Archive for December, 2011

Some Fallacies in the Interpretation of Inflation

In a post earlier this week I took reporter Jon Hilsenrath of the Wall Street Journal to task for asserting that the recent reduction in inflation was good news, because it meant that more money would be left in people’s pockets than if inflation hadn’t come down.

The real problem with that sentence is the unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is. I do not expect Mr. Hilsenrath to accept my theoretical position that, under current conditions, inflation would contribute to a speedup in the rate of growth in real income, but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.

Blogger Jonathan Catalan in turn took me to task in this post.

What Glasner seems to be arguing, though, is that because inflation amongst consumers’ goods necessarily requires rising nominal expenditure (by consumers) real wages remain the same.  That is, prices rise proportionally to the increase in consumer spending.  In order for Glasner’s proposition to be true all consumers’ nominal wages would have to increase proportionally, and the change in prices of individual goods would have to occur in such a way that the value of money in relation to all consumer goods remains the same.  We can deduce right away that such a set of prerequisites is impossible to fulfill.

Actually Catalan is reading more into that quotation than I put into it. All I meant to say was that the existence of inflation is predicated on an increase in total spending compared to an alternative world in which there was no inflation. I am not saying that inflation raises all prices proportionally, I am just saying that if prices in general have risen, total spending, and therefore total income, must also have risen. This not a matter of diagnosing the cause or effects of inflation, it is just simple bookkeeping. Thus, Catalan is aiming at a strawman in his next paragraph, not at me.

Right away, we know that not all consumers’ have had their nominal incomes grow proportionally.  A little over eight percent of the United States’ labor force is unemployed; to that, we can add a large quantity of discouraged workers.  These are consumers who are not earning an income, besides any unemployment or welfare benefits they are receiving (benefits that follow inflation trends, if even that).  The employed labor force are all working for wages set by their employers (based on the demand for specific/unspecific labor and supply of adequate laborers) — I do not think that anybody is assuming that all wages are rising proportionally and simultaneously. [DG:  Just wondering, does Catalan think that wages rise only when employers feel like raising them?]

I didn’t say that all wages were rising proportionally. What I said was that with nominal income rising along with prices, the gains in nominal income as a result of those price increases had to accrue to someone. Thus, insofar as some people were made worse off by inflation, others were made better off. There are of course theories asserting that inflation has either good effects – and others asserting that inflation has bad effects — on the economy, but, for purposes of this discussion, I am not taking sides for or against those theories. In his next paragraph, Catalan repeats the same point, suggesting erroneously that I argued that no one can be made worse off by inflation. But at the most naïve level, i.e., not trying to figure out the indirect and long-term effects of inflation, the losses of some are offset by the gains of others.

Catalan continues, and here he gets himself into trouble.

But, if wages are not rising simultaneously and proportionally for all consumers, then some must suffer from a reduction of the real purchasing power of the dollar.  Abstracting sufficiently, we can pool individuals into those who receive newly created dollars and those who do not.  Those who receive money first will be able to bid new currency towards consumers’ goods at their prices of the immediate past, causing prices to increase.  Those who do not receive this money will have to suffer from an increase in the prices of consumers’ goods.

What is wrong with this statement? Well, first, it’s not clear if new currency is injected into the economy in just one dose, or if injections are ongoing. If the injection is a one-time dose, then Catalan is correct that the sequence in which the new money reaches individuals has some transitory significance on the distribution of gains and losses from transitory inflation. People who get the money first may have some fleeting advantage over people who receive the money only after it has already gone through many hands before reaching them (although even this proposition is subject to any number of potential qualifications). However, if money is being injected continuously or periodically, Catalan’s statement is erroneous, because once the cycle of injection and dispersal is repeated, it is no longer meaningful to identify a particular point of entry as prior to any other point in a continuing cycle. What matters is not the temporal sequence in which the new funds are spent, but whether the injection of new money alters the overall distribution of spending.

Catalan concludes:

Glasner’s mistake — unless I terribly misinterpreted his point — is an over-reliance on the mechanical quantity theory of money and prices.  Yes, inflation is a monetary phenomenon.  That does not mean that inflation actually takes place simultaneously and proportionally amongst the prices of all economic goods and wages.  Instead, prices change relative to each other; some lose and some win.  It was this lack of focus on relative prices that Friedrich Hayek warned about in Prices and Production (although, he was referring to relative prices amongst goods of different stages in the structure of production and this would lead him to his elucidation of intertemporal discoordination).

