In what sense are central banks infallible?

It’s never the central bank’s fault.  Or at least that’s what I hope to show.

I will argue that there has never been an inflation or deflation that was “blamed” on central bank policy.  More specifically, this is my argument:

Undesirable inflations and deflations are never blamed on central banks by the consensus of expert opinion in the country affected, during the period when prices are actually changing.  Can you think of any counterexamples?

Think of this as a contest.  If I am right, then it is no surprise that very few economists agree with my view that the Fed caused the recent deflation.  After all, it’s never the Fed’s fault, or at least it’s never perceived to be the Fed’s fault at the time.  At a later date, however, economists may be able to take a more dispassionate look at what really happened.

Here’s how I started thinking about this topic.  I asked myself whether central banks were ever blamed for any inflation or deflation.  One place to start is with hyperinflation, something America has never really experienced.  Was the German central bank blamed for the 1920s hyperinflation?  I’m not an expert here, but aren’t hyperinflations usually blamed on fiscal authorities?  Isn’t it assumed that the central bank is in some sense forced to print a lot of money to pay the government’s bills?  I can’t imagine why a central bank would suddenly start printing such a vast quantity of paper money for no good reason.  Thus I will provisionally assume that not only the German hyperinflation, but also more recent hyperinflations in developing and former communist countries were actually a failure of fiscal policy, and that the central bank was not blamed.

What about the US?  We have had two types of high inflation, wartime inflation and the Great Inflation of 1966-81.  During the Civil War we had to go off gold and print money, so that was another fiscal inflation.  During WWI many other countries went off gold, so the value of gold fell in world markets, and again the Fed did not seem to be at fault.  The most promising case is 1966-81.  Here I really think you can make a case that it was the Fed’s fault.  But there is just one problem, it wasn’t perceived that way at the time.  First it was the “guns and butter” fiscal policy of President Johnson.  Then it was labor unions—a cost-push wage spiral; then it was crop failures in 1973, then OPEC in 1974 and again in 1979-80.  One excuse after another was made for the Fed.

Now that’s not to say a few farsighted observers didn’t see the real problem at the time.  Unless I am mistaken, people like Milton Friedman, Anna Schwartz, and Allan Meltzer did recognize that the Fed was to blame very early on.  But it was never the Fed’s fault according to the consensus opinion.  By the way, notice how all these far-sighted observers happen to have been members of a “discredited” school of thought that does not start with the letter “K.”  That group was also the first to notice that the Fed was to blame for some important deflationary episodes.

If you take a close look at my original assertion, you’ll notice all sorts of hidden qualifications.  One is that it has to be an undesirable inflation or deflation.  I believe that there are five important deflations or disinflations since the Fed was founded.  The 4 important deflations were 1920-21, 1929-33, 1937-38 and late 2008.  And there was also a very important disinflation in 1981-82, when the rate of inflation fell from double digits to about 4%.  The 1920-21 deflation was partly attributed to the Fed, but not really “blamed” on the Fed.  In other words, it was viewed as a necessary corrective to the high prices of WWI.  The 1981-82 disinflation was also partly attributed to the Fed, but once again was viewed as a painful if necessary adjustment to a lower trend rate of inflation.

I do believe that the 1929-33 and 1937-38 deflations were undesirable and are now mostly blamed on the Fed.  But at the time, most observers gave the Fed a pass.  First it was the effect of the stock bubble bursting.  Then we had the banking panics.  Then there was the international monetary crisis and the hoarding of gold.  But it was never the Fed’s fault.  In 1937 few observers paid any attention to the reserve requirement increases.  By 1938 interest rates were very low and it was assumed that any monetary expansion would be “pushing on a string.”  Again, not the Fed’s fault.  Of course that is also the view of the profession toward the late 2008 deflation.  It’s not the Fed’s fault, it was the greedy bankers that made bad loans.  Somehow that led to a banking panic which led to a brief but important deflation in late 2008.  Money?  Money is always important at some other time in history, never right now.  Or at least so it seems.

What about the great Japanese deflation?  Don’t most economists blame that on the BOJ?  I don’t know if that’s right, but I would agree that many prominent US macroeconomists blame it on the BOJ.  But if you return to my original assertion, you will notice some more weasel words.  It has to be blamed on the central bank by the consensus of opinion in the country in question.  Did expert opinion in Japan blame the BOJ for the deflation?  I don’t think so, at least not in any direct way involving “tight money.”  My sense is that many in Japan blamed it on the weak banking sector and falling real estate prices.  But if I am wrong, please correct me and I will admit that the theory in the post is wrong.  I am not “infallible.”

So it seems like central banks are never blamed for producing undesirable inflation or deflation by expert opinion in the country, at the time the problems occur.  Do I have a theory for this?  Yes, a very simple one.  Central banks almost invariably do what the consensus opinion suggests is a sound and reasonable policy.  Obviously one wouldn’t expect most economists to blame themselves!

So it’s never “our” fault, it’s always some special factor.  But here’s the problem, if it is never the central bank’s fault, then virtually all of modern macroeconomics disappears.  New Keynesian models, monetarist models, even Austrian models are all predicated on the notion that nominal shocks created by poor monetary policy generate business cycles.  But if it’s never the central bank’s fault, then aren’t we in an endogenous money world?  Isn’t this getting close to what the post-Keynesians argue?

Those who read this blog know that I am about as far from post-Keynesianism as it is possible to be.  I do blame the Fed for all the recessions and inflations for which others blame the Fed, plus the 2008 fiasco.  But what does the history I just recited tell us?  It says that monetary mistakes never, ever, look like monetary policy mistakes at the time. The Fed is always doing what sober sensible opinion says they should be doing.  And if it doesn’t work out, that sober sensible opinion will point anywhere but at themselves; they’ll point at guns and butter spending, labor unions, market bubbles, OPEC, crop failures, banking crises, stock market crashes, or international forces.  There is no end to the list of excuses.

Yes, with the benefit of hindsight the conventional wisdom does come around to blame the Fed or BOJ for undesirable inflations or deflations.  Those who didn’t live through the period with all the “non-monetary shocks” constantly in the headlines, can take a calm look at the falling price level on a graph, and ask themselves “why did the Fed let that happen?”  Then it becomes the Fed’s fault.   In some cases they develop indicators (i.e. M2 for the Great Contraction) that were not even used when the problem actually occurred.  Or they develop a better understanding of the distinction between real and nominal rates (for 1966-81.)  But at the time it always looks like something else is the cause.  And most often that “something else” is actually a symptom of the inept monetary policies.



54 Responses to “In what sense are central banks infallible?”

  1. Gravatar of Niklas Blanchard Niklas Blanchard
    27. May 2009 at 13:40

    Do the Austrians count? ;]

  2. Gravatar of Bill Stepp Bill Stepp
    27. May 2009 at 15:43


    You haven’t been reading the Austrians have you?
    You also need to crack open George Selgin’s book The Theory of Free Banking, particularly chap. 7, “The Dilemma of Central Banking.”

    A point Selgin makes, and one which can’t be stressed to often, is that central banks are essentially monetary central planners trying to peg interest rates, or the price level, or whatever aggregate they have in mind.
    On the impossibility of the planners getting interest rates rights, see Selgin, pp. 104-5; on prices, see pp. 101-3.

    Free banking is vastly superior to central monetary planning for achieving monetary equilibrium. So why don’t we ditch the central monetary planning Soviets and go with freedom? We do it a few other markets (e.g., shoes) with good results.

