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What Is Free Banking All About?

I notice that there has been a bit of a dustup lately about free banking, triggered by two posts by Izabella Kaminska, first on FTAlphaville followed by another on her own blog. I don’t want to get too deeply into the specifics of Kaminska’s posts, save to correct a couple of factual misstatements and conceptual misunderstandings (see below). At any rate, George Selgin has a detailed reply to Kaminska’s errors with which I mostly agree, and Scott Sumner has scolded her for not distinguishing between sensible free bankers, e.g., Larry White, George Selgin, Kevin Dowd, and Bill Woolsey, and the anti-Fed, gold-bug nutcases who, following in the footsteps of Ron Paul, have adopted free banking as a slogan with which to pursue their anti-Fed crusade.

Now it just so happens that, as some readers may know, I wrote a book about free banking, which I began writing almost 30 years ago. The point of the book was not to call for a revolutionary change in our monetary system, but to show that financial innovations and market forces were causing our modern monetary system to evolve into something like the theoretical model of a free banking system that had been worked out in a general sort of way by some classical monetary theorists, starting with Adam Smith, who believed that a system of private banks operating under a gold standard would supply as much money as, but no more money than, the public wanted to hold. In other words, the quantity of money produced by a system of competing banks, operating under convertibility, could be left to take care of itself, with no centralized quantitative control over either the quantity of bank liabilities or the amount of reserves held by the banking system.

So I especially liked the following comment by J. V. Dubois to Scott’s post

[M]y thing against free banking is that we actually already have it. We already have private banks issuing their own monies directly used for transactions – they are called bank accounts and debit/credit cards. There are countries like Sweden where there are now shops that do not accept physical cash (only bank monies) – a policy actively promoted government, if you can believe it.

There are now even financial products like Xapo Debit Card that automatically converts all payments received on your account into non-monetary assets (with Xapo it is bitcoins) and back into monies when you use the card for payment. There is a very healthy international bank money market so no matter what money you personally use, you can travel all around the world and pay comfortably without ever seeing or touching official local government currency.

In opposition to the Smithian school of thought, there was the view of Smith’s close friend David Hume, who famously articulated what became known as the Price-Specie-Flow Mechanism, a mechanism that Smith wisely omitted from his discussion of international monetary adjustment in the Wealth of Nations, despite having relied on PSFM with due acknowledgment of Hume, in his Lectures on Jurisprudence. In contrast to Smith’s belief that there is a market mechanism limiting the competitive issue of convertible bank liabilities (notes and deposits) to the amount demanded by the public, Hume argued that banks were inherently predisposed to overissue their liabilities, the liabilities being issuable at almost no cost, so that private banks, seeking to profit from the divergence between the face value of their liabilities and the cost of issuing them, were veritable engines of inflation.

These two opposing views of banks later morphed into what became known almost 70 years later as the Banking and Currency Schools. Taking the Humean position, the Currency School argued that without quantitative control over the quantity of banknotes issued, the banking system would inevitably issue an excess of banknotes, causing overtrading, speculation, inflation, a drain on the gold reserves of the banking system, culminating in financial crises. To prevent recurring financial crises, the Currency School proposed a legal limit on the total quantity of banknotes beyond which limit, additional banknotes could be only be issued (by the Bank of England) in exchange for an equivalent amount of gold at the legal gold parity. Taking the Smithian position, the Banking School argued that there were market mechanisms by which any excess liabilities created by the banking system would automatically be returned to the banking system — the law of reflux. Thus, as long as convertibility obtained (i.e., the bank notes were exchangeable for gold at the legal gold parity), any overissue would be self-correcting, so that a legal limit on the quantity of banknotes was, at best, superfluous, and, at worst, would itself trigger a financial crisis.

As it turned out, the legal limit on the quantity of banknotes proposed by the Currency School was enacted in the Bank Charter Act of 1844, and, just as the Banking School predicted, led to a financial crisis in 1847, when, as soon as the total quantity of banknotes approached the legal limit, a sudden precautionary demand for banknotes led to a financial panic that was subdued only after the government announced that the Bank of England would incur no legal liability for issuing banknotes beyond the legal limit. Similar financial panics ensued in 1857 and 1866, and they were also subdued by suspending the relevant statutory limits on the quantity of banknotes. There were no further financial crises in Great Britain in the nineteenth century (except possibly for a minicrisis in 1890), because bank deposits increasingly displaced banknotes as the preferred medium of exchange, the quantity of bank deposits being subject to no statutory limit, and because the market anticipated that, in a crisis, the statutory limit on the quantity of banknotes would be suspended, so that a sudden precautionary demand for banknotes never materialized in the first place.

