Allen Sanderson on Milton Friedman

Allen Sanderson has collected a number of anecdotes and stories about Milton Friedman. I most admit reading stories like this about Milton Friedman always make me smile.

But please take a look for yourself. Here is Remembering Milton

HT Marcus Nunes.

Daniel Lin will be teaching Intermediate Micro – Robert Clower would have told him to be happy about it

See this Facebook update from Daniel Lin who teaches at American University:

Just learned that the economics department has an urgent need for more Intermediate Micro classes in spring 2013. My Public Choice class has been cancelled, and I’ve been reassigned to Intermediate Micro. Disappointing. I’ll keep requesting it, and maybe it’ll happen in another semester.

I can understand Daniel’s hopes to teach Public Choice theory. It is a wonderful and interesting topic. In fact had I not been such a monetary theory nerd I would probably have been blogging about Public Choice theory. However, who can seriously imagine public choice theory without microeconomics?

What do we learn in microeconomics? We learn that individuals make choices. Microeconomics – or rather economics – is about choice. With choices comes benefits and costs. All choices come with costs. If I choose to do something I will not be able to do another thing. I can not write this post and sleep at the same time even though I badly needs sleep. It is the cost of writing the post. However, we can also deduct (we do that a lot in microeconomics – no fancy pancy econometrics here…) that my expected marginal utility of writing this post is higher than my expected marginal cost of doing it. The cost obviously include the opportunity cost of not sleeping.

In microeconomics we learn about comparative advantages, we learn about marginalism. We learn about Welfare Theory – Pareto Optimality. These are terribly important concepts. Unfortunately far too many economists soon forget about these concepts and then instead remembers rather misguided ideas that they learn in “traditional” macroeconomics. That is extremely unfortunate. Microeconomics is the foundation for our science. Economics without microeconomics is Marxism – or something worse.

And Daniel remember that no Public Choice theory is possible without microeconomics. Just imagine my favourite Public Choice model – William Niskanen’s Bureaucrat model. It is 100% microeconomics. We start out with an economic agent. The bureaucrat. He is maximizing utility. Niskanen assumed that what would give the  Bureaucrat maximum utility would be to maximize his institution’s budget. A quite fair assumption I think. Niskanen introduces asymmetrical information in his model. Something that might enter into Daniel’s class quite late in the semester, but nonetheless he will probably have to tell a story about peaches and lemons at some point during the semester. So Daniel have the fun of telling your students that when Joseph Stiglitz tells you why there is information problems in the market for used cars it also teaches us why the World Bank is an overblown bureaucracy.

However, it is not only Public Choice theory that is standing on the shoulders of Microeconomics. That is also the case for monetary theory – and of course macroeconomics. The problem with old-school keynesian macroeconomics – before the days of New Keynesian macroecomomics – was exactly that there was no microeconomic foundation for the “theory” and as a result the policy conclusions from old-school keynesian economics lead us to the insanities of price and wage controls and the idea of the fiscal multiplier (yes, Scott feel free to scream at the screen!).

I have earlier suggested that we can not teach macroeconomics with out starting with microeconomics. Or said in another way we start with microeconomics. In the most generalized form that is some kind of general equilibrium theory – a Walrasian economy.

Let imagine the simplest Walrasian economy. We got two goods A and B. The price of A is PA and the price of B is PB. The production of A and B is terms YA and YB. In the Walrasian economy there is no money. So it mean to buy something we will have to produce something. To buy A I must produce B. That is basically Say’s Law:


This is a recession free economy. Supply and demand will also be in equilibrium. There will never be an net excess supply of either A or B.

This is exactly how Robert Clower started out when he was teaching monetary theory. We have a Walrasian model of the world. What he then did was to introduce a third good called M. He would then set the price of M at 1. Then we have


Hence, we can buy the production of A and B for the production of M. We can also call M for money. Hence, the production of money – what we call the money supply – must equal the production. This is also what we know as the equation of exchange:


Where PY is an aggregation of the total production in the economy –  PA*YA+PB*YB. V is as we know money-velocity.

So Daniel, Robert Clower would tell you that if you don’t teach your students proper microeconomics how are we able to teach them about monetary policy?  And William Niskanen would equally tell you – with out microeconomics we will never be able to understand the behavior of bureaucrats.

And David Eagle would tell you that you would never figure out the optimal monetary policy rule without Welfare theory (John Taylor did you miss micro 101?) – as would I.

So Daniel go teach your students Intermediate Micro and make sure that they never forget that if they fail to understand Micro they will really never understand anything else. Not even why Sumo wrestlers cheat.


David Beckworth on Bernanke’s inconsistencies

David Beckworth has an extremely insightful blog post on the inconsistencies of Ben Bernanke’s views as an academic and as a central bank chief.

