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Nick Rowe’s Gold Standard, and Mine

Published April 24, 2012 gold standard , monetary policy , monetary theory 18 Comments

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.

Edmund Phelps Should Read Hawtrey and Cassel

Published April 18, 2012 Cassel , gold standard , Great Depression , Hawtrey , Keynes , monetary history , monetary policy 17 Comments

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.

Endogenous Money

Published April 11, 2012 monetary policy , monetary theory 57 Comments

During my little vacation recently from writing about monetary policy, it seems that there has been quite a dust-up about endogenous money in econo-blogosphere. It all started with a post by Steve Keen, an Australian economist of the post-Keynesian persuasion, in which he expounded at length the greatness of Hyman Minsky, the irrelevance of equilibrium to macroeconomic problems, the endogeneity of the money supply, and the critical importance of debt in explaining macroeconomic fluctuations. In making his argument, Keen used as a foil a paper by Krugman and Eggerston “Debt, Delevereging, and the Liquidity Trap: A Fisher-Minsky-Koo Approach,” which he ridiculed for its excessive attachment to wrong-headed neoclassicism, as exemplified in the DSGE model in which Krugman and Eggerston conducted their analysis. I can’t help but note parenthetically that I was astounded by the following sentence in Keen’s post.

There are so many ways in which neoclassical economists misinterpret non-neoclassical thinkers like Fisher and Minsky that I could write a book on the topic.

No doubt that it would be a fascinating book, but what would be even more fascinating would be an, explanation of how Irving Fisher – yes, that Irving Fisher – could possibly be considered as anything other than a neo-classical economist.

At any rate, this assault did not go unnoticed by Dr. Krugman, who responded with evident annoyance on his blog, focusing in particular on the question whether a useful macroeconomic model requires an explicit model of the banking system, as Keen asserted, or whether a simple assumption that the monetary authority can exercise sufficient control over the banking system makes an explicit model of the banking sector unnecessary, as Krugman, following the analysis of the General Theory, asserted. Sorry, but I can’t resist making another parenthetical observation. Post-Keynesians, following Joan Robinson, rarely miss an opportunity to dismiss the IS-LM model as an inauthentic and misleading transformation of the richer analysis of the General Theory. Yet, the IS-LM model’s assumption of a fixed nominal quantity of money determined by the monetary authority was taken straight from the General Theory, a point made by, among others, Jacques Rueff in his 1948 critique of the General Theory and the liquidity-preference theory of interest, and by G.L.S. Shackle in his writings on Keynes, e.g., The Years of High Theory. Thus, in arguing for an endogenous model of the money supply, it is the anti-IS-LM post-Keynesians who are departing from Keynes’s analysis in the GT.

Krugman’s dismissive response to Keen, focusing on the endogeneity issue, elicited a stinging rejoinder, followed by several further rounds of heated argument. In the meantime, Nick Rowe joined the fray, writing at least three posts on the subject (1, 2, 3) generally siding with Krugman, as did Scott Fullwiler and Randall Wray, two leading lights of what has come to be known as Modern Monetary Theory (MMT), siding with Keen. Further discussion and commentary was provided by Steve Randy Waldman and Scott Sumner, and summaries by Edward Harrison, John Carney, Unlearning Economics, and Business Insider.

In reading through the voluminous posts, I found myself pulled in both directions. Some readers may recall that I got into a bit of a controversy with Nick Rowe some months back over the endogeneity issue, when Nick asserted that any increase in the quantity of bank money is a hot potato. Thus, if banks create more money than the public want to hold, the disequilibrium cannot be eliminated by a withdrawal of the excess money, rather the money must be passed from hand to hand, generating additional money income until the resulting increase in the demand to hold money eliminates the disequilibrium between the demand for money and the amount in existence. I argued that Nick had this all wrong, because banks can destroy, as well as create, money. Citing James Tobin’s classic article “Commercial Banks as Creators of Money,” I argued that responding to the interest-rate spreads between various lending and deposit rates, profit-maximizing banks have economic incentives to create only as much money as the public is willing to hold, no more and no less. Any disequilibrium between the amount of money in existence and the amount the public wants to hold can be eliminated either by a change (positive or negative) in the quantity of money or by a change in the deposit rates necessary to induce the pubic to hold the amount of money in existence.

The idea stressed by Keen, Fullwiler and Wray, that banks don’t lend out deposits and hold reserves against their deposits, but create deposits in the course of lending and hold reserves only insofar as reserves offer some pecuniary or non-pecuniary yield is an idea to which I fully subscribe. They think that the money multiplier is a nonsensical concept, and so do I. I was actually encouraged to see that Nick Rowe now appears willing to accept that this is the right way to think about how banks operate, and that because banks are committed to convert their liabilities into currency on demand, they cannot create more liabilities than the public is willing to hold unless they are prepared to suffer losses as a consequence.

