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Monetarism v. Hawtrey and Cassel

The following is an updated and revised version of the penultimate section of my paper with Ron Batchelder “Pre-Keynesian Theories of the Great Depressison: What Ever Happened to Hawtrey and Cassel?” which I am now preparing for publication. The previous version is available on SSRN.

In the 1950s and early 1960s, empirical studies of the effects of money and monetary policy by Milton Friedman, his students and followers, rehabilitated the idea that monetary policy had significant macroeconomic effects. Most importantly, in research with Anna Schwartz Friedman advanced the seemingly remarkable claim that the chief cause of the Great Depression had been a series of policy mistakes by the Federal Reserve. Although Hawtrey and Cassel, had also implicated the Federal Reserve in their explanation of the Great Depression, they were unmentioned by Friedman and Schwartz or by other Monetarists.[1]

The chief difference between the Monetarist and the Hawtrey-Cassel explanations of the Great Depression is that Monetarists posited a monetary shock (bank failures) specific to the U.S. as the primary, if not sole, cause of the Depression, while Hawtrey and Cassel considered the Depression a global phenomenon reflecting a rapidly increasing international demand for gold, bank failures being merely an incidental and aggravating symptom, specific to the U.S., of a more general monetary disorder.

Arguing that the Great Depression originated in the United States following a typical business-cycle downturn, Friedman and Schwartz (1963) attributed the depth of the downturn not to the unexplained initial shock, but to the contraction of the U.S. money stock caused by the bank failures. Dismissing any causal role for the gold standard in the Depression, Friedman and Schwartz (359-60) acknowledged only its role in propagating, via PSFM, an exogenous, policy-driven, contraction of the U.S. money stock to other gold-standard countries. According to Friedman and Schwartz, the monetary contraction was the cause, and deflation the effect.

But the causation posited by Friedman and Schwartz is the exact opposite of the true causation. Under the gold standard, deflation (i.e., gold appreciation) was the cause and the decline in the quantity of money the effect. Deflation in an international gold standard is not a local phenomenon originating in any single country; it occurs simultaneously in all gold standard countries.

To be sure the banking collapse in the U.S. exacerbated the catastrophe. But the collapse was the localized effect of a more general cause: deflation. Without deflation, neither the unexplained 1929 downturn nor the subsequent banking collapse would have occurred. Nor was an investment boom in the most advanced and most productive economy in the world unsustainable as posited, with no evidence of unsustainability other than the subsequent economic collapse, by the Austrian malinvestment hypothesis.

Friedman and Schwartz based their assertion that the monetary disturbance that caused the Great Depression occurred in the U.S. on the observation that, from 1929 to 1931, gold flowed into, not out of, the U.S. Had the disturbance occurred elsewhere, they argued, gold would have flowed out of, not into, the U. S.

Table 1 shows the half-year changes in U.S., French, and world gold reserves starting in June 1928, when the French monetary law re-establishing the gold standard was enacted.

TABLE 1: Gold Reserves in US, France, and the World June 1928-December 1931 (measured in dollars)
Date World ReservesUS ReservesUS Share (percent)French ReservesFrench Share (percent)
June 19289,7493,73238.31,13611.7
Dec. 192810,0573,74637.21,25412.4
2nd half 1928 change31214-1.11180.7
June 192910,1263,95639.11,43614.2
1st half 1929 change692101.91821.8
Dec. 192910,3363,90037.71,63315.8
2nd half 1929 change210-56-1.41971.6
June 193010,6714,17839.21,72716.2
1st half 1930 change3352781.5940.4
Dec. 193010,9444,22538.72,10019.2
2nd half 1930 change 27347-0.53733.0
June 193111,264459340.82,21219.6
1st half 1931 change3203682.11120.4
Dec. 193111,3234,05135.82,69923.8
2nd half 1931 change59-542-5.04874.2
June 1928-Dec. 1931 change1,574319-2.51,56312.1
Source: H. C. Johnson, Gold, France and the Great Depression

In the three-and-a-half years from June 1928 (when gold convertibility of the franc was restored) to December 1931, gold inflows into France exceeded gold inflows into the United States. The total gold inflow into France during the June 1928 to December 1931 period was $1.563 billion compared to only $319 billion into the United States.

However, much of the difference in the totals stems from the gold outflow from the U.S. into France in the second half of 1931, reflecting fears of a possible U.S. devaluation or suspension of convertibility after Great Britain and other countries suspended the gold standard in September 1931 (Hamilton 2012). From June 1928 through June 1931, the total gold inflow into the U.S. was $861 billion and the total gold inflow into France was $1.076 billion, the U.S. share of total reserves increasing from 38.3 percent to 40.6 percent, while the total French share increased from 11.7 percent to 19.6 percent.[2]

In the first half of 1931, when the first two waves of U.S. bank failures occurred, the increase in U.S. gold reserves exceeded the increase in world gold reserves. The shift by the public from holding bank deposits to holding currency increased reserve requirements, an increase reflected in the gold reserves held by the U.S. The increased U.S. demand for gold likely exacerbated the deflationary pressures affecting all gold-standard countries, perhaps contributing to the failure of the Credit-Anstalt in May 1931 that intensified the European crisis that forced Britain off the gold standard in September.

The combined increase in U.S. and French gold reserves was $1.937 billion compared to an increase of only $1.515 billion in total world reserves, indicating that the U.S. and France were drawing reserves either from other central banks or from privately held gold stocks. Clearly, both the U.S. and France were exerting powerful deflationary pressure on the world economy, before and during the downward spiral of the Great Depression.[3]

Deflationary forces were operating directly on prices before the quantity of money adjusted to the decline in prices. In some countries the adjustment of the quantity of money was relatively smooth; in the U.S. it was exceptionally difficult, but, not even in the U.S., was it the source of the disturbance. Hawtrey and Cassel understood that; Friedman did not.

In explaining the sources of his interest in monetary theory and the role of monetary policy, Friedman (1970) pointedly distinguished between the monetary tradition from which his work emerged and the dominant tradition in London circa 1930, citing Robbins’s (1934) Austrian-deflationist book on the Great Depression, while ignoring Hawtrey and Cassel. Friedman linked his work to the Chicago oral tradition, citing a lecture by Jacob Viner (1933) as foreshadowing his own explanation of the Great Depression, attributing the loss of interest in monetary theory and policy by the wider profession to the deflationism of LSE monetary economists. Friedman went on to suggest that the anti-deflationism of the Chicago monetary tradition immunized it against the broader reaction against monetary theory and policy, that the Austro-London pro-deflation bias provoked against monetary theory and policy.

Though perhaps superficially plausible, Friedman’s argument ignores, as he did throughout a half-century of scholarship and research, the contributions of Hawtrey and Cassel and especially their explanation of the Great Depression. Unfortunately, Friedman’s outsized influence on economists trained after the Keynesian Revolution distracted their attention from contributions outside the crude Keynesian-Monetarist dichotomy that shaped his approach to monetary economics.

Eclectics like Hawtrey and Cassel were neither natural sources of authority, nor obvious ideological foils for Friedman to focus upon. Already forgotten, providing neither convenient targets, nor ideological support, Hawtrey and Cassel, could be easily and conveniently ignored.


[1] Meltzer (2001) did mention Hawtrey, but the reference was perfunctory and did not address the substance of his and Cassel’s explanation of the Great Depression.

[2] By far the largest six-month increase in U.S. gold reserves was in the June-December 1931 period coinciding with the two waves of bank failures at the end of 1930 and in March 1931 causing a substantial shift from deposits to currency which required an increase in gold reserves owing to the higher ratio of required gold reserves against currency than against bank deposits.

[3] Fremling (1985) noted that, even during the 1929-31 period, the U.S. share of world gold reserves actually declined. However, her calculation includes the extraordinary outflow of gold from the U.S. in the second half of 1931. The U.S. share of global gold reserves rose from June 1928 to June 1931.

My Paper (with Sean Sullivan) on Defining Relevant Antitrust Markets Now Available on SSRN

UPDATE: The paper was selected by Concurrences as the best academic antitrust economics paper of 2020, and is forthcoming in the Antitrust Law Journal volume 83, number 2.

Antitrust aficionados may want to have a look at this new paper (“The Logic of Market Definition”) that I have co-authored with Sean Sullivan of the University of Iowa School of Law about defining relevant antitrust markets. The paper is now posted on SSRN.

