Posts Tagged 'Paul Volcker'

Welcome to Uneasy Money, aka the Hawtreyblog

UPDATE: I’m re-upping my introductory blog post, which I posted ten years ago toady. It’s been a great run for me, and I hope for many of you, whose interest and responses have motivated to keep it going. So thanks to all of you who have read and responded to my posts. I’m adding a few retrospective comments and making some slight revisions along the way. In addition to new posts, I will be re-upping some of my old posts that still seem to have relevance to the current state of our world.

What the world needs now, with apologies to the great Burt Bachrach and Hal David, is, well, another blog.  But inspired by the great Ralph Hawtrey and the near great Scott Sumner, I decided — just in time for Scott’s return to active blogging — to raise another voice on behalf of a monetary policy actively seeking to promote recovery from what I call the Little Depression, instead of the monetary policy we have now:  waiting for recovery to arrive on its own.  Just like the Great Depression, our Little Depression was caused mainly by overly tight money in an environment of over-indebtedness and financial fragility, and was then allowed to deepen and become entrenched by monetary authorities unwilling to commit themselves to a monetary expansion aimed at raising prices enough to make business expansion profitable.

That was the lesson of the Great Depression.  Unfortunately that lesson, for reasons too complicated to go into now, was never properly understood, because neither Keynesians nor Monetarists had a fully coherent understanding of what happened in the Great Depression.  Although Ralph Hawtrey — called by none other than Keynes “his grandparent in the paths of errancy,” and an early, but unacknowledged, progenitor of Chicago School Monetarism — had such an understanding,  Hawtrey’s contributions were overshadowed and largely ignored, because of often irrelevant and misguided polemics between Keynesians and Monetarists and Austrians.  One of my goals for this blog is to bring to light the many insights of this perhaps most underrated — though competition for that title is pretty stiff — economist of the twentieth century.  I have discussed Hawtrey’s contributions in my book on free banking and in a paper published years ago in Encounter and available here.  Patrick Deutscher has written a biography of Hawtrey.

What deters businesses from expanding output and employment in a depression is lack of demand; they fear that if they do expand, they won’t be able to sell the added output at prices high enough to cover their costs, winding up with redundant workers and having to engage in costly layoffs.  Thus, an expectation of low demand tends to be self-fulfilling.  But so is an expectation of rising prices, because the additional output and employment induced by expectations of rising prices will generate the demand that will validate the initial increase in output and employment, creating a virtuous cycle of rising income, expenditure, output, and employment.

The insight that “the inactivity of all is the cause of the inactivity of each” is hardly new.  It was not the discovery of Keynes or Keynesian economics; it is the 1922 formulation of Frederick Lavington, another great, but underrated, pre-Keynesian economist in the Cambridge tradition, who, in his modesty and self-effacement, would have been shocked and embarrassed to be credited with the slightest originality for that statement.  Indeed, Lavington’s dictum might even be understood as a restatement of Say’s Law, the bugbear of Keynes and object of his most withering scorn.  Keynesian economics skillfully repackaged the well-known and long-accepted idea that when an economy is operating with idle capacity and high unemployment, any increase in output tends to be self-reinforcing and cumulative, just as, on the way down, each reduction in output is self-reinforcing and cumulative.

But at least Keynesians get the point that, in a depression or deep recession, individual incentives may not be enough to induce a healthy expansion of output and employment. Aggregate demand can be too low for an expansion to get started on its own. Even though aggregate demand is nothing but the flip side of aggregate supply (as Say’s Law teaches), if resources are idle for whatever reason, perceived effective demand is deficient, diluting incentives to increase production so much that the potential output expansion does not materialize, because expected prices are too low for businesses to want to expand. But if businesses can be induced to expand output, more than likely, they will sell it, because (as Say’s Law teaches) supply usually does create its own demand.

