Archive for January, 2012

The Fog of Inflation

Blogger Jonathan Catalan seems like a pretty pleasant and sensible fellow, and he is certainly persistent. But I think he is a bit too much attached to the Austrian story of inflation in which inflation is the product of banks reducing their lending rates thereby inducing borrowers to undertake projects at interest rates below the “natural rate of interest.” In the Austrian view of inflation, the problem with inflation is not so much that the value of money is reduced (though Austrians are perfectly happy to throw populist red meat to the masses by inveighing against currency debasement and the expropriation of savings), but that the newly created money distorts relative prices misleading entrepreneurs and workers into activities and investments that will turn out to be unprofitable when interest rates are inevitably raised, leading to liquidation and abandonment, causing a waste of resources and unemployment of labor complementary to no longer usable fixed capital.

That story has just enough truth in it to be plausible; it may even be relevant in explaining particular business-cycle episodes. But despite the characteristic (and really annoying) Austrian posturing and hyperbole about the apodictic certainty of its a priori praxeological theorems (non-Austrian translation:  assertions and conjectures), to the exclusion of every other explanation of inflation and business cycles, Austrian business cycle theory simply offers a theoretically possible account of how banks might simultaneously cause an increase in prices generally and a particular kind of distortion in relative prices. In fact, not every inflation and not every business cycle expansion has to conform to the Austrian paradigm, and Austrian assertions that they possess the only valid account of inflation and business cycles are pure self-promotion, which is why most of the reputable economists that ever subscribed to ABCT (partial list:  Gottfried Haberler, Fritz Machlup, Lionel Robbins, J. R. Hicks, Abba Lerner, Nicholas Kaldor, G. L. S. Shackle, Ludwig Lachmann, and F. A. Hayek) eventually renounced it entirely or acknowledged its less than complete generality as an explanation of business cycles.

So when in a recent post, I chided Jon Hilsenrath, a reporter for the Wall Street Journal, for making a blatant logical error in asserting that inflation necessarily entails a reduction in real income, Catalan responded, a tad defensively I thought, by claiming that inflation does indeed necessarily reduce the real income of some people. Inasmuch as I did not deny that there can be gainers and losers from inflation, it has been difficult for Catalan to articulate the exact point on which he is taking issue with me, but I suspect that the reason he feels uncomfortable with my formulation is that I rather self-consciously and deliberately formulated my characterization of the effects of inflation in a way that left open the possibility that inflation would not conform to the Austrian inflation paradigm, without, by the way, denying that inflation might conform to that paradigm.

In his latest attempt to explain why my account of inflation is wrong, Catalan writes that all inflation must occur over a finite period of time and that some prices must rise before others, presumably meaning that those raising their prices earlier gain at the expense of those who raise their prices later. I don’t think that that is a useful way to think about inflation, because, as I have already explained, if inflation is a process that takes place through time, it is arbitrary to single out a particular time as the starting point for measuring its effects. Catalan now tries to make his point using the following example.

[If] Glasner were correct then it would not make sense to reduce the value of currency to stimulate exports.  If the intertemporal aspect of the money circulation was absent, then exchange ratios between different currencies (all suffering from continuous tempering) would remain constant.  This is not the case, though: a continuous devaluation of currency is necessary to continuously artificially stimulate exports, because at some point relative prices (the price of one currency to another) fall back into place —, reality is the exact opposite of what Glasner proposes.  The example is imperfect and very simple (it does not have anything to do with the prices between different goods amongst different international markets), but I think it illustrates my point convincingly.

