Archive for July, 2011

What Bernanke Giveth, Fisher Taketh Away

It’s fun to bat clean-up behind Scott Sumner in the line-up. He just posted this news item on his blog:

NEW YORK (AP) — Comments from Fed Chairman Ben Bernanke set off a stock market rally early Wednesday, but it wasn’t long before another Fed official helped cut it short.

In testimony before Congress, Bernanke said the central bank would be open to new economic stimulus measures, but only if the economy gets much worse. The remarks were far from a promise for more Fed action, but markets reacted immediately nonetheless. The Dow Jones industrial average jumped as many as 164 points, or 1.3 percent.

Most of those gains evaporated later in the day after Federal Reserve Bank of Dallas President Richard Fisher said in a speech that the Fed had already “pressed the limits of monetary policy.”

Then Scott added this comment:

I wonder what it feels like to be able to destroy several hundred billion dollars in wealth (worldwide) by just opening your mouth.

One of the commenters wrote:

Blaming Richard Fisher for “destroying wealth” sure is a funny way of looking at things. Markets bounce around all the time on all kinds of news, odds are very high that the market would have pulled back eventually whether he talked or not. It could be that some speculators tried to ride out the Bernanke statement bounce then sold at the top.

In my post yesterday, I quoted from the Bloomberg item on the “Bernanke rally,” noting that the yield on the 10-year Treasury had risen, along with the stock market, from 2.88 to 2.95. By the end of the day, the yield had fallen back to 2.88.

Was it just coincidence that the yield on the 10-year Treasury and the S&P 500 were moving in sync? I don’t think so. Nor do I think that the timing of the turning point yesterday was unrelated to Fisher’s comment. Last September, after Bernanke first signaled a second round of quantitative easing, the stock market did not really start to move strongly upward until James Bullard, President of the St. Louis Fed, and William Dudley, President of the New York Fed, publicly endorsed QE2. Unfortunately, Bullard, head of that bastion of Chicago-School Monetarism in St. Louis, seems to have switched sides.


Why the Stock Market Loves Inflation

Scott Sumner just posted an item on his blog pointing out how the stock market rallied today when Ben Bernanke testified that the Fed would take action to stimulate the economy if needed. Bloomberg reports:

The greenback fell the most in six months versus the euro as Bernanke said central bank is prepared to take additional action, including buying more government bonds, if the economy appears to be in danger of stalling. The Australian and New Zealand dollars led earlier gains against the currency after China’s economic growth exceeded analysts’ estimates. The euro advanced as Italian and Spanish bonds rose for a second day.

“The markets are weighing the trade-off between the potential for liquidity injections and worsening in global growth prospects,” said Aroop Chatterjee, a currency strategist at Barclays Plc in New York. “For the time being liquidity is winning out. Bernanke’s comments may take some of the focus off what markets have been trading on, which have been largely linked to European news.”

The dollar weakened 1.4 percent against the euro to $1.4166 at 12:38 p.m. in New York, its biggest drop since Jan. 13. It reached $1.3837 yesterday, the strongest level since March 11.

The Standard & Poor’s 500 Index rose 1.2 percent and the yield on 10-year Treasuries increased seven basis points to 2.95 percent.

The weakening of the dollar and the increase in the 10-year Treasury both suggest an increase in inflation expectations. If stock prices are increasing in the face of increased interest rates at which future earnings must be discounted it can only mean that investors are expecting earnings to increase faster than prices. In other words, investors expect that inflation under current conditions will increase earnings in real terms. That relationship between expected inflation and the expected growth of earning seems to have prevailed, as I showed in my paper “The Fisher Effect Under Deflationary Expectations,” since early in 2008 when inflation expectations started to falter as the economic downturn started. My data analysis only went as far as the end of 2010. The last six months show basically the same relationship except for a while when oil prices spiked in February because of the Libyan situation. I hope to revise and update the paper sometime this summer.

Scott writes:

But you might ask “weren’t the high inflation 1970s really bad for stocks?” Yes they were. Just like in the story of the three little bears, the stock market doesn’t want too much inflation, nor too little. Something for the inflation hawks to think about.

That is not quite how I would put it. Whether the market likes inflation or not depends on how high real interest rates are. If real interest rates are high, then markets can tolerate deflation. But when the real rate is already low and for sure if it’s negative, deflation, or even the very low inflation we have now, is very damaging and holds back the recovery. In the 1970s, however, nominal interest rates were at double-digit levels. At those levels, inflation provides little or no stimulus to growth, and has all sorts of negative side effects. In addition, there were supply side shocks in the 1970s, which should properly have been accommodated by monetary easing. Stock prices fell in response to the supply-side shocks not only because inflation was too high.

