Some thoughts on Selgin’s productivity norm
Now that George Selgin has placed his almost legendary “Less Than Zero” essay online, I thought it was a good time to discuss his ideas. I’m going to nitpick a few points, so it might be useful to first lay my cards on the table—do I support the productivity norm or not?
I think there are actually two (or three) distinct ideas in George’s essay, which I see as being logically separate issues. There are two versions of the productivity norm, based on labor productivity and total factor productivity. But the difference between them is not all that important in my view. Much more important is his argument that prices should fall at the rate that productivity is increasing. I see this as a completely separate argument that raises an entirely different set of problems. So here is my preliminary response, before getting into details:
1. The productivity norm as a monetary policy regime? It’s OK with me if it is OK with you (meaning my fellow Americans.)
2. Mild deflation at the rate of productivity increase? Yes, but only if several stringent preconditions are met. And we haven’t yet met them.
George uses many of the same methods that I employ to make arguments. He mixes intuitive thought experiments, economic history, history of thought, pragmatic arguments, fairness arguments, and illuminating analogies/metaphors.
He starts with an intuitive argument. Suppose you had n industries, and there was a sudden increase in productivity in one of those industries, say computers. The increase in productivity in the computer industry would lower the relative price of computers. Under a price level target, you would have to inject enough money to slightly raise the price of all other goods, in order to offset the fall in the price of computers. That seems unnecessarily cumbersome. In contrast, under a productivity norm (assuming unit elastic demand for computers) you could let the price of computers fall and keep all other prices the same. This little thought experiment shows that the “menu cost” argument doesn’t necessarily show that price level targets are superior to the productivity norm. (BTW, he employs a very nice analogy using Baroque fugues and Romantic symphonies. It’s too long to summarize here, but take a look at pages 23-25.)
Selgin actually discusses several versions of this policy. He considers a NGDP rule to be superior to a price level rule, as it would allow productivity increases to depress the overall price level. But he thinks a productivity norm would be even better. He discusses both a labor productivity norm (where prices fall at the rate labor productivity increases) and a total factor productivity norm (where prices fall at the rate which total factor productivity increases.) Although he leans toward the TFP standard, I am going to use the labor standard in my examples, for these reasons:
1. In practice, I don’t think the implications differ very much from the TFP norm.
2. I like it better.
3. I find it easier to understand and explain.
4. It is similar to Earl Thompson’s 1982 proposal.
Those interested in the TFP version should consult his essay.
In practice, with the US trend GDP growth rate around 3% and the labor supply growing around 1% per year, the labor version would result in a trend rate of deflation of about 2%. (And I believe the TFP version would lead to closer to 1.5% deflation, on average, but am not certain.) So aggregate nominal wages would be stable and workers would earn real wage increases through falling prices. Indeed something like this occurred between 1870-1897. This is another reason to discount the “menu cost argument” for a price level rule. Yes, a price level rule would keep the average price of goods stable. But it wouldn’t stabilize factor prices. And wages are an especially sticky factor price, which suggests changes in the aggregate wage level may be very costly.
Another common argument for preventing inflation is that it harms creditors. But suppose prices rise because of an adverse productivity shock; George asks why creditors shouldn’t bear some of the burden. If a big asteroid devastated the US, then under a price level target the Fed would prevent all T-bond holders from suffering any loss in purchasing power. The lifestyle of those government bond coupon clippers would be supported by the back-breaking labor of the remaining citizens, picking through the wreckage of a Cormac McCarthy-type landscape. Is that fair? Maybe, but it’s not obvious why it’s more fair than spreading out the pain.
In principle, a productivity norm does not have to aim for mild deflation. You could target nominal wages to grow at 2% per year. In that case inflation would average about zero percent, but the actually rate of inflation would vary inversely with labor productivity shocks. Since I find most of George’s arguments for the productivity norm to be fairly persuasive, I’d like to nit-pick his arguments for a mild deflation productivity norm, rather than near-zero inflation productivity norm.
First let me start with an issue on which I think we agree. George indicated that he agreed with my argument that 2008 was not a good time to institute a policy of even mild deflation. Many wage and price contracts had been negotiated under higher inflation expectations, and of course the banking system was already heavily stressed by defaults from the housing crash. So let’s consider the long run arguments for mild deflation, assuming the system was phased in during a more stable period.
Selgin has several arguments for mild deflation:
1. Friedman’s optimum quantity of money argument (i.e. mild deflation lowers the inflation tax on cash balances.)
2. Rising factor prices can lead to macroeconomic instability (boom, followed by recession.)
3. Prices would be stable in industries with no productivity variation, thus the price system would more effectively send signals about productivity to consumers and producers.
4. With stable aggregate wage levels, workers would find it easier to respond to labor market signals.
These are aesthetically pleasing arguments, and I’ll add one more ugly pragmatic argument, one that might be even more important. Our tax system discriminates against saving and in favor of current consumption. This is even true when inflation is zero, and becomes worse at high inflation rates. Mild deflation would lower the real effective tax rate on capital, and this would increase the real growth rate in the economy. Cutting the other way is the fact that cash is extremely useful in the underground economy, so mild deflation (and near zero interest rates) might expand the size of the underground economy. Japan has this problem.
Now for the other side:
I am not convinced by the wage rate argument. I worry about two problems. One is money illusion, the fear that workers are irrationally antagonistic to nominal wage cuts. George’s response is that wages don’t have to be cut in declining industries, as any attempt to cut wages will push workers toward growing industries. If this works smoothly, the wages ought to be about the same in each industry (adjusted for skill levels obviously.) But I worry that labor markets don’t work that well. Labor is heterogeneous and it is very costly to move from one industry to another. Thus real wage cuts are often necessary in declining industries. And if aggregate nominal wages are stable, then you are back to the money illusion problem–you must convince workers to take nominal pay cuts, but you can’t “trick them into doing the right thing” with inflation. A very aesthetically ugly argument, but one that I fear is true.
My other major concern relates to the current interest rate-oriented monetary regime, in which central banks see themselves as being powerless in a near-zero interest rate environment. Yes, the US did OK in the late 1800s. But the gold standard somewhat anchored price level expectations during that period, and this helped us avoid a liquidity trap. In addition, real interest rates were higher than today because of the rapid population growth and the industrial revolution.
George makes some theoretical arguments based on the assumption that equilibrium real rates should be at least as high as the rate of productivity growth. But I am not sure that is always the case. Government bonds offer liquidity advantages, and it seems to me that in the US the real interest rate on government bonds may fall below the growth rate on productivity.
My nightmare scenario is Japan. My critics point out that the Japanese should have adjusted to mild deflation by now. True, if the rate was absolutely steady. But what seems to happen is that Japan does adjust for a few years, but then when it falls into recession (like right now) the central bank doesn’t know how to use its policy tools to prevent deflation from intensifying. I think this problem could be eliminated with a futures-oriented NGDP target, level targeting (or indeed the same level targeting approach concept applied to Selgin’s productivity norm.) But we haven’t gotten there yet. So right now I oppose mild deflation. Here is the order in which things need to be fixed:
1. First, we need level targeting of a nominal aggregate.
2. Then let’s target the forecast of that aggregate.
3. Then let’s adopt a near zero inflation productivity norm.
4. Then we can go to a mild deflation productivity norm.
I am also less than convinced by George’s argument that stable wage rates would avoid the boom and bust cycle that can develop when nominal wages trend upward. I don’t see how this argument is consistent with the superneutrality of money. On the other hand you know that I like pragmatic arguments, so I imagine there are all sorts of real world factors that might make rising wage levels more prone to lead to business cycles. So I’ll leave that as an open issue. (As an aside, I completely agree with George’s view that price level targeting can push up factor prices during productivity booms, with possible destabilizing consequences. But I don’t see a problem with a slightly positive trend rate of wage growth, as long as the rate of inflation can still vary inversely with fluctuations in productivity growth.)
A few minor comments on his historical section:
1. There is nothing technically wrong with his comments on WWI, but he might leave some readers with the impression that most of the inflation was merely offsetting the hit to productivity associated with wartime disruption. In fact, the inflation of both goods and factor prices was extremely large, and mostly monetary.
2. I disagree with his view that the post-1929 deflation cannot explain the 1929 crash. I think the crash occurred when the market correctly saw the way things were going. I have mixed feelings about the Austrian argument that the problem was the Fed’s refusal to allow mild deflation in the 1920s. I think a case can be made for that argument, but only as part of a broader argument for discretionary monetary policy under a gold standard regime. Under a fiat regime, the actual 1920s policy could have continued indefinitely.
