A Few Thoughts on Tapering and the Real Economy

by Steve Horwitz December 26th, 2013 3:55 pm

That's what I have today at the LSE blog on US Politics and Policy.  A snippet:  "The Federal Reserve’s recent decision to begin to taper off its quantitative easing (QE) program is long overdue. QE was a mistake from thebeginning and the risks it created will outlast the continuation of the program as its effects cannot be as easily unwound. Ending QE will also allow us to focus on the real problems causing the slow recovery, which have little to do with the need for more expansionary monetary policy."


A visit from Nicolas

by Kurt Schuler December 24th, 2013 8:24 pm

Not Saint Nicholas--Nicolas Copernicus. Laissez Faire Books has issued a new translation of Copernicus's Essay on Money by Gerald Malsbary. Like Isaac Newton later, Copernicus was both a natural scientist and an expert on coinage consulted by his government.  He worked on iterations of this brief work on and off over 20 years, which gives an idea of the importance he attached to it. In it one sees the most pressing monetary problems of his day, some of which have echoes in ours. Copernicus analyzes problems with a confusing multiplicity of units of account, of the deprecation of coinage, and of the problems of transition from old to new units of account. He offers solutions for each. Along the way, he discusses a version of Gresham's Law and offers glimpses of some other ideas that are surprisingly modern.

Not really knowing Latin, I cannot comment on the quality of the translation, but the translator has thoughtfully included the original text as an appendix.

Merry Christmas to all, and to all a good night.

(Hat tip to Ralph Benko.)


The Federal Reserve System at 100

by Larry White December 23rd, 2013 12:28 pm

Today is the 100th anniversary of the Federal Reserve Act. In this talk I discuss how the Fed has done over the past century.


Ideas, interests, and free banking

by Kurt Schuler December 16th, 2013 12:50 am

At the Coordination Problem blog, Pete Boettke remarks that economists are more comfortable with theories of politics that focus on the narrow self-interest of participants rather than on ideas. Ideas matter, though, and many policies cannot be explained purely in terms of self-interest. A group exists that benefits from a policy, but it makes arguments couched in broader terms that have wide appeal. Sometimes it need not even take an obvious success or failure to shift the policy despite the influence of entrenched interests; a change in the appeal of the ideas can make the difference.

A possible case in point, mentioned in another of Pete’s recent posts, is education. (This is going to be a bit of a digression, but I hope an instructive one.) For a long time it was simply assumed that education is a necessary government function, and that governments should own the schools as well as funding them. Even now the ideological presupposition in favor of government education runs deep. Think about the last several U.S. presidential elections. The contenders in the general elections were George W. Bush (Phillips Academy, Yale, Harvard Business School), Al Gore (St. Alban’s School, Harvard, Vanderbilt Law School), John Kerry (St. Paul’s School, Yale), Barack Obama (Punahou School, Columbia, Harvard Law School), John McCain (Episcopal High School, U.S. Naval Academy), and Mitt Romney (Cranbrook School, Brigham Young, Harvard Law and Business schools). Not only did they all attend private colleges (except for the U.S. Naval Academy, which although government-owned has admission procedures like those of the elite private colleges), all went to private high schools and all who went to graduate school went to private graduate schools. And yet, rather than say, “Private schools certainly worked for me; they can also work for many others,” they focused on government schools. The same is true of such people as Bill Gates in his philanthropic efforts; Ed Glaeser, the Harvard professor of urban economics professor who sometimes writes on education; the publisher of The Nation magazine, Katerina vanden Heuvel; and many others. They all went to private high schools and private colleges!

The idea that all or at least most education must be government education is being partly worn down by experience and reporting. The Netherlands and Sweden have voucher systems for primary and secondary education, as do some localities in the United States. More important, recent research has shown in detail that in quite a few poor countries, parents who are themselves poor eschew free government schools in favor of private schools, which they prefer for their greater effectiveness both in terms of cost and educational results. Although I see some change occurring because of these experiences, I doubt they will be enough to change the balance of opinion from favoring government schools to favoring private schools. The change that has to happen is in the realm of ideas--even emotions--rather than self-interest.