Let me pause here to comment on the factual and conceptual misunderstandings in Kaminska’s first post. Discussing the role of the Bank of England in the British monetary system in the first half of the nineteenth century, she writes:

But with great money-issuance power comes great responsibility, and more specifically the great temptation to abuse that power via the means of imprudent money-printing. This fate befell the BoE — as it does most banks — not helped by the fact that the BoE still had to compete with a whole bunch of private banks who were just as keen as it to issue money to an equally imprudent degree.

And so it was that by the 1840s — and a number of Napoleonic Wars later — a terrible inflation had begun to grip the land.

So Kaminska seems to have fallen for the Humean notion that banks are inherently predisposed to overissue and, without some quantitative restraint on their issue of liabilities, are engines of inflation. But, as the law of reflux teaches us, this is not true, especially when banks, as they inevitably must, make their liabilities convertible on demand into some outside asset whose supply is not under their control. After 1821, the gold standard having been officially restored in England, the outside asset was gold. So what was happening to the British price level after 1821 was determined not by the actions of the banking system (at least to a first approximation), but by the value of gold which was determined internationally. That’s the conceptual misunderstanding that I want to correct.

Now for the factual misunderstanding. The chart below shows the British Retail Price Index between 1825 and 1850. The British price level was clearly falling for most of the period. After falling steadily from 1825 to about 1835, the price level rebounded till 1839, but it prices again started to fall reaching a low point in 1844, before starting another brief rebound and rising sharply in 1847 until the panic when prices again started falling rapidly.

uk_rpi_1825-50

From a historical perspective, the outcome of the implicit Smith-Hume disagreement, which developed into the explicit dispute over the Bank Charter Act of 1844 between the Banking and Currency Schools, was highly unsatisfactory. Not only was the dysfunctional Bank Charter Act enacted, but the orthodox view of how the gold standard operates was defined by the Humean price-specie-flow mechanism and the Humean fallacy that banks are engines of inflation, which made it appear that, for the gold standard to function, the quantity of money had to be tied rigidly to the gold reserve, thereby placing the burden of adjustment primarily on countries losing gold, so that inflationary excesses would be avoided. (Fortunately, for the world economy, gold supplies increased fairly rapidly during the nineteenth century, the spread of the gold standard meant that the monetary demand for gold was increasing faster than the supply of gold, causing gold to appreciate for most of the nineteenth century.)

When I set out to write my book on free banking, my intention was to clear up the historical misunderstandings, largely attributable to David Hume, surrounding the operation of the gold standard and the behavior of competitive banks. In contrast to the Humean view that banks are inherently inflationary — a view endorsed by quantity theorists of all stripes and enshrined in the money-multiplier analysis found in every economics textbook — that the price level would go to infinity if banks were not constrained by a legal reserve requirement on their creation of liabilities, there was an alternative view that the creation of liabilities by the banking system is characterized by the same sort of revenue and cost considerations governing other profit-making enterprises, and that the equilibrium of a private banking system is not that value of money is driven down to zero, as Milton Friedman, for example, claimed in his Program for Monetary Stability.

The modern discovery (or rediscovery) that banks are not inherently disposed to debase their liabilities was made by James Tobin in his classic paper “Commercial Banks and Creators of Money.” Tobin’s analysis was extended by others (notably Ben Klein, Earl Thompson, and Fischer Black) to show that the standard arguments for imposing quantitative limits on the creation of bank liabilities were unfounded, because, even with no legal constraints, there are economic forces limiting their creation of liabilities. A few years after these contributions, F. A. Hayek also figured out that there are competitive forces constraining the creation of liabilities by the banking system. He further developed the idea in a short book Denationalization of Money which did much to raise the profile of the idea of free banking, at least in some circles.

If there is an economic constraint on the creation of bank liabilities, and if, accordingly, the creation of bank liabilities was responsive to the demands of individuals to hold those liabilities, the Friedman/Monetarist idea that the goal of monetary policy should be to manage the total quantity of bank liabilities so that it would grow continuously at a fixed rate was really dumb. It was tried unsuccessfully by Paul Volcker in the early 1980s, in his struggle to bring inflation under control. It failed for precisely the reason that the Bank Charter Act had to be suspended periodically in the nineteenth century: the quantitative limit on the growth of the money supply itself triggered a precautionary demand to hold money that led to a financial crisis. In order to avoid a financial crisis, the Volcker Fed constantly allowed the monetary aggregates to exceed their growth targets, but until Volcker announced in the summer of 1982 that the Fed would stop paying attention to the aggregates, the economy was teetering on the verge of a financial crisis, undergoing the deepest recession since the Great Depression. After the threat of a Friedman/Monetarist financial crisis was lifted, the US economy almost immediately began one of the fastest expansions of the post-war period.

Nevertheless, for years afterwards, Friedman and his fellow Monetarists kept warning that rapid growth of the monetary aggregates meant that the double-digit inflation of the late 1970s and early 1980s would soon return. So one of my aims in my book was to use free-banking theory – the idea that there are economic forces constraining the issue of bank liabilities and that banks are not inherently engines of inflation – to refute the Monetarist notion that the key to economic stability is to make the money stock grow at a constant 3% annual rate of growth.

