What Hath Merkel Wrought?

In my fifth month of blogging in November 2011, I wrote a post which I called “The Economic Consequences of Mrs. Merkel.” The title, as I explained, was inspired by J. M. Keynes’s famous essay “The Economic Consequences of Mr. Churchill,” which eloquently warned that Britain was courting disaster by restoring the convertibility of sterling into gold at the prewar parity of $4.86 to the pound, the dollar then being the only major currency convertible into gold. The title of Keynes’s essay, in turn, had been inspired by Keynes’s celebrated book The Economic Consequences of the Peace about the disastrous Treaty of Versailles, which accurately foretold the futility of imposing punishing war reparations on Germany.

In his essay, Keynes warned that by restoring the prewar parity, Churchill would force Britain into an untenable deflation at a time when more than 10% of the British labor force was unemployed (i.e., looking for, but unable to find, a job at prevailing wages). Keynes argued that the deflation necessitated by restoration of the prewar parity would impose an intolerable burden of continued and increased unemployment on British workers.

But, as it turned out, Churchill’s decision turned out to be less disastrous than Keynes had feared. The resulting deflation was quite mild, wages in nominal terms were roughly stable, and real output and employment grew steadily with unemployment gradually falling under 10% by 1928. The deflationary shock that Keynes had warned against turned out to be less severe than Keynes had feared because the U.S. Federal Reserve, under the leadership of Benjamin Strong, President of the New York Fed, the de facto monetary authority of the US and the world, followed a policy that allowed a slight increase in the world price level in terms of dollars, thereby moderating the deflationary effect on Britain of restoring the prewar sterling/dollar exchange rate.

Thanks to Strong’s enlightened policy, the world economy continued to expand through 1928. I won’t discuss the sequence of events in 1928 and 1929 that led to the 1929 stock market crash, but those events had little, if anything, to do with Churchill’s 1925 decision. I’ve discussed the causes of the 1929 crash and the Great Depression in many other places including my 2011 post about Mrs. Merkel, so I will skip the 1929 story in this post.

The point that I want to make is that even though Keynes’s criticism of Churchill’s decision to restore the prewar dollar/sterling parity was well-taken, the dire consequences that Keynes foretold, although they did arrive a few years thereafter, were not actually caused by Churchill’s decision, but by decisions made in Paris and New York, over which Britain may have had some influence, but little, if any, control.

What I want to discuss in this post is how my warnings about potential disaster almost six and a half years ago have turned out. Here’s how I described the situation in November 2011:

Fast forward some four score years to today’s tragic re-enactment of the deflationary dynamics that nearly destroyed European civilization in the 1930s. But what a role reversal! In 1930 it was Germany that was desperately seeking to avoid defaulting on its obligations by engaging in round after round of futile austerity measures and deflationary wage cuts, causing the collapse of one major European financial institution after another in the annus horribilis of 1931, finally (at least a year after too late) forcing Britain off the gold standard in September 1931. Eighty years ago it was France, accumulating huge quantities of gold, in Midas-like self-satisfaction despite the economic wreckage it was inflicting on the rest of Europe and ultimately itself, whose monetary policy was decisive for the international value of gold and the downward course of the international economy. Now, it is Germany, the economic powerhouse of Europe dominating the European Central Bank, which effectively controls the value of the euro. And just as deflation under the gold standard made it impossible for Germany (and its state and local governments) not to default on its obligations in 1931, the policy of the European Central Bank, self-righteously dictated by Germany, has made default by Greece and now Italy and at least three other members of the Eurozone inevitable. . . .

If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

Greece did default, but the European Community succeeded in imposing draconian austerity measures on Greece, while Italy, Spain, France, and Portugal, which had all been in some danger, managed to avoid default. That they did so is due first to the enormous cost that would have be borne by a country in the Eurozone to extricate itself from the Eurozone and reinstitute its own national currency and second to the actions taken by Mario Draghi, who succeeded Jean Claude Trichet as President of the European Central Bank in November 2011. If monetary secession from the eurozone were less fraught, surely Greece and perhaps other countries would have chosen that course rather than absorb the continuing pain of remaining in the eurozone.

But if it were not for a decisive change in policy by Draghi, Greece and perhaps other countries would have been compelled to follow that uncharted and potentially catastrophic path. But, after assuming leadership of the ECB, Draghi immediately reversed the perverse interest-rate hikes imposed by his predecessor and, even more crucially, announced in July 2012 that the ECB “is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.” Draghi’s reassurance that monetary easing would be sufficient to avoid default calmed markets, alleviated market pressure driving up interest rates on debt issued by those countries.

But although Draghi’s courageous actions to ease monetary policy in the face of German disapproval avoided a complete collapse, the damage inflicted by Mrs. Merkel’s ferocious anti-inflation policy did irreparable damage, not only on Greece, but, by deepening the European downturn and delaying and suppressing the recovery, on the rest of the European community, inflaming anti-EU, populist nationalism in much of Europe that helped fuel the campaign for Brexit in the UK and has inspired similar anti-EU movements elsewhere in Europe and almost prevented Mrs. Merkel from forming a government after the election a few months ago.

Mrs. Merkel is perhaps the most impressive political leader of our time, and her willingness to follow a humanitarian policy toward refugees fleeing the horrors of war and persecution showed an extraordinary degree of political courage and personal decency that ought to serve as a model for other politicians to emulate. But that admirable legacy will be forever tarnished by the damage she inflicted on her own country and the rest of the EU by her misguided battle against the phantom threat of inflation.


What Do Stock Prices Tell Us about the Economy?

Stock prices (as measured by the S&P 500) in 2017 rose by over 20%, an impressive amount, and what is most impressive about it is perhaps that this rise prices came after eight previous years of steady increases.

Here are the annual year-on-year and cumulative changes in the S&P500 since 2009.

2009              21.1%              21.1%*

2010              12.0%              33.1%*

2011              -0.0%               33.1%*

2012              12.2%               45.3%*

2013              25.9%               71.2%*

2014              10.8%               82.0%*

2015              -0.7%                81.3%*

2016             9.1%                   90.4%*            (4.5%)**          (85.9%)***

2017             17.7%                 108.1%*          (22.3%)****

2018 (YTD)    2.0%                  110.1%*           (24.3%)****

* cumulative increase since the end of 2008

** increase from end of 2015 to November 8, 2016

*** cumulative increase from end of 2008 to November 8, 2016

**** cumulative increase since November 8, 2016

So, from the end of 2008 until the start of 2017, approximately coinciding with Obama’s two terms as President, the S&P 500 rose in every year except 2011 and 2015, when the index was essentially unchanged, and rose by more than 10% in five of the eight years (twice by more than 20%), with stock prices nearly doubling during the Obama Presidency.

But what does the doubling of stock prices under Obama really tell us about the well-being of the American economy, and, even more importantly, about the well-being of the American public during those years? Is there any correlation between the performance of the stock market and the well-being of actual people? Does the doubling of stock prices under Obama mean that most Americans were better off at the end of his Presidency than they were at the start of it?

My answer to these questions is a definite — though not very resounding — yes, because we know that the US economy at the end of 2008 was in the middle of the sharpest downturn since the Great Depression. Output was contracting, employment was falling, and the financial system was on the verge of collapse, with stock prices down almost 50% from where they had been at the end of August, and nearly 60% from the previous all-time high reached in 2007. In 2016, after seven years of slow but steady growth, employment and output had recovered and surpassed their previous peaks, though only by small amounts. But the recovery, although disappointingly slow, was real.

That improvement was reflected, albeit with a lag, in changes in median household and median personal income between 2008 and 2016.

2009                    -0.7%                   -0.7%

2010                    -2.6%                    -3.3%

2011                     -1.6%                    -4.9%

2012                    -0.1%                    -5.0%

2013                      3.5%                    -1.5%

2014                    -1.5%                     -3.0%

2015                     5.1%                       2.0%

2016                      3.1%                      5.1%

But it’s also striking how weak the correlation was between rapidly rising stock prices and rising median incomes in the Obama years. Given a tepid real recovery from the Little Depression, what accounts for the associated roaring recovery in stock prices? Well, for one thing, much of the improvement in the stock market was simply recovering losses in stock valuations during the downturn. Stock prices having fallen further than incomes in the Little Depression, it’s not surprising that the recovery in stocks was steeper than the recovery in incomes. It took four years for the S&P 500 to reach its pre-Depression peak, so, normalized to their pre-Depression peaks, the correlation between stock prices and median incomes is not as weak as it seems when comparing year-on-year percentage changes.

But considering the improvement in stock prices under Obama in historical context also makes the improvement in stock prices under Obama seem less remarkable than it does when viewed without taking the previous downturn into account. Stock prices simply returned (more or less) to the path that, one might have expected them to follow by extrapolating their past performance. Nevertheless, even if we take into account that, during the Little Depression, stocks prices fell more sharply than real incomes, stocks have clearly outperformed the real economy during the recovery, real output and income having failed to return to the growth path that it had been tracking before the 2008 downturn.

Why have stocks outperformed the real economy? The answer to that question is a straightforward application of the basic theory of asset valuation, according to which the value of real assets – machines, buildings, land — and financial assets — stocks and bonds — reflects the discounted expected future income streams associated with those assets. In particular, stock prices represent the discounted present value of the expected future cash flows (dividends or stock buy-backs) from firms to their shareholders. So, if the economy has “recovered” (more or less) from the 2008-09 downturn, the expected future cash flows from firms have presumably – and on average — surpassed the cash flows that had been expected before the downturn.

But the weakness in the recovery suggests that the increase in expected cash flows can’t fully account for the increase in stock prices. Why did stock prices rise by more than the likely increase in expected cash flows? The basic theory of asset valuation tells us that the remainder of the increase in stock prices can be attributed to the decline of real interest rates since the 2008 downturn to historically low levels.