Actually, devaluations frequently do not stimulate exports. When they do stimulate exports, it is usually because real wages in the devaluing country are too high, making the tradable goods sector of the country uncompetitive, and it is easier to reduce real wages via inflation and devaluation than through forcing workers to accept nominal wage cuts. This was precisely the argument against England rejoining the gold standard in 1925 at the prewar dollar/sterling parity, an argument accepted by von Mises and Hayek. Under these circumstances does inflation reduce real wages? Yes. But the reason that it does so is not that inflation necessarily entails a reduction in real wages; the reason is that in those particular instances the real wage was too high (i.e., the actual real wage was above the equilibrium real wage) and devaluation (inflation) was the mechanism by which an equilibrating reduction in real wages could be most easily achieved. In this regard I would refer readers to the classic study of the proposition that inflation necessarily reduces real wages, the paper by Kessel and Alchian “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices” reprinted in The Collected Works of Armen A. Alchian.

Whether inflation reduces or increases real wages, either in general or in particular instances, depends on too many factors to allow one to reach any unambiguous conclusion. The real world is actually more complicated than Austrian business cycle theory seems prepared to admit. Funny that Austrians would have to be reminded of that by neo-classical economists.

Just How Scary Is the Gold Standard?

With at least one upper-tier Republican candidate for President openly advocating the gold standard and pledging to re-establish it if he is elected President, more and more people are trying to figure out what going back on a gold standard would mean.

Tyler Cowen wrote about the gold standard on his blog the week before last, explaining why restoring the gold standard is a dangerous idea.

The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment.  There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.

Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?

Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold.  A gold standard, by the way, is still compatible with plenty of state intervention.

Tyler’s short comment seems basically right to me, but some commenters were very critical.

Lars Christensen, commenting favorably on Tyler’s criticism of the gold standard, opened up his blog to a debate about the merits of the gold standard, and Blake Johnson, who registered sharp disagreement with Tyler’s take on the gold standard in a comment on Tyler’s post, submitted a more detailed criticism which Lars posted on his blog. Johnson makes some interesting arguments against Tyler, showing considerably more sophistication than your average gold bug, so I thought that it would be worthwhile to analyze Blake’s defense of the gold standard.

Blake begins by quibbling with Tyler’s statement that if the relative price of gold rises under a gold standard, the appreciation of gold is expressed in falling prices, reducing output and employment. Johnson points out that when prices are falling in proportion to increases in productivity deflation is not necessarily bad. That’s valid (but not necessarily conclusive) point, but I suspect that that is not the scenario that Tyler had in mind when he made his comment, as Johnson himself recognizes:

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

The plot thickens. The problem with Johnson’s comment is that he is presuming that there ever were any clearly articulated rules of the gold standard. The most ardent supporters of the gold standard at the time, people like von Mises and Hayek, Lionel Robbins, Jacques Rueff and Charles Rist in France, Benjamin Anderson in America, were all defending the Bank of France against criticism for its actions. (See this post about Hayek’s defense of the Bank of France.)  I don’t think that they were correct in their interpretation of what the rules of the gold standard required, but it is clearly not possible to look up the relevant rules of how to play the gold-standard game, as one could look up, say, the rules of playing baseball. Central bankers were not playing by the rules of the gold standard, because the existence of such rules was a convenient myth, covering up the fact that central banks, especially the Bank of England, ran the gold standard in the late 19th and early 20th centuries and exercised considerable discretion in doing so. The gold standard was never a fully automatic self-regulating system.

Johnson continues:

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency [to] exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did.

Unfortunately, I cannot make any sense out of this. “Central banks that wanted to inflate” presumably refers to central banks keeping their lending rate at a level below the rates in other countries, thereby issuing an excess supply of banknotes that financed a balance of payments deficit and causing an outflow of gold (adverse clearings). Somehow Johnson transitions from the assumption of inflationary bias to the opposite one of deflationary bias in which, “funded via taxpayer money,” central banks were insulated from the profit motive that generally caused private banks to economize on gold reserves, thus refraining from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Sorry, but I don’t see how we get from point A to point B.

