Archive for the 'Wall Street Journal' Category

The Verbally Challenged John Taylor Strikes Again

John Taylor, tireless self-promoter of “rules-based monetary policy” (whatever that means), inventor of the legendary Taylor Rule, and very likely the next Chairman of the Federal Reserve Board if a Republican is elected President of the United States in 2016, has a history of verbal faux pas, which I have been documenting not very conscientiously for almost three years now.

Just to review my list (for which I make no claim of exhaustiveness), Professor Taylor was awarded the Hayek Prize of the Manhattan Institute in 2012 for his book First Principles: Five Keys to Restoring America’s Prosperity. The winner of the prize (a cash award of $50,000) also delivers a public Hayek Lecture in New York City to a distinguished audience consisting of wealthy and powerful and well-connected New Yorkers, drawn from the city’s financial, business, political, journalistic, and academic elites. The day before delivering his public lecture, Professor Taylor published a teaser as an op-ed in that paragon of journalistic excellence the Wall Street Journal editorial page. (This is what I had to say when it was published.)

In his teaser, Professor Taylor invoked Hayek’s Road to Serfdom and his Constitution of Liberty to explain the importance of the rule of law and its relationship to personal freedom. Certainly Hayek had a great deal to say and a lot of wisdom to impart on the subjects of the rule of law and personal freedom, but Professor Taylor, though the winner of the Hayek Prize, was obviously not interested enough to read Hayek’s chapter on monetary policy in The Constitution of Liberty; if he had he could not possibly have made the following assertions.

Stripped of all technicalities, this means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge. . . .

Rules for monetary policy do not mean that the central bank does not change the instruments of policy (interest rates or the money supply) in response to events, or provide loans in the case of a bank run. Rather they mean that they take such actions in a predictable manner.

But guess what. Hayek took a view rather different from Taylor’s in The Constitution of Liberty:

[T]he case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain.

Now that was bad enough – quoting Hayek as an authority for a position that Hayek explicitly declined to take in the very source invoked by Professor Taylor. But that was just Professor Taylor’s teaser. Perhaps it got a bit garbled in the teasing process. So I went to the Manhattan Institute website and watched the video of the entire Hayek Lecture delivered by Professor Taylor. But things got even worse in the lecture – much worse. I mean disastrously worse. (This is what I had to say after watching the video.)

Taylor, while of course praising Hayek at length, simply displayed an appalling ignorance of Hayek’s writings and an inability to comprehend, or a carelessness so egregious that he was unable to properly read, the title — yes, the title! — of a pamphlet written by Hayek in the 1970s, when inflation was reaching the double digits in the US and much of Europe. The pamphlet, entitled Full Employment at any Price?, was an argument that the pursuit of full employment as an absolute goal, with no concern for price stability, would inevitably lead to accelerating inflation. The title was chosen to convey the idea that the pursuit of full employment was not without costs and that a temporary gain in employment at the cost of higher inflation might well not be worth it. Professor Taylor, however, could not even read the title correctly, construing the title as prescriptive, and — astonishingly — presuming that Hayek was advocating the exact policy that the pamphlet was written to confute.

Perhaps Professor Taylor was led to this mind-boggling misinterpretation by a letter from Milton Friedman, cited by Taylor, complaining about Hayek’s criticism in the pamphlet in question of Friedman’s dumb 3-perceent rule, to which criticism Friedman responded in his letter to Hayek. But Professor Taylor, unable to understand what Hayek and Friedman were arguing about, bewilderingly assumed that Friedman was criticizing Hayek’s advocacy of increasing the rate of inflation to whatever level was needed to ensure full employment, culminating in this ridiculous piece of misplaced condescension.

Well, once again, Milton Friedman, his compatriot in his cause — and it’s good to have compatriots by the way, very good to have friends in his cause. He wrote in another letter to Hayek – Hoover Archives – “I hate to see you come out, as you do here, for what I believe to be one of the most fundamental violations of the rule of law that we have, namely, discretionary activities of central bankers.”

So, hopefully, that was enough to get everybody back on track. Actually, this episode – I certainly, obviously, don’t mean to suggest, as some people might, that Hayek changed his message, which, of course, he was consistent on everywhere else.

And all of this wisdom was delivered by Professor Taylor in his Hayek Lecture upon being awarded the Hayek Prize. Well done, Professor Taylor, well done.