Of course, to say that the increase in stock prices is attributable to the decline in real interest rates just raises a different question: what accounts for the decline in real interest rates? The answer, derived from Irving Fisher, is basically that if perceived opportunities for future investment and growth are diminished, the willingness of people to trade future for present income also tends to diminish. What the rate of interest represents in the Fisherian framework is the rate at which people are willing to trade future for present income – i.e., the premium (discount) that is placed on present (future) income.

The Fisherian view is totally at odds with the view that the real interest rate is – or can be — controlled by the monetary authority. According to the latter view, the reason that real interest rates since the 2008 downturn have been at historically low levels is that the Federal Reserve has forced interest rates down to those levels by flooding the economy with huge quantities of printed money. There is a certain sense in which that view has a small element of truth: had the Fed adopted a different set of policy goals concerning inflation and nominal GDP, real interest rates might have risen to more “normal” levels. But given the overall policy framework within which it was operating, the Fed had only minimal control over the real rate of interest.

The essential idea is that in the Fisherian view the real rate of interest is not a single price determined in a single market; it is a distillation of the entire intertemporal structure of price relationships simultaneously determined in the myriad of individual markets in which transactions for present and future delivery are continuously being agreed upon. To imagine that the Fed, or any monetary authority, could control or even modestly influence this almost incomprehensibly complicated structure of price relationships according to its wishes is simply delusional.

If the decline in real interest rates after the 2008 downturn reflected generally reduced optimism about future economic growth, then the increase in stock prices actually reflected declining optimism by most people about their future well-being compared to their pre-downturn expectations. That loss of optimism might have been, at least in part, self-fulfilling insofar as it discouraged potentially worthwhile – i.e., profitable — investments that would have been undertaken had expectations been more optimistic.

Nevertheless, the near doubling of stock prices during the Obama administration did coincide with a not insignificant improvement in the well-being of most Americans. Most Americans were substantially better off at the end of 2016, after about seven years of slow but steady economic growth, than they were at the end of 2008 when total output and employment were contracting at the fastest rate since the Great Depression. But to use the increase in stock prices as a quantitative measure of the improvement in their well-being would be misleading.

I would also mention as an aside that a favorite faux-populist talking point of Obama and Fed critics used to be that rising stock prices during the Obama years revealed the bias of the elitist Fed Governors appointed by Obama in favor of the wealthy owners of corporate stock, and their callous disregard of the small savers who leave their retirement funds in bank savings accounts earning minimal interest and of workers whose wage increases barely kept up with inflation. But this refrain of critics – and I am thinking especially of the Wall Street Journal editorial page – who excoriated the Obama administration and the Fed for trying to raise stock prices by keeping interest rates at abnormally low levels now unblushingly celebrate record-high stock prices as proof that tax cuts mostly benefiting corporations and their stockholders signal the start of a new golden age of accelerating growth.

So the next question to consider is what can we infer about the well-being of Americans and the American economy from the increase in stock prices since November 8, 2016? For purposes of this mental exercise, let me stipulate that the rise in stock prices since the moment when it became clear who had been elected President by the voters on November 8, 2016 was attributable to the policies that the new administration was expected to adopt.

Because interest rates have risen along with stock prices since November 8, 2016, increased stock prices must reflect investors’ growing optimism about the future cash flows to be distributed by corporations to shareholders. So, our question can be restated as follows: which policies — actual or expected — of the new administration could account for the growing optimism of investors since the election? Here are five policy categories to consider: (1) regulation, (2) taxes, (3) international trade, (4) foreign affairs, (5) macroeconomic and monetary policies.

The negative reaction of stock prices to the announcement last week that tariffs will be imposed on steel and aluminum imports suggests that hopes for protectionist trade policies were not the main cause of rising investor optimism since November 2016. And presumably investor hopes for rising corporate cash flows to shareholders were not buoyed up by increasing tensions on the Korean peninsula and various belligerent statements by Administration officials about possible military responses to North Korean provocations.

Macroeconomic and monetary policies being primarily the responsibility of the Federal Reserve, the most important macroeconomic decision made by the new Administration to date was appointing Jay Powell to succeed Janet Yellen as Fed Chair. But this appointment was seen as a decision to keep Fed monetary policy more or less unchanged from what it was under Yellen, so one could hardly ascribe increased investor optimism to a decision not to change the macroeconomic and monetary policies that had been in place for at least the previous four years.

That leaves us with anticipated or actual changes in regulatory and tax policies as reasons for increased optimism about future cash flows from corporations to their shareholders. The two relevant questions to ask about anticipated or actual changes in regulatory and tax policies are: (1) could such changes have raised investor optimism, thereby raising stock prices, and (2), if so, would rising stock prices reflect enhanced well-being on the part of the American economy and the American people?

Briefly, the main idea for regulatory reform that the Administration wants to pursue is to require that whenever an agency adopts a new regulation, it should simultaneously eliminate two old ones. Supposedly such a requirement – sometimes called a regulatory budget – is to limit the total amount of regulation that the government can impose on the economy, the theory being that new regulations would not be adopted unless they were likely to be really effective.

But agencies are already required to show that regulations pass some cost-benefit test before imposing new regulations. So it’s not clear that the economy would be better off if new regulations, which can now be adopted only if they are expected to generate benefits exceeding the costs associated with their adoption, cannot be adopted unless two other regulations are eliminated. Presumably, underlying the new regulatory approach is a theory of bureaucratic behavior positing that the benefits of new regulations are systematically overestimated and their costs systematically underestimated by bureaucrats.

I’m not going to argue the merits of the underlying theory, but obviously it is possible that the new regulatory approach would result in increased profits for businesses that will have fewer regulatory burdens imposed upon them, thereby increasing the value of ownership shares in those firms. So, it’s possible that the new regulatory approach adopted by the Administration is causing stock prices to rise, presumably by more than they would have risen under the old simple cost-benefit regulatory approach that was followed by the Obama Administration.

But even if the new regulatory approach has caused stock prices to rise, it’s not clear that increasing stock valuations represent a net increase in the well-being of the American economy and the American people. If regulations that are costly to the economy in general are eliminated, the benefits of fewer regulations would accrue not just to the businesses whose profits rise as a result; eliminating inefficient regulations would also benefit the rest of the economy by freeing up resources to produce goods and services whose value to consumers would the benefits foregone when regulations were eliminated. But it’s also possible, that regulations are providing benefits greater than the costs of implementing and enforcing them.

If eliminating regulations leads to increased pollution or sickness or consumer fraud, and the value of those foregone benefits exceeds the costs of those regulations, it will not be corporations and their shareholders that suffer; it will be the general public that will bear the burden of their elimination. While corporations increase the cash flows paid to shareholders, members of the public will suffer more-than-offsetting reductions in well-being by being exposed to increased pollution, suffering increased illness and injury, or suffering added fraud and other consumer harms.

Since 1970, when the federal government took serious measures to limit air and water pollution, air and water quality have improved greatly in most of the US. Those improvements, for the most part, have probably not been reflected in stock prices, because environmental improvements, mostly affecting common-property resources, can’t be easily capitalized, though, some of those improvements have likely been reflected in increasing land values in cities and neighborhoods where air and water quality have improved. Foregoing pollution-reducing regulations might actually have led to increased stock prices for many corporations burdened by those regulations, but the US as a whole, and its inhabitants, would not have been better off without those regulations than they are with them.

So, rising stock prices are not necessarily a good indicator of whether the new regulatory approach of the Administration is benefiting or harming the American economy and the American public. Market valuations convey a lot of important information, but there is also a lot of important information that is not conveyed in stock prices.

As for taxes, it is straightforward that reducing corporate-tax liability increases funds available to be paid directly to shareholders as dividends and share buy-backs, or indirectly through investments expected to increase cash flows to shareholders in the more distant future. Does an increase in stock prices caused by a reduction in corporate-tax liability imply any enhancement in the well-being of the American economy and the American people

The answer, as a first approximation, is no. A reduction in corporate tax liability implies a reduction in the tax liability of shareholders, and that reduction is immediately capitalized into the value of shares. Increased stock prices simply reflect the expected reduction in shareholder tax liability.

Of course, reducing the tax burden on shareholders may improve economic performance, causing an increase in corporate cash flows to shareholders exceeding the reduction in shareholder tax liabilities. But it is unlikely that the difference between the increase in cash flows to shareholders and the reduction in shareholder tax liabilities would be more than a few percent of the total reduction in corporate tax liability, so that any increase in economic performance resulting from a reduction in corporate tax liability would account for only a small fraction of the increase in stock prices.

The good thing about the corporate-income tax is that it is so easy to collect, and that it is so hard to tell who really bears the tax burden: shareholders, workers or consumers. That’s why governments like taxing corporations. But the really bad thing about the corporate-income tax is that it is so hard to tell who really bears the burden of the corporate tax, shareholders, workers or consumers.

Because it is so hard to tell who bears the burden of the tax, people just think that “corporations” pay the tax, but “corporations” aren’t people, and they don’t really pay taxes, they are just the conduit for a lot of unidentified people to pay unknown amounts of tax. As Adam Winkler has just explained in this article and in an important new book, It is a travesty that the Supreme Court was hoodwinked in the latter part of the nineteenth century into accepting the notion that corporations are Constitutional persons with essentially the same rights as actual persons – indeed, with far greater rights than human beings belonging to disfavored racial or ethnic categories.

As I wrote years ago in one of my early posts on this blog, there are some very good arguments for abolishing the corporate income tax altogether, as Hyman Minsky argued. Forcing corporations to distribute their profits to shareholders would diminish the incentives for corporate empire building, thereby making venture capital more available to start-ups and small businesses. Such a reform might turn out to be an important democratizing and decentralizing change in the way that modern capitalism operates. But even if that were so, it would not mean that the effects of a reduction in the corporate tax rate could be properly measured by looking that resulting change in corporate stock prices.

