Archive for November, 2011

Once Again The Stock Market Shows its Love for Inflation

The S&P 500 rose by 4% today on news that the Federal Reserve System and other central banks were taking steps to provide liquidity to banks, especially European banks with heavy exposure to sovereign debt issued by countries in the Eurozone. Other stock markets in Europe and Asia also rose sharply, and the euro rose about 1% against the dollar.

What was encouraging about today’s announcement was that the news reflected coordination and cooperation among the world’s leading central banks, sending a positive signal that central bankers were capable of working in concert to stabilize monetary conditions. One other point worth noting, already mentioned by Scott Sumner, is that the provision of liquidity so much welcomed by the markets was associated with rising, not falling interest rates, confirming that under current conditions, monetary ease works not by reducing, but by raising, nominal interest rates.

It is worth drilling down just a bit deeper to see what caused the increase in interest rates. I like to focus on the 5- and 10-year constant maturity Treasuries, and the corresponding 5- and 10-year constant maturity TIPS bonds from which one can infer an estimate of real interest rates. The yield on the 5-year Treasury rose by 3 basis points from 0.93% to 0.96%. At the same time the yield on the 5-year TIPS fell from -0.77% to -0.80%, so that the breakeven TIPS spread, an estimate (or, according to the Cleveland Federal Reserve Bank, more likely a slight overestimate) of inflation expectations, rose 1.70% to 1.76%. What that says is that, even though the nominal interest rate was rising, inflation expectations were rising even faster, so that the real interest rate was falling even deeper into negative territory. The negative real interest rate provides a measure of how pessimistic investors are about the profitability of investment. Poor profit expectations (flagging animal spirits in Keynesian terminology) are a drag on investment, but that is exactly why rising expectations of inflation can induce additional real investment to take place, despite investor pessimism. As expected inflation rises, additional not so profitable real investment opportunities, become worth undertaking, because the negative return on holding cash makes investing in real capital less unattractive than just holding cash or other low-yielding financial instruments. The profitability of additional real investment projects will increase economic activity and output , raising future income levels, which is why the stock market rose even as real interest rates fell.  (For more on the underlying theory and the empirical evidence supporting it, see my paper “The Fisher Effect under Deflationary Expectations” here.)

Now let’s look at the 10-year constant maturity Treasury and the 10-year constant maturity TIPS bond. The yield on the 10-year Treasury rose 8 basis points from 2% to 2.08%, while the yield on the 10-year TIPS rose from 0.01% to 0.03%, implying an increase in the breakeven TIPS spread from 1.99% to 2.05%. At both 5- and 10-year time horizons, inflation expectations rose by 6 basis points. But the difference is that real interest rates rose over a 10-year time horizon even though real interest rates fell over a 5-year time horizon. That suggests that the markets are projecting improved long-run prospects for profitable investment as a result of higher inflation. That was just the relationship that we observed a year ago after the start of QE2, when inflation expectations were rising and nominal interest rates were rising even faster, when investors’ projections for future profit opportunities were becoming increasingly positive. After a rough 2011, that still seems to be the way that markets are reacting to prospects for rising inflation.

In its story on the stock-market rally, the New York Times wrote:

Market indexes gained more than 4 percent after central banks acted to contain the debt crisis in the euro zone. But a half-dozen similar rallies in the last 18 months have quickly withered.

What unfortunately has happened is that each time the markets start to expect enough inflation to get a real recovery going, the inflation hawks on the FOMC throw a tantrum and make sure that we get the inflation rate back down again. Will they prevail yet again? For Heaven’s sake, let’s hope not.

The Tender-Hearted Prof. Sumner Gives Mises and Hayek a Pass

Scott Sumner is such a kindly soul. You can count on him to give everyone the benefit of the doubt, bending over backwards to find a way to make sense out of the most ridiculous statement that you can imagine. Even when he disagrees, he expresses his disagreement in the mildest possible terms. And if you don’t believe me, just ask Paul Krugman, about whom Scott, despite their occasional disagreements, always finds a way to say something nice and complimentary. I have no doubt that if you were fortunate enough to take one of Scott’s courses at Bentley, you could certainly count on getting at least a B+ if you showed up for class and handed in your homework, because Scott is the kind of guy who just would not want to hurt anyone’s feelings, not even a not very interested student. In other words, Scott is the very model of a modern major general – er, I mean, of a modern sensitive male.

But I am afraid that Scott has finally let his niceness get totally out of hand. In his latest post “The myth at the heart of internet Austrianism,” Scott ever so gently points out a number of really serious (as in fatal) flaws in Austrian Business Cycle Theory, especially as an explanation of the Great Depression, which it totally misdiagnosed, wrongly attributing the downturn to a crisis caused by inflationary monetary policy, and for which it prescribed a disastrously mistaken remedy, namely, allowing deflation to run its course as a purgatory of the malinvestments undertaken in the preceding boom. Scott certainly deserves a pat on the back for trying to shed some light on a subject as fraught with fallacy and folly as Austrian Business Cycle Theory, but unfortunately Scott’s niceness got the better of him when he made the following introductory disclaimer:

This post is not about Austrian economics, a field I know relatively little about. [Scott is not just nice, he is also modest and self-effacing to a fault, DG] Rather it is a response to dozens of comments I have received by people who claim to represent the Austrian viewpoint.

