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Christina Romer Really Gets It

Published December 18, 2011 monetary history , monetary policy 24 Comments

Marcus Nunes beat me to it, highlighting Christina Romer’s column in today’s New York Times, but her column today deserves all the attention and praise that it can get, and a lot more besides. Romer debunks then notion that real downturns that follow financial crises are necessarily deeper and longer-lasting than ordinary downturns, showing that the policy pessimism engendered by the notion that recoveries from recessions precipitated by financial crises are necessarily weak and drawn out, given currency by the recent book by Rogoff and Reinhart This Time Is Different, is not at all justified by the historical record.

I will just elaborate on a couple of points made by Romer. Citing the account of the Great Depression in the United States given by Milton Friedman and Anna Schwartz in their Monetary History of the United States, Romer observes:

The Friedman-Schwartz study found four distinct waves of banking panics in the early 1930s. After the first three, output plummeted. But after the last one, in early 1933, output skyrocketed, with industrial production rising nearly 60 percent from March to July. That time was very different.

What accounts for the difference? Romer explains:

[T]he policy response largely explains why output fell after the American banking panics in 1930 and 1931, but rose after the final wave in early 1933. After the first waves, the Fed did little, and President Herbert Hoover signed a big tax increase to replenish revenue. After the final wave, President Franklin D. Roosevelt abandoned the gold standard, increased the money supply and began a program of New Deal spending.

I don’t disagree with that, but I understand the process differently. It was the gold standard itself that had caused the downturn, because gold was appreciating (meaning that prices and wages were falling), causing profits to drop and business and households to stop spending. Bank failures were caused by a deflation that made it impossible for debts fixed in nominal terms to be repaid, so that the assets held by banks were becoming worthless. Bank failures were not the cause of the problem, they were a symptom of a problem — falling prices — inherent in and inseparable from the perverse dynamics of the gold standard. Once FDR abandoned the gold standard, the dollar depreciated relative to gold allowing dollar prices to start rising, the money supply increasing more or less automatically as a result.

Romer also disscusses a paper comparing the severity of the Great Depression in Spain and in the US.

Why was the Great Depression so much worse here than in Spain? According to an influential paper by Ehsan Choudhri and Levis Kochin, Spain benefited from not being on the gold standard. Its central bank was able to lend freely and increase the money supply after the panic. By contrast, in 1931, the Federal Reserve in the United States raised interest rates to defend its gold reserves and stay on the gold standard, setting off further declines in output and exacerbating the banking crisis.

It’s true that freedom from the gold standard allowed Spain to take monetary measures it could not have taken while on the gold standard, but the more important point is that by not being on the gold standard, prices in Spain did not have to fall to reflect the increasing value of gold. So the deflationary forces that suffused all the countries on the gold standard simply bypassed Spain and other countries not on the gold standard. It was not the increase in interest rates by the US that was caused the deflation in the US it was the gold standard. Raising interest rates were necessary only insofar as a country did not want to allow an export of its gold reserves.

In closing, I will just mention that the paper by Choudri and Kochin contains a diagram on p. 569 showing that Belgium experienced a rapid deflation and a big drop in industrial production in the early 1930s. In my post last week about the analysis of the Deutsche Bank comparing the euro crisis to the 1930s gold standard crisis, the diagram copied from the DB analysis seemed to indicate that Belgium did not suffer a substantial drop in real GDP. The Choudri and Kochin paper provides further reason to be skeptical about the graph in the DB analysis.

Hayek’s 1932 Defense of the Insane Bank of France

Published December 17, 2011 Hawtrey , Hayek , monetary history , monetary policy , monetary theory 27 Comments

In my post last Monday, I suggseted that Hayek’s attachment to the gold standard led him to recommend a policy of deflation during the Great Depression even though his own neutral-money policy criterion of stabilizing aggregate monetary expenditure would have implied aggressive monetary expansion during the Great Depression. Forced to choose between two conflicting principles, Hayek made the wrong choice, opting for defense of the gold standard rather than for stabilizing nominal GDP. He later changed his views, disavowing support for the gold standard as early as 1943 in a paper (“A Commodity Reserve Currency”) in the Economic Journal (reprinted as chapter 10 of Individualism and Economic Order) and reaffirming his opposition to the gold standard in The Constitution of Liberty (p. 335). I cited his 1932 paper “the Fate of the Gold Standard” translated from the original German and republished in his collected works and quoted his opening paragraph lamenting that Britain had abandoned the gold standard because (in September 1931 as the Great Depression was rapidly spiraling downward) Britain found the discipline of the gold standard “irksome.”

I also referred to Hayek’s defense of what I called “the insane French policy of gold accumulation.” I did not want to burden readers of an already long post with further quotations from Hayek’s article, so I just left it there without giving another quotation. But I think it may be worth analyzing what Hayek wrote, not because I want to make Hayek look bad, but because his defense of the Bank of France betrays a basic misunderstanding of the theory of international monetary adjustment and how the gold standard worked that is characteristic of many discussions of the gold standard.

Here is what Hayek wrote (F. A. Hayek, The Collected Works of F. A. Hayek, Good Money, Part 1, p. 160).

The accusation that France systematically hoarded gold seems at first sight to be more likely to be correct [than the charge that the US Federal Reserve had been hoarding gold, an accusation dismissed in the previous paragraph]. France did pursue an extremely cautious foreign policy after the franc stabilized at a level which considerably undervalued it with respect to its domestic purchasing power, and prevented an expansion of credit proportional to the amount of gold coming in. Nevertheless, France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow – and this alone is necessary for the gold standard to function.

Hayek made a fundamental error here, assuming that a small open economy (which France could be considered to have been in the late 1920s) had control over its money supply and its price level under the gold standard. The French price level, once France pegged the franc to the dollar in 1926 at $0.0392/franc, was no longer under the control of French monetary authorities, commodity arbitrage requiring commodity prices quoted in francs to equal commodity prices quoted in dollars adjusted for the fixed dollar/franc parity. The equalization was not perfect, because not all commodities enter into international trade and because there are differences between similar products sold in different countries that preclude full price equalization. But there are strict limits on how much national price levels could diverge under a gold standard. Similarly, the money supply in a country on the gold standard could not be controlled by the monetary authority of that country, because if people in that country wanted to hold more money than the monetary authority made available, they could increase their holdings of money by increasing exports or decreasing imports, thereby generating an inflow of gold, which could be converted into banknotes or deposits.