    It’s but a short step from monetary central planners to real Soviets–you know the guys who were trying to determine the correct number of shoes to put in shoe stores in Moscow for most of the last century. They never got it right of course, but that’s the reality of central planning.

    Meanwhile, here in the USS, I mean the USA, we continue to have learned discussions about our monetary central planners’ targeting the monetary base, targeting interest rates, “sopping up” excess reserves (or whatever it is the USA Soviets are planning to sop up).

  3. Gravatar of TGGP TGGP
    27. May 2009 at 16:13

    Central banks almost invariably do what the consensus opinion suggests is a sound and reasonable policy.
    At the same time, independence seems to improve their performance. So do they just act according to educated opinion rather than that of voters more broadly?

  4. Gravatar of Bill Stepp Bill Stepp
    27. May 2009 at 16:31

    Yes, seignorage is a small part of government revenue (as Scott pointed out in an email to me), but–and this is the point I should have made–the Fed (whether independent or not) is a political institution, created by an act of Congress, and it is still under political pressure to follow the mandate established in the Full Employment Act of 1946 (Humphrey-Hawkins?). More importantly, it has an inflationary bias and always will because governments tend to be debtors, particularly when they try to solve the very crises that they create in the first place (recessions and wars are Exhibits A and B).

    Comrade Bernanke recently testified before Congress saying that the right inflation rate was 2%. At that rate, a dollar loses half its purchasing power in 36 years, and three-quarters of it in less than a lifetime.

    He should do the honorable thing and resign. He could get a job as a pitchman for Uncle Ben’s Rice, or maybe at a medivac helicopter company.

    The idea of central bank independence is more or less bogus. I especially got (get) a kick every time I saw (see) discussions of Fed independence with Bernanke was (is) pictured huddling with Paulson/Geithner and assorted state planners/Soviets.

  5. Gravatar of ssumner ssumner
    27. May 2009 at 16:41

    TGGP and Bill, I think the Fed is fairly independent, but that’s not the focus of this post. The problem isn’t that the Fed does what Congress wants them to do, the problem is that they do what they think is in the best interest of the country, and what most outside experts also think is in the best interest of the country. That’s the problem, if there is one. I am arguing the experts are wrong.

  6. Gravatar of Nick Rowe Nick Rowe
    27. May 2009 at 16:48

    Scott: This reminds me of your post about people who complain that journalists are too “liberal”.

    There’s an old British term, “the establishment”, that means roughly orthodox opinion and interest of those who have the power and influence to create and enforce that opinion and interest.

    Central banks reflect the establishment in monetary policy circles just as journalists reflect the establishment in their circles.

    To find a counterexample, we would need a central bank which was independent enough to ignore the establishment, and which somehow got staffed by people who were not part of the establishment. Hard to think of how it could happen.

    Unless of course a central bank got privatised.

    Which brings me to Bill Stepp’s point:

    If I run a coat factory, I have to decide how many coats to produce, or what price to charge for my coats, or what rental rate to charge on my coats, or something. I can’t just leave these things to the market; I am one of the players in the market, and I have to, logically, decide how to play.

    If I run a bank, printing my own money, I also have to decide how much money I print, or what price to set, or what interest rate to lend it at, or something. I can’t just leave it to the market. I am one of the players in the market, so I have to decide how to play.

    That point is true regardless if I am a government-owned central bank, or a private bank in a free-banking world.

    Suppose the government were producing coats and making a profit. And suppose there were no laws against anyone else producing coats, providing they did not infringe on the government’s brand name for its own coats (by producing counterfeits, for example). And suppose that despite the absence of laws preventing competition, there were no private producers of coats. What would a call for “free coat production” or “competitive coat production” actually mean”?

    There’s just one difference between coats and money. A coat functions to keep you warm; a promise to pay one coat does not keep you warm. A dollar functions as a medium of exchange; a promise to pay one dollar can also function as a medium of exchange, sometimes.

    So if I set up a private bank, producing my own money, but my money is a promise to pay dollars, then I am infringing on the government’s brand name, “dollar”. Just as if I record a cassette off a CD, I am infringing on the rights of the producer of the CD, even though my cassette is not a counterfeit (I label it clearly as produced by me).

    Punchline: is there any law in the US (I can’t find any in Canada), that really restricts competition in money, provided it does not infringe in any way on the government’s brand name, “The dollar”? I read plenty of stories about people setting up their own monies (they often say they are barter systems, but usually they are genuine media of exchange), where they call them different names, not using the name “dollar”. Usually lefty hippy types.

    In other words, free banking already exists in the US. It just has failed the test of the market (except in very small niches, like babysitting rings).

  7. Gravatar of Nick Rowe Nick Rowe
    27. May 2009 at 17:08

    Scott: back to your main point, towards the end.

    I remember once talking to an econometrician at the Bank of Canada. He had a model where he claimed to have identified “monetary policy shocks”, and was estimating the effects of monetary policy shocks on inflation. This was during the time when the Bank of Canada was targeting inflation. I told him that if he believed his model, he would believe it was grounds for dismissal of the Governor of the Bank of Canada, his boss.

    The Bank of Canada publishes many working papers identifying monetary policy shocks econometrically, never seeming to appreciate the irony. Their own publications suggest they play dice with monetary policy.

    A formal proof of this point is simple. A central banker uses an instrument M, watching indicators I, to keep a target variable P equal to a target P*.

    Given rational expectations, this means the central bank sets M such that E{P/{M,I}=P*.

    By rational expectations, the deviations from target (P-P*) are forecast errors and are therefore uncorrelated with all elements in the information set, namely M and I. So there are no monetary policy shocks affecting the target variable, conditional on information available at the time.

  8. Gravatar of Nick Rowe Nick Rowe
    27. May 2009 at 17:11

    By the way. I am not picking on the Bank of Canada, or any one econometrician. The same story could almost certainly be told of any central bank with economists on staff.

  9. Gravatar of ssumner ssumner
    27. May 2009 at 17:34

    Nick, That’s a good point about free banking. I suppose this would be the counterargument (although I basically agree with you):

    A free banking types might point to some sort of network externalities. After all people often continue to use domestic currency even when the performance of the central bank is pretty bad. So there is a built in competitive advantage. Free banking types sometimes favor gold standards, but I believe George Selgin has argued that free banking could be grafted onto a fiat regime. Banks might be allowed to issue currency while the central bank merely has some sore or interbank reserves. It’s not an area I look at much, but your argument seems pretty hard to refute.

    Maybe an Austrian economist will come in and respond.

    Regarding the point about the establishment: I don’t want the Fed to pay more attention to me than to the establishment. That would be ignoring the “wisdom of the crowds.” Rather I hope to change the establishment view. I actually don’t think any institutional change is needed at the Fed, rather we need need new approaches to macroeconomics in the academy. We need forward-looking models. (Maybe that was obvious, but I thought I’d mention it in case people thought I was arguing they shouldn’t follow conventional wisdom.)

    The comment about the BOC is pretty funny, and as you say could be applied to any central bank. What bothers me about recent Fed policy is they are setting the monetary instrument at a level expected to equate the policy goal and internal Fed forecast: P =/= P* You are right that if they were doing their job then policy errors would be unforecastable. If only . . .

