Archive for July, 2011

The Journal and the Recovery

In an editorial in its weekend edition, The Wall Street Journal, picking up where editorial writer Stephen Moore left off five weeks earlier in his piece touting a report by the Republican staff of the Joint Economic Committee, compares the powerful 1983-84 recovery from the 1981-82 recession with the anemic recovery since 2009 from the 2007-09 downturn.  And guess what?  The Journal finds the present recovery wanting.

No surprise there.  Everyone knows that this recovery is feeble and that, in a very real sense, the Little Depression is ongoing.  But the Journal, of course, wants to teach us a deeper lesson by comparing these two recoveries.  The 1983-84 recovery was presided over by none other than the Journal’s hero, Ronald Reagan, in the full bloom of supply-side economics while the current recovery is the product of the detested doctrines of Keynesian economics embraced by the misguided Barack Obama.

This tale of two recoveries is an object lesson in economic policy. Taking office in 2009, President Obama embarked on one of the greatest reflation bets in history. He deployed the entire arsenal of neo-Keynesian policies to lift domestic demand, much as former White House economist Larry Summers still instructs at Harvard and most of the media still recommend.

So Congress deployed nearly a $1 trillion in stimulus, plus a battalion of temporary and targeted programs: cash for clunkers, cash for caulkers, tax credits for home buyers, 99 weeks of jobless benefits, “clean energy” grants, subsidies to states, and so much more. We were told that every $1 of this spending would conjure $1.50 in new economic output. The Federal Reserve has also more than cooperated by keeping interest rates near-zero for 31 months.

The Journal tells a good story, but the actual data tell a different one.  The revised national income accounts data show that measured as a percentage of GDP, federal spending increased from 20.6 percent of GDP in the fourth quarter of 2007 when the downturn began to 25.4 percent of GDP in the second quarter of 2009 less than six months after Mr. Obama took office.  Since then federal spending has held steady at about 25.5% of GDP.  So most of the increase in federal spending relative to GDP was already in place by the time Mr. Obama took office, reflecting not a significant amount of new spending but rather the contraction of the economy.  A relatively constant amount of spending increases as a share of GDP when GDP shrinks. 

[Added 8/1/11 8:35PM.  I should acknowledge that I overstated my caee here, as one of my commenters noted below.  Federal spending did increase by almost 9% in real terms in the second quarter of 2009.  GDP in the second quarter was just about flat, so it was the increse in spending that accounted for the increasing share of federal spending in GDP.  Of course, without increased federal spending, GDP would likely have been even less than it was.  In addition, since real federal spending during the 1981-82 recession was increasing under Reagan, it is plausible to assume that a substantial portion of the increase in federal spending in the second quarter of 2009 would  have taken place even without Obama’s stimulus program.   So the correct statement is that even without Obama’s Keynesian fiscal policy, the share of federal spending in GDP would have risen to between 24 and 24.5% rather than 25.5%.]

The patterns in the 1981-82 recession and the 1983-84 recovery are instructive in both their similarities and their differences.  In the third quarter of the 1981, the last quarter before the downturn, federal spending as a share of GDP was 21.6%.  When the downturn hit bottom in the fourth quarter of 1982, federal spending as a percentage of GDP was 24.1%.  If the economy had continued to contract, federal spending relative to GDP would undoubtedly have continued to increase.  When the economy did  begin to expand, federal spending relative to GDP declined only slightly under President Reagan, staying over 22% until the last year of his second term, while tax revenues actually declined relative GDP, going down from 19.9% to just over 18%, where they stayed for most of his two terms.

In the 1981-82 recession, the decline in real GDP was about 2.7%; in the 2007-09 downturn, the decline was about 5.1%, nearly twice as much.  In 1981-82 spending as a share of GDP increased about 2.5%, in 2007-09 federal spending relative to GDP increased about 5%, twice as much.  So the Journal has it almost exactly backwards; the rise in federal spending since the downturn in 2007 reflects, for the most part, the depth of the downturn.  It was not, as the Journal bizarrely alleges, a reflation bet made by Obama, much less “one of the greatest in history.” 

So how does the Journal explain the exceptionally slow pace of this recovery?  The Obama administration has frightened businesses and consumers. 

An economy recovering from financial duress [sic] needs incentives to invest again, not threats of higher taxes.  It needs encouragement to rebuild [sic] animal spirits, not rants against “millionaires and billionaires” and banker baiting.  It needs careful monetary management, not endless easing that leads to commodity bubbles and $4 gasoline.

Such an economy also needs consistent and restrained government policy, not the frenetic rewriting of the entire health-care (ObamaCare), financial (Dodd-Frank), and energy (29 major EPA rule-makings) industries.

