Archive for November 2011


Sado-fiscalists, indentured servants, and an eminence grise

Here is the essential Ambrose Evans-Pritchard, one of the few journalists to see the monetary nature of the recession early on.

Nobel economist Myron Scholes first floated the idea over lunch at a Riksbank forum in August. “I wonder whether Bernanke might not say that `we believe in a harmonized world, that the Europeans are our friends, and we know that the ECB can’t print money to buy bonds because the Germans won’t let them. And since the ECB will soon run out of money, we will step in and start buying European government bonds for them’. It is something to think about,” he said.

This is not as eccentric as it sounds. The Fed’s Ben Bernanke touched on the theme in a speech in November 2002 – “Deflation: making sure it doesn’t happen here” – now viewed as his policy `road map’ in extremis.

“The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt. Potentially, this class of assets offers huge scope for Fed operations,” he said.

Berkeley’s Brad DeLong said it is time for Bernanke to act on this as the world lurches straight into 1931 and a Great Depression II. “The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash,” he said.

The Fed could buy €2 trillion of EMU debt or more, intervening with crushing power. The credible threat of such action by the world’s paramount monetary force might alone bring Italian and Spanish yields back down below 5pc, before one bent nickel is even spent.

One presumes that the Fed would purchase both the triple AAA core and Club Med in a symmetric blast of monetary stimulus across the board, avoiding the (fiscal) error of targeting semi-solvent states. In sense, the Fed would do quantitative easing for the Europeans, whether they liked it or not.

David Zervos from Jefferies has proposed an extreme variant of this, accusing Germany’s fiscal Puritans of reducing Europe’s periphery to “indentured servants” and driving the whole region into depression with combined fiscal and monetary contraction.

“We in the US need to snuff out these sado-fiscalists and fast, they are a danger to the world. The US can force monetisation at the ECB. We should back up the forklift and buy Euro area bonds. Lots of them,” he said.

Some of the purchases could be achieved by tapping the Fed’s euro account at the ECB, flush with funds as a result of currency swaps provided by Washington to help Europe shore up its banks. Ultimately mass EMU bond purchases would cause a sudden and potentially dangerous spike in the euro against the dollar. There lies the rub. If the ECB failed to loosen monetary policy drastically to offset this, the experiment could go badly wrong.

A pioneering school of “market monetarists” – perhaps the most creative in the current policy fog – says the Fed should reflate the world through a different mechanism, preferably with the Bank of Japan and a coalition of the willing.

Their strategy is to target nominal GDP (NGDP) growth in the United States and other aligned powers, restoring it to pre-crisis trend levels. The idea comes from Irving Fisher’s “compensated dollar plan” in the 1930s.

The school is not Keynesian. They are inspired by interwar economists Ralph Hawtrey and Sweden’s Gustav Cassel, as well as monetarist guru Milton Friedman. “Anybody who has studied the Great Depression should find recent European events surreal. Day-by-day history repeats itself. It is tragic,” said Lars Christensen from Danske Bank, author of a book on Friedman.

“It is possible that a dramatic shift toward monetary stimulus could rescue the euro,” said Scott Sumner, a professor at Bentley University and the group’s eminence grise. Instead, EU authorities are repeating the errors of the Slump by obsessing over inflation when (forward-looking) deflation is already the greater threat.

“I used to think people were stupid back in the 1930s. Remember Hawtrey’s famous “Crying fire, fire, in Noah’s flood”? I used to wonder how people could have failed to see the real problem. I thought that progress in macroeconomic analysis made similar policy errors unlikely today. I couldn’t have been more wrong. We’re just as stupid,” he said.

Needless to say, reflation alone will not make Euroland a workable currency area. Nor will fiscal union, Eurobonds, and debt pooling down the road.

“Even if they do two years of fiscal transfers, and the ECB buys all the bonds, and the problems are swept under the carpet, we are still going to be facing a crisis at the end of it,” said professor Scholes.

I’m not too clear on whether “grise” (grey in French) means I’m boring or have grey hair.  But I’ll take it either way.  However I doubt that I have the required subtlety and sophistication to fulfill that role.  I got a C in high school French.

The proposal itself is not my first choice.  But it does kill two birds with one stone.  And that’s two birds more than we’re killing from our current Fed and ECB policies.  So if that’s what’s on offer, I’m strongly for it.

