Archive for the Category Gold standard


Playing with fire

There has been a recent upswing in conservative articles discussing the idea of going back to some sort of gold standard.  I don’t think people realize how dangerous this idea is.  You can’t just “give it a shot” and see how it works out.  It’s like marrying the daughter of a Mafia chieftain–you need to be very sure you are willing to commit.

A true gold standard (not Bretton Woods) allows Americans to buy or sell gold.  If you are not 100% committed to staying on gold, but instead hint you might devalue the dollar at some point, people will dump dollars and buy gold.  The increase in demand for gold will raise its value, or purchasing power.  This is deflationary under a gold standard, where the nominal price of gold is fixed.

Nor is this merely a theoretical problem.  There were large bouts of private gold hoarding during four periods of the Great Depression, all associated with devaluation fears; the last half of 1931, spring 1932, February 1933, and late 1937.  All four were associated with economic distress, falling stock and commodity prices, etc.  And there is event studies-type evidence showing causation going from gold hoarding to deflation.

It’s not easy to know which price of gold would be appropriate.  Perhaps market gold prices would go to the right level after an “announcement” of a return to gold, but even that depends on the announcement being 100% credible.  But after you re-peg, the real value of gold can change due to industrial demand shifts, even if there is no monetary hoarding of gold.  Furthermore, all countries are not likely to follow the US back on gold, so you might have monetary gold hoarding in Europe, as people feared for the euro.  Booming Asia might increase the industrial demand for gold, just as it has raised the demand for many other metals.

And there is little room for error.  A 10% increase or decrease in the real value of gold seems very small when it is just a commodity.  But under a gold standard that sort of shift can be accommodated only by changing the overall price level by 10%.  A sudden 10% rise or fall in the price level is very destabilizing to the economy.

Even if the government is committed to gold, investors may fear the next government won’t be (remember FDR?)  In that case the promise to stay on gold may not be credible.  In the old days there was a powerful emotional attachment to gold, as paper money was feared as inevitably leading to hyperinflation.  Only then will voters be willing to suffer austerity to stay on gold.  A modern analogy is the long painful struggle of Argentina to stay on its currency board during the 1998-2001 deflation, attributable to a fear they would return to hyperinflation.  But we now know that fiat money can produce modest inflation rates, so our voters won’t undergo the pain of the mid-1890s, or early 1930s, just to stay on gold.  And if you aren’t willing to undergo that pain, the system won’t work.

Some supporters point to Bretton Woods, but that “worked” in direct proportion to the extent that the gold constraints were ignored.  Gold was highly overvalued after the 1933 devaluation, and then the US grabbed a huge share of the world’s gold in the run-up to WWII.  After the war those two factors gave us an unprecedented amount of slack, where we could mildly inflate until gold was no longer overvalued.  Once we reached that point in the late 1960s, the system immediately fell apart.  It would have collapsed even sooner if Americans had been allowed to own gold.  And if LBJ had tried to deflate to stay on gold, Americans (if allowed to) would have hoarded gold in the (correct) expectation that the next president would devalue the dollar, putting expediency ahead of principle.  That hoarding would have had the same effect as the hoarding of the early 1930s–deflation and depression.

HT:  Bruce Bartlett

PS:  Today’s NYT said:

Economists are now engaged in a spirited debate, much of it conducted on popular blogs like Marginal Revolution, about the causes of the American jobs slump. Lawrence Katz, a Harvard labor economist, calls the full picture “genuinely puzzling.”

If you check the four links you won’t find me, but the link to MR (Alex Tabarrok) starts as follows:

I find myself in the unusual position of being closer to Paul Krugman (and Scott Sumner, less surprising) than Tyler on the question of Zero Marginal Product workers.

Close, but no cigar.  Still I guess it’s progress being just “one degree of separation” away from the Times.

Saving conservatives from themselves: Forbes magazine and anti-intellectualism

I’ve always liked Forbes magazine, and I’m a big fan of Malcolm Forbes’ proposal to “blow-up” the income tax.  So I don’t have any big problem with the magazine on ideological grounds.  But I do have a problem with several recent Forbes articles by John Tamny, who seems proud of his lack of expertise in the subject he writes about.

