Archive for the Category Monetary History


Don’t underestimate monetarism

A commenter sent me the following:

This slim volume describes a weighty and wonderful event. In 1920, the American economy entered what would presently be diagnosed as a depression. The successive administrations of Woodrow Wilson and Warren G. Harding met the downturn by seeming to ignore it—or by implementing policies that an average 21st century economist would judge disastrous. Confronted with plunging prices, incomes and employment, the government balanced the budget and, through the newly instituted Federal Reserve, raised interest rates. By the lights of Keynesian and monetarist doctrine alike, no more primitive or counterproductive policies could be imagined. Yet by late 1921, a powerful, job-filled recovery was under way. This is the story of America’s last governmentally unmedicated depression.

Sometimes it seems like everyone wants to pick on the monetarists, including to some extent even market monetarists.  Monetarism is ridiculed by Keynesians, Austrians, MMTers, Real Business Cycle supporters, fiscal theory of the price level proponents, etc., etc. It seems out of date, with not many young supporters.  It allegedly “failed” in the 1979-82 monetarist experiment, even though:

1.  That period successfully broke the back of inflation, as the monetarists predicted and others doubted, especially given the Reagan fiscal stimulus.  It led to a severe recession, as the monetarists predicted.  And it was followed by a strong recovery, as the monetarist predicted (but the Keynesians thought unlikely without a rise in inflation.)

2.  Furthermore, the policy of 1979-82 was not truly monetarist (money growth varied), and the monetarists would never have expected velocity to be stable during a period of rapid disinflation. Their argument was that V would stabilize in the long run, if money growth were stable in the long run.  That was never tried.

I find even that weaker claim to be dubious, which is one reason that I am not a traditional monetarist. And of course Friedman made some bad predictions in the 1980s (but since when do bad predictions discredit a model?) Nonetheless, let’s give monetarists their due; contrary to the implication of the quotation above, Friedman and Schwartz’s Monetary History does explain the depression of 1921:

M2 money supply:

May 1920 peak:  $30,304 million.

Sept. 1921 trough:  $27,830 million

December 1922:  $31,920 million

Monetarists would predict a steep recession and fast recovery.  And that’s what happened.

PS:  Rereading the quote, it doesn’t actually say the monetarists failed to predict a fast recovery, but I sort of think that was implied.  Did I misinterpret the quotation? How would the average person interpret the quote?

PPS.  I have not read Grant’s book, but I do believe the 1921 depression is a good example of the natural recuperative powers of a free market economy.  In that sense, it could be viewed as being inconsistent with old Keynesianism, as well as modern variants that say wage cuts will make the depression worse, and that massive fiscal stimulus is needed.  Of course Keynesianism is a slippery critter, which is hard to pin down.  They would probably point to the lack of a zero bound problem. They mention positive interest rates when convenient (1921) but ignore positive interest rates when inconvenient (eurozone 2008-12.)

Chris Rock gives new meaning to “creative destruction,” and Ezra Klein responds

I’m afraid that I don’t know much about Chris Rock.  I stopped watching TV decades ago and don’t keep up with pop culture.  Most of my readers will find this interview to be too liberal (as I do), but you can’t deny that he’s an interesting thinker, and has some provocative observations.  One of my favorites was when he compared being a rich black man in America to the Bill Murray role in Lost in Translation.

Ezra Klein also enjoyed the Rock interview, but he criticized Rock’s claim that Obama should have let the economy drop sharply in early 2009 (no bailouts or stimulus), so that the GOP would have owned the fiasco, and then later in 2009 Obama could come in and rescue the economy.  I’m going to slightly disagree with both Rock and Klein, but not quite in the way you might expect. Before doing so let me point out that Ezra Klein may well be the most talented reporter in America, and I was honored to make a recent list of “must read” bloggers he mentioned.  However even there I’d respectfully disagree.  I’m probably a bit more moderate and pragmatic that Bryan Caplan, but he’s someone liberals need to read more than me, even if they are annoyed.  He should replace me on the list.  Robin Hanson too.

Here’s Klein discussing Rock:

The big problem with this idea — which I’ve heard other liberals propose in the past — is it’s morally odious: it would have meant putting millions of Americans through harrowing pain in order to help Obama out politically. If a GM lets a team flatline the team loses a few games. If the president lets the country’s financial sector flatline millions of people’s lives are destroyed.

But the other problem with this idea is it would have be a political disaster for any president, including Obama, who tried it.