Another way of making that point is that the stable prices of the 1920s might have been destabilizing in retrospect, but not so much because productivity gains were not allowed to depress prices, but rather because there wasn’t enough gold in the world to maintain this policy indefinitely. If I went back in a time machine to 1922, I would suggest to the Fed that they aim for 1-2% deflation per year as the best way of staving off a collapse after 1929.
[BTW, that’s an idea! Perhaps I should tell the Fed that I came in a time machine from the future, where all central banks target NGDP futures contracts, level targeting. I could tell them that because Bernanke implemented the policy in 2010, he went down in history as the greatest Fed chairman ever.]
3. Again, I can’t find any specific error in his discussion of negative productivity shocks and inflation during the 1970s. However, it is important to recognize that RGDP increased at a fairly normal rate in the 1970s. So George’s argument probably only applies to brief periods when there were severe productivity shocks, such as 1974. The reader should certainly not infer that George favors the high inflation that we actually observed during the 1970s.
A few final comments. I really liked this pragmatic argument on page 66:
The real choice we face is therefore, not really a choice between a true productivity norm or a truly constant price level, but between some crude approximation of a productivity norm and some equally crude approximation of a constant price level.
As you may guess, I’d go further and say; “and some even cruder approximation of a constant price level.”
There is a discussion of free banking at the end of the essay. His proposal to freeze the monetary base and allow free banking might or might not work. It depends how stable the demand for bank reserves is. He assumes the demand is proportional to transactions, i.e. to NGDP. But that is not at all clear (as he admits in footnote 57.) I’d be terrified to put my reputation on the line advocating something like this, especially given the long and sad history of Goodhart’s Law. I’d feel much safer getting to free banking via Bill Woolsey’s index futures convertibility approach.
To summarize, I am mostly convinced by the theoretical arguments for the labor productivity standard. Indeed I reached this conclusion on my own from a different direction, publishing a paper favoring a wage index target in 1995. And Earl Thompson proposed this idea in 1982. My half facetious comment “if it’s OK with you” in the intro referred to the strange politics of this idea. What would workers think about the Fed freezing aggregate nominal wage rates? You and I know that this policy does not impact on real wages over the long run, but would the public perceive it that way? When minimum wages (nominal) were recently increased by 40%, above minimum wages (nominal) would have had to fall. Of course this makes obvious what we would hope voters already understand about the costs of minimum wages, but for now I think the politics of a NGDP target are less iffy. Still, you have to start somewhere, and so I am glad to see George trying to educate people about this idea. I would add that there are cases where you could easily sell the benefits to workers, for instance the sharp reduction in wage growth seen in the current recession would not have occurred under a productivity norm (where nominal wage growth stays constant at zero.)
Bill Woolsey has several interesting posts on the Selgin paper. I would also recommend this recent Cato paper by David Beckworth. Interestingly, David’s paper was published in the fall of 2008. So he did not realize that deflation was about to become a problem. Although I completely accept George and David’s distinction between good deflation (from productivity increases) and bad deflation (from tight money), I still worry that many people may draw the wrong implications from this argument.
I was on a panel at the Southern Economics meetings in San Antonio with fellow bloggers David Beckworth, Josh Hendrickson, and also George Selgin, who would be a better blogger than any of us three if he decided to throw his life away and blog full time. A year earlier at the SEA meeting in late November, 2008, I attended a panel with five right-leaning monetary economists. Several of them seemed a bit too dismissive of the looming deflation threat for my taste. And this is my fear. Playing with deflation is like playing with fire. We need to sort out much more fundamental problems with monetary policy before we risk an intentional policy of deflation, despite the fact that many of George and David’s arguments are quite persuasive. If we don’t, we could accidently burn down the house entitled “free market economics.”
Tags: George Selgin
2. December 2009 at 17:37
“When minimum wages (nominal) were recently increased by 40%, above minimum wages (nominal) would have had to fall.”
But if the minimum wage was effectively indexed to productivity, there wouldn’t be a need to raise its nominal value in the first place. You would only need to ensure it was at some (political) “equilibrium” level when the policy was implemented, or allow a one-off exception afterwards.
2. December 2009 at 19:00
Can anyone tell me how well we know (empirically) how large nominal rigidities are both in an absolute an relative sense? People frequently assert that wages are quite sticky, and this seems plausible enough to me, but I don’t know any actual evidence for this assertion. Are there any good lit review sources our there?
2. December 2009 at 19:49
“And if aggregate nominal wages are stable, then you are back to the money illusion problem”
–Why does everything in macro have to go back to this faith in sticky wages? For all your criticisms of Keynesians, you still fall back on this red herring when questioned.
“My other major concern relates to the current interest rate-oriented monetary regime, in which central banks see themselves as being powerless in a near-zero interest rate environment.”
— I struggle to see any argument here. You’re basically saying ‘under this regime, we have this problem’, under Selgin’s regime, where this problem wouldn’t exist, “we wouldn’t be able to deal with this problem.” Note in free banking, no one centrally sets an interest rate; interest rates are market prices determined by supply and demand.
“I am also less than convinced by George’s argument that stable wage rates would avoid the boom and bust cycle that can develop when nominal wages trend upward.”
–That’s because for all your talk of Hayek, you have absolutely no clue about his business cycle theories, because you refuse to read him. Your ignorance of his theories is no argument against them, it’s an argument for you to read them!
“Under a fiat regime, the actual 1920s policy could have continued indefinitely.”
–No, it couldn’t because you would get Zimbabwe.
When we first had this argument on a previous thread here, I made the case that it was inflationary monetary policy that led to the crash in 1929. You retorted by saying that it couldn’t have because the monetary base didn’t increase. I retorted with data on the total money supply, which did increase significantly. You yourself would obviously admit that the total money supply is the relevant metric here, and not the monetary base (after all, you care about trageting NGDP, not the base). But you then shifted the goalposts and told me that the Fed had inflated in other periods and that didn’t lead to such a big crash, so its inflation in the 1920’s couldn’t be the reason. I bring this up to point out the glaring incoherence of your view, and the fact that it is a belief looking for an argument–any argument–to justify it. First, you dismissed the Austrian story by resorting to the monetary base, and when that argument was destroyed, you resorted to another. And you still haven’t tried to understand the Hayekian story of why monetary manipulation is the one and only cause of business cycles. Look, his business cycle theory speaks directly to your belief that this bubble could be continued, and he won the Nobel for it, so you might want to read it.
“but rather because there wasn’t enough gold in the world to maintain this policy indefinitely. ”
This is another manifestation of your grave misunderstanding of how the gold standard works–or doesn’t work. There is no magical quantity of gold needed, or needed growth rate in gold. Any quantity of gold is enough; what matters is that the authorities do not inflate beyond this quantity. When monetary inflation happens under a gold standard, this leads to a rise in the exchange ratio between the dollar and the gold backing it. This is also known as a rise in the gold price. (increased money supply=more dollars. more dollars=rising exchange ratio between gold and dollars. this makes gold prices go up.) This is what gives you the illusion that the problem is not enough gold. It isn’t. The problem is inflationary monetary policy messing up the backing of the currency with gold. And since inflation will always happen with a central bank, this is why a gold standard is unworkable.
It was the inflationary policy that was destabilizing. Without it, the economy would have grown, prices would’ve dropped, wages would’ve adjusted between industries and prosperity continued. But with inflation, you had a bubble (read Hayek), then you had a crash, then you had interventionist government policy, and then you had constant failed attempts to centrally plan the currency and prices.
“If we don’t, we could accidently burn down the house entitled “free market economics.””
–You can’t successfully centrally plan anything in a free market economy. And yet, for some strange reason, you maintain the illusion that centrally planning the price mechanism is necessary for the market to work. And somehow you see all the disasters that this central planning causes as evidence for the need of more central planning. I invite you to consider the alternative hypothesis that this central planning just cannot work, and that the disasters we’ve seen are caused by it.
3. December 2009 at 01:38
I think we need more experiments. A double blind experiment seems impossible. But how about we ditch the dollar, create new currency for each state, and then randomly assign a few different policies for the states. Then watch and learn. How politically impossible wouldn’t that be to implement?
3. December 2009 at 03:34
It’s important to bear in mind that the degree to which prices are “sticky” depends on the nature of the innovation that’s behind a change in their equilibrium values–a point universally overlooked in modern macroeconomic theories with their one-size-fits-all-shocks Calvo staggered pricing parameters and such. In particular, firms often engage in production innovations having as their sole aim that of reducing unit production costs and allowing the firms to cut prices accordingly. There’s no question of “stickiness” in such cases! And this describes most if not all positive productivity innovations! Such cases are quite unlike those of flagging demand, where the innovation is truly a surprise or shock to many firms–and one they may well misinterpret (e.g., by hoping it’s just transient).
