Archive for the 'Keynes' Category

Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

Imagination and Identity

Before continuing my summary of the key points of Richard Lipsey’s important paper, “The Foundations of the Theory of National Income,” I want to clear up a point that the deliberately provocative title may have obscured. The accounting identities that I am singling out for criticism are the identities between income and expenditure (and output) and between savings and investment. It is true that, as Scott Sumner points out in a comment on my previous post, every theory has to define its terms in some way or another, so there is no point in asserting that a definition is wrong. Scott believes that I am a saying that it is wrong to define investment and savings as the same thing, but I am not saying that. I am saying that, in the context of the basic income-expenditure theory of national income, it makes the theory incoherent, so that there is a mismatch between the definition and the theory.

It is also true that sometimes identities follow directly from basic definitions. Such identities are like conservation laws in physics. For example, purchases must equal sales, because purchasing and selling are reciprocal activities; to assert that purchases are, or could be, unequal to sales would be self-contradictory. Keynes, when ridiculed by Hawtrey for asserting that a) savings and investment are equal by definition, and b) that the equality of savings and investment is achieved by variations in income, responded by comparing the equality of savings and investment to the equality of purchases and sales. Purchases are necessarily equal to sales, but prices adjust to achieve equality between desired purchases and desired sales.

The problem with Keynes’s response to Hawtrey is that to assert that purchases are unequal to sales is to misconstrue in a really fundamental way the meaning of the terms “purchase” and “sales.” But when it comes to national-income accounting, the identity of “investment” and “savings” does not follow immediately from the meaning of those terms. It must be derived from the meaning of two other terms: income and expenditure. So the question becomes whether the act of spending (i.e., expenditure) necessarily entails an immediate and corresponding accrual of income, in the same way that the act of purchasing necessarily entails the act of selling. To assert that expenditure and income are identical is then to assert that any expenditure necessarily and simultaneously entails a corresponding accrual of income.

Before pursuing this line of thought further, let’s just pause for a moment to recall the context for this discussion. We are talking about a fairly primitive model of an economy in which there are households that are units of consumption and providers of factor services. Households purchase consumption goods and provide factor services to business firms. Business firms are units of production that combine factor services provided by households with raw materials purchased from other business firms, and new or existing capital goods produced now or previously by other business firms, to produce raw materials, consumption goods, and capital goods. Raw materials and capital goods are sold to other business firms and consumption goods are sold to households. Business firms are owned by households, so profits earned by business firms are remitted, along with payments for factor services, to households. But although the flow of payments from households to business firms corresponds to a flow of payments from business firms to households, the two flows, which can be measured separately, are, at not identical, or at least not obviously so. When I bought a tall Starbucks coffee just now at a Barnes & Noble cafe, my purchase of $1.98 was exactly and necessarily matched by a sale by Barnes & Noble to the guy who writes for the Uneasy Money blog. But expenditure of $1.98 by the Uneasy Money blogger to Barnes & Noble did not trigger an immediate and corresponding flow of $1.98 to households from Barnes & Noble.

Now I grant that it is possible for income so to be defined that every act of expenditure involves a corresponding accrual of income to providers of factor services to the firm, and of profit to owners of the firm. But expenditure entails simultaneous accrual of income only by virtue of an imputation of income to providers of factor services and of profit to owners of firms. Mere imputation does not and cannot constitute an actual flow of payments by firms to households. The identity between purchases and sales is entailed by the definition of “purchase” and “sales,’ but the supposed identity between expenditure and income is entailed by nothing but an act of imagination. I am not criticizing imagination, which may often provide us with an excellent grasp of reality. But imagination, no matter how well attuned to reality, does not and cannot establish identity.

CAUTION Accounting Identity Handle with Care

About three years ago, early in my blogging career, I wrote a series of blog posts (most or all aimed at Scott Sumner) criticizing him for an argument in a blog post about the inefficacy of fiscal stimulus that relied on the definitional equality of savings and investment. Here’s the statement I found objectionable.