[Comment after 10 years: In a comment, Rowe asked why I wrote that Say’s Law teaches that supply “usually” creates its own demand. At that time, I responded that I was just using “usually” as a weasel word. But I subsequently realized (and showed in a post last year) that the standard proofs of both Walras’s Law and Say’s Law are defective for economies with incomplete forward and state-contingent markets. We actually know less than we once thought we did!] 

Keynesians mistakenly denied that, by creating price-level expectations consistent with full employment, monetary policy could induce an expansion of output even in a depression. But at least they understood that the private economy can reach an impasse with price-level expectations too low to sustain full employment. Fiscal policy may play a role in remedying a mismatch between expectations and full employment, but fiscal policy can only be as effective as monetary policy allows it to be. Unfortunately, since the downturn of December 2007, monetary policy, except possibly during QE1 and QE2, has consistently erred on the side of uneasiness.

With some unfortunate exceptions, however, few Keynesians have actually argued against monetary easing. Rather, with some honorable exceptions, it has been conservatives who, by condemning a monetary policy designed to provide incentives conducive to business expansion, have helped to hobble a recovery led by the private sector rather than the government which  they profess to want. It is not my habit to attribute ill motives or bad faith to people whom I disagree with. One of the finest compliments ever paid to F. A. Hayek was by Joseph Schumpeter in his review of The Road to Serfdom who chided Hayek for “politeness to a fault in hardly ever attributing to his opponents anything but intellectual error.” But it is a challenge to come up with a plausible explanation for right-wing opposition to monetary easing.

[Comment after 10 years: By 2011 when this post was written, right-wing bad faith had already become too obvious to ignore, but who could then have imagined where the willingness to resort to bad faith arguments without the slightest trace of compunction would lead them and lead us.] 

In condemning monetary easing, right-wing opponents claim to be following the good old conservative tradition of supporting sound money and resisting the inflationary proclivities of Democrats and liberals. But how can claims of principled opposition to inflation be taken seriously when inflation, by every measure, is at its lowest ebb since the 1950s and early 1960s? With prices today barely higher than they were three years ago before the crash, scare talk about currency debasement and future hyperinflation reminds me of Ralph Hawtrey’s famous remark that warnings that leaving the gold standard during the Great Depression would cause runaway inflation were like crying “fire, fire” in Noah’s flood.

The groundlessness of right-wing opposition to monetary easing becomes even plainer when one recalls the attacks on Paul Volcker during the first Reagan administration. In that episode President Reagan and Volcker, previously appointed by Jimmy Carter to replace the feckless G. William Miller as Fed Chairman, agreed to make bringing double-digit inflation under control their top priority, whatever the short-term economic and political costs. Reagan, indeed, courageously endured a sharp decline in popularity before the first signs of a recovery became visible late in the summer of 1982, too late to save Reagan and the Republicans from a drubbing in the mid-term elections, despite the drop in inflation to 3-4 percent. By early 1983, with recovery was in full swing, the Fed, having abandoned its earlier attempt to impose strict Monetarist controls on monetary expansion, allowed the monetary aggregates to grow at unusually rapid rates.

However, in 1984 (a Presidential election year) after several consecutive quarters of GDP growth at annual rates above 7 percent, the Fed, fearing a resurgence of inflation, began limiting the rate of growth in the monetary aggregates. Reagan’s secretary of the Treasury, Donald Regan, as well as a variety of outside Administration supporters like Arthur Laffer, Larry Kudlow, and the editorial page of the Wall Street Journal, began to complain bitterly that the Fed, in its preoccupation with fighting inflation, was deliberately sabotaging the recovery. The argument against the Fed’s tightening of monetary policy in 1984 was not without merit. But regardless of the wisdom of the Fed tightening in 1984 (when inflation was significantly higher than it is now), holding up the 1983-84 Reagan recovery as the model for us to follow now, while excoriating Obama and Bernanke for driving inflation all the way up to 1 percent, supposedly leading to currency debauchment and hyperinflation, is just a bit rich. What, I wonder, would Hawtrey have said about that?

