Tuesday, November 25, 2014

Turning Back the Police State: Knowledge is Power

“The problem is at once to distinguish among events, to differentiate the networks and levels to which they belong, and to reconstitute for the lines along which they are connected and engender one another.  From this follows a refusal of domain analysis couched in terms of the symbolic field or the domain of signifying structures, and a recourse to analyses in terms of the genealogy of relations of force, strategic developments, and tactics. Here I believe one’s point of reference should not be to the great model of language (langue) and signs, but to that of war and battle. . . .

“It is hard to see where, either on the Right or the Left, this problem of power could then have been posed. . . . The way power was exercised – concretely and in detail – with its specificity, its techniques and tactics, was something that that no one attempted to ascertain; they contented themselves with denouncing it in a polemical and global fashion as it existed among the ‘other’ in the adversary camp. . . . but the mechanics of power in themselves were never analysed. This task could only begin after 1968, that is to say on the basis of daily struggles at the grassroots level, among those whose fight was located in the fine meshes of the web of power.”

-          Michel Foucault, “Truth and Power” in Power / Knowledge

Today I was pleasantly surprised to see that protests concerning the Michael Brown / Darren Wilson verdict have erupted across the nation. The moment I saw this, I knew that these must have been organized by people who are passionate about overcoming social injustices.

Power accumulates around particular nodes in any system. It is important that power does not accumulate in such a way as to neuter the citizenry of their civil liberties. In a fair legal system, individuals are treated as legal equals, not having any advantage over another in trial due to wealth, race, or gender of an individual. Neither should one be afforded a position of privilege by virtue of working for the state. Only under such a legal system can individuals work together to improve their own lives by cooperating with total strangers in social exchange of all kinds. When legal systems are hacked into by plunderers with political connections – in this case arms manufacturers that are part of the military industrial complex and corrupt police and police departments – individuals lose the ability to exercise their civil liberties. Property is seized indefinitely from those charged with drug possession, often never to return to its rightful owner.  The police departments reap the benefits. Individuals have their personal space violated upon any suspicion by an officer. And day after day, reports and videos of police shooting innocent civilians are published (I’ve linked to a Google news search for “police shoot unarmed”). Something must be done.

The first step is for community leaders to educate themselves concerning the politics that lead to their oppression. For this purpose, I have collected a number of articles that reveal, point by point, how the military industrial complex is destroying the public safety function of police, instead turning them into plunderers and oppressors of the weak and powerless. Also included are works that dig deeply into the philosophy, ethics, and, most basically, the heart state-sponsored aggression. I write this as a former public safety dispatcher for California Highway Patrol. When I worked there, I was surrounded by many good men and women, many of whom I still correspond with. It is time to renew the system that they work for and fight to defend. Incentives that encourage malicious activity, especially if of great pecuniary measure, can turn individuals and the groups they form into a machinery of grave evil and perpetual injustice. I hope that readers will use the information contained in the following literature to turn back this machinery.


1.       Radley Balko

Radley Balko is a journalist “who writes about criminal justice, the drug war, and civil liberties for The Washington Post.” He has made a video that is a great starting point for anyone trying to understand the growing police state and its display in Ferguson. See his Washington Post columns here. Also see his book Rise of the Warrior Cop.

2.       Christopher Coyne and Abigail Hall

There are a number of incisive works on the subject of the spreading militarization of police that any interested reader should read. I leave it to you to search Chris’s and Abby’s curriculums vitae. I find the following to be especially informative.

Coercive government actions that target another country often act like a boomerang, turning around and knocking down freedoms and liberties in the “throwing” nation. Two developments in the United States illustrate the boomerang effect: the rise of government surveillance and the growing militarization of the police.

This paper develops the political economy of the militarization of domestic policing. We analyze the mechanisms through which the “protective state” — where the government utilizes its monopoly on force to protect citizens’ rights — devolves into a “predatory state” which undermines the rights of the populace. We apply our theory to the U.S., where we trace the (failed) historical attempts to establish constraints to separate the military functions and policing functions of government. In doing so we emphasize the role of crises in the form of perpetual wars — the “War on Drugs” and the “War on Terror” — in the accelerated militarization of domestic policing.

General Smedley Butler had been on the inside. With a fervent cry, he digs into the military industrial complex before it was a distinct concept. He names those individuals and corporations that have much to gain from war. And shows how they can disguise their rent-seeking by wrapping their deeds in patriotism. Whether just or unjust, wars invite profiteering with the military-industrial complex demanding more war and in nuanced forms.

Here is a peak.
In the World War [I] a mere handful garnered the profits of the conflict. At least 21,000 new millionaires and billionaires were made in the United States during the World War. That many admitted their huge blood gains in their income tax returns. How many other war millionaires falsified their tax returns no one knows. 
How many of these war millionaires shouldered a rifle? How many of them dug a trench? How many of them knew what it meant to go hungry in a rat-infested dug-out? How many of them spent sleepless, frightened nights, ducking shells and shrapnel and machine gun bullets? How many of them parried a bayonet thrust of an enemy? How many of them were wounded or killed in battle? 
Out of war nations acquire additional territory, if they are victorious. They just take it. This newly acquired territory promptly is exploited by the few -- the selfsame few who wrung dollars out of blood in the war. The general public shoulders the bill. 
And what is this bill? 
This bill renders a horrible accounting. Newly placed gravestones. Mangled bodies. Shattered minds. Broken hearts and homes. Economic instability. Depression and all its attendant miseries. Back-breaking taxation for generations and generations.
For a great many years, as a soldier, I had a suspicion that war was a racket; not until I retired to civil life did I fully realize it. Now that I see the international war clouds gathering, as they are today, I must face it and speak out.

4.       Bastiat’s The Law

The Law is a primer on political plunder – i.e., the effects of special interests lobbying government. Within the context of Ferguson, these plunders include those mentioned above: organizations comprised of police officers and the military industrial complex. This is a nice starting point for anyone trying to understand and correct a system that generates unintended consequences that take the form of legal and physical aggression by agents of the state. See also What is Seen, and Unseen.
The law perverted! And the police powers of the state perverted along with it! The law, I say, not only turned from its proper purpose but made to follow an entirely contrary purpose! The law become the weapon of every kind of greed! Instead of checking crime, the law itself guilty of the evils it is supposed to punish.
If this is true, it is a serious fact, and moral duty requires me to call the attention of my fellow-citizens to it.

5.       Henry David Thoreau’s On Civil Disobedience

This goes without saying. See the opening below.
I HEARTILY ACCEPT the motto—"That government is best which governs least"; and I should like to see it acted up to more rapidly and systematically. Carried out, it finally amounts to this, which also I believe—"That government is best which governs not at all"; and when men are prepared for it, that will be the kind of government which they will have. Government is at best but an expedient; but most governments are usually, and all governments are sometimes, inexpedient. The objections which have been brought against a standing army, and they are many and weighty, and deserve to prevail, may also at last be brought against a standing government. The standing army is only an arm of the standing government. The government itself, which is only the mode which the people have chosen to execute their will, is equally liable to be abused and perverted before the people can act through it. Witness the present Mexican war, the work of comparatively a few individuals using the standing government as their tool; for, in the outset, the people would not have consented to this measure.

