Uneasy Money

The front-page headline in today’s Financial Times reads “Inflation outlook on US lowest for a year.”  So obviously some people in the financial community and in the financial press are beginning to realize that what monetary policy does affects inflation expectations.

Market expectations for US inflation have dropped to their lowest level in a year and are now below the Federal Reserve’s unofficial target, as investors respond to the central bank’s latest attempt to stimulate the economy.

The expected rate of inflation over the next 30 years, as measured by the difference between Treasury Inflation Protected Securities, Tips, and cash government bonds, dropped as low as 1.85 per cent in recent days from 2.73 per cent since last month. The rate was just under 2 per cent on Tuesday.

The article goes on to note that inflation expectations dropped after the FOMC announced Operation Twist, as gold and oil prices dropped, quoting a Deutsche Bank economist that the TIPS market shows that the Fed’s policy “is no longer seen as inflationary.”

The good news is that people are starting to catch on to what Scott Sumner and a few other lonely voices have been trying to tell us since the financial crisis.  The bad news is that the FOMC doesn’t appear to be among them.

This will be my last post for several days, as I am about to observe the Jewish New Year.  Sorry to go on leave when things seem to be getting really interesting in the blogosphere, but there are some things even more important than monetary policy.  Did I really just say that?  My best wishes go out to all of you for a happy, healthy, and peaceful New Year.

In today’s Wall Street Journal, Harold Cole and Lee Ohanian try to teach us some lessons from the Great Depression.  According to Cole and Ohanian, those of us who believe that increasing aggregate demand had anything to do with recovery from the Great Depression are totally misguided.

[B]oosting aggregate demand did not end the Great Depression.  After the initial stock-market crash of 1929 and subsequent economic plunge, recovery began in the summer of 1932, well before the New Deal.  The Federal Reserve Board’s Index of Industrial Production rose nearly 50% between the Depression’s trough of July 1932 and June 1933.  This was a period of significant deflation.  Inflation began after June 1933, following the demise of the gold standard.  Despite higher aggregate demand, industrial production was flat over the following year.

Though not wrong in every detail, the version of events offered by Cole and Ohanian is still a shocking distortion of what happened before FDR took office in March 1933.  In particular, although Cole and Ohanian are correct that the trough of the Great Depression was reached in July 1932, when the Industrial Production Index stood at 3.67, rising to 4.15 in October, an increase of about 13%, they conveniently leave out the fact that there was a double dip; industrial production was flat in November and started falling in December, the Industrial Production Index dropping to 3.78 in March 1933, barely above its level the previous July.  And their assertion that deflation continued during the recovery is even farther from the truth than their description of what happened to industrial production.  When industrial production started to rise, the Producer Price Index (PPI) increased almost 1% three months in a row, July to September, the only monthly increases since July 1929.  The PPI resumed its downward trend in October, falling about 9% from September 1932 t0 February 1933, at the same time that industrial production peaked and started falling again.

That is why most observers date the trough of the Great Depression in the US not in July 1932, but in March 1933 when FDR took office in the midst of a banking crisis that threatened to drive the US economy even deeper into deflation and depression than it had been in July 1932. So when Cole and Ohanian assert that recovery from the Great Depression started in July 1932, and go on to say that the recovery took place during a period of significant deflation, it is hard to avoid the conclusion that they are twisting the facts to suit their own ideological predilection.

The misrepresentation perpetrated by Cole and Ohanian only gets worse when they describe what happened during the period of true recovery, April through July 1933.  Contrary to their assertion, deflation stopped in February 1933, the PPI hitting its low point of 10.3.  Prices began to rise as soon as FDR suspended the gold standard shortly after taking office in March (not June as Cole and Ohanian mistakenly assert) 1933, the PPI rising to 11.9 in July (an increase of about 14% over February) when industrial production hit a peak of 5.95, 57% above the March low point.

The two attached charts (supplied courtesy of Marcus Nunes) illustrate the sequence of events that I have just described.  The close correlation between the PPI and industrial production is especially striking.

To assert that the rapid price increases from March to July, a proxy for increased aggregate demand, played no role in what was then (and remains) the fastest increase in industrial production in any four-month period in American history is a gross misrepresentation of the facts.  What is perhaps even more shocking is that Cole and Ohanian would misrepresent facts so easily ascertainable.

Nevertheless, not everything Cole and Ohanian say is wrong.  They properly criticize New Deal policies that slowed down the spectacular recovery from April to July 1933 to almost a crawl.  What stopped April to July recovery almost in its tracks?  The answer is almost certainly that FDR forced his misguided National Industrial Recovery Act through Congress in June, and by July its effects were beginning to be felt.  Simultaneously forcing up nominal wages in the face of high unemployment (though unemployment started had falling rapidly when recovery started in April) and cartelizing large swaths of the American economy, the NRA effectively shut down the recovery that was still gaining momentum.  As shown in the chart representing industrial production, industrial production resumed its rapid expansion almost immediately after the NIRA was unanimously struck down by the Supreme Court in May 1935.  The aborted recovery was a tragedy for the American economy and for the world, but the premature end of (or extended pause in) the recovery tells us nothing about whether an economy can recover from a depression with no increase in aggregate demand.

