Here’s Arnold Kling discussing the Great Inflation and its aftermath:

Let me throw a third hypothesis into the mix. There was a fair amount of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and thought that this would slow down inflation. In fact, interest rates were not high enough. Relative to financial markets, the Fed was following rather than leading. It was reflecting the views of Wall Street. Finally, in the early 1980s, the “bond market vigilantes” took over, and we had high real interest rates, high unemployment, and a slowdown in inflation. Just to be clear, I am giving the credit for high interest rates to the bond market vigilantes, not to Paul Volcker.

This is a good example of the problems associated with “reasoning from price change.” Kling is implicitly associating higher interest rates with contractionary policy. That might be true if the higher interest rates are caused by a contraction in the money supply (giving credit to Paul Volcker.) However in this case Kling is holding the money supply fixed and assuming the higher interest rates are caused by higher inflation expectations. In that case the higher interest rates will lead to higher nominal GDP growth and inflation, because higher nominal rates tend to increase velocity.

Note that this is not some sort of weird “market monetarist” result. Higher inflation expectations are also expansionary (or at least non-contractionary) in the new Keynesian model.

BTW, NGDP growth reached an annual rate of 19% in late 1980 and early 1981.  Volcker is to blame for that surge.

There’s an old saying that if you kill one man they put you in prison, if you kill 100,000 men they build a statue in your honor. A new article in The Economist suggests a corollary; if an individual extorts money he’s put into prison, if a government extorts money it’s praised for getting tough on banks:

To a public angry at banks for their role in the financial crisis, this may all seem like reasonable retribution. Yet in many cases the rush to punish is overturning basic principles of justice. Take the settlement agreed to by JPMorgan. The accompanying statements from both the bank and the regulator involved, the Federal Housing Finance Agency, provided no indication of what the firm did wrong and no admission of guilt. JPMorgan is the fourth institution to settle over its dealings with Fannie and Freddie without going to trial, following settlements by General Electric, Citigroup and UBS.

Bank executives contend that they have little choice but to accept punitive settlements because the alternative, facing a criminal indictment and going to court, could destroy their businesses, even if they are subsequently found not guilty. This is because they risk losing their banking licences or being shunned by clients while charges are pending. In some cases regulators make these threats explicitly. Last year New York’s financial regulator threatened to revoke the state banking licence of Standard Chartered, which would in effect have excluded the British bank from America. “If you’re a financial institution and you’re threatened with criminal prosecution, you have no ability to negotiate,” Warren Buffett, an investor, said recently. “Basically, you’ve got to be like a wolf that bares its throat…You cannot win.”

Most people react to this type of story that an emotional level; either the banks deserve what they’re getting (liberals) or they’re being treated unfairly (conservatives.) Let’s try to rise above emotions and look at this from a public policy perspective. I see two other issues here:

1. This allows President Obama to raise taxes on banks without congressional approval:

JPMorgan Chase agreed to the biggest of these settlements, of $5.1 billion (with perhaps billions more to come) related to mortgages that it, and banks it later acquired, had sold to two government-backed firms, Fannie Mae and Freddie Mac. In Europe Rabobank, a Dutch co-operative, agreed to pay almost $1.1 billion after admitting that some of its employees had joined in the manipulation of LIBOR, a benchmark interest rate. Piet Moerland, its boss, resigned. In Germany Deutsche Bank set aside €1.2 billion ($1.7 billion) in provisions for litigation. Swiss regulators told UBS to set aside 586m francs ($652m) against possible legal costs and fines.

A billion here and a billion there soon add up. SNL Financial, a data firm, reckons that over the past three-and-a-half years America’s six biggest banks have agreed to pay more than $65 billion in settlements related to the financial crisis and mortgages. Further claims and expected settlements will soon push this figure to $85 billion, it says.

Add in settlements agreed to or being negotiated by European banks and the bill easily tops $100 billion. These include the $1.9 billion fine imposed on HSBC over weak money-laundering controls, the $1.5 billion settlement agreed to by UBS for manipulating LIBOR and the £16 billion ($26 billion) British banks have set aside to compensate customers who bought useless loan-insurance policies. It is not just banks in the firing line. SAC Capital, a hedge fund, was expected to reach a $1.2 billion settlement of criminal charges relating to securities fraud as The Economist was going to press. This follows an earlier $616m settlement of civil claims against the fund.

Whenever the Obama administration needs more tax revenue they can simply “ask” banks for more money. Just like someone in the Mafia might “ask” a small shopkeeper for some money. In the old days the GOP-controlled House of Representatives would’ve been able to stop the Obama people from raising more revenue. That is no longer true.

2.  And the problems don’t stop there. The Fed’s tight money policy, which created the Great Recession and greatly worsened the financial crisis, has many other costs as well:

The bill presented to banks does not stop at fines and redress. The industry is spending billions more trying to comply with new rules of dubious worth. In the first half of this year HSBC added 1,600 people to ensure compliance with proliferating regulation. JPMorgan has added 4,000 people to “control efforts” since the beginning of last year, and increased spending to that end by $1 billion this year alone. Standard Chartered has added 2,000 compliance staff over three years, even as its total headcount has fallen.