    On another topic, I recently read that government spending in Canada is about to fall below US levels (as a share of GDP) for the first time in ages. Is that true? And if so did it receive much coverage in Canada? Most Americans know very little about Canada. Indeed when talking politics with my left liberal friends, I like to tell them that we right wing liberals know much more about left wing liberals, than vice versa, for the same reason that Canadians know more about Americans than vice versa.

  10. Gravatar of Nick Rowe Nick Rowe
    27. May 2009 at 18:24

    Thanks Scott.

    I agree with you about network externalities in money. Very important. I think Kevin Dowd had a good paper on that a few years ago, IIRC. (Why isn’t he commenting on this board, by the way? You reading this Kevin? Come on in; the water’s lovely!) But one does not normally stress the importance of network externalities when making the case for competition; the normal policy response to network externalities creating a natural monopoly is either nationalisation or regulated private de facto monopoly.

    I just checked the Bank of Canada’s internal forecast. They are now forecasting the return of CPI to its 2% target in roughly 2 years. Their normal targeting horizon is 18 months to 2 years. They have made a “conditional commitment” to keep the overnight rate low for an extended period, as part of unconventional monetary policy, and say they are ready to do quantitative easing and credit easing if needed (my guess at the moment is that they won’t).

    What is ironic is that they don’t have any way to explain how QE could work within their “establishment” official view of how monetary policy works (it works via interest rates). I did a blog post on this, if anyone’s interested:

    I have read US blog posts on how Canada’s share of government is now getting smaller than the US. It doesn’t seem to have made any news here, that I have noticed. I’m not sure how comparable the data are. It may depend on whether you include state/provincial spending, and if you include the recent US asset purchases. Here’s Stephen Gordon’s post showing the size of Candian Federal government spending and revenues over the last few years: Federal program spending was around 13% of GDP, before the current crisis. We are probably looking at around 14% according to the recent budget, and a deficit of around 3.3% of GDP.

  11. Gravatar of Bob Murphy Bob Murphy
    27. May 2009 at 18:51


    As usual, I can’t decide if you are a genius or a fool. (Do you happen to know? If so, end my suspense and tell me.)

    Your argument is valid (and interesting) that whenever the Fed really screws up, it must not have realized it was doing so at the time. (Else, it wouldn’t have done so.)

    But I think you are begging the larger question without realizing you are doing it. Did most economists really think the Fed was truly incapable of preventing the mild deflation in late 2008? Like, if the Fed bought up every house in America and then got to work on the S&P 500, you’re saying most economists would predict, “Nope, liquidity trap baby, CPI won’t budge”?

    I don’t think they would say that, even if their op eds and CNBC prognostications at the time suggested otherwise. I think they all had in mind the constraint, “Assuming the Fed stays within the bounds of sanity.”

    So when I (for example) say, “Bernanke didn’t cause the deflation in late 2008, it was the popping of the credit bubble originally set in motion by the Maestro, exacerbated by Paulson telling everyone the world was ending,” I am not denying that Bernanke could have stopped it, had he really wanted to.

    Instead, I mean that he shouldn’t have stopped it.

    So the difference between you and me on the deflation of 2008 isn’t the role played by Bernanke, it’s more fundamentally that you call it a disaster and I call it the road to recovery.

    So yes I blame Bernanke, because that dolt raised the monetary base 57% (or whatever) and prevented the necessary price readjustments. And that’s why we’re still mired in this recession after 17 official months.

  12. Gravatar of knapp knapp
    27. May 2009 at 20:46

    In the US, the Fed employs many of the people trained to critique them creating a system in which they essentially get to grade their own report card.

    see Larry White’s The Federal Reserve’s Influence on Monetary Economics

    here’s a snippet:

    research by American monetary economists it is also a major sponsor of
    their research. The Fed (the Board of Governors plus the twelve regional
    Reserve Banks) employed about 495 full-time staff economists in 2002.
    That year it engaged more than 120 leading academic economists as
    consultants and visiting scholars, and conducted some 30 conferences that
    brought 300-plus academics to the podium alongside its own staff
    economists. It published more than 230 articles in its own research
    periodicals. Judging by the abstracts compiled by the December 2002 issue
    of the e-JEL, some 74 percent of the articles on monetary policy published
    by US-based economists in US-edited journals appear in Fed-published
    journals or are co-authored by Fed staff economists.

  13. Gravatar of Pedro Bento Pedro Bento
    27. May 2009 at 21:43

    Nick: I don’t know about actual legislation, but yes, the government definitely does crack down on currency producers. The holding of gold coins was illegal for a long time, and for a recent example, see

    U.S. citizens (and Canadians before them) have come to accept the old Soviet rule-of-thumb, “what isn’t specifically authorized, is prohibited.” You can call this a market test, or you can call it the result of 50 years of public schooling.

  14. Gravatar of Bill Woolsey Bill Woolsey
    28. May 2009 at 01:57


    I think you would do well to follow journalistic practice and say what you have in mind at the beginning. Like a thesis sentance? The Fed screws up but why don’t economists ever recognize it until well after the fact? It is because the Fed follows a policy that mainstream ecnomists favor, so the mistakes of the Fed are also the mistakes of mainstream economists.


    Next to no economists support Rothbardian pro-deflationism.

    So, while you may have thought that the Fed could expand base money enough to avoid the drop in nominal income in the last two quarters, but that it shouldn’t expand it at all and that price and nominal income deflation should be allowed to run its course and bring about recovery, that is hardly what most economists thought.

    I think that the “experts” on the nitty gritty of monetary policy were, like the Fed, focused on getting back to business as usual (targetting federal funds through open market operations in T-bills) and that requires getting the shadow banking system going again. This should raise the equilibrium interest rate for T-bills and Federal Funds, and so allow their wonderful policies that had led to the great moderation to continue. Oh, and fiscal policy should work too. It involves selling a bunch of T-bills their equilibrium yields.

    The market-clearing macroeconomists don’t care about nominal income. The recession is necessarily about resource reallocation and/or some kind of supply side impact reduced real intermediation. If anything should be done, fixing credit markets is it. Nominal income isn’t an issue.

    The more traditional monetarists looked at M2 (or base money, or some M or other) and saw that the expanded. The Fed has done all it needs to do (or too much.) Nothing will happen right away. We must wait for the long and variable lags to work themsleves out.

  15. Gravatar of RebelEconomist RebelEconomist
    28. May 2009 at 02:16

    “it is no surprise that very few economists agree with my view that the Fed caused the recent deflation”

    What recent deflation?

    “What about the great Japanese deflation?”

    Never happened; deflation in Japan was negligible.

    Unless of course, you are including asset prices in your inflation measure (which I would), and then both examples of “deflation” would have been preceded by inflation.

  16. Gravatar of ssumner ssumner
    28. May 2009 at 04:10

    Nick, I think the private money types might agree that there is a sort of “nationalization” required, but they would say it is minimally invasive. The state defines the dollar as some some specified weight in gold, and then gets out of the way. That definition solves the network externality, and then commercial banks can produce gold-backed notes. This is not my preferred system, but it is one way to go. I did a paper called “Privatizing the Mint” (JMCB, 1995), which had the government retained a much larger role, merely auctioning off the rights to produce specified denominations to various private mints. The Fed would still control monetary policy with a fiat money regime.

    I saw the post on Canadian spending, and it is clearly total spending that people are referring to in the comparison. Our federal government is much bigger–spending something like 22% of GDP. Our state governments are smaller. I thought the total spending numbers were quite interesting, as in America there is a perception that Canada has a bigger government than the US, I guess that is not true. I believe Australia’s is also smaller. Even given a 2-3% differential in military spending (as a share of GDP) I still find it interesting, especially given the national health care system in Canada.