Sarah Palin, Economist

Who knew?

Reporter Peter J. Boyer in the current issue of Newsweek magazine:


[Sarah] Palin has also become conversant on the subject of quantitative easing, the inflationary effects of which she illustrated with a personal anecdote. “I was ticked off at Todd yesterday,” she said. “He walks into a gas station as we’re driving over from Minnesota. He buys a Slim Jim—we’re always eating that jerky stuff—for $2.69. I said, ‘Todd, those used to be 99 cents, just recently!’ And he says, ‘Man, the dollar’s worth nothing anymore.’ A jug of milk and a loaf of bread and a dozen eggs—every time I walk into that grocery store, a couple of pennies more.”

Why Is This Recovery Different from all Others?

I have mentioned a couple of times in previous posts that I was working on a comparison of the anemic recovery from our Little Depression to recoveries from previous post-World War II recessions.  The comparison actually involved getting my hands dirty with some data, doing some actual, but low-level, empirical work.  My results seem interesting enough to share, even if they are not exactly the sort of thing that one would publish in an econ journal.  The exposition may be slightly more technical than is customary for blogs, but I hope that some readers may be willing to at least skim through to the end to get a sense of what I have done.  So here it goes.

About two weeks ago while I was in the final stages of talking myself into starting this blog, I saw a short piece (in the weekend (June 24) edition of the Wall Street Journal) by editorial writer Stephen Moore, touting a report (“Uncharted Depths”) of the Republican staff of the Congressional Joint Economic Committee, purporting to show that, on every metric, this recovery is by far the weakest recovery since World War II.

Disdaining any pretense of objectivity, Mr. Moore, in his second paragraph, highlighted the finding of the JEC report that employment is still 5 percent below what it was at the start of the downturn 38 months ago.  “This,” Moore continued, “compares to an average rise in employment of 3.7% over the same period in prior post-WWII recessions.” But the latest downturn was both deeper and longer-lasting than any post-WWII recession.  So for Mr. Moore et al. to compare, on the one hand, employment 38 months ago at the start of the downturn with employment now, and on the other hand, employment at the start of previous recessions with employment 38 months later, is to bias the comparison of the recoveries from the get-go.  Obviously, if one downturn is deeper and longer-lasting than another, the ratio of employment (or any other cyclical variable) in the bigger downturn a given length of time after it began relative to employment when the downturn started will be less than the same ratio in the smaller downturn even if, once underway, the recoveries are equally strong.  But, obviously, the point of the exercise for Mr. Moore and the authors of the JEC report was not to perform a fair and balanced comparison;  it was to inflict damage in a political battle.

Nevertheless, their bias notwithstanding, Mr. Moore et al. had the germ of an interesting idea.  So I decided to try to redo their comparison of recoveries from post-WWII downturns, while also taking into account the length and severity of the downturn preceding the recoveries.  So for each of the 10 stand-alone downturns (i.e., excluding the 1980 recession, overtaken a year and a half after it began by the steep 1981-82 recession), I took the peak quarterly real GDP at or before the downturn and real GDP 13 quarters after the downturn started.  (After the 1957-58 downturn, another recession started 11 quarters later, so I compared the peak quarterly GDP before the downturn with peak GDP 11 quarters later.)  I also calculated the difference between the peak quarterly GDP before the downturn and the lowest quarterly GDP after the downturn, as well as the percentage of months in which the economy was in recovery for each (with the above-mentioned exception) 14-quarter downturn-recovery cycle.

So I amassed data for the following 10 post-WWII downturns and subsequent recoveries:  1948-49, 1953, 1957-58, 1960-61, 1969-70, 1973-75, 1981-82, 1993, 2001, 2007-09.  The data consisted in the percentage increase in real GDP 13 quarters after the start of each downturn over the peak GDP at or before the downturn, the percentage decline in real GDP at the depth of the downturn from peak GDP at or before the downturn, and the percentage of each downturn-recovery cycle (measured in terms of months) in which the economy was recovering.

With these data, I performed a simple statistical analysis, an ordinary least-squares regression, dropping the constant term from the regression (thereby greatly improving its fit).  Ordinary least squares estimation produced the following equation:

% increase in RGDP = .95 X (% fall in RGDP) + 16.18 X (% of cycle in expansion)

The equation says that the percentage change in real GDP 13 quarters after the start of the downturn relative to peak real GDP at or before the downturn can be broken down into two components.  The first component equals .95 of the percentage reduction in real GDP during the downturn (measuring the depth of the downturn).  (This means that reducing the fall of real GDP during the downturn was associated with an increase in the growth of GDP over the 13 quarters following the downturn of about 0.95%.)  The second component is 16.18 times the percentage of the 14-quarter cycle in which the economy was recovering (measuring the length of the downturn).  (This means that a 10-percentage point increase in the percentage of the cycle in which the economy was expanding was associated with an increase in the growth of GDP over the 14-quarter cycle of about 1.62%.)