Another point overlooked by Cole and Ohanian, presumably because it doesn’t exactly fit the ideological message that they want to propagate, is that the timing of the recovery — immediately after the monetary stimulus resulting from suspension of the gold standard – shows that monetary policy can be effective with little or no fiscal stimulus.  It is hard to see how any fiscal stimulus could have taken effect by April 1933 when the recovery had already begun.  Moreover, Roosevelt campaigned as a fiscal conservative, so it would not be easy to argue that anticipated fiscal stimulus was being felt in advance of its actual implementation.

The real lesson the Great Depression is that monetary policy works — for good or ill.

HT:  Bill Woolsey, Marcus Nunes, Scott Sumner

The Cleveland Fed recently released its estimates of inflation expectations.  The simple (I hope not simplistic) way to infer inflation expectations is to calculate the breakeven rate between the yield on a conventional Treasury for a given duration and the yield on the corresponding TIPS for the same duration.  Thus, for the 10-year Treasury, the yield yesterday was 1.72% and the yield on the 10-year TIPS was .01%, so the implied inflation expectation was 1.71%.

However, economists at the Cleveland Fed figured out that this calculation ignores what they call the inflation-risk premium.   In other words, when you form an expectation of what the future inflation is going to be, you also have some notion of how confident you are that your expectation will turn out to be on target.  You also have a notion of how upset you will be if it turns out that your expectation is off the mark.  Your uncertainty about your expectation and your tolerance for being wrong about your expectation together determine the inflation-risk premium.  The TIPS-spread reflects both expected inflation and the inflation-risk premium.  The Cleveland economists have developed methods for estimating the inflation-risk premium, potentially allowing them to estimate the implied market expectation of inflation more accurately than by just calculating the breakeven TIPS spread.

Every month, coinciding with the release of the CPI for the previous month, the Cleveland Fed releases its estimates of real interest rates for various durations, the expected rate of inflation for corresponding durations, and the inflation risk premium.  So for the 10-year duration that I generally use as a benchmark, the Cleveland Fed estimated the implied inflation expectation on September 1 to be only 1.37%, down form 1.98% in April and 1.56% in August.  Since September 1, the breakeven TIPS spread on the 10-year Treasury has fallen 37 basis points.

If half of that fall reflects falling inflation expectations, then inflation expectations over a 10-year time  horizon may be approaching 1.2%.  With real interest close to being negative, inflation expectations that low should be setting off alarm bells.  Let’s hope somebody is listening.

HT:  Lars Christensen

On August 18, I did a post after the S&P 500 fell by 4.6% to 1140.65, observing that inflation expectations as reflected in the breakeven TIPS spread on constant-maturity 10-year Treasuries fell by a whopping 18 basis points from 2.17% to 1.99%.  I also provided a table showing that in 26 instances in which inflation expectations (measured by the 10-year constant maturity TIPS spread) had fallen by 11 basis points or more in a single day since September 2008, 17 had been associated with a decline of more than 1% in the S&P 500.  Today, the TIPS spread fell by 15 basis points from 1.86% to 1.71% while the S&P 500 fell by 3.2%. (For an explanation of the theory behind this relationship and for a description of the econometric evidence supporting it, see my paper here and an earlier post on this blog.)  Inflation expectations are now at their lowest point in over a year just about the time that Chairman Bernanke and other Fed officials began signalling that they were concerned about the dangers of deflation.   The S&P 500 is now barely above its low for 2011, and only about 7-8% above its level in August 2010 just before the Fed moved to ease deflationary fears.

Josh Hendrickson provides a good explanation for why the Fed’s feeble moves to flatten the yield curve are irrelevant to the problem now staring us in the face:  price level expectations are not high enough to make capacity-expanding investment worthwhile.  Even though profits are high at current levels of output, businesses have no confidence that they can sell increased output at prices that will generate a return on investment.  They therefore hold on to their cash hoards, investing only in projects that reduce their costs without expanding capacity, carefully limiting the hiring of new workers, lest they have to lay them off later because of insufficient demand.

And with inflation expectations dropping like a stone, Professor John Taylor can think of nothing better than to admonish the Fed for even mentioning that it has a mandate to promote full employment in addition to ensuring price stability.

[F]or most of the 1980s and 1990s — starting when Paul Volcker became chairman — the Fed stressed the goal of price stability in its actions. The result was much lower unemployment than before or since.

Sorry to be pedantic, but what exactly does Professor Taylor mean when he says “the Fed stressed the goal of price stability in its actions?”  I know actions speak louder than words, but is Professor Taylor saying that inflation was lower under Paul Volcker’s chairmanship than it is now?  I don’t think so!  Even after the 1981-82 recession, the average rate of inflation was higher under Chairman Volcker than it has been since 2008 (see here).  Is he saying that the Fed under Chairman Volcker was aiming (and, evidently, missing) at a lower rate of inflation than the Fed is now?  Well since the Fed did not even have an explicit inflation target under Chairman Volcker while the current inflation target is 2% or a bit less, I can’t see how that is possible, though I would love to hear Professor Taylor’s explanation.  But perhaps Professor Taylor, in his wisdom, knows how to infer something else from his “reading” of the Fed’s “actions” under Chairman Volcker?  Or perhaps Professor Taylor knows how to compare Chairman Volcker’s body language to Chairman Bernanke’s body language.  Or maybe Professor Taylor is playing to a certain audience that likes to hear a respected academic economist bash the Fed?  But I can’t imagine who could possibly be in that audience.  I must be hallucinating.