And then after his partial listing of the problems with Austrian Business Cycle Theory, Scott just couldn’t help softening the blow with the following comment.

Austrian monetary economics has some great ideas – most notably NGDP targeting. I wish internet Austrians would pay more attention to Hayek, and less attention to whoever is telling them that the Depression was triggered by the collapse of an inflationary bubble during the 1920s. There was no inflationary bubble, by any reasonable definition of the world “inflation.”

Scott greatly admires Hayek (as do I), so he sincerely wants to believe that the mistakes of Austrian Business Cycle Theory are not Hayek’s fault, but are the invention of some nasty inauthentic Internet Austrians. In fact, because in a few places Hayek seemed to understand that an increased demand for money (aka a reduction in the velocity of circulation) would cause a reduction in total spending (aggregate demand or nominal income) unless matched by an increased quantity of money, acknowledging that, at least in principle, the neutral monetary policy he favored should not hold the stock of money constant, but should aim at a constant level of total spending (aggregate demand or nominal income), Scott wants to absolve Hayek from responsibility for the really bad (as in horrendous) policy advice he offered in the 1930s, opposing reflation and any efforts to increase spending by deliberately increasing the stock of money. During the Great Depression, Hayek’s recognition that in principle the objective of monetary policy ought to be to stabilize total spending was more in the way of a theoretical nuance than a bedrock principle of monetary policy. The recognition is buried in chapter four of Prices and Production. The tenor of his remarks and the uselessness of his recognition in principle that total spending should be stabilized are well illustrated by the following remark at the beginning of the final section of the chapter

Anybody who is sceptical of the value of theoretical analysis if it does not result in practical suggestions for economic policy will probably be deeply disappointed by the small return of so prolonged an argument.

Then in the 1932 preface to the English translation of his Monetary Theory and the Trade Cycle, Hayek wrote the following nugget:

Far from following a deflationary policy, Central Banks, particularly in the United States, have been making earlier and more far reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion – with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices which existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. (pp. 19-20)

And then Hayek came to this staggering conclusion (which is the constant refrain of all Internet Austrians):

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind which has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve system in 1927, an experiment which Mr. A. C. Miller, the only economist on the Federal Reserve Board [the Charles Plosser of his time, DG] and, at the same time, its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal reserve system”, an operation which “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years”. It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world [like, say, France for instance? DG] has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown. [OMG, DG] (pp. 21-22)

That the orthodox Austrian (espoused by Mises, Hayek, Haberler, and Machlup) view at the time was that the Great Depression was caused by an inflationary monetary policy administered by the Federal Reserve in concert with other central banks at the time is clearly shown by the following quotation from Lionel Robbins’s book The Great Depression. Robbins, one of the great English economists of the twentieth century, became a long-distance disciple of Mises and Hayek in the 1920s and was personally responsible for Hayek’s invitation to deliver his lectures (eventually published as Prices and Production) on Austrian Business Cycle Theory at the London School of Economics in 1931, and after their huge success, arranged for Hayek to be offered a chair in economic theory at LSE. Robbins published his book on the Great Depression in 1934 while still very much under the influence of Mises and Hayek. He subsequently changed his views, publicly disavowing the book, refusing to allow it to be reprinted in his lifetime.

Thus in the last analysis, it was deliberate co-operation between Central bankers, deliberate “reflation” on the part of the Federal Reserve authorities, which produced the worst phase of this stupendous fluctuation. Far from showing the indifference to prevalent trends of opinion, of which they have so often been accused, it seems that they had learnt the lesson only too well. It was not old-fashioned practice but new-fashioned theory which was responsible for the excesses of the American disaster. (p. 54)

Like Robbins, Haberler and Machlup, who went on to stellar academic careers in the USA, also disavowed their early espousal of ABCT. Mises, unable to tolerate apostasy on the part of traitorous erstwhile disciples, stopped speaking to them. Hayek, though never disavowing his earlier views as Robbins, Haberler, and Machlup had, acknowledged that he had been mistaken in not forthrightly supporting a policy of stabilizing total spending. Mises was probably unhappy with Hayek for his partial u-turn, but continued speaking to him nevertheless. Of course, Internet Austrians like Thomas Woods, whose book Meltdown was a best-seller and helped fuel the revival of Austrianism after the 2008 crisis, feel no shame in citing the works of Hayek, Haberler, Machlup, and Robbins about the Great Depression that they later disavowed in whole or in part, without disclosing that the authors of the works being cited changed or even rejected the views for which they were being cited.

So I am sorry to have to tell Scott: “I know it’s hard for you, but stop trying to be nice to Mises and Hayek. They were great economists, but they got the Great Depression all wrong. Don’t try to sugarcoat it. It can’t be done.”