    I don’t know what happened to Kevin Dowd. I emailed him a few months ago but never heard back.

    Bob asks: “As usual, I can’t decide if you are a genius or a fool.”

    Answer: I’m definitely not a genius, and am not qualified to judge whether I am a fool. Only time will tell.

    The premise of your argument is wrong. You seem to assume that most economists did not favor a more expansionary stimulus during 2008. But that is clearly wrong. The vast majority of mainstream macroeconomists favored aggressive fiscal stimulus. So they clearly thought there was a problem, they just didn’t think the Fed could fix it. “Period. End of story.” as Krugman likes to say. The thought experiment about the Fed buying up real estate is besides the point. There is around $8-9 trillion in government debt out there, and cash in circulation is around 1/10 that level. There is zero doubt in my mind that the Fed had plenty of “ammunition” without resorting to unconventional measures, as long as they took steps to prevent hoarding of excess reserves.

    I would also say that most macroeconomists are completely INCOHERENT in the way they think about monetary policy. They will say that Fed errors “caused” the Great Contraction, and than a minute later say my argument that the Fed caused the recent crisis is absurd because rates were cut to low levels and the base was increased sharply. And yet the same thing happened in the Great Contraction. So no, I am not going to let the mainstream off the hook so easily.

    Thanks Knapp, Even if they didn’t do that, my hunch is that they’d follow conventional wisdom, but the fact that they do hire so many economists makes it almost inevitable that they will follow conventional wisdom. I wonder where I’d be now if I had accepted the NY Fed job offer in 1988?

  17. Gravatar of ssumner ssumner
    28. May 2009 at 04:36

    Pedro, Thanks for the article. But note that that doesn’t contradict Nick. It refers to private production of “dollars” which violates the Treasury’s copyright. It doesn’t say that private companies are not allowed to produce non-dollar money.

    Bill, That may be a good idea. But one could argue that I also have another “thesis,” which is that monetary failures never look like monetary failures at the time. So suppose the Fed does what the consensus wants in 1966-81. That’s a long time. The consensus is quite free to say “oops, we were wrong, our suggestion caused a lot of inflation.” But they don’t (in the 1970s), as for some reason it never seems like money is the cause of our problems RIGHT NOW, it is always at some other time in history. This is similar to the way 99% of people misuse the term “in the long run” falsely equating it with “in the future” which is not at all what it means.

    My bottom line is that we eventually came to see money as the cause of the Great Depression not because we got smarter than they were in 1930 (actually they understood monetary economics better than we do in many ways) but rather because we can look on it from a distance. If you took the 1929-33 data and sent it back in a time machine to Hume, he could have easily explained what went wrong. It’s all in his writings. But had Hume been alive in 1929-33, I think he would have missed the story–he would have been too close to it. Milton Friedman was alive during the Depression, unless I am mistaken he totally missed what went wrong at the time. Later, he saw the problem clearly.

    Rebeleconomist, Isn’t the CPI today lower than 12 months ago, for the first time since 1955?

    Japan has averaged 1% deflation for about 15 years, at least in the GDP deflator. I am not sure about the Jpanese CPI. But their GDP deflator is roughly 15% below the 1994 levels as I recall. I’d call that deflation.

    If you want to call the current period disinflation as in 1981-82, that’s fine with me. Disinflation has identical effects on output to deflation. BTW, may commenters insisted that I was grossly underestimating the true rate of inflation in 2005-06 because housing wasn’t accounted for. I did agree there was some bias, but less than most of my commenters thought. But those commenters who did make that argument should now be arguing that the actual deflation is far worse that the estimated deflation, as housing prices are falling fast. Again I think there is a bit if truth to that, but not as much as most think. I felt inflation was understated in 2005-06, but probably by only 1-2%. Today, the actual rate of deflation over the past year is probably more like 2%, rather than the 0.4% reported.

  18. Gravatar of Rafael Rafael
    28. May 2009 at 06:07


    Post-Keynesians argue too that the experts are wrong. What if they are right? Tyler Cowen pointed out recently that “Section iii (of Keynes GT) pokes a hole in the Fisher Effect. Keynes points out that if expectations of inflation induce a higher nominal interest rate, why don’t those same expectations cause prices to go up now? This adjustment, by the way, would eliminate the nominal premium on the rate of interest. This simple yet powerful point doesn’t get the attention it ought to.”

    But ALL New-Keynesian models rely heavily on the Fisher equation. Isn´t it a problem?

    On the sources of the Great Inflation, Alan Blinder on a recent NBER Conference ( revisited the cost-push view.


  19. Gravatar of RebelEconomist RebelEconomist
    28. May 2009 at 06:17


    Have you no sense of shame? You use US cpi to make your point for the US (where the on-a-year-ago change in the GDP deflator is positive) and the GDP deflator for Japan in consecutive sentences. For what it is worth, I prefer the cpi, because the GDP deflator concerns the price of domestic production. The fall in the US cpi over the last year is quite small and sufficiently small to be within the range of methodological ambiguity (ie the pre-Boskin cpi, which I would assume you would prefer judging by your previous comment about cost of living indices, would have probably showed a positive change). Anyway, the recent oya fall in the US cpi is due to the unwinding of the oil inflation that you dismissed in the context of last year’s blip in Michigan inflation expectations. The average rate of cpi deflation during the deflationary period in Japan was just 0.5% – hardly “great”.

  20. Gravatar of Bob Murphy Bob Murphy
    28. May 2009 at 07:44


    Again, you are totally right that most mainstream economists have internally contradictory views. No argument from me on that score.

    But still, when the typical economist in 4q 2008 said, “I think Bernanke is pushing hard enough, we should let fiscal stimulus do the job,” that is not equivalent to what you need for your argument in this blog post to work.

    You interpret that statement to mean, “Bernanke couldn’t cause inflation no matter what he did.”

    I don’t think that’s what they believed. I think they believed, “Holy cow, Bernanke has already pumped in x% more base, and we still have falling prices. Sure he could quadruple the base and that would do it, but it’s best if we try a different instrument, since monetary expansion obviously isn’t giving much bang for the buck.”

    So to repeat, I think everyone (except some true outliers) would agree with you that Bernanke had it in his power to prevent CPI from falling in late 2008, but they thought the cure would be worse than the disease.

    You’re right, their arguments for why the cure would be worse, are inconsistent with their stated views about the Great Depression etc.

    But still, in parts of your original blog post, you were trying to show that if Bernanke had the power to prevent it, you were right and they were wrong. And I’m saying no, that fact alone doesn’t render you the winner, because no serious economist would deny that Bernanke could have increased CPI if he’d, say, pumped up the base by $80 quadrillion.

  21. Gravatar of Nick Rowe Nick Rowe
    28. May 2009 at 08:06

    Pedro: Thanks for posting the link to that article. It seems the US laws are more intrusive than I thought they were. It doesn’t absolutely contradict my point, because they did use the word “Dollar”. But I get the sense from that article the government would have gone after them anyway, even if they hadn’t. But it’s funny that governments don’t (usually) try to make use of foreign currencies illegal. Cuba did, in some times, but even then it wasn’t very successful, despite the considerable power of the Cuban state.

