Uneasy Money

In a comment  earlier today to this post, David Pearson shocked me by quoting the following passage from the Financial Services Regulatory Relief Act of 2006:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest rates.

As I said to David Pearson in my reply to his comment, I am flabbergasted by this.  The Fed is now paying 0.25% interest on reserve balances while and the interest rate on 3-month T-bills is now 0.01%.  Yet the statute states in black letters that the rate that the Fed may pay on reserves is “not to exceed the general level of short-term interest rates.”  In fact, as can be easily seen on the Treasury’s Daily Yield Curve webpage,  only on rare occasions was the 3-month T-bill rate as high as 0.25% in 2009 and it has been consistently less than 0.20% for most of 2009 and all of 2010 and 2011.  Perhaps the definition of short-term interest rates is more than 3-months, but the yield even on a one-year Treasury has been in the neighborhood of 0.1% for months and has been below 0.25% since April.  So can anyone explain to me by what authority the Federal Reserve System continues to pay banks 0.25% interest on their reserve balances held at the Fed?

In looking around to see if anyone else has noticed that the Fed seems to be violating the very statute that authorizes it to pay interest on reserves, I found the following post from April 2010 by Stephen Williamson on his blog.

The Federal Reserve Act specifies that decisions about the interest rate on reserves are made by the Board of Governors, not by the FOMC. Obviously Congress did not think through the issue properly when it amended the Act. Since the interest rate on reserves is now the key policy rate, decisions about how to set it would appropriately reside with the FOMC. An interesting section of the Act is this one:

Balances maintained at a Federal Reserve bank by or on behalf of a depository institution may receive earnings to be paid by the Federal Reserve bank at least once each calendar quarter, at a rate or rates not to exceed the general level of short-term interest r ates.

This passage may be vague, but 1-month T-bills are now trading at 0.139% and the interest rate on reserves is 0.25%. The problem is that the Fed cannot do its job and (apparently) conform to the law. The T-bill rate has to be lower now, as the marginal liquidity value of a T-bill is higher than for reserves.

So Williamson also believes that the Fed lacks the statutory authority to pay as high an interest on reserves as it is now paying banks, except that he believes that the Fed would not be discharging its other statutory responsibilities properly if it followed the letter of the law on the rate of interest it may pay on bank reserves.  But I admit to being totally unable to understand his reasoning.  How can he conclude that the marginal liquidity yield of a T-bill is higher than the liquidity yield on reserves?  Presumably in a competitive equilibrium, the pecuniary yield plus the liquidity yield on alternative assets must be equalized.  But if banks can earn a higher rate on reserves than they can on T-bills, they hold only reserves and no T-bills.  Non-banks, on the other hand, are ineligible to hold interest-bearing reserves with the Federal Reserve System, and must hold lower-yielding, less-liquid T-bills.  So the rates on T-bills and reserves held at the Fed are not consistent with competitive equilibrium, and no inference about liquidity yields, premised on the existence of competitive equilibrium, follows from current yields on reserves and T-bills.

Let’s play a little guessing game.  Who wrote the following?

A corporate income tax, which allows interest to be deducted prior to the determination of taxable income, induces debt-financing and is therefore undesirable.  A corporate income tax also allows nonproduction expenses such as advertising, marketing, and the pleasures of the executive suites to be charged against revenues in determining the taxable income.  As advertising and marketing are techniques for building market power and as ’executive style’ is a breeder of inefficiency, the corporate income tax abets market power and inefficiency just as the corporate income tax abets the use of debt-financing.  Elimination of the corporate income tax should be on the agenda.

If you couldn’t tell even before reading the quotation that I was not going to quote a typical right-wing free-market ideologue, the passage about advertising and marketing being techniques for building market power should certainly have tipped you off.  At any rate, the author of this quasi-reactionary screed against the corporate income tax is none other than Hyman Minsky (Stabilizing an Unstable Economy 1986 edition, p. 340) who has, posthumously, become a kind of cult figure among today’s progressives and anti-capitalists.  But obviously Minsky was not a simple-minded fellow, and his work, from the little of it that I have read (mainly his biography of Keynes) is the work of a sophisticated and knowledgeable thinker who had a very practical understanding of how markets, especially financial markets, operate.  That doesn’t mean that I share his general outlook on economics and finance, just that his view ought to be taken seriously, and his proposals given careful consideration.

