Archive for the 'inflation' Category

Just How Infamous Was that Infamous Open Letter to Bernanke?

There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 

Explaining Post-Traumatic-Inflation Stress Disorder

Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Never Reason from a Disequilibrium

One of Scott Sumner’s many contributions as a blogger has been to show over and over and over again how easy it is to lapse into fallacious economic reasoning by positing a price change and then trying to draw inferences about the results of the price change. The problem is that a price change doesn’t just happen; it is the result of some other change. There being two basic categories of changes (demand and supply) that can affect price, there are always at least two possible causes for a given price change. So, until you have specified the antecedent change responsible for the price change under consideration, you can’t work out the consequences of the price change.

In this post, I want to extend Scott’s insight in a slightly different direction, and explain how every economic analysis has to begin with a statement about the initial conditions from which the analysis starts. In particular, you need to be clear about the equilibrium position corresponding to the initial conditions from which you are starting. If you posit some change in the system, but your starting point isn’t an equilibrium, you have no way of separating out the adjustment to the change that you are imposing on the system from the change the system would be undergoing simply to reach the equilibrium toward which it is already moving, or, even worse, from the change the system would be undergoing if its movement is not toward equilibrium.

Every theoretical analysis in economics properly imposes a ceteris paribus condition. Unfortunately, the ubiquitous ceteris paribus condition comes dangerously close to rendering economic theory irrefutable, except perhaps in a statistical sense, because empirical refutations of the theory can always be attributed to changes, abstracted from only in the theory, but not in the real world of our experience. An empirical model with a sufficient number of data points may be able to control for the changes in conditions that the theory holds constant, but the underlying theory is a comparison of equilibrium states (comparative statics), and it is quite a stretch to assume that the effects of perpetual disequilibrium can be treated as nothing but white noise. Austrians are right to be skeptical of econometric analysis; so was Keynes, for that matter. But skepticism need not imply nihilism.

Let me try to illustrate this principle by applying it to the Keynesian analysis of involuntary unemployment. In the General Theory Keynes argued that if adequate demand is deficient, the likely result is an equilibrium with involuntary unemployment. The “classical” argument that Keynes disputed was that, in principle at least, involuntary unemployment could not persist, because unemployed workers, if only they would accept reduced money wages, would eventually find employment. Keynes denied that involuntary unemployment could not persist, arguing that if workers did accept reduced money wages, the wage reductions would not get translated into reduced real wages. Instead, falling nominal wages would induce employers to cut prices by roughly the same percentage as the reduction in nominal wages, leaving real wages more or less unchanged, thereby nullifying the effectiveness of nominal-wage cuts, and, instead, fueling a vicious downward spiral of prices and wages.

In making this argument, Keynes didn’t dispute the neoclassical proposition that, with a given capital stock, the marginal product of labor declines as employment increases, implying that real wages have to fall for employment to be increased. His argument was about the nature of the labor-supply curve, labor supply, in Keynes’s view, being a function of both the real and the nominal wage, not, as in the neoclassical theory, only the real wage. Under Keynes’s “neoclassical” analysis, the problem with nominal-wage cuts is that they don’t do the job, because they lead to corresponding price cuts. The only way to reduce unemployment, Keynes insisted, is to raise the price level. With nominal wages constant, an increased price level would achieve the real-wage cut necessary for employment to be increased. And this is precisely how Keynes defined involuntary unemployment: the willingness of workers to increase the amount of labor actually supplied in response to a price level increase that reduces their real wage.

Interestingly, in trying to explain why nominal-wage cuts would fail to increase employment, Keynes suggested that the redistribution of income from workers to entrepreneurs associated with reduced nominal wages would tend to reduce consumption, thereby reducing, not increasing, employment. But if that is so, how is it that a reduced real wage, achieved via inflation, would increase employment? Why would the distributional effect of a reduced nominal, but unchanged real, wage be more adverse to employment han a reduced real wage, achieved, with a fixed nominal wage, by way of a price-level increase?