Before closing this excessively long post, I will just remark that although I have been using the basic theory of asset pricing that underlies the efficient market hypothesis (EMH), adopting that theory of asset pricing does not imply that I accept the EMH. What separates me from the EMH is the assumption that there is a single unique equilibrium toward which the economy is tending at any moment in time, and that the expectations of market participants are unbiased and efficient estimates of the equilibrium price vector toward which the price system is moving. I reject all of those assumptions about the existence and uniqueness of an equilibrium price vector. If there is no equilibrium price vector toward which the economy is tending, the idea that expectations are governed by some objective equilibrium which is already there to be discovered is erroneous; expectations create their own reality and equilibrium is itself determined by expectations. When the existence of equilibrium depends on expectations, it becomes impossible to assign any meaning to the term “efficient market.”

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

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

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

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

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

World War I inflation.

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

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

The Post-War Collapse of 1921

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

The Great Depression

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

World War II Inflation

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

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

1970s Inflation

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

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

Pedantry and Mastery in Following Rules

From George Polya’s classic How to Solve It (p. 148).

To apply a rule to the letter, rigidly, unquestioningly, in cases where it fits and cases where it does not fit, is pedantry. Some pedants are poor fools; they never did understand the rule which they apply so conscientiously and so indiscriminately. Some pedants are quite successful; they understood their rule, at least in the beginning (before they became pedants), and chose a good one that fits in many cases and fails only occasionally.

To apply a rule with natural ease, with judgment, noticing the cases where it fits, and without ever letting the words of the rule obscure the purpose of the action or the opportunities of the situation, is mastery.

Polya, of course, was distinguishing between pedantry and mastery in applying rules for problem solving, but his distinction can be applied more generally: a distinction between following rules using judgment (aka discretion) and following rules mechanically without exercising judgment (i.e., without using discretion). Following rules by rote need not be dangerous when circumstances are more or less those envisioned when the rules were originally articulated, but, when unforeseen circumstances arise,  making the rule unsuitable to the new circumstances, following rules mindlessly can lead to really bad outcomes.

In the real world, the rules that we live by have to be revised and reinterpreted constantly in the light of experience and of new circumstances and changing values. Rules are supposed to conform to deeper principles, but the specific rules that we try to articulate to guide our actions are in need of periodic revision and adjustment to changing circumstances.

In deciding cases, judges change the legal rules that they apply by recognizing subtle — and relevant — distinctions that need to be taken into account in rendering decisions. They do not adjust rules willfully and arbitrarily. Instead, relying on deeper principles of justice and humanity, they adjust or bend the rules to temper the injustices that would from a mechanical and unthinking application of the rules. By exercising judgment — in other words, by doing what judges are supposed to do — they uphold, rather than subvert, the rule of law in the process of modifying the existing rules. The modern fetish for depriving judges of the discretion to exercise judgment in rendering decisions is antithetical to the concept of the rule of law.

A similar fetish for rules-based monetary policy, i.e., a monetary system requiring the monetary authority to mechanically follow some numerical rule, is an equally outlandish misapplication of the idea that law is nothing more than a system of rules and that judges should do more than select the relevant rule to be applied and render a decision based on that rule without considering whether the decision is consistent with the deeper underlying principles of justice on which the legal system as a whole is based.

Because judges exercise coercive power over the lives and property of individuals, the rule of law requires their decisions to be justified in terms of the explicit rules and implicit and explicit principles of the legal system judges apply. And litigants have a right to appeal judgments rendered if they can argue that the judge misapplied the relevant legal rules. Having no coercive power over the lives or property of individuals, the monetary authority need not be bound by the kind of legal constraints to which judges are subject in rendering decisions that directly affect the lives and property of individuals.

The apotheosis of the fetish for blindly following rules in monetary policy was the ideal expressed by Henry Simons in his famous essay “Rules versus Authorities in Monetary Policy” in which he pleaded for a monetary rule that “would work mechanically, with the chips falling where they may. We need to design and establish a system good enough so that, hereafter, we may hold to it unrationally — on faith — as a religion, if you please.”

However, Simons, recovering from this momentary lapse into irrationality, quickly conceded that his plea for a monetary system good enough to be held on faith was impractical, abandoning it in favor of the more modest goal of stabilizing the price level. However, Simons’s student Milton Friedman, surpassed his teacher in pedantry, invented what came to be known as his k-percent rule, under which the Federal Reserve was to be required to make the total quantity of  money in the economy increase continuously at an annual rate of growth equal to k percent. Friedman actually believed that his rule could be implemented by a computer, so that he confidently — and foolishly — recommended abolishing the Fed.

Eventually, after erroneously forecasting the return of double-digit inflation for nearly two decades, Friedman, a fervent ideologue but also a superb empirical economist, reluctantly allowed his ideological predispositions to give way in the face of contradictory empirical evidence and abandoned his k-percent rule. That was a good, if long overdue, call on Friedman’s part, and it should serve as a lesson and a warning to advocates of imposing overly rigid rules on the monetary authorities.

Noah Smith on Bitcoins: A Failure with a Golden Future

Noah Smith and I agree that, as I argued in my previous post, Bitcoins have no chance of becoming a successful money, much less replacing or displacing the dollar as the most important and widely used money in the world. In a post on Bloomberg yesterday, Noah explains why Bitcoins are nearly useless as money, reiterating a number of the points I made and adding some others of his own. However, I think that Bitcoins must sooner or later become worthless, while Noah thinks that Bitcoins, like gold, can be a worthwhile investment for those who think that it is fiat money that is going to become worthless. Here’s how Noah puts it.

So cryptocurrencies won’t be actual currencies, except for drug dealers and other people who can’t use normal forms of payment. But will they be good financial investments? Some won’t — some will be scams, and many will simply fall into disuse and be forgotten. But some may remain good investments, and even go up in price over many decades.

A similar phenomenon has already happened: gold. Legendary investor Warren Buffett once ridiculed gold for being an unproductive asset, but the price of the yellow metal has climbed over time:

Why has gold increased in price? One reason is that it’s not quite useless — people use gold for jewelry and some industrial applications, so the metal slowly goes out of circulation, increasing its scarcity.

And another reason is that central banks now own more than 17% of all the gold in the world. In the 1980s and 1990s, when the value of gold was steadily dropping to as little as $250 an ounce, central banks were selling off their unproductive gold stocks, until they realized that, in selling off their gold stocks, they were driving down the value of all the gold sitting in their vaults. Once they figured out what they were doing, they agreed among themselves that they would start buying gold instead of selling it. And in the early years of this century, gold prices started to rebound.

But another reason is that people simply believe in gold. In the end, the price of an asset is what people believe it’s worth.

Yes, but it sure does help when there are large central banks out there buying unwanted gold, and piling it up in vaults where no one else can do anything with it.

Many people believe that fiat currencies will eventually collapse, and that gold will reemerge as the global currency.

And it’s the large central banks that issue the principal fiat currencies whose immense holdings of gold reserves that keep the price of gold from collapsing.

That narrative has survived over many decades, and the rise of Bitcoin as an alternative hasn’t killed it yet. Maybe there’s a deeply embedded collective memory of the Middle Ages, when governments around the world were so unstable that gold and other precious metals were widely used to make payments.

In the Middle Ages, the idea of, and the technology for creating, fiat money had not yet been invented, though coin debasement was widely practiced. It took centuries before a workable system for controlling fiat money was developed.

Gold bugs, as advocates of gold as an investment are commonly known, may simply be hedging against the perceived possibility that the world will enter a new medieval period.

How ill-mannered of them not to thank central banks for preventing the value of gold from collapsing.

Similarly, Bitcoin or other cryptocurrencies may never go to zero, even if no one ends up using them for anything. They represent a belief in the theory that fiat money is doomed, and a hedge against the possibility that fiat-based payments systems will one day collapse. When looking for a cryptocurrency to invest in, it might be useful to think not about which is the best payments system, but which represents the most enduring expression of skepticism about fiat money itself.

The problem with cryptocurrencies is that there is no reason to think that central banks will start amassing huge stockpiles of cryptocurrencies, thereby ensuring that the demand for cryptocurrencies will always be sufficient to keep their value at or above whatever level the central banks are comfortable with.

It just seems odd to me that some people want to invest in Bitcoins, which provide no present or future real services, and almost no present or future monetary services, in the belief that it is fiat money, which clearly does provide present and future monetary services, and provides the non-trivial additional benefit of enabling one to discharge tax liabilities to the government, is going to become worthless sometime in the future.

If your bet that Bitcoins are going to become valuable depends on the forecast that dollars will become worthless, you probably need to rethink your investment strategy.

Is “a Stable Cryptocurrency” an Oxymoron?

By way of a tweet by the indefatigable and insightful Frances Coppola, I just came upon this smackdown by Preston Byrne of the recent cryptocurrency startup called the Basecoin. I actually agree with much of Byrne’s critique, and I am on record (see several earlier blogposts such as this, this, and this) in suggesting that Bitcoins are a bubble. However, despite my deep skepticism about Bitcoins and other cryptocurrencies, I have also pointed out that, at least in theory, it’s possible to imagine a scenario in which a cryptocurrency would be viable. And because Byrne makes such a powerful (but I think overstated) case against Basecoin, I want to examine his argument a bit more carefully. But before I discuss Byrne’s blogpost, some theoretical background might be useful.

One of my first posts after launching this blog was called “The Paradox of Fiat Money” in which I posed this question: how do fiat moneys retain a positive value, when the future value of any fiat money will surely fall to zero? This question is based on the backward-induction argument that is widely used in game theory and dynamic programming. If you can figure out the end state of a process, you can reason backwards and infer the values that are optimally consistent with that end state.