The r-squared of the regression, measuring how much of the variation in the increase in real GDP is accounted for by the regression, is .855, which is not too bad, actually.  Using the regression coefficients, I calculated the implied increase in GDP 13 quarters after the start of each of the 10 recessions and plotted those predicted values against the actual values in following chart.  What is noteworthy about the chart is that although the current recovery is obviously the weakest of the 10 post-WWII recoveries, it is not, contrary to Mr. Moore and associates, the worst post-WWII under-achiever.  Relative to the depth and duration of the earlier recession, the current recovery is no worse, perhaps even slightly better, than the recoveries from the 1990-91 and 2001 recessions.  The other under-achiever, as one might have guessed, is the truncated recovery to the 1957-58 downturn.

Now it also occurred to me that some other factors might also help account for the variations in the strength of the recoveries to post-WWII downturns.  The most plausible or most interesting ones that I could think of were the rate of inflation (of course) and the tax rate.  There are multiple ways to measure these variables, but, for purposes of this exercise, the GDP price deflator and the top marginal tax rate seemed the most informative and relevant.

But a moment’s reflection is enough to make it obvious that it isn’t even worth trying to estimate a regression with the top marginal tax rate as a variable; the top marginal tax rate, having  started at about 90% percent in the late 1940s, falling to 70% in the 1964 and to 50% in 1982, 39.6% in 1993 and 35% in 2003, clearly tends to be positively correlated with the strength of a recovery, the weakest recoveries having all been registered when the top marginal rate was lowest and the strongest recovery (to the 1948-49 downturn) when the top marginal rate was at its maximum.  Hardly anyone would believe that there is a causal link between high tax rates and strong recoveries, so the observed correlation is, somehow or other, either purely random or coincidental, with some other, as yet unspecified, variable.  Nevertheless, the strong apparent correlation between high marginal tax rates and strong recoveries ought to suggest to those who argue that low taxes will solve any problem, that they may be overstating the miracle-working powers of low marginal tax rates, at least as a method of promoting cyclical recoveries.   Even the powerful recovery from the 1981-82 recession, when that famous tax-cutter Ronald Reagan was President, coincided with a top marginal rate of 50%, a rate that would now trigger howls of outrage from Reagan’s present-day acolytes.

But it did seem worthwhile to reestimate a regression including a variable for inflation.  In each downturn-recovery cycle, I compared the GDP price deflator in the last quarter of the downturn with the GDP deflator 13 quarters after the downturn started.   Doing so isolates inflation in the recovery, because I want to know if greater inflation is associated with a stronger recovery.  Taking the overall increase in the GDP deflator during the recovery, I calculated the implied annual rate of inflation over the entire recovery and estimated the regression using the natural logarithm of the average annual rate of inflation during the recovery.  I used the logarithm, because additional doses of inflation might well have a declining stimulative power, implying that the logarithm of the inflation rate would give a better fit than the inflation rate itself.  In fact, estimating the regression both ways, I found that, as expected, the logarithm of inflation gave a better fit than did inflation itself.

Here is the regression equation that I estimated:

%increase in RGDP = .94 X (%fall in RGDP) + 12.77 X (% of cycle in expansion) + 2.75 X (log of inflation)

The equation says that the percentage increase over the whole cyclical episode can be broken down into three components.  The first two are as they were previously, but with somewhat reduced coefficients.  The third component is 2.75 times the logarithm of the rate of inflation, which implies that a 1% increase in inflation was associated with an increased real GDP growth over the cycle of somewhat more than 1%.

The r-squared of the new regression is .881.  The adjusted r-squared, which takes into account the number of variables, rises from .82 with no inflation variable to .83 with an inflation variable.  Not spectacular, but still respectable.

As before, I also calculated the predicted values for real GDP growth in each cycle and plotted them against the actual values.  Those plots are in the chart below.

It is apparent that adjusting for the rate of inflation makes the current recovery seem a bit less of an under-achiever than when no account was taken of inflation.  In the previous chart, the current recovery performed only slightly less well relative to the prediction than did the recoveries after the 1990-91 and 2001 recessions.  In this chart, it does noticeably, though not very much, better than did the two previous recoveries, and also better than the 1973-75 recession (which makes sense inasmuch as inflation in that recession was driven largely by supply-side, not demand-side, factors).