So Hayek’s observation that France did not prevent her monetary circulation from increasing by the very same amount as that of the gold inflow means only that the Bank of France refused to increase the French money supply at all (or even attempted to decrease it), forcing the French to increase their holdings of cash by acquiring gold through an export surplus. Hayek’s statement thus betrays a total misunderstanding of what “is necessary for the gold standard to function.” All that was necessary was that France maintain a fixed parity between the dollar and the franc, not that the Bank of France achieve a particular change in the money supply governed by the amount that its holdings of gold had changed. Hayek wrongly assumed that the French monetary authorities had control over the French money supply and that the inflow of gold was somehow determined by real forces independent of French monetary conditions. But it was just the opposite. The French money supply increased because the French wanted to increase the amount of cash balances they were holding. The only question was whether the French banking system would be allowed by the Bank of France to accommodate the French demand for money by increasing the French money supply, or whether the desired increase in the money supply would be permitted only through gold imports generated by an export surplus. Refusing to allow the French money supply to increase except through the importation of gold meant that the increase in the French demand for money was transformed into an equivalent increase in French (and, hence, the world) demand for gold, thereby driving up the value of gold, the proximate source of the deflation that produced the Great Depression.

As I said, this misconception of money supply adjustment under the gold standard was not unique to Hayek.  In some ways it is characteristic of many orthodox treatments of the gold standard and it can be traced back at least to the British Currency School of the 1830 and 1840s, if not even further back to David Hume in the 18th century.  Milton Friedman was similarly misguided in many of his discussions of the gold standard and international adjustment, especially in his discussion of the Great Depression in his Monetary History of the United States.  Ralph Hawtrey, as usual, got it right.  But the analysis was much later articulated in more conventional model by Harry Johnson and his associates in their development of the monetary approach to the balance of payments.

Deutsche Bank Gets It, Why Can’t Mrs. Merkel?

Published December 14, 2011 monetary history , monetary policy 24 Comments

A report by the Deutsche Bank comparing the current euro crisis with the gold standard crisis of the 1930s has been quoted by a few bloggers. I can’t seem to find a link to the report itself, but here is what seems to be an extract from the Deutsche Bank report itself.

The 1930s in Europe was a slow moving game of falling dominoes with countries one by one leaving the narrow confines of the Gold Standard after chronic growth problems that a fixed currency system intensified. There was a definite trend in the 1930s that saw those countries that left the Gold Standard seeing a much quicker recovery from the Depression than those that stayed on for a number of years into the latter half of the decade. Figure 12 shows a case study of six countries currencies relative to Gold in the 1930s. We’ve rebased them to 100 at the start of the series. In order of leaving the Gold Standard, we had the UK (left September 1931), Sweden (also left September 1931), US (April 1933), Belgium (March 1935), France (September 1936) and Italy (October 1936).


Interestingly, by the middle of 1937 all had devalued by at least 40% to Gold except Belgium who had devalued by around 30% in 1935. France, which held on until September 1936, then saw its currency collapse by nearly 70% in the three years up to WWII. Figure 13 then shows the same six countries nominal (left) and real (right) GDP performance over the same period.


The UK and Sweden, which left the Gold Standard earliest (September 1931) in this sample, saw a ‘relatively’ mild negative growth shock compared to the other four. In contrast, France which stuck to Gold until late 1936 saw growth notably under-perform until they left the standard. Interestingly as discussed above, France later saw a dramatic 3 year 70% devaluation to Gold which helped restore nominal GDP close to that of the UK and Sweden by the end of the 1930s. However, in real terms they were still the laggard at this point. The worst slump of all was that seen in the US between 1929 and 1932 where they lost nearly half the value of their economy in nominal terms and nearly 30% in real terms. However, the bottom pretty much corresponded to the end of the Dollar’s gold convertibility and subsequent devaluation. From this point on, the recovery was fairly dramatic until the 1937 recession we’ll discuss below. Overall, Figure 13 does indicate some fairly strong evidence that growth did seem to respond to currency debasement and that countries which left this later ended up with weaker economies for longer and also, in France’s case, a more dramatic end devaluation.

Here is DBs comparison of the current crisis and the one eighty years ago.

In real terms, we are not too different in many countries to the outcome seen in the Depression. However, the overall price level in the economy has held up much better than it did in the 1930s leaving nominal GDP above its 2007/2008 peak in Austria (106.5 relative to a rebased 100 peak), Belgium (106.4), US (105.3), UK (104.7), Germany (103.7), France (103.3), Finland (102.9) and the Netherlands (101.3). Much of this has been because of QE and other dramatic interventions preventing the collapse of much systemically crucial debt (particularly banks) that would otherwise have defaulted and led to deflation.

However, all the peripheral five are below their nominal peak still with Portugal, Italy and Spain just below their peak but with Greece (92.8) and Ireland (82.4) well below. When using Ireland as a positive case study for what others can achieve, it is worth being aware that they have seen a near 20% fall in their economy on a nominal basis. This has allowed them to dramatically improve their competitiveness. Unless others are prepared to make the same hard decisions and can be funded in the meantime, we think they are unlikely to be able to repeat Ireland’s competitive gains.

The problem is that a country could just leave the gold standard or devalue its currency, as did Great Britain and Sweden in 1931, followed eventually by everyone else, if it wanted to. No one has yet figured out an escape from the euro trap. If Mrs. Merkel could only give her OK to the ECB to conduct a policy of aggressive monetary expansion, the euro might still be saved.  But, in her consummate narrow-mindedness, Mrs. Merkel seems determined to drive Europe into the abyss. OMG!

Keynes v. Hayek: Enough Already

Published December 12, 2011 Cassel , Hawtrey , Hayek , Keynes , monetary history , monetary policy , monetary theory 78 Comments

First, it was the Keynes v. Hayek rap video, and then came the even more vulgar and tasteless Keynes v. Hayek sequel video reducing the two hyperintellectuals to prize fighters. (The accuracy of the representations signaled in its portrayal of Hayek as bald and Keynes with a full head of hair when in real life it was the other way around.) Then came a debate broadcast by the BBC at the London School of Economics, and then another sponsored by Reuters with a Nobel Prize winning economist on the program arguing for the Hayek side. Now comes a new book by Nicholas Wapshott Keynes Hayek, offering an extended account of the fraught relationship between two giants of twentieth century economics who eventually came to a sort of intellectual détente toward the end of Keynes’s life, a decade or more after a few years of really intense, even brutal, but very high level, polemical exchanges between them (and some of their surrogates) in the pages of England’s leading economics journals. Tyler Cowen has just reviewed Wapshott’s book in the National Review (see Marcus Nunes’s blog).

