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Arthur Burns and How Things Fell Apart in the 1970s

Back in 2013 Karl Smith offered a startling rehabilitation of Arthur Burns’s calamitous tenure as Fed Chairman, first under Richard Nixon who appointed him, later under Gerald Ford who reappointed him, and finally, though briefly, under Jimmy Carter who did not reappoint him. Relying on an academic study of Burns by Fed economist Robert Hetzel drawing extensively from Burns’s papers at the Fed, Smith argued that Burns had a more coherent and sophisticated view of how the economy works and of the limitations of monetary policy than normally acknowledged by the standard, and almost uniformly negative, accounts of Burns’s tenure, which portray Burns either as a willing, or as a possibly reluctant, and even browbeaten, accomplice of Nixon in deploying Fed powers to rev up the economy and drive down unemployment to ensure Nixon’s re-election in 1972, in willful disregard of the consequences of an overdose of monetary stimulus.

According to Smith, Burns held a theory of inflation in which the rate of inflation corresponds to the average, or median, expected rate of inflation held by the public. (I actually don’t disagree with this at all, and it’s important, but I don’t think it’s enough to rationalize Burns’s conduct and policies as Fed chairman.) When, as was true in the 1970s, wages determined through collective bargaining between big corporations and big labor unions, the incentive of every union was to negotiate contracts providing members with wage increases not less than the average rate of wage increase being negotiated by other unions.

Given the pressure on all unions to negotiate higher-than-average wage increases, using monetary policy to reduce inflation would inevitably aggregate spending to fall short of the level needed to secure full employment, but without substantially moderating the rate of increase in wages and prices. As long as the unions were driven to negotiate increasing rates of wage increase for their members, increasing rates of wage inflation could be accommodated only by ever-increasing growth rates in the economy or by progressive declines in the profit share of business. But without accelerating real economic growth or a declining profit share, union demands for accelerating wage increases could be accommodated only by accelerating inflation and corresponding increases in total spending.

But rising inflation triggers political demands for countermeasures to curb inflation. Believing the Fed incapable of controlling inflation through monetary policy, restrictive monetary policy affecting output and employment rather than wages and prices, Burns concluded that inflation could controlled only by limiting the wage increases negotiated between employers and unions. Control over wages, Burns argued, would cause inflation expectations to moderate, thereby allowing monetary policy to reduce aggregate spending without reducing output and employment.

This, at any rate, was the lesson that Burns drew from the short and relatively mild recession of 1970 after he assumed the Fed chairmanship in which unemployment rose to 6 percent from less than 4 percent, with only a marginal reduction in inflation from the pre-recession rate of 4-5%, before Nixon, fearing his bid for re-election would fail, literally assaulted Burns, blaming him for a weak recovery that, Nixon believed, had resulted in substantial Republican losses in the 1970 midterm elections, just as a Fed-engineered recession in 1960 had led to his own loss to John Kennedy in the 1960 Presidential election. Here is how Burns described the limited power of monetary policy to reduce inflation.

The hard fact is that market forces no longer can be counted on to check the upward course of wages and prices even when the aggregate demand for goods and services declines in the course of a business recession. During the recession of 1970 and the weak recovery of early 1971, the pace of wage increases did not at all abate as unemployment rose….The rate of inflation was almost as high in the first half of 1971, when unemployment averaged 6 percent of the labor force, as it was in 1969, when the unemployment rate averaged 3 1/2 percent….Cost-push inflation, while a comparatively new phenomenon on the American scene, has been altering the economic environment in fundamental ways….If some form of effective control over wages and prices were not retained in 1973, major collective bargaining settlements and business efforts to increase profits could reinforce the pressures on costs and prices that normally come into play when the economy is advancing briskly, and thus generate a new wave of inflation. If monetary and fiscal policy became sufficiently restrictive to deal with the situation by choking off growth in aggregate demand, the cost in terms of rising unemployment, lost output, and shattered confidence would be enormous.

So in 1971 Burns began advocating for what was then called an incomes policy whose objective was to slow the rate of increase in wages being negotiated by employers and unions so that full employment could be maintained while inflation was reduced. Burns declared the textbook rules of economics obsolete, because big labor and big business had become impervious to the market forces that, in textbook theory, were supposed to discipline wage demands and price increases in the face of declining demand. The ability of business and labor to continue to raise prices and wages even in a recession made it impossible to control inflation by just reducing the rate of growth in total spending. As Burns wrote:

. . . the present inflation in the midst of substantial unemployment poses a problem that traditional monetary and fiscal policy remedies cannot solve as quickly as the national interest demands. That is what has led me…to urge additional governmental actions involving wages and prices….The problem of cost-push inflation, in which escalating wages lead to escalating prices in a never-ending circle, is the most difficult economic issue of our time.

As for excessive power on the part of some of our corporations and our trade unions, I think it is high time we talked about that in a candid way. We will have to step on some toes in the process. But I think the problem is too serious to be handled quietly and politely….we live in a time when there are abuses of economic power by private groups, and abuses by some of our corporations, and abuses by some of our trade unions.

Relying on statements like these, Karl Smith described Burns’s strategy as Fed Chairman as a sophisticated approach to the inflation and unemployment problems facing the US in the early 1970s when organized labor exercised substantial market power, making it impossible for monetary policy to control inflation without bearing an unacceptable cost of lost output and employment, with producers unable to sell the output that could be produced at prices sufficient to cover their costs (largely determined by union contracts already agreed to). But the rub is that even if unions recognized that their wage demands would result in unemployment, they would still find it in their self-interest not to moderate their wage demands.

[T]he story here is pretty sophisticated and well beyond the simplistic tale of wage-price spirals I heard as an econ student. The core idea is that while unions and corporations are nominally negotiating with each other, the real action is an implicit game between various unions.

One union, say the autoworkers, pushes for higher wages. The auto industry will consent and then the logic of profit maximization dictates that industry push at least some, if not all, of that cost on to their customers as high beer prices, and the rest on to their investors as a lower dividends and the government as lower taxes (since profits are lower.)

Higher prices for cars, increases the cost of living for most workers in the economy and thus lowers their real wages. In response, those workers will ask for a raise. Its straightforward how this will echo through the economy raising all prices. The really sexy part, however, is yet to come. The autoworkers union understands that all of this is going to happen, and so they push for even higher wages, to compensate them for the loss they know they are going to experience through the resulting ripple of price increases throughout the country.

Now, one might say – shouldn’t the self-defeating nature of this exercise be obvious and lead union leaders to give up? Oh [sic] contraire! The self-defeating nature of the enterprise demands that they participate. Suppose all unions except one stopped demanding excessive wage increases. Then the general increase in prices would stop and that one union would receive a huge windfall. Thus, there is a prisoners dilemma encouraging all unions to seek unreasonably high wage increases.

Yet, the plot thickens still. This upward push in prices factors into expectations throughout the entire economy, so that interest rates, asset prices, etc. are all set on the assumption that the upward push will continue. At that point the upward push must continue or else there will be major dislocations in financial markets. And, in order to accommodate that push the Fed must print more money. . . .

So, casting Burn’s view in our modern context would go something like this. Unemployment rises when inflation falls short of expected inflation. Expected inflation is determined by how much consumers think major corporations will raises their prices. Corporations plan price raises based on what they expect their unions to demand. Unions set their demands based on what they expect other unions to do. “Other unions” are always expected to make unreasonable demands because the unions are locked in prisoners dilemma. Actual inflation tends towards expected inflation unless the Fed curtails money growth.

Thus the Federal Reserve could only halt inflation by refusing to play along. . . In general, high unemployment would persist for however long it took to breakdown this entire chain of expectations. Moreover, unless the power of unions was broken the cycle would simply start back immediately after the disinflation.

No, instead the government had to find a way to get all participants in the economy to expect low inflation. How to do this? Outlaw inflation. Then unemployment need not rise since everyone expects the law to be followed. At that point the Federal Reserve could slow money creation without doing damage to the economy. Wage and price controls are thus a means of coordinating expectations.

Burns’s increasingly outspoken advocacy for an incomes policy after Nixon began pressing him to ease monetary policy in time to ensure Nixon’s re-election bore fruit in August 1971 when Nixon announced a 90-day wage and price freeze to be followed by continuing wage and price controls to keep inflation below 3% thereafter. Relieved of responsibility for controlling inflation, Burns was liberated to provide the monetary stimulus on which Nixon was insisting.

I pause here to note that Nixon had no doubt about the capacity of the Fed to deliver the monetary stimulus he was demanding, and there is no evidence that I am aware to suggest that Burns told Nixon that the Fed was not in a position to provide the desired stimulus.

To place the upsurge in total spending presided over by Burns in context, the figure below shows the year over year increase in nominal GDP from the first quarter of 1960 in the last year of the Eisenhower administration when the economy was in recession through the second quarter of 1975 when the economy had just begun to recover from the 1974-75 recession that followed the Yom Kippur War between Israel and its Arab neighbors, which triggered an Arab embargo of oil shipments to the United States and a cutback in the total world output of oil resulting in a quadrupling of crude oil prices within a few months.

 

https://fred.stlouisfed.org/graph/?graph_id=552628

As Hetzel documents, Burns sought to minimize the magnitude of the monetary stimulus provided after August 15, 1971, instead attributing inflation to special factors like increasing commodity prices and devaluation of the dollar, as if rising commodity prices were an independent of cause of inflation, rather than a manifestation of it, and as if devaluation of the dollar was some sort of random non-monetary event. Rising commodity prices, such as the increase in oil prices after the Arab oil embargo, and even devaluation of the dollar could, indeed, be the result of external non-monetary forces. But the Arab oil embargo did not take place until late in 1973 when inflation, wage-and-price controls notwithstanding, had already surged well beyond acceptable limits, and commodity prices were rising rapidly, largely because of high demand, not because of supply disruptions. And it strains credulity to suppose that devaluation of the dollar was not primarily the result of the cumulative effects of monetary policy over a long period of time rather than a sudden shift in the terms of trade between the US and its trading partners.

Burns also blamed loose fiscal policy in the 1960s for the inflation that started rising in the late 1960s. But the notion that loose fiscal policy in the 1970s significantly affected inflation is inconsistent with the fact that the federal budget deficit exceeded 2% of GDP only once (1968) between 1960 and 1974.

It’s also clear that the fluctuation in the growth rate of nominal GDP in the figure above were quite closely related to changes in Fed policy. The rise in nominal GDP growth after the 1960 recession followed an easing of Fed policy while the dip in nominal GDP growth in 1966-67 was induced by a deliberate tightening by the Fed as a preemptive move against inflation that was abandoned because of a credit crunch that adversely affected mortgage lending and the home building industry.

When Nixon took office in Q1 1969 was 9.3% higher than in Q1 1968, the fourth consecutive quarter in which the rate of NGDP increase was between 9 and 10%. Having pledged to reduce inflation without wage and price controls or raising taxes, the only anti-inflation tool in Nixon’s quiver was monetary policy. It was therefore up to the Fed, then under the leadership of William McChesney Martin, an Eisenhower appointee, was thus expected to tighten monetary policy.

A moderate tightening, reflected in a modestly slower increases in NGDP in the remainder of 1969 (8% in Q2, 8.3% in Q3 and 7.2% in Q4) began almost immediately. The slowdown in the growth of spending did little to subdue inflation, leading instead to a slowing of real GDP growth, but without increasing unemployment. Not until 1970, after Burns replaced Martin at the Fed, and further tightened monetary policy, causing nominal spending growth to slow further (5.8% in Q1 and Q2, 5.4% in Q3 and 4.9% in Q4), did real GDP growth stall, with unemployment sharply rising from less than 4% to just over 6%. The economy having expanded and unemployment having fallen almost continuously since 1961, the sharp rise in unemployment provoked a strong outcry and political reaction, spurring big Democratic gains in the 1970 midterm elections.