Wren-Lewis seems to be . . . making a simple logical error (which is common among Keynesians.)  He equates “spending” with “consumption.”  But the part of income not “spent” is saved, which means it’s spent on investment projects.  Remember that S=I, indeed saving is defined as the resources put into investment projects.  So the tax on consumers will reduce their ability to save and invest.

I’m not going to quote any further from that discussion. If you’re interested here are links to the posts that I wrote (here, here, here, here, here, and this one in which I made an argument so obviously false that, in my embarrassment, I felt like giving up blogging, and this one in which I managed to undo, at least partially, the damage of the self-inflicted wound). But, probably out of exhaustion, that discussion came to an inconclusive end, and Scott and I went on with our lives with no hard feelings.

Well, in a recent post, Scott has again invoked the savings-equals-investment identity, so I am going to have to lodge another protest, even though I thought that, aside from his unfortunate reference to the savings-investment identity, his post made a lot of sense. So I am going to raise the issue one more time – we have had three years to get over our last discussion – hoping that I can now convince Scott to stop using accounting identities to make causal statements.

Scott begins by discussing the simplest version of the income-expenditure model (aka the Keynesian cross or 45-degree model), while treating it, as did Keynes, as if it were interchangeable with the national-accounting identities:

In the standard national income accounting, gross domestic income equals gross domestic output.  In the simplest model of all (with no government or trade) you have the following identity:

NGDI = C + S = C + I = NGDP  (it also applies to RGDI and RGDP)

Because these two variables are identical, any model that explains one will, ipso facto, explain the other.

There is a lot of ground to cover in these few lines. First of all, there are actually three relevant variables — income, output, and expenditure – not just two. Second aggregate income is not really the same thing as consumption and savings. Aggregate income is constituted by the aggregate earnings of all factors of production. However, an accounting identity assures us that all factor incomes accruing to factors of production, which are all ultimately owned by the households providing services to business firms, must be disposed of either by being spent on consumption or by being saved. Aggregate expenditure is different from aggregate income; expenditure is constituted not by the earnings of households, but by their spending on consumption and by the spending of businesses on investment, the purchase of durable equipment not physically embodied in output sold to households or other businesses. Aggregate expenditure is very close to but not identical with aggregate output. They can differ, because not all output is sold, some of it being retained within the firm as work in progress or as inventory. However, in an equilibrium situation in which variables were unchanging, aggregate income, expenditure and output would all be equal.

The equality of these three variables can be thought of as a condition of macroeconomic equilibrium. When a macroeconomic system is not in equilibrium, aggregate factor incomes are not equal to aggregate expenditure or to aggregate output. The inequality between factor incomes and expenditure induces further adjustments in spending and earnings ultimately leading to an equilibrium in which equality between those variables is restored.

So what Scott should have said is that because NGDI and NGDP are equal in equilibrium, any model that explains one will, ipso facto, explain the other, because the equality between the two is the condition for finding a solution to the model. It therefore follows that savings and investment are absolutely not the same thing. Savings is the portion of household earnings from providing factor services that is not spent on consumption. Investment is what business firms spend on plant and equipment. The two magnitudes are obviously not the same, and they do not have to be equal. However, equality between savings and investment is, like the equality between income and expenditure, a condition for macroeconomic equilibrium. In an economy not in equilibrium, savings does not equal investment. But the inequality between savings and investment induces adjustments that, in a stable macroeconomic system, move the economy toward equilibrium. Back to Scott:

Nonetheless, I think if we focus on NGDI we are more likely to be able to think clearly about macro issues.  Consider the recent comment left by Doug:

Regarding Investment, changes in private investment are the single biggest dynamic in the business cycle. While I may be 1/4 the size of C in terms of the contribution to spending, it is 6x more volatile. The economy doesn’t slip into recession because of a fluctuation in Consumption. Changes in Investment drive AD.

