Archive for April, 2012

Benjamin Cole Recounts Some Inconvenient History

The peripatetic Benjamin Cole, a frequent and valued commenter on  this and many other blogs, wrote a guest post the other day on Marcus Nunes’s blog, putting the current “sound money” rhetoric emanating from the self-appointed heirs to Ronald Reagan’s political legacy in proper historical perspective.  An important public service and a must read.  Kudos to Benjamin and to Marcus.

Why NGDP Targeting?

Last week, David Andolfatto challenged proponents of NGDP targeting to provide the reasons for their belief that targeting NGDP, or to be more precise the time path of NGDP, as opposed to just a particular rate of growth of NGDP, is superior to any alternative nominal target. I am probably the wrong person to offer an explanation (and anyway Scott Sumner and Nick Rowe have already responded, probably more ably than I can), because I am on record (here and here) advocating targeting the average wage level.  Moreover, at this stage of my life, I am skeptical that we know enough about the consequence of any particular rule to commit ourselves irrevocably to it come what may.  Following rules is a good thing; we all know that.  Ask any five-year old. But no rule is perfect, and even though one of the purposes of a rule is to make life more predictable, sometimes following a rule designed for, or relevant to, very different circumstances from those in which we may eventually find ourselves can produce really bad results, making our lives and our interactions with others less, not more, predictable.

So with that disclaimer, here is my response to Andolfatto’s challenge by way of comparing NGDP level targeting with inflation targeting. My point is that if we want the monetary authority to be committed to a specific nominal target, the level of NGDP seems to be a much better choice than the inflation rate.

As I mentioned, Scott Sumner and Nick Rowe have already provided a bunch of good reasons for preferring targeting the time path of NGDP to targeting either the level (or time path) of the price level or the inflation rate. The point that I want to discuss may have been touched on in their discussions, but I don’t think its implications were fully worked out.

Let me start by noting that there is a curious gap in contemporary discussions of inflation targeting; which is that despite the apparent rigor of contemporary macro models of the RBC or DSGE variety, supposedly derived from deep microfoundations, the models don’t seem to have much to say about what the optimal inflation target ought to be. The inflation target, so far as I can tell – and I admit that I am not really up to date on these models – is generally left up to the free choice of the monetary authority. That strikes me as curious, because there is a literature dating back to the late 1960s on the optimal rate of inflation. That literature, whose most notable contribution was Friedman’s 1969 essay “The Optimal Quantity of Money,” came to the conclusion that the optimal quantity of money corresponded to a rate of inflation equal to the negative of the equilibrium (or natural) real rate of interest in an economy operating at full employment.

So, Friedman’s result implies that the optimal rate of inflation ought to fluctuate as the real equilibrium (natural) rate of interest fluctuates, fluctuations to which Friedman devoted little, if any, attention in his essay. But from our perspective there is an even more serious shortcoming with Friedman’s discussion, namely, his assumption of perpetual full employment, so that the real interest rate could be identified with the equilibrium (or natural) rate of interest. Nevertheless, although Friedman seemed content with a steady-state analysis in which a unique equilibrium (natural) real interest rate defined a unique optimal rate of deflation (given a positive equilibrium real interest rate) over time, thereby allowing Friedman to achieve a partial reconciliation between the optimal-inflation analysis and his x-percent rule for steady growth in the money supply (despite the mismatch between his theoretical analysis of the rate of inflation in terms of the monetary base and his x-percent rule in terms of M1 or M2), Friedman’s analysis provided only a starting point for a discussion of optimal inflation targeting over time. But the discussion, to my knowledge, has never taken place. A Taylor rule takes into account some of these considerations, but only in an ad hoc fashion, certainly not in the spirit of the deep microfoundations on which modern macrotheory is supposedly based.