Anybody who have read the academic Ben Bernanke’s analysis of the Great Depression and particularly of Japan’s 1990s deflation will be stroke by how different his views are from Fed chairman Bernanke’s views. Bernanke obviously claims that he is not inconsistent. Furthermore, Bernanke claims that the situation in the US is very different from Japan in the 1990s. David on the other very clearly shows that Bernanke is indeed inconsistent and that the academic Bernanke would have realized that there are significant similarities between Japan in the 1990s and the US today.

David’s graph on Japanese and US demand deficiency shows it all. Have a look here.

I really have not much to add other than I think David is 100% right. The Federal Reserve is risking repeating the failures of the Bank of Japan if the Fed chairman keeps forgetting about the excellent research on Japan by the academic Ben Bernanke.

Scott Sumner has two post on Bernanke – here and here. Marcus Nunes also has a comment on Bernanke’s inconsistencies.

PS This discussion reminded me of one of my own earlier posts: Needed: Rooseveltian Resolve. The story is the same – I miss Ben Bernanke the academic.

“Good E-money” can solve Zimbabwe’s ‘coin problem’

The New York Times reports on the Zimbabwe’s so-called “coin problem”:

“When Zimbabweans say they are waiting for change, they are usually talking about politics. After all, the country has had the same leader since 1980.

But these days, Robson Madzumbara spends a lot of time quite literally waiting around for change. Pocket change, that is. He waits for it at supermarkets, on the bus, at the vegetable stall he runs and just about anywhere he buys or sells anything.

“We never have enough change,” he said, manning the vegetable stall he has run for the past two decades. “Change is a big problem in Zimbabwe.”

For years, Zimbabwe was infamous for the opposite problem: mind-boggling inflation. Trips to the supermarket required ridiculous boxloads of cash. By January 2009, the country was churning out bills worth 100 trillion Zimbabwean dollars, which were soon so worthless they would not buy a loaf of bread.

But since Zimbabwe started using the United States dollar as its currency in 2009, it has run into a surprising quandary. Once worth too little, money in Zimbabwe is now worth too much.

“For your average Zimbabwean, a dollar is a lot of money,” said Tony Hawkins, an economist at the University of Zimbabwe.

Zimbabweans call it “the coin problem.” Simply put, the country hardly has any. Coins are heavy, making them expensive to ship here. But in a nation where millions of people live on a dollar or two a day, trying to get every transaction to add up to a whole dollar has proved a national headache.”

This is of course is a very visible monetary disequilibrium – the demand for coins simply is outpacing the supply of coins. As a consequence Zimbabwe is now struggling with a quasi-deflationary problem. Somewhat paradoxically taking recent Zimbabwean monetary history into account.

Monetary history is full of this kind of “coin problems” that we now have in Zimbabwe and there are numerous solutions to the problem. In the NYT article one such solution is suggested is that the Zimbabwe government should start minting coins again. However, in Zimbabwe nobody is willing to accept in coins made produced by the government and who can blame them for that?

Good E-money

However, there is another solution that would make a lot more sense and that is simply to allow for private minting of coins. George Selgin in his 2010 masterpiece “Good Money” describe how Britain’s ‘coin problem’ in the 1780s was solved. Here is the book description:

“In the 1780s, when the Industrial Revolution was gathering momentum, the Royal Mint failed to produce enough small-denomination coinage for factory owners to pay their workers. As the currency shortage threatened to derail industrial progress, manufacturers began to mint custom-made coins, called “tradesman’s tokens.” Rapidly gaining wide acceptance, these tokens served as the nation’s most popular currency for wages and retail sales until 1821, when the Crown outlawed all moneys except its own.”

In fact we are already seeing this happening in Zimbabwe in a very primitive form – again from the NYT:

“Zimbabweans have devised a variety of solutions to get around the change problem, none of them entirely satisfactory. At supermarkets, impulse purchases have become almost compulsory. When the total is less than a dollar, the customer is offered candy, a pen or matches to make up the difference. Some shops offer credit slips, a kind of scrip that has begun to circulate here.”

So credit slips, candy, pens and matches are used as coins. Obviously this is not a very good solution. Mostly because the “storage” quality of these quasi-coins is very bad. The quality of candy after all deteriorates rather fast is you walk around with it in your pockets for a couple of days.

Among the problems in Zimbabwe is also that there is really not any local “manufacturers” that would be able to issue coins which would be trusted by the wider public and as the general “trust” level in Zimbabwean society is very low it is questionable whether any local “agent” would be able to produce a trustworthy coin.