After presiding over the first recession in almost a decade, Burns, under pressure from Nixon, reversed course, eased monetary policy to fuel a modest recovery in 1971, with nominal GDP growth increasing to rates higher than 1969 and almost as high as in 1968 (8% in Q1, 8.3% in Q2 and 8.4% in Q3). It was at the midpoint of Q3 (August 15) that Nixon imposed a 90-day wage-and-price freeze, and nominal GDP growth accelerated to 9.3% in Q4 (the highest rate since Q4 1968). With costs held in check by the wage-and-price freeze, the increase in nominal spending induced a surge in output and employment.

In 1972, nominal GDP growth, after a slight deceleration in Q1, accelerated to 9.5% in Q2, to 9.6% in Q3 and to 11.6% in Q4, a growth rate maintained during 1973. So Burns’s attempt to disclaim responsibility for the acceleration of inflation associated with accelerating growth in nominal spending and income between 1971 and 1973 was obviously disingenuous and utterly lacking in credibility.

Hetzel summed up Burns’s position after the imposition of wage-and-price controls as follows:

More than anyone else, Burns had created widespread public support for the wage and price controls imposed on August 15, 1971. For Burns, controls were the prerequisite for the expansionary monetary policy desired by the political system—both Congress and the Nixon Administration. Given the imposition of the controls that he had promoted, Burns was effectively committed to an expansionary monetary policy. Moreover, with controls, he did not believe that expansionary monetary policy in 1972 would be inflationary.

Perhaps Burns really did believe that an expansionary monetary policy would not be inflationary with wage-and-price controls in place. But if that’s what Burns believed, he was in a state of utter confusion. An expansionary monetary policy followed under cover of wage-and-price controls could contain inflation only as long as there was sufficient excess capacity and unemployment to channel increased aggregate spending to induce increased output and employment rather than create shortages of products and resources that would drive up costs and prices. To suppress the pressure of rising costs and prices wage-and-price controls would inevitably distort relative prices and create shortages, leading to ever-increasing and cascading waste and inefficiency, and eventually to declining output. That’s what began to happen in 1973 making it politically impossible, to Burns’s chagrin, to re-authorize continuation of those controls after the initial grant of authority expired in April 1974.

I discussed the horrible legacy of Nixon’s wage-and-price freeze and the subsequent controls in one of my first posts on this blog, so I needn’t repeat myself here about the damage done by controls; the point I do want to emphasize is, Karl Smith to the contrary notwithstanding, how incoherent Burns’s thinking was in assuming that a monetary policy leading aggregate spending to rise by a rate exceeding 11% for four consecutive quarters wasn’t seriously inflationary.

If monetary policy is such that nominal GDP is growing at an 11% rate, while real GDP grows at a 4% rate, the difference between those two numbers will necessarily manifest itself in 7% inflation. If wage-and-price controls suppress inflation, the suppressed inflation will be manifested in shortages and other economic dislocations, reducing the growth of real GDP and causing an unwanted accumulation of cash balances, which is what eventually happened under wage-and-price controls in late 1973 and 1974. Once an economy is operating at full capacity, as it surely was by the end of 1973, there could have been no basis for thinking that real GDP could increase at substantially more than a 4% rate, which is why real GDP growth diminished quarter by quarter in 1973 from 7.6% in Q1 to 6.3% in Q2 to 4.8% in Q3 and 4% in Q4.

Thus, in 1973, even without an oil shock in late 1973 used by Burns as an excuse with which to deflect the blame for rising inflation from himself to uncontrollable external forces, Burns’s monetary policy was inexorably on track to raise inflation to 7%. Bad as the situation was before the oil shock, Burns chose to make the situation worse by tightening monetary policy, just as oil prices were quadrupling, It was the worst possible time to tighten policy, because the negative supply shock associated with the rise in oil and other energy prices would likely have led the economy into a recession even if monetary policy had not been tightened.

I am planning to write another couple of posts on what happened in the 1970s, actually going back to the late sixties and forward to the early eighties. The next post will be about Ralph Hawtrey’s last book Incomes and Money in which he discussed the logic of incomes policies that Arthur Burns would have done well to have studied and could have provided him with a better approach to monetary policy than his incoherent embrace of an incomes policy divorced from any notion of the connection between monetary policy and aggregate spending and nominal income. So stay tuned, but it may take a couple of weeks before the next installment.

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James Buchanan Calling the Kettle Black

In the wake of the tragic death of Alan Krueger, attention has been drawn to an implicitly defamatory statement by James Buchanan about those who, like Krueger, dared question the orthodox position taken by most economists that minimum-wage laws increase unemployment among low-wage, low-skilled workers whose productivity, at the margin, is less than the minimum wage that employers are required to pay employees.

Here is Buchanan’s statement:

The inverse relationship between quantity demanded and price is the core proposition in economic science, which embodies the presupposition that human choice behavior is sufficiently relational to allow predictions to be made. Just as no physicist would claim that “water runs uphill,” no self-respecting economist would claim that increases in the minimum wage increase employment. Such a claim, if seriously advanced, becomes equivalent to a denial that there is even minimal scientific content in economics, and that, in consequence, economists can do nothing but write as advocates for ideological interests. Fortunately, only a handful of economists are willing to throw over the teachings of two centuries; we have not yet become a bevy of camp-following whores.

Wholly apart from its odious metaphorical characterization of those he was criticizing, Buchanan’s assertion was substantively problematic in two respects. The first, which is straightforward and well-known, and which Buchanan was obviously wrong not to acknowledge, is that there are obvious circumstances in which a minimum-wage law could simultaneously raise wages and reduce unemployment without contradicting the inverse relationship between quantity demanded and price. Such circumstances obtain whenever employers exercise monopsony power in the market for unskilled labor. If employers realize that hiring additional low-skilled workers drives up the wage paid to all the low-skilled workers that they employ, not just the additional ones hired, the wage paid by employers will be less than the value of the marginal product of labor. If employers exercise monopsony power, then divergence between the wage and the marginal product is not a violation, but an implication, of the inverse relationship between quantity demanded and price. If Buchanan had written on his price theory preliminary exam for a Ph. D at Chicago that support for a minimum wage could be rationalized only be denying the inverse relationship between quantity demanded and price, he would have been flunked.

The second problem with Buchanan’s position is less straightforward and less well-known, but more important, than the first. The inverse relationship by which Buchanan set such great store is valid only if qualified by a ceteris paribus condition. Demand is a function of many variables of which price is only one. So the inverse relationship between price and quantity demanded is premised on the assumption that all the other variables affecting demand are held (at least approximately) constant.

Now it’s true that even the law of gravity is subject to a ceteris paribus condition; the law of gravity will not control the movement of objects in a magnetic field. And it would be absurd to call a physicist an advocate for ideological interests just because he recognized that possibility.

Of course, the presence or absence of a magnetic field is a circumstance that can be easily ascertained, thereby enabling a physicist to alter his prediction of the movement of an object according as the the relevant field for predicting the motion of the object under consideration is gravitational or magnetic. But the magnitude and relevance of other factors affecting demand are not so easily taken into account by economists. That’s why applied economists try to focus on markets in which the effects of “other factors” are small or on markets in which “other factors” can easily be identified and measured or treated qualitatively as fixed effects.

But in some markets the factors affecting demand are themselves interrelated so that the ceteris paribus assumption can’t be maintained. Such markets can’t be analyzed in isolation, they can only be analyzed as a system in which all the variables are jointly determined. Economists call the analysis of an isolated market partial-equilibrium analysis. And it is partial-equilibrium analysis that constitutes the core of price theory and microeconomics. The ceteris paribus assumption either has to be maintained by assuming that changes in the variables other than price affecting demand and supply are inconsequential or by identifying other variable whose changes could affect demand and supply and either measuring them quantitatively or at least accounting for them qualitatively.

But labor markets, except at a granular level, when the focus is on an isolated region or a specialized occupation, cannot be modeled usefully with the standard partial-equilibrium techniques of price theory, because income effects and interactions between related markets cannot appropriately be excluded from the partial-equilibrium analysis of supply and demand in a broadly defined market for labor. The determination of the equilibrium price in a market that encompasses a substantial share of economic activity cannot be isolated from the determination of the equilibrium prices in other markets.

Moreover, the idea that the equilibration of any labor market can be understood within a partial-equiilbrium framework in which the wage responds to excess demands for, or excess supplies of, labor just as the price of a standardized commodity adjusts to excess demands for, or excess supplies of, that commodity, reflects a gross misunderstanding of the incentives of employers and workers in reaching wage bargains for the differentiated services provided by individual workers. Those incentives are in no way comparable to the incentives of businesses to adjust the prices of their products in response to excess supplies of or excess demands for those products.

Buchanan was implicitly applying an inappropriate paradigm of price adjustment in a single market to the analysis of how wages adjust in the real world. The truth is we don’t have a good understanding of how wages adjust, and so we don’t have a good understanding of the effects of minimum wages. But in arrogantly and insultingly dismissing Krueger’s empirical research on the effects of minimum wage laws, Buchanan was unwittingly exposing not Krueger’s ideological advocacy but his own.

There They Go Again (And Now They’re Back!)

Note: On August 5, 2011, one month after I started blogging, I wrote the following post responding to an op-ed in the Wall Street Journal by David Malpass, an op-ed remarkable for its garbled syntax, analytical incoherence, and factual misrepresentations. All in all, quite a performance. Today, exactly seven and a half years later, we learn that the estimable Mr. Malpass, currently serving as Undersecretary for International Affairs in the U.S. Treasury Department, is about to be nominated to become the next President of the World Bank.

In today’s Wall Street Journal, David Malpass, who, according to the bio, used to be a deputy assistant undersecretary of the Treasury in the Reagan administration, and is now President of something called Encima Global LLC (his position as Chief Economist at Bear Stearns was somehow omitted) carries on about the terrible damage inflicted by the Fed on the American economy.

The U.S. is practically alone in the world in pursuing a near-zero interest rate and letting its central bank leverage to the hilt to buy up the national debt. By choosing to pay savers nearly nothing, the Fed’s policy discourages thrift and is directly connected to the weakness in personal income.

Where Mr. Malpass gets his information, I haven’t a clue, but looking at the table of financial and trade statistics on the back page of the July 16 edition of the Economist, I see that in addition to the United States, Japan, Switzerland, Hong Kong, and Singapore, had 3-month rates less than 0.5%.  Britain, Canada, and Saudi Arabia had rates between 0.5 and 1%.  The official rate of the Swedish Riksbank is now 2.5%, but it held the rate at 0.5% until economic conditions improved.

As for Malpass’s next sentence, where to begin?  I won’t dwell on the garbled syntax, but, even if that were its intention, the Fed is obviously not succeeding in discouraging thrift, as private indebtedness has been falling consistently over the past three years.  The question is whether it would be good for the economy if people were saving even more than they are now, and the answer to that, clearly, is:  not unless there was a great deal more demand by private business to invest than there is now.  Why is business not investing?  Despite repeated declamations about the regulatory overkill and anti-business rhetoric of the Obama administration, no serious observer doubts that the main obstacle to increased business investment is that expected demand does not warrant investments aimed at increasing capacity when existing capacity is not being fully utilized.  And for the life of me I cannot tell what it is that Mr. Malpass thinks is connected to the weakness in personal income.  Nor am I am so sure that I know what “weakness in personal income” even means.

From here Malpass meanders into the main theme of his tirade which is how terrible it is that we have a weak dollar.