What is the point of all this?  Well, with only 10 observations, one would hardly want to put much reliance on any statistical result, so the main lesson is negative.  Although the current recovery is certainly very weak, in the sort of naïve comparison that Stephen Moore and associates were performing, the current recovery is actually less of an under-achiever,  given the length and depth of the preceding downturn and the very low rate of inflation, than either of the previous two recoveries.

To put a slightly finer point on it, if the rate of inflation in the current recovery had been equal to the rate of inflation in the recovery from the 1981-82 recession when Ronald Reagan was President, the corresponding increase in the predicted rate of growth would have been 3%.  According to Okun’s Law, adding 3% to real GDP would reduce the unemployment rate by 1%.  Do the data prove that that is what would have happened?  By no means.  Correlation is not causation.  But perhaps Mr. Moore and associates, so quick to draw conclusions from a simplistic, if not simple-minded, comparison of this recovery with earlier recoveries, should entertain the possibility that the data, apparently so compelling, may be telling a different story from the one they thought they were hearing.

HT:  Marcus Nunes

Krugman on Mr. Keynes and the Moderns

Paul Krugman recently gave a lecture “Mr. Keynes and the Moderns” (a play on the title of the most influential article ever written about The General Theory, “Mr. Keynes and the Classics,” by another Nobel Prize winner J. R. Hicks) at a conference in Cambridge, England commemorating the publication of Keynes’s General Theory 75 years ago.  Scott Sumner and Nick Rowe, among others, have already commented on his lecture.  Coincidentally, in my previous posting (Friday July 8), I discussed the views of Sumner and Krugman on the zero-interest lower bound, a topic that figures heavily in Krugman’s discussion of Keynes and his relevance for our current difficulties.  (I note in passing that Krugman credits Brad Delong for applying the term “Little Depression” to those difficulties, a term that I thought I had invented, but, oh well, I am happy to share the credit with Delong).

In Friday’s posting, I mentioned that Keynes’s, slightly older, colleague A. C. Pigou responded to the zero-interest lower bound in his review of The General Theory.  In a way, the response enhanced Pigou’s reputation, attaching his name to one of the most famous “effects” in the history of economics, but it made no dent in the Keynesian Revolution.  I also referred to “the layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes.”  One large element of those dynamics was that Keynes chose to make, not Hayek or Robbins, not French devotees of the gold standard, not American laissez-faire ideologues, but Pigou, a left-of-center social reformer, who in the early 1930s had co-authored with Keynes a famous letter advocating increased public-works spending to combat unemployment, the main target of his immense rhetorical powers and polemical invective.  The first paragraph of Pigou’s review reveals just how deeply Keynes’s onslaught had wounded Pigou.

When in 1919, he wrote The Economic Consequences of the Peace, Mr. Keynes did a good day’s work for the world, in helping it back towards sanity.  But he did a bad day’s work for himself as an economist.  For he discovered then, and his sub-conscious mind has not been able to forget since, that the best way to win attention for one’s own ideas is to present them in a matrix of sarcastic comment upon other people.  This method has long been a routine one among political pamphleteers.  It is less appropriate, and fortunately less common, in scientific discussion.  Einstein actually did for Physics what Mr. Keynes believes himself to have done for Economics.  He developed a far-reaching generalization, under which Newton’s results can be subsumed as a special case.  But he did not, in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers.  The example is illustrious:  but Mr. Keynes has not followed it.  The general tone de haut en bas and the patronage extended to his old master Marshall are particularly to be regretted.  It is not by this manner of writing that his desire to convince his fellow economists is best promoted.

Krugman acknowledges Keynes’s shady scholarship (“I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way”), only to absolve him of blame.  He then uses Keynes’s example to attack “modern economists” who deny that a failure of aggregate demand can cause of mass unemployment, offering up John Cochrane and Niall Ferguson as examples, even though Ferguson is a historian not an economist.

Krugman also addresses Robert Barro’s assertion that Keynes’s explanation for high unemployment was that wages and prices were stuck at levels too high to allow full employment, a problem easily solvable, in Barro’s view, by monetary expansion.  Although plainly annoyed by Barro’s attempt to trivialize Keynes’s contribution, Krugman never addresses the point squarely, preferring instead to justify Keynes’s frustration with those (conveniently nameless) “classical economists.”

Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained.

Not so, as I pointed out last Tuesday in my first post.  Frederick Lavington, an even more orthodox disciple of Marshall than Pigou, had no trouble understanding that “the inactivity of all is the cause of the inactivity of each.”  It was Keynes who failed to see that the failure of demand was equally a failure of supply.

They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested.