Keynes’s explanation for all this is confused. In chapter 19, where he makes the argument that money-wage cuts can’t eliminate involuntary unemployment, he presents a variety of reasons why nominal-wage cuts are ineffective, and it is usually not clear at what level of theoretical abstraction he is operating, and whether he is arguing that nominal-wage cuts would not work even in principle, or that, although nominal-wage cuts might succeed in theory, they would inevitably fail in practice. Even more puzzling, It is not clear whether he thinks that real wages have to fall to achieve full employment or that full employment could be restored by an increase in aggregate demand with no reduction in real wages. In particular, because Keynes doesn’t start his analysis from a full-employment equilibrium, and doesn’t specify the shock that moves the economy off its equilibrium position, we can only guess whether Keynes is talking about a shock that had reduced labor productivity or (more likely) a shock to entrepreneurial expectations (animal spirits) that has no direct effect on labor productivity.

There was a rhetorical payoff for Keynes in maintaining that ambiguity, because he wanted to present a “general theory” in which full employment is a special case. Keynes therefore emphasized that the labor market is not self-equilibrating by way of nominal-wage adjustments. That was a perfectly fine and useful insight: when the entire system is out of kilter; there is no guarantee that just letting the free market set prices will bring everything back into place. The theory of price adjustment is fundamentally a partial-equilibrium theory that isolates the disequiibrium of a single market, with all other markets in (approximate) equilibrium. There is no necessary connection between the adjustment process in a partial-equilibrium setting and the adjustment process in a full-equilibrium setting. The stability of a single market in disequilibrium does not imply the stability of the entire system of markets in disequilibrium. Keynes might have presented his “general theory” as a theory of disequilibrium, but he preferred (perhaps because he had no other tools to work with) to spell out his theory in terms of familiar equilibrium concepts: savings equaling investment and income equaling expenditure, leaving it ambiguous whether the failure to reach a full-employment equilibrium is caused by a real wage that is too high or an interest rate that is too high. Axel Leijonhufvud highlights the distinction between a disequilibrium in the real wage and a disequilibrium in the interest rate in an important essay “The Wicksell Connection” included in his book Information and Coordination.

Because Keynes did not commit himself on whether a reduction in the real wage is necessary for equilibrium to be restored, it is hard to assess his argument about whether, by accepting reduced money wages, workers could in fact reduce their real wages sufficiently to bring about full employment. Keynes’s argument that money-wage cuts accepted by workers would be undone by corresponding price cuts reflecting reduced production costs is hardly compelling. If the current level of money wages is too high for firms to produce profitably, it is not obvious why the reduced money wages paid by entrepreneurs would be entirely dissipated by price reductions, with none of the cost decline being reflected in increased profit margins. If wage cuts do increase profit margins, that would encourage entrepreneurs to increase output, potentially triggering an expansionary multiplier process. In other words, if the source of disequilibrium is that the real wage is too high, the real wage depending on both the nominal wage and price level, what is the basis for concluding that a reduction in the nominal wage would cause a change in the price level sufficient to keep the real wage at a disequilibrium level? Is it not more likely that the price level would fall no more than required to bring the real wage back to the equilibrium level consistent with full employment? The question is not meant as an expression of policy preference; it is a question about the logic of Keynes’s analysis.

Interestingly, present-day opponents of monetary stimulus (for whom “Keynesian” is a term of extreme derision) like to make a sort of Keynesian argument. Monetary stimulus, by raising the price level, reduces the real wage. That means that monetary stimulus is bad, as it is harmful to workers, whose interests, we all know, is the highest priority – except perhaps the interests of rentiers living off the interest generated by their bond portfolios — of many opponents of monetary stimulus. Once again, the logic is less than compelling. Keynes believed that an increase in the price level could reduce the real wage, a reduction that, at least potentially, might be necessary for the restoration of full employment.

