The biggest cost of nominal stability is ignorance

Anybody who has visited a high inflation country (there are few of those around today, but Belarus is one) will notice that the citizens of that country is highly aware of the developments in nominal variables such as inflation, wage growth, the exchange rates and often also the price of gold and silver.

I am pretty sure that an average Turkish housewife in the Turkish countryside in 1980s would be pretty well aware of the level of inflation, the lira exchange rate both against the dollar and the D-Mark and undoubtedly would know the gold price. This is only naturally as high and volatile inflation had a great impact on the average Turk’s nominal (and real!) income. In fact for most Turks at that time the most important economic decision she would make would be how she would hedge against nominal instability.

The greatest economic crisis in world history always involve nominal instability whether deflation or inflation. Likewise economic prosperity seems to be conditioned on nominal stability.

The problem, however, is that when you have massive nominal instability then everybody realises this, but contrary to this when you have a high degree of monetary stability then households, companies and most important policy makers tend to become ignorant of the importance of monetary policy in ensuring that nominal stability.

I have touched on this topic in a couple of earlier posts. First, I have talked about the “Great Moderation economist” who “grew” up in the Great Moderation era and as a consequence totally disregards the importance of money and therefore come up with pseudo economic theories of the business cycle and inflation. The point is that during the Great Moderation nominal variables in the US and Europe more or less behaved as if the Federal Reserve and the ECB were targeting a NGDP growth level path and therefore basically was no recessions and inflationary problems.

As I argued in another post (“How I would like to teach Econ 101”) the difference between microeconomy and macroeconomy is basically the introduction of money and price rigidities (and aggregation). However, when we target the NGDP level we basically fix MV in the equation of exchange and that means that we de facto “abolish” the macroeconomy. That also means that we effectively do away with recessions and inflationary and deflationary problems. In such a world the economic agents will not have to be concerned about nominal factors. In such a world the only thing that is important is real factors. In a nominally stable world the important economic decisions are what education to get, where to locate, how many hours to works etc. In a nominally unstable world all the time will be used to figure out how to hedge against this instability. Said in another way in a world where monetary institutions are constructed to ensure nominal stability either through a nominal GDP level target or Free Banking money becomes neutral.

A world of nominal stability obviously is what we desperately want. We don’t have that anymore. The great nominal stability – and therefore as real stability – of the Great Moderation is gone. So one would believe that it should be easy to convince everybody that nominal instability is at the core of our problems in Europe and the US.

However, very few economists and even fewer policy makers seem to get it. In fact it has often struck me as odd how many central bankers seem to have very little understanding of monetary theory and it sometimes even feels like they are not really interested in monetary matters. Why is that? And why do central bankers – in especially Europe – keep spending more time talking about fiscal reforms and labour market reform than about talking about ensuring nominal stability?

I believe that one of the reasons for this is that the Great Moderation basically made it economically rational for most of us not to care about monetary matters. We lived in a micro world where there where relatively few monetary distortions and money therefore had a very little impact on economic decisions.

Furthermore, because monetary policy was extremely credible and economic agents de facto expected the central banks to deliver a stable growth level path of nominal GDP monetary policy effectively became “endogenous” in the sense that it was really expectations (and our friend Chuck Norris) that ensured NGDP stability . Hence, during the Great Moderation any “overshoot” in money supply growth was counteracted by a similar drop in money-velocity (See also my earlier post on  “The inverse relationship between central banks’ credibility and the credibility of monetarism”).

Therefore, when nominal stability had been attained in the US and Europe in the mid-1980s monetary policy became very easy. The Federal Reserve and the ECB really did not have to do much. Market expectations in reality ensured that nominal stability was maintained. During that period central bankers perfected the skill of looking and and sounding like credible central bankers. But in reality many central bankers around the really forgot about monetary theory. Who needs monetary theory in a micro world?

We are therefore now in that paradoxical situation that the great nominal stability of the Great Moderation makes it so much harder to regain nominal stability because most policy makers became ignorant of the importance of money in ensuring nominal stability.

Today it seems unbelievable that policy makers failed to see the monetary causes for the Great Depressions and policy makers in 1970s would refuse to acknowledge the monetary causes of the Great Inflation. But unfortunately policy makers still don’t get it – the cause of economic crisis is nearly always monetary and we can only get out of this mess if we understand monetary theory. The only real cost of the Great Moderation was the monetary theory became something taught by economic historians. It is about time policy makers study monetary theory – it is no longer enough to try to look credible when everybody know you have failed.

PS there is also an investment perspective on this discussion – as investors in a nominal stable world tend to become much more leveraged than in a world of monetary instability. That is fine as long as nominal stability persists, but when it breaks down then deleveraging becomes the name of the game.

Guest blog: Tyler Cowen is wrong about gold (By Blake Johnson)

In a recent post I commented on Tyler Cowen’s reservations about the gold standard on his excellent blog Marginal Revolution. In my comment I invited to dialogue between Market Monetarists and gold standard proponents and to a general discussion of commodity standards. I am happy that Blake Johnson has answered my call and written a today’s guest blog in which he discusses Tyler’s reservations about the gold standard.