Those are fine arguments, and I mostly agree.  But consider the following historical analogy. Between July and October 1932, the economy finally began recovering.  Then a relapse occurred, partly due to Hoover’s incompetence.  In a campaign speech Hoover indicated that we were almost forced off gold early in the year, and that only his adroit leadership had saved the gold standard. Of course that made the markets doubt the future stability of the gold standard, especially with FDR leading in the race for president.

FDR was never willing to commit to staying on the gold standard, despite it being part of the Democratic platform in 1932.  Unfortunately, fixed exchange rate regimes are one area where (for better or worse) governments have to lie.  If they even hint that they might consider devaluation, markets will lose confidence in the currency and attack the peg.  FDR should have either lied and said he’d stay on gold, or announce he planned to devalue, which would have immediately forced a devaluation.  The uncertainty from October 1932 to March 1933 created a run on the dollar and then a collapse of the banking system during the long interregnum.  In the last days of the Hoover administration, the President tried to put together a bank holiday plan and asked for FDR’s cooperation (i.e. commitment to continue the policy.)  FDR would not cooperate.  This is not to exonerate Hoover; he should have done the bank holiday anyway.  He was a very incompetent president, despite being perhaps the most competent person to ever be elected president.  There must be a lesson in there somewhere for the “great man” theory of history.

Then FDR took office, and immediately saved the day with a bank holiday.  But that was not enough to spur a recovery, so 6 weeks later he devalued the dollar.  Now FDR was the hero.  Then he implemented lots of Hoover’s ideas in his New Deal–mostly bad ideas, like the cartelization of industry and artificially high wages.

FDR’s sabotage (if that’s what it was–which is of course debatable) occurred before he took office. So it’s not exactly what Rock proposed.  But given how much liberals revere FDR, I could not help thinking of this episode when reading Klein’s piece.  So in a sense I agree with Klein, and that’s why I believe FDR should have avoided ambiguity over the dollar.  Don’t do something that hurts the economy, in the hope that the later political implications will allow you to become a hero by saving it.  It’s like a three bumper shot in billiards, theoretically possible, but highly unlikely.  And that means unethical.

Now for my contrarian view.  I don’t think Obama could have sabotaged the economy, even if he had tried. Unlike FDR, he had little control over monetary policy in the short run.  If during the campaign he had promised to put a hawk in charge of the Fed, his promise would have been laughed at.  All he had was fiscal policy, and you all know about my views on monetary offset. Indeed I think an Obama attempt to sabotage the economy via austerity might have actually helped.  Here’s the argument:

1.  Depression scholar Ben Bernanke had no intention to preside over another Great Depression. While he preferred that fiscal policymakers would share the burden, he was prepared to go it alone if necessary.

2.  Some of the suggestions Bernanke gave Japan in the early 2000s (like level targeting of prices, or focusing on NGDP) would have probably been more effective than the actual monetary and fiscal stimulus combined.  Would he have pulled out a nuclear option like level targeting?  I can’t be sure, but I’d say that without fiscal stimulus there is at least a 25% chance the recovery would have been faster due to strong monetary stimulus, and perhaps a 40% chance it would have been about the same.  And yes, that means there’s a non-negligible probability that I am wrong about monetary offset, as I’ve always acknowledged.

I don’t expect this argument to change the minds of any Keynesians, and I’m not sure I’m entirely convinced myself.  But I do believe we overrate the ability of any one person, even the president, to boost the economy.  And that also means we also overrate their ability to hurt the economy.

I don’t believe that President Obama understands economics well enough to be qualified to sabotage the economy, or save it.

PS.  Check out David Henderson’s excellent piece on police brutality, and also Adam Ozimek’s great post.

The Great Inflation

For God’s sake will people stop talking about inflation!  Especially you inflation “truthers” who insist the BLS is lying and the actual inflation rate is between 7% and 10%. Those are the sorts of rates we averaged during the Great Inflation of 1965-81. For those too young to remember, a little history lesson:

I was so excited when my dad came home with a red 1964 Oldsmobile 88.  That was a car for upper middle class Americans.  We were only middle class, but lived in an upper middle class house, because my dad was smart.  The car was actually used, but almost new.  He used to say a car lost 15% of it’s value the minute it was driven out the door of the dealer.  Now when I go look for late model used cars the dealers ask more money than for a new model. Here’s the car (which sold for $3600):

Screen Shot 2014-09-09 at 8.15.01 PM

Now let’s flash forward to 1986.  The Japanese cars are in style, and the first upper middle class Japanese car on the market is the Acura Legend, which sells for $22,500, more than a six-fold increase in 22 years. It was voted Car of the Year. That’s what high inflation feels like.