Here is the abstract:

Despite the voluminous commentary that the topic has attracted in recent years, much confusion still surrounds the proper definition of antitrust markets. This paper seeks to clarify market definition, partly by explaining what should not factor into the exercise. Specifically, we identify and describe three common errors in how courts and advocates approach market definition. The first error is what we call the natural market fallacy: the mistake of treating market boundaries as preexisting features of competition, rather than the purely conceptual abstractions of a particular analytical process. The second is the independent market fallacy: the failure to recognize that antitrust markets must always be defined to reflect a theory of harm, and do not exist independent of a theory of harm. The third is the single market fallacy: the tendency of courts and advocates to seek some single, best relevant market, when in reality there will typically be many relevant markets, all of which could be appropriately drawn to aid in competitive effects analysis. In the process of dispelling these common fallacies, this paper offers a clarifying framework for understanding the fundamental logic of market definition.

My Paper Schumpeterian Enigmas Is Now Available on SSRN

I have just posted a paper I started writing in 2007 after reading Thomas McCraw’s excellent biography of Joseph Schumpeter, Prophet of Innovation. The paper, almost entirely written in 2007, lay unfinished until a few months ago, when I finally figured out how to conclude the paper. I greatly benefited from the comments and encouragement of David Laidler, R. G. Lipsey and Geoff Harcourt in its final stages.

The paper can be accessed or downloaded here.

Here is the abstract:

Drawing on McCraw’s (2007) biography, this paper assesses the character of Joseph Schumpeter. After a biographical summary of Schumpeter’s life and career as an economist, the paper considers a thread of deliberate posturing and pretense in Schumpeter’s grandiose ambitions and claims about himself. It also takes account of his ambiguous political and moral stance in both his personal, public and scholarly lives, in particular his tenure as finance minister in the short-lived German Socialist government after World War I and his famous prediction of the ultimate demise of capitalism in his celebrated Capitalism, Socialism and Democracy. Although he emigrated to the US in the 1930s Schumpeter was suspected of harboring pro-German or even pro-Nazi sympathies during World War II, sympathies that are at least partially confirmed by the letters and papers discussed at length by McCraw. Moreover, despite Schumpeter’s support for his student Paul Samuelson, when Samuelson, owing to anti-Semitic prejudice, was rejected for a permanent appointment at Harvard, Samuelson himself judged Schumpeter to have been antisemitic. Nevertheless, despite his character flaws, Schumpeter exhibited a generosity of spirit in his assessments of the work of other economists in his last and greatest work The History of Economic Analysis, a work also exhibiting uncharacteristic self-effacement by its author. That self-effacement may beattributable to Schumpeter’s own tragic and largely unrealized ambition to achieve the technical analytical breakthroughs to which he accorded highest honors in his assessments of the work of other economists, notably, Quesnay, Cournot and Walras.

Why The Wall Street Journal Editorial Page is a Disgrace

In view of today’s absurdly self-righteous statement by the Wall Street Journal editorial board, I thought it would be a good idea to update one of my first posts (almost nine years ago) on this blog. Plus ca change plus c’est la meme chose; just gets worse and worse even with only occasional contributions by the estimable Mr. Stephen Moore.

Stephen Moore has the dubious honor of being a member of the editorial board of The Wall Street Journal.  He lives up (or down) to that honor by imparting his wisdom from time to time in signed columns appearing on the Journal’s editorial page. His contribution in today’s Journal (“Why Americans Hate Economics”) is noteworthy for typifying the sad decline of the Journal’s editorial page into a self-parody of obnoxious, philistine anti-intellectualism.

Mr. Moore begins by repeating a joke once told by Professor Christina Romer, formerly President Obama’s chief economist, now on the economics department at the University of California at Berkeley. The joke, not really that funny, is that there are two kinds of students:  those who hate economics and those who really hate economics.  Professor Romer apparently told the joke to explain that it’s not true. Mr. Moore repeats it to explain why he thinks it really is. Why does he? Let Mr. Moore speak for himself:  “Because too often economic theories defy common sense.” That’s it in a nutshell for Mr. Moore:  common sense — the ultimate standard of truth.

So what’s that you say, Galileo? The sun is stationary and the earth travels around it? You must be kidding! Why any child can tell you that the sun rises in the east and moves across the sky every day and then travels beneath the earth at night to reappear in the east the next morning. And you expect anyone in his right mind to believe otherwise. What? It’s the earth rotating on its axis? Are you possessed of demons? And you say that the earth is round? If the earth were round, how could anybody stand at the bottom of the earth and not fall off? Galileo, you are a raving lunatic. And you, Mr. Einstein, you say that there is something called a space-time continuum, so that time slows down as the speed one travels approaches the speed of light. My God, where could you have come up with such an idea?  By that reasoning, two people could not agree on which of two events happened first if one of them was stationary and the other traveling at half the speed of light.  Away with you, and don’t ever dare speak such nonsense again, or, by God, you shall be really, really sorry.

The point of course is not to disregard common sense–that would not be very intelligent–but to recognize that common sense isn’t enough. Sometimes things are not what they seem – the earth, Mr. Moore, is not flat – and our common sense has to be trained to correspond with a reality that can only be discerned by the intensive application of our reasoning powers, in other words, by thinking harder about what the world is really like than just accepting what common sense seems to be telling us. But once you recognize that common sense has its limitations, the snide populist sneers–the stock-in-trade of the Journal editorial page–mocking economists with degrees from elite universities in which Mr. Moore likes to indulge are exposed for what they are:  the puerile defensiveness of those unwilling to do the hard thinking required to push back the frontiers of their own ignorance.

In today’s column, Mr. Moore directs his ridicule at a number of Keynesian nostrums that I would not necessarily subscribe to, at least not without significant qualification. But Keynesian ideas are also rooted in certain common-sense notions, for example, the idea that income and expenditure are mutually interdependent, the income of one person being derived from the expenditure of another. So when Mr. Moore simply dismisses as “nonsensical” the idea that extending unemployment insurance to keep the unemployed from having to stop spending, he is in fact rejecting an idea that is no less grounded in common sense than the idea that paying people not to work discourages work. The problem is that our common sense cuts in both directions. Mr. Moore likes one and wants to ignore the other.

What we would like economists–even those unfortunate enough to have graduated from an elite university–to tell us is which effect is stronger or, perhaps, when is one effect stronger and when is the other stronger. But all that would be too complicated and messy for Mr. Moore’s–and the Journal‘s–cartoonish view of the world.

In that cartoonish view, the problem is that good old Adam Smith of “invisible hand” fame and his virtuous economic doctrines supporting free enterprise got tossed aside when the dastardly Keynes invented “macroeconomics” in the 1930s. And here is Mr. Moore’s understanding of macroeconomics.

Macroeconomics simply took basic laws of economics we know to be true for the firm or family –i.e., that demand curves are downward-sloping; that when you tax something, you get less of it; that debts have to be repaid—and turned them on their head as national policy.

Simple, isn’t it? The economics of Adam Smith (the microeconomics of firm and family) is good because it is based on common sense; the macroeconomics of Keynes is bad because it turns common sense on its head. Now I don’t know how much Mr. Moore knows about economics other than that demand curves are downward-sloping, but perhaps he has heard of, or even studied, the law of comparative advantage.

The law of comparative advantage says, in one of its formulations, that even if a country is less productive (because of, say, backward technology or a poor endowment of natural resources) than other countries in producing every single product that it produces, it would still have a lower cost of production in at least one of those products, and could profitably export that product (or those products) in international markets in sufficient amounts to pay for its imports of other products. If there is a less common-sensical notion than that in all of macroeconomics, indeed in any scientific discipline, I would like to hear about it. And trust me as a former university teacher of economics, there is no proposition in economics that students hate more or find harder to reconcile with their notions of common sense than the law of comparative advantage. Indeed, even most students who can correctly answer an exam question about comparative advantage don’t believe a word of what they wrote. The only students who actually do believe it are the ones who become economists.

But the law of comparative advantage is logically unassailable; you might as well try to disprove “two plus two equals four.” So, no, Mr. Moore, you don’t know why Americans hate economics, not unless, by Americans you mean that (one hopes small) group of individuals who happen to think exactly the same way as does the editorial board of The Wall Street Journal.