In a new column, Tamny has accused me of calling anyone who favors the gold standard a “knuckle-dragger.” I don’t recall making that accusation (in this post), nor do I believe it to be true.  Indeed many highly intelligent economists favored the gold standard, as Tamny accurately points out.  Here’s the statement that led me to accuse Forbes magazine of anti-intellectualism:

Assuming the Fed could do what it cannot; as in fine tune economic activity on the way to stable prices, we would be much worse off if Bernanke et al were to actually succeed.

To see why, it has to be remembered that the cure for high prices is in fact high prices. Or better yet, high prices foretell low prices.

If producers create a consumer product that fulfills unmet needs on the way to high prices, the latter is the signal to other producers to enter the market for the same good on the way to lowering its cost. Gyrating prices are the necessary market signal telling businesses what we need.

Taking this further, if price stability were policy, it would still be the case that a phone call from Houston to Dallas would cost $15 for a half hour of conversation. It would similarly mean that we’d be paying thousands of dollars for flat-screen televisions, not to mention even more for computers that perform very few functions.

When I tell other economists about this passage, even Tamny’s fellow libertarians, they break out laughing.  That’s not good.  I want libertarians to succeed.  We both favor small government.  But we won’t get anywhere if Forbes keeps publishing articles than make conservative/libertarians the laughing stock of the blogosphere.  Just imagine what a Krugman or DeLong would do if they stumbled across this defense of the gold standard.  We need arguments that can stand up to the best the other side has to offer.

In his rebuttal Tamny points out that I am not famous (like he is?)  That’s true.  But the quality of an argument isn’t related to the fame of the person making the argument; it is based on reason, evidence, and even a familiarity with basic terminology.  In the new article Tamny seems to not understand the meaning of the term ‘deflation:’

For that we need stable money values, nothing else. Gold has historically served as the measure meant to make the tickets in our pockets most stable in value. As the great financier J.P. Morgan put it, “Gold is money. Nothing else.”

After that, the money prices of goods change with great regularity for reasons ranging from consumer preference to productivity enhancements. Confused about what deflation is, Sumner presumes that it’s a function of falling prices, but were he to ever emerge from the campus one of these days, he’d understand by virtue of walking the aisles of most any retailer that prices fall all the time.

If this were true, then the Great Deflation of 1929-32 would never have happened, as the price of gold was stable throughout that period.  Then he compounds his mistake, by citing Mill:

Or, as Mill put it, “If one-half of the commodities in the market rise in exchange value, the very terms imply a fall of the other half.” Put more simply, what Sumner presumes to be deflation is not that. The price level can only be altered through a change in the value of money itself, and with the dollar at near all-time lows against gold and nearly every foreign currency, the presumption of deflation promoted by Sumner is laughable, and also sad.

Obviously Mill cannot be referring to the nominal price of goods, as the statement would be absurd.  While I don’t have the Mill volume in front of me, I assume he must be referring to the real or relative price of goods.  But of course in that case the statement has no relevance to the case Tamny is trying to make, as it’s equally true of Zimbabwe and Switzerland.  Indeed it’s merely a property of averages.

Tamny then engages in false modesty:

To answer Sumner’s initial presumption, I should first say I’m decidedly not an intellectual, and will leave what is now a debased adjective to people of his ilk at obscure colleges. But a curious sort, I’ve long sought to read intellectuals of the past and present who actually impacted the policy debate.

It’s clear from reading Tamny’s column that he is an intellectual, quite engaged in policy ideas.  And a very well read intellectual as well.  What makes these two Forbes column’s anti-intellectual is that Tamny is writing on a topic that he knows little about, monetary economics.  He cites famous economists of the past, like Keynes, who supported a fixed price of gold.  But Keynes would be horrified by the arguments that Tamny is making in support of a gold standard.  The problem isn’t so much Tamny, it is Forbes, for choosing columnists who pander to crude populist prejudices, rather than those with expertise in the issues being discussed.

