Uneasy Money

Over the weekend I received a comment on my post about Clark Johnson’s new paper from someone who disputed Johnson’s assertion that it is a myth that the Fed has been following an expansionary monetary policy since the 2008 financial crisis. Here is the relevant part of the comment:

The Fed cannot fix the economy by changing “expectations” because they have no tools to follow through. Just saying that they should “change expectations” is not enough. I cannot change expectations of the whole economy, because I have no tools to follow through, the same applies to the Fed.

Even though I disagree with the commenter that the Fed cannot affect expectations, I understand and sympathize with the commenter’s skepticism that Fed could actually do so. As I have written here before, I don’t think that our current theory of fiat money explains very well how the value of a fiat money (i.e., the inverse of a comprehensively defined price level) is determined. Without such a theory, it is hard to specify the exact mechanism or channel by which a central bank can control the price level. Nevertheless, it seems clear that an essential element in that mechanism is control, though perhaps limited and imperfect, over the price-level expectations of economic agents.

Then I read this morning on Scott Sumner’s blog the following quotation from a news item in the New York Times:

WASHINGTON — The Federal Reserve made a rare promise on Tuesday to hold short-term interest rates near zero through at least the middle of 2013, in a sign that it has all but written off the chances of an expansion strong enough to drive up wages and prices. . . .

By its action, the Fed is declaring that it, too, sees little prospect of rapid growth and little risk of inflation. Its hope is that the showman’s gesture will spur investment and risk-taking by convincing markets that the cost of borrowing will not rise for at least two years.

The Fed’s statement, with its mix of grim tidings and welcome aid, contributed to wild market oscillations as investors struggled to make sense of the economy and the path ahead.

The juxtaposition of my commenter’s skepticism about the ability of the Fed to affect expectations with the news item quoted by Scott suggests to me (or, to be more precise, reinforces for me) the following observations about expectations:

1. Expectations are partly autonomous, partly induced by policy rules or by policy announcements made by policy makers;
2. Expectations sometimes affect outcomes;
3. Expectations can therefore be self-fulfilling (referred to by Karl Popper as the Oedipus effect);
4. Expectations are often contagious;
5. Expectations can be cyclical (even exhibiting bubble-like characteristics);
6. Expectations sometimes are, and sometimes are not, consistent with equilibrium
7. There may be multiple equilibria corresponding to various sets of expectations;
8. Keynes’s famous characterization (General Theory, chapter 12) of the stock market as a beauty contest has an important kernel of truth to it and does not presume that traders act irrationally;
9. There is no clear distinction between expectations and fundamentals, because expectations are fundamentals.

If these observations about expectations are right, then conventional rational expectations (DSGE) models, which assume a unique equilibrium determined by fundamentals, are flawed at the most basic level, because they exclude a priori the existence of multiple potential equilibria. If there are many possible equilibria, each corresponding to a particular set of expectations, economic policy can affect outcomes by altering expectations, leading to the realization of a different equilibrium from the one that would have been realized under the old set of expectations. What real business cycle theorists identify as productivity shocks could just as easily be regarded as expectational shocks, possibly induced by policy choices. Put another way, by affecting expectations, monetary policy can affect not only the expected rate of inflation, it can affect the real rate of interest, so that the standard interpretation of the Fisher equation, in which expected inflation is added to an unvarying real rate of interest, is valid only on the assumption that there is a unique real equilibrium independent of the expected rate of inflation. But if there are multiple possible equilibria, whose realizations depend on what rate of inflation is expected, the observed nominal rate is not simply the sum of expected inflation and a uniform real rate, because the real rate is not uniform with respect to the expected rate of inflation.

This is what Keynes meant when (General Theory, p. 219) he rejected the concept of a unique natural rate (which in his terminology corresponded to the Fisherian real rate), because there is a different real rate corresponding to each level of employment. In fact, it is even more complicated than that because in Keynesian terminology, the real marginal efficiency of capital may shift as the expected rate of inflation changes. But we can save that complication for another time.

