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Why the US labour market is softening – the one graph version

Friday’s US labour market report was a huge disappointment. This graph explains why.

Muscial Chairs model

This is of course Scott Sumner’s Musical Chairs model of the US labour markets. Simply said the model predicts unemployment to rise if demand growth (nominal GDP) slows relative to the growth of labour costs (average hourly earnings).

With monetary conditions tightening (NGDP growth slowing) and minimum wage hikes helping push up wage growth it should hardly be surprising that we are now seeing a softening of US labour market conditions.

It is not dramatic, but there can be little doubt about the trend and it is essentially the same kind of policy mistakes that we saw in the 1930s – too tight monetary policy combined with labour regulation that push up wage growth. Scott of course documents this very well in his new book the Midas Paradox

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Guest post: Tight Money, High Wages: a review of Scott Sumner’s The Midas Paradox

My friend the great economic historian Clark Johnson has written a review of Scott Sumner’s new book The Midas Paradox.

I am very happy that Clark has given me the possibility to publish the review on my blog as a guest post.

If you are interested in the causes of the Great Depression you should certainly read Scott’s new book, but you should not miss Clark’s own book on the Great Depression Gold, France, and the Great Depression, 1919-1932

Here is Clark’s review…

Tight Money, High Wages: a review of Scott Sumner’s The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression (Independent Institute, 2015)

By Clark Johnson

January 2016

Scott Sumner’s new book, The Midas Paradox, uses a “gold market approach” to understand the causes and persistence of the depression of the 1930s.  By wide agreement, the roots of the 1929-1932 depression lay in a shortfall of aggregate demand – which was a consequence of systemic monetary constraint.  Sumner uses the world’s quantity of monetary gold and the ratio of gold-to-money to determine the stance of monetary policy and to identify lost opportunities.  The more usual indicators of interest rates and the quantity of money turn out to be misleading under a gold standard.

He then moves beyond the roots of the downturn to the reasons for persistence of weak economic conditions for years after the underlying monetary problem was solved.  He develops the unexpected view that the US in particular saw a supply-side depression that began in 1933, one driven in large part by New-Deal-driven interferences in labor markets.

Monetary Origins of Depression

Sumner credits what he calls the Mundell-Johnson hypothesis, according to which the roots of the depression were in the post-WWI undervaluation of gold, as a precursor to his study. As the junior placeholder on that hypothesis, I recap my understanding of it here.  The purchasing power of an ounce of gold changed little from the middle of the seventeenth century to the middle of the twentieth.  Gold constraints were typically relaxed during wars to facilitate official spending and borrowing – and allowing price inflation.  But English deflation restored prewar price levels in the years after the Puritan wars of the seventeenth century and the Napoleonic wars of the nineteenth.

A similar deflation was likely to occur after the First World War as major economies of Germany, Britain, and France would return to gold convertibility at the prewar value of $20.67/ ounce during the 1920s.  The low postwar gold value affected monetary reserves in two ways: 1) it depressed the value of outstanding stocks; and 2) it reduced the price incentive for new gold production.  In France, the US, and Germany, which had traditionally had large gold coin circulations, gold was mostly taken out of circulation during and after the war, which lessened confidence in convertible paper money.  Economist Gustav Cassel drew attention to the “gold standard paradox,” by which a gold-based monetary system would require ever-increasing gold production to accommodate economic growth while maintaining reserve ratios.

Yet world gold production during the 1920s was below what it had beezn in the decade before the war; and given the postwar decline in gold’s purchasing power, the real value of new gold produced in the mid-1920s was just over 50 percent of what it had been in 1914.

Read the rest of the review here

Scott Sumners’ new book: The Midas Paradox – Buy it now!

For years my friend Scott Sumner has been working on his book on the Great Depression. It has taken some time to get it out,  but now it will soon be available (December).

The book The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression published by the Independent Institute can be preorder from Amazon now. See here (US) and here (Europe/UK). Needless to say I have already ordered the book.

This is the official book description:

Economic historians have made great progress in unraveling the causes of the Great Depression, but not until Scott Sumner came along has anyone explained the multitude of twists and turns the economy took. In The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, Sumner offers his magnum opus-the first book to comprehensively explain both monetary and non-monetary causes of that cataclysm.

Drawing on financial market data and contemporaneous news stories, Sumner shows that the Great Depression is ultimately a story of incredibly bad policymaking-by central bankers, legislators, and two presidents-especially mistakes related to monetary policy and wage rates. He also shows that macroeconomic thought has long been captive to a false narrative that continues to misguide policymakers in their quixotic quest to promote robust and sustainable economic growth.

The Midas Paradox is a landmark treatise that solves mysteries that have long perplexed economic historians, and corrects misconceptions about the true causes, consequences, and cures of macroeconomic instability. Like Milton Friedman and Anna J. Schwartz’s A Monetary History of the United States, 1867-1960, it is one of those rare books destined to shape all future research on the subject.

What I particularly like about the book – yes, I have read it – is that it re-tells the story of the Great Depression by combining financial market data and news stories from the time of the Great Depression. I very much think of this as the Market Monetarist method of analyzing economic, financial and monetary events.