This is beyond pathetic.  Profits and stock prices have recovered smartly since the economy hit bottom in the second quarter of 2009.  What reason is there to suppose that, if businesses saw profitable opportunities to expand output and employment, they would forego those opportunities because they are afraid that the Obama administration would say unkind things about them?  “Millionaires and billionaires” are always easy targets for politicians, and we have little reason to suspect that they are, as a class, easily intimidated or deterred from doing what they can to further enrich themselves by an occasional unkind remark by a politician, even if he happens to be President of the United States.  And it is simply preposterous to suppose that if businesses thought they could make more profit by increasing output and expanding employment than by streamlining their operations, that they would not choose to make the larger profit, whatever the politicians might be saying.  Does the Journal believe that the business climate is now worse than it was in 1971-72, when Richard Nixon imposed wage and price controls on the entire US economy, railed against the obscene profits of oil companies, and coerced Arthur Burns to open the monetary spigots to fuel a short-lived boom, albeit long-enough lasting to ensure his landslide re-election? 

In 1971-72, rapid monetary expansion was unnecessary for recovery, but effective in achieving the goal for which it was implemented.  In 2011, however, though necessary for recovery, monetary expansion has, appearances to the contrary notwithstanding, not been implemented, banks having been induced by an interest rate almost double that on 6-month Treasury bills to hold all the newly created reserves idle in their accounts with the Fed. 

The Journal accuses Obama’s economic advisers of being unable to explain the failure of their economic policy advice.  Perhaps they are.  But some of us, especially Scott Sumner and, before his untimely passing a year ago, Earl Thompson, have been arguing all along that it was tight monetary policy that got us into this mess, and that monetary policy, despite appearances, had remained tight making recovery impossible.  The malign effects of paying interest on reserves were identified almost immediately, and warnings that the policy would undermine the effectiveness of quantitative easing were issued from the get-go.  Everything that has happened since has confirmed the validity and prescience of the initial analysis of the downturn and of the warnings about how paying interest on reserves would undercut monetary policy to promote recovery. 

The Journal would do well to consider the possibility that there may be other explanations for the Little Depression of the past three years than the simplistic “us vs.them,” “supply-side vs. Keynesian” view of the world seemingly  governing the pronouncements of its editorial page.  Sophomoric outbursts like the one in last weekend’s edition bring no credit to a once venerable journalistic enterprise.

GDP Growth Has Stalled: Where is FDR?

The report issued this morning by the Bureau of Economic Analysis that real GDP grew at only 1.3 percent in the second quarter and revising the estimate of growth in the first quarter down to 0.3 percent is really depressing (pun intended).

This reminds me of 1932.  That’s when the Fed engaged in a program of open market purchases that had at most a minimal effect in slowing the downturn and reversing the slide in prices.  The program was widely dismissed as a failure and evidence of the impotence of monetary policy in a depression.  (Keynes had not yet invented the liquidity trap, but the idea that monetary policy is ineffective in stimulating a depressed economy because the interest rate channel is blocked predates Keynes.  People mistakenly think that Keynes invented the “you can’t push on a string” metaphor, but it seems to have originated with Congressman T. Alan Goldsborough.)  Scott Sumner has written about this episode in his (unfortunately still unpublished) book on the Great Depression, clearing up a lot of the confusion surrounding the program.  It was not until FDR took office in March 1933 and immediately suspended the gold standard, raising the price of gold, that deflation was halted, and reflation and recovery began.

All current monetary policy is doing, intentionally or inadvertently, is inducing banks to hold reserves yielding more interest than Treasury bills.  Looking at the amazing growth in bank reserves and the Fed balance sheet, people are amazed that banks are not lending despite all the “high-powered” money that the Fed has created.  The current policy, like the half-hearted open market purchases of 1932 is a prescription for failure, but the failure is interpreted not as a failure to adopt an expansionary monetary policy, but as a failure of expansionary monetary policy.  In 1933 FDR proved, despite the skeptics, that expansionary monetary policy does work.  Why can’t we learn from FDR?  Where are all the historians of the New Deal?  Why aren’t they pointing out how FDR used monetary policy to start a recovery at the deepest point of the Great Depression?

HT  Benjamin Cole

Central Banking Is Not Central Planning

A few days ago in my posting on gold and ideology, I remarked that gold ideologists like to accuse central bankers of being central planners.  I am not sure when this particular form of rhetorical character assassination got started, but it has become a commonplace of attacks on the Fed coming from the gold party.  A Google search on “central banking” together with “central planning” generates 54,600 results.  Here are some results from the first page.

Robert Blumen, “Will Central Bankers Become Central Planners?” Mises Daily July 31, 2006

Jeff Cooper, “The Fed: From Central Banking to Central Planning.” December 8, 2010

Ajay Shah, “Central Banking, Not Central Planning,”  Financial Express October 30, 2009

Richard Ebelling,”Monetary Central Planning and the State.”  Freedom Daily November 1999.

Thomas Dilorenzo, “The Malicious Myth of the ‘Libertarian’ Fed,”, May 8, 2009

Steve Stanek, “We Mocked Soviet Central Planning; Why Not Mock America’s Central Planning.”, April 29, 2011

Michael Brendan Dougherty, “Bernanke Reinvents Central Banking as Central Planning.”, November 6, 2010

Richard M. Ebelling, “Ninety Years of Central Planning in the United States.”, July 7, 2011

Detlev Schlichter, “Nothing Solved.”  April 28, 2011.