Then last July, in another Wall Street Journal op-ed, Professor Taylor replied to Alan Blinder’s criticism of a bill introduced by House Republicans to require the Fed to use the Taylor Rule as its method for determining what its target would be for the Federal Funds rate. The title of the op-ed was “John Taylor’s reply to Alan Blinder,” and the subtitle was “The Fed’s ad hoc departures from rule-based monetary policy has [sic!] hurt the economy.” When I pointed out the grammatical error, and wondered whether the mistake was attributable to Professor Taylor or stellar editorial writers employed by the Wall Street Journal editorial page, David Henderson, a frequent contributor to the Journal, wrote a comment to assure me that it was certainly not Professor Taylor’s mistake. I took Henderson’s word for it. (Just for the record, the mistake is still there, you can look it up.)

But now there’s this. In today’s New York Times, there is an article about how, in an earlier era, criticism of the Fed came mainly from Democrats complaining about money being too tight and interests rates too high, while now criticism comes mainly from Republicans complaining that money is too easy and interest rates too low. At the end of the article we find this statement from Professor Taylor:

Practical experience and empirical studies show that checklist-free medical care is wrought with dangers just as rules-free monetary policy is,” Mr. Taylor wrote in a recent defense of his proposal.

There he goes again. Here are five definitions of “wrought” from the online Merriam-Webster dictionary:

1:  worked into shape by artistry or effort <carefully wrought essays>

2:  elaborately embellished :  ornamented

3:  processed for use :  manufactured <wrought silk>

4:  beaten into shape by tools :  hammered —used of metals

5:  deeply stirred :  excited —often used with up <gets easily wrought up over nothing>

Obviously, what Professor Taylor meant to say is that medical care is “fraught” (rhymes with “wrought”) with dangers, but some people just can’t be bothered with pesky little details like that, any more than winners of the Hayek Prize can be bothered with actually reading the works of Hayek to which they refer in their Hayek Lecture. Let’s just hope that if Professor Taylor’s ambition to become Fed Chairman is realized, he’ll be a little bit more attentive to, say, the position of decimal points than he is to the placement of question marks and to the difference in meaning between words that sound almost alike.

PS I see that the Manhattan Institute has chosen James Grant as the winner of the 2015 Hayek Prize for his book America’s Forgotten Depression. I’m sure that 2015 Hayek Lecture will be far more finely wrought grammatically and stylistically than the 2012 Hayek Lecture, but, judging from book for which the prize was awarded, I am not overly optimistic that it will make a great deal more sense than the 2012 Hayek Lecture, but that is not a very high bar to clear.

Who Is Grammatically Challenged? John Taylor or the Wall Street Journal Editorial Page?

Perhaps I will get around to commenting on John Taylor’s latest contribution to public discourse and economic enlightenment on the incomparable Wall Street Journal editorial page. And then again, perhaps not. We shall see.

In truth, there is really nothing much in the article that he has not already said about 500 times (or is it 500 thousand times?) before about “rule-based monetary policy.” But there was one notable feature about his piece, though I am not sure if it was put in there by him or by some staffer on the legendary editorial page at the Journal. And here it is, first the title followed by a teaser:

John Taylor’s Reply to Alan Blinder

The Fed’s ad hoc departures from rule-based monetary policy has hurt the economy.

Yes, believe it or not, that is exactly what it says: “The Fed’s ad hoc departures from rule-based monetary policy has [sic!] hurt the economy.”

Good grief. This is incompetence squared. The teaser was probably not written by Taylor, but one would think that he would at least read the final version before signing off on it.

UPDATE: David Henderson, an authoritative — and probably not overly biased — source, absolves John Taylor from grammatical malpractice, thereby shifting all blame to the Wall Street Journal editorial page.

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

Who Sets the Real Rate of Interest?