The S&P 500 rose 3.4% today, closing at 1284.59, the highest close since August 1. And not coincidentally, the breakeven TIPS spread – a slightly upward biased estimate of inflation expectations — on a constant maturity 10-year Treasury rose 9 basis points to 2.18%, the highest the TIPS spread has been since mid-August.

At the end of September, after a miserable third quarter, in which both stock prices and inflation expectations dropped sharply, there was a great deal of hand-wringing (some of it my own, see here, here and here) about the prospects for stock prices and the possibility of another bear market.  The economy had performed badly since the start of 2011, and the FOMC in its September meeting had held out little hope for further easing of monetary policy, the attempt to flatten the yield curve by lengthening the maturity of Fed holding being widely regarded as meaningless and ineffectual.  In addition, the determined resistance of three regional Fed bank presidents, Plosser, Fisher and Kocherlakota, to any further easing of monetary policy combined with the overt hostility of prominent Republican politicians to monetary easing seemed to have tied the hands of Chairman Bernanke.

However, sometimes it really is darkest just before the dawn.  The widespread expressions of despair about the future of the economy in the absence of any new measures taken by the Fed coupled with strong statements by Fed vice-chairman Janet Yellen, and by Presidents Charles Evans of the Chicago Fed and William Dudley of the New York Fed seemed to provide markets with renewed hope that the possibility  of further easing had still not yet been definitively taken off the table.

Hopes for monetary easing received a further boost on October 14, when Goldman Sachs released a staff report supporting a shift in Fed policy toward targeting nominal GDP as advocated by Scott Sumner and other Market Monetarists.  Thanks to revived hopes for monetary easing, the TIPS spread on the constant maturity 10-year Treasury has risen by 43 basis point since the end of September.

The chart below plots the daily change (measured in basis points) in the TIPS spread on the constant maturity 10-year Treasury and the percentage change in the S&P 500. Here is yet further evidence that the strongly positive correlation between inflation expectations and stock prices since early 2008 identified in my January 2011 paper (and discussed in earlier blog posts here and here) continues to hold.

A recent blog post by Daniel Nielson questions whether central banks can accomplish anything by targeting NGDP, because they have no credible means of achieving their objectives, but market measures of inflation expectations obviously are responding even to scraps of new information about changes in monetary policy.

I was thumbing through my copy of Hayek’s wonderful collection of essays, Studies in Philosophy, Politics, and Economics, and perused his (heavily underlined) essay, “Full, Employment, Planning, and Inflation,” originally published in the Institute of Public Affairs Review, Melbourne, vol. IV, 1950. The essay is an argument against the adoption of Keynesian (including monetary) policies to maintain full employment, warning that increasing aggregate demand to achieve the maximum attainable level of employment would lead not only to chronic inflation, but also to a mismatch between the distribution of demand and the distribution of labor. The inevitable mismatch between the demand for and supply of labor would cause unemployment to rise despite inflation, inviting the imposition of direct controls and the piecemeal implementation of central planning.

I will make two observations in passing. First, it is obvious from the discussion that although Hayek believed that there was a connection between expansionary monetary policy aimed at maintaining full employment (actually he meant “over-full” employment), he viewed the connection as indirect, clearly not identifying the conduct of monetary policy with central planning as such. Second, Hayek, already in 1950, had anticipated the essence of the argument for a vertical long-run Phillips Curve.

The main point of this post, however, is to focus on a few other gems about monetary policy from Hayek’s essay. Here is one:

Full employment has come to mean that maximum of employment that can be brought about in the short run by monetary pressure. This may not be the original meaning of the theoretical concept, but it was inevitable that it should have come to mean this in practice. Once it was admitted that the momentary state of employment should form the main guide to monetary policy, it was inevitable that any degree of unemployment which might be removed by monetary pressure should be regarded as sufficient justification for applying such pressure. That in most situations employment can be temporarily increased by monetary expansion has long been known. If this possibility has not always been used, this was because it was thought that by such measures not only other dangers were created, but that long-term stability of employment itself might be endangered by them. What is new about present beliefs is that it is now widely held that so long as monetary expansion creates additional employment, it is innocuous or at least will cause more benefit than harm.