Now I am hardly one who thinks that the Fed does not deserve to be criticized for many sins of commission and omission over the years.  On the contrary, I believe that it bears a heavy responsibility for the Little Depression in which we have been mired for over three years.  But, whatever its faults and mistakes, that hardly makes the Fed a central planning agency.  And there is something disreputable about using a term like “central planning,” with its overtones of totalitarian domination and suppression of individual rights, as a rhetorical bludgeon with which to beat up a person or an institution with whom you have a policy disagreement.

When I remarked that Dr. Judy Shelton had indulged in this of ideological overkill in her recent paean to the gold standard, one commenter, R. H. Murphy, was kind enough to provide a link to a forthcoming paper by Jeffrey Hummel comparing the views of Milton Friedman and Ben Bernanke on the causes of the Great Depression and the appropriate role for monetary policy in general and in countering a severe economic downturn in particular.  I don’t know Hummel’s work that well, so I was pleasantly surprised with what I read.  I learned a lot from the paper, even though, at a theoretical level, it seems to me that Hummel dismisses Bernanke’s concerns about the breakdown of financial intermediation in a depression without sufficiently considering the potential consequences of such a breakdown.  And I would also observe in passing that the paper mistakenly takes Friedman’s view of the causes of the Great Depression as being somehow definitive, when, in fact, Friedman’s explanation misses almost entirely the nature of the monetary disturbance that caused the Great Depression, attaching far too much attention to the bank failures that were just a symptom of a far larger monetary dysfunction rather than an independent cause of the monetary contraction.

But I bring up Hummel’s paper not to comment on Friedman’s explanation of the Great Depression, but because Hummel, in his concluding section, attempts to make the case that Bernanke has gone beyond the kind of central banking that Friedman considered appropriate.   Defending the now much maligned Alan Greenspan, Hummel points out that Greenspan’s approach of flooding the market with liquidity during times of economic distress was not followed by Bernanke in 2008 when the economy was already in the early stages of a financial crisis and in a rapidly worsening recession.  Instead, Bernanke was attempting to provide more sophisticated targeted assistance to the financial sectors experiencing acute distress while keeping the lid tight on overall monetary base.  This is an extremely important observation and a damning criticism of Bernanke.  But even if true, and I am pretty sure that it is, how does that make Bernanke a central planner?  It may make him an interventionist, or even a dirigiste, but that does not make him a central planner.

If you go back to the classical discussions of central planning by Mises and Hayek, you will find that their key point about central planning was that the idea of a central plan is incoherent, because the informational requirements to formulate a central plan were beyond the capacity of an aspiring central planner to satisfy.  In The Road to Serfdom Hayek extended the critique to explain why a serious attempt to implement central planning as an economic system would inevitably lead to a totalitarian political system.  This position has been characterized over the years by Hayek’s critics (and, in their supreme cluelessness, by many of his self-styled supporters) as a claim that any intervention in the economy leads to totalitarianism, a mischaracterization that Hayek always resented and protested against.  But those who call central banking a form of central planning are making exactly the same categorical error about the relationships between intervention, central planning, and totalitarianism to which Hayek took extreme personal offense.

I come not to support central banking, but to defend clear thinking.

Are Markets Finally Getting Scared about the Debt Ceiling?

For weeks, pundits have noted with bemusement that the markets have been pretty calm about the ongoing struggle over raising the debt ceiling, notwithstanding warnings of catastrophic consequences should the ceiling not be raised.  The conventional wisdom has been that the markets simply could not imagine that Congress and the President would allow themselves to cause a catastrophe.  Eventually someone has to blink.  So the markets seem to have been treating all the ups and downs in the negotiations for the last month as inconsequential, yields on US debt and stock prices having generally traded within a narrow range over the past two or three months.

In my paper “The Fisher Effect Under Deflationary Expectations” available here, I presented evidence that since early 2008, shortly after the downturn began, stock prices have been strongly correlated with inflation expectations as reflected in both TIP spreads and the dollar/euro exchange rate.  These correlations, not implied by economic or finance theory under “normal” conditions, did not begin to appear in the data until after the Little Depression started.

In updating the empirical results in my paper to include the data since the end of 2010, I have found that the unusual correlation between stock prices and inflation expectations continues to show up in the more recent data.  However, on Monday the TIPS spread (reflecting the expected rate of inflation over 10 years) increased by .04 percentage points and the dollar depreciated by half a percent against the euro, both of which changes having been associated with rising stock prices.  According to my regression estimates, the S&P 500 should have increased by almost half a percent on Monday.  Instead the S&P 500 fell by over half a percent.  On Tuesday, the model seemed to be working, perhaps because it looked like an agreement might be in sight.  But today Speaker Boehner seemed unable to deliver a majority, the S&P 500 fell 2 percent, and the process of raising the debt as if it may really be unraveling.