One of the fastest, most decisive ways to restart U.S. private-sector job growth would be to end the Fed’s near-zero interest rate and the Bush-Obama weak-dollar policy. As Presidents Reagan and Clinton showed, sound money is a core growth strategy—the fastest and most effective way to tell world capital that the U.S. is back in business.

Mr. Malpass served in the Reagan administration, so I would have expected him to know something about what happened in that administration.  Obviously, my expectations were too high.  According to the Federal Reserve’s index of trade weighted dollar exchange rate, the dollar exchange rate stood at 95.66 when Reagan took office in January 1981 and at 90.82 when Reagan left office 8 years later.  Now it is true that the dollar rose rapidly in Reagan’s first term reaching about 141 in May 1985, but it fell even faster for the remainder of Reagan’s second term.  So what exactly is the lesson that Mr. Malpass thinks that the Reagan administration taught us?  Certainly the reduction in dollar exchange rate in Reagan’s second term was much greater than the reduction in the exchange rate so far under Mr. Obama, from about 83 to 68.

Then going in for the kill, Mr. Malpass warns us not to repeat Japan’s mistakes.

Only Japan, after the bursting of its real-estate bubble in 1990, has tried anything similar to U.S. policy. For close to a decade, Tokyo pursued a policy of amped-up government spending, high tax rates, zero-interest rates and mega-trillion yen central-bank buying of government debt. The weak recovery became a deep malaise, with Japan’s own monetary officials warning the U.S. not to follow their lead.

Funny, Mr. Malpass seems to forget that Japan also pursued the sound money policy that he extols.  Consider the foreign exchange value of the yen.   In April 1990, the yen stood at 159 to the dollar.  Last week it was at 77 to the dollar.  Sounds like a strong yen policy to me.  Is that the example Mr. Malpass wants us to follow?

Actually the Wall Street Journal in its editorial today summed up its approach to economic policy making rather well.

The Keynesians have fired all their ammo, and here we are, going south.  Maybe now President Obama should consider everything he’s done to revive the American economy — and do the opposite.

That’s what it comes down to for the Journal.  If Obama is for it, we’re against it.  Simple as that.  Leave your brain at the door.

Friedman and Schwartz, Eichengreen and Temin, Hawtrey and Cassel

Barry Eichengreen and Peter Temin are two of the great economic historians of our time, writing, in the splendid tradition of Charles Kindleberger, profound and economically acute studies of the economic and financial history of the nineteenth and early twentieth centuries. Most notably they have focused on periods of panic, crisis and depression, of which by far the best-known and most important episode is the Great Depression that started late in 1929, bottomed out early in 1933, but lingered on for most of the 1930s, and they are rightly acclaimed for having emphasized and highlighted the critical role of the gold standard in the Great Depression, a role largely overlooked in the early Keynesian accounts of the Great Depression. Those accounts identified a variety of specific shocks, amplified by the volatile entrepreneurial expectations and animal spirits that drive, or dampen, business investment, and further exacerbated by inherent instabilities in market economies that lack self-stabilizing mechanisms for maintaining or restoring full employment.

That Keynesian vision of an unstable market economy vulnerable to episodic, but prolonged, lapses from full-employment was vigorously, but at first unsuccessfully, disputed by advocates of free-market economics. It wasn’t until Milton Friedman provided an alternative narrative explaining the depth and duration of the Great Depression, that the post-war dominance of Keynesian theory among academic economists seriously challenged. Friedman’s alternative narrative of the Great Depression was first laid out in the longest chapter (“The Great Contraction”) of his magnum opus, co-authored with Anna Schwartz, A Monetary History of the United States. In Friedman’s telling, the decline in the US money stock was the critical independent causal factor that directly led to the decline in prices, output, and employment. The contraction in the quantity of money was not caused by the inherent instability of free-market capitalism, but, owing to a combination of incompetence and dereliction of duty, by the Federal Reserve.

In the Monetary History of the United States, all the heavy lifting necessary to account for both secular and cyclical movements in the price level, output and employment is done by, supposedly exogenous, changes in the nominal quantity of money, Friedman having considered it to be of the utmost significance that the largest movements in both the quantity of money, and in prices, output and employment occurred during the Great Depression. The narrative arc of the Monetary History was designed to impress on the mind of the reader the axiomatic premise that monetary authority has virtually absolute control over the quantity of money which served as the basis for inferring that changes in the quantity of money are what cause changes in prices, output and employment.

Friedman’s treatment of the gold standard (which I have discussed here, here and here) was both perfunctory and theoretically confused. Unable to reconcile the notion that the monetary authority has absolute control over the nominal quantity of money with the proposition that the price level in any country on the gold standard cannot deviate from the price levels of other gold standard countries without triggering arbitrage transactions that restore the equality between the price levels of all gold standard countries, Friedman dodged the inconsistency repeatedly invoking his favorite fudge factor: long and variable lags between changes in the quantity of money and changes in prices, output and employment. Despite its vacuity, the long-and-variable-lag dodge allowed Friedman to ignore the inconvenient fact that the US price level in the Great Depression did not and could not vary independently of the price levels of all other countries then on the gold standard.

I’ll note parenthetically that Keynes himself was also responsible for this unnecessary and distracting detour, because the General Theory was written almost entirely in the context of a closed economy model with an exogenously determined quantity of money, thereby unwittingly providing with a useful tool with which to propagate his Monetarist narrative. The difference of course is that Keynes, as demonstrated in his brilliant early works, Indian Currency and Finance and A Tract on Monetary Reform and the Economic Consequences of Mr. Churchill, had a correct understanding of the basic theory of the gold standard, an understanding that, owing to his obsessive fixation on the nominal quantity of money, eluded Friedman over his whole career. Why Keynes, who had a perfectly good theory of what was happening in the Great Depression available to him, as it was to others, was diverted to an unnecessary, but not uninteresting, new theory is a topic that I wrote about a very long time ago here, though I’m not so sure that I came up with a good or even adequate explanation.

So it does not speak well of the economics profession that it took nearly a quarter of a century before the basic internal inconsistency underlying Friedman’s account of the Great Depression was sufficiently recognized to call for an alternative theoretical account of the Great Depression that placed the gold standard at the heart of the narrative. It was Peter Temin and Barry Eichengreen, both in their own separate works (e.g., Lessons of the Great Depression by Temin and Golden Fetters by Eichengreen) and in an important paper they co-authored and published in 2000 to remind both economists and historians how important a role the gold standard must play in any historical account of the Great Depression.

All credit is due to Temin and Eichengreen for having brought to the critical role of the gold standard in the Great Depression to the attention of economists who had largely derived their understanding of what had caused the Great Depression from either some variant of the Keynesian narrative or of Friedman’s Monetarist indictment of the Federal Reserve System. But it’s unfortunate that neither Temin nor Eichnegreen gave sufficient credit to either R. G. Hawtrey or to Gustav Cassel for having anticipated almost all of their key findings about the causes of the Great Depression. And I think that what prevented Eichengreen and Temin from realizing that Hawtrey in particular had anticipated their explanation of the Great Depression by more than half a century was that they did not fully grasp the key theoretical insight underlying Hawtrey’s explanation of the Great Depression.

That insight was that the key to understanding the common world price level in terms of gold under a gold standard is to think in terms of a given world stock of gold and to think of total world demand to hold gold consisting of real demands to hold gold for commercial, industrial and decorative uses, the private demand to hold gold as an asset, and the monetary demand for gold to be held either as a currency or as a reserve for currency. The combined demand to hold gold for all such purposes, given the existing stock of gold, determines a real relative price of gold in terms of all other commodities. This relative price when expressed in terms of a currency unit that is convertible into gold corresponds to an equivalent set of commodity prices in terms of those convertible currency units.

This way of thinking about the world price level under the gold standard was what underlay Hawtrey’s monetary analysis and his application of that analysis in explaining the Great Depression. Given that the world output of gold in any year is generally only about 2 or 3 percent of the existing stock of gold, it is fluctuations in the demand for gold, of which the monetary demand for gold in the period after the outbreak of World War I was clearly the least stable, that causes short-term fluctuations in the value of gold. Hawtrey’s efforts after the end of World War I were therefore focused on the necessity to stabilize the world’s monetary demands for gold in order to avoid fluctuations in the value of gold as the world moved toward the restoration of the gold standard that then seemed, to most monetary and financial experts and most monetary authorities and political leaders, to be both inevitable and desirable.

In the opening pages of Golden Fetters, Eichengreen beautifully describes backdrop against which the attempt to reconstitute the gold standard was about to made after World War I.

For more than a quarter of a century before World War I, the gold standard provided the framework for domestic and international monetary relations. . .  The gold standard had been a remarkably efficient mechanism for organizing financial affairs. No global crises comparable to the one that began in 1929 had disrupted the operation of financial markets. No economic slump had so depressed output and employment.

The central elements of this system were shattered by . . . World War I. More than a decade was required to complete their reconstruction. Quickly it became evident that the reconstructed gold standard was less resilient that its prewar predecessor. As early as 1929 the new international monetary system began to crumble. Rapid deflation forced countries to  producing primary commodities to suspend gold convertibility and depreciate their currencies. Payments problems spread next to the industrialized world. . . Britain, along with United State and France, one of the countries at the center of the international monetary system, was next to experience a crisis, abandoning the gold standard in the autumn of 1931. Some two dozen countries followed suit. The United States dropped the gold standard in 1933; France hung on till the bitter end, which came in 1936.

The collapse of the international monetary system is commonly indicted for triggering the financial crisis that transformed a modes economic downturn gold standard into an unprecedented slump. So long as the gold standard was maintained, it is argued, the post-1929 recession remained just another cyclical contraction. But the collapse of the gold standard destroyed confidence in financial stability, prompting capital flight which undermined the solvency of financial institutions. . . Removing the gold standard, the argument continues, further intensified the crisis. Having suspended gold convertibility, policymakers manipulated currencies, engaging in beggar thy neighbor depreciations that purportedly did nothing to stimulate economic recovery at home while only worsening the Depression abroad.

The gold standard, then, is conventionally portrayed as synonymous with financial stability. Its downfall starting in 1929 is implicated in the global financial crisis and the worldwide depression. A central message of this book is that precisely the opposite was true. (Golden Fetters, pp. 3-4).

That is about as clear and succinct and accurate a description of the basic facts leading up to and surrounding the Great Depression as one could ask for, save for the omission of one important causal factor: the world monetary demand for gold.

Eichengreen was certainly not unaware of the importance of the monetary demand for gold, and in the pages that immediately follow, he attempts to fill in that part of the story, adding to our understanding of how the gold standard worked by penetrating deeply into the nature and role of the expectations that supported the gold standard, during its heyday, and the difficulty of restoring those stabilizing expectations after the havoc of World War I and the unexpected post-war inflation and subsequent deep 1920-21 depression. Those stabilizing expectations, Eichengreen argued, were the result of the credibility of the commitment to the gold standard and the international cooperation between governments and monetary authorities to ensure that the international gold standard would be maintained notwithstanding the occasional stresses and strains to which a complex institution would inevitably be subjected.

The stability of the prewar gold standard was instead the result of two very different factors: credibility and cooperation. Credibility is the confidence invested by the public in the government’s commitment to a policy. The credibility of the gold standard derived from the priority attached by governments to the maintenance of to the maintenance of balance-of-payments equilibrium. In the core countries – Britain, France and Germany – there was little doubt that the authorities would take whatever steps were required to defend the central bank’s gold reserves and maintain the convertibility of the currency into gold. If one of these central banks lost gold reserves and its exchange rate weakened, fund would flow in from abroad in anticipation of the capital gains investors in domestic assets would reap once the authorities adopted measures to stem reserve losses and strengthen the exchange rate. . . The exchange rate consequently strengthened on its own, and stabilizing capital flows minimized the need for government intervention. The very credibility of the official commitment to gold meant that this commitment was rarely tested. (p. 5)

But credibility also required cooperation among the various countries on the gold standard, especially the major countries at its center, of which Britain was the most important.