Noah Smith Gives Elizabeth Warren’s Economic Patriotism Plan Two Cheers; I Give it a Bit Less

Update 2/25/20 4:41pm EST: I wrote this post many months ago; I actually don’t remember where or when, but never posted it. I don’t remember why I didn’t post it. I don’t even know how it got posted, because, having long forgotten about it, I certainly wasn’t trying to post it. I was just searching for another old and published post of mine that I wanted to look at. But since it’s seen the light of day, I guess I will just leave it out there for whoever is interested.

Elizabeth Warren issued another one of her policy documents, this one a plan for advancing what she calls “economic patriotism,” a term that certainly doesn’t resonate in my own ears. But to each his own. Noah Smith lost no time publishing his own analysis of Warren’s proposals, no doubt after giving it a careful reading and a lot of careful thought.

Being less diligent than Noah, I haven’t actually read Warren’s policy proposals, but I did read Noah’s analysis of Warren’s proposals, and  here are some quick reactions to Noah and indirectly to Senator Warren.

It’s safe to say that the postwar free-trade consensus in Washington has crumbled. The main agent of its destruction was President Donald Trump, who fulfilled his campaign promises by canceling free-trade deals and launching trade wars with almost every country with which the U.S. does business. But the turn against free trade is bipartisan — socialist presidential candidate Bernie Sanders also promised to pull out of some international deals, and some prominent Democrats have backed Trump’s tariffs against China.

Now Senator and 2020 presidential candidate Elizabeth Warren has released a trade plan that goes squarely against the old consensus. Warren’s “A Plan For Economic Patriotism” would seek to revive U.S. industry in a number of ways — some of them smart, some of them problematic. The plan would leverage government-funded research and development to boost industry — a very good but hardly novel idea — and promote manufacturing (Warren also released a companion proposal specifically about manufacturing). The plan also would aggressively promote U.S. exports.

Although the purpose of the plan may be to triangulate Trump on trade, doing more to promote exports is probably a good idea in its own right. There is a growing body of evidence that nudging developing-country manufacturers to export increases their productivity, and some studies suggest that the phenomenon extends to rich countries like the U.S. This makes sense — when a company starts competing in international markets, it must up its game against global competition, improving efficiency, developing new products and so on.  But the U.S. domestic market is so large that American companies are often tempted to ignore the outside world; export promotion would fight this corrosive complacency.

I am inclined to favor free trade, but as I have observed before, the standard case for unilateral free trade is based on a number of implicit welfare assumptions that are not necessarily true and may leave out important considerations that are relevant to an appropriate analysis of trade policy. If we are trying to promote high employment then the best way of doing that is not by raising the price of imports which mainly benefits the owners of specialized domestic capital used in import-competing industries. It would be better to subsidize employment in industries that produce exports encouraging their expansion.

Then there’s the trade deficit. Countries can’t all run trade surpluses at each other’s expense, and attempts to do so can easily degenerate into a game of beggar-thy-neighbor. If a country runs trade deficits in order to fuel a temporary investment boom, which can help growth. But for more than two decades now, the U.S. has run substantial trade deficits even as investment’s share of the economy has fallen:

That suggests that U.S. consumers are consistently living beyond their means, which seems unsustainable. Increasing exports, rather than trying to cut imports as Trump has done, is a smart way to try to make U.S. consumption levels more sustainable.

The problem is how exactly to do it. Warren would dramatically expand the Export-Import bank’s activities, and direct more of its loans to smaller companies instead of big ones — a great idea that I have called for in the past. Warren would also consolidate the vast array of federal government agencies responsible for industrial policy into a single Department of Economic Development — another smart move.

I’m not following Noah’s reasoning. If the trade deficit is, as Noah correctly suggests, a reflection of a low US saving rate compared to saving in other countries, how will subsidizing exports raise the US propensity to save. Increasing the exports of some products will not induce Americans to increase their saving rate. If aggregate US saving doesn’t increase, the size of the trade deficit will not change; only the composition of that deficit will change.

A less savory tool is Warren’s proposal to have the federal government buy only American-made goods — a protectionist move that would do nothing to promote exports and would simply raise costs for the infrastructure that U.S. manufacturers need to be competitive. Warren should discard this piece of the plan.

Agreed.

More actively managing our currency value to promote exports and domestic manufacturing…We should consider a number of tools and work with other countries harmed by currency misalignment to produce a currency value that’s better for our workers and our industries.

The dollar now functions as the world’s so-called reserve currency — other countries hold dollar assets as buffers against capital outflows, and many internationally traded commodities are priced in dollars. This increases global demand for dollars, which pushes up their value against other currencies. That makes it easier for Americans to borrow, but harder for them to export.

It’s hard to see how Warren’s plan would change that state of affairs. Currency intervention would probably come from the Federal Reserve; if the Fed prints dollars, it puts downward pressure on the dollar. But because the U.S. doesn’t have the same control over its financial system that China does, creating all those dollars would risk inflation.  The difficulty of maintaining an independent monetary policy while also targeting exchange rates is a well-known dilemma in international economics.

Precisely. Noah seems to referencing a policy of exchange-rate protection, which I have written about many times already on this blog, based on the classic article on the subject of the eminent Max Corden. The upshot of Corden’s article was that exchange-rate protection can only work if the monetary authority simultaneously intervenes to reduce the value of its currency in the foreign-exchange market by selling its currency in exchange for foreign currencies and tightens its domestic monetary policy. Exchange-rate intervention means increasing the quantity of the domestic currency, thereby causing domestic prices to rise. If domestic prices rise along with the depreciation of the exchange rate of the domestic currency, exporters gain no advantage. If exports are to be promoted by exchange-rate intervention, the monetary authority must either reduce the domestic quantity of money or increase the demand for it (usually by increasing reserve requirements for the banking system) while the exchange rate is depreciated, creating an excess domestic demand for money. If the domestic economy is chronically short of cash, the only way for cash balances to be increased is through reduced expenditure which means that imports will decrease and exports will increase as a result of reduced domestic expenditure. That doesn’t sound like the sort of strategy for currency manipulation to reduce the real effective exchange rate that Senator Warren would be inclined to support

As an alternative, the U.S. could try to stop other countries from holding U.S. dollar reserves and pricing commodities in dollars, thus forfeiting the dollar’s role as the global reserve currency. But this could destabilize the global financial system in ways that are poorly understood, and thus would be a risky move.

In the end, the best approach on the currency may simply be to put pressure on countries that intervene to reduce the value of their own currencies against the dollar. The problem is that China is by far the biggest of these — although it hasn’t had to intervene to hold down the yuan in recent years, its capital controls and currency management policies are still in place, limiting the potential for yuan appreciation. If other countries allow their own currencies to appreciate against the dollar, they’ll be putting themselves in an uncompetitive position relative to China.

Thus, the issues of economic patriotism, export promotion and currency revaluation will ultimately come back to China. Until and unless that giant country gives up its strategy of promoting manufactured exports to the U.S., it will be an uphill battle to correct the U.S.’s imbalances or revive its export competitiveness. A President Warren would be smarter than a President Trump on trade, but she would find herself confronting much the same challenges.

While China probably was a currency manipulator in the early years of this century, as reflected China’s rapid accumulation of foreign exchange, the pace of foreign exchange accumulation has since tapered off. China could be pressured to disgorge some of its enormous foreign-exchange holdings, which would require China to buy more foreign assets or increase imports from abroad. How that could be done is not exactly obvious, but the most likely way to achieve that result would be for the US to aim for a higher rate of inflation thereby increasing the cost to China and other holders of US foreign exchange of holding low-yielding US financial assets. Whether President Warren would find such a policy approach to her liking is far from obvious.

My Paper “Hayek, Hicks, Radner and Four Equilibrium Concepts” Is Now Available Online.

The paper, forthcoming in The Review of Austrian Economics, can be read online.