Supply does create its own demand when economic agents succeed in executing their plans to supply; it is when, owing to their incorrect and inconsistent expectations about future prices, economic agents fail to execute their plans to supply, that both supply and demand start to contract.  Lavington understood that; Pigou understood that.  Keynes understood it, too, but believing that his new way of understanding how contractions are caused was superior to that of his predecessors, he felt justified in misrepresenting their views, and attributing to them a caricature of Say’s Law that they would never have taken seriously.

And to praise Keynes for understanding the difference between accounting identities and causal relationships that befuddled his predecessors is almost perverse, as Keynes’s notorious confusion about whether the equality of savings and investment is an equilibrium condition or an accounting identity was pointed out by Dennis Robertson, Ralph Hawtrey and Gottfried Haberler within a year after The General Theory was published.  To quote Robertson:

(Mr. Keynes’s critics) have merely maintained that he has so framed his definition that Amount Saved and Amount Invested are identical; that it therefore makes no sense even to inquire what the force is which “ensures equality” between them; and that since the identity holds whether money income is constant or changing, and, if it is changing, whether real income is changing proportionately, or  not at all, this way of putting things does not seem to be a very suitable instrument for the analysis of economic change.

It just so happens that in 1925, Keynes, in one of his greatest pieces of sustained, and almost crushing sarcasm, The Economic Consequences of Mr. Churchill, offered an explanation of high unemployment exactly the same as that attributed to Keynes by Barro.  Churchill’s decision to restore the convertibility of sterling to gold at the prewar parity meant that a further deflation of at least 10 percent in wages and prices would be necessary to restore equilibrium.  Keynes felt that the human cost of that deflation would be intolerable, and held Churchill responsible for it.

Of course Keynes in 1925 was not yet the Keynes of The General Theory.  But what historical facts of the 10 years following Britain’s restoration of the gold standard in 1925 at the prewar parity cannot be explained with the theoretical resources available in 1925?  The deflation that began in England in 1925 had been predicted by Keynes.  The even worse deflation that began in 1929 had been predicted by Ralph Hawtrey and Gustav Cassel soon after World War I ended, if a way could not be found to limit the demand for gold by countries, rejoining the gold standard in aftermath of the war.  The United States, holding 40 percent of the world’s monetary gold reserves, might have accommodated that demand by allowing some of its reserves to be exported.  But obsession with breaking a supposed stock-market bubble in 1928-29 led the Fed to tighten its policy even as the international demand for gold was increasing rapidly, as Germany, France and many other countries went back on the gold standard, producing the international credit crisis and deflation of 1929-31.  Recovery came not from Keynesian policies, but from abandoning the gold standard, thereby eliminating the deflationary pressure implicit in a rapidly rising demand for gold with a more or less fixed total supply.

Keynesian stories about liquidity traps and Monetarist stories about bank failures are epiphenomena obscuring rather than illuminating the true picture of what was happening.  The story of the Little Depression is similar in many ways except the source of monetary tightness was not the gold standard, but a monetary regime that focused attention on rising price inflation in 2008 when the appropriate indicator, wage inflation, was already starting to decline.  That I hope will be the subject of a future posting

Krugman and Sumner on the Zero-Interest Lower Bound: Some History of Thought

I indicated in my first posting on Tuesday that I was going to comment on some recent comparisons between the current anemic recovery and earlier more robust recoveries since World War II.  The comparison that I want to perform involves some simple econometrics, and it is taking longer than anticipated to iron out the little kinks that I keep finding.  So I will have to put off that discussion a while longer.  As a diversion, I will follow up on a point that ScottSumner made in discussing Paul Krugman’s reasoning for having favored fiscal policy over monetary policy to lead us out of the recession.

Scott’s focus is on the factual question whether it is really true, as Krugman and Michael Woodford have claimed, that a monetary authority, like, say, the Bank of Japan, may simply be unable to create the inflation expectations necessary to achieve equilibrium, given the zero-interest-rate lower bound, when the equilibrium real interest rate is less than zero.  Scott counters that a more plausible explanation for the inability of the Bank of Japan to escape from a liquidity trap is that its aversion to inflation is so well-known that it becomes rational for the public to expect that the Bank of Japan would not permit the inflation necessary for equilibrium.

It seems that a lot of people have trouble understanding the idea that there can be conditions in which inflation — or, to be more precise, expected inflation — is necessary for a recovery from a depression.  We have become so used to thinking of inflation as a costly and disruptive aspect of economic life, that the notion that inflation may be an integral element of an economic equilibrium goes very deeply against the grain of our intuition.