By the way, Scott: I prefer to think of the productivity norm as a specific form of nominal income targeting, rather than as an alternative to such targeting. And thanks for your very generous and thoughtful review of my argument!
3. December 2009 at 04:13
Two more quick observations, one on WWI and the 70s; the other on Austrian cycle theory. Concerning the two inflation episodes, my point in discussing those was of course not to deny that they were mainly due to excessive monetary expansion, but rather to insist that a strict zero inflation policy would have been inappropriate in both cases in so far as they also involved serious adverse supply shocks.
The downturn phase of an Austrian cycle is often misunderstood–even by some of its proponents–as necessarily involving a reduced rate of monetary expansion. In fact it comes about as the result of the return of real interest rates to their “natural” levels, which is inevitable no matter how rapidly nominal money and credit grow. The return is a result of credit demand catching up to supply in consequences of rising prices, of goods generally perhaps but especially of factors of production. It follows that you don’t have to have a gold standard or other nominally-constrained monetary regime to have an Austrian cycle: resort to fiat money doesn’t suffice to allow authorities to keep a boom going forever. Indeed, I think that in some respects the Austrian theory fits 2001-2009 better than it fits 1924-1933. (I hasten to add that in both cases tight money made the downturns far worse than the Austrian payback story alone could account for.)
3. December 2009 at 06:35
Declan, Good point. I wonder how politically feasible that would be.
jsalvatier, That is an extremely hard question. We got no pay increase this year at Bentley. So it seems are wages are flexible, as we usually get a 4% increase. But everyone’s nominal wages would have had to fall 8% below trend, in order for 8% below trend NGDP growth to have had no real effects. I don’t think many workers got 8% below trend wage changes.
saifedean, You asked;
“Why does everything in macro have to go back to this faith in sticky wages? For all your criticisms of Keynesians, you still fall back on this red herring when questioned.”
I’ve never seen any other persuasive explanation for why deflation causes high (involuntary) unemployment. Do you have any?
You said;
“- I struggle to see any argument here. You’re basically saying ‘under this regime, we have this problem’, under Selgin’s regime, where this problem wouldn’t exist, “we wouldn’t be able to deal with this problem.” Note in free banking, no one centrally sets an interest rate; interest rates are market prices determined by supply and demand.”
I was not yet considering free banking (which won’t happen anytime soon.) Selgin is willing to advocate the productivity norm even without free banking. That is the issue I was addressing.
You said;
“-That’s because for all your talk of Hayek, you have absolutely no clue about his business cycle theories, because you refuse to read him. Your ignorance of his theories is no argument against them, it’s an argument for you to read them!”
If Hayek has a good argument against the superneutrality of money, I’d love to hear it. Since no one has presented that argument to me, I doubt it exists. The comment section is the place for you to counter my arguments, not tell me what to read. What is Hayek’s argument against the superneutrality of money?
The US had stable prices in the 1920s, Zimbabwe had hyperinflation. I fail to see the similarity.
I have never argued that the broader aggregates are the correct way to judge the stance of monetary policy.
I never tried to “dismiss the Austrian story by resorting to the monetary base.” I simply respond to false assertions when they are made. The base is the form of money produced by the Fed. It is not true that the Fed injected a lot of new money into the economy during the 1920s.
You said:
“It was the inflationary policy that was destabilizing. Without it, the economy would have grown, prices would’ve dropped, wages would’ve adjusted between industries and prosperity continued. But with inflation, you had a bubble (read Hayek), then you had a crash, then you had interventionist government policy, and then you had constant failed attempts to centrally plan the currency and prices.”
If policy was inflationary, why was there no inflation in the 1920s?
malavel, 100% impossible.
George. I agree with you on the importance of the type of price stickiness. As another example, prices that are adjusted on the basis of time periods (say once a year) are more macroeconomically destabilizing than prices that are adjusted on the basis of gap between actual and equilibrium price. That is why I think wage stickiness is more of a problem that price stickiness. Wages are more likely to be adjusted on the basis of elapsed time.
George#2, Yes, I hope I didn’t created the impression you favored high inflation, I was mostly trying to put the issues in context in case someone read you essay quickly and got the wrong impression. You did have the appropriate qualifiers.
In my view a mild recession can occur without monetary tightness, simply from the after-effects of an overheated economy. So in that sense I agree with you. I doubt whether this could cause a severe recession, and I gather that my views are similar to the “secondary deflation” concept discussed by Austrians.
3. December 2009 at 07:46
Two more very minor notes, Scott–but worth mentioning as they go to showing that our views are really closer than might otherwise appear to be the case. First, concerning the likely average deflation rate under a total factor productivity norm, I’d estimate it at no more than 1% rather than 1.5%, as most estimates place the long-run trend growth rate of capital input at somewhat over 1 percent; that is to say, that of the 3 percent average growth of real GDP, about one third belongs to each of the three factors of labor input, capital deepening, and TFP growth. That the first two factors are far easier to project than the last strengthens the case for a TFP norm (and indeed for other types of nominal income targets) as opposed to stable P norms, as the former don’t call for the monetary authorities to accommodate (and therefore to have to try and anticipate) output growth due to productivity improvements.
3. December 2009 at 07:54
Oh dear–I hit “Submit” before getting to my second point, which is that I quite agree that the present intermediate interest-rate target regime is the wrong one for implementing a productivity norm–or for maintaining a sound monetary policy of any sort in an environment of low interest rates. Like you I favor McCallum’s intermediate base targeting approach–that is, a money base growth rule with feedback from NGDP growth–for implementing a productivity norm under the present fiat CB regime; and I believe that such an approach, combined with the very low trend deflation we are talking about, would together suffice to avoid any risk of the policy leading us into a liquidity trap.
3. December 2009 at 09:27
As I understand Hayek, e.g. section 4 of _Monetary Theory and the Trade Cycle_, this is also Hayek’s view.
Scott writes:
“In my view a mild recession can occur without monetary tightness, simply from the after-effects of an overheated economy.”
3. December 2009 at 09:35
Scott writes:
“In my view a mild recession can occur without monetary tightness, simply from the after-effects of an overheated economy.”
There is a distinction to be made here. At the turning point of the trade cycle, money WILL tighten for those who have over-extended themselves, e.g. those who have over-leveraged, or depended on an ever expanding asset bubble, or have erroneously anticipated future demand for long-term capital project outputs at unobtainable high prices. The will have a demand for money and credit and capital that they can’t afford or acquire — think of those Las Vegas casinos now rusting, those housed bulldozed in SoCal, those Michigan auto factories shuttered and closed.
But this “tightening” doesn’t have to be a matter of fluctuating central banking policy
3. December 2009 at 11:12
I think, Greg, that your last post confuses “tight money” with losses. In any event, I don’t understand what it means to speak of persons having “a demand for [capital] that they can’t afford or acquire.” Merely _wanting_ isn’t demanding, right?
3. December 2009 at 12:02
George, this is about plans over time, right?
Folks have plans that cannot be sustained — and can only be sustained via money and credit that they must compete for in the market: they have a demand at a price and credit risk that can’t now be met on the market.
(An aside. At a low enough price I have a demand for a Lear jet, right?)
George writes:
“I think, Greg, that your last post confuses “tight money” with losses. In any event, I don’t understand what it means to speak of persons having “a demand for [capital] that they can’t afford or acquire.” Merely _wanting_ isn’t demanding, right?”
3. December 2009 at 12:32
Four points, some quite unrelated to this post:
(1) A wage inflation target is equivalent to a productivity norm, because productivity = (price of goods produced) / (labour needed). An ngdp or nominal spending target, however, is strongly different, because it seeks to stabilize amount traded, not price (of labor).
(2) In Chapter 1 of “Interest and Prices”, Woodford writes:
“[C]entral banks should target a measure of “core”
inflation that places greater weight on those prices that are stickier. Furthermore, insofar as wages are also sticky, a desirable inflation target should take account of wage inflation as well as goods prices. The empirical results
discussed in Chapter 3 suggest that wages and prices are sticky to a similar extent, suggesting (as I show in Chapter 8) that a desirable inflation target should put roughly equal weight on wage and price inflation.”
(read here: http://press.princeton.edu/chapters/s7603.pdf)
I do not know about the quality of the empirical evidence cited by Woodford, but it’s probably better to cite something empirical rather than simply “believing” something or postulating it more or less as an axiom. And Woodford’s method leaves it open to the future to learn more about the exact distribution of stickiness in the economy. Also, wage vs. other price stickiness might be different for different countries and change over time. Wages are really just the price for labor, and labor is a good like others. Therefore, it makes sense to only speak of price stickiness, simply to save ink.