In my paper “The Fisher Effect under Deflationary Expectations,” I tried to explain and illustrate why the optimal rate of inflation is very sensitive to the real rate of interest, providing empirical evidence that the financial crisis of 2008 was a manifestation of a pathological situation in which the expected rate of deflation was greater than the real rate of interest, a disequilibrium phenomenon triggering a collapse of asset prices. I showed that, even before asset prices collapsed in the last quarter of 2008, there was an unusual positive correlation between changes in expected inflation and changes in the S&P 500, a correlation that has continued ever since as a result of the persistently negative real interest rates very close to, if not exceeding, expected inflation. In such circumstances, expected rates of inflation (consistently less than 2% even since the start of the “recovery”) have clearly been too low.

Targeting nominal GDP, at least in qualitative terms, would adjust the rate of inflation and expected inflation in a manner consistent with the implications of Friedman’s analysis and with my discussion of the Fisher effect. If the monetary authority kept nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically rise in recessions, just when the real interest rate would be falling and the optimal inflation rate rising. And in a recovery, with nominal GDP increasing at a 5% annual rate, the rate of inflation would automatically fall, just when the real rate of interest would be rising and the optimal inflation rate falling.  Viewed from this perspective, the presumption now governing contemporary central banking that the rate of inflation should be held forever constant, regardless of underlying economic conditions, seems, well, almost absurd.

What Hath Bernanke Wrought?

The advance estimate of GDP for the first quarter of 2012 published today provides little cause for celebration, and not much reason for hope.  Real GDP growth slowed to a 2.2% annual rate from the 3.0% rate in the previous quarter.  Nominal GDP growth remained at 3.8%, reflecting a spike in oil prices as a result of nervousness about disruptions in oil supplies from the Persian Gulf.  But despite the lackluster performance, Ben Bernanke no doubt feels well satisfied, as this answer, responding to criticism from Paul Krugman, from his press conference after this week’s FOMC meeting, demonstrates all too clearly.

So there’s this, uh, view circulating that the views I expressed about 15 years ago on the Bank of Japan are somehow inconsistent with our current policies. That is absolutely incorrect. My views and our policies today are completely consistent with the views that I held at that time. I made two points at that time. To the Bank of Japan, the first was that I believe a determined central bank could, and should, work to eliminate deflation, that it’s [sic] falling prices.

The second point that I made was that, um, when short-term interest rates hit zero, the tools of a central bank are no longer, are not exhausted there, are still other things that, um, that the central bank can do to create additional accommodation.

Now looking at the current situation in the United States, we are not in deflation. When deflation became a significant risk in late 2010 or at least a moderate risk in late 2010, we used additional balance sheet tools to return inflation close to the 2% target.   Likewise, we’ve been aggressive and creative in using nonfederal funds rate centered tools to achieve additional accommodation for the U.S. economy. So the, the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that, Japan was in deflation and clearly, when you’re in deflation and in recession, then both sides of your mandate, so to speak, are demanding additional deflation [sic].

Why don’t we do more? I would reiterate, we’re doing a great deal of policies extraordinarily accommodative.  You know all the things we’ve done to try to provide support to the economy. I guess the, uh, the question is, um, does it make sense to actively seek a higher inflation rate in order to, uh, achieve a slightly increased pace of reduction in the unemployment rate?  The view of the committee is that that would be very, uh, uh, reckless. We have, uh, we, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable, in that we’ve been able to take strong accommodative actions in the last four or five years to support the economy without leading to a, [indiscernible] expectations or destabilization of inflation. To risk that asset, for, what I think would be quite tentative and, uh, perhaps doubtful gains, on the real side would be an unwise thing to do.