Another goal was to explain that competitive banks necessarily have to select some outside asset into which to make their liabilities convertible. Otherwise those liabilities would have no value, or at least so I argued, and still believe. The existence of what we now call network effects forces banks to converge on whatever assets are already serving as money in whatever geographic location they are trying to draw customers from. Thus, free banking is entirely consistent with an already existing fiat currency, so that there is no necessary link between free banking and a gold (or other commodity) standard. Moreover, if free banking were adopted without abolishing existing fiat currencies and legal tender laws, there is almost no chance that, as Hayek argued, new privately established monetary units would arise to displace the existing fiat currencies.

My final goal was to suggest a new way of conducting monetary policy that would enhance the stability of a free banking system, proposing a monetary regime that would ensure the optimum behavior of prices over time. When I wrote the book, I had been convinced by Earl Thompson that the optimum behavior of the price level over time would be achieved if an index of nominal wages was stabilized. He proposed accomplishing this objective by way of indirect convertibility of the dollar into an index of nominal wages by way of a modified form of Irving Fisher’s compensated dollar plan. I won’t discuss how or why that goal could be achieved, but I am no longer convinced of the optimality of stabilizing an index of nominal wages. So I am now more inclined toward nominal GDP level targeting as a monetary policy regime than the system I proposed in my book.

But let me come back to the point that I think J. V. Dubois was getting at in his comment. Historically, idea of free banking meant that private banks should be allowed to issue bank notes of their own (with the issuing bank clearly identified) without unreasonable regulations, restrictions or burdens not generally applied to other institutions. During the period when private banknotes were widely circulating, banknotes were a more prevalent form of money than bank deposits. So in the 21st century, the right of banks to issue hand to hand circulating banknotes is hardly a crucial issue for monetary policy. What really matters is the overall legal and regulatory framework under which banks operate.

The term “free banking” does very little to shed light on most of these issues. For example, what kind of functions should banks perform? Should commercial banks also engage in investment banking? Should commercial bank liabilities be ensured by the government, and if so under what terms, and up to what limits? There are just a couple of issues; there are many others. And they aren’t necessarily easily resolved by invoking the free-banking slogan. When I was writing, I meant by “free banking” a system in which the market determined the total quantity of bank liabilities. I am still willing to use “free banking” in that sense, but there are all kinds of issues concerning the asset side of bank balance sheets that also need to be addressed, and I don’t find it helpful to use the term free banking to address those issues.

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.

Ludwig von Mises Explains (and Solves) Market Failure

Last week Major Freedom, a relentless and indefatigable web-Austrian troll – and with a name like that, I predict a bright future for him as a professional wrestler should he ever tire of internet trolling — who regularly occupies Scott Sumner’s blog, responded to a passing reference by Scott to F. A. Hayek’s support for NGDP targeting with an outraged rant against Hayek, calling Hayek a social democrat, a description of Hayek that for some reason brought to my mind Saul Steinberg’s famous New Yorker cover showing what the world looks like from 9th Avenue in Manhattan.

saul_steinberg_newyorker

Hayek was not a libertarian by the way. He was a social democrat. If you read his works closely, you’ll realize he was politically leftist very soon after his earlier economics works. Hayek was actually an economist for only a short period of time. He soon became disenchanted with free market economics, and delved into sociology where his works were all heavily influenced by leftist politics. He was an ardent critic of government, but not because he was anti-government, but because the present day governments were not his ideal.

Hayek favored central banks preventing NGDP from falling yes, but he was a contradictory writer. It is dishonest to only focus on the one side of the contradiction that supports your own ideology. If you were honest, you would make it a point that Hayek also favored monetary denationalization, of competitive free market currencies. He wrote a book on that for crying out loud. His contradictions are “Hayekian.” NGDP targeting is merely the Dr. Jekyll to his Mr. Hyde.

Then responding to the incredulity of another commenter at his calling Hayek a social democrat, the Major let loose this barrage:

From [Hans-Hermann] Hoppe:

According to Hayek, government is “necessary” to fulfill the following tasks: not merely for “law enforcement” and “defense against external enemies” but “in an advanced society government ought to use its power of raising funds by taxation to provide a number of services which for various reasons cannot be provided, or cannot be provided adequately, by the market.” (Because at all times an infinite number of goods and services exist that the market does not provide, Hayek hands government a blank check.)

Among these goods and services are:

“…protection against violence, epidemics, or such natural forces as floods and avalanches, but also many of the amenities which make life in modern cities tolerable, most roads … the provision of standards of measure, and of many kinds of information ranging from land registers, maps and statistics to the certification of the quality of some goods or services offered in the market.”