Okay, now to the application to free banking. Although there are strong interests present, I suspect that ideas are the main barrier. Supplying the monetary base, like education, is one of those things that people think must be done by the government, despite the historical fact that it has often not been done by the government and despite the very bad record of governments in maintaining the purchasing power of currencies they issue. Bitcoin and the like, if they become widely used enough, will be like the private schools of India, or for that matter, the United States: able to pry minds open a bit, not enough to change the balance of opinion in favor of free banking.

So, how can the balance of opinion be changed? My ideas, and work, have been in the realm of historical research and argument, aimed at the small audience that cares about such things. It is not enough. Other people using other methods will come forward, I hope, and find some part of what I and others have done to be valuable. Some of us who blog here have been on the case for a generation now and we still don’t have traction even among monetary economists to get them to recognize that the question of monopoly versus competition in money is a key issue, not to be dismissed in a couple of paragraphs before proceeding with the rest of the discussion. Something on the order of a change in the Gestalt of the public, or at least of economists, is needed, and the issue is how to do it.


Pearl Harbor and all that (partly off topic)

by Kurt Schuler December 9th, 2013 11:57 pm

Quite a few libertarians of my acquaintance have trouble thinking straight about World War II in the Pacific. The recent anniversary of Pearl Harbor brings them out with their arguments that U.S. government provoked the Japanese government into starting the war. Let’s review the facts, with a complementary glance at Japanese colonial monetary arrangements.

Japan emerged as an international power with the Sino-Japanese War of 1894-5. The Korean monarchy appealed to the Chinese and Japanese governments to help it suppress a revolt. Both sent troops. Japan’s troops seized the royal family and installed a new government that repudiated all Korean treaties with China. War followed, and Japan won. China ceded Taiwan and the Pescadores Islands. In 1904-5 Japan fought Russia after breaking off talks over spheres of influence in Korea and Manchuria. Japan started the war by sinking Russian warships at Inchon. Russia ceded part of Sakhalin island to Japan and recognized a Japanese sphere of influence in Korea. Japan annexed Korea in 1910. Early in World War I, Japanese forces occupied German colonies in the Pacific. In 1915 Japan presented the “Twenty-One Demands” to China, which would have reduced China to a Japanese protectorate, but withdrew them in the face of pressure from foreign governments.  During the Russian civil war, Japanese forces occupied Vladivostok and nominally controlled a huge territory in eastern Siberia, though they had to retreat after the Red Army defeated anti-Bolshevik forces.  In 1919-1920 Japanese forces violently suppressed the Samil independence movement in Korea. In the interwar period the former German colonies in the Pacific became a League of Nations mandate under Japanese administration. In violation of the mandate agreement, Japan established substantial military bases on the islands.

In 1931 Japanese military forces staged an explosion near a Japanese-owned railroad in Manchuria as a pretext to launch an invasion of the region. In 1932 the Japanese army invaded neighboring Jehol province. In 1935 Japan turned eastern Hebein and Chahar provinces into a puppet state. In 1937 a Japanese army unit, conducting unannounced nighttime maneuvers near  Peking, came under fire from a Chinese unit fearing an invasion. After a series of further incidents Japan launched another war on China, conquering large areas near the coast. In 1939 the Japanese army attempted to occupy a disputed territory in Mongolia. A large-scale though undeclared war soon resulted in which Japanese forces were defeated by Mongolian and Soviet troops (the Nomonhan Incident). To end the conflict Japan signed a cease-fire pact with the Soviet  Union on September 15, 1939. (The Soviet Union under Stalin then proceeded to invade Poland two days later.) In September 1940 Japanese forces invaded French Indochina.