Paul Krugman responded on his blog to this not very edifying answer by Mr. Bernanke; Krugman pointed out that the sharp distinction between the situation in Japan and the situation in the US is not as clear cut as Bernanke makes it out to be.  Moreover, there is no basis for saying that there is a bright line between positive and negative inflation so that the economic effects change radically when you go from very low positive inflation to very low negative inflation.
I would make a further comment on Bernanke’s performance.  Since 1947, every single recovery has been associated with several quarters of nominal GDP growth in excess of 5% as the chart below demonstrates.  The only recovery in which nominal GDP growth did not initially exceed 5% for several quarters was the anemic recovery from the 2001 recession in which nominal GDP growth remained under 5% for several quarters before increasing above 5%, but only slightly above 5%.
With what passion does Mr. Bernanke invoke the experience of the past 30 years during which the Federal Reserve, has patiently “built up its credibility for low and stable inflation,” credibility that “proved extremely valuable” in enabling the Fed “to take strong accommodative actions in the last four or five years to support the economy without leading to . . . expectations or destabilization of inflation.”  Well, I am deeply moved by Mr. Bernanke’s deeply pious reverence for the lessons of the last 30 years, but let’s have a little closer look at the record of the last 30 years in the next chart.
And what does the chart show?  It shows over the past 30 years in which the Fed has built up so much credibility that the Fed has been able to do all the wonderful things that it has done to promote . . ., well, to promote the weakest recovery since World War II, nominal GDP growth after each recession during the past 30 years substantially exceeded 5% quarter after quarter.  During this recovery, however, the annual rate of nominal GDP growth has not exceeded 5.5% in any quarter since the “recovery” began, while averaging less than 4%.  And Mr. Bernanke has the nerve to tell us that he is unwilling to allow inflation to increase above 2% because it would squander the precious credibility achieved by the Fed over the past 30 years when nominal GDP during recoveries almost always grew at an annual rate greater, often substantially greater, than 5%?  Remember the audacity of hope?  This is the audacity of complacency and indifference.

Wicksteed on the Value of Paper Money

P. H. Wicksteed has a strong claim to having been the greatest amateur economist in the history of our subject.  By profession, he was a Unitarian minister, theologian, classicist, medievalist, perhaps the foremost Dante scholar of his time, translator of the Inferno, who was inspired to the study of economics and later mathematics by his reading of Henry George which led him to study William Stanley Jevons’s Theory of Political Economy.  Wicksteed’s claim to having been the greatest economist in the history of our subject is somewhat weaker, but only somewhat.  Wicksteed was the first economic imperialist, the first economist to take seriously the notion that economic theory in the form of marginal utility analysis could explain supposedly non-economic behavior, providing a coherent statement of the idea that all rational goal-oriented action could be anlayzed using economic theory, thereby giving a very different interpretation to the term “homo economicus” from the way it had previously been understood.  In that sense, Wicksteed anticipated the ideas of both Ludwig von Mises and Gary Becker.

What is less well known is that Wicksteed discovered and stated the Coase Theorem, or at least the key lemma required to prove the Coase Theorem 46 years before Coase first published the theorem in his 1959 article on the Federal Communications Commission.  Wicksteed’s anticipation of the Coase Theorem appeared in a celebrated essay “The Scope and Method of Political Economy in the Light of the “Marginal” Theory of Value and Distribution.”  The proposition that Wicksteed proved is well known:  that there is no supply curve.

But what about the “supply curve” that usually figures as a determinant of price, co-ordinate with the demand curve?  I will say it boldly and baldly:  There is no such thing.

What does this have to do with the Coase Theorem?  Read on.

For it will be found on a careful analysis that the construction of a diagram of intersecting demand and “supply” curves always involves, but never reveals, a definite assumption as to the amount of the total supply possessed by the supposed buyers and sellers taken together as a single homogenous body,and that if this total is changed the emerging price changes too; whereas a change in its initial distribution (if the collective curve is unaffected, while the component or intersecting curves change) will have no effect on the market, or equilibrating price itself, which will come out exactly the same.  Naturally, for neither the one curve nor the one quantity which determine the price has been changed.

There you  have the Coase Theorem: a competitive equilibrium is independent of the initial allocation (given, as Wicksteed implicitly assumed, zero transactions costs).  What Coase added was the insight that what is being traded when people engage in exchange is not physical commodities but rights to those commodities, so that the our conception of the process of exchange should be expanded to include the exchange of rights to engage in certain kinds of action, say, the emission of smoke or other nuisances.

All this is by way of introduction to the following lengthy excerpt from Book II, Chapter 7 of Wicksteed’s magnum opus, The Common Sense of Political Economy in which Wicksteed analyzed the role of the government in conferring value on so-called fiat money.  Although Wicksteed was through and through a neo-classical economist, he provided the most elegant and comprehensive statement of the theory, nowadays generally associated with Modern Monetary Theorists and usually traced back to Georg Friedrich Knapp’s State Theory of Money.  Nick Rowe mentioned Wicksteed in a post yesterday as the source for the theory that acceptability as payment for taxes is what allows fiat money to have value, but didn’t provide a source.  Although the quotation is rather long, it is such a powerful piece of analysis that I thought that it deserves to be quoted in full.