    Bill Woolsey had a very cogent critique of my arguments above, but he posted his comment on the wrong thread, and now I will have to look for it. 😉

  22. Gravatar of Alex Golubev Alex Golubev
    28. May 2009 at 09:38

    Scott, IF ONLY the Fed was the only entity doing this. I would blame the Fed as much as I would blame every politician in hindsight. Majority was on board for the Iraq invasion with the WMD argument. Then the blame game started when that claim turned out to be not so solid. Most thought Bill Clinton was ok DURING his term, but a disgrace cause he hooked up with some intern and lied about it in court. WaMu pegged their pricing to be just outside of the most agressive offers (Countrywide, New Century, etc) because that was the market rate, even if internal analysis showed somethign else. CYA baby. You just need an excuse. All politicans (the Fed definitely included) and corporate executives play the CYA game while maximizing their power and $. If the outcome turns out to be favorable, one gets credit/power/$. If it’s not favorable, then the Plan B (CYA) is always ready. It’s NOT a conspiracy theory, because there’s no grand plan or secret society – simply incentives and game theory… oh yeah, and “ethics”. (but who needs ethics, when the board of directors are the ones that create your incentives/excuses).

    Now given the rules of the game as outline above, we can try to predict what EQUILIBRIUM will likely result. If THAT is the game that is played by even a small portion (if you say so) of politicans, executives, fund managers, etc… DECISION MAKERS, then they will be the most agressive bidders and fund raisers, because by definition they will be better than market due to superior CYA planning. They will be in the driver’s seat. this won’t necessarily result in bubbles, but it WILL result in inferior RISK-ADJUSTED returns. if they win the bet, you won’t know that they overpromised or underpaid. If they lose the bet, they have a great explanation of why the decision was justified. They get paid in call options, you hold the bag. You say minor crisis, i say UNFAIR continous allocation of resources, but it’s the best system we got. 😉 blame away, i got CYA (goggle trends “unprecedented”. how the f*k was this crisis unprecedented?! oh yeah, cause “everyone” was looking at the last 10-20 years for precedents AT BEST)

  23. Gravatar of adam adam
    28. May 2009 at 11:30


    The answer to your blogpost is: Groupthink.

    The economists who run the Fed and the “outside experts” who pontificate from the media and the universities are all part of the same groupthink machine that continues to believe in the same textbook macro nonsense that has been proven utterly false in every way imaginable since Fischer wanted to scientifically manage prices.

    Central Banks are not infallible; central banks are responsible for every disaster you mention and many many more. But fortunately for them, anyone in a university, newspaper column or TV interview has drank the very same macro nonsense kool-aid that led the Fed to cause this disaster in the first place. So all of those people will indeed agree that the Fed is doing the right thing. But all these people, and the Fed, are very wrong.

  24. Gravatar of adam adam
    28. May 2009 at 11:36

    In support of the Groupthink explanation, you might want to check out Larry White’s excellent paper on the influence of the Fed on monetary economics research.

    With such a mechanism in place, you not only have groupthink, you have the necessary apparatus to propagate groupthink to the point where even people who view themselves as “outsiders” from the mainstream are well within its fold.

  25. Gravatar of Rafael Rafael
    28. May 2009 at 15:03

    PS: Not to mention all the empirical studies rejecting the fisher effect.

  26. Gravatar of ssumner ssumner
    28. May 2009 at 15:51

    Rafael, I’m afraid Keynes argument doesn’t merit much attention, as he really didn’t understand the Fisher effect very well. Keynes did not think in terms of varying trend rates of inflation, therefore lacked the intellectual tools to understand the Fisher effect. Fisher understood the concept, but his application to the real world was flawed. It doesn’t really work under a gold standard, and Fisher mistook actual inflation for expected inflation.
    I haven’t studied post-Keynesianism, but my sense is that it has the same problem as Keynes had, an inability to model changes in the trend rate of inflation, or NGDP growth. If I am wrong, perhaps someone can explain to me what that model is. After my vacation I should do a post-Keynesian post, similar to my earlier Austrian one.

    I have little interest in revisiting the cost-push theories of inflation. I lived through that era, I studied it at school, and I just don’t see any merit in those theories. They were discredited by the early 1980s, and for very good reasons.

    Rebeleconomist, I actually used the GDP deflator because I didn’t know the CPI for Japan. And yes, I have no shame.

    I think the GDP deflator is the more theoretically appropriate index, as it merely includes domestic goods. But to be quite honest, I think the NGDP growth rate is far more meaningful than either price index. I simply don’t trust price indices. For me, tight money is falling NGDP, and easy money is rapidly rising NGDP. NGDP rises at 5% on average–in the last 6 months it’s been falling at close to 5% rate. That’s very tight money in my view, and the major cause of the current crisis. If people would rather call that disinflation rather than deflation, that’s fine–it doesn’t change my underlying argument one bit. There was no deflation in 1982, yet that disinflation was almost universally viewed as resulting from tight money.

    Bob, “More bang for the buck?” Let’s see, fiscal expansion will cost trillions in higher taxes that greatly reduce the efficiency of the economy. Monetary stimulus has an expected cost of . . . zero dollars and zero cents. How can fiscal policy have more bang for the buck?

    You said:

    You’re right, their arguments for why the cure would be worse, are inconsistent with their stated views about the Great Depression etc.

    That was my argument, period. The claim you make that they would have thought a much more expansionary policy might have worked is not relevant to my argument. The point is that all things considered they didn’t blame the Fed. I say they will eventually blame the Fed.

    The 80 quadrillion number is meaningless. I am claiming the Fed could have stopped the deflation with a much smaller increase in the base than what actually occurred. Indeed a more expansionary policy would have meant the base went up by 100 or 200 billion, not 900 billion. The large increase was precisely because of the Fed’s deflationary policy of paying banks to hoard reserves. Hume understood this in 1752, as I pointed out in my second post.

    Nick, I think you are wrong about being wrong. Which I guess makes you right, or doubly wrong, or something. In any case I don’t think a gold coin that says “50 grams” on it is illegal. But perhaps someone can correct me. I think “dollars” was the problem.

    Alex, I may be incredibly naive, but I think a lot of these people have idealistic motives. I feel that I do, and I see no reason why those why don’t agree with me don’t also. But again, maybe I’m naive.

    Adam, You say they rely on discredited textbooks, but if you go back to my “League of Monetary Cranks” post you will see that the number one money textbook implies it is the Fed’s fault. That’s what so weird. They have thrown away the textbooks and come up with these slapdash fiscal remedies that as far as I know had been almost discarded from graduate economics textbooks. The textbooks provide a straightforward answer. Don’t pay interest on reserves, and do enough OMOs until the TIPS spread is at least 2%. How complicated is that? And yet nobody, or almost nobody goes for the obvious remedy.

    Thanks, I’ll take a look at the White paper.

    Rafael#2, The Fisher effect is a necessary part of modeling any fiat money regime. You simply cannot explain nominal interest rates in very high inflation countries without it. The only thing that was discredited is the idea that the real interest rate is constant.

    OK, I’m going on vacation, so you guys can have the last word. I won’t be able to respond for a week to 10 days.

  27. Gravatar of Rafael Rafael
    28. May 2009 at 16:19

    Thanks for the answers Scott. Enjoy your vacation.

