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 This explanation has of course been picked up by my Market Monetarists friends – Scott Sumner (in his excellent, but unpublished book on the Great Depression), Clark Johnson’s fantastic account of French monetary history in his book “Gold, France and the Great Depression, 1919-1932” and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!).

George Selgin outlines strategy for the privatisation of the money supply

I have earlier argued that NGDP targeting is a effectively emulating the outcome under a perfect Free Banking system and as such NGDP level targeting can be seen as a privatisation strategy. George Selgin has just endorsed this kind of idea in a presentation at the Italian Free Market think tank the Bruno Leoni Institute. The presentation is available on twitcam.

You can see the presentation here. You need a bit of patience if you are not Italian speaking, but George eventually switch to English. The presentation lasts around 45 minutes.

I will not go through all of George’s arguments – instead I recommend everybody to take a look at George’s presentation on your own. However, let me give a brief overview.

Basically George see a three step procedure for the privatisation of the money supply and how to go from the present fiat based monetary monopoly to what he calls a Free Banking system based on a Quasi Commodity Standard. Often Free Banking proponents tend to start out with some kind of gold standard – or at least assume that some sort of commodity standard is necessary for a Free Banking system to work. George does not endorse a gold standard. Rather he favours a privatisation strategy based on a NGDP targeting rule.

Essentially George spells out a three step procedure toward the privatisation of the money supply.

The first step (and this is especially directed towards the US Federal Reserve) is to move towards a much more flexible system provision of liquidity to the market than under the present US system where the Federal Reserve historically has relied on so-called primary dealers in the money market. George wants to abolish this system and instead wants the Fed to control the money base directly through open market operations. I fully endorse such a system. There is no reason why the monetary system and the banking system will have to be so closely intertwined as is the case in many countries. A system based on open market operations would also do away with the ad hoc nature of the many lending facilities that have been implemented in both the euro zone and the US since 2008.  George is essentially is saying what Market Monetarists have argued as well and that is that central banks should be less focused on “saving” the financial sector and more focused on ensuring the flow of liquidity (and yes, that is two very different things). George discusses these ideas in depth in his recent paper “L STREET:Bagehotian Prescriptions for a 21st-century Money Market”. I hope to return to a discussion of this paper at a later point.

The second step – and that should interest Market Monetarists – is that George comes out and strongly endorses NGDP targeting – or as George puts it a “stable rule for growth of aggregate (nominal) spending” and argues that central banks should do away with discretion in the conduct of monetary policy. George directly refers to Scott Sumner as he is making this argument. George’s preferred rate of growth of nominal spending is 2.5-3% – contrary to Scott’s suggestion of a 5% growth. That said, I am pretty sure that George would be happy if the Federal Reserve implemented Scott’s suggested rule. George is not religious about this. I on my part I am probably closer to George’s view than to Scott’s view, but again this is not overly important and practically a 5% growth rate would more or less be a return to the Great Moderation standard at least for the US. It should of course be noted that there is nothing new in the fact that George supports NGDP targeting – just read “Less than zero” folks! However, George in his presentation puts this nicely into the perspective of strategy to privatise the supply of money.

In arguing in favour of nominal spending targeting George makes it clear that it is not about indirectly ensuring some stable inflation rate in the long run, but rather “stability of (nominal) spending is the ultimate goal”. I am sure Scott will be applauding loudly. Furthermore – and this is in my view extremely important – a rule to ensure stability of nominal spending will ensure that there is no excuse for ad hoc and discretionary policy. With liquidity provision based on a flexible framework of open market operations and NGDP targeting the money supply will effectively be endogenous and any increase in money demand will always be met by an increase in the the money supply. So even if a financial crisis leads to a sharp increase in money demand there will be no argument at all for discretionary changes in the monetary policy framework. (Recently I have been talking about whether pro-NGDP targeting keynesians like Paul Krugman are saying the same as Market Monetarists. My argument is that they are not – Paul Krugman probably would hate the suggestion that monetary discretion should be given up).