This is probably how most people look at things, but in my view it’s highly misleading. Monetary policy drives AD, and AD drives investment. This is easier to explain if we think in terms of NGDI, not NGDP.  Tight money reduces NGDI.  That means the sum of nominal consumption and nominal saving must fall, by the amount that NGDI declines.  What about real income?  If wages are sticky, then as NGDI declines, hours worked will fall, and real income will decline.

So far we have no reason to assume that C or S will fall at a different rate than NGDI. But if real income falls for temporary reasons (the business cycle), then the public will typically smooth consumption.  Thus if NGDP falls by 4%, consumption might fall by 2% while saving might fall by something like 10%.  This is a prediction of the permanent income hypothesis.  And of course if saving falls much more sharply than gross income, investment will also decline sharply, because savings is exactly equal to investment.

First, I observe that consumption smoothing and the permanent-income hypothesis are irrelevant to the discussion, because Scott does not explain where any of his hypothetical numbers come from or how they are related. Based on commenter Doug’s suggestion that savings is ¼ the size of consumption, one could surmise that a 4% reduction in NGDP and a 2% reduction in consumption imply a marginal propensity to consumer of 0.4. Suppose that consumption did not change at all (consumption smoothing to the max), then savings, bearing the entire burden of adjustment, would fall through the floor. What would that imply for the new equilibrium of NGDI? In the standard Keynesian model, a zero marginal propensity to consume would imply a smaller effect on NGDP from a given shock than you get with an MPC of 0.4.

It seems to me that Scott is simply positing numbers and performing calculations independently of any model, and then tells us that the numbers have to to be what he says they are because of an accounting identity. That does not seem like an assertion not an argument, or, maybe like reasoning from a price change. Scott is trying to make an inference about how the world operates from an accounting identity between two magnitudes. The problem is that the two magnitudes are variables in an economic model, and their values are determined by the interaction of all the variables in the model. Just because you can solve the model mathematically by using the equality of two variables as an equilibrium condition does not entitle you to posit a change in one and then conclude that the other must change by the same amount. You have to show how the numbers you have posited are derived from the model.

If two variables are really identical, rather than just being equal in equilibrium, then they are literally the same thing, and you can’t draw any inference about the real world from the fact that they are equal, there being no possible state of the world in which they are not equal. It is only because savings and investment are not the same thing, and because in some states of the world they are not equal, that we can make any empirical statement about what the world is like when savings and investment are equal. Back to Scott:

This is where Keynesian economics has caused endless confusion.  Keynesians don’t deny that (ex post) less saving leads to less investment, but they think this claim is misleading, because (they claim) an attempt by the public to save less will boost NGDP, and this will lead to more investment (and more realized saving.)  In their model when the public attempts to save less (ex ante), it may well end up saving more (ex post.)

I agree that Keynesian economics has caused a lot of confusion about savings and investment, largely because Keynes, who, as a philosopher and a mathematician, should have known better, tied himself into knots by insisting that savings and investment are identical, while at the same time saying that their equality was brought about, not by variations in the rate of interest, but by variations in income. Hawtrey, Robertson, and Haberler, among others, pointed out the confusion, but Keynes never seemed to grasp the point. Textbook treatments of national-income accounting and the simple Keynesian cross still don’t seem to have figured this out. But despite his disdain for Keynesian economics, Scott still has to figure it out, too. The best place to start is Richard Lipsey’s classic article “The Foundations of the Theory of National Income: An Analysis of Some Fundamental Errors” (a gated link is available here).