The other day I praised Lars Christensen’s survey of the new Market Monetarism School. Apparently, Lars was a bit overwhelmed by my comparison of his survey to Friedman’s 1956 restatement of the quantity theory and the 1976 paper by Johnson and Frenkel on the monetary approach to the balance of payments.  In fact, Lars, in some respects at any rate, outdid both Friedman and Johnson and Frenkel.  After all, he avoided making any remark even remotely comparable to Friedman’s infamous reference to a non-existent Chicago oral tradition or even the gross error made by Johnson and Frenkel of citing David Hume as a forerunner of the monetary approach based on his exposition of the price-specie-flow mechanism when the monetary approach implies that the price-specie-flow mechanism is not how the gold standard operated (as demonstrated by McCloskey and Zecher in their paper in the volume edited by Johnson and Frenkel in which their paper was the opening chapter).  But the point of my comparison was more contextual than a comparison of the papers as such.  The common characteristic of the three papers is how they provide a clear summary of and introduction to the key issues raised by a new literature along with an account of the historical origins of the new theory.  Such a survey paper serves a really important rhetorical (to use McCloskey’s idea) role in propagating new set of ideas and making them accessible and attractive to a broader group of readers than those actively involved in developing those ideas.  Well done, Lars.

But despite my genuine admiration for Lars’s accomplishment, I did not agree with everything he wrote, so in this post, and perhaps some future posts as well, I will explain why I look at things a bit differently from how Lars does, though it is not clear whether what Lars writes always reflects his own views or actually reflects those of some or all of the Market Monetarists whose views he is surveying.

So I shall begin my commentary with the first substantive section of Lars’s paper under the heading “Recessions are always and everywhere a monetary phenomenon.” The discussion in this section concerns the idea that an aggregate excess supply of goods (which is how economists often characterize an economy in recession) must be matched by an excess demand for money. Now that way of thinking about recessions is well-established and not really very controversial, but I have serious reservations about it. First, it treats all money as if it just came into existence out of thin air and not as the result of a voluntary economic transaction with a supplier and a demander. In other words, most money has come into existence as the result of a banking transaction in which a deposit (the bank’s liability) was created in exchange for an individual’s liability, the liability of the bank, unlike that of an individual, being generally acceptable in exchange.

Lars (pp. 3-4) then quotes Nick Rowe as follows:

In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.

Nick is here giving formal expression to the old idea of money as a hot potato, once created it is there and can only be passed from one pair of hands to another; it can’t be gotten rid of. Following Jim Tobin’s classic paper (“Commercial Banks as Creators of Money”) I reject that view of bank money. Bank money is created by banks in the course of economic transactions designed to satisfy a demand, and can be extinguished by a corresponding transaction in the opposite direction. So I don’t accept the proposition that an excess demand for (supply of) bank money necessarily corresponds to an excess supply of (demand for) real goods. There is a market for money backing services in which an excess demand for (supply of) money finds its counterpart in an excess supply of (demand for) money backing. The price that is determined in this market for bank money is the interest paid on deposits, which adjusts as needed to equilibrate the supply of deposits with the demand to hold deposits.

That’s why I believe, unlike traditional (and Market) Monetarists, that the price level and associated macroeconomic variables like employment and output should be viewed as being determined strictly in terms of government currency, with any disequilibrium between the supply of and demand for bank money being viewed (at least as a first approximation) as triggering an adjustment in the interest paid on deposits rather than on the excess demand for real goods. (Bill Woolsey and I had an exchange on this point a few weeks ago in the comments to my post “Are Recessions Efficient?”). I have the impression (perhaps mistaken) that Scott Sumner actually may be closer to my position than to Nick Rowe’s and Bill Woolsey’s on this point, but Scott can weigh in for himself on this.

The policy significance of this disagreement may actually not be that great, because an equilibrium view of money creation by banks does not imply that monetary policy is ineffective as Tobin mistakenly concluded, inviting the everlasting (and in my view completely misguided) hostility of Monetarists to his understanding of money creation by banks.  At any rate, in my view of the world, the price level is determined in a market for currency and (when it is not interest-bearing) bank reserves.  There is a supply of and demand for bank money convertible into currency whose equilibrium determines the interest paid on bank deposits.  And finally, the money multiplier is cast into the theoretical dustbin as a useless and hopelessly senseless confusion of supply and demand concepts.

