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Wherein I Try to Calm Professor Blanchard’s Nerves

Olivier Blanchard is rightly counted among the most eminent macroeconomists of our time, and his pronouncements on macroeconomic matters should not be dismissed casually. So his commentary yesterday for the Peterson Institute of International Economics, responding to a previous policy brief, by David Reifschneider and David Wilcox, arguing that the recent burst of inflation is likely to recede, bears close attention.

Blanchard does not reject the analysis of Reifschneider and Wilcox outright, but he argues that they overlook factors that could cause inflation to remain high unless policy makers take more aggressive action to bring inflation down than is recommended by Reifschneider and Wilcox. Rather than go through the details of Blanchard’s argument, I address the two primary concerns he identifies: (1) the potential for inflation expectations to become unanchored, as they were in the 1970s and early 1980s, by persistent high inflation, and (2) the potential inflationary implications of wage catchup after the erosion of real wages by the recent burst of inflation.

Unanchored Inflation Expectations and the Added Cost of a Delayed Response to Inflation

Blanchard cites a forthcoming book by Alan Blinder on soft and hard landings from inflation in which Blinder examines nine Fed tightening episodes in which tightening was the primary cause of a slowdown or a recession. Based on the historical record, Blinder is optimistic that the Fed can manage a soft landing if it needs to reduce inflation. Blanchard doesn’t share Blinder’s confidence.

[I]n most of the episodes Blinder has identified, the movements in inflation to which the Fed reacted were too small to be of direct relevance to the current situation, and the only comparable episode to today, if any, is the episode that ended with the Volcker disinflation of the early 1980s.
I find that a scary comparison. . . .
[I]t shows what happened when the Fed got seriously “behind the curve” in 1974–75. . . . It then took 8 years, from 1975 to 1983, to reduce inflation to 4 percent.

And I find Blanchard’s comparison of the 1975-1983 period with the current situation problematic. First, he ignores the fact that the 1975-1983 episode did not display a steady rate of inflation or a uniform increase in inflation from 1975 until Volcker finally tamed it by way of the brutal 1981-82 recession. As I’ve explained previously in posts on the 1970s and 1980s (here, here, and here), and in chapters 7 and 8 of my book Studies in the History of Monetary Theory the 1970s inflation was the product of a series of inflationary demand-side and supply-shocks and misguided policy responses by the Fed, guided by politically motivated misconceptions, with little comprehension of the consequences of its actions.

It would be unwise to assume that the Fed will never embark on a similar march of folly, but it would be at least as unwise to adopt a proposed policy on the assumption that the alternative to that policy would be a repetition of the earlier march. What commentary on the 1970s largely overlooks is that there was an enormous expansion of the US labor force in that period as baby boomers came of age and as women began seeking and finding employment in steadily increasing numbers. The labor-force participation rate in the 1950s and 1960s fluctuated between about 58% to about 60%, mirroring fluctuations in the unemployment rate. Between 1970 and 1980 the labor force participation rate rose from just over 60% to just over 64% even as the unemployment rate rose from about 5% to over 7%. The 1970s were not, for the most part, a period of stagflation, but a period of inflation and strong growth interrupted by one deep recession (1974-75) and bookended by two minor recessions (1969-70) and (1979-80). But the rising trend of unemployment during the decade was largely attributable not to stagnation but to a rapidly expanding labor force and a rising labor participation rate.

The rapid increase in inflation in 1973 was largely a policy-driven error of the Nixon/Burns collaboration to ensure Nixon’s reelection in 1972 without bothering to taper the stimulus in 1973 after full employment was restored just in time for Nixon’s 1972 re-election. The oil shock of 1973-74 would have justified allowing a transitory period of increased inflation to cushion the negative effect of the increase in energy prices and to dilute the real magnitude of the nominal increase in oil prices. But the combined effect of excess aggregate demand and a negative supply shock led to an exaggerated compensatory tightening of monetary policy that led to the unnecessarily deep and prolonged recession in 1974-75.

A strong recovery ensued after the recession which, not surprisingly, was associated with declining inflation that fell below 5% in 1976. However, owing to the historically high rate of unemployment, only partially attributable to the previous recession, the incoming Carter administration promoted expansionary fiscal and monetary policies, which Arthur Burns, hoping to be reappointed by Carter to another term as Fed Chairman, willingly implemented. Rather than continue on the downward inflationary trend inherited from the previous administration, inflation resumed its upward trend in 1977.

Burns’s hopes to be reappointed by Carter were disappointed, but his replacement G. William Miller made no effort to tighten monetary policy to reverse the upward trend in inflation. A second oil shock in 1979 associated with the Iranian Revolution and the taking of US hostages in Iran caused crude oil prices over the course in 1979 to more than double. Again, the appropriate monetary-policy response was not to tighten monetary policy but to accommodate the price increase without causing a recession.

However, by the time of the second oil shock in 1979, inflation was already in the high single digits. The second oil shock, combined with the disastrous effects of the controls on petroleum prices carried over from the Nixon administration, created a crisis atmosphere that allowed the Reagan administration, with the cooperation of Paul Volcker, to implement a radical Monetarist anti-inflation policy. The policy was based on the misguided presumption that keeping the rate of growth of some measure of the money stock below a 5% annual rate would cure inflation with little effect on the overall economy if it were credibly implemented.

Volcker’s reputation was such that it was thought by supporters of the policy that his commitment would be relied upon by the public, so that a smooth transition to a lower rate of inflation would follow, and any downturn would be mild and short-lived. But the result was an unexpectedly deep and long-lasting recession.

The recession was needlessly prolonged by the grave misunderstanding of the causal relationship between the monetary aggregates and macroeconomic performance that had been perpetrated by Milton Friedman’s anti-Keynesian Monetarist counterrevolution. After triggering the sharpest downturn of the postwar era, the Monetarist anti-inflation strategy adopted by Volcker was, in the summer of 1982, on the verge of causing a financial crisis before Volcker announced that the Fed would no longer try to target any of the monetary aggregates, an announcement that triggered an immediate stock-market boom and, within a few months, the start of an economic recovery.

Thus, Blanchard is wrong to compare our current situation to the entire 1975-1983 period. The current situation, rather, is similar to the situation in 1973, when an economy, in the late stages of a recovery with rising inflation, was subjected to a severe supply shock. The appropriate response to that supply shock was not to tighten monetary policy, but merely to draw down the monetary stimulus of the previous two years. However, the Fed, perhaps shamed by the excessive, and politically motivated, monetary expansion of the previous two years, overcompensated by tightening monetary policy to counter the combined inflationary impact of its own previous policy and the recent oil price increase, immediately triggering the sharpest downturn of the postwar era. That is the lesson to draw from the 1970s, and it’s a mistake that the Fed ought not repeat now.

The Catch-Up Problem: Are Rapidly Rising Wages a Ticking Time-Bomb

Blanchard is worried that, because price increases exceeded wage increases in 2021, causing real wages to fall in 2021, workers will rationally assume, and demand, that their nominal wages will rise in 2022 to compensate for the decline in real wages, thereby fueling a further increase in inflation. This is a familiar argument based on the famous short-run Phillips-Curve trade-off between inflation and unemployment. Reduced unemployment resulting from the real-wage reduction associated with inflation will cause inflation to increase.

This argument is problematic on at least two levels. First, it presumes that the Phillips Curve represents a structural relationship, when it is merely a reduced form, just as an observed relationship between the price of a commodity and sales of that commodity is a reduced form, not a demand curve. Inferences cannot be made from a reduced form about the effect of a price change, nor can inferences about the effect of inflation be made from the Phillips Curve.

But one needn’t resort to a somewhat sophisticated argument to see why Blanchard’s fears that wage catchup will lead to a further round of inflation are not well-grounded. Blanchard argues that business firms, having pocketed windfall profits from rising prices that have outpaced wage increases, will grant workers compensatory wage increases to restore workers’ real wages, while also increasing prices to compensate themselves for the increased wages that they have agreed to pay their workers.

I’m sorry, but with all due respect to Professor Blanchard, that argument makes no sense. Evidently, firms have generally enjoyed a windfall when market conditions allowed them to raise prices without raising wages. Why, if wages finally catch up to prices, will they raise prices again? Either firms can choose, at will, how much profit to make when they set prices or their prices are constrained by market forces. If Professor Blanchard believes that firms can simply choose how much profit they make when they set prices, then he seems to be subscribing to Senator Warren’s theory of inflation: that inflation is caused by corporate greed. If he believes that, in setting prices, firms are constrained by market forces, then the mere fact that market conditions allowed them to increase prices faster than wages rose in 2021 does not mean that, if market conditions cause wages to rise at a faster rate than they did in 2022, firms, after absorbing those wage increases, will automatically be able to maintain their elevated profit margins in 2022 by raising prices in 2022 correspondingly.

The market conditions facing firms in 2022 will be determined by, among other things, the monetary policy of the Fed. Whether firms are able to raise prices in 2022 as fast as wages rise in 2022 will depend on the monetary policy adopted by the Fed. If the Fed’s monetary policy aims at gradually slowing down the rate of increase in nominal GDP in 2022 from the 2021 rate of increase, firms overall will not easily be able to raise prices as fast as wages rise in 2022. But why should anyone expect that firms that enjoyed windfall profits from inflation in 2021 will be able to continue enjoying those elevated profits in perpetuity?

Professor Blanchard posits simple sectoral equations for the determination of the rate of wage increases and for the rate of price increases given the rate of wage increases. This sort of one-way causality is much too simplified and ignores the fundamental fact all prices and wages and expectations of future prices and wages are mutually determined in a simultaneous system. One can’t reason from a change in a single variable and extrapolate from that change how the rest of the system will adjust.

Sic Transit Inflatio Mundi

Published December 19, 2021 Federal Reserve , Larry Summers , Milton Friedman , Monetarism 6 Comments

Larry Summers continues to lead the charge for a quick, decisive tightening of monetary policy by the Federal Reserve to head off an inflationary surge that, he believes, is about to overtake us. Undoubtedly one of the most capable economists of his generation, Summers also had a long career as a policy maker at the highest levels, so his advice cannot be casually dismissed. Even aside from Summers’s warning, the current economic environment fully justifies heightened concern caused by the recent uptick in inflation.

I am, nevertheless, not inclined to share Summers’s confidence in his oft-repeated predictions of resurgent inflation unless monetary policy is substantially tightened soon to prevent current inflation from being entrenched into the expectations of households and businesses. Summers’s’ latest warning came in a Washington Post op-ed following the statement by the FOMC and by Chairman Jay Powell that Fed policy would shift to give priority to maintaining price stability.

After welcoming the FOMC statement, Summers immediately segued into a critique of the Fed position on every substantive point.

There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.
The not-very-encouraging history of disinflation efforts suggests that the Fed will need to be both skillful and lucky as it seeks to apply sufficient restraint to cause inflation to come down to its 2 percent target without pushing the economy into recession. Unfortunately, several aspects of the Open Market Committee statement and Powell’s news conference suggest that the Fed may not yet fully grasp either the current economic situation or the implications of current monetary policy.

Summers cites the recessions between the Korean War and the 1979-82 Volcker Monetarist experiment to support his anti-inflationary diagnosis and remedy. But none of the three recessions in the 1950s during the Eisenhower Presidency was needed to cope with any significant inflationary threat. There was no substantial inflation in the US during the 1950s, never reaching 3% in any year between 1953 and 1960, and rarely exceeding 2%.

Inflation during the late 1960 and 1970s was caused by a combination of factors, including both excess demand fueled by Vietnam War spending and politically motivated monetary expansion, plus two oil shocks in 1973-74 and 1979-80, an economic environment with only modest similarity to the current economic situation.

But the important lesson from the disastrous Volcker-Friedman recession is that most of the reduction in inflation following Volcker’s decisive move to tighten monetary policy in early 1981 did not come until a year and a half later, when with the US unemployment rate above 10%, Volcker finally abandoned the futile and counterproductive Monetarist policy of making the monetary aggregates policy instruments. Had it not been for the Monetarist obsession with controlling the monetary aggregates, a recovery could have started six months to a year earlier than it did, with inflation continuing on the downward trajectory as output and employment expanded.

The key point is that falling output, in and of itself, tends to cause rising, not falling, prices, so that postponing the start of a recovery actually delays, rather than hastens, the reduction of inflation. As I explained in another post, rather than focusing onthe monetary aggregates, monetary policy ought to have aimed to reduce the rate of growth of total nominal spending from well over 12% in 1980-81 to a rate of about 7%, which would have been consistent with the informal 4% inflation target that Volcker and Reagan had set for themselves.

The appropriate lesson to take away from the Volcker-Friedman recession of 1981-82 is therefore that a central bank can meet its inflation target by reducing the rate of increase in total nominal spending and income to the rate, given anticipated real expansion of capacity and productivity, consistent with its inflation target. The rate of growth in nominal spending and income cannot be controlled with a degree of accuracy, but rates of increase in spending above or below the target rate of increase provide the central bank with real time indications of whether policy needs to be tightened or loosened to meet the inflation target. That approach would avoid the inordinate cost of reducing inflation associated with the Volcker-Friedman episode.