Here are the actual values for the S&P 500 and my predicted values since Monday

Date           Actual S&P 500        Predicted S&P 500

7/25                    1337.43                         1350.76

7/26                    1331.94                          1330.47

7/27                    1304.89                         1334.48

Here’s a chart with the actual and predicted values of the S&P 500 since last week.

Maybe this is starting to get serious.

On the other hand, maybe there’s a silver lining.  If people start dumping Treasuries, the Fed may feel constrained to start buying them, and voila!  Inflationary monetary expansion.  Problem solved.  Go figure.

UPDATE:  When I made my calculations I used the wrong value for the yield on the constant maturity 10-year Treasury.  Fixing that slight glitch changes my little table as follows:

Date           Actual S&P 500        Predicted S&P 500

7/25                    1337.43                         1350.76

7/26                    1331.94                         1335.28

7/27                    1304.89                         1329.71

Here’s the revised chart:

UPDATE 7/29:  I used 3.00% percent as the yield on the 10-year constant maturity Treasury for 7/27 when it should have been 3.01%.  So the predicted value for the S&P500 was slightly understated for 7/27.  Yesterday, the predicted value for the S&P500 fell sharply, almost as low as  the actual value, so there no longer seems to be any residual to attribute to  the debt-ceiling.  Economic conditions seem to be getting worse all on their own, thank you very much.  This will probably be my last update on this topic, even if the world doesn’t come to an end next Tuesday.

Date           Actual S&P 500        Predicted S&P 500

7/25                    1337.43                         1350.76

7/26                    1331.94                         1335.28

7/27                    1304.89                         1330.90

7/28                    1300.67                         1302.21


Gold and Ideology, Continued

Last week I commented on the views of James Grant about the gold standard.  I disagree with Mr. Grant about the gold standard, but he knows a great deal about a lot of things and he understands really well how financial markets work at the ground level.  Aside from that he is a really good writer, which suggests that he is a clear, if occasionally misguided, thinker.  This week, I turn to Dr. Judy Shelton, writing in the new (August 1) issue of the Weekly Standard (“Gold Standard or Bust”) and extolling the virtues of the gold standard.  I don’t know, and have never met Dr. Shelton, but she has been a frequent op-ed contributor to the Wall Street Journal and various other publications of a like ideological orientation for 20 years or more, invariably advocating a return to the gold standard.  In 1994, she published a book Money Meltdown touting the gold standard as a cure for all our monetary ills.  I also observe that she is listed as a contributor on the Free Banking blog, but has yet to post anything.

I was tempted to provide a line-by-line commentary on Dr. Shelton’s Weekly Standard piece, but it would be  tedious and churlish to dwell excessively on her deficiencies as a wordsmith or lapses from lucidity.

But consider the following passage:

As government-issued claims against our country’s future output accumulate, there is a hollowing-out effect, with financial capital drawn away from the real economy.  Real economic growth happens when private investors take their chances on innovative entrepreneurs – not when they are induced to purchase “safe” government securities.

What can this possibly mean?  That government borrowing necessarily takes resources away from the private economy?  What if those resources are not being used and would remain (temporarily or permanently) idle but for government borrowing?  What does it mean for “financial capital to be drawn away from the real economy”?  Drawn by what?  By rising interest rates?  Aren’t interest rates now at the lowest levels since the Great Depression?  And how does government borrowing induce private investors not to “take their chances on innovative entrepreneurs?”  Might the level of aggregate demand possibly be relevant to this discussion?  I don’t say that the answers to these questions are obvious, but Dr. Shelton, securely ensconced in her own ideological cocoon, seems blissfully unaware that the questions even exist.

Dr. Shelton continues:

Since the resources needed to pay for current government expenditures are not available, the government is laying claim to future revenues.

That seems like a truism, but Dr. Shelton is just preparing us for the following profundity:

The notion of money as a claim on tangible assets is thus rendered abstract.

OK, time to move on.

After having established, to her own satisfaction at any rate, the imminent danger of currency debasement, Dr. Shelton conjectures that the interests of ordinary Americans have come into perfect alignment with those of la haute finance internationale.

The connection was made last November when former Alaska governor Sarah Palin called for a stable dollar to put our economy back on the right track.  ‘The Fed’s pump priming addiction has got our small businesses running scared,” she noted, “and our allies worried.”  Robert Zoellick, who heads the World Bank, lamented in a Financial Times op-ed that global consternation over the Fed’s quantitative easing was prompting talk of currency wars.  Zoellick proposed that the global monetary regime be reformed to spur economic growth —and suggested that nay new system should “consider employing gold as an international reference point.”

Perhaps Dr. Shelton has forgotten, but within two days of his reference to gold, Mr. Zoellick specifically denied that he meant to support or suggest restoring the gold standard.  But for Dr. Shelton, gold should not be a mere reference point, but a standard.  Why?  Because gold stands for discipline, so that people who mistrust the government can cash their currency in for gold at the fixed parity.  In this way, the money supply will adjust to “the collective assessment of market participants” rather than to the “less-than-omniscient hunches of central bankers.” 

