Conventional Thinking at the Brink (by Clark Johnson)

From the day I started my blog I have always been happy to invite other economists to contribute to my blog with guest posts.

Today I can present something even better than a guest post. Today I can present a new paper by Clark Johnson – “Conventional Thinking at the Brink: Comments on Ben Bernanke’s The Federal Reserve and the Financial Crisis (2013)”. Clark in his great paper comments on Ben Bernanke’s book “The Federal Reserve and the Financial Crisis”. 

While I obviously do not agree with all of Clark’s points the paper is as usual very informative and insightful. Clark remains an extremely knowledgeable scholar with a deep insight into particularly monetary history.

Enjoy! You can read Clark’s paper here.

Lars Christensen

PS I have earlier published Clark Johnson’s paper “Keynes: Evidence for Monetary Policy Ineffectiveness?”

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Clark Johnson on “Keynes: Evidence for Monetary Policy Ineffectiveness?”

Over the last couple of days we have published four guest posts by Clark Johnson on “Keynes:  Evidence for Monetary Policy Ineffectiveness?”. Here you can read the paper in its entirety.

Clark, thank you for your contribution to my blog. I am sure my readers have enjoyed it as much as me.

PS here is Keynes celebrating the UK giving up the gold standard in 1931. Unfortunately at the time her wrote General Theory (1936) he had forgot about how powerful monetary policy can be and instead as Clark has so clearly demonstrated advocated the use of fiscal policy. Maybe the problem was that Keynes thought that devaluation of the pund worked through a competitiveness channel rather than through an increase in the money supply and money velocity. See more on that topic here and here.

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 4, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

EQUILIBRIUM WITH UNEMPLOYMENT

Keynes essential claim in the General Theory was that unemployment could persist for years, even if wages and other factor costs were flexible.  The point was that even if factor costs fell, the marginal efficiency of capital might not recover because it was driven by market expectations — which were volatile, and trending downward.  Falling costs might even be taken, not as restorative, but as evidence of weak demand and sagging investment prospects.  Investment might then stay below the level needed to maintain full employment.  Keynes was not claiming that general equilibrium was maintained in the face of unemployment, as critics were later to assert.  He used the term “equilibrium” more modestly to mean that unemployment could persist, and that it was not self-correcting.

Keynes never really explained why he thought monetary policy worked mainly through its effect on interest rates, rather than directly on demand.  This paper suggests the hypothesis that he saw accumulation of physical capital as inexorably leading to lower capital efficiency and declining profits.  With this premise, an attempt to reboot investment by increasing money and prices – even if it succeeded in the short run — would just mean more rapid accumulation of capital, and hence more rapid decline in profits, in a self-reinforcing stagnationist circle.  This conclusion was falsifiable, and has been falsified.  To be fair, it pushes Keynes’ suppositions to the edge of what his text might support, and Keynes never wrote it down, not in so many words.

Keynes was more inclined to dodge the whole topic, either by indirection or deliberately.  The best example of his dodge on monetary factors comes near the beginning of the General Theory, where Keynes quotes John Stuart Mill’s description of Say’s Law, the classical doctrine according to which “supply creates its own demand.”  Keynes sets up Say’s Law as a counterpoint for his own theoretical grand design.  Keynes quoted Mill to demonstrate that “classical” economists thought it possible to “double the purchasing power” merely by “doub[ling] the supply of commodities in every market.”[1]  Astonishingly, Keynes then chopped off the rest of Mill’s paragraph, in which was included –

…money is a commodity; and if all commodities are supposed to be doubled in quantity, we must suppose money to be doubled too, and then prices would no more fall than values would.[2]

Algebraically, an excess supply in one market must be matched by an excess demand in another.  A shortfall of demand for goods implies a matching excess (unsatisfied) demand for money.  Mill and other Classics recognized this – it was not Mill but Keynes who typically neglected discussion of such monetary dynamics.  Mundell highlighted this omission decades ago:

…Keynes perpetrated an historical error in the economics profession lasting several years, a distortion of the classical position that to this day remains in the elementary textbooks.  By thus attacking the logic of the central feature of the classical theory through carelessness or mischievous omission of its essential parts, Keynes was able to win disciples over to the belief that there was a fatal logical defect, an absurd premise, in the classical system.[3]

With somewhat more effect, Keynes did provide a critique of the conventional Quantity Theory   of money – which he had himself endorsed in his earlier Tract on Monetary Reform.  In the Treatise, he argued the case over several chapters that some cost and other factor price increases were tied directly to increases in the quantity of money, while price increases that feed into profits might be less correlated with changes in the money supply.  Indeed, where demand for money increases, a higher quantity of money might even correlate with lower aggregate profits and hence with lower prices.[4] Slaying the Quantity Theory, so to speak, was important to many of Keynes’ early followers, in whose understanding it opened the way to an active role for the State and to deploying an array of fiscal “multipliers.”