A further aggravating factor in the 1981-82 recession was that interest rates had risen to double-digit levels even before Volcker embarked on his Monetarist anti-inflation strategy, showing how deeply embedded inflation expectations had become in the plans of households and businesses. By contrast, interest rates have actually been falling for months, suggesting that Summers’s warnings about inflation expectations becoming entrenched are overstated.

The Fed forecast calls for inflation to significantly subside even as the economy sustains 3.5 percent unemployment — a development without precedent in U.S. economic history. The Fed believes this even though it regards the sustainable level of unemployment as 4 percent. This only makes sense if the Fed is clinging to the idea that current inflation is transitory and expects it to subside of its own accord.

Summers’s factual assertion that the US unemployment rate has never fallen, without inflationary stimulus, to 3.5%, an argument predicated on the assumption that the natural (or non-accelerating- inflation rate of unemployment) is firmly fixed at 4% is not well supported by the data. In 2019 and early 2020, the unemployment rate dropped to 3.5% without evident inflationary pressure. In the late 1990s unemployment also dropped below 4% without inflationary pressure. So, the expectation that a 3.5% unemployment rate could be restored without inflationary pressure may be optimistic, but it’s hardly unprecedented.

Summers suggests that the Fed is confused because it expects the unemployment rate to fall back to the 3.5% rate of 2019 even while supposedly regarding a 4%, not a 3.5%, rate of unemployment as sustainable. According to Summers, reaching a 3.5% rate of unemployment would be possible only if the current increase in the inflation rate is temporary. But the bond market seems to share that view with the Fed given the recent decreases in the yields on Treasury bonds of 5 to 30 years duration. But Summers takes a different view.

In fact, there is solid reason to think inflation may accelerate. The consumer price index’s shelter component, which represents one-third of the index, has gone up by less than 4 percent, even as private calculations without exception suggest increases of 10 to 20 percent in rent and home prices. Catch-up is likely. More fundamentally, job vacancies are at record levels and the labor market is still heating up, according to the Fed forecast. This portends acceleration rather than deceleration in labor costs — by far the largest cost for the business sector.

Projecting how increases in rent and home prices that have already occurred will affect reported inflation in the future is a tricky exercise. It is certain that those effects will show up in the future, but those effects are already baked into those future inflation reports, so they provide an uneasy basis on which to conduct monetary policy. Insofar as inflation is a problem, it is a problem not because of short-term fluctuations in prices in specific goods, even home prices and rents, or whole sectors of the economy, but because of generalized and potentially continuing long-term trends affecting the whole structure of prices.

The current number of job vacancies reflects both the demand for, and the supply of, labor. The labor-force participation rate is still well below the pre-pandemic level, reflecting the effect of withdrawal from the labor force by workers afraid of contracting the COVID virus, or unable to find day care for children, or deterred from seeking by other pandemic-related concerns from seeking or accepting employment. Under such circumstances, the re-allocations associated with high job-vacancy rates are likely to enhance the efficiency and productivity of the workers that are re-employed, and need not exacerbate inflationary pressures.

Presumably, the Fed has judged that current aggregate-demand increases have less to do with observed inflation than labor-supply constraints or other supply-side bottlenecks whose effects on prices are likely self-limiting. This judgment is neither obviously right nor obviously wrong. But, for now at least, it is not unreasonable for the Fed to remain cautious before making a drastic policy change, neither committing itself to an immediate tightening, as Summers is proposing, nor doubling down on a commitment to its current accommodative stance.

Meanwhile, the pandemic-related bottlenecks central to the transitory argument are exaggerated. Prices for more than 80 percent of goods in the CPI have increased more than 3 percent in the past year.With the economy’s capacity growing 2 percent a year and the Fed’s own forecast calling for 4 percent growth in 2022, price pressures seem more likely to grow than to abate.

This argument makes no sense. We have, to be sure, gone through a period of actual broad-based inflation, so pointing out that 80% of goods in the CPI have increased in price by more than 3% in the past year is unsurprising. The bottleneck point is that supply constraints have prevented the real economy from growing as fast as nominal spending has grown. As I’ve pointed out recently, there’s an overhang of cash and liquid assets, accumulated rather than spent during the pandemic, which has amplified aggregate-demand growth since the economy began to recover from the pandemic, opening up previously closed opportunities for spending. The mismatch between the growth of demand and the growth of supply has been manifested in rising inflation. If the bottleneck theory of inflation is true, then the short-term growth potential of the economy is greater than the 2% rate posited by Summers. As bottlenecks are removed and workers that withdrew from the labor force during the pandemic are re-employed, the economy could easily grow faster than Summers is willing to acknowledge. Summers simply assumes, but doesn’t demonstrate, his conclusion.

This all suggests that policy will need to restrain demand to restore price stability.

No, it does not suggest that at all. It only suggests the possibility that demand may have to be restrained to keep prices stable. Recent inflation may have been a delayed response to an expansive monetary policy designed to prevent a contraction of demand during the pandemic. A temporary increase in inflation does not necessarily call for an immediate contractionary response. It’s too early to tell with confidence whether preventing future inflation requires, as Summers asserts, monetary policy to be tightened immediately. That option shouldn’t be taken off the table, but the Fed clearly hasn’t done so.

How much tightening is required? No one knows, and the Fed is right to insist that it will monitor the economy and adjust. We do know, however, that monetary policy is far looser today — in a high-inflation, low-unemployment economy — than it was about a year ago when inflation was below the Fed’s target and unemployment was around 8 percent. With relatively constant nominal interest rates, higher inflation and the expectation of future inflation have led to dramatic reductions in real interest rates over the past year. This is why bubbles are increasingly pervasive in asset markets ranging from crypto to beachfront properties and meme stocks to tech start-ups.

Summers, again, is just assuming, not demonstrating, his own preferred conclusion. A year ago, high unemployment was caused by the unique confluence of essentially simultaneous negative demand and supply shocks. The unprecedented coincidence of two simultaneous shocks posed a unique policy challenge to which the Fed has so far responded with remarkable skill. But the unfamiliar and challenging economic environment remains murky, and premature responses to unclear conditions may not yield the anticipated results. Undaunted by any doubt in his own reading of an opaque situation, Summers self-assurance is characteristic and impressive, but his argument is less than compelling.

The implication is that restoring monetary policy to a normal posture, let alone to applying restraint to the economy, will require far more than the three quarter-point rate increases the Fed has predicted for next year. This point takes on particular force once it is recognized that, contrary to Powell’s assertion, almost all economists believe there is a lag of about a year between the application of a rate change and its effect. Failure to restore policy neutrality next year means allowing two more years of highly inflationary monetary policy.
All of this suggests that even with its actions this week, the Fed remains well behind the curve in its commitment to fighting inflation. If its statements reflect its convictions, this is a matter of serious concern.

The idea that there is a one-year lag between applying a policy and its effect is hardly credible. The problem is not the length of the lag, but the uncertain effects of policy in a given set of circumstances. The effects of a change in the money stock or a change in the policy rate may not be apparent if they are offset by other changes. The ceteris-paribus proviso that qualifies every analysis of the effects of monetary policy is rarely satisfied in the real world; almost every policy action by the central bank is an uncertain bet. Under current circumstances, the Fed response to the recent increase in inflation seems eminently sensible: signal that the Fed is anticipating the likelihood that monetary policy will have to be tightened if the current rate of increase in nominal spending remains substantially above the rate consistent with the Fed’s average inflation target of 2%, but wait for further evidence before deciding about the magnitude of any changes in the Fed’s policy instruments.

The Hawley-Smoot Tariff and the Great Depression

Published March 5, 2021 expectations , Federal Reserve , gold standard , Great Depression 3 Comments

The role of the Hawley-Smoot Tariff (aka Smoot-Hawley Tariff) in causing the Great Depression has been an ongoing subject of controversy for close to a century. Ron Batchelder and I wrote a paper (“Debt, Deflation and the Great Depression”) published in this volume (Money and Banking: The American Experience) that offered an explanation of the mechanism by which the tariff contributed to the Great Depression. That paper was written before and inspired another paper “Pre-Keynesian Theories of the Great Depression: What Ever Happened to Hawtrey and Cassell“) I am now revising the paper for republication, and here is the new version of the relevant section discussing the Hawley-Smoot Tariff.

Monetary disorder was not the only legacy of World War I. The war also left a huge burden of financial obligations in its wake. The European allies had borrowed vast sums from the United States to finance their war efforts, and the Treaty of Versailles imposed on Germany the obligation to pay heavy reparations to the allies, particularly to France.

We need not discuss the controversial question whether the burden imposed on Germany was too great to have been discharged. The relevant question for our purposes is by what means the reparations and war debts could be paid, or, at least, carried forward without causing a default on the obligations. To simplify the discussion, we concentrate on the relationship between the U.S. and Germany, because many of the other obligations of the allies to the U.S. were offset by those of Germany to the allies.[1]

The debt to the U.S. could be extinguished either by a net payment in goods reflected in a German balance-of-trade surplus and a U.S. balance-of-trade deficit, or by a transfer of gold from Germany to the U.S. Stretching out the debt would have required the U.S., in effect to lend Germany the funds required to service its obligations.

For most of the 1920s, the U.S. did in fact lend heavily to Germany, thereby lending Germany the funds to meet its financial obligations to the U.S. (and its European creditors). U.S. lending was not explicitly for that purpose, but on the consolidated national balance sheets, U.S. lending offset German financial obligations, obviating any real transfer.

Thus, to avoid a transfer, in goods or specie, from Germany to the U.S., continued U.S. lending to Germany was necessary. But the sharp tightening of monetary policy by the Federal Reserve in 1928 raised domestic interest rates to near record levels and curtailed lending abroad, as foreign borrowers were discouraged from seeking funds in U.S. capital markets. Avoiding an immediate transfer from Germany to the U.S. was no longer possible except by default. To effect the necessary transfer in goods, Germany would have been required to shift resources from its non-tradable-goods sector to its tradable-goods sector, which would require reducing spending on, and the relative prices of, non-tradable goods. Thus, Germany began to slide into a recession in 1928.

In 1929 the United States began making the transfer even more difficult when the newly installed Hoover administration reaffirmed the Republican campaign commitment to raising U.S. tariffs, thereby imposing a tax on the goods transfer through which Germany could discharge its obligations. Although the bill to increase tariffs that became the infamous Hawley-Smoot Act was not passed until 1930, the commitment to raise tariffs made it increasingly unlikely that the U.S. would allow the debts owed it to be discharged by a transfer of goods. The only other means by which Germany could discharge its obligations was a transfer of gold. Anticipating that its obligations to the U.S. could be discharged only by transferring gold, Germany took steps to increase its gold holdings to be able to meet its debt obligations. The increased German demand for gold was reflected in a defensive tightening of monetary policy to raise domestic interest rates to reduce spending and to induce an inflow of gold to Germany.

The connection between Germany’s debt obligations and its demand for gold sheds light on the deflationary macroeconomic consequences of the Hawley-Smoot tariff. Given the huge debts owed to the United States, the tariff imposed a deflationary monetary policy on all U.S. debtors as they attempted to accumulate sufficient gold to be able to service their debt obligations to the U.S. But, under the gold standard, the United States could not shield itself from the deflationary effects that its trade policy was imposing on its debtors.[2]

The U.S. could have counteracted these macroeconomic pressures by a sufficiently expansive monetary policy, thereby satisfying the demand of other countries for gold. Monetary expansion would have continued, by different means, the former policy of lending to debtors, enabling them to extend their obligations. But preoccupied with, or distracted by the stock-market boom, U.S. monetary authorities were oblivious to the impossible alternatives that were being forced on U.S. debtors by a combination of tight U.S. monetary policy and a protectionist trade policy.

As the prospects that protectionist legislation would pass steadily improved even as tight U.S. monetary policy was being maintained, deflationary signs became increasingly clear and alarming. The panic of October 1929, in our view, was not, as much Great Depression historiography describes it, the breaking of a speculative bubble, but a correct realization that a toxic confluence of monetary and trade policies was leading the world over a deflationary precipice.

Once the deflation took hold, the nature of the gold standard with a fixed price of gold was such that gold would likely appreciate against weak currencies that were likely to be formally devalued, or allowed to float, relative to gold. A vicious cycle of increasing speculative demand for gold in anticipation of currency devaluation further intensified the deflationary pressures (Hamilton, 1988). Moreover, successive devaluations by one country at a time increased the deflationary pressure in the remaining gold-standard countries. A uniform all-around devaluation might have had some chance of quickly controlling the deflationary process, but piecemeal deflation could only prolong the deflationary pressure on nations that remained on the gold standard.

FOOTNOTES

[1] The United States, as a matter of law, always resisted such a comparison, contending that the war debts were commercial obligations in no way comparable to the politically imposed reparations. However, as a final matter, there was obviously a strict correspondence between the two sets of obligations. The total size of German obligations was never precisely determined. However, those obligations were certainly several times the size of the war debts owed the United States. Focusing simply on the U.S.-German relationship is therefore simply a heuristic device.