However, a solution might be found in another African country – Kenya. In Kenya the so-called M-pesa has become a widely accepted “coin”. The M-pesa is mobile telephone based payments. Today it is very common that Kenyans use there cell phone to make payments in shops with M-pesa – even with very small amounts. Hence, one can say that this technological development is making “normal” coins irrelevant. You don’t need coins in Kenya. You can basically pay with M-pesa anywhere also in small village shops. M-pesa is Good Money – or rather Good E-Money.

Therefore, the Zimbabwean authorities should invite international telecoms operators to introduce telephone based payments in Zimbabwe. The mobile penetration in Zimbabwe is much lower than in Kenya, but nonetheless even in very poor Zimbabwe mobile telephones are fairly widespread. Furthermore, if it could help solve the “coin problem” more Zimbabwean’s would likely invest in mobile phones.

Hence, if private telecom operators were allowed to introduce (lets call it) M-Mari (Mari is shona for ‘money’ as Pesa is swahili for money) then the coin problem could easily be solved. In Kenya M-pesa is backed by Kenyan shilling. In Zimbabwe it M-Mari could be backed by US dollars (or something else for that matter).

The future African monetary regime – M-pesa meets Bitcoin

This might all seem like fantasy, but the fact remains that there today are around 500 million cell phones in Africa and there is 1 billion Africans. In the near future most Africans will own their own cell phone. This could lay the foundation for the formation of what would be a continent wide mobile telephone based Free Banking system.

Few Africans trust their governments and the quality of government institutions like central bankers is very weak. However, international companies like Coca Cola or the major international telecom companies are much more trusted. Therefore, it is much more likely that Africans in the future (probably a relatively near future) would trust money (or near-money) issued by international telecom companies – or Coca Cola for that matter.

In fact why not imagine a situation where Bitcoin merges with M-pesa so you get mobile telephone money backed by a quasi-commodity standard like the Bitcoin? I think most Africans readily would accept that money – at least their experience with government issued money has not exactly been so great.

Bacon, Brits and the Swissy

This morning I am flying to London so I think it is an excellent opportunity to celebrate the long Danish-British trade relationship.

Danes and Brits do not only share a same sense of irony and a love of beer, but also the love of Bacon. Or rather we love to produce it and the Brits love to consume it. It has been the basis of a good relation between the two nations for ages. As a consequence a shock to the bacon shock would be a demand shock to the Danish economy (under a fixed exchange rate regime), while it would be a supply shock to the British economy. In the proud tradition of Market Monetarism and in the tradition of the teaching of George Selgin we should argue that the Danish central bank (Danmarks Nationalbank) should “accommodate” shocks to the bacon prices (assuming that bacon is all we export), while the Bank of England (BoE) should let the shock to bacon prices be reflected in the price of the Brits favourite breakfast product.

However, David Stinson in a response to my previous “bacon post” raised an interesting question:

“As I understand from your previous posts, your argument is that, under a fixed exchange rate, changes in export prices are demand shocks because they affect the money supply. But changes in import prices would also affect the money supply under a fixed regime. An increase in import prices would cause the money supply to fall as the central bank engages in domestic currency purchases to support the exchange rate. In that case, a fixed exchange rate would add a negative demand shock to a negative supply shock. Is that the basis for targeting only export prices?”

David hits it right on the nail and his question very clearly illustrates the problem with a “normal” exchange rate peg.

Lets say that the upcoming exit of BoE governor Mervyn King simply is to much to handle for the British government and the government decides to peg the pound to the tremendously stable euro (note the Danish-British irony…). Then imagine that the UK is hit by the a triple hit – the prices of bacon, butter and beer are doubled overnight to the joy of Danish exporters (This is revenge for Bombardment of Copenhagen 1807…ok, no Danes really remember that…). However, this would be a massive negative supply shock to the British economy – just try to imagine a British worker functioning without these essential products.

The sharp rise in British  import prices would lead to downward pressure on the pound and to avoid it becoming a much devalued pound the BoE would defend the peg against the euro by intervening in the currency market selling foreign currency and buying pounds. This is the same as a contraction in the British money supply. Hence, the response to the negative supply shock is to impose a negative demand shock. Now the British workers truly would be dissatisfied – then they have to pay more for their bacon, butter and beers and being out of a job! And the average British would likely find very little joy in the fact that real estate prices would have dropped.

So David got it completely right – by pegging to export prices monetary policy will not react to supply shock and hence not distort relative prices in the in the economy.

It should of course be noted that the Bank of England even in the present monetary policy set-up – inflation targeting – would react to a doubling of bacon, butter and beer prices as the increase in the three Bs would effectively shoot the aggregate supply (AS) curve to the left. This of course is a core problem with inflation targeting and a problem that caused the ECB wrongly to increase interest rates twice in 2011.

