Friday, July 18, 2014

Matt Yglesias Should Spend More Time Learning Economics and Less Writing About Gold

Matt Yglesias has taken up critiquing arguments pertaining to the gold standard. To the general reader, his arguments might seem convincing, but the devil is in the details. There are a few points worth considering and elaborating on. I’ll go through 1 point at a time. Worth highlighting is Matt does a poor job of distinguishing between the use of gold as money with and without a legal tender regime, and shows his ignorance of the differences between a change in supply and a change in quantity supplied and of the significance of the existence of multiple markets for a particular good.
1) A gold standard wouldn’t stabilize inflation
Matt provides a nice graph of oil prices measured in troy ounces of gold over the last several decades. He’s right on this one. Prices fluctuate, sometimes wildly. I would prefer if he also presented a chart of oil prices alongside the gold graph. Compared to its price in terms of dollars, the gold price of oil has exhibited more stability. Notice that the price of oil in terms of gold stays pretty tightly between 10 ounces and 30 ounces. Compare that to the dollar price that has fluctuated between 140 and 10 dollars. We need to compare the price stability of gold to the status quo. I in no way support the return of an international gold standard with legal tender regimes, but clearly gold beats the dollar in this case.



2) A gold standard wouldn’t stabilize exchange rates
This is true. We live in a world where individuals and firms can hedge against exchange rate fluctuations by diversifying their portfolio of currencies and asset holding. Not much to say here except that exchange rates fluctuated under the gold standard whenever central banks changed their reserve ratios. Any time the demand or the stock of a given currency changes, exchange rates change. This is a mundane point!
3) There’s no inflation problem to cure
The problem to cure is policy induced price instability. Federal Reserve policy has done a good job of minimizing this problem in the last few decades. After Greenspan, we inherited new problems where, instead of engaging in injections of liquidity, Bernanke targeted particular institutions so as to prevent systemic collapse of the banking sector. We have a new problem now: what to do with the part of the monetary base which is parked at the Fed. This activism from the Federal Reserve nurtures unclear expectations.
4) There’s nothing stopping you from writing gold contracts
This is simply false. 1) I expect that courts might not uphold these contracts. (I’m willing to hear examples of this that prove me wrong here). 2) The same result might be arrived at by immediately converting all deposits in one’s account into holdings of gold ETFs, mining companies, etc… The problem is that these are not treated as money by law, so the use of gold is expensive. They are subject to capital gains taxes, making use of gold as a store of value less efficient than otherwise. The same holds true for any asset that one might want to employ as a store of value, and gives reason for us to question this form of taxation.
5) Gold recessions could last for years
This critique is legitimate for a gold standard where gold operates as legal tender. When there are no substitutes available to use for base money in the economy, liquidity crises are endemic. This was true under the gold standard, though the market innovated around this intervention to some extent as clearinghouse associations often provided emergency liquidity during crises.
6) The gold standard wouldn’t eliminate political money
True. Any money that is regulated by the government is subject to political interests. This is reason to, in the least, restrain money creation according to a rule and remove regulations that inhibit the creation of moneys in the market, if not attempt to find a way to remove government from this industry altogether.
7) Gold-backed money reduces the supply of gold
This is a misunderstanding of economic theory and of the gold standard more generally. What Matt means is that the adoption of a gold standard will raise demand for gold, and therefore, raise its price. This increased demand pulls gold out of the non-monetary market – for arts, jewelry, manufacturing, etc… – and into the monetary market. This means that the available stock of gold for non-monetary uses will decrease as non-monetary gold flows into the market for monetary gold. However, increased demand for gold will lead to an increase in the quantity supplied in a given time period because the increase in price will provide incentive for miners to mine more.

He should also consider functioning of a gold standard. Modern finance allows for most transactions to take place digitally. From a small amount of base money – i.e., gold – a much larger money stock will form. Again, imagine that ETFs serve as a store a value from which you can draw directly and cheaply convert into dollars. For all intents and purposes, the resource costs of a gold standard are miniscule whether we include typical banking deposits or ETFs in our analysis. (Larry White makes this point about deposits in his wonderful book).