In a sense, Catalan and I are not that far apart. We agree that monetary expansion can raise prices, and that as it raises prices, newly injected money may also affect relative prices. However, I don’t think that it’s possible to say much about how injections of money affect relative prices unless the monetary authorities are deliberately aiming to put money into the pockets of specific groups of people. But that’s not really how new money is injected into the economy, so I don’t think that trying to find the relative-price effects associated with inflation is very useful way of analyzing the effects of inflation. And that is why Hayek was unable to make a positive contribution to the analysis of business cycles beyond articulating some very general (but nonetheless important) principles about the conditions necessary for intertemporal equilibrium, the importance of stabilizing nominal income over the business cycle, and the ineffectiveness (in most circumstances) of anticipated inflation in increasing employment.

So to come back to the specific point that Catalan took me to task for, although I did not argue that inflation does not affect real wages, I do think that it is far from obvious that inflation has reduced real wages, i.e., that inflation has caused prices to rise faster than wages. Surely some wages have risen less rapidly than prices, but some wages have gone up more rapidly than prices. And as a general proposition, we have little way of determining whether recent changes in relative prices (and wages) were caused by real forces affecting relative prices and wages or by the forces affecting inflation. Given our ignorance of what is causing individual prices to change, there is no obvious basis for suggesting that anyone’s real income has been affected by inflation. If you want to make that claim, be my guest. But there is no inherent property of inflation that justifies it. If you want to make the claim, it’s your burden to come up with an argument to make the claim credible. Good luck.

PS  It looks like this will be my last post for 2011.  Best wishes for 2012.  May it be an improvement on 2011!

Which Fed Policy Is Boosting Stocks?

In yesterday’s (December 27, 2011) Wall Street Journal, Cynthia Lin (“Fed Policy Delivers a Tonic for Stocks”) informs us that the Fed’s Operation Twist program “has been a boon for investors during the year’s final quarter.”

The program, which has its final sale of short-dated debt for the year on Wednesday, pushed up a volatile U.S. stock market over the past few months and helped lower mortgage rates, breathing some life into the otherwise struggling U.S. housing sector, they said. Last week, Freddie Mac showed a variety of loan rates notching or matching record lows; the 30-year fixed rate fell to 3.91%, a record low.

In Operation Twist, the Fed sells short-dated paper and buys longer-dated securities. The program’s aim is to push down longer-term yields making Treasurys less attractive and giving investors more reason to buy riskier bonds and stocks. While share prices have risen considerably since then, Treasury yields have barely budged from their historic lows. Fear about the euro zone has caused an overwhelming number of investors to seek safety in Treasury debt. . . .

The Fed’s stimulus plan is the central bank’s third definitive attempt to aid the U.S.’s patchy economy since 2008. As expectations grew that the Fed would act in the weeks leading up to the bank’s actual announcement, which came Sept. 21, 10-year yields dropped nearly 0.30 percentage point. Since the Fed’s official statement, yields have risen modestly, to 2.026% on Friday, from 1.95% on Sept. 20. Fed Chairman Ben Bernanke said in October that rejiggering the bank’s balance sheet with Operation Twist would bring longer-term rates down 0.20 percentage points.

Sounds as if we should credit Chairman Bernanke with yet another brilliant monetary policy move. There have been so many that it’s getting hard to keep track of all his many successes. Just one little problem. On September 1, around the time that expectations that the Fed would embark on Operation Twist were starting to become widespread, the yield on the 10-year Treasury stood at 2.15% and the S&P 500 closed at 1204.42. Three weeks later on September 22, the 10-year Treasury stood at 1.72%, but the S&P 500, dropped to 1129.56. Well, since then the S&P 500 has bounced back, rising about 10% to 1265.43 at yesterday’s close. But, guess what? So did the yield on the 10-year Treasury, rising to 2.02%. So, the S&P 500 may have been risen since Operation Twist began, but it would be hard to argue that the reason that stocks rose was that the yield on longer-term Treasuries was falling. On the contrary, it seems that stocks rise when yields on long-term Treasuries rise and fall when yields on long-term Treasuries fall.