In Praise of Gustav Cassel

When I started this blog almost 5 months ago, I decided to highlight my intellectual debt to Ralph Hawtrey by emblazoning his picture (to the annoyance of some – sorry, but deal with it) on the border of the blog and giving the blog an alias ( to go along with its primary name. I came to realize Hawtrey’s importance when, sometime after being exposed as a graduate student to Earl Thompson’s monetary, but anti-Monetarist (in the Friedmanian sense), theory of the Great Depression, according to which the Depression was caused by a big increase in the world’s monetary demand for gold in the late 1920s when many countries, especially France, almost simultaneously rejoined the gold standard, driving down the international price level, causing ruinous deflation. Thompson developed his theory independently, and I assumed that his insight was unprecedented, so it was a surprise when (I can’t remember exactly how or when) I discovered that Ralph Hawtrey (by the 1970s a semi-forgotten fugure in the history of monetary thought) had developed Thompson’s theory years earlier. Not only that, but I found that Hawtrey had developed the theory before the fact, and had predicted almost immediately after World War I exactly what would happen if restoration of the gold standard (effectively suspended during World War I) was mismanaged, producing a large increase in the international monetary demand for gold.  It dawned on me that there was a major intellectual puzzle, how was it that Hawtrey’s theory of the Great Depression had been so thoroughly forgotten (or ignored) by the entire economics profession.

A few years later, in a conversation with my old graduate school buddy, Ron Batchelder, also a student of Thompson, I mentioned to him that Earl’s theory of the Great Depression had actually been anticipated right after World War I by Ralph Hawtrey. Batchelder then told me that he had discovered that Earl’s theory had also been anticipated by the great Swedish economist, Gustav Cassel, who also had been warning during the 1920s that a depression could result from an increased monetary demand for gold. That was the genesis of the paper that Ron and I wrote many years ago, “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” Ron and I wrote the paper in 1991, but always planning to do one more revision, we have submitted it for publication. I am hoping finally to do another revision in the next month or so and then submit it. An early draft is still available as a UCLA working paper, and I will post the revised version on the SSRN website. Scott Sumner wrote a blog post about the paper almost two years ago.

At any rate, when I started the blog, I had a bit of a guilty conscience for not giving Cassel his due as well as Hawtrey. I suppose that I prefer Hawtrey’s theoretical formulations, emphasizing the law of one price rather than the price-specie-flow mechanism, and the endogeneity of the money supply to Cassel’s formulations which are closer to the standard quantity theory than I feel comfortable with. But the substantive differences between Hawtrey and Cassel were almost nil, and both of these estimable scholars and gentlemen are deserving of all the posthumous glory that can be bestowed on them, and then some.

So, with that lengthy introduction, I am happy to give a shout-out to Doug Irwin who has just written a paper “Anticipating the Great Depression? Gustav Cassel’s Analysis of the Interwar Gold Standard.” Doug provides detailed documentation of Cassel’s many warnings before the fact about the potentially disastrous consequences of not effectively controlling the international demand for gold during the 1920s as countries returned to the gold standard, of his identification as they were taking place of the misguided policies adopted by the Bank of France and the Federal Reserve Board that guaranteed that the world would be plunged into a catastrophic depression, and his brave and lonely battle to persuade the international community to abandon the gold standard as the indispensable prerequisite for recovery.

Here is a quotation from Cassel on p. 19 Doug’s paper:

All sorts of disturbances and maladjustments have contributed to the present crisis. But it is difficult to see why they should have brought about a fall of the general level of commodity prices. . . . A restriction of the means of payment has caused a fall of the general level of commodity prices – a deflation has taken place. But people shut their eyes to what is going on in the monetary sphere and pay attention only to the other disturbances.

Another quote from Cassel appears in footnote 21 (pp. 31-32). Here is the entire footnote:

Before accepting the view that monetary policy was impotent, Cassel insisted that “we should make sure that the necessary measures have been applied with sufficient resoluteness. A central bank ought not to stop its purchases of Government securities just at the moment when such purchases could be expected to exercise a direct influence on the volume of active purchasing power. If it is stated in advance that [the?]central bank intends to go on supplying means of payment until a certain rise in the general level of prices has been brought about, the result will doubtless be much easier to attain.”

On top of all that, the paper is a pleasure to read, providing many interesting bits of personal and historical information as well as a number of valuable observations on Cassel’s relationships with Keynes and Hayek. In other words, it’s a must read.

What Are They Thinking?

The common European currency seems well on its way toward annihilation, and the demise is more likely to happen with a bang than a whimper. One might have thought that the looming catastrophe would elicit a sense of urgency in the statements and actions of European officials. “Depend upon it, sir,” Samuel Johnson once told Boswell, “when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” So far, however, there is little evidence that minds are being concentrated, least of all the minds of those who really count, Chancellor Merkel and the European Central Bank (ECB).

As I pointed out in a previous post in August, the main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries. Even worse, stagnating incomes impose added borrowing requirements on governments to cover expanding fiscal deficits. When a private borrower, having borrowed in expectation of increased future income, becomes insolvent, regaining solvency just by reducing expenditures is rarely possible. So if the borrower’s income doesn’t increase, the options are usually default and bankruptcy or a negotiated write down of the borrower’s indebtedness to creditors. A community or a country is even less likely than an individual to regain solvency through austerity, because the reduced spending of one person diminishes the incomes earned by others (the paradox of thrift), meaning that austerity may impair the income-earning, and, hence, the debt-repaying, capacity of the community as a whole.