Obviously I do not agree with everything that my guest bloggers write and that is also the case with Blake’s excellent guest blog. However, I think Blake is making some very valid points about the gold standard and commodity standards and I think that it is important that we continue to discuss the validity of different monetary institutions – including commodity based monetary systems – even though I would not “push the button” if I had the option to reintroduce the gold standard (I am indirectly quoting Tyler here).

Blake, thank you very much for contributing to my blog and I look forward to have you back another time.

Lars Christensen

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Guest blog: Tyler Cowen is wrong about gold

By Blake Johnson

I have been reading Marginal Revolution for several years now, and genuinely find it to be one of the more interesting and insightful blogs out there. Tyler Cowen’s prolific blogging covers a massive range of topics, and he is so well read that he has something interesting to say about almost anything.

That is why I was surprised when I saw Tyler’s most recent post on the gold standard. I think Tyler makes some claims based on some puzzling assumptions. I’d like to respond here to Cowen’s criticism of the gold standard, as well as one or two of Lars’ points in his own response to Cowen.

“The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment.  There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.”

I am surprised that Cowen would call this the most fundamental argument against the gold standard. First, regular readers of the Market Monetarist are likely very familiar with Selgin’s excellent piece “Less than Zero” which Lars is very fond of. There is plenty of evidence that suggests that there is nothing necessarily harmful about deflation. Cowen’s blanket statement of the harmful effects of deflation neglects the fact that it matters very much why the price level is falling/the real price of gold is going up. The real price of gold could increase for many reasons.

If the deflation is the result of a monetary disequilibrium, i.e. an excess demand for money, then it will indeed have the kind of negative consequences Cowen suggests. However, the purchasing power of gold (PPG) will also increase as the rest of the economy becomes more productive. An ounce of gold will purchase more goods if per unit costs of other goods are falling from technological improvements. This kind of deflation, far from being harmful, is actually the most efficient way for the price system to convey information about the relative scarcity of goods.

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Indeed, one does not generally hear the claim that private banks will issue too little currency, the fear of those in opposition to private banks issuing currency is often that they will issue currency ad infinitum and destroy the purchasing power of that currency.

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

Finally, I would dispute the claim that the gold standard has the potential for “radically high inflation”. First, one has to ask the question, radically high compared to what? If one compares it to the era of fiat currency, the argument seems to fall flat on its face rather quickly. In a study by Rolnick and Weber, they found that the average inflation rate for countries during the gold standard to be somewhere between -0.5% and 1%, while the average inflation rate for fiat standards has been somewhere between 6.5% and 8%. That result is even more striking because Rolnick and Weber found this discrepancy even after throwing out all cases of hyperinflation under fiat standards. Perhaps the most fundamental benefit of a gold run is its property of keeping the long run price level relatively stable.

“Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?”

I think Cowen makes two mistakes here. First, the forces behind a functioning gold standard are not random. They are the forces of supply and demand that seem to work pretty well in basically every other market. Lawrence H. White’s book “The Theory of Monetary Institutions” has an excellent discussion of the response in both the flow market for gold as well as the market for the stock of monetary gold to changes in the PPG. To go over it here in detail would take far too much space.

Second, commodity prices have not been increasing independent of monetary policy; the steady inflation over the last 30 years has had a significant effect on commodity prices. This is rather readily apparent if one looks at a graph of the real price of gold, which is extremely stable and even falling slightly until Nixon closes the Gold Window and ends the Bretton Woods system, at which point it begins fluctuating wildly. Market forces stabilize the purchasing power of the medium of redemption in a commodity standard; this would be true for any commodity standard, it is not something special about gold in particular.

As an aside, in response to Lars question, why gold and not some other commodity or basket of commodities, I would argue that without a low transaction cost medium of redemption the process of adverse clearings that ensures that money supply tends toward equilibrium becomes significantly less efficient. The reason the ANCAP standard, or a multi-commodity standard such as Yeager’s valun standard are not likely to have great success is mainly the problems of redemption (they also have not tracked inflation well since the 1980’s and 1990’s respectively.) I would gladly say that I believe there are many other commodities that a monetary standard could be based upon. C.O. Hardy argued that a clay brick standard would work fairly well if not for the problem of trying to get people to think of bricks as money (and Milton Friedman commented favorably on Hardy’s idea in a 1981 paper.)

“Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold.  A gold standard, by the way, is still compatible with plenty of state intervention.”

This is Cowen’s best point in my opinion. There would indeed be some sizable difficulties in returning from a fiat standard to a gold standard. In particular, it would not be fully effective if only one or two countries returned to a commodity standard, it would need to be part of a broader international movement to have the full positive effects of a commodity standard. Further, the parity at which countries return to the commodity standard would need to be better coordinated than the return to the gold standard in the 1920’s, when some countries returned with the currencies overvalued, and others returned with their currencies undervalued.

My main gripe is that Cowen’s claims seemed to be a broad indictment of the gold standard (or commodity standards) in general, rather than on the difficulties of returning to a gold standard today. They are two separate debates, and in my opinion, there is plenty of reason to believe that theoretically the gold standard is the better choice, particularly for lesser-developed countries. Even for countries such as the US with more advanced countries, the record does not seem so rosy. Central banks not only watched over, but we have reason to believe that their actions (or inaction) have been significant factors in the severity of both the Great Depression and the Great Recession.

© Copyright (2012) Blake Johnson

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