Additional government functions include “the assurance of a certain minimum income for everyone”; government should “distribute its expenditure over time in such a manner that it will step in when private investment flags”; it should finance schools and research as well as enforce “building regulations, pure food laws, the certification of certain professions, the restrictions on the sale of certain dangerous goods (such as arms, explosives, poisons and drugs), as well as some safety and health regulations for the processes of production; and the provision of such public institutions as theaters, sports grounds, etc.”; and it should make use of the power of “eminent domain” to enhance the “public good.”

Moreover, it generally holds that “there is some reason to believe that with the increase in general wealth and of the density of population, the share of all needs that can be satisfied only by collective action will continue to grow.”

Further, government should implement an extensive system of compulsory insurance (“coercion intended to forestall greater coercion”), public, subsidized housing is a possible government task, and likewise “city planning” and “zoning” are considered appropriate government functions — provided that “the sum of the gains exceed the sum of the losses.” And lastly, “the provision of amenities of or opportunities for recreation, or the preservation of natural beauty or of historical sites or scientific interest … Natural parks, nature-reservations, etc.” are legitimate government tasks.

In addition, Hayek insists we recognize that it is irrelevant how big government is or if and how fast it grows. What alone is important is that government actions fulfill certain formal requirements. “It is the character rather than the volume of government activity that is important.” Taxes as such and the absolute height of taxation are not a problem for Hayek. Taxes — and likewise compulsory military service — lose their character as coercive measures,

“…if they are at least predictable and are enforced irrespective of how the individual would otherwise employ his energies; this deprives them largely of the evil nature of coercion. If the known necessity of paying a certain amount of taxes becomes the basis of all my plans, if a period of military service is a foreseeable part of my career, then I can follow a general plan of life of my own making and am as independent of the will of another person as men have learned to be in society.”

But please, it must be a proportional tax and general military service!

The disgust felt by the Major for the crypto-statist Hayek is palpable, reminiscent of Ayn Rand’s pathological abhorrence of Hayek for tolerating welfare-statism. Ah, but Ludwig von Mises, there is a man after the Major’s very own heart.

In distinct contrast, how refreshingly clear — and very different — is Mises! For him, the definition of liberalism can be condensed into a single term: private property. The state, for Mises, is legalized force, and its only function is to defend life and property by beating antisocial elements into submission. As for the rest, government is “the employment of armed men, of policemen, gendarmes, soldiers, prison guards, and hangmen. The essential feature of government is the enforcement of its decrees by beating, killing, and imprisonment. Those who are asking for more government interference are asking ultimately for more compulsion and less freedom.”

Moreover (and this is for those who have not read much of Mises but invariably pipe up, “but even Mises is not an anarchist”), certainly the younger Mises allows for unlimited secession, down to the level of the individual, if one comes to the conclusion that government is not doing what it is supposed to do: to protect life and property.

Well, the remark about Hayek’s support for — perhaps acquiescence in would be a better description — conscription (see the Constitution of Liberty) reminded me that in Human Action no less – for the uninitiated that’s Mises’s magnum opus, a 900+ page treatise on economics and praxeology — Mises himself weighed in on the issue of military conscription.

From this point of view one has to deal with the often-raised problem of whether conscription and the levy of taxes mean a restriction of freedom. If the principles of the market economy were acknowledged by all people all over the world, there would not be any reason to wage war and the individual states could live in undisturbed peace. But as conditions are in our age, a free nation is continually threatened by the aggressive schemes of totalitarian autocracies. If it wants to preserve its freedom, it must be prepared to defend its independence. If the government of a free country forces every citizen to cooperate fully in its designs to repel the aggressors and every able-bodied man to join the armed forces, it does not impose upon the individual a duty that would step beyond the tasks the praxeological law dictates. In a world full of unswerving aggressors and enslavers, integral unconditional pacifism is tantamount to unconditional surrender to the most ruthless oppressors. He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government. The essential task of government is defense of the social system not only against domestic gangsters but also against external foes. He who in our age opposes armaments and conscription is, perhaps unbeknown to himself, an abettor of those aiming at the enslavement of all.

There it is. With characteristic understatement, Ludwig von Mises, a card-carrying member of the John Birch Society listed on the advisory board of the Society’s flagship publication American Opinion during the 1960s, calls anyone opposed to conscription an abettor of those aiming at the enslavement of all. But what I find interesting in Mises’s diatribe are the two sentences before the last one in the paragraph.

He who wants to remain free, must fight unto death those who are intent upon depriving him of his freedom. As isolated attempts on the part of each individual to resist are doomed to failure, the only workable way is to organize resistance by the government.