I reproduce below a new version of the table that I included in my August post. It shows that from the third quarter of 2009 to the first quarter of 2011, NGDP for the Eurozone as a whole increased at the anemic rate of 2.95%. Eight countries (Luxembourg, Malta, Austria, Finland, Belgium, Slovakia, Germany, and the Netherlands) grew faster than the Eurozone as a whole, and eight countries (France, Italy, Portugal, Cyprus, Spain, Slovenia, Greece, and Ireland) grew less rapidly than the Eurozone as a whole. Guess which of the two groups the countries with debt problems are in. I have now added NGDP growth rates for the first, second and (where available) third quarters.

Comparing NGDP growth rates in Q1 with growth rates in Q2 and Q3 is instructive inasmuch as the ECB raised its benchmark interest rates by 25 basis points at the start of Q2 (April 13). In Q1, Eurozone NGDP rose by 5.01%, but in Q2, Eurozone NGDP growth fell to just 2.17%, with Q2 NDGP growth less than Q1 growth in every Eurozone country except Slovakia and Cyprus (Greece not yet reporting NGDP for Q2). On July 13, the ECB raised its benchmark interest rates by another 25 basis points. For the five countries (Austria, France, Germany, Netherlands, and Spain) already reporting NGDP growth for Q3, four had slower NGDP growth in Q3 than in Q1, with three reporting slower NGDP growth in Q3 than the average between Q3 2009 and Q1 2011. Rebecca Wilder has an important recent post with graph showing that the spreads between bonds issued by Belgium, Italy and Spain and bonds issued by Germany began increasing almost immediately after the ECB announced the increase in its benchmark interest rates on April 13, with the spreads continuing to increase in Q3. The connection between monetary policy, NGDP growth and the debt crisis could not be any more plain.

Nevertheless, there are those (and not just the Wall Street Journal) that seem to find merit in the unyielding stance of the Mrs. Merkel and the ECB. In his column last week in the Financial Times, John Kay, usually an insightful and sensible commentator, compares bailing out the insolvent Eurozone countries with a martingale strategy in which a bettor increases his bet each time he loses, in the expectation that he will eventually win enough to pay off his losses. Such a strategy only works if one has deep enough pockets to sustain the losses while waiting for a lucky strike. The problem in John Kay’s view is that the other side (the rest of the world) has deeper and can raise the ante to an intolerable level. Here is how Kay sums up the current situation:

Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more.

Up to a point. Money created by a central bank is not free – if it were, we could all be as rich as Croesus. The resources of a monetary agency come either directly from taxpayers or indirectly from everyone through general inflation. To fund the bet the ECB would have to stand ready to buy, not just every Eurozone government bond issued so far, but any that might be issued. And more. . . .

Of course, say the advocates of this course, if only the banker would promise to underwrite our losses he would not actually have to pay. If you will only lend me a bit more money, says the gambler, you will get it all back, and more. That is the seductive song of the martingale.

The difference, of course, is that gambling is a zero-sum game. When the ECB is asked to print more money, the point is not to lend money with which insolvent governments can place a bet in the hope of winning enough to repay what they owe; the point is to create an economic environment conducive to growth. The inflation that John Kay finds so scary is actually the last best hope for all those creditors holding the sovereign debt of five or more Eurozone countries, debt increasingly unlikely, thanks to Mrs. Merkel and the ECB, ever to be repaid.

Before leaving the subject of inflation, I will make one further comment on German inflation-phobia. It is certainly true that the German hyperinflation of 1923-24 was a traumatic event in German history, undoubtedly leaving a deep imprint on the German national memory. Although a deep aversion to inflation has been a constant feature of German economic policy since World War II, it is also true that inflation in Germany for the past three years has been at or near its lowest level since the end of World War II. Nor is there much doubt that German inflation hawkishness has increased since the creation of the ECB, Germans becoming more sensitive about the danger of inflation created by a non-German institution than they were about inflation produced by the good old German Bundesbank. Conversely, the ECB has been all too eager to show that it can be even more hawkish on inflation than even a German central bank.

But have a look at German inflation in historical context. Here are two charts presenting German CPI. The first shows the annual change in the CPI in Germany from 1951 to 2009.

The second shows the year-on-year change in the CPI by month from January 1961 to October 2011.

The charts are instructive in showing that even in the heyday of the German Wirtschaftswunder from 1950 to 1966 under conservative governments headed by Konrad Adenauer and then by Ludwig Erhard (friend and disciple of Hayek, member of the Mont Pelerin Society, and the acknowledged architect of the Wirtschaftswunder) the rate of inflation was often above 3%. For long stretches of time since 1950, Germany has had inflation above 3%, sometimes over 5%, nevertheless managing to avoid the political and economic disasters that, we are now told, supposedly follow inexorably whenever inflation exceeds 2%.

A similar story is told by the third chart showing the German GDP price deflator measured quarterly since 1971. The price deflator is now running at the lowest rates in 40 years.

Is the risk to the German economy from a rate of inflation closer to the mean rate of the last 40 years, say 3-4%, really so intolerable? What are they thinking?