It is otherwise less important.  Monetary economics has by now moved past the Quantity Theory, or growth of the money supply, as a policy marker.  Lars Svensson and Scott Sumner recommend that central banks stabilize expectations by targeting a steady rate of growth in Nominal GDP.  Svensson has written that Milton Friedman told him late in his life that monetarists should target nominal GDP rather than growth in the money supply.[5]  I would qualify their recommendation with the suggestion, given the dollar’s role as the world economy’s key liquid asset, that US monetary authorities should also target foreign exchange rates during financial crises, especially the dollar-euro rate.  But nothing about moving beyond the Quantity Theory makes monetary policy less important, or makes interest rates the only channel, or they main channel, through which it can be effective.

The historical illustrations in the opening section suggest that economic slumps and unemployment persisted because effective monetary expansion did not occur.  This was true even where interest rates were already very low and where the marginal efficiency of capital was falling sharply.  The de-stabilizing factor was inept monetary policy, or inability to change such arrangements as the international gold standard.  The irony is that Keynes, the acclaimed revolutionary of Depression economics, had so little to say about the uses of monetary policy when interest rates fell to historic lows and anticipated investment returns went even lower.  Perhaps this was because he sought changes in the relationship between State and Market for which considerations of monetary economics were a distraction.

But faced with the aftermath of the 2008 financial sector crisis and the ongoing Euro-zone crisis, we should avoid such distraction.


[1] General Theory, p. 18.

[2] J. S. Mill, Principles of Political Economy, 1909 edition; p. 558.)

[3] Mundell, Man and Economics, 1968; p. 110

[4] See also, General Theory, pp. 208-209.

[5] Lars E.O. Svensson, What have economists learned about monetary policy over the past 50 years?  January 2008.  At http://www.princeton.edu/svensson/papers/Buba%20709.pdf

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 2, by Clark Johnson)

Guest post: Part 2 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the previous post in this series here)

a)    The 1937-38 Contraction in the US

A few years later, Keynes disregarded evidence of the role of monetary policy in triggering a sharp relapse into near-depression conditions in the US during 1937-1938.  The dollar depreciation of 1933 and the formal increase of the gold price to $35/ ounce in 1934 meant automatic revaluation of central bank gold stocks and gave impetus to increased gold exploration and production – concentrated, as it happened, in the Soviet Union.  (Keynes noted the irony that increased Soviet efficiency in mining of gold was bailing out world capitalism!) He also noted that new gold reserves were bringing increased effective demand to the world economy that might result in “abnormal profits.” [1]  Keynes understood (at least some of the time) the role of growing liquidity in the economic recovery of the mid-1930s.

In what now appears as one of the worst mis-steps in its history, the Federal Reserve, responded to rising wholesale prices in 1936 by deliberately sterilizing new gold inflows.[2]  A money supply measure (M2) that increased by 12 percent annually during 1934 -1936, suddenly turned flat and even slightly negative from about January 1937 to July 1938.[3]  Real GDP fell by 11 percent during this period, and industrial production fell by 30 percent.  Rather than sterilize gold, had the Fed intervened in financial markets to target a modest rate of increase in any of a number of variables – a price index, industrial production, either real or nominal GDP growth, even a money supply indicator – most of the 1937-1938 contraction could have been avoided.  By August 1938, the sterilization policy was jettisoned, and economic recovery resumed.

In February 1938, Keynes offered advice in a private letter to President Roosevelt that mentioned little of this.  He did acknowledge that addressing “credit and insolvency problems” was an essential step toward recovery, as this created a necessary “supply of credit” – while, one infers, demand for that credit would have to come from elsewhere.  This comment reflected Keynes’ ongoing view that expected returns on investment – the schedule of marginal efficiencies of capital — was independent of monetary policy.  He went on the recommend that the US could “maintain prosperity at a reasonable level” only through “large-scale recourse to … public works and other Investments aided by Government funds or guarantees.” [4]

Despite Keynes’ recommendations, the lesson of all four of the illustrations here is that increasing money balances – through open market purchases, or through new gold or foreign exchange reserves – does affect expected returns on investment in plant and equipment, in equities, and in real estate.

ARGUMENTS FOR FISCAL  ACTIVISM

We could stop here, having assembled evidence of Keynes’ dubious conclusions about relative un-importance of monetary factors in specific pivotal events.  Indeed, evidence from these cases points strongly in the opposite direction, toward the crucial role of such factors.  But the prominence of Keynes’ fiscalist legacy requires that we go further.   Evidence aside, what was Keynes’ argument?   In fact, he had a sequence of arguments.

In 1929, Keynes offered a comparative argument in favor of fiscal stimulus, and against monetary stimulus, specific to economic circumstances in Britain at the time.[5]  Keynes anticipated some portion of an argument Robert Mundell was to make decades later regarding the “policy mix,” that is, the appropriate mix of monetary and fiscal policy to meet both domestic output and external exchange rate targets.[6]  Britain in 1929 was on the international gold standard, hence was constrained externally by the need to maintain gold reserves.  The Bank of England could not simply create credit, because, Keynes reasoned, “such credit might find its way to foreign borrowers, with the result of a drain of gold out of the Bank.”  Hence Keynes proposed fiscal stimulus to increase domestic demand and employment, alongside monetary constraint to maintain Britain’s reserve and exchange rate targets.