If the value of money must go to zero in some future time period, and the demand for money now is derived entirely from the expectation that it will retain a positive value tomorrow, so that other people will accept from you the money that you have accepted in exchange today, then the value of the fiat money should go to zero immediately, because everyone, knowing that its future value must fall to zero, will refuse to accept between now and that future time when its value must be zero. There are ways of sidestepping the logic of backward induction, but I suggested, following a diverse group of orthodox neoclassical economists, including P. H. Wicksteed, Abba Lerner, and Earl Thompson, that the value of fiat money is derived, at least in part, from the current acceptability of fiat money in discharging tax liabilities, thereby creating an ongoing current demand for fiat money.

After I raised the problem of explaining the positive value of fiat money, I began thinking about the bitcoin phenomenon which seems to present a similar paradox, and a different approach to the problem of explaining the positive value of fiat money, and of bitcoins. The alternative approach focuses on the network externality that is associated with the demand for money; the willingness of people to hold and accept a medium of exchange increases as the number of other people that are willing to accept and hold that medium of exchange. Your demand for money increases the usefulness that money has for me. But the existence of that network externality creates a certain lock-in effect, because if you and I are potential transactors with each other, your demand for a  particular money makes it more difficult for me to switch away the medium of exchange that we are both using to another one that you are not using.  So while backward induction encourages us to switch away from the fiat money that we are both using, the network externality encourages us to keep using the fiat money that we are both using. The net effect is unclear, but it suggests that an equilibrium with a positive value for a fiat money may be unstable, creating a tipping point beyond which the demand for a fiat money, and its value, may start to fall very rapidly as people all start rushing for the exit at the same time.

So the takeaway for cryptocurrencies is that even though a cryptocurrency, offering nothing to the holder of the currency but its future resale value, is inherently worthless and therefore inherently vulnerable to a relentless and irreversible loss of value once that loss of value is generally anticipated, if the cryptocurrency can somehow attract sufficient initial acceptance as a medium of exchange, the inevitable loss of value can at least be delayed, allowing the cryptocurrency to gain acceptance, through a growing core of transactors offering and accepting it as payment. For this to happen, the cryptocurrency must provide some real advantage to its core transactors not otherwise available to them when transacting with other currencies.

The difficulty of attracting transactors who will use the cryptocurrency is greatly compounded if the value of the cryptocurrency rapidly appreciates in value. It may seem paradoxical that a rapid increase in the value of an asset – or more precisely the expectation of a rapid increase in the value of an asset – detracts from its suitability as a medium of exchange, but an expectation of rapid appreciation tends to drive any asset already being used as a currency out of circulation. That tendency is a long-and-widely recognized phenomenon, which even has both a name and a pithy epigram attached to it: “Gresham’s Law” and “bad money drives out the good.”

The phenomenon has been observed for centuries, typically occurring when two moneys with equal face value circulate concurrently, but with one money having more valuable material content than the other. For example, if a coinage consists of both full-bodied and clipped coins with equal face value, people hoard the more valuable full-bodied coins, offering only the clipped coins in exchange. Similarly, if some denominations of the same currency are gold coins and others are silver coins, so that the relative values of the coins are legally fixed, a substantial shift in the relative market values of silver and gold causes the relatively undervalued (good) coins to be hoarded, disappearing from circulation, leaving only the relatively overvalued (bad) coins in circulation. I note in passing that a fixed exchange rate between the two currencies is not, as has often been suggested, necessary for Gresham’s Law to operate when the rate of appreciation of one of the currencies is sufficiently fast.

So if I have a choice of exchanging dollars with a stable or even falling value to obtain the goods and services that I desire, why would I instead use an appreciating asset to buy those goods and services? Insofar as people are buying bitcoins now in expectation of future appreciation, they are not going be turning around to buy stuff with bitcoins when they could just as easily pay with dollars. The bitcoin bubble is therefore necessarily self-destructive. Demand is being fueled by the expectation of further appreciation, but the only service that a bitcoin offers is acceptability in exchange when making transactions — one transaction at any rate: being sold for dollars — while the expectation of appreciation is precisely what discourages people from using bitcoins to buy anything. Why then are bitcoins appreciating? That is the antimony that renders the widespread acceptance of bitcoins as a medium of exchange inconceivable.

Promoters of bitcoins extol the blockchain technology that makes trading with bitcoins anonymous and secure. My understanding of the blockchain technology is completely superficial, but there are recurring reports of hacking into bitcoin accounts and fraudulent transactions, creating doubts about the purported security and anonymity of bitcoins. Moreover, the decentralized character of bitcoin transactions slows down and increases the cost of executing a transaction with Bitcoin.

But let us stipulate for discussion purposes that Bitcoins do provide enhanced security and anonymity in performing transactions that more than compensate for the added costs of transacting with Bitcoins or other blockchain-based currencies, at least for some transactions. We all know which kinds of transactions require anonymity, and they are only a small subset of all the transactions carried out. So the number of transactions for which Bitcoins or blockchain-based cryptocurrencies might be preferred by transactors can’t be a very large fraction of the total number of transactions mediated by conventional currencies. But one could at least make a plausible argument that a niche market for a medium of exchange designed for secure anonymous transactions might be large enough to make a completely secure and anonymous medium of exchange viable. But we know that the Bitcoin will never be that alternative medium of exchange.

Understanding the fatal internal contradiction inherent in the Bitcoin, creators of cryptocurrency called Basecoin claim to have designed a cyptocurrency that will, or at any rate is supposed to, maintain a stable value even while profits accrue to investors from the anticipated increase in the demand for Basecoins. Other cryptocurrencies like Tether and Dai also purport to provide a stable value in terms of dollars, though the mechanism by which this is accomplished has not been made transparent, as promoters of Basecoins promise to do. But here’s the problem: for a new currency, whose value its promoters promise to stabilize, to generate profits to its backers from an increasing demand for that currency, the new currency units issued as demand increases must be created at a cost well below the value at which the currency is to be stabilized.

Because new Bitcoins are so costly to create, the quantity of Bitcoins can’t be increased sufficiently to prevent Bitcoins from appreciating as the demand for Bitcoins increases. The very increase in demand for Bitcoins is what renders it unsuitable to serve as a medium of exchange. So if the value of Basecoins substantially exceeds the cost of producing Basecoins, what prevents the value of Basecoins from falling to the cost of creating new Basecoins, or at least what keeps the market from anticipating that the value of Basecoins will fall to to the cost of producing new Basecoins?

To address this problem, designers of the Basecoin have created a computer protocol that is supposed to increase or decrease the quantity of Basecoins according as the value of Basecoins either exceeds, or falls short of, its target exchange value of $1 per Basecoin.  As an aside, let me just observe that even if we stipulate that the protocol would operate to stabilize the value of Basecoins at $1, there is still a problem in assuring traders that the protocol will be followed in practice. So it would seem necessary to make the protocol code publicly accessible so that potential investors backing Basecoin and holders of Basecoin could ascertain that the protocol would indeed operate as represented by Basecoin designers. So what might be needed is a WikiBasecoin.

But what I am interested in exploring here is whether the Basecoin protocol or some other similar protocol could actually work as asserted by the Basecoin White Paper. In an interesting blog post, Preston Byrne has argued that such a protocol cannot possibly work

Basecoin claims to solve the problem of wildly fluctuating cryptocurrency prices through the issuance of a cryptocurrency for which “tokens can be robustly pegged to arbitrary assets or baskets of goods while remaining completely decentralized.” This is achieved, the paper states in its abstract, by the fact that “1 Basecoin can be pegged to always trade for 1 USD. In the future, Basecoin could potentially even eclipse the dollar and be updated to a peg to the CPI or basket of goods. . . .”

Basecoin claims that it can “algorithmically adjust…the supply of Basecoin tokens in response to changes in, for example, the Basecoin-USD exchange rate… implementing a monetary policy similar to that executed by central banks around the world”.

Two points.

First, this is not how central banks manage the money supply. . . .

But of course, Basecoin isn’t actually creating a monetary supply, which central banks will into existence and then use to buy assets, primarily debt securities. Basecoin works by creating an investable asset which the “central bank” (i.e. the algorithm, because it’s nothing like a central bank) issues to holders of the tokens which those token holders then sell to new entrants into the scheme.

Buying assets to create money vs. selling assets to obtain money. There’s a big difference.

Byrne, of course, is correct that there is a big difference between the buying of assets to create money and the selling of assets to obtain money by promoters of a cryptocurrency. But the assets being sold to create money are created by the promoters of the money-issuing concern to accumulate the working capital that the promoters are planning to use in creating their currency, so the comparison between buying assets to create money and selling assets to obtain money is not exactly on point.

What Byrne is missing is that the central bank can take the demand for its currency as more or less given, a kind of economic fact of nature, though the exact explanation of that fact remains disturbingly elusive. The goal of a cryptocurrency promoter, however, is to create a demand for its currency that doesn’t already exist. That is above all a marketing and PR challenge. (Actually, a challenge that has been rather successfully met, though for Bitcoins at any rate the operational challenge of creating a viable currency to meet the newly created demand seems logically impossible.)


We need to talk about how a peg does and doesn’t work. . . .

Currently there are very efficient ways to peg the price of something to something else, let’s say (to keep it simple) $1. The first of these would be to execute a trust deed (cost: $0) saying that some entity, e.g. a bank, holds a set sum of money, say $1 billion, on trust absolutely for the holders of a token, which let’s call Dollarcoin for present purposes. If the token is redeemable at par from that bank (qua Trustee and not as depository), then the token ought to trade at close to $1, with perhaps a slight discount depending on the insolvency risk to which a Dollarcoin holder is exposed (although there are well-worn methods to keep the underlying dollars insolvency-remote, i.e. insulated from the risk of a collapse of that bank).