Paul Volcker is a big man, 6 feet 7 inches tall.  He is also a great man — truly great.  Appointed chairman of the Federal Reserve Board in 1979 after his predecessor, the unfortunate G. William Miller, obviously out of his depth, had to be replaced to avoid a collapse of confidence in the dollar.  A consensus quickly formed that only one man, Paul Volcker, then President of the New York Federal Reserve Bank, could restore the confidence of the nation and the rest of the world in the US monetary system.  Facing double-digit inflation, Volcker immediately took the steps needed to bring inflation down, raising interest rates and slowing monetary expansion, precipitating a recession in the process, a recession intensified by rapidly rising oil prices in the wake of the Iranian Revolution that brought the Ayatollah Khomeini to power.  However, the year was 1980, and Jimmy Carter, desperately seeking reelection, demanded a relaxation of monetary policy, forcing Volcker to subordinate monetary policy to Carter’s political requirements.  After Carter lost the election anyway, Ronald Reagan, who had pledged to bring inflation under control, gave Volcker a blank check to do whatever was necessary to reduce — but not eliminate — inflation.  And so he did, but it wasn’t pretty.  Interest rates skyrocketed to the highest levels in US history, unemployment rising above 10 percent for the first time since the Great Depression.  But Volcker, notwithstanding almost universal condemnation, held fast, and in the end gained vindication for his courageous anti-inflation stance.  In the annals of central banking, there are few, if any, figures that loom any larger than Paul Volcker.

So when Paul Volcker writes a column in the New York Times, warning against any increase in the Fed’s inflation target as a means of hastening our painfully slow recovery (if we can even call it that) from the Little Depression of 2008-09, his opinion cannot be dismissed lightly.

There is great and understandable disappointment about high unemployment and the absence of a robust economy, and even concern about the possibility of a renewed downturn. There is also a sense of desperation that both monetary and fiscal policy have almost exhausted their potential, given the size of the fiscal deficits and the already extremely low level of interest rates.

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.

Well, good luck.

Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.

Well, I am not ashamed to admit to being somewhat overawed and intimidated by Paul Volcker.  So I am going to call on Mark Twain to respond to Mr. Volcker on my behalf.  “We should be careful,” Mr. Twain observes, “to get out of an experience all the wisdom that is in it — not like the cat that sits on a hot stove lid. She will never sit down on a hot lid again — and that is well; but also she will never sit down on a cold one anymore.“

What Mark Twain meant was that history alone can’t teach us anything.  To learn anything from history, we need a theory to explain why history worked out as it did.  The cat doesn’t have a theory, so she learns the wrong lesson:  don’t sit down on a stove lid.  But, with the benefit of a theory, we know that the lesson that the cat ought to have learned was:  don’t sit down on a hot stove lid.

Paul Volcker is a practical man.  That was one of his great strengths as a central banker, but it can also be a weakness when his practical instinct leads him to take an overly simplified – dare I say, simplistic – view of a complicated economic disorder.  Mr. Volcker knows from experience how terribly difficult it is to eradicate, or even reduce, inflationary expectations after they have become embedded in the psychological fabric of an economy.  Lacking a theory of how inflation might be an essential element of a recovery from a recession in which profit and demand expectations have become deeply pessimistic, Mr. Volcker assumes that every inflation is of exactly the same type as the one with which he had to contend in the early 1980s.  Like the cat, he thinks that every lid is hot.

Well, that wasn’t quite fair.  Mr. Volcker is not like the cat.  He acknowledges that there may be “mathematical models spawned in academic seminars” in which inflation could be essential, or at least very conducive, to a recovery.  But, as a practical man, he cannot bring himself to take seriously the esoteric mathematical models supporting such a scenario.  The condescending reference to mathematical models and academic seminars, however, betrays Mr. Volcker’s own anti-theoretical bias, because one doesn’t need a mathematical model to see how inflation could promote recovery.  That conclusion is a straightforward implication of straightforward macroeconomics that has been understood for at least a century.  The question is whether we should take the risk that if we use inflation to get a recovery going, we will become hopelessly hooked on inflation, like someone experimenting with drugs becoming addicted after his first fix, or the risk that our slow, faltering recovery is really a reflection of deep structural problems immune to the stimulus of inflation.

Furthermore, Mr. Volcker’s view of economic history seems to be focused almost exclusively on the 1970s, which is understandable, but not necessarily practical.  It would also be worth paying attention to March 1933, when FDR, taking office with an economy seemingly unable to recover from the Great Depression, prices having fallen 30% or more since 1929, suspended the gold standard and announced a goal of restoring the US price level to where it had been in 1926.  By devaluing the dollar, Roosevelt produced a rapid rise in prices (wholesale price rose 14 percent from April to July 1933), triggering the fastest recovery in US history, industrial output increasing by over 70% from April to July while the Dow Jones average nearly doubled.

So, yes, Mr. Volcker, history shows that inflation can produce a recovery.  Maybe we need to learn from it.

Lars Christensen, Chief Analyst at Danske Bank and a regular and valued commenter on this blog since it started over two months ago, has been following and participating in debates about monetary policy in the blogosphere for the past two or three years.  Drawing on his considerable expertise as a monetary economist, a wealth of hands-on knowledge of financial markets and monetary policy, and his comprehensive knowledge of what the blogosphere is saying about monetary policy, Lars has performed a huge public service in distilling some of the most significant results of those debates in his excellent working paper “Market Monetarism: The Second Monetarist Counterrevolution” posted on Marcus Nunes’s blog. The paper appeared while I was in Japan, so I am tardy in acknowledging Lars’s contribution and in offering some of my own thoughts on various points in his paper.  But better late than never.

In addition to doing a great job of extracting the key analytical and policy contributions from nearly three years of discussions about monetary policy in the blogosphere, Lars performs an equally valuable and impressive service in tracing and explaining the monetary- and macoreconomic-theoretic background of the blogosphere discussion. And besides summarizing the relevant theoretical background for market monetarism, Lars shows how the blogosphere discussion is already advancing traditional scholarship, suggesting that the contributions are likely to increase in significance as the interface between academic and blogosphere discussions widens and becomes increasingly permeable.