As I observed in September after watching the first Keynes-Hayek debate, we can still learn a lot by going back to Keynes’s and Hayek’s own writings, but all this Keynes versus Hayek hype creates the terribly misleading impression that the truth must lie with only one side or the other, that one side represents truth and enlightenment and the other represents falsehood and darkness, one side represents pure disinterested motives and the other is shilling for sinister forces lurking in the wings seeking to advance their own illegitimate interests, in short that one side can be trusted and the other cannot. All this attention on Keynes and Hayek, two charismatic personalities who have become figureheads or totems for ideological movements that they might not have endorsed at all — and certainly not endorsed unconditionally — encourages an increasingly polarized discussion in which people choose sides based on pre-existing ideological commitments rather than on a reasoned assessment of the arguments and the evidence.

In part, this framing of arguments in ideological terms simply reflects existing trends that have been encouraging an increasingly ideological approach to politics, law, and public policy. For an example of this approach, see Naomi Klein’s recent musings about global warming and the necessity for acknowledging that combating global warming requires the very social transformation that makes right-wingers oppose, on ideological principle, any measure to counter global warming.  Those are just the terms of debate that Naomi Klein wants.  Thus, both sides have come to see global warming not as a problem to be addressed or mitigated, but as a weapon to be used in the context of a comprehensive ideological struggle. Those who want to address the problem in a pragmatic, non-ideological, way are losing control of the conversation.

The amazing thing about the original Keynes-Hayek debate is not only that both misunderstood the sources of the Great Depression for which they were confidently offering policy advice, but that Ralph Hawtrey and Gustav Cassel had explained what was happening ten years before the downturn started in the summer of 1929. Both Hawtrey and Cassel understood that restoring the gold standard after the demonetization of gold that took place during World War I would have hugely deflationary implications if, when the gold standard was reinstated, the world’s monetary demand for gold would increase back to the pre-World War I level (as a result of restoring gold coinage and the replenishment of the gold reserves held in central bank coffers). That is why both Hawtrey and Cassel called for measures to limit the world’s monetary demand for gold (measures agreed upon in the international monetary conference in Genoa in 1922 of which Hawtrey was the guiding spirit). The measures agreed upon at the Genoa Conference prevented the monetary demand for gold from increasing faster than the stock of gold was increasing so that the world price level in terms of gold was roughly stable from about 1922 through 1928. But in 1928, French demand for gold started to increase rapidly just as the Federal Reserve began tightening monetary policy in a tragically misguided effort to squelch a supposed stock-price bubble on Wall Street, causing an inflow of gold into the US while the French embarked on a frenzied drive to add to their gold holdings, and other countries rejoining the gold standard were increasing their gold holdings as well, though with a less fanatical determination than the French. The Great Depression was therefore entirely the product of monetary causes, a world-wide increase in gold demand causing its value to increase, an increase manifesting itself, under the gold standard, in deflation.

Hayek, along with his mentor Ludwig von Mises, could also claim to have predicted the 1929 downturn, having criticized the Fed in 1927, when the US was in danger of falling into a recession, for reducing interest rates to 3.5%, by historical standards far from a dangerously expansionary rate, as Hawtrey demonstrated in his exhaustive book on the subject A Century of Bank Rate. But it has never been even remotely plausible that a 3.5% discount rate at the Fed for a little over a year was the trigger for the worst economic catastrophe since the Black Death of the 14th century. Nor could Keynes offer a persuasive explanation for why the world suddenly went into a catastrophic downward spiral in late 1929. References to animal spirits and the inherent instability of entrepreneurial expectations are all well and good, but they provide not so much an explanation of the downturn as a way of talking about it or describing it. Beyond that, the Hawtrey-Cassel account of the Great Depression also accounts for the relative severity of the Depression and for the sequence of recovery in different counties, there being an almost exact correlation between the severity of the Depression in a country and the existence and duration of the gold standard in the country. In no country did recovery start until after the gold standard was abandoned, and in no country was there a substantial lag between leaving the gold standard and the start of the recovery.

So not only did Hawtrey and Cassel predict the Great Depression, specifying in advance the conditions that would, and did, bring it about, they identified the unerring prescription – something provided by no other explanation — for a country to start recovering from the Great Depression. Hayek, on the other hand, along with von Mises, not only advocated precisely the wrong policy, namely, tightening money, in effect increasing the monetary demand for gold, he accepted, if not welcomed, deflation as the necessary price for maintaining the gold standard. (This by the way is what explains the puzzle (raised by Larry White in his paper “Did Hayek and Robbins Deepen the Great Depression?”) of Hayek’s failure to follow his own criterion for a neutral monetary policy, stated explicitly in chapter 4 of Prices and Production: stabilization of nominal expenditure (NGDP). However, a policy of stabilizing nominal expenditure was inconsistent with staying on the gold standard when the value of gold was rising by 5 to 10% a year. Faced with a conflict between maintaining the gold standard and following his own criterion for neutral money, Hayek, along with his friend and colleague Lionel Robbins in his patently Austrian book The Great Depression, both opted for maintaining the gold standard.)

Not only did Hayek make the wrong call about the gold standard, he actually defended the insane French policy of gold accumulation in his lament for the gold standard after Britain wisely disregarded his advice and left the gold standard in 1931. In his paper “The Fate of the Gold Standard” (originally Das Schicksal der Goldwahrung) reprinted in The Collected Works of F. A. Hayek: Good Money, Part 1, Hayek mourned the impending demise of the gold standard after Britain tardily did the right thing. The tone of Hayek’s lament is struck in his opening paragraph (p. 153).

There has been much talk about the breakdown of the gold standard, particularly in Britain where, to the astonishment of every foreign observer, the abandonment of the gold standard was very widely welcomed as a release from an irksome constraint. However, it can scarcely be doubted that the renewed monetary problems of almost the whole world have nothing to do with the tendencies inherent in the gold standard, but on the contrary stem from the persistent and continuous attempts from many sides over a number of years to prevent the gold standard from functioning whenever it began to reveal tendencies which were not desired by the country in question. Hence it was by no means the economically strong countries such as America and France whose measures rendered the gold standard inoperative, as is frequently assumed, but the countries in a relatively weak position, at the head of which was Britain, who eventually paid for their transgression of the “rules of the game” by the breakdown of their gold standard.