At any rate, Johnson seems to be suggesting — though this is just a guess – that central banks are more likely than private banks to hoard gold reserves. That may perhaps be true, but it might not be true if there are significant economies of scale in holding reserves. Under a gold standard with no central banks and no lender of last resort, the precautionary demand for gold reserves by individual banks might be so great that the aggregate monetary demand for gold by the banking system could be greater than the monetary demand of central banks for gold. We just don’t know. And the only way to find out is to make ourselves guinea pigs and see how a gold standard would work itself out with or without central banks. I personally am curious to see how it would turn out, but not curious enough to actually want to live through the experiment.

Johnson goes on:

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

What Johnson fails to consider is that inflation expectations are not totally arbitrary; inflation expectations in the 1930s plunged, because people understood that gold was appreciating toward its pre-World War I level. The only way to avoid that result for an individual country on the gold standard was to get off the gold standard, because the price level of any country on the gold standard is determined by the value of gold. That’s why FDR was able to initiate a recovery in March 1933 with the stroke of a pen by suspending the convertibility of the dollar into gold, allowing the dollar to depreciate against gold and gold-standard currencies, causing prices in dollar terms to start rising, thereby stimulating increased output and employment practically over night. The critical difference that Johnson is ignoring is that no country under a gold standard could stop deflating until it got off the gold standard. The FOMC is doing a terrible job, but all they have to do is figure out what needs to be done. They don’t have to get permission to do what is right from anyone else.

So how scary is the gold standard? Scarier than you think.

Is Joblessness a Skills Problem or an FOMC Problem?

Jeffrey Lacker, President of the Richmond Federal Reserve Bank, is joining the Federal Open Market Committee (FOMC), the body within the Federal Reserve with the final say on monetary policy. The presidents of the 12 regional banks occupy five of the seats on the FOMC on a rotating basis (except that the President of the New York Fed is always on the FOMC), Presidents of the Richmond, Philadelphia, and Boston Banks occupying one of the seats on the FOMC, each president serving every third year. Dr. Lacker is replacing Dr. Charles Plosser, President of the Philadelphia Fed, for the 2012 calendar year.

Among Lacker’s duties as President of Richmond Federal Reserve Bank is writing a message in the bank’s quarterly publication Region Focus, the third quarter edition of which I found in my mailbox yesterday. Knowing that Lacker has just become one of the most important people on the planet, I was curious to find out his thoughts at the start of his year on the FOMC. My reading of Lacker’s message in the second quarter Region Focus was not exactly an uplifting experience (see this post from October), but I try to look for glimmers of hope wherever I can find them. Sadly, Dr. Lacker’s message, entitled “Is Joblessness Now a Skills Problem?” offers nothing hopeful.

Lacker begins by painting a bleak picture of the plight of the long-term unemployed.

Today long-term unemployment – that is, unemployment lasting six months or longer – is at a record high. The share of unemployed Americans whose job searches have lasted this agonizingly long is 43.1 percent, a figure that is unprecedented since the Bureau of Labor Statistics began keeping records in 1948.

His explanation?

A growing number of observers have argued that this state of affairs is caused in significant part by a mismatch between available jobs and available workers, especially a mismatch in skills.

I agree that the long-term component of unemployment has structural origins, including a substantial degree of skills mismatch. I hear a fair number of stories from around our District of hard-to-fill job vacancies in certain specialties. Looking at the world around us, it is reasonable to assume that employers need higher skill levels from their workers today, on average, than they did a generation ago. . . . Economic research indicates that the relationship between unemployment and the job vacancy rate changed during the recession; we’re seeing more unemployment for a given rate of job vacancies – which suggests matching problems.

Lacker acknowledges that the skill-mismatch story has been criticized because the empirical evidence suggests that skill-mismatch accounts for only 0.6 to 1.7 percentage points of current unemployment. In turn, Lacker doubts the relevance of the data on which critics of the skill-mismatch story calculate its contribution to current high rates of unemployment. And even if the critics are right, “a percentage point, or 1.5 percentage points, is significant even within the context of today’s unemployment rate of roughly 9 percent.” Lacker concludes:

In short, I think it is quite plausible that skills mismatch is an important factor holding back improvements in the labor market. The question is how important – and that’s an issue that economists are working to answer as precisely as possible.