In my next posting I will look a little more closely at some recent comparisons between the current non-recovery and recoveries from previous recessions, especially that of 1983-84.

Cluelessness about Strategy, Tactics and Discretion

In his op-ed in the weekend Wall Street Journal, John Taylor restates his confused opposition to what Ben Bernanke calls the policy of constrained discretion followed by the Federal Reserve during his tenure at the Fed, as vice-chairman under Alan Greenspan from 2003 to 2005 and as Chairman from 2005 to 2013. Taylor has been arguing for the Fed to adopt what he calls the “rules-based monetary policy” supposedly practiced by the Fed while Paul Volcker was chairman (at least from 1981 onwards) and for most of Alan Greenspan’s tenure until 2003 when, according to Taylor, the Fed abandoned the “rules-based monetary rule” that it had followed since 1981. In a recent post, I explained why Taylor’s description of Fed policy under Volcker was historically inaccurate and why his critique of recent Fed policy is both historically inaccurate and conceptually incoherent.

Taylor denies that his steady refrain calling for a “rules-based policy” (i.e., the implementation of some version of his beloved Taylor Rule) is intended “to chain the Fed to an algebraic formula;” he just thinks that the Fed needs “an explicit strategy for setting the instruments” of monetary policy. Now I agree that one ought not to set a policy goal without a strategy for achieving the goal, but Taylor is saying that he wants to go far beyond a strategy for achieving a policy goal; he wants a strategy for setting instruments of monetary policy, which seems like an obvious confusion between strategy and tactics, ends and means.

Instruments are the means by which a policy is implemented. Setting a policy goal can be considered a strategic decision; setting a policy instrument a tactical decision. But Taylor is saying that the Fed should have a strategy for setting the instruments with which it implements its strategic policy.  (OED, “instrument – 1. A thing used in or for performing an action: a means. . . . 5. A tool, an implement, esp. one used for delicate or scientific work.”) This is very confused.

Let’s be very specific. The Fed, for better or for worse – I think for worse — has made a strategic decision to set a 2% inflation target. Taylor does not say whether he supports the 2% target; his criticism is that the Fed is not setting the instrument – the Fed Funds rate – that it uses to hit the 2% target in accordance with the Taylor rule. He regards the failure to set the Fed Funds rate in accordance with the Taylor rule as a departure from a rules-based policy. But the Fed has continually undershot its 2% inflation target for the past three years. So the question naturally arises: if the Fed had raised the Fed Funds rate to the level prescribed by the Taylor rule, would the Fed have succeeded in hitting its inflation target? If Taylor thinks that a higher Fed Funds rate than has prevailed since 2012 would have led to higher inflation than we experienced, then there is something very wrong with the Taylor rule, because, under the Taylor rule, the Fed Funds rate is positively related to the difference between the actual inflation rate and the target rate. If a Fed Funds rate higher than the rate set for the past three years would have led, as the Taylor rule implies, to lower inflation than we experienced, following the Taylor rule would have meant disregarding the Fed’s own inflation target. How is that consistent with a rules-based policy?

It is worth noting that the practice of defining a rule in terms of a policy instrument rather than in terms of a policy goal did not originate with John Taylor; it goes back to Milton Friedman who somehow convinced a generation of monetary economists that the optimal policy for the Fed would be to target the rate of growth of the money supply at a k-percent annual rate. I have devoted other posts to explaining the absurdity of Friedman’s rule, but the point that I want to emphasize now is that Friedman, for complicated reasons which I think (but am not sure) that I understand, convinced himself that (classical) liberal principles require that governments and government agencies exercise their powers only in accordance with explicit and general rules that preclude or minimize the exercise of discretion by the relevant authorities.