This well-grounded argument also offers possible insight into the 1890s, where demand for gold reserves among central banks generated monetary contraction.  Keynes, as we saw, did not make that argument – but we can construct it post facto.  While the best solution might have been some international agreement to increase demand by modifying the international gold standard, a purely national approach could have looked to a fiscalist demand boost.  But Keynes soon abandoned this policy-mix argument.

a)    Removing external constraint on Monetary Policy

The US had freedom of action in monetary policy in 1933 and 1934.  By March 1933, the dollar had been floated against gold, hence removing the external policy constraint – and, in any event, the US had by then accumulated vast gold reserves.  In Keynes’ comments in January 1934, he had moved beyond his 1929 analysis.  His newer interest was to argue that fiscal activism was preferable to monetary expansion even if the latter was not constrained.

Keynes in the General Theory (Ch. 15, “Incentives to Liquidity,”) offered the argument that monetary policy was specifically unsuited to boost economic demand when interest rates approached zero percent.  In conditions where interest rates could not be lowered further, he reasoned, a condition of “absolute liquidity preference” held, later dubbed a “liquidity trap.”  He observed, “In this event, the monetary authority would have lost effective control over the rate of interest.”  This argument is cited endlessly by later-day Keynesians in support of a fiscalist agenda.  (For example, see the reference to Summers mentioned at the outset.)

But the argument establishes much less than Keynes needed for his fiscalist agenda.  Near-zero interest rates did not prevail in any of the four situations discussed earlier – yet Keynes wanted fiscal activism in all of them.  So his case against monetary activism went beyond situations of absolute liquidity preference.

As noted earlier, Keynes pointed to a collapse in the marginal efficiency of capital as the trigger for the “slump of 1930.”  The General Theory does much more to advance the concept that investment volume is unstable.   Much of Keynes’ vision for government intervention, including fiscal activism, follows from his discussion of the fickleness of financial markets (Ch. 12, “Long Term Expectations.”)  Noting the instability of private sector investment volume, he advocated a larger role by the government in stabilizing investment demand, often through direct outlays.

Keynes’ argument often shifted from the instability of the investment function to concern that investment was and would remain chronically weak – hence the conclusion that high unemployment was not self-correcting, but could persist for years.  In Ch. 17 on the “Essential Properties of Interest and Money,” Keynes noted situations where the:

…rate of interest declines more slowly, as output increases, than the marginal efficiencies of capital-assets measured in terms [of the same asset].[7]

As formulated in one of several instances in Ch. 22 (“Notes on the Trade Cycle”):

A more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.[8]

This pattern of falling marginal efficiencies of capital made Keynes increasingly skeptical of monetary remedies.[9]

A counter-argument is that adding liquidity – through open market purchases, gold inflows, or variations on these – might directly boost demand, and hence boost the marginal efficiency of capital, by increasing cash balances.  But Keynes usually argued, to the contrary, that monetary policy worked mainly through raising or lowering interest rates –this was certainly a premise of the “liquidity trap” argument in Ch. 15.  Further on, he wrote that “the primary effect of a change in the quantity of money on the quantity of effective demand is through its effect on the rate of interest.”[10]  In the Treatise chapter on “Control of Investment,” where he calls for open market operations a outrance, the goal is to bring “the market rate of interest … down to the limiting point.”  In 1937 articles on “finance,” where Keynes stressed the crucial role of monetary policy, he again emphasized the channel of lowering interest rates.[11]


[1] Keynes, “The Supply of Gold,” Economic Journal, Sept 1936.

[2] That is, coupling purchases of gold with offsetting sales of other central bank assets to drain liquidity

[3] Doug Irwin, Gold Sterilization and the Recession of 1937-1938,  NBER Working Paper No. 17595, Nov 2011.

[4] In Collected Works of JM Keynes, Vol 21, pp. 434-39.

[5] Keynes, “A Program of Expansion (General Election, May 1929),” in Essays on Persuasion (1931), p. 124f.

[6] For ex., Robert Mundell, The Dollar and the Policy Mix (1973)

[7]Keynes, General Theory of Employment, Interest, and Money (1936), p. 236.

[8] General Theory, p. 315.

[9] Axel Leijonhufvud offers a variation on this argument with the comment that in in Ch. 37 of the Treatise “the assumption that entrepreneurs are right was dispensed with” – that is, entrepreneurs became, in Keynes’ judgment, excessively bearish.  In “Keynes and the Effectiveness of Monetary Policy,” Information and Coordination (1981).  Leijonhufvud argues that Keynes’ subsequent arguments therefore relied more on fiscal intervention.

[10] General Theory, p. 298.

[11] For ex.,Keynes, “The ‘Ex Ante’ Theory of the Rate of Interest,” Economic Journal 46 (1937)

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 1, by Clark Johnson)

I am extremely happy to announce that my blog this week will feature four guest posts by Clark Johnson. I have for some time tried to convince Clark to write something for my blog so I was very happy when Clark’s manuscript for his paper Keynes:  Evidence for Monetary Policy Ineffectiveness?” arrived in my in-box recently. Clark and I have decided to split up the paper in four parts which will be published in the coming four days.

Clark Johnson is not only a brilliant economic historian and author of the great book “Gold, France, and the Great Depression, 1919-1932″, but he is also a clever observer of the current monetary policy debate. Clark last year authored an insightful paper on the causes of the Great Recession, which in my view already is a Market Monetarist classic.