Put another way, there is a way to turn 1 dollarcoin into a $1 here [sic]. Easy-peasy, no questions asked, with ancient technology like paper and pens or SQL tables. The downside of course is that you need to 100% cash collateralize the system, which is (from a cost of capital perspective) rather expensive. This is the reason why fractional reserve banking exists.

The mistake here is that 100% cash collateralization is not required for convertibility and parity. Under the gold-standard, the convertibility of various national currencies into gold at fixed parities was maintained with far less than 100% gold cover against those currencies, and commercial banks and money-market funds routinely maintain the convertibility of deposits into currency at one-to-one parities with far less than 100% currency reserves against deposits. Sometimes convertibility in such systems breaks down temporarily, but such breakdowns are neither necessary nor inevitable, though they may sometimes, given the alternatives, be the best available option. I understand that banks undertake a legal obligation to convert deposits into currency at a one-to-one rate, but such a legal obligation is not the only possible legal rule under which banks could operate. The Bank of England during the legal restriction of convertibility of its Banknotes into gold from 1797 to 1819, was operating without any legal obligation to convert its Banknotes into gold, though it was widely expected at some future date convertibility would be resumed.

While I am completely sympathetic to Byrne’s skepticism about the viability of cryptocurrencies, even cryptocurrencies with some kind of formal or informal peg with respect to an actual currency like the dollar, he seems to think that because there are circumstances under which the currencies will fail, he has shown that it is impossible for the currencies ever to succeed. I believe that it would be a stretch for a currency like the Basecoin to be successful, but one can at least imagine a set of circumstances under which, in contrast to the Bitcoin, the Basecoin could be successful, though even under the rosiest possible scenario I can’t imagine how the Basecoin or any other cryptocurrency could displace the dollar as the world’s dominant currency. To be sure, success of the Basecoin or some other “stabililzed” cryptocurrency is a long-shot, but success is not logically self-contradictory. Sometimes a prophecy, however improbable, can be self-fulfilling.

Milton Friedman and the Phillips Curve

In December 1967, Milton Friedman delivered his Presidential Address to the American Economic Association in Washington DC. In those days the AEA met in the week between Christmas and New Years, in contrast to the more recent practice of holding the convention in the week after New Years. That’s why the anniversary of Friedman’s 1967 address was celebrated at the 2018 AEA convention. A special session was dedicated to commemoration of that famous address, published in the March 1968 American Economic Review, and fittingly one of the papers at the session as presented by the outgoing AEA president Olivier Blanchard, who also wrote one of the papers discussed at the session. Other papers were written by Thomas Sargent and Robert Hall, and by Greg Mankiw and Ricardo Reis. The papers were discussed by Lawrence Summers, Eric Nakamura, and Stanley Fischer. An all-star cast.

Maybe in a future post, I will comment on the papers presented in the Friedman session, but in this post I want to discuss a point that has been generally overlooked, not only in the three “golden” anniversary papers on Friedman and the Phillips Curve, but, as best as I can recall, in all the commentaries I’ve seen about Friedman and the Phillips Curve. The key point to understand about Friedman’s address is that his argument was basically an extension of the idea of monetary neutrality, which says that the real equilibrium of an economy corresponds to a set of relative prices that allows all agents simultaneously to execute their optimal desired purchases and sales conditioned on those relative prices. So it is only relative prices, not absolute prices, that matter. Taking an economy in equilibrium, if you were suddenly to double all prices, relative prices remaining unchanged, the equilibrium would be preserved and the economy would proceed exactly – and optimally – as before as if nothing had changed. (There are some complications about what is happening to the quantity of money in this thought experiment that I am skipping over.) On the other hand, if you change just a single price, not only would the market in which that price is determined be disequilibrated, at least one, and potentially more than one, other market would be disequilibrated. The point here is that the real economy rules, and equilibrium in the real economy depends on relative, not absolute, prices.

What Friedman did was to argue that if money is neutral with respect to changes in the price level, it should also be neutral with respect to changes in the rate of inflation. The idea that you can wring some extra output and employment out of the economy just by choosing to increase the rate of inflation goes against the grain of two basic principles: (1) monetary neutrality (i.e., the real equilibrium of the economy is determined solely by real factors) and (2) Friedman’s famous non-existence (of a free lunch) theorem. In other words, you can’t make the economy as a whole better off just by printing money.

Or can you?

Actually you can, and Friedman himself understood that you can, but he argued that the possibility of making the economy as a whole better of (in the sense of increasing total output and employment) depends crucially on whether inflation is expected or unexpected. Only if inflation is not expected does it serve to increase output and employment. If inflation is correctly expected, the neutrality principle reasserts itself so that output and employment are no different from what they would have been had prices not changed.

What that means is that policy makers (monetary authorities) can cause output and employment to increase by inflating the currency, as implied by the downward-sloping Phillips Curve, but that simply reflects that actual inflation exceeds expected inflation. And, sure, the monetary authorities can always surprise the public by raising the rate of inflation above the rate expected by the public , but that doesn’t mean that the public can be perpetually fooled by a monetary authority determined to keep inflation higher than expected. If that is the strategy of the monetary authorities, it will lead, sooner or later, to a very unpleasant outcome.

So, in any time period – the length of the time period corresponding to the time during which expectations are given – the short-run Phillips Curve for that time period is downward-sloping. But given the futility of perpetually delivering higher than expected inflation, the long-run Phillips Curve from the point of view of the monetary authorities trying to devise a sustainable policy must be essentially vertical.

Two quick parenthetical remarks. Friedman’s argument was far from original. Many critics of Keynesian policies had made similar arguments; the names Hayek, Haberler, Mises and Viner come immediately to mind, but the list could easily be lengthened. But the earliest version of the argument of which I am aware is Hayek’s 1934 reply in Econometrica to a discussion of Prices and Production by Alvin Hansen and Herbert Tout in their 1933 article reviewing recent business-cycle literature in Econometrica in which they criticized Hayek’s assertion that a monetary expansion that financed investment spending in excess of voluntary savings would be unsustainable. They pointed out that there was nothing to prevent the monetary authority from continuing to create money, thereby continually financing investment in excess of voluntary savings. Hayek’s reply was that a permanent constant rate of monetary expansion would not suffice to permanently finance investment in excess of savings, because once that monetary expansion was expected, prices would adjust so that in real terms the constant flow of monetary expansion would correspond to the same amount of investment that had been undertaken prior to the first and unexpected round of monetary expansion. To maintain a rate of investment permanently in excess of voluntary savings would require progressively increasing rates of monetary expansion over and above the expected rate of monetary expansion, which would sooner or later prove unsustainable. The gist of the argument, more than three decades before Friedman’s 1967 Presidential address, was exactly the same as Friedman’s.

A further aside. But what Hayek failed to see in making this argument was that, in so doing, he was refuting his own argument in Prices and Production that only a constant rate of total expenditure and total income is consistent with maintenance of a real equilibrium in which voluntary saving and planned investment are equal. Obviously, any rate of monetary expansion, if correctly foreseen, would be consistent with a real equilibrium with saving equal to investment.

My second remark is to note the ambiguous meaning of the short-run Phillips Curve relationship. The underlying causal relationship reflected in the negative correlation between inflation and unemployment can be understood either as increases in inflation causing unemployment to go down, or as increases in unemployment causing inflation to go down. Undoubtedly the causality runs in both directions, but subtle differences in the understanding of the causal mechanism can lead to very different policy implications. Usually the Keynesian understanding of the causality is that it runs from unemployment to inflation, while a more monetarist understanding treats inflation as a policy instrument that determines (with expected inflation treated as a parameter) at least directionally the short-run change in the rate of unemployment.

Now here is the main point that I want to make in this post. The standard interpretation of the Friedman argument is that since attempts to increase output and employment by monetary expansion are futile, the best policy for a monetary authority to pursue is a stable and predictable one that keeps the economy at or near the optimal long-run growth path that is determined by real – not monetary – factors. Thus, the best policy is to find a clear and predictable rule for how the monetary authority will behave, so that monetary mismanagement doesn’t inadvertently become a destabilizing force causing the economy to deviate from its optimal growth path. In the 50 years since Friedman’s address, this message has been taken to heart by monetary economists and monetary authorities, leading to a broad consensus in favor of inflation targeting with the target now almost always set at 2% annual inflation. (I leave aside for now the tricky question of what a clear and predictable monetary rule would look like.)

But this interpretation, clearly the one that Friedman himself drew from his argument, doesn’t actually follow from the argument that monetary expansion can’t affect the long-run equilibrium growth path of an economy. The monetary neutrality argument, being a pure comparative-statics exercise, assumes that an economy, starting from a position of equilibrium, is subjected to a parametric change (either in the quantity of money or in the price level) and then asks what will the new equilibrium of the economy look like? The answer is: it will look exactly like the prior equilibrium, except that the price level will be twice as high with twice as much money as previously, but with relative prices unchanged. The same sort of reasoning, with appropriate adjustments, can show that changing the expected rate of inflation will have no effect on the real equilibrium of the economy, with only the rate of inflation and the rate of monetary expansion affected.

This comparative-statics exercise teaches us something, but not as much as Friedman and his followers thought. True, you can’t get more out of the economy – at least not for very long – than its real equilibrium will generate. But what if the economy is not operating at its real equilibrium? Even Friedman didn’t believe that the economy always operates at its real equilibrium. Just read his Monetary History of the United States. Real-business cycle theorists do believe that the economy always operates at its real equilibrium, but they, unlike Friedman, think monetary policy is useless, so we can forget about them — at least for purposes of this discussion. So if we have reason to think that the economy is falling short of its real equilibrium, as almost all of us believe that it sometimes does, why should we assume that monetary policy might not nudge the economy in the direction of its real equilibrium?

