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:

“ROOSEVELT WON’T CHANGE GOVERNMENT’S GOLD POLICY, IGNORING ATTACK BY [former New York Governor Al] SMITH”  (11/25/33)

“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)

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[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.

Why does stuff like this have to happen when I have no time to blog?  I promise commenters that I will eventually get to comments from recent posts.  Perhaps tomorrow night.  And then there is the backlog of posts I need to do.  But this one can’t wait.  I saw the following comment from someone whose byline is an apparent reference to Keynesian economics (“Obsolete Dogma“):

If it makes you feel any better, the latest FOMC minutes (http://read.bi/8Xejge) show the board considered implementing either a NGDP or price level target instead of targeting the rate of inflation.

The FOMC brings to mind Churchill’s quip about Americans: they always do the right thing “” after they have exhausted all other possibilities.

He or she is referring to this comment in the Fed minutes:

Participants noted a number of possible strategies for affecting short-term inflation expectations, including providing more detailed information about the rates of inflation the Committee considered consistent with its dual mandate, targeting a path for the price level rather than the rate of inflation, and targeting a path for the level of nominal GDP.

Like the hardy band of hobbits who brought the ring to Mordor, our little group of bloggers from schools like Texas State, Bentley, The Citadel, Wayne State University have finally succeeded in bringing NGDP targeting (level targeting no less!) into the formerly impregnable Federal Reserve System.  Kudos to Matt Yglesias as well.  And of course level targeting-advocate Michael Woodford, who in all seriousness does have influence at the Fed.

Here’s Yahoo’s explanation of why stocks turned around after Yellen’s scary statement depressed prices this morning:

 WASHINGTON (AP) — The Federal Reserve is leaning toward taking two steps to boost the economy: Buying more Treasury bonds to drive down loan rates, and signaling an openness to higher prices later to encourage more spending now.

And another Yahoo story explained the market reaction:

NEW YORK (AP) — Traders pushed shares higher Tuesday after minutes from the latest Federal Reserve meeting kept hope alive that the central bank would take more action to stimulate the economy.

The Fed had said after its Sept. 21 meeting that it was concerned that inflation was too low, and suggested it could step up its purchases of government bonds and take other action to encourage lending.

Minutes from the September meeting, released Tuesday afternoon, indicated that Fed Chairman Ben Bernanke and his colleagues were nearing a consensus on what steps to take. Traders are hoping for more concrete news from the Fed following its next meeting in early November.  (Emphasis added.)

Yes, I understand that the details will probably be underwhelming, and I shouldn’t get my hopes up.  But the fact that they are thinking along these lines may pay off in the next business cycle.  Imagine if these policies had been adopted in September/October 2008.  Remember, NGDP fell in 2009 at the fastest rate since 1938—level targeting would have made a huuuuuge difference in October 2008.

PS:  The post title is a reference to this Paul Krugman post.  In fairness to Krugman, any price level or NGDP target announced by the Fed is probably going to be too low to make a dramatic difference.  But I think he might underestimate the advantages of level targeting over “memory-less” growth rate targeting.  At least I don’t recall him discussing the topic.

I already commented on this Paul Krugman post, but I thought of another angle that seems kind of odd.  See what you guys think.  Krugman was commenting on this statement by Laurence Meyer:

There’s also another tradition that began to build up in the late seventies to early eighties””the real business cycle or neoclassical models. It’s what’s taught in graduate schools. It’s the only kind of paper that can be published in journals. It is called “modern macroeconomics.”

I found this confusing, as it wasn’t clear where Meyer put new Keynesianism, which is surely the dominant macro paradigm in the last 30 years.  Paul Krugman also seemed a bit perplexed, and offered this interpretation:

My first reaction, on reading this, was to say that Meyer overstates the case “” and he does, a bit. It has been possible to publish New Keynesian models in the journals, and these models do, I think, provide some useful guidance “” if only as a consistency check on more ad hoc approaches.

But fundamentally Meyer is right. And it has been going on a long time. By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote.

When I left Wisconsin for Chicago in 1977, some of my professors suggested that it was a rather nutty place.  Most schools were Keynesian in 1977, only Chicago and a few others (Rochester, Minnesota, etc) dissented from this orthodoxy.  Certainly the elite Ivy League universities that dominated the field were not sympathetic to Chicago.