Lars Christensen

Guest post 

Keynes:  Evidence for Monetary Policy Ineffectiveness? (Part 1)

by Clark Johnson

Lawrence Summers, who was President Obama’s chief economist during 2009-2010, and who by accounts continues to be an important advisor, recently called on the US and other government to increase borrowing at current very low interest rates.[1]  He observes that, based on inflation-protected bond rates, current Treasury borrowing costs for securities of five and ten year maturities are negative.  He adds that interest rates elsewhere in the world – Germany, Japan, and Britain – are also extremely low.  He then argues that governments should look on such rates as an opportunity to borrow cheaply and thereby improve their long-term fiscal positions.

Summers is presumably correct from a fiscal management perspective about benefits of borrowing when interest rates are low.  But as a macroeconomic strategy for recovery, that is only the beginning.  Whether we turn to John Taylor on the right or Paul Krugman on the left, the essential element for fiscal stimulus to succeed is to stabilize expectations: will the stimulus continue for long enough to drive expectations, so that market participants know the boost will ongoing and not soon withdrawn?    Summers’ then shifts to monetary policy, where his case is weaker.  He says there is no point in “quantitative easing”, the open-market mechanism the Federal Reserve uses to inject reserves, as interest rates are already rock-bottom – and monetary easing works, he explains, through the mechanism of lowering interest rates.  Presumably, this is what he has been telling Obama since 2009.

Summers’ reasoning draws at least in part, on John Maynard Keynes’ discussion about “absolute liquidity preference” that occur when interest rates are very low, and demonstrates a key argument used in policy circles against more aggressive use of monetary policy.   I believe Keynes was, and Summers is, mistaken.  Literature on Keynes is abundant.  To gain a different perspective, I want to look at various evidence Keynes adduced against monetary remedies.  I will then return to arguments he used in the General Theory (1936) and elsewhere, hopefully with fresh perspectives.

KEYNES’  ILLUSTRATIONS FOR MONETARY POLICY INEFFECTIVENESS

A portion of Keynes’ reputation as an economist, and of his place in history, rest on his diagnoses of crisis situations and his proposed remedies.  Well-known examples include his tract on the post-World War One Versailles Conference, The Economic Consequences of the Peace (1921), and subsequent writings on hyperinflations and then on British deflation during the 1920s.   Another, less well-known, was his discussion of French monetary and political crises during 1925 and 1926, which I credited in my own work on the period.[2]  His two-volume Treatise on Money (1930) provided detailed and often shrewd observations on a wide range of economic policy matters.

In contrast, the General Theory, the heart of Keynes’ contribution to economic ideas, is light on historical or even contemporary illustration.  So the reader seeks to fill in the gaps by turning to other writings.  Consider four prominent cases as they reflect on Keynes’ view of roles of monetary and fiscal policy.

a)    British Deflation in the 1890s

An unexpected embrace of fiscal activism comes in the Treatise discussion of the deflation of the early 1890s, where Keynes argued that the Bank of England’s gold reserves were abundant and credit was easy.  But prices in Britain and the world nevertheless went into decline, which undermined profit and investment and reduced employment.  He wrote:

I consider, therefore, that the history of this period [1890-1896] is a perfect example of a prolonged Commodity Deflation – developing and persisting in spite of a great increase in the total volume of Bank-Money.  There has been no other case where one can trace so clearly the effects of a prolonged withdrawal of entrepreneurs from undertaking the production of new fixed capital on a scale commensurate with current savings.

Keynes then concluded (anticipating his arguments a few years later, including in the General Theory,) that monetary expansion does not always work, and that there might therefore be a role for public investment projects to boost demand.[3]

Keynes’ discussion of the 1890s misses the point.  Britain in the late nineteenth century was part of an open world economy, with easy movement of goods, people, and especially capital.  Keynes neglected to mention that system-wide demand for gold rose much more than the supply from the 1870s through the 1890s as nearly two dozen countries adopted or re-adopted the gold standard, and hence needed to accumulate reserves.  Indeed, demand drove the commodity-exchange value of gold to the highest level it was to reach in four centuries of record-keeping[4] — the flip-side of commodity price deflation.  The commodity price decline reduced profits and chilled investment demand; but commodity prices were determined in international markets, not in Britain.

While demand for gold was surging, the world’s monetary gold supply in the mid-1890s was at its lowest point it was ever to reach relative to its 1800-1920 trend line.[5]  As the mines in the South African Rand cranked up production in the 1890s, relative gold supply and commodity prices increased, nearly in tandem after 1896 – thus ending the Commodity Deflation, and initiating a gentle inflation.  A growing money stock affected not just the supply of credit (as reflected in a declining interest rate), but also the demand for it.  A result was nearly two decades of economic growth in all of the industrial powers, which was sadly interrupted by the First World War.