[2] Viewed from a different perspective, the tariff aimed at transferring wealth from the foreign debtors to the U.S. government by taxing debt payments on debt already fixed in nominal terms. Moreover, deflation from whatever source increased the real value of the fixed nominal debts owed the U.S.

The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Published February 2, 2021 David Hume , expectations , Federal Reserve , gold standard , Great Depression , Gustav Cassel , Henry Simons , Henry Thornton , John Fullarton , lender of last resort , Little Depression , R. G. Hawtrey , Walter Bagehot 69 Comments

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

C Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

Milton Friedman’s Rabble-Rousing Case for Abolishing the Fed

Published February 19, 2018 1920-21 Depression , Earl Thompson , Federal Reserve , gold standard , Milton Friedman 7 Comments

I recently came across this excerpt from a longer interview of Milton Friedman conducted by Brian Lamb on Cspan in 1994. In this excerpt Lamb asks Friedman what he thinks of the Fed, and Friedman, barely able to contain his ideological fervor, quickly rattles off his version of the history of the Fed, blaming the Fed, at least by implication, for all the bad monetary and macroeconomic events that happened between 1914, when the Fed came into existence, and the1970s.

Here’s a rough summary of Friedman’s tirade:

I have long been in favor of abolishing [the Fed]. There is no institution in the United States that has such a high public standing and such a poor record of performance. . . . The Federal Reserve began operations in 1914 and presided over a doubling of prices during World War I. It produced a major collapse in 1921. It had a good period from about 1922 to 1928. It took actions in 1928 and 1929 that led to a major recession in 1929 and 1930, and it converted that recession by its actions into the Great Depression. The major villain in the Great Depression in my opinion was unquestionably the Federal Reserve System. Since that time, it presided over a doubling of price in World War II. It financed the inflation of the 1970s. On the whole it has a very poor record. It’s done far more harm than good.

Let’s go through Friedman’s complaints one at a time.

World War I inflation.

Friedman blames World War I inflation on the Fed. Friedman, as I have shown in many previous posts, had a very shaky understanding of how the gold standard worked. His remark about the Fed’s “presiding over a doubling of prices” during World War I is likely yet another example of Friedman’s incomprehension, though his use of the weasel words “presided over” rather than the straightforward “caused” does suggest that Friedman was merely trying to insinuate that the Fed was blameworthy when he actually understood that the Fed had almost no control over inflation in World War I, the US remaining formally on the gold standard until April 6, 1917, when the US declared war on Germany and entered World War I, formally suspending the convertibility of the dollar into gold.

As long as the US remained on a gold standard, the value of the dollar was determined by the value of gold. The US was importing lots of gold during the first two and a half years of the World War I as the belligerents used their gold reserves and demonetized their gold coins to finance imports of war material from the US. The massive demonetization of gold caused gold to depreciate on world markets. Another neutral country, Sweden, actually left the gold standard during World War I to avoid the inevitable inflation associated with the wartime depreciation of gold. So it was either ignorant or disingenuous for Friedman to attribute the World War I inflation to the actions of the Federal Reserve. No country could have remained on the gold standard during World War I without accepting inflation, and the Federal Reserve had no legal authority to abrogate or suspend the legal convertibility of the dollar into a fixed weight of gold.

The Post-War Collapse of 1921

Friedman correctly blames the 1921 collapse to the Fed. However, after a rapid wartime and postwar inflation, the US was trying to recreate a gold standard while holding 40% of the world’s gold reserves. The Fed therefore took steps to stabilize the value of gold, which meant raising interest rates, thereby inducing a further inflow of gold into the US to stop the real value of gold from falling in international markets. The problem was that the Fed went overboard, causing a really, and probably unnecessarily, steep deflation.

The Great Depression

Friedman is right that the Fed helped cause the Great Depression by its actions in 1928 and 1929, raising interest rates to try to quell rapidly rising stock prices. But the concerns about rising stock-market prices were probably misplaced, and the Fed’s raising of interest rates caused an inflow of gold into the US just when a gold outflow from the US was needed to accommodate the rising demand for gold on the part of the Bank of France and other central banks rejoining the gold standard and accumulating gold reserves. It was the sudden tightening of the world gold market, with the US and France and other countries rejoining the gold standard simultaneously trying to increase their gold holdings, that caused the value of gold to rise (and nominal prices to fall) in 1929 starting the Great Depression. Friedman totally ignored the international context in which the Fed was operating, failing to see that the US price level under the newly established gold standard, being determined by the international value of gold, was beyond the control of the Fed.

World War II Inflation

As with World War I, Friedman blamed the Fed for “presiding over” a doubling of prices in World War II. But unlike World War I, when rising US prices reflected a falling real value of gold caused by events outside the US and beyond the control of the Fed, in World War II rising US prices reflected the falling value of an inconvertible US dollar caused by Fed “money printing” at the behest of the President and the Treasury. But why did Friedman consider Fed money printing in World War II to have been a blameworthy act on the part of the Fed? The US was then engaged in a total war against the Axis powers. Under those circumstances, was the primary duty of the Fed to keep prices stable or to use its control over “printing press” to ensure that the US government had sufficient funds to win the war against Nazi totalitarianism and allied fascist forces, thereby preserving American liberties and values even more fundamental than keeping inflation low and enabling creditors to extract what was owed to them by their debtors in dollars of undiminished real purchasing power.

Now it’s true that many of Friedman’s libertarian allies were appalled by US participation in World War II, but Friedman, to his credit, did not share their disapproval of US participation in World War II. But, given his support for World War II, Friedman should have at least acknowledged the obvious role of inflationary finance in emergency war financing, a role which, as Earl Thompson and I and others have argued, rationalizes the historic legal monopoly on money printing maintained by almost all sovereign states. To condemn the Fed for inflationary policies during World War II without recognizing the critical role of the “printing press” in war finance was a remarkably uninformed and biased judgment on Friedman’s part.

1970s Inflation

The Fed certainly had a major role in inflation during the 1970s, which as early as 1966 was already starting to creep up from 1-2% rates that had prevailed from 1953 to 1965. The rise in inflation was again triggered by war-related expenditures, owing to the growing combat role of the US in Vietnam starting in 1965. The Fed’s role in rising inflation in the late 1960s and early 1970s was hardly the Fed’s finest hour, but again, it is unrealistic to expect a public institution like the Fed to withhold the financing necessary to support a military action undertaken by the national government. Certainly, the role of Arthur Burns, appointed by Nixon in 1970 to become Fed Chairman in encouraging Nixon to impose wage-and-price controls as an anti-inflationary measure was one of the most disreputable chapters in the Fed’s history, and the cluelessness of Carter’s first Fed Chairman, G. William Miller, appointed to succeed Burns, is almost legendary, but given the huge oil-price increases of 1973-74 and 1978-79, a policy of accommodating those supply-side shocks by allowing a temporary increase in inflation was probably optimal. So, given the difficult circumstances under which the Fed was operating, the increased inflation of the 1970s was not entirely undesirable.

But although Friedman was often sensitive to the subtleties and nuances of policy making when rendering scholarly historical and empirical judgments, he rarely allowed subtleties and nuances to encroach on his denunciations when he was operating in full rabble-rousing mode.

Milton Friedman and How not to Think about the Gold Standard, France, Sterilization and the Great Depression

Published November 13, 2017 Bank of France , David Beckworth , Douglas Irwin , Emile Moreau , Federal Reserve , gold standard , Great Depression , Gustav Cassel , Milton Friedman , price-specie-flow mechanism , R. G. Hawtrey , rules of the game , sterilization 33 Comments

Last week I listened to David Beckworth on his excellent podcast Macro Musings, interviewing Douglas Irwin. I don’t think I’ve ever met Doug, but we’ve been in touch a number of times via email. Doug is one of our leading economic historians, perhaps the foremost expert on the history of US foreign-trade policy, and he has just published a new book on the history of US trade policy, Clashing over Commerce. As you would expect, most of the podcast is devoted to providing an overview of the history of US trade policy, but toward the end of the podcast, David shifts gears and asks Doug about his work on the Great Depression, questioning Doug about two of his papers, one on the origins of the Great Depression (“Did France Cause the Great Depression?”), the other on the 1937-38 relapse into depression, (“Gold Sterlization and the Recession of 1937-1938“) just as it seemed that the US was finally going to recover fully from the catastrophic 1929-33 downturn.

Regular readers of this blog probably know that I hold the Bank of France – and its insane gold accumulation policy after rejoining the gold standard in 1928 – primarily responsible for the deflation that inevitably led to the Great Depression. In his paper on France and the Great Depression, Doug makes essentially the same argument pointing out that the gold reserves of the Bank of France increased from about 7% of the world stock of gold reserves to about 27% of the world total in 1932. So on the substance, Doug and I are in nearly complete agreement that the Bank of France was the chief culprit in this sad story. Of course, the Federal Reserve in late 1928 and 1929 also played a key supporting role, attempting to dampen what it regarded as reckless stock-market speculation by raising interest rates, and, as a result, accumulating gold even as the Bank of France was rapidly accumulating gold, thereby dangerously amplifying the deflationary pressure created by the insane gold-accumulation policy of the Bank of France.

Now I would not have taken the time to write about this podcast just to say that I agreed with what Doug and David were saying about the Bank of France and the Great Depression. What prompted me to comment about the podcast were two specific remarks that Doug made. The first was that his explanation of how France caused the Great Depression was not original, but had already been provided by Milton Friedman, Clark Johnson, and Scott Sumner. I agree completely that Clark Johnson and Scott Sumner wrote very valuable and important books on the Great Depression and provided important new empirical findings confirming that the Bank of France played a very malign role in creating the deflationary downward spiral that was the chief characteristic of the Great Depression. But I was very disappointed in Doug’s remark that Friedman had been the first to identify the malign role played by the Bank of France in precipitating the Great Depression. Doug refers to the foreward that Friedman wrote for the English translation of the memoirs of Emile Moreau the Governor of the Bank of France from 1926 to 1930 (The Golden Franc: Memoirs of a Governor of the Bank of France: The Stabilization of the Franc (1926-1928). Moreau was a key figure in the stabilization of the French franc in 1926 after its exchange rate had fallen by about 80% against the dollar between 1923 and 1926, particularly in determining the legal exchange rate at which the franc would be pegged to gold and the dollar, when France officially rejoined the gold standard in 1928.

That Doug credits Friedman for having – albeit belatedly — grasped the role of the Bank of France in causing the Great Depression, almost 30 years after attributing the Depression in his Monetary History of the United States, almost entirely to policy mistakes mistakes by the Federal Reserve in late 1930 and early 1931 is problematic for two reasons. First, Doug knows very well that both Gustave Cassel and Ralph Hawtrey correctly diagnosed the causes of the Great Depression and the role of the Bank of France during – and even before – the Great Depression. I know that Doug knows this well, because he wrote this paper about Gustav Cassel’s diagnosis of the Great Depression in which he notes that Hawtrey made essentially the same diagnosis of the Depression as Cassel did. So, not only did Friedman’s supposed discovery of the role of the Bank of France come almost 30 years after publication of the Monetary History, it was over 60 years after Hawtrey and Cassel had provided a far more coherent account of what happened in the Great Depression and of the role of the Bank of France than Friedman provided either in the Monetary History or in his brief foreward to the translation of Moreau’s memoirs.

That would have been bad enough, but a close reading of Friedman’s foreward shows that even though, by 1991 when he wrote that foreward, he had gained some insight into the disruptive and deflationary influence displayed exerted by the Bank of France, he had an imperfect and confused understanding of the transmission mechanism by which the actions of the Bank of France affected the rest of the world, especially the countries on the gold standard. I have previously discussed in a 2015 post, what I called Friedman’s cluelessness about the insane policy of the Bank of France. So I will now quote extensively from my earlier post and supplement with some further comments:

Friedman’s foreward to Moreau’s memoir is sometimes cited as evidence that he backtracked from his denial in the Monetary History that the Great Depression had been caused by international forces, Friedman insisting that there was actually nothing special about the initial 1929 downturn and that the situation only got out of hand in December 1930 when the Fed foolishly (or maliciously) allowed the Bank of United States to fail, triggering a wave of bank runs and bank failures that caused a sharp decline in the US money stock. According to Friedman it was only at that point that what had been a typical business-cycle downturn degenerated into what he liked to call the Great Contraction. Let me now quote Friedman’s 1991 acknowledgment that the Bank of France played some role in causing the Great Depression.

Rereading the memoirs of this splendid translation . . . has impressed me with important subtleties that I missed when I read the memoirs in a language not my own and in which I am far from completely fluent. Had I fully appreciated those subtleties when Anna Schwartz and I were writing our A Monetary History of the United States, we would likely have assessed responsibility for the international character of the Great Depression somewhat differently. We attributed responsibility for the initiation of a worldwide contraction to the United States and I would not alter that judgment now. However, we also remarked, “The international effects were severe and the transmission rapid, not only because the gold-exchange standard had rendered the international financial system more vulnerable to disturbances, but also because the United States did not follow gold-standard rules.” Were I writing that sentence today, I would say “because the United States and France did not follow gold-standard rules.”