(3) A comment on the monetary policy indicator discussion: For me, interest rates and monetary base are just two coordinates, which you can transform into one another using the clearing balances demand curve. That is the curve which has interest rate on the one axis and base on the other. At the fed, this curve is estimated on a daily basis and the base is then adjusted using open market operations to change the base to where it is thought that the interest rate will equal the fed funds target. At the ecb, however, banks bid every week for clearing balances, that is, they tell the ecb what amount of money they are willing to lend and at what interest rate. Thus, the ecb does not have to estimate the clearing balances demand curve.
I agree with Sumner that the relationship between both interest rates and the base on the one side and the economy on the other side is quite unstable. However, interest rates are clearly more useful, for two reasons:
Firstly, the interest rate makes clear the effect of the zero lower bound: a target cannot be hit if all interest rate paths that lead to the target being hit involve a point in time where the interest rate is below zero.
Secondly, the relationship between the interest rate and the macro economy is independent from the deposit rate, while the relationship between the base and the macro economy strongly isn’t. So you really need two variables to descibe monetary policy. Apart from that, the incentive to reduce money holdings is proportional to the difference between deposit rate and riskless interest rate, while being independent from the monetary base. In other words, by describing monetary policy in terms of the two variables interest rate and difference between interest rate and deposit rate, you perfectly decompose its effects on the macro economy, which determines ngdp, cpi, etc, and its effects on the opportunity cost of holding money, which determines the amount of money the public will invest in its efforts to reduce money holdings.
(4) I’d like to criticize Sumner’s position that we should favor looking at expectations over looking at interest rates and the base. To me, this is skipping one step, because it is not obvious what the relationship between expectations and policy is. Instead, targeting something and discovering the relationship what you do (and credibly commit to do) and the market’s expectations are two different things.
For the former, I favor targeting minimization of a social loss function that is derived from explicit welfare analysis. For the latter, I favor a prediction market that tells you the social loss function, as defined by the central bank, conditional on the monetary policy conducted.
3. December 2009 at 12:35
“Cutting the other way is the fact that cash is extremely useful in the underground economy, so mild deflation (and near zero interest rates) might expand the size of the underground economy.”
Why is the wonderful bonus a problem?
3. December 2009 at 13:10
For Felix: A wage index target is equivalent to a _labor_ productivity norm, which is what Scott focuses on, but not to a TFP norm, which I favor. As for wages being no more sticky than prices, that’s not the most common finding; and please, _please_ bear in mind my point above (made also in LTZ), that the “stickiness” of P depends on the shock. Empirical studies that report a measure of “average” stickiness overstate the stickiness of P under a productivity norm, where the only shocks to which P must adapt are those to aggregate productivity. Woodford, like most, overlooks this crucial point. (He also overlooks the fact that Wicksell had not one but three criteria for interest rates being at their “natural” levels, and that these coincide only for the constant productivity case. Indeed, if you read Woodford (2003) carefully (on “Inflation targeting and optimal monetary policy”) and go through his conditions for P stability being “roughly” optimal, you will find that they are practically all violated when there are innovations to TFP, and that the violations are such as suggest that in such cases optimal policy is in fact “roughly” achieved by letting P move the opposite way from TFP. This is so notwithstanding that Woodford’s own aim here is to defend a P stability norm.
3. December 2009 at 13:20
No offense to Mr. Selgin, but I don’t see why this paper is considered “legendary”. I don’t spend a lot of time reading theoretical economics so I was unaware of this paper until today, but this is basically the same argument I’ve been making for many years. I just had this very debate with an economist (who runs a well known investment site) in January of this year. He took the zero inflation side and I took the position that deflation is essentially the payoff for the produtivity gains of capitalism. If deflation is not the result of your monetary system, some of the benefits of capitalism (division of labor), which should be pretty farily distributed, are being stolen. I’m not positive but I think I came to that view after reading Adam Smith many, many years ago.
The beneficiaries of a purposeful inflation are elites – the wealthy and politicians (often one and the same). Since they also happen to be the ones who get to decide what kind of monetary system we have, it should surprise exactly no one that we have a system which is beneficial to its designers. Public choice theory indeed.
By the way Scott, I also thought immediately of Earl Thompson in reading through Mr. Selgin’s paper. Very similar.
3. December 2009 at 13:20
George, Thanks for the estimate on TFP growth. I think 1% deflation is fine as long as we can get a suitably forward-looking monetary policy, and level targeting. I think those two innovations (even without explicit futures targeting) would keep us out of a liquidity trap.
Was is St. Augustine who said “Lord, help me be good, but not quite yet?”
George#2, Actually I don’t favor an intermediate target of the base. I favor using the base as an instrument to target NGDP growth expectations. I favor a forward-looking policy. But you are right, our views are very similar. I think we are both skeptical of interest rate targeting.
Greg, Those are good points. I prefer to call the tightening at the end of a cycle “credit tightening” because the perceived risk of loans has increased. Monetary policy can prevent all this from spiraling into secondary deflation, but I agree with you and George that if we’ve overheated we have to take something of a hit in terms of real GDP. I think this would typically be a modest rise in unemployment, not a very steep rise.
I just noticed George also thought “tight money” was the wrong term. I wonder whether he thinks “tight credit” is appropriate.
Felix, Good questions. You said;
“(1) A wage inflation target is equivalent to a productivity norm, because productivity = (price of goods produced) / (labour needed). An ngdp or nominal spending target, however, is strongly different, because it seeks to stabilize amount traded, not price (of labor).”
I presume by “amount traded” you mean nominal amount. But yes, they are somewhat different, under a wage target NGDP would fluctuate with hours worked.
You said;
“I do not know about the quality of the empirical evidence cited by Woodford, but it’s probably better to cite something empirical rather than simply “believing” something or postulating it more or less as an axiom.”
Good point, but the empirical evidence is very hard to evlauate. For instance, I don’t believe price indices are accurate, and I do believe their inaccuracy makes prices seem more sticky that they really are. For instance, the “rents” used as proxies for housing prices are not economic prices at all, they are installment payments in debt contracts. Thus actually CPI fell much more sharply than measured CPI this year.
In my defense, I have published papers on the issue of wage vs price stickiness, including one in the JPE, so it’s not like I’m just dreaming up theories.
You said:
“(3) A comment on the monetary policy indicator discussion: For me, interest rates and monetary base are just two coordinates, which you can transform into one another using the clearing balances demand curve. That is the curve which has interest rate on the one axis and base on the other.”
There is more than one monetary base consistent with any given interest rate, so there is a solution multiplicity issue (if that’s the right term.) Interest rates depend on the expected future path of the base. I don’t like to use either interest rates or the base as an indicator of policy, I prefer the expected future level of NGDP. The higher the expected future NGDP, the more expansioanry the monetary policy. But more expansionary policy will often be asociated with higher nominal rates, and in some cases even higher real rates.
You said;
“Firstly, the interest rate makes clear the effect of the zero lower bound: a target cannot be hit if all interest rate paths that lead to the target being hit involve a point in time where the interest rate is below zero.”
I don’t follow this. If you are talking about a target like inflation or NGDP, there is always some path of the monetary base that would be expected to hit the target. So there must also be an interest rate path. Liquidity traps aren’t really traps at all.
I see your point about how with two rates you can influence both the supply and demand for base money, whereas a base instrument only influences the supply side. But I am not clear why this is an advantage. In any case, an open market operation will influence both interest rates and the base, so as long as you are targeting NGDP growth expectations using OMOs, I don’t see how this debate is important. I am not a monetarist who favors using the base as an intermediate target, so I find the whole debate rather sterile.
I completely agree with your last point about first developing a social loss function, and then using prediction markets to hit that target. Indeed I published those ideas in 1989 and 1995.
Gene, Touche.
3. December 2009 at 13:27
Joe, George’s paper makes more than one argument for mild deflation, it is the most comprehensive treatment of the issue that I am aware of.
I didn’t mean “legendary” in the sense of “The Wealth of Nations”, I meant in the sense of often cited, but hard to find a copy.
3. December 2009 at 14:41
George, one interesting point in your idea is that the natural rate of deflation will increase over time. I don’t know if you have already covered this, but technology growth tends to be faster than exponential. For example, moore’s law.
http://upload.wikimedia.org/wikipedia/commons/c/c5/PPTMooresLawai.jpg
The slight upward curve in the plot signifies the growth is happening faster than exponentially.
3. December 2009 at 15:54
Scott,
I just finished reading the entire paper and it is certainly comprehensive. I also think it is very intuitive and would probably make more sense to the average person on the street than the average economist. As Selgin has pointed out in other places, people grasp “good deflation” pretty easily; it is the economists who seem to have a fetish about falling prices. It would be interesting to hear Selgin’s view of current policy in light of the productivity figures released today.
