Archive for March, 2012

A New Version of My Paper (With Ron Batchelder) on Hawtrey and Cassel Is Available on SSRN

It’s now over twenty years since my old UCLA buddy (and student of Earl Thompson) Ron Batchelder and I started writing our paper on Ralph Hawtrey and Gustav Cassel entitled “Pre-Keynesian Monetary Theories of the Great Depression:  Whatever Happened to Hawtrey and Cassel?”  I presented it many years ago at the annual meeting of the History of Economics Society and Ron has presented it over the years at a number of academic workshops.  Almost everyone who has commented on it has really liked it.  Scott Sumner plugged it on his blog two years ago.  Scott’s own very important work on the Great Depression has been a great inspiration for me to continue working on the paper.  Doug Irwin has also written an outstanding paper on Gustav Cassel and his early anticipation of the deflationary threat that eventually turned into the Great Depression.

Unfortunately, Ron and I have still not done that last revision to make it the almost-perfect paper that we want it to be.  But I have finally made another set of revisions, and I am turning the paper back to Ron for his revisions before we submit it to a journal for publication.  In  the meantime, I thought that we should make an up-to-date version of the paper available on SSRN as the current version (UCLA working paper #626) on the web dates back to (yikes!) 1991.

Here’s the abstract.

A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman.  Designed to counter the Keynesian notion that the Great Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an inept Federal Reserve Board.  More recent work on the Great Depression suggests that the causes of the Great Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed.  We document that current views about the causes of the Great Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who warned that restoring the gold standard risked causing a disastrous deflation unless an increasing international demand for gold could be kept within strict limits.  Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored and forgotten.  We offer some possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.

More on Bernanke and the Gold Standard

Last week I criticized Ben Bernanke’s explanation in a lecture at George Washington University of what’s wrong with the gold standard. I see that Forbes has also been devoting a lot of attention to criticizing what Bernanke had to say about the gold standard, though the criticisms published in Forbes, a pro-gold-standard publication, are different from the ones that I was making.

So let’s have a look at what Brian Domitrovic, a history professor at Sam Houston State University, author of a recent book on supply-side economics, and a member of the advisory board of The Gold Standard Now, an advocacy group promoting the gold standard, had to say.

Domitrovic dismisses most of Bernanke’s criticisms of the gold standard as being trivial and inconsequential.

Whatever criticism there is to be leveled at the gold standard during its halcyon days in the late 19th and early 20th centuries, we now know, it is small potatoes. However many panics and bank failures you can point to from 1870 to 1913, the underlying economic reality is that the period saw phenomenal growth year after year, far above the twentieth-century average, and in the context of price oscillations around par that have no like in their modesty in the subsequent century of history.

This sounds like a strong case for the performance of the gold standard, but one has to be careful. Just because the end of the nineteenth century till World War I saw rapid growth, we can’t infer that the gold standard was the cause. The gold standard may just have been lucky to be around at the time. But no serious student of the gold standard has ever argued that it inherently and inevitably must cause financial panics and other monetary dysfunctions, just that it is vulnerable to serious recessions caused by sudden increases in the value of gold.

Domitrovic then reaches for a very questionable historical argument in favor of the gold standard.

Moreover, the silence of the critics about the renewed if modified gold-standard era of 1944-1971, the “Bretton Woods” run of substantial growth and considerable price stability, indicates that it too is innocent of sponsoring an irreducibly faulty monetary system.

I can’t speak on behalf of other critics of the gold standard, but the relevance of 1944-1971 Bretton Woods era to an evaluation of the gold standard is dubious at best. The value of gold was in that period was did not in any sense govern the value of the dollar, the only currency at the time formally convertible into gold. The list of economic agents entitled to demand redemption of dollars from the US was very tightly controlled. There was no free market in gold. The $35 an ounce price was an artifact not a reflection of economic reality, and it is absurd, as well as hypocritical, to regard such a dirigiste set of arrangements as an sort of evidence in favor of the efficacy of a truly operational gold standard.

As a result, Domitrovic contends that Bernanke’s case against the gold standard comes down to one proposition: that it caused the Great Depression. Domitrovic cites Barry Eichengreen’s 1992 book Golden Fetters as the most influential recent study holding the gold standard responsible for the Great Depression.

Eichengreen lays out a case that it was the effort on the part of central banks to defend their currencies’ gold parities from 1929 on that led to the severity of the crisis. The more countries tried to defend their currencies’ values against gold, the more their economies were starved of cash and thus spun into depression; the more nonchalant countries became about gold, the quicker and bigger their recoveries.

But Domitrovic argues that the work of Richard Timberlake – identified by Domitrovic as Milton Friedman’s greatest student in the area of monetary history – to show that there is no evidence “that the Fed was following gold-standard rules or rubrics when it contracted the money supply from 1928 to 1933.”

Gold is nowhere in this story. There’s no evidence that Fed tightening was done in view of any gold-standard requirement, no evidence that gold-market moves pressured the Fed into tightening, no evidence that dwindling gold stocks or the prospect thereof scared the Fed into keeping money extra tight and triggering the Great Contraction.

In fact, the whole while gold was cascading into the Treasury, making it fully possible, indeed mandated, under gold-standard rules (had they been obliged) for the Fed to print money with abandon. Indeed, as Timberlake notes, and this argument is killer, the gold-standard convention had it that all gold was to be monetized by central banks and treasuries in the event of crisis. Here was a crisis, and these institutions stockpiled gold at the expense of money! In sum: the gold standard was inoperative from 1928 to 1933.