Here Mises says that we have to defend ourselves to maintain our freedom, otherwise we will be enslaved. OK. And then he says that voluntary self-defense will not work. Why won’t it work? Because the market isn’t working. And what causes the market to fail? “Isolated attempts on the part of each individual to resist” will fail. In other words, defense is a public good. People will free ride on the efforts of others. But Mises has the solution. Impose a draft, and compel the able-bodied to defend the homeland and force everyone to pay taxes to finance the provision of the public good, which the unhampered free market is unable to do on its own. Of course, this is just one example of market failure, but Mises doesn’t actually explain why the provision of national defense is the only public good. But, analytically of course, there is no distinction between national defense and other public goods, which confer benefits on people irrespective of whether they have paid for the good. So Mises acknowledges that there is such a thing as a public good, and supports the use of government coercion to supply the public good, but without providing any criterion for which public goods may be provided by the government and which may not. If conscription can be justified to solve a certain kind of public-good problem, why is it unthinkable to rely on taxation to solve other kinds of public-good problems, whose existence Mises, apparently unbeknown to himself, has implicitly conceded?

With the logical rigor that his acolytes find so compelling, Mises concludes this particular diatribe with the following pronouncement:

Every step a government takes beyond the fulfillment of its essential functions of protecting the smooth operation of the market economy against aggression, whether on the part of domestic or foreign disturbers, is a step forward on a road that directly leads into the totalitarian system where there is no freedom at all.

Let’s think about that one. “Every step a government takes beyond the fulfillment of its essential function of protecting the smooth operation of the market economy against aggression . . . is a step forward on a road that leads into the totalitarian system where there is no freedom at all.” Pretty scary words, but how logically compelling is this apodictally certain praxeological law?

Well, I live in Montgomery County, Maryland, a short distance from US Route 29. When I visit Baltimore about 35 miles from my home, I often come back from Baltimore via Interstate 70 which starts at a park-and-ride station near Baltimore and continues for about 2153 miles to Cove Fort, Utah. I am happy to report that I have never once driven from Baltimore to Cove Fort. In fact the first exit off of Interstate 70 puts me on US Route 29. What’s more, even if I miss the exit for Route 29, as I have done occasionally, there are other exits further down the highway that allow me to get to Route 29; just because I drive the first four miles on Interstate 70 from Baltimore, it doesn’t necessarily follow that I will wind up in Cove Fort, Utah. So this particular example of the supposedly impeccable Misesian logic sure seems like a non-sequitur to me.

 

John Cochrane Explains Neo-Fisherism

In a recent post, John Cochrane, responding to an earlier post by Nick Rowe about Neo-Fisherism, has tried to explain why raising interest rates could plausibly cause inflation to rise and reducing interest rates could plausibly cause inflation to fall, even though almost everyone, including central bankers, seems to think that when central banks raise interest rates, inflation falls, and when they reduce interest rates, inflation goes up.

In his explanation, Cochrane concedes that there is an immediate short-term tendency for increased interest rates to reduce inflation and for reduced interest rates to raise inflation, but he also argues that these effects (liquidity effects in Keynesian terminology) are transitory and would be dominated by the Fisher effects if the central bank committed itself to a permanent change in its interest-rate target. Of course, the proviso that the central bank commit itself to a permanent interest-rate peg is a pretty important qualification to the Neo-Fisherian position, because few central banks have ever committed themselves to a permanent interest-rate peg, the most famous attempt (by the Fed after World War II) to peg an interest rate having led to accelerating inflation during the Korean War, thereby forcing the peg to be abandoned, in apparent contradiction of the Neo-Fisherian view.

However, Cochrane does try to reconcile the Neo-Fisherian view with the standard view that raising interest rates reduces inflation and reducing interest rates increases inflation. He suggests that the standard view is strictly a short-run relationship and that the way to target inflation over the long-run is simply to target an interest rate consistent with the desired rate of inflation, and to rely on the Fisher equation to generate the actual and expected rate of inflation corresponding to that nominal rate. Here’s how Cochrane puts it:

We can put the issue more generally as, if the central bank does nothing to interest rates, is the economy stable or unstable following a shock to inflation?

For the next set of graphs, I imagine a shock to inflation, illustrated as the little upward sloping arrow on the left. Usually, the Fed responds by raising interest rates. What if it doesn’t?  A pure neo-Fisherian view would say inflation will come back on its own.

cochrane1

Again, we don’t have to be that pure.

The milder view allows there may be some short run dynamics; the lower real rates might lead to some persistence in inflation. But even if the Fed does nothing, eventually real interest rates have to settle down to their “natural” level, and inflation will come back. Mabye not as fast as it would if the Fed had aggressively tamed it, but eventually.

cochrane2

By contrast, the standard view says that inflation is unstable. If the Fed does not raise rates, inflation will eventually careen off following the shock.

cochrane3

Now this really confuses me. What does a shock to inflation mean? From the context, Cochrane seems to be thinking that something happens to raise the rate of inflation in the short run, but the persistence of increased inflation somehow depends on an underlying assumption about whether the economy is stable or unstable. Cochrane doesn’t tell us what kind of shock to inflation he is talking about, and I can imagine only two possibilities, either a nominal shock or a real shock.