If we now turn to paper currencies, again, we shall remodel the statement thus: It is not true that a government can confer on pieces of paper, or other intrinsically worthless articles, the collective power of doing the business of the country, but it can within certain limits confer a defined power of doing business on certain pieces of printed paper. For the government, as general guardian of contracts and of property, has the power to enforce or to decline to enforce any contracts, and as guardian of the rights of property it can determine whose property anything shall be. It is possible, then, for a Government at any time to say: “There are in this country a number of persons under legal obligation to pay fixed rents for premises, fixed interest on capital, fixed salaries for services, over such periods as their several contracts cover. There are also a number of persons under definite obligations to pay such and such gold, at such and such dates, once for all. Now we, the Government, can, if we like, issue stamped papers bearing various face denominations of one, ten, a hundred, etc., units of gold currency, and we can decree that any one who possesses himself of such papers, to the face value of his debts, and hands them over to his creditor shall be held to have discharged his debt, and we will henceforth defend his property against his late creditor and declare that he has, in the eye of the law, paid the sum of gold which he owed.” It is obvious that these pieces of paper will thereby acquire definite values to all persons who are under obligation to discharge debts or to pay salaries or rents or other sums due under contract; for to command one of these pieces of paper will be, for certain of their purposes, exactly equivalent to commanding a sovereign. As these persons constitute a large and easily accessible portion of the community, there will at first be no difficulty whatever in circulating the notes, for those who have no direct use for them themselves will know that there are plenty of people who have, and a certain number of these certificates can, in this way, be floated. Each will be able to transact business to the same extent as a piece of gold of its face value. But as the contracts gradually expire and the debts are gradually discharged, the original force that gave currency to the Government’s paper will become exhausted. At first the holder of such a bond will from time to time come across men who will say: “Oh, yes, I was just looking out for paper in order to discharge my debt or pay my rent”; and if there were the smallest tendency to depreciation, competition would instantly rise amongst these persons who would be glad to get, at any reduction whatever, these things which their creditors would be compelled to receive at full value. If people chose to go on making fresh contracts and giving fresh credit, without specifying that the payment should be in gold, and thus went on perpetually bringing themselves under legal obligation to receive paper in full payment, the process might go on for a certain time, by its own impetus, but there would be nothing to compel any one to enter into such a contract; and if at any time, for any reason, there were a slight preference for making contracts in gold, so that there was a dearth of people of whom it could be definitely asserted that for their own immediate purposes, independent of the general understanding, the paper was worth the gold, there would obviously be no firm basis for the structure, and every one would become nervous and would want to make some allowance for the risk of not finding any one who would take the paper at or near the face value.