In addition, if a left-wing cult figure like Minsky could have advocated doing away with the corporate income tax, then maybe there is some hope that a revenue-raising budget deal could be reached between Republicans and Democrats in which the corporate income tax and the employer “contribution” to social security (i.e. an employment tax) also opposed by Minsky could be traded for a Value Added Tax (with some exemptions to make its incidence somewhat progressive).  To start with the trade could be revenue-neutral, but presumably a somewhat progressive VAT would generate a faster rate of growth in revenue (both from progressivity and enhanced efficiency) than the corporate income tax and employer “contribution” to social security.

On the subject of corporations, I would also like to mention a great little book (unfortunately long out of print) written by my late friend, Harvey Segal, at one time an editorial writer for the Washington Post and later chief economist for Citi Bank in the Walter Wriston era, Corporate Makeover.  The automatic identification of free-market capitalism with a system of business organization dominated by corporate ownership, which sprang up almost overnight in the late nineteenth century, deserves more critical attention than free-marketers are usually willing to give it.  Perhaps anti-corporate rhetoric from the left produces a compensating defensiveness on the part of free-marketers, causing them to defend corporations against all negative criticism, but even Hayek expressed considerable unease with the extent to which the corporate model separates corporate decision-making from the interests of the (nominal) owners.

HT:  June Flanders

Update:  As an anonymous commenter points out below, there is no reason to restrict the trade to corporate taxes for VAT, pollution taxes and certain other kinds of taxes on rent-producing activities could also be part of the mix.

IS-LM is quite the rage this week.  Perhaps I will come back with some further observations another time, IS-LM being a perpetual object of argumentation among monetary theorists and macroeconomists, but here are some of my own, mostly critical, observations about that old standby of Keynesian economics.

Everyone recognizes that, in its original Hicksian form, IS-LM is a static one-period model, which sharply limits its practical application unless it is augmented to give it some dynamic features.  But augmenting it in the standard fashion doesn’t address, much less fix, its basic deficiency.  What is the nature of a static one-period equilibrium in which there is positive investment and saving and a rate of interest?  The model doesn’t have a coherent intuitive economic interpretation even in its one-period form.  Merely adding some dynamics doesn’t address the disconnect between the model and basic economic concepts.

For example, does anyone outside of Cambridge England actually think of the rate of interest as the price of holding money?  In the IS-LM model, the rate of interest is determined by the demand for money and a fixed supply of money (though in more up-to-date versions the interest rate is chosen by monetary authority).  The demand for money depends on income, so investment spending and consumption spending do affect the interest rate by way of their influence on the demand for money.  Now it’s true that there are bonds in the IS-LM model, otherwise there would be no way to measure the cost of holding money, but the presence of bonds doesn’t fix the underlying problem.  Even though a bond market is included, it can be kept in the background out of sight inasmuch as you only have to solve for equilibrium in two of the markets in a three-good system to find the equilibrium for the third market as well (Walras’s Law).

The trouble is that the bond market, reflecting the supply of and the demand for loanable funds, is an epiphenomenon.  There is a mismatch between the money market (demand for and supply of a stock) and the market for loanable funds (demand for and supply of a flow).  In the real world, interest rates are not equilibrating the supply of and demand for loanable funds; interest rates emerge out of the process of evaluating all durable assets, which are nothing but claims to either fixed or variable future cash flows of various durations and risk characteristics.  The structure of interest rates and risk and liquidity factors must adjust to bring about equilibrium between the demand for and the fixed supply of the current stock of physical assets.  The interest rates on the subset of financial assets that we call bonds are determined as part of the process of valuing all durable assets, the valuation of bonds being constrained by the valuations placed on the entire range of durable assets.  One of the good things about Milton Friedman’s 1956 restatement of the quantity theory of money was his explicit recognition that interest rates are determined not in a narrow subset of markets for fixed income financial assets, but in the complete spectrum of interrelated markets for long-lived physical and financial assets.