Lars’s piece reminds me of two other important survey articles introducing an emergent new literature in the context of both historical antecedents and opposing views: Milton Friedman’s 1956 restatement of the quantity theory and the introductory essay Harry Johnson and Jacob Frenkel wrote to their 1976 volume on the monetary approach to the balance of payments. It is far too early to tell how the story of market monetarism will play itself out, but if story turns out as many of us hope it will, Lars’s paper will likely be viewed as an early milestone.

Much of Lars’s survey focuses on the intellectual leader of market monetarism, Scott Sumner, whose influential blog (www.TheMoneyIllusion.com) was a catalyst in the formation and development of market monetarism and whose tireless blogging and relentless, but witty and good-natured, advocacy was critical in making market monetarism a force to be reckoned with in the blogosphere and, increasingly, in academic discourse. But Lars also gives due credit to other contributors like Nick Rowe (www.worthwhile.typepad.com), David Beckworth (www.macromarketmusings.blogsopt.com), Bill Woolsey (www.monetaryfreedom-billwoolsey.blogspot.com), and Josh Hendrickson (www.everydayeconomist.wordpress.com), while citing Robert Hetzel of the Richmond Federal Reserve Bank as a seminal figure and influence on Sumner and the others. Lars also mentions me and this blog as well as Marcus Nunes and his blog as “part of the bigger Market Monetarist family.”

I am happy to be included in this family, but the question has come up in various off-line exchanges (perhaps even in an earlier draft of Lars’s paper) whether I consider myself to be a Market Monetarist (or a quasi-Monetarist, as Paul Krugman has referred to Scott and company). Lars’s paper actually touches on certain theoretical issues about which I am inclined to disagree with my Market Monetarist colleagues, and I hope to have something to say about those issues in some future posts. I am certainly less a fan of Milton Friedman and old-fashioned Monetarism than they tend to be, so I am not all that eager to adopt a label suggesting that I am a follower Friedman and Monetarism. (I am afraid that may sound a bit too critical of Friedman, who was certainly a great economist, but I regard much of his work on money as seriously flawed and a long step backwards from the achievements of earlier monetary theorists, especially Hawtrey.) The labeling problem is that any view that holds that monetary policy is crucial to macroeconomic stability, even one based on non-Friedmanian sources, can legitimately be identified as Monetarist, however different the underlying theory of how monetary policy operates, or should operate, from Friedman’s.

Of course, this raises the question, debated already in a number of places, what exactly to call the school of monetary thought formerly known as a quasi-Monetarism. Lars has opted for Market Monetarism, and by the force of his reasoning, charm, personality, and good timing, it looks as if he just may carry the day. Scott Sumner actually sent me an email recently (I think I got it while I was in Japan), asking me what I thought about the different alternatives. Because of my (perhaps overly finicky) reservations about Monetarism, but perhaps also because of a temperamental reluctance to identify myself with any particular school of thought, I didn’t register a preference for any of the names. But as I have thought further about the various names I have belatedly decided that I favor neo-monetarism over Market Monetarism, quasi-Monetarism, or other candidates.

I concluded that Market Monetarism is not such a good choice, because, as others have already pointed out, it is not at all clear what adding “market” to “monetarism” is intended to signify. Presumably, Market Monetarists are supposed to be more sensitive to information generated by markets in formulating monetary policy than were traditional Monetarists who favored a mechanical, preset rule for controlling one or more monetary aggregates. Nevertheless, traditional Monetarism was hardly antagonistic toward markets and market-oriented economic policies, so the modifier “market” carries a certain invidious, though unintended, implication about traditional Monetarism. Even worse, the vagueness of the adjective “market” when used in connection with Monetarism calls to mind F. A. Hayek’s pointed remark about what happens when the adjective “social” is combined with any other term.

“Social” became more and more the description of the pre-eminent virtue, the attribute in which the good man excelled and the ideal by which communal action was to be guided. But while this development indefinitely extended the field of application of the term “social,” it did not give it the required new meaning. It even so much deprived it of its original descriptive meaning that American sociologists have found it necessary to coin the new term “societal” in its place. Indeed, it has produced a situation in which “social” can be used to describe almost any action as publicly desirable and has at the same time the effect of depriving any terms with which it is combined of clear meaning. Not only “social justice” but also “social democracy,” or “social market economy” or the “social state of law” . . . are expressions which, though justice, democracy, the market economy or the Rechstaat have by themselves perfectly good meanings, the addition of the adjective “social” makes them capable of meaning almost anything one likes. The word has indeed become one of the chief sources of confusion of political discourse and can probably no longer be reclaimed for a useful purpose.  (Law, Legislation and LIberty, vol. 2, pp. 79-80)

Do we really want the same fate to befall “market”?

