Old but not stale news

by Kurt Schuler March 31st, 2012 10:13 pm

An article by Orley Ashenfelter of Princeton University in the current issue of the Journal of Economic Literature mentions a survey published ten years ago that reported that only 13 of what were considered the top 62 graduate programs in economics at the time reported offering any course in the history of economic thought in the previous five years. As the current article mentions, it is likely that the numbers have shrunk rather than grown since the survey was conducted.

Ashenfelter goes on to offer some reasons for studying the history of economic thought, which he borrows from a recent book on the subject by Agnar Sandmo, Economics Evolving. They are that it can be fun; that it is part of a liberal education; and that it shows that economic analysis is not a static field but an evolving one. Ashenfelter and apparently Sandmo (whose book I have not read) omit the most important reason: sometimes the present has forgotten what the past knew.

Free banking is a case in point. Widely practiced until the early 20th century, a partial understanding of it was for a while part of the body of knowledge among economists. As the number of countries with free banking shrank, so did knowledge of free banking among economists. Thanks in particular to the interest sparked by Friedrich Hayek’s Denationalisation of Money (1976, 1978) and Lawrence H. White’s Free Banking in Britain (1984), much of the old knowledge has been recovered and new knowledge has been developed, but it is still not part of the corpus even among specialists in monetary economics.

Economics is in fact so neglectful of its past that its practitioners risk forgetting not only what past generations knew, but what they themselves once knew. A case in point is another article in the current issue of the Journal of Economic Literature, by Gary Gorton and Andrew Metrick. Writing on the global financial crisis of 2007-09, they term it “perhaps the most important economic event since the Great Depression.” Come on, fellows, even if you are not old enough to remember World War II and the great global inflation of the 1970s and 1980s (much worse in the Third World than in the United States, leading to a decade of lost growth in many poor countries), you are old enough to remember the collapse of socialism.


Problems facing every monetary system

by Kurt Schuler March 28th, 2012 10:06 pm

Readers of George Selgin’s post just below should be aware that there is a an extensive comment section about it, including a few of his own remarks, over at Marginal Revolution.

Now, on to what I promised to discuss in my last post, some time ago. Every monetary system faces a number of major problems to solve or fail at. Here I will discuss how a free banking system, assumed for the sake of concreteness to operate on a fixed exchange rate with gold or on what George Selgin termed a quasi commodity standard (a frozen fiat monetary base), compares with a central banking system, assumed to operate on a floating exchange rate, with inflation as the target. In a future post I will have more to say about targeting the path of nominal GDP, but I will leave it aside now because it is not a system that has yet been put into practice in explicit fashion.

Knowledge. Does the monetary system generate enough knowledge and enable people to use it efficiently enough to coordinate activity well? The major argument in favor of free banking is that the competition it permits generates knowledge of consumer preferences, especially about preferences for saving as opposed to consuming, that a central banking system cannot elicit to the same degree. Unfortunately, it is an argument that mainstream economics still typically ignores.

Technique. Can the monetary system hit its stated targets with a high degree of accuracy? We know from experience that an exchange rate is an easy target to hit in a technical sense, and that it is likewise easy for the public to tell the difference between meeting and not meeting the target. A similar point applies to a quasi commodity money: if banks promise to redeem their liabilities for the quasi commodity money at a specified rate, either they do or they don’t. When it comes to a central bank meeting an inflation target, in practice judging whether it is meeting the target has proved harder. The target is generally forward-looking, but judgment about it is backward-looking. As a result, central banks typically have not suffered any punishment for persistently missing targets by what seem like wide margins, given the small tolerance bands within which they claim to operate.

Politics. Can the monetary system be sufficiently insulated from politics that it can coordinate activities in an economically efficient way? This is the question of the Public Choice school of economists. No monetary system provides perfect protection against politically motivated inefficiencies. By design, though, under free banking the government is not both player and referee, whereas under central banking it is a bit of both and where it also owns large commercial banks the combination of roles and the potential for conflicts between them is even stronger. Since the high inflations that plagued many countries in the 1980s and early 1990s, central banks around the world have been remarkably successful in asserting greater independence from political pressure than they previously had. It is still the case, though, that a central bank by design is subject to a higher degree of overt political influence than free banks.