Regular readers of this blog already know that I have a different explanation for movements in the stock market. As I argued in my paper “The Fisher Effect Under Deflationary Expectations,” movements in asset prices since the spring of 2008 have been dominated by movements (up or down) in inflation expectations. That is very unusual. Aside from tax effects, there is little reason to expect stocks to be affected by inflation expectations, but when expected deflation exceeds the expected yield on real capital, asset holders want to sell their assets to hold cash instead, thereby causing asset prices to crash until some sort of equilibrium between the expected yields on cash and on real assets is restored. Ever since the end of the end of the financial crisis in early 2009, there has been an unstable equilibrium between very low expected inflation and low expected yields on real assets. In this environment small changes in expected inflation cause substantial movements into and out of assets, which is why movements in the S&P 500 have been dominated by changes in expected inflation.  And this unhealthy dependence will not be broken until either expected inflation or the expected yield on real assets increases substantially.

The close relationship between changes in expected inflation (as measured by the breakeven TIPS spread for 10-year Treasuries) and changes in the S&P 500 from September 1 through December 27 is shown in the chart below.

In my paper on the Fisher effect, I estimated a simple regression equation in which the dependent variable was the daily percentage change in the S&P 500 and the independent variables were the daily change in the TIPS yield (an imperfect estimate of the expected yield on real capital), the daily change in the TIPS spread and the percentage change in the dollar/euro exchange rate (higher values signifying a lower exchange value of the dollar, thus providing an additional measure of inflation expectations or possibly a measure of the real exchange rate). Before the spring of 2008, this equation showed almost no explanatory power, from 2008 till the end of 2010, the equation showed remarkable explanatory power in accounting for movements in the S&P 500. My regression results for the various subperiods between January 2003 till the end of 2010 are presented in the paper.

I estimated the same regression for the period from September 1, 2011 to December 27, 2011. The results were startlingly good. With a sample of 79 observations, the adjusted R-squared was .636. The coefficients on both the TIPS and the TIPS spread variables were positive and statistically significant at over a 99.9% level. An increase of .1 in the real interest rate was associated with a 1.2% increase in the S&P and an increase of .1 in expected inflation was associated with a 1.7% increase in the S&P 500. A 1% increase the number of euros per dollar (i.e., a fall in the value of the dollar in terms of euros) was associated with a 0.57% increase in the S&P 500. I also introduced a variable defined as the daily change in the ratio of the yield on a 10-year Treasury to the yield on a 2-year Treasury, calculating this ratio for each day in my sample. Adding the variable to the regression slightly improved the fit of the regression, the adjusted R-squared rising from .636 to .641. However, the coefficient on the variable was positive and not statistically significant. If the supposed rationale of Operation Twist had been responsible for the increase in the S&P 500, the coefficient on this variable would have been negative, not positive. So, contrary to the story in yesterday’s Journal, Operation Twist has almost certainly not been responsible for the rise in stock prices since it was implemented.

Why has the stock market been rising? I’m not sure, but most likely market pessimism about the sway of the inflation hawks on the FOMC was a bit overdone during the summer when the inflation expectations and the S&P 500 both were dropping rapidly. The mere fact that Chairman Bernanke was able to implement Operation Twist may have convinced the market that the three horseman of the apocalypse on the FOMC (Plosser, Kocherlakota, and Fisher) had not gained an absolute veto over monetary policy, so that the doomsday scenario the market may have been anticipating was less likely to be realized than had been feared. I suppose that we should be thankful even for small favors.

Surprise! Inflation Is Falling

The Wall Street Journal, in an article by Jon Hilsenrath, reports today (December 27, 2011) that recent reductions in the rate of inflation improve the chances that the Fed will decide to ease monetary policy.

U.S. inflation is slowing after a surge early in the year.

Some surge. From about 1.5% to 4% in the CPI and from about 1.5% to 3% in the PCE index. The GDP deflator barely moved staying roughly at 2.5%.

This is good news for Americans, as it means the money in their pockets goes further.