But Keen, Fullwiler and Wray go a step further, which is to say that, since banks can create money out of thin air, there is no limit to their ability to create money. I don’t understand this point. Do they mean that banks are in a perpetual state of disequilibrium? I understand that they are uncomfortable with any notion of equilibrium, but all other profit-maximizing firms can be said to be subject to some limit, not necessarily a physical or quantitative limit, but an economic limit to their expansion. Tobin, in his classic article, was very clear that banks do not have an incentive to create unlimited quantities of deposits. At any moment, a bank must perceive that there is a point beyond which it would be unprofitable to expand (by making additional loans and creating additional deposits) its balance sheet further.

Fullwiler argues at length that it makes no sense to speak about reserves or currency as setting any sort of constraint on the expansion of the banking system, ridiculing the notion that any bank is prevented from expanding by an inability to obtain additional reserves or additional currency should it want to do so. But banks are not constrained by any quantitative limit; they are constrained by the economic environment in which they operate and the incentives associated with the goal of maximizing profit. And that goal depends critically on the current and expected future price level, and on current lending and deposit rates. The current and expected future price level are controlled (or, at least, one may coherently hypothesize that they are controlled) by the central bank which controls the quantity of currency and the monetary base. Fullwiler denies that the central bank can control the quantity of currency or the monetary base, because the central bank is obligated to accommodate any demand for currency and to provide sufficient reserves to ensure that the payment system does not break down. But in any highly organized, efficiently managed market, transactors are able to buy and sell as much as they want to at the prevailing market price. So the mere fact that there are no frustrated demands for currency or reserves cannot prove that the central bank does not have the power to affect the value of currency. That would be like saying that the government could not affect the value of a domestically produced, internationally traded, commodity by applying a tariff on imports, but could do so only by imposing an import quota. Applying a tariff and imposing a quota are, in principle (with full knowledge of the relevant supply and demand curves), equivalent methods of raising the price of a commodity. However, in the absence of the requisite knowledge, if fluctuations in price would be more disruptive than fluctuations in quantity, the tariff is a better way to raise the price of the commodity than a numerical quota on imports.

So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level. The central bank may not be trying to target a particular quantity of currency or of the monetary base, but it can target a price level by varying its lending rate or by taking steps to vary the interbank overnight rate on bank reserves. This, it seems to me, is not very different from trying to control the domestic value of an imported commodity by setting a tariff on imports rather than controlling the quantity of imports directly. Endogeneity of bank money does not necessarily mean that a central bank cannot control the price level. If it can, I am not so sure that the post-Keynesian, MMT critique of more conventional macroeconomics is quite as powerful as they seem to think.

Reading John Taylor’s Mind

Published April 2, 2012 Little Depression , monetary policy 23 Comments

Last Saturday, John Taylor posted a very favorable comment on Robert Hetzel’s new book, The Great Recession: Market Failure or Policy Failure? Developing ideas that he published in an important article published in the Federal Reserve Bank of Richmond Economic Quarterly, Hetzel argues that it was mainly tight monetary policy in 2008, not the bursting of the housing bubble and its repercussions that caused the financial crisis in the weeks after Lehman Brothers collapsed in September 2008. Hetzel thus makes an argument that has obvious attractions for Taylor, attributing the Great Recession to the mistaken policy choices of the Federal Open Market Committee, rather than to any deep systemic flaw in modern free-market capitalism. Nevertheless, Taylor’s apparent endorsement of Hetzel’s main argument comes as something of a surprise, inasmuch as Taylor has sharply criticized Fed policies aiming to provide monetary stimulus since the crisis. However, if the Great Recession (Little Depression) was itself caused by overly tight monetary policy in 2008, it is not so easy to argue that a compensatory easing of monetary policy would not be appropriate.

While acknowledging the powerful case that Hetzel makes against Fed policy in 2008 as the chief cause of the Great Recession, Taylor tries very hard to reconcile this view with his previous focus on Fed policy in 2003-05 as the main cause of all the bad stuff that happened subsequently.

One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.

In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008.

A bit later, Taylor continues:

[T]here is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.

Moreover in a blog post last November, when targeting nominal GDP made a big splash, receiving endorsements from such notables as Christina Romer and Paul Krugman, Taylor criticized NGDP targeting on his blog and through his flack Amity Shlaes.

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals. It may be why those who propose the idea have been reluctant to show how it actually would work over a range of empirical models of the economy as I have been urging here. Christina Romer’s article, for instance, leaves the instrument decision completely unspecified, in a do-whatever-it-takes approach. More quantitative easing, promising low rates for longer periods, and depreciating the dollar are all on her list. NGDP targeting may seem like a policy rule, but it does not give much quantitative operational guidance about what the central bank should do with the instruments. It is highly discretionary. Like the wolf dressed up as a sheep, it is discretion in rules clothing.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

Taylor does not indicate whether, after reading Hetzel’s book, he is now willing to reassess either his view that monetary policy should be tightened or his negative view of NGDP. However, following Taylor post on Saturday, David Beckworth wrote an optimistic post suggesting that Taylor was coming round to Market Monetarism and NGDP targeting. Scott Sumner followed up Beckworth’s post with an optimistic one of his own, more or less welcoming Taylor to ranks of Market Monetarists. However, Marcus Nunes in his comment on Taylor’s post about Hetzel may have the more realistic view of what Taylor is thinking, observing that Taylor may have mischaracterized Hetzel’s view about the 2003-04 period, thereby allowing himself to continue to identify Fed easing in 2003 as the source of everything bad that happened subsequently. And Bill Woolsey also seems to think that Marcus’s take on Taylor is the right one.