Sorry to have to do this, but I discovered a serious error in the table in my post from August on the European crisis.  I have inserted a new revised table correcting and updating the growth rates in the eurozone countries since 2008 and 2009.  I had hoped to post something new on the European crisis before Thanksgiving, but I have been struggling to correct and update the old table before I could get around to writing up something new on the European situation.  Perhaps I’ll have something ready over the weekend.  Again, my apologies.

Rules v. Discretion

I gave a talk this afternoon at a panel on the Heritage of Monetary Economics and Macroeconomics at the meetings of the Southern Economic Association in Washington. The panel was brought together to commemorate a confluence of significant anniversaries this year: the 300th anniversary of David Hume’s birth, the 200th anniversary of the publication of the Bullion Report to the British Parliament, the 100th anniversary of the publication of Irving Fisher’s Purchasing Power of Money, the 75th anniversary of the publication of Keynes’s General Theory, and the 50th anniversary of the publication of John Muth’s paper on rational expectations. I spoke about the Bullion Report and the contributions of classical monetary theory. At some point, I may post the entire paper on SSRN, but I thought that the section of my paper on rules versus discretion in monetary policy might be of interest to readers of the blog, so here is an abridged version of that section of my paper.

The Bullion Report, whose 200th anniversary we are observing, is an appropriate point from which to start a discussion of the classical contribution to the perpetual debate over rules versus discretion in the conduct of monetary policy. The Bullion Report contained an extended discussion of several important theoretical issues, but its official purpose was to recommend an early resumption of convertibility (suspended since 1797) of Bank of England banknotes, to make them redeemable again at a fixed parity in terms of gold. In other words, the Bullion Report called for a rapid return to the gold standard, then regarded as a safe and workable rule for the conduct of monetary policy.

Despite the rejection by Parliament of the Report’s recommendation to quickly restore the gold standard, the general argument of the Bullion Report for the gold standard undoubtedly influenced the ultimate decision to restore the gold standard after the Napoleonic Wars. But full restoration of gold standard in 1821 did not produce the promised monetary stability, with ongoing disturbances punctuated by financial crises every 10 years or so, in 1825, 1836, 1847, 1857 and 1866. The result of the early disturbances was the adoption of new rules motivated by the idea that monetary disturbances were symptomatic of the failure of a mixed (gold and paper) currency to fluctuate exactly as a purely metallic currency would have.

These new rules seem to me to have been altogether misguided and pernicious, but their adoption reflected a fear that the simple rule embodying the gold standard, the requirement that banknotes be convertible into gold, would not ensure monetary stability unless supplemented by further rules limiting the creation of banknotes by the banks. The rules had to be tightened and spelled out in increasing detail to effectively limit the discretion of the bankers and prevent them from engaging in the destabilizing behavior that they would otherwise engage in.

Thus, over the course of the nineteenth century, there evolved a conception of the rules of the game governing the behavior of the monetary authorities under gold standard. However, the historical record is far from clear on the extent to which the rules of the game were actually observed. The record of equivocal adherence by the monetary authorities under the gold standard to the rules of the game can be interpreted to mean either that the rules of the game were unworkable or irrelevant — in which case following the rules would have been destabilizing — or that it was the failure to follow the rules of the game that caused the instabilities observed even in the heyday of the international gold standard (1880-1914).

The outbreak of World War I led quickly to the effective suspension of the international gold. The prestige of the gold standard was such that hardly anyone questioned the objective of restoring it after the war.  However, there was an increasing understanding that the assumption that the gold standard was the simplest and most effective arrangement by which to achieve price-level stability was unlikely to be valid in the post-war environment. Ralph Hawtrey and Gustav Cassel were especially emphatic after the war about the deflationary dangers associated with restoring the international gold standard unless measures were taken to reduce the monetary demand for gold as countries went back on the gold standard. As a result, the 1920s literature on monetary policy contain frequent derogatory references by supporters of the orthodox gold standard to supporters of managed money, i.e., to advocates of using monetary policy to stabilize prices rather than accept whatever price level was generated by allowing the gold standard to operate according to the rules of the game.

Advocates of price-level stabilization, especially Hawtrey and Cassel, attributed the Great Depression to a failure to manage the gold standard in a way that prevented a sharp increase in the worldwide monetary demand for gold after France, followed by a number of other countries, rejoined the gold standard in 1928 and began redeeming foreign exchange holdings for gold. It was at just this point that the Federal Reserve, having followed a somewhat accommodative policy since 1925, shifted to a tighter policy in late 1928 out of concern with stock-market speculation supposedly fueling a bubble in stock prices. Supporters of the traditional gold standard blamed the crisis on the “inflationary” policies of the Federal Reserve which prevented the “natural” deflation that would otherwise have started in 1927.

Supporters of the traditional gold standard thought that they were upholding the classical tradition of a monetary policy governed by rules not discretion. But Hawtrey and Cassel were not advocates of unlimited policy discretion; they believed that the gold standard ought to be managed by the leading central banks with an understanding of how their policies jointly would determine the international price level and that they should therefore do what was necessary to avoid the deflation to which the world economy was dangerously susceptible because of the rapidly increasing monetary demand for gold.