Here is the abstract:

Hayek was among the first to realize that for intertemporal equilibrium to obtain all agents must have correct expectations of future prices. Before comparing four categories of intertemporal, the paper explains Hayek’s distinction between correct expectations and perfect foresight. The four equilibrium concepts considered are: (1) Perfect foresight equilibrium of which the Arrow-Debreu-McKenzie (ADM) model of equilibrium with complete markets is an alternative version, (2) Radner’s sequential equilibrium with incomplete markets, (3) Hicks’s temporary equilibrium, as extended by Bliss; (4) the Muth rational-expectations equilibrium as extended by Lucas into macroeconomics. While Hayek’s understanding closely resembles Radner’s sequential equilibrium, described by Radner as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium seems to have been the natural extension of Hayek’s approach. The now dominant Lucas rational-expectations equilibrium misconceives intertemporal equilibrium, suppressing Hayek’s insights thereby retreating to a sterile perfect-foresight equilibrium.

And here is my concluding paragraph:

Four score and three years after Hayek explained how challenging the subtleties of the notion of intertemporal equilibrium and the elusiveness of any theoretical account of an empirical tendency toward intertemporal equilibrium, modern macroeconomics has now built a formidable theoretical apparatus founded on a methodological principle that rejects all the concerns that Hayek found so vexing denies that all those difficulties even exist. Many macroeconomists feel proud of what modern macroeconomics has achieved, but there is reason to think that the path trod by Hayek, Hicks and Radner could have led macroeconomics in a more fruitful direction than the one on which it has been led by Lucas and his associates.

Yield-Curve Inversion and the Agony of Central Banking

Suddenly, we have been beset with a minor panic attack about our increasingly inverted yield curve. Since fear of yield-curve inversion became a thing a little over a year ago, a lot of people have taken notice of the fact that yield-curve inversion has often presaged recessions. In June 2018, when the yield curve was on the verge of flatlining, I tried to explain the phenomenon, and I think that I provided a pretty good — though perhaps a tad verbose — explanation, providing the basic theory behind the typical upward slope of the yield curve as well as explaining what seems the most likely, though not the only, reason for inversion, one that explains why inversion so often is a harbinger of recession.

But in a Tweet yesterday responding to Sri Thiruvadanthai I think I framed the issue succinctly within the 280 character Twitter allotment. Here are the two tweets.

 

 

And here’s a longer version getting at the same point from my 2018 post:

For purposes of this discussion, however, I will focus on just two factors that, in an ultra-simplified partial-equilibrium setting, seem most likely to cause a normally upward-sloping yield curve to become relatively flat or even inverted. These two factors affecting the slope of the yield curve are the demand for liquidity and the supply of liquidity.

An increase in the demand for liquidity manifests itself in reduced current spending to conserve liquidity and by an increase in the demands of the public on the banking system for credit. But even as reduced spending improves the liquidity position of those trying to conserve liquidity, it correspondingly worsens the liquidity position of those whose revenues are reduced, the reduced spending of some necessarily reducing the revenues of others. So, ultimately, an increase in the demand for liquidity can be met only by (a) the banking system, which is uniquely positioned to create liquidity by accepting the illiquid IOUs of the private sector in exchange for the highly liquid IOUs (cash or deposits) that the banking system can create, or (b) by the discretionary action of a monetary authority that can issue additional units of fiat currency.

The question that I want to address now is why has the yield curve, after having been only slightly inverted or flat for the past year, suddenly — since about the beginning of August — become sharply inverted.

Last summer, when concerns about inversion was just beginning to be discussed, the Fed, which had been signaling a desire to raise short-term rates to “normal” levels, changed signals, indicating that it would not automatically continue raising rates as it had between 2003 and 2006, but would evaluate each rate increase in light of recent data bearing on the state of the economy. So after a further half-a-percent increase in the Fed’s target rate between June and the end of 2018, the Fed held off on further increases, and in July actually cut its rate by a quarter of a percent and even signaled a likely further quarter of a percent decrease in September.

Now to be sure the Fed might have been well-advised not to have raised its target rate as much as it did, and to have cut its rate more steeply than it did in July. Nevertheless, it would be hard to identify any particular monetary cause for the recent steep further inversion of the yield curve. So, the most likely reason for the sudden inversion is nervousness about the possibility of a trade war, which most people do not think is either good or easy to win.

After yesterday’s announcement by the administration that previously announced tariff increases on Chinese goods scheduled to take effect in September would be postponed until after the Christmas buying season, the stock market took some comfort in an apparent easing of tensions between the US and China over trade policy. But this interpretation was shot down by none other than Commerce Secretary Wilbur Ross who, before the start of trading, told CNBC that the administration’s postponement of the tariffs on China was done solely in the interest of American shoppers and not to ease tensions with China. The remark — so unnecessary and so counterproductive — immediately aroused suspicions that Ross had an ulterior motive, like, say, a short position in the S&P 500 index, in sharing it on national television.

So what’s going on? Monetary policy has probably been marginally too tight for that past year, but only marginally. Unlike other inverted yield curve episodes that Fed has not been attempting to reduce the rate of inflation and has even been giving lip service to the goal of raising the rate of inflation, so if the Fed’s target rate was raised too high, it was based on an expectation that the economy was in the midst of an expansion; it was not an attempt to reduce growth. But the economy has weakened, and all signs suggest that the weakness stems from an uncertain economic environment particularly owing to the risk that new tariffs will be imposed or existing ones raised to even higher levels, triggering retaliatory measures by China and other affected countries.

In my 2018 post I mentioned a similar, but different, kind of uncertainty that held back recovery from the 2001-02 recession.

The American economy had entered a recession in early 2001, partly as a result of the bursting of the dotcom bubble of the late 1990s. The recession was short and mild, and the large tax cut enacted by Congress at the behest of the Bush administration in June 2001 was expected to provide significant economic stimulus to promote recovery. However, it soon became clear that, besides the limited US attack on Afghanistan to unseat the Taliban regime and to kill or capture the Al Qaeda leadership in Afghanistan, the Bush Administration was planning for a much more ambitious military operation to effect regime change in Iraq and perhaps even in other neighboring countries in hopes of radically transforming the political landscape of the Middle East. The grandiose ambitions of the Bush administration and the likelihood that a major war of unknown scope and duration with unpredictable consequences might well begin sometime in early 2003 created a general feeling of apprehension and uncertainty that discouraged businesses from making significant new commitments until the war plans of the Administration were clarified and executed and their consequences assessed.

The Fed responded to the uncertain environment of 2002 with a series of interest rate reductions that prevented a lapse into recession.

Gauging the unusual increase in the demand for liquidity in 2002 and 2003, the Fed reduced short-term rates to accommodate increasing demands for liquidity, even as the economy entered into a weak expansion and recovery. Given the unusual increase in the demand for liquidity, the accommodative stance of the Fed and the reduction in the Fed Funds target to an unusually low level of 1% had no inflationary effect, but merely cushioned the economy against a relapse into recession.

Recently, the uncertainty caused by the imposition of tariffs and the threat of a destructive trade war seems to have discouraged firms to go forward with plans to invest and to expand output as decision-makers prefer to wait and see how events play out before making long-term commitments that would put assets and investments at serious risk if a trade war undermines the conditions necessary for those investment to be profitable. In the interim, decision-makers seeking short-term safety and the flexibility to deploy their assets and resources profitably once future prospects become less uncertain leads them to take highly liquid positions that don’t preclude taking future profitable actions once profitable opportunities present themselves.

However, when everyone resists making commitments, economic activity doesn’t keep going as before, it gradually slows down. And so a state of heightened uncertainty eventually leads to a stagnation or recession or something worse. To prevent or mitigate that outcome, a reduction in interest rates by the central bank can prevent or at least postpone the onset of a recession, as the Fed succeeded in doing in 2002-03 by reducing its interest rate target to 1%. Similar steps by the Fed may now be called for.

But there is another question that ought to be discussed. When the Fed reduced interest rates in 2002-03 because of the uncertainty created by the pending decision of the US government about whether to invade Iraq, the Fed was probably right to take that uncertainty as an exogenous decision in which it had no decision-making role or voice. The decision to invade or not would be made based on considerations over which the Fed rightly had no role to evaluate or opine upon. However, the Fed does have a responsibility for creating a stable economic environment and eliminating avoidable uncertainty about economic conditions caused by bad policy-making. Insofar as the current uncertain economic environment is the result of deliberate economic-policy actions that increase uncertainty, reducing interest rates to cushion the uncertainty-increasing effects of imposing, or raising, tariffs or of promoting a trade war would enable those uncertainty-increasing actions to be continued.