Sometimes I feel like I am trying to save conservatives from themselves.  The free market is a great idea.  Taking monetary policy decisions away from the Fed and letting the market determine the money supply is a great idea.  But when conservatives/libertarians show a contempt for everything that’s been learned in the past 80 years, including the scholarship of distinguished fellow libertarians such as Milton Friedman, they are not going to win out in the battle of ideas.  I don’t have any problem with Forbes publishing a piece with which I totally disagree.  I do have a problem with conservative outlets that publish authors who are ignorant of the key tenets of monetary theory, that do not know the meaning of basic economic terminology, indeed that seem to have created a private language that has nothing to do with the real world.  We won’t get anywhere unless we offer solid reasoned arguments written by people who have the expertise to handle the issues they are writing about.

My criticism of Tamny was not personal; most highly intelligent people know nothing about monetary theory.  He’s obviously very intelligent.  But he’s writing on the wrong topic.  I’d sound like an idiot if I wrote on nuclear physics (a simple field compared to monetary economics.)  Forbes should be publishing pieces on monetary policy that are written by distinguished monetary economists.  (And I don’t give a damn about credentials.  A distinguished monetary economist is someone who understands the field, not someone who happens to teach at a big name university or work at the Fed.)

PS.  It’s Bentley University, not College.  I couldn’t care less, by my bosses do care.

PPS.  I’m not generally viewed as a “quantity theorist” as I don’t favor targeting money, nor do I think the money supply is a good monetary policy indicator.  But it’s a forgivable mistake, as I occasionally make quasi-monetarist arguments.

PPPS.  But I’m definitely not a fan of “collectivist economics.”  That’s unforgivable.

PPPPS.  I am greatly indebted to Bruce Bartlett, without whom I would be a complete nobody.  His encouragement pushed me up to the exalted position of “little-known Bentley College economics professor.”  I’d also like to thank John Tamny, who has pushed me up from the position of being an obscure professor at Bentley, to someone so famous that Forbes devotes an entire article to trashing my “droolings” on monetary economics.  Ma! Top of the world!

Have conservatives always been this anti-intellectual?

Yes, I know about the famous JS Mill quotation.  But when I was younger I thought the right had a lot of intellectual momentum.  The world was moving away from statism and toward neoliberalism, and it seemed like conservatives had most of the good economic ideas.

Of course there has always been a anti-intellectual strain to populist conservatism, as when the right romanticizes the “Golden Age” of the 1950s, before all those evil liberation movements of the 60s gave rights to blacks, women, and gays.  But at least on economics I used to think of conservatives as being relatively hard-headed.  So what is one to make of this appalling column in Forbes magazine:

Amid the very reasonable handwringing about the Fed’s charitably naive attempts to stimulate the economy through “quantitative easing”, there’s an understandable drive among some Fed critics to severely reduce its mandate. Specifically, the Fed can’t create jobs as its defenders inside and outside the central bank presume, so better it would be limit its role to that of inflation watchdog.

All that is fine on its face, but in seeking to redefine the Fed’s doings, naysayers have happened upon the false notion of “price stability.” A recent editorial argued in favor of repealing the Fed’s dual mandate so that it can concentrate “on the single task of stable prices”, and then politicians such as Reps. Paul Ryan and Mike Pence have similarly called for price stability in working to redefine the activities of the world’s foremost central bank.

Sadly, handing the alleged wise men at the Fed control over prices is every bit as mistaken as allowing the central bank to manage unemployment.

Indeed, it is through prices that the market economy is organized. In that certain sense, prices rise and fall with great regularity as consumers tell producers what they want less and more of. Assuming the Fed could do what it cannot; as in fine tune economic activity on the way to stable prices, we would be much worse off if Bernanke et al were to actually succeed.

To see why, it has to be remembered that the cure for high prices is in fact high prices. Or better yet, high prices foretell low prices.

If producers create a consumer product that fulfills unmet needs on the way to high prices, the latter is the signal to other producers to enter the market for the same good on the way to lowering its cost. Gyrating prices are the necessary market signal telling businesses what we need.

Taking this further, if price stability were policy, it would still be the case that a phone call from Houston to Dallas would cost $15 for a half hour of conversation. It would similarly mean that we’d be paying thousands of dollars for flat-screen televisions, not to mention even more for computers that perform very few functions.