The Keynesian Revolution after the Great Depression provided a rationale for not allowing policy rules (e.g., keeping the government’s budget balanced, or keeping an exchange rate or an internal price level constant) to preclude taking fiscal or monetary actions designed to increase employment. Achieving full employment by controlling aggregate spending by manipulating fiscal and monetary instruments became the explicit goal of economic policy for the first time. The gold standard having been effectively discredited, opponents of discretionary policies had to search for an alternative rule in terms of which they could take a principled stand against discretionary Keynesian policies. A natural rule to specify would have been to stabilize a price index, as Irving Fisher had proposed after World War I, with his plan for a compensated dollar based on adjusting the price of gold at which the dollar would be made convertible as necessary to keep the price level constant. But Fisher’s plan was too complicated for laymen to understand, and Milton Friedman, the dominant anti-Keynesian of the 1950s and 1960s, preferred to formulate a monetary rule in terms of the quantity of money, perhaps reflecting the Currency School bias for quantitative rules he inherited from his teacher at Chicago Lloyd Mints. A quantitative rule, Friedman argued, imposes a tighter, more direct, constraint on the actions of the central bank than a price-level rule.

The attempt by the Federal Reserve under Paul Volcker to implement a strict Monetarist control over the growth of the money aggregates proved unsuccessful even though the Fed succeeded in its ultimate goal of reducing inflation. Friedman himself, observing the rapid growth of the monetary aggregates, after inflation had been brought down, predicted that inflation would soon rise again to near double-digit rates. That error marked the end of Monetarism as a serious guide to conducting monetary policy.

However, traditional Keynesian prescriptions were, by then, no longer fashionable either, and we entered a two-decade period in which monetary policy aimed at a gradually declining inflation target, falling from 3.5% in the late 1980s to about 2% at present. The instrument used to achieve the inflation target was the traditional pre-Keynesian instrument of the bank rate. John Taylor suggested a rule for setting the bank rate based on the target inflation rate and the gap between actual and potential output that seemed consistent with the recent behavior of the Fed and other central banks. Everything seemed to be going well, and central banks basked in a glow of general approval and gratitude for achieving what was called the Great Moderation. But, perhaps because the Fed didn’t follow the Taylor rule for a few years after the dot-com bubble and the 9/11 attack, there was a housing bubble and then a recession and then a financial crisis, and we now find ourselves mired in the worst recession – actually a Little Depression — since the Great Depression.

The classical monetary theorists, with very few exceptions, believed in some sort of monetary rule, for the most part, either a simple gold standard governed only by the obligation to maintain convertibility or a gold standard hedged in by a variety of rules specifying the appropriate adjustments. Only a few classical economists had other ideas about a monetary regime, and of these they were also rule-based systems such as bimetallism or some form of a tabular standard. The idea of a purely discretionary regime unconstrained by any rule was generally beyond their comprehension.

The problem, for which we as yet have no solution, is that it is dangerous to formulate a rule governing monetary policy if one doesn’t have a fully adequate model of the economy and of the monetary system for which the rule is supposed to determine policy. Ever since the nineteenth century, monetary reformers have been proposing rules to govern policy whose effects they have grossly misunderstood. The Currency School erroneously believed that monetary and financial crises were caused by the failure of a mixed currency to fluctuate in exactly the same way as a purely metallic currency would have. The attempt to impose such a rule simply aggravated the crises to which any gold standard was naturally subject as a result of more or less random fluctuations in the value of gold. The Great Depression was caused by a misguided attempt to recreate the prewar gold standard without taking into account the effect that restoring the gold standard would have on the value of gold. A Monetarist rule to control the rate of growth of the money supply was nearly impossible to implement, because Monetarists stubbornly believed that the demand for money was extremely stable and almost unaffected by the rate of interest so that a steady rate of growth in the money supply was a necessary and sufficient condition for achieving the maximum degree of macroeconomic stability monetary policy was capable of.

After those failures, it was thought that a policy of inflation targeting would achieve macroeconomic stability. But there are two problems with inflation targeting. First, it calls for a perverse response to supply shocks, adding stimulus when a positive productivity shock speeds economic growth and reduces inflation, and reducing aggregate demand when a negative supply shock reduces economic growth and increases inflation. Thus, in one of the greatest monetary policy mistakes since the Great Depression, the FOMC stubbornly tightened policy for most of 2008, because negative supply shocks were driving up commodities prices, causing fears that inflation expectations would become unanchored. The result was an accelerating downturn in the summer of 2008, producing deflationary expectations that precipitated a financial panic and a crash in asset prices.

Second, even without a specific supply shock, if profit expectations worsen sufficiently, causing equilibrium real short-term interest rates to go negative, the only way to avoid a financial crisis is for the rate of inflation to increase sufficiently to allow the real short term interest rate to drop to the equilibrium level. If inflation doesn’t increase sufficiently to allow the real interest rate to drop to its equilibrium level, the expected rate of return on holding cash will exceed the expected return from holding capital causing a crash in asset prices, just what happened in October 2008.

Some of us are hoping that targeting nominal GDP may be an improvement over the rules that have been followed to date.  But the historical record, at any rate, does not offer much comfort to anyone who believes that adopting a following a simple rule is the answer to our monetary ills.