The Government has, however, a further resource. It has the means of maintaining a perpetual recurrence of persons thus desiring money at its face value, for the Government itself has more or less defined powers of taking the possessions of its subjects for public purposes, that is to say, enforcing them to contribute thereto by paying taxes. Ultimately it requires food, clothing, shelter, and a certain amount of amusement and indulgence for its soldiers and all its officials; and it requires fire-arms, ammunition, and the like. And in proportion to its advance in civilization it may have other and humaner purposes to fulfil. Now, as long as gold has any application in the arts and sciences it exchanges at a certain rate with other commodities, just as oxen exchange at a certain rate against potatoes, pig-iron, or the privilege of listening, in a certain kind of seat, to a prima donna at a concert. The Government, then, levying taxes upon the community, may say: “I shall take from you, in proportion to your resources, as a tribute to public expenses, the value of so much gold. You may pay it to me in actual metallic gold or you may pay it to me in anything which I choose to accept in lieu of the gold. If you do not give it me I shall take it from you, in gold or any other such articles as I can find, and which would serve my purpose, to the value of the gold. But if you can give me a piece of paper, of my own issue, to the face value of the gold that I am entitled to claim of you, I will accept that in payment.” Now, as these demands of the Government are recurrent, there will always be a set of persons to whom the Government paper stamped with a unit weight of gold is actually equivalent to that weight of gold itself, because it will secure immunity from requisitions to the exact extent to which the gold would secure it. This gives to the piece of paper an actual power of doing the work that gold to its face value could do, in the way of effecting exchanges; and therefore the Government will find that the persons of whom it has made purchases, or whom it has to pay for their services, will not only be obliged to accept the paper in lieu of payments already due, and which it chooses to say that these papers discharge, but will also be willing to enter into fresh bargains with it, to supply services or to surrender things for the paper, exactly as if it were gold; as long as it is easy to find persons who, being themselves under obligation to the Government, actually find the Government promise to relinquish their claim for gold as valuable as the gold itself. The persons who pay taxes constitute a very large portion of the community and the taxes they have to pay form a very appreciable fraction of their total expenditure, and consequently a very large number of easily accessible persons actually value the paper as much as the gold up to a certain determined point, the point, to wit, of their obligations to the Government. Thus it is that a limited demand for paper, at its face value in gold, constitutes a permanent market, and furnishes a basis on which a certain amount of other transactions will be entered into. The Government, in fact, is in a position very analogous to that of an issuing bank. An issuing bank promises to pay gold to any one who presents its notes, and to a certain extent that promise performs the functions of the gold itself, and a certain volume of notes can be floated as long as the credit of the bank is good. Because bank promises to pay are found to be convenient, as a means of conducting exchanges. After this number has been floated the notes begin to be presented at the bank, and presently it has to redeem its promises as quickly as it issues them. The limit then has been reached and the operation cannot be repeated. After this people will decline to accept the promises of the bank in lieu of the money, or, which is the same thing, they will instantly present the promise and require its fulfillment. The amount of notes in circulation may be maintained, but it cannot be increased. The issuing Government does not, without qualification, say that it will pay gold to any one who presents the note, but, in accepting its own notes instead of gold, it says, in effect, that it will give gold for its own notes to any of its own debtors; and as long as there is a sufficient body of these debtors to vivify the circulating fluid the Government can get its promises accepted at par. Any Government which, even for a short time, insists on paying in paper and receiving in gold, that is to say, any Government that does not honour its own issue when presented by its debtors, will find that its subjects decline to enter into voluntary contracts with it except on the gold basis; and if its paper still retains any value whatever, it will only be because of an expectation of a different state of things hereafter that gives a certain speculative value to the promise. In fact a Government which refuses to take its own money at par has no vivifying sources to rely on except the very disreputable and rapidly exhausted one of proclaiming to debtors, and persons under contract to pay periodic sums, that they need not do so if they hold a certificate of immunity from the Government. Such immunity will be purchased at a price determined, like all other market prices, by the stock available (qualified by the anticipations of the stock likely to be available presently) and the nature of the services it can render. The power, then, of Governments to make their issues do exchange work depends on their power to make a note of a certain face value do a definite amount of exchange work; and this they can effect by giving it a definite primary value to certain persons, and then keeping the issue within the corresponding limits. It does not consist in an anomalous, and, in fact, inconceivable, power of enabling an indefinite issue to perform a definite work, and arriving at the value of each individual unit by a division sum.