3. December 2009 at 16:51
For Joe Calhoun: Actually, when I first began thinking about these issues and came to conclude that P should decline with unit costs, I thought I had arrived at a novel view. But then I did my homework and found that I had reinvented an old idea. I eventually published two HOPE articles on the history of the productivity norm idea, at least one of which is referred to in LTZ. So I don’t think I can be accused of pretending to all that original.
On the other hand, when I was working on this stuff, starting in the late 80s (my first long and never published working paper on the subjects dates from that time), _no one_ believed in good deflation. Even in ’97, when my pamphlet came out, it was very fringe stuff–as the cites testify! Now, I hope, people are more prepared to take the argument seriously.
3. December 2009 at 16:57
“Declan, Good point. I wonder how politically feasible that would be.”
I think it would be exactly as feasible as the rest of the policy. If everyone else is willing to have stable nominal wages, then I don’t see any problem in extending that to the minimum wage. If people aren’t willing to accept a constant nominal minimum wage even when prices are falling, then they wouldn’t accept it for other wages either, and the policy wouldn’t work even without a minimum wage.
Or if you were referring to the one off adjustment, Australia did a similar thing with our CPI target when we introduced the GST (a consumption tax/VAT). I think other countries have also done this without a problem.
3. December 2009 at 19:00
Mr. Selgin,
Unfortunately, I guess you are right; this is/was fringe but what the hell, I’ve spent a good part of my life in the fringe and I kind of like it. All the best ideas and interesting people are out here. Let’s hope that you and Scott (and a few others) aren’t always considered fringe. As for originality, well most people probably think Art Laffer came up with the Laffer curve too. There isn’t much new in the world or much that one of our ancestors didn’t figure out. Why we have to keep figuring out the same things over and over I don’t know but at least there are folks like you and Scott around to do it.
3. December 2009 at 23:58
Also, another question for Dr. Selgin:
As productivity growth increases but standard inflation targeting increases the money supply anyway, the difference between the two would grow even faster.
Does your theory predict that bubbles and such should become much more common as time goes on?
4. December 2009 at 05:54
Doc: Although some posts here have suggested otherwise, the _growth rate_ of productivity hasn’t been steadily increasing. Instead, it varies around a mean that appears to be constant. So there’s no reason to expect bubbles to become more common–at least, not on the score you mention.
4. December 2009 at 06:27
You said: “I’ve never seen any other persuasive explanation for why deflation causes high (involuntary) unemployment. Do you have any?”
YES! I do! Anyone who’s read Hayek does!
-Hayek’s theory explains that monetary manipulation distorts capital allocation, causes bubbles and leads to busts. The bubble bursting exposes all sorts of malinvestments (investments that should not have been carried out, but were only carried out because of the monetary manipulation). These bad ventures need to be liquidated. The labor that was employed in these ventures needs to go work in other places, and that takes time. This isn’t frictional unemployment. It isn’t that one guy has to quit his job in housing and go into factory work. It’s that millions of people are laid off from housing at the same time, and all need to find other jobs. And there is nowhere near enough manufacturing to absorb them, because most capital had been tied up in the housing bubble. So a massive misdirection is needed from housing to other things. That is the recession. You need to be able to have a basic understanding of capital theory to realize that not all capital is the same, that prices allocate capital differently between industries, and that this carries costs.
The current recession is a perfect example. In all your writings, you seem to ignore that there was anything wrong with the housing bubble. You seem to imagine that if NGDP growth was maintained, the housing bubble could be maintained indefinitely! The reason there was a collapse in NGDP, a recession and large unemployment, is that the monetary expansion of the 2000s led to misdirection of capital and labor into a housing bubble.
Have you ever thought about this? Isn’t there a limit to how much houses the country should be producing? Aren’t there more useful avenues for investing capital? Isn’t there any cost to wasting too much labor and capital on housing?
“If Hayek has a good argument against the superneutrality of money, I’d love to hear it. Since no one has presented that argument to me, I doubt it exists.”
–YES! He does!
For monetary manipulation to have no distortionary effect on production, you need to assume neutrality of money, and you need to also assume that all prices will seamlessly adjust in general, and in individual sectors, and that people will have perfect expectations of how prices will move in aggregate and in each particular good. No one, not even Robert Lucas, believes these things are possible. In reality, monetary changes will have differing effects on different goods and sectors of the economy, leading to distortions of the patterns of production.
Again, you continue to argue with the Austrians based on the patently absurd presumption that if something isn’t mentioned in the comments section of your blog, then it doesn’t exist. Hayek has a whole appendix in Price and Production dedicated specifically to discussing the neutrality of money. You can find the whole book here http://mises.org/books/pricesproduction.pdf, and the discussion starts on p.129. I’ll excerpt the punchline, since I know you are physically allergic to clicking through to any Austrian books:
“The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a, distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly,all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realised by any kind of monetary policy.”
You said: “The US had stable prices in the 1920s, Zimbabwe had hyperinflation. I fail to see the similarity.”
–Zimbabwe is what would have happened had the US followed your advice and continued to increase NGDP irrespective. That they stopped is what caused the stock bubble. You can’t print prosperity, and increasing the money supply will not lead to increased wealth, it will lead to mangling production and productivity, business cycles, and finally hyperinflation.
You said: “If policy was inflationary, why was there no inflation in the 1920s?”
For the millionth time: increased money supply was concurrent with productivity increases. The first raises prices, the second lowers them. Irving Fisher’s genius attempts at fixing the prices gave him and the government the illusion that they know what’s going on and that prices and stocks are under control. They didn’t, and Fisher’s genius was apparent for all to see when the stock market burst.
You can’t possibly convince me that you don’t understand this simple point, especially after you’ve read Selgin!
Scott, you’ve favorably mentioned Hayek many times, and have even used his arguments to support yours. Hayek’s life’s work in economics is about the business cycle. His work on the business cycle destroys your belief in targeting NGDP growth and a bubble that never pops. Hayek has won the Nobel Prize for this work. It strikes me as really odd that you continue to willfully ignore the work of someone you like, whose work is very relevant to yours, who’s been awarded the highest accolade for this work.
Will you please read Monetary Theory and the Trade Cycle? It’s very short and an easy read and you can find it all here: http://mises.org/books/hayekcollection.pdf
4. December 2009 at 07:08
Joe, I agree.
Declan, I can’t say whether it is politically feasible or not, but your response points to one potrential problem. When you say it would be similar to George’s proposal for stable aggregate nominal wages, you confuse real and nominal wages. george’s proposal has no influence on the long run path of real wages. If that proposal was adopted than any attempt to stabilize the nominal minimum wage would be effectively control the real minimum wage.
saifedean, There are several problems with your response.
1. It is completely unrelated to the question I asked. I asked how delation could cause unemployment without sticky wages, and you responded by telling me how misallocation could cause unemployment.
2. You don’t seem to have read my blog, as I have frequently explained how the housing bust caused higher unemployment in 2006-08. My explanation is similar to that of Hayek. Those losing jobs in contruction looked for jobs elsewhere. But the other industries were not able to quickly absorb all the laid off construction workers, hence the total unemplyment rate went up a tiny bit.
But after mid-2008 NGDP started falling, and almost all industries starting losing jobs, even industries with no bubble, or overcapacity. Even the job market for economics professors has tanked. That’s not because there was a bubble in economists, its because AD dropped.
3. You don’t understand Hayek’s work. You are confusing malinvestment with a secondary deflation. Hayek would have considered 2006-08 to be due to malinvestment. But the severe recession that occurred after mid-2008 was not due to the housing market, it was due to secodary deflation. Hayek would have opposed that secondary deflation, as he opposed letting NGDP fall. So Hayek would have agreed me me.
4. Hayek certainly did not win the Nobel prize for his macroeconomic research. He won it for his work in microeconomics, which was far superior.
5. Your comments about Zimbabwe make no sense. Suppose NGDP had continued to increase at 2% or 3% a year. How in the world would that have caused hyperinflation? What are you assuming about the path of RGDP?
6. I’m not sure you understand the concept of the superneutrality of money, as the quotation you provide from Hayek is unrelated to the question. No one denies that unancitipated changes in M have real effects. The question is what would happen if there was a predicatable growth in M. The Hayek quotation doesn’t address that issue, as it refers to unexpected changes not priced into wages, prices, and debt contracts.
4. December 2009 at 08:33
Well, well, well…
“It is completely unrelated to the question I asked. I asked how delation could cause unemployment without sticky wages, and you responded by telling me how misallocation could cause unemployment.”
–I apologize; I overestimated how much you understood Hayek and so thought this was obvious. The deflation is only caused by the bursting of the bubble. The inflation causes the misallocation, which causes the bubble; the bursting of the bubble causes the deflation, which is accompanied by the unemployment.