Monetary events were at the heart of both the origins of and recovery from the depression of the early 1890s.  Keynes himself gave this backhand acknowledgement with his comment a few paragraphs later that, “the fall of prices [in the early 1890s] could only have been avoided by a much greater expansion of the volume of bank-money.”  It is revealing that Keynes could discuss price trends during that period without mentioning the geographic expansion of the gold standard – easily the most important monetary development of the era.

b)    The onset of the Great Depression

Moving to then contemporary events, Keynes’ discussion of the “slump of 1930,” also in the Treatise, builds on similar themes.[6]  Gustav Cassel and Ralph Hawtrey had argued a few years earlier that the undervaluation of gold following restoration of gold standards at prewar gold prices would force world-wide monetary contraction, especially as former belligerents Britain, France, Germany, and Italy restored their gold standards.   Keynes, in contrast, told the Royal Commission on Indian Currency in 1926 that central banks would adjust their currency reserve cover ratios if  their gold stocks became inadequate – which allowed him to dismiss the danger.  Keynes underestimated what we might call the mystique of gold money.

Keynes listed factors driving interest rates higher during the 1920s: corporate borrowing for new industries; governments borrowing to pay reparations and war debts; central banks borrowing to add reserves; and speculators borrowing to buy shares of stock.  He identified but was less able to explain the collapse internationally in anticipated returns in investment – what he would later call the marginal efficiency of capital — that occurred in the mid-1920s.  As in considering the early 1890s, he did not connect the fall-off in real yields on new investment with systemic monetary constraint.  Parallel to what happened in the 1890s, the middle and late 1920s saw a commodity deflation as key countries adopted or returned to gold standards.  He thought monetary expansion worked through lowering interest rates, without directly affecting demand for goods and services.  He wrote that the only ways to boost demand were by lowering interest rates, especially long rates, further – or by government fiscal activism.  He did not understand that the world required a higher gold price to restore gold-to-currency reserve ratios, or perhaps needed a departure from gold money altogether.

c)     The Roosevelt Recovery in 1933

Keynes’ comments in January 1934 on the monetary-fiscal mix in the US were baffling.  In one of his initial acts after Roosevelt’s accession to power in March 1933, the dollar was allowed to depreciate against gold.  This was a momentous event in monetary history – the underlying cause of the interwar deflation had been removed, and the gold standard was never restored with the same conviction.  Keynes nevertheless wrote:

One half of [Roosevelt’s] programme has consisted in abandoning the gold standard, which was probably wise, and in taking various measures … to depreciate the gold value of the dollar… [But i]t is not easy to bring about business expansion merely by monetary manipulation.  The other half of his programme, however, is infinitely more important and offers in my opinion much greater hopes.  I mean the effort to cure unemployment by large-scale expenditure on public works and similar purposes.[7]

This summary scarcely acknowledges the results of the real-time experiment in expansionary monetary policy undertaken in the US within the previous year.  Depreciation succeeded at least to the extent any advocate could have hoped.  Industrial production soared by 57 percent during the first four months of the Roosevelt Administration beginning in March 1933 – this was the actual increase, not an annualized rate — making up half of what had been lost since 1929.  It was the fastest four-month rate of expansion in industrial production in the history of the US. Yet Keynes apparently considered this event to be “infinitely” less important than the boost to come from fiscal borrowing for public works programs.

Had the experiment continued for a few months more, pre-crash production levels might have been recovered.  Unfortunately, the NIRA (National Industrial Recovery Act, announced in July 1933, brought micro-policy changes that had the effect of stopping the recovery in its tracks.  The NRA (National Recovery Administration), set up under NIRA, then negotiated specific sets of codes with leaders of the nation’s major industries; the most important provisions were anti-deflationary floors below which no company would lower prices or wages, and agreements on maintaining employment and production. Within a short time, the NRA reached agreements with most major industries. In a phrase, the NIRA wanted to increase prices by restricting output rather than by increasing demand.   Scott Sumner provides several rounds of evidence for the contractionary impact of NIRA policy in his soon-to-arrive book, The Midas Curse: Gold, Wages, and the Great Depression.

Lest this appear suspect as a predictable right-wing narrative of the New Deal, consider that Keynes himself pointed to the “fallacy” of the NRA approach: He noted that “rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.”  He added that it was “hard to detect any material aid to recovery in the National Industrial Recovery Act.”[8]  Within six months after the NRA went into effect, industrial production had dropped twenty-five percent,[9] erasing nearly half of the gains recorded during Roosevelt’s more successful initial months in office.

So here we are.  We saw an historically sharp recovery for four months during 1933, driven almost entirely by a decision to break the straightjacket imposed on monetary policy by the international gold standard.  Keynes had previously been an able critic of the gold standard, for example in the Tract on Monetary Reform (1923) and then in several chapters in the Treatise. The 1933 recovery was then stalled by micro-policies of which he was explicitly critical.  Yet Keynes seemed to dismiss this entire episode in his call a few months later for fiscal stimulus!


[1] Lawrence Summers, “Look beyond interest rates to get out of the gloom,” Financial Times, 3 June 2012

[2] H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932  (Yale, 1997)

[3] John Maynard Keynes, Treatise on Money (1930), Ch. 30 (ii).

[4] Roy Jastram, The Golden Constant (1977)

[5] League of Nations chart, reproduced in Johnson, p. 52.

[6] Treatise, Ch. 37 (iv) “The Slump of 1930.”

[7] Keynes, “Roosevelt’s Economic Experiments,” The Listener, 17 January, 1934.

[8] Keynes, “Mr. Roosevelt’s Experiments,” London Times, 02 Jan 1934.