OK, so what does this all mean for policy? First, Lacker goes out on a limb and announces that he is actually in favor of – hold on to your hats – job training!

Finally, Lacker gets to the point, monetary policy:

Another, more immediate, implication is the extent to which monetary policy can make a difference in getting more Americans into jobs. To the extent that skills mismatch is identified as a significant portion of the long-term unemployment problem, monetary policy will have difficulty making meaningful inroads into the jobs problem without increasing inflation. Monetary policy, after all, doesn’t train people.

This is hugely depressing. Lacker is telling us that because, on the basis of some stories he has heard from around his district (Maryland, Virginia, West Virginia, North Carolina, South Carolina), and because the ratio of unemployed workers to job vacancies has been increasing, he thinks that our unemployment problem is largely the result of skills mismatches, mismatches impervious to monetary policy.

I won’t even bother asking how all these skills matches suddenly appeared out of nowhere in 2008, so let’s just assume that some percentage of the currently unemployed are unemployed because they don’t have the skills to take the jobs that employers are trying so hard to fill, but can’t. But if there is this huge unsatisfied demand for workers out there (of which Lacker claims to have, if not direct personal knowledge, at least hearsay evidence), wouldn’t one expect to observe employers bidding up wages for those desirable employees with those coveted skills?

I mean Lacker can’t have it both ways. Either there are lot of unfilled vacancies that employers are trying to fill, and wages are being bid up to attract the highly prized workers that can fill them, or there are not that many unfilled vacancies and wages are not being driven up by desperate employers trying to fill those vacancies. If Lacker is right about the magnitude of unsatisfied demand for labor, there should be some evidence for it showing up in the wages actually being paid.

So what do the data show? Well, the Bureau Labor Statistics has published since 2001 an employment cost index of wages and salaries for workers in private industry. The chart below shows the quarterly year-on-year change in the index since 2002. As you can see the year-on-year change has come down steadily since 2002, bottoming out at a rate of increase well below anything observed in the 2002-2008 period. If Lacker is right that job mismatch accounts for a significant fraction of currently observed unemployment, why is the rate of wage inflation nearly a percentage point below the lowest observed rate of wage inflation in the 2002 to 2008 period?

Of course, some people regard the 2002-2008 period as one of wild inflationary excess. So I also looked at a similar, but slightly different, index that goes back further than the employment cost index, the labor cost index which takes into account changes in both wages and productivity. The next chart shows the quarterly year on year change in unit labor costs since 1983 (the beginning of the recovery from the 1981-82 recession). The rate of increase in unit labor costs since 2008 is clearly well below the rates of increase for almost the entire period.

And, at the armchair level of analysis at which Lacker is comfortably operating in making his assessments about the role of skills mismatch in the labor market, it is not at all clear that skill deficiencies are the only, or chief, reason for the increasing number of unemployed per vacancy. It would be at least as plausible to suggest that employers are becoming increasingly choosy in selecting job applicants for the few available vacancies that they are trying to fill. Because they are not trying hard to increase output, employers can afford to wait a little longer to find the perfect employee than they would wait if they were trying to expand output. There are two sides to every matching problem, and Lacker seems interested in just one side.

Finally, it is just astonishing that, at a time when inflation is at its lowest rate in a half century, Lacker could offer as an implied rationale for his opposition to using monetary policy to reduce unemployment: “monetary policy will have difficulty making meaningful inroads into the job problem without increasing inflation,” as if any policy option that would increase inflation above its current historically low rate is not even worthy of consideration.

On Multipliers, Ricardian Equivalence and Functioning Well

In my post yesterday, I explained why if one believes, as do Robert Lucas and Robert Barro, that monetary policy can stimulate an economy in an economic downturn, it is easy to construct an argument that fiscal policy would do so as well. I hope that my post won’t cause anyone to conclude that real-business-cycle theory must be right that monetary policy is no more effective than fiscal policy. I suppose that there is that risk, but I can’t worry about every weird idea floating around in the blogosphere. Instead, I want to think out loud a bit about fiscal multipliers and Ricardian equivalence.