Friedman’s confusions about his k-percent rule were deep and comprehensive, as a quick perusal of Friedman’s chapter 3 in Capitalism and Freedom, “The Control of Money,” amply demonstrates. In practice, the historical gold standard was a mixture of gold coins and privately issued banknotes and deposits as well as government banknotes that did not function particularly well, requiring frequent and significant government intervention. Unlike, a pure gold currency in which, given the high cost of extracting gold from the ground, the quantity of gold money would change only gradually, a mixed system of gold coin and banknotes and deposits was subject to large and destabilizing fluctuations in quantity. So, in Friedman’s estimation, the liberal solution was to design a monetary system such that the quantity of money would expand at a slow and steady rate, providing the best of all possible worlds: the stability of a pure gold standard and the minimal resource cost of a paper currency. In making this argument, as I have shown in an earlier post, Friedman displayed a basic misunderstanding of what constituted the gold standard as it was historically practiced, especially during its heyday from about 1880 to the outbreak of World War I, believing that the crucial characteristic of the gold standard was the limitation that it imposed on the quantity of money, when in fact the key characteristic of the gold standard is that it forces the value of money – regardless of its material content — to be equal to the value of a specified quantity of gold. (This misunderstanding – the focus on control of the quantity of money as the key task of monetary policy — led to Friedman’s policy instrumentalism – i.e., setting a policy rule in terms of the quantity of money.)

Because Friedman wanted to convince his friends in the Mont Pelerin Society (his egregious paper “Real and Pseudo Gold Standards” was originally presented at a meeting of the Mont Pelerin Society), who largely favored the gold standard, that (classical) liberal principles did not necessarily entail restoration of the gold standard, he emphasized a distinction between what he called the objectives of monetary policy and the instruments of monetary policy. In fact, in the classical discussion of the issue by Friedman’s teacher at Chicago, Henry Simons, in an essay called “Rules versus Authorities in Monetary Policy,” Simons also tried to formulate a rule that would be entirely automatic, operating insofar as possible in a mechanical fashion, even considering the option of stabilizing the quantity of money. But Simons correctly understood that any operational definition of money is necessarily arbitrary, meaning that there will always be a bright line between what is money under the definition and what is not money, even though the practical difference between what is on one side of the line and what is on the other will be slight. Thus, the existence of near-moneys would make control of any monetary aggregate a futile exercise. Simons therefore defined a monetary rule in terms of an objective of monetary policy: stabilizing the price level. Friedman did not want to settle for such a rule, because he understood that stabilizing the price level has its own ambiguities, there being many ways to measure the price level as well as theoretical problems in constructing index numbers (the composition and weights assigned to components of the index being subject to constant change) that make any price index inexact. Given Friedman’s objective — demonstrating that there is a preferable alternative to the gold standard evaluated in terms of (classical) liberal principles – a price-level rule lacked the automatism that Friedman felt was necessary to trump the gold standard as a monetary rule.

Friedman therefore made his case for a monetary rule in terms of the quantity of money, ignoring Simons powerful arguments against trying to control the quantity of money, stating the rule in general terms and treating the selection of an operational definition of money as a mere detail. Here is how Friedman put it:

If a rule is to be legislated, what rule should it be? The rule that has most frequently been suggested by people of a generally liberal persuasion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of a rule [my emphasis]. It is the wrong kind of a rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway.

As an aside, I note that Friedman provided no explanation of why such a rule would disperse responsibilities. Who besides the monetary authority did Friedman think would have responsibility for controlling the price level under such a rule? Whether such a rule would give the monetary authorities “too much leeway” is of course an entirely different question.

There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities. (p. 53)

Friedman continues:

In the present state of our knowledge, it seems to me desirable to state the rule in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. I would specify that the Reserve System shall see to it [Friedman’s being really specific there, isn’t he?] that the total stock of money so defined rises month by month, and indeed, so far as possible day by day, at an annual rate of X per cent, where X is some number between 3 and 5. (p. 54)

Friedman, of course, deliberately ignored, or, more likely, simply did not understand, that the quantity of deposits created by the banking system, under whatever definition, is no more under the control of the Fed than the price level. So the whole premise of Friedman’s money supply rule – that it was formulated in terms of an instrument under the immediate control of the monetary authority — was based on the fallacy that quantity of money is an instrument that the monetary authority is able to control at will.