Greek and French political news slipped into the financial section

The political effects of monetary strangulation never fails to show up. That was the case during the 1930s and that is the case today.

The European political news over the weekend: Socialist  Francois Hollande won the second round of the French presidential elections on an anti-austerity platform and in Greece the mainstream political parties took a major beating with extremist parties doing extremely well in yesterday’s Greek parliament vote.

The radical-leftist grouping Syriza is now the second largest party in the Greek parliament with 16.7% of the vote. The effectively neo-nazi party Golden Dawn Party won 7% and will now for the first time be represented in the Greek parliament. (I dare you to have a look at Golden Dawn’s logo…scary)

It does not exactly look like the “reform-through-tight-money” policy is working…just have a look at the European markets today…

PS The outcome of the French presidential election reminded me of what happened in France during the Great Depression. If you are interested in that topic you should have a look at Clark Johnson’s classic “Gold, France and the Great Depression”.

I am blaming Murray Rothbard for my writer’s block

I have promised to write an article about monetary explanations for the Great Depression for the Danish libertarian magazine Libertas (in Danish). The deadline was yesterday. It should be easy to write it because it is about stuff that I am very familiar with. Friedman’s and Schwartz’s “Monetary History”, Clark Warburton’s early monetarist writings on the Great Depression. Cassel’s and Hawtrey’s account of the (insane) French central bank’s excessive gold demand and how that caused gold prices to spike and effective lead to an tigthening of global monetary conditions. This explanation has of course been picked up by my Market Monetarists friends – Scott Sumner (in his excellent, but unpublished book on the Great Depression), Clark Johnson’s fantastic account of French monetary history in his book “Gold, France and the Great Depression, 1919-1932″ and super star economic historian Douglas Irwin.

But I didn’t finnish the paper yet. I simply have a writer’s block. Well, that is not entirely true as I have no problem writing these lines. But I have a problem writing about the Austrian school’s explanation for the Great Depression and I particularly have a problem writing about Murray Rothbard’s account of the Great Depression. I have been rereading his famous book “America’s Great Depression” and frankly speaking – it is not too impressive. And that is what gives me the problem – I do not want to be too hard on the Austrian explanation of the Great Depression, but dear friends the Austrians are deadly wrong about the Great Depression – maybe even more wrong than Keynes! Yes, even more wrong than Keynes – and he was certainly very wrong.

So what is the problem? Well, Rothbard is arguing that US money supply growth was excessive during the 1920s. Rothbard’s own measure of the money supply  apparently grew by 7% y/y on average from 1921 to 1929. That according to Rothbard was insanely loose monetary policy. But was it? First of all, money supply growth was the strongest in the early years following the near-Depression of 1920-21. Hence, most of the “excessive” growth in the money supply was simply filling the gap created by the Federal Reserve’s excessive tightening in 1920-21. Furthermore, in the second half of the 1920s money supply started to slow relatively fast. I therefore find it very hard to argue as Rothbard do that US monetary policy in anyway can be described as being very loose during the 1920s. Yes, monetary conditions probably became too loose around 1925-7, but that in no way can explain the kind of collapse in economic activity that the world and particularly the US saw from 1929 to 1933 – Roosevelt finally did the right thing and gave up the gold standard in 1933 and monetary easing pulled the US out of the crisis (later to return again in 1937). Yes dear Austrians, FDR might have been a quasi-socialist, but giving up the gold standard was the right thing to do and no we don’t want it back!

But why did the money supply grow during the 1920s? Rothbard – the libertarian freedom-loving anarchist blame the private banks! The banks were to blame as they were engaging in “pure evil” – fractional reserve banking. It is interesting to read Rothbard’s account of the behaviour of banks. One nearly gets reminded of the Occupy Wall Street crowd. Lending is seen as evil – in fact fractional reserve banking is fraud according to Rothbard. How a clever man like Rothbard came to that conclusion continues to puzzle me, but the fact is that the words “prohibit” and “ban” fill the pages of Rothbard’s account of the Great Depression. The anarchist libertarian Rothbard blame the Great Depression on the fact that US policy makers did not BAN fractional reserve banking. Can’t anybody see the the irony here?

Austrians like Rothbard claim that fractional reserve banking is fraud. So the practice of private banks in a free market is fraud even if the bank’s depositors are well aware of the fact that banks do not hold 100% reserve? Rothbard normally assumes that individuals are rational and it must follow from simple deduction that if you get paid interest rates on your deposits then that must mean that the bank is not holding 100% reserves otherwise the bank would be asking you for a fee for keeping your money safe. But apparently Rothbard do not think that individuals can figure that out. I could go on and on about how none-economic Rothbard’s arguments are – dare I say how anti-praxeological Rothbard’s fraud ideas are. Of course fractional reserve banking is not fraud. It is a free market phenomenon. However, don’t take my word for it. You better read George Selgin’s and Larry White’s 1996 article on the topic “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”. George and Larry in that article also brilliantly shows that Rothbard’s view on fractional reserve banking is in conflict with his own property right’s theory:

“Fractional-reserve banking arrangements cannot then be inherently or inescapably fraudulent. Whether a particular bank is committing a fraud by holding fractional reserves must depend on the terms of the title-transfer agreements between the bank and its customers.