But here is my question: why would an increase in the price level reduce the real wage rather than raise money wages along with the price level. To answer that question, you need to have some idea of whether the current level of real wages is above or below the equilibrium level. If unemployment is high, there is at least some reason to think that the equilibrium real wage is less than the current level, which is why an increase in the price level would be expected to cause the real wage to fall, i.e., to move the actual real wage in the direction of equilibrium. But if the current real wage is about equal to, or even below, the equilibrium level, then why would one think that an increase in the price level would not also cause money wages to rise correspondingly? It seems more plausible that, in the absence of a good reason to think otherwise, that inflation would cause real wages to fall only if real wages are above their equilibrium level.

On a Difficult Passage in the General Theory

Keynes’s General Theory is not, in my estimation, an easy read. The terminology is often unfamiliar, and, so even after learning one of his definitions, I have trouble remembering what the term means the next time it’s used.. And his prose style, though powerful and very impressive, is not always clear, so you can spend a long time reading and rereading a sentence or a paragraph before you can figure out exactly what he is trying to say. I am not trying to be critical, just to point out that the General Theory is a very challenging book to read, which is one, but not the only, reason why it is subject to a lot of conflicting interpretations. And, as Harry Johnson once pointed out, there is an optimum level of difficulty for a book with revolutionary aspirations. If it’s too simple, it won’t be taken seriously. And if it’s too hard, no one will understand it. Optimally, a revolutionary book should be hard enough so that younger readers will be able to figure it out, and too difficult for the older guys to understand or to make the investment in effort to understand.

In this post, which is, in a certain sense, a follow-up to an earlier post about what, or who, determines the real rate of interest, I want to consider an especially perplexing passage in the General Theory about the Fisher equation. It is perplexing taken in isolation, and it is even more perplexing when compared to other passages in both the General Theory itself and in Keynes’s other writings. Here’s the passage that I am interested in.

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

The statement is problematic on just about every level, and one hardly knows where to begin in discussing it. But just for starters, it is amazing that Keynes seems (or, for rhetorical purposes, pretends) to be in doubt whether Fisher is talking about anticipated or unanticipated inflation, because Fisher himself explicitly distinguished between anticipated and unanticipated inflation, and Keynes could hardly have been unaware that Fisher was explicitly speaking about anticipated inflation. So the implication that the Fisher equation involves some confusion on Fisher’s part between anticipated and unanticipated inflation was both unwarranted and unseemly.

What’s even more puzzling is that in his Tract on Monetary Reform, Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates, which is simply an extension of Fisher’s uncovered interest arbitrage condition (alluded to by Keynes in referring to “Appreciation and Interest”). So when Keynes found Fisher’s distinction between the nominal and real rates of interest to be incoherent, did he really mean to exempt his own covered interest arbitrage condition from the charge?

But it gets worse, because if we flip some pages from chapter 11, where the above quotation is found, to chapter 17, we see on page 224, the following passage in which Keynes extends the idea of a commodity or “own rate of interest” to different currencies.

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys. . . .

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a percent per annum in terms of money; the marginal efficiency of an asset, which is x percent in terms of money, will then be x – a percent in terms of wheat. Since the marginal efficiencies of all capital assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

So Keynes in chapter 17 explicitly allows for the nominal rate of interest to be adjusted to reflect changes in the expected value of the asset (whether a money or a commodity) in terms of which the interest rate is being calculated. Mr. Keynes, please meet Mr. Keynes.

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen. But any change in inflation expectations, by definition, cannot have been foreseen, because to say that an expectation has changed means that the expectation is different from what it was before. Perhaps that is why Keynes tied himself into knots trying to figure out whether Fisher was talking about a change in the value of money that was foreseen or not foreseen. In any equilibrium, the change in the value of money is foreseen, but in the transition from one equilibrium to another, the change is not foreseen. When an unforeseen change occurs in expected inflation, leading to a once-and-for-all change in the value of money relative to other assets, the new equilibrium will be reestablished given the new value of money relative to other assets.