HT:  Tim Worstall and David Levey

AD shocks make structural problems MUCH worse

Tyler Cowen has a post criticizing the widespread view that Germany is the key to solving the euro crisis.  He’s right that moral hazard is a much bigger problem than most bloggers seem to think, and he’s right that Germany can’t be expected to bail out the PIIGS.  But I’m not so sure about this:

Furthermore, there is no “half hearted recovery” in the offing, not even with better AD policy.  A lot of institutional arrangements were set up in an unstable fashion and now they are unwinding, as indeed they had to do, with economic carnage along the way.  The periphery countries all thought they were wealthier than they in fact are, and behaved as such, but now is the painful unwinding, including the collapse of a lot of ultimately unworkable EU governance structures.  Markets now see this, and the ECB cannot so easily reverse it.

In other posts I’ve argued that even if your “real problem” is pneumonia, it’s very much in your interest to avoid being stabbed by a mugger.  And even if your real problem is structural (and I agree with Tyler that this is the big problem in the Mediterranean economies) you very much want to avoid a sharp fall in NGDP growth.

Let’s suppose Tyler is right that “no half hearted recovery” is likely if the ECB pumps up NGDP by 5% over the next 12 months.  Even in that case I’d argue that demand stimulus is of crucial importance.  Why?  Because if 5% NGDP growth will produce a recession, then negative 5% NGDP growth will produce a depression.  And that could happen if the ECB remains completely passive.  I’m not sure that Tyler disagrees with that, but I think most people reading the excerpt I provided would assume that he disagrees.

Trotsky once said “You may not be interested in war, but war is interested in you.”

I’d say the same about AD shocks.

As far as what the markets can see, I’d say the wild gyrations on Wall Street suggest the markets don’t know what’s going to happen.  The Europeans are playing a game of chicken, with one side asking for austerity and the other side asking for bailouts (via ECB bond purchases.)  As with the NBA strike I expect a deal before the worst case develops, but in any game of chicken the worst case is a possibility.  Tyler Cowen pointed out in a previous post that if the worst case was not a possible outcome, then the negotiators would have no leverage.  You must be willing to unleash Armageddon.

Wasn’t the European Union set up to prevent exactly this sort of dangerous brinkmanship?

PS.  And don’t forget that the difference between positive 5% and negative 5% NGDP growth in the eurozone is the difference between a Greek default and a dramatically larger Greece/Italy/Portugal and perhaps Spanish default.

Update: Paul Krugman discusses some interesting evidence put together by Rebecca Wilder:

You can see the big divergence as the euro crisis has exploded. But I think it’s interesting that Finland and Sweden started to diverge back in April. What happened then?

Ah, yes “” the ECB started raising rates. And as Rebecca Wilder points out, that’s precisely when euro bond spreads began their upward march, culminating in the current crisis.

By itself, that rate hike “” although it was obviously, obviously a big mistake “” should not have mattered that much. But maybe it acted as a signal of the ECB’s bloody-mindedness, and that’s what set off the panic.

If that’s what happened, then the ECB’s hard-money madness may have destroyed the euro.

A signal indeed.  We keep seeing over and over again that expectations of future monetary policy drive current asset prices.  And wasn’t April the last time we saw a decent jobs number in the US?  It’s also roughly the time that the Fed sent out strong signals that QE2 would be shutdown.

Did Keynes understand his own theory? Apparently not.

At least if we are to believe modern Keynesians like Paul Krugman, who insist that the deep 1937-38 recession was produced by a tightening of fiscal policy.

In previous posts I’ve pointed out that there are all sorts of problems with the modern Keynesian explanation for 1937.  The tightening was mostly in taxes and transfers, not government output.  In contrast, modern Keynesians suggest that stimulus involving government output is far more effective than tax cuts.

The timing is also wrong.  Investors were fully aware of fiscal tightening in early 1937, yet stocks were at very high levels.  In contrast, my explanation of the deep recession (mostly a turnaround in the world gold market which led to deflation) correlates very closely with movements in the stock market.  (I also think FDR’s high wage policy played a role in the recession.)

But who cares what I think.  I’m more interested in Keynes’s views.  Would he agree with me or Krugman?

Keynesians like to make a big deal of Keynes’s skill in investing, which is mostly (albeit not entirely) a myth.  He lost lots of money in the 1920s and had to be bailed out by his father so that he could start over again.  In the spring of 1937 he thought it was a great time to own US equities, indeed so much so that he purchased many on margin.  How’d that work out?  Here John Hussman:.