Indeed, this division sum is impossible in any case to make; for the proposed divisor is arrived at by multiplying the number of units in the face value of the issue by the rate at which, on an average, they circulate. Now the Government can undoubtedly regulate the amount of the issue, but it cannot regulate the average rate at which the units will circulate. Nor indeed can it rely on the dividend, namely the amount of business which the circulating medium shall perform, remaining constant. For it is a matter of convenience how much of the business of a country shall be carried on by the aid of a circulating medium and how much without it; and as a matter of fact, at periods when there is a dearth of small change in a country a great amount of retail business is conducted on account, and balances are more often settled in kind. Thus business which would ordinarily have been carried on by the circulating medium is carried on without it, because of its rarity. In Italy, for instance, when coppers were rare the exchange value of a copper did not rise because a smaller number had to do a greater amount of work, but each unit did as much business as it could, and the rest of the business was done without them. Again, the history of paper money abounds in instances of sudden changes, within the country itself, in the value of paper money, caused by reports unfavourable to the Government’s credit. The value of the currency was lowered in these cases by a doubt as to whether the Government would be permanently stable and would be in a position to honour its drafts, that is to say, whether, this day three months, the persons who have the power to take my goods for public purposes will accept a draft of the present Government in lieu of payment. It is not easy to see how, on the theory of the quantity law, such a report could affect very rapidly the magnitudes on which the value of a note is supposed to depend, viz. the quantity of business to be transacted and the amount of the currency. Nor is it easy to see why we should suppose that the frequency with which the notes pass from hand to hand is independently fixed. On the other hand, the quantity of business done by the notes, as distinct from the quantity of business done altogether, and the rapidity of the circulation of the notes may obviously be affected by sinister rumours. Two of the quantities, then, supposed to determine the value of the unit of circulation are themselves liable to be determined by it.

Finally, I’ll just mention that in the Wealth of Nations Adam Smith off-handedly mentioned acceptability in payment of taxes as a condition for inconvertible money not to be worthless.  So the lineage of the idea, despite its somewhat disreputable and unorthodox associations, is really quite impeccable.

Nick Rowe’s Gold Standard, and Mine

One of my regular commenters J. P. Koning recently drew my attention to this post by Nick Rowe about the “identity” (to use a somewhat loaded term) between the gold standard and the CPI standard (aka inflation targeting). Nick poses the following question:

Is there any fundamental theoretical difference between how monetary policy worked under the gold standard and how monetary policy works today for a modern inflation-targeting central bank?

I will just note parenthetically that being a Canadian and therefore likely having been spared from listening to seemingly endless soundbites of Newt Gingrich pontificating about “fundamental this” and “fundamental that,” and “fundamentally this” and “fundamentally that,” Nick obviously has not developed the sort of allergic reaction to the mere sound or appearance of that now hopelessly hackneyed word with which many of his neighbors to the south are now incurably afflicted.

To attack the question, Nick starts with the most extreme version of the gold standard in which central bank notes are nothing but receipts for an equivalent amount of gold (given the official and unchangeable legal conversion rate between bank notes and gold. He then proceeds to relax the assumptions underlying the extreme version of the gold standard from which he starts, allowing central bank reserves to be less than its liabilities, then allowing reserves to be zero, but still maintaining a fixed conversion rate between central bank notes and gold. (Over 25 years ago, Fischer Black developed a theoretical model of a gold standard with (near) zero reserves. See his paper “The Gold Standard with Double Feedback and Near Zero Reserves” published as chapter 5 of his book Business Cycles and Equilibrium. Whether anyone else has explored the idea of a gold standard with zero reserves I don’t know. But I don’t dispute that a gold standard could function with zero reserves, but I think there may be doubt about the robustness of such a gold standard to various possible shocks.) From here Nick further relaxes the underlying assumptions to allow a continuous adjustment of the legal conversion rate between central bank notes and gold at say a 2% annual rate. Then he allows the actual conversion rate to fluctuate within a range of 1% above to 1% below the official rate. And then he allows the base to be changed while keeping any changes in the base unbiased so the expectation is always that the conversion rate will continue to rise at a 2% annual rate. Having reached this point, Nick starts to relax the assumption that gold is the sole standard, first adding silver to get a symmetallic standard, and then many goods and services to get a broad based standard from which a little addition and subtraction and appropriate weighting bring us to the CPI standard.

Having gone through this lengthy step-by-step transformation, Nick seems to think that he has shown an identity between the gold standard and a modern inflation-targeting central bank. To which my response is: not so fast, Nick.