Well not quite, because inflation is still running above zero. But let’s not quibble about arithmetic. The real problem with that sentence is the unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is. I do not expect Mr. Hilsenrath to accept my theoretical position that, under current conditions, inflation would contribute to a speedup in the rate of growth in real income, but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.

It also is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth.

Well now, we are switching theories, aren’t we? According to that assessment of the Fed’s options, falling inflation means that the Fed could ease monetary policy, thereby helping the economy grow more rapidly than it is now growing. How, one wonders, could the Fed do that? Um, maybe by preventing the rate of inflation from falling even faster? In other words, maybe inflation would drop down to zero or even to a negative rate, i.e., deflation. Don’t want that. But if falling inflation is good news, then, really, why not let inflation keep falling? In fact, why not go for deflation? How does falling inflation turn suddenly from being good to being bad?

The answer is that whether inflation is good or bad depends on the circumstances. Sometimes inflation can be too high; sometimes it can be too low.  But we are operating under a monetary regime in which the rate of inflation is always supposed to be 2% or a bit lower.  Anything above is too high; anything below is too low.  There is just one problem:  there is no single rate of inflation that is optimal under all circumstances. And the corollary of the idea that there is a unique optimal rate of inflation — the notion that the only concern of monetary policy is to keep the rate of inflation at that target rate, regardless of what is happening to the economy in general is not, as far as I can tell, grounded either in economic theory or in economic history. And please spare me any comparisons to the stagflation of the 1970s, which resulted from two severe supply shocks within five years sandwiched by two periods of rapid monetary expansion aimed at reducing unemployment below any reasonable estimate of what the natural rate of unemployment would have been at the time.

No Monetary Policy Is Not Just Another Name for Fiscal Policy

I just read John Cochrane’s essay “Inflation and Debt” in the Fall 2011 issue of National Affairs. On his webpage, Cochrane gives this brief summary of what the paper is about.

An essay summarizing the threat of inflation from large debt and deficits. The danger is best described as a “run on the dollar.” Future deficits can lead to inflation today, which the Fed cannot control. I also talk about the conventional Keynesian (Fed) and monetarist views of inflation, and why they are not equipped to deal with the threat of deficits. This essay complements the academic (equations) “Understanding Policy” article (see below) and the Why the 2025 budget matters today WSJ oped (see below).

And here’s the abstract to his “Understanding Policy in the Great Recession” article:

I use the valuation equation of government debt to understand fiscal and monetary policy in and following the great recession of 2008-2009. I also examine fiscal and monetary policy alternatives to avoid deflation, and how fiscal pressures might lead to inflation. I conclude that the central bank might be almost powerless to avoid inflation or deflation; that an eventual fiscal inflation can come well before fiscal deficits or monetization are realized, and that it is likely to come with stagnation rather than a boom.

The crux of Cochrane’s argument is that government currency is a form of debt so that inflation is typically the result of a perception by bondholders and potential purchasers of government debt that the government will not be able to raise enough revenues to cover its expenditures and repay its debt obligations, implying an implicit default through inflation. However, the expectation of future inflation because of an anticipated future fiscal crisis may suddenly — when an expectational tipping point is reached — trigger a “run” on the currency well before the crisis, a run manifesting itself in rapidly rising nominal interest rates and rising inflation even before the onset of a large fiscal deficit.

This is certainly an important, though hardly original, insight, and provides due cause for concern about our long-term fiscal outlook. The puzzle is why Cochrane thinks the possibility of a run on the dollar because of an anticipated future fiscal crisis is at all relevant to an understanding of why we are stuck in a lingering Little Depression. Cochrane is obviously very pleased with his fiscal theory of inflations, believing it to have great explanatory power.  But that explanatory power, as far as I can tell, doesn’t quite extend to explaining the origins of, or the cure for, the crisis in which we now find ourselves.

Cochrane’s recent comments on a panel discussion at the Hoover Institution give the flavor of his not very systematic ideas about the causes of the Little Depression, and the disconnect between those ideas and his fiscal theory of inflation.

Why are we stagnating? I don’t know. I don’t think anyone knows, really. That’s why we’re here at this fascinating conference.

Nothing on the conventional macro policy agenda reflects a clue why we’re stagnating. Score policy by whether its implicit diagnosis of the problem makes any sense.