6.       Herbert Spencer’s “On Patriotism

This piece speaks for itself.
To me the cry – “Our country, right or wrong!” seems detestable. By association with love of country the sentiment it expresses gains a certain justification. Do but pull off the cloak, however, and the contained sentiment is seen to be of the lowest. Let us observe the alternative cases.
Suppose our country is in the right – suppose it is resisting invasion. Then the idea and feeling embodied in the cry are righteous. It may be effectively contended that self-defence is not only justified but is a duty. Now suppose, contrariwise, that our country is the aggressor – has taken possession of others’ territory, or is forcing by arms certain commodities on a nation which does not want them, or is backing up some of its agents in “punishing” those who have retaliated. Suppose it is doing something which, by the hypothesis, is admitted to be wrong. What is then the implication of the cry? The right is on the side of those who oppose us; the wrong is on our side. How in that case is to be expressed the so-called patriotic wish? Evidently the words must stand – “Down with the right, up with the wrong!” Now in other relations this combination of aims implies the acme of wickedness. In the minds of past men there existed, and there still exists in many minds, a belief in a personalized principle of evil – a Being going up and down in the world everywhere fighting against the good and helping the bad to triumph. Can there be more briefly expressed the aim of that Being than in the words “Up with the wrong and down with the right”? Do the so-called patriots like the endorsement? 

7.       Henry Highland Garnet’s “An Address to the Slaves of the United States

Garnet serves as a timely reminder that individual dignity and liberty lie in legal equity, not privilege which is anathema a legal system that commands common respect to all persons. Slavery was the utmost evil of his age. Now we face another.
Brethren, it is as wrong for your lordly oppressors to keep you in slavery, as it was for the man thief to steal our ancestors from the coast of Africa. You should therefore now use the same manner of resistance, as would have been just in our ancestors when the bloody foot prints of the first remorseless soul thief was placed upon the shores of our fatherland. The humblest peasant is as free in the sight of God as the proudest monarch that ever swayed a sceptre. Liberty is a spirit sent out from God, and like its great Author, is no respecter of persons.

8.       Percy Bysshe Shelley’s “The Mask of Anarchy

I’ve included the final blocks of this timely poem. Tyranny is self-consuming. Best to be rid of it.

‘The old laws of England—they
Whose reverend heads with age are gray,
Children of a wiser day ;
And whose solemn voice must be
Thine own echo—Liberty !

‘On those who first should violate
Such sacred heralds in their state
Rest the blood that must ensue,
And it will not rest on you.

‘And if then the tyrants dare
Let them ride among you there,
Slash, and stab, and maim, and hew, —
What they like, that let them do.

‘With folded arms and steady eyes,
And little fear, and less surprise,
Look upon them as they slay
Till their rage has died away.’

‘Then they will return with shame
To the place from which they came,
And the blood thus shed will speak
In hot blushes on their cheek.

‘Every woman in the land
Will point at them as they stand—
They will hardly dare to greet
Their acquaintance in the street.

‘And the bold, true warriors
Who have hugged Danger in wars
Will turn to those who would be free,
Ashamed of such base company.

‘And that slaughter to the Nation
Shall steam up like inspiration,
Eloquent, oracular ;
A volcano heard afar.

‘And these words shall then become
Like Oppression’s thundered doom
Ringing through each heart and brain.
Heard again—again—again—

‘Rise like Lions after slumber
In unvanquishable number—
Shake your chains to earth like dew
Which in sleep had fallen on you—
Ye are many—they are few.’


Last of all, the Ferguson National Response Network is organizing protests across the country, and even outside the United States. If any readers are participating, I encourage you to bring the material that you believe is most adequate for promoting insight into the problems faced by persons confronted with legally condoned brutality.

* Thank you to those of you who helped me form this list. Without you, what you just read would not exist.

**Edited link for Thoreau at 1106 PM EST.

Monday, November 10, 2014

Is a Commodity Reserve Standard with a Fixed Reserve Ratio More Tractable than a Nominal Income Target?

Formulating the blueprints of a commodity reserve standard with a fixed reserve ratio has proven to be more difficult to detail than I first imagined. In spite of that, I believed I have worked out the most important details. 
1) The central bank holds a bundle of commodities as a part of its reserves. The fraction of central bank notes and credits that these reserves represent must stay constant. 
2) The central bank also hold short-term securities for its remaining reserves. 
3) (Here’s the important part!) The central bank must hold constant its nominal value of reserves comprised by the commodity basket and its reserves comprised of credit. When interest rates fall, the central bank will sell securities, when they rise the central bank will buy securities. Likewise, when the price of the bundle falls, the government will buy shares of the bundle.
    a. The government does not buy the physical commodities, only promises to them.
That is the plan in a nutshell. Other details are, of course, important. For example, as I mentioned previously, the government should purchase from a variety of dealers so as to minimize Cantillon effects.

The core of good macroeconomics lies behind the proposal. Theoretically, it relies on Say’s principle, the equation of exchange, and expectations. Briefly, when prices fail to fully adjust there is a fall in output. If this was a one-time phenomenon, then it might be worth living with, but often the process is dragged out due to a high degree of deflationary expectations. It is not uncommon for bad policy to be the culprit in all of this. Given that monetary policy is not disappearing in the near future, the best policy makes the monetary base responsive to changes in demand for money.

So far you might be asking, why not just stick with nominal income targeting? Nominal income targeting does share the characteristics that I am describing, but I believe that providing good information may be a problem. How thick does the betting market need to be in order for information to be accurate and for the market not to be swallowed in volatility? Is NGDP the best indicator for monetary policy? Difficulty arises because in targeting macroeconomic variables, there will always be errors and transactions unaccounted for in the estimates. These problems are complicated which may be why the profession has not voiced widespread support for the proposal. (There are of course other reasons including bias, ignorance, gold-buggery, etc…) A commodity reserve currency with a fixed reserve ratio nominal value for the central bank's asset side of the ledger lacks these problems.

The policy makes money responsive to prices. Market prices already exist and they are reliable indicators concerning the demands of consumers relative to the supply of available goods and services. One problem that I have been confronting with nominal income targeting is that the immediate change in the money supply may distort prices too much as all changes in demand for money will be fully and immediately compensated by changes in the base money stock. There may be good reasons that agents have increased demand their demand to hold money. A commodity reserve currency with a fixed reserve ratio would allow agents to exercise this preference and let it be reflected in prices. It simply prevents a deflationary spiral that may arise because of policy uncertainty or institutional collapse. Finally, a last advantage of the policy is that it not only constrains the central bank by a rule, but it makes the central bank act as a storehouse. By holding a stock of commodities during a bust and releasing them during a boom, the policy would alleviate, but not eliminate, price volatility. It would serve the same role for credit, preventing credit markets from seizing when liquidity dries up.

Perhaps the most attractive feature of the policy is that it does not need any more information than is already available. There is no need for policymakers to try to guess the future or to target a particular interest rate or price level. In fact, there is no need for policy makers once the rule is implemented. The rule is the only policy necessary. Prices and interests rates move and the base money stock responds. It is as simple as that.