So I would opt for neo-monetarism, which is not exactly descriptive except insofar as it suggests that there is some undefined difference between old Monetarism and new monetarism (to be distinguished from New Monetarism), just as the nature of the difference between classical and neo-classical economics is not evident from the labels. But classical and neo-classical economics are, indeed, very different theoretical constructs; one cannot discern the difference just from the name; one has to learn a little about each to see wherein the difference lies. In that sense, market monetarism tends to obscure, and perhaps mislead, rather than to inform, while neo-monetarism neither misleads nor misinforms. Anyway, that, for whatever it’s worth, is my take.

Tomorrow I fly to Tokyo to present a paper to a conference of the Ricardo Society of Japan. My paper is on “Causes and Effects of Monetary Disequilibrium in Ricardo and Thornton,” probably not the most exciting paper written on monetary economics in the last year, but I hope that those interested in the monetary theory of David Ricardo will find something in it to think about. I try to use the framework of the monetary approach to the balance of payments to elucidate Ricardo’s contention that the only possible cause of the depreciation of an inconvertible currency is the creation of too many inconvertible banknotes. While in Tokyo for four days I also hope to find out a little bit more about Japan’s monetary policy. Perhaps I will blog about that at some point as I have hoped, and Benjamin Cole has urge me, to do for some time. But chances are that I will not be blogging again until next week. I just don’t know how functional I will be while I am in Tokyo.

While writing up my post on the Keynes-Hayek debate at LSE, I visited a couple of blogs to gauge the reaction in the blogosphere to the debate.  One of those was the very interesting Social Democracy for the 21^st Century:  A Post-Keynesian Perspective.  In his post on the debate, the blogger, AKA Lord Keynes, had some interesting observations about the famous (well, maybe among Austrians and Keynesians – especially post-Keynesians — with an inordinate interest in the history of economic thought) exchange in the Economic Journal between Piero Sraffa, reviewing Hayek’s Prices and Production, a short book containing his remarkably successful LSE lectures on the nascent Austrian theory of business cycles, Hayek’s response and Sraffa’s rejoinder.  The general consensus about the debate is that Sraffa got the better of Hayek in the exchange, indeed, that the debate marked the peak in Hayek’s influence, having risen steadily after Hayek’s LSE lectures and his lengthy and damaging review of Keynes’s Treatise on Money and Keynes’s ill-tempered reply.  Though Hayek continued working and writing tirelessly, the decline in his influence and reputation eventually led him away from technical economics into the more philosophical writings on which his lasting reputation was built, though he received some belated recognition for his early contributions when he was awarded the 1974 Nobel Memorial Prize in economics.

Sraffa attacked Hayek’s exposition of the Austrian business cycle theory on two fronts.  First, Hayek argued that monetary expansion necessarily produces a distorting and unsustainable effect on the capital structure of production, ultimately  causing a costly readjustment back to the earlier capital structure.  Sraffa observed that the distortion identified by Hayek was not caused by monetary expansion per se, but by a change in the distribution of money, but a distributionally neutral expansion would have no such distorting effect.   Sraffa also observed that it was entirely possible that the addition to the capital structure induced by what Hayek called forced saving might actually turn out to be sustainable inasmuch as the augmented capital stock might itself imply a reduced natural rate of interest rate corresponding to the reduced money rate achieved through monetary expansion.

Sraffa’s second, and perhaps more damaging, line of attack was on the very concept of a natural rate of interest, borrowed by Hayek from the Swedish economist Knut Wicksell, though transforming it in the process.  According to Hayek, the natural rate corresponds to the interest rate in a pure barter equilibrium undisturbed by the influence of money.  The goal of monetary policy should therefore be to ensure that the money rate of interest equaled the natural rate, thus neutralizing the effect of money and facilitating an intertemporal equilibrium in which money is not a distorting factor, i.e., in monetary expansion by banks to finance investments in excess of voluntary savings does not drive the money rate of interest below the natural rate, a state of affairs that could never obtain in a barter equilibrium.

Sraffa, however, argued that Hayek’s use of the natural rate of interest as a benchmark for monetary policy was incoherent, because there would be no unique natural interest rate in a growing barter economy with net investment in capital goods of the kind Hayek wished to use as a benchmark for monetary policy in a growing, money-using, economy.  In the barter economy, interest rates would correspond to the price ratios over time (own rates of interest, i.e., ratios of spot to forward prices) between durable or storable commodities.   But these own rates would fluctuate in response to the changing demands characterizing a growing economy, implying that there is no single natural rate of interest, but a collection of natural own rates of interest.  Only if Hayek were willing to follow Wicksell in defining a price level in terms of some average of prices would Hayek have been able to define a natural rate of interest as some average of own rates.  But Hayek explicitly rejected the use of statistical price levels.  Hayek’s reply was ineffective, leaving Sraffa the clear winner in that exchange.

However, a quarter of a century later, Hayek’s student Ludwig Lachmann in his book Capital and its Structure elegantly explained the critical point that neither Sraffa nor Hayek had quite comprehended.  The natural interest rate in a barter economy has a perfectly clear meaning, independent of any statistical average, in an intertemporal equilibrium setting, because equilibrium requires that the expected return from holding all durable or storable assets be the same.  The weakness of the natural-rate concept is not that it necessarily pertains to a monetary rather than to a barter economy, as Hayek supposed, but that it could only be given meaning in the context of a full intertemporal equilibrium.

In his discussion of Sraffa and Hayek on his blog, Lord Keynes insists that Sraffa got it right.