“2. You don’t seem to have read my blog, …
3. You don’t understand Hayek’s work. You are confusing malinvestment with a secondary deflation.”
–No, I do understand it very well, and I know that your idea of increasing NGDP is built on the premise of combating Hayek’s secondary deflation, and that that’s why you like to talk about Hayek. And I have read your blog a lot. And that’s why I understand exactly why your idea of targeting NGDP is wrong, and why your understanding of Hayek is backwards. It’s because your fixation with the secondary deflation makes you completely ignore the point on the malinvestments and dislocations””the cause of the crisis. Worse, by ignoring the cause of the crisis and fixating on its aftermath (the secondary deflation) your proposals for how to combat the deflation (targeting NGDP growth) will only exacerbate the original cause of the crisis! This is why I’ve been dying to get you to read Hayek. If you only read him as much as you quote him, you’d realize that it is monetary expansion that causes the boom and bust, and that then causes the awful secondary deflation. You would also realize that the only solution that works is to not inflate in the first place, and that once you start inflating, then you’re holding a tiger by the tail: it can’t end well. No matter how small the inflation (such as your NGDP 3%-growth rule, or whatever), at any point you stop it, it will cause a recession and the secondary deflation. And if you keep holding on to it, you get Zimbabwe.
“4. Hayek certainly did not win the Nobel prize for his macroeconomic research. He won it for his work in microeconomics, which was far superior.”
–Wrong again! He won it for his work on the Business Cycle! But don’t take my word for it, ask the Swedes: http://nobelprize.org/nobel_prizes/economics/laureates/1974/press.html
“von Hayek’s contributions in the field of economic theory are both profound and original. His scientific books and articles in the twenties and thirties aroused widespread and lively debate. Particularly, his theory of business cycles and his conception of the effects of monetary and credit policies attracted attention and evoked animated discussion. He tried to penetrate more deeply into the business cycle mechanism than was usual at that time. Perhaps, partly due to this more profound analysis, he was one of the few economists who gave warning of the possibility of a major economic crisis before the great crash came in the autumn of 1929.”
“5. Your comments about Zimbabwe make no sense. Suppose NGDP had continued to increase at 2% or 3% a year. How in the world would that have caused hyperinflation? What are you assuming about the path of RGDP?”
–Please read Hayek’s A Tiger by the Tail, which is precisely an answer to this question. Inflation always begets more inflation. As the central bank expands the money supply, the banking system expands credit, and then the monetary authorities need to expand money even more to keep up with expanding credit’s demands for redemption, cash and liquidity. This is when you’ve held on to the tiger’s tail. It starts running. The expansion continues apace, and at any time it stops a recession ensues (whatever inflation has been created causes a boom-bust cycle, the bigger the inflation, the bigger the bust). If inflation were to be continued, then people would begin to realize that their money is being debauched at an increasing rate, and so people start taking flight from their money to commodities, foreign currencies and gold. The more people flee the currency, the more the central bank needs to print money to achieve any particular goal (since the money is losing value). The more money is printed, the more people flee the currency. Over a relatively short period of time, you find yourself going from your wonderful 3% inflation to highly increasing price level as people flee the currency and the central bank prints more of it. Suddenly: Zimbabwe.
Ask yourself: Did the monetary authorities in the Weimar Republic plan on hyperinflation? Did they expect it? Did they ever find themselves at a point where they thought “gee, if we do X, we’ll get hyper-inflation next year, so we shouldn’t?” No, they never did. They were just printing money and increasing NGDP and trying to achieve political goals and help banks meet their obligations. And then inflation started creeping in, and it became more pressing that they print money to meet the government’s goals and help out banks and allow redemption, and so they printed more. At this point, you’ve crossed the point of no-return: people are increasingly abandoning your money; and your money is losing more value.
This isn’t me making this stuff up; this is Hayek’s work. Feel free to disagree, but please don’t tell me you’re disagreeing with me based on Hayek’s work!
“6. I’m not sure you understand the concept of the superneutrality of money, as the quotation you provide from Hayek is unrelated to the question. No one denies that unancitipated changes in M have real effects. The question is what would happen if there was a predicatable growth in M. The Hayek quotation doesn’t address that issue, as it refers to unexpected changes not priced into wages, prices, and debt contracts.”
–I’d urge you to read more Hayek, but I’m sure you won’t. So I’ll try to summarize: The key insight from all of Hayek’s life’s work is the problem of knowledge. Knowledge is distributed in a human society and no single mind could know everything. The growth of M is a function of monetary policy, quantitative easing, interest rates, credit creation, liquidity, velocity, real production, productivity growth, natural shocks, weather, trade, and countless other factors. No human being, agency, or central planning body could ever know enough to correctly:
1- predict the growth in M
2- plan the growth in M
Anyone who thinks they can predict it or plan it is suffering from the Fatal Conceit. Hayek’s life’s work is to try to argue that you simply cannot figure these things out, anymore than you can figure out how to plan the market of tin. And so any interventions in the market of tin will backfire, and if governments leave the market of tin to be based on free exchange of individuals, it will work to aggregate all the necessary knowledge and to satisfy consumers and producers. Similarly, if the market for capital and money is left alone, it would work. Once the government starts planning it, the whole thing falls apart. However, to truly understand where people like you would come up with their economic ideas, one would need to read his non-economic book: the Road to Serfdom. As government intervention leads to market disasters, people continue to think that the solution lies in more government intervention, which leads to more disasters, and so on.
Your idea on NGDP targeting is just an unfortunate effect of the previous rounds of government intervention, which have caused disasters and have convinced you that this can be fixed if only you were allowed to centrally plan things correctly. If only you’d take the time to read his books to figure out why these problems originate in the first place, you’d realize your proposal is part of the problem, not the solution.
Finally, I think it’s pretty rich that someone who has clearly never read anything by Hayek is accusing someone who has of not understanding him. Hayek isn’t god and he may be wrong, and I personally disagree with him about a lot of things. But you, of all people, truly must read him.
4. December 2009 at 08:53
One more thing…
“That’s not because there was a bubble in economists, its because AD dropped.”
I don’t know, dude…
I wouldn’t write off your initial hypothesis so easily!
4. December 2009 at 09:19
Scott,
I worry too that people will think George Selgin and I are making an argument for deflation period. We are not, but are merely trying to get folks to see take a more nuanced view of deflation since it has big policy implications. For example, in the Cato article you reference above (thanks!) I make a clear distinction between aggregate supply-induced and aggregate-demand induced deflationary pressures. I also try to make that distinction on my blog.
The big concern for me is that most economists at the first whiff of deflationary pressures go into panic mode and call for more monetary easing. They fail to look at the source of the deflation pressures and, as a result, often misdiagnose the problem. As I note here, a good example of this is the deflation scare of 2003. Productivity was soaring as was nominal spending. But policymakers–including Bernanke and Greenspan–assumed the downwawrd price level pressures were the result of a drop in aggregate demand and responded accordingly. What is ironic about this response is that by trying to eliminate the more benign form of deflation in 2003 they helped contribute to creation of the malign form we have today.
4. December 2009 at 09:59
Actually, this is false:
“Hayek certainly did not win the Nobel prize for his macroeconomic research. He won it for his work in microeconomics, which was far superior.”
Hayek’s Nobel citation clearly includes his macroeconomics — and Hayek saw no discontinuity between the two in any case, e.g. his micro advances were in large measure inspired by and were part of his “macro” thinking, e.g. on capital, knowledge, the IE construct, etc.
More significantly, the “brief” for Hayek prepared by Fritz Machlup put Hayek’s work on capital theory and macro front and center, and placed it within the context of his “micro” work.
These things are interrelated in Hayek — and the Nobel committee makes note of that in the language of its citation.
4. December 2009 at 10:13
Saifedean writes: “No matter how small the inflation (such as your NGDP 3%-growth rule, or whatever), at any point you stop it, it will cause a recession and the secondary deflation. And if you keep holding on to it, you get Zimbabwe.” Well, the first part is correct; but it’s just repeating Scott’s own point: that unexpected downward changes in NGDP growth are depressing. The second point does contradict Scott’s view–but it’s not correct. There’s nothing unsustainable about 3 percent NGDP growth, and no reason to suppose that it will lead to hyperinflation. After all, the Fed and many other central banks have maintained average NGDP growth rates several percentage points above 3 percent for many years now, without raising inflation rates much above 2 percent.
4. December 2009 at 11:02
It is true that the Nobel Committee cited Hayek’s early work in monetary theory and economic fluctuations. Certainly his contributions in that area were very important and richly deserve the recognition of the Nobel Prize. But does anyone really believe that the Nobel Prize conferred any intellectual validity or authority on anything Hayek ever said or wrote? Hayek certainly did not think so. If you think so, then what about the award to Paul Samuelson, a hard-core Keynesian interventionist, or to J.R. Hicks, an apostate Hayekian convert to Keynesianism, or to Milton Friedman, who liked Hayek but hated his monetary theory, feelings that Hayek equally reciprocated about Friedman and his monetary theory.