I find this minimal adjustment by Friedman of his earlier position in the Monetary History totally unsatisfactory. Why do I find it unsatisfactory? To begin with, Friedman makes vague references to unnamed but “important subtleties” in Moreau’s memoir that he was unable to appreciate before reading the 1991 translation. There was nothing subtle about the gold accumulation being undertaken by the Bank of France; it was massive and relentless. The table below is constructed from data on official holdings of monetary gold reserves from December 1926 to June 1932 provided by Clark Johnson in his important book Gold, France, and the Great Depression, pp. 190-93. In December 1926 France held $711 million in gold or 7.7% of the world total of official gold reserves; in June 1932, French gold holdings were $3.218 billion or 28.4% of the world total. [I omit a table of world monetary gold reserves from December 1926 to June 1932 included in my earlier post.]

What was it about that policy that Friedman didn’t get? He doesn’t say. What he does say is that he would not alter his previous judgment that the US was responsible “for the initiation of a worldwide contraction.” The only change he would make would be to say that France, as well as the US, contributed to the vulnerability of the international financial system to unspecified disturbances, because of a failure to follow “gold-standard rules.” I will just note that, as I have mentioned many times on this blog, references to alleged “gold standard rules” are generally not only unhelpful, but confusing, because there were never any rules as such to the gold standard, and what are termed “gold-standard rules” are largely based on a misconception, derived from the price-specie-flow fallacy, of how the gold standard actually worked.

New Comment. And I would further add that references to the supposed gold-standard rules are confusing, because, in the misguided tradition of the money multiplier, the idea of gold-standard rules of the game mistakenly assumes that the direction of causality between monetary reserves and bank money (either banknotes or bank deposits) created either by central banks or commercial banks goes from reserves to money. But bank reserves are held, because banks have created liabilities (banknotes and deposits) which, under the gold standard, could be redeemed either directly or indirectly for “base money,” e.g., gold under the gold standard. For prudential reasons, or because of legal reserve requirements, national monetary authorities operating under a gold standard held gold reserves in amounts related — in some more or less systematic fashion, but also depending on various legal, psychological and economic considerations — to the quantity of liabilities (in the form of banknotes and bank deposits) that the national banking systems had created. I will come back to, and elaborate on, this point below. So the causality runs from money to reserves, not, as the price-specie-flow mechanism and the rules-of-the-game idea presume, from reserves to money. Back to my earlier post:

So let’s examine another passage from Friedman’s forward, and see where that takes us.

Another feature of Moreau’s book that is most fascinating . . . is the story it tells of the changing relations between the French and British central banks. At the beginning, with France in desperate straits seeking to stabilize its currency, [Montagu] Norman [Governor of the Bank of England] was contemptuous of France and regarded it as very much of a junior partner. Through the accident that the French currency was revalued at a level that stimulated gold imports, France started to accumulate gold reserves and sterling reserves and gradually came into the position where at any time Moreau could have forced the British off gold by withdrawing the funds he had on deposit at the Bank of England. The result was that Norman changed from being a proud boss and very much the senior partner to being almost a supplicant at the mercy of Moreau.

What’s wrong with this passage? Well, Friedman was correct about the change in the relative positions of Norman and Moreau from 1926 to 1928, but to say that it was an accident that the French currency was revalued at a level that stimulated gold imports is completely — and in this case embarrassingly — wrong, and wrong in two different senses: one strictly factual, and the other theoretical. First, and most obviously, the level at which the French franc was stabilized — 125 francs per pound — was hardly an accident. Indeed, it was precisely the choice of the rate at which to stabilize the franc that was a central point of Moreau’s narrative in his memoir . . . , the struggle between Moreau and his boss, the French Premier, Raymond Poincaré, over whether the franc would be stabilized at that rate, the rate insisted upon by Moreau, or the prewar parity of 25 francs per pound. So inquiring minds can’t help but wonder what exactly did Friedman think he was reading?

The second sense in which Friedman’s statement was wrong is that the amount of gold that France was importing depended on a lot more than just its exchange rate; it was also a function of a) the monetary policy chosen by the Bank of France, which determined the total foreign-exchange holdings held by the Bank of France, and b) the portfolio decisions of the Bank of France about how, given the exchange rate of the franc and given the monetary policy it adopted, the resulting quantity of foreign-exchange reserves would be held.

I referred to Friedman’s foreward in which he quoted from his own essay “Should There Be an Independent Monetary Authority?” contrasting the personal weakness of W. P. G. Harding, Governor of the Federal Reserve in 1919-20, with the personal strength of Moreau. Quoting from Harding’s memoirs in which he acknowledged that his acquiescence in the U.S. Treasury’s desire to borrow at “reasonable” interest rates caused the Board to follow monetary policies that ultimately caused a rapid postwar inflation

Almost every student of the period is agreed that the great mistake of the Reserve System in postwar monetary policy was to permit the money stock to expand very rapidly in 1919 and then to step very hard on the brakes in 1920. This policy was almost surely responsible for both the sharp postwar rise in prices and the sharp subsequent decline. It is amusing to read Harding’s answer in his memoirs to criticism that was later made of the policies followed. He does not question that alternative policies might well have been preferable for the economy as a whole, but emphasizes the treasury’s desire to float securities at a reasonable rate of interest, and calls attention to a then-existing law under which the treasury could replace the head of the Reserve System. Essentially he was saying the same thing that I heard another member of the Reserve Board say shortly after World War II when the bond-support program was in question. In response to the view expressed by some of my colleagues and myself that the bond-support program should be dropped, he largely agreed but said ‘Do you want us to lose our jobs?’

The importance of personality is strikingly revealed by the contrast between Harding’s behavior and that of Emile Moreau in France under much more difficult circumstances. Moreau formally had no independence whatsoever from the central government. He was named by the premier, and could be discharged at any time by the premier. But when he was asked by the premier to provide the treasury with funds in a manner that he considered inappropriate and undesirable, he flatly refused to do so. Of course, what happened was that Moreau was not discharged, that he did not do what the premier had asked him to, and that stabilization was rather more successful.

Now, if you didn’t read this passage carefully, in particular the part about Moreau’s threat to resign, as I did not the first three or four times that I read it, you might not have noticed what a peculiar description Friedman gives of the incident in which Moreau threatened to resign following a request “by the premier to provide the treasury with funds in a manner that he considered inappropriate and undesirable.” That sounds like a very strange request for the premier to make to the Governor of the Bank of France. The Bank of France doesn’t just “provide funds” to the Treasury. What exactly was the request? And what exactly was “inappropriate and undesirable” about that request?

I have to say again that I have not read Moreau’s memoir, so I can’t state flatly that there is no incident in Moreau’s memoir corresponding to Friedman’s strange account. However, Jacques Rueff, in his preface to the 1954 French edition (translated as well in the 1991 English edition), quotes from Moreau’s own journal entries how the final decision to stabilize the French franc at the new official parity of 125 per pound was reached. And Friedman actually refers to Rueff’s preface in his foreward! Let’s read what Rueff has to say:

The page for May 30, 1928, on which Mr. Moreau set out the problem of legal stabilization, is an admirable lesson in financial wisdom and political courage. I reproduce it here in its entirety with the hope that it will be constantly present in the minds of those who will be obliged in the future to cope with French monetary problems.

“The word drama may sound surprising when it is applied to an event which was inevitable, given the financial and monetary recovery achieved in the past two years. Since July 1926 a balanced budget has been assured, the National Treasury has achieved a surplus and the cleaning up of the balance sheet of the Bank of France has been completed. The April 1928 elections have confirmed the triumph of Mr. Poincaré and the wisdom of the ideas which he represents. . . . Under such conditions there is nothing more natural than to stabilize the currency, which has in fact already been pegged at the same level for the last eighteen months.

“But things are not quite that simple. The 1926-28 recovery restored confidence to those who had actually begun to give up hope for their country and its capacity to recover from the dark hours of July 1926. . . . perhaps too much confidence.

“Distinguished minds maintained that it was possible to return the franc to its prewar parity, in the same way as was done with the pound sterling. And how tempting it would be to thereby cancel the effects of the war and postwar periods and to pay back in the same currency those who had lent the state funds which for them often represented an entire lifetime of unremitting labor.

“International speculation seemed to prove them right, because it kept changing its dollars and pounds for francs, hoping that the franc would be finally revalued.

“Raymond Poincaré, who was honesty itself and who, unlike most politicians, was truly devoted to the public interest and the glory of France, did, deep in his heart, agree with those awaiting a revaluation.

“But I myself had to play the ungrateful role of representative of the technicians who knew that after the financial bloodletting of the past years it was impossible to regain the original parity of the franc.

“I was aware, as had already been determined by the Committee of Experts in 1926, that it was impossible to revalue the franc beyond certain limits without subjecting the national economy to a particularly painful re-adaptation. If we were to sacrifice the vital force of the nation to its acquired wealth, we would put at risk the recovery we had already accomplished. We would be, in effect, preparing a counter-speculation against our currency that would come within a rather short time.

“Since the parity of 125 francs to one pound has held for long months and the national economy seems to have adapted itself to it, it should be at this rate that we stabilize without further delay.

“This is what I had to tell Mr. Poincaré at the beginning of June 1928, tipping the scales of his judgment with the threat of my resignation.” [my emphasis, DG]

So what this tells me is that the very act of personal strength that so impressed Friedman . . . was not about some imaginary “inappropriate” request made by Poincaré (“who was honesty itself”) for the Bank to provide funds to the treasury, but about whether the franc should be stabilized at 125 francs per pound, a peg that Friedman asserts was “accidental.” Obviously, it was not “accidental” at all, but . . . based on the judgment of Moreau and his advisers . . . as attested to by Rueff in his preface.

Just to avoid misunderstanding, I would just say here that I am not suggesting that Friedman was intentionally misrepresenting any facts. I think that he was just being very sloppy in assuming that the facts actually were what he rather cluelessly imagined them to be.

Before concluding, I will quote again from Friedman’s foreword:

Benjamin Strong and Emile Moreau were admirable characters of personal force and integrity. But in my view, the common policies they followed were misguided and contributed to the severity and rapidity of transmission of the U.S. shock to the international community. We stressed that the U.S. “did not permit the inflow of gold to expand the U.S. money stock. We not only sterilized it, we went much further. Our money stock moved perversely, going down as the gold stock went up” from 1929 to 1931. France did the same, both before and after 1929.

Strong and Moreau tried to reconcile two ultimately incompatible objectives: fixed exchange rates and internal price stability. Thanks to the level at which Britain returned to gold in 1925, the U.S. dollar was undervalued, and thanks to the level at which France returned to gold at the end of 1926, so was the French franc. Both countries as a result experienced substantial gold inflows.

New Comment. Actually, between December 1926 and December 1928, US gold reserves decreased by almost $350 million while French gold reserves increased by almost $550 million, suggesting that factors other than whether the currency peg was under- or over-valued determined the direction in which gold was flowing.

Gold-standard rules called for letting the stock of money rise in response to the gold inflows and for price inflation in the U.S. and France, and deflation in Britain, to end the over-and under-valuations. But both Strong and Moreau were determined to prevent inflation and accordingly both sterilized the gold inflows, preventing them from providing the required increase in the quantity of money. The result was to drain the other central banks of the world of their gold reserves, so that they became excessively vulnerable to reserve drains. France’s contribution to this process was, I now realize, much greater than we treated it as being in our History.

New Comment. I pause here to insert the following diatribe about the mutually supporting fallacies of the price-specie-flow mechanism, the rules of the game under the gold standard, and central-bank sterilization expounded on by Friedman, and, to my surprise and dismay, assented to by Irwin and Beckworth. Inflation rates under a gold standard are, to a first approximation, governed by international price arbitrage so that prices difference between the same tradeable commodities in different locations cannot exceed the cost of transporting those commodities between those locations. Even if not all goods are tradeable, the prices of non-tradeables are subject to forces bringing their prices toward an equilibrium relationship with the prices of tradeables that are tightly pinned down by arbitrage. Given those constraints, monetary policy at the national level can have only a second-order effect on national inflation rates, because the prices of non-tradeables that might conceivably be sensitive to localized monetary effects are simultaneously being driven toward equilibrium relationships with tradeable-goods prices.

The idea that the supposed sterilization policies about which Friedman complains had anything to do with the pursuit of national price-level targets is simply inconsistent with a theoretically sound understanding of how national price levels were determined under the gold standard. The sterilization idea mistakenly assumes that, under the gold standard, the quantity of money in any country is what determines national price levels and that monetary policy in each country has to operate to adjust the quantity of money in each country to a level consistent with the fixed-exchange-rate target set by the gold standard.