Scott begins by sayings that Keynesians don’t deny that (ex post) less saving leads to less investment. I don’t understand that assertion at all; Keynesians believe that a desired increase in savings, if desired savings exceeded investment, leads to a decrease in income that reduces saving. But the abortive attempt to increase savings has no effect on investment unless you posit an investment function (AKA an accelerator) that includes income as an independent variable. The accelerator was later added to the basic Keynesian model Hicks and others in order to generate cyclical fluctuations in income and employment, but non-Keynesians like Ralph Hawtrey had discussed the accelerator model long before Keynes wrote the General Theory. Scott then contradicts himself in the next sentence by saying that Keynesians believe that by attempting to save less, the public may wind up saving more. Again this result relies on the assumption of an accelerator-type investment function, which is a non-Keynesian assumption. In the basic Keynesian model investment is determined by entrepreneurial expectations. An increase (decrease) in thrift will be self-defeating, because in the new equilibrium income will have fallen (risen) sufficiently to reduce (increase) savings back to the fixed amount of investment entrepreneurs planned to undertake, entrepreneurial expectations being held fixed over the relevant time period.

I more or less agree with the rest of Scott’s post, but Scott seems to have the same knee-jerk negative reaction to Keynes and Keynesians that I have to Friedman and Friedmanians. Maybe it’s time for both of us to lighten up a bit. Anyway in honor of Scott’s recent appoint to the Ralph Hawtrey Chair of Monetary Policy at the Mercatus Center at George Mason University, I will just close with this quotation from Ralph Hawtrey’s review of the General Theory (chapter 7 of Hawtrey’s Capital and Employment) about Keynes’s treatment of savings and investment as identically equal.

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.

A Keynesian Postscript on the Bright and Shining, Dearly Beloved, Depression of 1920-21

In his latest blog post Paul Krugman drew my attention to Keynes’s essay The Great Slump of 1930. In describing the enormity of the 1930 slump, Keynes properly compared the severity of the 1930 slump with the 1920-21 episode, noting that the price decline in 1920-21 was of a similar magnitude to that of 1930. James Grant, in his book on the Greatest Depression, argues that the Greatest Depression was so outstanding, because, in contrast to the Great Depression, there was no attempt by the government in 1920-21 to cushion the blow. Instead, the powers that be just stood back and let the devil take the hindmost.

Keynes had a different take on the difference between the Greatest Depression and the Great Depression:

First of all, the extreme violence of the slump is to be noticed. In the three leading industrial countries of the world—the United States, Great Britain, and Germany—10,000,000 workers stand idle. There is scarcely an important industry anywhere earning enough profit to make it expand—which is the test of progress. At the same time, in the countries of primary production the output of mining and of agriculture is selling, in the case of almost every important commodity, at a price which, for many or for the majority of producers, does not cover its cost. In 1921, when prices fell as heavily, the fall was from a boom level at which producers were making abnormal profits; and there is no example in modern history of so great and rapid a fall of prices from a normal figure as has occurred in the past year. Hence the magnitude of the catastrophe.

In diagnosing what went wrong in the Great Depression, Keynes largely, though not entirely, missed the most important cause of the catastrophe, the appreciation of gold caused by the attempt to restore an international gold standard without a means by which to control the monetary demand for gold of the world’s central banks — most notoriously, the insane Bank of France. Keynes should have paid more attention to Hawtrey and Cassel than he did. But Keynes was absolutely on target in explaining why the world more easily absorbed and recovered from a 40% deflation in 1920-21 than it was able to do in 1929-33.

Is John Cochrane Really an (Irving) Fisherian?

I’m pretty late getting to this Wall Street Journal op-ed by John Cochrane (here’s an ungated version), and Noah Smith has already given it an admirable working over, but, even after Noah Smith, there’s an assertion or two by Cochrane that could use a bit of elucidation. Like this one:

Keynesians told us that once interest rates got stuck at or near zero, economies would fall into a deflationary spiral. Deflation would lower demand, causing more deflation, and so on.

Noah seems to think this is a good point, but I guess that I am less easily impressed than Noah. Feeling no need to provide citations for the views he attributes to Keynesians, Cochrane does not bother either to tell us which Keynesian has asserted that the zero lower bound creates the danger of a deflationary spiral, though in a previous blog post, Cochrane does provide a number of statements by Paul Krugman (who I guess qualifies as the default representative of all Keynesians) about the danger of a deflationary spiral. Interestingly all but one of these quotations were from 2009 when, in the wake of the fall 2008 financial crisis, a nasty little relapse in early 2009 having driven the stock market to a 12-year low, the Fed finally launched its first round of quantitative easing, the threat of a deflationary spiral did not seem at all remote.