Since Saifedean is so obsessed with reading what Hayek actually said, I hope that he won’t mind if I quote from Hayek’s Denationalization of Money (3rd edition, 1990, p. 87)
While the modern author who first drew attention to the
crucial importance of these divergences between investment
and saving, Knut Wicksell, believed that they would disappear
if the value of money were kept constant, this has unfortunately proved to be not strictly correct. It is now generally recognised that even those additions to the quantity of money that in a growing economy are necessary to secure a stable price level may cause an excess of investment over saving. But though I was among those who early pointed out this difficulty, [Monetary Theory and the Trade Cycle, p. 114] I am inclined to believe that it is a problem of minor practical significance. If increases or decreases of the quantity of money never exceeded the amount necessary to keep average prices approximately constant, we would come as close to a condition in which investment approximately corresponded to saving as we are likely to do by any conceivable method. Compared, anyhow, with the divergences between investment and saving which necessarily accompany the major swings in the price level, those which would still occur under a stable price level would probably be of an order of magnitude about which we need not worry.
4. December 2009 at 11:33
Regarding David Glasner’s quote: the best proof that Hayek was mistaken in concluding that “we need not worry” about the non-neutral effects of monetary expansion so long as it goes along with stable prices is the recent housing boom and bust. I believe that posterity will show that bubble to have been very much the result of the Fed’s having treated a productivity surge as an opportunity to maintain an easy money stand without fueling inflation.
Hayek’s reversal was, I believe, a rather unfortunate “pragmatic” turn aimed at bolstering his theory of competing currencies, according to which competition would favor issuers of stable purchasing power monies. He wished to portray this supposed outcome of competition as something close to optimal, and so he tossed out a whole decades worth of his own thought and writings on the requirements for monetary neutrality.
The irony of this is that Hayek’s theory of competitive (fiat) currencies was itself quite unsound: if anything, currency holders would favor currencies with positive real returns over those bearing a real return of zero.
4. December 2009 at 11:48
George, The reason that I offered the quote was that I wanted to point out the dangers of invoking the authority of sacred texts. Sacred texts are rarely unproblematic. Your attempt to explain away the inconvenient sacred text that I cited may or may not be valid, but let us at least acknowledge that the full range of sacred texts are in some tension.
I also do not believe that Hayek’s reversal had anything to do with his competing currency argument. I don’t think that you could cite a single postwar writing of his on monetary policy in which he argued that a policy of price stability would lead to significant adverse macroeconomic consequences.
On the substance of the housing bubble, rather than offer anything new, I will simply incorporate by reference everything that Scott Sumner has said on the subject.
Sorry, if the tone is a bit abrupt, but I am rushing to get out of the office. Good to be in touch with you again after so long.
4. December 2009 at 12:32
There’s all sorts of contemporaneous evidence that in the 1970s Hayek still very much believed the macroeconomics he produced in the 20s, 30s, 40s, 50s, and 60s — and his few 1970s remarks which pull back on that are hard to square with his own words from the same period. And, yes, it sometimes seems that Hayek trims his sails so he won’t offend or turn off Keynesian schooled economists in the old way, and instead will gain an audience otherwise closed to him among folks who have no knowledge or understanding of the marginalist economics of production goods — i.e. the stuff which lies behind Hayek’s “non-mainstream crazy ideas”.
George writes:
“Regarding David Glasner’s quote: the best proof that Hayek was mistaken in concluding that “we need not worry” about the non-neutral effects of monetary expansion so long as it goes along with stable prices is the recent housing boom and bust. I believe that posterity will show that bubble to have been very much the result of the Fed’s having treated a productivity surge as an opportunity to maintain an easy money stand without fueling inflation.
Hayek’s reversal was, I believe, a rather unfortunate “pragmatic” turn aimed at bolstering his theory of competing currencies, according to which competition would favor issuers of stable purchasing power monies. He wished to portray this supposed outcome of competition as something close to optimal, and so he tossed out a whole decades worth of his own thought and writings on the requirements for monetary neutrality.”
4. December 2009 at 12:44
For Greg and David (once he’s back at a computer!): Indeed, there are no sacred texts! And don’t think I meant to “explain away” the quote: Hayek said it, sure ’nuff; and I don’t suppose other than that he meant what he said. I do believe, though, that he found himself having to reconcile what he came to believe to be the best practical solution to the inflation problem–competing currencies–with his earlier claims concerning optimal monetary policy.
Larry White has published a very good paper on the evolution of Hayek’s views, “Hasyek’s Monetary Theory and Policy: A Critical Reconstruction,” JMCB 1999.
4. December 2009 at 14:04
@Greg
Yah agreed, Austrian thinking doesn’t distinguish between micro and macro the same way other schools do. The Austrian school is a “bottom up” methodology. You start with incentives and micro and then you ask, “what happens if…” and you take the chain of incentives and micro behavior to its logical conclusion as it propagates though the economy, which gives you macro.
This is why Austrian theory is mostly innumerate when it starts talking about macro effects. Because of the detail of the problems and the bottom up way of doing things, the problems are completely mathematically intractable. The method they use does, however make true statements, if the premises are true. Innumeracy is the weakness the Austrian macro, and its strength is making correct qualitative predictions.
5. December 2009 at 20:46
George, my reference to sacred texts was not meant as a jab at you. If you go back to my first post in this thread you will see that I was responding to someone else’s comment which was citing Hayek in what I thought was a one-sided manner. I appreciate your willingness to take Hayek’s comment in the Denationalization of Money at face value. Your first comment came uncomfortably close, I thought, to the ungracious reaction of some hard-core Austrians to the long and incredibly distinguished list of apostate (sorry, there I go again using theological metaphors) Austrians e.g., Haberler, Machlup, Robbins, Kaldor, Lerner, Hicks, Shackle (have I left anyone out?) which is to dismiss them all as “sell outs.”
I share your reservations about Hayek’s argument about how competition would actually settle on a monetary standard, and I also think that there was an even more serious problem in his argument that a private issuer without taxing power could create a money that was not convertible into a real asset.
My take on the reconciliation between his theoretical position in the 1920s and 1930s and the quotation from Denationalization of Money argument is that he was simply recognizing that under most circumstances there would probably not be a substantial disequilibrating effect that would result from monetary expansion sufficient to keep prices stable rather than fall at the rate of technical progress. See The Constitution of Liberty p. 337 middle paragraph where he also gives a qualified endorsement to price stability while recognizing that in a case of “rapid technological advance” price stability “might. . . produce a significant inflationary tendency.” So in my view his long-standing position was that moderate monetary expansion might be a theoretical problem but was not likely to be a big deal if prices were kept really stable. Not that I would necessarily agree, but I don’t think that Hayek would have been happy with 2 percent inflation. Maybe if he were alive today he would revise his empirical judgment in light of recent experience, but I think that experience between, say, 1930 and 1960 convinced him that a policy of price stability would not have seriously bad consequences.
Greg, exactly which of Hayek’s writing on monetary theory and policy from the 1940, 50s, and 60s, were you referring to?
6. December 2009 at 10:46
saifedean, You say:
“-I apologize; I overestimated how much you understood Hayek and so thought this was obvious. The deflation is only caused by the bursting of the bubble.”
But this doesn’t explain anything. Deflation is by definition always going to be preceded by rising prices or stable prices. So if you define either rising prices or stable prices as an inflationary bubble, then your theory become tautological. In fact, deflation is not caused by the bursting of bubbles. When the tech bubble burst we did not get deflation, nor did we get it when the 1987 stock bubble burst. Deflation is caused by tight money, not bubbles.
You might be right about the Swedish academy, but Hayek’s current reputation is mostly based on his micro work, which is far more respected than his macro work. Whether this is fair is another issue.
You say mild inflation inevitably leads to Zimbabwe. Not true. Check out the 20th century in most developed
economies.
I do not favor targeting the money supply, so I have no idea what your comment about predicting money refers to. If you are talking about predicting NGDP growth, people certainly do make such predictions all the time, at least implicitly. Most people I know expect roughly 4% pay raises each year, if they are doing an average job. Where do you think they get these predictions from? If we have stable 5% NGDP growth that people will simply assume that what is the “normal” is 4% pay raises each year (assuming population rises at 1%.) If we have 3% NGDP growth, then 2% raises will be regarded as normal. People can and do make those sorts of calculations all the time. There is no reason this can’t work forever, without ending up in Zimbabwe.
Do you think Hayek would have favored the deflationary monetary policies last year, which reduced NGDP? I don’t.