My Conclusion

I’m not sure why Matt chose the number 7, but his write-up would have been greatly improved if he considered the significance of legal tender regimes and limited his analysis to those points. The problems that he finds with the gold standard are existent with any standard, fiat or otherwise. He would also benefit from reading my analysis of the classical and interwar gold standards.

P.S. Steve Horwitz isn't happy about this either.

Tuesday, July 15, 2014

Sumner and Christensen Harangue Incompetent Technocrats

At EconLog, Scott Sumner is being witty. Not only did he title his post, Governments don't create problems, they solve them. He closes with this:

For you math jocks, here is a mathematical translation of the absurdity:
NGDP = M*V
NGDP = C + I + G + NX
Increases in the money supply obviously cannot boost NGDP, because the real problem is excessively low consumption, investment, government spending, and net exports. Don't think top government officials would ever be so blind as to think this way? Think again.
PS. Here's the equation that they should put in principles textbooks:
M*V = C + I + G + NX
It will never happen---as it might get students thinking dangerous thoughts.
The post stems from a comment about low inflation in Europe and the inability of central bank officials to take responsibility for the effects of their policies. Lars Christensen covers the same point today. 

Sunday, July 13, 2014

Considering Crypto-Currencies and Difficulties with NGDP Targeting

Today, in considering nominal GDP targeting under a non-legal tender, crypto-currency standard, I discovered that what seemed like an obvious solution to the problem of NGDP targeting is actually quite complicated. Justin Merill asked,
Theoretical question: if there were a digital currency, let's call it NGDP coin, that adjusted its supply to target NGDP, how do you imagine it happening or what is the ideal mechanism?

Let's take for granted that it is not a national currency and not intended to target the NGDP of a geographical region.

The good news is that the ledger makes it incredibly easy to calculate NGDP because you know both the size and quantity of transactions. But if the currency becomes more widely adopted, would it warrant a shrinking of the supply of currency? Financial transactions would be included in the calculus, is that problematic? This would be more like Fisher's version than Friedman's.

The other potential problem is what is the reaction function? Over what time period should it average the transactions and make adjustments? If volume cuts in half in one day, it would seem odd to double the currency.
Seems like a good idea right? All the data is there, so why not target actual changes in NGDP as defined by the crypto-currency? My study of the gold standard has taught me that the adoption of a standard is complicated and breeds unexpected difficulties. Increased use of the currency is the equivalent of an increase in demand assuming that the definition of the price level remains constant, and most importantly, does not include FX transactions.

Justin and I had a fruitful exchange in considering the problem.
Jim Caton: Wider adoption would be equivalent to a drop in V (a rise in k), thus meriting an increase in M if the goal is to target NGDP. Otherwise, P must drop as the money will be used in more transactions. If P is sticky downward, will lead to a drop in y.

Justin Merill: But FX transactions would be included as V, would they not?

Jim Caton: But then you are changing the definition of P to include FX transactions, which does not solve the problem. Depending on the index, we can target input goods or consumer goods or both.

Justin Merill: But then that becomes problematic for calculating since as stipulated, it isn't restricted to a geographic region. It has to be self-referential somehow.

Justin Merill: I guess you could survey participants at the time of transaction if this is a "real" transaction of goods/services or a financial transaction, but that seems tedious.

Jim Caton: Yes, so it appears that the problem is not as simple as it looks at first. It would as though we included all currency transactions as part of GDP if we were to use only the raw data. Since fx trading is recorded, you could take (total nominal expenditure) - (expenditures in exchanges that are not included in your index).

Justin Merill: That would be tricky if you have decentralized exchanges. Yeah, the whole thing is tricky.
The trick is that, even though the initial adoption of a currency by an individual requires a transaction, that transaction is not considered in the measure of the price level, and therefore velocity has not changed. The crypto-currency economy has experienced an increase in y according to the equation of exchange, MV = Py. This is not necessarily true for the economy as a whole, which includes exchanges that don't employ the crypto-currency. Changes in the crypto-currency money stock, M, should therefore target changes in y that do not represent actual changes in production - i.e., increases in y that result from the expansion of the crypto-currency economy - in addition to changes in V. If the whole economy has experienced growth, M should not be adjusted to match changes in y that represent real growth, only changes in y that represent increased adoption of the currency.