Hayek here seems to be intimating a fairly hard-line stance against the use of monetary policy to increase employment. But two paragraphs later he adds an important qualification.

That so long as a state of general unemployment prevails, in the sense that unused resources of all kinds exist, monetary expansion can only be beneficial [my emphasis], few people will deny. But such a state of general unemployment is something rather exceptional, and it is by no means evident that a policy which will be beneficial in such a state will also always and necessarily be so in the kind of intermediate position in which an economic system finds itself most of the time, when significant unemployment is confined to certain industries, occupations or localities.

So Hayek here acknowledges that monetary policy can be effective in times of widespread unemployment of all kinds throughout the economy, i.e., (to use a more conventional idiom than Hayek used) when aggregate demand is deficient. Some people may regard our current levels of unemployment as not “unexceptional,” but nearly three years of 9-10% unemployment will hardly qualify as an “intermediate position” in the minds of most people. Hayek continues:

Of a system in a state of general unemployment it is roughly true that employment will fluctuate in proportion with money income, and that if we succeed in increasing money income we shall also in the same proportion increase employment. But it is just not true that all unemployment is in this manner due to an insufficiency of aggregate demand and can be lastingly cured by increased demand. The causal connection between income and employment is not a simple one-way connection so that by raising income by a certain ratio we can always raise employment by the same ratio.

Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek’s position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don’t know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

A staple argument of right-wing opponents of monetary expansion to increase prices and nominal income is that, given high unemployment, inflation will not increase nominal wages, so that increasing prices must reduce real wages. This response is classic faux populism at its worst, as practiced with consummate hypocrisy by the Wall Street Journal editorial page.

What makes this argument so disreputable is not just the obviously insincere pretense of concern for the welfare of the working class, but the dishonest implication that employment in a recession or depression can be increased without an, at least temporary, reduction in real wages. Rising unemployment during a contraction implies that real wages are, in some sense, too high, so that a falling real wage tends to be a characteristic of any recovery, at least in its early stages. The only question is whether the falling real wage is brought about through prices rising faster than wages or by wages falling faster than prices. If the Wall Street Journal and other opponents of rising prices don’t want prices to erode real wages, they are ipso facto in favor of falling money wages.

Here is how Ludwig von Mises, with his unique gift for understatement, put it in his magnum opus, Human Action (3^rd ed., p. 789), explaining the connection between real wages and unemployment in the Great Depression.

In the boom period that ended in 1929 labor unions succeeded in almost all countries in enforcing wage rates higher than those which the market, if manipulated only by migration barriers, would have determined. These wage rates already produced in many countries institutional unemployment of a considerable amount while credit expansion was still going on at an accelerated pace. When finally the inescapable depression came and commodity prices began to drop, the labor unions, firmly supported by the governments, even by those disparaged as anti-labor, clung stubbornly to their high-wages policy. They either flatly denied permission for any cut in nominal wage rates or conceded only insufficient cuts. The result was a tremendous increase in institutional unemployment. (On the other hand, those workers who retained their jobs improved their standard of living as their hourly real wages went up.) The burden of unemployment doles became unbearable. The millions of unemployed were a serious menace to domestic peace. The industrial countries were haunted by the specter of revolution. But the union leaders were intractable, and no statesman had the courage to challenge them openly.

In this plight the frightened rulers bethought themselves of a makeshift long since recommended by inflationist doctrinaires. As unions objected to an adjustment of wages to the state of the money relation and commodity prices to the height of wage rates. As they saw it, it was not wage rates that were too high; their own nation’s monetary unit was overvalued in terms of gold and foreign exchange and had to be readjusted. Devaluation was the panacea.