**Thanks to Justin Merill, editor of the facebook groups freebanking and Emergent Society, for discussing this with me**

Late Thoughts: The purchase of commodities should also channel expansion into labor markets during the downturn. It therefore can be a replacement for discretionary fiscal stimulus.

**Edited 11/20/2014

Sunday, November 9, 2014

An Always Consistent David Glasner

After waiting a couple days and receiving no response, I was beginning to think I might not get a response from David Glasner. This would be, I believe, the first time. It wasn't. In fact, Glasner had 17 comments on his thread and took the time to go through each of them.  You can find his response to me if you want to read through.

  1. Jim, You are right, the Swiss central bank is not bound by a fixed exchange rate between its currency and gold, so there is a basic difference between its position, even if the referendum passes, and the Bank of France. The post was mainly intended as a sendup of gold-buggism as a social-psychological phenomenon and only partly as a warning about the policy consequences should the referendum actually pass. However, I suspect that requiring 20% gold cover will make it more costly for Swiss National Bank to maintain a peg against the euro, and will therefore increase the deflationary pressure on the Swiss franc.
    Tom, Thanks.
    Don, Thanks. There is a like button by the way, but you are free to keep ignoring it.
    Andrew, I am not worried about the Swiss balance of payments, and I don’t think anyone else needs to worry about it either, but I take your point about the consequences on the asset portfolio of the central bank.
    Elsa, Imply? I thought that I was being pretty unequivocal. People don’t have to hold euros. They can use their euros to buy all kinds of assets that are likely to appreciate or generate pecuniary returns that will provide their owners with a much higher return than gold. Same goes for holding sterling or any other currency. Gold, thank God, is not the only inflation hedge.
    Mike, I don’t say that a central bank should not hold any gold, but gold is certainly not the only asset with the property that its value is not highly correlated with the value of the currency issued by the central bank.
    Maynard, A gold bug is a gold bug regardless of nationality.
    elwailly, QE is about the total size of the central banks’s balance sheet. The referendum is not about the size of the balance sheet but about its composition.
    Shahid, I agree.
    Benjamin, Well they haven’t voted yet, so don’t assume that they have gone nuts.
    Mikael, Why do you assume it’s a helicopter drop? They will convert their foreign exchange to gold. They don’t have to increase their outstanding liabilities.
    Jim, Thanks for the link. Interesting.
    Scott, As I pointed out in my initial response to Jim, I was mostly responding to gold-buggery as social-psychology, not to the policy implications. However, although you may be right that the Swiss may be able to continue with a reasonable policy even if the referendum passes, I do think that the referendum would increase the risks of deflation in Switzerland, which would not be a good thing.

  2. I was pleased to see that he was mostly upset about "gold-buggery", but also has a legitmate concern about deflation. 
    As far as the monetary policy proposal goes, I've been working through some more bugs that I think I have finally ironed out including making the base money stock responsive to interest rates. I hope to have a full post later this week.

A Fixed Reserve Ratio Commodity Standard - More on Operating Procedures

Yesterday I laid out the basics of a fixed reserve ratio commodity reserve standard. The basic idea is that the central bank hold a broad basket of commodities. It does not attempt to stabilize the price of the basket. Instead, it buys or sells the basket as the reserve ratio deviates from its target, and only does so until the official reserve ratio has been reestablished.

I did not fully lay out the nature of central bank non-commodity reserves. Expansion in this system would not only occur through the purchase of the commodity basket. The central bank would also purchase securities. The rate of purchase of these securities would be equal to the rate of purchase of the commodity basket. If the central bank need to increase it dollar value of commodity holdings by 10%, it would also increase by 10% it holding of treasuries. This should have two effects. First, the price of the bundle will not be determined by the central bank. Under this policy, the change in the price of the bundle cues action by the central bank. Central bank purchases of the commodity should make price movement  more shallow, but it will not eliminate price volatility altogether. This is a nice advantage as a change in prices is a force that pulls speculators into the market, and thus, information provided by speculators will not be lost or greatly distorted. Second, the central bank will also purchase or sell securities at the same rate that it alters holdings of the commodity basket. When it purchases these securities, it should do so from a large number of investment firms and from a variety of types of securities so as to minimize distortions in the market. When interest rates rise, the value of these holdings will increase, so the central bank will buy more commodities and securities. When interest rates fall, the opposite will occur. So we can see that holdings of commodities will make the base money stock responsive to changes in prices. Holdings of securities will make the base also help stabilize the interest rate. However, it would by no means determine the interest rate. That would be left up to the market process to decide. This proposal moderates prices and interest rates.

The final piece left to complete this sketch of policy is to determine the ratio of commodities that comprise central bank reserves. It may make sense to let commodities make up the same proportion of central bank reserves as they do for the proportion of total consumption they represent. The proportion of reserves that the commodities comprise should definitely be no greater than that proportion.

Saturday, November 8, 2014

A Workable Commodity Reserve Currency

I seem to have developed a reputation as being a "market monetarist" but not being an Austrian economist according to one corner of the web. I am far more interested in the principles behind policy rules than the rules themselves. In fact, I have been considering the nature of a proposal different than a nominal income target, but which is derived from the same principles. This proposal came to my attention when David Glasner decried the possibility of the Swiss National Bank adopting a fixed ratio of gold reserves as this issue will be decided in a vote at the end of the month.
There they go again. The gold bugs are rallying to prop up the gold-price bubble with mandated purchases of the useless yellow metal so that it can be locked up to lie idle and inert in the vaults of the Swiss National Bank. How insane is that?
Being intimately familiar with the gold standard in both its historical and theoretical forms, I noted in the comment that having a fixed reserve ratio without a fixed-exchange rate for gold itself may actually make for a good monetary policy rule. As the price of gold rises, the bank will sell its gold. When the price falls, the bank will purchase more gold. There is a problem though. Employing only gold as a reserve commodity adds noise as the price of a single commodity is unlikely to reflect underlying market conditions. I suggest this can be amended by broadening the basket of commodities.

The functioning of a commodity reserve currency is straight forward (Hayek 1943; Graham 1944). Hayek and Graham suggested that base money be fully backed by a basket of commodities and that authorities peg the price of the basket, selling the basket when the price rose above the target price and purchasing it when its price moved below that price. I suggest some slight deviations from this formulation. Under a regime with fractional reserves, the monetary authority agrees to back a particular fraction of its notes with a basket of a broad array of commodities. When the price of these commodities rise, the central bank must automatically sell its holdings of this basket until the ratio returns to its statutory level. If the value of the basket falls, the central bank will purchase shares of this basket to maintain the statutory reserve ratio. As prices are procyclical during the business cycle, this policy automatically acts as a stabilizing force in the economy, as it stabilizes prices and provides liquidity when money is dear. This rule is convenient because, once the basket of commodities and operating structure are chosen, it is simple to execute. That the base money stock is responsive to changes in prices means that this rule promotes a money stock that is adaptive to changing market conditions. That is, it tends to facilitate changes in demand for money. Furthermore, since not all base money must be backed by the basket, expansion and contraction will also target credit markets and, therefore, regulate them according to market conditions as reflected by the value of the basket of commodities.