Saturday, July 5, 2014

The Gold Standard was a Central Bank Standard: In One Graph



Notice that even in 1913, more the 60 percent of the world's monetary gold was held by central banks. This is noteworthy because the Fed was yet to consolidate the monetary gold stock in the United States. Even while belligerent nations in Europe were lowering their reserves during World War I, the consolidation of the gold stock in the U.S. by the Federal Reserve pushed the proportion of central bank monetary gold holdings close to 80% of the world's stock. Only once the gold stock in the United States was mostly consolidated did the proportion drop. It is not unlikely that, even if belligerent nations had not abandoned the gold standard in 1914, central banks would have held 90% of the world's gold at the end of the 1920s. With this level of consolidation, even small increases in gold holding exhibit tremendous downward pressure on prices. The problem, then, was not that Europe was on a pseudo-gold standard, - gold exchange standard - after the war. The problem was that central banks employed only a single commodity and continually increased their demand for that commodity.

Friday, July 4, 2014

My One Paragraph Summary of the Gold Standard

Here is the conclusion of an essay I am working on for a macroeconomics anthology/textbook. The essay is essentially a less technical summary of my "Good as Gold?" paper, currently under review at the Financial History Review.
Both during and after the classical gold standard, policies of governments and central banks were responsible for unusual changes in prices. First, with the demonetization of silver during the 1870s, prices fell as demand for gold outpaced the growth of the gold stock. The increase in demand, however, was not so severe as to cause an international depression. By the end of the classical era, changes in policies had a much greater impact on prices. Instead of exerting a persistent, but shallow, downward effect on prices, prices in terms of gold became unhinged. Rising rapidly during and shortly after the war, then falling dramatically in two stages. Each of these swings was accompanied by substantial changes in gold holdings by central banks.  When central banks had finally consolidated nearly all of the world’s monetary gold stock at the end of the 1920s, increased demand for gold pushed down prices persistently enough to initiate the Great Depression. By this logic, it appears that the Great Depression was not a glitch, but was the logical end of a monometallic standard. The elimination of metallic base money substitutes by governments and sweeping consolidation of gold made the international monetary system increasingly fragile until, in 1929, it broke.

Tuesday, July 1, 2014

Response to Sumner on Keynes and Market Monetarism

Yesterday Scott Sumner made the claim that market monetarists are the true heirs of Keynes. Sumner is a terrific scholar who I am much indebted to for my own intellectual growth and the trajectory of my own research. I do not believe that his claim is  altogether unfounded, but I do believe that it is contradicted by intellectual history. I commented that his claim was not exactly true because 1) Hawtrey was the first to formulate the relationship between deficiencies in aggregate demand and money and 2) Keynes posited that, in order to be effective, the increase in the money stock must be channeled through the labor market via fiscal expansion, at least in times of depression. Keynes's support of fiscal expansion as necessary to make monetary policy effective, which,as I have discussed previously, was attacked by Hawtrey, fundamentally shifts him away from the tradition of the market monetarists. As I noted in my comment, market monetarists are the heirs of Hawtrey, not Keynes.

Consider this passage from a lecture by Keynes in 1931 (quoted by Don Patinkin):

I am not confident, however, that on this occasion money the cheap money phase will be sufficient by itself to bring about an adequate recovery of new investment. Cheap money means that the riskless or supposedly riskless, rate of interest will be low. But actual enterprise always involves some degree of risk. It may still be the case that the lender, with his confidence shattered by his experiences, will continue to ask for new enterprise rates of interest which the borrower cannot expect to earn. Indeed this was already the case in the moderately cheap money phase which preceded the financial crisis of last autumn.
If this proves to be so, there will be no means of escape from prolonged and perhaps interminable depression except by direct State intervention to promote and subsidize new investment. Formerly there was no expenditure out of the proceeds of borrowing, which it was though proper for the state to incur, except war. In the past, therefore, we have not infrequently had to wait for a war to terminate a major depression. I hope that in the future we shall not adhere to this purist financial attitude, and that we shall be ready to spend on the enterprises of peace what the financial maxims of the past would only allow us to spend on the devastations of war. At any rate I predict with an assured confidence that the only way out is for us to discover some object which is admitted even by the deadheads to be a legitimate excuse for largely increasing the expenditure of someone on something! (211)