As biographer Robert Skidelski observes, “In the year of the ‘terrific decline’ which had started in the spring of 1937, he lost nearly two-thirds of his money.”

Keynes was fully aware of the fiscal tightening by this time.  And he was fully aware that a steep recession would cause a sharp sell-off on Wall Street.

So which is it?  Is the Keynesian theory wrong?  Or did Keynes not believe his own theory?

I say the Keynesian theory is wrong.  There was no reason for Keynes not to own stocks in 1937.  The events that caused the severe recession also caused the stock market crash–and those occurred in the last half of 1937.  EMH + market monetarism >>>>>> Keynesian theory.

Was Von Mises a post-modernist?

You may recall that I have frequently argued that inflation is a useless concept.  It’s not that we can’t construct rough estimates of the average rate of price change.  We can.  Instead I argue that there is no “true rate of inflation” out there to be measured.  Any measure is an arbitrary social construct.  So any defense of inflation must rely on pragmatic arguments.  And for almost every use of ‘inflation’ there is a more appropriate variable (usually NGDP growth.)

Von Mises felt the same way.  Here’s Joseph Salerno:

By the time Human Action was published in 1949 (actually, by 1940 when the German-language forerunner to Human Action, Nationalökonomie, was published) Mises had come to recognize that the concept of inflation was completely empty and useless for the purposes of technical monetary theory. For the later Mises, it was impossible to separate the effects on market prices of monetary influences from the effects of “real” influences emanating from the markets for goods. The supply of and demand for money were intertwined with the supply of and demand for every good, because goods and money were ranked together and compared on individuals’ value scales. Any change in the demand for money inevitably affected the relative demands for the various goods, and vice versa.

Just in time for my January debate with Bob Murphy.  (I should have kept this secret, and sprung it on Bob.)

PS.  I said “almost every use” because there is one valid use of inflation.  Take the rate of NGDP growth per capita and subtract out your subjective estimate of how much NGDP growth would have left us equally happy as before.  The difference is inflation.  But inflation still doesn’t have practical value, it’s merely your personal estimate of how much of the increase in NGDP is not “real.”

HT:  Derrill Watson

PS.  I just noticed this in a Nick Rowe post:

And I have sympathy with Scott Sumner’s approach too, in trying to ban the use of the “i-word”, and talk about NGDP instead.

Actually there are three i-words that need to be banned; inflation, income and interest rates.  And they need to be replaced with NGDP growth, consumption, and asset prices.

At first they call you crazy . . . . and in the end they say “we knew that all along.”  (I can’t recall the exact quotation.)

Don’t know much about history

Alex Tabarrok reminds us what really happened at the first Thanksgiving:

It’s one of the ironies of American history that when the Pilgrims first arrived at Plymouth rock they promptly set about creating a communist society.  Of course, they were soon starving to death.

Fortunately, “after much debate of things,” Governor William Bradford ended corn collectivism, decreeing that each family should keep the corn that it produced.

So America quickly moved away from an economic system based on sharing equally, where there is no incentive to work.  Unfortunately peasants in Russia, China, Cambodia, and North Korea were not so lucky.  With no incentive to produce, farm output plummeted and tens of millions starved to death.  Collectivization of agriculture was (along with WWII) one of the two great tragedies of the 20th century.

Like many “progressives,” Paul Krugman seems to think fear of  socialism is a big joke.

Here’s how it went down: a bunch of people got together, with each group bringing what it could “” the Wampanoag brought deer, the Pilgrims apparently shot some birds, etc.. Then everyone shared equally in the feast “” regardless of how much they brought to the table. Socialism!

Worse yet, many of the lucky duckies benefiting from the largesse of this 17th-century welfare state were illegal immigrants. (That would be the Pilgrims).

We need to stop celebrating this deeply un-American event, and start celebrating something more in tune with the things that make America great, such as the Ludlow Massacre.

In fairness, Krugman probably doesn’t understand what actually happened at Plymouth.  He certainly doesn’t favor an extreme form of socialism where there’s zero incentive to produce.  But if you want to mock conservatives for believing that an economic system based on sharing could leads to all sorts of unspeakable evils, you might want to pick an example that doesn’t prove their point.

PS.  Read Tabarrok’s entire post.  It’s excellent.