I am inspired to do so by something that John Cochrane wrote on his blog defending Robert Lucas from Paul Krugman’s charge that Lucas didn’t understand Ricardian equivalence. Here’s what Cochrane, explaining what Ricardian equivalence means, had to say:

So, according to Paul [Krugman], “Ricardian Equivalence,” which is the theorem that stimulus does not work in a well-functioning economy, fails, because it predicts that a family who takes out a mortgage to buy a $100,000 house would reduce consumption by $100,000 in that very year.

Cochrane was a little careless in defining Ricardian equivalance as a theorem about stimulus, when it’s really a theorem about the equivalence of the effects of present and future taxes on spending. But that’s just a minor slip. What I found striking about Cochrane’s statement was something else: that little qualifying phrase “in a well-functioning economy,” which Cochrane seems to have inserted as a kind of throat-clearing remark, the sort of aside that people are just supposed to hear but not really pay much attention to, that sometimes can be quite revealing, usually unintentionally, in its own way.

What is so striking about those five little words “in a well-functioning economy?” Well, just this. Why, in a well-functioning economy, would anyone care whether a stimulus works or not? A well-functioning economy doesn’t need any stimulus, so why would you even care whether it works or not, much less prove a theorem to show that it doesn’t? (I apologize for the implicit Philistinism of that rhetorical question, I’m just engaging in a little rhetorical excess to make my point a little bit more colorfully.)

So if a well-functioning economy doesn’t require any stimulus, and if a stimulus wouldn’t work in a well-functioning economy, what does that tell us about whether a stimulus works (or would work) in an economy that is not functioning well? Not a whole lot. Thus, the bread and butter models that economists use, models of how an economy functions when there are no frictions, expectations are rational, and markets clear, are guaranteed to imply that there are no multipliers and that Ricardian equivalence holds. This is the world of a single, unique, and stable equilibrium. If you exogenously change any variable in the system, the system will snap back to a new equilibrium in which all variables have optimally adjusted to whatever exogenous change you have subjected the system to. All conventional economic analysis, comparative statics or dynamic adjustment, are built on the assumption of a unique and stable equilibrium to which all economic variables inevitably return when subjected to any exogenous shock. This is the indispensable core of economic theory, but it is not the whole of economic theory.

Keynes had a vision of what could go wrong with an economy: entrepreneurial pessimism — a dampening of animal spirits — would cause investment to flag; the rate of interest would not (or could not) fall enough to revive investment; people would try to shift out of assets into cash, causing a cumulative contraction of income, expenditure and output. In such circumstances, spending by government could replace the investment spending no longer being undertaken by discouraged entrepreneurs, at least until entrepreneurial expectations recovered. This is a vision not of a well-functioning economy, but of a dysfunctional one, but Keynes was able to describe it in terms of a simplified model, essentially what has come down to us as the Keynesian cross. In this little model, you can easily calculate a multiplier as the reciprocal of the marginal propensity to save out of disposable income.

But packaging Keynes’s larger vision into the four corners of the Keynesian cross diagram, or even the slightly more realistic IS-LM diagram, misses the essence of Keynes’s vision — the volatility of entrepreneurial expectations and their susceptibility to unpredictable mood swings that overwhelm any conceivable equilibrating movements in interest rates. A numerical calculation of the multiplier in the simplified Keynesian models is not particularly relevant, because the real goal is not to reach an equilibrium within a system of depressed entrepreneurial expectations, but to create conditions in which entrepreneurial expectations bounce back from their depressed state. As I like to say, expectations are fundamental.