The theoretical background of this point actually goes back to A. C. Pigou (another famous Cambridge economist, Alfred Marshall’s successor) who, in his 1936 review of Keynes’s General Theory, referred to what he called Mr. Keynes’s vision of the day of judgment, namely, a situation in which, because of depressed entrepreneurial profit expectations or a high propensity to save, macroequilibrium (the equality of savings and investment) would correspond to a level of income and output below the level consistent with full employment.  The “classical” or “orthodox” remedy to such a situation was to reduce the rate of interest, or, as the British say “Bank Rate” (as in “Magna Carta” with no definite article) at which the Bank of England lends to its customers (mainly banks).  But if entrepreneurs are that pessimistic, or households that determined to save rather than consume, an equilibrium corresponding to a level of income and output consistent with full employment could, in Keynes’s ghastly vision, only come about with a negative interest rate.  Now a zero interest rate in economics is a little bit like the speed of light in physics; all kinds of crazy things start to happen if you posit a negative interest rate and it seems inconsistent with the assumptions of rational behavior to assume that people would lend for a negative interest when they could simply hold the money that is already in their pocket.  That’s why Pigou’s metaphor was so powerful.   There are layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes, but I won’t pursue that tangent here, tempting though it would be to go in that direction.

The conclusion that Keynes drew from his model is the one that we all were taught in our first course in macro and that Paul Krugman holds close to his heart, the government can come to the rescue by increasing its spending on whatever, thereby increasing aggregate demand, raising income and output up to the level consistent with full employment.  But Pigou, whose own policy recommendations were not much different from those of Keynes, felt that Keynes had left out an important element of the model in his discussion.  As a matter of logic, which to Pigou was as, or more important than, policy, an economy confronting Keynes’s day of judgment would not forever be stuck in “underemployment equilibrium” just because the rate of interest could not fall to the (negative) level required for full employment.  Rather, Pigou insisted, at least in theory, though not necessarily in practice, deflation, resulting from unemployed workers bidding down wages to gain employment, would raise the real value of the money supply (fixed in nominal terms in Keynes’s model) thereby generating a windfall to holders of money, inducing them to increase consumption, raising aggregate demand and eventually restoring full employment.  Discussion of the theoretical validity and policy relevance of what came to be known as the Pigou effect (or, occasionally, as the Pigou-Haberler Effect, or even the Pigou-Haberler-Scitovsky effect) became a really big deal in macroeconomics in the 1940s and 1950s and was still being taught in the 1960s and 1970s.

What seems remarkable to me now about that whole episode is that the analysis simply left out the possibility that the zero-interest-rate lower bound becomes irrelevant if the expected rate of inflation exceeds the putative negative equilibrium real interest rate that would hypothetically generate a macroequilibrium at a level of income and output consistent with full employment.  If only Pigou had corrected the logic of Keynes’s model by positing an expected rate of inflation greater than the negative real interest rate rather than positing a process of deflation to increase the real value of the money stock, how different would the course of history and the development of macreconomics and monetary theory have been.

One economist who did think about the expected rate of inflation as an equilibrating variable in a macroeconomic model was one of my teachers, the late, great Earl Thompson, who introduced the idea of an equilibrium rate of inflation in his remarkable unpublished paper, “A Reformulation of Macreconomic Theory.”  If inflation is an equilibrating variable, then it cannot make sense for monetary authorities to commit themselves to a single unvarying target for the rate of inflation.   Under certain circumstances, macroeconomic equilibrium may be incompatible with a rate of inflation below some minimum level.  Has it occurred to the inflation hawks on the FOMC and their supporters that the minimum rate of inflation consistent with equilibrium is above the 2 percent rate that Fed has now set as its policy goal?

One final point, which I am still trying to work out more coherently, is that it really may not be appropriate to think of the real rate of interest and the expected rate of inflation as being determined independently of each other.  They clearly interact.  As I point out in my paper “The Fisher Effect Under Deflationary Expectations,” increasing the expected rate of inflation when the real rate of interest is very low or negative tends to increase not just the nominal rate, but the real rate as well, by generating the positive feedback effects on income and employment that result when a depressed economy starts to expand.

Schuler on the Ground for Opposing Monetary Easing

On the Free Banking blog, Kurt Schuler kindly takes note of my blogging debut, even throwing in a plug for my book.  Many thanks, Kurt.  But just to show that he is no pushover, Kurt takes exception to my comment about “the groundlessness of right-wing opposition to monetary easing.”

In his first post, Glasner speaks of “the groundlessness of right-wing opposition to monetary easing.” Whoa, fella. You accept Scott Sumner’s argument that the Federal Reserve didn’t respond fast enough to a large, sudden rise in demand for the monetary base in 2008. Eventually it did respond, and now the monetary base is about three times what it was just before the recession. Isn’t it equally conceivable that the Fed won’t respond fast enough if there is a large, sudden fall in demand for the monetary base? If so, the right-wing critics have a concern that may  become valid sooner than you expect. That being said, I look forward to reading further installments of the blog.