The answer to that question is not so obvious, but one answer might be that if you use monetary policy to move the economy toward its real equilibrium, you might make mistakes sometimes and overshoot the real equilibrium and then bad stuff would happen and inflation would run out of control, and confidence in the currency would be shattered, and you would find yourself in a re-run of the horrible 1970s. I get that argument, and it is not totally without merit, but I wouldn’t characterize it as overly compelling. On a list of compelling arguments, I would put it just above, or possibly just below, the domino theory on the basis of which the US fought the Vietnam War.

But even if the argument is not overly compelling, it should not be dismissed entirely, so here is a way of taking it into account. Just for fun, I will call it a Taylor Rule for the Inflation Target (IT). Let us assume that the long-run inflation target is 2% and let us say that (YY*) is the output gap between current real GDP and potential GDP (i.e., the GDP corresponding to the real equilibrium of the economy). We could then define the following Taylor Rule for the inflation target:

IT = α(2%) + β((YY*)/ Y*).

This equation says that the inflation target in any period would be a linear combination of the default Inflation Target of 2% times an adjustment coefficient α designed to keep successively chosen Inflation targets from deviating from the long-term price-level-path corresponding to 2% annual inflation and some fraction β of the output gap expressed as a percentage of potential GDP. Thus, for example, if the output gap was -0.5% and β was 0.5, the short-term Inflation Target would be raised to 4.5% if α were 1.

However, if on average output gaps are expected to be negative, then α would have to be chosen to be less than 1 in order for the actual time path of the price level to revert back to a target price-level corresponding to a 2% annual rate.

Such a procedure would fit well with the current dual inflation and employment mandate of the Federal Reserve. The long-term price level path would correspond to the price-stability mandate, while the adjustable short-term choice of the IT would correspond to and promote the goal of maximum employment by raising the inflation target when unemployment was high as a countercyclical policy for promoting recovery. But short-term changes in the IT would not be allowed to cause a long-term deviation of the price level from its target path. The dual mandate would ensure that relatively higher inflation in periods of high unemployment would be compensated for by periods of relatively low inflation in periods of low unemployment.

Alternatively, you could just target nominal GDP at a rate consistent with a long-run average 2% inflation target for the price level, with the target for nominal GDP adjusted over time as needed to ensure that the 2% average inflation target for the price level was also maintained.

Does Economic Theory Entail or Support Free-Market Ideology?

A few weeks ago, via Twitter, Beatrice Cherrier solicited responses to this query from Dina Pomeranz

It is a serious — and a disturbing – question, because it suggests that the free-market ideology which is a powerful – though not necessarily the most powerful — force in American right-wing politics, and probably more powerful in American politics than in the politics of any other country, is the result of how economics was taught in the 1970s and 1980s, and in the 1960s at UCLA, where I was an undergrad (AB 1970) and a graduate student (PhD 1977), and at Chicago.

In the 1950s, 1960s and early 1970s, free-market economics had been largely marginalized; Keynes and his successors were ascendant. But thanks to Milton Friedman and his compatriots at a few other institutions of higher learning, especially UCLA, the power of microeconomics (aka price theory) to explain a very broad range of economic and even non-economic phenomena was becoming increasingly appreciated by economists. A very broad range of advances in economic theory on a number of fronts — economics of information, industrial organization and antitrust, law and economics, public choice, monetary economics and economic history — supported by the award of the Nobel Prize to Hayek in 1974 and Friedman in 1976, greatly elevated the status of free-market economics just as Margaret Thatcher and Ronald Reagan were coming into office in 1979 and 1981.

The growing prestige of free-market economics was used by Thatcher and Reagan to bolster the credibility of their policies, especially when the recessions caused by their determination to bring double-digit inflation down to about 4% annually – a reduction below 4% a year then being considered too extreme even for Thatcher and Reagan – were causing both Thatcher and Reagan to lose popular support. But the growing prestige of free-market economics and economists provided some degree of intellectual credibility and weight to counter the barrage of criticism from their opponents, enabling both Thatcher and Reagan to use Friedman and Hayek, Nobel Prize winners with a popular fan base, as props and ornamentation under whose reflected intellectual glory they could take cover.

And so after George Stigler won the Nobel Prize in 1982, he was invited to the White House in hopes that, just in time, he would provide some additional intellectual star power for a beleaguered administration about to face the 1982 midterm elections with an unemployment rate over 10%. Famously sharp-tongued, and far less a team player than his colleague and friend Milton Friedman, Stigler refused to play his role as a prop and a spokesman for the administration when asked to meet reporters following his celebratory visit with the President, calling the 1981-82 downturn a “depression,” not a mere “recession,” and dismissing supply-side economics as “a slogan for packaging certain economic ideas rather than an orthodox economic category.” That Stiglerian outburst of candor brought the press conference to an unexpectedly rapid close as the Nobel Prize winner was quickly ushered out of the shouting range of White House reporters. On the whole, however, Republican politicians have not been lacking of economists willing to lend authority and intellectual credibility to Republican policies and to proclaim allegiance to the proposition that the market is endowed with magical properties for creating wealth for the masses.

Free-market economics in the 1960s and 1970s made a difference by bringing to light the many ways in which letting markets operate freely, allowing output and consumption decisions to be guided by market prices, could improve outcomes for all people. A notable success of Reagan’s free-market agenda was lifting, within days of his inauguration, all controls on the prices of domestically produced crude oil and refined products, carryovers of the disastrous wage-and-price controls imposed by Nixon in 1971, but which, following OPEC’s quadrupling of oil prices in 1973, neither Nixon, Ford, nor Carter had dared to scrap. Despite a political consensus against lifting controls, a consensus endorsed, or at least not strongly opposed, by a surprisingly large number of economists, Reagan, following the advice of Friedman and other hard-core free-market advisers, lifted the controls anyway. The Iran-Iraq war having started just a few months earlier, the Saudi oil minister was predicting that the price of oil would soon rise from $40 to at least $50 a barrel, and there were few who questioned his prediction. One opponent of decontrol described decontrol as writing a blank check to the oil companies and asking OPEC to fill in the amount. So the decision to decontrol oil prices was truly an act of some political courage, though it was then characterized as an act of blind ideological faith, or a craven sellout to Big Oil. But predictions of another round of skyrocketing oil prices, similar to the 1973-74 and 1978-79 episodes, were refuted almost immediately, international crude-oil prices falling steadily from $40/barrel in January to about $33/barrel in June.

Having only a marginal effect on domestic gasoline prices, via an implicit subsidy to imported crude oil, controls on domestic crude-oil prices were primarily a mechanism by which domestic refiners could extract a share of the rents that otherwise would have accrued to domestic crude-oil producers. Because additional crude-oil imports increased a domestic refiner’s allocation of “entitlements” to cheap domestic crude oil, thereby reducing the net cost of foreign crude oil below the price paid by the refiner, one overall effect of the controls was to subsidize the importation of crude oil, notwithstanding the goal loudly proclaimed by all the Presidents overseeing the controls: to achieve US “energy independence.” In addition to increasing the demand for imported crude oil, the controls reduced the elasticity of refiners’ demand for imported crude, controls and “entitlements” transforming a given change in the international price of crude into a reduced change in the net cost to domestic refiners of imported crude, thereby raising OPEC’s profit-maximizing price for crude oil. Once domestic crude oil prices were decontrolled, market forces led almost immediately to reductions in the international price of crude oil, so the coincidence of a fall in oil prices with Reagan’s decision to lift all price controls on crude oil was hardly accidental.

The decontrol of domestic petroleum prices was surely as pure a victory for, and vindication of, free-market economics as one could have ever hoped for [personal disclosure: I wrote a book for The Independent Institute, a free-market think tank, Politics, Prices and Petroleum, explaining in rather tedious detail many of the harmful effects of price controls on crude oil and refined products]. Unfortunately, the coincidence of free-market ideology with good policy is not necessarily as comprehensive as Friedman and his many acolytes, myself included, had assumed.

To be sure, price-fixing is almost always a bad idea, and attempts at price-fixing almost always turn out badly, providing lots of ammunition for critics of government intervention of all kinds. But the implicit assumption underlying the idea that freely determined market prices optimally guide the decentralized decisions of economic agents is that the private costs and benefits taken into account by economic agents in making and executing their plans about how much to buy and sell and produce closely correspond to the social costs and benefits that an omniscient central planner — if such a being actually did exist — would take into account in making his plans. But in the real world, the private costs and benefits considered by individual agents when making their plans and decisions often don’t reflect all relevant costs and benefits, so the presumption that market prices determined by the elemental forces of supply and demand always lead to the best possible outcomes is hardly ironclad, as we – i.e., those of us who are not philosophical anarchists – all acknowledge in practice, and in theory, when we affirm that competing private armies and competing private police forces and competing judicial systems would not provide for common defense and for domestic tranquility more effectively than our national, state, and local governments, however imperfectly, provide those essential services. The only question is where and how to draw the ever-shifting lines between those decisions that are left mostly or entirely to the voluntary decisions and plans of private economic agents and those decisions that are subject to, and heavily — even mainly — influenced by, government rule-making, oversight, or intervention.

I didn’t fully appreciate how widespread and substantial these deviations of private costs and benefits from social costs and benefits can be even in well-ordered economies until early in my blogging career, when it occurred to me that the presumption underlying that central pillar of modern right-wing, free-market ideology – that reducing marginal income tax rates increases economic efficiency and promotes economic growth with little or no loss in tax revenue — implicitly assumes that all taxable private income corresponds to the output of goods and services whose private values and costs equal their social values and costs.

But one of my eminent UCLA professors, Jack Hirshleifer, showed that this presumption is subject to a huge caveat, because insofar as some people can earn income by exploiting their knowledge advantages over the counterparties with whom they trade, incentives are created to seek the kinds of knowledge that can be exploited in trades with less-well informed counterparties. The incentive to search for, and exploit, knowledge advantages implies excessive investment in the acquisition of exploitable knowledge, the private gain from acquiring such knowledge greatly exceeding the net gain to society from the acquisition of such knowledge, inasmuch as gains accruing to the exploiter are largely achieved at the expense of the knowledge-disadvantaged counterparties with whom they trade.