That is the background to Pearl Harbor. For more than 40 years Japan had pursued a policy of aggression and conquest. In each case it was the aggressor. As an island nation with a modern military it was in no real danger of invasion from neighboring countries. In the territories it invaded, Japanese forces murdered civilian opponents of its rule by the thousands and suppressed them by the millions.

The 1940 U.S embargo of certain materials frequently used for military purposes was intended to pressure Japan to stop its campaign of invasion and murder in China. The embargo was a peaceful response to violent actions. Japan could have stopped; it would have been the libertarian thing to do. For libertarians to claim that the embargo was a provocation is like saying that it is a provocation to refuse to sell bullets to a killer.

Then, in December 1941, came not just the Japanese bombing of Pearl Harbor, but an attack on the whole of Southeast Asia: Hong Kong, Singapore, what is now Malaysia (British colonies), Indonesia (a Dutch colony), the Philippines (scheduled under American law to become independent in 1945), Thailand (independent). In 1942 there followed the invasion of Burma, a bit of India, and a few of the Aleutian Islands, plus the bombing of Darwin, Australia.

With that history in mind, how can anybody think that the United States could have made a durable peace with Japan? It would have lasted as long as would have been to Japan’s military advantage, no longer. Japan was hell-bent on conquest. Nothing since its emergence as a major international power suggested a limit to its ambitions. It only ceded in the face of superior force. Even as Allied forces retook territory, Japanese fanaticism was such that the government did not surrender until after the U.S. military dropped two atomic bombs. To ignore the long pattern of Japanese aggression as quite a few libertarians are wont to do is not just historically ignorant but dangerous, because it closes its eyes to the hard truth that some enemies are so implacable that the only choice is between fighting them and being subjugated by them. It took a prolonged U.S. military occupation to turn Japan from the aggressor it was to the peaceful country it has become.

Now for some words on Japanese colonial monetary arrangements. In Taiwan, Korea, and Manchuria Japan established local banks combining central and commercial banking functions, whose currencies were tied to the yen. The former German colonies of the Pacific simply used the yen directly. In China, Japan established multiple note issuing authorities but then largely consolidated them into two, the Federal Reserve Bank of China(!) in the north and the Central Reserve Bank of China in the south. During World War II, Japanese occupation forces in some Southeast Asian countries issued paper currency derided as "banana money" for the pictures of bananas that some notes had and their lack of credibility. Elsewhere, as in French Indochina and Thailand, the Japanese hijacked the previously existing local note issuers. In all cases the wartime policy was to use the currency as a means of extracting resources. Where Japanese forces issued banana  money they established exchange rates with local currency that overvalued the banana money. Later the Japanese established a kind of regional central bank, the Southern Development Bank, with headquarters in Singapore, to issue currency for what are now Malaysia, Indonesia, Burma, the Philipines, Brunei, and Singapore. There is probably an interesting book to be written about it. There may even be one  in Japanese, for all I know, but there is not one in English. Being unable to read Japanese, the two best sources I have found are Money and Banking in China and Southeast Asia During the Japanese Military Occupation 1937-1945 by Richard Bányai (1974) and “Japanese Military Currency (1937-1945): Quantities Printed and Issued” in the I.B.N.S. Journal of the International Bank Note Society, v. 42, no. 3: 1-24, 2003, by Kazuya Fujita. The Philippines prior to Japanese occupation were the only territory with a kind of free banking: two commercial banks issued notes alongside the government, whose issue was a type of currency board.

The territories Japanese forces conquered by 1931 were part of what can be considered an inner yen zone, where monetary policy was basically a mirror image of policy in Japan itself and was intended to promote long-term economic development in line with Japanese interests. In what might be termed the outer yen zone, the territories conquered after 1931, the policy was frankly extractive. The populace continued to prefer the currency it had previously used, and the currency board notes of Hong Kong and Malaya were particularly valued and continued to be held despite penalties for doing so. They were backed by sterling reserves held in London, and after the war they again became convertible into sterling at the prewar exchange rate. (The notes were printed in England, so the Japanese could not obtain the paper and design expertise to produce plausible imitations.) As the war continued, banana money became worth increasingly less on the black market, and by the end of the war it was almost worthless in all the countries where it had been issued. Japan's monetary policy in the outer yen zone was the monetary counterpart of its brutal military and political policies.


