciating against the dollar. However, the Chinese central bank has been sterilizing inflows of foregin exchange and preventing domestic price increases that would have slowed the growth of Chinese exports and encouraged Chinese imports. In other words, the Chinese central bank has been printing too little money. Let’s follow Dr. Stelzer a bit further.

Now, Japan’s new prime minister Shinzo Abe has joined the war, pressuring his central bank to print money and drive down the value of the yen to rescue Japan from “the strengthening yen.” From Mr. Abe’s point of view, so far so good: the yen has fallen about 15 percent against other currencies, making Japanese cars and other products considerably cheaper overseas; the Nikkei share price index is up about 35 percent; and U.S. importers are again ordering Japanese products that they discontinued in the stronger-yen era.

Stelzer is also afraid that Brazil and Great Britain under the new Governor of the Bank of England are going to follow the bad example of China and Japan. This has him really worried.

It should be obvious that the currency war is a trade war by other means. The use of traditional weapons—tariffs to keep out imports and thereby increase demand for homemade products and create jobs—was outlawed by mutual consent of the warring parties when they agreed to abide by the rules of the World Trade Organization. So a new weapon of trade destruction has been rolled out—the printing press. Run the presses, flood the markets with your currency, and later, if not sooner, your currency will depreciate, giving you an edge in world markets. Until trading partners respond.

I’m sorry, but this is all wrong. Trade war, Chinese style, involves reducing the nominal exchange rate to gain a competitive advantage and tightening monetary policy, i.e., not running the printing presses, repeat, not running the printing presses, to prevent the increase in the money stock that would normally follow from an export surplus. The depreciation of the nominal exchange rate in response to money printing makes everyone better off, because it raises the home demand for imports while increasing the foreign demand for exports.

Last February, I published a post about Ralph Hawtrey’s take on currency wars, aka competitive devaluation, quoting at length from Hawtrey’s excellent book, Trade Depression and the Way Out. I reproduce the last three paragraphs of the passage I quoted in my earlier post.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better.

I would have been happy to end the post here, having a) clarified an important, but often overlooked, distinction between the nominal and the real exchange rate, b) made the important analytical point that currency manipulation or trade war via monetary policy, requires tightening, not easing, monetary policy, and c) concluded the whole discussion with a wonderful quote from R. G. Hawtrey. Unfortunately, my work is not yet complete, because Stelzer writes the following in the penultimate paragraph of his piece.

The U.S. and the UK, among others, have already deployed that weapon, and the new head of Japan’s central bank is likely to be chosen by Abe from the warrior class. Germany, not overjoyed with Draghi’s hint that he might take up arms, continues to insist that the ECB remain a non-combatant. Angela Merkel has made it clear that the long unpleasantness that followed Germany’s decision to run the money presses overtime in the 1930s is still etched in Germans’ minds, and that she agrees with Vladimir Ilyich Lenin that “the surest way to destroy a nation is to debauch its currency,” a view on which John Maynard Keynes put his stamp of approval: “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”

OMG! Something has gone very, very wrong here. I repeat the critical passage to make sure it sinks all the way in.

Angela Merkel has made it clear that the long unpleasantness that followed Germany’s decision to run the money presses overtime in the 1930s is still etched in Germans’ minds

I can’t tell if Stelzer’s memory has failed him, and he is misrepresenting what Mrs. Merkel believes, or if — and this is an even more frightening thought — Mrs. Merkel actually believes that Hitler came to power, because Germany ran the money presses overtime in the 1930s. But the plain facts are that the German hyperinflation occurred in 1923, and Hitler came to power in 1933 when Germany, after years of deflation, austerity and wage cuts imposed in a futile, and self-destructive, attempt to remain on the gold standard, was still wallowing in the depths of the Great Depression. If Chancellor Merkel’s policy is now premised on the presumed fact that Hitler came to power, not because of the misguided deflationary policies of 1929-33, but the hyperinflation of the previous decade, I tremble at the thought of what disasters may still be waiting to befall us.

Another Nail in the Money-Multiplier Coffin

It’s been awhile since my last rant about the money multiplier. I am not really feeling up to another whack at the piñata just yet, but via Not Trampis, I saw this post on the myth of the money multiplier by the estimable Barkley Rosser. Rosser discusses a recent unpublished paper by two Fed economists, Seth Carpenter and Selva Demiralp, entitled “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?”

Rosser concludes his post as follows:

That Fed control over the money supply has become a phantom has been quite clear since the Minsky moment in 2008, with the Fed massively expanding its balance sheet without much resulting increase in measured money supply.  This of course has made a hash of all the people ranting about the Fed “printing money,” which presumably will lead to hyperinflation any minute (eeek!).  But the deeper story that some of us were unaware of is that apparently this disjuncture happened a long time ago.  Even so, one of our number pointed out that official Fed literature and even many Fed employees still sell the reserve base story tied to a money multiplier to the public, just as one continues to find it in the textbooks,  But apparently most of them know better, and the money multiplier became a myth a long time ago.

Here’s the abstract of the Carpenter and Demiralp paper.

With the use of nontraditional policy tools, the level of reserve balances has risen significantly in the United States since 2007. Before the financial crisis, reserve balances were roughly $20 billion whereas the level has risen well past $1 trillion. The effect of reserve balances in simple macroeconomic models often comes through the money multiplier, affecting the money supply and the amount of lending in the economy. Most models currently used for macroeconomic policy analysis, however, either exclude money or model money demand as entirely endogenous, thus precluding any causal role for money. Nevertheless, some academic research and many textbooks continue to use the money multiplier concept in discussions of money. We explore the institutional structure of the transmissions mechanism beginning with open market operations through to money and loans. We then undertake empirical analysis of the relationship among reserve balances, money, and bank lending. We use aggregate as well as bank-level data in a VAR framework and document that the mechanism does not work through the standard multiplier model or the bank lending channel. In particular, if the level of reserve balances is expected to have an impact on the economy, it seems unlikely that the standard multiplier analysis will explain the effect.

And here’s my take from 25 years ago in my book Free Banking and Monetary Reform (p. 173)

The conventional models break down the money supply into high-power money [the monetary base] and the money multiplier. The money multiplier summarizes the supposedly stable numerical relationship between high-powered money and the total stock of money. Thus an injection of reserves, by increasing high-powered money, is supposed to have a determinate multiplier effect on the stock of money. But in Tobin’s analysis, the implications of an injection of reserves were ambiguous. The result depended on how the added reserves affected interest rates and, in turn, the costs and revenues from creating deposits. It was only a legal prohibition of paying interest on deposits, which kept marginal revenue above marginal cost, that created an incentive for banks to expand whenever they acquired additional reserves.

When regulation Q was abolished, it meant lights out for the money-multiplier.


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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