Ultimately, however, the credibility of the prewar gold standard rested on international cooperation. When the stabilizing speculation and domestic intervention proved incapable of accommodating a disturbance, the system was stabilized through cooperation among governments and central banks. Minor problems could be solved by tacit cooperation, generally achieved without open communication among the parties involved. . .  Under such circumstances, the most prominent central bank, the Bank of England, signaled the need for coordinated action. When it lowered its discount rate, other central banks usually responded in kind. In effect, the Bank of England provided a focal point for the harmonization of national monetary policies. . .

Major crises in contrast typically required different responses from different countries. The country losing gold and threatened by a convertibility crisis had to raise interest rates to attract funds from abroad; other countries had to loosen domestic credit conditions to make funds available to the central bank experiencing difficulties. The follow-the-leader approach did not suffice. . . . Such crises were instead contained through overt, conscious cooperation among central banks and governments. . . Consequently, the resources any one country could draw on when its gold parity was under attack far exceeded its own reserves; they included the resources of the other gold standard countries. . . .

What rendered the commitment to the gold standard credible, then, was that the commitment was international, not merely national. That commitment was achieved through international cooperation. (pp. 7-8)

Eichengreen uses this excellent conceptual framework to explain the dysfunction of the newly restored gold standard in the 1920s. Because of the monetary dislocation and demonetization of gold during World War I, the value of gold had fallen to about half of its prewar level, thus to reestablish the gold standard required not only restoring gold as a currency standard but also readjusting – sometimes massively — the prewar relative values of the various national currency units. And to prevent the natural tendency of gold to revert to its prewar value as gold was remonetized would require an unprecedented level of international cooperation among the various countries as they restored the gold standard. Thus, the gold standard was being restored in the 1920s under conditions in which neither the credibility of the prewar commitment to the gold standard nor the level of international cooperation among countries necessary to sustain that commitment was restored.

An important further contribution that Eichengreen, following Temin, brings to the historical narrative of the Great Depression is to incorporate the political forces that affected and often determined the decisions of policy makers directly into the narrative rather than treat those decisions as being somehow exogenous to the purely economic forces that were controlling the unfolding catastrophe.

The connection between domestic politics and international economics is at the center of this book. The stability of the prewar gold standard was attributable to a particular constellation of political as well as economic forces. Similarly, the instability of the interwar gold standard is explicable in terms of political as well as economic changes. Politics enters at two levels. First, domestic political pressures influence governments’ choices of international economic policies. Second, domestic political pressures influence the credibility of governments’ commitments to policies and hence their economic effects. . . (p. 10)

The argument, in a nutshell, is that credibility and cooperation were central to the smooth operation of the classical gold standard. The scope for both declined abruptly with the intervention of World War I. The instability of the interwar gold standard was the inevitable result. (p. 11)

Having explained and focused attention on the necessity for credibility and cooperation for a gold standard to function smoothly, Eichengreen then begins his introductory account of how the lack of credibility and cooperation led to the breakdown of the gold standard that precipitated the Great Depression, starting with the structural shift after World War I that made the rest of the world highly dependent on the US as a source of goods and services and as a source of credit, rendering the rest of the world chronically disposed to run balance-of-payments deficits with the US, deficits that could be financed only by the extension of credit by the US.

[I]f U.S. lending were interrupted, the underlying weakness of other countries’ external positions . . . would be revealed. As they lost gold and foreign exchange reserves, the convertibility of their currencies into gold would be threatened. Their central banks would be forced to  restrict domestic credit, their fiscal authorities to compress public spending, even if doing so threatened to plunge their economies into recession.

This is what happened when U.S. lending was curtailed in the summer of 1928 as a result of increasingly stringent Federal Reserve monetary policy. Inauspiciously, the monetary contraction in the United States coincided with a massive flow of gold to France, where monetary policy was tight for independent reasons. Thus, gold and financial capital were drained by the United States and France from other parts of the world. Superimposed on already weak foreign balances of payments, these events provoked a greatly magnified monetary contraction abroad. In addition they caused a tightening of fiscal policies in parts of Europe and much of Latin America. This shift in policy worldwide, and not merely the relatively modest shift in the United States, provided the contractionary impulse that set the stage for the 1929 downturn. The minor shift in American policy had such dramatic effects because of the foreign reaction it provoked through its interactions with existing imbalances in the pattern of international settlements and with the gold standard constraints. (pp. 12-13)

Eichengreen then makes a rather bold statement, with which, despite my agreement with, and admiration for, everything he has written to this point, I would take exception.

This explanation for the onset of the Depression, which emphasizes concurrent shifts in economic policy in the Unites States and abroad, the gold standard as the connection between them, and the combined impact of U.S. and foreign economic policies on the level of activity, has not previously appeared in the literature. Its elements are familiar, but they have not been fit together into a coherent account of the causes of the 1929 downturn. (p. 13)

I don’t think that Eichengreen’s claim of priority for his explanation of the onset of the 1929 downturn can be defended, though I certainly wouldn’t suggest that he did not arrive at his understanding of what caused the Great Depression largely on his own. But it is abundantly clear from reading the writings of Hawtrey and Cassel starting as early as 1919, that the basic scenario outlined by Eichengreen was clearly spelled out by Hawtrey and Cassel well before the Great Depression started, as papers by Ron Batchelder and me and by Doug Irwin have thoroughly documented. Undoubtedly Eichengreen has added a great deal of additional insight and depth and done important quantitative and documentary empirical research to buttress his narrative account of the causes of the Great Depression, but the basic underlying theory has not changed.

Eichengreen is not unaware of Hawtrey’s contribution and in a footnote to the last quoted paragraph, Eichengreen writes as follows.

The closest precedents lie in the work of the British economists Lionel Robbins and Ralph Hawtrey, in the writings of German historians concerned with the causes of their economy’s precocious slump, and in Temin (1989). Robbins (1934) hinted at many of the mechanism emphasized here but failed to develop the argument fully. Hawtrey emphasized how the contractionary shift in U.S. monetary policy, superimposed on an already weak British balance of payments position, forced a draconian contraction on the Bank of England, plunging the world into recession. See Hawtrey (1933), especially chapter 2. But Hawtrey’s account focused almost entirely on the United States and the United Kingdom, neglecting the reaction of other central banks, notably the Bank of France, whose role was equally important. (p. 13, n. 17)

Unfortunately, this footnote neither clarifies nor supports Eichengreen’s claim of priority for his account of the role of the gold standard in the Great Depression. First, the bare citation of Robbins’s 1934 book The Great Depression is confusing at best, because Robbins’s explanation of the cause of the Great Depression, which he himself later disavowed, is largely a recapitulation of the Austrian business-cycle theory that attributed the downturn to a crisis caused by monetary expansion by the Fed and the Bank of England. Eichengreen correctly credits Hawtrey for attributing the Great Depression, in almost diametric opposition to Robbins, to contractionary monetary policy by the Fed and the Bank of England, but then seeks to distinguish Hawtrey’s explanation from his own by suggesting that Hawtrey neglected the role of the Bank of France.

Eichengreen mentions Hawtrey’s account of the Great Depression in his 1933 book, Trade Depression and the Way Out, 2nd edition. I no longer have a copy of that work accessible to me, but in the first edition of this work published in 1931, Hawtrey included a brief section under the heading “The Demand for Gold as Money since 1914.”

[S]ince 1914 arbitrary changes in monetary policy and in the demand for gold as money have been greater and more numerous than ever before. Frist came the general abandonment of the gold standard by the belligerent countries in favour of inconvertible paper, and the release of hundreds of millions of gold. By 1920 the wealth value of gold had fallen to two-fifths of what it had been in 1913. The United States, which was almost alone at that time in maintaining a gold standard, thereupon started contracting credit and absorbing gold on a vast scale. In June 1924 the wealth value of gold was seventy per cent higher than at its lowest point in 1920, and the amount of gold held for monetary purposes in the United States had grown from $2,840,000,000 in 1920 to $4,488,000,000.

Other countries were then beginning to return to the gold standard, Gemany in 1924, England in 1925, besides several of the smaller countries of Europe. In the years 1924-8 Germany absorbed over £100,000,000 of gold. France stabilized her currency in 1927 and re-established the gold standard in 1928, and absorbed over £60,000,000 in 1927-8. But meanwhile, the Unitd States had been parting with gold freely and her holding had fallen to $4,109,000,000 in June 1928. Large as these movements had been, they had not seriously disturbed the world value of gold. . . .

But from 1929 to the present time has been a period of immense and disastrous instability. France has added more than £200,000,000 to her gold holding, and the United Statesmore than $800,000,000. In the two and a half years the world’s gold output has been a little over £200,000,000, but a part of this been required for the normal demands of industry. The gold absorbed by France and America has exceeded the fresh supply of gold for monetary purposes by some £200,000,000.

This has had to be wrung from other countries, and much o of it has come from new countries such as Australia, Argentina and Brazil, which have been driven off the gold standard and have used their gold reserves to pay their external liabilities, such as interest on loans payable in foreign currencies. (pp. 20-21)

The idea that Hawtrey neglected the role of the Bank of France is clearly inconsistent with the work that Eichengreen himself cites as evidence for that neglect. Moreover in Hawtrey’s 1932 work, The Art of Central Banking, his first chapter is entitled “French Monetary Policy” which directly addresses the issues supposedly neglected by Hawtrey. Here is an example.

I am inclined therefore to say that while the French absorption of gold in the period from January 1929 to May 1931 was in fact one of the most powerful causes of the world depression, that is only because it was allowed to react an unnecessary degree upon the monetary policy of other countries. (p. 38)

In his foreward to the 1962 reprinting of his volume, Hawtrey mentions his chapter on French Monetary Policy in a section under the heading “Gold and the Great Depression.”

Conspicuous among countries accumulating reserves foreign exchange was France. Chapter 1 of this book records how, in the course of stabilizing the franc in the years 1926-8, the Bank of France accumulated a vast holding of foreign exchange [i.e., foreign bank liabilities payable in gold], and in the ensuing years proceeded to liquidate it [for gold]. Chapter IV . . . shows the bearing of the French absorption of gold upon the starting of the great depression of the 1930s. . . . The catastrophe foreseen in 1922 [!] had come to pass, and the moment had come to point to the moral. The disaster was due to the restoration of the gold standard without any provision for international cooperation to prevent undue fluctuations in the purchasing power of gold. (pp. xiv-xv)

Moreover, on p. 254 of Golden Fetters, Eichengreen himself cites Hawtrey as one of the “foreign critics” of Emile Moreau, Governor of the Bank of France during the 1920s and 1930s “for failing to build “a structure of credit” on their gold imports. By failing to expand domestic credit and to repel gold inflows, they argued, the French had violated the rules of the gold standard game.” In the same paragraph Eichengreen also cites Hawtrey’s recommendation that the Bank of France change its statutes to allow for the creation of domestically supplied money and credit that would have obviated the need for continuing imports of gold.

Finally, writers such as Clark Johnson and Kenneth Mouré, who have written widely respected works on French monetary policy during the 1920s and 1930s, cite Hawtrey extensively as one of the leading contemporary critics of French monetary policy.