One way to handle this would have been to make explicit the consumption/investment tradeoff by defining a purchase price (for consumption) and a rental or hire price for current use of the output as an input in producing units of output for the next period.  The rental price over the purchase price represents a real interest rate and allows in an obvious way for both expected inflation and a consistent distinction between the real and the nominal interest rate.  (In the General Theory, Keynes explicitly rejected that distinction, based on reasoning implicitly assuming the existence of a liquidity trap, but in fact, using a comparative-statics approach, you can derive an effect on the interest rate in IS-LM from expected inflation when there is no liquidity trap.  And if you start from full employment equilibrium, the comparative-statics exercise increases the interest rate by as much as expected inflation.  Allyn Cottrell showed this in a paper some years ago, “Keynes and the Keynesians on the Fisher Effect,” Scottish Journal of Political Economy 41:416-33, 1994.

The conditions of factor-market equilibrium and money-market equilibrium can then be used to derive an equilibrium time path for the economy with the Keynesian spending (consumption and investment) functions suppressed instead of a meaningless bond market which can be discarded.  Earl Thompson developed such a model nearly 40 years ago, but never published it.  The 1977 version of his working paper deriving and applying the model is available here.  He also modeled the monetary sector in a way that can be made consistent either with the competitive nature of a modern banking system or with the fixed money-supply approach of the General Theory.

Earl’s paper is tough to follow in a number of places, which may have something to do with its lack of influence.  His earlier papers were not always written in the most accessible style, as he tended to leave out too many steps in his argument that were obvious to him, but not so obvious to his readers.  To achieve a level of aggregation comparable to IS-LM requires some heroic assumptions, and making them explicit, as Earl did, underscored the unrealistic nature of his model, a characteristic that Hicks’s matter-of-fact presentation of IS-LM tended to obscure in his presentation.  Also carrying out the analysis in terms of spending functions imparts a certain appearance of realism that is lacking from characterizing factor-market equilibrium in terms of a single labor input and the rental rate for using the single output as in input into its own production.  That is probably why IS-LM, for all its faults, remains popular with people with a moderate degree of economic sophistication when trying to get a handle on economic policy.  The fact that, despite its many shortcomings, some recognized some not, so many economists and policy makers are still using it is a sad commentary on the deplorable lack of progress made by macroeconomics over the past 40 years than on the virtues of IS-LM, a lack of progress for which both Keynesians and non-Keynesians alike can take the blame in roughly equal shares.

Our very own redoubtable Benjamin Cole ventured onto Stephen Williamson’s blog to argue the case for an aggressive monetary policy after Williamson’s admiring post about Charles Plosser’s recent speech which prompted my own, less than admiring, post about the speech.  As you might expect Benjamin was received less than cordially, but he stood his ground and gave as good as he got.  Way to go, Benjamin!

I am not going to review the details of the exchange between Benjamin, Williamson, and an anonymous interlocutor (you can go there and read it for yourselves), but I was struck by what appears (to me at any rate) to be an inconsistency in Williamson’s position.

Replying to Benjamin’s call for a more aggressively expansionary monetary policy, Williamson replied as follows:

[Quoting Benjamin] “I am flabbergasted anyone thinks the Fed is doing enough. Really? Inflation is dead, unemployment is at 9 percent, and we are 10-15 percent below GDP growth trend.”

I am flabbergasted to know that you think there is any action the Fed can take now that would increase aggregate activity and/or increase the inflation rate.

Lest you think that that was a slip of the pen, Williamson makes the same point again, even more explicitly, in response to Benjamin’s reference to Milton Friedman’s advice to the Bank of Japan:

[Quoting Benjamin] “The Fed could announce it is targeting 7 percent nominal GDP growth, and follow Milton Friedman’s advice to Japan, and start printing money.”

The Fed can announce whatever it wants. If it can’t actually accomplish what it announces, what good is the announcement? “Printing money” would be, I assume, exchanging reserves for some Treasury debt. That will be essentially neutral – no effect on any prices or quantities.