But I think that something else is also going on here, which is that Keynes was implicitly assuming that a change in inflation expectations would alter the real rate of interest. This is a point that Keynes makes in the paragraph following the one I quoted above.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relativevly to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Keynes comes back to this point at the end of chapter 17, making it more forcefully than he did the first time.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

So what Keynes is saying, I think, is this. Consider an economy with a given fixed marginal efficiency of capital (MEC) schedule. There is some interest rate that will induce sufficient investment expenditure to generate enough spending to generate full employment. That interest rate Keynes calls the “neutral” rate of interest. If the nominal rate of interest is more than the neutral rate, the amount of investment will be less than the amount necessary to generate full employment. In such a situation an expectation that the price level will rise will shift up the MEC schedule by the amount of the expected increase in inflation, thereby generating additional investment spending. However, because the MEC schedule is downward-sloping, the upward shift in the MEC schedule that induces increased investment spending will correspond to an increase in the rate of interest that is less than the increase in expected inflation, the upward shift in the MEC schedule being partially offset by the downward movement along the MEC schedule. In other words, the increase in expected inflation raises the nominal rate of interest by less than increase in expected inflation by inducing additional investment that is undertaken only because the real rate of interest has fallen.

However, for an economy already operating at full employment, an increase in expected inflation would not increase employment, so whether there was any effect on the real rate of interest would depend on the extent to which there was a shift from holding money to holding real capital assets in order to avoid the inflation tax.

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Bhide and Phelps v. Reality

I don’t know who Amar Bhide (apologies for not being able to insert an accent over the “e” in his last name) is, but Edmund Phelps is certainly an eminent economist and a deserving recipient of the 2006 Nobel Prize in economics. Unfortunately, Professor Phelps attached his name to an op-ed in Wednesday’s Wall Street Journal, co-authored with Bhide, consisting of little more than a sustained, but disjointed, rant about the Fed and central banking. I am only going to discuss that first part of the op-ed that touches on the monetary theory of increasing the money supply through open-market operations, and about the effect of that increase on inflation and inflation expectations. Bhide and Phelps not only get the theory wrong, they seem amazingly oblivious to well-known facts that flatly contradict their assertions about monetary policy since 2008. Let’s join them in their second paragraph.

Monetary policy might focus on the manageable task of keeping expectations of inflation on an even keel—an idea of Mr. Phelps’s [yes that same Mr. Phelps whose name appears as a co-author] in 1967 that was long influential. That would leave businesses and other players to determine the pace of recovery from a recession or of pullback from a boom.

Nevertheless, in late 2008 the Fed began its policy of “quantitative easing”—repeated purchases of billions in Treasury debt—aimed at speeding recovery. “QE2″ followed in late 2010 and “QE3″ in autumn 2012.

One can’t help wondering what planet Bhide and Phelps have been dwelling on these past four years. To begin with, the first QE program was not instituted until March 2009 after the target Fed funds rate had been reduced to 0.25% in December 2008. Despite a nearly zero Fed funds rate, asset prices, which had seemed to stabilize after the September through November crash, began falling sharply again in February, the S&P 500 dropping from 869.89 on February 9 to 676.53 on March 9, a decline of more than 20%, with inflation expectations as approximated, by the TIPS spread, again falling sharply as they had the previous summer and fall.

Apart from their confused chronology, their suggestion that the Fed’s various quantitative easings have somehow increased inflation and inflation expectations is absurd. Since 2009, inflation has averaged less than 2% a year – one of the longest periods of low inflation in the entire post-war era. Nor has quantitative easing increased inflation expectations. The TIPS spread and other measures of inflation expectations clearly show that inflation expectations have fluctuated within a narrow range since 2008, but have generally declined overall.

The graph below shows the estimates of the Cleveland Federal Reserve Bank of 10-year inflation expectations since 1982. The chart shows that the latest estimate of expected inflation, 1.65%, is only slightly above its the low point, reached in March, over the past 30 years. Thus expected inflation is now below the 2% target rate that the Fed has set. And to my knowledge Professor Phelps has never advocated targeting an annual inflation rate less than 2%. So I am unable to understand what he is complaining about.

cfimg8685191149364015372

Bhide and Phelps continue:

Fed Chairman Ben Bernanke said in November 2010 that this unprecedented program of sustained monetary easing would lead to “higher stock prices” that “will boost consumer wealth and help increase confidence, which can also spur spending.”