The Fed, therefore, now faces a cruel dilemma. Should it try to mitigate, by reducing interest rates, the effects of policies that increase uncertainty, thereby acting as a perhaps unwitting enabler of those policies, or should it stand firm and refuse to cushion the effects of policies that are themselves the cause of the uncertainty whose destructive effects the Fed is being asked to mitigate? This is the sort of dilemma that Arthur Burns, in a somewhat different context, once referred to as “The Agony of Central Banking.”

August 15, 1971: Unhappy Anniversary (Update)

[Update 8/15/2019: It seems appropriate to republish this post originally published about 40 days after I started blogging. I have made a few small changes and inserted a few comments to reflect my improved understanding of certain concepts like “sterilization” that I was uncritically accepting. I actually have learned a thing or two in the eight plus years that I’ve been blogging. I am grateful to all my readers — both those who agreed and those who disagreed — for challenging me and inspiring me to keep thinking critically. It wasn’t easy, but we did survive August 15, 1971. Let’s hope we survive August 15, 2019.]

August 15, 1971 may not exactly be a day that will live in infamy, but it is hardly a day to celebrate 40 years later.  It was the day on which one of the most cynical Presidents in American history committed one of his most cynical acts:  violating solemn promises undertaken many times previously, both before and after his election as President, Richard Nixon declared a 90-day freeze on wages and prices.  Nixon also announced the closing of the gold window at the US Treasury, severing the last shred of a link between gold and the dollar.  Interestingly, the current (August 13th, 2011) Economist (Buttonwood column) and Forbes  (Charles Kadlec op-ed) and today’s Wall Street Journal (Lewis Lehrman op-ed) mark the anniversary with critical commentaries on Nixon’s action ruefully focusing on the baleful consequences of breaking the link to gold, while barely mentioning the 90-day freeze that became the prelude to  the comprehensive wage and price controls imposed after the freeze expired.

Of the two events, the wage and price freeze and subsequent controls had by far the more adverse consequences, the closing of the gold window merely ratifying the demise of a gold standard that long since had ceased to function as it had for much of the 19th and early 20th centuries.  In contrast to the final break with gold, no economic necessity or even a coherent economic argument on the merits lay behind the decision to impose a wage and price freeze, notwithstanding the ex-post rationalizations offered by Nixon’s economic advisers, including such estimable figures as Herbert Stein, Paul McKracken, and George Schultz, who surely knew better,  but somehow were persuaded to fall into line behind a policy of massive, breathtaking, intervention into private market transactions.

The argument for closing the gold window was that the official gold peg of $35 an ounce was probably at least 10-20% below any realistic estimate of the true market value of gold at the time, making it impossible to reestablish the old parity as an economically meaningful price without imposing an intolerable deflation on the world economy.  An alternative response might have been to officially devalue the dollar to something like the market value of gold $40-42 an ounce.  But to have done so would merely have demonstrated that the official price of gold was a policy instrument subject to the whims of the US monetary authorities, undermining faith in the viability of a gold standard.  In the event, an attempt to patch together the Bretton Woods System (the Smithsonian Agreement of December 1971) based on an official $38 an ounce peg was made, but it quickly became obvious that a new monetary system based on any form of gold convertibility could no longer survive.

How did the $35 an ounce price became unsustainable barely 25 years after the Bretton Woods System was created?  The problem that emerged within a few years of its inception was that the main trading partners of the US systematically kept their own currencies undervalued in terms of the dollar, promoting their exports while sterilizing the consequent dollar inflow, allowing neither sufficient domestic inflation nor sufficient exchange-rate appreciation to eliminate the overvaluation of their currencies against the dollar. [DG 8/15/19: “sterilization” is a misleading term because it implies that persistent gold or dollar inflows just happen randomly; the persistent inflow occur only because they are induced by a persistent increased demand for reserves or insufficient creation of cash.] After a burst of inflation in the Korean War, the Fed’s tight monetary policy and a persistently overvalued exchange rate kept US inflation low at the cost of sluggish growth and three recessions between 1953 and 1960.  It was not until the Kennedy administration came into office on a pledge to get the country moving again that the Fed was pressured to loosen monetary policy, initiating the long boom of the 1960s some three years before the Kennedy tax cuts were posthumously enacted in 1964.

Monetary expansion by the Fed reduced the relative overvaluation of the dollar in terms of other currencies, but the increasing export of dollars left the $35 an ounce peg increasingly dependent on the willingness of foreign government to hold dollars.  However, President Charles de Gaulle of France, having overcome domestic opposition to his rule, felt secure enough to assert [his conception of] French interests against the US, resuming the traditional French policy of accumulating physical gold reserves rather than mere claims on gold physically held elsewhere.  By 1967 the London gold pool, a central bank cartel acting to control the price of gold in the London gold market, was collapsing, as France withdrew from the cartel, demanding that gold be shipped to Paris from New York.  In 1968, unable to hold down the market price of gold any longer, the US and other central banks let the gold price rise above the official price, but agreed to conduct official transactions among themselves at the official price of $35 an ounce.  As market prices for gold, driven by US monetary expansion, inched steadily higher, the incentives for central banks to demand gold from the US at the official price became too strong to contain, so that the system was on the verge of collapse when Nixon acknowledged the inevitable and closed the gold window rather than allow depletion of US gold holdings.

Assertions that the Bretton Woods system could somehow have been saved simply ignore the economic reality that by 1971 the Bretton Woods System was broken beyond repair, or at least beyond any repair that could have been effected at a tolerable cost.

But Nixon clearly had another motivation in his August 15 announcement, less than 15 months before the next Presidential election.  It was in effect the opening shot of his reelection campaign.  Remembering all too well that he lost the 1960 election to John Kennedy because the Fed had not provided enough monetary stimulus to cut short the 1960-61 recession, Nixon had appointed his long-time economic adviser, Arthur Burns to replace William McChesney Martin as chairman of the Fed in 1970.  A mild tightening of monetary policy in 1969 as inflation was rising above a 5% annual rate, had produced a recession in late 1969 and early 1970, without providing much relief from inflation.  Burns eased policy enough to allow a mild recovery, but the economy seemed to be suffering the worst of both worlds — inflation still near 4 percent and unemployment at what then seemed an unacceptably high level of almost 6 percent. [For more on Burns and his deplorable role in all of this see this post.]

With an election looming ever closer on the horizon, Nixon in the summer of 1971 became consumed by the political imperative of speeding up the recovery.  Meanwhile a Democratic Congress, assuming that Nixon really did mean his promises never to impose wage and price controls to stop inflation, began clamoring for controls as the way to stop inflation without the pain of a recession, even authorizing the President to impose controls, a dare they never dreamed he would accept.  Arthur Burns, himself, perhaps unwittingly [I was being too kind], provided support for such a step by voicing frustration that inflation persisted in the face of a recession and high unemployment, suggesting that the old rules of economics were no longer operating as they once had.  He even offered vague support for what was then called an incomes policy, generally understood as an informal attempt to bring down inflation by announcing a target  for wage increases corresponding to productivity gains, thereby eliminating the need for businesses to raise prices to compensate for increased labor costs.  What such proposals usually ignored was the necessity for a monetary policy that would limit the growth of total spending sufficiently to limit the growth of wage incomes to the desired target. [On incomes policies and how they might work if they were properly understood see this post.]

Having been persuaded that there was no acceptable alternative to closing the gold window — from Nixon’s perspective and from that of most conventional politicians, a painfully unpleasant admission of US weakness in the face of its enemies (all this was occurring at the height of the Vietnam War and the antiwar protests) – Nixon decided that he could now combine that decision, sugar-coated with an aggressive attack on international currency speculators and a protectionist 10% duty on imports into the United States, with the even more radical measure of a wage-price freeze to be followed by a longer-lasting program to control price increases, thereby snatching the most powerful and popular economic proposal of the Democrats right from under their noses.  Meanwhile, with the inflation threat neutralized, Arthur Burns could be pressured mercilessly to increase the rate of monetary expansion, ensuring that Nixon could stand for reelection in the middle of an economic boom.

But just as Nixon’s electoral triumph fell apart because of his Watergate fiasco, his economic success fell apart when an inflationary monetary policy combined with wage-and-price controls to produce increasing dislocations, shortages and inefficiencies, gradually sapping the strength of an economic recovery fueled by excess demand rather than increasing productivity.  Because broad based, as opposed to narrowly targeted, price controls tend to be more popular before they are imposed than after (as too many expectations about favorable regulatory treatment are disappointed), the vast majority of controls were allowed to lapse when the original grant of Congressional authority to control prices expired in April 1974.