Then when Benjamin invokes John Taylor’s 2006 advocacy that the Bank of Japan engage in QE, Williamson dismisses Taylor with the a wave of his hand, while dismissing the idea of any trade-off between inflation and unemployment as akin to a belief in the Phillips Curve, as if that were like believing that the earth is flat or that the sun revolves around the earth.

I would not call Taylor’s 2006 paper serious science. You seem to have a firm belief in a Phillips curve tradeoff. I’m not sure why.

Here is where things start to get tricky.  Why does Williamson think that the Phillips Curve is so off the wall?  Based on his earlier responses, you might think that it is because he rejects the notion that policymakers (i.e. the Fed) can control the rate of inflation.  If you can’t control the rate of inflation, the Phillips Curve is useless.  There is another possibility, however, which is that the rate of unemployment is unaffected by whatever rate of inflation the Fed chooses, because the Phillips Curve is vertical.  Now either view is defensible, but, as far as I can tell, they are mutually exclusive.  Either the Fed is powerless to affect the rate of inflation, or it isn’t.

Yet that is exactly where Williamson is headed, because in his next response to Benjamin, Williamson says the following:

[Quoting Benjamin] “No one suggests that inflation cannot be tamped down at some point–if we were so lucky as to have five years of robust growth, we could then start tightening the money supply.”[

It’s costly to reduce inflation once it gets going, right? What if all your inflation does not produce the robust growth you are expecting. Now everyone is complaining, not only about being unemployed, but about the high inflation rate, just as they were in 1980. Then you have to put them through the wringer again to get the high inflation out of the system. Do you think that will go over well?

So Williamson is no longer flabbergasted at the thought that the Fed might be able to increase the rate of inflation; it’s perfectly doable.  The problem now is that the Phillips Curve is vertical, so even if you raise the rate of inflation, it won’t get you the reduction in unemployment that you thought you would get.

There are two points to make about this.  First, on substance.  The argument that a vertical Phillips Curve means that monetary policy is useless only works if we assume that the natural rate of unemployment is a constant of nature in the sense that the actual rate of unemployment must always equal the natural rate.  If the actual rate of unemployment can exceed the natural rate, then monetary policy can hasten the return of the actual unemployment rate to the natural rate, though, to be sure, there is a risk of overshooting the natural rate.  Opponents of using monetary policy to reduce unemployment like to suggest, but without saying so explicitly, that the natural rate of unemployment has risen sharply so that monetary policy can’t reduce unemployment below its current level.  But to my knowledge, no one has come out and actually said in so many words that the natural rate of unemployment is now 9%.

Second, sliding effortlessly back and forth between an argument that says that the Fed is powerless and an argument that says that although the Fed can indeed raise the rate of inflation, doing so would be bad policy, because higher inflation would drive up unemployment to an even higher level in the endwhen inflation eventually had to be reduced does seem a tad, shall we say, ad hoc.  And, as we all know, serious scientists never engage in ad hocery.  (Query:  but isn’t the Phillips Curve vertical?  Answer: Well, it’s vertical when you increase the rate of inflation, but it’s negatively sloped when you reduce the rate of inflation.  Go figure.)

The stock market apparently took heart from Chairman Bernanke’s testimony today to the Joint Economic Committee of Congress, rising 4% from its low for the day and 2% from yesterday’s close.  I fear that this is just the market whistling past the graveyard, because Bernanke said very little – actually almost nothing — that he has not said before.  Why the market would have taken any comfort from his remarks is a mystery to me.

What is even more ominous is how closely Bernanke’s testimony tracks the recent message of Jeffrey M. Lacker, President of the Federal Reserve Bank of Richmond whose recent contribution to the second quarter 2011 issue of Region Focus, a publication of the Richmond Federal Reserve Bank, can be found here.

I offer a few of Mr. Lacker’s juicier morsels for your reading pleasure.

Typically following a recession, the economy rebounds strongly, growing more rapidly than the long-run trend for a few years, and then settles back to its more traditional growth path. . . . Occasionally this process has taken a bit longer than one might have expected.  For instance, following the recessions of 1990-1991 and 2001, it was a while before growth exceeded its long-run average of 3 percent. . . . And we may see a similar growth curve this time as well. . . .