Besides raising costs for banks and their clients the current climate of fear poses a number of longer-term risks to the financial system. The first is that big banks will be less ready to buy units of failed rivals, as JPMorgan and others did during the financial crisis. That will make future crises more difficult to manage. As worrying is that banks are being discouraged from confessing to wrongdoing or sharing concerns with regulators. That may make it more difficult for supervisors to assess future risks. And without any proper accounting of banks’ sins, no one will ever know whether justice has been done.

I know what you’re thinking; no regulatory bill is perfect. “Yes, there are flaws, but at least Dodd-Frank put an end to subprime mortgages and reined in the GSE’s.” Oh wait…

3. Or perhaps you are thinking; “Those rich bastards deserve it, at least they won’t come at little people like me.” In that case you may not want to read this article from the same issue of The Economist:

THE names of court cases usually make sense. Think of “US v Bernard Madoff” or“US v Timothy McVeigh”. What, then, is“US v $35,651.11″? Why is Uncle Sam prosecuting a heap of money?

The answer, alas, makes even less sense than the name on the docket. Terry Dehko and his daughter Sandy Thomas (pictured) run a grocery store in Fraser, Michigan. It sells everything from bread to hand-made sausages. Fairly often, someone takes cash from the till and puts it in the bank across the street. Deposits are nearly always less than $10,000, because the insurance covers the theft of cash only up to that sum.

In January, without warning, the government seized all the money in the shop account: more than $35,000. The charge was that the Dehkos had violated federal money-laundering rules, which forbid people to “structure” their bank deposits so as to avoid the $10,000 threshold that triggers banks to report a transaction to the Internal Revenue Service (IRS).

Prosecutors offered no evidence that the Dehkos were laundering money or dodging tax. Indeed, the IRS gave their business a clean bill of health last year. But still, the Dehkos cannot get their cash back. “They offered us 20%,” says Ms Thomas, “But if we settle, it looks like we’re guilty of something, which we’re not.”

In criminal cases, the government can confiscate assets only after a conviction. Under “civil forfeiture”, however, it can grab first and ask questions later. Property can be seized merely on the suspicion that it has been involved in a crime. Citizens have no right to a swift hearing.

Don’t you love the term “structure”?

The rule of law? What a quaint notion!

PS.  Just imagine the complexity of the ObamaCare regulations, and the possibilities it will open up for prosecutors. Remember that in America prosecutors are not interested in justice, they are interested in accumulating scalps to burnish the reputation when they run for higher office.

PPS.  Alex Tabarrok and Matt Yglesias have two very good posts on geese and golden eggs.  Both loosely relate to this post.

Have a nice day.

Here’s Mark Rank at the NYT:

Contrary to popular belief, the percentage of the population that directly encounters poverty is exceedingly high. My research indicates that nearly 40 percent of Americans between the ages of 25 and 60 will experience at least one year below the official poverty line during that period ($23,492 for a family of four), and 54 percent will spend a year in poverty or near poverty (below 150 percent of the poverty line).

Even more astounding, if we add in related conditions like welfare use, near-poverty and unemployment, four out of five Americans will encounter one or more of these events.

I’m not at all astounded, as I earned $1500 when I was 25 years old.  (I taught one section at UW Eau Claire that year. Don’t even ask about my diet.)  But of course when people think about poverty they are not thinking about people who have gone to grad school at the University of Chicago.

Philip Crawford sent me an interesting article on poverty in Madison, Wisconsin, which appeared at SocialistWorker.org.  In the end they fail to come to grips with the information they provide, but they certainly do provide a lot of useful information.  It seems that my hometown, ultra-liberal “Madtown,” might be the most racist city in America:

The most racist city in the U.S.?

Obviously economics is about more than public policy.  But to me it seems to be mostly about public policy, and I’d be interested in your thoughts about whether I am right.  Let’s approach this in a roundabout fashion.  I just finished Tyler Cowen’s new book (which is excellent–highly recommended) and noticed this claim (p. 222):

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service . . .

I don’t think that’s true.  Never reason from a price change.  Perhaps Tyler saw me looking over his shoulder, and hence the complete sentence is:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually buy less of that good or service, all other things being held equal.

OK, am I happy now?  No, I still think it’s wrong.  Recall that every transaction is two-sided.  When someone buys something, someone else sells something.  So when you describe the quantity of something purchased changing, you are also describing the quantity of something sold changing.  Let’s re-word Tyler’s claim into something exactly equivalent:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually sell less of that good or service, all other things being held equal.

If Tyler had said this, I believe some eyebrows would have been raised.  But Tyler did say this!  It’s not easy to avoid reasoning from a price change.  So how should he explain this concept to the public?  How about this:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when price goes up, people usually have a lower quantity demanded of that good or service, all other things being held equal.

That’s true, but since it’s impossible to directly observe “quantity demanded,” it’s sort of a weak claim. Don’t we want to show non-economists some sort of claim that can be directly observed?  OK, how about this:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when a frost destroys 90% of the orange crop, people will buy fewer oranges, all other things being held equal.

