Archive for the Category Monetary History

 
 

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.

Why does Geithner think money was tight during the 1930s?

Matt Yglesias has moved, which creates a dilemma.  Do I keep reading the old link at Slate, and then end up reading all the other fascinating/appalling non-Moneybox articles written by the kids over there, or do I follow him to his new link?  I don’t have time for both.  Here Yglesias quotes from Tim Geithner’s book Stress Test:

Loose monetary policy can have limited power in a crisis, because low interest rates don’t help that much when borrowers don’t want to borrow and lenders don’t want to lend, but as the central bankers of the 1930s demonstrated, tight monetary policy can be disastrous.

That last claim caught my attention.  I wondered why Geithner thought money was tight during the 1930s. I presume he’s mostly referring to the Great Contraction, from roughly August 1929 to March 1933. Here are some things the Fed did during the Great Contraction:

1.  Short term interest rates were cut quickly and sharply, from about 6.5% to just above zero.

2.  When rates got low the Fed did more and more QE, raising the monetary base through open market purchases of securities.

3.  There was also the Reconstruction Finance Corporation, aimed at helping to support the banking system.

I know what you are thinking; “Sumner, haven’t you claimed those indicators are misleading, and that money has been tight since 2008 despite all the QE and rate cuts?”  Yes, that’s what I’ve been saying.  And yes, I believe Geithner is right in claiming that money was tight during the 1930s.

But here’s what I can’t understand, why does Geithner think money was tight during the 1930s? I’m pretty sure he’s not a market monetarist, based on his other expressed opinions.  I suppose he might cite the Friedman and Schwartz data on M2, but does anyone seriously think he uses M2 as an indicator of the stance of monetary policy?  Didn’t the Fed stop publishing M3 (its modern equivalent) because almost no one even cared?

So once again, what are these “lessons” that the Fed learned from the Great Depression?  Why does Geithner think monetary policy was tight in the 1930s but easy since 2008?  How does he determine the stance of monetary policy?

I also noticed some other good Yglesias posts.  This one on taxes is excellent.  There’s also a very good post on capital, but I’m going to quibble a bit with his conclusion:

But there are some things mainstream economics doesn’t seem to explain very well.

For example, on the neoclassical theory poor countries that successfully get rich should do so by liberalizing their financial systems, running trade deficits, and importing foreign money until over time they build up enough capital for the marginal productivity of labor to increase. In practice, successful catchup stories (first in Japan, then in Singapore and Taiwan and Korea, now in China) work the other way around — countries use financial repression and run trade surpluses to develop increasingly sophisticated local businesses.

During Korea’s high growth phase they ran fairly consistent current account deficits.  Between 1960 and 1985 I am pretty sure they ran deficits every single year, averaging close to 8% of GDP. That was because domestic investment was far higher than domestic saving.  Then they moved into surplus in the late 1980s, before moving back into deficits in the 1990-97 period.  I think people have a tendency to assume that because Korea has recently run surpluses, it has always done so.  It did things the correct way, borrowing when it was poor to build up its capital stock.

Why quibble over a single country?  Because some people (not Matt) make sweeping conclusions based on a single characteristic of a successful country.  I suppose I’ve been guilty at times.  One thing Korea did do, for instance, is infant-industry policies.  But Hong Kong was just as successful without those policies, and AFAIK, they have not played a particularly important role in a few of the other cases (these things are actually hard to measure, for instance import tariffs and export subsidies offset each other.  If the two policies are done across the board they net out to nothing.)

I don’t know what explains all of the East Asian growth miracles, but I’m skeptical of factors that show up in only some of the countries.  Those factors might have helped, but I doubt they were decisive, especially if others did just as well without those policies.  Perhaps the closest thing to a generalization one can make is “export-oriented.”  But how did they do that?

PS.  In a recent post I quoted Paul Krugman claiming that he couldn’t think of important intellectuals on the other side changing their mind after the worries of high inflation didn’t pan out. Later a bunch of people sent me one quote after another of Krugman praising policy hawks like Kocherlakota and Arthur Laffer for having the guts to admit they were wrong and change their mind.  One commenter prefaced his comment with, “In Krugman’s defense.”  That made me smile. Please, I beg of you, don’t ever “defend” me that way.

On the other hand, Krugman has very good posts bashing the ECB here and here.

Let’s play 1960s-era Fed

Marcus Nunes has a nice post comparing the views of Janet Yellen and Martin Feldstein.  I noticed that Feldstein is worried that we are going to repeat the mistakes of the 1960s.

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later.

Before we consider whether we are likely to repeat the mistakes of the 1960s era Fed, let’s review precisely what those mistakes actually were. Here’s the data as of November 1966:

Unemployment rate = 3.6%, and falling.

