I almost stopped reading

by Kurt Schuler November 28th, 2011 10:41 pm

Michael Woodford of Columbia University is acknowledged as probably the most influential academic monetary economist today. His 2003 book Interest and Prices: Foundations of a Theory of Monetary Policy is his magnum opus. It is not a book for laymen, but it is one of the handful of books over the last 40 years that everyone who participates in academic debate on monetary economics needs to have read.

When introducing his theoretical framework, Woodford writes near the bottom of page 63, "I begin by considering price-level determination in an economy in which both goods markets and financial markets are completely frictionless: markets are pefectly competitive, prices adjust continuously to clear markets, and there exist markets in which state-contingent securities of any kind may be traded."

By page 64, though, a central bank somehow becomes part of this system of perfectly competitive markets. It is a perfect example of how limiting it is to know only the present. Free banking has a history centuries long: the first free banking system began in China apparently about 995, more than 600 years before the first central bank. More than 60 countries have had free banking. And yet, Woodford does not even pause for a page to consider what a banking system would look like without a central bank.


Pay attention to demand, too

by Kurt Schuler November 24th, 2011 12:03 am

During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:

To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.

In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.


Paper bugs, or, Stupid Arguments Against Gold

by George Selgin November 10th, 2011 12:45 am

Persons familiar with my writings on monetary reform know that, far from being anyone's idea of a gold bug, and despite my conviction that those monies work best that governments govern least, I've always shied away from arguing that we ought to re-establish a gold standard. Instead, I've favored reforms aimed at preserving our existing fiat standard while eliminating the role of bureaucrats, and increasing that of competitive market forces, in regulating that standard.

I respect nonetheless those who, having given serious thought to the matter, conclude that gold remains our best hope. Alas, such people make up but a small fraction of self-described gold bugs. My standard reaction to finding myself within earshot of any of the rest is to look for a more remote and unoccupied bar stool.

But there's one thing that's guaranteed to bring out the gold bug in me, and that is ill-informed arguments against the gold standard. No, make that stupid arguments, because the ones I have in mind aren't merely ill-informed. They are ill-informed in a way that suggests that the persons who make them don't even think about what they're saying.

An example of the sorts of arguments I have in mind is this opinion piece from yesterday's New York Times, in which Eduardo Porter responds to recent pro-gold testimonials of various Republican presidential candidates and conservative talking heads. Such persons aren't exactly heavyweights when it comes to making good arguments for returning to gold. Yet in trying to show just what lightweights they really are, Mr. Porter mainly succeeds in revealing his own featherweight grasp of monetary economics and history.

For his opening salvo Mr. Porter turns to R.A. Radford's famous article on the employment of cigarettes as money in German P.O.W. camps, noting how, according to Radford, the prices of other goods sometimes fluctuated dramatically in response to new cigarette deliveries or to cigarettes' gradual disappearance in the absence of such. This experience, we are assured, proves that a gold standard is a dumb idea since gold, "as money,...share's tobacco's basic drawback" of being a commodity.

This would be an unanswerable argument against the gold standard were it not for two minor issues: first, gold isn't tobacco; second, P.O.W. camps aren't ordinary economies. Those who plead for a return to gold have a right to be understood to be extolling the merits of a gold standard rather than those of a tobacco standard or a cowrie shell standard or some other commodity standard; and the instability exhibited by any standard in a P.O.W. camp might not supply an accurate indication of the same standard's likely performance in a more usual economic setting. I would bet, for example, that the real price of cigarettes was subject to more violent changes within the confines of Stalag Luft III than in the surrounding German economy; and after the war the real price of a pack of cigarettes net of taxes, in the U.S. at least, was more-or-less constant until the early '80s, when it started to rise gradually. (It is now about twice what it was then). Finally, there isn't even any good reason for supposing that cigarettes were a poor monetary medium for P.O.W. camps, given the available options. Indeed, having often assigned Radford's article myself in teaching monetary economics, I have always understood its lesson to be, not that cigarettes make crummy money, but that markets are remarkably clever when it comes to expediting exchange. The logical implication of Mr. Porter's argument, on the other hand, seems to be that by relying on the market the P.O.W.s blew it: it would have been wiser, according to his point of view, for them to have invited their captors to supply, in exchange for some of their precious Red-Cross parcel contents, fiat money especially designed for their use, and backed by a solemn promise to manage the stuff scientifically, so as to best provide for the prisoners' macroeconomic well-being.