David Beckworth, I see what you are saying. But it is odd that Bernanke fought vigorously against the risk of deflation, and indeed deflation that might have been benign, and is not fighting vigorously against recent deflation caused by falling AD.
One complication is inflationary expectations. Even if the optimal rate of inflation is minus 1% in the steady state. It is not minus one in an economy where inflation expectations are 3%. You need to get there gradually.
Greg, Thanks for pointing that out.
George, Thanks. And unlike me you have read your Hayek.
David Glasner and George, It isn’t quite clear what Hayek is saying there. If he’s saying that stable prices would avoid something like the Great Depression, or even a Great Recession, then I agree. At the same time I agree with George that a stable price level policy can create some malinvestment, and perhaps to some extent this explains the housing boom (although I think part of that was either stupidity or bad regulation). But let’s say George is right. What problem did this cause? Did it cause wasteful investment? Yes, Did it cause subprime bubble to burst and damage banking? Yes. Did it cause some macroeconomic difficulty between mid-2006 and mid-2008? Yes. Did it cause unemployment to rise from 5.5% to 10% in the past 17 months? No. That was the secondary deflation that would have been prevented by a stable price level policy (or more accurately a stable 2% if that’s what the policy rule was prior to the bubble bursting.)
So I am sympathetic with both your arguments. I think George is right that stable prices are inferior to the productivity norm, and that the housing fiasco may partly reflect the problems with stable prices. But I think Hayek’s statement is defensible if viewed as saying the worst sorts of problems could be avoided with a stable price level. Recall that unlike us three Hayek lived through the Depression, so his dividing line between small and big macro problems may be different from ours.
Greg. That might be it. Also recall that inflation had become so bad in the post war period (especially the 70s) that perhaps Hayek thought that stable prices were the best we could hope for. But here is another thought. Friedman’s natural rate hypothesis (which David pointed out was anticipated by Hayek) may have slightly changed Hayek’s views on the real effects of different trend rates of inflation. So Hayek might have still preferred a productivity norm, but I could easily imagine him being OK with Woolsey 3% rule, under the influence of “natural rate” theory that says the trend rates of inflation doesn’t matter for real variables in the long run. Obviously I have no evidence for this, but I don’t think it is implausible. I’ve noticed that most great macroeconomists subtly shift their views as macro conditions change.
George, Yes, and didn’t he and Garrison also have a recent piece on Hayek in the JMCB?
8. December 2009 at 03:16
Scott,
You said: “But this doesn’t explain anything.”
-Yes it does. You offered, as an argument against Selgin’s productivity norm, Keynesian “sticky wages” and said that there is no other explanation of why deflation causes unemployment. I offered you a coherent explanation that does not need to resort to the fiction of “sticky prices”. Inflationary monetary expansion causes misallocations of capital and labor and an unsustainable boom, which is followed by a deflationary bust that causes unemployment.
You said: “Deflation is by definition always going to be preceded by rising prices or stable prices.”
–No, productivity rises cause deflation, and they don’t have to be proceeded by inflation. Deflationary busts, however, are preceded by inflationary expansion.
You said: “In fact, deflation is not caused by the bursting of bubbles.”
–Again, deflation could be caused by productivity increases (as Selgin explains) or through the bursting of bubbles, unless monetary authorities counteract it, as you suggest. So, with the tech bubble and the 1987 stock bubble there was no deflation because the Fed lowered rates and kept on propping the money supply, as you would advocate. The difference between us is that you think this is a good thing; I look a few years down the line and see the disasters that this unleashes, and conclude that it’s a bad thing.
“Do you think Hayek would have favored the deflationary monetary policies last year, which reduced NGDP? I don’t.”
This is your biggest problem. You continue to shift the discussion to the aftermath of the bubble and refuse to ever consider any evidence about the causes of the bubble. You’ve completely dodged all my questions and points about how this comes about.
George,
You said: “There’s nothing unsustainable about 3 percent NGDP growth, and no reason to suppose that it will lead to hyperinflation. After all, the Fed and many other central banks have maintained average NGDP growth rates several percentage points above 3 percent for many years now, without raising inflation rates much above 2 percent.”
And Scott also said: “You say mild inflation inevitably leads to Zimbabwe. Not true. Check out the 20th century in most developed economies.”
That’s a good point, but in retort, I’d argue that inflation has been very high considering how much productivity has been increasing. And I’d also point out that these low inflation periods were regularly checked with deflationary depressions that slowed down inflation. Further, these have not been very long periods of time, and they are becoming worse with time. They won’t be good examples if massive inflation happens in the next few years.
I have a serious question here on which I’d love to hear both your takes: Historically, what could we see as the longest continuous period of sustainable low inflation that did not lead to high or hyper-inflation?
A caveat: crashes, bubbles and depressions are deflationary corrections of the moderate inflationary booms, and so they check this mild inflation. In that sense, any significant deflationary depressions cannot count as part of a period I’m looking for. Whenever central banks lets deflation take place then this is a stop of continuous inflation. I am looking for the longest period in history which would receive the Scott Sumner seal of approval””with no deflation or contraction of the money supply.
David,
I agree with you entirely. I do not believe the Nobel prize confers any intellectual authority, and I only invoke it when arguing with people who do, to get them to consider the work of someone who’s earned it but is curiously ignored in the mainstream.
And I agree with you on the problems with invoking sacred texts, and hate doing so myself. In my defense, I did it this time because our argument was specifically about what Hayek said, since Scott specifically argued that Hayek had never said something he had said. This invoking of sacred texts is particularly problematic in the case of Hayek since he was a voluminous writer who changed his mind on a few things over the decades. For me, it’s not his authority; it’s the argument itself that matters.
8. December 2009 at 18:36
Saifedean, Suppose you find a deflation that began in year 19xx. Then what happened the year before? It had to be stable prices or inflation. Otherwise deflation wouldn’t have begun in 19xx. So your argument makes no sense. If the year before 19xx was a year of deflation, then deflation would not have begun in year 19xx, it would have begun a year earlier. So I still claim that any deflation must be preceded by inflation or stable prices. And since the Austrians consider stable prices to be inflation, then deflation is always preceded by inflation. Which proves nothing.
You said:
“So, with the tech bubble and the 1987 stock bubble there was no deflation because the Fed lowered rates and kept on propping the money supply, as you would advocate. The difference between us is that you think this is a good thing; I look a few years down the line and see the disasters that this unleashes, and conclude that it’s a bad thing.”
Where were the disasters from propping up the economy after the 1987 crash? I thought the 1990s one one of the most prosperous decades in world history. Or was that just an illusion too?
The longest inflation I know of was 1955-2008 in the US. But countries like Australia may have had longer ones. In economics 50 years is virtually forever, all long run adjustments occur in well under 50 years.
9. December 2009 at 01:25
Scott wrote: “George, Yes, and didn’t he [L. H. White] and Garrison also have a recent piece on Hayek in the JMCB?”
The only piece I’ve co-authored with Garrison in the JMBC (Nov. 1997) was a critique of the Sumner (JMCB Feb. 1995) scheme to have the Fed create a GDP futures market and then tie its policy to the net positions taken by speculators in that market. Summer (Nov. 1997) replied.
10. December 2009 at 12:08
Larry, Thanks for clearing that up. I have a bad memory. How about a solo piece then?
12. January 2010 at 14:08
[…] alleged to distort financial markets, to redistribute wealth between lenders and borrowers. But George Selgin has argued (and I agree) that this argument better fits NGDP instability. (Although Selgin uses a […]
12. March 2010 at 20:20
Really I think there are actually two or three distinct ideas in George’s essay, which I see as being logically separate issues. There are some posts that have suggested otherwise, the growth rate of productivity hasn’t been steadily increasing. Instead, it varies around a mean that appears to be constant.CNA Training
13. March 2010 at 06:51
The result of the German public’s belief in the productivity norm is mass unemployment. To relieve German mass unemployment it must be understood that the myth of the “productivity norm” is very harmful, that it is based on a concept of “labor productivity” that makes no economical or logical sense. Moreover, from an ethical point of view, the application of the “productivity norm” must be considered unjust.
Follow this…
13. March 2010 at 07:22
Karen, I agree.
Roger, The productivity norm cannot solve all problems. If unions drive real wages above their equilibrium value, this may increase structural unemployment. But this would be a problem under any stable money rule.
2. August 2010 at 21:30
Agree with Karen’s comments above. However I do question the moral standing that such a government would take in the face of a global economic disaster and mass labor and/or productivity loss.
12. May 2011 at 16:44
[…] For a greater expansion on deflation, see this Cato Journal article, a blog by David Beckworth, and two blogs by Scott Sumner ( here and here ). […]