Already by the summer of 1973, shortages of gasoline and other petroleum products were becoming commonplace, and shortages of heating oil and natural gas had been widely predicted for the winter of 1973-74.  But in October 1973 in the wake of the Yom Kippur War and the imposition of an Arab Oil Embargo against the United States and other Western countries sympathetic to Israel, the shortages turned into the first “Energy Crisis.”  A Democratic Congress and the Nixon Administration sprang into action, enacting special legislation to allow controls to be kept on petroleum products of all sorts together with emergency authority to authorize the government to allocate products in short supply.

It still amazes me that almost all the dislocations manifested after the embargo and the associated energy crisis were attributed to excessive consumption of oil and petroleum products in general or to excessive dependence on imports, as if any of the shortages and dislocations would have occurred in the absence of price controls.  And hardly anyone realizes that price controls tend to drive the prices of whatever portion of the supply is exempt from control even higher than they would have risen in the absence of any controls.

About ten years after the first energy crisis, I published a book in which I tried to explain how all the dislocations that emerged from the Arab oil embargo and the 1978-79 crisis following the Iranian Revolution were attributable to the price controls first imposed by Richard Nixon on August 15, 1971.  But the connection between the energy crisis in all its ramifications and the Nixonian price controls unfortunately remains largely overlooked and ignored to this day.  If there is reason to reflect on what happened forty years ago on this date, it surely is for that reason and not because Nixon pulled the plug on a gold standard that had not been functioning for years.

The Mendacity of Yoram Hazony, Virtue Signaler

Yoram Hazony, an American-educated, Israeli philosopher and political operator, former assistant to Benjamin Netanyahu, has become a rising star of the American Right. The week before last, Hazony made his media debut at the Washington DC National Conservatism Conference inspired by his book The Virtue of Nationalism. Sponsored by the shadowy Edmund Burke Foundation, the Conference on “National Conservatism” – a title either remarkably tone-deaf, or an in-your-face provocation echoing another “national ‘ism” ideological movement – featured a keynote address by Fox New personality and provocateur par excellence Tucker Carlson, and various other right-wing notables of varying degrees of respectability, though self-avowed white nationalists were kept at a discreet distance — a distance sufficient to elicit resentful comments and nasty insinuations about Hazony’s origins and loyalties.

I had not planned to read Hazony’s book, having read enough of his articles to know Hazony’s would not be book to read for either pleasure or edification. But sometimes duty calls, so I bought Hazony’s book on Amazon at half price. I have now read the Introduction and the first three chapters. I plan to continue reading till the end, but I thought that I would write down some thoughts as I go along. So consider yourself warned, this may not be my last post about Hazony.

Hazony calls his Introduction “A Return to Nationalism;” it is not a good beginning.

Politics in Britain and America have taken a turn toward nationalism. This has been troubling to many, especially in educated circles, where global integration has long been viewed as a requirement of sound policy and moral decency. From this perspective, Britain’s vote to leave the European Union and the “America First” rhetoric coming out of Washington seem to herald a reversion to a more primitive stage in history, when war-mongering and racism were voiced openly and permitted to set the political agenda of nations. . . .

But nationalism was not always understood to be the evil that current public discourse suggests. . . . Progressives regarded Woodrow Wilson’s Fourteen Points and the Atlantic Charter of Franklin Roosevelt and Winston Churchill as beacons of hope for mankind – and this precisely because they were considered expressions of nationalism, promising national independence and self-determination to enslaved peoples around the world. (pp. 1-2)

Ahem, Hazony cleverly – though not truthfully — appropriates Wilson, FDR and Churchill to the cause of nationalism. Although it was clever move by Hazony to try to disarm opposition to his brief for nationalism by misappropriating Wilson, FDR and Churchill to his side, it was not very smart, it being so obviously contradicted by well-known facts. Merely because Wilson, FDR, and Churchill all supported, with varying degrees of consistency and sincerity, the right of self-determination by national ethnic communities that had never, or not for a long time, enjoyed sovereign control over the territories in which they dwelled, does not mean that they did not also favor international cooperation and supra-national institutions.

For example, points 3 and 4 of Wilson’s Fourteen Points were the following:

The removal, so far as possible, of all economic barriers and the establishment of an equality of trade conditions among all the nations consenting to the peace and associating themselves for its maintenance.

Adequate guarantees given and taken that national armaments will be reduced to the lowest point consistent with domestic safety.

And here is point 14:

A general association of nations must be formed under specific covenants for the purpose of affording mutual guarantees of political independence and territorial integrity to great and small states alike. That association of course was realized as the League of Nations, which Wilson strove mightily to create but failed to convince the United States Senate to ratify the Treaty whereby the US would have joined the League.

I don’t know about you, but to me that sounds awfully globalist .

Now what about The Atlantic Charter?

While it supported the right of self-determination of all peoples, it also called for the lowering of trade barriers and for global economic cooperation. Moreover, Churchill, far from endorsing the unqualified right of all peoples to self-determination, flatly rejected the idea that the right of self-determination extended to British India.

But besides withholding the right of self-determination from British colonial possessions and presumably those of other European powers, Churchill, in a famous speech, endorsed the idea of a United States of Europe. Now Churchill did not necessarily envision a federal union along the lines of the European Union as now constituted, but he obviously did not reject on principle the idea of some form of supra-national governance.

We must build a kind of United States of Europe. In this way only will hundreds of millions of toilers be able to regain the simple joys and hopes which make life worth living.

So it is simply a fabrication and a misrepresentation to suggest that nationalism has ever been regarded as anything like a universal principle of political action, governance or justice. It is one of many principles, all of which have some weight, but must be balanced against, and reconciled with, other principles of justice, policy and expediency.

Going from bad to worse, Hazony continues,

Conservatives from Teddy Roosevelt to Dwight Eisenhower likewise spoke of nationalism as a positive good. (Id.)

Where to begin? Hazony, who is not adverse to footnoting (216 altogether, almost one per page, often providing copious references to sources and scholarly literature) offers not one documentary or secondary source for this assertion. To be sure Teddy Roosevelt and Dwight Eisenhower were Republicans. But Roosevelt differed from most Republicans of his time, gaining the Presidency only because McKinley wanted to marginalize him by choosing him as a running mate at a time when no Vice-President since Van Buren had succeeded to the Presidency, except upon the death of the incumbent President.

Eisenhower had been a non-political military figure with no party affiliation until his candidacy for the Republican Presidential nomination, as an alternative to the preferred conservative choice, Robert Taft. Eisenhower did not self-identify as a conservative, preferring to describe himself as a “modern Republican” to the disgust of conservatives like Barry Goldwater, whose best-selling book The Conscience of a Conservative was a sustained attack on Eisenhower’s refusal even to try to roll back the New Deal.

Moreover, when TR coined the term “New Nationalism” in a famous speech he gave in 1912, he was running for the Republican Presidential nomination against his chosen successor, William Howard Taft, by whom TR felt betrayed for trying to accommodate the conservative Republicans TR so detested. Failing to win the Republican nomination, TR ran as the candidate of the Progressive Party, splitting the Republican party, thereby ensuring the election of the progressive, though racist, Woodrow Wilson. Nor was that the end of it. Roosevelt was himself an imperialist, who had supported the War against Spain and the annexation of the Phillipines, and an early and militant proponent of US entry into World War I against Germany on the side of Britain and France. And, after the war, Roosevelt supported US entry into the League of Nations. These are not obscure historical facts, but Hazony, despite his Princeton undergraduate degree and doctorate in philosophy from Rutgers, shows no awareness of them.

Hazony seems equally unaware that, in the American context, nationalism had an entirely different meaning from its nineteenth-century European meaning, as the right of national ethnic populations, defined mainly by their common language, to form sovereign political units rather than the multi-ethnic, largely undemocratic kingdoms and empires by which they were ruled. In America, nationalism was distinguished from sectionalism, expressing the idea that the United States had become an organic unit unto itself, not merely an association of separate and distinct states. This idea, emphasized by Hamilton and the Federalists, and later the Whigs, against the states’ rights position of the Jeffersonian Democrats who resisted the claims of national and federal primacy. The classic expression of the uniquely American national sensibility was provided by Lincoln in his Gettysburg Address.