According to the ideology of the gold standard, a gold standard would make the value of  money totally independent of the “less-than-omniscient hunches of central bankers.”  The value of a dollar would be identical to the value of gold, not to what the central bankers want it to be.  But, in a recent New York Times story about the revival of interest in the gold standard, it was reported that central banks still have 29,000 tons of gold sitting in their vaults out of perhaps 166,000 tons of gold that have been mined throughout world history.  Why does Dr. Shelton, or anyone else, imagine that, with such an enormous stockpile of gold under their control, the value of gold would be insulated from the decisions or whims of central bankers?

Gold provides a self-correcting mechanism for irrational exuberance; as credit begins to flow too freely, as equity values or commodity prices appear frothy, the astute observer at the margin cashes out in gold. Monetary central planning gives way to the aggregate wisdom of the free market.

Here Dr. Shelton indulges in a favorite trope of modern gold standard ideology: the facile identification (and deliberate confusion) of central banking with central planning.

Quoting Ludwig von Mises, Dr. Shelton extols the gold standard as a barrier against runaway government spending, as if there was no government borrowing under the gold standard.  Once in a lecture, Mises offered the following argument:

If, under the gold standard, a government is asked to spend money for something new, the minister of finance can say: “And where do I get the money? Tell me, first, how I will find the money for this additional expenditure.”

Yet, without a tinge of embarrassment, Dr. Shelton also invokes the memory of Jack Kemp, who not very successfully sought the Presidency on a promise to cut taxes and restore the gold standard.  Some of us,  however, still remember when Kemp, defending the Reagan administration, to the delight of the Wall Street Journal editorial page, for running huge deficits during a recession, declared that Republicans “no longer worship at the altar of a balanced budget.”  But that was then and now is now.

The Paradox of Fiat Money

Hal Varian is a very, very smart economist, now Professor emeritus at UC Berkeley, and chief economist at Google.  For a number of years, he used to write a monthly column for the New York Times.  In a January 2004 column, he posed the question “Why Is that Dollar in Your Wallet Worth Anything?.”  The first answer he considered was the one in which most lay people probably believe:  that the government makes it worth something by declaring it legal tender.  The problem with that answer, Varian observed, is that whatever the government says, nothing prevents people who want to from using something other than dollars to execute the transactions or discharge their debts.  If people didn’t find it in their own best interest to transact in dollars, all the legal tender laws in the world couldn’t force them to keep making transactions in dollars.

Varian therefore proposed another explanation, suggesting that people accept fiat money out of social convention.  In other words, the expectation that people will accept payment in dollars creates mutually reinforcing expectations, what we now call a network effect, that induce others to adopt the same expectation.  Writing in the aftermath of the US invasion of Iraq, Varian cited the experience of Kurdistan, which, having achieved de facto autonomy from Iraq after the first Gulf war, continued using the old Iraqi dinar as its local currency even after Saddam Hussein introduced a new currency that became the legal and the customary currency in the non-Kurdish part of Iraq remaining under Saddam’s effective control until the US invaded in March 2003.

That column elicited a response from Frank Shostak in the Mises Daily, a web-based publication of the Ludwig von Mises Institute at Auburn University.  Shostak made a powerful objection to Varian’s explanation of the value of fiat money.

And yet that still doesn’t tell us why the dollar bill in our pocket has value. To say that the value of money is on account of social convention is to say very little. In fact, what Varian has told us is that money has value because it is accepted, and why is it accepted? . . . because it is accepted! Obviously this is not a good explanation of why money has value.

To bolster his thesis Varian suggests that the value of the dollar is a result of the “network effect.” According to him, “Just as a fax machine is valuable to you only if lots of other people you correspond with also have fax machines, a currency is valuable to you only if a lot of people you transact with are willing to accept it as payment.”

Shostak tried a different tack, invoking the famed (well, famed, at any rate among the hard-core of the Austrian School) Regression Theorem of Ludwig von Mises, the most venerated, and most authoritative figure in the pantheon of Austrian economics.  (Many outsiders erroneously assume that F. A. Hayek is the leading figure in twentieth century Austrian economics, but among insiders, Hayek is viewed with less than unequivocal admiration for having appropriated Mises’s earlier insights in business-cycle theory, for his willingness to adopt the terminology and methods of mainstream economic theory in his exposition of Mises’s theory, for his subsequent recantation of his early opposition to any form of countercyclical policy by the monetary authority, and, more generally, an insufficiently rigorous opposition to all forms of interventionist economic policies.) 

According to the Regression Theorem, the demand for any money, i.e., an asset demanded because it is accepted in exchange, not for any direct services that it provides, is contingent on its previous value.  Thus, the value of any medium of exchange must have been derived from its value as a commodity before anyone ever accepted it as a medium of exchange.  The Regression Theorem traces back the demand for every medium of exchange to some earlier time when it had value strictly as a commodity, not as a medium of exchange.  But then, how does one explain the value of a fiat money which provides no real services and never did provide any real services that made it valuable in its own right?  The Regression Theorem asserts (some theorem!  But despite his extravagant claims to have created a purely deductive, apodictically certain, theory of human action, Mises did not overly concern himself with the logical rigor of his “proofs”) that every fiat money must, at some point, have been convertible into a real asset to have become valuable in the first place.  Only then, having acquired value through its convertibility into a real asset, usually gold or silver, could the money retain any value after the link to a real asset with commodity value was severed.