Yes, that’s true, but it’s also obvious.  Supply changes.  If there are 90% fewer oranges, it stands to reason that people will consume fewer oranges.  It’s so obvious that it won’t even strike non-economists as a “model.”

So let’s do a supply shift that doesn’t obviously reduce the quantity of oranges available:

We [economists] still haven’t dispensed with models, because there are a few models we believe in pretty strongly, such as that when a tax is placed on a good, people will buy fewer of that good, all other things being held equal.

Finally we have something that is both true and observable and also non-trivial.  And it’s a public policy issue. Here are some more public policy claims:

1.  Increasing the money supply will raise all wages and prices by the same proportion, in the long run.

2.  Increasing the money supply growth rate will raise nominal interest rates in the long run.

3.  Rent controls will lead to housing shortages.

4.  People should be allowed to sell a kidney.

5.  Higher tax rates might lead to less government tax revenue.

6.  A higher legal minimum wage might hurt low income workers.

7.  Mandating certain employment benefits might hurt workers.

8.  Mandating higher product quality, or lower service fees, might hurt consumers.

9.  Taxes are a more effective deterrent to pollution that regulations.

10.  Income from capital should not be taxed at all.

11.  Congestion fees are often better than building new roads.

12.  Trade barriers hurt the country that imposes them.

13.  If an orgy of debt-fueled borrowing leads to a bubble that bursts, the government should borrow dramatically larger amounts during the subsequent recession.

Put aside the question of whether you agree with these claims.  I agree with most but not all.  The fact remains that these are the sorts of claims that economists make.  And they are all about public policy. There are also interesting claims about issues unrelated to public policy, but in my view they are much fewer.  What do you think?

Tyler tried to make a claim unrelated to public policy, and fell short.  I wonder if it is because economics is so focused on public policy issues that we are not used to making those sorts of non-policy claims.

Marcus Nunes sent me a very interesting talk by Ben Bernanke, which discusses the 1907 banking crisis:

But even as the banks stabilized, concerns intensified about the financial health of a number of so-called trust companies–financial institutions that were less heavily regulated than national or state banks and which were not members of the Clearinghouse. As the runs on the trust companies worsened, the companies needed cash to meet the demand for withdrawals. In the absence of a central bank, New York’s leading financiers, led by J.P. Morgan, considered providing liquidity. However, Morgan and his colleagues decided that they did not have sufficient information to judge the solvency of the affected institutions, so they declined to lend. Overwhelmed by a run, the Knickerbocker Trust Company failed on October 22, undermining public confidence in the remaining trust companies.

To satisfy their depositors’ demands for cash, the trust companies began to sell or liquidate assets, including loans made to finance stock purchases. The selloff of shares and other assets, in what today we would call a fire sale, precipitated a sharp decline in the stock market and widespread disruptions in other financial markets. Increasingly concerned, Morgan and other financiers (including the future governor of the Federal Reserve Bank of New York, Benjamin Strong) led a coordinated response that included the provision of liquidity through the Clearinghouse and the imposition of temporary limits on depositor withdrawals, including withdrawals by correspondent banks in the interior of the country. These efforts eventually calmed the panic. By then, however, the U.S. financial system had been severely disrupted, and the economy contracted through the middle of 1908.

The recent crisis echoed many aspects of the 1907 panic.

Bernanke’s right that the crises were similar.  He also discusses the advances in policy that have occurred since 1907, such as FDIC, which prevented a run on deposits, and the Federal Reserve, which pumped in massive quantities of base money.  This might partly explain why RGDP only declined slightly over 4% from 2007:4 to 2009:2, as compared to 12% between 1907:2 and 1908:1 (using Gordon and Balke).  But the recovery from the 1907 crisis was also very swift (which that shows financial crises are not inevitably followed by slow recoveries.)  By 1909:4 RGDP was up by nearly 19% from its 1908 low point.

Why was the recovery from the 1907 crisis so swift?  The proximate cause is obvious, monetary policy was much more expansionary in 1908-09 than in 2009-13.  NGDP soared by nearly 28% between 1908:1 and 1909:4.  But why was that?

I believe the gold standard helps explain the rapid recovery in 1908-09.  The international gold standard was a very crude sort of “level targeting” regime.  It didn’t necessarily work when there were international shocks to the real value of gold, due to changes in the supply or demand for gold.  Price levels tended to move in a sort of random walk.  You could have fairly long periods of deflation, as in the 1870s and the 1890s and the early 1930s.  But when the international gold market was relatively stable, a sharp domestic shock that greatly depressed prices and output was likely to be quickly reversed, as prices and output recovered to their original trend line.  In contrast, the Fed made a decision in 2009 to avoid going back to the original trend line, and instead to start a new and lower trend line.  This explains the slow growth in NGDP, and also the slow recovery in RGDP.

I still think that fiat money is better than a gold standard, but it’s also clear that fiat money policymakers could learn something by studying the cyclical properties of the international gold standard.

[Marcus Nunes has a post with some graphs comparing the two episodes.]