Understanding economics requires, among other things, understanding the distinction between real and nominal variables. Confusion between real and nominal variables is pervasive, constantly presenting barriers to clear thinking, and snares and delusions for the mentally lazy. In this post, I want to talk about the distinction between the real rate of interest and the nominal rate of interest. That distinction has been recognized for at least a couple of centuries, Henry Thornton having mentioned it early in the nineteenth century. But the importance of the distinction wasn’t really fully understood until Irving Fisher made the distinction between the real and nominal rates of interest a key element of his theory of interest and his theory of money, expressing the relationship in algebraic form — what we now call the Fisher equation. Notation varies, but the Fisher equation can be written more or less as follows:

i = r + dP/dt,

where i is the nominal rate, r is the real rate, and dP/dt is the rate of inflation. It is important to bear in mind that the Fisher equation can be understood in two very different ways. It can either represent an ex ante relationship, with dP/dt referring to expected inflation, or it can represent an ex post relationship, with dP/dt referring to actual inflation.

What I want to discuss in this post is the tacit assumption that usually underlies our understanding, and our application, of the ex ante version of the Fisher equation. There are three distinct variables in the Fisher equation: the real and the nominal rates of interest and the rate of inflation. If we think of the Fisher equation as an ex post relationship, it holds identically, because the unobservable ex post real rate is defined as the difference between the nominal rate and the inflation rate. The ex post, or the realized, real rate has no independent existence; it is merely a semantic convention. But if we consider the more interesting interpretation of the Fisher equation as an ex ante relationship, the real interest rate, though still unobservable, is not just a semantic convention. It becomes the theoretically fundamental interest rate of capital theory — the market rate of intertemporal exchange, reflecting, as Fisher masterfully explained in his canonical renderings of the theory of capital and interest, the “fundamental” forces of time preference and the productivity of capital. Because it is determined by economic “fundamentals,” economists of a certain mindset naturally assume that the real interest rate is independent of monetary forces, except insofar as monetary factors are incorporated in inflation expectations. But if money is neutral, at least in the long run, then the real rate has to be independent of monetary factors, at least in the long run. So in most expositions of the Fisher equation, it is tacitly assumed that the real rate can be treated as a parameter determined, outside the model, by the “fundamentals.” With r determined exogenously, fluctuations in i are correlated with, and reflect, changes in expected inflation.

Now there’s an obvious problem with the Fisher equation, which is that in many, if not most, monetary models, going back to Thornton and Wicksell in the nineteenth century, and to Hawtrey and Keynes in the twentieth, and in today’s modern New Keynesian models, it is precisely by way of changes in its lending rate to the banking system that the central bank controls the rate of inflation. And in this framework, the nominal interest rate is negatively correlated with inflation, not positively correlated, as implied by the usual understanding of the Fisher equation. Raising the nominal interest rate reduces inflation, and reducing the nominal interest rate raises inflation. The conventional resolution of this anomaly is that the change in the nominal interest rate is just temporary, so that, after the economy adjusts to the policy of the central bank, the nominal interest rate also adjusts to a level consistent with the exogenous real rate and to the rate of inflation implied by the policy of the central bank. The Fisher equation is thus an equilibrium relationship, while central-bank policy operates by creating a short-term disequilibrium. But the short-term disequilibrium imposed by the central bank cannot be sustained, because the economy inevitably begins an adjustment process that restores the equilibrium real interest rate, a rate determined by fundamental forces that eventually override any nominal interest rate set by the central bank if that rate is inconsistent with the equilibrium real interest rate and the expected rate of inflation.

It was just this analogy between the powerlessness of the central bank to hold the nominal interest rate below the sum of the exogenously determined equilibrium real rate and the expected rate of inflation that led Milton Friedman to the idea of a “natural rate of unemployment” when he argued that monetary policy could not keep the unemployment rate below the “natural rate ground out by the Walrasian system of general equilibrium equations.” Having been used by Wicksell as a synonym for the Fisherian equilibrium real rate, the term “natural rate” was undoubtedly adopted by Friedman, because monetarily induced deviations between the actual rate of unemployment and the natural rate of unemployment set in motion an adjustment process that restores unemployment to its “natural” level, just as any deviation between the nominal interest rate and the sum of the equilibrium real rate and expected inflation triggers an adjustment process that restores equality between the nominal rate and the sum of the equilibrium real rate and expected inflation.

So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about? The Fed has no legal power to set interest rates; it can only announce what interest rate it will lend at, and it can buy and sell assets in the market. It has an advantage because it can create the money with which to buy assets. But if you believe that the Fed cannot reduce the rate of unemployment below the “natural rate of unemployment” by printing money, why would you believe that the Fed can reduce the real rate of interest below the “natural rate of interest” by printing money? Martin Feldstein and the Wall Street Journal believe that the Fed is unable to do one, but perfectly able to do the other. Sorry, but I just don’t get it.