Why the brilliant Swiss franc peg might not be so brilliant

We now continue from the Britain and Denmark to Switzerland. Here is David’s second question:

In the case of Switzerland’s recent peg, I have been interpreting that as the central bank basically accommodating the increased external demand to hold the franc for safe haven investment purposes. I wonder if one might characterize the franc as the “export” against which the central bank is pegging, except in their case an increase in the value of the “export” would represent a negative demand shock absent pegging?

This is interesting way of putting it and I am actually reminded about Robert Clower’s monetary theory (and I am sure Nick Rowe would be as well). Clower would basically start out with a Walrasian economy with no money and then introduce money as the m’th good in a Walrasian economy and setting the price of m equal to on 1. If we open the Clowerian monetary economy then we can think about the m’th good as the main export of the country. This is basically what David is saying. I, however, think that that makes things slightly too complicated.

David is, however, not wrong in his analysis. But I would rather take a slightly simpler rout. What happened during 2011 was that the demand for Swiss franc increased sharply as the euro crisis was intensifying in the autumn. With the demand for Swiss francs increasing – for a given supply of Swiss franc – there will be a sharp tightening of Swiss monetary conditions, which obviously will be deflationary.

The decision to introduce a one-side peg for EUR/CHF at 1.20 meant that the Swiss central bank (SNB) effectively said that if the demand for CHF increase (and lead to a strengthening of CHF below 120 against the euro) then the SNB will increase the money supply so much as to meet any increase in money demand.

Market Monetarists including myself have applaud the SNB’s move to introduce the 1.20 one sided peg as it mean that the Swiss money supply becomes completely elastic and any increase in the demand for money will be meet by an increase in the money supply. This is the same thing that would happen under a nominal GDP level target.

However, this does certainly not mean that Market Monetarists in general would think of this kind of peg as a good idea. Rather what Market Monetarists have applaud is that the SNB understand that if it does not accommodate the increase in money demand then it will becomes deflationary. Furthermore, Market Monetarists would point to the fact that the Swiss actions illustrate the powers of the Chuck Norris effect.

There are however, a more serious problem with the Swiss peg, which should be address. It is pretty clear I think that the appreciation pressures on the Swiss economy in 2011 were caused by an increase in Swiss franc demand on the back of the euro crisis.

However, there could be other causes why the Swiss franc should appreciate. Imagine for example that the global cocoa prices by dropped 50%. This would be a massive positive supply to the Swiss luxury chocolate industry as cocoa as far as I know is the main input to Swiss chocolate production. If we assume that the luxury chocolate is the only thing the Swiss are producing then this surely would lead to appreciation pressures on the Swissy.

Under the present peg the SNB would respond to this positive supply shock by trying the curb the strengthening of Swiss franc by increasing the money supply. This is a real no, no. The SNB is responding to a positive supply shock by easing monetary policy. If you want property market bubbles then this is the right policy, but if you want nominal stability this is certainly not what you should do.

Hence, the Swiss 1.20-peg is only a good idea as long as there are no major positive supply shocks to the Swiss economy and the only reason for Swiss franc appreciation is increase money demand. On the other there is no real reason to be concerned about negative supply under the present policy as the EUR/CHF peg is asymmetrical. The SNB will allow for any up move in EUR/CHF (an depreciation of the Swissy), but will curb any strengthening of EUR/CHF below 1.20.

Looking at the Swiss economy there is actually reasons to worry about this. Unlike the US and euro zone Swiss nominal GDP has more or less returned to the pre-crisis trend and as such monetary tightening might be warranted. However, the SNB does not have an NGDP level target, but rather a inflation target and hence we are having deflation in Switzerland the SNB can rightly say that it should maintain its 1.20-peg for now. However, if the SNB had been targeting the NGDP level would the peg now looks so brilliant?

So what should the SNB do? Well, I would certainly not recommend to peg the Swissy to Swiss export prices – as the Swiss exports are far to diversified to find a good real-time measure of Swiss export prices. However, why not introduce a NGDP level target? The Swiss economy is very developed and the Swiss financial markets are highly liquidity. There would certainly be no problem introducing a futures based NGDP targeting regime. However, SNB could also introduce an exchange rate based NGDP targeting regime. If NGDP is too low it would move up the one-side peg against the euro and if NGDP is too high it would move it down. I think that would work pretty well.

Concluding, the 1.20 peg works well to curb a sharp rise in money demand. However, the policy carries some serious risks. However, the problem is not using the FX rate to conduct monetary policy, but rather that the SNB is targeting inflation rather than the NGDP level. So I were to make a recommendation then the SNB would make the 1.20-peg conditional on where Swiss NGDP is forecasted to be in lets say 12-18 months. That would ensure nominal stability and be the best way to avoid the development of “secondary inflation” and asset bubbles.