So what do we learn from this depressing tale? Hawtrey and Cassel did everything right. They identified the danger to the world economy a decade in advance. They specified exactly the correct policy for avoiding the danger. Their policy was a huge success for about nine years until the Americans and the French between them drove the world economy into the Great Depression, just as Hawtrey and Cassel warned would happen if the monetary demand for gold was not held in check. Within a year and a half, both Hawtrey and Cassel concluded that recovery was no longer possible under the gold standard. And as countries, one by one, abandoned the gold standard, they began to recover just as Hawtrey and Cassel predicted. So one would have thought that Hawtrey and Cassel would have been acclaimed and celebrated far and wide as the most insightful, the most farsighted, the wisest, economists in the world. Yep, that’s what one would have thought. Did it happen? Not a chance. Instead, it was Keynes who was credited with figuring out how to end the Great Depression, even though there was almost nothing in the General Theory about the gold standard and a 30% deflation as the cause of the Great Depression, despite his having vilified Churchill in 1925 for rejoining the gold standard at the prewar parity when that decision was expected to cause a mere 10% deflation.

But amazingly enough, even when economists began looking for alternative ways to Keynesianism of thinking about macroeconomics, Austrian economics still being considered too toxic to handle, almost no one bothered to go back to revisit what Hawtrey and Cassel had said about the Great Depression. So Milton Friedman was considered to have been daring and original for suggesting a monetary explanation for the Great Depression and finding historical and statistical support for that explanation. Yet, on the key elements of the historical explanation, Hawtrey and Cassel either anticipated Friedman, or on the numerous issues on which Friedman did not follow Hawtrey and Cassel — in particular the international gold market as the transmitter of deflation and depression across all countries on the gold standard, the key role of the Bank of France (which Friedman denied in the Monetary History and for years afterwards only to concede the point in the mid to late 1990s), the absence of an explanation for the 1929 downturn, the misplaced emphasis on the contraction of the US money stock and the role of U.S. bank failures as a critical factor in explaining the severity of the Great Depression — Hawtrey and Cassel got it right and Friedman got it wrong.

So what matters in the success in the marketplace of ideas seems to be not just the quality or the truth of a theory, but also (or instead) the publicity machine that can be deployed in support of a theory to generate interest in it and to attract followers who can expect to advance their own careers in the process of developing, testing, or otherwise propagating, the theory. Keynes, Friedman, and eventually Hayek, all had powerful ideologically driven publicity machines working on their behalf. And guess what? It’s the theories that attract the support of a hard core of ideologically motivated followers that tend to outperform those without a cadre of ideological followers.

That’s why it was very interesting, important, and encouraging that Tyler Cowen, in his discussion of the Keynes-Hayek story, felt the need to mention how Scott Sumner has shifted the debate over the past two years away from the tired old Keynes vs. Hayek routine. Of course Tyler, about as well read an economist as there is, slipped up when he said that Scott is reviving the Friedman Monetarist tradition. No, Scott is reviving the Hawtrey-Cassel pre-Monetarist tradition, of which Friedman’s is a decidedly inferior, and obsolete, version. It just goes to show that one person sometimes really can make a difference, even without an ideologically driven publicity machine working on his behalf. Just imagine what Hawtrey and Cassel could have accomplished if they had been bloggers.

NGDP Targeting v. Nominal Wage Targeting

Published December 9, 2011 expectations , monetary policy 39 Comments

This post follows up on an observation I made in my post about George Selgin’s recent criticism of John Taylor’s confused (inasmuch as the criticism was really of level versus rate targeting which is a completely different issue from whether to target nominal GDP or the price level) critique of NGDP targeting. I found Selgin’s discussion helpful to me in thinking through a question that came up in earlier discussions (like this) about the relative merits of targeting NGDP (or a growth path for NGDP) versus targeting nominal wages (or a growth path for nominal wages).

The two policies are similar inasmuch as wages are the largest component of nominal income, so if you stabilize the nominal wage, chances are that you will stabilize nominal income, and if you stabilize nominal income (or its growth path), chances are that you will stabilize the nominal wage (or its growth path). Aside from that, the advantage of NGDP targeting is that it avoids a perverse response to an adverse supply shock, which, by causing an increase in the price level and inflation, induces the monetary authority to tighten monetary policy, exacerbating the decline in real income and employment. However, a policy of stabilizing nominal income, unlike a policy of price level (or inflation) targeting, implies no tightening of monetary policy. A policy of stabilizing nominal GDP sensibly accepts that an adverse supply shock, by reducing total output, automatically causes output prices to increase, so that trying to counteract that automatic response to the supply shock subjects the economy to an unnecessary, and destabilizing, demand-side shock on top of the initial supply-side shock.

Here’s Selgin’s very useful formulation of the point:

[A]lthough it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.”

The question I want to explore is which policy, NGDP targeting or nominal-wage targeting, does the better job of minimizing departures from what Selgin calls the “full-information” level of output. To simplify the discussion let’s compare a policy of constant NGDP with a policy of constant nominal wages. In this context, constant nominal wages means that the average level of wages is constant, any change in a particular nominal meaning an equivalent change in the relative wage. Let’s now suppose that our economy is subjected to an adverse supply shock, meaning that the supply of a non-labor input has been reduced or withheld. The reduction in the supply of the non-labor input increases its rate of remuneration and reduces the real wage of labor. If the share of labor in national income falls as a result of the supply shock (as it typically does after a supply shock), then the equilibrium nominal (as well as the real) wage must fall under a policy of constant nominal GDP. Under a policy of stabilizing nominal wages, it would be necessary to counteract the adverse supply shock with a monetary expansion to prevent nominal wages from falling.

Is it possible to assess which is the better policy? I think so. In most employment models, workers accept unemployment when they observe that wage offers are low relative to their expectations. If workers are accustomed to constant nominal wages, and then observe falling nominal wages, the probability rises that they will choose unemployment in the mistaken expectation that they will find a higher wages by engaging in search or by waiting. Thus, falling nominal wages induces inefficient (“involuntary”) unemployment, with workers accepting unemployment because their wage expectations are too optimistic.  Because of their overly-optimistic expectations, workers’ decisions to accept unemployment cause a further contraction in economic activity, inducing a further unexpected decline in nominal wages and a further increase in involuntary unemployment, producing a kind of Keynesian multiplier process whose supply-side analogue is Say’s Law.

So my conclusion is that even nominal GDP targeting does not provide enough monetary stimulus to offset the contractionary tendency of a supply shock.  Although my example was based on a comparison of constant nominal GDP with constant nominal wages, I think an analogous argument would lead to a similar conclusion in a comparison between nominal NGDP targeting at say 5 percent with nominal wage inflation of say 3 percent.  The quantitative difference between nominal GDP targeting and nominal wage targeting may be small, but, at least directionally, nominal wage targeting seems to be the superior policy.

Policy Rules Are Not Rules, They Are Policies

Published December 6, 2011 Hayek , monetary policy 38 Comments

I have been giving John Taylor a lot of attention lately (see here, here, here, and here). I should probably lay off, but I think there is an important point to be made, and I am going to try one more time to get to the bottom of what I find disturbing about Taylor’s advocacy of rule-like behavior by central bankers. Some of what I want to say has already been said by Nick Rowe in his excellent post responding to Taylor’s criticism of NGDP targeting, but I want to address more directly Taylor’s actual statements than Nick did.