The “jobs” bill. Even if there were a ghost of a chance of building new roads and schools in less than two years, do we have 9% unemployment because we stopped spending on roads & schools? No. Do we have 9% unemployment because we fired lots of state workers? No.

Taxing the rich is the new hot idea. But do we have 9% unemployment-of anything but tax lawyers and lobbyists–because the capital gains rate is too low? Besides, in this room we know that total marginal rates matter, not just average Federal income taxes of Warren Buffet. Greg Mankiw figured his marginal tax rate at 93% including Federal, state, local, and estate taxes. And even he forgot about sales, excise, and corporate taxes. Is 93% too low, and the cause of unemployment?

The Fed is debating QE3. Or is it 5? And promising zero interest rates all the way to the third year of the Malia Obama administration. All to lower long rates 10 basis points through some segmented-market magic. But do we really have 9% unemployment because 3% mortgages with 3% inflation are strangling the economy from lack of credit? Or because the market is screaming for 3 year bonds, but Treasury issued at 10 years instead? Or because $1.5 trillion of excess reserves aren’t enough to mediate transactons?

I posed this question to a somewhat dovish Federal Reserve bank president recently. He answered succinctly, “Aggregate demand is inadequate. We fill it. ” Really? That’s at least coherent. I read the same model as an undergraduate. But as a diagnosis, it seems an awfully simplistic uni-causal, uni-dimensional view of prosperity. Medieval doctors had three humors, not just one.

Of course in some sense we are still suffering the impact of the 2008 financial crisis. Reinhart and Rogoff are endlessly quoted that recessions following financial crises are longer. But why? That observation could just mean that policy responses to financial crises are particularly wrongheaded.

In sum, the patient is having a heart attack. The doctors debating whether to give him a double espresso vs. a nip of brandy. And most likely, the espresso is decaf and the brandy watered.

So what if this really is not a “macro” problem? What if this is Lee Ohanian’s 1937-not about money, short term interest rates, taxes, inadequately stimulating (!) deficits, but a disease of tax rates, social programs that pay people not to work, and a “war on business.” Perhaps this is the beginning of eurosclerosis. (See Bob Lucas’s brilliant Millman lecture for a chilling exposition of this view).

If so , the problem is heart disease. If so, macro tools cannot help. If so, the answer is “Get out of the way.”

Cochrane seems content to take the most naïve Keynesian model as the only possible macro explanation of the current slump, and, after cavalierly dismissing it, concludes that there is no macroeconomic explanation for the slump, leaving “get out of the way” as the default solution. That’s because he seems convinced that all that you need to know about money is that expected future fiscal deficits can cause inflation now, because the expectation triggers a “run” on the currency. This is an important point to recognize, but it does not exhaust all that we know or should know about monetary theory and monetary policy. It is like trying to account for the price level under the gold standard by only taking into account the real demand for gold (i.e., the private demand for gold for industrial and ornamental purposes) and ignoring the monetary demand for gold (i.e., the demand by banks and central banks to hold gold as reserves or for coinage). If you looked only at the private demand for gold, you couldn’t possibly account for the Great Depression.

PS I also have to register my amazement that Cochrane could bring himself to describe Lucas’s Millman lecture as brilliant. It would be more accurate to describe the lecture as an embarrassment.

HT:  David Levey

Bill Gross Doesn’t Get It

In today’s Financial Times, the famed investor Bill Gross tries to explain why low interest rates are harming the economy (“The ugly side of ultra-cheap money”). The interesting thing about his piece is that much, if not most, of what he says is totally correct.  But he just can’t quite seem to put all the pieces together and make sense out of them. What seems to be Mr. Gross’s problem?

Well, first let’s see what Mr. Gross gets right. The first thing that he gets right is that banks and other financial intermediaries make their profits off of the spread between their cost of funds, their borrowing rates, and their lending rates. When the interest rates at which banks and financial intermediaries can lend have been depressed by monetary policy — supposedly in the interest of spurring investment — banks and financial intermediaries can’t function profitably. Money dries up, because banks can’t earn a profit unless their lending rates exceed their borrowing rates by more than, say, 100 basis points, while current spreads are between 20 and 90 basis points. “It is no coincidence” Mr. Gross observes, “that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry wide.”