Look at the accompanying chart. It tracks the three variables in the Fisher equation (the nominal interest rate, the real interest rate, and expected inflation) from October 1, 2007 to July 2, 2013. To measure the nominal interest rate, I use the yield on 10-year Treasury bonds; to measure the real interest rate, I use the yield on 10-year TIPS; to measure expected inflation, I use the 10-year breakeven TIPS spread. The yield on the 10-year TIPS is an imperfect measure of the real rate, and the 10-year TIPS spread is an imperfect measure of inflation expectations, especially during financial crises, when the rates on TIPS are distorted by illiquidity in the TIPS market. Those aren’t the only problems with identifying the TIPS yield with the real rate and the TIPS spread with inflation expectations, but those variables usually do provide a decent approximation of what is happening to real rates and to inflation expectations over time.

real_and_nominal_interest_rates

Before getting to the main point, I want to make a couple of preliminary observations about the behavior of the real rate over time. First, notice that the real rate declined steadily, with a few small blips, from October 2007 to March 2008, when the Fed was reducing the Fed Funds target rate from 4.75 to 3% as the economy was sliding into a recession that officially began in December 2007. The Fed reduced the Fed Funds target to 2% at the end of April, but real interest rates had already started climbing in early March, so the failure of the FOMC to reduce the Fed Funds target again till October 2008, three weeks after the onset of the financial crisis, clearly meant that there was at least a passive tightening of monetary policy throughout the second and third quarters, helping create the conditions that precipitated the crisis in September. The rapid reduction in the Fed Funds target from 2% in October to 0.25% in December 2008 brought real interest rates down, but, despite the low Fed Funds rate, a lack of liquidity caused a severe tightening of monetary conditions in early 2009, forcing real interest rates to rise sharply until the Fed announced its first QE program in March 2009.

I won’t go into more detail about ups and downs in the real rate since March 2009. Let’s just focus on the overall trend. From that time forward, what we see is a steady decline in real interest rates from over 2% at the start of the initial QE program till real rates bottomed out in early 2012 at just over -1%. So, over a period of three years, there was a steady 3% decline in real interest rates. This was no temporary phenomenon; it was a sustained trend. I have yet to hear anyone explain how the Fed could have single-handedly produced a steady downward trend in real interest rates by way of monetary expansion over a period of three years. To claim that decline in real interest rates was caused by monetary expansion on the part of the Fed flatly contradicts everything that we think we know about the determination of real interest rates. Maybe what we think we know is all wrong. But if it is, people who blame the Fed for a three-year decline in real interest rates that few reputable economists – and certainly no economists that Fed critics pay any attention to — ever thought was achievable by monetary policy ought to provide an explanation for how the Fed suddenly got new and unimagined powers to determine real interest rates. Until they come forward with such an explanation, Fed critics have a major credibility problem.

So please – pleaseWall Street Journal editorial page, Martin Feldstein, John Taylor, et al., enlighten us. We’re waiting.

PS Of course, there is a perfectly obvious explanation for the three-year long decline in real interest rates, but not one very attractive to critics of QE. Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate. The real interest rate might have adjusted more rapidly to the reduced equilibrium rate, but that would have required expected inflation to have risen. What that means is that sometimes it is the real interest rate, not, as is usually assumed, the nominal rate, that adjusts to the expected rate of inflation. My next post will discuss that alternative understanding of the implicit dynamics of the Fisher equation.

The Golden Constant My Eye

John Tamny, whose economic commentary I usually take with multiple grains of salt, writes an op-ed about the price of gold in today’s Wall Street Journal, a publication where the probability of reading nonsense is dangerously high. Amazingly, Tamny writes that the falling price of gold is a good sign for the US economy. “The recent decline in the price of gold, ” Tamny informs us, “is cause for cautious optimism.” What’s this? A sign that creeping sanity is infiltrating the editorial page of the Wall Street Journal? Is the Age of Enlightenment perhaps dawning in America?

Um, not so fast. After all, we are talking about the Wall Street Journal editorial page. Yep, it turns out that Tamny is indeed up to his old tricks again.