More problematic than the failure of the Regression Theorem to provide a valid deductive argument for a historical conjecture about the origins of fiat money is that the Regression Theorem completely misses the point of the whole exercise.   The difficult question, for which Varian struggled to find an answer, is why a fiat money, regardless of why it might once have had value, can retain any value.  The Regression Theorem, as its name attests, is backward-looking.  But economic problems, as Austrian economics to its credit usually recognizes, are forward-looking.  Whether a fiat money once had value is irrelevant to an understanding of why and how it retains value. 

Why should a fiat money not be able to retain value?  Well, consider the following thought experiment.  For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else.  Without that expectation, a fiat money could not, by definition, have value.  But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it.  But if it is clear that at some time in the future, no one will accept fiat money and will then lose its value, a logical process of backward induction implies that it must lose its value now.

I first heard this backward induction argument from Earl Thompson in his graduate macroeconomics course at UCLA (in those days both Axel Leijonhufvud and Earl Thompson taught graduate macro, and having taken Axel’s course for credit in my first year, I audited Earl’s course in my second year).  To say that not everyone was willing to accept the backward induction proof that fiat money must be worthless would be an understatement, and for a long time, I, too, tried to resist.  But eventually, I had to yield to the force of logic that seemed compelling. 

Since I have found that the backward induction argument rarely convinces anyone that fiat money can’t have value, perhaps I should try to explain the process that led me to accept it despite my initial qualms.  While still an undergraduate at UCLA, I took Ben Klein’s course in money and banking.  Ben had just arrived at UCLA, Ph. D. not quite in hand, from the University of Chicago.  His dissertation on the Competitive Supply of Money (a portion of which was published under that title in the Journal of Money Credit and Banking) made a historic breakthrough in modeling the behavior of banks in terms of the standard theory of the firm, instead of the usual ad hoc derivation of the money multiplier, disproving in the process, Milton Friedman’s oft-made assertion that free competition in the supply of money would force the value of money down to its zero marginal cost of production.  Ben pointed out that the argument works only if banks produce indistinguishable monies and are forced to redeem each other’s monies at par.  Rather than competing to increase the amount of money they issued, banks would compete to increase the demand to hold their monies by paying interest to depositors.  Ben started a theoretical revolution in the analysis of banks and the money supply, unfortunately still not fully incorporated into modern money and banking theory.

As yet unknown to me, Earl Thompson had also developed a similar theory of a competitive money supply, except that in Earl’s model bank money was convertible into a real asset, gold.  The theoretical difference between Ben’s model and Earl’s model was that Earl argued that only through convertibility into a real asset could a private bank make its money valuable while Ben held that, even without a convertibility commitment, a bank could invest in brand name capital by incurring sunk costs that would be forfeited should it later depreciate its money. 

So there the argument stood until the spring quarter of my second year as a graduate student, when I took Armen Alchian’s seminar in applied price theory.  The seminar involved Armen discussing some current event or issue in the news or some problem for a journal article, working the problem out with us by applying the logic of economic theory.  I have never seen another economist who, using only chalk and a blackboard and elementary economic theory, could provide such a deep and empirically meaningful analysis of any problem that he put his mind to.  One of the papers that we discussed in Armen’s seminar was Ronald Coase’s paper “Durability and Monopoly” which had just been, or was about to be, published in the Journal of Law and Economics

Coase posited a monopolist over a durable good, and asked the question: what price can the monopolist charge for the good.  The surprising answer that Coase arrived at was:  the competitive price.  And the reason was that if the monopolist tried to set the price any higher, then no one would buy the good, because each prospective purchaser would assume that after selling as much as he could sell at the monopoly price, the monopolist would then try to sell additional units of the good at a lower price inasmuch as the incremental sales at that price would still exceed the incremental cost.  And after selling as much as he could at the lower price, the monopolist would have an incentive to cut price yet again to sell additional units, selling the last unit at a price equal to marginal cost.  Anticipating that the monopolist would eventually sell at a price equal to marginal cost, no purchaser would be willing to pay more than marginal cost in the first place.  After going through that argument, Coase then reasoned that to avoid having to sell at a price equal to marginal cost, the monopolist could offer either to rent rather than sell the durable good, or, alternatively, could offer to sell the durable good with a buy-back option if the price were reduced below the initial selling price.  Either way, a renter or a purchaser would be protected against a capital loss on his purchase in case of opportunistic sales by the monopolist.