By studying the signals from the markets we can essentially decompose if the economy has been hit by nominal/monetary or real shocks and if we combine this with information from the media about different events we can find the source of these shocks. It takes Christina (and David) Romer’s method of analyzing monetary shocks to a new level so to speak. This is exactly what Scott skillfully does in The Midas Paradox.

So I strongly recommend to buy Scott Sumners’ The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression.

The young Keynes was a monetarist

I am continuing my reporting on my survey of monetary thinkers’ book recommendations for students of monetary matters. The next “victim” is Scott Sumner and lets jump right into it. Here is Scott’s book list:

David Hume.  Essays on Economics

Irving Fisher. The Purchasing Power of Money

Keynes.  A Tract on Monetary Reform

Ralph Hawtrey.  The Gold Standard in Theory and Practice

Friedman and Schwartz. A Monetary History of the US

David Glasner.  Free Banking and Monetary Reform

Robert Barro.  Macroeconomics

I had asked for five book recommendations, but Scott gave me seven to choose between, but that doesn’t really matter the important thing is that we inspire people to read these books. Nonetheless Scott told me that if we had to cut it to five we should cut out Hume and Keynes. So my next step is not completely fair – I will focus on Keynes’ “A Tract on Monetary Reform”.

The reason is that Tract is a popular book among many of the monetary thinkers I have surveyed and it is not only Scott who has it on his list. The reason I find it interesting is that Tract is really a monetarist book rather than a Keynesian book. Keynesian here meaning the Keynes is The General Theory – Keynes’ most famous book.

To realise that Tract is very much a monetarist book just take a look at that preface. Here is a photo from my own copy of the book:

Tract

The point Keynes makes here is that in a free market without money the markets will tend to “clear” – supply and demand will match each other. This is basically a Walrasian world. However, once we introduce money there is a possibility that if get a disequilibrium between money supply and money demand this disequilibrium will spill-over into other markets or as Keynes express it:

“But they (other markets) cannot work properly if money, which they assume as a stable measuringrod, is undependable.”

In fact this is very much how Leland Yeager or Clark Warburton would explain macroeconomic disequilibrium – recession, deflation, inflation are results of monetary policy failure. It doesn’t get anymore monetarist than that.

Brad DeLong in an excellent review of Tract from 1996 went so far as to say that it was “the best monetarist economics book ever written”. I wouldn’t go so far as Brad, but I certainly agree that Tract fundamentally is monetarist and that is also is very good book. But it is not the best monetarist book ever written – far from it.

In general I would very much like to recommend Brad’s 1996 review of the Tract. It covers all five chapters of the book and  in my view gives a pretty good description of Keynes’ views from the period prior to he became an “Keynesian”.

Get the monetary framework right and let the market take care of the rest

The overall message in the Tract in my view is that Keynes wants to demonstrate that if you mess up the monetary system you will mess up the entire economy. But if on the other hand ensures a stable and predictable – rule based – monetary system then the free market will tend to work well and the price mechanism will more or less ensure an efficient allocation of economic ressources. This of course has been Scott Sumner’s message all along. The Federal Reserve should conduct monetary policy based on – a predictable rule NGDP level targeting – and then the free market will take care of the rest.

The Federal Reserve and other central banks since 2008 has messed up the monetary system and as a result they have done great economic damage. Keynes has a message to today’s central bankers (also from the preface):

“Nowhere do conservative notions consider themselves more in place than in currency; yet nowhere is the need for innovation more urgent. One is often warned that a scientific treatment of currency questions is impossible because the banking world is intellectually incapable of understanding its own problems. If this is true, the order of Society, which they stand for, will decay. But I do not believe it. What we have lacked is a clear analysis of the real facts, rather than ability to understand an analysis already given. If the new ideas, now developing in many quarters, are sound and right, I do not doubt that sooner or later they will prevail.”

I find Keynes’ words from 1923 extremely suiting for the crisis of central banking today and even more suiting for Scott Sumner’s endless campaign to enlighten central bankers and the general society about the importance of proper “Monetary Reform”. In that sense Scott Sumner follows in the footsteps of the younger Keynes, Gustav Cassel, Leland Yeager and Milton Friedman in advocating radical monetary reform.

And finally I should of course note that later in the year Scott’s great work on the Great Depression will be published. I am sure it will become a classic on its own. I have been so privileged to read a draft version of the book and I hope you all buy it when it is published. Scott tells me the title of the book will be  “The Midas Paradox: A New Look at the Great Depression and Economic Instability” 

PS I just have to share Brad Delong’s great comments about the young and the old Keynes:

“The implicit point of view is that if the value of money is dependable then leaving saving to the private investors and investment to business will work well. The magnitude of the Great Depression of the 1930s would destroy Keynes’s faith in the proposition that stable internal prices implied a well-functioning macroeconomy and small business cycles. But from our perspective today–in which the Great Depression is seen as a unique disaster brought on by an unprecedented collapse in financial intermediation and in world trade, rather than as the largest species of the genus of business cycles–it is far from clear that Keynes of 1936 is to be preferred to Keynes of 1924. Besides, Keynes of 1924 writes better: his prose is clearer, less academic, less formal; his argument is more straightforward, linear, easier to follow; his style is as witty.”

PPS It is Sumner in Skyrup…

Tract white wine

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