Redeemability. Banks operate with less than 100% reserves, with the level of reserves reflecting their judgments about how big a cushion they need against mistakes in estimating the difference between debits against them and credits in their favor. In a system where the ultimate monetary base, whether gold or a quasi commodity, has a limited supply, if the public decides that it wants to redeem bank deposits for the monetary base quickly and on a large scale, as in a financial panic, banks must contract credit or limit redeemability. Under a floating exchange rate fiat system, the central bank can create further supplies of the monetary base at will, so no system-wide question of redeemability need arise, though the central bank may allow individual commercial banks to fail. The downside of the unlimited power to create reserves is, of course, that it contains the potential for unlimited inflation.

Credibility. How believable are the promises that the monetary authority or banks make? With a fixed exchange rate into gold or into a quasi commodity money (which itself floats), the ability to hit the target and to judge easily whether the target it being hit contribute to credibility. With inflation targeting, credibility is fuzzier. Critics of the gold standard might say that a free banking gold standard goes overboard on credibility, tying banks to a standard that in some cases is best abandoned. That is another topic for a later post, concerning implicit and explicit “option clauses” that some free banking systems have had.

Economic growth. Economists often compare economic growth under different monetary arrangements. To me, growth is secondary in the sense that I do not think it is something that monetary policy can target. A good monetary policy can facilitate growth, by enlarging the sphere of exchanges, but it is only one factor in growth and often a decidedly secondary factor compared to property rights, taxes, regulation, etc. In the cases where monetary policy is decisive for influencing growth, it is usually where it is spectacularly bad rather than spectacularly good.



by George Selgin March 21st, 2012 11:41 pm

Despite the bright light streaming into my office window, reminding me of the beautiful spring weather here in Athens, I managed to spend most of yesterday afternoon listening to the first installment of Ben Bernanke's 4-part lecture series on "The Federal Reserve and the Financial Crisis." The lecture took place on Tuesday evening at George Washington University. The other parts will be given on the 22nd, 27th, and 29th of this month.

In this opening lecture Bernanke offers a brief overview of the role of central banks, their general origins, the specific origins of the Federal Reserve System, and the Fed's early performance.

It would of course be silly to expect any sitting central banker, much less the head of the world's most important central bank, to deliver an entirely candid lecture on the origins of central banking. But then again, Ben Bernanke is no run-of-the-mill central banker: he is a former academic economist and economic historian, and one with very high standing in the profession. So one might expect him to at least avoid gross distortions of the historical record to which his less academically-minded counterparts might be expected to resort. But no: as the lecture lumbered on (for Chairman Bernanke's classroom demeanor is all too reminiscent of his demeanor when testifying to Congress), it became increasingly evident that the man lecturing at Duquès Hall was at least 99 and 44/100ths percent pure Federal Reserve spokesman.

So like any central banker, and unlike better academic economists, Bernanke consistently portrays inflation, business cycles, financial crises, and asset price "bubbles" as things that happen because...well, the point is that there is generally no "because." These things just happen; central banks, on the other hand, exist to prevent them from happening, or to "mitigate" them once they happen, or perhaps (as in the case of "bubbles") to simply tolerate them, because they can't do any better than that. That central banks' own policies might actually cause inflation, or contribute to the business cycle, or trigger crises, or blow-up asset bubbles--these are possibilities to which every economist worth his or her salt attaches some importance, if not overwhelming importance. But they are also possibilities that every true-blue central banker avoids like so many landmines. Are you old enough to remember that publicity shot of Nixon's "inflation czar," Alfred Kahn, holding a baseball bat and declaring that he was about to "knock inflation out of the economy"? That was Kahn talking, not like a monetary economist, but like the government propagandist that he was. Bernanke talks the same way throughout much (though not quite all) of his lecture.

In describing the historical origins of central banking, for instance, Bernanke makes no mention at all of the fiscal purpose of all of the earliest central banks--that is, of the fact that they were set up, not to combat inflation or crises or cycles but to provide financial relief to their sponsoring governments in return for monopoly privileges. He is thus able to steer clear of the thorny challenge of explaining just how it was that institutions established for function X happened to prove ideally suited for functions Y and Z, even though the latter functions never even entered the minds of the institutions' sponsors or designers!