PS I showed Barry Eichengreen a draft of this post a short while ago, and he agrees with my conclusion that Hawtrey, and presumably Cassel also, had anticipated the key elements of his explanation of how the breakdown of the gold standard, resulting largely from the breakdown of international cooperation, was the primary cause of the Great Depression. I am grateful to Barry for his quick and generous response to my query.

Was There a Blue Wave?

In the 2018 midterm elections on two weeks ago on November 6, Democrats gained about 38 seats in the House of Representatives with results for a few seats still incomplete. Polls and special elections for vacancies in the House and Senate and state legislatures indicated that a swing toward the Democrats was likely, raising hopes among Democrats that a blue wave would sweep Democrats into control of the House of Representatives and possibly, despite an unfavorable election map with many more Democratic Senate seats at state than Republican seats, even the Senate.

On election night when results in the Florida Senate and Governor races suddenly swung toward the Democrats, the high hopes for a blue wave began to ebb, especially as results from Indiana, Misouri, and South Dakota showed that Democratic incumbent Senators trailing by substantial margins. Other results seemed like a mixed bag, with some Democratic gains, but hardly providing clear signs of a blue wave. The mood was not lifted when the incumbent Democratic Senator from Montana fell behind his Republican challenger and Ted Cruz seemed to be maintaining a slim lead over his charismatic opponent Beto O’Rourke and the Republican candidate for the open Senate seat held by the retiring Jeff Flake of Arizona was leading the Democratic candidate.

As the night wore on, although it seemed that the Democrats would gain a majority in the House of Representatives, estimates of the number of seats gained were only in the high twenties or low thirties, while it appeared that Republicans might gain as many as five Senate Seats. President Trump was able to claim, almost credibly, the next morning at his White House news conference that the election results had been an almost total victory for himself and his party.

It was not till later the next day that it became clear that the Democratic gains in the House would not be just barely enough (23) to gain a majority in the House but would likely be closer to 40 than to 30. The apparent losses of the Montana seat was reversed by late results, and the delayed results from Nevada showed that a Democrat had defeated the Republican incumbent while the Democratic candidate in Arizona had substantially cut into the lead built up by the Republican candidate with most of the of the uncounted votes in Democratic strongholds. Instead of winning 56 Senate seats a pickup of 5, as seemed likely on Tuesday night, the Republicans gains were cut to no more than 2, and the apparent defeat of an incumbent in the Florida election was thrown into doubt, as late returns showed a steadily shrinking Republican margin, sending Republicans into an almost hysterical panic at the prospect gaining no more than one seat rather than five they had been expecting on Tuesday night.

So, within a day or two after the election, the narrative of a Democratic wave began to reemerge. Many commentators accepted the narrative of a covert Democratic wave, but others disagreed. For example, Sean Trende at Real Clear Politics argues that there really wasn’t a Blue Wave, even though Democratic House gains of nearly 40 seats, taken in isolation, might qualify for that designation. Trende thinks the Democratic losses in the Senate, though not as large as they seemed originally, are inconsistent with a wave election as were Democratic gains in governorships and state legislatures.

However, a pickup of seven governorships, while not spectacular is hardly to be sneezed at, and Democratic gains in state legislative seats would have been substantially greater than they were had it not been for extremely effective gerrymandering that kept democratic gains well below their share of the vote in state legislatures even though their effect on races for the House were fairly minimal. So I think that the best measure of the wave-like character of the 2018 elections is provided by the results for the House of Representatives.

Now the problem with judging whether the House results were a wave or were not a wave is that midterm election results are sensitive to economic conditions, so before you can compare results you need to adjust for how well or poorly the economy was performing. You also need to adjust for how many seats the President’s party has going into the election. The more seats the President’s Party has to defend, the greater its potential loss in the election.

To test this idea, I estimated a simple regression model with the number of seats lost by the President’s party in the midterm elections as the dependent variable and the number of seats held by the President’s party as one independent variable and the ratio of real GDP in the year of the midterm election to real GDP in the year of the previous Presidential election as the other independent variable. One would expect the President’s party to perform better in the midterm elections the higher the ratio of real GDP in the midterm year to real GDP in the year of the previous Presidential election.

My regression equation is thus ΔSeats = C + aSeats + bRGDPratio + ε,

where ΔSeats is the change in the number of seats held by the President’s party after the midterm election, Seats is the number of seats held before the midterm, RGDPratio is the ratio of real GDP in the midterm election year to the real GDP in the previous Presidential election year, C is a constant reflecting the average change in the number of seats of the President’s party in the midterm elections, and a and b are the coefficients reflecting the marginal effect of a change in the corresponding independent variables on the dependent variable, with the other independent variable held constant.

I estimated this equation using data in the 18 midterm elections from 1946 through 2014. The estimated regression equation was the following:

ΔSeats = 24.63 – .26Seats + 184.48RGDPratio

The t values for Seats and RGDPratio are both slightly greater than 2 in absolute value, indicating that they are statistically significant at the 10% level and nearly significant at the 5% level. But given the small number of observations, I wouldn’t put much store on the significance levels except as an indication of plausibility. The assumption that Seats is linearly related to ΔSeats doesn’t seem right, but I haven’t tried alternative specifications. The R-squared and adjusted R-squared statistics are .31 and .22, which seem pretty high.

At any rate when I plotted the predicted changes in the number of seats against the actual number of seats changed in the elections from 1946 to 2018 I came up with the following chart:

 

The blue line in the chart represents the actual number of seats gained or lost in each midterm election since 1946 and the orange line represents the change in the number of seats predicted by the model. One can see that the President’s party did substantially better than expected in 1962, 1978, 1998, and 2002 elections, while the President’s party did substantially worse than expected in the 1958, 1966, 1974, 1994, 2006, 2010 and 2018 elections.

In 2018, the Democrats gained approximately 38 seats compared to the 22 seats the model predicted, so the Democrats overperformed by about 16 seats. In 2010 the Republicans gained 63 seats compared to a predicted gain of 35. In 2006, the Democrats gained 32 seats compared to a predicted gain of 22. In 1994 Republicans gained 54 seats compared to a predicted gain of 26 seats. In 1974, Democrats gains 48 seats compared to a predicted gain of 20 seats. In 1966, Republicans gained 47 seats compared to a predicted gain of 26 seats. And in 1958, Democrats gained 48 seats compared to a predicted gain of 20 seats.

So the Democrats in 2018 did not over-perform as much as they did in 1958 and 1974, or as much as the Republicans did in 1966, 1994, and 2010. But the Democrats overperformed by more in 2018 than they did in 2006 when Mrs. Pelosi became Speaker of the House the first time, and actually came close to the Republicans’ overperformance of 1966. So, my tentative conclusion is yes, there was a blue wave in 2018, but it was a light blue wave.

 

More on Sticky Wages

It’s been over four and a half years since I wrote my second most popular post on this blog (“Why are Wages Sticky?”). Although the post was linked to and discussed by Paul Krugman (which is almost always a guarantee of getting a lot of traffic) and by other econoblogosphere standbys like Mark Thoma and Barry Ritholz, unlike most of my other popular posts, it has continued ever since to attract a steady stream of readers. It’s the posts that keep attracting readers long after their original expiration date that I am generally most proud of.

I made a few preliminary points about wage stickiness before getting to my point. First, although Keynes is often supposed to have used sticky wages as the basis for his claim that market forces, unaided by stimulus to aggregate demand, cannot automatically eliminate cyclical unemployment within the short or even medium term, he actually devoted a lot of effort and space in the General Theory to arguing that nominal wage reductions would not increase employment, and to criticizing economists who blamed unemployment on nominal wages fixed by collective bargaining at levels too high to allow all workers to be employed. So, the idea that wage stickiness is a Keynesian explanation for unemployment doesn’t seem to me to be historically accurate.

I also discussed the search theories of unemployment that in some ways have improved our understanding of why some level of unemployment is a normal phenomenon even when people are able to find jobs fairly easily and why search and unemployment can actually be productive, enabling workers and employers to improve the matches between the skills and aptitudes that workers have and the skills and aptitudes that employers are looking for. But search theories also have trouble accounting for some basic facts about unemployment.

First, a lot of job search takes place when workers have jobs while search theories assume that workers can’t or don’t search while they are employed. Second, when unemployment rises in recessions, it’s not because workers mistakenly expect more favorable wage offers than employers are offering and mistakenly turn down job offers that they later regret not having accepted, which is a very skewed way of interpreting what happens in recessions; it’s because workers are laid off by employers who are cutting back output and idling production lines.

I then suggested the following alternative explanation for wage stickiness:

Consider the incentive to cut price of a firm that can’t sell as much as it wants [to sell] at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting.

I think that what I wrote four years ago is clearly right, identifying an important reason for wage stickiness. But there’s also another reason that I didn’t mention then, but whose importance has since come to appear increasingly significant to me, especially as a result of writing and rewriting my paper “Hayek, Hicks, Radner and three concepts of intertemporal equilibrium.”

If you are unemployed because the demand for your employer’s product has gone down, and your employer, planning to reduce output, is laying off workers no longer needed, how could you, as an individual worker, unconstrained by a union collective-bargaining agreement or by a minimum-wage law, persuade your employer not to lay you off? Could you really keep your job by offering to accept a wage cut — no matter how big? If you are being laid off because your employer is reducing output, would your offer to work at a lower wage cause your employer to keep output unchanged, despite a reduction in demand? If not, how would your offer to take a pay cut help you keep your job? Unless enough workers are willing to accept a big enough wage cut for your employer to find it profitable to maintain current output instead of cutting output, how would your own willingness to accept a wage cut enable you to keep your job?

Now, if all workers were to accept a sufficiently large wage cut, it might make sense for an employer not to carry out a planned reduction in output, but the offer by any single worker to accept a wage cut certainly would not cause the employer to change its output plans. So, if you are making an independent decision whether to offer to accept a wage cut, and other workers are making their own independent decisions about whether to accept a wage cut, would it be rational for you or any of them to accept a wage cut? Whether it would or wouldn’t might depend on what each worker was expecting other workers to do. But certainly given the expectation that other workers are not offering to accept a wage cut, why would it make any sense for any worker to be the one to offer to accept a wage cut? Would offering to accept a wage cut, increase the likelihood that a worker would be one of the lucky ones chosen not to be laid off? Why would offering to accept a wage cut that no one else was offering to accept, make the worker willing to work for less appear more desirable to the employer than the others that wouldn’t accept a wage cut? One reaction by the employer might be: what’s this guy’s problem?

Combining this way of looking at the incentives workers have to offer to accept wage reductions to keep their jobs with my argument in my post of four years ago, I now am inclined to suggest that unemployment as such provides very little incentive for workers and employers to cut wages. Price cutting in periods of excess supply is often driven by aggressive price cutting by suppliers with large unsold inventories. There may be lots of unemployment, but no one is holding a large stock of unemployed workers, and no is in a position to offer low wages to undercut the position of those currently employed at  nominal wages that, arguably, are too high.

That’s not how labor markets operate. Labor markets involve matching individual workers and individual employers more or less one at a time. If nominal wages fall, it’s not because of an overhang of unsold labor flooding the market; it’s because something is changing the expectations of workers and employers about what wage will be offered by employers, and accepted by workers, for a particular kind of work. If the expected wage is too high, not all workers willing to work at that wage will find employment; if it’s too low, employers will not be able to find as many workers as they would like to hire, but the situation will not change until wage expectations change. And the reason that wage expectations change is not because the excess demand for workers causes any immediate pressure for nominal wages to rise.