So I am finishing of this post as we are approaching London City airport. A small airport, but centrally located in London so clearly my favourite airport when I have to fly to London. Back to Copenhagen tonight…that is the one of joys of working in the financial sector, but if I am lucky I might have time to taste a bit of bacon, butter and beer…

PS sorry for the typos…no time for proofreading…and I will hopefully add a view links in a later update…

Atlas Sound Money Project Interview with George Selgin

See this new excellent interview with George Selgin. I think it is harder to find any bigger expert on Free Banking theory and Free Banking history than George. Great stuff – even though I do not agree with everything (yes, believe it of not – I do not agree with everything George is saying).

George in the interview recommends that the Fed should introduce a NGDP target rule as a second best to his preferred solution to abolish the Fed. George thinks that a NGDP target rule could be introduced as a Bitcoin style computer algorithm – similar to what he suggests in his recent paper on Quasi-Commodity money (in the paper he discuss a Free Baning solution rather than a central bank solution). I personally think that a Quasi-Commodity standard could be the future for Free Banking money, but I think Scott Sumner’s suggestion for a futures based NGDP targeting regime would work better as long as you maintain central banks.

Political news kept slipping into the financial section – European style

European news over the weekend:

Françcois Hollande won the first round of voting ahead for incumbent president Sarkozy. However, nationalist candidate and leader of Front National (FN) Marine Le Pen got 18%. That is the highest support for a FN presidential candidate ever.

The Dutch government de facto collapsed after Geert Wilders’ populist Freedom Party refused to back anymore austerity measures.

 At the core of these two events obviously is the ongoing European crisis.

The response from European central bankers (all from the last couple of days):

ECB chief Mario Draghi in response to calls for European monetary easing from the IMF said: “None of the advice that the IMF is offering has been discussed by the Governing Council, in recent times at least”

Luc Coene, ECB Governing Council member and governor of Belgium’s central bank: “We have done what we can do so far within our mandate and within the possibilities we have”

Bundesbank president Jens Weimann: “the problems in Europe can’t be solved by monetary policy measures.”

Weidmann continues: “Higher interest rates are also a spur toward reforms” (Weidman is referring to bond yields in countries like Spain)

I feel like quoting Scott Sumner:

I once read all the New York Times from the 1930s (on microfilm.)  You can’t even imagine how frustrating it was.  They knew they had a big problem.  Then knew that deflation had badly hurt the economy (including the capitalists.)  They knew that monetary policy could reflate.  And yet . . .

Weeks went by, then months, then years.  Somehow they never connected the dots.

“Monetary policy is already highly stimulative.”

“There’s a danger we’d overshoot toward too much inflation.”

“Maybe the problems are structural.”

“There are green shoots, things are getting worse at a slower pace.  The economy needs to heal itself.”

“Consumer demand is saturated.  Even workingmen can now afford iceboxes and automobiles.  We produced too much stuff in the 1920s.”

And the worst part was the way political news kept slipping into the financial section.  Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc.  In the 1930s the readers didn’t know what came next—but I did. 

Thankfully we can learn from their mistakes.

Thanks Scott. I don’t feel I need to add anything…Very depressing indeed.

Food shortage is always and everywhere a monetary phenomenon

When policy makers mess around with the price mechanism it nearly always have negative consequences – things certainly gets no better when they do that to “solve” problems created by a failed monetary policy. New York Times has a story that confirms this once again.

The story is about increasing food shortage in Venezuela. It is an all too familiar story. The Venezuelan central bank certainly is proving that there is not such a thing as a liquidity trap – it is clearly capable of creating inflation by printing money. However, the authoritarian-socialist Venezuelan government refuses to accept the monetary causes of high and increasing Venezuelan inflation and instead of putting measures in place to curb money supply growth has implemented draconian price controls. Any normally educated economist would tell you that when you introduce a price-cap in a certain market the result will always be same –shortages. This unfortunately has also been the case in Venezuela. Here is from the NYT article:

Some residents arrange their calendars around the once-a-week deliveries made to government-subsidized stores like this one, lining up before dawn to buy a single frozen chicken before the stock runs out. Or a couple of bags of flour. Or a bottle of cooking oil.

The shortages affect both the poor and the well-off, in surprising ways. A supermarket in the upscale La Castellana neighborhood recently had plenty of chicken and cheese — even quail eggs — but not a single roll of toilet paper. Only a few bags of coffee remained on a bottom shelf.

Asked where a shopper could get milk on a day when that, too, was out of stock, a manager said with sarcasm, “At Chávez’s house.”

Chávez of course refers to Venezuela’s socialist president Hugo Chávez.

Monetary disequilibrium causes food shortage in Venezuela and ‘job shortage’ in the US and Europe

When more money is printed than is demanded then you get inflation. That is the case in Venezuela. The opposite is the case in the euro zone and the US – here demand for money is outpacing the supply of money and as a result you get deflationary pressures. Both are examples of monetary disequilibrium.