Taylor argues that targeting objectives, like NGDP, is not a policy rule at all, but rather a way of giving the central bank the discretion to do what it wants under the guise of what purports to be a policy rule that isn’t a rule at all. Here is how Taylor put it.

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.

As I pointed out in my previous post, Friedman’s proposed rule for money supply growth is an exceedingly inapt example of an instrument rule, because the Fed has no more control over the money supply than it does over NGDP, as Friedman himself belatedly had to acknowledge. Now it is true that the Fed can control the short-term interest rate, so it is an instrument. The Taylor rule, a recipe for the short-term interest rate, specified in terms of the difference between the actual and the target rates of inflation and the difference between actual and potential GDP, does qualify as an instrument rule (on Taylor’s understanding of the term). But, as Nick Rowe points out, potential GDP being unobservable, it must be estimated. The higher potential GDP, the lower the implied short-term interest rate. So even the Taylor rule does not preclude an exercise of discretion by the Fed.

Perhaps the failure of the Taylor rule to preclude any exercise of discretion is why Taylor in the article by Amity Shlaes to which he refers seems to be offering a pared down version of the Taylor rule. Shlaes writes:

In response to my query about NGDP, Taylor sent a description of the reform he seeks — not widening the Fed’s growth mandate, but rather removing it [my emphasis]. Taylor says he would like to see reform happen in this order: 1) Congress enacts a single mandate for price stability; 2) Congress enacts reporting requirements for the Fed on what its strategy or policy rule is; and 3) the Fed picks a strategy relating to money and interest rates and tells the public what that strategy is.

One can’t really be sure what this means, but wouldn’t enacting “a single mandate for price stability” require the Fed to base its choice of the short-term interest rate solely on the difference between the actual and the target rates of inflation regardless of the difference between actual and potential GDP? After all, allowing the Fed to take into consideration whether actual GDP is less than potential increases the scope for the Fed to exercise discretion.

But there is something else disturbing about Taylor’s fixation on rules. I have been writing about the long-running debate about rules versus discretion in monetary policy on this blog for a while, especially the past couple of weeks, but failing to identify the critical semantic confusion that infects much of the rules versus discretion debate, and especially Taylor’s pronouncements. It was not until I read the following comment by W. Peden on my post Rules v. Discretion that the point suddenly became clear to me.

It’s a shame that there isn’t a widely used term in economics that means something like “precise orders” to distinguish from our usual use of “rule”, which means something like a restriction on possible action. A rule does not give exact and invariable instructions.

So, for example, the Taylor rule is really a kind of varying imperative, since it gives precise instructions on the short-term interest rate. In contrast, targeting NGDP along a trend is a rule because it allows for a huge variety of actions within that period; in a once-in-a-lifetime financial crisis like the early 1930s or 2008-2009, it would require quite radical discretionary actions so that the trend could be maintained.

Peden is completely right to say that the Taylor rule is not a rule at all, it is a command to a policy maker to adopt a policy of a certain kind. But policies are not rules. Rules do not prescribe specific actions they impose certain constraints on the manner in which agents can take actions in the pursuit of goals that they, not the author of the rules, have chosen. Introducing the language of rules into a discussion of policy reflects an effort (either conscious or unconscious) to borrow the authority of the political ideal of the rule of law as a support for the particular policy being advocated. The point was obliquely recognized by F. A. Hayek in a passage from the Constitution of Liberty that I quoted in my previous post. And it bears repeating.

It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals.

The political ideal of the rule of law does bear on the use of coercive powers of government, because the political ideal of the rule of law (sometimes called substantive due process by Constitutional lawyers) is meant to constrain the government in exercising coercive powers. But that political ideal has nothing to do with the formulation of policy when (e.g., in the case of setting monetary policy) it involves no exercise of coercion.

So, notwithstanding Friedman’s assertion in Capitalism and Freedom, endorsed by Taylor, there is no principled presumption in favor of formulating policies in terms of specific commands requiring the monetary authorities to set instruments under their direct control according to a recipe or formula defined in terms of an arithmetic formula. The notion that there is any political principle requiring a policy supposed to achieve some desired objective to be so formulated is based on a semantic confusion between rules and policies and on a complete misunderstanding of the political principle requiring governments to follow rules in exercising their coercive powers.

It is still conceivable that monetary policy in terms of a recipe for an instrument of monetary policy might lead to the best possible outcome. It is also conceivable that flying an airplane on automatic pilot would lead to a better outcome than having a trained pilot fly the plane. Indeed, that could be true under some circumstances, but it verges on the preposterous to suppose that it would never be desirable (or indeed imperative) for a live pilot to override the automatic pilot. But that suggests that ultimately policy ought to be formulated in terms of the objectives sought rather than in terms of what is no more than a recipe for an instrument by which the policy objective is to be pursued.

John Taylor’s Obsession with Rules

Published December 3, 2011 Hayek , monetary policy 18 Comments

In my previous post about George Selgin’s comment on John Taylor’s critique of NGDP targeting, I observed that Selgin had correctly focused on Taylor’s ambiguous use of the concept of an “inflation shock” without identifying the nature of the shock (violating Scott Sumner’s dictum “never reason from a price change). As Selgin pointed out, if the inflation shock were caused by a shock to aggregate supply, NGDP targeting would do better than a price-level or inflation rule. If the source of the inflation shock were excessive aggregate demand, well, that just means that NGDP had not been targeted. But there was another part of Taylor’s post, not addressed by Selgin, deserving of attention.  Taylor writes:

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.

Taylor goes on to elaborate, invoking the authority of Milton Friedman, on the properties that a rule governing the conduct of a central bank ought to have.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, [coincidentally mentioning Taylor six times and quoting him twice!] 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.

The first point to make about this remark is that the money supply rule Friedman advocated, and Taylor endorses — despite its unworkability in theory (Goodhart’s Law) and its demonstrated unworkability in practice when adopted by the Fed under Paul Volcker in the early 1980s — did not – obviously did not! — satisfy Friedman’s own criterion of being stated in terms of “objectives that the monetary authorities . . . have the clear and direct power to achieve by their own actions.” The monetary aggregate that Friedman wanted to grow at a fixed rate was, for the most part, produced by private banks, not by the Fed, so there was obviously no way that the Fed could achieve its objectives for the growth of M1, M2, or Mwhatever by its own actions.