Mises actually describes the situation fairly accurately, if allowance is made for his political extremism and insane anti-inflationism, as if devaluation, in the face of 5 to 10% annual deflation from 1930 to 1933, were the problem not the solution. So if the Wall Street Journal and other opponents of monetary expansion to raise prices and nominal GDP don’t want rising prices to erode real wages, they need to explain how employment is supposed to expand after a depression without a fall in real wages. If they can’t do that, then, by the laws of arithmetic, they, like their hero Ludwig von Mises, must be in favor cutting nominal wages.

Clark Johnson wrote a really excellent book, Gold, France and the Great Depression, 1919-1932 on the international monetary disorders that produced the Great Depression, published by Yale University Press in 1997. The work stems from his doctoral dissertation at Columbia Yale University. Although Johnson wrote his dissertation in the history department (at Yale), Robert Mundell (from the economics department at Columbia) was involved in supervising the dissertation, and the final product is obviously the work of a gifted and insightful historian/economist. Additionally, Johnson gives ample recognition to the sadly neglected contributions of Gustav Cassel and R. G. Hawtrey, who more than anyone else at the time and almost anyone else since, diagnosed and understood the monetary pathology that produced the Great Depression.

In a newly published paper (in the Miliken Institute Review), Johnson compares the monetary disorders producing the current Little Depression to the monetary disorders that produced the Great Depression some 80 years ago. He organizes his paper around six widespread myths about monetary policy, explaining how reality is almost exactly the opposite of the myths now paralyzing the implementation of effective monetary policy.

Myth #1: The Federal Reserve has followed a highly expansionary monetary policy since August 2008.

Myth #2: Recovery from recessions triggered by financial crises is necessarily slow.

Myth #3: Monetary policy becomes ineffective when short-term interest rates fall to close to zero.

Myth #4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

Myth #5: When monetary policy breaks down, there is a plausible case for a fiscal response.

Myth #6: The rising prices of food and other commodities are evidence of expansionary monetary policy and inflationary pressure.

One of Johnson’s most important points is to challenge the notion that the near-term objective of monetary ease ought to be to reduce interest rates. The objective of monetary policy in current circumstances must be to raise prices and to increase inflation expectations. Doing so will increase estimates of profitability and encourage investment, causing interest rates to rise not fall. Focusing on reducing interest rates simply feeds into the pessimistic expectations that are holding down spending (both investment and consumption) inasmuch as expectations of low interest rates into the future can be validated only by low levels of economic activity or falling prices, both of which are deterrents to current spending and inducements to holding cash. Whether Johnson is right in endorsing Ronald McKinnon’s suggestion that the leading central banks cooperate to increase short-term interest rates immediately is not so clear, but he is almost certainly right to argue that the FOMC’s promise to keep interest rates low for an extended period of time was, whatever its intent, deflationary in effect. I would also quibble with his suggestion that rising commodities prices are entirely independent of monetary policy, even though he is correct to observe that rapid economic growth by China and other developing countries is an independent, and perhaps more important, factor in fueling increases in commodities prices. (And let’s not forget ethanol subsidies and mandates, either.)

At any rate, kudos to Clark Johnson for this timely contribution. Let’s hope that Johnson will provide further valuable insights on economic and monetary policy.

Update 10/28:  I made a few changes in the first paragraph in response to Clark Johnson’s comment.

See Scott Sumner’s post today about this piece about nominal GDP targeting by Kelly Evans.  Scott writes:

What’s happened to the Wall Street Journal?  They seem to be increasingly veering toward the Rick Perry school of monetary analysis.

And then:

I can’t imagine any reputable economist disagreeing with me on any of these three points, even if he or she hated NGDP targeting.  The WSJ is simply flat out wrong.

And again:

Don’t you love it how the WSJ switches over to Keynesian economics, just after they’ve trashed the idea that the economy needs demand stimulus.  Is there any model there?

But you really need to read Scott’s entire post to get the full flavor of his skewering of the Journal‘s “analysis.”