At some point, I had a eureka moment realizing that Coase’s argument was simply an informal version of the backward induction argument for the worthlessness of fiat money that Earl Thompson had used.  So, after Armen’s seminar one day, I suggested to him that if Coase’s reasoning about durability and monopoly was right, Ben Klein’s argument that investments in brand name capital would enable a competitive supplier of money to maintain a positive value for its money, even without convertibility, could not be right.  I don’t know if Armen had already seen the connection, but he responded that Klein had also discussed a case in which competing money suppliers made their moneys convertible into what Ben called a “dominant” money.  The motivation for that case, it now seems to me, had more to do with a recognition of what would now be called the network effects of a single monetary standard than with the logic of backward induction or Coase’s durability and monopoly argument, but Alchian’s response persuaded me that the backward induction argument was more than an application of esoteric and possibly dubious game-theoretic reasoning, but was well grounded in basic price theory. 

So if the argument that fiat money is worthless is as strong as I believe it to be, how does one answer Hal Varian’s question why is a dollar worth anything?  There are two possibilities.  First, the real world could be less rational than pure economic logic would suggest.  I no longer would dismiss this possibility out of hand, as I once did.  But we should at least recognize that a positive value for fiat money may involve an element of irrationality.  A positive value for fiat money may be no less a bubble than tulips in 17th century Holland, or houses in 21st century America.  People may be accepting money in the false expectation that they will always be able to find some other sucker willing to accept it.  If so, everyone will eventually realize what’s going on, and the game will be over.

The other possibility, the one proposed by Earl Thompson, is that fiat money actually does provide a real service, which is that governments accept it as payment to discharge tax liability.  By making fiat money acceptable as payment for taxes, the government ensures that there is another source of demand for money aside from its use as a means of exchange for private transactions, which is all that is necessary to avoid the backward induction argument.  That the US government accepts other currencies than the dollar in payment of the taxes that it imposes does not mean that there is zero demand to hold dollars with which to discharge tax liability.  Similarly, just because most people hold money for reasons other than paying taxes does not prove that acceptability in payment of taxes is not a necessary condition for dollars to have positive exchange value.  Under a gold standard, most people did not hold gold for the real services it provided.  But without those real services, gold could not have rendered any services as a medium of exchange.

Earl Thompson wasn’t the first economist to offer this explanation for the value of a fiat currency.  Abba Lerner suggested it in the 1940s.  But the most famous source is the German economist G. F. Knapp in his State Theory of Money.  This doctrine was dubbed by Keynes as chartalism.  I believe that at least some of the bad press that chartalism has gotten over the years is due to the hostile and dismissive treatment Knapp’s theory received at the hands of Ludwig von Mises in his Theory of Money and Credit, which grossly misrepresented what Knapp was trying to say.  Offering few specifics, Mises heaped scorn on Knapp’s work, unjustly accusing Knapp of a complete lack of understanding of economic theory.  However, 15 years before the State Theory of Money was published, P. H. Wicksteed, in his magnificent Common Sense of Political Economy (1910), the most elegant and most comprehensive verbal presentation of neoclassical economic theory ever written, a work subsequently embraced by Austrian economists as one of their own despite the lack of any interaction between Wicksteed and the Austrian economists, based his explanation of why inconvertible paper money had a positive value squarely on its being made acceptable by the government for the payment of taxes (volume 2, pp. 618-22).  So any notion that chartalism is at odds with orthodox economic theory, as Mises alleged, is utterly unfounded.

Recently Scott Sumner has been engaged in some pretty acrimonious debates about whether the Fed or central banks in general have the power to control the price level with supporters of what is called Modern Monetary Theory.  One of the main tenets is of Modern Monetary Theory is chartalism.  On my, possibly biased, reading of those debates, I think that Scott has gotten the better of those exchanges.  But it seems to me that the opinion one has about why fiat money has positive value is independent of whether one thinks that central banks really can control the price level.  Perhaps I will have more to say about that in a future posting.

What Should the Fed Target?

Over the past 30 years a consensus has formed among central bankers around the notion that their job is to keep the rate of inflation at or perhaps just under 2 percent a year.  Exactly how they arrived at this figure is not exactly clear to me; I think the idea is that you want inflation to be so low that people aren’t very conscious of it in their everyday lives, but you don’t actually want to bring it down to zero, because if you did, you might inadvertently fall into a deflationary downward spiral.  So about 2 percent inflation provides a bit of protective cushion against drifting into that deflationary danger zone without raising inflation enough to become imbedded in the public consciousness.

Of course there are many different ways to measure inflation, and it was long ago understood by economists that no single price index could perfectly measure what we mean when we talk about the purchasing power of money.  The most popular inflation measure is the consumer price index, but the CPI tracks only a subset of goods, those entering into the budget of a typical urban working household.  In addition, there are all kinds of issues associated with adjusting for quality changes (generally improvement) in the goods consumed over time and issues associated with taking into account the changing composition of the basket of goods the typical urban household purchases (in part in response to relative price changes among the goods in the basket).