What Nick seems to be missing is that a central bank under a gold standard is operating passively unless it changes its stock of gold reserves, and even if it does change its stock of gold reserves, the central bank is still effectively passive unless, by changing its holdings of reserves, it can alter the real value of gold. On the other hand, I don’t see how one could characterize an inflation-targeting central bank as acting passively unless there was a direct market mechanism by which the public forced the central bank to achieve its inflation target. If a central bank did not maintain the legal conversion rate between its bank notes and gold, it would be violating a precise legal obligation to engage in a specific set of transactions. Instead of buying and selling gold at $20.67 an ounce, it would be buying and selling at some other price. If an inflation-targeting central bank does not meet its inflation target, can anyone specify the specific transactions that it was obligated to make that it refused to make when called upon to do so by a member of the public? And this is aside from the fact that no one even knows whether an inflation targeting central bank is achieving or not achieving its target at the time that it is conducting whatever transactions it is conducting in pursuit of whatever goal it is pursuing.

In short, an inflation-targeting central bank cannot be said to be operating under the same or an analogous set of constraints as a central bank operating under a gold standard, at least not under any gold standard that I would recognize as such.

Mrs. Merkel’s Triumph?

Three weeks ago, Stein Ringem, Professor of Sociology at Oxford University, wrote a rather smug op-ed piece in the Financial Times entitled “Time for economists to eat humble pie . . . again,” ridiculing all the economists who had been criticizing Mrs. Merkel for not being more forthcoming in negotiating debt relief for Greece and other over-indebted European countries, who had warned that the euro would collapse if Mrs. Merkel did not relent in her opposition to bailouts, proving her economist critics wrong.  Rejoicing in Mrs. Merkel’s vindication, Professor Ringen let loose on her critics.

Economists warned politicians not to dither. In the New York Times, Paul Krugman poured scorn over Europe’s politicians.

The implication of these calls for bold action was simple: Greece was in effect bankrupt; governments, notably Germany, would one way or another have to pay up if they wanted to save the euro. Ms Merkel’s line was different. Yes, Greece was bankrupt, but the solution was that Greece would carry as much as possible of its own debt, that private bondholders would be made to write down as much as possible, with speculators punished, and that other governments and the European Central Bank would contribute as little as possible.

Had the balance of opinion among economists prevailed, private bondholders, who had lent recklessly, would have been let off scot-free at European taxpayers’ expense. Why were so many commentators so careless? I have no problem with the “chief economists”, whose job is to protect the banking sector, but what about the independent academic economists?

There was never a sovereign debt crisis. There were two separate problems. The Greek government had more debt than it could manage and would somehow have to default. No other European government had an unmanageable debt level but some, such as Italy and Spain, did not have the trend under control and were at risk of moving to an unsustainable level. The solution to that problem was not bailouts, which would have been counterproductive and benefited lenders too much, but pressurize these governments to get their own affairs under control. That is being achieved in Italy.

Here is where Professor Ringem’s disdain for economics gets him into serious trouble. He is right that there was no debt crisis. Spain and Italy need to control and reform their finances, but that is not why interest rates on their 10-year notes have jumped more than 50 basis points in the three weeks since Ringem wrote his little paean to Mrs. Merkel. The real problem is that the European Central Bank, despite occasional signs of independence, remains firmly under Mrs. Merkel’s control, refusing to provide enough cash to the Eurozone economy to allow a real recovery to get started. As long as interest rates exceed the rate of growth of nominal GDP, the real debt burden in Europe will continue to increase, no matter how ruthlessly Mrs. Merkel inflicts austerity on the rest of Europe.

The need to predict, a psychological urge in the economic tribe, led to the wildest warnings. Ms. Merkel’s genius was to see that serious problems are solved by hard work and that what is at its core political cannot be solved by technocratic fiat. . . While experts panicked, politicians kept their cool.

No, serious problems are solved by clear thinking about their causes, and, once the causes are identified, taking the appropriate steps to counteract them. If the cause of an unmanageable debt burden is that nominal debt is growing faster than nominal income, the solution is to increase the rate of growth of nominal income until it is growing faster than nominal debt.

So what we have seen was not pretty. But it has been political craftsmanship of the highest order. Government borrowing has not been discredited but chronic borrowing to fund consumption is hopefully on its way to becoming history.

Nominal income fell in the Eurozone in the fourth quarter of 2011, the first time it fell since the second quarter of 2009, falling in Ireland, Italy, Malta, Netherlands, Portugal, and Spain. Some craftsmanship.