It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)

There are three really serious problems with this passage. First, and most obvious to just about anyone who has not been asleep for the last four years, central-bank purchases have not put the price level on a higher path than it was on before 2008; the rate of inflation has clearly fallen since 2008. Or would Bhide and Phelps have preferred to allow the deflation that briefly took hold in the fall of 2008 to have continued? I don’t think so. But if they aren’t advocating deflation, what exactly is their preferred price level path? Between zero and 1.5% perhaps? Is their complaint that the Fed has allowed inflation to be a half a point too high for the last four years? Good grief.

Second, Bhide and Phelps completely miss the point of the Metzler paper (“Wealth, Saving and the Rate of Interest”), one of the classics of mid-twentieth-century macroeconomics. (And I would just mention as an aside that while Metzler was indeed at the University of Chicago, he was the token Keynesian in the Chicago economics department in 1940s and early 1950s, until his active career was cut short by a brain tumor, which he survived, but with some impairment of his extraordinary intellectual gifts. Metzler’s illness therefore led the department to hire an up-and-coming young Keynesian who had greatly impressed Milton Friedman when he spent a year at Cambridge; his name was Harry Johnson. Unfortunately Friedman and Johnson did not live happily ever after at Chicago.) The point of the Metzler paper was to demonstrate that monetary policy, conducted via open-market operations, could in fact alter the real interest rate. Money, on Metzler’s analysis, is not neutral even in the long run. The conclusion was reached via a comparative-statics exercise, a comparison of two full-employment equilibria — one before and one after the central bank had increased the quantity of money by making open-market purchases.

The motivation for the exercise was that some critics of Keynes, arguing that deflation, at least in principle, could serve as a cure for involuntary unemployment — an idea that Keynes claimed to have refuted — had asserted that, because consumption spending depends not only on income, but on total wealth, deflation, by increasing the real value of the outstanding money stock, would actually make households richer, which would eventually cause households to increase consumption spending enough to restore full employment. Metzler argued that if consumption does indeed depend on total wealth, then, although the classical proposition that deflation could restore full employment would be vindicated, another classical proposition — the invariance of the real rate of interest with respect to the quantity of money — would be violated. So Metzler’s analysis — a comparison of two full-employment equilbria, the first with a lower quantity of money and a higher real interest rate and the second with a higher quantity of money and lower real interest rate – has zero relevance to the post-2008 period, in which the US economy was nowhere near full-employment equilibrium.

Finally, Bhide and Phelps, mischaracterize Metzler’s analysis. Metzler’s analysis depends critically on the proposition that the reduced real interest rate caused by monetary expansion implies an increase in household wealth, thereby leading to increased consumption. It is precisely the attempt to increase consumption that, in Metzler’s analysis, entails an inflationary gap that causes the price level to rise. But even after the increase in the price level, the real value of household assets, contrary to what Bhide and Phelps assert, remains greater than before the monetary expansion, because of a reduced real interest rate. A reduced real interest rate implies an increased real value of the securities retained by households.

Under Metzler’s analysis, therefore, if the starting point is a condition of less than full employment, increasing the quantity of money via open-market operations would tend to increase not only household wealth, but would also increase output and employment relative to the initial condition. So it is also clear that, on Metzler’s analysis, apparently regarded by Bhide and Phelps as authoritative, the problem with Fed policy since 2008 is not that it produced too much inflation, as Bhide and Phelps suggest, but that it produced too little.

If it seems odd that Bhide and Phelps could so totally misread the classic paper whose authority they invoke, just remember this: in the Alice-in-Wonderland world of the Wall Street Journal editorial page, things aren’t always what they seem.

HT: ChargerCarl

What’s a Central Banker To Do?

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.

What Gives? Has the Market Stopped Loving Inflation?