Again, the causality runs in the opposite direction; under a gold standard, national price levels are, as a first approximation, determined by convertibility, and the quantity of money in a country is whatever amount of money that people in that country want to hold given the price level. If the quantity of money that the people in a country want to hold is supplied by the national monetary authority or by the local banking system, the public can obtain the additional money they demand exchanging their own liabilities for the liabilities of the monetary authority or the local banks, without having to reduce their own spending in order to import the gold necessary to obtain additional banknotes from the central bank. And if the people want to get rid of excess cash, they can dispose of the cash through banking system without having to dispose of it via a net increase in total spending involving an import surplus. The role of gold imports is to fill in for any deficiency in the amount of money supplied by the monetary authority and the local banks, while gold exports are a means of disposing of excess cash that people are unwilling to hold. France was continually importing gold after the franc was stabilized in 1926 not because the franc was undervalued, but because the French monetary system was such that the additional cash demanded by the public could not be created without obtaining gold to be deposited in the vaults of the Bank of France. To describe the Bank of France as sterilizing gold imports betrays a failure to understand the imports of gold were not an accidental event that should have triggered a compensatory policy response to increase the French money supply correspondingly. The inflow of gold was itself the policy and the result that the Bank of France deliberately set out to implement. If the policy was to import gold, then calling the policy gold sterilization makes no sense, because, the quantity of money held by the French public would have been, as a first approximation, about the same whatever policy the Bank of France followed. What would have been different was the quantity of gold reserves held by the Bank of France.

To think that sterilization describes a policy in which the Bank of France kept the French money stock from growing as much as it ought to have grown is just an absurd way to think about how the quantity of money was determined under the gold standard. But it is an absurdity that has pervaded discussion of the gold standard, for almost two centuries. Hawtrey, and, two or three generations later, Earl Thompson, and, independently Harry Johnson and associates (most notably Donald McCloskey and Richard Zecher in their two important papers on the gold standard) explained the right way to think about how the gold standard worked. But the old absurdities, reiterated and propagated by Friedman in his Monetary History, have proven remarkably resistant to basic economic analysis and to straightforward empirical evidence. Now back to my critique of Friedman’s foreward.

These two paragraphs are full of misconceptions; I will try to clarify and correct them. First Friedman refers to “the U.S. shock to the international community.” What is he talking about? I don’t know. Is he talking about the crash of 1929, which he dismissed as being of little consequence for the subsequent course of the Great Depression, whose importance in Friedman’s view was certainly far less than that of the failure of the Bank of United States? But from December 1926 to December 1929, total monetary gold holdings in the world increased by about $1 billion; while US gold holdings declined by nearly $200 million, French holdings increased by $922 million over 90% of the increase in total world official gold reserves. So for Friedman to have even suggested that the shock to the system came from the US and not from France is simply astonishing.

Friedman’s discussion of sterilization lacks any coherent theoretical foundation, because, working with the most naïve version of the price-specie-flow mechanism, he imagines that flows of gold are entirely passive, and that the job of the monetary authority under a gold standard was to ensure that the domestic money stock would vary proportionately with the total stock of gold. But that view of the world ignores the possibility that the demand to hold money in any country could change. Thus, Friedman, in asserting that the US money stock moved perversely from 1929 to 1931, going down as the gold stock went up, misunderstands the dynamic operating in that period. The gold stock went up because, with the banking system faltering, the public was shifting their holdings of money balances from demand deposits to currency. Legal reserves were required against currency, but not against demand deposits, so the shift from deposits to currency necessitated an increase in gold reserves. To be sure the US increase in the demand for gold, driving up its value, was an amplifying factor in the worldwide deflation, but total US holdings of gold from December 1929 to December 1931 rose by $150 million compared with an increase of $1.06 billion in French holdings of gold over the same period. So the US contribution to world deflation at that stage of the Depression was small relative to that of France.

Friedman is correct that fixed exchange rates and internal price stability are incompatible, but he contradicts himself a few sentences later by asserting that Strong and Moreau violated gold-standard rules in order to stabilize their domestic price levels, as if it were the gold-standard rules rather than market forces that would force domestic price levels into correspondence with a common international level. Friedman asserts that the US dollar was undervalued after 1925 because the British pound was overvalued, presuming with no apparent basis that the US balance of payments was determined entirely by its trade with Great Britain. As I observed above, the exchange rate is just one of the determinants of the direction and magnitude of gold flows under the gold standard, and, as also pointed out above, gold was generally flowing out of the US after 1926 until the ferocious tightening of Fed policy at the end of 1928 and in 1929 caused a sizable inflow of gold into the US in 1929.

However, when, in the aggregate, central banks were tightening their policies, thereby tending to accumulate gold, the international gold market would come under pressure, driving up the value of gold relative goods, thereby causing deflationary pressure among all the gold standard countries. That is what happened in 1929, when the US started to accumulate gold even as the insane Bank of France was acting as a giant international vacuum cleaner sucking in gold from everywhere else in the world. Friedman, even as he was acknowledging that he had underestimated the importance of the Bank of France in the Monetary History, never figured this out. He was obsessed, instead with relatively trivial effects of overvaluation of the pound, and undervaluation of the franc and the dollar. Talk about missing the forest for the trees.

Golden Misconceptions

Published December 25, 2016 gold standard , Great Depression , Federal Reserve , Bank of France 16 Comments
Tags: price-specie-flow mechanism, sterlization

The gold standard, as an international institution, existed for less than 40 years, emerging first, and by accident, in England, and more than a century and a half later, spreading by a rapid series of independent, but interrelated, decisions to the United States, Germany, and most of Europe and much of the rest of the world. After its collapse with the outbreak of World War I, reconstruction of the gold standard was thought by many to be a precondition for recreating the stable and prosperous international order that had been brutally demolished by the Great War. But that attempt ended catastrophically when the restoration of the gold standard was subverted by the insane gold-accumulation policy of the Bank of France and the failure of the Federal Reserve and other national monetary authorities to heed the explicit warnings of two of the leading monetary theorists of immediate postwar era, R. G. Hawtrey and Gustav Cassel, that unless the monetary demand for gold was kept from increasing as a result of the resumption of convertibility, a renewed gold standard could trigger a disastrous deflation.

But despite its short, checkered, and not altogether happy, history as an international institution, the gold standard, in its idealized and largely imagined form has retained a kind of nostalgic aura of stability, excellence and grandeur, becoming an idiom for anything that’s the best of its kind. So no, Virginia, there is no Santa Claus, and the gold standard is not the gold standard of monetary systems.

My own impression is that most, though not all, supporters of the gold standard are smitten by a kind of romantic, unthinking, and irrational attachment to the idea that the gold standard is a magic formula for recovering a lost golden age. But having said that, I would also add that I actually think that the gold standard, in its brief first run as an international monetary system, did not perform all that badly, and I can even sympathize with the ultimately unsuccessful attempt to restore the gold standard after World War I. I just think that the risks of scrapping our current monetary arrangements and trying to replace them with a gold standard recreated from scratch, over a century after it ceased to function effectively in practice, are far too great to consider it seriously as a practical option.

Not long ago I was chided by Larry White for being unduly harsh in my criticism of the gold standard in my talk at the Mercatus Center conference on Monetary Rules for a Post-Crisis World. I responded to Larry in this post. But I now find myself somewhat exasperated by a post by Stephen Cecchetti and Kermit Schoenholtz on the blog they maintain for their money and banking textbook. I don’t know much about Schoenholtz, but Cecchetti is an economist of the first rank. They clearly share my opposition to gold standard, but I’m afraid that some of their arguments against the gold standard are misguided or misconceived. I don’t write this post just to be critical; it’s only because their arguments reflect common and long-standing misconceptions and misunderstandings that have become part of the received doctrine about the gold standard that those arguments are worth taking the time and effort to criticize.

So let’s start from the beginning of their post, which is actually quite a good beginning. They quote Barry Eichengreen, one of our most eminent economic historians.

“Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.” Barry Eichengreen, Golden Fetters.

That’s certainly true, but notice that the quotation from Eichengreen explicitly refers to the interwar period; it’s not a blanket indictment.

After quoting Eichengreen, Cecchetti and Schoenholtz refer to a lecture delivered by Ben Bernanke when he was still Chairman of the Federal Reserve Board. Quoting this lecture is not a good sign, because back in 2012 after Bernanke gave the lecture, I wrote a post in which I explained why Bernanke had failed to provide a coherent criticism of the gold standard.

In his 2012 lecture Origins and Mission of the Federal Reserve, then-Federal Reserve Board Chair Ben Bernanke identifies four fundamental problems with the gold standard:

When the central bank fixes the dollar price of gold, rather than the price of goods we consume, fluctuations in the dollar price of goods replace fluctuations in the market price of gold.
Since prices are tied to the amount of money in the economy, which is linked to the supply of gold, inflation depends on the rate that gold is mined.
When the gold standard is used at home and abroad, it is an exchange rate policy in which international transactions must be settled in gold.
Digging gold out of one hole in the ground (a mine) to put it into another hole in the ground (a vault) wastes resources.

Bernanke’s first statement is certainly correct, but his second statement ignores the fact that the amount of new gold extracted from the earth in a year is only a small fraction of the existing stock of gold. Thus, fluctuations in the value of gold are more likely to be caused by fluctuations in the demand for gold than by fluctuations in supply. The third statement makes as much sense as saying that since the US economy operates on a dollar standard transactions must be settled in hard currency. In fact, the vast majority of legal transactions are settled not by the exchange of currency but by the exchange of abstract claims to currency. There is no reason why, under a gold standard, international transactions could not be settled by abstract claims to gold rather than in physical gold. I agree with the fourth statement.

Consistent with Bernanke’s critique, the evidence shows that both inflation and economic growth were quite volatile under the gold standard. The following chart plots annual U.S. consumer price inflation from 1880, the beginning of the post-Civil War gold standard, to 2015. The vertical blue line marks 1933, the end of the gold standard in the United States. The standard deviation of inflation during the 53 years of the gold standard is nearly twice what it has been since the collapse of the Bretton Woods system in 1973 (denoted in the chart by the vertical red line). That is, even if we include the Great Inflation of the 1970s, inflation over the past 43 years has been more stable than it was under the gold standard. Focusing on the most recent quarter century, the interval when central banks have focused most intently on price stability, then the standard deviation of inflation is less than one-fifth of what it was during the gold standard epoch.

Annual Consumer Price Inflation, 1880 to 2016

Source: Federal Reserve Bank of Minneapolis.

I am sorry to say this, but comparing the average rate and the variability of inflation under the gold standard (1880-1933) and under a pure dollar standard (1973-2016) is tendentious and misleading, because the 20-year period from 1914 to 1933, a period marked by rapid wartime and post-war inflation and two post-war deflations, was a period when the gold standard either was not functioning at all (1914 to about 1922) or was being unsuccessfully reconstructed. Now it would be one thing to conclude from the failed attempt at reconstruction that a second attempt at reconstruction would be futile and potentially as disastrous as the first attempt, but that doesn’t seem to be what Ceccheti and Schoenholz are arguing. Instead, they include data from 20 years when the gold standard was either not operating at all or was operating dysfunctionally to make an unqualified comparison between the performance of the US economy under the gold standard and under a pure dollar standard. That simplistic comparison conveys almost no useful information.

A fairer comparison would be between the gold standard as it operated between 1880 and 1914 and either the dollar standard of the post-Bretton Woods era (1973 – 2016) or the period from 1991 to 2016 when, according to Cecchetti and Schoenholz, the Fed adopted an explicit or implicit inflation target as its primary policy objective. Changing the gold-standard period in this way reduces the average inflation rate from 0.86% to 0.23% a year and the standard deviation from 5.06% to 2.13%. That comparison is not obviously disadvantageous to the gold standard.

What about economic growth? Again, the gold standard was associated with greater volatility, not less. The following chart plots annual growth as measured by gross national product (gross domestic product only came into common use in the 1991.) The pattern looks quite a bit like that of inflation: the standard deviation of economic growth during the gold-standard era was more than twice that of the period since 1973. And, despite the Great Recession, the past quarter century has been even more stable. To use another, simpler, measure, in the period from 1880 to 1933 there were 15 business cycles identified by the National Bureau of Economic Research. That is, on average there was a recession once every 3½ years. By contrast, since 1972, there have been 7 recessions; one every 6 years.

Annual GNP Growth, 1880-2016

Source: FRED and Romer (1986)

Again, this comparison, like the inflation comparison is distorted by the exogenous disruption associated with World War I and its aftermath. Excluding the 1914 to 1933 period from the comparison would make for a far less one-sided comparison than the one presented by Cecchetti and Schoenholtz.

Finally, consider a crude measure of financial stability: the frequency of banking crises. From 1880 to 1933, there were at least 5 full-fledged banking panics: 1893, 1907, 1930, 1931, and 1933. Including the savings and loan crisis of the 1980s, in the past half century, there have been two.

But if we exclude the Great Depression period from the comparison, there were two banking panics under the gold standard and two under the dollar standard. So the performance of the gold standard when it was operating normally was not clearly inferior to the operation of the dollar standard.

So, on every score, the gold standard period was less stable. Prices were less stable; growth was less stable; and the financial system was less stable. Why?

We see six major reasons. First, the gold standard is procyclical. When the economy booms, inflation typically rises. In the absence of a central bank to force the nominal interest rate up, the real interest rate falls, providing a further impetus to activity. In contrast, countercyclical monetary policy—whether based on a Taylor rule or not—would lean against the boom.

I don’t know what the basis is for the factual assertion that high growth under a gold standard is associated with inflation. There were periods of high growth with very low or negative inflation under the gold standard. Periods of mild inflation, owing to a falling real value of gold, perhaps following significant discoveries of previously unknown gold deposits, may have had a marginal stimulative effect under the gold standard, but such episodes were not necessarily periods of economic instability.