Screen Shot 2014-09-09 at 8.18.52 PM

Now let’s go up to the present.  I’m not quite sure what model would be comparable to the Legend, but the Accord is made by the same company, and is slightly larger.  Here’s a picture of the Accord:

Screen Shot 2014-09-09 at 8.22.44 PMI’m pretty sure the Accord LX is better than the Legend LS in almost every way you could imagine.  It’s price?  Brace yourself, because 28 years is even more than 22 years. Surely the price of cars has risen more than 6-fold in the last 28 years. I’d say around $200,000.  Nope.

OK, $100,000.  No.


Actually it’s $22,105. (The link has all the specs.)

Cars have gotten cheaper over the past 28 years.

In nominal terms.

(The CPI says car prices have risen about 35% in the past 28 years–I don’t believe that.)

BTW, wages of factory workers rose from just over $2.50 an hour in 1964, to about $8.90 in 1986, to $20.68 today.  Put away the tissue paper, the middle class is doing fine.

My favorite car was a 1976 powder blue Olds Cutlass with a T-bar roof, whitewall tires and white bucket seats:

Screen Shot 2014-09-09 at 8.47.42 PM

It was a $6000 dollar car, but I bought it used for $3500 in 1981. That’s actually a 1977, I don’t have a picture of my car.

Hmmm, I thought they were a bit better looking than that.

And no, I did not have a “Landau roof.”  I do have standards.

PS.  OK, I cheated a bit by using a Wikipedia photo of the Legend, which isn’t too flattering, and a very pretty official Honda web site photo of the Accord.  But I’m not kidding, I’d rather have the Accord, even for the same price.

Millennials have no idea how lucky they are that they can just go out and buy a Honda Accord, brand new.  On a middle class income.

That BMW you always dreamed of?  Back in 1970 they looked like something made in a Soviet factory.

PPS.  Labor intensive service prices have risen much more than car prices, and high tech goods have fallen dramatically in price.  There is no such thing as a “true rate of inflation,” but there’s also no reason to assume that inflation has not averaged 2% in recent decades.  It’s just as reasonable as any other number the BLS might pull out of the air.

DeLong on the mother of all black swans

Brad DeLong has a post that is mildly critical of Shiller’s stock market model in almost precisely the same way that I am critical of Shiller’s stock market model.  The only difference is that DeLong knows more finance than I do, and makes the case far more effectively than I can.  I was intrigued by his conclusion:

That is a perspective very different from mine, which regards the failure of the CAPE to spend most of its time north of 25 as a mystery.

But given that it does not, it would be very rash for anybody who is not certain that they can wait out the market to invest more than they can afford to lose. And past performance is not only not a guarantee it may not be an indicator of future results. We have had one real Black Swan–World War I–in the past 130 years.

The first part refers to what DeLong and I think is the real mystery—not so much why stocks were so high in 1929, 2000, and now, but rather why they were so low 90% of the time.

I think WWI is a great black swan example, but without really disagreeing with DeLong I’d like to throw out another possible black swan—1968.  And no, I’m not thinking of all the assassinations and political turmoil in the US (as well as many other countries.)  It’s not clear that the political events of 1968 had much permanent effect; 1979 was the real turning point (see the PPS of this post.)  Instead I’m going to argue the shift from gold to fiat money was a black swan.

First let me digress with a bit of history.  It became illegal for Americans to redeem dollars for gold in 1933.  I seem to recall that in 1968 the gold window was closed to foreign individuals, and in 1971 the window was closed to foreign central banks.  (Someone correct me if I am wrong.)  So the gold standard sort of faded away over a 40-year period.  Then why pick 1968?

Even though Americans could not redeem dollars for gold in the 1960s, they could buy foreign currencies, and/or goods in foreign countries.  And there was a free market in gold in some foreign countries.  So up until 1968 gold continued to provide at least a weak anchor to the monetary system, at an international price of $35/oz.

My second point is that switching to a permanent fiat system was much more inconceivable to people in the old days than you might imagine.  Yes there were brief experiments like the greenbacks of the Civil War and the German paper money of 1920-23.  But even Keynes opposed a pure fiat regime, and viewed these historical examples as sort of pathological cases.  If you had told someone in 1968 that by 1980 the price of gold would be over $800/oz. they would have thought you were a lunatic.  It was $20.67/oz. in 1879.  It was still $20.67 an ounce in 1932.  It was $35/oz. in 1934.  It was still $35/oz. in early 1968. I recall that when gold was around $150/oz. in the 1970s, one of my economic professors at Wisconsin predicted the price would soon fall back into the $40s, as it was far overvalued.