By ignoring the true origins of early central banks, and of the Bank of England in particular, and simply asserting that the (immaculately conceived) Bank gradually figured-out its "true" purpose, especially by discovering that it could save the British economy now and then by serving as a Lender of Last Resort, Bernanke is able to overlook the important possibility that central banks' monopoly privileges--and their monopoly of paper currency especially--may have been a contributing cause of 19th-century financial instability. How currency monopoly contributed to instability is something I've explained elsewhere. More to the point, it is something that Walter Bagehot was perfectly clear about in his famous 1873 work, Lombard Street. Bernanke, in typical central-bank-apologist fashion, refers to Bagehot's work, but only to recite Bagehot's rules for last-resort lending. He thus allows all those innocent GWU students to suppose (as was surely his intent) that Bagehot considered central banking a jolly good thing. In fact, as anyone who actually reads Bagehot will see, he emphatically considered central banking--or what he called England's "one-reserve system" of banking--a very bad thing, best avoided in favor of a "natural" system, like Scotland's, in which numerous competing banks of issue are each responsible for maintaining their own cash reserves.

Besides ignoring the destabilizing effects of central banking--or of any system based on a currency monopoly--Bernanke carefully avoids any mention of the destabilizing effects of other sorts of misguided financial regulation. He thus attributes the greater frequency of banking crises in the post-Civil War U.S. than in England solely to the lack of a central bank in the former country, making one wish that some clever GWU student had interrupted him to observe that Canada and Scotland, despite also lacking central banks, each had far fewer crises than either the U.S. or England. Hearing Bernanke you would never guess that U.S. banks were generally denied the ability to branch, or that state chartered banks were prevented by a prohibitive federal tax from issuing their own notes, or that National banks found it increasingly difficult to issue their own notes owing to the high cost of government securities required (originally for fiscal reasons) as backing for their notes. Certainly you would not realize that economic historians have long recognized (see, for starters, here and here) how these regulations played a crucial part in pre-Fed U.S. financial instability. No: you would be left to assume that U.S. crises just...happened, or rather, that they happened "because" there was no central bank around to put a stop to them.

Because he entirely overlooks the role played by legal restrictions in destabilizing the pre-1914 U.S. financial system, Bernanke is bound to overlook as well the historically important "asset currency" reform movement that anticipated the post-1907 turn toward a central-bank based monetary reform. Instead of calling for yet more government intervention in the monetary system the earlier movement proposed a number of deregulatory solutions to periodic financial crises, including the repeal of Civil-War era currency-backing requirements and the dismantlement of barriers to nationwide branch banking. Canada's experience suggested that this deregulatory program might have worked very well. Unfortunately concerted opposition to branch banking, by both established "independent" bankers and Wall Street (which gained lots of correspondent business thanks to other banks' inability to have branches there) blocked this avenue of reform. Instead of mentioning any of this, Bernanke refers only to the alternative of relying upon private clearinghouses to handle panics, which he says "just wasn't sufficient." True enough. But the Fed, first of all (as Bernanke himself goes on to admit, and as Friedman and Schwartz argue at length), turned out be be an even less adequate solution than the clearinghouses had been; more importantly, the clearinghouses themselves, far from having been the sole or best alternative to a central bank, were but a poor second-best substitute for needed deregulation.

To be fair, Bernanke does eventually get 'round to offering a theory of crises. The theory is the one according to which a rumor spreads to the effect that some bank or banks may be in trouble, which is supposedly enough to trigger a "contagion" of fear that has everyone scrambling for their dough. Bernanke refers listeners to Frank Capra's movie "It's a Wonderful Life," as though it offered some sort of ground for taking the theory seriously, though admittedly he might have done worse by referring them to Diamond and Dybvig's (1983) even more factitious journal article. Either way, the impression left is one that ought to make any thinking person wonder how any bank ever managed to last for more than a few hours in those awful pre-deposit insurance days. That quite a few banks, and especially ones that could diversify through branching, did considerably better than that is of course a problem for the theory, though one Bernanke never mentions. (Neither, for that matter, do many monetary economists, most of whom seem to judge theories, not according to how well they stand up to the facts, but according to how many papers you can spin off from them.) In particular, he never mentions the fact that Canada had no bank failures at all during the 1930s, despite having had no central bank until 1935, and no deposit insurance until many decades later. Nor does he acknowledge research by George Kaufman, among others, showing that bank run "contagions" have actually been rare even in the relatively fragile U.S. banking system. (Although it resembled a system-wide contagion, the panic of late February 1933 was actually a speculative attack on the dollar spurred on by the fear that Roosevelt was going to devalue it--which of course he eventually did.) And although Bernanke shows a chart depicting high U.S. bank failure rates in the years prior to the Fed's establishment, he cuts it off so that no one can observe how those failure rates increased after 1914. Finally, Bernanke suggests that the Fed, acting in accordance with his theory, only offers last-resort aid to solvent ("Jimmy Stewart") banks, leaving others to fail, whereas in fact the record shows that, after the sorry experience of the Great Depression (when it let poor Jimmy fend for himself), the Fed went on to employ its last resort lending powers, not to rescue solvent banks (which for the most part no longer needed any help from it), but to bail out manifestly insolvent ones. All of these "overlooked" facts suggest that there is something not quite right about the suggestion that bank failure rates are highest when there is neither a central bank nor deposit insurance. But why complicate things? The story is a cinch to teach, and the Diamond-Dybvig model is so..."elegant." Besides, who wants to spoil the plot of "It's a Wonderful Life?"