Now an internet search shows that Krugman does have a model showing that a downward deflationary spiral is possible at the zero lower bound. I would just note, for the record, that Earl Thompson, in an unpublished 1976 paper, derived a similar result from an aggregate model based on a neo-classical aggregate production function with the Keynesian expenditure functions (through application of Walras’s Law) excluded. So what’s Keynes got to do with it?

But even more remarkable is that the most famous model of a deflationary downward spiral was constructed not by a Keynesian, but by the grandfather of modern Monetarism, Irving Fisher, in his famous 1933 paper on debt deflation, “The Debt-Deflation Theory of Great Depressions.” So the suggestion that there is something uniquely Keynesian about a downward deflationary spiral at the zero lower bound is simply not credible.

Cochrane also believes that because inflation has stabilized at very low levels, slow growth cannot be blamed on insufficient aggregate demand.

Zero interest rates and low inflation turn out to be quite a stable state, even in Japan. Yes, Japan is growing more slowly than one might wish, but with 3.5% unemployment and no deflationary spiral, it’s hard to blame slow growth on lack of “demand.”

Except that, since 2009 when the threat of a downward deflationary spiral seemed more visibly on the horizon than it does now, Krugman has consistently argued that, at the zero lower bound, chronic stagnation and underemployment are perfectly capable of coexisting with a positive rate of inflation. So it’s not clear why Cochrane thinks the coincidence of low inflation and sluggish economic growth for five years since the end of the 2008-09 downturn somehow refutes Krugman’s diagnosis of what has been ailing the economy in recent years.

And, again, what’s even more interesting is that the proposition that there can be insufficient aggregate demand, even with positive inflation, follows directly from the Fisher equation, of which Cochrane claims to be a fervent devotee. After all, if the real rate of interest is negative, then the Fisher equation tells us that the equilibrium expected rate of inflation cannot be less than the absolute value of the real rate of interest. So if, at the zero lower bound, the real rate of interest is minus 1%, then the equilibrium expected rate of inflation is 1%, and if the actual rate of inflation equals the equilibrium expected rate, then the economy, even if it is operating at less than full employment and less than its potential output, may be in a state of macroeconomic equilibrium. And it may not be possible to escape from that low-level equilibrium and increase output and employment without a burst of unexpected inflation, providing a self-sustaining stimulus to economic growth, thereby moving the economy to a higher-level equilibrium with a higher real rate of interest than the rate corresponding to lower-level equilibrium. If I am not mistaken, Roger Farmer has been making an argument along these lines.

Given the close correspondence between the Keynesian and Fisherian analyses of what happens in the neighborhood of the zero lower bound, I am really curious to know what part of the Fisherian analysis Cochrane finds difficult to comprehend.

Misunderstanding Reserve Currencies and the Gold Standard

In Friday’s Wall Street Journal, Lewis Lehrman and John Mueller argue for replacing the dollar as the world’s reserve currency with gold. I don’t know Lewis Lehrman, but almost 30 years ago, when I was writing my book Free Banking and Monetary Reform, which opposed restoring the gold standard, I received financial support from the Lehrman Institute where I gave a series of seminars discussing several chapters of my book. A couple of those seminars were attended by John Mueller, who was then a staffer for Congressman Jack Kemp. But despite my friendly feelings for Lehrman and Mueller, I am afraid that they badly misunderstand how the gold standard worked and what went wrong with the gold standard in the 1920s. Not surprisingly, that misunderstanding carries over into their comments on current monetary arrangements.