[T]here is another possible path the economy might take. . . . We may not see that faster, catch-up level of growth that has followed most recessions.  Instead, we may simply settle into a growth rate of 3 percent.  In short, we may not gain back the ground we lost during the recession.

There are many reasons why this scenario might occur, among them changes in public policuy.  New tax and regulatory policies – including both the recent health care and financial reform bills – could have significant persistent effects on output and consumption.  Moreover, there remains considerable policy uncertainty surrounding such issues – for instance, how fiscal balance will be achieved over the long run.

Nobel Prize winning economist Robert Lucas, among others, has argued that the United States may be headed toward an overall policy regime similar to that of many other developed countries, especially those of continental Europe.  On balance, these countries have more regulated labor markets, higher tax rates, and larger social safety net programs.  While they have roughly the same average rate of growth as the United States, they generally employ less labor and produce less output per capita.  Although these countries are rich by global standards, they typically have been less economically dynamic and are poorer than the United States.

Given that we can’t be sure which recovery path the U.S. economy will take, what should the Federal Reserve do? . . . I think the direction we should take is roughly the same in either case.  Monetary policy is highly accommodative right now.  While inflation trends are currently well-contained at around 2 percent, we need to be alert to the risk that the monetary stimulus now in place might set off an inflationary surge.  [Time out for a comment from the peanut gallery:  Excuse me, but how alert were you (i.e. the FOMC) to the risk of a recession and a financial meltdown in the spring and summer of 2008 when the economy began contracting rapidly while you (the FOMC) were obsessed with preventing inflation expectations from becoming unanchored because of rising oil and food prices?  Does the FOMC have any less obligation to be alert to deflationary surges than to inflationary ones?]  More broadly, it is important that people recognize that, as Chairman Bernanke recently noted, monetary policy is not a panacea.  Monetary policy determines the inflation rate over time, and has only a transitory effect on real economic growth.  Further monetary stimulus is unlikely to alleviate the impediments to more rapid growth, but could raise inflation to undesirably high levels.

The U.S. economy is remarkably resilient.  But . . . we must face the possibility that we  may never fully regain what was lost during the downturn, especially if policymakers do not squarely address those issues that have long loomed over the U.S. economy but can no longer be ignored.

Now for the closing paragraph of Chairman Bernanke’s testimony before the Joint Economic Committee:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

Downright scary.

On his blog, Steve Williamson discusses the recent (September 29, 2011) speech by Charles Plosser, President of the Federal Reserve Bank of Philadelphia, to the Business Leaders’ Forum at the Villanova School of Business.  Plosser explains why he disagrees with recent moves by the Fed such as forward guidance about keeping short-term interest rates at current low levels, and operation twist to lengthen the maturity structure of the Fed’s asset holdings.  Williamson likes the speech; I don’t.  So let’s explore my reasons for disagreeing with Plosser and Williamson.

The first half of the speech reviews the current economics situation, the slow recovery from the 2008-09 downturn and financial crisis, and the deteriorating economic situation since the beginning of the year, despite what Plosser calls “the extraordinary degree of monetary accommodation” provided by the Fed, resulting in a tripling of the size of the Fed’s balance sheet, and a shift in holdings “from mostly short- to medium-term Treasuries to longer-term Treasuries, mortgage-backed securities, and agency debt.”  Furthermore,

In August, the FOMC changed its guidance about its expectations for the future path of the federal funds rate. In particular, it stated that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” At its meeting last week, the FOMC announced additional accommodative action. In an effort to reduce long-term Treasury yields from already historically low levels, the FOMC intends to purchase $400 billion of longer-term Treasury securities and to sell an equal amount of shorter-term Treasuries by the end of June 2012.

Plosser goes on to defend his dissent from the recent FOMC decisions, arguing that the ineffectiveness of past monetary stimulus in reducing unemployment should serve as a warning to “be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated.”  In other words, monetary accommodation has proven ineffective in reducing unemployment, but it may cause inflation in the future, and without reducing unemployment in the process. 