Rothbard (1983a, p. 142) in The Ethics of Liberty gives two examples of fraud, both involving blatant misrepresentations (in one, “A sells B a package which A says contains a radio, and it contains only a pile of scrap metal”). He concludes that “if the entity is not as the seller describes, then fraud and hence implicit theft has taken place.” The consistent application of this view to banking would find that it is fraudulent for a bank to hold fractional reserves if and only if the bank misrepresents itself as holding 100percent reserves, or if the contract expressly calls for the holding of 100 percent reserves.’ If a bank does not represent or expressly oblige itself to hold 100 percent reserves, then fractional reserves do not violate the contractual agreement between the bank and its customer (White 1989, pp. 156-57). (Failure in practice to satisfy a redemption request that the bank is contractually obligated to satisfy does of course constitute a breach of contract.) Outlawing voluntary contractual arrangements that permit fractional reserve-holding is thus an intervention into the market, a restriction on the freedom of contract which is an essential aspect of private property rights.”

Another thing that really is upsetting to me is Rothbard’s claim that Austrian business cycle theory (ABCT) is a general theory. That is a ludicrous claim in my view. Rothbard style ABCT is no way a general theory. First of all it basically describes a closed economy as it is said that monetary policy easing will push down interest rates below the “natural” interest rates (sorry Bill, Scott and David but I think the idea of a natural interest rates is more less useless). But what determines the interest rates in a small open economy like Denmark or Sweden? And why the hell do Austrians keep on talking about the interest rate? By the way interest rates is not the price of money so what do interest rates and monetary easing have to do with each other? Anyway, another thing that mean that ABCT certainly not is a general theory is the explicit assumption in ABCT – particularly in the Rothbardian version – that money enters the economy via the banking sector. I wonder what Rothbard would have said about the hyperinflation in Zimbabwe. I certainly don’t think we can blame fractional reserve banking for the hyperinflation in Zimbabwe.

Anyway, I just needed to get this out so I can get on with writing the article that I promised would be done yesterday!

PS Dear GMU style Austrians – you know I am not talking about you. Clever Austrians like Steve Horwitz would of course not argue against fractional reserve banking and I am sure that he thinks that Friedman’s and Schwartz’s account of the Great Depression makes more sense than “America’s Great Depression”.

PPS not everything Rothbard claims in “America’s Great Depression” is wrong – only his monetary theory and its application to the Great Depression. To quote Selgin again: “To add to the record, I had the privilege of getting to know both Murray and Milton. Like most people who encountered him while in their “Austrian” phase, I found Murray a blast, not the least because of his contempt for non-Misesians of all kinds. Milton, though, was exceedingly gracious and generous to me even back when I really was a self-styled Austrian. For that reason Milton will always seem to me the bigger man, as well as the better monetary economist.”

PPPS David Glasner also have a post discussing the Austrian school’s view of the Great Depression.

Update: Steve Horwitz has a excellent comment on this post over at Coordination Problem and Peter Boettke – also at CP – raises some interesting institutional questions concerning monetary policy and is asking the question whether Market Monetarists have been thinking about these issues (We have!).

Clark Johnson has written what will become a Market Monetarist Classic

As I have written about in an earlier post I am reading Clash Johnson’s book on the Great Depression “Gold, France and the Great Depression”. So far it has proved to be an interesting and insightful book on what (to me) is familiar story of how especially French and US gold hoarding was a major cause for the Great Depression.

Clark Johnson’s explanation of Great Depression is similar to that of two other great historians of the Great Depression Scott Sumner and Douglas Irwin. Both are of course as you know Market Monetarists.

Given Johnson’s “international monetary disorder view” of the Great Depression I have been wondering whether he also had a Market Monetarist explanation for the Great Recession. I now have the answer to that question and it is affirmative – Clark Johnson is indeed a Market Monetarist, which becomes very clear when reading a new paper from the Milken Institute written by Johnson.

One thing I find especially interesting about Johnson’s paper is that he notes the importance of the US dollar as the global reserve currency and this mean that US monetary policy tightening has what Johnson calls “secondary effects” on the global economy. I have long argued that Market Monetarists should have less US centric and more global perspective on the global crisis. Johnson seems to share that view, which is not really surprising given Johnson’s work on the international monetary perspective on the Great Depression.

Johnson presents six myths about monetary policy and the six realities, which debunk these myths. Here are the six myths.

Myth 1: The Federal Reserve has followed a highly expansionary monetary policy since August, 2008.

Johnson argues that US monetary policy has not been expansionary despite the increase in the money base and the key reason for this is a large share of the money base increase happened in the form of a similar increase in bank reserves. This is a result of the fact that the Federal Reserve is paying positive interest rates on excess reserves. This is of course similar to the explanation by other Market Monetarists such as David Beckworth and Scott Sumner. Furthermore, Johnsons notes that the increase that we have seen in broader measure of the money supply mostly reflects increased demand for dollars rather than expansionary monetary policies.

Johnson notes in line with Market Monetarist reasoning: “Monetary policy works best by guiding expectations of growth and prices, rather than by just reacting to events by adjusting short-term interests”.

Myth 2: Recoveries from recessions triggered by financial crises are necessarily low.