This is one of many troubling features of the Little Depression in which we now find ourselves. But Mr. Gross mistakenly blames it on a monetary policy that is trying to stimulate the economy by keeping interest rates low.

Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economics, it is appropriate not only to question the effectiveness of historical conceptual models but to entertain the possibility that they may, counterintuitively, be hazardous to an economy’s health.

But Mr. Gross needs to ask himself why it is that banks, which would certainly like to lend at profitable rates, can’t seem to do so. It is no answer to say that the Fed has forced banks’ lending rates down; the Fed has done no such thing. The Fed’s policy rate is the rate at which banks can borrow reserves; it is not the rate at which banks can lend to customers. One might say that the Fed, through quantitative easing, has forced down the interest rates on government debt to very low levels as well. Yes, but banks are not lending to the government, they are lending to businesses. And if banks can’t lend to businesses at interest rates high enough to earn a profit, it is because businesses just aren’t willing to borrow at interest rates that high, not because the central bank policy rate is so low. Why won’t businesses pay a higher interest rate on bank loans?  What businesses are willing to pay for bank loans simply reflects their depressed demand for financing, which in turn reflects their rather pessimistic expectations about the profitability of future investment and the sizable quantity of cash they have on hand, not the effect of quantitative easing. If central banks raised interest rates, i.e., the interest banks must pay for reserves, it would not make banks more profitable; it would just reduce further the amount of funds businesses wanted to borrow from banks. Current low interest rates reflect the depressed state of the economy, not a ceiling on bank lending rates imposed by the Fed.

So Mr. Gross has it backwards, current low interest rates are not being imposed on the economy by the central bank, low interest rates are a symptom of an economy in a state of severe and chronic depression. Now it is true that banks and financial intermediaries are unable to operate normally when the spread between their borrowing and lending rates is as narrow as it is now. But there is a solution to that problem: raise inflation expectations, thereby raising lending rates and the spread between bank borrowing and lending rates. The Fed knows how to do that; it just needs to make up its mind that that is what it wants to do.  That’s just what Market Monetarists have been pleading for the Fed to do. Mr. Gross, isn’t it time for you to get with the program?

Update:  I see that Paul Krugman also wrote about Bill Gross today on his blog.  As the recipient of four shout-outs from Krugman since this blog started, I guess that it’s only fair that I return the favor.  I’m sure that he will appreciate the added traffic on his blog.

Straight Talk from Benjamin Cole

Our very own Benjamin Cole (actually he’s not our very own because the peripatetic Mr. Cole shows up all over the blogosphere, but he’s like family) has recently written a guest post for another frequent commentator on this blog Lars Christensen whose blog is a must read. Working in the private sector, Lars has an entrepreneurial eye for what will appeal to the market, and so he is always ready and willing to open up his own blog to guest bloggers with something interesting and worthwhile to say. One more reason to always keep Lars’s blog on your radar screen.

Regular readers of this and other blogs know that Benjamin is a no-nonsense guy who is interested in results not idle chatter. So everyone could expect that when Benjamin got the opportunity to give us all a piece of his mind, he would get right to the point and talk about how to implement Market Monetarism with a sophisticated understanding of the issues and in simple and direct terms that ordinary people can follow. And that’s just what he did.

Benjamin makes a strong case that adopting a simple and transparent policy that the public can understand can monitor. So he recommends that the Fed commit to buy $100 billion of securities a month for up to 5 years in order to achieve a target annual growth rate of NGDP of 7.5% over the next 5 years.

The recommended concrete sum of $100 billion a month in QE is not an amount rendered after consultation with esoteric, complex and often fragile econometric models.  Quite the opposite—it is sum admittedly only roughly right, but more importantly a sum that sends a clear signal to the market.  It is a sum that can be tracked every month by all market players.  It has the supreme attributes of resolve, clarity and conviction. The sum states the Fed will beat the recession, that is the Fed’s goal, and that the Fed is bringing the big guns to bear until it does, no ifs, ands, or buts.