How is that possible?  Wouldn’t an increase in aggregate demand resulting from an easy money policy tend to increase inflation while reducing unemployment?  Plosser thinks not, because monetary expansion could create “an environment of stagflation, reminiscent of the 1970s [that] will not help businesses, the unemployed, or the consumer.” 

This seems to me a most remarkable assertion.  The experience of the 1970s used to be viewed as evidence that the long-run Phillips Curve is vertical, so that monetary policy can’t force the unemployment rate down permanently below its “natural” level, because ultimately, when the price level effects are foreseen, workers will not let themselves be fooled into accepting lower real wages than they are really willing to work for.  From this proposition, Plosser apparently infers that even if there is unemployment, because (in a Phillips-curve framework) real wages are too high to allow a full-employment equilibrium, you can’t use monetary policy to reduce the real wage, because workers won’t let their real wage be reduced by inflation even when the real wage is above its equilibrium level. 

This is actually a curious inversion of Keynes’s argument about the futility of nominal wage reductions as a method or eliminating unemployment.  Keynes held that falling nominal wages would simply be passed through by employers to customers in the form of lower prices, negating the nominal wage cut.  The logic by which Keynes concluded that falling nominal wages would cause a proportionate fall in prices rather than a less than proportionate fall in prices to restore equilibrium was far from ironclad; one could argue at least as plausibly that firms would not be quite so obliging as to pass forward their full savings from reduced money wages to consumers without trying to increase their depressed profit margins even a smidgen.  Similarly, Plosser seems to be suggesting that workers, despite high levels of unemployment, are so determined to preserve their current above-equilibrium real wage that any increase in prices tending to reduce real wages would elicit immediate and effective demands by workers for increased nominal wages thereby negating the incentive to hire additional workers otherwise following from an increase in prices relative to wages.  If this is the lesson Plosser draws from 1970s stagflation, it is a very different lesson from the one that Friedman and Phelps thought that they were teaching when they formulated the natural rate hypothesis 40 years ago. 

The only other possibility is that Plosser thinks that the natural rate of unemployment is now approximately 9%.  Perhaps it is, but if that is what he thinks, he ought to be willing to make that argument explicitly and not pretend that he is simply applying the lessons of the 1970s.

But Plosser seems to be making just that suggestion in the next paragraph of his speech (quoted approvingly by Williamson).

In my view, the actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not. We should not take certain actions simply because we can. . . . The ills we currently face are not readily resolved through ever more accommodative monetary policy. If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined. The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future.

Plosser offers an assessment that the actions taken by the FOMC in August and September cannot affect the speed of the recovery.  I agree with that assessment, because monetary policy has failed to change pessimistic expectations about the course of future prices and nominal incomes.  Plosser, however, apparently believes that monetary policy could not under any circumstances do any more than it already has.  But he seems unwilling to defend his assessment that monetary policy cannot reduce the current rate of unemployment in terms of any commonly understood macroeconomic model.  We are supposed to just take his word that monetary policy cannot help speed the adjustment of an unemployment rate above its natural level back to its natural level.  So unless Plosser believes that the current unemployment rate is already at its natural level, I cannot understand how he could suggest that a policy of moving the unemployment rate down toward its natural level is tantamount to asking the Fed to “solve all our economic problems.”  And if he thinks that the unemployment rate is now at the natural rate of unemployment, he ought to say that that is what he thinks and explain why he thinks that is the case.

Steve Williamson supports Plosser with the following observation:

A large fraction of the population is significantly worse off than they were in 2007. But there are no monetary policy actions available currently that will make them better off. However, by continuing to engage in unconventional policy actions – QE1, QE2, “forward guidance,” and Operation Twist, the Fed is acting as if it knows what it is doing, and can actually reduce unemployment by taking those actions. Further, public statements by some Fed officials, particularly Bernanke, express confidence that these actions actually work. Bernanke, and like-minded people such as Charles Evans, Chicago Fed President, are unfortunately engaged in wishful thinking.

What is the wishful thinking here?  Is it that speeding the adjustment of unemployment toward the natural rate will make the reduction in unemployment unsustainable?  What is the theory that explains why speeding a reduction in unemployment to the natural level is unsustainable?  What evidence supports such a view?  Or is that the natural rate of  unemployment is now at 9%.  And again I ask, what is the basis for believing that the current natural rate is now at 9%?