Let’s say it’s a nominal shock. What kind of nominal shock might Cochrane have in mind? An increase in the money supply? Well, presumably an increase in the money supply would cause an increase in the price level, and a temporary increase in the rate of inflation, but if the increase in the money supply is a once-and-for-all increase, the system must revert, after a temporary increase, back to the old rate of inflation. Or maybe, Cochrane is thinking of a permanent increase in the rate of growth in the money supply. But in that case, why would the rate of inflation come back on its own as Cochrane suggests it would? Well, maybe it’s not the money supply but money demand that’s changing. But again, one would normally assume that an appropriate change in central-bank policy could cope with such a scenario and stabilize the rate of inflation.

Alright, then, let’s say it’s a real shock. Suppose some real event happens that raises the rate of inflation. Well, like what? A supply shock? That raises the rate of inflation, but since when is the standard view that the appropriate response by the central bank to a negative supply shock is to raise the interest-rate target? Perhaps Cochrane is talking about a real shock that reduces the real rate of interest. Well, in that case, the rate of inflation would certainly rise if the central bank maintained its nominal-interest-rate target, but the increase in inflation would not be temporary unless the real shock was temporary. If the real shock is temporary, it is not clear why the standard view would recommend that the central bank raise its target rate of interest. So, I am sorry, but I am still confused.

Now, the standard view that Cochrane is disputing is actually derived from Wicksell, and Wicksell’s cycle theory is in fact based on the assumption that the central bank keeps its target interest rate fixed while the natural rate fluctuates. (This, by the way, was also Hayek’s assumption in his first exposition of his theory in Monetary Theory and the Trade Cycle.) When the natural rate rises above the central bank’s target rate, a cumulative inflationary process starts, because borrowing from the banking system to finance investment is profitable as long as the expected return on investment exceeds the interest rate on loans charged by the banks. (This is where Hayek departed from Wicksell, focusing on Cantillon Effects instead of price-level effects.) Cochrane avoids that messy scenario, as far as I can tell, by assuming that the initial position is one in which the Fisher equation holds with the nominal rate equal to the real plus the expected rate of inflation and with expected inflation equal to actual inflation, and then positing an (as far as I can tell) unexplained inflation shock, with no change to the real rate (meaning, in Cochrane’s terminology, that the economy is stable). If the unexplained inflation shock goes away, the system must return to its initial equilibrium with expected inflation equal to actual inflation and the nominal rate equal to the real rate plus inflation.

In contrast, the Wicksellian assumption is that the real rate fluctuates with the nominal rate and expected inflation unchanged. Unless the central bank raises the nominal rate, the difference between the profit rate anticipated by entrepreneurs and the rate at which they can borrow causes the rate of inflation to increase. So it does not seem to me that Cochrane has in any way reconciled the Neo-Fisherian view with the standard view (or at least the Wicksellian version of the standard view).

PS I would just note that I have explained in my paper on Ricardo and Thornton why the Wicksellian analysis (anticipated almost a century before Wicksell by Henry Thornton) is defective (basically because he failed to take into account the law of reflux), but Cochrane, as far as I can tell, seems to be making a completely different point in his discussion.

Is Insanity Breaking out in Switzerland?

The other day, I saw this item on Bloomberg.com “1500 Tons of Gold on the Line in Swiss Vote Buy Back Bullion.” Have a look:

There are people in Switzerland who resent that the country sold away much of its gold last decade. They may be a splinter group of Swiss politics, but they’re a persistent bunch.

And if they get their way in a referendum this month, these voters will make their presence known to gold traders around the world.

The proposal from the “Save Our Swiss Gold” proponents is simple: Force the central bank to build its bullion position up to at least 20 percent of total assets from 8 percent today. Holding 522 billion Swiss francs ($544 billion) of assets in its coffers, the Swiss National Bank would have to buy at least 1,500 tons of gold, costing about $56.3 billion at current prices, to get to the required threshold by 2019.

Those purchases, equal to about 7 percent of annual global demand, would trigger an 18 percent rally, giving a lift to gold bulls who’ve suffered 32 percent losses in the past two years, Bank of America Corp. estimates. With polls showing voters split before the Nov. 30 referendum, the SNB and national government are warning that such a move could undermine efforts to prevent the franc from surging against the euro and erode the bank’s annual dividend distribution to regional governments.

There they go again. The gold bugs are rallying to prop up the gold-price bubble with mandated purchases of the useless yellow metal so that it can be locked up to lie idle and inert in the vaults of the Swiss National Bank. How insane is that?

But wait! There is method to their madness.

A “yes” victory means Switzerland would face buying the metal at prices that quadrupled since it began selling more than half its reserves in 2000. The move would make the SNB the world’s third-biggest holder of gold. The initiative would also force the central bank to repatriate the 30 percent of its gold held abroad in the U.K. and Canada and bar it from ever selling bullion again.