Lehrman and Mueller begin by discussing the 1922 Genoa Conference, a conference largely inspired by the analysis of Ralph Hawtrey and Gustav Cassel of post-World War I monetary conditions, and by their proposals for restoring an international gold standard without triggering a disastrous deflation in the process of doing so, the international price level in terms of gold having just about doubled relative to the pre-War price level.

The 1922 Genoa conference, which was intended to supervise Europe’s post-World War I financial reconstruction, recommended “some means of economizing the use of gold by maintaining reserves in the form of foreign balances”—initially pound-sterling and dollar IOUs. This established the interwar “gold exchange standard.”

Lehrman and Mueller then cite the view of the gold exchange standard expressed by the famous French economist Jacques Rueff, of whom Lehrman is a fervent admirer.

A decade later Jacques Rueff, an influential French economist, explained the result of this profound change from the classical gold standard. When a foreign monetary authority accepts claims denominated in dollars to settle its balance-of-payments deficits instead of gold, purchasing power “has simply been duplicated.” If the Banque de France counts among its reserves dollar claims (and not just gold and French francs)—for example a Banque de France deposit in a New York bank—this increases the money supply in France but without reducing the money supply of the U.S. So both countries can use these dollar assets to grant credit. “As a result,” Rueff said, “the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” A vast expansion of dollar reserves had inflated the prices of stocks and commodities; their contraction deflated both.

This is astonishing. Lehrman and Mueller do not identify the publication of Rueff that they are citing, but I don’t doubt the accuracy of the quotation. What Rueff is calling for is a 100% marginal reserve requirement. Now it is true that under the Bank Charter Act of 1844, Great Britain had a 100% marginal reserve requirement on Bank of England notes, but throughout the nineteenth century, there was an shift from banknotes to bank deposits, so the English money supply was expanding far more rapidly than English gold reserves. The kind of monetary system that Rueff was talking about, in which the quantity of money in circulation, could not increase by more than the supply of gold, never existed. Money was being created under the gold standard without an equal amount of gold being held in reserve.

The point of the gold exchange standard, after World War I, was to economize on the amount of gold held by central banks as they rejoined the gold standard to prevent a deflation back to the pre-War price level. Gold had been demonetized over the course of World War I as countries used gold to pay for imports, much of it winding up in the US before the US entered the war. If all the demonetized gold was remonetized, the result would be a huge rise in the value of gold, in other words, a huge, catastrophic, deflation.

Nor does the notion that the gold-exchange standard was the cause of speculation that culminated in the 1929 crisis have any theoretical or evidentiary basis. Interest rates in the 1920s were higher than they ever were during the heyday of the classical gold standard from about 1880 to 1914. Prices were not rising faster in the 1920s than they did for most of the gold standard era, so there is no basis for thinking that speculation was triggered by monetary causes. Indeed, there is no basis for thinking that there was any speculative bubble in the 1920s, or that even if there was such a bubble it was triggered by monetary expansion. What caused the 1929 crash was not the bursting of a speculative bubble, as taught by the popular mythology of the crash, it was caused by the sudden increase in the demand for gold in 1928 and 1929 resulting from the insane policy of the Bank of France and the clueless policy of the Federal Reserve after ill health forced Benjamin Strong to resign as President of the New York Fed.

Lehrman and Mueller go on to criticize the Bretton Woods system.

The gold-exchange standard’s demand-duplicating feature, based on the dollar’s reserve-currency role, was again enshrined in the 1944 Bretton Woods agreement. What ensued was an unprecedented expansion of official dollar reserves, and the consumer price level in the U.S. and elsewhere roughly doubled. Foreign governments holding dollars increasingly demanded gold before the U.S. finally suspended gold payments in 1971.

The gold-exchange standard of the 1920s was a real gold standard, but one designed to minimize the monetary demand for gold by central banks. In the 1920s, the US and Great Britain were under a binding obligation to convert dollars or pound sterling on demand into gold bullion, so there was a tight correspondence between the value of gold and the price level in any country maintaining a fixed exchange rate against the dollar or pound sterling. Under Bretton Woods, only the US was obligated to convert dollars into gold, but the obligation was largely a fiction, so the tight correspondence between the value of gold and the price level no longer obtained.