Here’s what I’d like to know.  How was it that just a few years later it was almost impossible to get anything published without assuming rational expectations, efficient markets, etc.  I’d like to offer two hypotheses:

1.  Sometime around 1980 an elite team of Chicago macroeconomists stormed the offices of all the major economics journals with AK-47s, ousting all the editors and replacing them with inferior people who just happened to have studied under Lucas and Fama.  Call it the academic equivalent of the Chilean coup.

2.  The discovery of rational expectations and the efficient market hypothesis at the University of Chicago caused a scientific revolution.  A paradigm shift.  Economists began to realize that the expectations assumed in a model ought to be consistent with the model’s predictions.  That it made no sense to have models that assume the world works one way, and populate it with people who believe the world works in an entirely different way.  And economists also realized that it made no sense to build models that implied it was easy to set up mutual funds that would out-perform an indexed fund, simply by following the implications of a model.  After all, it’s really hard to beat indexed funds, despite the fact that lots of very smart people try hard to do so.

So which view seems more plausible?

I hope I haven’t unfairly stacked the deck by presenting only these two hypotheses.  I’ve tried to present both views in an even-handed way.  Please let me know what you think.  (I don’t doubt that readers will provide a third hypothesis in the comment section.)

HT:  Matt Yglesias

PS,  I recall that Yglesias is highly critical of conservatives who reject the scientific consensus on global warming.  I agree.  But I wonder how he feels about liberals who reject the economic consensus about rational expectations and efficient markets.  Krugman says you can’t get published without assuming ratex—doesn’t that sound a lot like climate science, where it’s almost impossible to get published without assuming global warming?  (And don’t say economics is a soft science where proof is difficult to achieve.  Prediction is also difficult in climate science; and for the same reason—both the economy and the climate are very complex.)

Here’s a very important comment by Michael Woodford:

This proposal is different from that made in some quarters (and rejected by Fed officials) for an increase in the Fed’s inflation target. In order to obtain the benefits just cited, it is not necessary to make people expect a continuing high rate of inflation. Indeed, that would be counterproductive. To the extent that expectations of a permanently higher inflation rate would create uncertainty about the value of the dollar, for instance, they could easily make long-run real bond yields higher, rather than lower.

Instead, as suggested in a recent speech by William Dudley of the Federal Reserve Bank of New York, the Fed should commit to make up for current “inflation shortfalls” due to its inability to cut interest rates. If, for example, inflation was predicted to run half a percentage point below the Fed’s target for the next two years, the Fed could announce plans to offset this by allowing an additional one per cent rise in prices after that. Once the shortfall has been made up, the Fed would return to its previous, lower target.

Critics will say this will undermine the Fed’s credibility on price stability. They are wrong because the price increases allowed under this “catch-up” policy would be limited in advance. Catch-up inflation would simply put prices back on the path they would have followed had the Fed been able to cut interest rates earlier.

Others argue the opposite case: that a modest increase in prices would have too small an effect to boost the recovery. But the true value of such a commitment would be precluding a disinflationary spiral, in which expectations of disinflation without any possibility of offsetting interest-rate cuts lead to further economic contraction and hence to further declines in inflation. A commitment subsequently to offset any inflation deficit would allow higher future inflation to be anticipated in step with the size of the current inflation shortfall. This in turn would automatically limit the degree of disinflation that can occur.

The instinct of policymakers such as Mr Bernanke is to say less about future policy during a time of economic turmoil, on the grounds that the future seems especially difficult to predict at such times. Yet it is precisely when policymakers face unprecedented conditions that it is most difficult to assume that the public will be able to form correct expectations without explicit guidance. At times like the present, uncertainty about the future is one of the greatest impediments to faster recovery.  (Emphasis added.)

And what is true of “times like the present” was even more true of September/October 2008, when the Fed allowed enormous uncertainty to develop about the future path of prices and NGDP.  If they had followed level targeting at that time then the recession would have been far milder.