I’m not going to insult my readers’ intelligence by describing what’s wrong with the last paragraph.  If you don’t know, go read someone elses blog.  At first I thought this might be an innocent slip up.  Nobody’s perfect.  Editors are very busy people, they can’t spot all mistakes.  But the rest of the piece is equally bewildering:

In that case, rather than price stability, the sole goal of monetary policy should be dollar-price stability. Fed officials would credibly argue that the latter is the preserve of the U.S. Treasury, and they would have a point. Be it Treasury, or Treasury working with the Fed, the mandate should be in favor of stabilizing the dollar’s value.

Um, isn’t the entire point of price stability (which I don’t favor, BTW) stabilizing the value of the dollar?  Indeed isn’t true that, by definition, a stable value of money means a stable purchasing power?  Not to John Tamny.  He seems to define a stable value of money as a stable price of gold.  Why gold?  Why not a stable price of bricks, or toothpicks, or zinc?  He doesn’t say.  Nor does he seem to have the slightest intellectual curiosity about periods in history when the dollar price of gold was stable, like 1929-33, when we had severe deflation (which provided falling prices of electronic goods like radios!), and 25% unemployment, and so discredited capitalism that we elected exactly the sort of politician that Forbes magazine would despise.

Oddly enough, Marx once again had the answer there. Marx, much like the classical economic thinkers of his era, knew that for money values to be stable, they would have to be defined in terms of gold. Marx referred to gold as “money, par excellence.”

Looked at through the prism of today, the dollar lacks a golden anchor, and the result is a money illusion that distorts the real price of everything. Worse, with consumer prices sticky in concert with commodity prices that are most sensitive to dollar-price movements, the beneficiaries of the money illusion tend to be the hard, unproductive assets of yesterday (think housing, art, rare stamps, and oil) that are least vulnerable to currency weakness, and which in fact do best when the unit of account is devalued.

Well if Marx says money must be good as gold, who am I to argue?  Reading this column I can’t help but wonder why all this talk about currency depreciation is occurring when inflation is at the lowest point of my lifetime, indeed lower than during 1896-1914, the so-called Golden Age of the gold standard.

The answer to all of this is very basic. Price stability is a utopian concept on its best day that would hamper innovation on the way to reduced living standards.

The greater, more obvious answer is dollar price stability of the gold kind that would allow investors to rate ideas on their actual merits, as opposed to how they’ll perform amid dollar policy since 2001 that has erred in an economically crippling way in favor of weakness. Fix the dollar, and you fix the U.S. economy. Simple as that.

Isn’t that wonderful!  No need to worry about messy real world issues like macroeconomics.  No need to worry about how nominal shocks can have devastating real effects.  Gold is like a magic wand that will fix the US economy.  But there is one huge flaw with this argument; there are two types of gold standards, and neither produces anything like satisfactory macroeconomic outcomes:

1.  One type is a managed standard, such as we had in the US between 1879-33, and in a weaker form under Bretton Woods.  In that standard the nominal price of gold is fixed (just as Tamny wants) but its real value is highly unstable, as the economy would often suffer from deflation.  The most devastating example was 1929-33.  It’s true that the supply of gold rises at a fairly steady rate, but central bank real demand for gold was highly unstable, and thus the price level was unstable.  Of course you could argue that the central banks should have done a better job of stabilizing gold demand, but by that logic why not just have fiat money and then have them do a better job of stabilizing monetary policy.  Even worse, if we returned to the gold standard almost no other country would be nutty enough to follow.  In that case when people in places like China and India hoarded gold out of fear of inflation, America would suffer deflation.  And from history we know that deflation in America would lead to fears of devaluation, which would cause gold hoarding in America as well, and even more deflation.  Tamny doesn’t even think about those issues, but why should he when he considers deflation to be a good thing?

2.  Some have advocated a laissez-faire gold standard.  In this case the government simply pegs the price of gold, but doesn’t hold large stocks of gold.   This would be even worse than a managed standard, as the relative price of gold would then be determined exactly as the relative price of any other metal is determined, by “industrial demand.”   Rapid economic growth in Asia has been boosting the relative prices of other metals such as silver, copper and iron.  If gold was just an industrial commodity, then its relative price would also be quite volatile.

So either way the gold standard offers no advantages.  At best, a highly managed international gold standard might lead to rough price stability.  But if central banks were really able to manage gold that well, they’d also be able to mange fiat money.