This message from Robert Gordon was posted on EH.net yesterday:

Ken Burns’ anticipated three-part series on “Prohibition” runs this coming Sunday, Monday, Tuesday on PBS at 8pm E/P and 7pm central. I wanted to call it to the attention of the economic history community.

I would judge from the long interview with him and his co-producer 9/30 on “Chicago Tonight” that this series is not just a lot of crime-oriented documentary footage, but also probes into fairly significant issues in American political and cultural history. His description of the absolutist non-compromising approach of the prohibition movement sounds a lot like the tea party of today. The first episode characterizes the alcohol and saloon-driven male-dominated culture of the late 19th century and its corollary of female oppression as something that everyone should know about.

There is also an implication of Prohibition for U. S. economic history that I learned recently in researching my book on the history of the American standard of living. The standard Lebergott data on real consumer expenditures which cover 1900-1930 contain a significant downward bias after 1918 by measuring the consumption of alcoholic beverages as exactly 0.00 for 1920-30, completely ignoring the underground economy of Prohibition which by some estimates involved higher expenditures (because of higher relative prices) than the legal alcohol industry which (according to Lebergott) accounted for 5.4 percent of total personal consumption expenditures in 1910.

This issue explains at least a part of a great underresearched puzzle of American economic history, which is why standard measures of growth in real GDP and consumption are so low when the period 1913-28 is compared to 1870-1913 even though this was the period when electrification and the internal combustion engine changed America and ultimately the world.

Bob Gordon

Sounds like an issue worth looking into more carefully than has so far been the case.  Our statistics on economic growth in the US at least from 1919 through 1933 may require a major overhaul.  That could also affect some of what we think we know about monetary policy in the US over that period as well.

Lars Christensen has been a valued commenter and a frequent source of advice and information offline since this blog got started in July.  And those who follow other blogs know that Lars has been sharing his valuable insights on many other blogs as well.  Lars recently made an important contribution to the blogosphere and to scholarship with his excellent survey of the emerging school of monetary theory and policy which he calls Market Monetarism.   So I am happy to recommend to any readers of this blog who haven’t already heard about Lars’s new blog, The Market Monetarist, that they check it out at http://www.marketmonetarist.com.  Good luck, Lars, and don’t forget that you are always welcome at Uneasy Money.

The front-page headline in today’s Financial Times reads “Inflation outlook on US lowest for a year.”  So obviously some people in the financial community and in the financial press are beginning to realize that what monetary policy does affects inflation expectations.

Market expectations for US inflation have dropped to their lowest level in a year and are now below the Federal Reserve’s unofficial target, as investors respond to the central bank’s latest attempt to stimulate the economy.

The expected rate of inflation over the next 30 years, as measured by the difference between Treasury Inflation Protected Securities, Tips, and cash government bonds, dropped as low as 1.85 per cent in recent days from 2.73 per cent since last month. The rate was just under 2 per cent on Tuesday.

The article goes on to note that inflation expectations dropped after the FOMC announced Operation Twist, as gold and oil prices dropped, quoting a Deutsche Bank economist that the TIPS market shows that the Fed’s policy “is no longer seen as inflationary.”

The good news is that people are starting to catch on to what Scott Sumner and a few other lonely voices have been trying to tell us since the financial crisis.  The bad news is that the FOMC doesn’t appear to be among them.

This will be my last post for several days, as I am about to observe the Jewish New Year.  Sorry to go on leave when things seem to be getting really interesting in the blogosphere, but there are some things even more important than monetary policy.  Did I really just say that?  My best wishes go out to all of you for a happy, healthy, and peaceful New Year.

In today’s Wall Street Journal, Harold Cole and Lee Ohanian try to teach us some lessons from the Great Depression.  According to Cole and Ohanian, those of us who believe that increasing aggregate demand had anything to do with recovery from the Great Depression are totally misguided.