Where to begin?  OK, I not only accept Scott’s argument, I thought of it myself.  What is it that they say about great minds?  But actually the argument is slightly more complicated, and the historical component was laid out very nicely by Robert Hetzel in a piece in the Federal Reserve Bank of Richmond Economic Quarterly in the spring 2009 issue.

But Kurt’s main point is that regardless of what happened in 2008, the big increase in the demand for the monetary base is eventually going to be reversed.  And what assurance do we have that all that extra cash sloshing around will not cause a rip-roaring inflation down the road?  I admit that anything is possible, but this is just the reasoning that led to a huge increase in required reserves in 1937 to mop up all that excess liquidity on bank balance sheets, triggering a renewed deflation just as the US economy seemed on the verge of recovery from the Great Depression.  I say let’s worry about the problem that we have now, and then take care of tomorrow’s problem then.  Now Kurt might say that solving today’s problem will inevitably lead to the problem tomorrow.  He might, but that’s not what he did say.  So, following my own dictum, I will not answer an argument he has not yet made.  Moreover, if the Fed would make explicit what price level trajectory it is aiming for, it would not have to worry as much about inflation from a temporary excess supply of base money as it does when its price-level objectives are opaque.

Finally, when I referred to right-wing opponents of monetary easing, I was not referring as much to free banking types like Kurt, who have opposed inflation consistently under more or less all conditions.  I may not agree with that position, but I don’t consider it groundless.  My criticism was directed more at those who are using inflation as just one more political argument in their arsenal, even though they were more than happy to accept a much higher rate of inflation than we now have during an earlier recovery when there was a different president of a different party in office.

Monetary Policy in Action

When I looked at the Financial Times this morning, I was struck by the following article entitled “Booming Sweden Raises Rates”.

Sweden is a small open economy, so the potential for monetary policy to be effective is limited.  But, it is still notable that by aggressively reducing its lending rate to zero and not paying interest on reserves, the Swedish Riksbank has promoted a recovery.  With the recovery come higher interest rates.  Not the other way around.  FOMC, please take note.

Welcome to Uneasy Money, aka the Hawtreyblog

What the world needs now, with apologies to the great Burt Bachrach and Hal David, is, well, another blog.  But inspired by the great Ralph Hawtrey and the near great Scott Sumner, I decided — just in time for Scott’s return to active blogging — to raise another voice on behalf of a monetary policy actively seeking to promote recovery from what I call the Little Depression, instead of the monetary policy we have now:  waiting for recovery to arrive on its own.  Just like the Great Depression, our Little Depression was caused mainly by overly tight money in an environment of over-indebtedness and financial fragility, and was then allowed to deepen and become entrenched by monetary authorities unwilling to commit themselves to a monetary expansion aimed at raising prices enough to make business expansion profitable.

That was the lesson of the Great Depression.  Unfortunately that lesson, for reasons too complicated to go into now, was never properly understood, because neither Keynesians nor Monetarists had a fully coherent understanding of what happened in the Great Depression.  Although Ralph Hawtrey — called by none other than Keynes “his grandparent in the paths of errancy,” and an early, but unacknowledged, progenitor of Chicago School Monetarism — had such an understanding,  Hawtrey’s contributions were overshadowed and largely ignored, because of often irrelevant and misguided polemics between Keynesians and Monetarists and Austrians.  One of my goals for this blog is to bring to light the many insights of this perhaps most underrated — though competition for that title is pretty stiff — economist of the twentieth century.  I have discussed Hawtrey’s contributions in my book on free banking and in a paper published years ago in Encounter and available here.  Patrick Deutscher has written a biography of Hawtrey.

What deters businesses from expanding output and employment in a depression is lack of demand; they fear that if they do expand, they won’t be able to sell the added output at prices high enough to cover their costs, winding up with redundant workers and having to engage in costly layoffs.  Thus, an expectation of low demand tends to be self-fulfilling.  But so is an expectation of rising prices, because the additional output and employment induced by expectations of rising prices will generate the demand that will validate the initial increase in output and employment, creating a virtuous cycle of rising income, expenditure, output, and employment.