I suppose I am wasting my time with this post.  If the right now believes that deflation doesn’t matter, that 1929-33 is like some bad dream that never really happened, then nothing I say will make any difference.

HT:  Bruce Bartlett

What should FDR have done during the interregnum?

Paul Krugman made the following comment about a recent statement by Obama:

And here’s this, from Thomas Ferguson: Obama saying

“We didn’t actually, I think, do what Franklin Delano Roosevelt did, which was basically wait for six months until the thing had gotten so bad that it became an easier sell politically because we thought that was irresponsible. We had to act quickly.”

As Ferguson explains, this is a right-wing smear. What actually happened was that during the interregnum between the 1932 election and the1933 inauguration “” which was much longer then, because the inauguration didn’t take place until March “” Herbert Hoover tried to rope FDR into maintaining his policies, including rigid adherence to the gold standard and fiscal austerity. FDR declined to be part of this.

But Obama buys the right-wing smear.

I’m not a FDR hater; I think he was “magnificently right” to devalue the dollar (to quote Keynes.)  But FDR probably should have cooperated with Hoover–even if it meant (falsely) promising not to devalue the dollar.

And please don’t say “but that would have been lying.”   Here’s the Democratic Party platform that FDR campaigned on:

The Democratic Party solemnly promises by appropriate action to put into effect the principles, policies, and reforms herein advocated, and to eradicate the policies, methods, and practices herein condemned. We advocate an immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than twenty-five per cent in the cost of the Federal Government. And we call upon the Democratic Party in the states to make a zealous effort to achieve a proportionate result.

We favor maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.

We advocate a sound currency to be preserved at all hazards and an international monetary conference called on the invitation of our government to consider the rehabilitation of silver and related questions.

Politicians lie all the time.  They are expected to lie.  The British government lied in 1931, 1967, and 1992, when it said it wasn’t going to devalue, before it did devalue.  That’s expected.  Everyone knows that if you say you will devalue in the future, it forces an immediate devaluation.  And under a gold standard if there is uncertainty about whether a devaluation will occur then gold hoarding increases, which is deflationary.  This happened on four occasions during the Great Depression, and on each occasion asset prices and industrial production declined sharply.

FDR basically had three choices.  The traditional route would have been to lie and say that he would adhere to the platform, maintaining the gold standard while working toward an international agreement to give silver a monetary role.  The markets knew that other countries weren’t going to adopt silver.   Then when he took office he could have said; “Because I wasn’t able to get agreement, we have to go it alone with a currency devaluation.”

Or he could have told the truth and said he was going to devalue the dollar.  That would have forced Hoover’s hand, and a devaluation would have occurred almost immediately.  The promising upswing of July to October 1932 would have turned into an explosive boom.  The 57% increase in industrial production that occurred during the first four months of FDR’s term would have instead occurred in the last 4 months of the Hoover administration.  If FDR had gone ahead with the NIRA’s high wage policy then he would have been blamed for aborting the Hoover recovery.

Instead he was continually evasive.  Even in Hoover’s last days in office he refused to support any of Hoover’s actions to address the banking crisis.

The interregnum was a horrible period, with an enormous amount of suffering during the winter of 1932-33.  It was the low point of the Great Depression.   And although the Depression itself was Hoover’s fault, this especially bleak period was partly FDR’s fault.  I’m not one of those conspiracy buffs who thinks FDR intentionally allowed Pearl Harbor to happen.  And I doubt he fully understood the effect of his evasive answers.  But most educated observers back then knew what was going on.  They knew that uncertainty about the dollar was depressing the economy.  The press pointed to similar events during the late 1800s, when fears about the soundness of the dollar had also had a deflationary impact.  FDR had three options, and he picked the one that imposed maximum harm on the economy.  That’s no right wing smear, it’s the truth.

Update:  Commenter Russ Anderson pointed out that this post was confusing.  I should have been clearer that while the best option for the country was for FDR to state he would devalue, and force Hoover’s hand, that option was a complete non-starter, politically unacceptable.  Those things just are done.  Given that the best option wasn’t really on the table, he should have said he’d maintain the gold standard.  Nothing I said should be seen as implying that the Great Contraction was caused by anyone other than Hoover.