With 1,040 metric tons, Switzerland is already the seventh-largest holder of gold by country, International Monetary Fund data show. According to UBS, a change in the law may force the SNB to buy about 1,500 tons, while ABN Amro Group NV and Societe Generale SA estimate the need at closer to 1,800 tons.

The SNB’s assets have expanded by more than a third in the past three years because of currency interventions to enforce a minimum exchange rate of 1.20 per euro. As of August, just under 8 percent of its assets were in gold, compared with a ratio of 15 percent for Germany‘s Bundesbank.

Many people get all bent out of shape at the mere mention of bailing out the banks and Wall Street, but those same people don’t seem to mind bailing out all those hedge funds and gold investment trusts, as well as all the individual investors, egged on by the Peter Schiffs of the world and by the sleazy characters advertising on Fox News and talk radio, who recklessly jumped on the gold bandwagon at the height of the gold bubble from 2008 to 2011.

Gold price tanking? No problemo. Just get the central banks to start buying all the gold now being dumped into the market by people who have finally realized that it’s time to cut their losses before prices fall even further. The price of gold having fallen by almost 20% from its 2014 high, a central-bank rescue operation looks awfully attractive to a lot of desperate people. Even better, the rescue operation can be dressed up and packaged as if it were the quintessence of monetary virtue, merely requiring central banks to hold gold backing for the paper money they issue.

Of course, this referendum, even if passed by Swiss electorate, is less than half as insane as the Monetary Law enacted in 1928, at the urging of the Bank of France, by the French Parliament, a law requiring the Bank to hold gold equal to at least 35% of its outstanding note issue. The Bank in its gold frenzy went way beyond its legal obligation to accumulate gold. The proposed Swiss Law is less than half as insane as the French Monetary Law of 1928, because in 1928 France and much of the rest of the world were either on the gold standard or about to rejoin the gold standard, so that increasing the demand for gold meant forcing the world into the deflationary death spiral that turned into the Great Depression. The most that the proposed Swiss Law could do is force Switzerland into a deflationary spiral.

That would be too bad for Switzerland, but probably not such a big deal for the rest of the world. If the Swiss want to lock up 1500 tons of gold in the vaults of their central bank, well, it’s their sovereign right to go insane. Luckily, the rest of the world has figured out how to have a monetary system in which the gyrations of the hyper-volatile gold price can no longer ruin the lives of many hundreds of millions, if not billions, of people.

Why Are Corporations Hoarding all that Cash?

One of the ongoing puzzles of this joyless recovery (to give it the benefit of the doubt) has been the huge accumulation of cash by corporations. The puzzle is that the huge cash hoards that companies are sitting on are being generated by high earnings, high earning reflected in – or, perhaps more accurately, anticipated by — rising stock prices since the stock market bottomed out in March 2009. So one would think that the high earnings would have encouraged these highly profitable companies to expand output, building new capacity and hiring new workers, rather than accumulate all that cash. But the growth in cash holdings by companies has dwarfed the growth in new capital spending and employment. So what gives?

Corporations, obviously, are not all the same, so that any simple broad generalizations about what they are doing and why are very questionable. A disproportionate share of the newly accumulated cash is in the hands of large companies, especially in the telecommunications sector, the most notorious case being Apple, whose hoard is reportedly close to 200 billion dollars. Let me also observe that the increase in cash holding by corporations has been increasing for a long time, especially since the mid-1990s, tapering off in the mid-2000s before dipping during the financial crisis. But the upward trend resumed and accelerated after the crisis.

Here are some of the reasons that I have seen mentioned or have thought of myself for all this corporate cash hoarding.

A basic proposition of the theory of the demand for money is that an increase in uncertainty increases the demand for money. It is certain that the financial crisis was associated with increased uncertainty, raising the demand for money during and, owing to residual effects of the crisis, after the crisis. One might wonder why, if the demand for money increased during the crisis, corporate cash holdings decreased. The answer is that cash flows during the crisis were drastically reduced, requiring companies to expend cash even though they would have preferred to squirrel it away. The crisis was a period of extreme disequilibrium, and corporations (like many other economic agents) were forced way off their demand curves. So some part of the increase in corporate cash holdings can probably be attributed to a general increase in overall macroeconomic uncertainty. However, macroeconomic conditions has been fairly stable now for the last two or three years, at least in the US. So, although one could argue that the general macroeconomic environment is more uncertain than it was before the crisis, it would be hard to argue that uncertainty has not been gradually diminishing over the past few years, even as corporate cash hoards have continued to grow rapidly.