For example, substantial resources are now almost certainly wasted by various forms of financial research aiming to gain information that would have been revealed in due course anyway slightly sooner than the knowledge is gained by others, so that the better-informed traders can profit by trading with less knowledgeable counterparties. Similarly, the incentive to exploit knowledge advantages encourages the creation of financial products and structuring other kinds of transactions designed mainly to capitalize on and exploit individual weaknesses in underestimating the probability of adverse events (e.g., late repayment penalties, gambling losses when the house knows the odds better than most gamblers do). Even technical and inventive research encouraged by the potential to patent those discoveries may induce too much research activity by enabling patent-protected monopolies to exploit discoveries that would have been made eventually even without the monopoly rents accruing to the patent holders.

The list of examples of transactions that are profitable for one side only because the other side is less well-informed than, or even misled by, his counterparty could be easily multiplied. Because much, if not most, of the highest incomes earned, are associated with activities whose private benefits are at least partially derived from losses to less well-informed counterparties, it is not a stretch to suspect that reducing marginal income tax rates may have led resources to be shifted from activities in which private benefits and costs approximately equal social benefits and costs to more lucrative activities in which the private benefits and costs are very different from social benefits and costs, the benefits being derived largely at the expense of losses to others.

Reducing marginal tax rates may therefore have simultaneously reduced economic efficiency, slowed economic growth and increased the inequality of income. I don’t deny that this hypothesis is largely speculative, but the speculative part is strictly about the magnitude, not the existence, of the effect. The underlying theory is completely straightforward.

So there is no logical necessity requiring that right-wing free-market ideological policy implications be inferred from orthodox economic theory. Economic theory is a flexible set of conceptual tools and models, and the policy implications following from those models are sensitive to the basic assumptions and initial conditions specified in those models, as well as the value judgments informing an evaluation of policy alternatives. Free-market policy implications require factual assumptions about low transactions costs and about the existence of a low-cost process of creating and assigning property rights — including what we now call intellectual property rights — that imply that private agents perceive costs and benefits that closely correspond to social costs and benefits. Altering those assumptions can radically change the policy implications of the theory.

The best example I can find to illustrate that point is another one of my UCLA professors, the late Earl Thompson, who was certainly the most relentless economic reductionist whom I ever met, perhaps the most relentless whom I can even think of. Despite having a Harvard Ph.D. when he arrived back at UCLA as an assistant professor in the early 1960s, where he had been an undergraduate student of Armen Alchian, he too started out as a pro-free-market Friedman acolyte. But gradually adopting the Buchanan public-choice paradigm – Nancy Maclean, please take note — of viewing democratic politics as a vehicle for advancing the self-interest of agents participating in the political process (marketplace), he arrived at increasingly unorthodox policy conclusions to the consternation and dismay of many of his free-market friends and colleagues. Unlike most public-choice theorists, Earl viewed the political marketplace as a largely efficient mechanism for achieving collective policy goals. The main force tending to make the political process inefficient, Earl believed, was ideologically driven politicians pursuing ideological aims rather than the interests of their constituents, a view that seems increasingly on target as our political process becomes simultaneously increasingly ideological and increasingly dysfunctional.

Until Earl’s untimely passing in 2010, I regarded his support of a slew of interventions in the free-market economy – mostly based on national-defense grounds — as curiously eccentric, and I am still inclined to disagree with many of them. But my point here is not to argue whether Earl was right or wrong on specific policies. What matters in the context of the question posed by Dina Pomeranz is the economic logic that gets you from a set of facts and a set of behavioral and causality assumptions to a set of policy conclusion. What is important to us as economists has to be the process not the conclusion. There is simply no presumption that the economic logic that takes you from a set of reasonably accurate factual assumptions and a set of plausible behavioral and causality assumptions has to take you to the policy conclusions advocated by right-wing, free-market ideologues, or, need I add, to the policy conclusions advocated by anti-free-market ideologues of either left or right.

Certainly we are all within our rights to advocate for policy conclusions that are congenial to our own political preferences, but our obligation as economists is to acknowledge the extent to which a policy conclusion follows from a policy preference rather than from strict economic logic.

Hayek’s Rapid Rise to Stardom

For a month or so, I have been working on a paper about Hayek’s early pro-deflationary policy recommendations which seem to be at odds with his own idea of neutral money which he articulated in a way that implied or at least suggested that the ideal monetary policy would aim to keep nominal spending or nominal income constant. In the Great Depression, prices and real output were both falling, so that nominal spending and income were also falling at a rate equal to the rate of decline in real output plus the rate of decline in the price level. So in a depression, the monetary policy implied by Hayek’s neutral money criterion would have been to print money like crazy to generate enough inflation to keep nominal spending and nominal income constant. But Hayek denounced any monetary policy that aimed to raise prices during the depression, arguing that such a policy would treat the disease of depression with the drug that had caused the disease in the first place. Decades later, Hayek acknowledged his mistake and made clear that he favored a policy that would prevent the flow of nominal spending from ever shrinking. In this post, I am excerpting the introductory section of the current draft of my paper.

Few economists, if any, ever experienced as rapid a rise to stardom as F. A. Hayek did upon arriving in London in January 1931, at the invitation of Lionel Robbins, to deliver a series of four lectures on the theory of industrial fluctuations. The Great Depression having started about 15 months earlier, British economists were desperately seeking new insights into the unfolding and deteriorating economic catastrophe. The subject on which Hayek was to expound was of more than academic interest; it was of the most urgent economic, political and social, import.

Only 31 years old, Hayek, director of the Austrian Institute of Business Cycle Research headed by his mentor Ludwig von Mises, had never held an academic position. Upon completing his doctorate at the University of Vienna, writing his doctoral thesis under Friedrich von Wieser, one of the eminent figures of the Austrian School of Economics, Hayek, through financial assistance secured by Mises, spent over a year in the United States doing research on business cycles, and meeting such leading American experts on business cycles as W. C. Mitchell. While in the US, Hayek also exhaustively studied the English-language  literature on the monetary history of the eighteenth and nineteenth centuries and the, mostly British, monetary doctrines of that era.

Even without an academic position, Hayek’s productivity upon returning to Vienna was impressive. Aside from writing a monthly digest of statistical reports, financial news, and analysis of business conditions for the Institute, Hayek published several important theoretical papers, gaining a reputation as a young economist of considerable promise. Moreover, Hayek’s immersion in the English monetary literature and his sojourn in the United States gave him an excellent command of English, so that when Robbins, newly installed as head of the economics department at LSE, and having fallen under the influence of the Austrian school of economics, was seeking to replace Edwin Cannan, who before his retirement had been the leading monetary economist at LSE, Robbins thought of Hayek as a candidate for Cannan’s position.

Hoping that Hayek’s performance would be sufficiently impressive to justify the offer of a position at LSE, Robbins undoubtedly made clear to Hayek that if his lectures were well received, his chances of receiving an offer to replace Cannan were quite good. A secure academic position for a young economist, even one as talented as Hayek, was then hard to come by in Austria or Germany. Realizing how much depended on the impression he would make, Hayek, despite having undertaken to write a textbook on monetary theory for which he had already written several chapters, dropped everything else to compose the four lectures that he would present at LSE.

When he arrived in England in January 1931, Hayek actually went first to Cambridge to give a lecture, a condensed version of the four LSE lectures. Hayek was not feeling well when he came to Cambridge to face an unsympathetic, if not hostile, audience, and the lecture was not a success. However, either despite, or because of, his inauspicious debut at Cambridge, Hayek’s performance at LSE turned out to be an immediate sensation. In his History of Economic Analysis, Joseph Schumpeter, who, although an Austrian with a background in economics similar to Hayek’s, was neither a personal friend nor an ideological ally of Hayek’s, wrote that Hayek’s theory

on being presented to the Anglo-American community of economists, met with a sweeping success that has never been equaled by any strictly theoretical book that failed to make amends for its rigors by including plans and policy recommendations or to make contact in other ways with its readers loves or hates. A strong critical reaction followed that, at first, but served to underline the success, and then the profession turned away to other leaders and interests.

The four lectures provided a masterful survey of business-cycle theory and the role of monetary analysis in business-cycle theory, including a lucid summary of the Austrian capital-theoretic approach to business-cycle theory and of the equilibrium price relationships that are conducive to economic stability, an explanation of how those equilibrium price relationships are disturbed by monetary disturbances giving rise to cyclical effects, and some comments on the appropriate policies for avoiding or minimizing such disturbances. The goal of monetary policy should be to set the money interest rate equal to the hypothetical equilibrium interest rate determined by strictly real factors. The only policy implication that Hayek could extract from this rarified analysis was that monetary policy should aim not to stabilize the price level as recommended by such distinguished monetary theorists as Alfred Marshall and Knut Wicksell, but to stabilize total spending or total money income.

This objective would be achieved, Hayek argued, only if injections of new money preserved the equilibrium relationship between savings and investment, investments being financed entirely by voluntary savings, not by money newly created for that purpose. Insofar as new investment projects were financed by newly created money, the additional expenditure thereby financed would entail a deviation from the real equilibrium that would obtain in a hypothetical barter economy or in an economy in which money had no distortionary effect. That  interest rate was called by Hayek, following Wicksell, the natural (or equilibrium) rate of interest.

But according to Hayek, Wicksell failed to see that, in a progressive economy with real investment financed by voluntary saving, the increasing output of goods and services over time implies generally falling prices as the increasing productivity of factors of production progressively reduces costs of production. A stable price level would require ongoing increases in the quantity of money to, the new money being used to finance additional investment over and above voluntary saving, thereby causing the economy to deviate from its equilibrium time path by inducing investment that would not otherwise have been undertaken.

