No question about it Charles Schwab is a very smart man, and performed a great service by making the stock brokerage business a lot more competitive than it used to be before he came on the scene. But does that qualify him as an expert on monetary policy? Not necessarily. But I am not sure what qualifies anyone as an expert on monetary policy, so I don’t want to suggest that a lack of credentials disqualifies Mr. Schwab, or anyone else, even Ron Paul, from offering an opinion on monetary policy. But in his op-ed piece in today’s Wall Street Journal, Mr. Schwab certainly gets off to a bad start when he says:
We’re now in the 37th month of central government manipulation of the free-market system through the Federal Reserve’s near-zero interest rate policy. Is it working?
Thirty-seven months ago, the US and the world economy were in a state of crisis, with stock prices down almost 50 percent from their level six months earlier. To suggest that taking steps to alleviate that crisis constitutes government manipulation of the free-market system is clearly an ideologically loaded statement, acceptable to a tiny sliver of professional economists, lacking any grounding in widely accepted economic principles. The tiny sliver of economists who would agree with Mr. Schwab’s assessment may just be right — though I think they are wrong — but on as controversial a topic as this, it bespeaks a certain arrogance to assert as simple fact what is in fact the view of a tiny, and not especially admired, minority of the economics profession. (I don’t mean the preceding sentence to be construed as in any way an attack on economists favoring a free-market monetary system. I know and admire a number of economists who take that view, I am just emphasizing how unorthodox that view is considered by most of the profession.)
It’s actually a pity that Mr. Schwab chose to couch his piece in such ideological terms, because much of what he says makes a lot of sense. For example:
Business and consumer loan demand remains modest in part because there’s no hurry to borrow at today’s super-low rates when the Fed says rates will stay low for years to come. Why take the risk of borrowing today when low-cost money will be there tomorrow?
Many of us in the Market Monetarist camp already have pointed out that the Fed’s low interest policy is a double-edged sword, because the policy, as Mr. Schwab correctly points out, tends to reinforce self-fulfilling market pessimism about future economic conditions. The problem arises because the economy now finds itself in what Ralph Hawtrey called a “credit deadlock.” In a credit deadlock, pessimistic expectations on the part of traders, consumers and bankers is so great that reducing interest rates does little to stimulate investment spending by businesses, consumer spending by households, and lending by banks. While recognizing the obstacles to the effectiveness of monetary policy conducted in terms of the bank rate, Hawtrey argued that there are alternative instruments at the disposal of the monetary authorities by which to promote recovery.
Mr. Schwab goes on to provide a good description of the symptoms of a credit-deadlock except that he attributes the cause of the deadlock entirely to Fed actions rather than to an underlying pessimism that preceded them.
The Fed policy has resulted in a huge infusion of capital into the system, creating a massive rise in liquidity but negligible movement of that money. It is sitting there, in banks all across America, unused. The multiplier effect that normally comes with a boost in liquidity remains at rock bottom. Sufficient capital is in the system to spur growth—it simply isn’t being put to work fast enough.
He makes a further astute observation about the ambiguous effects of the Fed’s announcement that it is planning to keep interest rates at current levels through 2014.
The Fed’s Jan. 25 statement that it would keep short-term interest rates near zero until at least late 2014 is sending a signal of crisis, not confidence. To any potential borrower, the Fed’s policy is saying, in effect, the economy is still in critical condition, if not on its deathbed. You can’t keep a patient on life support and expect people to believe he’s gotten better.
Mr. Schwab then argues that all that is required to cure the credit deadlock is for the Fed to declare victory and begin a strategic withdrawal from the field of battle.
This is what investors, business people and everyday Americans should hope to hear from Mr. Bernanke after the next Federal Open Market Committee meeting:
The Federal Reserve used its emergency powers effectively and appropriately when the financial crisis began, but it is very clear that the economy is on the mend and that the benefit of inserting massive liquidity into the economy has passed. We will let interest rates move where natural markets take them. Our experiment with market manipulation will stop beginning today. Effective immediately, we will begin to move Fed rate policy toward its natural longer-term equilibrium. With the extremes of the financial crisis of 2008 and 2009 long behind us, free markets are the best means to create stable growth. Our objective is now to let the system work on its own. It is now healthy enough to do just that. We hope today’s announcement does two things immediately: first, that it highlights our confidence—supported by the data—that the U.S. economy is out of its emergency state and in the process of mending, and second, that it reflects our belief that the Federal Reserve’s role in economic policy is limited.