The confusions abound. As I pointed out in my earlier post on Bernanke’s problems explaining the gold standard, there is only one rule defining the gold standard: making your currency convertible on demand at a fixed rate into gold or into another currency convertible into gold. References to non-existent “gold-standard rules” obliging the Fed (or any other central bank) to do this or that are irrelevant distractions. No critic of the gold standard and its role in causing the Great Depression ever claimed that the Fed, much less the insane Bank of France, had no choice but to follow the misguided (or insane) policies that they followed. The point is that by following misguided and insane policies that implied a huge increase in the world’s demand for gold, they produced a huge increase in the value of gold which meant that all countries on the gold standard were forced to endure a catastrophic deflation as long as they observed the only rule of the gold standard that is relevant to a discussion of the gold standard, namely the rule that says that the value of your currency must be equal the value of a fixed weight of gold into which you will make your currency freely convertible at a fixed rate. Timberlake is a fine economist and historian, but he unfortunately misinterprets the gold standard as a prescription for a particular set of economic policies, which leads him to make the mistake of suggesting that the gold standard was not operational between 1928 and 1933.

In the 1920s Ralph Hawtrey and Gustav Cassel favored maintaining a version of the gold standard that might have saved the Western Civilization.  Unfortunately, at a critical moment their advice was ignored, with disastrous results.  Why would we want to restore a system with the potential to produce such a horrible outcome, especially when the people advocating recreating a gold standard from scratch seem to have a very high propensity for cluelessness about what a gold standard actually means and why it went so wrong the last time it was put into effect?

Soak the Rich?

I am about to venture slightly out of my usual comfort zone, monetary theory, history, and policy to talk about taxes. You guessed it, March is almost gone, and I still haven’t filed my income tax returns. But that’s not what I am going to write about. I am going to discuss an article by Eduardo Porter (“The Case for Raising Top Tax Rates’) in today’s New York Times Business Section which caught my eye. Porter gives a good summary of the sea change in tax policy that was inspired by a brash young economist with a Ph. D. from the University of Chicago working in the Nixon and then Ford Administration in the early 1970s. His name was Arthur Laffer.  Porter tells the (apocryphal?) story of how Laffer drew his immortal curve for his bosses (Donald Rumsfeld and Dick Cheney — once upon a time able public servants!) on a cocktail napkin showing that any feasible amount of tax revenue could be generated by two tax rates (one high and one low) except for the maximum total revenue achievable only by a unique rate. The Laffer curve became the inspiration for what became known as supply-side economics. Despite enduring much ridicule, the Laffer curve became the central plank in the platform on which Ronald Reagan won the Presidency in 1980. Cutting taxes became the unifying principle on which almost all Republicans could agree, becoming the central pillar of conservative and eventually Republican orthodoxy. It was not always so. Barry Goldwater voted against the Kennedy across-the-board tax cuts of 1963. His vote against tax cuts, cuts supported by his chief opponent for the Republican Presidential nomination in 1964, Nelson Rockefeller — the object of conservative revulsion and outrage to this day — did not evoke so much as a peep of protest by conservatives when Goldwater was carrying the conservative torch in his epic campaign for the GOP nomination.

But as Porter points out, it’s not just conservative and Republican views on taxes that have changed. There was bipartisan support for cutting rates in 1986 when the top marginal rate was cut to 28%. Although Democrats consistently want to raise the top marginal rate, President Obama has not proposed raising the top marginal rate even to 40%, 10% below the 50% top rate under the Reagan tax cuts of 1981.

Why this sea change since the 1960s in views about top marginal rates? Obviously, tax cutting has proved itself to be politically popular, and that may be all the explanation necessary to account for the change in the political consensus about how high marginal tax rates can be raised. But Porter also notes that there was an important economic component in support for keeping tax rates low.

For 30 years, any proposal to raise taxes had to overcome an unshakable belief that higher taxes inevitably led to less growth. The belief survived the Clinton administration, when taxes rose and the economy surged. It survived George W. Bush’s administration, when taxes were cut yet growth sagged.

Porter cites new research suggesting that the scope for tax increases is really a lot greater than had been thought. Not only could the government “raise much more tax revenue by sharply raising the top tax rates paid by the richest Americans, but it could do so without slowing economic growth.” To support this idea, Porter cites a recently published paper by Emmanuel Saez and Nobel Laureate Peter Diamond. They argue that raising the top marginal rate to 80% would NOT cause revenue to fall if the loopholes available to the rich were closed. One obvious problem with that proposal is that the rich have a huge incentive to spend money lobbying against any increase in rates that is accompanied by closing loopholes and against any closing of loopholes not accompanied by a reduction in rates. Guess what? Spending money on Congress works, so don’t hold your breath waiting for tax rates to rise while loopholes are closed. But Saez and Diamond also estimate that even without closing loopholes the top marginal rate could be increased to 48% before any further rate increases would reduce revenue.

Moreover, in another study Saez, Slemrod and Giertz found that although the rich would respond to increases in marginal rates by trying to shelter more of their income, doing so would not cause economic growth to slow down. Porter explains:

That’s because a lot of what the rich do does not, in fact, generate economic growth. So if they reduced their effort in response to higher taxes, the economy wouldn’t suffer.

