Well that didn’t take long.  I have to admit that when I made this prediction eight days ago I didn’t really expect it to happen so fast:

The great irony of the Depression period is that by 1936 things had gotten so bad that even the French had to devalue.  The French had helped cause the Depression by their obsessive hoarding of gold, and their refusal to help out the weaker countries.  In other words, in monetary terms France was the Germany of the 1930s.  When you see doubts raised about countries like Finland and Austria, you really have to wonder if even the German debt is truly safe.

I still think the policy elite are slightly less pigheaded than in the 1930s, so I doubt things will go that far.  But it would be a lot simpler if they recognized reality right now, instead of dragging out the pain.

First a bit of background.  In the late 1920s and the early 1930s the Bank of France hoarded vast quantities of gold.  This raised the value of gold, which meant deflation (once the US and Britain stopped offsetting the French hoarding after October 1929.)  An international financial crisis ensued, with one country after another leaving the gold standard.  Britain in 1931, the US in 1933, etc.  At first France got off lightly, as their currency had been undervalued on the eve of the Depression.  But by 1936 the deflation in France was so bad that even they had to devalue.  In each case countries didn’t begin recovering until they had left the gold standard.

In the modern world things seem to move much faster than during the long agonizing 1931-36 collapse of the gold standard.  Today German bonds were hit hard:

The debt crisis that began more than two years ago now risks engulfing Germany. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments rose to an all- time high as Germany failed to find buyers for 35 percent of the bonds offered at an auction.

Germany is of course the France of the 21st century.

It’s now quite possible that the Fed may have to move toward NGDP targeting before they would have liked.  The Fed cannot allow another collapse of NGDP like we saw in 2009.  The cost in terms of banking distress, worsening public finances, international discord and mass unemployment is simply too great to contemplate.  I have no doubt that Ben Bernanke of all people understands this.

Perhaps the Europeans will come together and do something dramatic in the next few days.  But if not, the Fed must be prepared to hold an emergency meeting and do whatever it takes.  To quote David Beckworth:

Also, if a nominal GDP level target is explicit and widely understood it would actually serve to mitigate the effects of financial shocks.  If the public understood the Fed would always close return nominal GDP to its trend path, public expectations would be better anchored and thus be less susceptible to wide swings.  That means velocity (i.e. real money demand) would be more stable.  For these reasons, it is reasonable to conclude that had the Fed been targeting nominal GDP during the 2008-2009 financial crisis, the outcome would have been far milder.  And for the same reasons, the Fed should be targeting nominal GDP now given the looming financial threat coming from the Eurozone crisis.

It’s Bernanke’s moment of truth.

PS.  Also check out Beckworth’s post showing the non-German NGDP in the eurozone.  And people wonder why the eurozone is having a sovereign debt crisis.

HT:  Joe2

The ironies are piling up so fast, and becoming so surreal, that I’m almost at a loss for words.  Fortunately Paul Krugman isn’t, and makes some very good points. After quoting Mario Draghi on the importance of keeping inflation expectations well anchored, Krugman points out that they are failing:

Unbelievable. Right now, the ECB has too much credibility on the inflation front; the spread between German nominal and real interest rates, which is an implicit forecast of the inflation rate, is pointing to disastrously low medium-term inflation:

You’d think at a time like this if the ECB was going to err, they’d want to err on the side of a bit too much stimulus.  Instead they’ll miss their inflation target on the low side.

The events of the last few years have caused me to radically revise my views of the Great Depression.  Not in terms of the causal factors, those have been amply confirmed.  Falling NGDP does create domestic and international financial turmoil—no doubt about that.  But 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 as they are.

Sometimes I get commenters saying that the Germans are inflation-phobic because of their experience with hyperinflation.  I doubt that’s the reason; when countries make mistakes they tend to repeat them again and again.  I don’t see much fear of inflation in Argentina.  And the Swiss are just as inflation-phobic as Germans, but they never had a hyperinflation.  The lesson that should be taught to German children is that the deflation of 1929-32 caused much more harm than the hyperinflation.  Here’s Krugman:

Dylan Grice of SocGen points out that it was the deflationary policies of 1930-32, not the inflation of 1923, that brought you-know-who to power.