What Mr. Schwab fails to note is that the value of money (its purchasing power at any moment) and the rate of inflation cannot be determined in a free market. That is the job of the monetary authority. Aside from the tiny sliver of the economics profession that believes that the value of money ought to be determined by some sort of free-market process, that responsibility is now taken for granted. The problem at present is that the expected future price level (or the expected rate of growth in nominal GDP) is below the level consistent with full employment. The problem with Fed policy is not that it is keeping rates too low, but that it is content to allow expectations of inflation (or expectations of future growth in nominal GDP) to remain below levels necessary for a strong recovery. The Reagan recovery, as I noted recently, is hailed as a model for the Obama administration and the Fed by conservative economists like John Taylor, and the Wall Street Journal editorial page, and presumably by Mr. Charles Schwab himself. The salient difference between our anemic pseudo recovery and the Reagan recovery is that inflation averaged 3.5 to 4 percent and nominal GDP growth in the Reagan recovery exceeded 10 percent for 5 consecutive quarters (from the second quarter of 1983 to the second quarter of 1984). The table below shows the rate of NGDP growth during the last six years of the Reagan administration from 1983 through 1988. This is why, as I have explained many times on this blog (e.g., here and here)and in this paper, since the early days of the Little Depression in 2008, the stock market has loved inflation.
Here’s how Hawtrey put it in his classic A Century of Bank Rate:
The adequacy of these small changes of Bank rate, however, depends upon psychological reactions. The vicious circle of expansion or contraction is partly, but not exclusively, a psychological phenomenon. It is the expectation of expanding demand that leads to a creation of credit and so causes demand to expand; and it is the expectation of flagging demand that deters borrowers and so causes demand to flag. . . . The vicious circle may in either case have any degree of persistence and force within wide limits; it may be so mild as to be easily counteracted, or it may be so violent as to require heroic measures. (p. 275)
Therefore the monetary authorities of a country which has been cut loose from any metallic or international standard find themselves compelled to some degree to regulate the foreign exchanges, either by buying and selling foreign currencies or gold, or (deplorable alternative) by applying exchange control. Thus at any moment the problem of monetary policy presents itself as a choice between a modification of the rate of exchange credit an adjustment of the credit system through Bank rate. And if the modification of the rate of exchange is such as to favour stable activity, the need for a change in Bank rate may be all the less. When a credit deadlock has thrown Bank rate out of action, modification of rates of exchange may be found to be the most valuable and effective instruments of monetary policy. (p. 277)
There is thus no doubt that the Fed could achieve (within reasonable margins of error) any desired price level or rate of growth in nominal GDP by announcing its target and expressing its willingness to drive down the dollar exchange rate in terms of one or several currencies until its price level or NGDP target were met. That, not abdication of its responsibility, is the way the Fed can strengthen the ever so faint signs of a budding recovery (remember those green shoots?).
Uneasy Money 
In case you’re curious, the reason why Schwab cares about interest rates is that customer cash is a major profit source, which has been much reduced. They don’t particularly care whether the rate is 1% or 2%, but they care a lot about whether it is 0% or 1%.
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The right-wing laissez-faire ideology that anything government does is wrong and the market is automatically self-correcting is paralyzing this country. It reflects simple-minded thinking from people that want to ignore history and reality. The United States used to be a country that prided itself on pragmatism and avoided ideological shibboleths. Now, especially on the right, that’s all we get.
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As I am sure you are aware, there are and have been some very respectable economists in that “tiny sliver of the economics profession that believes that the value of money ought to be determined by some sort of free-market process.” Notable examples include Gary Becker, Milton Friedman, and Anna Schwartz.
Sources:
Gary S. Becker, “A Proposal for Free Banking,” unpublished manuscript (1957).
Milton Friedman and Anna J. Schwartz, “Has Government Any Role in Money?” J. Monetary Econ. 17 (January 1986): 37-62.
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The topic of money is of religious and moral significance to many, evidently including Schwab. He joins the Econo-Shamans and Theo-Monetarists in asserting that tight money will lead to economic salvation. The psychic income derived from monetary asceticism trumps the lost aerial gains.
Actually, the Fed has been tight—why else is inflation dead and interest rates near zero? Schwab should read Milton Friedman’s observations about Japan. The question is why is the Fed passively tight when the CPI is flat for three months running, unit labor costs are falling and GDP is 13 percent below trend.
Additionally, an inchoate rhetoric conflates fiscal and monetary policy, as in “We have to balance the federal budget and stop printing so much money.”
This flatulent excretion from Schwab was probably cathartic for him, but regrettably a less ennobling experience for the rest of us.
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Add on: I find it worth noting that the WSJ is ever arguing against monetary stimulus now, when inflation is dead. Back in the 1980s, they told Volcker is ease up when inflation was a notch below five percent.