How little they knew!

by Kurt Schuler December 3rd, 2013 10:18 pm

In the latest issue of the Journal of Economic Perspectives there are several articles in a symposium on the first 100 years of the Federal Reserve. Displaying what Donald (now Dierdre) McCloskey once characterized as "the intellectual range from M to N," there is no real comparison of the Fed's record with that of the system that preceded it; no mention of other monetary systems circa 1913 that had better records than the United States (most pertinently, that of Canada); not nearly enough acknowledgment of the great harm the Fed has caused more than once in its  history; no discussion of why a few other central banks--though surprisingly, only a few--have performed better than the Fed; and no inkling that central banking may not be the best of all possible systems in the best of all possible worlds.

In among the articles by the academics, though, there is an interview with Paul Volcker. It was of particular interest to me because I recently read William Silber's book Volcker: The Triumph of Persistence. Rather than being a fully rounded biography, it focuses on key episodes of Volcker's life as a policy maker and how he came to the decisions he did. Since Volcker is acknowledged as probably the best Fed chairman ever--the one who inherited a bad situation and left it much better, without planting the seeds of a new bubble--the book is well worth reading. (As is common, though, the biographer is a little too fond of his subject.)

The opening section of the interview briefly discusses Volcker's part in the U.S. abandonment of the Bretton Woods gold standard, a subject treated in much more depth in the book.  What struck me when reading the book was how little Volcker and the other major participants in making the policy knew. Volcker was in a powerful but subordinate post, secondary to the major players Arthur Burns, John Connally, George Shultz, and Richard Nixon. They needed his knowledge of markets, his international contacts, and his bureaucratic expertise, but they and not he made the decisions. It was incredible to me that as market pressure on the U.S. dollar mounted, there was no real acknowledgment among the group that the underlying problem was overly expansionary Federal Reserve policy. Arthur Burns, though a fine academic, was a terrible policy maker. He was willing to subordinate the Fed, and by implication the U.S. financial system, to Nixon's wish to keep the economy pumped up during his re-election campaign, even at the risk of a substantial hangover later. Nobody understood that the steps they were about to take would shake the pillars of the world financial system. The focus was instead on gold and the alleged need to devalue against gold, as if gold were the problem rather than a signal that the monetary policy was the problem. It took more than a decade of costly experimentation to establish some credibility for the dollar on new foundations under a floating exchange rate.


Mike Sproul responds (guest post)

by Kurt Schuler December 1st, 2013 9:53 pm

(Mike Sproul's response to points I raised in a comment on his first guest post.)

In reply to Kurt’s commentary on the backing theory/real bills view, let me start with a reasonable working statement of the real bills doctrine:

Money should be issued in exchange for

(1) short-term

(2) real bills

(3) of adequate value.

 Rule 3 is by far the most important. No bank should (or would) issue $100 to someone who offered securities worth only $90 in exchange. A bank that fails to follow rule 3 will soon become insolvent, while a bank that follows rule 3 will get a dollar’s worth of new assets for every new dollar that it issues, so that bank’s dollars will hold their value, even as more are issued. Furthermore, no law is needed to force banks to follow rule 3. This is why the real bills doctrine is the natural ideology of free banking. Sargent and Wallace also equate the real bills doctrine with the free banking view.