At the other extreme is Janet Yellen.  Last year I argued that she wasn’t qualified to serve on the FOMC.  Nevertheless, I would have voted to confirm her and the other two, who I also think are unqualified (despite one just getting a Nobel Prize) because I think we need more voices for monetary stimulus.  Now it’s not clear we got even that:

LONDON (AP) — World markets fell Tuesday after a leading U.S. rate-setter dampened expectations that the Federal Reserve is preparing a massive monetary stimulus next month and amid mounting speculation that China is planning to raised reserve requirements for banks to cool lending.

.   .   .

Comments from Janet Yellen, the vice chairman of the Fed, Monday reined in the most exuberant hopes in the markets.

In remarks to economists in Denver, Yellen warned that excessively easy monetary policy, involving ultra-low interest rates and an expansion in the Fed’s balance sheet, could create big problems down the line.

“It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking,” Yellen said.

.   .   .

Yellen’s comments helped ease the pressure on the dollar — by mid-morning London time, the euro was down 0.4 percent at $1.3814 while the dollar was 0.2 percent lower at 81.93 yen.

Obama just can’t catch a break right now.  My commenter Benjamin Cole suggested that she might have been simply trying to establish credibility.  Yes, but the market reaction speaks for itself.  The stock market follows a random walk, meaning any changes are expected to be permanent.  (Yes, I know this isn’t precisely true, but it’s roughly true.) 

Instead of Yellen and Peter Diamond, Obama should have picked Woodford and Svensson.  Surely we could have stolen Svensson away from the Riksbank?

PS.  It’s entirely possible that in the entire world there are fewer people qualified to serve on the FOMC than there are seats.  (And no, I don’t see myself as being qualified.  The job requires knowledge in many different areas.)

HT,  Marcus Nunes,  JimP, David Glasner

This post was motivated by the following comment in a recent Paul Krugman post:

By the early 1980s it was already common knowledge among people I hung out with that the only way to get non-crazy macroeconomics published was to wrap sensible assumptions about output and employment in something else, something that involved rational expectations and intertemporal stuff and made the paper respectable. And yes, that was conscious knowledge, which shaped the kinds of papers we wrote. So you could do exchange rate models that actually had realistic assumptions about prices and employment, but put the focus on rational expectations in the currency market, so that people really didn’t notice. Or you could model optimal investment choices, with the underlying framework fairly Keynesian, but hidden in the background. And so on.

I can’t quite tell whether Krugman thinks “rational expectations and intertemporal stuff” are counterproductive, so the following isn’t really aimed at Krugman, but rather the many economists who I am quite certain do regret the influence of ratex and the efficient markets hypothesis.

The most important macro event of my lifetime was the precipitous drop in inflation and NGDP growth expectations during the late summer and early fall of 2008.  Because inflation had been running around 5% over the previous year, antique macro models based on adaptive expectations were completely useless during this period.  Indeed, I’m guessing that one of the reasons why the Fed was behind the curve in the fall of 2008 was precisely because their models were far too backward-looking.  During the financial crisis Fed policy got effectively tighter and tighter, and as a result there was a whole lotta “rational expectations and intertemporal stuff” going on.

Here’s what I find so ironic.  Everyone talks about how the profession became obsessed with ratex and the EMH after 1980, but from my perspective most economists still seem stuck in the adaptive expectations era.  If you really believed in ratex and the EMH, wouldn’t you be really, really interested in market forecasts of the policy goal variable?  I would be.  Yet instead of trying to infer market forecasts, they built elaborate structural models to try to forecast the goal variables.  In the 1980s when I tried to peddle my futures targeting approach, no one seemed interested.  I presented papers at the AEA meetings, the NY Fed, the Philly Fed, and everyone just yawned.  So from my perspective we face exactly the opposite problem; the profession doesn’t take ratex and the EMH seriously enough.  If the Fed really believed in ratex and efficient markets, they would have put the pedal to the metal in the infamous September 16, 2008 meeting.  Instead they yawned, and left rates unchanged at 2%.

PS.  Perhaps me and the other futures targeting proponents were just ahead of our time.  One famous macroeconomist endorsed futures targeting just recently.  A sign of things to come?

PPS.  Yes, the Fed did use the EMH as an excuse not to intervene in the housing bubble.  But that’s exactly where it was not appropriate.  The existence of FDIC and TBTF means the EMH provides no justification for not regulating bank risk-taking.