At any rate it is not even clear why, if a countericyclical monetary policy were desirable, such a policy could not be conducted under the gold standard by a central bank constrained by an obligation to convert its liabilities into gold on demand. Some gold standard proponents, like Larry White for example, insist that a gold standard could and would function better without a central bank than with a central bank. I am skeptical about that position, but even if it is correct, there is nothing inherent in the idea of a gold standard that is inconsistent with the existence of a central bank that conducts a countercyclical policy, so I don’t understand why Cecchetti and Schoenholtz assert, without argument, that a central bank could not conduct a countercyclical policy under a gold standard.

Second, the gold standard has exchange rate implications. While we do not know for sure, we suspect that current U.S. advocates of a shift to gold are thinking of the case where the United States acts alone (rather than waiting to coordinate a global return to the gold standard). If so, the change would impose unnecessary risks on exporters and importers, their employees and their creditors. To see why, consider the consequences of a move in the global price of gold measured in some other currency, say British pounds. If the pound price of gold changed, but the dollar price of gold did not, the result would be a move in the real dollar-pound exchange rate. That is, unless the dollar prices of U.S. goods and the dollar wages of U.S. workers adjust instantly to offset gold price fluctuations, the real dollar exchange rate changes. In either case, the result would almost surely induce volatility of production, employment, and the debt burden.

If the US monetary policy were governed by a commitment to convert the dollar into gold at a fixed conversion rate, the dollar price of gold would remain constant and exchange rates of the dollar in terms of the pound and other non-gold currencies would fluctuate. We have fluctuating exchange rates now against the pound and other currencies. It is not clear to me why exchange rates would be more volatile under this system than they are currently.

More broadly, a gold standard suffers from some of the same problems as any fixed-exchange rate system. Not only can’t the exchange rate adjust to buffer external shocks, but the commitment invites speculative attacks because it lacks time consistency. Under a gold standard, the scale of the central bank’s liabilities—currency plus reserves—is determined by the gold it has in its vault. Imagine that, as a consequence of an extended downturn, people come to fear a currency devaluation. That is, they worry that the central bank will raise the dollar price of gold. In such a circumstance, it will be natural for investors to take their dollars to the central bank and exchange them for gold. The doubts that motivate such a run can be self-fulfilling: once the central bank starts to lose gold reserves, it can quickly be compelled to raise its dollar price, or to suspend redemption entirely. This is what happened in 1931 to the Bank of England, when it was driven off the gold standard. It happened again in 1992 (albeit with foreign currency reserves rather than gold) when Britain was compelled to abandon its fixed exchange rate.

Cecchetti and Schoenholtz articulate a valid concern, and it is a risk inherent in any gold standard or any monetary system based on trust in a redemption commitment. My only quibble is that Cecchetti and Schoenholtz overrate the importance of gold reserves. Foreign-exchange reserves would do just as well, and perhaps better, than gold reserves, because, unlike gold, foreign-exchange reserves yield interest.

Third, as historians have emphasized, the gold standard helped spread the Great Depression from the United States to the rest of the world. The gold standard was a global arrangement that formed the basis for a virtually universal fixed-exchange rate regime in which international transactions were settled in gold.

Here Cecchetti and Schoenholtz stumble into several interrelated confusions. First, while the gold standard was certainly an international transmission mechanism, the international linkage between national price levels being an essential characteristic of the gold standard, there is no reason to identify the United States as the source of a disturbance that was propagated to the rest of the world. Because the value of gold must be equalized in all countries operating under the gold standard, changes in the value of gold are an international, not a national, phenomenon. Thus, an increase in the demand for gold causing an increase in its value would have essentially the same effects on the world economy irrespective of the geographic location of the increase in the demand for gold. In the 1920s, the goal of reestablishing the gold standard meant restoring convertibility of the leading currencies into gold, so that price levels in all gold standard countries, all reflecting the internationally determined value of gold, were closely aligned.

This meant that a country with an external deficit — one whose imports exceed its exports — was required to pay the difference by transferring gold to countries with external surpluses. The loss of gold forced the deficit country’s central bank to shrink its balance sheet, reducing the quantity of money and credit in the economy, and driving domestic prices down. Put differently, under a gold standard, countries running external deficits face deflationary pressure. A surplus country’s central bank faced no such pressure, as it could choose whether to convert higher gold stocks into money or not. Put another way, a central bank can have too little gold, but it can never have too much.

Cecchetti and Schonholtz are confusing two distinct questions: a) what determines the common international value of gold? and b) what accounts for second-order deviations between national price levels? The important point is that movements in national price levels under the gold standard were highly correlated because, owing to international arbitrage of tradable goods, the value of gold could not differ substantially between countries on the gold standard. Significant short-run changes in the value of gold had to reflect changes in the total demand for gold because short-run changes in the supply of gold are only a small fraction of the existing stock. To be sure, short-run differences in inflation across countries might reflect special circumstances causing over- or under-valuation of particular currencies relative to one another, but those differences were of a second-order magnitude relative to the sharp worldwide deflation that characterized the Great Depression in which the price levels of all gold-standard countries fell simultaneously. It is always the case that some countries will be running trade deficits and some will be running trade surpluses. At most, that circmstance might explain small differences in relative rates of inflation or deflation across countries; it can’t explain why deflation was rampant across all countries at the same time.

The shock that produced the Great Depression was a shock to the real value of gold which was caused mainly by the gold accumulation policy of the Bank of France. However, the United States, holding about 40 percent of the world’s monetary gold reserves after World War I, could have offset or mitigated the French policy by allowing an outflow of some of its massive gold reserves. Instead, the Fed, in late 1928, raised interest rates yet again to counter what it viewed as unhealthy stock-market speculation, thereby intensifying, rather than mitigating, the deflationary effect of the gold-accumulation policy of the Bank of France. Implicitly, Cecchetti and Schoenholtz assume that the observed gold flows were the result of non-monetary causes, which is to say that gold flows were the result of trade imbalances reflecting purely structural factors, such as national differences in rates of productivity growth, or propensities to save, or demand and supply patterns, over which central banks have little or no influence. But in fact, central banks and monetary authorities based their policies on explicit or implicit goals for their holdings of gold reserves. And the value of gold ultimately reflected the combined effect of the policy decisions taken by all central banks thereby causing a substantial increase in the demand of national monetary authorities to hold gold.

This policy asymmetry helped transmit financial shocks in the United States abroad. By the late 1920s, the major economies had restored the pre-World War I gold standard. At the time, both the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults.

Cecchetti and Schoneholtz say explicitly “the United States and France were running external surpluses, absorbing the world’s gold into their central bank vaults” as if those surpluses just happened and were unrelated to the monetary policies deliberately adopted by the Bank of France and the Federal Reserve.

But, instead of allowing the gold inflows to expand the quantity of money in their financial systems, authorities in both countries tightened monetary policy to resist booming asset prices and other signs of overheating. The result was catastrophic, compelling deficit countries with gold outflows to tighten their monetary policies even more. As the quantity of money available worldwide shrank, so did the price level, adding to the real burden of debt, and prompting defaults and bank failures virtually around the world.

Cecchetti and Schoenholtz have the causation backwards; it was the tightness of monetary policy that caused gold inflows into France and later into the United States. The gold flows did not precede, but were the result of, already tight monetary policies. Cecchetti and Schoenholtz are implicitly adopting the sterilization model based on the price-specie-flow mechanism in which it is gold flows that cause, or ought to cause, changes in the quantity of money. I debunked the simplistic sterilization idea in this post. But, in fairness, I should acknowledge that Cecchetti and Schoenholz do eventually acknowledge that the demand by central banks to hold gold reserves is what determines actual monetary policy under the gold standard. But despite that acknowledgment, they can’t free themselves from the misconception that it was a reduction in the quantity of money, rather than an increase in the demand for gold, that caused the value of gold to rise in the Great Depression.

Fourth, economists blame the gold standard for sustaining and deepening the Great Depression. What makes this view most compelling is the fact that the sooner a country left the gold standard and regained discretionary control of its monetary policy, the faster it recovered. The contrast between Sweden and France is striking. Sweden left gold in 1931, and by 1936 its industrial production was 14 percent higher than its 1929 level. France waited until 1936 to leave, at which point its industrial production was fully 26 percent below the level just 7 years earlier (see here and here.) Similarly, when the U.S. suspended gold convertibility in March 1933—allowing the dollar to depreciate substantially—the financial and economic impact was immediate: deflation turned to inflation, lowering the real interest rate, boosting asset prices, and triggering one of the most powerful U.S. cyclical upturns (see, for example, Romer).

This is certainly right. My only quibble is that Cecchetti and Schoenholtz do not acknowledge that the Depression was triggered by a rapid increase in the international demand for gold by the world’s central banks in 1928-29, in particular the Bank of France and the Federal Reserve.

Turning to financial stability, the gold standard limits one of the most powerful tools for halting bank panics: the central bank’s authority to act as lender of last resort. It was the absence of this function during the Panic of 1907 that was the primary impetus for the creation of the Federal Reserve System. Yet, under a gold standard, the availability of gold limits the scope for expanding central bank liabilities. Thus, had the Fed been on a strict gold standard in the fall of 2008—when Lehman failed—the constraint on its ability to lend could again have led to a collapse of the financial system and a second Great Depression.

At best, the charge that the gold standard limits the capacity of a central bank to act as a lender of last resort is a serious oversimplification. The ability of a central bank to expand its liabilities is not limited by the gold standard in any way. What limits the ability of the central bank to expand its liabilities are gold-cover requirements such as those enacted by the Bank Charter Act of 1844 which imposed a 100% marginal reserve requirement on the issue of banknotes by the Bank of England beyond a fixed fiduciary issue requiring no gold cover. Subsequent financial crises in 1847, 1857, and 1866 were quelled as soon as the government suspended the relevant provisions of the Bank Charter Act, allowing the Bank of England to increase its note issue and satisfy the exceptional demands for liquidity that led to the crisis in the first place.

Finally, because the supply of gold is finite, the quantity available to the central bank likely will grow more slowly than the real economy. As a result, over long periods—say, a decade or more—we would expect deflation. While (in theory) labor, debt and other contracts can be arranged so that the economy will adjust smoothly to steady, long-term deflation, recent experience (including that with negative nominal interest rates) makes us skeptical.

Whether gold appreciates over the long-term depends on the rate at which the quantity of gold expands over time and the rate of growth of demand for gold over time. It is plausible to expect secular deflation under the gold standard, but it is hardly inevitable. I don’t think that we yet fully understand the conditions under which secular deflation is compatible with full employment. Certainly if we were confident that secular deflation is compatible with full employment, the case for secular deflation would be very compelling.

This brings us back to where we started. Under a gold standard, inflation, growth and the financial system are all less stable. There are more recessions, larger swings in cons umer prices and more banking crises. When things go wrong in one part of the world, the distress will be transmitted more quickly and completely to others. In short, re-creating a gold standard would be a colossal mistake.

These conclusions are based on very limited historical experience, and it is not clear how relevant that experience is for contemporary circumstances. The argument against a gold standard not so much that a gold standard could not in principle operate smoothly and efficiently. It is that, a real gold standard having been abandoned for 80 years, recreating a gold standard would be radical and risky undertaking completely lacking in a plausible roadmap for its execution. The other argument against the gold standard is that insofar as gold would be actually used as a medium of exchange in a recreated gold standard with a modern banking system, the banking system would be subject to the potentially catastrophic risk of a flight to quality in periods of banking instability, leading to a disastrous deflationary increase in the value of gold.

HT: J. P. Koning

How not to Win Friends and Influence People

Published January 31, 2016 Bank of France , David Beckworth , demand for money , expectations , Federal Reserve , financial crisis , Great Depression , Milton Friedman , Paul Krugman , Ted Cruz 31 Comments
Tags: Cassel, Friedman, Hawtrey, Krugman

Last week David Beckworth and Ramesh Ponnuru wrote a very astute op-ed article in the New York Times explaining how the Fed was tightening its monetary policy in 2008 even as the economy was rapidly falling into recession. Although there are a couple of substantive points on which I might take issue with Beckworth and Ponnuru (more about that below), I think that on the whole they do a very good job of covering the important points about the 2008 financial crisis given that their article had less than 1000 words.

That said, Beckworth and Ponnuru made a really horrible – to me incomprehensible — blunder. For some reason, in the second paragraph of their piece, after having recounted the conventional narrative of the 2008 financial crisis as an inevitable result of housing bubble and the associated misconduct of the financial industry in their first paragraph, Beckworth and Ponnuru cite Ted Cruz as the spokesman for the alternative view that they are about to present. They compound that blunder in a disclaimer identifying one of them – presumably Ponnuru — as a friend of Ted Cruz – for some recent pro-Cruz pronouncements from Ponnuru see here, here, and here – thereby transforming what might have been a piece of neutral policy analysis into a pro-Cruz campaign document. Aside from the unseemliness of turning Cruz into the poster-boy for Market Monetarism and NGDP Level Targeting, when, as recently as last October 28, Mr. Cruz was advocating resurrection of the gold standard while bashing the Fed for debasing the currency, a shout-out to Ted Cruz is obviously not a gesture calculated to engage readers (of the New York Times for heaven sakes) and predispose them to be receptive to the message they want to convey.