The only surprise here is that Scott actually seems to be surprised.  What an innocent!

Kurt Schuler over at the Free Banking Blog takes issue yet again with my earlier posts in which I disputed the identification increasingly made by ideological opponents of the Federal Reserve Board that central banking is a form of central planning. I don’t have much to add to my earlier posts (here, here, and here), and interested readers can go back and have a look at what I have already said on the subject. Readers may also want to have a look at Lars Chistensen’s blog in which he gives a brief summary and commentary of the debate between Kurt and me and provides links to the relevant posts as well as to a post by Bill Woolsey on his blog supporting my view. Lars actually finds Bill’s argument, quoted at length, more persuasive than mine, which is OK, because I think that Bill spells out what I wanted to say by way of a specific example illustrating the difference between central planning and government ownership of, or a legal monopoly over, an economically critical service.

But I will take this opportunity to reply to the following passage from Kurt’s post expressing surprise that, having published a book on free banking, I would now dispute that central banking is a form of free banking central planning, a proposition, according to Kurt, crucial to free-banking thought.

the idea that central banking is a form of central planning is a crucial part of free banking thought, and because I am amazed by Glasner’s view given that he once wrote a book on free banking,

I did indeed write a book nearly 25 years ago in which I advocated free banking. The truth is that I still believe that most of what I wrote in my book was correct, but I would admit to having greater doubts than I did then about the practicality of adopting a free-banking system. The main source of my doubts is that I don’t think that we have yet come up with a model for dealing with insolvent or even illiquid banks. I suggested in my book that money market mutual funds provided a workable model for free banking, but the experience of September and October 2008 in which a run on money market mutual funds that had invested heavily in the commercial paper backed by mortgage backed securities issued by Lehman Brothers and others was a key part of the financial panic suggests to me that we need a more fundamental redesign of monetary institutions than I had imagined if we are to shift to a monetary system without a lender of last resort. I understand all the arguments about the distorted incentives that regulation and other interventions created, promoting risk taking by too-big-to-fail financial institutions, but I don’t know if there is any way of showing that a system of free banking would not entail a higher level of systemic risk than our current system.

But forget about that very big question mark in my mind about the potential instability of a free-banking system. In my book I argued that a system of indirect convertibility under a labor standard could ensure a socially optimal time path for the price level while a free-banking system would provide the public with just as much money as they wished to hold, thereby eliminating socially undesirable fluctuations in economic activity. Just because free banking under a labor standard could outperform central banking doesn’t mean that central banking is central planning; it means that central banking is a less effective way of arranging our monetary system than a possible alternative. There may be some infringements on liberty associated with central banking, with certain types of transactions being prohibited.  But is every infringement on liberty the same as central planning? The identification of central banking with central planning suggests to me a certain kind of rhetorical extremism, a casual tendency not merely to disagree with or to criticize, but to vilify and to demonize, our current institutions and political leaders, that I find a tad scary. To see what I mean, have a look at the comments on Kurt’s post on the Free Banking Blog.  Comrade Bernanke, first a traitor, now a commie.

Commentary on rational expectations since the 2011 Nobel Prize in economics was awarded to Tom Sargent and Chris Sims continues to pour in.  Last week, in addition to a post of my own, John Kay posted a hostile assessment of rational expectations on his website, prompting a half-hearted defense of sorts from Matt Yglesias likening the rational expectations revolution to the Copernican Revolution, a comparison of which Noah Smith, launching a renewed attack on rational expectations and its claims to have transformed economics into a hard science, heartily disapproves.  In today’s Financial Times, John Kay returns to the attack with an ironic jab at the Nobel committee for avoiding any mention of rational expectations in its citation of Sargent and Sims, and some well-aimed barbs at the pretensions of rational expectations to a sort of infallible knowledge.