So what should one conclude from this? That Friedman was a hypocrite? I don’t think so. But he did have a propensity for getting carried away by his enthusiasms, and he took his enthusiasm for rules to an extreme, supposing that all problems of monetary policy could be solved by prescribing a rule for a fixed rate of growth in the money supply. Even in 1960, that was a remarkably simplistic, actually simple-minded, position to have taken, but in his obsession for simple rules, he thought he had found the Holy Grail of monetary policy. That John Taylor, half a century later, could approvingly cite Friedman’s rule for the rate of growth in the money supply as a benchmark by which to judge other monetary policy rules speaks volumes about Taylor’s grasp of what constitutes good monetary policy.

Actually to gain some obviously needed insight into monetary policy rules, Professor Taylor could do a lot worse than to start with Chapter 21 of Hayek’s Constitution of Liberty. Friedman could have profited from reading it as well, but Friedman, obviously disdaining Hayek’s abilities as an economist, probably did not take it seriously. Let’s have a look at some of what Hayek had to say on the subject of rules and monetary policy.

The case for “rules versus authorities in monetary policy” has been persuasively argued by the late Henry Simons [one of Friedman’s teachers at Chicago] in a well-known essay. The arguments advanced there in favor of strict rules are so strong that the issue is now largely one of how far it is practically possible to tie down monetary authority by appropriate rules. It may still be true that if there were full agreement as to what monetary policy ought to aim for, an independent monetary authority, fully protected against political pressure and free to achieve the ends it has been assigned, might be the best arrangement. . . . But the fact that the responsibility for monetary policy today inevitably rests in part with agencies whose main concern is with government finance probably strengthens the case against allowing much discretion and for making decisions on monetary policy as predictable as possible.

It should perhaps be explicitly stated that the case against discretion in monetary policy is not quite the same as that against discretion in the use of the coercive powers of government. Even if the control of money is in the hands of a monopoly, its exercise does not necessarily involve coercion of private individuals. The argument against discretion in monetary policy rests on the view that monetary policy and its effects should be as predictable as possible. The validity of the argument depends, therefore, on whether we can devise an automatic mechanism which will make the effective supply of money change in a more predictable and less disturbing manner than will any discretionary measures likely to be adopted. The answer is not certain. No automatic mechanism is known which will make the total supply of money adapt itself exactly as we would wish, and the most we can say in favor of any mechanism (or action determined by rigid rules) is that it is doubtful whether in practice any deliberate control would be better. The reason for this doubt is partly that the conditions in which monetary authorities have to make their decisions are usually not favorable to the prevailing of long views, partly that we are not too certain what they should do in particular circumstances and that, therefore, uncertainty about what they will do is necessarily greater when they do not act according to fixed rules. (p. 334)

And a bit later:

There is one basic dilemma, which all central banks face, which makes it inevitable that their policy must involve much discretion. A central bank can exercise only an indirect and therefore limited control over all the circulating media. Its power is based chiefly on the threat of not supplying cash when it is needed. Yet at the same time it is considered to be its duty never to refuse to supply this case at a price when needed. It is this problem, rather than the general effects of policy on prices or the value of money, that necessarily preoccupies the central banker in his day-to-day actions. It is a task which makes it necessary for the central bank constantly to forestall or counteract development in the realm of credit, for which no simple rules can provide sufficient guidance.

The same is nearly as true of the measure intended to affect prices and employment. They must be directed more at forestalling changes before they occur than at correcting them after they have occurred. If a central bank always waited until rule or mechanism forced it to take action, the resulting fluctuations would be much greater than they need be. . . .

[U]nder present conditions we have little choice but to limit monetary policy by prescribing its goals rather than its specific actions. The concrete issue today is whether it ought to kepp stable some level of employment or some level of prices. Reasonably interpreted and with due allowance made for the inevitability of minor fluctuations around a given level, these two aims are not necessarily in conflict, provided that the requirements for monetary stability are given first place and the rest of economic policy is adapted to them. A conflict arises, however, if “full employment” is made the chief objective and this is interpreted, as it sometimes is, as that maximum of employment which can be produced by monetary means in the short run. That way lies progressive inflation. (pp. 336-37)

Professor Taylor, forget Friedman, and study Hayek.

Selgin Takes Down Taylor on NGDP Targeting

Published December 1, 2011 expectations , monetary policy , monetary theory 5 Comments

A couple of weeks ago (November 18, 2011), responding to the recent groundswell of interest in NGDP targeting, John Taylor wrote a critique of NGDP targeting on his blog (“More on Nominal GDP Targeting”). Taylor made two main points in his critique. First, noting that recent proposals for NGDP targeting (in contrast to earlier proposals advanced in the 1980s) propose targeting the level (or more precisely a trend line) of NGDP rather than the growth rate of NGDP, Taylor conceded that in recoveries from recessions there is a case for allowing NGDP to grow faster than the long-run trend. Strict rate targeting would not accommodate faster than normal NGDP growth in recoveries, level targeting would. However, Taylor argued that level targeting has a corresponding drawback.

[I]f an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targetting and most likely result in abandoning the NGDP target.

Taylor’s second point was that NGDP targeting is not an adequate rule, because it allows the monetary authorities too much discretion in choosing how to hit the specified target. Taylor regards this as a dangerous concession of arbitrary authority to the central bank.

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.

In reply Scott Sumner wrote a good defense of NGDP targeting, focusing mainly on the forward-looking orientation of NGDP targeting in contrast to the backward-looking orientation of the rule favored by Taylor. Further, Taylor’s criticism is beside the point, having nothing to do with NGDP targeting; it’s all about level targeting versus growth targeting. Scott also points out that his own version of NGDP targeting precisely specifies what the central bank is supposed to do to implement its objective, avoiding entirely Taylor’s charge of giving too much discretion to the central bank.

All well and good, but no coup de grace.

It took almost two weeks, but the coup de grace was finally administered with admirable clarity and efficiency at 3:58 PM on December 1, 2011 by George Selgin on the Free Banking Blog. Selgin’s main point is that it is illegitimate for Taylor to posit an inflation shock to the price level, because inflation shocks don’t just happen, they must be caused by some other, more fundamental, cause. That cause can either be classified as a (negative) shift in aggregate supply or a (positive) shift in aggregate demand. If the shift affected aggregate supply, meaning that aggregate demand has not changed, there is no particular reason to suppose that any change has occurred in NGDP. So there is no reason for the Fed to tighten monetary policy to counteract the increase in the price level. On the other hand, if the inflation shock was caused by an increase in aggregate demand, then NGDP has certainly increased, and a tightening action would be required, but the cause of the tightening would have been the targeting of NGDP,  but the failure to do so.