The precious metal has long been referred to as “the golden constant” for its steady value. An example is the skyrocketing price of gold in the 1970s, which didn’t so much signal a spike in gold’s value as it showed the decline of the dollar in which it was priced. If gold’s constancy as a measure of value is doubted, consider oil: In 1971 an ounce of gold at $35 bought 15 barrels, in 1981 an ounce of gold at $480 similarly bought 15 barrels, and today an ounce once again buys a shade above 15.

OMG! The golden constant! Gold was selling for about $35 an ounce in 1970 rose to nearly $900 an ounce in 1980, fell to about $250 an ounce in about 2001, rose back up to almost $1900 in 2011 and is now below $1400, and Mr. Tamny thinks that the value of gold is constant. Give me a break. Evidently, Mr. Tamny attaches deep significance to the fact that the value of gold relative to the value of a barrel of oil was roughly 15 barrels of oil per ounce in 1971, and again in 1981, and now, once again, is at roughly 15 barrels per ounce, though he neglects to inform us whether the significance is economic or mystical.

So I thought that I would test the constancy of this so-called relationship by computing the implied exchange rate between oil and gold since April 1968 when the gold price series maintained by the Federal Reserve Bank of St. Louis begins. The chart below, derived from the St. Louis Fed, plots the monthly average of the number of barrels of oil per ounce of gold from April 1968 (when it was a bit over 12) through March 2013 (when it was about 17). But as the graph makes clear the relative price  of gold to oil has been fluctuating wildly over the past 45 years, hitting a low of 6.6 barrels of oil per ounce of gold in June 2008, and a high of 33.8 barrels of oil per ounce of gold in July 1973. And this graph is based on monthly averages; plotting the daily fluctuations would show an even greater amplitude.

barrels_of_oil_per_ounce_of_goldDo Mr. Tamny and his buddies at the Wall Street Journal really expect people to buy this nonsense? This is what happens to your brain when you are obsessed with gold. If you think that the US and the world economies have been on a wild ride these past five years, imagine what it would have been like if the US or the world price level had been fluctuating as the relative price of gold in terms of oil has been fluctuating over the same time period. And don’t even think about what would have happened over the past 45 years under Mr. Tamny’s ideal, constant, gold-based monetary standard.

Let’s get this straight. The value of gold is entirely determined by speculation. The current value of gold has no relationship — none — to the value of the miniscule current services gold now provides. It is totally dependent on the obviously not very well-informed expectations of people like Mr. Tamny.

Gold indeed had a relatively stable value over long periods of time when there was a gold standard, but that was largely due to fortuitous circumstances, not the least of which was the behavior of national central banks that would accumulate gold or give up gold as needed to prevent the value of gold from fluctuating as wildly as it otherwise would have. When, as a result of the First World War, gold was largely demonetized, prices were no longer tied to gold. Then, in the 1920s, when the world tried to restore the gold standard, it was beyond the capacity of the world’s central banks to recreate the gold standard in such a way that their actions smoothed the inevitable fluctuations in the value of gold. Instead, their actions amplified fluctuations in the value of the gold, and the result was the greatest economic catastrophe the world had seen since the Black Death. To suggest another restoration of the gold standard in the face of such an experience is sheer lunacy. But, as members of at least one of our political parties can inform you, just in case you have been asleep for the past decade or so, the lunatic fringe can sometimes transform itself . . . into the lunatic mainstream.

Mary Anastasia O’Grady Needs to Take a Deep Breath

Obviously upset at Tuesday’s election results, Mary Anastasia O’Grady, member of the Wall Street Journal editorial board, takes out her frustration on Ben Bernanke, accusing Mr. Bernanke of buying the election for Mr. Obama. I mean who needs Sheldon Adelson when you’ve got the Chairman of the Federal Reserve Board out there working for you day and night?

Which brings us to whom Mr. Obama, if he is going to be honest, ought to thank for his victory. It is the man behind the curtain at the Federal Reserve in Washington. By pulling the monetary levers driving credit—fast and furiously and out of the view of most Americans—Fed Chairman Ben Bernanke artificially juiced asset prices and the housing market just in time for Election Day.

If you doubt that, consider this: The total return on the S&P 500 from the beginning of this election year until yesterday was almost 13.9%. The Dow Jones Industrial Average returned almost 9.2%. That means that as millions of Americans have opened their monthly 401 (K) statement this year, they have been under the impression that the losses they suffered after the 2008 financial crisis are being recovered. There has also been a recovery in a number of housing markets around the country.