If prices and wages are fully flexible then monetary disequilibrium will not lead to disequilibrium in the labour and goods markets. There is so to speak be no “spill-over” from the market for money to other markets. However, price and wage rigidities create such a spill-over. In the case of Venezuela government regulated prices create such rigidities and as a result you get food shortages. Said, in another way – Food shortage is always and everywhere a monetary phenomenon (that’s of course not correct, but you get the point…).

In the case of the euro zone and the US it is not price caps, which are causing the macroeconomic problems, but rather downward rigidities in wages and prices – some of which undoubtedly also are a consequence of government regulation.

Obviously any government regulation, which reduces price flexibility and hampers the market mechanism is problematic and as such should be done away with. However, some rigidities obviously are also facts of nature that would exist even in my dream world of a completely unhampered free market.

Interestingly enough any Internet Austrian who heard the story of Venezuelan food shortages would as I immediately respond: “Stop printing all that money and then you would not ‘need’ price controls”. Unfortunately it is much harder to convince the same Austrians (and many policy makers) that the “job shortage” in Europe and the US is also primarily a result of monetary disequilibrium.

Obviously both food shortage and job shortage is a result of the combination of monetary disequilibrium and price rigidities. However, if the monetary institutions reduce monetary disequilibrium then the problems with rigidities will be much smaller.

Hence, if the Venezuelan central bank stops printing more money than is demanded and the ECB on the other hand prints enough money to meet the demand for money then the problem of food shortage in Venezuela and the problem of job shortage in Europe will be solved and there would be no (perceived) “need” for fiscal stimulus in Europe and price caps in Venezuela.

Central bank rituals and legitimacy

One of the most interesting aspects of US monetary policy since 2008 is that while Ben Bernanke certainly is not ignorant of economic history or monetary theory it seems like the Fed under his leadership has not responded nearly as aggressive to the crisis as one should have expected if one from reading Bernanke’s academic work. Furthermore, one can question why the Bank of Japan for more than a decade has failed to seriously address the deflationary pressures in the Japanese economy. Similarly why have central banks in for example the Baltic States, Bulgaria and Denmark maintained an unwavering support for keeping their currencies pegged to euro while the euro crisis has continued to escalate?

Scott Sumner has sometimes – I guess in frustration – suggested that central bankers are just stupid and this is the reason why mistaken monetary policies are continued for years. I on the other hand have suggested that one should look for a public choice based explanation for central bank behavior and that particularly William Nishanen’s Bureaucrat theory would be relevant. I have also suggested that the success of monetary policy during the Great Moderation has created a certain level of ignorance among policy makers and commentators about monetary policy.

However, there might be an additional explanation for the behavior of central bankers and that has to do with ensuring the the legitimacy of central banks (this could of course be said to be related to my Nishanenian explanation). I found a interesting discussion of this topic in a 1969 paper by Kenn Boulding – “The Legitimacy of Central Banks”.

Here is Boulding’s introduction:

The problem of legitimacy is one of the most neglected aspects of the study of social systems. There may be good reasons for this, for it is inevitably a hot subject. One can hardly discuss the legitimacy of anything without seeming to threaten it, for a great deal of legitimacy depends on things being taken for granted and not talked about at all. The more one looks at the dynamics of social systems, however, the more it becomes clear that the dynamics of legitimacy is one of the most important elements in the total long-run dynamics of society. It certainly ranks with such things as population and demographic movements, and even with technological change with which it is closely intertwined. Its importance can be seen in the remark that if a person or institution loses legitimacy it loses everything. It can no longer maintain itself in the social system. No amount of wealth, that is exchange capability, or power, that is, threat capability, can keep an institution alive if there is a widespread denial of the legitimacy of its role in society. This is because the performance of any continuous and repeated role requires an acceptance of its legitimacy on the part of those role occupants whose roles are related to it. A role in the social system is a focal point or node of inputs and outputs of many different kinds, the output of one role being the input of another. Inputs, therefore, depend on the willingness of other role occupants to give outputs, and they will not do this continuously unless there is legitimacy. Where people feel that certain outputs are illegitimate they will eventually find ways of stopping them. The corresponding inputs will likewise stop. To use a rather crude illustration, a bandit can take your money once, but anyone who wants to take it every week either has to be a landlord or a tax collector, or perhaps even a bank.