The further point I would make is that the optimal responses of workers and the optimal responses of their employers to a recessionary reduction in demand, in which the employers, given current input and output prices, are planning to cut output and lay off workers, are mutually interdependent. While it is, I suppose, theoretically possible that if enough workers decided to immediately offer to accept sufficiently large wage cuts, some employers might forego plans to lay off their workers, there are no obvious market signals that would lead to such a response, because such a response would be contingent on a level of coordination between workers and employers and a convergence of expectations about future outcomes that is almost unimaginable.

One can’t simply assume that it is in the independent self-interest of every worker to accept a wage cut as soon as an employer perceives a reduced demand for its product, making the current level of output unprofitable. But unless all, or enough, workers decide to accept a wage cut, the optimal response of the employer is still likely to be to cut output and lay off workers. There is no automatic mechanism by which the market adjusts to demand shocks to achieve the set of mutually consistent optimal decisions that characterizes a full-employment market-clearing equilibrium. Market-clearing equilibrium requires not merely isolated price and wage cuts by individual suppliers of inputs and final outputs, but a convergence of expectations about the prices of inputs and outputs that will be consistent with market clearing. And there is no market mechanism that achieves that convergence of expectations.

So, this brings me back to Keynes and the idea of sticky wages as the key to explaining cyclical fluctuations in output and employment. Keynes writes at the beginning of chapter 19 of the General Theory.

For the classical theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment.

A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes. My difference from this theory is primarily a difference of analysis. . . .

The generally accept explanation is . . . quite a simple one. It does not depend on roundabout repercussions, such as we shall discuss below. The argument simply is that a reduction in money wages will, cet. par. Stimulate demand by diminishing the price of the finished product, and will therefore increase output, and will therefore increase output and employment up to the point where  the reduction which labour has agreed to accept in its money wages is just offset by the diminishing marginal efficiency of labour as output . . . is increased. . . .

It is from this type of analysis that I fundamentally differ.

[T]his way of thinking is probably reached as follows. In any given industry we have a demand schedule for the product relating the quantities which can be sold to the prices asked; we have a series of supply schedules relating the prices which will be asked for the sale of different quantities. .  . and these schedules between them lead up to a further schedule which, on the assumption that other costs are unchanged . . . gives us the demand schedule for labour in the industry relating the quantity of employment to different levels of wages . . . This conception is then transferred . . . to industry as a whole; and it is supposed, by a parity of reasoning, that we have a demand schedule for labour in industry as a whole relating the quantity of employment to different levels of wages. It is held that it makes no material difference to this argument whether it is in terms of money-wages or of real wages. If we are thinking of real wages, we must, of course, correct for changes in the value of money; but this leaves the general tendency of the argument unchanged, since prices certainly do not change in exact proportion to changes in money wages.

If this is the groundwork of the argument . . ., surely it is fallacious. For the demand schedules for particular industries can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption amount to an ignoratio elenchi. For whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money wages will or will not be accompanied by the same aggregate effective demand as before measured in money, or, at any rate, measured by an aggregate effective demand which is not reduced in full proportion to the reduction in money-wages. . . But if the classical theory is not allowed to extend by analogy its conclusions in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have. For it has no method of analysis wherewith to tackle the problem. (General Theory, pp. 257-60)

Keynes’s criticism here is entirely correct. But I would restate slightly differently. Standard microeconomic reasoning about preferences, demand, cost and supply is partial-equilbriium analysis. The focus is on how equilibrium in a single market is achieved by the adjustment of the price in a single market to equate the amount demanded in that market with amount supplied in that market.

Supply and demand is a wonderful analytical tool that can illuminate and clarify many economic problems, providing the key to important empirical insights and knowledge. But supply-demand analysis explicitly – but too often without realizing its limiting implications – assumes that other prices and incomes in other markets are held constant. That assumption essentially means that the market – i.e., the demand, cost and supply curves used to represent the behavioral characteristics of the market being analyzed – is small relative to the rest of the economy, so that changes in that single market can be assumed to have a de minimus effect on the equilibrium of all other markets. (The conditions under which such an assumption could be justified are themselves not unproblematic, but I am now assuming that those problems can in fact be assumed away at least in many applications. And a good empirical economist will have a good instinctual sense for when it’s OK to make the assumption and when it’s not OK to make the assumption.)

So, the underlying assumption of microeconomics is that the individual markets under analysis are very small relative to the whole economy. Why? Because if those markets are not small, we can’t assume that the demand curves, cost curves, and supply curves end up where they started. Because a high price in one market may have effects on other markets and those effects will have further repercussions that move the very demand, cost and supply curves that were drawn to represent the market of interest. If the curves themselves are unstable, the ability to predict the final outcome is greatly impaired if not completely compromised.

The working assumption of the bread and butter partial-equilibrium analysis that constitutes econ 101 is that markets have closed borders. And that assumption is not always valid. If markets have open borders so that there is a lot of spillover between and across markets, the markets can only be analyzed in terms of broader systems of simultaneous equations, not the simplified solutions that we like to draw in two-dimensional space corresponding to intersections of stable supply curves with stable supply curves.

What Keynes was saying is that it makes no sense to draw a curve representing the demand of an entire economy for labor or a curve representing the supply of labor of an entire economy, because the underlying assumption of such curves that all other prices are constant cannot possibly be satisfied when you are drawing a demand curve and a supply curve for an input that generates more than half the income earned in an economy.

But the problem is even deeper than just the inability to draw a curve that meaningfully represents the demand of an entire economy for labor. The assumption that you can model a transition from one point on the curve to another point on the curve is simply untenable, because not only is the assumption that other variables are being held constant untenable and self-contradictory, the underlying assumption that you are starting from an equilibrium state is never satisfied when you are trying to analyze a situation of unemployment – at least if you have enough sense not to assume that economy is starting from, and is not always in, a state of general equilibrium.

So, Keynes was certainly correct to reject the naïve transfer of partial equilibrium theorizing from its legitimate field of applicability in analyzing the effects of small parameter changes on outcomes in individual markets – what later came to be known as comparative statics – to macroeconomic theorizing about economy-wide disturbances in which the assumptions underlying the comparative-statics analysis used in microeconomics are clearly not satisfied. That illegitimate transfer of one kind of theorizing to another has come to be known as the demand for microfoundations in macroeconomic models that is the foundational methodological principle of modern macroeconomics.

The principle, as I have been arguing for some time, is illegitimate for a variety of reasons. And one of those reasons is that microeconomics itself is based on the macroeconomic foundational assumption of a pre-existing general equilibrium, in which all plans in the entire economy are, and will remain, perfectly coordinated throughout the analysis of a particular parameter change in a single market. Once you relax the assumption that all, but one, markets are in equilibrium, the discipline imposed by the assumption of the rationality of general equilibrium and comparative statics is shattered, and a different kind of theorizing must be adopted to replace it.

The search for that different kind of theorizing is the challenge that has always faced macroeconomics. Despite heroic attempts to avoid facing that challenge and pretend that macroeconomics can be built as if it were microeconomics, the search for a different kind of theorizing will continue; it must continue. But it would certainly help if more smart and creative people would join in that search.

Only Idiots Think that Judges Are Umpires and Only Cads Say that They Think So

It now seems besides the point, but I want to go back and consider something Judge Kavanaugh said in his initial testimony three weeks ago before the Senate Judiciary Committee, now largely, and deservedly, forgotten.

In his earlier testimony, Judge Kavanaugh made the following ludicrous statement, echoing a similar statement by (God help us) Chief Justice Roberts at his confirmation hearing before the Senate Judiciary Committee:

A good judge must be an umpire, a neutral and impartial arbiter who favors no litigant or policy. As Justice Kennedy explained in Texas versus Johnson, one of his greatest opinions, judges do not make decisions to reach a preferred result. Judges make decisions because “the law and the Constitution, as we see them, compel the result.”

I don’t decide cases based on personal or policy preferences.

Kavanaugh’s former law professor Akhil Amar offered an embarrassingly feeble defense of Kavanaugh’s laughable comparison, in a touching gesture of loyalty to a former student, to put the most generous possible gloss on his deeply inappropriate defense of an indefensible trivialization of what judging is all about.

According to the Chief Justice and to Judge Kavanaugh, judges, like umpires, are there to call balls and strikes. An umpire calls balls and strikes with no concern for the consequences of calling a ball or a strike on the outcome of the game. Think about it: do judges reach decisions about cases, make their rulings, write their opinions, with no concern for the consequences of their decisions?

Umpires make their calls based on split-second responses to their visual perceptions of what happens in front of their eyes, with no reflection on what implications their decisions have for anyone else, or the expectations held by the players whom they are watching. Think about it: would you want a judge to decide a case without considering the effects of his decision on the litigants and on the society at large?

Umpires make their decisions without hearing arguments from the players before rendering their decisions. Players, coaches, managers, or their spokesmen do not submit written briefs, or make oral arguments, to umpires in an effort to explain to umpires why justice requires that a decision be rendered in their favor. Umpires don’t study briefs or do research on decisions rendered by earlier umpires in previous contests. Think about it: would you want a judge to decide a case within the time that an umpire takes to call balls and strikes and do so with no input from the litigants?

Umpires never write opinions in which they explain (or at least try to explain) why their decisions are right and just after having taken into account on all the arguments advanced by the opposing sides and any other relevant considerations that might properly be taken into account in reaching a decision. Think about it: would you want a judge to decide a case without having to write an opinion explaining why his or her decision is the right and just one?

Umpires call balls on strikes instinctively, unreflectively, and without hesitation. But to judge means to think, to reflect, to consider both (or all) sides, to consider the consequences of the decision for the litigants and for society, and for future judges in future cases who will be guided by the decision being rendered in the case at hand. Judging — especially appellate judging — is a deeply intellectual and reflective vocation requiring knowledge, erudition, insight, wisdom, temperament, and, quite often, empathy and creativity.

To reduce this venerable vocation to the mere calling of balls and strikes is deeply dishonorable, and, coming from a judge who presumes to be worthy of sitting on the highest court in the land, supremely offensive.

What could possibly possess a judge — and a judge, presumably neither an idiot nor insufficiently self-aware to understand what he is actually doing — to engage in such obvious sophistry? The answer, I think, is that it has come to be in the obvious political and ideological self-interest of many lawyers and judges, to deliberately adopt a pretense that judging is — or should be — a mechanical activity that can be reduced to simply looking up and following already existing rules that have already been written down somewhere, and that to apply those rules requires nothing more than knowing how to read them properly. That idea can be summed up in two eight-letter words, one of which is nonsense, and those who knowingly propagate it are just, well, dare I say it, deplorable.

My Paper “The Fisher Effect and the Financial Crisis of 2008” Is Now Available

Back in 2009 or 2010, I became intrigued by what seemed to me to be a consistent correlation between the tendency of the stock market to rise on news of monetary easing and potentially inflationary news. I suspected that there might be such a correlation because of my work on the Great Depression inspired by Earl Thompson, from whom I first learned about a monetary theory of the Great Depression very different from Friedman’s monetary theory expounded in his Monetary History of the United States. Thompson’s theory focused on disturbances in the gold market associated with the demonetization of gold during World War I and the attempt to restore the gold standard in the 1920s, which, by increasing the world demand for gold, was the direct cause of the deflation that led to the Great Depression.

I later came to discover that Ralph Hawtrey had already propounded Thompson’s theory in the 1920s almost a decade before the Great Depression started, and my friend and fellow student of Thompson, Ron Batchelder made a similar discovery about Gustave Cassel. Our shared recognition that Thompson’s seemingly original theory of the Great Depression had been anticipated by Hawtrey and Cassel led us to collaborate on our paper about Hawtrey and Cassel. As I began to see parallels between the financial fragility of the 1920s and the financial fragility that followed the housing bubble, I began to suspect that deflationary tendencies were also critical to the financial crisis of 2008.