Market Monetarists should have no problem endorsing these two first steps. However, the third step and that is the total privation of the supply on money will be more hard to endorse for some Market Monetarists. Hence, Scott Sumner has not endorsed Free Banking – neither has Nick Rowe nor has Marcus Nunes. However, I guess Bill Woolsey, David Beckworth and myself probably have some (a lot?) sympathy for the idea of eventually getting rid of central banks altogether.

This, however, is a rather academic discussion and at least to me the discussion of NGDP targeting and changing of central bank operating procedures for now is much more important. That said, George discusses a privatisation of the money supply based on what he calls a Quasi Commodity Standard (QCS). QCS is inspired by the technological development of the so-called Bitcoins. I will not discuss this issue in depth here, but I hope to return to the discussion once George has spelled out the idea in a paper.

Once again – have a look at George’s presentation.

HT Blake Johnson

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

Tyler Cowen on the gold standard

Here is Tyler Cowen on the gold standard:

“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.

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?

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.”

I fully agree – I think it would be an extremely bad idea to introduce a gold standard today. That does not mean that the gold standard does not have some merits. It has – the gold standard will for example significantly reduce discretion in monetary policy and I surely prefer rules to discretion in monetary policy. Furthermore, I think that exchange rate based monetary policy also has some merits as it can “circumvent” the financial sector. Monetary policy is not conducted via a credit channel, but via a exchange rate channel – that makes a lot of sense in a situation will a financial crisis.

However, why gold? Why not silver? Or Uranium? Or rather a basket of commodities. Robert Hall has suggested a method that I fundamentally think has a lot of merit – the ANCAP standard, which is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood. Why these commodities? Because as Robert Hall shows they have been relatively highly correlated with the general cost of living. I am not sure that these commodities are the best for a basket – I in fact think it would make more sense to use a even broader basket like the so-called CRB index, but that is not important – the important thing is that the best commodity standard is not one with one commodity (like gold), but rather a number of commodities so to reduce the volatility of the basket.

Furthermore, it makes very little sense to me to keep the exchange rate completely fixed against the the commodity basket. As I have advocated in a number of earlier posts I think a commodity-exchange rates based NGDP targeting regime could make sense for small open economies – and maybe even for large economies. Anyway, the important thing is that we can learn quite a bit from discussing exchange rate and commodity based monetary standards. Therefore, I think the Market Monetarists should engage gold standard proponents in in 2012. We might have more in common than we think.

Now I better stop blogging for this year – the guests will be here in a second and my wife don’t think it is polite to write about monetary theory while we have guests;-)

Happy new year everybody!

The Compensated dollar and monetary policy in small open economies

It is Christmas time and I am spending time with the family so it is really not the time for blogging, but just a little note about something I have on my mind – Irving Fisher’s Compensated dollar plan and how it might be useful in today’s world – especially for small open economies.

I am really writing on a couple of other blog posts at the moment that I will return to in the coming days and weeks, but Irving Fisher is hard to let go of. First of all I need to finalise my small series on modern US monetary history through the lens of Quasi-Real Indexing and then I am working on a post on bubbles (that might in fact turn into a numbers of posts). So stay tuned for these posts.

Back to the Compensated dollar plan. I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US. However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

As a consequence I also come to think that variations of Fisher’s proposal could be an idea for small open economies – especially as these countries typically have less developed financial markets and due to financial innovation – in especially Emerging Markets – have a hard time controlling the domestic money supply. Furthermore, a key advantage of using the exchange rate to conduct monetary policy is that there is no “lower zero bound” on the exchange rate as is the case with interest rates and the central bank can effectively “circumvent” the financial sector in the conduct of monetary policy – something which is likely to be an advantage when there is a financial crisis.

The Compensated dollar plan 

But lets first start out by revisiting Fisher’s compensated dollar plan. Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

Three reservations about the Compensated dollar plan

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

Exchange rate based NGDP targeting for small-open economies

If we take this reservations into account we get to a proposal for an exchange rate based NGDP target regime which I believe would be particularly suiting for small open economies and Emerging Markets. I have in an earlier post spelled out the proposal – so I am repeating myself here, but I think the idea is worth it.