Watching the CPI Can Get You into Deep Trouble

This post is just a footnote to Marcus Nunes’s demolition of Glenn Hubbard’s recent comments on Fed policy, pointing out that Hubbard, as late as July 2008 when the US economy was rapidly contracting in the run-up to the impending financial crisis, was warning that monetary policy was too easy. OMG he though monetary policy was too easy in 2008! Just to put things into a little clearer perspective, here is a comparison of the monthly year on year change in the CPI in 2008 and 2011.

As you can see, the monthly year-on-year change in the CPI, driven by rising oil and food prices, was running at over 5% in the summer of 2008, providing the inflation hawks on the FOMC with the ammunition they needed to keep the Fed from easing money in time to avert the financial catastrophe down the road. And now with inflation running 2 percentage points lower than it was in 2008 before the crash, we are again being warned that inflation is the problem. Plus ca change.

Nicholas Crafts on the Lessons of the 1930s

In Wednesday’s Financial Times, Nicholas Crafts, Professor of Economics at Warwick University, writes a superb op-ed “Fiscal stimulus is not our only option” explaining how an easy money policy worked for England in the 1930s, generating a 20% increase in real GDP between 1933 and 1937 despite fiscal retrenchment.  The op-ed summarizes a report (Delivering growth while reducing deficits:  Lessons from the 1930s) just published by the Centre Forum, a liberal think tank based in London.

Here is the opening paragraph:

The lessons of the 1930s are not well understood but are important. Britain enjoyed a strong recovery from the depression, with growth exceeding 3 per cent in each year between 1933 and 1937, despite a double-dip recession in 1932 and continuing turmoil in the international economy. Until 1936, growth owed nothing to rearmament. Indeed, as now, in the early 1930s the government was engaged in fiscal consolidation at a time of very precarious public finances, while from mid-1932 short-term interest rates were close to zero and could not be cut to deliver monetary stimulus. The parallels with today are clear, but today’s policymakers are unaware of the successful economic policy that revived growth. How did they pull this off 80 years ago – and could we do the same?

Crafts answers his question — correctly! — in the affirmative.

Some Unpleasant Fisherian Arithmetic

I have been arguing for the past four months on this blog and before that in my paper “The Fisher Effect Under Deflationary Expectations” (available here), that the Fisher equation which relates the nominal rate of interest to the real (inflation-adjusted) interest rate and to expected inflation conveys critical information about the future course of asset prices and the economy when the expected rate of deflation comes close to or exceeds the real rate of interest. When that happens, the expected return to holding cash is greater than the expected rate of return on real capital, inducing those holding real capital to try to liquidate their holdings in exchange for cash. The result is a crash in asset prices, such as we had in 2008 and early 2009, when expected inflation was either negative or very close to zero, and the expected return on real capital was negative. Ever since, expected inflation has been low, usually less than 2%, and the expected return on real capital has been in the neighborhood of zero or even negative. With the expected return on real capital so low, people (i.e., households and businesses) are reluctant to spend to acquire assets (either consumer durables or new plant and equipment), preferring to stay liquid while trying to reduce, or at least not add to, their indebtedness.

According to this way of thinking about the economy, a recovery can occur either because holding cash becomes less attractive or because holding real assets more attractive. Holding cash becomes less attractive if expected inflation rises; holding assets becomes more attractive if the expected cash flows associated with those real assets increase (either because expected demand is rising or because the productivity of capital is rising).

The attached chart plots expected inflation since January 2010 as measured by the breakeven 5-year TIPS spread on constant maturity Treasuries, and it plots the expected real return over a 5-year time horizon since January 2010 as reflected in the yield on constant maturity 5-year TIPS bonds.

In the late winter and early spring of 2010, real yields were rising even as inflation expectations were stable; stock prices were also rising and there were some encouraging signs of economic expansion. But in the late spring and summer of 2010, inflation expectations began to fall from 2% to less about 1.2% even as real yields started to drop.  With stock prices falling and amid fears of deflation and a renewed recession, the Fed felt compelled to adopt QE2, leading to an almost immediate increase in inflation expectations. At first, the increase in inflation expectations allowed real yields to drop, suggesting that expected yields on real assets had dropped further than implied by the narrowing TIPS spreads in the spring and summer. By late fall and winter, real yields reversed course and were rising along with inflation expectations, producing a substantial increase in stock prices. Rising optimism was reflected in a sharp increase in real yields to their highest levels in nearly a year in February of 2011. But the increase in real yields was quickly reversed by a combination of adverse supply side shocks that drove inflation expectations to their highest levels since the summer before the 2008 crash. However, after the termination of QE2, inflation expectations started sliding back towards the low levels of the summer before QE2 was adopted. The fall in inflation expectations was accompanied by an ominous fall in real yields and in stock prices.

Although suggestions that weakness in the economy might cause the Fed to resume some form of monetary easing seem to have caused some recovery in inflation expectations, real yields continue to fall. With real yield on capital well into negative territory (the real yield on a constant maturity 5-year TIPS bond is now around -1%, an astonishing circumstance. With real yields that low, 2% expected inflation would almost certainly not be enough to trigger a significant increase in spending. To generate a rebound in spending sufficient to spark a recovery, 3 to 4% inflation (the average rate of inflation in the recovery following the 1981-82 recovery in the golden age of Reagan) is probably the absolute minimum required.