[B]oosting aggregate demand did not end the Great Depression.  After the initial stock-market crash of 1929 and subsequent economic plunge, recovery began in the summer of 1932, well before the New Deal.  The Federal Reserve Board’s Index of Industrial Production rose nearly 50% between the Depression’s trough of July 1932 and June 1933.  This was a period of significant deflation.  Inflation began after June 1933, following the demise of the gold standard.  Despite higher aggregate demand, industrial production was flat over the following year.

Though not wrong in every detail, the version of events offered by Cole and Ohanian is still a shocking distortion of what happened before FDR took office in March 1933.  In particular, although Cole and Ohanian are correct that the trough of the Great Depression was reached in July 1932, when the Industrial Production Index stood at 3.67, rising to 4.15 in October, an increase of about 13%, they conveniently leave out the fact that there was a double dip; industrial production was flat in November and started falling in December, the Industrial Production Index dropping to 3.78 in March 1933, barely above its level the previous July.  And their assertion that deflation continued during the recovery is even farther from the truth than their description of what happened to industrial production.  When industrial production started to rise, the Producer Price Index (PPI) increased almost 1% three months in a row, July to September, the only monthly increases since July 1929.  The PPI resumed its downward trend in October, falling about 9% from September 1932 t0 February 1933, at the same time that industrial production peaked and started falling again.

That is why most observers date the trough of the Great Depression in the US not in July 1932, but in March 1933 when FDR took office in the midst of a banking crisis that threatened to drive the US economy even deeper into deflation and depression than it had been in July 1932. So when Cole and Ohanian assert that recovery from the Great Depression started in July 1932, and go on to say that the recovery took place during a period of significant deflation, it is hard to avoid the conclusion that they are twisting the facts to suit their own ideological predilection.

The misrepresentation perpetrated by Cole and Ohanian only gets worse when they describe what happened during the period of true recovery, April through July 1933.  Contrary to their assertion, deflation stopped in February 1933, the PPI hitting its low point of 10.3.  Prices began to rise as soon as FDR suspended the gold standard shortly after taking office in March (not June as Cole and Ohanian mistakenly assert) 1933, the PPI rising to 11.9 in July (an increase of about 14% over February) when industrial production hit a peak of 5.95, 57% above the March low point.

The two attached charts (supplied courtesy of Marcus Nunes) illustrate the sequence of events that I have just described.  The close correlation between the PPI and industrial production is especially striking.

To assert that the rapid price increases from March to July, a proxy for increased aggregate demand, played no role in what was then (and remains) the fastest increase in industrial production in any four-month period in American history is a gross misrepresentation of the facts.  What is perhaps even more shocking is that Cole and Ohanian would misrepresent facts so easily ascertainable.

Nevertheless, not everything Cole and Ohanian say is wrong.  They properly criticize New Deal policies that slowed down the spectacular recovery from April to July 1933 to almost a crawl.  What stopped April to July recovery almost in its tracks?  The answer is almost certainly that FDR forced his misguided National Industrial Recovery Act through Congress in June, and by July its effects were beginning to be felt.  Simultaneously forcing up nominal wages in the face of high unemployment (though unemployment started had falling rapidly when recovery started in April) and cartelizing large swaths of the American economy, the NRA effectively shut down the recovery that was still gaining momentum.  As shown in the chart representing industrial production, industrial production resumed its rapid expansion almost immediately after the NIRA was unanimously struck down by the Supreme Court in May 1935.  The aborted recovery was a tragedy for the American economy and for the world, but the premature end of (or extended pause in) the recovery tells us nothing about whether an economy can recover from a depression with no increase in aggregate demand.

Another point overlooked by Cole and Ohanian, presumably because it doesn’t exactly fit the ideological message that they want to propagate, is that the timing of the recovery — immediately after the monetary stimulus resulting from suspension of the gold standard – shows that monetary policy can be effective with little or no fiscal stimulus.  It is hard to see how any fiscal stimulus could have taken effect by April 1933 when the recovery had already begun.  Moreover, Roosevelt campaigned as a fiscal conservative, so it would not be easy to argue that anticipated fiscal stimulus was being felt in advance of its actual implementation.

The real lesson the Great Depression is that monetary policy works — for good or ill.

HT:  Bill Woolsey, Marcus Nunes, Scott Sumner