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

It could be done, but will anybody dare?

Central bankers are conservative people and they don’t go around and change their monetary policy set-up on a daily basis. Nonetheless it might be time for central banks around the world to reconsider their current set-up as monetary policy far from having been successfully in recent years. I believe Irving Fisher’s Compensated dollar plan is an excellent place to start and I have provided a (simple) proposal for how small-open economies might implement it.

November 1932: Hitler, FDR and European central bankers

The headline of most stock markets reports yesterday said something like “Stocks: Worst Thanksgiving Drop Since ’32”. That made me think – what really happened in November 1932?

As is the case this time around European worries dominated the financial headlines back in November 1932. The first of two key events of November 1932 was the German federal elections on November 6 1932. We all know the outcome – Hitler’s National Socialist Germans Workers’ Party (NSDAP) won a landslide victory and got 33.1% of the vote. As the Communist Party won 16.9% the totalitarian parties commanded a firm majority – what at the time was called the “negative majority”. This eventually led to the formation of Hitler’s first cabinet in January 1933.

The second key event of November 1932 of course was the US presidential elections. Two days after the German in elections Franklin D. Roosevelt won the US presidential elections defeating incumbent president Herbert Hoover on November 8 1932. FDR of course in 1933 took the US of the gold standard, but also introduced the catastrophic National Industrial Recovery Act (NIRA).

Going through the New York Times articles of November 1932 I found a short article on the gold standard in which it said the following:

“Governors of Europe’s central banks who met today (November 13 1932) at the Bank of International Settlements expressed the unanimous opinion that the gold standard was the only basis on which the world economic situation could be bettered”

Obviously we today’s know that the failed gold standard was the key reason for the Great Depression and especially European central bankers’ desperate attempt to save the failed monetary regime created the environment in which Hitler and his nazi party was able to win the German elections in November 1932. What would have happened for example if Germany had been given proper debt relief, the European central banks had given up the gold standard and the French central bank had stopped the hoarding of gold?

Had I been a Marxist I would had been extremely depressed today because then I would had believed in historical determinism. Fortunately I think we can learn from history and avoid repeating past mistakes. I hope today’s European central bankers share this view and will learn a bit from the events of November 1932.

If European central bankers this time around decide not to learn from events of 1932 then they might be interested in learning about the dissolution of the Austro-Hungarian currency union in 1919. Then they just have to read this excellent paper by Peter Garber and Michael Spencer.

“Fed greatly destabilized the U.S. economy”

As the European crisis just gets worse and worse I am reminded by what a clever man once said – he is that clever man Ben Bernanke in 2004:

“Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.”

I wonder what he is thinking of his colleagues in the ECB and about his own responsibilities today.

The Tragic year: 1931

Benjamin Anderson termed 1931 the “the tragic year” – these are some of the events in that tragic year: 

  1. One of Europe’s largest banks with large exposure to Central and Eastern Europe gets into serious trouble (It is of course Austria’s largest bank Österiechishe Kredit Anstalt – and it of course collapsed)
  2. Europe’s Sovereign debt crisis is threatening financial stability and currency collapse (It’s the Germans that are to blame – they can’t pay their war debts)
  3. Major international banks push for a big country to save the sinners (The US banks ask US president Hoover to help ease the pain on Germany)
  4. Debt restructuring (The Hoover moratorium gives Germany a bit of relief – the US banks are happy to begin with)
  5. Monetary policy keeps deflationary pressures on (The French central bank keeps hoarding gold)
  6. An insane commitment to a failed monetary system (the gold standard mentality keeps the commitment to the gold standard despite the fact that it is killing Europe)
  7. Some countries have had enough and give up the monetary standard (The UK leaves the gold standard – the Scandinavian countries follows suit – and recover fast from the Great Depression)
  8. Technocracy is popular and it suggested that indebted nations should be run by technocrats (The so-called Technocracy Movement became increasingly popular in German)

And here we are 80 years on…do you see any similarities? I wonder what 2012 will bring – in 1932 10 countries (or so…) defaulted…

Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief

Recently I in a post came up with what I described as a crazy idea – that might in fact not be so crazy.