Porter adds:

The arguments are not the mainstream view. Some economists really dislike them. And they are not absolutely airtight. The calculations rely on estimates about how higher tax rates would discourage the rich from working or investing over a couple of years at most. But we know little about how they might affect long-term decisions, like whether to become a brain surgeon or a hedge fund manager. We do know that in countries with higher tax rates, like France, people work fewer hours than in the United States.

Is there any way of explaining why raising top marginal rates to very high levels would not cause a loss of real income? Here’s an idea. The era of low marginal tax rates in the US has been associated with a huge expansion in the US financial sector. Wall Street has consistently been paying the highest salaries and giving the largest bonuses ever since the 1980s, attracting the best and the brightest from each year’s new crop of grads from our elite colleges and universities. What has been the social payoff to this expansion of finance? I am not so sure. Over a century ago, Thorstein Veblen wrote his book The Theory of the Leisure Class, followed some years later by his essay “The Engineers and the Price System.” He distinguished between engineers who actually make things that people use and financiers who simply make investments on behalf of the leisure class, adding no value to society. This was a vulgar distinction, premised on the unwarranted assumption that finance is unproductive simply because it generate no tangible physical product. On that criterion, Veblen would have ranked pretty low as a contributor to social welfare. Mainstream economists felt pretty comfortable dismissing Veblen because he was presuming that only physical stuff can be valuable.

However in 1971, Jack Hirshleifer, one of my great teachers at UCLA, wrote a classic article “The Private and Social Value of Information and the Reward to Inventive Activity.” The great insight of that article is that the private value of information, say, about what the weather will be tomorrow, is greater than its value to society. The reason is that if I know that it will rain tomorrow, I can go out today and buy lots of cheap umbrellas (suppose I live in Dallas during a drought), and then sell them all tomorrow at a much higher price than I paid for them. The example does not depend on my having a monopoly in umbrellas; I sell every umbrella that I have at the rainy-day market price for umbrellas instead of the sunny-day price. The gain to me from getting that information exceeds the gain to society, because part of my gain comes at the expense of everyone who sold me an umbrella at the sunny-day price but would not have sold to me yesterday had they known that it would rain today.

Our current overblown financial sector is largely built on people hunting, scrounging, doing whatever they possibly can, to obtain any scrap of useful information — useful, that is for anticipating a price movement that can be traded on. But the net value to society from all the resources expended on that feverish, obsessive, compulsive, all-consuming search for information is close to zero (not exactly zero, but close to zero), because the gains from obtaining slightly better information are mainly obtained at some other trader’s expense. There is a net gain to society from faster adjustment of prices to their equilibrium levels, and there is a gain from the increased market liquidity resulting from increased trading generated by the acquisition of new information. But those gains are second-order compared to gains that merely reflect someone else’s losses. That’s why there is clearly overinvestment — perhaps massive overinvestment — in the mad quest for information.

So I am inclined to conjecture that over the last 30 years, reductions in top marginal tax rates may have provided a huge incentive to expand the financial services industry. The increasing importance of finance also seems to have been a significant factor in the increasing inequality in income distribution observed over the same period. But the net gain to society from an expanding financial sector has been minimal, resources devoted to finance being resources denied to activities that produce positive net returns to society. So if my conjecture is right — and I am not at all confident that it is, but if it is – then raising marginal tax rates could actually increase economic growth by inducing the financial sector and its evil twin the gaming sector — to release resources now being employed without generating any net social benefit.

UPDATE 9:39PM EDST:  I left out “not” (now in CAPS) in between “would” and “cause to fall” in the fourth sentence of the paragraph beginning with “Porter cites.”

UPDATE 9:46PM EDST:  I revised the final sentence of the same paragraph which had been unclear.

Bernanke Has Trouble Explaining What’s Wrong with the Gold Standard

Ben Bernanke went to George Washington University on Wednesday to give the first of four lectures on about the Federal Reserve System and the financial crisis.   Wednesday’s lecture was entitled “Origins of the Federal Reserve:  Economic Stability Concerns.”  Most of the news coverage and commentary about the lecture seemed to be addressed to Bernanke’s discussion, about mid-way through the 75 minute lecture, of the gold standard and its shortcomings.  Bernanke’s intentions were certainly admirable, inasmuch as a foolhardy attempt to restore the gold standard now, four score years after its slow, agonizing, disastrous demise in the early 1930s, would recklessly risk a repetition of that catastrophic episode.  Unfortunately, Bernanke did not do a great job of explaining why we ought not give the gold standard one more shot.

Bernanke gave his lecture by going through a power-point presentation consisting of about 50 slides.  He got to the gold standard on slide 22 on which he describes the gold standard as “an alternative to a central bank.”  That is not quite correct, there having been central banks in existence, notably the Bank of England, under the gold standard.  But we can let that pass, because modern-day advocates of the gold standard like to hold up the gold standard as an alternative to central banking.  Bernanke provided a couple of further statements describing the workings of the gold standard.