The economic crisis of 2008-09 was similar to the crisis that triggered the Great Depression. This time, foreign monetary authorities had purchased trillions of dollars in U.S. public debt, including nearly $1 trillion in mortgage-backed securities issued by two government-sponsored enterprises, Fannie Mae and Freddie Mac. The foreign holdings of dollars were promptly returned to the dollar market, an example of demand duplication. This helped fuel a boom-and-bust in foreign markets and U.S. housing prices. The global excess credit creation also spilled over to commodity markets, in particular causing the world price of crude oil (which is denominated in dollars) to spike to $150 a barrel.

There were indeed similarities between the 1929 crisis and the 2008 crisis. In both cases, the world financial system was made vulnerable because there was a lot of bad debt out there. In 2008, it was subprime mortgages, in 1929 it was reckless borrowing by German local governments and the debt sold to refinance German reparations obligations under the Treaty of Versailles. But in neither episode did the existence of bad debt have anything to do with monetary policy; in both cases tight monetary policy precipitated a crisis that made a default on the bad debt unavoidable.

Lehrman and Mueller go on to argue, as do some Keynesians like Jared Bernstein, that the US would be better off if the dollar were not a reserve currency. There may be disadvantages associated with having a reserve currency – disadvantages like those associated with having a large endowment of an exportable natural resource, AKA the Dutch disease – but the only way for the US to stop having a reserve currency would be to take a leaf out of the Zimbabwe hyperinflation playbook. Short of a Zimbabwean hyperinflation, the network externalities internalized by using the dollar as a reserve currency are so great, that the dollar is likely to remain the world’s reserve currency for at least a millennium. Of course, the flip side of the Dutch disease is at that there is a wealth transfer from the rest of the world to the US – AKA seignorage — in exchange for using the dollar.

Lehrman and Mueller are aware of the seignorage accruing to the supplier of a reserve currency, but confuse the collection of seignorage with the benefit to the world as a whole of minimizing the use of gold as the reserve currency. This leads them to misunderstand the purpose of the Genoa agreement, which they mistakenly attribute to Keynes, who actually criticized the agreement in his Tract on Monetary Reform.

This was exactly what Keynes and other British monetary experts promoted in the 1922 Genoa agreement: a means by which to finance systemic balance-of-payments deficits, forestall their settlement or repayment and put off demands for repayment in gold of Britain’s enormous debts resulting from financing World War I on central bank and foreign credit. Similarly, the dollar’s “exorbitant privilege” enabled the U.S. to finance government deficit spending more cheaply.

But we have since learned a great deal that Keynes did not take into consideration. As Robert Mundell noted in “Monetary Theory” (1971), “The Keynesian model is a short run model of a closed economy, dominated by pessimistic expectations and rigid wages,” a model not relevant to modern economies. In working out a “more general theory of interest, inflation, and growth of the world economy,” Mr. Mundell and others learned a great deal from Rueff, who was the master and professor of the monetary approach to the balance of payments.

The benefit from supplying the resource that functions as the world’s reserve currency will accrue to someone, that is the “exorbitant privilege” to which Lehrman and Mueller refer. But It is not clear why it would be better if the privilege accrued to owners of gold instead of to the US Treasury. On the contrary, the potential for havoc associated with reinstating gold as the world’s reserve currency dwarfs the “exorbitant privilege.” Nor is the reference to Keynes relevant to the discussion, the Keynesian model described by Mundell being the model of the General Theory, which was certainly not the model that Keynes was working with at the time of the Genoa agreement in which Keynes’s only involvement was as an outside critic.

As for Rueff, staunch defender of the insane policy of the Bank of France in 1932, he was an estimable scholar, but, luckily, his influence was much less than Lehrman and Mueller suggest.

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.

 


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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