I therefore note, as a further aside, that in his latest Wall Street Journal op-ed, Taylor responded to Bernanke’s observation that the Taylor rule becomes inoperative when the rule implies an interest-rate target below zero. Taylor disagrees:

The zero bound is not a new problem. Policy rule design research took that into account decades ago. The default was to move to a stable money growth regime not to massive asset purchases.

Taylor may regard the stable money growth regime as an acceptable default rule when the Taylor rule is sidelined at the zero lower bound. But if so, he is caught in a trap of his own making, because, whether he admits it or not, the quantity of money, unlike the Fed Funds rate, is not an instrument under the direct control of the Fed. If Taylor rejects an inflation target as a monetary rule, because it grants too much discretion to the monetary authority, then he must also reject a stable money growth rule, because it allows at least as much discretion as does an inflation target. Indeed, if the past 35 years have shown us anything it is that the Fed has much more control over the price level and the rate of inflation than it has over the quantity of money, however defined.

This post is already too long, but I think that it’s important to say something about discretion, which was such a bugaboo for Friedman, and remains one for Taylor. But the concept of discretion is not as simple as it is often made out to be, especially by Friedman and Taylor, and if you are careful to pay attention to what the word means in ordinary usage, you will see that discretion does not necessarily, or usually, refer to an unchecked authority to act as one pleases. Rather it suggests that a certain authority to make a decision is being granted to a person or an official, but the decision is to be made in light of certain criteria or principles that, while not fully explicit, still inform and constrain the decision.

The best analysis of what is meant by discretion that I know of is by Ronald Dworkin in his classic essay “Is Law a System of Rules?” Dworkin discusses the meaning of discretion in the context of a judge deciding a “hard case,” a case in which conflicting rules of law seem to be applicable, or a case in which none of the relevant rules seems to fit the facts of the case. Such a judge is said to exercise discretion, because his decision is not straightforwardly determined by the existing set of legal rules. Legal positivists, against whom Dworkin was arguing, would say that the judge is able, and called upon, to exercise his discretion in deciding the case, meaning, that by deciding the case, the judge is simply imposing his will. It is something like the positivist view that underlies Friedman’s intolerance for discretion.

Countering the positivist view, Dworkin considers the example of a sergeant ordered by his lieutenant to take his five most experienced soldiers on patrol, and reflects on how to interpret an observer’s statement about the orders: “the orders left the sergeant a great deal of discretion.” It is clear that, in carrying out his orders, the sergeant is called upon to exercise his judgment, because he is not given a metric for measuring the experience of his soldiers. But that does not mean that when he chooses five soldiers to go on patrol, he is engaging in an exercise of will. The decision can be carried out with good judgment or with bad judgment, but it is an exercise of judgment, not will, just as a judge, in deciding a hard case, is exercising his judgment, on a more sophisticated level to be sure than the sergeant choosing soldiers, not just indulging his preferences.

If the Fed is committed to an inflation target, then, by choosing a setting for its instrumental target, the Fed Funds rate, the Fed is exercising judgment in light of its policy goals. That exercise of judgment in pursuit of a policy goal is very different from the arbitrary behavior of the Fed in the 1970s when its decisions were taken with no clear price-level or inflation target and with no clear responsibility for hitting the target.

Ben Bernanke has described the monetary regime in which the Fed’s decisions are governed by an explicit inflation target and a subordinate commitment to full employment as one of “constrained discretion.” When using this term, Taylor always encloses it in quotations markets, apparently to suggest that the term is an oxymoron. But that is yet another mistake; “constrained discretion” is no oxymoron. Indeed, it is a pleonasm, the exercise of discretion usually being understood to mean not an unconstrained exercise of will, but an exercise of judgment in the light of relevant goals, policies, and principles.