I agree with these criticisms of rational expectations, though as I suggested, the rational-expectations hypothesis can be, and often is, a useful one.  Rational expectations only becomes dangerous when transformed from an empirical hypothesis and a way of testing the coherence of a model into a methodological principle and an axiom purporting to embody a necessary attribute of the world, on the order of Newton’s laws of motion.  Thus, through a program of methodological imperialism, rational expectations has been imposed on much of mainstream economics as the only acceptable modeling strategy.

The spirit of this methodological imperialism is captured remarkably well by the abstract to the entry on “calibration” contributed by Edward Prescott and Graham Candler to the New Palgrave Dictionary of Economics, second edition.

The methodologies used in aerospace engineering and macroeconomics to make quantitative predictions are remarkably similar now that macroeconomics has developed into a hard science. Theory provides engineers with the equations, with many constants that are not well measured. Theory provides macroeconomists with the structure of preference and technology and many parameters that are not well measured. The procedures that are used to select the parameters of the agreed upon structures are what have come to be called ‘calibration’ in macroeconomics.

I would like to comment on another aspect of the methodological imperialism of rational expectations which is its reductionism.  (The reductionism of rational expectations has, to my knowledge, been noted only by Allesandro Vercelli in a paper “Keynes, Schumpeter and Beyond:  A Non Reductionist Perspective” in A Second Edition of the General Theory, edited by G. C. Harcourt.)  In philosophy, reductionism refers generally to the idea that all higher level (i.e., more particular theories) are (can be? will be?) ultimately derived from and translatable into (can be reduced to”) lower-level, deeper, theories.  Thus, the laws of chemistry, geology, astronomy, meteorology, biology (?) can ultimately be “reduced to” the laws of physics.

One field in particular in which the idea of reductionism is very much alive and discussed is in the nexus between brain science and the philosophy of mind — the old mind-body problem.  Many philosophers and brain scientists argue that all mental states are “reducible to” physical states.  The problem with reductionism in brain science and the philosophy of mind is that, unlike chemistry and physics, where the reduction is to some (unknown to me) extent already worked out, there is not even a glimmer of understanding of the physics that would allow one to derive mental states from physical states.  Thus, reductionism in brain science and the philosophy of mind is a purely metaphysical notion that has no basis in known science.  (Admittedly, I am speaking largely out of relative ignorance of the relevant philosophy and total ignorance of the relevant science, but my impression is that there are philosophers and scientists who would agree with my assertions about the current state of brain and physical science.)  Moreover, even if we had all the science worked out, it is still not clear that mental states would in fact be reducible to physical states because there is not necessarily any way of bridging the chasm between mental and physical.

Rational expectations as a methodological principle requires that agents in every model base their decisions on the expected values of the stochastic variables, ruling out divergent expectations among agents, thereby promoting the adoption of representative agent models.  Macroeconomic models not derived from explicit utility or wealth-maximizing assumptions and rational expectations are inadmissible.  This sharply limits the possibility for deriving anything like what Keynes referred to as involuntary unemployment.

Thus, involuntary unemployment is to rational expectations theorists what consciousness is to mental reductionists.  Even though we all have direct experience of consciousness, mental reductionists deny that there is any such thing as consciousness (which obviously is a far stronger claim than that consciousness is a figment of our imagination).  Similarly, rational expectationists deny that there is such a thing as involuntary unemployment even though we seem to have plausible evidence that there are people who would be willing to work at the prevailing wage but are unable to find work.  One can imagine that such evidence for involuntary unemployment might be discounted, but generally to do so, one would have to be able to provide a plausible reinterpretation of the evidence combined with compelling independent evidence that supported an alternative theoretical conclusion.  But where is the compelling alternative evidence of the rational expectationists?  And what is the plausible reinterpretation of the plausible evidence that there is involuntary unemployment?  Rather than confront these issues squarely, rational expectationists simply insist that they are following the dictates of rigorous science.  But their conception of rigorous science confuses an axiomatic method designed to deduce logical inferences from a set of assumptions and definitions with an attempt to compare the implications of alternative hypotheses with the evidence.  The latter it seems to me is closer to true science than the former, unless your conception of true science is very close to that of Ludwig von Mises.