* I'm still working out the details, so I would be more than happy to read your critiques in the comments.
** The above is taken from an amendment to "Wither Gold". The new draft is up online!

Late: The 20% reserve requirement for the Swiss National Bank is a minimum, not a fixed reserve ratio.

Tuesday, November 4, 2014

Two Roads?: Theoretical Case and Historical Precedent for a Nominal Anchor (Part IV)

We have left to consider the a defense of an endogenous fiat money base. Like the gold standard, but more responsive, a nominal income standard will alleviate excess demand for money. Sumner argues that nominal income targeting provides a nominal anchor, meaning that it prevents dramatic swings in prices that would otherwise result from an unstable demand for money (2012, 152). He notes that “the current price level and current NGDP are far more affected by the future expected money supply than they are by the current money supply (144).” If prices reflect expectations, then it is critical that growth rate of one of the major determinants of prices, the money stock, be predictable. Much in the way that “dynamic equilibrium requires consistency of plans which . . . depends on a flexible price system,” a rule that makes the expansion of the stock of base money stock both responsive to prices and predictable will help facilitate coordination of plans among economic actors (Lachmann 1978, 116). As convergent expectations are requisite for Say’s principle to hold, and therefore, for markets to clear, a clearly defined rule that predictably governs growth of the base money stock will reduce policy uncertainty and thereby increase the efficacy of the price system to convey tacit information (Hayek 1943).

The benefits of a nominal income level target are especially of significance for the loanable funds market as it should stabilize inflation expectations. By this effect, it will also better enable credit markets to clear as interest rates, the price of money in the future, will not suffer from distortions stemming from nominal factors such as volatile demand for base money. A nominal income target can also ensure that the rate of inflation remain positive. The significance of this becomes clear upon considering a scenario where the real rate, r, is less than the rate of deflation, -π. The Fisher equation denotes that in the long run the nominal – observed – interest rate as the sum of the real interest rate and the inflation rate. This is formally stated as:

i = r + π

We can imagine a scenario where the market clearing nominal rate of interest is negative. That is the abovementioned case where the real interest rate is less than the rate of deflation:

               r < -π

This special case was recognized in 1913 by Ralph Hawtrey:

What if the rate of depreciation of prices is actually greater than the natural rate of interest? If that is so nothing that the bankers can do will make borrowing sufficiently attractive. Business will be revolving in a vicious circle; the dealers unwilling to buy in a falling market, the manufacturers unable to maintain their output in face of ever-diminishing order, dealers and manufacturers alike cutting don their borrowings in proportion to the decline of business, demand falling in proportion to the shrinkage in credit money and with the falling demand, the dealers more unwilling to buy than ever. (186)

A reduction in the quantity of credit demanded leads to a surplus of savings. If, due to an abnormally high rate of deflation, the equilibrium nominal rate necessary to clear the loanable funds market is negative, then this surplus is inevitable. Since credit doubles as money, a fall in credit outstanding leads to an equivalent drop in total output. A nominal income target stops this problem in its tracks and will allow markets to more efficiently liquidate inventory. Instead of a fall in output, markets will respond by more quickly reallocating previously overvalued goods as a general expansion of the money stock is unlikely to save from bankruptcy those firms that made the most egregious mistakes during the boom. A base money stock that responds to changes in demand for money will help facilitate the reallocation of resource toward their highest valued use. Compare this to a general fall in prices whose end date is unknown.

The danger of tremendous deflation is not a new concern as bankers have long been concerned about financial destabilization due to deflation. Even before the establishment of the Federal Reserve, private banks innovated the means to mitigate the damaging effects of an elevated demand for money during recessions and depressions. Banks would issue temporary currency to stem a deflationary impulse (Timberlake 1984, 6). Money demand shocks were endogenously offset by temporary increases in the money stock. Those who issued the currency provided it to banks that appeared to be illiquid, but were unavailable to those banks that were clearly insolvent (7). Like endogenous gold and credit stocks, the increase in temporary currency arose due to the deflationary impulse set off by a sudden increase in demand for money. This temporary currency was elastic enough to prevent a crisis from turning systemic. Absent activist central bank policies, the gold standard, was able to serve as a nominal anchor. Only as a result of gold hoarding policies from the Bank of France and the Federal Reserve did the gold standard prevent a runaway deflation like occurred due to central bank intervention in 1929 (Eichengreen 1996; Irwin 2012). It does not take much imagination to see that a nominal income level target will serve a similar role to what temporary currency played in moderating crises.

Monday, November 3, 2014

Microfoundations?: Pascal Salin Needs Macroeconomic Tools to Conduct Macroeconomic Analysis

Pascal Salin’s “Money and Micro-Economics” is now online. I was hoping to find some insights into market process oriented macro, but instead found a blasé overview with a weak critique of market monetarism. Perhaps nothing stands out more than Salin’s distaste for monetary expansion. This attitude is reflected clearly in Salin’s suggestion that market monetarism should be called “market Kenesianism” as “it is simply a branch of new-Keynesianism." I’m not sure what book in intellectual history that Salin is reading from, but I do know that he lacks foundation for his interpretation of market monetarism. As I have noted before, market monetarists of the heirs of Ralph Hawtrey, not John Maynard Keynes. Macroeconomic outcomes are dependent upon microeconomic outcomes, but certain macroeconomic variables tell us a lot about economic conditions. This information can be employed in a manner that considers market process in analysis and policy implementation, rather than inhibits market robustness.

Salin's prime error appears to be the assumption that the macroeconomy can be defined solely in terms of microeconomic agents. A macroeconomics that does not give special attention to certain macrovariables is of little service. While it is understandable that economists interested in market process emphasize that information is lost in aggregation, a loss of information does not necessitate that useful information does not exist in these macrovariables. This really requires a detour into the pillars of macroeconomic analysis:
1.  Say’s Principle
2. The Equation of Exchange
3. Expectations
These concepts permeate any discussion of macroeconomics, although their employment is not always recognized explicitly. Consider Say’s principle. Say’s law expresses the principle in its most basic form. Goods must pay for goods. In other words, if you want to demand a good, you must have the means to facilitate exchange with payment. This means is tied at some point to either one’s labor, a good in one’s possession, or a promise, of a good or service outstanding. Say’s principle, as formulated by Leijonhufvud and Clower (1973), identify money as an nth commodity included in Say’s identity. It conveys that if there is an excess demand for money, there must be an excess supply of goods in some other market or markets. The only way for all markets of available goods and services to clear is for either more money to enter the hands of those agents demanding more money or for prices to fall. Prices, especially wages, tend to be sticky downward, so the extent to which prices are unable to adjust there is a shortfall in demand and a falloff in economic activity.