  28. Gravatar of Alex Golubev Alex Golubev
    29. May 2009 at 06:48

    you’re an optimist and i grew up in the USSR with a culture rich with pessimism and drama 🙂 anyways, you MIGHT find this interesting and you most probably read this a long time ago:
    Understanding Inflation-Indexed Bond Markets
    John Y. Campbell, Robert J. Shiller, Luis M. Viceira
    “This paper explores the history of inflation-indexed bond markets in the US and the UK. It documents a massive decline in long-term real interest rates from the 1990’s until 2008, followed by a sudden spike in these rates during the financial crisis of 2008. Breakeven inflation rates, calculated from inflation- indexed and nominal government bond yields, stabilized until the fall of 2008, when they showed dramatic declines. The paper asks to what extent short-term real interest rates, bond risks, and liquidity explain the trends before 2008 and the unusual developments in the fall of 2008. Low inflation-indexed yields and high short-term volatility of inflation-indexed bond returns do not invalidate the basic case for these bonds, that they provide a safe asset for long-term investors. Governments should expect inflation-indexed bonds to be a relatively cheap form of debt financing going forward, even though they have offered high returns over the past decade.”

  29. Gravatar of azmyth azmyth
    29. May 2009 at 09:48

    Scott: “I felt inflation was understated in 2005-06, but probably by only 1-2%. Today, the actual rate of deflation over the past year is probably more like 2%, rather than the 0.4% reported.”

    Shelter makes up 33.2% of the CPI. (BLS, “Relative Importance of Components in the CPI”, December 2008, page 2) The BLS uses rental equivalence for owner occupied housing rather than housing prices to calculate their shelter index. (, page 24). Homeownership in America hovers around 67%.
    Rental prices increased by around 3% year over year from 2004 to 2006 (CPIHOSSL, Consumer Price Index for All Urban Consumers: Housing), which is in line with the rest of the CPI. Home prices increased by around 16% per year (Case-Shiller Home Price Indices) from January 2003 to July 2006.
    Percent of CPI that could be attributed to housing prices: (2/3)*(1/3) = 2/9.
    (2/9) * 16% + (7/9)* 3% = 5.9%.
    I would estimate that the CPI was understated by around 3% due to the use of rental equivalence rather than home prices. Since interest rates were low from 2004-2006, mortgage payments did not keep pace with home values, so my method overstates housing CPI by a bit.
    The downside is also understated by the imputed rent method by a bit, and I agree with Professor Sumner’s estimate of 2% deflation. Going from 3% inflation to .4% deflation is a small shift. Going from 6% inflation to 2% deflation is not.

    I realize that this is a rough estimate, but I hope that this will serve as a starting point for further discussion.

  30. Gravatar of 123 123
    29. May 2009 at 09:59

    it is even worse than you write. Instead of blaming Fed for insufficient monetary stimulus, many are blaming Fed for blowing housing bubble. They are also criticizing mop-up strategy that Greenspan advocated (I think that mop-up strategy would have more stable expected NGDP path compared to what would happen under preemptively fighting bubbles approach.

  31. Gravatar of adam adam
    29. May 2009 at 10:44


    I am afraid what you refer to as the textbook model is also part of the groupthink on macro I was talking about. From where you stand, this is courageously out of the mainstream.
    From where I stand, all of this is standard mainstream garbage.

    Here’s an interesting proposition which you might like to chew over during your vacation:

    Human knowledge and science has gone for centuries believing things that were later known to be completely false and absurd: bloodletting, flat-earthery, earth-centrism, phlogiston, and many others. Would it not be possible for all of the macro and monetary economics of the 20th century to be equally absurd?

    Here, I am not trying to say that a lot of the models are useless. I am not saying that the policy-implications derived are not useful. I’m not trying to suggest that macro needs to be reformed. I am suggesting that the whole premise of this whole edifice is utterly and completely invalid–as invalid as astrology.

    What makes you think that any of it must be true? You must think of macro from outside macro to contemplate this possibility properly. I thoroughly recommend you start with Hayek’s Nobel Prize acceptance speech and then start working your way through some more of his work, before moving on to other Austrians.

    My position is that all non-Austrian economics is utterly meaningless garbage. But that’s just me!

  32. Gravatar of DG DG
    2. June 2009 at 23:28

    Nick: “free banking already exists in the US. It just has failed the test of the market.” I find this a very puzzling statement.

    The reason free banking doesn’t exist in the US or anywhere else that I’m aware of – as a matter of 100% categorical fact – is that a system of free banking is logically incompatible with the notion of legal tender. You can only have one or the other and we have the latter. End of story. If we’re in NY and you try to pay for a coffee in EUR, CHF, GBP, CNY etc the merchant can accept or decline that payment. It’s their choice. If you offer to pay in dollars it is illegal for them to refuse. That is what legal tender is – the outlawing of refusal to accept payment of a given currency. Given such skewing of the playing field in the market for a unit of exchange, I struggle to understand what “market test” exactly has been failed.

    That, of course, is before you even get to the Norfed example, where the FBI henchmen scared the hell out of anyone trying to use these (gold backed!!) coins. From the US Mint site

    “The Department of Justice have determined that the use of these gold and silver NORFED “Liberty Dollar” medallions as circulating money is a Federal crime.”

    There you go – a Federal Crime. Is this a “copyright infringement” on the term Dollar in their Liberty Dollars? In which case, are the Australians, New Zealanders, Canadians etc are in breach? I very much doubt it. I suspect this was a guarding of monopoly power as aggressive as you’d expect of any monopoly incumbent. It would have been very interesting had the NORFED founders taken up the FBI’s challenge and gone to court to see exactly what they’d done wrong, but why risk a prison sentence and the endless harassment?

    Bill: “Next to no economists support Rothbardian pro-deflationism.” Why does that make his argument wrong?


  33. Gravatar of Nick Rowe Nick Rowe
    3. June 2009 at 03:57

    DG: You might be right, and I might be wrong. The Norfed example certainly does look like a restriction on free money.

    But it does depend on the interpretation of “legal tender” laws. If the coffee shop posts prices in “dollars”, and you offer payment in US dollars, I think he should accept. It would be false advertising if he advertised prices in dollars, and yet refused payment in US dollars. But supposed he posted prices in ounces of gold or silver. Would he still be required to accept US dollars?

    In other words, I can imagine a libertarian interpretation of legal tender laws in which those laws merely clarified an ambiguity in private contracts: that the word “dollar”, or “$”, when used in the US, means “Federal Reserve notes”.

    I would see legal tender laws, interpreted in that way, as legitimate. But are they interpreted and applied in that way in fact? I am less sure than I was.

  34. Gravatar of Nick Rowe Nick Rowe
    3. June 2009 at 04:02

    By the way, I know that the abrogation of the “gold clause” in US debt contracts, sometime in the 1930s (?), happened, and that is a clear violation of the right of free contract.

  35. Gravatar of Nick Rowe Nick Rowe
    3. June 2009 at 04:32

    And here’s an example of a private medium of exchange system. It doesn’t use paper notes (I think), but what does the physical form matter? They call it “barter”, but it isn’t.

  36. Gravatar of DG DG
    3. June 2009 at 21:37

    Nick – I hate to sound pedantic here, but it’s such a key point. The fact is, you have to accept $ in the US. Full stop. No one is allowed to refuse.

    In normal times, when all major currency is pretty sound, you’re right – who cares what currency they get paid in really? But suppose the $ for whatever reason becomes a less attractive payment option in the future and you’d rather be payed in another currency? Tough. You have to accept $. And the Norfed example suggests the government would mobilise the full force of the law in the face of any attempt displace it.