Unlike a well-functioning economy with a unique equilibrium, a not-so-well functioning economy may have multiple equilibria corresponding to different sets of expectations. The point of increased government spending is then not to increase the size of government, but to restore entrepreneurial confidence by providing assurance that if they increase production, they will have customers willing and able to buy the output at prices sufficient to cover their costs.

Ricardian equivalence assumes that expectations of future income are independent of tax and spending decisions in the present, because, in a well-functioning economy, there is but one equilibrium path for future output and income. But if, because the economy not functioning well, expectations of future income, and therefore actual future income, may depend on current decisions about spending and taxation. No matter what Ricardian equivalence says, a stimulus may work by shifting the economy to a different higher path of future output and income than the one it now happens to be on, in which case present taxes may not be equivalent to future taxes, after all.

Krugman v. Lucas on Fiscal Stimulus

The blogosphere has been buzzing recently over the recent confrontation between Nobelists Paul Krugman and Robert Lucas, Krugman charging Lucas with not understanding Ricardian equivalence. The controversy has already gone on too long with too many contributions from too many sources to even attempt to summarize it, so if you have been asleep for the last week and haven’t yet heard about this minor internet conflagration, I suggest that you do a google search on Krugman + Lucas + Ricardian equivalence.

I am not even going to try to comment on Krugman’s criticism of Lucas or on criticisms of Krugman’s criticism by Andolfatto and Williamson and Cochrane. But I do want to go back to the statement that Lucas made in his talk that got Krugman all bent out of shape, because it reminded me of a piece that Robert Barro wrote a while back in the Wall Street Journal, a piece I commented on here. First, here’s what Lucas said in his talk.

We had some lively sessions this morning about fiscal stimulus.  Now, would a fiscal stimulus somehow get us out of this bind, or add another weapon that would help in this problem?  I’ve already said I think what the Fed is now doing is going to be enough to get a reasonably quick recovery committed.  But, could we do even better with fiscal stimulus?

I just don’t see this at all.  If the government builds a bridge, and then the Fed prints up some money to pay the bridge builders, that’s just a monetary policy.  We don’t need the bridge to do that.  We can print up the same amount of money and buy anything with it.  So, the only part of the stimulus package that’s stimulating is the monetary part.

So Lucas remains enough of a Monetarist to agree that printing money can provide a stimulus to an ailing economy. However, he denies that government spending can provide any stimulus if there is no money printing.

Last August, Robert Barro had a take similar to Lucas on the ineffectiveness of fiscal policy.

If [the Keynesian multiplier were] valid, this result would be truly miraculous.  The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit.  Another $1 billion appears that can make the rest of society better off.  Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

How can it be right?  Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people?  Keynes in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

I also pointed out that Barro had written an earlier piece in the Journal in which he explicitly stated that a business downturn and high unemployment could be prevented by monetary expansion (printing money).

[A] simple Keynesian macroeconomic model implicitly assumes that the government is better than the private market at marshalling idle resources to produce useful stuff.  Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out.  In other words, there is something wrong with the price system.

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels.  But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.

I then suggested that if monetary policy is indeed effective in providing stimulus to an economy in recession, it is not that hard to construct an argument that fiscal policy can also be effective in providing stimulus, fiscal stimulus being a method of transferring cash from those indifferent between holding cash and holding bonds to those who would spend cash.

[H]ow is it that monetary expansion works according to regular economics?  People get additional pieces of paper;  they have already been holding pieces of paper, and don’t want to hold any more paper.  Instead they start spending to get rid of the the extra pieces of paper, but what one person spends another person receives, so in the aggregate they cannot reduce their holdings of paper as intended until the total amount of spending has increased sufficiently to raise prices or incomes to the point where everyone is content to hold the amount of paper in existence.  So the mechanism by which monetary expansion works is by creating an excess supply of money over the demand.