As Paul Zimmerman and I have pointed out in our paper on Hayek’s response to Piero Sraffa’s devastating, but flawed, review of Prices and Production (the published version of Hayek’s LSE lectures) Hayek’s argument that only an economy in which no money is created to finance investment is consistent with the real equilibrium of a pure barter economy depends on the assumption that money is non-interest-bearing and that the rate of inflation is not correctly foreseen. If money bears competitive interest and inflation is correctly foreseen, the economy can attain its real equilibrium regardless of the rate of inflation – provided, at least, that the rate of deflation is not greater than the real rate of interest. Inasmuch as the real equilibrium is defined by a system of n-1 relative prices per time period which can be multiplied by any scalar representing the expected price level or expected rate of inflation between time periods.

So Hayek’s assumption that the real equilibrium requires a rate of deflation equal to the rate of increase in factor productivity is an arbitrary and unfounded assumption reflecting his failure to see that the real equilibrium of the economy is independent of the price levels in different time periods and rates of inflation between time periods, when prices levels and rates of inflation are correctly anticipated. If inflation is correctly foreseen, nominal wages will rise commensurately with inflation and real wages with productivity increases, so that the increase in nominal money supplied by banks will not induce or finance investment beyond voluntary savings. Hayek’s argument was based on a failure to work through the full implications of his equilibrium method. As Hayek would later come to recognize, disequilibrium is the result not of money creation by banks but of mistaken expectations about the future.

Thus, Hayek’s argument mistakenly identified monetary expansion of any sort that moderated or reversed what Hayek considered the natural tendency of prices to fall in a progressively expanding economy, as the disturbing and distorting impulse responsible for business-cycle fluctuations. Although he did not offer a detailed account of the origins of the Great Depression, Hayek’s diagnosis of the causes of the Great Depression, made explicit in various other writings, was clear: monetary expansion by the Federal Reserve during the 1920s — especially in 1927 — to keep the US price level from falling and to moderate deflationary pressure on Britain (sterling having been overvalued at the prewar dollar-sterling parity when Britain restored gold convertibility in March 1925) distorted relative prices and the capital structure. When distortions eventually become unsustainable, unprofitable investment projects would be liquidated, supposedly freeing those resources to be re-employed in more productive activities. Why the Depression continued to deepen rather than recover more than a year after the downturn had started, was another question.

Despite warning of the dangers of a policy of price-level stabilization, Hayek was reluctant to advance an alternative policy goal or criterion beyond the general maxim that policy should avoid any disturbing or distorting effect — in particular monetary expansion — on the economic system. But Hayek was incapable of, or unwilling to, translate this abstract precept into a definite policy norm.

The simplest implementation of Hayek’s objective would be to hold the quantity of money constant. But that policy, as Hayek acknowledged, was beset with both practical and conceptual difficulties. Under a gold standard, which Hayek, at least in the early 1930s, still favored, the relevant area within which to keep the quantity of money constant would be the entire world (or, more precisely, the set of countries linked to the gold standard). But national differences between the currencies on the gold standard would make it virtually impossible to coordinate those national currencies to keep some aggregate measure of the quantity of money convertible into gold constant. And Hayek also recognized that fluctuations in the demand to hold money (the reciprocal of the velocity of circulation) produce monetary disturbances analogous to variations in the quantity of money, so that the relevant policy objective was not to hold the quantity of money constant, but to change the quantity of money proportionately (inversely) with the demand to hold money (the velocity of circulation).

Hayek therefore suggested that the appropriate criterion for the neutrality of money might be to hold total spending (or alternatively total factor income) constant. With constant total spending, neither an increase nor a decrease in the amount of money the public desired to hold would lead to disequilibrium. This was a compelling argument for constant total spending as the goal of policy, but Hayek was unwilling to adopt it as a practical guide for monetary policy.

In the final paragraph of his final LSE lecture, Hayek made his most explicit, though still equivocal, policy recommendation:

[T]he only practical maxim for monetary policy to be derived from our considerations is probably . . . that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by overcaution. . . . It is probably an illusion to suppose that we shall ever be able entirely to eliminate industrial fluctuations by means of monetary policy. The most we may hope for is that the growing information of the public may make it easier for central banks both to follow a cautious policy during the upward swing of the cycle, and so to mitigate the following depression, and to resist the well-meaning but dangerous proposals to fight depression by “a little inflation “.

Thus, Hayek concluded his series of lectures by implicitly rejecting his own idea of neutral money as a policy criterion, warning instead against the “well-meaning but dangerous proposals to fight depression by ‘a little inflation.’” The only sensible interpretation of Hayek’s counsel of “resistance” is an icy expression of indifference to falling nominal spending in a deep depression.

Larry White has defended Hayek against the charge that his policy advice in the depression was liquidationist, encouraging policy makers to take a “hands-off” approach to the unfolding economic catastrophe. In making this argument, White relies on Hayek’s neutral-money concept as well as Hayek’s disavowals decades later of his early pro-deflation policy advice. However, White omitted any mention of Hayek’s explicit rejection of neutral money as a policy norm at the conclusion of his LSE lectures. White also disputes that Hayek was a liquidationist, arguing that Hayek supported liquidation not for its own sake but only as a means to reallocate resources from lower- to higher-valued uses. Although that is certainly true, White does not establish that any of the other liquidationists he mentions favored liquidation as an end and not, like Hayek, as a means.

Hayek’s policy stance in the early 1930s was characterized by David Laidler as a skepticism bordering on nihilism in opposing any monetary- or fiscal-policy responses to mitigate the suffering of the general public caused by the Depression. White’s efforts at rehabilitation notwithstanding, Laidler’s characterization seems to be on the mark. The perplexing and disturbing question raised by Hayek’s policy stance in the early 1930s is why, given the availability of his neutral-money criterion as a justification for favoring at least a mildly inflationary (or reflationary) policy to promote economic recovery from the Depression, did Hayek remain, during the 1930s at any rate, implacably opposed to expansionary monetary policies? Hayek’s later disavowals of his early position actually provide some insight into his reasoning in the early 1930s, but to understand the reasons for his advocacy of a policy inconsistent with his own theoretical understanding of the situation for which he was offering policy advice, it is necessary to understand the intellectual and doctrinal background that set the boundaries on what kinds of policies Hayek was prepared to entertain. The source of that intellectual and doctrinal background was David Hume and the intermediary through which it was transmitted was none other than Hayek’s mentor Ludwig von Mises.

Has the S&P 500 Risen by 25% since November 8, 2016 Thanks to Economic Nationalist America First Policies?

Many people – I don’t think that I need to mention names — are saying that the roughly 25% rise US stock prices in the 13 months since the last Presidential election shows that the economic nationalist America First policies adopted since then have been a roaring success.

Responding to those claims some people have pointed out that the increase in the S&P500 since November 8, 2016 or since January 20, 2017 has been very close to the average yearly rate of increase in the S&P 500 since January 20, 2009, when Barrack Obama took office. Here is a comparison of the year on year rate of increase in the S&P500 since January 20, 2010, one year after Obama took office.


% year over year change in S&P 500



















Now the percent change in the S&P 500 for 2018 is just the change for the 10 and a half months between January 20, 2017 and December 5 2017, so if the current rate of increase in the S&P 500 since January 20 is maintained, the annual increase would be about 18% which would still be less than the year-on-year increase in the last year of the Obama administration. Over the entire 8 years of the Obama administration, the S&P 500 increased by about 220%, or an annual rate of increase of a little over 12% a year. So the S&P 500 in the first year since the adoption of the current economic nationalist America First policies has done better — but only slightly better — than it did on average in the eight years of the Obama administration.

But if we are trying to gauge the success of the economic nationalist America First policies of the current administration, it seems appropriate to take not just the performance of the S&P 500, which disproportionately represents US companies but also the performance of stocks in other countries. One such index is the MSCI EAFE index. (The MSCI EAFE Index is an index designed to measure the equity market performance of developed markets outside of the U.S. and Canada. It is maintained by MSCI Inc.,; the EAFE acronym stands for Europe, Australasia and Far East.)

The accompanying chart shows the performance of the S&P500 and the MSCI EAFE index since January 20, 2009. I have normalized both indices to equal 100 on November 8, 2016.

The two vertical lines are drawn at November 8, 2016 and January 20, 2017, the two dates of especial interest for comparison purposes. In the period between the election and the inauguration, the S&P 500 actually performed slightly better than did the MSCI EAFE. But the opposite has obviously been the case since the new administration actually came into power. Since the inauguration, the economic nationalist America First policies adopted by the administration have resulted in proportionately much greater increases in stock prices in Europe, Australia and the Far East than in the US (as reflected in the S&P 500).

Here are the year over year comparisons:


% year-over-year change in S&P 500

% year-over-year change in the MSCI EAFE




























In fact, the MSCI EAFE has outperformed the S&P 500 in every year since 2013. But the gap in the rates of increase in the two indices has skyrocketed since last January 20. I have no doubt that inquiring minds will want to know why the the economic nationalist America First policies of the new administration have been allowing the rest of the world to outperforming the US by an increasingly wide margins. Is that really what winning looks like? Sad!

PS I also can’t help but observe that during the Obama administration, rising stock prices were routinely dismissed by the geniuses at places like the Wall Street Journal editorial page, the Heritage Foundation, and Freedomworks as evidence that Quantitative Easing was an elitist regressive policy aimed at enriching Wall Street and the one-percent at the expense of retirees living on fixed incomes, workers with stagnating wages, and all the others being left behind by the callous and elitist policies of the Fed and the previous administration. Under the current administration, it seems that rising stock prices are no longer evidence that the elites are exploiting the common people as used to be the case before the economic nationalist America First policies now being followed were adopted.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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