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The ECB has the model to understand the Great Recession – now use it!

By chance I today found an ECB working paper from 2004 – “The Great Depression and the Friedman-Schwartz hypothesis” by Christiano, Motto and Rostagno.

Here is the abstract:

“We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild.”

It is interesting stuff and you would imagine that the model developed in the paper could also shed light on the causes and possible cures for the Great Recession as well.

Is it only me who is reminded about 2008-9 when you read this:

“The empirical exercise conducted on the basis of the model ascribes the sharp contraction of 1929-1933 mainly to a sudden shift in investors’ portfolio preferences from risky instruments used to finance business activity to currency (a flight-to-safety explanation). One interpretation of this finding could be that households . in strict analogy with commercial banks holding larger cash reserves against their less liquid assets . might add to their cash holdings when they feel to be overexposed to risk. This explanation seems plausible in the wake of the rush to stocks that occurred in the second half of the 1920.s. The paper also documents how the failure of the Fed in 1929-1933 to provide highpowered money needed to meet the increased demand for a safe asset led to a credit crunch which in turn produced deflation and economic contraction.”

The authors also answer the question about the appropriate policy response.

“We finally conduct a counterfactual policy experiment designed to answer the following questions: could a different monetary policy have avoided the economic collapse of the 1930s? More generally: To what extent does the impossibility for central banks to cut the nominal interest rate to levels below zero stand in the way of a potent counter-deflationary monetary policy? Our answers are that indeed a different monetary policy could have turned the economic collapse of the 1930s into a far more moderate recession and that the central bank can resort to an appropriate management of expectations to circumvent – or at least loosen – the lower bound constraint.

The counterfactual monetary policy that we study temporarily expands the growth rate in the monetary base in the wake of the money demand shocks that we identify. To ensure that this policy does not violate the zero lower-bound constraint on the interest rate, we consider quantitative policies which expand the monetary base in the periods a shock. By injecting an anticipated inflation effect into the interest rate, this delayed-response feature of our policy prevents the zero bound constraint from binding along the equilibrium paths that we consider. At the same time, by activating this channel, the central bank can secure control of the short-term real interest rate and, hence, aggregate spending.

The conclusion that an appropriately designed quantitative policy could have largely insulated the economy from the effects of the major money demand shocks that had manifested themselves in the   late 1920s is in line with the famous conjecture of Milton Friedman and Anna Schwartz (1963).”

So what policy rule are the authors talking about? Well, it is basically a feedback rule where the money base is expanded to counteract negative shocks to money-velocity in the previous period. This is not completely a NGDP targeting rule, but it is close – at least in spirit. Under NGDP level targeting the central bank will increase in the money base to counteract shocks to velocity to keep NGDP on a stable growth path. The rule suggested in the paper is a soft version of this. It could obviously be very interesting to see how a real NGDP rule would have done in the model.

Anyway, I can highly recommend the paper – especially to the members of the ECB’s The Governing Council and I see no reason that they should not implement a rule for the euro zone similar to the one suggested in the paper. If the ECB had such a rule in place then Spanish 10-year bond yields probably would not have been above 7% today.

PS Scott Sumner has been looking for a model for some time. Maybe the Christiano-Motto-Rostagno model would be something for Scott…


 

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Gustav Cassel on Hoover’s Mistake and monetary policy failure

While I was going through old Australian newspaper articles (don’t ask me why…) I came across a wonderful little article by Gustav Cassel published on February 17 1930. In the article Cassel spells out why fiscal policy would not be able to pull out the US of the Depression and why the Great Depression was caused by  monetary policy failure. The whole thing sounds very Market Monetarist.

I have reproduced the entire article below. Enjoy the wisdom of Gustav Cassel.

President Hoover’s Mistake

– By Professor Gustav Cassel, the Distinguished Swedish Economist

It has been an open question for many years as to what Governments can do to counteract an economic depression… It has above all been suggested that public works should be regulated according to the fluctuations caused from time to time by economic conditions. In other words, the Government should start comprehensive undertakings at the moment when private enterprise begins to lag. The United States are at present in such a condition. Under the energetic leadership of President Hoover it seems that the Government is to intervene promptly and effectively in order to prevent the Stock Exchange crisis from developing into an economic depression.

This case can provide a most useful lesson for the general treatment of this problem and deserves special attention because Europe is more or less bound to be affected by an American depression and will then have to face the same difficulties against which America is fighting today. President Hoover’s programme, which has been given the name of ‘Prosperity Maintenance’ mainly comprises the starting of big undertakings in order to prevent the threatened reduction of industrial employment. To this purpose the official departments are to co-operate with the private employers.

The President called together at the White House several groups representing the economic activity of the country, and the representatives of the railways at once assured him of their cooperation in the form of a comprehensive programme of extensions.

Apart from a certain psychological influence, the President’s programme, is, however, in every way a mistake. It rests not only on an incorrect conception of the actual conditions, but also on an over-estimate the Government’s power.