I think it a justifiable suspicion that what the WSJ wants is Obama out of office, by monetary asphyxiation if necessary.
Sheesh, John Taylor, Allan Meltzer, Milton Friedman and Ben Bernanke all told Japan to print more money in similar circumstances.
I suspect sentiments have become so hysterically partisan that almost anything written in the WSJ has to be taken with a truckload of salt.
Crickey, Rove is even sniveling about a Super Bowl ad.
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For comedic relief—-I think.
States seek currencies made of silver and gold
By Blake Ellis @CNNMoney February 3, 2012: 10:53 AM ET
Worried that the Federal Reserve and the U.S. dollar are on the brink of collapse, more than a dozen states have proposed using their own alternative currencies of silver and gold.place.
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It seems to me that the disagreement is not so much in the realm of entrepreneurial expectations,* but rather in the real consequences of a monetary contraction (to be more specific than “deflation”). That is, it is believed to be efficient for a central monetary authority to respond to a financial crisis characterized by a general monetary contraction, because monetary contraction tends to reinforce itself in some sort of cycle (Fisher’s theory of debt-deflation).
If this is true, then why aren’t these points of contentions being debated? I think, to some extent, those in the majority simply don’t see a sufficient enough benefit to re-opening the debate. It seems more beneficial to simply assume the case as closed and go on developing more theory. As of right now, however, the development of theory isn’t in question; rather, what’s in question are the policy prescriptions. Thus, the cost to re-opening the debate is the loss of the opportunity to push for your policy prescription — but, what if your policy prescription is based on an erroneous theoretical foundation (as much as you believe otherwise)?
I guess you can cross-analyze the merits of re-opening debate thought closed in the 1920s, 1930s, and 1940s (but, apparently not) in many different directions and come to many different conclusions. I would think, though, that the blogosphere gives the unique opportunity for re-opening the debate at a lesser cost — it allows the different sides to revisit the roots of their disagreement, and with much less time lost. Otherwise, I feel as if the debate will continue to go on rediculously superficially (because, if your opponent doesn’t agree with Fisher’s debt-deflation theory and you fail to recognize and address this, you guys are just simply going to be arguing over each others’ heads).
By the way, Benjamin Cole, the accusations can go both way (and, unfortunately, have gone both ways) — market monetarists don’t agree with those who prefer a completely free market in money, because it is the market monetarists who are religiously invested in their theories! For those of us who are serious, I think it is obvious that the accusations — in both direction — are wrong, silly, and not particularly constructive. Neither does characterizing your intellectual opponents with accusations of religious dogma give any credibility to your own beliefs, since the accuracy of your theory is completely unrelated to the accuracy of others (an accuracy that you fail to challenge).
* And, expectations can only be understood within the context of real economic phenomena.
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Jon Feingold-
As a Market Monetarist (layman version) I can tell you I am only interested in what works. If the gold standard would work, I would be for that.
I do not sense the same detachment when reading the works of gold nuts, currency worshippers or others of the ilk. A lot of pseudo-moralism creeps into the copy, as in “debasement of currency,” or “inflation is theft.” Even the simple evocation of gold—rarely silver, or platinum—bespeaks of quasi-religious undertones to much of what we hear from traditional monetarists.
And why the peevish fixation on inflation (if not a form of currency worship)?
From 1982 to 2008, the USA had CPI inflation from 2 percent to 6 percent, and we boomed. Industrial production doubled. Obviously, we can thrive with moderate inflation. It is an irrefutable historical fact. Indeed, moderate inflation may be conducive to overcoming sticky wages, and encouraging business borrowing and lending. Right now, moderate inflation would help the USA deleverage.
Yet we have an hysterical obsession that inflation might be above zero or two percent!!!
I have to say, neither the Keynesians and their deficits, nor the tight money crowd, have anything to offer the USA today. The Market Monetarists have something to offer. I think it will work, and I would sure like to try.
Come on and join the Market Monetarists.
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Benjamin,
What your first sentence implies is that those of us who are not market monetarists must be interested in what does not work! But, it does not work that way — we simply disagree on what works and what does not. Figuring out who is right is the point of debate. If you are not interested in debate, but in re-affirming your point of view regarding “what works,” then who is the religious dogmatist?
Not all “gold nuts” support the gold standard (I could place a period at the end of standard) on the basis of “theft” or inflation. Many support a free market in money (which may or may not see the use of gold as a form of money) because they honestly believe that the theoretical evidence suggests this is the most stable currency system. There are many good arguments made by the “tight money crowd” (a very broad category, I might add) that you simply wave away — I’m not really sure this is the correct way of approaching disagreement in economics.
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Jon-
Well, I am just a layman. A business guy, washed-up financial reporter.