Now every so often I have recommended that the Fed and Treasury announce that they would target the dollar/euro exchange at a level 20% below the current dollar/euro exchange rate (something like $1.50 or $1.60 per euro), through open market operations and unsterilized purchases of euros in foreign-exchange markets  and would continue to do so until a suitably defined price level rose by 20 percent. This would mean that the only way for the Europeans to avoid an increase in the euro’s value against the dollar would be for them to inflate at nearly the same rate as the dollar was inflating. But once the new higher price level was achieved, the policy of driving down the dollar’s exchange rate against the euro would be terminated. Benjamin’s proposal is similar in the sense that is easily articulated and easily monitored, and therefore, credible. If the policy is credible, the public will believe in it and adjust their expectations accordingly, thereby ensuring its ultimate success.

Just to show that I am not a complete pushover, let me just mention a couple of points on which I don’t entirely agree with Benjamin. Benjamin opposes further extensions in the duration of unemployment insurance, but I am not so sure. Theoretically, the effects cut in both directions, so it is doubtful whether limiting unemployment insurance would do very much to reduce unemployment. Perhaps a better approach would be to scale back the benefit when extending unemployment insurance rather than terminate it altogether. Nor do I think that reducing federal expenditures to 18% of GDP, as Benjamin proposes, is a realistic goal given the increasing age of the population, meaning that the government will be paying more and more for the medical bills of an aging population. Discretionary non-defense spending has already been reduced as a percentage of GDP to historically low levels. So I think people are kidding themselves if they think that spending can be cut just by picking a number like 18% out of thin air. If you want to cut the budget, Benjamin, tell us what you want to cut.

Christina Romer Really Gets It

Marcus Nunes beat me to it, highlighting Christina Romer’s column in today’s New York Times, but her column today deserves all the attention and praise that it can get, and a lot more besides. Romer debunks then notion that real downturns that follow financial crises are necessarily deeper and longer-lasting than ordinary downturns, showing that the policy pessimism engendered by the notion that recoveries from recessions precipitated by financial crises are necessarily weak and drawn out, given currency by the recent book by Rogoff and Reinhart This Time Is Different, is not at all justified by the historical record.

I will just elaborate on a couple of points made by Romer. Citing the account of the Great Depression in the United States given by Milton Friedman and Anna Schwartz in their Monetary History of the United States, Romer observes:

The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.

What accounts for the difference? Romer explains:

[T]he policy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending.

I don’t disagree with that, but I understand the process differently. It was the gold standard itself that had caused the downturn, because gold was appreciating (meaning that prices and wages were falling), causing profits to drop and business and households to stop spending. Bank failures were caused by a deflation that made it impossible for debts fixed in nominal terms to be repaid, so that the assets held by banks were becoming worthless. Bank failures were not the cause of the problem, they were a symptom of a problem — falling prices — inherent in and inseparable from the perverse dynamics of the gold standard. Once FDR abandoned the gold standard, the dollar depreciated relative to gold allowing dollar prices to start rising, the money supply increasing more or less automatically as a result.

Romer also disscusses a paper comparing the severity of the Great Depression in Spain and in the US.

Why was the Great Depression so much worse here than in Spain? According to an influential paper by Ehsan Choudhri and Levis Kochin, Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931, the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard, setting off further declines in output and exacerbating the banking crisis.

It’s true that freedom from the gold standard allowed Spain to take monetary measures it could not have taken while on the gold standard, but the more important point is that by not being on the gold standard, prices in Spain did not have to fall to reflect the increasing value of gold. So the deflationary forces that suffused all the countries on the gold standard simply bypassed Spain and other countries not on the gold standard. It was not the increase in interest rates by the US that was caused the deflation in the US it was the gold standard. Raising interest rates were necessary only insofar as a country did not want to allow an export of its gold reserves.

In closing, I will just mention that the paper by Choudri and Kochin contains a diagram on p. 569 showing that Belgium experienced a rapid deflation and a big drop in industrial production in the early 1930s. In my post last week about the analysis of the Deutsche Bank comparing the euro crisis to the 1930s gold standard crisis, the diagram copied from the DB analysis seemed to indicate that Belgium did not suffer a substantial drop in real GDP. The Choudri and Kochin paper provides further reason to be skeptical about the graph in the DB analysis.

About Me

David Glasner
Washington, DC

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

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 417 other followers


Get every new post delivered to your Inbox.

Join 417 other followers