My suggestion was based on what I termed the Chuck Norris effect of monetary policy – that a central banks can ease monetary policy without printing money if it has a credible target. The Swiss central bank’s (SNB) actions to introduce a one-sided peg for the Swiss franc against the euro have demonstrated the power of the Chuck Norris effect.

The SNB has said it will maintain the peg until deflationary pressures in the Swiss economy disappears. The interesting thing is that the markets now on its own is doing the lifting so when the latest Swiss consumer prices data showed that we in fact now have deflation in Switzerland the franc weakened against the euro because market participants increased their bets that the SNB would devalue the franc further.

In recent days the euro crisis has escalated dramatically and it is pretty clear that what we are seeing in the European markets is having a deflationary impact not only on the European economy, but also on the global economy. Hence, monetary easing from the major central banks of the world seems warranted so why do the ECB not just do what the SNB has done? For that matter why does the Federal Reserve, the Bank of England and the Bank of Japan not follow suit? The “crazy” idea would be a devaluation of euro, dollar, pound and yen not against each other but against commodity prices. If the four major central banks (I am leaving out the People’s Bank of China here) tomorrow announced that their four currencies had been devalued 15% against the CRB commodity index then I am pretty sure that global stock markets would increase sharply and the positive effects in global macro data would likely very fast be visible.

The four central banks should further announce that they would maintain the one-sided new “peg” for their currencies against CRB until the nominal GDP level of all for countries/regions have returned to pre-crisis trend levels around 10-15% above the present levels and that they would devalue further if NGDP again showed signs of contracting. They would also announce that the policies of pegging against CRB would be suspended once NGDP had returned to the pre-crisis trend levels.

If they did that do you think we would still talk about a euro crisis in two months’ time?

PS this idea is a variation of Irving Fisher’s compensated dollar plan and it is similar to the scheme that got Sweden fast and well out of the Great Depression. See Don Patinkin excellent paper on “Irving Fisher and His Compensated Dollar Plan” and Claes Berg’s and Lars Jonung’s paper on Swedish monetary policy in 1930s.

PPS this it not really my idea, but rather a variation of an idea one of my colleagues came up with – he is not an economist so that is maybe why he is able to think out of the box.

PPPS I real life I am not really a big supporter of coordinated monetary action and I think it has mostly backfired when central banks have tried to manipulate exchange rates. However, the purpose of this idea is really not to manipulate FX rates per se, but rather to ease global monetary conditions and the devaluation against CRB is really only method to increase money velocity.

Germany 1931, Argentina 2001 – Greece 2011?

The events that we are seeing in Greece these days are undoubtedly events that economic historians will study for many years to come. But the similarities to historical crises are striking. I have already in previous posts reminded my readers of the stark similarities with the European – especially the German – debt crisis in 1931. However, one can undoubtedly also learn a lot from studying the Argentine crisis of 2001-2002 and the eventual Argentine default in 2002.

What this crises have in common is the combination of rigid monetary regimes (the gold standard, a currency board and the euro), serious fiscal austerity measures that ultimately leads to the downfall of the government and an international society that is desperately trying to solve the problem, but ultimately see domestic political events makes a rescue impossible – whether it was the Hoover administration and BIS in 1931, the IMF in 2001 or the EU (Germany/France) in 2011. The historical similarities are truly scary.

I have no clue how things will play out in Greece, but Germany 1931 and Argentina 2001 does not give much hope for optimism, but we can at least prepare ourselves for how things might play out by studying history.

I can recommend having a look at this timeline for how the Argentine crisis played out. You can start on page 3 – the Autumn of 2001. This is more or less where we are in Greece today.

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