One of these deadheads was Hawtrey, with whom Keynes clashed at the Macmillan Commission. Hawtrey wrote an article decrying this position before the Keynes wrote his General Theory

Keynes believed monetary policy to be inadequate to lift the economy from deep depression. He was not referring to only the Great Depression amidst which he was writing, but depressions more generally as he said explicitly that "we have not infrequently had to wait for a war to terminate a major depression." In other words, Keynes believed that his posited economic scenario was relatively common. This aligns with much of what he wrote in The General Theory.

Market monetarists like Scott Sumner - in some ways I consider myself in this camp -  promote NGDP targeting because it can offset deficiencies in aggregate demand. Given that Keynes believed that this policy could not successfully lift the economy out of depression, precisely the time when it would be most useful, I find any claim to the Keynesian legacy far-reaching. Most of what was Keynes said that was useful had already been stated by Hawtrey long before Keynes said it (for example, see Glasner's working paper ).


I should close by noting that any claim to a Keynes's legacy is difficult to substantiate because Keynes's ideas across his academic career were not wholly consistent. This is typically true of anyone. But if Keynes's legacy is wrapped up in his General Theory, which is no great claim to make, then it is appropriate to accept the doctrine set forth in that work as most accurately representing his legacy. I would say much the same for Hayek at the end of his career with regard to his work on social orders and currencies. Sumner is right that market monetarists have some agreement with Keynes, and even much overlap, but I believe that the few discrepancies between Hawtrey and Keynes left a chasm between the programs of these two thinkers. This gap leaves market monetarism squarely within the tradition of Hawtrey contra Keynes.

Late Thought: Scott definitely agrees that Hawtrey is a better representative of market monetarism. 1359 EST

Thursday, June 19, 2014

Keynes's Not-So-General Theory and the Supposed Impotence of Monetary Policy

In 1935, John Maynard Keynes wrote to George Bernard Shaw:

I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years—the way the world thinks about economic problems.”

After he published The General Theory, Keynes’s formulation of economics was received as though it was revolutionary, especially by his younger followers. Many older economists were not quick to embrace Keynes’s doctrine. As David Laidler points out, “Pigou and Knight in particular, were scornful of his claims to novelty (Fabricating the Keynesian Revolution, 21).” In The General Theory Keynes draws upon arguments from both his contemporaries and past economists, but especially in the case of his contemporaries, he typically fails to cite them. So what did Keynes actually contribute to economic theory? His main contribution was to call attention the need for economic analysis where the macro-economy fails to reach an equilibrium, but this contribution is obscured by a framing of the argument that ignored the economic significance of institutional collapse and his denial of the ability of monetary policy on its own to aid the process of recovery.

In the opening chapter of The General Theory, Keynes immediately clarifies his stance and his goals. “The postulates of the classical theory,” Keynes writes, “are applicable to a special case only and not to the general case (3).” The particular case, according to Keynes, is the case of full employment and the general case includes all states where the economy operates below full employment. He builds his theory with the belief that the economy does not typically operate at full employment, but rather “without any marked tendency either towards recovery or toward complete collapse (249).” If both of these claims are true, then in most circumstances the classical model is inadequate to employ in analysis. For the sake of remaining concise, I shall only briefly state that this proposition is untrue. Empirical investigation shows that the economy tends to move toward the long-run outcome predicted by the classical model (Kehoe and Prescott 2007). Only in the case of a general fall in prices and sticky wages is there a shortfall in demand where the economy operates below its potential (Galloway and Vedder, 89-97; Leijonhufvud, 49-50).
                