In yesterday’s post about the effects of QE2, I discussed the tendency of an increase in expected  inflation to cause the prices of real assets, including the prices of commodities, to increase.  That is, if we expect prices to rise in the future, we will choose to reallocate our asset holdings, exchanging cash for physical assets, driving up the prices of those assets in the process.  So the expectation of increased inflation occasioned last year by the announcement of QE2 undoubtedly was one factor in causing the subsequent run-up in commodity prices, expectations of accelerating economic growth and negative supply shocks being two others.

However, the rise in commodities prices triggered by an increase in expected inflation is not the same as an increase in inflation.  Rather it is a once-and-for all adjustment in the relative values of physical assets and money associated with the inflation-induced shift in desired asset holdings.  If inflation stabilizes at the newly expected rate, commodities prices will not continue to rise faster than the rate of inflation (for purposes of this exercise I am assuming that inflation is uniform across all good and services).  But this also means that measured inflation will tend to overshoot the new higher expected steady-state rate of inflation.  I note again that other factors probably contributed to the temporary spike in inflation, but increased inflation expectations, in and of themselves, tend to cause a transitional measured rate of inflation above the new expected rate.

The distinction between steady-state inflation on the one hand and a once-and-for-all increase in prices (apart from the expected increase in inflation) on the other may clarify one of the most puzzling (for me at any rate) passages in the General Theory (p. 142) in which Keynes criticizes Fisher’s distinction between the real and nominal rates of interest.  After observing that an expected reduction (increase) in the value of money would tend to raise (depress) the marginal efficiency of capital curve, Keynes goes on to make the following comment on Fisher:

This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money.  It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen.  [The latter comment is itself a curious statement by Keynes inasmuch as Fisher was totally explicit in basing the distinction on foreseen changes in the value of money.]  There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalised, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. 

Keynes, referring to changes in the value of money, seems to have had in mind a once-and-for-all change in the price level rather than a change in the rate of change in the price level (i.e. a change in the rate of inflation).  Fisher, however, when discussing the distinction between the real and the nominal rates of interest, was clearly analyzing changes in the rate of inflation .  There is a lot more to be said about Keynes’s views on the effect of inflation (or changes in the price level) on the rate of interest and other macroeconomic variables, but this simple point may help to achieve some sort of reconciliation between Fisher’s and Keynes’s views on the rate of interest.  Allyn Cottrell wrote a very interesting paper on the subject many years ago.  A couple of years ago this subject came up on Scott Sumner’s blog, and Kevin Donoghue was helpful to me in understanding what Keynes was saying.  By the way I seem to recall that in the Treatise on Money, Keynes accepted Fisher’s distinction without quibble.  If Kevin is out there and would care to weigh in on the subject, I would be glad to hear from him.

In Thursday’s (October 13, 2011) Financial Times, Tim Bond, investment strategist at Odey Asset Management, wrote a column welcoming “a world without QE.”  Acknowledging that equity markets around the world were disappointed by the failure of the Fed to restore a program of monetary easing, some form of QE3, Mr. Bond contends that the reaction was “myopic and mistaken,” calling QE2 “a mistake with problematic unintended consequences.”  He explains:

The underlying defect in QE is that it stirred investors’ fears of monetary inflation, whilst stimulating the wrong sort of inflation in the wrong places. The early positive economic effects were subsequently overwhelmed by a negative inflationary blowback that played a key role in disrupting the recovery.

This is a rather different take from mine, which is that investors don’t fear inflation, they yearn for it, as evidenced by the strikingly positive correlation, since spring 2008, shortly after the downturn starting the previous December, between changes in the TIPS breakeven spread and changes in the S&P 500 .  (I have presented  evidence for this correlation, based on data through the end of 2010, in my paper “The Fisher Effect Under Deflationary Expectations” available here, and I explained why the stock market loves inflation in this posting.)