PS I apologize for not having responded to comments recently. I will try to catch up later this week.

Watch out for that Fed Reaction Function

Scott Sumner had a terrific post today. The title said it all, but the rest of it wasn’t bad either.

The stock market wants fast economic growth, and they want the Fed to think economic growth is slow

Eureka!  Today we found out that NGDP (which the Fed looks at) grew at a 2.19% rate over the past 6 months and the more accurate NGDI grew by 5.06%.

Stocks soared on the news.

And shhhh!  Don’t anyone tell the Fed about NGDI!

Scott hit it right on the nose with that one.

It reminded me of something, so I went an looked it up in a book I happen to have at home.

Here’s what it says about Fed policy coming out of the 1981-82 recession.

The renewed stringency forced interest rates to rise slightly while driving the dollare ever higher and commodities prices ever lower. Yet the recovery, once under way, was too powerful to be slowed down perceptibly by the monetary pressure. . . .

The recovery continued in the first half of 1984. But the amazing strength of the recovery pulled the growth of M-1 above its targets, reviving fears that the Fed would have to tighten. Instead of being welcomed, each bit of favorable economic news – strong growth in real GNP, reduced unemployment, higher factory orders – was greeted with fear and trepidation in the financial markets, because such reports were viewed as portents of future tightening by the Fed. Those fears generated continuing increases in interest rates, appreciation of the dollar, and falling commodities prices. In the summer of 1984, monetary stringency and fears that the Fed would clamp down even more tightly to bring the growth of M-1 back within its targets were threatening to produce a credit crunch and abort the recovery.

With interest rates and the dollar’s exchange rate again starting to rise rapidly, and with commodity prices losing the modest gains they had made in the previous year, the recovery was indeed threatened. In late July of 1984, two years after the Fed had given up its earlier effort to meet its monetary targets, the conditions for a credit crunch, if not a full scale panic, were again developing. The most widely reported monetary aggregate, M-1, was above the upper limit of the Fed’s growth target, and economic growth in the second quarter of 1984 was reported to have been an unexpectedly strong 7.5%. Commodities prices were practically in free fall and the dollar was soaring.

Once again, however, a timely intervention by Mr. Volcker calmed the markets and put to rest fears that the Fed would strive to keep monetary growth within the announced target ranges. Appearing before Congress, he announced that he expected inflation to remain low [around 4%!!!] and that the Fed would maintain its policy without seeking any further tightening to bring monetary growth within the target range. This assurance stopped, at least for a brief spell, the dollar’s rise in foreign exchange markets and permitted a slight rebound in commodities prices. Mr. Volcker’s assurance that monetary policy would not be tightened encouraged the public to stop trying to build up precautionary balances. As a consequence, M-1 growth leveled off even as interest rates fell back somewhat.

All the while Monetarist were loudly protesting the conduct of monetary policy. Before the Fed abandoned its attempt to target M-1, Monetarists criticized the Fed for not keeping monetary growth steady enough. For a time, they even attributed the failure of interest rates to fall as rapidly as the rate of inflation in 1981, or to fall at all in the first half of 1982, to uncertainty created by too much variability in the rate of monetary growth. Later, when the Fed abandoned, at any rate deemphasized, monetary targets, they warned that inflation would soon start to rise again. In late 1982, just as the economy was hitting bottom, Milton Friedman was predicting the return of double-digit inflation [sound familiar?] before the next election.

What book did I get that from? OK, I admit it. It’s from my book Free Banking and Monetary Reform, pp. 220-21. So we’ve been through this before. When the Fed adopts a crazy reaction function in which it won’t tolerate real growth above a certain threshold, which is what the Fed seems to have done, with the threshold at 3% or less, funny things start to happen.

How come no one is laughing?

PS I apologize again for not replying to comments lately. I am still trying to cope with my workload.


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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