    Is this a glimpse of the future? Who knows? But it seemed a pretty harsh overreaction to me (as an aside, the 100% gold backed currency was not legal tender, while the almost completely unbacked paper currency was! – as we say in the UK, the law is an ass).

    Anyway, that’s why it is technically impossible for there to be a system of free banking along side legal currency legislation. A custody bank, for example, issuing it’s own receipts redeemable in gold, silver, CHF, EUR, goats, or whatever is only going be used if it is very sound. Such a medium of exchange would find it very difficult to compete with a currency everyone had to accept regardless of its soundness.

    You’d think that if the govt abuse it’s monopoly as currency issuer so much that people switched to prefer alternatives, there would be a groundswell of opinion railing against a law forcing them to accept worthless paper. But who knows where the tipping point is? With the bill for the current great depression 2, oops, I mean recession, coming due just as those for ss, medicaid etc build, I guess the next few decades will be interesting in that regard. But if we do get there, as the Norfed case demonstrates, any organisation trying to displace the govt’s money would be entering into quite a fight.

    For more see:

    and to quote from the page

    “To finance the Civil War, the federal government in 1862 passed the Legal Tender Act, authorizing the creation of paper money not redeemable in gold or silver. About $430 million worth of “greenbacks” were put in circulation, and this money by law had to be accepted for all taxes, debts, and other obligations””even those contracted prior to the passage of the act.”

  37. Gravatar of Nick Rowe Nick Rowe
    4. June 2009 at 02:07

    So if I own an oil, or wheat, or gold, futures contract, I cannot insist on delivery of oil, or wheat, or gold, but must accept greenbacks instead?

  38. Gravatar of Bill Woolsey Bill Woolsey
    4. June 2009 at 07:38


    You are correct about legal tender. It doesn’t prevent the use of alternative monetary systems. That requires other sorts of regulations.

  39. Gravatar of TGGP TGGP
    4. June 2009 at 17:55

    The same argument about legal tender is taking place right now in the comments section of the Mises blog. Mike Sproul, an adherent of the “Real Bills Doctrine” is arguing that there has never been such a thing as fiat money (distinct from the Post-Keynesian claim that what we have now is not fiat money). My home I.P address is banned there, so I don’t comment often.

  40. Gravatar of DG DG
    5. June 2009 at 00:45

    Nick – I’m not sure I’m with you here. Aren’t you confusing the purchase of a good with the medium of exchange used for that purchase? If, using a futures contract, you agree to receive gold, wheat, or oil in exchange for whatever currency is in the agreement (usually dollars though they’re trying to launch euro based oil contracts in the ME), you’re contractually obliged to receive that oil, wheat or gold in the same you are to receive, say, books you ordered off amazon.

    Can you go around with your futures contract and use it as a medium of exchange, say by trying to buy a car with it for your local car dealer? Maybe, if the dealer accepts the oil futures contract, which he probably won’t. Similarly, you might be able to pay in pounds sterling if the dealer accepted the contract, though he probably wouldn’t. He is allowed to refuse those mediums of exchange. The medium of exchange he isn’t allowed to refuse (assuming you’re in the States) is US dollars.

    As for alternative monetary systems Bill, of course they can develop alongside a system of legal tender. The Zimbabwe dollar being legal tender there didn’t stop the dollar being used in parallel and becoming the store of value as hyperinflation took hold. Indeed you have dollarised and euroised economies all over the world. In a way, the outcome of a global reserve currency is the consequence of a form of free banking – competition between state-sponsored monopoly providers of currency.

    But there is a very big difference between saying the existence of legal tender doesn’t prevent alternative monetary systems, and saying we live in a system of free banking in which the dollar has won it’s place thanks to market forces.

  41. Gravatar of Jon Jon
    5. June 2009 at 08:58


    1) in court you can get damages not necessarily fulfillment

    2) there are different kinds of futures contracts… cash-settled and delivery-settled. Of delivery-settled contracts, less than 1% are held to expiry. Others are hybrids, the ICE Brent Futures contract has a cash settlement option.

    The latter innovation has been essential to the recent rise in commodity speculation by pensions, trusts, etc. Historically, those organizations could not legally engage in the future’s trading because of the possibility of having to take or make delivery.

  42. Gravatar of Nick Rowe Nick Rowe
    5. June 2009 at 15:53

    DG: An oil futures contract is a debt that must be paid in oil. I am using it is a counterexample to the idea that legal tender laws require all debts to be paid in greenbacks. Only a subset of debts, those that are futures contracts in US dollars, fall within the scope of legal tender laws. A legal tender law is thus no different than a law which specifies precisely what “oil” means in an oil futures contract.

    (Jon is being more precise than I was, since he clearly knows more about futures contracts than I do. So I would need to specify a delivery-settled contract. And if I fail to deliver oil, as promised, the damages might be payable in greenbacks, but would presumably be punitive.)

    Let me give another, hypothetical, counterexample. Suppose I sign a contract with you to swap my house for your house, then I sign a second contract with Jon, to swap your house for Jon’s house. Would the law enforce those two contracts? I think so. Would it prohibit them? I think not. And yet I am using your house as a medium of exchange.

  43. Gravatar of Bill Woolsey Bill Woolsey
    6. June 2009 at 03:26


    The Federal Reserve note didn’t win its place by virtue of competition, though I don’t think legal tender was important either. It won as strong market share as a redeemable financial instrument. Of course, competition during that period was highly resitricted. A prohibitive tax on banknotes from state chartered banks, and a Treasury bond collateral requirement for national banknotes. Then, in the thrities, the redeemability was suspended. While it is possible that legal tender was essential for the medium of exchange and medium of account function to switch to Federal Reserve note, not necessarily. It wasn’t necessary when the Bank of England suspended in 1797.

    Nick, however, is correct that all evidence points to the FRN maintaining its position due to an inability of competitors to enter and win market share.

    As was noted earlier in this thread, network externalities make it very difficult for a new money to replace an existing one. Legal tender isn’t the real stumbling block. There are possible regulatory threats, however. Mostly this involves the regulatory treatment of banks offering deposits denominated in alternative units. And, of course, there is the nominal capital gains issue.

    Still, the notion that if there is a breach of contract, that the settlement will be in “official” money, is absurdly unimportant. Nothing requires that those receiving such payment don’t promptly sell FRN for a preferred money.

    Personally, I find these arguments pointless. Changing the dollar-based money and banking system is the only realistic path to reform.

  44. Gravatar of DG DG
    6. June 2009 at 05:13

    OK guys – now I’m becoming confused.

    Bill – I could have sworn I was the one arguing all along that FRNs were dominant because of restricted competition! Nick started out arguing the opposite, and that free banking effectively already existed in the US. I agree with you on the network externalities as key drivers of the adoption of a currency, but there are countless examples of the market “choosing” one provider of a service where network externalities make such an outcome desirable (e.g. ebay). I’m not sure it justifies a government monopoly. Would be interested in your ideas for reform of the dollar-based money and banking system.

    Nick – if I’ve misunderstood your point then I apologise. Likewise if I’m not being clear enough. I don’t think I said anywhere that contracts not based on dollars were unenforcable. Two parties can contract to transact in whatever medium they wish and any such agreement is a binding contract, I believe. The point I’m making is that while the vendor can REFUSE payment in any of the suggested mediums, he may not refuse to accept payment in $ because of the legal tender act 1862. You may refuse any form of payment not to your liking but you may not refuse $. Follow the logic through and you’ll see why it’s incompatible with the notion of free banking. This is very different to what you seem to think I’m saying – that debts can only be repaid in dollars, which clearly isn’t true.