  • In a gold standard, the value of the currency is fixed in terms of a quantity of gold
  • The gold standard sets the money supply and price level with limited central bank intervention

Now the first statement is perfectly fine.  The gold standard is quintessentially a means by which a unit of account, say the dollar, is defined as a certain weight of gold.  In the US from the late 19th century until 1933, the dollar was defined as a quantity of gold such that an ounce of gold would be worth $20.67.  But the second statement is totally wrong.  The gold standard, by defining what the value of a dollar is in terms of gold, does nothing to “set” the money supply.  (Actually, I don’t know what it means to “set” the money supply, but I am assuming it means something like fixing a particular numerical limit on the number of dollars.)  Under the gold standard, the number of dollars in existence depends on how many dollars the public wants to hold given the value of gold.  Of course, the value of gold means more than the fixed conversion rate between gold and dollars; it means the purchasing power of gold in terms of all other goods.  The more valuable gold is, the fewer dollars people will want to hold at a given conversion rate between the dollar and gold, but the amount of dollars that people will want to hold, not some numerical relationship between gold and dollars, is what determines how many dollars people actually do hold.

Things get even worse (much worse) on the next slide with the heading:  “Problems with the gold standard.”  Here is what Bernanke has to say about that:

  • The strength of the gold standard is its greatest weakness too:  Because the money supply is determined by the supply of gold, it cannot be adjusted in response to changing economic conditions.

Sorry, Professor Bernanke, you got that one wrong, too.  The money supply is not determined, or set, by the supply of gold, so the money supply is perfectly capable of adjusting to changing economic conditions.  What Bernanke probably had in mind was something like the following.  Suppose people get nervous for whatever reason about the state of the economy.  When they get nervous, they want to increase the amount of money they have on hand rather than tying up their wealth in illiquid form.  In such situations, an effective central bank could increase the money supply, providing the public with the added liquidity that they want, thereby allowing the economy to keep functioning, without serious disruption, because the money supply was increased to match the increased demand to hold money.  However, if the money supply is fixed, because under a gold standard the amount of money is determined or set by the supply of gold, the only way that the money supply can increase is by obtaining additional gold.  But it takes a long time to mine more gold out of the ground, so in the meantime, people will have less money on hand than they want to hold, and the only way they can increase their cash holdings is to spend less.  But in the aggregate people can’t increase their holdings of money by reducing their spending; they just reduce money income, forcing prices and output to fall.  In other words the gold standard causes a recession.

So why is that wrong?  It’s wrong, because under a gold standard, if people want to hold more dollars, more dollars can be created.  Yes more dollars can be created out of thin air under a gold standard!  The whole point is that any dollars created have to be convertible on demand into gold.  Well if people want to hold more dollars, they can be created, and held, just as desired.  Given that people want to hold the dollars, not spend them (remember that that was the assumption we just started with), creating additional dollars to be held will not cause an increase in the rate of dollars returned for redemption.  So an increase in the demand for money need not cause a recession under the gold standard.

Well, in that case, so what exactly is the problem with the gold standard?  There’s only a problem with the gold standard if the increase in the demand for money is associated with an increase in the demand for gold.  An increase in the demand for gold over any short period of time implies an increase in the value of gold, because the amount of gold in existence is very large compared to the current rate of production.  So an increase in the demand for gold necessarily increases the value of gold, implying that the prices of everything else in terms of gold start to fall.  Suddenly falling prices – deflation — reduces money income and output, so there’s a recession.  The recession is caused not because the money supply failed to rise — it did rise!–, but because the demand for gold increased.

Why would an increase in the demand for money cause an increase in the demand for gold?  There are two possibilities.  First, there could be legal reserve requirements, so that whenever the quantity of money is increased more gold has to be held as “backing.”  Some (maybe most) people mistakenly believe that the reserve requirement is what constitutes a gold standard.  But it’s not; the gold standard is defining the value of a monetary unit as a fixed weight of gold.  That definition is consistent with any reserve requirement from zero to 100 percent.  The second possibility is that the general feeling of uncertainty that causes people to want to increase their holdings of money also causes them to want to increase their holdings of gold, because they think that the money issued by governments or banks may have become more risky.  This may be true under some circumstances, but not necessarily others.

The gold standard may be able to accommodate some increases in the demand for money, but not others.  It depends.  But historically some episodes in which the demand for money has increased have been associated with increases in the demand for gold.  When that happens, watch out!  Of course in the Great Depression, it was the demand for gold that increased, even before the demand for money increased, largely because of the monetary policy of the insane Bank of France in 1928-29.

Benjamin Cole Sets James Pethokoukis Straight

In the January issue of Commentary magazine, financial journalist James Pethokoukis wrote an article attacking the idea of NGDP targeting. The article was a bundle of silly arguments whose common thread was that NGDP targeting would lead us down the road to inflation and currency debasement. For example, Pethokoukis warned that targeting 5% nominal GDP growth would cause consumers and businesses to worry that inflation would get out of control, thereby undoing the “30 years of startlingly low inflation due to the visionary anti-Keynesian efforts of Paul Volcker in 1981 and 1982.”

How interesting.  The inflation record of Paul Volcker was about 3.5% a year measured in terms of the CPI, once the recovery from the 1981-82 recession got under way. From Q1 1983 through Q2 1987 when Volcker was replaced by Alan Greenspan as Fed Chairman there were only two quarters (Q1 1986 and Q3 1986) when nominal GDP grew at less than a 5% annual rate. For five consecutive quarters, from Q2 1983 through Q2 1984, nominal GDP increased at more than a 10% annual rate. And Mr. Pethokoukis is horrified at the prospect of allowing nominal GDP to grow at a 5% annual rate?

On his blog, David Beckworth responded to Pethokoukis’s article, having been singled out for special attention by Pethokoukis for a piece he wrote with Ramesh Ponnuru in the New Republic advocating NGDP targeting.