The last time the US government tried to raise the price level

My research career often focused on offbeat topics that no one else seemed to be interested in.  Now it might be paying off.  One of those topics was Roosevelt’s “gold-buying program” of October-December 1933.  The only other article I’ve ever seen on this topic was published in an agricultural journal back in the 1950s.  This program was the last time (and perhaps only other time) that the US government explicitly tried to raise the price level.  Admittedly the entire April 1933-January 1934 dollar depreciation policy was aimed at reflation, but only during the gold-buying phase was the policy made explicit, and was a methodical policy followed to raise prices.

I did a long post on this in early 2009, and won’t repeat it all here.  Check out the post if you want to know more about how it was done.  Instead I’d like to discuss one very interesting aspect of the program that is relevant to what is going on right now.  (The policy involved raising the dollar price of gold to devalue the dollar.)  Here is a short passage from my Depression manuscript:

Then on November 20 and 21, the RFC price rose by a total of 20 cents and the London price of gold rose 49 cents.  On November 22 the NYT headline reported “SPRAGUE QUITS TREASURY TO ATTACK GOLD POLICY” and on page 2, “Administration, Realizing This, Vainly Tried to Persuade Him to Silence on Gold Policy”.  As with the Woodin resignation, Sprague’s resignation led to a temporary hiatus in the RFC gold price increases, this time lasting five days.

Over the next several days the controversy continued to increase in intensity.  The November 23 NYTreported “RESERVE’S ADVISORS URGE WE RETURN TO GOLD BASIS; PRESIDENT HITS AT FOES” other stories reported opposition by J.P. Warburg, and a debate between Warburg and Irving Fisher (a supporter of the plan).[1]  Another story was headlined “WARREN CALLED DICTATOR”.  The November 24 NYT headline suggested that “END OF DOLLAR UNCERTAINTY EXPECTED SOON IN CAPITAL; RFC GOLD PRICE UNCHANGED”.  Nevertheless, over the next few days the NYT headlines showed the battle raging back and forth:


“SMITH SCORES POLICY . . . Says He Is in Favor of Sound Money and Not ‘Baloney’ Dollar . . . ASKS RETURN TO GOLD . . . Critical of Professors Who ‘Turn People Into Guinea Pigs’ in Experiments” (11/25/33)

“GOLD POLICY UPHELD AND ASSAILED HERE AT RIVAL RALLIES . . . 6,000 Cheer [Father] Coughlin as He Demands Roosevelt Be ‘Stopped From Being Stopped'” (11/28/33)

[1]  Fisher regarded Roosevelt’s policy as being essentially equivalent to his Compensated Dollar Plan.  Although there were important differences, the rhetoric used by Roosevelt to justify the policy was remarkably close to the rationale behind Fisher’s plan.

The Fed better fasten its seat-belt, as the previous price level raising policy was a bit controversial.  Several FDR advisers resigned in protest.

George Warren was the FDR advisor behind the plan.  Warren was to Irving Fisher roughly what I am to Milton Friedman—similar ideology but lacking the intellectual brilliance.   Here’s a more important passage:

“It is indeed difficult to find out exactly what are Wall Street’s views with regard to the monetary question.  When former Governor Smith made public his letter and stocks were going up, there seemed to be little doubt that Wall Street wanted sound money.  But yesterday, faced with the sharpest break of the month, opinion veered toward inflation again.  As one broker expressed it, it begins to appear as if Wall Street would like to see enough inflation to double the price of stocks and commodities, but little enough so that Liberty bonds can sell at a premium.” (NYT, 11/28/33, p.33.)

One explanation for this ambiguity is that investors distinguished between once and for all changes in the price level, and changes in the rate of inflation.  During the early stages of the dollar depreciation, long term interest rates held fairly steady, and the 3 month forward discount on the dollar (against the pound) remained below 1.5 percent.  The market apparently viewed the depreciation as a one-time monetary stimulus, which would not lead to persistent inflation.  Investor confidence was shaken during November, however, when persistent administration attempts to force down the dollar were associated with falling bond prices and an increase in the forward discount on the dollar.  Consistent with this interpretation, the Dow rose 4.6 percent in mid-January 1934, following the Administration’s announcement that a decision was imminent to raise, and then fix, the price of gold.  The NYT noted that:

“The satisfaction found by stock and commodity markets in the inflationary implications of the program was nearly matched by the bond market’s enthusiasm for the fact that the government had announced limitations to dollar devaluation.” (1/16/34, p. 1).