I suppose that this would be the appropriate spot for me to add a disclaimer of my own. I do not know, and am no friend of, Ted Cruz, but I was a FTC employee during Cruz’s brief tenure at the agency from July 2002 to December 2003. I can also affirm that I have absolutely no recollection of having ever seen or interacted with him while he was at the agency or since, and have spoken to only one current FTC employee who does remember him.

Predictably, Beckworth and Ponnuru provoked a barrage of negative responses to their argument that the Fed was responsible for the 2008 financial crisis by not easing monetary policy for most of 2008 when, even before the financial crisis, the economy was sliding into a deep recession. Much of the criticism focuses on the ambiguous nature of the concepts of causation and responsibility when hardly any political or economic event is the direct result of just one cause. So to say that the Fed caused or was responsible for the 2008 financial crisis cannot possibly mean that the Fed single-handedly brought it about, and that, but for the Fed’s actions, no crisis would have occurred. That clearly was not the case; the Fed was operating in an environment in which not only its past actions but the actions of private parties and public and political institutions increased the vulnerability of the financial system. To say that the Fed’s actions of commission or omission “caused” the financial crisis in no way absolves all the other actors from responsibility for creating the conditions in which the Fed found itself and in which the Fed’s actions became crucial for the path that the economy actually followed.

Consider the Great Depression. I think it is totally reasonable to say that the Great Depression was the result of the combination of a succession of interest rate increases by the Fed in 1928 and 1929 and by the insane policy adopted by the Bank of France in 1928 and continued for several years thereafter to convert its holdings of foreign-exchange reserves into gold. But does saying that the Fed and the Bank of France caused the Great Depression mean that World War I and the abandonment of the gold standard and the doubling of the price level in terms of gold during the war were irrelevant to the Great Depression? Of course not. Does it mean that accumulation of World War I debt and reparations obligations imposed on Germany by the Treaty of Versailles and the accumulation of debt issued by German state and local governments — debt and obligations that found their way onto the balance sheets of banks all over the world, were irrelevant to the Great Depression? Not at all.

Nevertheless, it does make sense to speak of the role of monetary policy as a specific cause of the Great Depression because the decisions made by the central bankers made a difference at critical moments when it would have been possible to avoid the calamity had they adopted policies that would have avoided a rapid accumulation of gold reserves by the Fed and the Bank of France, thereby moderating or counteracting, instead of intensifying, the deflationary pressures threatening the world economy. Interestingly, many of those objecting to the notion that Fed policy caused the 2008 financial crisis are not at all bothered by the idea that humans are causing global warming even though the world has evidently undergone previous cycles of rising and falling temperatures about which no one would suggest that humans played any causal role. Just as the existence of non-human factors that affect climate does not preclude one from arguing that humans are now playing a key role in the current upswing of temperatures, the existence of non-monetary factors contributing to the 2008 financial crisis need not preclude one from attributing a causal role in the crisis to the Fed.

So let’s have a look at some of the specific criticisms directed at Beckworth and Ponnuru. Here’s Paul Krugman’s take in which he refers back to an earlier exchange last December between Mr. Cruz and Janet Yellen when she testified before Congress:

Back when Ted Cruz first floated his claim that the Fed caused the Great Recession — and some neo-monetarists spoke up in support — I noted that this was a repeat of the old Milton Friedman two-step.

First, you declare that the Fed could have prevented a disaster — the Great Depression in Friedman’s case, the Great Recession this time around. This is an arguable position, although Friedman’s claims about the 30s look a lot less convincing now that we have tried again to deal with a liquidity trap. But then this morphs into the claim that the Fed caused the disaster. See, government is the problem, not the solution! And the motivation for this bait-and-switch is, indeed, political.

Now come Beckworth and Ponnuru to make the argument at greater length, and it’s quite direct: because the Fed “caused” the crisis, things like financial deregulation and runaway bankers had nothing to do with it.

As regular readers of this blog – if there are any – already know, I am not a big fan of Milton Friedman’s work on the Great Depression, and I agree with Krugman’s criticism that Friedman allowed his ideological preferences or commitments to exert an undue influence not only on his policy advocacy but on his substantive analysis. Thus, trying to make a case for his dumb k-percent rule as an alternative monetary regime to the classical gold standard regime generally favored by his libertarian, classical liberal and conservative ideological brethren, he went to great and unreasonable lengths to deny the obvious fact that the demand for money is anything but stable, because such an admission would have made the k-percent rule untenable on its face as it proved to be when Paul Volcker misguidedly tried to follow Friedman’s advice and conduct monetary policy by targeting monetary aggregates. Even worse, because he was so wedded to the naïve quantity-theory monetary framework he thought he was reviving – when in fact he was using a modified version of the Cambride/Keynesian demand for money, even making the patently absurd claim that the quantity theory of money was a theory of the demand for money – Friedman insisted on conducting monetary analysis under the assumption – also made by Keynes — that quantity of money is directly under the control of the monetary authority when in fact, under a gold standard – which means during the Great Depression – the quantity of money for any country is endogenously determined. As a result, there was a total mismatch between Friedman’s monetary model and the institutional setting in place at the time of the monetary phenomenon he was purporting to explain.

So although there were big problems with Friedman’s account of the Great Depression and his characterization of the Fed’s mishandling of the Great Depression, fixing those problems doesn’t reduce the Fed’s culpability. What is certainly true is that the Great Depression, the result of a complex set of circumstances going back at least 15 years to the start of World War I, might well have been avoided largely or entirely, but for the egregious conduct of the Fed and Bank of France. But it is also true that, at the onset of the Great Depression, there was no consensus about how to conduct monetary policy, even though Hawtrey and Cassel and a handful of others well understood how terribly monetary policy had gone off track. But theirs was a minority view, and Hawtrey and Cassel are still largely ignored or forgotten.

Ted Cruz may view the Fed’s mistakes in 2008 as a club with which to beat up on Janet Yellen, but for most of the rest of us who think that Fed mistakes were a critical element of the 2008 financial crisis, the point is not to make an ideological statement, it is to understand what went wrong and to try to keep it from happening again.

Krugman sends us to Mike Konczal for further commentary on Beckworth and Ponnuru.

Is Ted Cruz right about the Great Recession and the Federal Reserve? From a November debate, Cruz argued that “in the third quarter of 2008, the Fed tightened the money and crashed those asset prices, which caused a cascading collapse.”

Fleshing that argument out in the New York Times is David Beckworth and Ramesh Ponnuru, backing and expanding Cruz’s theory that “the Federal Reserve caused the crisis by tightening monetary policy in 2008.”

But wait, didn’t the Federal Reserve lower rates during that time?

Um, no. The Fed cut its interest rate target to 2.25% on March 18, 2008, and to 2% on April 20, which by my calculations would have been in the second quarter of 2008. There it remained until it was reduced to 1.5% on October 8, which by my calculations would have been in the fourth quarter of 2008. So on the face of it, Mr. Cruz was right that the Fed kept its interest rate target constant for over five months while the economy was contracting in real terms in the third quarter at a rate of 1.9% (and growing in nominal terms at a mere 0.8% rate)

Konczal goes on to accuse Cruz of inconsistency for blaming the Fed for tightening policy in 2008 before the crash while bashing the Fed for quantitative easing after the crash. That certainly is a just criticism, and I really hope someone asks Cruz to explain himself, though my expectations that that will happen are not very high. But that’s Cruz’s problem, not Beckworth’s or Ponnuru’s.

Konczal also focuses on the ambiguity in saying that the Fed caused the financial crisis by not cutting interest rates earlier:

I think a lot of people’s frustrations with the article – see Barry Ritholtz at Bloomberg here – is the authors slipping between many possible interpretations. Here’s the three that I could read them making, though these aren’t actual quotes from the piece:

(a) “The Federal Reserve could have stopped the panic in the financial markets with more easing.”

There’s nothing in the Valukas bankruptcy report on Lehman, or any of the numerous other reports that have since come out, that leads me to believe Lehman wouldn’t have failed if the short-term interest rate was lowered. One way to see the crisis was in the interbank lending spreads, often called the TED spread, which is a measure of banking panic. Looking at an image of the spread and its components, you can see a falling short-term t-bill rate didn’t ease that spread throughout 2008.

And, as Matt O’Brien noted, Bear Stearns failed before the passive tightening started.

The problem with this criticism is that it assumes that the only way that the Fed can be effective is by altering the interest rate that it effectively sets on overnight loans. It ignores the relationship between the interest rate that the Fed sets and total spending. That relationship is not entirely obvious, but almost all monetary economists have assumed that there is such a relationship, even if they can’t exactly agree on the mechanism by which the relationship is brought into existence. So it is not enough to look at the effect of the Fed’s interest rate on Lehman or Bear Stearns, you also have to look at the relationship between the interest rate and total spending and how a higher rate of total spending would have affected Lehman and Bear Stearns. If the economy had been performing better in the second and third quarters, the assets that Lehman and Bear Stearns were holding would not have lost as much of their value. And even if Lehman and Bear Stearns had not survived, arranging for their takeover by other firms might have been less difficult.

But beyond that, Beckworth and Ponnuru themselves overlook the fact that tightening by the Fed did not begin in the third quarter – or even the second quarter – of 2008. The tightening may have already begun in as early as the middle of 2006. The chart below shows the rate of expansion of the adjusted monetary base from January 2004 through September 2008. From 2004 through the middle of 2006, the biweekly rate of expansion of the monetary base was consistently at an annual rate exceeding 4% with the exception of a six-month interval at the end of 2005 when the rate fell to the 3-4% range. But from the middle of 2006 through September 2008, the bi-weekly rate of expansion was consistently below 3%, and was well below 2% for most of 2008. Now, I am generally wary of reading too much into changes in the monetary aggregates, because those changes can reflect either changes in supply conditions or demand conditions. However, when the economy is contracting, with the rate of growth in total spending falling substantially below trend, and the rate of growth in the monetary aggregates is decreasing sharply, it isn’t unreasonable to infer that monetary policy was being tightened. So, the monetary policy may well have been tightened as early as 2006, and, insofar as the rate of growth of the monetary base is indicative of the stance of monetary policy, that tightening was hardly passive.

(b) “The Federal Reserve could have helped the recovery by acting earlier in 2008. Unemployment would have peaked at, say, 9.5 percent, instead of 10 percent.”

That would have been good! I would have been a fan of that outcome, and I’m willing to believe it. That’s 700,000 people with a job that they wouldn’t have had otherwise. The stimulus should have been bigger too, with a second round once it was clear how deep the hole was and how Treasuries were crashing too.

Again, there are two points. First, tightening may well have begun at least a year or two before the third quarter of 2008. Second, the economy started collapsing in the third quarter of 2008, and the run-up in the value of the dollar starting in July 2008, foolishly interpreted by the Fed as a vote of confidence in its anti-inflation policy, was really a cry for help as the economy was being starved of liquidity just as the demand for liquidity was becoming really intense. That denial of liquidity led to a perverse situation in which the return to holding cash began to exceed the return on real assets, setting the stage for a collapse in asset prices and a financial panic. The Fed could have prevented the panic, by providing more liquidity. Had it done so, the financial crisis would have been avoided, and the collapse in the real economy and the rise in unemployment would have been substantially mitigate.

c – “The Federal Reserve could have stopped the Great Recession from ever happening. Unemployment in 2009 wouldn’t have gone above 5.5 percent.”

This I don’t believe. Do they? There’s a lot of “might have kept that decline from happening or at least moderated it” back-and-forth language in the piece.

Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

I think there’s an argument about “expectations,” and “expectations” wouldn’t have been set for a Great Recession. A lot of the “expectations” stuff has a magic and tautological quality to it once it leaves the models and enters the policy discussion, but the idea that a random speech about inflation worries could have shifted the Taylor Rule 4 percent seems really off base. Why doesn’t it go haywire all the time, since people are always giving speeches?

Well, I have shown in this paper that, starting in 2008, there was a strong empirical relationship between stock prices and inflation expectations, so it’s not just tautological. And we’re not talking about random speeches; we are talking about the decisions of the FOMC and the reasons that were given for those decisions. The markets pay a lot of attention to those reason.

And couldn’t it be just as likely that since the Fed was so confident about inflation in mid-2008 it boosted nominal income, by giving people a higher level of inflation expectations than they’d have otherwise? Given the failure of the Evans Rule and QE3 to stabilize inflation (or even prevent it from collapsing) in 2013, I imagine transporting them back to 2008 would haven’t fundamentally changed the game.

The inflation in 2008 was not induced by monetary policy, but by adverse supply shocks, expectations of higher inflation, given the Fed’s inflation targeting were thus tantamount to predictions of further monetary tightening.

If your mental model is that the Federal Reserve delaying something three months is capable of throwing 8.7 million people out of work, you should probably want to have much more shovel-ready construction and automatic stabilizers, the second of which kicked in right away without delay, as part of your agenda. It seems odd to put all the eggs in this basket if you also believe that even the most minor of mistakes are capable of devastating the economy so greatly.