I received the April issue of Commentary in the mail yesterday and I was pleased to find a letter to the editor sent by none other than our very own Benjamin Cole commenting on Pethokoukis’s article. Here’s what Benjamin had to say about the article.

James Pethokoukis worries that allowing a bit of inflation could easily “get out of hand,” thereby harming economic growth. But keeping inflation low doesn’t seem to be doing any good, either, which undermines the fear of inflation to which Mr. Pethokoukis subscribes. According to the Federal Reserve Bank of Cleveland, “its latest estimate of 10-year expected inflation is 1.34 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average the next decade.” And whata is this low-inflation-as-far-as-they-eye-can-see forecast doing for growth?

Inflation is not the problem. Inflation is dead. And judging from Japan, inflation is not likely to be a problem.

Growth is the problem — or, rather, lack thereof. The Fed should get aggressive (and not through fiscal stimulus). Really, would not five years of 5 percent real growth and 5 percent inflation do wonder for the economy. Is a slavish and peevish devotion to fighting inflation worth sacrificing prosperity?

Here’s Pethokoukis’s response.

Benjamin Cole makes a point with which I agree. Growth is the real problem. And it has been for a long time. That’s why the United States needs policies that create a fertile environment for stronger long-term growth via more innovation and productivity. Stable prices are a key part of that formula. Higher inflation makes investment less rewarding and creates massive uncertainty. There’s no doubt inflation is low today. Good. Let’s check that box and get to work on reforming the tax code and creating an education system that prepares Americans for the careers of tomorrow. I have a lot more faith in that working to create sustainable growth than in the ability of Ben Bernanke or his successors to precisely dial inflation up or down on command.

Well, the three months since Mr. Pethokoukis published his piece have evidently passed with little sign of any improvement in the ability of Mr. Pethotoukis to formulate a coherent argument. Is it too much to expect that a financial journalist writing in one of the premier opinion magazines in the US be able to distinguish between a strategy for speeding up a cyclical recovery, about which we have a fair amount of economic knowledge, and a strategy for increasing the long-term trend rate of growth of an advanced economy, about which we unfortunately have not much knowledge at all? And how on earth did a policy of stabilizing the rate of nominal GDP growth at 5 percent get transformed into having “Ben Bernanke or his successors . . . precisely dial inflation up or down on command?” Good grief.

The Midnight Economist Reminisces About His Colleague and Co-author Armen Alchian and the Brief but Wonderful Golden Age of the UCLA Econ Department

Bill Allen was a stalwart member of the UCLA economics department in the years of its glory from the late 1950s to the early 1970s. A distinguished economist in his own right, specializing in the international economics and the history of economic thought, Allen is probably best known for having been selected by Armen Alchian to be his co-author in writing the greatest economics textbook ever written and for later becoming the Midnight Economist, delivering daily economic commentaries over the radio from the late 1970s to the early 1980s. The broadcasts are now available on the web or as podcasts, and were also collected in book form.

I have written several earlier posts (e.g., this and this) in which I wrote about what a great place UCLA was to learn economics and what a loss it has been for the economics profession that the special brand of economics taught and practiced at UCLA has been overshadowed by the more formalistic and axiomatic approaches that now dominate the profession, and, alas, even the UCLA economics department itself.

Just yesterday I stumbled upon Bill Allen’s memoir about his own life in Econ Journal Watch and especially about his years at UCLA, and his relationships with his colleagues, and especially, of course, with Alchian. Herewith are a few excerpts:

What defined and distinguished the Core [the central group within the department who were the intellectual leaders of the department and gave the department its unique character, most notably during my day Alchian, Jack Hirshleifer, Allen, George Hilton, Harold Demsetz, Axel Leijonhufvud, and Earl Thompson; Karl Brunner left before I arrived–DG] is a question of considerable subtlety and nuance. The leader of the impressive band clearly was Alchian. His position of prominence evolved and developed, not by his intention or machinationn or the extroverted personality of a self-conscious and self-serving field marshall. (Much later, when as chairman I was recruiting the eminent Jim Buchanan, I apologized to Alchian for being obliged to offer Jim a salary greater than Alchian’s. Armen firmly put me at ease—after all, he had some understanding of how markets work.) Almost always soft-spoken, unaggressive, and seemingly bemused, he was genuinely curious about certain workings of the world, and he was imaginatively and innovatively bold in seeking explanations—and he was remarkably generous in helping other curious analysts. He was confident that much of previously unaccountable behavior and phenomena could be explicated by fundamental and often quite simple (when adroitly utilized) analytic propositions and techniques. The tools of Econ l and 2 can be powerful in masterly hands. Larry Miller observed, with some appreciation, that Alchian “found economics behind every rock.”

The department in its brief Golden Age was aware of being out of step with most of the profession both in the purpose and nature of the work of the Core and in how the work was conducted. For members of the Core, Economics was to be dedicated to genuine, bone fide, real-worldly, enlightening and useful empirical problem-solving. Who is to gain what from the efforts of economists? What is the relevance and worth of their meditations and exercises? How great and widespread would be the net calamity if all the economists suddenly departed for their esoteric Nirvana?