Bernanke's discussion of the gold standard is perhaps the low point of a generally poor performance, consisting of little more than the usual catalog of anti-gold clichés: like most critics of the gold standard, Bernanke is evidently so convinced of its rottenness that it has never occurred to him to check whether the standard arguments against it have any merit. Thus he says, referring to an old Friedman essay, that the gold standard wastes resources. He neglects to tell his listeners (1) that for his calculations Friedman assumed 100% gold reserves, instead of the "paper thin" reserves that, according to Bernanke himself, where actually relied upon during the gold standard era; (2) that Friedman subsequently wrote an article on "The Resource Costs of Irredeemable Paper Money" in which he questioned his own, previous assumption that paper money was cheaper than gold; and (3) that the flow of resources to gold mining and processing is mainly a function of gold's relative price, and that that relative price has been higher since 1971 than it was during the classical gold standard era, thanks mainly to the heightened demand for gold as a hedge against fiat-money-based inflation. Indeed, the real price of gold is higher today than it has ever been except for a brief interval during the 1980s. So, Ben: while you chuckle about how silly it would be to embrace a monetary standard that tends to enrich foreign gold miners, perhaps you should consider how no monetary standard has done so more than the one you yourself have been managing!

Bernanke's claim that output was more volatile under the gold standard than it has been in recent decades is equally unsound. True: some old statistics support it; but those have been overturned by Christina Romer's more recent estimates, which show the standard deviation of real GNP since World War II to be only slightly lower than that for the pre-Fed period. (For a detailed and up-to-date comparison of pre-1914 and post-1945 U.S. economic volatility see my, Bill Lastrapes, and Larry White's forthcoming Journal of Macroeconomics paper, "Has the Fed Been a Failure?").

Nor is Bernanke on solid ground in suggesting that the gold standard was harmful because it resulted in gradual deflation for most of the gold-standard era. True, farmers wanted higher prices for their crops, if not general inflation to erode the value of their debts--when haven't they? But generally the deflation of the 19th century did no harm at all, because it was roughly consistent with productivity gains of the era, and so reflected falling unit production costs. As a self-proclaimed fan of Friedman and Schwartz, Bernanke ought to be aware of their own conclusion that the secular deflation he complains about was perfectly benign. Or else he should read Saul's The Myth of the Great the Great Depression, or Atkeson and Kehoe's more recent AER article, or my Less Than Zero. In short, he should inform himself of the fundamental difference between supply-drive and demand-driven deflation, instead of lumping them together, and lecture students accordingly.

Although he admits later in his lecture (in his sole acknowledgement of central bankers' capacity to do harm) that the Federal Reserve was itself to blame for the excessive monetary tightening of the early 1930s, in his discussion of the gold standard Bernanke repeats the canard that the Fed's hands were tied by that standard. The facts show otherwise: Federal Reserve rules required 40% gold backing of outstanding Federal Reserve notes. But the Fed wasn’t constrained by this requirement, which it had statutory authority to suspend at any time for an indefinite period. More importantly, during the first stages of the Great (monetary) Contraction, the Fed had plenty of gold and was actually accumulating more of it. By August 1931, it's gold holdings had risen to $3.5 billion (from $3.1 billion in 1929), which was 81% of its then-outstanding notes, or more than twice its required holdings. And although Fed gold holdings then started to decline, by March 1933, which is to say the very nadir of the monetary contraction, the Fed still held over than $1 billion in excess gold reserves. In short, at no point of the Great Contraction was the Fed prevented from further expanding the monetary base by a lack of required gold cover.