In the endeavours to create employment by extraordinary new enterprises, it must be remembered very clearly that the burden will fill on the nation’s savings and reduce the amount of money available for the increase of true capital. An intervention by the State in order to increase the existing works and their machinery equipment might possibly be a sensible policy if a surplus of savings were available. The Hoover programme seems to assume that it is the case. In his message to Congress the President has proclaimed to the whole world that hitherto American capital was invested to an extraordinarily large proportion in stock speculation. The crisis is now said to have set this capital free, and made it available for general economic enterprises.

The ‘Government therefore considered it to be their duty to find employment for the capital supply. Every link in this chain or argument is a fallacy. Speculation in stocks has never involved any capital and cannot involve any. Therefore no capital can flow back from the Stock Exchange to economic enterprise. After all, America has no more available capital requiring a special effort for its employment.

The American Stock Exchange crisis signifies no more than that exaggerated quotations have been reduced to their normal value. There is no crisis in the economic life, but only a certain reduction of capital available, mostly for the building of dwelling houses. This reduction is caused immediately by the fact that the current new savings were not sufficient to maintain the production of real capital in the enormous proportions of last year.

The outstanding feature of the present position is therefore undoubtedly a great scarcity of capital. This being the case, is it not foolish to undertake large new enterprises in the belief that they can be paid for with available capital? Any effort in this direction, especially if made by the Government, is bound to waste the already scarce reserves, and thus to weaken the entire political economy.

That scarcity of capital is the principal feature of the present situation is also shown by the fact that the export of American capital has decreased very considerably indeed. If more surplus money were offered America would increase its export of capital and thereby improve the purchasing power of the other countries for the American export products. This would free the Government from many cares concerning inner political economy and at the same time render superfluous its efforts to exert its political power in creating outlets for American exports.

Such a development would be most welcome to all the countries needing capital. Conditions, the whole world over have shaped themselves in such a way that the export of American capital is an indispensable condition for a prosperous world economy. The whole world must therefore view with grave concern a Government intervention which, on account of its uneconomic investments, is bound to render impossible the accumulation of American savings.

Government intervention is in this case obviously to the detriment of the economic organisation. It would be far better to leave that organisation to look after itself. If this were done, any available new surplus money would very quickly be put, to use, provided that no new hindering circumstances should arise. An important American journal has recently collected a number of views on this subject by industrial leaders.

The general impression to be gathered from this inquiry is that the industrialists intend to carry on, notwithstanding the Stock Exchange crisis. In most branches of industry there is an acute necessity to enlarge the buildings and to improve the equipment. On reading the inquiry made by this journal we certainly do not feel that there is any lack of opportunities to use any available American capital. In the present situation there is indeed only one single factor which can seriously hinder development and this one factor has its origin in a Government Department. I am referring to the bank rate policy or in a wider sense to the limitation of money supplies to the economic life by the Federal Reserve System. This limitation has of late been far too strict. The reason is the attempt to regulate the bank rate in such a way that it, would have a supreme influence on the Stock Exchange, limiting the speculative inflation of share prices.

There is no doubt that this attempt constitutes an improper transgression of the natural limits of the tasks evolving upon a central banking institution – an attempt which ultimately can be traced back to the ardent desire of the Government to usurp an ever growing share of influence upon the country’s political economy. It is true that after the Stock Exchange crisis the bank rate has been slightly reduced. But this measure was taken far too slowly and hesitatingly.

The Federal Reserve system has not kept pace with the development, but since the last summer has adhered to rates which were far too high, with the result of a collapse in prices which seriously endangered the whole political economy, and which, so long as it continues will naturally prevent any sensible persons from making new investments. If the fall in prices were to continue, this would unavoidably prevent American economy from continuing its recent wonderful developments.

The collapse in prices is bound to drag with it the whole of the rest of the world and to create a universal condition which must react on the economy of the United States. And all this entirely unnecessary collapse of prices is exclusively the result of the mishandling of the American dollar value which in its turn is the consequence of an uncalled for excursion of Government influence into the province of economic problems.

The whole matter is a blatant example of what happens if we yield to the modern tendency of permitting the Government to meddle unnecessarily with economics. The Government assumes a task which is not in its province; in consequence of this it is driven to mismanage one of its most pertinent tasks, i.e., the supervision of money resources, this causes a depression, which the same government seeks to remedy by measures which are again outside the sphere of its true activity and which can only make the whole position worse.

The particular case under review is really only an illustration of a phenomenon which at present is very general; while neglecting their proper functions, governments greedily seize every opportunity to usurp provinces which are not their concern, and by doing so place themselves – with or against their will – on a plane inclined towards a form of socialism, the aim of which is, in this respect, to risk everything to obtain the utmost.

—–

Other posts on Gustav Cassel:

Gustav Cassel foresaw the Great Depression
Hawtrey, Cassel and Glasner
“Our Monetary ills Laid to Puritanism”
Calvinist economics – the sin of our times
Gustav Cassel on recessions

And Steve Horwitz on why Hoover was an interventionist.

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!).

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