Once again, it’s not a matter of just three months, but even if it were, in the summer of 2008 the economy was at a kind of inflection point, and the failure to ease monetary policy at that critical moment led directly to a financial crisis with cascading effects on the real economy. If the financial crisis could have been avoided by preventing total spending from dropping far below trend in the third quarter, the crisis might have been avoided, and the subsequent loss of output and employment could have been greatly mitigated.

And just to be clear, I have pointed out previously that the free market economy is fragile, because its smooth functioning depends on the coherence and consistency of expectations. That makes monetary policy very important, but I don’t dismiss shovel-ready construction and automatic stabilizers as means of anchoring expectations in a useful way, in contrast to the perverse way that inflation targeting stabilizes expectations.

More Economic Prejudice and High-Minded Sloganeering

Published September 1, 2015 Federal Reserve , monetary policy 9 Comments
Tags: David Rucker

I wasn’t planning to post today, but I just saw (courtesy of the New York Times) a classic example of the economic prejudice wrapped in high-minded sloganeering that I talked about yesterday. David Rocker, founder and former managing general partner of the hedge fund Rocker Partners, proclaims that he is in favor of a free market.

The worldwide turbulence of recent days is a strong indication that government intervention alone cannot restore the economy and offers a glimpse of the risk of completely depending on it. It is time to give the free market a chance. Since the crash of 2008, governments have tried to stimulate their economies by a variety of means but have relied heavily on manipulating interest rates lower through one form or other of quantitative easing or simply printing money. The immediate rescue of the collapsing economy was necessary at the time, but the manipulation has now gone on for nearly seven years and has produced many unwanted consequences.

In what sense is the market less free than it was before the crash of 2008? It’s not as if the Fed before 2008 wasn’t doing the sorts of things that are so upsetting to Mr. Rucker now. The Fed was setting an interest rate target for short-term rates and it was conducting open market purchases (printing money) to ensure that its target was achieved. There are to be sure some people, like, say, Ron Paul, that regard such action by the Fed as an intolerable example of government intervention in the market, but it’s not something that, as Mr. Rucker suggests, the Fed just started to do after 2008. And at a deeper level, there is a very basic difference between the Fed targeting an interest rate by engaging in open-market operations (repeat open-market operations) and imposing price controls that prevent transactors from engaging in transactions on mutually agreeable terms. Aside from libertarian ideologues, most people are capable of understanding the difference between monetary policy and government interference with the free market.

So what really bothers Mr. Rucker is not that the absence of a free market, but that he disagrees with the policy that the Fed is implementing. He has every right to disagree with the policy, but it is misleading to suggest that he is the one defending the free market against the Fed’s intervention into an otherwise free market.

When Mr. Rucker tries to explain what’s wrong with the Fed’s policy, his explanations continue to reflect prejudices expressed in high-minded sloganeering. First he plays the income inequality card.

The Federal Reserve, waiting for signs of inflation to change its policies, seems to be looking at the wrong data. . . .

Low interest rates have hugely lifted assets largely owned by the very rich, and inflation in these areas is clearly apparent. Stocks have tripled and real estate prices in the major cities where the wealthy live have been soaring, as have the prices of artwork and the conspicuous consumption of luxury goods.

Now it may be true that certain assets like real estate in Manhattan and San Francisco, works of art, and yachts have been rising rapidly in price, but there is no meaningful price index in which these assets account for a large enough share of purchases to generate a significant inflation. So this claim by Mr. Rucker is just an empty rhetorical gesture to show how good-hearted he is and how callous and unfeeling Janet Yellen and her ilk are. He goes on.

Cheap financing has led to a boom in speculative activity, and mergers and acquisitions. Most acquisitions are justified by “efficiencies” which is usually a euphemism for layoffs. Valeant Pharmaceuticals International, one of the nation’s most active acquirers, routinely fires “redundant” workers after each acquisition to enhance reported earnings. This elevates its stock, with which it makes the next acquisition. With money cheap, corporate executives have used cash flow to buy back stock, enhancing the value of their options, instead of investing for the future. This pattern, and the fear it engenders, has added to downward pressure on employment and wages.

Actually, according to data reported by the Institute for Mergers and Acquisitions and Alliances displayed in the accompanying chart, the level of mergers and acquisitions since 2008 has been consistently below what it was in the late 1990s when interest rates were over 5 percent and in 2007 when interest rates were also above 5 percent.

And if corporate executives are using cash flow to buy back stock to enhance the value of their stock options instead of making profitable investments that would enhance share-holder value, there is a serious problem in how corporate executives are discharging their responsibilities to shareholders. Violations of management responsibility to their shareholders should be disciplined and the legal environment that allows executives to disregard shareholder interests should be reformed. To blame the bad behavior of corporate executives on the Fed is a total distraction.

Having just attributed a supposed boom in speculative activity and mergers and acquisitions to the Fed’s low-interest rate policy, Mr. Rucker, without batting an eye, flatly denies that an increase in interest rates would have any negative effect on investment.

The Fed should raise rates in September. The focus on a quarter-point change in short rates and its precise date of imposition is foolishness. Expected rates of return on new investments are typically well above 10 percent. No sensible businessman would defer a sound investment because short-term rates are slightly higher for a few months. They either have a sound investment or they don’t.

Let me repeat that. “Expected rates of return on new investment are typically well above 10 percent.” I wonder what Mr. Rucker thinks the expected rate of return on speculative activity and mergers and acquisitions is.

But, almost despite himself, Mr. Rucker is on to something. Some long-term investment surely is sensitive to the rate of interest, but – and I know that this will come as a rude shock to adherents of Austrian Business Cycle Theory – most investment by business in plant and equipment depends on expected future sales, not the rate of interest. So the way to increase investment is really not by manipulating the rate of interest; the way to increase investment is to increase aggregate demand, and the best way to do that would be to increase inflation and expected inflation (aka nominal GDP and expected nominal GDP).

The Pot Calls the Kettle Black

Published July 17, 2015 Federal Reserve , inflation , Ludwig von Mises , Money Illusion , Say's Law , Uncategorized 7 Comments
Tags: Janet Yellen

I had not planned to post anything today, but after coming across an article (“What the Fed Really Wants Is to Reduce Real Wages”) by Alex Pollock of AEI on Real Clear Markets this morning, I decided that I could not pass up this opportunity to expose a) a basic, but common and well-entrenched, error in macroeconomic reasoning, and b) the disturbingly hypocritical and deceptive argument in the service of which the faulty reasoning was deployed.

I start by quoting from Pollock’s article.

To achieve economic growth over time, prices have to change in order to adjust resource allocation to changing circumstances. This includes the price of work, or wages. Everybody does or should know this, and the Federal Reserve definitely knows it.

The classic argument for why central banks should create inflation as needed is that this causes real wages to fall, thus allowing the necessary downward adjustment, even while nominal wages don’t fall. Specifically, the argument goes like this: For employment and growth, wages sometimes have to adjust downward; people and politicians don’t like to have nominal wages fall– they are “sticky.” People are subject to Money Illusion and they don’t think in inflation-adjusted terms. Therefore create inflation to make real wages fall.

In an instructive meeting of the Federal Reserve Open Market Committee in July, 1996, the transcript of which has been released, the Fed took up the issue of “long-term inflation goals.” Promoting the cause of what ultimately became the Fed’s goal of 2% inflation forever, then-Fed Governor Janet Yellen made exactly the classic argument. “To my mind,” she said, “the most important argument for some low inflation rate is…that a little inflation lowers unemployment by facilitating adjustments in relative pay”-in other words, by lowering real wages. This reflects “a world where individuals deeply dislike nominal pay cuts,” she continued. “I think we are dealing here with a very deep-rooted property of the human psyche”-that is, Money Illusion.

In sum, since “workers resist and firms are unwilling to impose nominal pay cuts,” the Fed has to be able to reduce real wages instead by inflation.

But somehow the Fed never mentions that this is what it does. It apparently considers it a secret too deep for voters and members of Congress to understand. Perhaps it would be bad PR?

This summary of why some low rate of inflation may promote labor-0market flexibility is not far from the truth, but it does require some disambiguation. The first distinction to make is that while Janet Yellen was talking about adjustments in relative pay, presumably adjustments in wages both across different occupations and also across different geographic areas — a necessity even if the overall level of real wages is stable — Pollock simply talks about reducing real wages in general.

But there is a second, more subtle distinction to make here as well, and that distinction makes a big difference in how we understand what the Fed is trying to do. Suppose a reduction in real wages in general, or in the relative wages of some workers is necessary for labor-market equilibrium. To suggest that only reason to use inflation to reduce the need for nominal wage cuts is a belief in “Money Illusion” is deeply misleading. The concept of “Money Illusion” is only meaningful when applied to equilibrium states of the economy. Thus the absence of “Money Illusion” means that the equilibrium of the economy (under the assumption that the economy has a unique equilibrium — itself, a very questionable assumption, but let’s not get diverted from this discussion to an even messier and more complicated one) is the same regardless of how nominal prices are scaled up or down. It is entirely possible to accept that proposition (which seems to follow from fairly basic rationality assumptions) without also accepting that it is irrelevant whether real-wage reductions in response to changing circumstances are brought about by inflation or by nominal-wage cuts.

Since any discussion of changes in relative wages presumes that a transition from one equilibrium state to another equilibrium state is occurring, the absence of Money Illusion, being a property of equilibrium, can’t tell us anything about whether the transition from one equilibrium state to another is more easily accomplished by way of nominal-wage cuts or by way of inflation. If, as a wide range of historical evidence suggests, real-wage reductions are more easily effected by way of inflation than by way of nominal-wage cuts, it is plausible to assume that minimizing nominal-wage cuts will ease the transition from the previous equilibrium to the new one.

Why is that? Here’s one way to think about it. The resistance to nominal-wage cuts implies that more workers will be unemployed initially if nominal wages are cut than if there is an inflationary strategy. It’s true that the unemployment is transitory (in some sense), but the transitory unemployment will be with reduced demand for other products, so the effect of unemployment of some workers is felt by other sectors adn other workers. This implication is not simply the multiplier effect of Keynesian economics, it is also a direct implication of the widely misunderstood Say’s Law, which says that supply creates its own demand. So if workers are more likely to become unemployed in the transition to an equilibrium with reduced real wages if the real-wage reduction is accomplished via a cut in nominal wages than if accomplished by inflation, then inflation reduces the reduction in demand associated with resistance to nominal-wage cuts. The point is simply that we have to consider not just the final destination, but also the route by which we get there. Sometimes the route to a destination may be so difficult and so dangerous, that we are better off not taking it and looking for an alternate route. Nominal wage cuts are very often a bad route by which to get to a new equilibrium.

That takes care of the error in macroeconomic reasoning, but let’s follow Pollock a bit further to get to the hypocrisy and deception.

This classic argument for inflation is of course a very old one. As Ludwig von Mises discussed clearly in 1949, the first reason for “the engineering of inflation” is: “To preserve the height of nominal wage rates…while real wage rates should rather sink.” But, he added pointedly, “neither the governments nor the literary champions of their policy were frank enough to admit openly that one of the main purposes of devaluation was a reduction in the height of real wage rates.” The current Fed is not frank enough to admit this fact either. Indeed, said von Mises, “they were anxious not to mention” this. So is the current Fed.

Nonetheless, the Fed feels it can pontificate on “inequality” and how real middle class incomes are not rising. Sure enough, with nominal wages going up 2% a year, if the Fed achieves its wish for 2% inflation, then indeed real wages will be flat. But Federal Reserve discussions of why they are flat at the very least can be described as disingenuous.

Actually, it is Pollock who is being disingenuous here. The Fed does not have a policy on real wages. Real wages are determined for the most part in free and competitive labor markets. In free and competitive labor markets, the equilibrium real wage is determined independently of the rate of inflation. Remember, there’s no Money Illusion. Minimizing nominal-wage cuts is not a policy aimed at altering equilibrium real wages, which are whatever market forces dictate, but of minimizing the costs associated with the adjustments in real wages in response to changing economic conditions.

I know that it’s always fun to quote Ludwig von Mises on inflation, but if you are going to quote Mises about how inflation is just a scheme designed to reduce real wages, you ought to at least be frank enough to acknowledge that what Mises was advocating was cutting nominal wages instead.

And it is worth recalling that even Mises recognized that nominal wages could not be reduced without limit to achieve equilibrium. In fact, Mises agreed with Keynes that it was a mistake for England in 1925 to restore sterling convertibility into gold at the prewar parity, because doing so required further painful deflation and nominal wage cuts. In other words, even Mises could understand that the path toward equilibrium mattered. Did that mean that Mises was guilty of believing in Money Illusion? Obviously not. And if the rate of deflation can matter to employment in the transition from one equilibrium to another, as Mises obviously conceded, why is it inconceivable that the rate of inflation might also matter?

So Pollock is trying to have his cake and eat it. He condemns the Fed for using inflation as a tool by which to reduce real wages. Actually, that is not what the Fed is doing, but, let us suppose that that’s what the Fed is doing, what alternative does Pollock have in mind? He won’t say. In other words, he’s the pot.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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