There are a considerable number of sources of legitimacy,and the functions which relate the determinants of legitimacy to its amount are extremely complex. They are certainly non-linear and they exhibit discontinuities which are to say the least disconcerting. Sometimes an institution, the legitimacy of which seems to be absolutely unques- tioned, collapses overnight. All of a sudden we reach some kind of a “cliff” in the legitimacy function and the institution suddenly becomes illegitimate. The same thing perhaps can even happen the other way, in which institutions quite suddenly become legitimate after having been illegitimate, A good example of the former is the collapse of the monarchy, beginning in the 17th century. The legitimacy of monarchy survived the Cromwellian war in England, largely because an ancient legitimacy is like a capital stock, it takes a great deal of spending before it can be exhausted. At the time of Louis XIV in the following century one might have thought that the legitimacy of monarchy was absolutely unquestioned and secure. In the following century, however, it collapsed everywhere and the only monarchs who survived were those who abandoned their power and became symbols of legitimacy, like the British, Dutch and Scandinavian monarchs. On the other side, abortion has been an institution which has been regarded as highly illegitimate and now in the face of the population problem seems to be acquiring a quite sudden legitimacy.

Sorry for the long quote, but Boulding’s discussion seem highly relevant for central banks and their behavior during the present crisis. Today (nearly) nobody dare suggesting that we could do without central banks. Take Denmark. In Denmark there is massive public support for the rather irrational institution of monarchy and only few Danes would seriously question the legitimacy of the monarchy. However, even fewer Danes would question the legitimacy of the Danish central bank. However, as history has shown support for institutions can disappear overnight. It is therefore, in the institutional interests of Kings (in the case of Denmark the Queen) and central bankers to insure that their legitimacy is maintained. Obviously we don’t have only to talk about the legitimacy of the central bank but also for example the legitimacy of certain policy rules for example inflation targeting or a fixed exchange rate regime.

Boulding discusses a number of sources of legitimacy:

The first consists of the payoffs of the institution in question:

If an institution provides good terms of trade with those who are related to it, up to a point this contributes to its legitimacy, especially in the long run. The case is clearer on the negative side. An institution which has very poor payoffs, demands a great deal of input from other people and gives very little output to them, is likely to have its legitimacy eventually eroded on this account. 

Therefore, a central bank which fails to “deliver” will eventually become illegitimate. The same can be said for a policy rule like inflation targeting. If inflation targeting stops working (as certainly is the case for example in the euro zone) then public support for it will  be eroded and sooner or later the central bank will have to give it up. However, the central bank is crucially dependent on the legitimacy and it therefore also be in the central bank’s bureaucratic interest to continue to claim that “everything is fine” despite this is in clearly conflict with reality. As Boulding explain: “therefore, a strong tendency to “throw good money after bad” and to continue making sacrifices for some institution, even after some possibly expected long-run payoffs have failed to materialize.”

The second source of legitimacy is age. The Danish monarchy’s legitimacy certainly has a lot to do with the fact that it has been around forever and the same goes for the legitimacy of many central banks. The Federal Reserve will have been around for a 100 years next year. In Denmark the present exchange rate regime has more or less been in place since 1982. Similarly, New Zealand was the first country introduce inflation targeting in 1988. There is no doubt that age provide significant legitimacy to different monetary regimes around the world and the despite of the seriousness of the crisis few well-established monetary regimes have really got under pressure.

The third source of legitimacy is mystery. In the words of Boulding: “Something which is not understood but which is dimly perceived as obscurely grand and magnificent, acquires an aura of legitimacy in the minds of those who do not understand it. The temples and impressive ceremonies of religion, the “state” of kings, the mystique of the brass hat and the military leader, the sanctity of priesthoods of all kinds and even the mystery of science and the laboratory are all related to this aspect of legitimacy”

This I think makes a lot of sense in the case of monetary institutions. Few people understand monetary theory and central banks are generally perceived as very complicated and even mysteries by most ordinary people. The mystery can only be maintained through the “temples”, “ceremonies” and the “brass hat”. Just think of a rate announcement from the ECB. There is a lot of ceremony to that. The same phrases are repeated again an again – and the central bankers all look the same in their dark suits and white shirts and ties (I look like that everyday as well – even though I occasionally would wear a bow-tie and probably are more comfortable with colours than most central bankers are…) As part of maintaining the mystery central bankers of course will also be careful in not questioning these rituals.

A forth source of legitimacy consists of the alliance of an institution with other legitimacies. Boulding terms this the “the legitimacy syndrome”. Just think of the relationship between the ECB and the European Commission. The languages and thinking of the two institutions are very similar. Think of now Prime Minister Mario Monti in Italy – he might as well have been ECB chief instead of the other Mario (Draghi). The thinking, the appearance and the norms very much seem to be the same. There are also strong alliances between central banks in different countries – one central bank would very rarely criticize another central bank. The Swedish Riksbank with its flexible inflation targeting and floating exchange rate regime would be very careful in for example avoiding saying anything bad about the Danish fixed exchange regime.