DeLong identifies three periods when stock investors did poorly over the following 10 years—right before WWI, the late 1960s and early 1970s, and the late 1990s.  Even today I’m not sure exactly how much of the poor stock market performance of 1968-81 was due to the Great Inflation. Inflation did punish savers given that the IRS taxes nominal capital income.  But does that explain the entire underperformance?  Was there money illusion (confusing real and nominal interest rates) when discounting future profits?  I’m not sure.  I am confident, however, that moving to a fiat money regime was a black swan for the US 30-year Treasury bond market, and pretty much every other bond market as well.

PS.  And take a look at this excellent post over at MarginalRevolution.

David Glasner on me on IS-LM

Here is David Glasner:

Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in two slides following almost immediately after the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest, and shows how to do the modification. Here are the slides:

.  .  .

Thus, expected deflation raises the real rate of interest thereby shifting the IS curve to the left while leaving the LM curve where it was. Expected deflation therefore explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, holding Foote up as an example of this confusion on the basis of the first of the slides, but Foote actually shows that IS-LM can be tweaked to accommodate a correct understanding of the dominant role of monetary policy in the Great Depression.

Was I really so unfair?  Did I actually accuse Foote of not understanding that tight money can reduce nominal rates.  You be the judge:

Note the very last comment on the slide, about the significance of deflation.  The rest of the PP slides develop this idea further, and correctly show that while tight money might raise real interest rates, it could lower nominal rates through the Fisher effect. Thus it could shift the IS curve.  That helps, but it seems to suggest that the IS-LM model can be rescued by switching the argument from nominal to real interest rates. Alas, that won’t work.  The Fisher effect is only one of the ways that monetary shocks impact interest rates.  Tight money also reduces expected future real GDP, and this also shifts the IS curve.  So it isn’t just nominal interest rates that fall, real rates also fell during the 1930s, as expected future real GDP plunged.

It sure looks like I’m suggesting that Foote “correctly” understood the distinction between the impact of monetary policy on real rates and nominal rates.  I’m not sure where David got the idea I was being critical of Foote.  Then David simply ignored my observation that switching from nominal to real interest rates in no way rescues the IS-LM model.  Tight money can also reduce real interest rates.  Ex ante real rates did fall during the 1930s.  So IS-LM cannot be “tweaked to accommodate a correct understanding” of the role of money Depression.  It’s rotten to the core.

David continues:

The Great Depression was triggered by a deflationary scramble for gold associated with the uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop “excessive” stock-market speculation, raised its discount rate to a near record 6.5% in early 1929, greatly amplifying the pressure on gold reserves, thereby driving up the value of gold, and causing expectations of the future price level to start dropping. It was thus a rise (both actual and expected) in the value of gold, not a reduction in the money supply, which was the source of the monetary shock that produced the Great Depression. The shock was administered without a reduction in the money supply, so there was no shift in the LM curve. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model.

I agree that the best way to visualize the Great Contraction is through a large increase in the demand for monetary gold.  But I’m confused by David’s claim that this would not shift the LM curve.  Gold was the medium of account.  Unless I’m mistaken, an increase in the demand for gold would certainly be expected to shift the LM curve to the left, wouldn’t it?  (But then IS-LM is not my forte, so please tell me if I am wrong.)

PS.  In case you think I cherry-picked a quote, here’s the opening to my post, where I describe the quality of Foote’s PP slides:

Commenter Joseph sent me an excellent set of PP slides by a professor at Harvard named Chris Foote.  He has a very clear derivation of the AD curve from the IS-LM model.

If I’m going to be accused of being unfair to someone, at least give me the satisfaction of trashing their work!  My post had no criticism of Foote at all.  Just some criticism of ideas he listed on one slide as things other people have claimed might have caused the Depression.  I never assumed that was his view, and indeed he himself criticized some of those arguments in later slides.

PPS.  And how does David know I am “emotionally committed” to the view that IS-LM is worthless? Perhaps I have rational reasons for holding that view.  I’ve claimed that monetary policy can shift the IS curve, or else one has to assume the IS curve is upward sloping (Nick Rowe’s view.) I haven’t seen anyone rebut that view, emotionally or unemotionally.