Fourscore and seven years ago our fathers brought forth on this continent, a new nation, conceived in Liberty, and dedicated to the proposition that all men are created equal.

Now we are engaged in a great civil war, testing whether that nation, or any nation so conceived and so dedicated, can long endure. We are met on a great battle-field of that war. We have come to dedicate a portion of that field, as a final resting place for those who here gave their lives that that nation might live.

Lincoln offered a conception of nationhood entirely different from that which inspired demands for the right of self-determination by European national ethnic and linguistic communities. If the notion of American exceptionalism is to have any clear meaning, it can only be in the context of Lincoln’s description of the origin and meaning of the American nationality.

After his clearly fraudulent appropriation of Theodore and Franklin Roosevelt, Winston Churchill and Dwight Eisenhower to the Nationalist Conservative cause, Hazony seizes upon Ronald Reagan and Margaret Thatcher. “In their day,’ Hazony assures us, “Ronald Reagan and Margaret Thatcher were welcomed by conservatives for the ‘new nationalism’ they brought to political life.” For good measure, Hazony also adds David Ben-Gurion and Mahatma Gandhi to his nationalist pantheon, though, unaccountably, he omits any mention of their enthusiastic embrace by conservatives.

Hazony favors his readers with a single footnote at the end of this remarkable and fantastical paragraph. Forget the fact that “new nationalism” is a term peculiarly associated with Teddy Roosevelt, not with Reagan, who to my knowledge, never uttered the phrase, but the primary source cited by Hazony doesn’t even refer to Reagan in the same context as “new nationalism.” Here is the text of that footnote.

On Reagan’s “new nationalism,” see Norman Podhoretz, “The New American Majority,” Commentary (January 1981); Irving Kristol, “The Emergence of Two Republican Parties,” Reflections of a Neo-Conservative (New York: Basic Books, 1983), 111. (p. 237)

I am unable to find the Kristol text on the internet, but I did find Podhoretz’s article on the Commentary website. I will quote the entire paragraph in which the words “new nationalism” make their only appearance (it is also the only appearance of “nationalism” in the article). But before reproducing the paragraph, I will register my astonishment at the audacity of Hazony in invoking the two godfathers of neo-conservatism as validators of spurious claim made by Hazony on Reagan’s behalf to posthumous recognition as a National Conservative hero, inasmuch as Hazony goes out of his way, as we shall see presently, to cast neo-conservatism into the Gehenna of imperialistic liberalism. But first, let us consider — and marvel at — Podhoretz’s discussion of the “new nationalism.”

In my opinion, because of Chappaquiddick alone, Edward Kennedy could not have become President of the United States in 1980. Yet even if Chappaquiddick had not been a factor, Edward Kennedy would still not have been a viable candidate — not for the Democratic nomination and certainly not for the Presidency in the general election. But if this is so, why did so many Democrats (over 50 percent in some of the early polls taken before he announced) declare their support for him? Here again it is impossible to say with complete assurance. But given the way the votes were subsequently cast in 1980, I think it is a reasonable guess that in those early days many people who had never paid close attention to him took Kennedy for the same kind of political figure his brother John had been. We know from all the survey data that the political mood had been shifting for some years in a consistent direction — away from the self-doubts and self-hatreds and the neo-isolationism of the immediate post-Vietnam period and toward what some of us have called a new nationalism. In the minds of many people caught up in the new nationalist spirit, John F. Kennedy stood for a powerful America, and in expressing enthusiasm for Edward Kennedy, they were in all probability identifying him with his older brother.

This is just an astoundingly brazen misrepresentation by Hazony in hypocritically misappropriating Reagan, to whose memory most Republicans and conservatives feel some lingering sentimental attachment, even as they discard and disavow many of his most characteristic political principles.

The extent to which Hazony repudiates the neo-conservative world view that was a major pillar of the Reagan Presidency becomes clear in a long paragraph in which Hazony sets up his deeply misleading, dichotomy between the virtuous nationalism he espouses and the iniquitous liberal imperialism that he excoriates as the only two possible choices for organizing our political institutions.

This debate between nationalism and imperialism became acutely relevant again with the fall of the Berlin Wall in 1989. At that time, the struggle against Communism ended, and the minds of Western leaders became preoccupied with two great imperialist project: the European Union, which has progressively relieved member nations of many of the powers usually associated with political independence; and the project of establishing an American “world order,” in which nations that do not abide by international law will be coerced into doing so principally by means of American military might. These imperialist projects, even though their proponents do not like to call them that, for two reasons: First, their purpose is to remove decision-making from the hands of independent national governments and place it in the hands of international governments or bodies. And second, as you can immediately see from the literature produced by these individuals and institutions supporting these endeavors, they are consciously part of an imperialist political tradition, drawing their historical inspiration from the Roman Empire, the Austro-Hungarian Empire, and the British Empire. For example, Charles Krauthammer’s argument for American “Universal Dominion,” written at the dawn of the post-Cold War period, calls for American to create a “super-sovereign,” which will preside over the permanent “depreciation . . . of the notion of sovereignty” for all nations on earth. Krauthammer adopts the Latin term pax Americana to describe this vision, invoking the image of the United States as the new Rome: Just as the Roman Empire supposedly established a pax Romana . . . that obtained security and quiet for all of Europe, so America would now provide security and quiet for the entire world. (pp. 3-4)

I do not defend Krauthammer’s view of pax Americana and his support for invading Iraq in 2003. But the war in Iraq was largely instigated by a small group of right-wing ideologists with whom Krauthammer and other neo-conservatives like William Kristol and Robert Kagan were aligned. In the wake of September 11, 2001, they leveraged fear of another attack into a quixotic and poorly-thought-out and incompetently executed military adventure into Iraq.

That invasion was not, as Hazony falsely suggests, the inevitable result of liberal imperialism (as if liberalism and imperialism were cognate ideas). Moreover, it is deeply dishonest for Hazony to single out Krauthammer et al. for responsibility for that disaster, when Hazony’s mentor and sponsor, Benjamin Netanyahu, was a major supporter and outspoken advocate for the invasion of Iraq.

There is much more to be said about Hazony’s bad faith, but I have already said enough for one post.

Dr. Shelton Remains Outspoken: She Should Have Known Better

I started blogging in July 2011, and in one of my first blogposts I discussed an article in the now defunct Weekly Standard by Dr. Judy Shelton entitled “Gold Standard or Bust.” I wrote then:

I don’t know, and have never met Dr. Shelton, but she has been a frequent op-ed contributor to the Wall Street Journal and various other publications of a like ideological orientation for 20 years or more, invariably advocating a return to the gold standard.  In 1994, she published a book Money Meltdown touting the gold standard as a cure for all our monetary ills.

I was tempted to provide a line-by-line commentary on Dr. Shelton’s Weekly Standard piece, but it would be tedious and churlish to dwell excessively on her deficiencies as a wordsmith or lapses from lucidity.

So I was not very impressed by Dr. Shelton then. I have had occasion to write about her again a few times since, and I cannot report that I have detected any improvement in the lucidity of her thought or the clarity of her exposition.

Aside from, or perhaps owing to, her infatuation with the gold standard, Dr. Shelton seems to have developed a deep aversion to what is commonly, and usually misleadingly, known as currency manipulation. Using her modest entrepreneurial skills as a monetary-policy pundit, Dr. Shelton has tried to use the specter of currency manipulation as a talking point for gold-standard advocacy. So, in 2017 Dr. Shelton wrote an op-ed about currency manipulation for the Wall Street Journal that was so woefully uninformed and unintelligible, that I felt obligated to write a blogpost just for her, a tutorial on the ABCs of currency manipulation, as I called it then. Here’s an excerpt from my tutorial:

[i]t was no surprise to see in Tuesday’s Wall Street Journal that monetary-policy entrepreneur Dr. Judy Shelton has written another one of her screeds promoting the gold standard, in which, showing no awareness of the necessary conditions for currency manipulation, she assures us that a) currency manipulation is a real problem and b) that restoring the gold standard would solve it.

Certainly the rules regarding international exchange-rate arrangements are not working. Monetary integrity was the key to making Bretton Woods institutions work when they were created after World War II to prevent future breakdowns in world order due to trade. The international monetary system, devised in 1944, was based on fixed exchange rates linked to a gold-convertible dollar.