And gold itself? Is its supply in fact subject to the sort of shocks to which P.O.W. camps' cigarette endowments were exposed? Though Mr. Porter seems to assume so, he offers no proof. Had he bothered to inquire into actual facts he might have learned that by far the most notorious of all precious metal "supply shocks"--the one following Spain's conquest of the New World--led to the sixfold increase in European prices that has since come to be known as the great European "Price Revolution." Q.E.D. for Mr. Porter? Well, not quite, because that sixfold increase occurred over an interval of over 150 years, which translates into a continuous rate of inflation of just 1.1 percent--a rate that would have Ben Bernanke and many other modern central bankers squawking about being on the brink of a deflationary crisis.

And what about that other famous gold supply shock started by a lucky discovery at Sutter's Mill? Well, have a look if you will at a chart showing the progress of the U.S. CPI since 1800 or so, and see if you can pick out the rise in prices this discovery caused. Unless you happen to be on drugs, you can't, because it isn't there: there are price jumps, sure enough--in or around 1812, 1862, and 1918--but they all mark moments when the U.S. temporarily abandoned the gold standard, which is to say moments when it embraced the sort of paper standard Mr. Porter thinks so obviously superior to gold. (During WWI, although the U.S. didn't suspend the gold standard outright, it limited gold exports.) Wars are exceptional, of course. But then what about the CPI lift-off after 1971, when the dollar's last link to gold was severed once and for all? Is the CPI a Republican plot?

If not, are we not entitled to wonder why Mr. Porter, in assuring us that "the Fed can print dollars at will to meet the growing demand for money as the economy grows," does not seem to realize that it can, and often does, "print" too many dollars? Are we not entitled to wonder why, in making a case against gold and in favor of paper money, he supplies us with an almost perfectly irrelevant story about tobacco-plus-paper inflation, without so much as hinting at the many far more serious inflations fueled by paper alone? Is "Zimbabwean" inflation to him nothing other than a bogeyman invented by some right-wing talking head? Perhaps Mr. Porter was so absorbed by his vision of P.O.W.s struggling to carry on despite occasional cigarette windfalls that he managed to overlook the damage irredeemable paper monies have done at one time or another to the entire populations of Angola, Argentina, Bolivia, Brazil, Bulgaria, China, France, Germany, Greece, Hungary, Israel, Mexico, North Korea, Nicaragua, Peru, the Philippines, Poland, Romania, Yugoslavia, and Zaire--to offer but a very incomplete list.

But why harp on inflation? After all, fiat money at least has the virtue of hardly ever being in short supply, so that economies need not fear being unable to grow for want of it. In contrast under a gold standard, Mr. Porter assures us, "the economy couldn't grow faster than the supply of gold." Evidently Mr. Porter here overlooks another relevant episode in economic history. This episode is known as "the 19th century."

It's hardly surprising under the circumstances that Mr. Porter should share the very widespread opinion that the gold standard was to blame for the United States Great Depression. Yet even by his own telling it wasn't the gold standard as such, but the particular rules by which the Fed administered that standard, that led to the Fed's failure to prevent the post-1930 collapse of the U.S. money stock. In fact the Federal Reserve's requirement of a 40 (not 60) percent gold cover for its outstanding notes was not a necessary part of the gold standard but a regulation based on naive ca. 1840 British Currency-School thinking. (In Scotland's free-banking based gold standard, in contrast, banks managed quite well with specie reserve ratios that varied little from one or two percent.)

The stipulated gold minimum was, moreover, something that the Fed itself had statutory authority to lower, had it considered doing so worthwhile. In fact, it didn't, because (as Dick Timberlake points out) the Fed never ran up against the 40 percent limit during the crucial, early years of the depression: in August 1931 the Fed's gold holdings of $3.5 billion were over twice what it needed to meet that requirement; and even at the time of the Bank Holiday in March 1933, despite having endured a run on gold triggered by fear of an impending devaluation, the Fed was sitting on more that $1 billion in excess gold reserves. What the Fed was short of wasn't gold but what clueless Fed officials, subscribing to the bogus "real-bills doctrine," considered good private securities, which until 1932 were the only assets eligible for backing its notes other than gold. If Mr. Porter knew his Friedman and Schwartz, he'd know that those authors, among several others, conclude on the basis of such facts that the gold standard was not the cause of the Fed's failure to combat the Great Depression. Since Christina Romer is among the authors in question, I trust that Mr. Porter will not be tempted to declare that they must all be Republicans.