However, Piero Sraffa had already demonstrated in 1932 that outside of a static equilibrium there is no single natural rate of interest in a barter or money-using economy, and Hayek never really addressed this problem for his trade cycle theory.

Sraffa did demonstrated that there was no single natural rate of interest in a disequilibrium, but he did not do so for an intertemporal equilibrium in which price changes are correctly foreseen.  Hayek actually had developed the concept of an intertemporal equilibrium in a paper originally published in German in 1929, eight years before providing a truly classic articulation of the concept in his wonderful 1937 paper “Economics and Knowledge,” so it is odd that he was unable to respond effectively to Sraffa’s critique of the natural rate in 1932.

Lord Keynes, who is aware of Lachmann’s contribution on the Sraffa-Hayek exchange, cites as authority for dismissing Lachmann, a paper by another blogger, an ardent, but surprisingly reasonable, Austrian business cycle theory supporter Robert Murphy, who has written a paper that addresses the Sraffa-Hayek debate.   Lord Keynes quotes the following passage from Murphy’s paper.

Lachmann’s demonstration—that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest—does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to ‘the’ real rate of interest.”

Murphy is almost right in that Lachmann demonstrates that the rate of return is equalized across all investment opportunities (allowing for the usual sources of difference in rates of return) in an intertemporal equilibrium.  It is not clear what he means by saying that the choice of a numeraire matters.  It doesn’t matter for any real property of the intertemporal equilibrium, i.e., a real quantity or a relative price; it matters only for nominal quantities and absolute prices.  But nominal quantities, by definition, depend on the choice of a numeraire and even in a static equilibrium there is no unique nominal rate of return just as there is no unique level of absolute prices.  The “real” rate of interest is determined in an intertemporal equilibrium; the nominal rate is not determined.  This is precisely the distinction between the real rate and the nominal rate identified in the Fisher equation.  And every kindergartener knows that the natural rate is a real rate not a nominal rate.

Perhaps Murphy is made uncomfortable by the fact that Lachmann’s point shows that a Hayekian intertemporal equilibrium could be consistent with any rate of inflation as long as the nominal rate reflected the equilibrium expected rate of inflation and inflation would have no effect on relative prices.  That indeed is a problem for a fundamentalist version of Austrian business cycle theory and would deny that as a matter of pure theory there cannot be an intertemporal equilibrium with inflation.  But that form of Austrian fundamentalism is simply inconsistent with the basic properties of an intertemporal equilibrium and with the non-uniqueness of absolute prices in either a static or intertemporal equilibrium.  So Austrians just need suck it up on that (not very important) point and move on.

Finally, to come back to Sraffa.  It is worth noting that the real Keynes in the General Theory said this about the natural rate of interest.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which . . . preserved equality between the rate of saving . . . and the rate of investment. . . .

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment.  And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment.  Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value fo rthe rate of interest irrespective of the level of employment.

So Keynes, like Sraffa, clearly had rejected the notion of a unique natural rate of interest.  But Keynes’s reasons for doing so are very different from Sraffa’s.  Keynes’ makes no mention of multiple natural rates corresponding to the different commodity own rates of interest that Sraffa had introduced in his attack on Hayek’s use of the natural rate.  (Keynes, of course, as editor of the Economic Journal, had selected Sraffa to write a review of Prices and Production, presumably knowing what to expect, so he knew exactly what Sraffa had said about the natural rate of interest.)

Indeed Keynes goes through Sraffa’s analysis in chapter 17 of the General Theory, “The Essential Properties of Interest and Money.”  It is one of my favorite chapters, especially because its analysis of portfolio choice is so acute.  I just quote one long paragraph (pp. 227-28).

To determine the relationships between the expected returns on different types of assets which are consistent with equilibrium, we must also know what the changes in relative values during the year are expected to be.  Taking money (which need only be a money of account for this purpose, and we could equally well take wheat) as our standard of measurement, let the expected percentage appreciation (or depreciation) of houses be a1 and of wheat a2.  q1, –c2 and l3 we have called own-rates of interest of houses, wheat and money in terms of themselves as the standard of value; i.e., q1 is the house-rate of interest in terms of houses, –c2 is the wheat-rate of interest in terms of wheat, and l3 is the money rate of interest in terms of money.  It will also be useful to call a1 + q1, a2 – c2 and l3, which stand for the same quantities reduced to money as the standard of value, the house-rate of money-interest, the wheat-rate of money-interest and the money-rate of money-interest respectively.  With this notation it is easy to see that the demand of wealth-owners will be directed to houses, to wheat or to money, according as a1 + q1 or a2 – c2 or l3 is greatest.  Thus in equilibrium the demand-prices of houses and wheat in terms of money will be such that there is nothing to choose in the way of advantage between alternatives; i.e, a1 + q1, a2 – c2 and l3 will be equal.  The choice of the standard of value will make no difference to this result because a shift from one standard to another will change all the terms equally, i.e. by an amount equal to the expected rate of appreciation (or depreciation) of the new standard in terms of the old.

In this particular post, I am happy to give Keynes the last word.