Rules 1 and 2 also play a role. Rule 1 prevents maturity mismatching, and assures that the assets backing the bank’s money will mature in 60 days or less, so that even if customers want to redeem all their money at once, the worst that can happen to customers (assuming the bank is solvent) is a 60-day wait to get their money. Rule 2 automatically matches the quantity of money to the needs of business. When farmers and factories are busy, they will generate many bills, some of which will find their way to local banks, to be exchanged for newly-issued money. Old-time note-issuing bankers usually found that if they issued new money based on the bills of farms and factories, then their notes would stay in circulation. But if they issued new notes to people not directly engaged in production, the new notes would return to the bank the next day. Here again, no law is needed to force banks to follow rules 1 and 2, though I should add that banks were not terribly strict in following rules 1 and 2, and they often found that new notes could safely and profitably be issued for government bonds or other “solid paper” with maturities over 60 days.

The backing view says that the real bills doctrine avoids inflation by assuring that money does not outrun the issuer’s assets. But quantity theorists mistakenly think that the real bills doctrine aims to prevent inflation by assuring that money does not outrun the quantity of goods produced in the economy. The difference between the “money outruns assets” view and the “money outruns goods” issue has been a prolific source of misunderstanding.

Adam Smith, in the passage referenced by Kurt, takes the view that the real bills doctrine will prevent money from outrunning goods, that is, that “(money) can never exceed the quantity which the circulation of the country can easily absorb and employ”. Henry Thornton (1801) and David Ricardo (1810) took a similar approach. Each of them contended that a bank that followed the real bills rule might still cause its money-issue to outrun the quantity of goods. This seemed to them a sufficient proof that the bank would cause inflation, but they failed to realize that as long as a bank only issued money in exchange for assets of adequate value, the bank’s money-issue would not outrun the bank’s assets, and the money would hold its value. (More on Thornton and Ricardo here)

Lloyd Mints (1945) attacked the real bills doctrine with his “money’s worth” argument, which can be explained with the following sequence of events:

  1. Banks lend dollars. Borrowers promise to repay the loan, not with a physical amount of their assets, but with a specified dollar’s worth of their assets.
  2. Lending of dollars creates new money.
  3. New money causes the value of existing money to fall,
  4. which reduces the real value of borrowers’ debts,
  5. which allows borrowers to borrow still more,
  6. which brings us back to #2, and a self-perpetuating cycle of more loans, more money, and more inflation.

Step 3 above, that new money causes inflation, assumes the correctness of the quantity theory. But on backing theory principles, the new money will be adequately backed by the borrower’s collateral, and so will not cause inflation. Thus Mints’ “self-perpetuating cycle” never gets off the ground. Only by assuming the incorrectness of the real bills doctrine to begin with was Mints able to conclude that the real bills doctrine was incorrect.

Now, to Kurt’s questions and comments:

  1. Question: Mike, to give me and other readers a better sense of where you fit in the long real bills tradition, please explain (a) whether the real bills doctrine as you define it is similar to the way Sargent and Wallace define it and (b) whether you think it was a misnomer for Sargent and Wallace to call their idea a version of the real bills doctrine.

Answer: I agree with Sargent and Wallace that “there should be unrestricted discounting of real bills”. Banks acting in their own best interest will only issue a new dollar to someone who offers a dollar’s worth of assets in exchange, so the bank’s assets will automatically be sufficient to cover the money it has issued. I disagree with Sargent and Wallace’s claim that the real bills doctrine leads to an indeterminate price level. As long as the bank holds some real assets, these will anchor the currency. Sargent and Wallace also accept the idea that modern paper moneys are fiat moneys, in the sense that they are unbacked. I think that modern paper moneys are backed by the assets of the issuing central bank, but they are normally not convertible into metal. But ‘inconvertible’ is not the same thing as ‘unbacked’.

  1. Question: Is the real bills doctrine as you define it a theory that is as generally applicable as the quantity theory claims to be, or is it a theory that applies to some kinds of monetary institutions and circumstances and not to others? (See my comment just below for a clarification.)

Answer: The backing version of the real bills doctrine says that money is valued according to the assets and liabilities of its issuer, just like stocks, bonds, bills, notes, warrants, and any other financial securities. In this sense it is generally applicable.