While the general thrust of Mr. Porter's essay is that one has to be daft to say nice things about the gold standard, he is generous enough to allow that this might not be the only reason for Ron Paul's defense of gold. After all, Porter informs us, "much of his [Paul's] wealth is tied up in gold-mining stocks." Consequently, Porter reasons, Paul "would certainly benefit if even more American's caught the gold bug." But would he? Have a look at any plot of the real price of gold, and ask yourself whether, if you had "much of your wealth" in gold mining, you would be pleading for a return to the gold standard, or pulling hard for a continuation of the fiat-money status quo. Besides not making sense, and being nasty, Porter's argumentum ad hominem is profoundly silly. Would he have us conclude that Paul is pro-life only because he's a pediatrician an obstetrician, or that, since he favors drug legalization, he must be long on marijuana, coca, and poppies?

What I find most obnoxious about Mr. Porter's arguments isn't that they are arguments against reviving the gold standard (for I recognize good arguments for not attempting such) or even that they are bad arguments. It is that they are both bad and smug; indeed they are bad because they are smug. Starting from the premise that only idiots can favor a gold standard, Mr. Porter imagines that no great effort is required to prove that such a standard is deeply flawed. He then cobbles up his proof, by plucking up a fistful of old anti-gold canards from the murky bottom of google.com, by recalling an old article describing inflation that wasn't the fault of some central bank, and by simply asserting his own a priori beliefs. After all, he reasons, why bother to use a tower or ram or even a ladder to assail something that mere wind ought to topple? In fine, Mr. Porter falls victim to the tempting but evidently mistaken assumption that he surely knows more about money than the average right-wing nut.


Talking points for the Keynes-Hayek Debate

by Larry White November 9th, 2011 1:06 am

Here is the prepared version of my opening statement for the Keynes-Hayek debate sponsored by Reuters that was held in New York City tonight. Due to time constraints, I skipped over some bullet points.

The video recording is now available: here.

• Friedrich Hayek developed a business cycle theory that explains how overly cheap credit from the central bank gives rise to an investment boom. In the boom, because interest rates are unsustainably low, investment is badly misallocated
o The boom is bound to go bust.
o Hayek’s theory doesn’t explain every recession in history, but it certainly does fit our recent housing boom and bust.
• The fit between Hayek’s theory and recent events is why we see the revival of interest in Hayek
o It’s why there’s a Hayek-Keynes rap video (“Fear the Boom and Bust”) with 3 million views.
o It’s why Nick Wapshott made Hayek the co-star of his book
o It’s why we are here discussing Hayek as the alternative to Keynes in anti-recession policy.
• By the way, for an account of the broader intellectual context of the Keynes-Hayek dispute, let me modestly recommend my forthcoming book, The Clash of Economic Ideas: Policy Debates and Experiments of the Last Hundred Years
o Available April 2012 from Cambridge University Press.

• In stark contrast to Hayek, the Keynesian theory of depressions offers no theory of the boom-bust cycle.
o Keynesian models completely abstract from the structure of production in the economy.
o The Capital stock is just one big uniformly productive lump
 Investment just makes the lump bigger, so there is no such thing as over-investment or wrongly directed investment
 it doesn’t matter where investment goes
 Employment is just employment.
o Keynesian models consequently fail to see how labor and capital are misallocated in a credit boom
o Or why economic recovery and sustainable growth are not just about aggregate demand.

• After the dot-com bubble burst in 2001, the Fed ramped up aggregate demand with rapid monetary expansion and ultralow interest rates, as Keynesians recommended.
o The Fed almost seemed to be trying to create a housing bubble to replace the Nasdaq bubble
o That experiment didn’t work out so well, did it?
o We have permanently reduced our real standard of living for wasting so much capital overinvesting in housing during the boom.