    It’s times like this we see the limits of technology. Surely a phone call would be easier! Happy to do that and everyone else is probably bored to death of this discussion. Mail me if you want to keep going on Skype.

  45. Gravatar of Jon Jon
    6. June 2009 at 10:45

    A bank note is a ‘money substitute’ not really different from cheques. Substitute for what? USD. To help get your head around think back to the 1920s.

    There was a lack of competition in the creation of money substitutes for USD.

    There are many rivals for ‘money’ though. As Nick suggests: oil could be used as money and we could trade notes backed by the oil in cushings.

    Side discussion:
    If we take the current price of gold as the ‘legal’ price, then the gold cover-ratio of FRN is around 20%.

  46. Gravatar of ssumner ssumner
    6. June 2009 at 12:28

    Alex, Thanks for the information about TIPS. On a related issue, some have argued that the T-bond/TIPS yield spread is not a good proxy for inflation expectations during periods of illiquidity. That may be the case, but if so it may be a good proxy for changes in NGDP growth expectations. When there is a rush for liquidity you would expect the TIPS-derived estimate of expected inflation to underestimate the actual expected rate of inflation. But periods of illiquidity are associated with recession, so it may actually be a good proxy for changes in NGDP expectations. Thus the sharp drop in the TIPS spread in late 2008 may have exaggerated how much inflation expectations fell, but probably did not exaggerate how much NGDP growth expectations fell.

    Azmyth, Your analysis seems very sensible to me. The only additional point I would make is that the C-S index slightly exaggerates housing inflation during booms, (and vice versa.) If I am not mistaken, that makes our estimates even more similar.
    On a side issue, my work on the Depression led me to believe that price indices that included mostly flexible asset prices often tracked NGDP more closely than the CPI. Thus I seem to recall that both the WPI and NGDP fell roughly in half during the early 1930s, but the CPI fell only about 25%. Since I am in favor of using NGDP growth as an indicator of monetary policy, I am sympathetic to those who prefer a price index that has lots of flexible asset prices.

    123, Yes, I agree. I have always had a problem with the notion that the Fed simply blows asset price bubbles. Yes, the Fed can affect real asset prices, but only by creating unexpected changes in NGDP growth. If NGDP growth were completely stable, any change in real asset prices would be due to real factors, not monetary policy. Of course NGDP growth has not been completely stable over the past 15 years, but it certainly hasn’t been unstable enough to blow up huge tech/RE/oil bubbles.

    Adam, I worked through a 189 comment post on Austrian economics, and didn’t see much advantage over textbook economics. It seemed to have many of the same flaws as Keynesian economics, such as the assumption that low interest rates means “easy money.” I have a lot of problems with textbook economics, but I don’t see any Austrian shortcuts to solving those problems.

    DG, Nick, Bill, TGGF, Jon, Are US stores allowed to price all goods in ounces of silver, and demand payment in silver? I don’t know the answer, but I assume someone does. Last night I flew home on American Airlines, and they refused to accept dollars in payment for the snack packs and alcoholic beverages. Was that refusal illegal? I would guess not.

    My hunch is that Nick is right and that alternative monetary regimes are not illegal. But in either case, there is no point in debating the issue, someone simply needs to look up the answer. If alternative monetary regimes are not illegal, the success of the dollar may be due to network effects.

  47. Gravatar of Jon Jon
    6. June 2009 at 13:49

    The refusal is not illegal. A store could price things in silver and demand payment in silver. But lets say the store lets you pay later. You don’t and a civil suit ensues.

    The store will be awarded a payment in FRN, albeit probably in excess of the market price of silver.

    This is different then say the merchant agreeing to accept a particular lot of silver–or you agreeing to trade a particular house etc. Then the court will be happy to assign title and custody–even if you had subsequent (improperly) transferred those items to someone else.

    So as the fine print on the bill says, “This note is legal tender for all debts, public and private”

  48. Gravatar of Jon Jon
    6. June 2009 at 13:53

    “If alternative monetary regimes are not illegal,”

    They are not. So far I understand, the Liberty Dollar people are being prosecuted for what amounts to ‘counterfeiting’. The basis of which is whether people haplessly assumed that 20 liberty dollars could be exchanged for a $20 FRN…

    It remains to be seen whether they are convicted anyways…

  49. Gravatar of Nick Rowe Nick Rowe
    7. June 2009 at 09:44

    DG: Nothing to apologise for. I’m not being as clear as I should be. I’m not really clear on this in my own mind!

    But my hunch is that the network externalities are what’s important, in making it difficult to have competing media of exchange and media of account.

    But if network externalities do restrict competition, if we did de-nationalise money, we might just replace a government monopoly with a private monopoly, which is not obviously better, and might be worse.

  50. Gravatar of TGGP TGGP
    7. June 2009 at 19:17

    Rather off-topic, but Bryan Caplan & Ed Stringham have a paper on network-effects & anarchy in reply to Tyler Cowen that can be found from here.

  51. Gravatar of TheMoneyIllusion » It’s (not) different this time. TheMoneyIllusion » It’s (not) different this time.
    7. June 2009 at 19:21

    […] an earlier post I argued that Fed policy almost always reflects the consensus views of economists, and therefore […]

  52. Gravatar of ssumner ssumner
    8. June 2009 at 03:54

    Jon, Thanks for the info, your analysis sounds right to me.

    Nick, I believe that most free banking types oppose any copyright on the unit of account. In that case you might well have competition in currency, despite network externalities. (Perhaps tied to a gold standard.) But competition in currency might be even less efficient than monopoly, as the seignorage could be dissipated in wasteful non-price competition. Price competition may be technically infeasible due to the inconvenience of paying interest on cash. (Some have proposed lotteries based on serial numbers at randomly chosen dates. This is probably the most efficient way of paying interest on cash.)

    TGGP, Thanks for the tip. I have never studied anarchy.

  53. Gravatar of saifedean saifedean
    9. June 2009 at 10:34


    With all due respect to your commenters, a blogpost comments’ section is not the right place to learn anything. Certainly, I would not use reading a comments section as evidence of me knowing something.

    I strongly urge you to start looking at Roger Garrison’s powerpoints on Hayek’s boom-bust cycle, then to pick up some Hayek and Rothbard, and eventually Mises. Until then, you cannot possibly make the claim that you did not find anything useful in Austrian economics.

    From where you stand, after years of mainstream education, reading a blogpost comment making an Austrian point will of coruse sound like alien nonsense to you. But until you actually know what Austrians are talking about and what they mean, and spend some time reading them, you can’t say they offer nothing useful.

  54. Gravatar of ssumner ssumner
    10. June 2009 at 06:13

    Saifedean, I should clarify that there are things in Austrian economics that I agree with (NGDP targeting) but I reached that view independently. I have seen Garrison’s slides, and i think I don’t get the gist of his argument. I have also read some Hayek (admittedly not much.)

    I disagree with you about the comment section. I forgive those I overlook, but I do recall names like Bill Woolsey, David Glasner, Greg Ransom, Bob Murphy, etc, who presented pro and con views and seemed well-informed. And there were many other good commenters. Of course in any comment section there will be less well-informed commenters, and I would certainly put myself in that class. But I do think I learned something about Austrian BCT. I still don’t believe it adds much to mainstream AS/AD, which I think explains business cycles and inflation pretty well.

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