In recent years, the Fed has been placing greater emphasis on what is called “core inflation” than on the standard CPI, also referred to as “headline inflation.”  Core inflation subtracts off from the CPI volatile energy and food prices, which, it is argued, are a) highly volatile, so that a given monthly change may present a misleading impression about inflation over a longer time horizon, and b) subject to various forces capable of producing significant price  movements even with no change in monetary conditions.  This reasoning suggests that by cross checking “headline inflation” with “core inflation,” the monetary authorities can reach a better judgment about the danger that inflation might accelerate than by looking at “headline inflation” in isolation.

Interestingly, the FOMC, in 2008, did just the opposite — with disastrous results.  Even though core inflation was fairly well contained in 2008, the Fed viewed with alarm the increases in headline inflation associated with the run up in oil prices in the first half of 2008.  Fearing that high headline inflation would cause inflation expectations to become unanchored, the FOMC refused to cut the Fed Funds rate below 3 percent from March to October — yes October! — 2008 despite all the evidence that the economy, even before the Lehman debacle, was already in, or about to fall into, a recession.

Once again, voices at the Fed and in the FOMC are being raised to focus attention on headline rather than core inflation.   James Bullard, President of the St. Louis Fed, recently (5/18/2011) gave a speech to the Money Marketeers of New York University, dispassionately titled “Measuring Inflation: The Core Is Rotten.”  The speech does not address directly whether current Fed policy is too tight or too loose, but Bullard, who supported QE2, providing crucial support to Bernanke in September 2010 after Bernanke’s Jackson Hole speech, signalling his intention to press forward with another round of quantitative easing, has since signaled his own opposition to further steps toward monetary ease.  What Bullard does do is review a lengthy list of reasons why the Fed should stay focused on headline rather than core inflation.  I have no reason to think that Bullard is not sincere in preferring that the Fed target headline rather than core inflation, but the subtext of Bullard’s remarks suggests to me that he believes that the current rate of headline inflation is higher than he would like it to be and that monetary policy should be adjusted accordingly.

The US focus on  core inflation tends to damage Fed credibility.  As I noted in the introduction, many other central banks have solidified their position on this question by adopting explicit, numerical inflation targets in terms of headline inflation, thus keeping faith with their citizens that they will work to keep headline inflation low and stable.  The Fed should do the same.

But why should headline inflation be the measure of inflation of most concern to the Fed?  Rather than explain, Bullard simply asserts that stabilizing headline inflation is what gives the Fed credibility.

With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy.

Historically, the rationale for stabilizing a price index has been that, by doing so, the monetary authority could damp down the business cycle.  This was the position of the great Swedish economist Knut Wicksell in the late nineteenth and early twentieth centuries.  He believed that swings of inflation and deflation were the cause of the business cycle in output and employment.  Stabilize prices in general and you would stabilize the rest of the economy.  The great American economist Irving Fisher reached the same conclusion, characterizing the business cycle as a dance of the dollar.

It was in this spirit that the Federal Reserve Act imposed a dual mandate on the Fed to achieve stable prices while also promoting maximum employment.  Does that dual mandate have any operational meaning?  I think it does.  It means, for starters, that you should not try to reduce inflation when it is already at a historically low level and when reducing it further threatens to decrease, not increase, employment.  That’s all well and good, but how is one to know whether inflation is at historically low levels?  Hasn’t headline CPI inflation has in fact been increasing over the past six months, rising by 3.3%.

I suggest looking at wages.  According to the Employment Cost Index published by the St. Louis Fed, wages between the first quarter of 2001 and the first quarter of 2008 increased at any annual rate of 2.94%.  In only two of those 29 quarters did wages increase at a less than 2% annual rate.  Since the second quarter of 2008, wages have increased at a rate of 1.51%, and for the last 10 quarters in a row wages have increased at a less than 2% annual rate.  So, despite the recent uptick in headline inflation, there is no sign that wage inflation is increasing.  With wages increasing now half as fast as the trend from 2001 to 2008, with the labor market clearly not tightening and unlikely to do so in the foreseeable future, what possible justification can there be, under the dual mandate, or under any reasonable assessment of the risk that  inflation will speed up, for monetary policy to aim at reducing inflation?  No increase in the trend rate of inflation is possible without a roughly corresponding increase in wages.  If wage inflation is virtually absent, there is negligible risk of an increase in the trend rate of inflation.

Throughout his long career, Ralph Hawtrey recommended stabilizing the wage level as the goal of monetary policy.  Hawtrey did not advocate stabilizing a wage index, he advocated stabilizing the wage for unskilled labor.  I am guessing that wages for skilled labor generally rise somewhat faster than the wages of unskilled labor, so we are very close to meeting Hawtrey’s criterion for wage stability.  But the middle of the deepest downturn in 80 years is not the time to pursue the long-term goal of wage stability.  If prices are now rising somewhat faster than wages, it is probably because of recent supply shocks that raised oil prices.  Until wages start rising faster than the 3 percent rate at which they rose from 2001 to 2008, those supply side factors will not translate into a sustained increase in price inflation.  Hawtrey was right.  We should keep our eye on wages.

About Me

David Glasner
Washington, DC

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

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