But, no doubt Professor Taylor will soon provide us with further enlightenment on his mental state. We hang on his next pronouncement.

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

Published March 29, 2012 Cassel , Friedman , gold standard , Hawtrey , Keynes , monetary history , monetary policy , monetary theory 7 Comments

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

Published March 29, 2012 gold standard , monetary history , monetary policy 16 Comments

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 19^th and early 20^th 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?

Benjamin Cole Sets James Pethokoukis Straight

Published March 20, 2012 inflation , monetary policy , Uncategorized 13 Comments

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.

Rising Inflation Expectations Work Their Magic

Published March 13, 2012 expectations , inflation , monetary policy 12 Comments

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.

When Ben Bernanke Talks, People Listen

Published March 1, 2012 expectations , monetary policy 4 Comments

Yesterday, the stock market (S&P 500) dropped sharply upon hearing Chairman Bernanke’s testimony before Congress in which he declined to promise that the Fed would engage in another round of quantitative easing as many observers were anticipating. The news sent the market tumbling, and the dollar rose 1% against the euro. Readers of a certain age will recall a well-known advertising slogan for a now defunct stock- brokerage house, E. F. Hutton: when E. F. Hutton talks, people listen. Ben Bernanke is not a stock trader, but when he talks, people do pay attention. By day’s end, however, the market recovered a bit of the ground that it lost immediately after Bernanke’s testimony was released, falling by just half a percent. What happened?

My guess is that the markets may have been factoring in two separate pieces of information. The first was the upward revision in real GDP growth in the fourth quarter of 2011 from 2.8% to 3%. Thus, the market was in positive territory before Bernanke’s testified. The news was reflected in rising real interest rates associated with improving expectations of real GDP growth. The improved expectations of future real GDP growth were countered by Bernanke’s testimony, which suggested that the anticipated easing might not be forthcoming. That sent inflation expectations south, and the market followed inflation expectations, as I have found that it usually has done ever since tight money sent the economy into steep decline in the spring of 2008 when the Fed was mistakenly focused on countering rising energy prices instead of supporting a faltering economy.

The combination of the two effects, the improvement in the real strength of the economy, a positive, was more than offset by the disappointment about the future course of monetary policy. The net effect was a slight fall in prices, but it is interesting to see an example of the two effects going in opposite directions on the same day.

Today the market more than recovered yesterday’s losses, the S&P 500 reaching a new post-crisis high. Real and nominal interest rates both rose, reflecting increasing optimism about economic recovery, and inflation expectations were unchanged. So there are some grounds for cautious optimism, but an oil-price shock could stall this fragile recovery yet again, especially if the inflation hawks on the FOMC have their way, yet again.

Hawtrey on Competitive Devaluation: Bring It On

Published February 28, 2012 gold standard , Hawtrey , inflation , monetary history , monetary policy , monetary theory 18 Comments

In a comment on my previous post about Ralph Hawtrey’s discussion of the explosive, but short-lived, recovery triggered by FDR’s 1933 suspension of the gold standard and devaluation of the dollar, Greg Ransom queried me as follows:

Is this supposed to be a lesson in international monetary economics . . . or a lesson in closed economy macroeconomics?

To which I responded:

I don’t understand your question. The two are not mutually exclusive; it could be a lesson in either.

To which Greg replied:

I’m pushing you David to make a clearer and cleaner claim about what sort of monetary disequilibrium you are asserting existed in the 1929-1933 period, is this a domestic disequilibrium or an international disequilibrium — or are these temprary effects any nation could achieve via competitive devaluations of the currency, i.e. improving the terms of international trade via unsustainable temporary monetary policy.

Or are a ping pong of competitive devaluations among nations a pure free lunch?

And if so, why?

You can read my response to Greg in the comment section of my post, but I also mentioned that Hawtrey had addressed the issue of competitive devaluation in Trade Depression and the Way Out, hinting that another post discussing Hawtrey’s views on the subject might be in the offing. So let me turn the floor over to Mr. R. G. Hawtrey.

When Great Britain left the gold standard, deflationary measure were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

The consequence was that the fall in the price level continued. The British price level rose in the first few weeks after the suspension of the gold standard, but then accompanied the gold price level in its downward trend. This fall of prices calls for no other explanation than the deflationary measures which had been imposed. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . .

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better. (pp. 154-57)

So yes, Greg, competitive devaluation is a free lunch. Bring it on.

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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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