Archive for the Category Monetary History


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.

Why history of thought matters

Tyler Cowen linked to a new blog by Chris House:

My guess is that the important insights of these earlier contributions have been, more or less, adequately incorporated into modern textbooks.  I’m fairly sure that few modern biologists read Darwin’s original Origin of Species, and even fewer modern mathematicians read Euclid’s Elements.  If you want to have a good understanding of modern geometry and number theory, you should simply read a good college-level mathematics text on the subject.  The same holds for the study of evolution.  As great as Darwin’s contribution was, our modern understanding of evolution now eclipses his.  This is the reason behind my casual dismissal of the idea of reading the original General Theory.  If you want a good understanding of these ideas, you are better served by consulting say Mankiw’s intermediate-level Macroeconomics than by reading Keynes or Hicks.  For a somewhat more advanced treatment, you can take a look at Chapter 10 in Blanchard and Fisher (1989).

.   .   .

I could of course be completely wrong.  I recall Christy Romer saying that her decision to spend one of her summers in graduate school reading Friedman and Schwarz’s A Monetary History of the United States was one of the best decisions she ever made.  In a course on the history of thought, or on the rhetoric of economics, I would expect the students to read selections of the originals.  And, of course, there are ideas in the earlier works that are poorly understood, underappreciated or simply forgotten.  Remember though, there is a probably a reason these ideas were not incorporated into the contemporary narrative of economics.

I’m in no position to give grad students advice, as I’m a bit out of touch with modern econ programs.  But I will say that whatever modest success I’ve had with this blog is mostly due to my reading of economic history and the history of thought—two fields that I believe are closely intertwined.  A few examples:

1.  I found that the macro environment during the interwar years is much more interesting than post-WWII, mostly because the government did all sorts of wild and crazy policy experiments. What if the world’s central banks sharply raised their gold reserve ratios, and depressed the global money supply?  What if the US devalued the dollar sharply and unexpectedly during a period of zero interest rates and 25% unemployment?  What if the government suddenly and unexpectedly ordered all firms to raise their nominal hourly wage rates by 20%?  All three of these experiments occurred in just a 5 year period.  Yes, the macro data wasn’t quite as good back then, so economists looked at how asset prices responded to policy shocks—which is the right way to do it in any case!

2.  The interwar economists saw this stuff going on and the results helped inform their policy views. It turns out that there are many ways of thinking about the macroeconomy, which is almost infinitely complex.  Consider the identification problem for monetary shocks, which still hasn’t been solved.  Should monetary policy be thought of in terms of the price of money (Mundell) the quantity of money (Friedman) or the rental cost of money (Keynes)?  During the interwar years many economists thought of policy issues using a very different mental framework from what economists use today.  And I would argue that researchers familiar with these alternative perspectives (Christy Romer, Robert Hetzel, David Glasner, etc.) tended to have more useful things to say about the recent crisis than those who were not.

Modern macro seems to have a certain methodological homogeniety, with the DSGE approach being particularly popular.  Even if it is the best single approach (and I’m not convinced it is) it still might be better for the field if researchers tried all sorts of different approaches so that they would be better prepared for crises like 2008.  We are like a city of 10 million clones where no one has immunity to bird flu.  Nick Rowe has a new post showing that from a certain perspective the New Keynesian (interest rate oriented) way of thinking about the world is really strange, and yet almost everyone thinks that way.   Recall that many of our most famous macroeconomists had little to say about the failures of monetary policy in 2008-09, with Romer/Hetzel/Glasner, etc., being notable exceptions.

PS.  It’s debatable as to whether the General Theory’s best ideas are incorporated into IS/LM-style textbooks.  But even if they are, I would suggest students look at the Tract and the Treatise, which are better books.  And then read Fisher, Cassel, Hawtrey, Pigou and the others.

PPS.  Here’s a post on bubbles I did over at Econlog.

Is finance an important part of macro?

I have an open mind on this question, but so far I don’t see much evidence that it is.  Let’s break this down into two parts:

1.  Does finance have an important impact on the path of NGDP.

2.  Does finance have an important impact on RGDP, through mechanisms other than its impact on NGDP?

A whole lot of miscommunication could be prevented if people would at least briefly frame their arguments in terms of these two questions, even if they prefer to spend 98% of their time ignoring these two questions.  That’s because it makes it much easier to understand what they are talking about.  For instance, consider a big drop in lending.  Is that a supply or demand shock?  Is it something that impacts RGDP directly, or only via it’s impact on AD?  It could be either, or both, and it’s often hard to tell from a person’s blog post which channel they are talking about. (Kudos to Arnold Kling for being crystal clear.)