Cue the equation of exchange and the role of expectations. The equation of exchange, MV = Py, tells us that changes in velocity can affect prices and output levels. An increase in demand for money materializes as an increase cash balances. An agent will increase portfolio demand for money as a result of deflationary expectations (money is expected to be worth more in the future), in response to increased uncertainty, or as a result of planned future expenditures not induced by expected deflation. The reader can see that demand for money is dependent on what one expects to use it for in the future and on expectation of future conditions more generally. Modern finance blurs the line between an increase in portfolio demand and an increase in investment, the latter of which tends also to increase the broader money stock. The difficulty comes when secure investments are exhausted and cease to respond to the amount of savings in the economy. When this occurs, short term rates fall toward zero and the yield curve steepens (Moreira and Savov 2013; Sunderam 2012). In the short run, low rates might result from an expansion of the monetary base, but it is unlikely that the market could be fooled for nearly a decade. The cause of our recent low rates lies elsewhere. If nominal rates on short term securities are depressed for an extended period of time, the likely cause is increased uncertainty, deflationary expectations, or both. In any case, the reader can see that expectations are intimately tied to demand for money and quasi-moneys.

A nominal income target can help eliminate both uncertainty about the availability of credit to creditworthy borrowers during a downturn and self-feeding deflationary expectations. And as I will later explain, the mechanisms by which a nominal income rule can be implemented need not lead to insurmountable systemic distortions. The key to understanding this lies in tying together the core principles of classical macroeconomics which I have outlined.

As many of my readers know, the mechanisms governing the gold standard closely parallel those governing a nominal income level target. It should be no surprise that it also illustrates the principle that I am attempting to convey.  Under the gold standard, the monetary gold stock consistently grew at a rate of 2 to 3% per year. The years during which the growth rate of the gold stock deviated from this range tend to correlate tightly with changes in the price level (see figure from a recent post). When gold denominated prices fell sharply (the price of gold rose), the rate of growth might be as high as 7 to 10%. Barring a sudden reduction of the world’s gold stock – perhaps the plot of a devious Goldfinger or simply the result of insane banking policies – a rise in the price of gold was concomitant with an increase in demand for gold. As Say’s principle tells us, an increase in demand leading to an excess demand for gold implies a relative increase in present surplus stocks of goods. Luckily, an increase in the price of gold tends to increase the quantity supplied in a given period. Thus, gold flowed from mines and the market for non-monetary gold into the hands of those who valued it more as money. In other words, a shortage of gold identifies itself by a rise in the price of gold and, thus, simultaneously promotes its own remedy. Unfortunately, modern monetary systems lack this sort of mechanism for the monetary base.

A nominal income target is an nth best policy option which economists in favor of free markets ought to seriously consider. I don’t expect that anyone in the developed world will find himself or herself living in Mises’s evenly rotating economy any time soon. Absent from reality is a robust free-banking system that would develop absent financial regulation and central bank accommodation. Since I do not expect the state to give up its monopoly on  money any time soon. A rule that endogenizes the base money stock so as to 1) compensate for changes in portfolio demand for money and 2) stabilize expectations about the growth rate of the money stock, and therefore about inflation/deflation and monetary policy more generally, can help promote the coallescence of the plans of economic agents and avoid distortions that arise from expectation of targeted bail outs. This is especially important in a world where banks have come to expect central bank accommodation during periods of constrained liquidity and crisis. The recent crisis has shown that those managing private banks have come to integrate fiscal and monetary intervention into their expectations (Calomiris 2009). When accommodation becomes expected, the result is increased leverage and irresponsible lending.
By essentially turning the central bank into a computer program, a monetary rule will stabilize expectations about monetary policy. A monetary rule will essentially vanquish deflationary expectations and any expectations of a future bailout. This allows credit to play a coordinating rule whereby lending can, at a price, alleviate a shortage in money. If monetary expansion is 1) expected and 2) distributed broadly across financial markets, distortions from expansion will be minimized and money will tend to enter the hands of those who value it most (Selgin 2012). A policy of nominal income targeting alongside the reforms suggested by George Selgin would go a long way to minimizing distortions that result from interventions in financial markets. Thus, I am not convinced that Salin is considering a novel or uncorrectable problem in his description of Cantillon effects:

Those who are the first ones to borrow obtain a gain in purchasing power in comparison with others, since they can spend the money thus obtained before the increase in prices occurs when there is more money creation. Insofar as money creation implies a decrease in interest rates, some people also receive a benefit from money creation for this reason. Money creation therefore has distributional effects which cannot be justified since they are completely arbitrary. (11)

There is a cost to inaction just as there is a cost to monetary activism. At least a rule promotes stable expectations.

Unfortunately, Salin does not consider the three principles that lie at the heart of macroeconomics. By concentrating on microeconomic relationships and ignoring the macroeconomic principles that I have outlined, Salin has not really presented much that is new or useful to the debate regarding monetary policy. Strangely, he also finds that predictable expansion leads to uncertainty, but does not fully explain why:

In addition, an expansionary monetary policy creates uncertainty since no one can forecast accurately and precisely the rate of inflation and, above all, the distortions in price structures (which depend on the structure of credit and the structure of expenditures made by those who benefit from credits of monetary origin). (12)

To the extent that Salin is correct, this problem holds true for any expansion of the monetary base or of credit. This includes, to a lesser extent, expansion under a decentralized commodity standard, which is Salin’s (and my) standard par excellence.

Those of us interested in market process and macroeconomic problems need to consider the full extent of the problems which we study.  If I or anyone else promotes a free market monetary system, we cannot simply rely on the systems theoretical superiority to win the day. We need to consider improvements to the current system that can be made. As long as the government continues to promote a legal tender monopoly, bright minds should consider how to make that standard as little damaging as possible. In addition to those made in this post, I have suggested a number of other reforms including the elimination of capital gains taxes and of regulations that inhibit liquidity. If we are stuck with a legal tender monopoly, a monetary base constrained by a predictable rule is probably the best policy possible. Hayek appears to have come to grips with this once he stopped defending the international gold standard (both the classical gold and gold exchange standards were managed standards; see Hayek 1943 and 1960 about rules and predictability). It is time that market process theorists consider how an nth best policy might do the least harm or even promote development. In doing so, we must also make clear that we are suggesting an nth best solution, not a road to Utopia.

I’ll close by briefly addressing one critique by Salin that appears to have teeth. He argues that “monetary instruments should be used to solve monetary problems and real instruments to solve real problems (19).” Salin critiques nominal income level targeting on the grounds that expansion under a target will lead to inflation even when there is no growth in real income. On these grounds, I might also criticize the gold standard. The gold stock tended to grow even in years of contraction. In essence, the gold standard was a de facto income target, but one that was not only guided by changes in demand for money, but also changes in the supply of gold. In some years, surprise discoveries led to gold production that was far above average. In other years, constrained supply led to a relatively unresponsive money stock. As Barsky and DeLong have shown, inflationary expectations do not appear to have been accurate under such a scenario. Although his phrase may roll smoothly off my tongue – “monetary instruments should be used to solve monetary problems” – it is unclear that the type of system that Salin suggests is actually an historical artifact. No natural money that I know of is governed by this principle. 

Markets use imperfect moneys. What is important for a monetary system is that market actors can collectively form accurate expectations about future monetary conditions. This need a nominal income target can fulfill. If this condition is fulfilled, a failure of expectations to converge will not be the fault of monetary policy but will lie elsewhere.