Well, let’s now think about how government spending works.  What happens when the government spends money in a depression?  It borrows money from people who are holding a lot money but are willing to part with it for a bond promising a very low interest rate.  When the interest rate is that low, people with a lot cash are essentially indifferent between holding cash and holding government bonds.  The government turns around and spends the money buying stuff from or just giving it to people.  As opposed to the people from whom the government borrowed the money, a lot of the people who now receive the money will not want to just hold the money.  So the government borrowing and spending can be thought of as a way to take cash from people who were willing to hold all the money that they held (or more) giving the money to people already holding as much money as they want and would spend any additional money that they received.  In other words, i.e., in terms of the demand to hold money versus the supply of money, the government is cleverly shifting money away from people who are indifferent between holding money and bonds and giving the money to people who are already holding as much money as they want to.  So without actually printing additional money, the government is creating an excess supply of money, thereby increasing spending, a process that continues until income and spending rise to a level at which the public is once again willing to hold the amount of money in existence.

Now I happen to think that there are solid reasons to prefer monetary over fiscal policy as a method of stimulus, but there is no reason to treat this issue as if some deep principle of economic theory depended on it. But that seems to be the way it is treated by Lucas and Barro. And, just to show that I can be even-handed in my assessments, many Keynesians, including Paul Krugman himself, like to argue that in a Depression only fiscal policy can work because of the liquidity trap.  However, at least Krugman displays the unfairly maligned virtue of inconsistency.

Nordhaus on Energy and Bathtubs

I rarely venture beyond the narrow confines of macroeconomics, monetary theory and monetary policy on this blog, and I am not planning to change that focus.  But it’s my blog, so I get to write about whatever I choose to.  How’s that for libertarianism in action?  At any rate, I just read an excellent essay on energy policy by William Nordhaus of Yale (“Energy: Friend or Enemy?” in the New York Review of Books, 10/27/11), not the least of whose many accomplishments was being chosen by Paul Samuelson as co-author of later editions of Samuelson’s legendary principles textbook (a wonderful textbook, but not the best economics textbook ever written.) Nordhaus’s essay is structured around a review of two new books The End of Energy: The Unmaking of America’s Environment, Security and Independence by Michael J. Graetz, and Hidden Costs of Energy: Unpriced Consequences of Energy Production and Use a report by the National Research Council’s Committee on Health, Environmental, and Other External Costs and Benefits of Energy Production and Consumption. National Academies Press (available for free at

Rather than try to summarize Nordhaus’s essay, I will just mention what seem to me to be the two most important points. First, all the major sources of energy now used in the US, (petroleum, natural gas, and coal) are associated with significant external effects (aka externalities), causing damage to property and injury to the health and well-being of individuals as well as contributing to global warming. Nordhaus cites estimates from Hidden Costs of Energy that if taxes on sulfur, carbon dioxide and other pollutants were imposed at levels corresponding to the damages caused, $300 billion a year in additional revenue would be raised. (Nordhaus doesn’t say what assumptions were made about the effect of taxation on the amount of pollution generated. If the estimates assume no reduction, less than $300 billion in revenue would be raised.)  And these estimates include only taxes on electricity generation, transportation, and heat production, leaving out other industrial and commercial uses of energy.

To put the $300 billion a year estimate in perspective, consider that the recent ill-fated Congressional super-committee was charged with reducing federal deficits by $1.5 trillion over 10 years. Thus, taxing pollution would generate (subject to the qualification mentioned in the previous paragraph) about twice as much deficit reduction as Congress agreed, but failed, to implement. Insofar as taxing pollution would lead a reduction of pollution, there would be further long-term budgetary benefits by reducing future expenditures on medical treatment for illnesses and diseases caused by pollution as well as avoiding income (and tax revenue) losses associated with those illnesses and diseases. “Environmental taxes,” Nordhaus observes,

can play a central role in reducing the fiscal gap in the years to come. These are efficient taxes because they tax “bads” rather than “goods.” Environmental taxes have the unique feature of raising revenues, increasing economic efficiency, and improving the public health.

Nordhaus sums up our dysfunctional energy-policy paralysis in a truly depressing paragraph.