As many bloggers (Marcus Nunes, David Beckworth, Scott Sumner, and  Scott Sumner, among others) have pointed out, the Swiss National Bank, in pledging not to tolerate a Swiss franc-euro exchange rate below SF1.20,  showed this week how much a central bank can accomplish in a very short time by acting decisively and with determination, qualities sadly lacking in the decision-making of the Federal Reserve Board, and, in particular the Federal Open Market Committee (FOMC).    Even The Wall Street Journal (to the evident consternation of the lunatic mainstream of the commenters populating its website) applauded the move by the Swiss central bank.

The Swiss National Bank’s announcement Tuesday that it would buy “unlimited quantities” of euros to keep the franc-euro exchange rate above 1.20 is a dramatic and helpful move amid the continuing euro crisis.

Acknowledging that the action taken by the Swiss central bank would benefit Swiss exporters, the Journal properly cautioned:

But throwing a bone to exporters is not the most important reason for the central bank to intervene. Central banks are the monopoly suppliers of the commodity known as money. When a currency like the Swiss franc appreciates rapidly, the market is sending a signal that not enough francs are being printed to meet demand.

In contrast to what central banks usually do when they conduct exchange-rate intervention, the Swiss central bank is saying that its monetary policy is subordinated to the peg.  The quantity of francs issued by the central bank will be whatever amount the public wants to hold at the peg (the peg, in this case, being one-sided, the franc-euro exchange rate  not permitted to fall felow SF1.20).

The Journal concludes with the following observation:

Since the collapse of the Bretton Woods exchange-rate system in the 1970s, policy makers have grown fond of saying that markets should set exchange rates. But markets can’t set the value of a commodity whose sole supplier is the central bank, and this pseudo-laissez-faire is an abdication of central banks’ duty to control the supply of their currency, both internally and externally.

Markets can’t set the value of a commodity whose sole supplier the central bank?!  What does the Journal editorialist think happens every day in the foreign exchange markets?  Who else but the market is setting the value of these monopolistically supplied commodities?  Didn’t the Journal editorialist just observe “when a currency like the Swiss franc appreciates rapidly, the market is sending a signal that not enough francs are being printed to meet demand”?

The point that the Journal editorialist was trying to make, albeit clumsily if not incoherently, is that it makes sense for a monopolist — even a monopolistic central bank — to take into account the signals about the demand for its product reflected in rapid changes in the market price of the product that it supplies.  A sudden sharp increase in the exchange rate of a currency signals that the demand for the currency is increasing.  Not responding to such an increase and just letting the increase in demand force up the price doesn’t make sense for the monopolist, and it surely makes no sense for a central bank.  Not increasing the supply of a rapidly appreciating currency can have all sorts of unpleasant consequences (e.g., deflation and a recession) for the country with a rising currency.  That’s why the Journal wasn’t wrong to label a policy of ignoring fluctuations in the exchange rate in the name of non-intervention as “pseduo-laissez-faire.”

But while the Journal endorses the decision of the Swiss central bank to halt the demand-driven appreciation of the franc, the Journal has shown less concern over the past three years with appreciations of a similar magnitude in the dollar relative to the euro.  The nearby graph shows how both the dollar and the Swiss franc have fluctuated against the euro since January 2007.

A recession beginning in December 2007, triggered by the bursting of the housing bubble, led to a gradual depreciation of the dollar relative to the euro from about $1.45 to just over $1.60 in April 2008, with the dollar fluctuating in a narrow range between $1.55 and $1.60 till the end of July.  From August 1 to August 31, the dollar rose from $1.5567 to $1.4669 against the euro.  On the Friday before Lehman collapsed (three years ago on September 5, 2008), the dollar stood at $1.4273, falling to $1.3939 on September 11, then falling to $1.4737 on September 23 and was still at $1.46 as late as Friday September 26.   On Monday September 29, the dollar rose sharply to $1.4381 and by the end of  October the dollar had risen to $1,26, nearly 30% higher than its value at the beginning of August.   From November to March, the dollar remained in the $1.25 to $1.30 range against the euro, except for a blip from mid-December to mid-January when the dollar fell to about $1.40 before quickly recovering.  Did the Journal ever once call for a reversal of this devastating appreciation of the dollar against the euro in the fall?

From March through December 2009, during QE1, the dollar fell gradually from about $1.25 to about $1.50 as a recovery of sorts began, the economy growing 3.8% in the fourth quarter.  The dollar then rose from $1.50 in early December to about $1.20 in June, remaining in the $1.20 to $1.30 range till the end of August, when, fearing the onset of deflation, Chairman Bernanke announced that QE2 would be tried.  The dollar quickly fell from $1.27 at the end of August to $1.40 in November and, with only occasional movements outside the range, has remained between $1.40 and $1.48 against the euro throughout 2011.  Yet the Journal and its regular columnists constantly complain about the dollar debasement caused by the Fed, even though dollar-euro exchange rate is roughly the same as it was in December 2007 when the downturn started.

The Journal properly defends the decision of the Swiss central bank to reduce the value of the franc after having risen by about 20-25% against euro since April.  Yet the Journal never misses an opportunity to castigate the Fed for reversing two episodes of dollar appreciation of at least as large as that of the franc against the euro, accusing the Fed of deliberate dollar debasement even though inflation over the last three years has been at the lowest level in half a century.  Anyone care to guess why the Journal is more understanding of the Swiss central bank than it is of the US central bank?