One of my few, and not very compelling, claims to fame is a (still unpublished) paper (“The Fisher Effect Under Deflationary Expectations“) that I wrote in late 2010 in which I used the Fisher Equation relating the real and nominal rates of interest via the expected rate of inflation to explain what happens in a financial panic. I pointed out that the usual understanding that the nominal rate of interest and the expected rate of inflation move in the same direction, and possibly even by the same amount, cannot be valid when the expected rate of inflation is negative and the real rate is less than expected deflation. In those perilous conditions, the normal equilibrating process, by which the nominal rate adjusts to reflect changes in inflation expectations, becomes inoperative, because the nominal rate gets stuck at zero. In that unstable environment, the only avenue for adjustment is in the market for assets. In particular, when the expected yield from holding money (the expected rate of deflation) approaches or exceeds the expected yield on real capital, asset prices crash as asset owners all try to sell at the same time, the crash continuing until the expected yield on holding assets is no longer less than the expected yield from holding money. Of course, even that adjustment mechanism will restore an equilibrium only if the economy does not collapse entirely before a new equilibrium of asset prices and expected yields can be attained, a contingency not necessarily as unlikely as one might hope.

I therefore hypothesized that while there is not much reason, in a well-behaved economy, for asset prices to be very sensitive to changes in expected inflation, when expected inflation approaches, or exceeds, the expected return on capital assets (the real rate of interest), changes in expected inflation are likely to have large effects on asset values. This possibility that the relationship between expected inflation and asset prices could differ depending on the prevalent macroeconomic environment suggested an empirical study of the relationship between expected inflation (as approximated by the TIPS spread on 10-year Treasuries) and the S&P 500 stock index. My results were fairly remarkable, showing that, since early 2008 (just after the start of the downturn in late 2007), there was a consistently strong positive correlation between expected inflation and the S&P 500. However, from 2003 to 2008, no statistically significant correlation between expected inflation and asset prices showed up in the data.

Ever since then, I have used this study (and subsequent informal follow-ups that have consistently generated similar results) as the basis for my oft-repeated claim that the stock market loves inflation. But now, guess what? The correlation between inflation expectations and the S&P 500 has recently vanished. The first of the two attached charts plots both expected inflation, as measured by the 10-year TIPS spread, and the S&P 500 (normalized to 1 on March 2, 2009). It is obvious that two series are highly correlated. However, you can see that over the last few months it looks as if the correlation has been reversed, with inflation expectations falling even as the S&P 500 has been regularly reaching new all-time highs.

TIPS_S&P500_new

Here is a second chart that provides a closer look at the behavior of the S&P 500 and the TIPS spread since the beginning of March.

TIPS_S&P500_new_2

So what’s going on? I wish I knew. But here is one possibility. Maybe the economy is finally emerging from its malaise, and, after four years of an almost imperceptible recovery, perhaps the overall economic outlook has improved enough so that, even if we haven’t yet returned to normalcy, we are at least within shouting distance of it. If so, maybe asset prices are no longer as sensitive to inflation expectations as they were from 2008 to 2012. But then the natural question becomes: what caused the economy to reach a kind of tipping point into normalcy in March? I just don’t know.

And if we really are back to normal, then why is the real rate implied by the TIPS negative? True, the TIPS yield is not really the real rate in the Fisher equation, but a negative yield on a 10-year TIPS does not strike me as characteristic of a normal state of affairs. Nevertheless, the real yield on the 10-year TIPS has risen by about 50 basis points since March and by 75 basis points since December, so something noteworthy seems to have happened. And a fairly sharp rise in real rates suggests that recent increases in stock prices have been associated with expectations of increasing real cash flows and a strengthening economy. Increasing optimism about real economic growth, given that there has been no real change in monetary policy since last September when QE3 was announced, may themselves have contributed to declining inflation expectations.

What does this mean for policy? The empirical correlation between inflation expectations and asset prices is subject to an identification problem. Just because recent developments may have caused the observed correlation between inflation expectations and stock prices to disappear, one can’t conclude that, in the “true” structural model, the effect of a monetary policy that raised inflation expectations would not be to raise asset prices. The current semi-normal is not necessarily a true normal.

So my cautionary message is: Don’t use the recent disappearance of the correlation between inflation expectations and asset prices to conclude that it’s safe to abandon QE.


About Me

David Glasner
Washington, DC

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

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