In a 1985 memorandum to me, Leijonhufvud wrote: [Alchian’s] unique brand of price theory is what gave UCLA Economics its own intellectual profile and achieved for us international recognition as an independent school of some importance—as a group of scholars who did not always take their leads from MIT, Chicago or wherever. When I came here (in 1964) the Department had Armen’s intellectual stamp on it (and he remained the obvious leader until just a couple of years ago ….). Even people outside Armen’s fields, like myself, learned to do Armen’s brand of economic analysis and a strong esprit de corps among both faculty and graduate students sprang from the consciousness that this ‘New Institutional Economics’ was one of the waves of the future and that we, at UCLA, were surfing it way ahead of the rest. But Armen’s true importance to the UCLA school did not stem just from the new ideas he taught or the outwardly recognized ‘brandname’ that he created for us. For many of his young colleagues he embodied qualities of mind and character that seemed the more important to seek to emulate the more closely you got to know him.

The entire essay is eminently worth reading, though, like all golden-age stories, it is also, sadly, one of decline and fall. Sic transit gloria mundi.

Was Milton Friedman a Closet Keynesian?

Commenting on a supremely silly and embarrassingly uninformed (no, Ms. Shlaes, A Monetary History of the United States was not Friedman’s first great work, Essays in Positive Economics, Studies in the Quantity Theory of Money, A Theory of the Consumption Function, A Program for Monetary Stability, and Capitalism and Freedom were all published before A Monetary History of the US was published) column by Amity Shlaes, accusing Ben Bernanke of betraying the teachings of Milton Friedman, teachings that Bernanke had once promised would guide the Fed for ever more, Paul Krugman turned the tables and accused Friedman of having been a crypto-Keynesian.

The truth, although nobody on the right will ever admit it, is that Friedman was basically a Keynesian — or, if you like, a Hicksian. His framework was just IS-LM coupled with an assertion that the LM curve was close enough to vertical — and money demand sufficiently stable — that steady growth in the money supply would do the job of economic stabilization. These were empirical propositions, not basic differences in analysis; and if they turn out to be wrong (as they have), monetarism dissolves back into Keynesianism.

Krugman is being unkind, but he is at least partly right.  In his famous introduction to Studies in the Quantity Theory of Money, which he called “The Quantity Theory of Money:  A Restatement,” Friedman gave the game away when he called the quantity theory of money a theory of the demand for money, an almost shockingly absurd characterization of what anyone had ever thought the quantity theory of money was.  At best one might have said that the quantity theory of money was a non-theory of the demand for money, but Friedman somehow got it into his head that he could get away with repackaging the Cambridge theory of the demand for money — the basis on which Keynes built his theory of liquidity preference — and calling that theory the quantity theory of money, while ascribing it not to Cambridge, but to a largely imaginary oral tradition at the University of Chicago.  Friedman was eventually called on this bit of scholarly legerdemain by his old friend from graduate school at Chicago Don Patinkin, and, subsequently, in an increasingly vitriolic series of essays and lectures by his then Chicago colleague Harry Johnson.  Friedman never repeated his references to the Chicago oral tradition in his later writings about the quantity theory, e.g., his essay on the quantity theory of money in the International Encyclopedia of the Social Sciences.  But the simple fact is that Friedman was never able to set down a monetary or a macroeconomic model that wasn’t grounded in the conventional macroeconomics of his time.

Friedman was above all else a superb applied price theorist who wound up doing a lot of worthwhile empirical work and historical on monetary economics, but his knowledge of the history of monetary theory seems to have been pretty much confined to whatever he learned from his teacher Lloyd Mints’s book, A History of Banking Theory in Great Britain and the United States and probably from a classic book, Studies in the Theory of International Trade, by Jacob Viner, another one of Friedman’s teachers at Chicago  That’s why when Friedman finally published an article in two part in the Journal of Political Economy in the early 1970s entitled “A Theoretical Framework for Monetary Analysis,” the papers pretty much flopped, and are now almost completely forgotten (but see here).  Actually Friedman’s intellectual forbears were really W. C. Mitchell and Friedman’s teacher at Columbia Arthur Burns from whom Friedman was schooled in the atheoretical, empirical approach of the old NBER founded by Mitchell.

But Krugman is not totally right either.  Although Friedman obviously liked the idea that the LM-curve was vertical, and liked the idea that money demand is very stable even more, those ideas were not essential to his theoretical position.  (Whether the stability of the demand for money was essential to his position would depend on whether Friedman’s 3-percent growth rule for the money supply is central to his thought.  Although Friedman obviously loved the 3-percent rule, I don’t think that objectively it was really that important to his intellectual position, his sentimental attachment to it notwithstanding.)  What really mattered was the idea that, in the long run, money is neutral and the long-run Phillips Curve is vertical.  Given those assumptions, Friedman could argue that ensuring reasonable monetary stability would lead to better economic performance than discretionary monetary or fiscal policy.  But Friedman, as far as I know, never actually considered the possibility of a negative equilibrium real interest rate.  That’s why, when we look for guidance from Friedman about the current situation, we can’t be completely sure what he would have said.  His comments on Japan suggest that he would have indeed favored quantitative easing.  But inasmuch as he did not explicitly advocate inflation, supporters and opponents of QE can make a case that Friedman would have been on their side.  My own view is that the argument that Friedman would have supported QE is not one of the five or even ten strongest arguments that could be made on its behalf.

Rising Inflation Expectations Work Their Magic

The S&P 500 rose by almost 2% today, closing at 1395.95, the highest level since June 2008, driven by an increase of 6 basis points in the breakeven TIPS spread on 10-year Treasuries, the spread rising to 2.34%. According to the Cleveland Federal Reserve Bank, which has developed a sophisticated method of extracting the implicit inflation expectations from the relationship between conventional Treasuries and TIPS, the breakeven TIPS spread overstates the expected inflation rate, so even at a 10-year time horizon, the market expectation of inflation is still well under 2%. The yield on 10-year Treasuries rose by 10 basis points, suggesting an increase of 4 basis points in the real 10-year interest rate.