No such system exists today. And no real leader can aspire to champion both the logic and the morality of free trade without confronting the practice that undermines both: currency manipulation.

Ahem, pray tell, which rules relating to exchange-rate arrangements does Dr. Shelton believe are not working? She doesn’t cite any. And, what, on earth does “monetary integrity” even mean, and what does that high-minded, but totally amorphous, concept have to do with the rules of exchange-rate arrangements that aren’t working?

Dr. Shelton mentions “monetary integrity” in the context of the Bretton Woods system, a system based — well, sort of — on fixed exchange rates, forgetting – or choosing not — to acknowledge that, under the Bretton Woods system, exchange rates were also unilaterally adjustable by participating countries. Not only were they adjustable, but currency devaluations were implemented on numerous occasions as a strategy for export promotion, the most notorious example being Britain’s 30% devaluation of sterling in 1949, just five years after the Bretton Woods agreement had been signed. Indeed, many other countries, including West Germany, Italy, and Japan, also had chronically undervalued currencies under the Bretton Woods system, as did France after it rejoined the gold standard in 1926 at a devalued rate deliberately chosen to ensure that its export industries would enjoy a competitive advantage.

The key point to keep in mind is that for a country to gain a competitive advantage by lowering its exchange rate, it has to prevent the automatic tendency of international price arbitrage and corresponding flows of money to eliminate competitive advantages arising from movements in exchange rates. If a depreciated exchange rate gives rise to an export surplus, a corresponding inflow of foreign funds to finance the export surplus will eventually either drive the exchange rate back toward its old level, thereby reducing or eliminating the initial depreciation, or, if the lower rate is maintained, the cash inflow will accumulate in reserve holdings of the central bank. Unless the central bank is willing to accept a continuing accumulation of foreign-exchange reserves, the increased domestic demand and monetary expansion associated with the export surplus will lead to a corresponding rise in domestic prices, wages and incomes, thereby reducing or eliminating the competitive advantage created by the depressed exchange rate. Thus, unless the central bank is willing to accumulate foreign-exchange reserves without limit, or can create an increased demand by private banks and the public to hold additional cash, thereby creating a chronic excess demand for money that can be satisfied only by a continuing export surplus, a permanently reduced foreign-exchange rate creates only a transitory competitive advantage.

I don’t say that currency manipulation is not possible. It is not only possible, but we know that currency manipulation has been practiced. But currency manipulation can occur under a fixed-exchange rate regime as well as under flexible exchange-rate regimes, as demonstrated by the conduct of the Bank of France from 1926 to 1935 while it was operating under a gold standard. And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

I leave it to interested readers to go back and finish the rest of my tutorial for Dr. Shelton. And if you read carefully and attentively, you are likely to understand the concept of currency manipulation a lot more clearly than when you started.

Alas, it’s obvious that Dr. Shelton has either not read or not understood the tutorial I wrote for her, because, in her latest pronouncement on the subject she covers substantially the same ground as she did two years ago, with no sign of increased comprehension of the subject on which she expounds with such misplaced self-assurance. Here are some samples of Dr. Shelton’s conceptual confusion and historical ignorance.

History can be especially informative when it comes to evaluating the relationship between optimal economic performance and monetary regimes. In the 1930s, for example, the “beggar thy neighbor” tactic of devaluing currencies against gold to gain a trade export advantage hampered a global economic recovery.

Beggar thy neighbor policies were indeed adopted by the United States, but they were adopted first in the 1922 (the Fordney-McCumber Act) and again in 1930 (Smoot-Hawley Act) when the US was on the gold standard with the value of the dollar pegged at $4.86 $20.67 for an ounce of gold. The Great Depression started in late 1929, but the stock market crash of 1929 may have been in part precipitated by fears that the Smoot-Hawley Act would be passed by Congress and signed into law by President Hoover.

At any rate, exchange rates among most major countries were pegged to either gold or the dollar until September 1931 when Britain suspended the convertibility of the pound into gold. The Great Depression was the result of a rapid deflation caused by gold accumulation by central banks as they rejoined the gold standard that had been almost universally suspended during World War I. Countries that remained on the gold standard during the Great Depression were condemned to suffer deflation as gold became ever more valuable in real terms, so that currency depreciation against gold was the only pathway to recovery. Thus, once convertibility was suspended and the pound allowed to depreciate, the British economy stopped contracting and began a modest recovery with slowly expanding output and employment.

The United States, however, kept the dollar pegged to its $4.86 $20.67 an ounce parity with gold until April 1933, when FDR saved the American economy by suspending convertibility and commencing a policy of deliberate reflation (i.e. inflation to restore the 1926 price level). An unprecedented expansion of output, employment and income accompanied the rise in prices following the suspension of the gold standard. Currency depreciation was the key to recovery from, not the cause of, depression.

Having exposed her ignorance of the causes of the Great Depression, Dr. Shelton then begins a descent into her confusion about the subject of currency manipulation, about which I had tried to tutor her, evidently without success.

The absence of rules aimed at maintaining a level monetary playing field invites currency manipulation that could spark a backlash against the concept of free trade. Countries engaged in competitive depreciation undermine the principles of genuine competition, and those that have sought to participate in good faith in the global marketplace are unfairly penalized by the monetary sleight of hand executed through central banks.

Currency manipulation is possible only under specific conditions. A depreciating currency is not normally a manipulated currency. Currencies fluctuate in relative values for many different reasons, but if prices adjust in rough proportion to the change in exchange rates, the competitive positions of the countries are only temporarily affected by the change in exchange rates. For a country to gain a sustained advantage for its export and import-competing industries by depreciating its exchange rate, it must adopt a monetary policy that consistently provides less cash than the public demands or needs to satisfy its liquidity needs, forcing the public to obtain the desired cash balances through a balance-of-payments surplus and an inflow of foreign-exchange reserves into the country’s central bank or treasury.

U.S. leadership is necessary to address this fundamental violation of free-trade practices and its distortionary impact on free-market outcomes. When the United States’ trading partners engage in currency manipulation, it is not competing — it’s cheating.

That is why it is vital to weigh the implications of U.S. monetary policy on the dollar’s exchange-rate value against other currencies. Trade and financial flows can be substantially altered by speculative market forces responding to the public comments of officials at the helm of the European Central Bank, the Bank of Japan or the People’s Bank of China — with calls for “additional stimulus” alerting currency players to impending devaluation policies.

Dr. Shelton here reveals a comprehensive misunderstanding of the difference between a monetary policy that aims to stimulate economic activity in general by raising the price level or increasing the rate of inflation to stimulate expenditure and a policy of monetary restraint that aims to raise the relative price of domestic export and import-competing products relative to the prices of domestic non-tradable goods and services, e.g., new homes and apartments. It is only the latter combination of tight monetary policy and exchange-rate intervention to depreciate a currency in foreign-exchange markets that qualifies as currency manipulation.

And, under that understanding, it is obvious that currency manipulation is possible under a fixed-exchange-rate system, as France did in the 1920s and 1930s, and as most European countries and Japan did in the 1950s and early 1960s under the Bretton Woods system so well loved by Dr. Shelton.

In the 1950s and early 1960s, the US dollar was chronically overvalued. The situation was not remediated until the 1960s under the Kennedy administration when consistently loose monetary policy by the Fed made currency manipulation so costly for the Germans and Japanese that they revalued their currencies upward to avoid the inflationary consequences of US monetary expansion.

And then, in a final flourish, Dr. Shelton puts her ignorance of what happened in the Great Depression on public display with the following observation.

When currencies shift downward against the dollar, it makes U.S. exports more expensive for consumers in other nations. It also discounts the cost of imported goods compared with domestic U.S. products. Downshifting currencies against the dollar has the same punishing impact as a tariff. That is why, as in the 1930s during the Great Depression, currency devaluation prompts retaliatory tariffs.

The retaliatory tariffs were imposed in response to the US tariffs that preceded the or were imposed at the outset of the Great Depression in 1930. The devaluations against gold promoted economic recovery, and were accompanied by a general reduction in tariff levels under FDR after the US devalued the dollar against gold and the remaining gold standard currencies. Whereof she knows nothing, thereof Dr. Shelton would do better to remain silent.


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.

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