So I began following daily fluctuations in the principal market estimate of expected inflation: the breakeven TIPS spread. I pretty quickly became persuaded that the correlation was powerful and meaningful, and I then collected data about TIPS spreads from 2003, when the Treasury began offering TIPS securities, to see if the correlation between expected inflation and asset prices had been present 2003 or was a more recent phenomenon.

My hunch was that the correlation would not be observed under normal macroeconomic conditions, because it is only when the expected yield from holding money approaches or exceeds the yield from holding real assets that an increase in expected inflation, by reducing the expected yield from holding money, would induce people to switch from holding money to holding assets, thereby driving up the value of assets.

And that’s what the data showed; the correlation between expected inflation and asset prices only emerged after in 2008 in the period after a recession started at the end of 2007, even before the start of the financial crisis exactly 10 years in September 2008. When I wrote up the paper and posted it (“The Fisher Effect Under Deflationary Expectations“), Scott Sumner, who had encouraged me to write up the results after I told him about my results, wrote a blogpost about the paper. Paul Krugman picked up on Scott’s post and wrote about it on his blog, generating a lot of interest in the paper.

Although I was confident that the data showed a strong correlation between inflation and stock prices after 2008, I was less confident that I had done the econometrics right, so I didn’t try to publish the original 2011 version of the paper. With Scott’s encouragement, I have continued to collected more data as time passed, confirming that the correlation remained even after the start of a recovery while short-term interest rates remained at or near the zero lower bound. The Mercatus Center whose Program on Monetary Policy is directed by Scott has just released the new version of the paper as a Working Paper. The paper can also be downloaded from SSRN.

Aside from longer time span covered, the new version of the paper has refined and extended the theoretical account for when and why a correlation between expected inflation and asset prices is likely be observed and when and why it is unlikely to be observed. I have also done some additional econometric testing beyond the basic ordinary least square (OLS) regression estimates originally presented, and explained why I think it is unlikely that more sophisticated econometric techniques such as an error-correction model would generate more reliable results than those generated by simple OLS regrissions. Perhaps in further work, I will attempt to actually construct an explicit error-correction model and compare the results using OLS and an error-correction model.

Here is the abstract of the new version of the paper.

This paper uses the Fisher equation relating the nominal interest rate to the real interest rate and
expected inflation to provide a deeper explanation of the financial crisis of 2008 and the subsequent recovery than attributing it to the bursting of the housing-price bubble. The paper interprets the Fisher equation as an equilibrium condition in which expected returns from holding real assets and cash are equalized. When inflation expectations decline, the return to holding cash rises relative to holding real assets. If nominal interest rates are above the zero lower bound, equilibrium is easily restored by adjustments in nominal interest rates and asset prices. But at the zero lower bound, nominal interest rates cannot fall, forcing the entire adjustment onto falling asset prices, thereby raising the expected real return from holding assets. Such an adjustment seems to have triggered the financial crisis of 2008, when the Federal Reserve delayed reducing nominal interest rates out of a misplaced fear of inflation in the summer of 2008 when the economy was already contracting rapidly. Using stock market price data and inflation-adjusted US Treasury securities data, the paper finds that, unlike the 2003–2007 period, when stock prices were uncorrelated with expected inflation, from 2008 through at least 2016, stock prices have been consistently and positively correlated with expected inflation.

Why Judge Kavanaugh Shamefully Refused to Reject Chae Chan Ping v. United States (AKA Chinese Exclusion Case) as Precedent

Senator Kamala Harris asked Judge Kavanaugh if he considered the infamous Supreme Court decision in Chae Chan Ping v. United States (AKA Chinese Exclusion Case) as a valid precedent. Judge Kavanaugh disgraced himself by refusing to say that the case was in error from the moment it was rendered, no less, if not even more so, than was Plessy v. Ferguson overturned by the Supreme Court in Brown v. Board of Education.

The question is why would he not want to distance himself from a racist abomination of a decision that remains a stain on the Supreme Court to this day? After all, Judge Kavanaugh, in his fastidiousness, kept explaining to Senators that he wouldn’t want to get within three zipcodes of a political controversy. But, although obviously uncomfortable in his refusal to do so, he could not bring himself to say that Chae Chan Ping belongs in the garbage can along with Dred Scott and Plessy.

Here’s the reason. Chae Chan Ping is still an important precedent that has been and continues to be relied on by the government and the Supreme Court to uphold the power of President to keep out foreigners whenever he wants to.

In a post in March 2017, I quoted from Justice Marshall’s magnificent dissent in Kleindienst v. Mandel, a horrible decision in which the Court upheld the exclusion of a Marxist scholar from the United States based on, among other precedents, the execrable Chae Chan Ping decision. Here is a brief excerpt from Justice Marshall’s opinion, which I discuss at greater length in my 2017 post.

The heart of appellants’ position in this case . . . is that the Government’s power is distinctively broad and unreviewable because “the regulation in question is directed at the admission of aliens.” Brief for Appellants 33. Thus, in the appellants’ view, this case is no different from a long line of cases holding that the power to exclude aliens is left exclusively to the “political” branches of Government, Congress, and the Executive.

These cases are not the strongest precedents in the United States Reports, and the majority’s baroque approach reveals its reluctance to rely on them completely. They include such milestones as The Chinese Exclusion Case, 130 U.S. 581 (1889), and Fong Yue Ting v. United States, 149 U.S. 698 (1893), in which this Court upheld the Government’s power to exclude and expel Chinese aliens from our midst.

Kleindienst has become the main modern precedent affirming the nearly unchecked power of the government to arbitrarily exclude foreigners from entering the United States on whatever whim the government chooses to act upon, so long as it can come up with an excuse, however pretextual, that the exclusion has a national security rationale.

And because Judge Kavanaugh will be a solid vote in favor of affirming the kind of monumentally dishonest decision made by Justice Roberts in the Muslim Travel Ban case, he can’t disavow Chae Chan Ping without undermining Kleindienst which, in turn, would undermine the Muslim Travel Ban. 

Aside from being a great coach of his daughter’s basketball team, and superb carpool driver, I’m sure Judge Kavanaugh appreciates and understands how I feel.

Whatta guy.

Hu McCulloch Figures out (More or Less) the Great Depression

Last week Houston McCulloch, one of the leading monetary economists of my generation, posted an  insightful and thoughtful discussion of the causes of the Great Depression with which I largely, though not entirely, agree. Although Scott Sumner has already commented on Hu’s discussion, I also wanted to weigh in with some of my comments. Here is how McCulloch sets up his discussion.

Understanding what caused the Great Depression of 1929-39 and why it persisted so long has been fairly characterized by Ben Bernanke as the “Holy Grail of Macroeconomics.” The fear that the financial crisis of 2008 would lead to a similar Depression induced the Fed to use its emergency powers to bail out failing firms and to more than quadruple the monetary base, while Congress authorized additional bailouts and doubled the national debt. Could the Great Recession have taken a similar turn had these extreme measures not been taken?

Economists have often blamed the Depression on U.S. monetary policy or financial institutions.  Friedman and Schwartz (1963) famously argued that a spontaneous wave of runs against fragile fractional reserve banks led to a rise in the currency/deposit ratio. The Fed failed to offset the resulting fall in the money multiplier with base expansion, leading to a disastrous 24% deflation from 1929 to 1933. Through the short-run Phillips curve effect (Friedman 1968), this in turn led to a surge in unemployment to 22.5% by 1932.

The Debt-Deflation theory of Irving Fisher, and later Ben Bernanke (1995), takes the deflation as given, and blames the severity of the disruption on the massive bankruptcies that were caused by the increased burden of nominal indebtedness.  Murray Rothbard (1963) uses the “Austrian” business cycle theory of Ludwig von Mises and F.A. Hayek to blame the downturn on excessive domestic credit expansion by the Fed during the 1920s that disturbed the intertemporal structure of production (cf. McCulloch 2014).

My own view, after pondering the problem for many decades, is that indeed the Depression was monetary in origin, but that the ultimate blame lies not with U.S. domestic monetary and financial policy during the 1920s and 30s. Rather, the massive deflation was an inevitable consequence of Europe’s departure from the gold standard during World War I —  and its bungled and abrupt attempt to return to gold in the late 1920s.

I agree with every word of this introductory passage, so let’s continue.

In brief, the departure of the European belligerents from gold in 1914 massively reduced the global demand for gold, leading to the inflation of prices in terms of gold — and, therefore, in terms of currencies like the U.S. dollar which were convertible to gold at a fixed parity. After the war, Europe initially postponed its return to gold, leading to a plateau of high prices during the 1920s that came to be perceived as the new normal. In the late 1920s, there was a scramble to return to the pre-war gold standard, with the inevitable consequence that commodity prices — in terms of gold, and therefore in terms of the dollar — had to return to something approaching their 1914 level.

The deflation was thus inevitable, but was made much more harmful by its postponement and then abruptness. In retrospect, the UK could have returned to its pre-war parity with far less pain by emulating the U.S. post-Civil War policy of freezing the monetary base until the price level gradually fell to its pre-war level. France should not have over-devalued the franc, and then should have monetized its gold influx rather than acting as a global gold sink. Gold reserve ratios were unnecessarily high, especially in France.

Here is where I start to quibble a bit with Hu, mainly about the importance of Britain’s 1925 resumption of convertibility at the prewar parity with the dollar. Largely owing to Keynes’s essay “The Economic Consequences of Mr. Churchill,” in which Keynes berated Churchill for agreeing to the demands of the City and to the advice of the British Treasury advisers (including Ralph Hawtrey), on whom he relied despite Keynes’s attempt to convince him otherwise, to quickly resume gold convertibility at the prewar dollar parity, warning of the devastating effects of the subsequent deflation on British industry and employment, much greater significance has been attributed to the resumption of convertibility than it actually had on the subsequent course of events. Keynes’s analysis of the deflationary effect of the resumption was largely correct, but the effect turned out to be milder than he anticipated. Britain had already undergone a severe deflation in the early 1920s largely as a result of the American deflation. Thus by 1925, Britain had already undergone nearly 5 years of continuous deflation that brought the foreign exchange value of sterling to within 10 percent of the prewar dollar parity. The remaining deflation required to enable sterling to appreciate another 10 percent was not trivial, but by 1925 most of the deflationary pain had already been absorbed. Britain was able to sustain further mild deflation for the next four years till mid-1929 even as the British economy grew and unemployment declined gradually. The myth that Britain was mired in a continuous depression after the resumption of convertibility in 1925 has no basis in the evidence. Certainly, a faster recovery would have been desirable, and Hawtrey consistently criticized the Bank of England for keeping Bank Rate at 5% even with deflation in the 1-2% range.

The US Federal Reserve was somewhat accommodative in the 1925-28 period, but could have easily been even more accommodative. As McCulloch correctly notes it was really France, which undervalued the franc when it restored convertibility in 1928, and began accumulating gold in record quantities that became the primary destabilizing force in the world economy. Britain was largely an innocent bystander.

However, given that the U.S. had a fixed exchange rate relative to gold and no control over Europe’s misguided policies, it was stuck with importing the global gold deflation — regardless of its own domestic monetary policies. The debt/deflation problem undoubtedly aggravated the Depression and led to bank failures, which in turn increased the currency/deposit ratio and compounded the situation. However, a substantial portion of the fall in the U.S. nominal money stock was to be expected as a result of the inevitable deflation — and therefore was the product, rather than the primary cause, of the deflation. The anti-competitive policies of the Hoover years and FDR’s New Deal (Rothbard 1963, Ohanian 2009) surely aggravated and prolonged the Depression, but were not the ultimate cause.