Since the beginning of 2012, the S&P 500 has risen by almost 10%, while expected inflation, as measured by the TIPS spread on 10-year Treasuries, has risen by 33 basis points. The increase in inflation expectations was at first associated with falling real rates, the implied real rate on 10-year TIPS falling from -0.04% on January 3 to -0.32% on February 27. Real rates seem to have begun recovering slightly, rising to -0.20% today, suggesting that profit expectations are improving. The rise in real interest rates provides further evidence that the way to get out of the abnormally low interest-rate environment in which we have been stuck for over three years is through increased inflation expectations. Under current abnormal conditions, expectations of increasing prices and increasing demand would be self-fulfilling, causing both nominal and real interest rates to rise along with asset values. As I showed in this paper, there is no theoretical basis for a close empirical correlation between inflation expectations and stock prices under normal conditions. The empirical relationship emerged only in the spring of 2008 when the economy was already starting the downturn that culminated in the financial panic of September and October 2008. That the powerful relationship between inflation expectations and stock prices remains so strikingly evident suggests that further increases in expected inflation would help, not hurt, the economy.  Don’t stop now.

Raising Reserve Requirements

In Monday’s Wall Street Journal, Charles Calomiris advocated raising reserve requirements on banks as a pre-emptive strike against gathering inflationary forces inherent in the huge growth in bank reserves since 2008, forces expected by Calomiris to become increasingly powerful in coming months.

The end of credit crunches like the one we’ve just gone through can see dramatic and sudden increases in bank lending. After six years of zero loan growth in the banking system from 1933 to 1939, for example, a sudden shift in the economic climate produced a surge in lending by U.S. banks, and from December 1939 to December 1941 lending grew by roughly 20%.

That is precisely the risk the U.S. faces over the next several years. Given the huge amount of reserves held by banks in excess of their legal requirements—excess reserves today stand at roughly $1.5 trillion—there is the potential for an even more sudden increase in credit and money growth today, accelerating the inflation rate.

By increasing reserve requirements, in effect quarantining a big chunk of those reserves, the Fed, Calomiris believes, could help keep a lid on inflation while it drained reserves from the banking system over a longer time horizon than it might otherwise have.

However, this recommendation flies in the face of a half-century old consensus, dating at least to the Monetary History of the United States by Friedman and Schwartz, that a key factor in causing the 1937-38 downturn, a downturn shorter but almost as sharp as the 1929-33 downturn, was the doubling of reserve requirements in 1936-37. It was thought at the time that since the banking system was then holding very large amounts of excess reserves, raising reserve requirements would entail no tightening of monetary policy, instead just eliminating slack in the system, thereby making it easier to implement monetary policy. Calomiris acknowledges that his proposal resembles the proposal to increase reserve requirements in 1936-37, now viewed as a disastrous mistake, but maintains that the consensus that raising reserve requirements in 1936-37 led to the downturn of 1937-38 is itself mistaken.

In 1936-37 the Fed doubled reserve requirements as an insurance policy against inflation, and some monetary economists have argued that this contributed to the recession of 1937-38. But recent microeconomic analysis of bank reserve holdings by Joseph Mason, David Wheelock and me in a 2011 working paper available from the National Bureau of Economic Research showed that the higher reserve requirements were small relative to the banks’ pre-existing excess reserves and had no effect on interest rates or the availability of credit.

In their recent paper, Calomiris, Mason and Wheelock attribute the 1937-38 downturn mainly to a policy of sterilization of gold inflows undertaken by the Treasury starting in early 1937. Scott Sumner has similarly emphasized the sterilization policy as a key factor in causing the downturn by increasing the real value of gold, a deflationary shock in the quasi-gold standard monetary regime of the time, with gold convertibility suspended but with gold still playing a very important role in the international monetary system. Doug Irwin has also attributed the 1937-38 downturn to the gold sterilization policy in his recent paper on the subject, and even Friedman and Schwartz in the Monetary History ascribed about as much importance to gold sterilization as they did to the increase in reserve requirements. So Calomiris’s argument that doubling reserve requirements in 1936-37 was not the cause of the 1937-38 downturn is not quite as far out of the mainstream as it seems at first. Nevertheless, Scott Sumner is very critical of Calomiris’s historical argument about the 1937-38 downturn and about his current policy proposal for launching a pre-emptive strike against the gathering inflationary threat.

Now I must admit that I am not that well-informed about the 1937-38 downturn, more or less accepting at face value what I learned as an undergraduate, second-hand from Friedman and Schwartz, that it was the doubling of reserve requirements that caused the problems. While I have come to reject much of what Friedman and Schwartz had to say about 1929-33, until I read what Scott Sumner wrote in his unpublished work on the Great Depression about the role of gold in the 1937-38 downturn, it never occurred to me that there might be more to the 1937-38 episode than the doubling of reserve requirements.  I’m also now aware if Hawtrey wrote anything about the 1937-38 downturn, though it would actually be pretty surprising if he did not.  So, I now have something new to think about. How nice.