Now lest you think that rising stock prices and a bottoming out of housing prices show that Mr. Bernanke is ably discharging his responsibilities as Fed Chairman, Mrs. O’Grady proceeds to explain why you are being taken for a sucker by a con artist.

That cheap credit and the search for yield is driving what is likely to become another bubble may not be appreciated by these investors. Instead, it is not unreasonable to suggest that some significant number, having had their portfolios injected with Mr. Bernanke’s feel-good monetary stimulus, decided that Mr. Obama is in fact making them better off.

But are near-zero interest rates and the central bank financing of the U.S. government, through quantitative easing, sustainable policies? To put it another way, can the Fed print our way out of economic and fiscal troubles? If that were possible, Argentina would be a rich country. Instead it is poor and its political system is dominated by leftwing populist demagogues.

Mrs. O’Grady has a point. A country cannot permanently increase its output beyond what its available resources are capable of producing. A poor country cannot become rich by inflating its currency. The problem in the US is not that we lack resources, but that we are not utilizing the resources that are available. There are millions of people not working, something that Mrs. O’Grady’s preferred candidate for President spent a fair amount of time repeating for more than a year. The question is not whether monetary policy can create resources that don’t exist, but whether monetary policy can help get idle resources back to work. Perhaps monetary policy can’t do that.  After all, there are some smart people who don’t think it can.  But we do have a lot of evidence that bad monetary policy does cause high unemployment, as in the Great Depression. And some of us are old enough to remember when, during the Reagan administration, the Wall Street Journal editorial page was continually berating Paul Volcker for holding back a recovery by keeping monetary policy too tight and interest rates too high. The evidence shows that in deep depressions currency devaluation and inflation can work wonders, as FDR proved in 1933. It even worked for Argentina after its financial crisis in 2001. The disastrous policies of the past several years don’t mean that monetary expansion was not instrumental for Argentina’s recovery from the earlier crisis.

On the Manipulation of Currencies

Mitt Romney is promising to declare China a currency manipulator on “day one” of his new administration. Why? Ostensibly, because Mr. Romney, like so many others, believes that the Chinese are somehow interfering with the foreign-exchange markets and holding the exchange rate of their currency (confusingly called both the yuan and the remnibi) below its “true” value. But the other day, Mary Anastasia O’Grady, a member of the editorial board of the avidly pro-Romeny Wall Street Journal, wrote an op-ed piece (“Ben Bernanke: Currency Manipulator” ) charging that Bernanke is no less a currency manipulator than those nasty Chinese Communists. Why? Well, that was not exactly clear, but it seemed to have something to do with the fact that Mr. Bernanke, seeking to increase the pace of our current anemic recovery, is conducting a policy of monetary expansion to speed the recovery.

So, is what Mr. Bernanke is doing (or supposed to be doing) really the same as what the Chinese are doing (or supposed to be doing)?

Well, obviously it is not. What the Chinese are accused of doing is manipulating the yuan’s exchange rate by, somehow, intervening in the foreign-exchange market to prevent the yuan from rising to its “equilibrium” value against the dollar. The allegation against Mr. Bernanke is that he is causing the exchange rate of the dollar to fall against other currencies by increasing the quantity of dollars in circulation. But given the number of dollars in circulation, the foreign-exchange market is establishing a price that reflects the “equilibrium” value of dollars against any other currency. Mr. Bernanke is not setting the value of the dollar in foreign-exchange markets, as the Chinese are accused of doing to the dollar/yuan exchange rate. Even if he wanted to control the exchange value of the dollar, it is not directly within Mr. Bernanke’s power to control the value that participants in the foreign-exchange markets attach to the dollar relative to other currencies.