Actually, the Fed, holding 40% of the world’s gold reserves in 1929, could have eased pressure on the world gold market by allowing an efflux of gold to accommodate the French demand for gold. However, instead of taking an accommodative stance, the Fed, seized by dread of stock-market speculation, kept increasing short-term interest rates, thereby attracting gold into the United States instead of allowing gold to flow out, increasing pressure on the world gold market and triggering the latent deflationary forces that until mid-1929 had been kept at bay. Anti-competitive policies under Hoover and under FDR were certainly not helpful, but those policies, as McCulloch recognizes, did not cause the collapse of output between 1929 and 1933.

Contemporary economists Ralph Hawtrey, Charles Rist, and Gustav Cassel warned throughout the 1920s that substantial deflation, in terms of gold and therefore the dollar, would be required to sustain a return to anything like the 1914 gold standard.[1]  In 1928, Cassel actually predicted that a global depression was imminent:

The post-War superfluity of gold is, however, of an entirely temporary character, and the great problem is how to meet the growing scarcity of gold which threatens the world both from increased demand and from diminished supply. We must solve this problem by a systematic restriction of the monetary demand for gold. Only if we succeed in doing this can we hope to prevent a permanent fall in the general price level and a prolonged and world-wide depression which would inevitably be connected with such a fall in prices [as quoted by Johnson (1997, p. 55)].

As early as 1919 both Hawtrey and Cassel had warned that a global depression would follow an attempt to restore the gold standard as it existed before World War I. To avoid such a deflation it was necessary to limit the increase in the monetary demand for gold. Hawtrey and Cassel therefore proposed shifting to a gold exchange standard in which gold coinage would not be restored and central banks would hold non-gold foreign exchange reserves rather than gold bullion. The 1922 Genoa Resolutions were largely inspired by the analysis of Hawtrey and Cassel, and those resolutions were largely complied with until France began its insane gold accumulation policy in 1928 just as the Fed began tightening monetary policy to suppress stock-market speculation, thereby triggering, more or less inadvertently, an almost equally massive inflow of gold into the US. (On Hawtrey and Cassel, see my paper with Ron Batchelder.)

McCulloch has a very interesting discussion of the role of the gold standard as a tool of war finance, which reminds me of Earl Thompson’s take on the gold standard, (“Gold Standard: Causes and Consequences”) that Earl contributed to a volume I edited, Business Cycles and Depressions: An Encyclopedia. To keep this post from growing inordinately long, and because it’s somewhat tangential to McCulloch’s larger theme, I won’t comment on that part of McCulloch’s discussion.

The Gold Exchange Standard

After the war, in order to stay on gold at $20.67 an ounce, with Europe off gold, the U.S. had to undo its post-1917 inflation. The Fed achieved this by raising the discount rate on War Bonds, beginning in late 1919, inducing banks to repay their corresponding loans. The result was a sharp 16% fall in the price level from 1920 to 1922. Unemployment rose from 3.0% in 1919 to 8.7% in 1921. However, nominal wages fell quickly, and unemployment was back to 4.8% by 1923, where it remained until 1929.[3]

The 1920-22 deflation thus brought the U.S. price level into equilibrium, but only in a world with Europe still off gold. Restoring the full 1914 gold standard would have required going back to approximately the 1914 value of gold in terms of commodities, and therefore the 1914 U.S. price level, after perhaps extrapolating for a continuation of the 1900-1914 “gold inflation.”

This is basically right except that I don’t think it makes sense to refer to the US price level as being in equilibrium in 1922. Holding 40% of the world’s monetary gold reserves, the US was in a position to determine the value of gold at whatever level it wanted. To call the particular level at which the US decided to stabilize the value of gold in 1922 an equilibrium is not based on any clear definition of equilibrium that I can identify.

However, the European countries did not seriously try to get back on gold until the second half of the 1920s. The Genoa Conference of 1922 recognized that prices were too high for a full gold standard, but instead tried to put off the necessary deflation with an unrealistic “Gold Exchange Standard.” Under that system, only the “gold center” countries, the U.S. and UK, would hold actual gold reserves, while other central banks would be encouraged to hold dollar or sterling reserves, which in turn would only be fractionally backed by gold. The Gold Exchange Standard sounded good on paper, but unrealistically assumed that the rest of the world would permanently kowtow to the financial supremacy of New York and London.

There is an argument to be made that the Genoa Resolutions were unrealistic in the sense that they assumed that countries going back on the gold standard would be willing to forego the holding of gold reserves to a greater extent than they were willing to. But to a large extent, this was the result of systematically incorrect ideas about how the gold standard worked before World War I and how the system could work after World War I, not of any inherent or necessary properties of the gold standard itself. Nor was the assumption that the rest of the world would permanently kowtow to the financial supremacy of New York and London all that unrealistic when considered in the light of how readily, before World War I, the rest of the world kowtowed to the financial supremacy of London.

In 1926, under Raymond Poincaré, France stabilized the franc after a 5:1 devaluation. However, it overdid the devaluation, leaving the franc undervalued by about 25%, according to The Economist (Johnson 1997, p. 131). Normally, under the specie flow mechanism, this would have led to a rapid accumulation of international reserves accompanied by monetary expansion and inflation, until the price level caught up with purchasing power parity. But instead, the Banque de France sterilized the reserve influx by reducing its holdings of government and commercial credit, so that inflation did not automatically stop the reserve inflow. Furthermore, it often cashed dollar and sterling reserves for gold, again contrary to the Gold Exchange Standard.  The Banking Law of 1928 made the new exchange rate, as well as the gold-only policy, official. By 1932, French gold reserves were 80% of currency and sight deposits (Irwin 2012), and France had acquired 28.4% of world gold reserves — even though it accounted for only 6.6% of world manufacturing output (Johnson 1997, p. 194). This “French Gold Sink” created even more deflationary pressure on gold, and therefore dollar prices, than would otherwise have been expected.

Here McCulloch is unintentionally displaying some of the systematically incorrect ideas about how the gold standard worked that I referred to above. McCulloch is correct that the franc was substantially undervalued when France restored convertibility in 1928. But under the gold standard, the French price level would automatically adjust to the world price level regardless of what happened to the French money supply. However, the Bank of France, partly because it was cashing in the rapidly accumulating foreign exchange reserves for gold as French exports were rising and its imports falling given the low internal French price level, and partly because it was legally barred from increasing the supply of banknotes by open-market operations, was accumulating gold both actively and passively. With no mechanism for increasing the quantity of banknotes in France, a balance of payment of surplus was the only mechanism by which an excess demand for money could be accommodated. It was not an inflow of gold that was being sterilized (sterilization being a misnomer reflecting a confusion about the direction of causality) it was the lack of any domestic mechanism for increasing the quantity of banknotes that caused an inflow of gold. Importing gold was the only means by which an excess domestic demand for banknotes could be satisfied.

The Second Post-War Deflation

By 1931, French gold withdrawals forced Germany to adopt exchange controls, and Britain to give up convertibility altogether. However, these countries did not then disgorge their remaining gold, but held onto it in the hopes of one day restoring free convertibility. Meanwhile, after having been burned by the Bank of England’s suspension, the “Gold Bloc” countries — Belgium, Netherlands and Switzerland — also began amassing gold reserves in earnest, raising their share of world gold reserves from 4.2% in June 1930 to 11.1% two years later (Johnson 1997, p. 194). Despite the dollar’s relatively strong position, the Fed also contributed to the problem by raising its gold coverage ratio to over 75% by 1930, well in excess of the 40% required by law (Irwin 2012, Fig. 5).

The result was a second post-war deflation as the value of gold, and therefore of the dollar, in terms of commodities, abruptly caught up with the greatly increased global demand for gold. The U.S. price level fell 24.0% between 1929 and 1933, with deflation averaging 6.6% per year for 4 years in a row. Unemployment shot up to 22.5% by 1932.

By 1933, the U.S. price level was still well above its 1914 level. However, if the “gold inflation” of 1900-1914 is extrapolated to 1933, as in Figure 3, the trend comes out to almost the 1933 price level. It therefore appears that the U.S. price level, if not its unemployment rate, was finally near its equilibrium under a global gold standard with the dollar at $20.67 per ounce, and that further deflation was probably unnecessary.[4]

Once again McCulloch posits an equilibrium price level under a global gold standard. The mistake is in assuming that there is a fixed monetary demand for gold, which is an assumption completely without foundation. The monetary demand for gold is not fixed. The greater the monetary demand for gold the higher the equilibrium real value of gold and the lower the price level in terms of gold. The equilibrium price level is a function of the monetary demand for gold.

The 1929-33 deflation was much more destructive than the 1920-22 deflation, in large part because it followed a 7-year “plateau” of relatively stable prices that lulled the credit and labor markets into thinking that the higher price level was the new norm — and that gave borrowers time to accumulate substantial nominal debt. In 1919-1920, on the other hand, the newly elevated price level seemed abnormally high and likely to come back down in the near future, as it had after 1812 and 1865.

This is correct, and I fully agree.

How It Could Have been Different

In retrospect, the UK could have successfully gotten itself back on gold with far less disruption simply by emulating the U.S. post-Civil War policy of freezing the monetary base at its war-end level, and then letting the economy grow into the money supply with a gradual deflation. This might have taken 14 years, as in the U.S. between 1865-79, or even longer, but it would have been superior to the economic, social, and political turmoil that the UK experienced. After the pound rose to its pre-war parity of $4.86, the BOE could have begun gradually buying gold reserves with new liabilities and even redeeming those liabilities on demand for gold, subject to reserve availability. Once reserves reached say 20% of its liabilities, it could have started to extend domestic credit to the government and the private sector through the banks, while still maintaining convertibility. Gold coins could even have been circulated, as demanded.

Again, I reiterate that, although the UK resumption was more painful for Britain than it need have been, the resumption had little destabilizing effect on the international economy. The UK did not have a destabilizing effect on the world economy until the September 1931 crisis that caused Britain to leave the gold standard.

If the UK and other countries had all simply devalued in proportion to their domestic price levels at the end of the war, they could have returned to gold quicker, and with less deflation. However, given that a country’s real demand for money — and therefore its demand for real gold reserves — depends only on the real size of the economy and its net gold reserve ratio, such policies would not have reduced the ultimate global demand for gold or lessened the postwar deflation in countries that remained on gold at a fixed parity.

This is an important point. Devaluation was a way of avoiding an overvalued currency and the relative deflation that a single country needed to undergo. But the main problem facing the world in restoring the gold standard was not the relative deflation of countries with overvalued currencies but the absolute deflation associated with an increased world demand for gold across all countries. Indeed, it was France, the country that did devalue that was the greatest source of increased demand for gold owing to its internal monetary policies based on a perverse gold standard ideology.

In fact, the problem was not that gold was “undervalued” (as Johnson puts it) or that there was a “shortage” of gold (as per Cassel and others), but that the price level in terms of gold, and therefore dollars, was simply unsustainably high given Europe’s determination to return to gold. In any event, it was inconceivable that the U.S. would have devalued in 1922, since it had plenty of gold, had already corrected its price level to the world situation with the 1920-22 deflation, and did not have the excuse of a banking crisis as in 1933.

I think that this is totally right. It was not the undervaluation of individual currencies that was the problem, it was the increase in the demand for gold associated with the simultaneous return of many countries to the gold standard. It is also a mistake to confuse Cassel’s discussion of gold shortage, which he viewed as a long-term problem, with the increase in gold demand associated with returning to the gold standard which was the cause of sudden deflation starting in 1929 as a result of the huge increase in gold demand by the Bank of France, a phenomenon that McCulloch mentions early on in his discussion but does not refer to again.


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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