Comment: In wartime many occupying armies have issued a kind of currency, usually forced into circulation at par with the existing currency on the official market. The aim of this currency was frankly to enable the occupier an easy means to commandeer goods. The currency was not readily exchangeable into any foreign currency, including the home currency of the occupying army, and there were no reserve assets of recognized international value held against it. Does the real bills doctrine as you define it apply to analysis of these currencies, or is it confined to more normal historical cases?

Answer: If, for example, Mexico has issued 100 pesos, backed by assets worth 100 oz of silver, then 1 peso=1 oz. If America then takes over, issues 200 “occupation pesos” and spends them, then there will be 300 pesos backed by only 100 oz of assets, so then 3 pesos=1 oz.

  1. Comment: To me, saying that acceptance of currency for tax payments provides a kind of backing is metaphorical rather than literal. When I think of backing I think of convertibility at a set rate of exchange. A currency that is supposedly backed by certain assets but cannot be exchanged for any of them at a set rate is not backed in the way I believe most people think of the term, or in the way that issuers backed their currencies under most types of gold standard.

Answer: In the American colonial period, colonial governments would collect taxes worth maybe 5 silver shillings (English coin) from each colonist every year. In 1690, the colony issued paper shillings and paid them to soldiers, declaring that those paper shillings would be acceptable in lieu of silver shillings at tax time. If those paper shillings had been convertible in the conventional sense, a colonist could have presented a paper shilling to the government and demanded a silver shilling in return. But these paper shillings were convertible in the sense that the colonist could present them to the tax man and be relieved of having to pay 1 silver shilling. Either way, the paper shilling is convertible. If the present value of the colony’s “taxes receivable” is 1000 shillings, then the colony could issue up to 1000 paper shillings against that asset, just like a banker could issue 1000 paper shillings against 1000 shillings worth of assets held in his vault.

  1. Comment: In your example of the playing card money, the retort from the quantity theory side is that inflation does not occur when the money supply triples because the velocity of money (inversely related to the demand to hold money) changes. Other things are not equal, in other words.

Answer: Nobody claims that the value of General Motors’ bonds or stock is affected by the velocity with which those stocks and bonds circulate. The values of GM’s stocks and bonds are determined by GM’s assets and liabilities (broadly defined). The backing theory says the same is true of money. In the case where each paper livre is convertible into 1 silver livre, velocity cannot affect that value. Once this is recognized, the next step is to recognize that convertibility can take many forms. A paper livre can be convertible into silver, into bonds, into taxes, land, loan repayments, etc. If metallic convertibility makes velocity irrelevant, then so do the other kinds of convertibility. (I should add that velocity is a notoriously slippery concept, and is easily used to allow quantity theorists’ models to always be right no matter what.)

  1. Comment: In the 1990s I heard this aphorism about central banks in poorer countries (which, remember, had had a terrible decade from 1982-1992): “The assets are garbage; the liabilities, everyone believes in.” For a floating currency during normal, noncrisis periods, as long as the central bank’s liabilities are limited in quantity, I don’t see what difference it makes whether the assets are Swiss government bonds or dodgy loans purchased from domestic banks. During a crisis it matters, because Swiss government bonds are easy to sell in quantity without having to offer fire-sale discounts and dodgy domestic loans are not. If backing matters so much, though, shouldn't we see less marked a difference between crisis and noncrisis periods in the value of the currency, since the assets on the day before the crisis and the assets the day the crisis begins are the same?

Answer: It makes no difference whether a central bank issues 100 pesos in exchange for Swiss bonds worth 100 oz of silver, or dodgy loans worth 100 oz. of silver. Either way, 1 peso=1 oz.  But if a crisis comes along, the Swiss bonds will stay at 100 oz, while the dodgy loans drop to 20 oz, and the pesos that are backed by the dodgy loans will fall from 1 oz/peso to 0.2 oz./peso.