Friday, October 24, 2014

Hayek, Auto-poetic Social Order, and Critical Realism: Critical Realist Social Ontology as a Theoretical Tool Set for Economists

I have heard some say, “if you can’t measure it, it doesn’t exist.” At first look, the statement seems innocuous. If you cannot measure something, how do you know that it exists? Empirical-realism attempts to measure the world directly through the five senses. It requires some “objective” measurement. Not all causation can be measured. Some structures in society only evidence themselves through the imprint they leave behind. These imprints appear, to the careful observer, in the form of networks, norms, and other patterns of organization that cannot always receive neat, numerical measurement. The world does not fit well onto the Cartesian plane as Cartesian reasoning implies causality through correlation, not rules. A critical realist social ontology suggests causality from rules and structure. We must seek different forms of confirmation than are typically sought within modern economics if we seek evidence that our theory conforms to reality. By adopting this toolset in parallel to existing tools may also provide further improvement of equilibrium modeling and econometrics.

If we search for the subject of our study by constantly breaking down objects, both material and immaterial, into their constituent parts, where does the search stop? What is the source of the parameters that we estimate? We are measuring chance occurrences and assuming them guided by some force represented by the average. I don’t mean to pick on econometricians here. Their job of providing additional data to the study of history is indispensable! Theory cannot be limited by the domain of econometric testing. The desire of some individuals to engage in a more modern and, sadly, more mundane form of sorcery, is another issue entirely. Fitting a line or curve to past data is not the same thing as extrapolating an estimation. Attempting to predict the future by these methods assumes that underlying parameters are constant. More than likely, parameters don’t govern reality. Parameters measured ex post provide information – though the information provided is not exhaustive – about the processes of the underlying system of interest. As long as individuals using these methods do not undermine theory by arguing that their tool set is a substitute for it, this is not a problem. It is critical to the promotion of good economics that economists remain cognizant of something approaching a pure theory as a source of inspiration for modeling and to ensure that a theory misrepresents as little as possible the content it is used to present.

What we search for is not just the unseen, but the unrecorded. We are missing the information not captured by conventional models. “If you can’t measure it, it doesn’t exist!” But some entities are beyond the ability of humans to model. Our reality is remarkably consistent and can conform, in piecemeal form, to equilibrium theory. The reason for the piecemeal nature of equilibrium theory is that it is not suited to describe complexity. Twentieth and early twenty-first century empirical work has spoken wonders to what the equilibrium analysis was able to produce. However, new methods of data interpretation are available to economists, and economic theorizing must stay ahead of these changes. 

At its core, economic theory points the way to entities not yet easily, if at all, measurable. Theory posits laws that govern the objects that we observe. Modern theory gravitates toward theories whose laws govern human action through statistically observable relationships. Individuals make decisions according to the calculus of optimization. This does not leave much room for actual decision making. Equilibrium theory posits the world as a closed system and assumes that outside of that closed system, no laws exist that govern the order. Hand waving is the far less than perfect backfall to which most economists resort when this constraint becomes a problem. Thus, the dependence on exogenous shocks to initiate change within the economic system is perpetuated through a combination of equilibrium theorizing and narration. This is not a useless approach, just a limited one.

Thankfully, this problem does not hold true for the whole of economic theory. During the 1950s and early 1960s, Hayek developed a robust program into the study of complexity that he observed in society’s institutions. His development of this program also produced a challenge to modern economists. As he argued in “The Pretense of Knowledge”,

It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences – an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude – an attitude which as I defined it some thirty years ago, “is decidedly unscientific in the true sense of the word., since it involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed [emphasis author]."

At first look this is the classic critique that correlation does not imply causation. Upon further reading, we see that Hayek presents the problem from a novel light.

While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process, for reasons which I shall explain later, will hardly ever be fully known or measurable.

Neoclassical economics, as it has come to be accepted among most modern economists, functions well when the world is “smooth, continuous, and twice differentiable,” to steal a phrase from Richard Wagner. To state it more clearly, causation is assumed to be consistent, continuous, and linear or log-linear. In these models, process comes to be represented – inappropriately as a means for deep theorizing – by parameters. But what use is a parameter if it is constantly fluctuating? While some have brilliantly addressed the problem by using models with fat tails and other more nuanced implements, the underlying process remains masked if we do not take off our econometrician hats. It is a mistaken method. When outcomes are generated by complex process, causation ceases to be identifiable by equilibrium analysis. Simultaneous events are subject to interdependency that prevents causation of the individual pieces of a system from being uniquely represented. Causation must be observed from a systems level. To observe features of the market system that are not currently measurable, we must investigate process in the system through the use of types.

Austrian economists would do well to be aware of, if not adopt to a greater or lesser extent, a critical realist social ontology. Fleetwood references 5 types of deep structures: structures, mechanisms, rules, powers, relations. These concepts have close relation to institutions consistently emphasized by Austrian economists. But they also include something that is not emphasized as greatly. Internal rule sets have not played a prominent role in Austrian economics in the way that it does in social ontology. The application of internal rule sets expands the scope of investigation to include not only formal and informal institutions, but the orientation of expectations through the employment of mental structures shared in common within particular networks. This provides a decent enough of a model for free individuals in the system to form coalescent plans over time.

Now we are ready to consider briefly some deep structures and their relation to Austrian analysis. The most fundamental aspect of society, I believe, are rules. These include both external rules that set bounds on allowable behavior and internal rules that guide decision-making. Informal norms arise through the interaction of rule sets within a population. Economic agents set out each period (I do not mean period in the homogeneous sense but as a period where there is planning followed by action) to accomplish some activity. It may be to buy a good or to do something as mundane as taking a nap. The ability of an agent to accomplish any activity requires that the agents internal and external rule sets allow for the special space necessary in the social system for actors to form expectation and attempt to make that expectation a reality. We see demonstrated that the other terms fall out of the analysis. Structures, mechanisms, powers, and relations all owe their existence to the interaction of rule sets. Fleetwood argues that “Owing to the existence of a set of deep structures in the form of social rules of conduct [emphasis author], a high degree of compatibility of actions and consequences is ensured, where incompatibility appears [emphasis mine] to be the more likely outcome.” Rules tie together deep structures that bring are responsible for order in society.

Norms, a type of informal rule, arise in order to tie together each individual’s internal rule set. Individual rules are allowed to interact. Rules develop that contain the information made available by a tortuous struggle of trial and error. Especially innovative rules that guide internal and external organizations tend to be adopted while failing rules lack the ability to survive absent a strong incentive for distortion. This is not to suggest that we suffer no loss from failing to adopt rule sets that may generally improve welfare. At least in a free society, if the benefits of a form of organization can be recognized by just one entrepreneur, that entrepreneur has the opportunity to also make the new organization a realization. Continuation of a bad rule set typically requires that the rule is not that costly to those practicing it or that the mode of conduct supported by a rule or rules be implemented through force. The latter case is associated with myriad complications that arise by limiting the span of human behavior in a way that prevents the information generated by that behavior from even coming into existence! That is, the more ways human behavior is restricted by force, the less adaptive the system becomes. Having expressed my point, I leave it to the reader to decide to what extent this approach is compatible with economics: Austrian and otherwise. I am certain that CR perspective will be a dominant method for the creation and discovery of the theory of auto-poetic orders.