Indeed. When we hear assertions that Germans are deeply hostile to loose money because of their historical memories, I always wonder why those memories are so selective. Why is 1923 seared into collective memory, while the Brüning disaster has apparently gone down the memory hole?

This is important “” and there’s not much time to get the record straight.

That’s right; it was deflation, not hyperinflation, which brought the Nazis to power.  As late as mid-1929 (six years after the hyperinflation) the Nazis had only a trivial share of seats in the Reichstag.  By early 1933 they were in power.

Here’s Krugman’s policy analysis:

There are strong self-fulfilling aspects to this crisis of confidence “” which is why Europe desperately needs the ECB to act as lender of last resort, and short-circuit the vicious circles.

But no, the ECB will defend its credibility. And it will end up as the highly credible defender of the value of a currency that no longer exists.

I’m not sure if the lender of last resort is needed.  It’s possible that a dramatic shift toward monetary stimulus could rescue the euro.  But we’ll never know for sure, as the ECH will definitely not undertake my moderate proposal.  Instead it’s all or nothing.  They will either do nothing, or they’ll start buying up lots of bad debt.  But there’ll be no conventional stimulus.

This reminds me of the US during the Great Depression.  Richard Timberlake pointed out that one of the most damning facts of the interwar period is that when the US left the gold standard in April 1933 it had the largest gold reserves in the world.  Just think about what that means.  Those reserves are there for a reason, and it’s not to prevent the NY Fed building from blowing away in a hurricane.  They are held in case of an emergency.  Why weren’t they used in 1929-33 to massively boost the money supply?  Because they were there for emergencies.  Are you stupid!  I’m sure Fed officials were quite proud of the fact that they maintained those reserves all through the financial hurricane of 1931-33.

Similarly, as Trichet left office he proudly stated that under his leadership the ECB had driven inflation to even lower levels than achieved by the Bundesbank.  The irony of 1933 is that the refusal to do more aggressive monetary stimulus prior to 1933, led to the eventually collapse of the international gold standard, a much more radical move.  And the irony of the ECB circa 2011 is that they’d prefer the collapse of the euro system, or the monetization of potentially worthless debt, to a more moderate program of targeting modestly higher NGDP growth.

Again, I’m not saying my proposal would definitely work, but surely there’s no excuse for undershooting your inflation target at a time like this.  The ECB seems determined to hold on to its credibility just as tightly as the Fed held on to its gold reserves.  And by doing so it may end up losing everything.

PS.  My unusual policy views puts me in the odd position of agreeing with both Krugman and Tyler Cowen.  Too much debt or too much disinflation?  Maybe both guys are right.

PPS.  I’m very grateful for the nice compliment from Tyler, but in all honesty I think both he and Krugman are much better at euro-analysis.  I’m like the hedgehog who knows one big thing—falling NGDP is very dangerous during a debt crisis.  Yes, it’s a rather important thing, but the euro crisis is very complex, and when I read others I am constantly reminded how much of it is beyond my comprehension.  That’s why I’m sticking to the “more NGDP” mantra, it’s the only advice I feel confident about offering.

Herbert Hoover succeeded in reversing the Depression during early 1931.  During the first 4 months of 1931, industrial production in the US rose slightly, after plunging sharply throughout 1930.  Then bad luck hit.  The German-Austrian agreement of late March poisoned relations with France.  Then the Austrian bank Kreditanstalt failed in May.  Then German banks came under pressure, then the German currency.  Then the British currency.  The crisis kept moving from one country to another.  People sought gold as a safe haven, and the value (or purchasing power) of gold increased.  More deflation set in.  The severe recession of 1930 turned into the Great Contraction.

Here’s Obama yesterday:

At a town hall meeting on his campaign-style tour of the Midwest, President Obama claimed that his economic program “reversed the recession” until recovery was frustrated by events overseas.

Hoover wasn’t able to print gold, but can be blamed for supporting the Fed’s tight money policies.  Obama can’t print dollars, but can be blamed for not moving aggressively to put people at the Fed who understand the need for more dollars.

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.

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!