Europe’s leading politicians have performed admirably. They have done their job by staying level-headed and trusting themselves. One lesson is clear: beware the experts who come bearing advice and in particular economic experts.

No, the lesson that is clear is to beware of politicians and sociologists unable to grasp the laws of arithmetic and compound interest.

Edmund Phelps Should Read Hawtrey and Cassel

Marcus Nunes follows Karl Smith and Russ Roberts in wondering what Edmund Phelps was talking about in his remarks in the second Hayek v. Keynes debate.  I have already explained why I find all the Hayek versus Keynes brouhaha pretty annoying, so, relax, I am not going there again.  But Marcus did point out that in the first paragraph of Phelps’s remarks, he actually came close to offering the correct diagnosis of the causes of the Great Depression, an increase in the value of gold.  Unfortunately, he didn’t quite get the point, the diagnosis independently provided 10 years before the Great Depression by both Ralph Hawtrey and Gustave Cassel.  Here’s Phelps:

Keynes was a close observer of the British and American economies in an era in which their depressions were wholly or largely monetary in origin – Britain’s slump in the late 1920s after the price of the British currency was raised in terms of gold, and America’s Great Depression of the 1930s, when the world was not getting growth in the stock of gold to keep pace with productivity growth.  In both cases, there was a huge fall of the price level.  Major deflation is a telltale symptom of a monetary problem.

What Phelps unfortunately missed was that from 1925 to mid-1929, Great Britain was not in a slump, at least not in his terminology.  Unemployment was high, a carryover from the deep recession of 1920-21, and there were some serious structural problems, especially in the labor market.  But the overvaluation of the pound that Phelps blames for a non-existent (under his terminology) slump caused only mild deflation.  Deflation was mild, because the Federal Reserve, under the direction of the great Benjamin Strong, was aiming at a roughly stable US (and therefore, world) price level.  Although there was still deflationary pressure on Britain, the pound being overvalued compared to the dollar, the accommodative Fed policy (condemned by von Mises and Hayek as intolerably inflationary) allowed a gradual diminution of the relative overvaluation of sterling with only mild British deflation.   So from 1925 to 1929, the British economy actually grew steadily, while unemployment fell from over 11% in 1925 to just under 10% in 1929.

The problem that caused the Great Depression in America and the rest of the world (or at least that portion of the world that had gone back on the gold standard) was not that the world stock of gold was not growing as fast as productivity was growing – that was a separate long-run problem that Cassel had warned about that had almost nothing to do with the sudden onset of the Great Depression in 1929.  The problem was that in 1928 the insane Bank of France started converting its holdings of foreign exchange into gold.  As a result, a tsunami of gold, drawn mostly from other central banks, inundated the vaults of the Bank of France, forcing other central banks throughout the world to raise interest rates and to cash in their foreign exchange holdings for gold in a futile effort to stem the tide of gold headed for the vaults of the IBOF.

One central bank, the Federal Reserve, might have prevented the catastrophe, but, the illustrious Benjamin Strong tragically having been incapacitated by illness in early 1928, the incompetent crew replacing Strong kept raising the discount rate in a frenzied attempt to curb stock-market speculation on Wall Street.  Instead of accommodating the world demand for gold by allowing an outflow of gold from its swollen reserves — over 40% of total gold reserves held by central banks, the Fed actually was inducing an inflow of gold into the US in 1929.

That Phelps agrees that the 1925-29 period in Britain was characterized by  a deficiency of effective demand because the price level was falling slightly, while denying that there is now any deficiency of aggregate demand in the US because prices are rising slightly, though at the slowest rate in 50 years, misses an important distinction, which is that when real interest rates are negative as they are now, an equilibrium with negative inflation is impossible.  Forcing down inflation lower than it is now would trigger another financial panic.  With positive real interest rates in the late 1920s, the British economy was able to tolerate deflation without imploding.  It was only when deflation fell substantially below 1% a year that the British economy, like most of the rest of the world, started to implode.

If Phelps wants to brush up on his Hawtrey and Cassel, a good place to start would be here.

About Me

David Glasner
Washington, DC

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

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