* This post is originally for an informal reading group.
**I am currently investigating the CR literature, so my own ignorance may be obvious those more knowledgeable. If you find that I have incorrectly represented any concept, please let me know in the comments.

Thursday, October 23, 2014

Brittney Wheeler at Thoughts on Liberty Need to be Familiar Scholarly Work by Libertarians

Last week I critiqued Brittney Wheeler in her attack on the Federal Reserve Transparency Act. To sum, I find two problems with her argument. 1) She should be more intimately familiar with both literature supporting Fed independence and literature that is written and read by libertarian academics. She may not realize it, but academic libertarians have a substantial and credible literature to draw from. To grow the school of thought, not any argument will do. 2) She fails to outline exactly what policies should be implemented by the Fed. Transparency or a lack thereof, means little without a plan for policy. I suggested that a better position is to eliminate implement transparency and initiate a rule. The Fed would be relegated to acting as a computer and market actors would be able to form accurate expectations about the availability of future liquidity.

Miss Wheeler responded and displayed that she does not seem to understand that by writing a blog called Thoughts on Liberty, she is representing the libertarian brand. I listed off the sources that she should be familiar with if she wants to represent this brand. Furthermore, I outlined a type of argument that she, as a brand bearer, should be making. I don’t think she picked up my point as she didn’t mention anything that I suggested that she read. Instead, she digs her heels in further.

Finally, I have been criticized for using academic research published by the Fed.  However, the same people who reject the Fed’s research could be said to have an ideological bias, but that doesn’t warrant the dismissal of their research.  I see no reason why both are not equally credible. Unless the critics can demonstrate a particular issue with the methodology used in the research, I will stand by its validity. However, if the research I originally cited isn’t enough to convince you of the pitfalls of allowing more congressional influence over monetary policy, here is another academic paper that explains how greater independence helps minimize political pressures and points to the supporting body of research, such asCukierman [sic] (1992) , Fischer (1995) , and Maloney, Pickering, and Hadri (2003). In fact, when the IGM Panel of Economic experts was surveyed regarding a similar bill, 70% disagreed with the idea that this type of audit  would improve the Fed’s legitimacy without hurting its decision making.

Comments like this make me think that Thoughts on Liberty should just be called, Thoughts. Sourcing her argument is an improvement, but falls short of the mark. Again, if you adopt the libertarian brand, which Miss Wheeler and the other blogger at Thoughts on Liberty have done, you need to do a good job of representing the school of thought. If you disagree, that is okay, but you need to demonstrate that you are familiar with these ideas. Again, I invite the girls at Thoughts on Liberty to take a look at my citations from last post. As libertarians, I’m sure they will find the literature appealing. I hope that any libertarian interested in economics spend time sifting through the sources I use throughout my posts.

Saturday, October 11, 2014

A Wacky Attack on the Federal Reserve Transparency Act at Thoughts on Liberty

Over at Thoughts on Liberty, Brittney Wheeler has made some poorly founded claims about Federal Reserve policy and oversight. Usually when I read some bit of foolishness promoted by the ToL crowd regarding liberty, I ignore it because they are arguing about social issues. This recent bit is too much for me sit back and let the authors at ToL continue to spout their ignorance. In this case, Brittney Wheeler needs to spend more time reading about the Federal Reserve, public choice economics, and monetary policy in order to formulate a useful opinion about the Fed. I find the lack of expertise and standards at ToL appalling, given that they are writing for such a broad audience. As usual, the author is bordering on charlatanism in this recent post.

Wheeler has chosen a poor time to defend a lack of transparency at the Fed. Recently, Carmen Segarra exposed officials at the Fed for specially favoring Goldman Sachs. According to USA Today,
In one session on tape, as the examining team was discussing tactics for probing a Goldman deal one of them characterized as "legal but shady," this timidity was on full display.

"I think we don't want to discourage Goldman from disclosing these types of things in the future," said one male participant who remained unidentified in the transcript, "and therefore maybe you know some comment that says don't mistake our inquisitiveness, and our desire to understand more about the marketplace in general, as a criticism of you as a firm necessarily. Like I don't want to, I don't want to hit them on the bat with the head [sic], and they say screw it, we're not gonna disclose it again, we don't need to."
Officials at the Fed were concerned with not offending a bank that they were bailing out. Think about the insanity of this. A large financial firm acts irresponsibly in the market. Not only did the U.S. government socialize the losses, they did not want to offend those responsible for this disaster. Instead of ensuring discipline within the market, they give a poorly behaved firm special treatment! When the Federal Reserve severs the decisions of a firm from the profits and losses that result from those decisions, they destroy market discipline and deal harm to the process by which markets provide information of scarcity and wants to consumers and producers. It is clear that officials are in no position to regulate the financial industry. Wheeler fails to consider this recent fiasco in her post.

Perhaps Miss Wheeler is living under a rock. This would explain why she ignores the recent revelation and argues for maintenance of Fed independence.
Why is the independence of the Federal Reserve important? Why shouldn’t Congress have a hand in monetary policy actions? The Fed was specifically designed to maintain as much independence from the political process as possible… and with good reason! Effective monetary policy must be concerned with long-run goals, not short-term political gain.Although the Fed ultimately does answer to Congress and the people in terms of its mandated goals, there is a difference between being accountable for achieving goals and actually allowing Congress to insert itself into the monetary policy making process.
But what is effective monetary policy? This is where Wheeler finds herself in the mud because she does not understand the topic about which she writes. Her statement also implies that she does not consider, or perhaps, lacks the facility to consider the dynamics and effects of political decision making.

Whether or not the Federal Reserve is independent, policy is decided on a political basis. In one case, firms receive special privileges according to the dictate of Fed officials. In the other case, those in the legislative branch sway policy in favor of interest groups. Of course, reality is a mixture of these cases, probably weighted more toward the first than the second at present. While the second case may be worse than the first – it is difficult to say for sure – robust political economy tells us that the actions of Fed officials today are not appropriately constrained so as to prevent both and provide an outcome better than the one that would likely result in the market. I expect that transparency will be a relatively effective constraint given a robust rules framework.

The appropriate policy decision, then, does not choose only between oversight or no oversight. Oversight is of little help without a robust framework to guide policy. Federal Reserve policy must be guided strictly by a well-defined and well-implemented rule in order to prevent the influence of special interests over monetary policy. Wheeler would be better off arguing that the Fed should be audited, but that any legislation that promotes an audit should also include a provision for a monetary rule. This would neuter the ability of Fed officials to grant special favors to firms and to politicians. And, in line with Hayek’s thesis in The Constitution of Liberty, this type of regime would make the consequences of one’s actions more predictable. As he writes early in the book,
This is possible only by the state’s protecting known private spheres of the individuals against interference by others and delimiting these private spheres, not by specific assignation, but by creating conditions under which the individual can determine his own sphere by relying on rules which tell him what the government will do in different types of situations.
If they want to do the world a favor, the authors at ToL should first read the thoughts of their forbearers and understand the deeper substance of the political debates in which they engage. (Wheeler did at least read one academic paper in building her argument.)  At the core of an argument for limited political intervention is a desire for good rules that constrain the behavior of agents both in the private and public spheres. Those rules require transparency in order to be effective. If independence is sacrificed by transparency as a consequence of the Federal Reserve Transparency Act, the independence lost is the sort of independence that allows Fed officials to treat banks like Goldman Sachs as above reproach. This is a type of independence that is not subject to rules. Instrument independence, the type on which Miss Wheeler focuses her post, can be facilitated by the inclusion of George Selgin's five suggestions to guide the form of Fed operations: “(1) abolish the primary dealer system, (2) limit or abolish repos, (3) abandon “Treasuries only,” (4) revive the Term Auction Facility, and (5) stop last-resort discount window lending (312).”