Ben Bernanke’s theory of the Great Depression is a “creditist” theory that explains (or rather does not…) the Great Depression as a consequence of the breakdown of financial intermediation. This is also at the core of the present Fed-thinking and as a result the policy reaction has been directed at banking bailouts and injection of capital into the US banking sector. Johnson strongly disagrees (as do other Market Monetarists) with this creditist interpretation of the Great Recession (and the Great Depression for that matter). Johnson correctly notes that the financial markets failed to react positively to the massive US banking bailout known as TARP, but on the other hand the market turned around decisively when the Federal Reserve announced the first round of quantitative easing (QE) in March 2009. This in my view is a very insightful comment and shows some real Market Monetarist inside: This crisis should not be solved through bailouts but via monetary policy tools.

Myth 3: Monetary policy becomes ineffective when short-term interest rates fall close to zero.

If there is an issue that frustrates Market Monetarists then it is the claim that monetary policy is ineffective when short-term rates are close to zero. This is the so-called liquidity trap. Johnson obviously shares this frustration and rightly claims that monetary policy primarily does not work via interest rate changes and that especially expectations are key to the understanding of the monetary transmission mechanism.

Myth 4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

It is a widespread view that the world is now facing a “New Normal” where growth will have to be below previous trend growth due to widespread deleveraging. Johnson quotes David Beckworth on the deleveraging issue as well site Milton Friedman’s empirical research for the fact there is no empirical justification for the “New Normal” view. In fact, the recovery after the crisis dependent on the monetary response to the crisis than on the size of the expansion prior to the crisis.

Myth 5: When money policy breaks down there is a plausible case for a fiscal response.

Recently the Keynesian giants Paul Krugman and Brad DeLong have joined the Market Monetarists in calling for nominal GDP targeting in the US. However, Krugman and DeLong continue to insist on also loosening of US fiscal policy. Market Monetarists, however, remain highly skeptical that a loosening of fiscal policy on its own will have much impact on the outlook for US growth. Clark Johnson shares this view. Johnson’s view on fiscal policy reminds me of Clark Warburton’s position on fiscal policy: fiscal policy only works if it can alter the demand for money. Hence, fiscal policy can work, but basically only through a monetary channel. I hope to do a post on Warburton’s analysis of fiscal policy at a later stage.

Myth 6: The rising prices of food and other commodities are evidence of expansionary policy and inflationary pressure.

It is often claimed that the rise in commodity prices in recent years is due to overly loose US monetary policy. Johnson refute that view and instead correctly notes that commodity price developments are related to growth on Emerging Markets in particular Asia rather than to US monetary policy.

Johnson’s answer: Rate HIKES!

Somewhat surprise after conducting an essentially Market Monetarist analysis of the causes of the Great Recession Clark Johnson comes up with a somewhat surprising policy recommendation – rate hikes! In fact he repeats Robert McKinnon’s suggestion that the four leading central banks of the world (the Federal Reserve, the ECB, the Bank of Japan and the Bank of England) jointly and coordinated increase their key policy rates to 2%.

Frankly, I have a very hard time seeing what an increase interest rates could do to ease monetary conditions in the US or anywhere else and I find it very odd that Clark Johnson is not even discussing changing the institutional set-up regarding monetary policy in the US after an essentially correct analysis of the state US monetary policy. It is especially odd, as Johnson clearly seem to acknowledge the US monetary policy is too tight. That however, does not take anything away from the fact that Clark Johnson has produced a very insightful and interesting paper on the causes for the Great Recession and monetary policy makers and students of monetary theory can learn a lot from reading Clark Johnson’s paper. In fact I think that Johnson’s paper might turnout to become an Market Monetarist classic similar to Robert Hetzel’s “Monetary Policy in the 2008-2009 Recession” and Scott Sumner’s “Real problem is nominal”.

———

Update: Marcus Nunes and David Beckworth also comment on Clark Johnson’s paper. Thanks to both Benjamin “Mr. PR” Cole and Marcus Nunes for letting me know about Johnson’s great paper.

Gold, France and book recommendations

Can you recommend a book that you haven’t read yet? I am not sure, but I will do it anyway. I believe we can learn a lot from the Great Depression and I am especially preoccupied with the international monetary consequences and causes of the Great Depression.

An issue that especially have come to my attention is the hoarding of gold by central bank prior and during the Great Depression and here especially France’s hoarding of gold is interesting and have already blogged about Douglas Irwin’s excellent paper “Did France Cause the Great Depression?”

However, both Scott Sumner and Douglas Irwin have recommend to me that I should read H. Clark Johnson’s book “Gold, France and the Great Depression”. I don’t want to disappoint Scott and Doug – after all they are both big heroes of mine so I better start reading, but I haven’t been able to find the time yet – especially since taking up blogging. Between the day-job and an active family life reading is something I do at very odd hours. That said, I know I will have to read this book. The parts of it I have already read is very interesting and well-written so it is only time that have kept me from reading the book.

Anyway, what I really what to ask my readers is the following: What books have had the biggest influence on your thinking about monetary theory and monetary history? I would love to be able to make a top ten list of monetary must-read books for the readers of this blog. So please give me your input. I will keep asking this question until I got at least 10 books. If you don’t want to put your name out here in the comment section drop me a mail instead: lacsen@gmail.com

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