But perhaps this is too narrow a view of what Mr. Bernanke is up to. If the Chinese government wants the yuan to have a certain exchange value against the dollar and other currencies, all it has to do is to create (or withdraw) enough yuan to ensure that the value of yuan on the foreign-exchange markets falls (or rises) to its target. In the limit, the Chinese government could peg its exchange rate against the dollar (or against any other currency or any basket of currencies) by offering to buy and sell dollars (or any other currency or any basket of currencies) in unlimited quantities at the pegged rate with the yuan. Does that qualify as currency manipulation? For a very long time, pegged or fixed exchange rates in which countries maintained fixed exchange rates against all other currencies was the rule, not the exception, except that the pegged rate was most often a fixed price for gold or silver rather than a fixed price for a particular currency. No one ever said that simply maintaining a fixed exchange rate between one currency and another or between one currency and a real commodity is a form of currency manipulation. And for some 40 years, since the demise of the Bretton Woods system, the Wall Street Journal editorial page has been tirelessly advocating restoration of a system of fixed exchange rates, or, ideally, restoration of a gold standard. And now the Journal is talking about currency manipulation?

So it’s all very confusing. To get a better handle on the question of currency manipulation, I suggest going back to a classic statement of the basic issue by none other than John Maynard Keynes in a book, A Tract on Monetary Reform, that he published in 1923, when the world was trying to figure out how to reconstruct an international system of monetary arrangements to replace the prewar international gold standard, which had been one of the first casualties of the outbreak of World War I.

Since . . . the rate of exchange of a country’s currency with the currency of the rest of the world (assuming for the sake of simplicity that there is only one external currency) depends on the relation between the internal price level and the external price level [i.e., the price level of the rest of the world], it follows that the exchange cannot be stable unless both internal and external price levels remain stable. If, therefore, the external price level lies outside our control, we must submit either to our own internal price level or to our exchange rate being pulled about by external influences. If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.

I like to call this proposition – that a country can control either its internal price level or the exchange rate of its currency, but cannot control both — Keynes’s Law, though Keynes did not discover it and was not the first to articulate it (but no one else did so as succinctly and powerfully as he). So, according to Keynes, whether a country pegs its exchange rate or controls its internal price level would not matter if the price level in the rest of the world were stable, because in that case for any internal price level there would be a corresponding exchange rate and for every exchange rate there would be a corresponding internal price level. For a country to reduce its own exchange rate to promote exports would not work, because the low exchange rate would cause its internal prices to rise correspondingly, thereby eliminating any competitive advantage for its products in international trade. This principle, closely related to the idea of purchasing power parity (a concept developed by Gustav Cassel), implies that currency manipulation is not really possible, except for transitory periods, because prices adjust to nullify any temporary competitive advantage associated with a weak, or undervalued, currency. An alternative way of stating the principle is that a country can control its nominal exchange rate, but cannot control its real exchange rate, i.e, the exchange rate adjusted for price-level differences. If exchange rates and price levels tend to adjust to maintain purchasing power parity across currency areas, currency manipulation is an exercise in futility.

That, at any rate, is what the theory says. But for any proposition derived from economic theory, it is usually possible to come up with exceptions by altering the assumptions. Now for Keynes’s Law, there are two mechanisms causing prices to rise faster in a country with an undervalued currency than they do elsewhere. First, price arbitrage between internationally traded products tends to equalize prices in all locations after adjusting for exchange rate differentials. If it is cheaper for Americans to buy wheat in Winnipeg than in Wichita at the current exchange rate between the US and Canadian dollars, Americans will buy wheat in Winnipeg rather than Wichita forcing the Wichita price down until buying wheat in Wichita is again economical. But the arbitrage mechanism works rapidly only for internationally traded commodities like wheat. Many commodities, especially factors of production, like land and labor, are not tradable, so that price differentials induced by an undervalued exchange rate cannot be eliminated by direct arbitrage. But there is another mechanism operating to force prices in the country with an undervalued exchange rate to rise faster than elsewhere, which is that the competitive advantage from an undervalued currency induces an inflow of cash from other countries importing those cheap products, the foreign cash influx, having been exchanged for domestic cash, becoming an additional cause of rising domestic prices. The influx of cash won’t stop until purchasing power parity is achieved, and the competitive advantage eliminated.

What could prevent this automatic adjustment process from eliminating the competitive advantage created by an undervalued currency? In principle, it would be possible to interrupt the process of international arbitrage tending to equalize the prices of internationally traded products by imposing tariffs or quotas on imports or by imposing exchange controls on the movement of capital across borders. All of those restrictions or taxes on international transactions prevent the price equalization implied by Keynes’s Law and purchasing power parity from actually occurring. But after the steady trend of liberalization since World War II, these restrictions, though plenty remain, are less important than they used to be, and a web of international agreements, codified by the International Trade Organization, makes resorting to them a lot trickier than it used to be.