Update:  Daniel Kuehn just posted an interesting comment on this post in his blog, correctly noting the conceptual similarity (if not identity) between the Fisher effect under deflationary expectations and the Keynesian liquidity trap.  I think that insight points to a solution of Keynes’s puzzling criticism of the Fisher effect in the General Theory even though he had previously endorsed Fisher’s reasoning in the Treatise on Money.

The Economic Consequences of Mrs. Merkel

Winston Churchill, in 1925 Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, was pressed by the Governor of the Bank of England, Montagu Norman, to restore the British pound to its pre-war parity of $4.86, thereby re-establishing the gold standard in Britain, paving the way for a general restoration of the international gold standard, one of the first casualties of war in August 1914. Having accumulated an enormous stockpile of gold in exchange for supplies it provided to the belligerents, US restored convertibility into gold soon after the end of hostilities, but sterling had depreciated against the dollar by about 25 percent after the war, so Britain could not achieve its goal of restoring the convertibility into gold at the prewar parity without a tight monetary policy aimed at raising the external value of the pound from about $4 to $4.86.

In 1925, sterling had risen to within about 10% of the old parity, making restoration of the pre-war dollar parity seem attainable, thus increasing the pressure from the London and the international financial communities to take the final steps toward the magic $4.86 level. Churchill understood that such a momentous step was both politically and economically dangerous and sought advice from a wide range of opinion, pro and con, both inside and outside government. The most persuasive advice he received was undoubtedly from J. M. Keynes, who, having served as a Treasury economist during World War I and then serving on the British delegation to the Versailles Peace Conference, became world famous after resigning from the Treasury to write The Economic Consequences of the Peace, his devastating critique of the Treaty of Versailles, protesting the overly harsh and economically untenable reparations obligations imposed on Germany. Keynes advised Churchill that the supposedly minimal 10% appreciation of sterling against the dollar would impose an intolerable burden on British workers, who had suffered from exceptionally high unemployment since the 1920-21 postwar deflation.

Despite Keynes’s powerful arguments, Churchill in the end followed the advice of the Bank of England and other members of the British financial establishment. Perhaps one argument that helped persuade him to follow the orthodox advice was that of another Treasury economist, the great Ralph Hawtrey, who submitted a paper analyzing the effects of restoring the prewar dollar parity. Hawtrey argued that Britain and the world would benefit from the restoration of an international gold standard, provided that the restoration was managed in a way that avoided the deflationary tendencies associated a remonetization of gold. Hawtrey suggested that there was reason to think that the institution that mattered most, the U.S. Federal Reserve, with its huge stockpile of gold, would follow a mildly inflationary policy allowing Britain to maintain the prewar parity without additional deflationary pressure. However, Hawtrey warned that if the US did not follow an accommodative policy, it would be a mistake and futile for Britain to defend the parity by deflating.

Keynes, who never suffered from a lack of self-confidence, undoubtedly thought that he had gotten the better of his opponents in presenting the case against restoring the prewar dollar parity to Churchill. When the decision went against him, he vented his outrage at the decision, and perhaps his own personal frustration, by writing a short pamphlet, The Economic Consequences of Mr. Churchill, a withering rhetorical assault on Churchill and the decision to restore the pre-war dollar parity. However, the consequences of the decision to restore the prewar parity were, at least initially, less devastating than Keynes predicted. Contrary to Keynes’s prediction, unemployment in Britain actually declined slightly in 1926 and 1927, falling below 10% for the first time in the 1920s. Hawtrey’s conjecture that the Federal Reserve, then led by the head of the New York Federal Reserve Bank, Benjamin Strong, would follow a mildly accommodative policy, alleviating the deflationary pressure on Britain, turned out to be correct. However, ill health forced Strong to resign in 1928 only months before his untimely death. His accommodative policy was reversed just as the Bank of France started accumulating gold, unleashing deflationary forces that had been contained since the deflation of 1920-21.

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

The only way to have saved the gold standard in 1930 would have been for France and the US to have radically changed their monetary policy to encourage an outflow of gold, driving down the international value of gold and reversing the deflation. Such a policy reversal, though advocated by Hawtrey and the great Swedish economist Gustav Cassel, was beyond the limited imagination of the world’s central bankers and monetary authorities at the time. But once started, the deflationary downward spiral did not stop until France, finally having had enough, abandoned gold in 1935. If the European central bank does not soon – and I mean really soon – grasp that there is no exit from the debt crisis without a reversal of monetary policy sufficient to enable nominal incomes in all the economies in the Eurozone to grow more rapidly than does their indebtedness, the downward spiral will overtake even the stronger European economies. (I pointed out three months ago that the European crisis is a NGDP crisis not a debt crisis.) As the weakest countries choose to ditch the euro and revert back to their own national currencies, the euro is likely to start to appreciate as it comes to resemble ever more closely the old deutschmark. At some point the deflationary pressures of a rising euro will cause even the Germans, like the French in 1935, to relent. But one shudders at the economic damage that will be inflicted until the Germans come to their senses. Only then will we be able to assess the full economic consequences of Mrs. Merkel.

About Me

David Glasner
Washington, DC

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

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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