Finance certainly has an impact on NGDP under a gold standard, as does drug smuggling, and also under a poorly run fiat regime, especially at the zero bound.  It’s not at all clear that finance has any impact under a well run fiat regime.  For instance, NGDP took off like a rocket after March 1933, even as much of the US banking system was shutdown.

Finance certainly might have an impact on RGDP, even if NGDP is well behaved, but I haven’t seen much evidence for that proposition.  At least not in the US.  For instance, RGDP took off like a rocket after March 1933, even as much of the US banking system was shutdown.  And no, I’m not repeating myself.

This post is partly in response to a recent post by David Glasner, which contains this observation:

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

Market monetarists have differing views of money.  For myself, I don’t find the aggregates to be at all interesting, and hence pay no attention to “money multipliers.”  I know there are people out there who are obsessed by the supposed implications of certain accounting relationships, but I try to avoid the subject as much as possible.  If it does arise I simply refer to Krugman’s brilliant dismissal of one pesky blogger—Krugman said “it’s a simultaneous system.”  In other words, accounting tells you nothing about causation.

Finance certainly looks important.  But that’s mostly because monetary policy has a huge impact on finance.  Since 99.999999% of people don’t know how to identify monetary shocks, they reverse the causation—assuming finance is impacting NGDP.  Remember 1931?  I thought not.  But how about 2008?

The focus on finance may have a downside that many people overlook.  Here’s a small passage from my Depression manuscript:

Enthusiasm for Hoover’s proposal was not confined to the NYT.  The June 27 [1931] issue of the CFC (p. 4635) enthused “President Hoover has electrified the whole world and possibly turned the tide of business depression”.   A “Hooverstrasse” was proposed for Berlin.  The British compared the proposal to a new armistice and suggested that the move ranked in importance with the U.S. entry into World War I.  Of course Hoover’s debt moratorium was subsequently shown to be ineffective in arresting the ongoing depression.  Nevertheless, the financial community had great hope for the plan, which indicates they saw the debt crisis as inhibiting recovery.

Between June 2 and June 27the Dow soared by almost 29 percent, and the next day’s NYT (p. 7N) suggested that “War Debt Plan Aids Commodity Prices. . . Sharpest Advance Since Last Summer Shown in Most Groups in Fortnight”.  Although the reaction of financial markets to the moratorium was unquestionably enthusiastic, the reasons are unclear.  Perhaps it was felt that the moratorium would reduce gold flows to countries with a high propensity to hoard (i.e. the U.S. and France.)  The June 27th CFC (p. 4653) suggested that Hoover’s goals were limited and that it was hoped that the agreement could lead to a climate of “international good will”.

On June 30th the NYT (p. 1) quoted a bank official as indicating that “it would be a mistake to over-emphasize the proposed debt adjustment as an economic factor in itself”.  Unfortunately, Hoover strongly opposed two initiatives that might have provided meaningful help for Germany; a coordinated international policy of tariff reduction, and a coordinated attempt to lower the world gold ratio through expansionary monetary policies.[1]  Those who have followed the recent events in Europe will see an obvious parallel.  The Europeans have worked hard to develop a debt relief plan for countries on the periphery, but have failed to take the one step that could actually make a big difference, an ECB policy aimed at faster nominal growth in the eurozone.

[1]  Hoover criticized the theory that deflation was resulting from a “maldistribution” of monetary gold stocks.

So they focused on debt relief thinking that would solve the problem, when the real problem was tight money.  Of course the ECB made the identical mistake in 2011-13.  Two European depressions, both caused by policymakers thinking finance was the problem when monetary policy was the real problem. Let’s hope it never happens again.

PS.  There is one important sense in which I pay more attention to finance than just about anyone else—the EMH.  The markets tell me the impact of QE.  I trust them more than anyone else, including myself.  As soon as the market start seeing QE as deflationary I’ll nominate Steven Williamson for a Nobel Prize.