Most of what I write comes from my gut instinct as to what will work. I don;t have a Phd.
You have to admit, the Market Monetarists have pasted together an impressive game plan, by patching together ideas online. No one knows is MM will work, unless we try. I do not see how it could not work, or do less well than the current peek-a-boo, inflation-obsessed style of the Fed.
A free market in money? I guess I think the power of the sovereign has to back up money. We also need to print money in case of war (I am a peacenik, but WWII does come to mind). What about counterfeiting? Lack of acceptance?
And what would back up this free market money? Assurances from Wall Street types? AIG? Bear Stearns? Bank of America? Long Term Capital Management? Washington Mutual? Merrill Lynch? I cannot think of a private-sector company that has enough gravitas to back up money. I need to know that USA can print more money and pay me off.
Even Greece comes to mind. No more power of the press, and they cannot pay off bonds, and now disaster. You want the USA to default on its debt? I would rather we inflate out of dent than default. We lose that option with private money.
A gold standard? Why gold? Money backed by what? A mix of commodities—more baubles? It all begins to sound koo-koo.
Listen, maybe your system is better. But I am talking about MM, and that is something we could effect right now. To good effect. Some nations, such as sweden, appear to already have embraced MM. We are not that far away in the USA.
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Jon, since when did Market Monetarists argue against a truely free market in money?
Yes, all of the MM bloggers oppose the gold standard, which none of us consider to be a true free market. However, David wrote an excellent book advocating Free Banking. Bill Woolsey have written numerous article that are pro-free banking. David Beckworth surely also have Free Banking sympathies. Finally I have personally also written favourably about Free Banking on my own blog. In fact I think I given more attention to George Selgin’s research than to any other monetary theorist. Finally even though Scott Sumner does not argue in favour of Free Banking he certainly is not hostile to Free Banking. In fact I have argued that Scott’s idea about NGDP futures could be seen as part of a privatisation strategy.
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Max, Thanks for that tidbit, but it doesn’t affect my take on his position one way or the other.
Marc, I agree that people are taking an ideological position to extremes, which is always a bad thing. Hayek and most other classical liberals did not oppose regulations or interventions in every case. The point was to make regulations and interventions conform to certain standards of generality and impartiality and to allow scope for prices to adjust to as an equilibrating mechanism.
William Luther, I tried to be precise in how I formulated a description of the tiny sliver. Milton Friedman and Anna Schwartz, by my reading of their work, were not in the tiny sliver, because they did not favor allowing the choice of the money in terms of which contracts are made to be left up to the market. After opposing free banking for most of his career, Friedman, along with Anna Schwartz, came to support free banking at some point. But, as far as I recall, they still favored making all domestically produced bank money convertible into US dollars (Federal Reserve notes or reserves). I recall that Gary Becker wrote a paper on free banking very early in his career; it’s possible that I once read it, but I don’t remember much about it.
Benjamin, I was trying to look at what was positive in Schwab’s piece, not just condemn his mistakes. I think it is legitimate to condemn the Fed for the low interest rates now in effect. The problem is to find the right strategy for getting interest rates back up to “normal” levels. But we agree that the hypocrisy of the critics of Fed policy because it is inflationary is pretty blatant.
Jon, Part of the problem is that there noise to signal (or nonsense to sense) ratio in gold standard talk (and other related kinds of talk) is so high that the sensible arguments tend to get obscured, which is why someone like Benjamin is likely to conclude that every argument for gold or against monetary expansion in a depression is nonsensical.
Lars, Thanks for the favorable mention of my book. I generally still support what I wrote, but I don’t regard those proposals as relevant in the current context. First things first. After a recovery, we can talk about fundamental monetary reform. But my proposal involves the government defining the monetary standard and ensuring by the establishment of a set of monetary institutions a prescribed time path for the wage level. For believers in free market money, my proposal is just a different form of monetary management, which they have condemned since the 1920s when they regarded Irving Fisher and Ralph Hawtrey and J.M. Keynes as the enemy.
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As a master’s student in Economics, one thing which sort of jumped out at me from what Mr. Schwab wrote is that there seems to be an assumption that the only relevant factor is the intertemporal expected returns, which he seems to link directly to the interest rate and not to the performance of the real economy. My quibble is primarily that the depression we are in looks to me more like a shortfall in aggregate demand, which would indicate a need for lower real interest rates (probably by increasing inflation expectations) or serious deficit spending.
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Julian, That pretty much how I look at it as well. But I think that an increase in inflation expectations associated with a monetary expansion would quickly cause real interest rates to rise as entrepreneurial optimism returned, providing a path for timely withdrawal of monetary stimulus.
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