Now in fairness to Professor Taylor, one could interpret his point in a different way: Central bankers are not infallible. Try as they might, they will not succeed in hitting their NGDP targets every time. But each miss will require an offsetting change in the opposite direction. The result of random errors in targeting, may be increased instability in NGDP. But if that was what Taylor meant, he should have said so. Selgin identifies the source of Taylor’s confusion as follows:

But lurking below the surface of Professor Taylor’s nonsensical critique is, I sense, a more fundamental problem, consisting of his implicit treatment of stabilization of aggregate demand or spending, not as a desirable end in itself, but as a rough-and-ready (if not seriously flawed) means by which the Fed might attempt to fulfill its so-called dual mandate–a mandate calling for it to concern itself with both the control of inflation and the stability of employment and real output.

What Selgin is arguing for is a policy targeting a (nearly) constant level of NGDP, taking seriously the vague (and essentially non-operational) goal, mentioned by Hayek in his early work, of a constant level of monetary expenditure.

[A]lthough it is true that unsound monetary policy tends to contribute to undesirable and unnecessary fluctuations in prices and output, it does not follow that the soundest conceivable policy is one that eliminates such fluctuations altogether. The goal of monetary policy ought, rather, to be that of avoiding unnatural fluctuations in output–that is, departures of output from its full-information level–while refraining from interfering with fluctuations that are “natural.”

I find Selgin’s formulation really interesting, because a few months ago I was trying to think through the following problem. Suppose there is a supply shock that causes real output to fall. Unless the supply shock is caused by a reduced supply of labor, the real wage must fall. Under a policy of stabilizing nominal income, the nominal wage as well as the real wage would (or at least could) fall if, as a result of the supply shock, labor’s share of factor income also declined. But a falling nominal wage would tend to cause inefficient (involuntary) unemployment, because workers, observing unexpectedly reduced wages, would therefore not accept the relatively low wage offers, becoming unemployed in the mistaken expectation of finding better paying jobs while unemployed. A policy of stabilizing nominal wages would avoid inefficient (involuntary) unemployment, which is an argument for making stable wages (as advocated by Hawtrey and Earl Thompson) rather than stable nominal income the goal of economic policy.  Thus, it seems to me that from the standpoint of optimal employment policy, a policy of stabilizing wages may do better than a policy of stabilizing NGDP.  Of course, if one adopts a policy of targeting a sufficiently high growth rate of NGDP, the likelihood that nominal wage would fall as a result of a supply shock would be correspondingly reduced.

I also want to comment further on Taylor’s criticism of NGDP targeting as unacceptably discretionary, but that will have to wait for another day.

Once Again The Stock Market Shows its Love for Inflation

Published November 30, 2011 expectations , monetary policy 7 Comments

The S&P 500 rose by 4% today on news that the Federal Reserve System and other central banks were taking steps to provide liquidity to banks, especially European banks with heavy exposure to sovereign debt issued by countries in the Eurozone. Other stock markets in Europe and Asia also rose sharply, and the euro rose about 1% against the dollar.

What was encouraging about today’s announcement was that the news reflected coordination and cooperation among the world’s leading central banks, sending a positive signal that central bankers were capable of working in concert to stabilize monetary conditions. One other point worth noting, already mentioned by Scott Sumner, is that the provision of liquidity so much welcomed by the markets was associated with rising, not falling interest rates, confirming that under current conditions, monetary ease works not by reducing, but by raising, nominal interest rates.

It is worth drilling down just a bit deeper to see what caused the increase in interest rates. I like to focus on the 5- and 10-year constant maturity Treasuries, and the corresponding 5- and 10-year constant maturity TIPS bonds from which one can infer an estimate of real interest rates. The yield on the 5-year Treasury rose by 3 basis points from 0.93% to 0.96%. At the same time the yield on the 5-year TIPS fell from -0.77% to -0.80%, so that the breakeven TIPS spread, an estimate (or, according to the Cleveland Federal Reserve Bank, more likely a slight overestimate) of inflation expectations, rose 1.70% to 1.76%. What that says is that, even though the nominal interest rate was rising, inflation expectations were rising even faster, so that the real interest rate was falling even deeper into negative territory. The negative real interest rate provides a measure of how pessimistic investors are about the profitability of investment. Poor profit expectations (flagging animal spirits in Keynesian terminology) are a drag on investment, but that is exactly why rising expectations of inflation can induce additional real investment to take place, despite investor pessimism. As expected inflation rises, additional not so profitable real investment opportunities, become worth undertaking, because the negative return on holding cash makes investing in real capital less unattractive than just holding cash or other low-yielding financial instruments. The profitability of additional real investment projects will increase economic activity and output , raising future income levels, which is why the stock market rose even as real interest rates fell.  (For more on the underlying theory and the empirical evidence supporting it, see my paper “The Fisher Effect under Deflationary Expectations” here.)

Now let’s look at the 10-year constant maturity Treasury and the 10-year constant maturity TIPS bond. The yield on the 10-year Treasury rose 8 basis points from 2% to 2.08%, while the yield on the 10-year TIPS rose from 0.01% to 0.03%, implying an increase in the breakeven TIPS spread from 1.99% to 2.05%. At both 5- and 10-year time horizons, inflation expectations rose by 6 basis points. But the difference is that real interest rates rose over a 10-year time horizon even though real interest rates fell over a 5-year time horizon. That suggests that the markets are projecting improved long-run prospects for profitable investment as a result of higher inflation. That was just the relationship that we observed a year ago after the start of QE2, when inflation expectations were rising and nominal interest rates were rising even faster, when investors’ projections for future profit opportunities were becoming increasingly positive. After a rough 2011, that still seems to be the way that markets are reacting to prospects for rising inflation.

In its story on the stock-market rally, the New York Times wrote:

Market indexes gained more than 4 percent after central banks acted to contain the debt crisis in the euro zone. But a half-dozen similar rallies in the last 18 months have quickly withered.

What unfortunately has happened is that each time the markets start to expect enough inflation to get a real recovery going, the inflation hawks on the FOMC throw a tantrum and make sure that we get the inflation rate back down again. Will they prevail yet again? For Heaven’s sake, let’s hope not.

The Tender-Hearted Prof. Sumner Gives Mises and Hayek a Pass

Published November 29, 2011 Hayek , monetary history , monetary policy , monetary theory 50 Comments

Scott Sumner is such a kindly soul. You can count on him to give everyone the benefit of the doubt, bending over backwards to find a way to make sense out of the most ridiculous statement that you can imagine. Even when he disagrees, he expresses his disagreement in the mildest possible terms. And if you don’t believe me, just ask Paul Krugman, about whom Scott, despite their occasional disagreements, always finds a way to say something nice and complimentary. I have no doubt that if you were fortunate enough to take one of Scott’s courses at Bentley, you could certainly count on getting at least a B+ if you showed up for class and handed in your homework, because Scott is the kind of guy who just would not want to hurt anyone’s feelings, not even a not very interested student. In other words, Scott is the very model of a modern major general – er, I mean, of a modern sensitive male.