That leaves another, less focused, method by which governments can offer protection from international competition to certain industries or groups. The method is precisely for the government and the monetary authority to do what Keynes’s Law says can’t be done:  to choose an exchange rate that undervalues the currency, thereby giving an extra advantage or profit cushion to all producers of tradable products (i.e., export industries and import-competing industries), perhaps spreading the benefits of protection more widely than governments, if their choices were not restricted by international agreements, would wish. However, to prevent the resulting inflow of foreign cash from driving up domestic prices and eliminating any competitive advantage, the monetary authority must sterilize the induced cash inflows by selling assets to mop up the domestic currency just issued in exchange for the foreign cash directed toward domestic exporters. (The classic analysis of such a policy was presented by Max Corden in his paper “Exchange Rate Protection,” reprinted in his Production, Growth, and Trade: Essays in International Economics.) But to borrow a concept from Austrian Business Cycle Theory, this may not be a sustainable long-run policy for a central bank, because maintaining the undervalued exchange rate would require the central bank to keep accumulating foreign-exchange reserves indefinitely, while selling off domestic assets to prevent the domestic money supply from increasing. The central bank might even run out of domestic assets with which to mop up the currency created to absorb the inflow of foreign cash. But in a rapidly expanding economy (like China’s), the demand for currency may be growing so rapidly that the domestic currency created in exchange for the inflow of foreign currency can be absorbed by the public without creating any significant upward pressure on prices necessitating a sell-off of domestic assets to prevent an outbreak of domestic inflation.

It is thus the growth in, and the changing composition of, the balance sheet of China’s central bank rather than the value of the dollar/yuan exchange rate that tells us whether the Chinese are engaging in currency manipulation. To get some perspective on how the balance sheet of Chinese central banks has been changing, consider that Chinese nominal GDP in 2009 was about 2.5 times as large as it was in 2003 while Chinese holdings of foreign exchange reserves in 2009 were more than 5 times greater than those holdings were in 2003. This means that the rate of growth (about 25% a year) in foreign-exchange reserves held by the Chinese central bank between 2003 and 2009 was more than twice as great as the rate of growth in Chinese nominal GDP over the same period. Over that period, the share of the total assets of the Chinese central bank represented by foreign exchange has grown from 48% in December 2003 to almost 80% in December 2010. Those changes are certainly consistent with the practice of currency manipulation.  However, except for 2009, there was no year since 2000 in which the holdings of domestic assets by the Chinese central bank actually fell, suggesting that there has been very little actual sterilization undertaken by the Chinese central bank.  If there has indeed been no (or almost no) actual sterilization by the Chinese central bank, then, despite my long-standing suspicions about what the Chinese have been doing, I cannot conclude that the Chinese have been engaging in currency manipulation. But perhaps one needs to look more closely at the details of how the balance sheet of the Chinese central bank has been changing over time.  I would welcome the thoughts of others on how to interpret evidence of how the balance sheet of the Chinese central bank has been changing.

At any rate, to come back to Mary Anastasia O’Grady’s assertion that Ben Bernanke is guilty of currency manipulation, her accusation, based on the fact that Bernanke is expanding the US money supply, is clearly incompatible with Max Corden’s exchange-rate-protection model. In Corden’s model, undervaluation is achieved by combining a tight monetary policy that sterilizes (by open-market sales!) the inflows induced by an undervalued exchange rate. But, according to Mrs. O’Grady, Bernanke is guilty of currency manipulation, because he is conducting open-market purchases, not open-market sales! So Mrs. O’Grady has got it exactly backwards.  But, then, what would you expect from a member of the Wall Street Journal editorial board?

PS  I have been falling way behind in responding to recent comments.  I hope to catch up over the weekend as well as write up something on medium of account vs. medium of exchange.

PPS  Thanks to my commenters for providing me with a lot of insight into how the Chinese operate their monetary and banking systems.  My frequent commenter J.P. Koning has an excellent post and a terrific visual chart on his blog Moneyness showing the behavior over time of the asset and liability sides of the Chinese central bank.  Scott Sumner has also added an excellent discussion of his own about what Chinese monetary policy is all about.  I am trying to assimilate the various responses and hope to have a further post on the subject in the next day or two.


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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