It appears that Keynes’s theory is the “special case”. Not only is it special, it is so particular as to call into question its applicability altogether. That is, Keynes questions the efficacy of monetary policy and its ability to return aggregate demand to its potential. In order for his theory to be useful, it needs to be better than just a second best option, which, if monetary policy is effective, is the ranking to which the theory must be relegated. As Hawtrey explained in a paper critiquing the support of Keynes and others for increased capital outlays as a remedy for depression,

Currency depreciation is far the most satisfactory measure of revival. Not only is it better balanced, but it is quicker and easier to bring about. I have already pointed out that a capital programme regarded as a measure for breaking the vicious circle of depression is likely to be too slow and too gradual to be successful, and I have suggested that, when cheap money fails to bring about a prompt revival, there is more to be hoped from an open market policy, the purchase of securities by the central bank. I should be inclined to leave the question at that, confident that a sufficient purchase of securities would overcome any depression however severe. For whereas cheap money reaches a limit when the rate of interest approaches zero, the purchases of securities can be increased indefinitely.

. . . The capital programme has the grave disadvantage of coming into operation tardily and gradually. Nor is it possible to say how great a programme will is needed to resolve the deadlock or whether any practicable programme will be great enough. If a capital programme were the only means of resolving the deadlock, we should have to make the best of it, but I believe that there are good reasons for supposing that a sufficiently liberal measure of open market purchases by the central bank would be bound to achieve this object.

. . . Since a programme of capital outlay offers so limited and doubtful a contribution towards revival, I think it is regrettable that excessive prominence is given to it by economists. (456-58)

The need for capital outlays is contingent on Keynes’s claim that the price level will not respond to an increase in the money supply when the economy is at less-than-full employment because he proposes that the price level is primarily a function of wages. If interest rates are too low to encourage investment, entrepreneurs will not invest, and therefore, output will remain stagnant.

The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money.

. . . But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. (308-9)

As Keynes links changes in the price level with changes in employment, this is his subtle way of saying that an increase in money will not lead to an increase in investment as holders of the new money will not lend it out. As mentioned in my last post on The General Theory, tremendous deflation occurred in England, Keynes home country, between 1929 and 1931. This continued in gold standard countries generally, including the U.S., until 1933. During this period of deflation, we can expect that the [hypothetical] equilibrium nominal rate of interest was negative for an extended period of time. Remember that,

i = π + r

Ex post real rates for this period are in the double digits during some years! (For example, see Thayer Watkins calculations for the U.S. here) The dramatic fall of in investment during this time period suggests that this was out of equilibrium play.

Deflation during these years was the result of a collapse of the banking system in the U.S. and of the international gold standard. Between 1929 and 1931, U.S. had experienced a tremendous increase in demand for money. This had made the Depression, to that point, one of the worst on record. Low levels of output in combination with a fragile unit-banking system that struggled to remain solvent prevented recovery. Between May 1931 and March 1933, a series of banking panics led to an increase in cash balances for a fearful public, and therefore, a continuation of the contraction of the money stock (Friedman and Schwartz, 308-315). Unit banking in the U.S. prevented the spread of liquidity which would have likely prevented or slowed the process – banking panics were prominent in the U.S. during this period, a problem not experienced by countries lacking this restriction.

Furthermore, some central banks had begun hoarding gold at the end of the 1920s and continued this practice into the 1930s. The prime offenders were the Bank of France and the Federal Reserve. The bank of France increased its holdings from 7 percent to 27 percent of the world’s total gold reserves (Board of Governors 1943, 544-55). In the U.S. gold holdings shrank only slightly as a proportion of the world’s gold reserves as board members at the Federal Reserve refused to adopt a policy of easy money until February 1932. Even then, they did so timidly until prodded by congress in the following months. By this time, the collapse of the banking system in the U.S. was already under way. 


If there were bottlenecks in production that resulted from interest rates failing to allocate resources across time, the demand deficiencies were the fault of bad monetary policy. Excessive deflation was the result of gold hoarding and tight monetary policy more generally. This being the case, fiscal policy is an unnecessary band-aid if the policy goal is to offset dramatic falls in aggregate demand. Aggressive monetary policy would have done just fine to offset the deflation, as is evidenced by the end of the first phase of the Great Depression in 1933 when FDR devalued the dollar.