The text I cite from ToL contains an additional problem. Wheeler fails to defend her claim that independence is necessary and sufficient for the Fed to be effective. She needs to consider whether the Fed was effective at all. Instead, she buys into the typical rationale for a central bank,
The Federal Reserve System was created in 1913 with the goal of providing a more stable and flexible monetary and financial system at a time when banking panics were a common occurrence and caused a lot of economic distress.
Really? According to Selgin, Lastrapes, and White, the Fed has caused more volatility than it has helped prevent. Anyone who reads this blog knows that Fed officials engaged in disastrous policies alongside the insane Bank of France during the Great Depression. Even when we remove these years from the record, Selgin, Lastrapes, and White show that the Fed regime has performed about as well as pre-Fed arrangements. The pre-Roosevelt Fed was had a high degree of independence, but this did not stop the implementation of destructive policies that ushered in the Great Depression. I hope that Miss Wheeler can see how the stated purpose of the Federal Reserve differs from its actual consequences. Let's not be given to the nirvana fallacy. Miss Wheeler would also benefit from reading Timberlake to understand the central bank role of clearinghouse associations before the establishment of the Fed.

Finally, Wheeler fails to show the reader what effective monetary policy looks like. As I have shown in the final section of “Whither Gold?”, good policy is both predictable and makes the monetary base respond to changes in demand for base money. As long as we the Fed exists, its actions should be limited to facilitating changes in demand for base money and thus provide a nominal anchor much like the gold standard provided. For this rule to be executed successfully requires increased transparency at the Fed. In other words, we cannot be sure monetary policy is effective unless we know the rationale behind the implementation of those policies. In the case of a nominal income level target, the rationale comes from Say’s identity and the equation of exchange. If implemented as a policy rule within the framework of the Federal Reserve Transperency Act environment, there is a much greater probability that the rule will be implemented properly.

Summing up, implementation of a good rule is not possible without transparency - the type which the Federal Reserve Transparency Act promotes. Given the special treatment of Goldman Sachs in the recent crisis, it is critical that we implement both a good policy rule and framework for transparency. These cannot be treated separately. Wheeler should not be arguing that the Federal Reserve Transparency Act is going to hurt the efficacy of monetary policy. She should argue that transparency must include a rule so that market actors can form more accurate expectations.

Monday, October 6, 2014

Two Roads?: Endogeneity of Credit, Expectations, and Fed Activism

Like gold, credit is subject to laws of supply and demand. Since it doubles as money, its quantity can adjust to alleviate an excess demand for money assuming that expansion is not limited by elevated credit risk. We can expect credit markets to conform more closely to the classical model if policy uncertainty is reduced (Koppl 2002, 184-194).[1] A consistent rule like nominal income targeting would help limit some of this risk by stabilizing expectations about monetary policy. Not only does the base money supply become responsive to demand under a nominal income target regime; credit markets become more flexible too. In what follows, I will outline the operation of credit markets as would occur absent outside interference. I will also analyze the effects of central bank activism and of regulation of credit on the responsiveness of credit markets to demand for money.

The relationship of credit and an endogenous money stock has long been recognized (Thornton 1939; Wicksell 1936; Hawtrey 1919). The response of credit to an increased demand for money is not only an empirical observation. As Glasner aptly points out, “nominal balances [of banks] fluctuated with ‘the needs of trade.’ . . . The law of reflux, in fact, is equivalent to Say’s Identity (1985, 47).” Much like the response of the gold production to an increase in the price of gold, an increased demand for money is concomitant with a rise in demand for money-like substitutes. Financial intermediaries respond to this demand by lowering reserve ratios and expanding their balance sheets (Leijonhufvud 1979; Gorton and Pennacchi 1990; Selgin and White 1994; White 1999).

For clarification, we can imagine a scenario where credit creation helps overcome a shortfall in aggregate demand. Consider an economy that is at the bottom of an economic depression. Prices are still falling, but production and employment have finally begun to increase. Sensing a rise in optimism, entrepreneurs begin to attract investment into new projects.[2] During the depression, banks had to increase their reserve levels in order to maintain solvency. Now that the outlook has improved, banks that survived the spike in defaults begin to increase net investment. They provide the money necessary for entrepreneurs to employ inputs left idle by the depression. Once economic volatility subsides enough to allow the expectations of investors and entrepreneurs to converge to a great enough extent, the former will extend credit to the latter. As realistic plans for a new ordering of resources emerge, output begins to increase and relieve the shortfall in demand.

In recent years, the Federal Reserve, under the chairmanship of Ben Bernanke, has failed to lead the economy into a robust recovery. Instead, the Bernanke Fed has taken on unprecedented roles as a financial regulator and credit allocator (Hummel 2012). Furthermore, the payment of interest on excess reserves has served to incentivize the persistence of low market rates of interest. Increased uncertainty is evidenced increased demand for liquidity as near zero returns on U.S. treasury bills and an elevated spread between these and treasury bonds reflect (U.S. Treasury). Due in part to policy uncertainty and in part to perverse incentives from risk free returns, creditors are more risk averse than usual. Since the start of the crisis in 2008, there has been drop in both the level and rate of growth of bank credit at all commercial banks (see FRED). This is true even as the recession ended 5 years ago. Given an increase in Fed activism under Bernanke, banks were better off lending only to the highest quality borrowers, investing in treasury bills, or leaving excess reserves on account at the Federal Reserve to collect interest.[3]

This pattern of policy activism has increased uncertainty.[4] Every time the officials at the Federal Reserve adopt an unexpected policy, market actors must recoordinate their actions to match these new circumstances. If these actors begin to expect numerous changes in policy within a certain time period but are unsure of what those policies will be, they will limit risky activity and the length of investment. In the case of banks, intermediaries will refuse to offer loans to borrowers to whom they would otherwise lend. As banking activity slows due to uncertainty, credit markets are less able to relieve an excess demand for money. Anemic economic growth results.

[1] Roger Koppl argues, “Fed activism did induce instability in money demand. The Fed should not abandon money supply targets, but should pursue them according to a fixed rule.”
[2] This story is consistent with the “stylized facts” of the business cycle. SeeSnowden and Vane (2005).
[3] During the crisis, inflation hedging waned as liquidity preference increased (Gurnayaka, Sack, and Wright 2010, 89).
[4] Ironically, Bernanke cited the importance of a “clear and credible commitments about future policy actions [author’s emphasis].” Cited in Espinosa (2012).