• So, What would Hayek have us do? Two things:
o Create a consistent monetary environment for saving and investment, without interest-rate distortions
o let necessary economic recalculation and adjustment take place.
• Critics have tried to tar Hayek as someone indifferent to the deflationary collapse of spending in the early 1930s, as though he counseled doing nothing to stop it.
o It's a bum rap.
o If they would actually read Hayek’s 1931 book Prices and Production, or his 1937 book Monetary Nationalism and International Stability, they would learn that he actually counseled central banks to prevent a collapse in spending.
o Hayek understood that a spending collapse has dire real consequences due to price stickiness.
o He did not subscribe to the Panglossian model of frictionless markets that some critics find a convenient straw man.
• Hayek explicitly called for constancy of what he called “the total money stream,” i.e. stabilization of nominal GDP.
o He was a forerunner of NGDP targeting
o To keep “the total money stream” constant means expanding the quantity of high-powered money to offset any forces shrinking the broader stock of money, or any increase in hoarding
o We can fault Hayek personally for failing to stay on this message consistently in the early 1930s.
 He himself later pleaded mea culpa on that.
o But his explicit monetary policy norm – to maintain nominal spending, is clear, and sensible, and not “do nothing”
 It would have prevented the deflationary spiral of the early 1930s, if the Fed had listened
 It would be an improvement today over the Fed’s unanchored policy

• Hayek’s perspective has further implications for re-starting sustainable economic growth after the bust:
o Don’t undertake public works whose costs exceed benefits—they are a waste
o Let market forces correct the real capital misallocations created by easy money during the boom
o Let artificially high asset prices fall relative to consumer prices
 Preferably not by inflating consumer prices.
o Let unemployed talent and idle machines move as rapidly as possible into appropriate and sustainable new employments.
 This means avoiding bailouts and subsidies and other forms of cronyism that misdirect investment
• If our goal is sustainable real growth, then we need to recognize that, contrary to Keynes, we cannot restore prosperity by building pyramids.


Communicating the ideas of free banking

by Kurt Schuler November 4th, 2011 11:41 pm

In my first post on this blog I promised that I would address several questions in later posts. One of those questions I have not addressed until now is how writers on free banking should communicate our findings so that they receive the consideration they deserve.

For many years, it surprised me how closed the mainstream of economists was to new ideas and even to old ideas. The first case of competitive issue of notes occurred about 1,000 years ago, in China. Free banking has existed in more than 60 countries, including such major economies as the United States (in a qualified way – a subject for a later post), the United Kingdom, Brazil, India, and Italy. One would think that with such a deep and broad historical record, economists would be more curious about it. But to most economists, the past is a closed book.

There have been exceptions. The world has enough economists that some are interested in treading unfamiliar paths. If you got your ideas just from reading the standard textbooks in introductory economics or in money and banking, though, you would not know that central banking is more recent than a number of other monetary systems, including free banking; that it has not always been so widespread; and that its record regarding inflation and financial crises compares poorly to that of some other systems.

Despite the scholarly work that has been done on free banking; despite its having been advocated by Friedrich Hayek and Milton Friedman in the full maturity of their careers; despite the seriousness with which a few experts on central banking (for instance, Charles Goodhart) have treated free banking, it is not part of mainstream economics.

It is essential for established scholars who are interested in free banking to continue working on it, to demonstrate to youngsters wanting to become scholars that the topic is deep enough to spend a career exploring. I now think that while such scholarship is essential for free banking to become part of the mainstream one day, it will not the catalyst.

Instead, I think the catalyst will be the events in what one of my college professors called “the so-called real world.” Something will happen in electronic money, in economic policy, or to central banks that requires expanding the mainstream presentation of ideas to let free banking in. What has happened with the idea of nominal GDP targeting is a possible pattern. It had been discussed among economists since the 1980s, but what has pushed it into the public eye has been the determined efforts of one able blogger, Scott Sumner of Bentley University. His blog The Money Illusion became the focal point for a number of other intelligent bloggers to establish a small community that has debated the idea in detail, examining its strengths and weaknesses in a way that would have taken much longer before blogs. (A few of the bloggers who have written on nominal GDP have also written scholarly work on free banking.) Their presentation of the idea was so compelling that a number of big-name economists have also taken up the topic in newspaper articles. Among those who also write textbooks, I suspect that nominal GDP targeting will appear in the next editions. The old process, by which economics journals served as a filter and delayed  new ideas from spreading into textbooks for years, is changing drastically. Articles in economics journals used to be birth announcements for new ideas; now they are more like graduation announcements.