Concluding, the survival of monetary regimes crucially dependents on the legitimacy of these regimes. This legitimacy can be maintained in many ways by central banks. Among these are the need for mystery and alliances with other legitimate institutions. I think that this should be kept in mind when we are discussing why central banks fail to do the “right thing”.

Kenneth Boulding end his paper with a warning to central banks and it rings as true today as it did in 1969:

“I am pretty certain, however, that whatever mutation may supplant the existing system has not yet been made, but if the legitimacy of the system rests firmly on its payoffs then the social invention which will supplant it, if it ever comes, should be welcomed with joy rather than fear. It is only what I do not now mind calling the fraudulent legitimacies which fear competition.”

“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression

Even though I am a Danish economist I am certainly no expert on the Danish economy and I have certainly not spend much time blogging about the Danish economy and I have no plans to change that in the future. However, for some reason I today came to think about what would have been the impact on the Danish economy if the Danish krone had been pegged to the price of bacon rather than to gold at the onset of the Great Depression in 1929. Lets call it the Bacon Standard – or a the PIG PEG (thanks to Mikael Bonde Nielsen for that suggestion).

Today less than 10% of Danish export revenues comes from bacon export – back during in the 1920s it was much more sizable and agricultural products dominated export revenues and Denmark’s main trading partner was Great Britain. Since bacon prices and other agricultural product were highly correlated (and still are) the bacon price probably would have been a very good proxy for Danish export prices. Hence, a the PIG PEG would basically have been similar to Jeff Frankel’s Peg the Export Price (PEP) proposal (see my earlier posts on this idea here and here).

When the global crisis hit in 1929 it put significant downward pressure on global agricultural prices and in two years most agricultural prices had been halved. As a consequence of the massive drop in agricultural prices – including bacon prices – the crisis put a serious negative pressures on the Danish krone peg against gold. Denmark had relatively successfully reintroduced the gold standard in 1927, but when the crisis hit things changed dramatically.

Initially the Danish central bank (Danmarks Nationalbank) defended the gold standard and as a result the Danish economy was hit by a sharp monetary contraction. As I argued in my post on Russian monetary policy a negative shock to export prices is not a supply shock, but rather a negative demand shock under a fixed exchange rate regime – like the gold standard. Said in another way the Danish AD curve shifted sharply to the left.

The shock had serious consequences. Hence, Danish economic activity collapsed as most places in the world, unemployment spiked dramatically and strong deflationary pressures hit the economy.

Things got even worse when the British government in 1931 decided to give up the gold standard and eventually the Danish government decided to follow the lead from the British government and also give up the gold standard. However, unlike Sweden the Danish authorities felt very uncomfortable to go it’s own ways (like today…) and it was announced that the krone would be re-pegged against sterling. That strongly limited the expansionary impact of the decision to give up the gold standard. Therefore, it is certainly no coincidence that Swedish economy performed much better than the Danish economy during the 1930s.

The Danish economy, however, started to recovery in 1933. Two events spurred the recovery. First, FDR’s decision to give the gold standard helped the US economy to begin pulling out of the recovery and that helped global commodity prices which certainly helped Danish agricultural exports. Second, the so-called  Kanslergade Agreementa political agreement named after the home address of then Prime Minister Thorvald Stauning in the street Kanslergade in Copenhagen – lead to a devaluation of the Danish krone. Both events effectively were monetary easing.

What would the Bacon standard have done for the Danish economy?

While monetary easing eventually started to pull Denmark out of the Great Depression it didn’t happen before four year into the crisis and the recovery never became as impressive as the development in Sweden. Had Denmark instead had a Bacon Standard then things would likely have played out in a significantly more positive way. Hence, had the Danish krone been pegged to the price of bacon then it would have been “automatically” devalued already in 1929 and the gradual devaluation would have continued until 1933 after, which rising commodity prices (and bacon prices) gradually would have lead to a tightening of monetary conditions.

In my view had Denmark had the PIG PEG in 1929 the crisis would been much more short-lived and the economy would fast have recovered from the crisis. Unfortunately that was not the case and four years was wasted defending an insanely tight monetary policy.

Monetary disequilibrium leads to interventionism   

The Danish authorities’ decision to maintain the gold standard and then to re-peg to sterling had significant economic and social consequences. As a consequence the public support for interventionist policies grew dramatically and effectively lay the foundation for what came to be known as the danish “Welfare State”. Hence, the Kanslergade Agreement not only lead to a devaluation of the krone, but also to a significant expansion of the role of government in the Danish economy. In that sense the Kanslergade Agreement has parallels to FDR’s policies during the Great Depression – monetary easing, but also more interventionist policies.

Hence, the Danish experience is an example of Milton Friedman’s argument that monetary disequilibrium caused by a fixed exchange rate policy is likely to increase interventionist tendencies.

Bon appetite – or as we say in Danish velbekomme…

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