But I am afraid that Scott has finally let his niceness get totally out of hand. In his latest post “The myth at the heart of internet Austrianism,” Scott ever so gently points out a number of really serious (as in fatal) flaws in Austrian Business Cycle Theory, especially as an explanation of the Great Depression, which it totally misdiagnosed, wrongly attributing the downturn to a crisis caused by inflationary monetary policy, and for which it prescribed a disastrously mistaken remedy, namely, allowing deflation to run its course as a purgatory of the malinvestments undertaken in the preceding boom. Scott certainly deserves a pat on the back for trying to shed some light on a subject as fraught with fallacy and folly as Austrian Business Cycle Theory, but unfortunately Scott’s niceness got the better of him when he made the following introductory disclaimer:

This post is not about Austrian economics, a field I know relatively little about. [Scott is not just nice, he is also modest and self-effacing to a fault, DG] Rather it is a response to dozens of comments I have received by people who claim to represent the Austrian viewpoint.

And then after his partial listing of the problems with Austrian Business Cycle Theory, Scott just couldn’t help softening the blow with the following comment.

Austrian monetary economics has some great ideas – most notably NGDP targeting. I wish internet Austrians would pay more attention to Hayek, and less attention to whoever is telling them that the Depression was triggered by the collapse of an inflationary bubble during the 1920s. There was no inflationary bubble, by any reasonable definition of the world “inflation.”

Scott greatly admires Hayek (as do I), so he sincerely wants to believe that the mistakes of Austrian Business Cycle Theory are not Hayek’s fault, but are the invention of some nasty inauthentic Internet Austrians. In fact, because in a few places Hayek seemed to understand that an increased demand for money (aka a reduction in the velocity of circulation) would cause a reduction in total spending (aggregate demand or nominal income) unless matched by an increased quantity of money, acknowledging that, at least in principle, the neutral monetary policy he favored should not hold the stock of money constant, but should aim at a constant level of total spending (aggregate demand or nominal income), Scott wants to absolve Hayek from responsibility for the really bad (as in horrendous) policy advice he offered in the 1930s, opposing reflation and any efforts to increase spending by deliberately increasing the stock of money. During the Great Depression, Hayek’s recognition that in principle the objective of monetary policy ought to be to stabilize total spending was more in the way of a theoretical nuance than a bedrock principle of monetary policy. The recognition is buried in chapter four of Prices and Production. The tenor of his remarks and the uselessness of his recognition in principle that total spending should be stabilized are well illustrated by the following remark at the beginning of the final section of the chapter

Anybody who is sceptical of the value of theoretical analysis if it does not result in practical suggestions for economic policy will probably be deeply disappointed by the small return of so prolonged an argument.

Then in the 1932 preface to the English translation of his Monetary Theory and the Trade Cycle, Hayek wrote the following nugget:

Far from following a deflationary policy, Central Banks, particularly in the United States, have been making earlier and more far reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion – with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices which existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. (pp. 19-20)

And then Hayek came to this staggering conclusion (which is the constant refrain of all Internet Austrians):

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection – a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end. It would not be the first experiment of this kind which has been made. We should merely be repeating, on a much larger scale, the course followed by the Federal Reserve system in 1927, an experiment which Mr. A. C. Miller, the only economist on the Federal Reserve Board [the Charles Plosser of his time, DG] and, at the same time, its oldest member, has rightly characterized as “the greatest and boldest operation ever undertaken by the Federal reserve system”, an operation which “resulted in one of the most costly errors committed by it or any other banking system in the last 75 years”. It is probably to this experiment, together with the attempts to prevent liquidation once the crisis had come, that we owe the exceptional severity and duration of the depression. We must not forget that, for the last six or eight years, monetary policy all over the world [like, say, France for instance? DG] has followed the advice of the stabilizers. It is high time that their influence, which has already done harm enough, should be overthrown. [OMG, DG] (pp. 21-22)

That the orthodox Austrian (espoused by Mises, Hayek, Haberler, and Machlup) view at the time was that the Great Depression was caused by an inflationary monetary policy administered by the Federal Reserve in concert with other central banks at the time is clearly shown by the following quotation from Lionel Robbins’s book The Great Depression. Robbins, one of the great English economists of the twentieth century, became a long-distance disciple of Mises and Hayek in the 1920s and was personally responsible for Hayek’s invitation to deliver his lectures (eventually published as Prices and Production) on Austrian Business Cycle Theory at the London School of Economics in 1931, and after their huge success, arranged for Hayek to be offered a chair in economic theory at LSE. Robbins published his book on the Great Depression in 1934 while still very much under the influence of Mises and Hayek. He subsequently changed his views, publicly disavowing the book, refusing to allow it to be reprinted in his lifetime.

Thus in the last analysis, it was deliberate co-operation between Central bankers, deliberate “reflation” on the part of the Federal Reserve authorities, which produced the worst phase of this stupendous fluctuation. Far from showing the indifference to prevalent trends of opinion, of which they have so often been accused, it seems that they had learnt the lesson only too well. It was not old-fashioned practice but new-fashioned theory which was responsible for the excesses of the American disaster. (p. 54)

Like Robbins, Haberler and Machlup, who went on to stellar academic careers in the USA, also disavowed their early espousal of ABCT. Mises, unable to tolerate apostasy on the part of traitorous erstwhile disciples, stopped speaking to them. Hayek, though never disavowing his earlier views as Robbins, Haberler, and Machlup had, acknowledged that he had been mistaken in not forthrightly supporting a policy of stabilizing total spending. Mises was probably unhappy with Hayek for his partial u-turn, but continued speaking to him nevertheless. Of course, Internet Austrians like Thomas Woods, whose book Meltdown was a best-seller and helped fuel the revival of Austrianism after the 2008 crisis, feel no shame in citing the works of Hayek, Haberler, Machlup, and Robbins about the Great Depression that they later disavowed in whole or in part, without disclosing that the authors of the works being cited changed or even rejected the views for which they were being cited.

So I am sorry to have to tell Scott: “I know it’s hard for you, but stop trying to be nice to Mises and Hayek. They were great economists, but they got the Great Depression all wrong. Don’t try to sugarcoat it. It can’t be done.”

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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