The insight that “the inactivity of all is the cause of the inactivity of each” is hardly new.  It was not the discovery of Keynes or Keynesian economics; it is the 1922 formulation of Frederick Lavington, another great, but underrated, pre-Keynesian economist in the Cambridge tradition, who, in his modesty and self-effacement, would have been shocked and embarrassed to be credited with the slightest originality for that statement.  Indeed, Lavington’s dictum might even be understood as a restatement of Say’s Law, the bugbear of Keynes and object of his most withering scorn.  Keynesian economics skillfully repackaged the well-known and long-accepted idea that when an economy is operating with idle capacity and high unemployment, any increase in output tends to be self-reinforcing and cumulative, just as, on the way down,each reduction in output is self-reinforcing and cumulative.

But at least Keynesians get the point that, in a depression or deep recession, individual incentives may not be enough to induce a healthy expansion of output and employment.  Aggregate demand can be too low for an expansion to get started on its own.  Even though aggregate demand is nothing but the flip side of aggregate supply (as Say’s Law teaches), if resources are idle for whatever reason, perceived effective demand is deficient, diluting incentives to increase production so much that the potential output expansion does not materialize, because expected prices are too low for businesses to want to expand.  But if businesses can be induced to expand output, more than likely, they will sell it, because (as Say’s Law teaches) supply usually does create its own demand.

Keynesians mistakenly denied that monetary policy could, by creating price-level expectations consistent with full employment, induce an expansion of output in a depression.  But at least they understood that the private economy can reach an impasse with price-level expectations too low to sustain full employment.  Fiscal policy may play a role in remedying a mismatch between expectations and full employment, but fiscal policy can only be as effective as monetary policy allows it to be.  Unfortunately, since the downturn of December 2007, monetary policy, except possibly during QE1 and QE2, has consistently erred on the side of uneasiness.

With some unfortunate exceptions, however, few Keynesians have actually argued against monetary easing.  Rather, with some honorable exceptions, it has been conservatives who, by condemning a monetary policy designed to provide incentives conducive to business expansion, have helped to hobble a recovery led by the private sector rather than the government which  they profess to want.  It is not my habit to attribute ill motives or bad faith to people whom I disagree with.  One of the finest compliments ever paid to F. A. Hayek was by Joseph Schumpeter in his review of The Road to Serfdom who chided Hayek for “politeness to a fault in hardly ever attributing to his opponents anything but intellectual error.”  But it is a challenge to come up with a plausible explanation for right-wing opposition to monetary easing.

In condemning monetary easing, right-wing opponents claim to be following the good old conservative tradition of supporting sound money and resisting the inflationary proclivities of Democrats and liberals.  But how can claims of principled opposition to inflation be taken seriously when inflation, by every measure, is at its lowest ebb since the 1950s and early 1960s?  With prices today barely higher than they were three years ago before the crash, scare talk about currency debasement and future hyperinflation reminds me of Ralph Hawtrey’s famous remark that opponents of leaving the gold standard during the Great Depression on the grounds that it would bring on a German-style hyperinflation were like those crying “fire, fire” in Noah’s flood.

The groundlessness of right-wing opposition to monetary easing becomes even plainer when one recalls the attacks on Paul Volcker during the first Reagan administration.  In that episode President Reagan and Volcker, previously appointed by Jimmy Carter to replace the feckless G. William Miller as Fed Chairman, agreed to make bringing double-digit inflation under control their top priority, whatever the short-term economic and political costs.  Reagan, indeed, courageously endured a sharp decline in popularity before the first signs of a recovery became visible late in the summer of 1982, too late to save Reagan and the Republicans from a drubbing in the mid-term elections, despite the drop in inflation to 3-4 percent.  By early 1983, with recovery was in full swing, the Fed, having abandoned its earlier attempt to impose strict Monetarist controls on monetary expansion, allowed the monetary aggregates to grow at unusually rapid rates.  However, in 1984 (a Presidential election year) after several consecutive quarters of GDP growth at annual rates above 7 percent, the Fed, fearing a resurgence of inflation, began limiting the rate of growth in the monetary aggregates.  Reagan’s secretary of the Treasury, Donald Regan, as well as a variety of outside Administration supporters like Arthur Laffer, Larry Kudlow, and the editorial page of the Wall Street Journal, began to complain bitterly that the Fed, in its preoccupation with fighting inflation, was deliberately sabotaging the recovery.  In fact, the argument against the Fed’s tightening of monetary policy in 1984 was not without merit.  But regardless of the wisdom of the Fed tightening in 1984 (when inflation was significantly higher than it is now), holding up the 1983-84 Reagan recovery as the model for us to follow now, while excoriating Obama and Bernanke for driving inflation all the way up to 1 percent, supposedly leading to currency debauchment and hyperinflation, is just a bit rich.  What, I wonder, would Hawtrey have said about that?

In my next posting I will look a little more closely at some recent comparisons between the current non-recovery and recoveries from previous recessions, especially that of 1983-84.

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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