Finally, Bernanke repeats the tired old claim that the gold standard is no good because gold supply shocks will cause the value of money to fluctuate. It is of course easy to show that gold will be inferior on this score to an ideally managed fiat standard. But so what? The question is, how do the price movements under gold compare to those under actual fiat standards? Has Bernanke compared the post-Sutter's Mill inflation to that of, say, the Fed's first five years, or the 1970s? Has he compared the average annual inflation rate during the so-called "price revolution" of the 16th century--a result of massive gold imports from the New-World--to the average U.S. rate during his own tenure as Fed chairman? If he bothered to do so, I dare say he'd clam up about those terrible gold supply shocks.

Speaking of the Fed's first years, I myself chuckled at hearing Bernanke say, matter of factly, that "The Fed was established in 1914, and for while life was not so bad," as if the Fed did a dandy job until 1930 or so. No mention of the high inflation before 1921--as high as 40%, on an annualized basis, during some quarters; no mention of the record numbers of bank failures throughout the 1914-1930 period; no mention of the sharp recession of 1920-21; and no mention of any possible contribution by the Fed to the stock market boom (or "bubble," as Bernanke would have it) of the 1920s. Rather less amusing was his quotation of that "famous statement by Andrew Mellon" about liquidating stocks etc.: poor Mellon never said it, in fact: the words were Hoover's, and were intended as parody. But why waste a perfectly good straw man? Besides, those lazy GWU students will never check.

It's true that Bernanke's whitewashing of the Fed isn't quite complete: he devotes considerable time to explaining how it "blew it" during the Great Depression. But the admission is intended to be anything but fatal to the case for central banking. On the contrary: the depression was a crucial learning experience. Since then, the Fed, we are assured, has gotten its act together. Well, O.K.: there are still a few bugs to be worked out. But never mind: some future Fed Chairman will manage to spin them away.


Name Your Favorite Geithner Nickname: "Turbotax Tim" "Chicken Little"

by Vern McKinley March 16th, 2012 9:40 am

By all indications by year end we will be granted a reprieve from listening to Secretary Geithner’s outrageous claims about how the bailouts, largely engineered from his perch as the President of the New York Fed, saved the world from absolute financial Armageddon. To Geithner anyone who disagrees with him has amnesia as this recent WSJ editorial from earlier this month details. In today’s Investor’s Business Daily I give the countervailing narrative (click the link for the full editorial):

“Timothy Geithner is in full "swan song" mode. Word is he will give up his job as secretary of the treasury at the end of 2012, regardless of whether President Obama wins or loses in November.

To influence history's judgment of his tenure as president of the New York Fed and as treasury secretary, he is now aggressively shaping a glowing narrative. This explains his current victory lap in the media highlighting the fourth anniversary of the bailout of Bear Stearns.

He recounts how the CEO of Bear, with his firm on the brink of bankruptcy, came to him looking for a shoulder to cry on. From his then leadership perch as president of the New York Fed, the bank ultimately extended nearly $30 billion for a bailout, the first in a series of such interventions.

Although this effort to shape a narrative has begun, the countervailing narrative is also clear. This narrative couches the bailout of Bear Stearns as the "original sin," the first in a series of short-sighted interventions with negative consequences and highlights that our system is just as vulnerable, if not more vulnerable, to similar crashes in the coming years.”


Near Zero Interest Rates

by Walker Todd March 7th, 2012 6:41 pm

I was recently interviewed for the New York Times article 0.2% Interest? You Bet We’ll Complain.

Fed board governor Sarah Bloom Raskin said in prepared remarks:

[M]any households are benefiting from the low level of interest rates [...] [H]ouseholds have been able to refinance their mortgages into lower-rate loans, freeing up income for other uses.

My take on mortgage refinancing:

She blithely assumes that everyone who could refinance their mortgages at current interest rates has done so. She ignores effects of credit scoring and outrageous fees banks are charging for those refinancings.

The more general point:

We are rapidly approaching a situation where Congress and the administration are unwilling to confront bankers on the need of thoroughgoing reform of everything involving household finance and credit reporting/credit scoring because it would cost the bankers money to do so. Our policy makers do need to think about what we are transferring to the banks. Why is the public obligated to provide them with all those subsidies?


"Why Was the Fed Created?"

by George Selgin March 3rd, 2012 10:14 am

Was the subject assigned to me for my "Tea Lecture" to congressional staffers last week. The lecture is one of a series being sponsored by Ron Paul's office. The true story of the Fed's origins needs to be more widely known, so please do pass it on!