In reality, U.S. energy policy has largely shunned environmental taxes in favor of environmental regulation. Virtually every proposal for an energy tax from Nixon to Obama was defeated in Congress. By way of explanation Graetz writes, “We have eschewed taxes and instead employed virtually every other policy too imaginable. Handing out tens of billions of dollars in subsidies annually is far more seductive to politicians.” And many of these subsidies mainly serve as tax shelters. Graetz quotes Congressman Pete Stark: “They are not wind farms; they are tax farms.”

Instead of raising taxes on energy to match the full costs of producing and using energy, we have engaged in an endless series of ad hoc regulatory interventions supposedly designed to reduce energy consumption and dependence on foreign oil. CAFE standards require car manufacturers to meet minimum average fuel economy standards on passenger cars. Do CAFE standards reduce fuel consumption? Perhaps they do, but not necessarily. Increasing average miles per gallon of new cars reduces the marginal cost of driving those cars, so the number of miles they are driven increases as a result. If the percentage increase in miles driven exceeds the percentage increase in miles per gallon, the net effect is an increase in fuel consumption. On the other hand, if you tax gasoline consumption, you raise the marginal cost of driving (at least compared to the cost if there is no tax), so fewer miles would be driven than with no tax on gasoline.

The second important point made by Nordhaus is the unity of the world oil market. The unity of the world oil market makes the very concept of national energy independence, to which every administration since the Nixon administration has paid foolish lip service, a snare and a delusion.

We can usefully think of the oil market as a single integrated world market – like a giant bathtub of oil. In the bathtub view, there are spigots from Saudi Arabia, Russia, and other producers that introduce oil into the inventory. And there are drains from which the United States, China, and other consumers draw oil. Nevertheless, the dynamics of the price and quantity are determined by the sum of these demands and supplies, and are independent of whether the faucets are labeled “US,” “Russia,” or “China.” In other words, prices are determined by global supply and demand, and the composition of supply and demand is irrelevant. . . .

This means crude oil is fungible, like dollar bills. A shortfall in one region can be made up by shipping a similar oil there from elsewhere in the world. U.S. oil policies make no more sense than trying to lower the water level in one end of the bathtub by taking a few cups of water from that end.

We know that the world oil market is unified because there is a single price of crude oil that holds no matter what the source. For example, we can look at whether prices (with corrections for gravity and sulfur) in fact move together. . . . A good test of this view would be to ask whether a benchmark crude price predicts the movement of other prices. Looking at crude oil from 28 different regions around the world from 1977 to 2009, I found that a 10.00 percent change in the price of “Brent” crude oil – a blend of crude often used as a benchmark for price – led to a 9.99 percent change in the prices of other crude oils. . . .

The implication of the bathtub view is profound. It means that virtually no important oil issue involves US dependency on foreign oil. Whether we consider pollution, macroeconomic impacts, price volatility, supply interruptions, or Middle East politics, our vulnerability depends upon the global market. It does not depend upon the fraction of our consumption that is imported.

Nordhaus is undoubtedly correct in emphasizing the bathtub view. However, he may be overstating the case just a bit. Over the past couple of years, and especially in 2011, the spread between WTI and Brent crudes, which for years was almost nil, has widened to an extraordinary extent, approaching $30 a barrel in July and still remaining close to $10 a barrel.  See the chart below.

Nordhaus argues that the bathtub theory implies that imposing sanctions or an embargo on Iranian oil exports would be futile, but I suspect that although an embargo on Iranian oil exports could not cut off Iranian oil exports from the world market, it could impose a real hardship on Iran, reducing its income from oil exports by some non-negligible amount, quite likely at least 5-10%, though probably less than 25%. But I am just quibbling about a detail, an important detail to be sure, but still a detail. If you want to understand energy policy and how it fits in with other aspects of economic policy, read what Nordhaus has to say.

About Me

David Glasner
Washington, DC

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


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