Intimating that the rise in commodity prices prompted by the QE2-induced expectation of rising inflation took everyone, especially policy makers, by surprise, Mr. Bond observes that “fears (my italics) of monetary inflation prompted a widespread portfolio reallocation into commodities.”  However, a portfolio reallocation from holding cash to holding physical capital is a key element of a recovery from a sharp downturn such as we experienced in 2008, expectations of increasing returns from holding capital assets relative to returns from holding cash spurring investments in working capital (i.e., inventories, including raw materials, intermediate goods, and final goods) and in fixed capital (machines and structures).  Why this salutary reallocation constitutes “negative blowback” is not explained, Mr. Bond apparently considering the adverse nature of any increase in commodity prices too obvious to require any elucidation on his part.

But  the “more important flaw in QE,” according to Mr. Bond,was that it “stimulated large financial flows into China and other emerging market (EM) economies, as investors sought a higher-yielding, hard currency alternative to the dollar.”  These hot money flows fueled an unwanted credit expansion in China, triggering a sharp rise in inflation and a real-estate bubble.  Rising inflation in China added to the pressure on commodity prices, boosting global inflation.  The increase in global inflation, in Bond’s view, is responsible “for the sharp slowdown in global growth since the start of the year,” presumably because “higher inflation eroded household incomes and demand at a time of very slow nominal income growth.”  The credit bubble forced the Chinese authorities to tighten policy, producing a slowdown in Chinese economic growth.

Mr. Bond attributes large recent money flows into China to a desire to avoid a depreciating US dollar.  That is a superficial view.  Large quantities of dollars have been flowing into China for over a decade, especially from about 2002 to 2007.  The primary cause of those dollar flows was a desire by China to accumulate foreign exchange and to promote Chinese exports (the two are closely related and it is not clear which desire is the more fundamental) by limiting the increase in Chinese consumption.  Criticism of China’s exchange-rate policy of pegging the yuan exchange rate against the dollar mistakenly focuses on the fixed nominal exchange rate between the yuan and the dollar.  That focus is misguided.  A fixed nominal exchange rate did not force China to limit the growth of Chinese consumer demand and to accumulate huge hoards of foreign exchange.  A more balanced Chinese monetary policy than that which has been followed (though the policy seems to have been moderated in the last couple of years) would, even with a fixed yuan-dollar exchange rate, have allowed Chinese wages to rise more rapidly than they did, fostering rapid growth in the non-tradable-goods sector in China rather than forcing all the growth into the tradable-goods sector.  The rapid increase in Chinese property values, mistakenly called a bubble by Mr. Bond, reflects the underinvestment by the Chinese in their domestic housing stock, not an inflationary real-estate boom, and certainly not a boom fueled by the modest QE2 program pursued by the Fed for only about 8 months.  To attribute recent hot money flows from the US to China to an increase in expected US inflation ignores the simple fact that if economic growth and, hence, real interest rates in China are much higher than in the US, cash will be drawn, one way or another, from the US to China pretty much irrespective of what the US rate of inflation is.  Even if some of the dollar flow to China is driven by speculation on an appreciation of the yuan, it is hardly clear how much of a role QE2, or QE3 if it were to happen,would play in the decision to raise the value of the yuan.

Mr. Bond confidently posits an almost immediate connection between increased inflation and reduced growth since the start of 2011, but the closest he comes to providing an explanation for this connection, lacking any basis in economic theory detectable by me, is that “higher inflation eroded household incomes and demand at a time of very slow economic growth.”  Obviously begging the question of how nominal income is determined, Mr. Bond evidently is suggesting that nominal income is determined by factors independent of monetary policy.  But if monetary has no effect on nominal income, the question then presents itself :  how is it that QE2 could have caused commodity prices to rise in the first place?

If Mr. Bond is prepared to assert both that QE2 raised commodity prices and that QE2 did not raise nominal income, he is a brave soul indeed.  Bravery is undoubtedly a virtue, and compensates for many shortcomings. Defective logic, however, is not one of them.  The audacity of confusion has its limits.