Some people – I don’t have to name them, you know who they are – like to say that the increase in uncertainty is all, or perhaps only mostly, due to the policies of the Obama administration and the Federal Reserve, especially, but not only, Obamacare and quantitative easing. But Obamacare was enacted in 2010, and it has been implemented gradually since then, coming more or less fully into effect this year. So the uncertainty associated with Obamacare should have been decreasing over time. Quantitative easing has been in effect in one form or another for most of the past four years, so people have gotten used to it. There is now uncertainty about when and how it will come to an end, but there is no sign that concerns about its gradual termination are causing any major market disturbances. So one can’t easily attribute the continuing increase in corporate cash-holding to uncertainty caused by Obamacare or quantitative-easing.

There are also microeconomic sources of uncertainty that are specific to particular sectors or industries, accounting for faster rates of increase in cash-holding by particular types of corporations, but the increase in cash-holding has not been confined to any single group of corporations, though large multi-national corporations, especially technology, media, and telecommunications companies have shown the largest increases in cash holdings. A study by economists at the St. Louis Fed suggested that R&D intensive corporations, being subject to high uncertainty owing to the unpredictable outcomes of their R&D activities, have been increasing their cash holdings more rapidly than less R&D intensive corporations. As R&D expenditures increase as a share of total investment, total cash holding by corporations would be expected to increase. But, again, this explanation can account for a long-term trend towards increased corporate cash holding, but not for the surge in corporate cash holding since 2009.

Let’s think again about why a profitable company is holding a lot of cash. So what can a profitable company do with all that cash gushing into its coffers? Well, 1) it can just hold on to the cash, 2) it could invest in new plant and equipment, (we’ll come back to this in a moment), 3) it could go out and buy other companies, 4) it could pay bonuses to some or all of the employees (guess which ones) of the company, or 5) it could return the cash to the owners of the company by paying dividends or by repurchasing stock.

As promised, let’s now think a bit more about option 2). There are broadly speaking three categories of capital investment. First, there is capital investment that replaces old and depreciating equipment with new and possibly improved equipment, but does not alter the firm’s structure or methods of production. It simply allows the company to keep doing what it has been doing, but perhaps a little bit more efficiently. Second, there is capital investment that aims to alter the structure of production, by adopting a new method or technique of production. Third, there is capital investment intended to increase the total productive capacity of the firm, enabling the firm to expand its output and increase its sales.

Notice that the first category is necessary for any firm unless it is about to go out of business. A firm may postpone such investment if it is not currently profitable, but it can’t postpone it for long without compromising the viability of the firm. Capital replacement is important, but to a large extent it is automatic, not being sensitive to relatively small changes in economic incentives.

The second category does depend importantly on the relative profitability of different techniques, and these decisions require pretty careful and detailed assessments by corporate management to decide which ones will be profitable and should be undertaken and which ones are unlikely to be profitable or involve too much risk to be undertaken. I note parenthetically that it is only a subset (probably a small subset) of this category that is sensitive to the interest-rate mechanism that looms so large in Austrian business-cycle theory. To presume that this probably small sub-category of interest-sensitive investment is what drives the business cycle involves a huge, and empirically unsupported, assumption.

The third – and undoubtedly the largest — category depends primarily not on calculations about the relative cost and profitability of different techniques, but on expectations about future demand for the firm’s output. If firms believe that they can increase sales at current prices, they will expand capacity to produce more output. If they don’t invest in increased capacity, they will probably lose market share to their competitors.

So, if corporations have been accumulating cash rather than investing in new plant and equipment to expand output – the sort of investment that would involve major expenditures and a significant drawdown of cash hoards — the most obvious explanation seems to be that firms don’t expect future demand at current prices to increase enough to justify such investments. A surge in corporate cash holding is an indication that corporate expectations about future demand are not very optimistic. Mildly pessimistic expectations about future demand are not inconsistent with high current profitability and rising stock prices.

I will not comment about why companies are not using their cash to buy other companies or to pay more and bigger bonuses to employees, but I do want to say something about why companies aren’t paying higher dividends to stockholders or buying back stock. One reason that they are not increasing dividend payments is that dividends are not tax-deductible. The non-deductibility of dividends is a terrible flaw in our corporate tax code. (See this post about Hyman Minsky’s opinion of the corporate income tax.) It penalizes giving the owners of companies the ability to decide how to allocate their capital, locking up capital in existing corporations because capital gains are taxed at a lower rate than dividends.

Now it would still be possible for corporations with excess cash to repurchase stock, allowing stockholders to be taxed at the lower rate on capital gains instead of the higher rate on dividends. But for multinational corporations, there is another obstacle to returning cash to stockholders either by paying dividends or by stock repurchase: cash now held overseas would be subject to the 35% corporate tax rate on either dividends or stock repurchases, imposing a huge penalty on returning idle cash to stockholders. So, instead of the cash being made available to millions of stockholders to spend or invest as they wish, creating new demand for output or providing capital to firms seeking new financing, the money is now effectively embargoed in corporate treasuries. What a waste.

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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