The takeaway from all this is that markets seem to really want higher prices, but not higher inflation.  You do that by switching from inflation targeting to level targeting, when inflation has recently run below target.  Yesterday when the Fed minutes suggested the Fed was about to do that, equity markets responded strongly all over the world.  I’d guess about $500 billion dollars in wealth was created worldwide in 24 hours by 13 words from the Fed’s minutes:

. . . targeting a path for the price level rather than the rate of inflation . . .

The markets already knew QE was likely, but now the Fed seems increasingly serious about level targeting.

In 1933, the markets were surprised when the gold buying program briefly pushed long term T-bond yields higher (Liberty bonds in the quotation.)  Under the gold standard, the expected rate of inflation was generally roughly zero.  Investors were used to a liquidity effect (easy money means low rates) but not a Fisher effect (easy money raises inflation expectations, and thus interest rates.)  Even Keynes was pretty much oblivious to the Fisher effect:

“If you are held back [i.e. reluctant to buy bonds], I cannot but suspect that this may be partly due to the thought of so many people in New York being influenced, as it seems to me, by sheer intellectual error.  The opinion seems to prevail that inflation is in its essential nature injurious to fixed income securities.  If this means an extreme inflation such as is not at all likely is more advantageous to equities than to fixed charges, that is of course true.  But people seem to me to overlook the fundamental point that attempts to bring about recovery through monetary or quasi-monetary methods operate solely or almost solely through the rate of interest and they do the trick, if they do it at all, by bringing the rate of interest down.” (J.M. Keynes, Vol. 21, pp. 319-20, March 1, 1934.)

Before we judge Keynes too harshly, recall that he lived in a time of near-zero inflation expectations, with the exception of clearly anomalous situations like the German hyperinflation.  So when FDR’s policy of reflation briefly seemed to be raising long term bond yields in November 1933, bond market participants were rather shocked.  And here’s what I find so fascinating; modern security markets are only now beginning to grapple with this distinction, which turns out to be pretty hard to wrap one’s mind around.  Here’s something from today’s news:

Neil MacKinnon, global macro strategist at VTB Capital, said the worry in the markets is that the Fed’s attempt to raise inflation may not be as manageable and as controllable as it thinks.

“The bond market is alert to the potential contradiction in Fed policy of buying U.S. Treasuries to keep bond yields down and ideas such as price-level targeting that are likely to raise bond yields,” he said.

That’s the conundrum; what counts as “success,” higher nominal bond yields or lower nominal bond yields?  Everyone seems to assume the Fed is trying to lower bond yields, but if the policy is expected to produce a robust recovery and higher inflation, how can bond yields not rise?  I can’t answer these questions, but my hunch is that it has something to do with the higher inflation/higher price level distinction.  If the Fed can convince markets that they can raise the price level without changing their 2% inflation target, it is likely that all markets will react positively.  If they are seen as raising inflation in a semi-permanent way, stocks may still rise (albeit by a smaller amount), but bonds will sell off.

This is such an unusual circumstance that I don’t have much confidence in my own opinion, nor anyone else’s.  I don’t even know of anyone else who bothered to study what happened the last time Uncle Sam tried to raise the price level.  Too busy doing those VAR studies and DSGE models.

PS:  Where did the $500 billion figure come from?  I guesstimated world stock market valuation at about $50 trillion, with a 1% bump from the Fed move.  The financial press reported that all the world’s stock markets were affected by the Fed action.  I noticed that European stocks rose about 2%, and the Fed move was cited as the primary factor.  So I think $500 billion is roughly the order of magnitude, although obviously the exact figure is unknowable.  BTW, sometimes it is possible to get semi-accurate estimates, as when a huge market reaction following immediately upon a 2:15 Fed announcement and we have relevant odds from the fed funds futures markets.  And in those cases the effect is often much bigger.  I can’t wait for November 3rd.