Inflation = 3.6% over previous 12 months.  That’s a big increase from the 1.7% of the 12 months before that, and the 1.3% inflation rate two years previous.  The “Great Inflation” began here.

The fed funds rate was 5.76%.

Hmm, what should the Fed do in a situation like this?  Inflation is beginning to accelerate.  Unemployment is near all time lows for peacetime.  Decisions, decisions.  You’ve taken EC101, what do we do next?

The answer is easy.  The Fed decided the economy needed a massive emergency jolt of easy money.  By December 1966 the fed funds rate was cut to 5.40%.  By January 1967 the rate was cut to 4.94%.  By April it was cut to 4.05%.  By October 1967 it’s at 3.88%.  Keep in mind NGDP was rising at 6% to 8% throughout the late 1960s.  If you prefer the monetary base as your “concrete steppe”, that indicator started growing much faster as the 1960s progressed.

Now read the minutes of September 2008, when the Fed refused to cut rates in the midst of the mother of all financial panics because of inflation worries, despite TIPS spreads showing 1.23% inflation over the next 5 years, and commodity prices plunging.  Does this seem like a Fed that would slash interest rates much lower when inflation is soaring above target and unemployment is 3.6%?

PS.  Keep this data in mind when some fool tells you that the Great Inflation was caused by oil shocks or the Vietnam War or budget deficits or unions, or some other nonsense.

PPS.  The economics profession (with a few exceptions) was complicit in the crime of 1966.  The Fed generally does what the consensus thinks it should do.  The “best and the brightest,” the VSPs.  Still think it’s impossible that the entire profession could have been as crazy in 2008-09 as I claim they were?  How will the Fed’s behavior in 2008 look 50 years later?  I’d say about like the 1966-67 Fed looks today. Out of their ******* minds.  And then there’s the ECB . . .

PPPS.  One economist that did understand what was going on was Friedman.  I find this (from an Edward Nelson paper) to be amusing:

From April 1966 to the end of the year, the evidence of monetary policy tightening started appearing uniformly across monetary aggregates; the “credit crunch” of 1966 is also evident in other financial indicators and is widely recognized as a period of monetary tightness (Romer and Romer, 1993, pp. 76−78). The Federal Reserve would shift to ease in 1967, and that easing marked a dividing point for Friedman. He would classify 1967 as the beginning of an extended departure from price stability, one in which monetary policy fitted the pattern he had laid out in 1954: an inflation roller-coaster around a rising trend, with the occasional deviations below that trend reflecting shifts to monetary restraint that were abandoned once recessions developed (M. Friedman, 1980, p. 82; Friedman, 1984, p. 26).

The FOMC did not, however, appreciate the scale of its easing during 1967. By explicitly associating high nominal interest rates with tight policy, Committee members and other Federal Reserve officials neglected the distinction between real and nominal interest rates. Friedman, in contrast, was pressing this distinction on policymakers. Chairman Martin could not ignore the criticism, not least because Friedman had attracted the interest of Martin’s Congressional interlocutors. Friedman’s revival of the Fisher effect was referred to when Martin appeared at a February 14, 1968, hearing of the Joint Economic Committee (1968, p. 1980):

Senator SYMINGTON. A famous economist has developed the theory that easy money creates higher interest rates. If you have not examined that concept, would you have someone on your staff do so? It is an interesting theory. I discussed it with the economist in question only last week. Would you have somebody look into it?

Mr. MARTIN. I will be very glad to. 

The “famous economist” was, of course, Friedman.

In 2008 no senator asked Bernanke to look into the theory of an obscure Bentley economist that low interest rates are often a sign that money has been tight.

Our monetary system is becoming increasingly primitive

David Glasner has a good post on the recent Bank of England essay on money, but I’d like to respond to one of his comments:

What the authors mean by a “modern economy” is unclear, but presumably when they speak about the money created in a modern economy they are referring to the fact that the money held by the non-bank public has increasingly been held in the form of deposits rather than currency or coins (either tokens or precious metals). Thus, Scott Sumner’s complaint that the authors’ usage of “modern” flies in the face of the huge increase in the ratio of base money to broad money is off-target. The relevant ratio is that between currency and the stock of some measure of broad money held by the public, which is not the same as the ratio of base money to the stock of broad money.

Actually my claim also applies to currency.  Here is the data for 1929 and today:

January 1929: Currency = $3.828b  M1 = $26.109b  M2 = $55.119b

Today:  Currency = $1239b    M1 = $2793b    M2 = $11137b

I realize that “everyone knows” that the modern economy relies more on bank deposits and less on cash than in the old days, but I’m afraid that’s just one of the many things “everyone knows” that is not true.  Note that the C/M1 ratio would have increased even if you had only looked at currency held within the US (believed to be as much as half of the total currency in circulation.)  It’s unclear what would have happened to the C/M2 ratio.