So here’s the first thing to cross my mind. Doubling reserve requirements increased the demand for reserves by the banking system. Calomiris et al. deny that increasing reserve requirements raised the demand for reserves, relying on regression estimates of the demand for reserves over 1934-35, which they use to simulate the demand for reserves in 1936-37, finding that there is little unexplained residual left to be attributed to the effect of increased reserve requirements. I still don’t understand the argument, so I can’t say that they are wrong. But it seems to me that if doubling reserve requirements did increase the demand for reserves, as I would expect to have happened, the consequence of the excess demand for reserves would be an influx of gold imports, which is just what happened. However, the policy of gold sterilization prevented the banks from increasing their holdings of reserves. The ongoing excess demand for reserves was translated into an ongoing increase in the demand for gold, causing an increase in its value and a drop in prices as long as the dollar price of gold remained stable. Thus, there was an underlying connection between the doubling of reserve requirements and the sterilization policy, a possibility that Calomiris seems to have overlooked.

There Are Microfoundations, and There Are Microfoundations; They’re Not the Same

Microfoundations are latest big thing on the econoblogosphere. Krugman, Wren-Lewis (and again), Waldmann, Smith (all two of them!) have weighed in on the subject. So let me take a shot.

The idea of reformulating macroeconomics was all the rage when I studied economics as an undergraduate and graduate student at UCLA in the late 1960s and early 1970s. The UCLA department had largely taken shape in the 1950s and early 1960s around its central figure, Armen Alchian, undoubtedly the greatest pure microeconomist of the second half of the twentieth century in the sense of understanding and applying microeconomics to bring the entire range of economic, financial, legal and social phenomena under its purview, and co-author of the greatest economics textbook ever written. There was simply no problem that he could not attack, using the simple tools one learns in intermediate microeconomics, with a piece of chalk and a blackboard. Alchian’s profound insight (though in this he was anticipated by Coase in his paper on the nature of the firm, and by Hayek’s criticisms of pure equilibrium theory) was that huge chunks of everyday economic activity, such as advertising, the holding of inventories, business firms, contracts, and labor unemployment, simply would not exist in the world characterized by perfect information and zero uncertainty assumed by general-equilibrium theory. For years, Alchian used to say, he could not make sense of Keynes’s General Theory and especially the Keynesian theory of involuntary unemployment, because it seemed to exclude the possibility of equilibration by way of price and wage adjustments, the fundamental mechanism of microeconomic equilibration. It was only when Axel Leijonhufvud arrived on the scene at UCLA, still finishing up his doctoral dissertation, published a few years after his arrival at UCLA as On Keynesian Economics and the Economics of Keynes that Alchian came to understand the deep connections between the Keynesian theory of involuntary unemployment and the kind of informational imperfections that Alchian had been working on for years at the micro-level.

So during my years at UCLA, providing microfoundations for macroeconomics was viewed as an intellectual challenge for gaining a better understanding of Keynesian involuntary unemployment, not as a means of proving that it doesn’t exist. Reformulating macroeconomic theory (I use this phrase in homage to the unpublished paper by the late Earl Thompson, one of Alchian’s very best students) based on microfoundations did not mean simply discarding Keynesian theory into the dustbin of history.  Unemployment was viewed as a search process in which workers choose unemployment because it would be irrational to accept the first offer of employment received regardless of the wage being offered. But a big increase in search activity by workers can have feedback effects on aggregate demand preventing a smooth transition to a new equilibrium after an interval of increased search. Alchian, an early member of the Mont Pelerin Society, was able to see the deep connection between Leijonhufvud’s microeconomic rationalization of Keynesian involuntary unemployment and the obscure work, The Theory of Idle Resources, of another member of the MPS, the admirable human being, and unjustly underrated, unfortunately now all but forgotten, economist, W. H. Hutt, who spent most of his professional life engaged in a battle against what he considered the fallacies of J. M. Keynes, especially Keynes’s theory of unemployment.

Unfortunately, this promising approach towards gaining a deeper and richer understanding of the interaction between imperfect information and uncertainty, on the one hand, and, on the other, a process of dynamic macroeconomic adjustment in which both prices and quantities are changing, so that deviations from equilibrium can be cumulative rather than, as conventional equilibrium models assume, self-correcting, has yet to fulfill its promise. Here the story gets complicated, and it would take a much longer explanation than I could possibly reduce to a blog post to tell it adequately. But my own view, in a nutshell, is that the rational-expectations revolution — especially the dogmatic view of how economics ought to be practiced espoused by Robert Lucas and his New Classical, Real Business Cycle and New Keynesian acolytes — has subverted the original aims of the microfoundations project. Rather than relax the informational assumptions underlying conventional equilibrium analysis to allow for a richer and more relevant analysis than is possible when using the tools of standard general-equilibrium theory, Lucas et al. developed sophisticated tools that enabled them to nominally relax the informational assumptions of equilibrium theory while using the tyrannical methodology of rational expectations combined with full market clearing to preserve the essential results of the general-equilibrium model. The combined effect of the faux axiomatic formalism and the narrow conception of microfoundations imposed by the editorial hierarchy of the premier economics journals has been to recreate the gap between the Keynesian theory of involuntary unemployment and rigorous microeconomic reasoning that Alchian, some forty years ago, thought he had found a way to bridge.

Update (1:16PM EST):  A commenter points out that the first sentence of my concluding paragraph was left unfinished.  That’s what happens when you try to get a post out at 2AM.  The sentence is now complete; I hope it’s not to disappointing.

About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner


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