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Broken by the fix

By Lorenzo

What do the goldzone Great Depression (1929-3?) and the Eurozone Great Recession (2008-?) have in common? They were both created by European central banks with the US Federal Reserve (the Fed) as accessory during and after the fact. (Yes, the monetary shock which set off the Great Recession started in Europe though the responsibility of the European Central Bank [ECB] in that initial shock was a bit more indirect than that of the Bank of France in the Depression; the ECB was much more directly culpable in the subsequent monetary contraction.)

When Nobel laureate Thomas Sargent described the euro as an artificial gold standard he was zeroing in on common features–the goldzone and the Eurozone both being fixed exchange rate systems operating over institutionally divergent countries with limited labour flows, no fiscal union (so no significant fiscal transfers) nor common risk pool otherwise (in the case of the Eurozone, no lender of last resort). Having the Eurozone include Mediterranean economies was not (pdf) a monetary union that conventional Optimum Currency Area (OCA) theory supported. While economist Charles Goodhart is quite correct when he points out that OCA theory cannot explain the boundaries of existing currency realms–that being a result of the operation of state power–if OCA theory is seen as providing an analysis of whether currency realms should amalgamate, it turns out to be very powerful, as the travails of the Eurozone are proceeding to demonstrate.

This surprised-by-American-scepticism paper [pdf] by European economists–scepticism largely driven by OCA theory–reads rather differently now. Though labour mobility is supposed to be one of the key differences between the US and the Eurozone, yet land-rationing in the richer US cities is seriously reducing labour mobility, making the US more like the Eurozone and undermining its macroeconomic resilience.

Inflation phobia
Milton Friedman was famously an advocate of (pdf) floating exchange rates, Frederich Hayek an advocate of (pdf) fixed exchange rates. The latter seems an odd position for a free market thinker to take. Especially when Hayek was also an advocate for the gold standard, if one was going to keep the state money monopoly. A series of fixed prices (fixed exchange rates, fixed gold price) erected on monopoly provision seems a very odd position for a free market thinker to take.

The explanation is simple: fear of inflation. A fixed price of money in gold means–given gold’s scarcity–that the possibilities of inflation are greatly reduced. A fixed exchange rate means giving up the ability to domestically inflate (as Greece, Italy, Portugal and Spain are currently discovering). A monetary authority can control price stability or it can control the exchange rate, it cannot do both. Being in the goldzone means inflation will only occur if the price of gold is falling, which it is unlikely to do by much, given that stocks greatly outweigh new production.[i]

The experience of inflation is another feature in common between the goldzone Great Depression and the eurozone Great Recession. Both the great deflation of the former and the disinflation of the latter occurred after dramatic periods of inflation. In the case of the interwar goldzone; the wartime inflations, the German and Austrian hyperinflations, the French early 1920s inflation. Fear of inflation dominated the thinking of monetary authorities–indeed, paralysed their thinking.

In our own time, the Great Inflation from the late 1960s to the early 1980s has profoundly affected the thinking of monetary authorities; indeed, paralysed it. The success of inflation targeting in squeezing inflation out of Western economies has made it a policy fetish that central bankers cannot see beyond, just as the gold standard was a policy fetish monetary authorities in the early 1930s could not see beyond. Not even to make adjustments necessary to save it. To the extent that the Fed is paying people not to spend money. It has been a continuing pattern for central bank policy to respond more to the traumas of the past than the dilemmas of the present.

Been there, done that
It is a sad reflection on the ability of policy makers to find new ways of making old mistakes that if one reads either version of the paper (pdf) by Barry Eichengreen and Peter Temin, The Gold Standard and the Great Depression, and replaces ‘gold standard’ with ‘inflation targeting’, one gets an almost perfect description of the current failures of central banks and the mentality behind such. Particularly when the Eichengreen and Temin say (p.19 of the NBER paper):

policies were perverse because they were designed to preserve the gold standard, not employment.

Replace ‘gold standard’ with ‘inflation target’ and that is exactly what has been happening in our own time.[ii] Indeed, it was worse than that, as the the Fed and the Bank of France were not even “doing” the gold standard properly (pdf). Just as the European Central Bank and the Fed are now not even doing inflation targeting properly. (To the extent that the IMF is now reporting a significant risk of deflation [pdf] in Mediterranean Eurozone countries.) Just to increase the similarities between the Great Depression and Great Recession, inflation targeting that implicitly or explicitly incorporates “headline” inflation which includes oil and commodity price shocks turns into a de facto commodity standard (since a rise in commodity prices leads to monetary tightening; so the value of money is tied to commodity prices).

As for the authors’ comment:

Central bankers continued to kick the world economy while it was down until it lost consciousness (p.2)

that is a fair description of the role of the ECB in the Eurozone crisis. With the added proviso that many think some beating is warranted: alas for such righteous monetary Calvinists, the policy of the beatings continuing until performance improves has long since degenerated into pointless and destructive monetary sadism.

Which makes Greece an enormously useful scapegoat for the ECB.  While people are pointing at its obvious policy dysfunctions (a country rated by the World Bank as 100 out of 183 in difficulty of doing business has considerable capacity to improve its economic performance through its state simply stopping spending money and effort getting in the way of people transacting[iii]), and the undoubted economic rigidities in other Mediterranean Eurozone countries (Italy is rated 87, Spain 44 and Portugal 30 in difficulty of doing business compared to Germany at 19), the ECB is avoiding any accountability for its actions. (Which would make it the ultimate EU creation; the EU being a construction where power without accountability is not a bug, it’s a feature.)

Conversely, the worst thing for the Eurozone would be for Greece, or any other country, to leave–and promptly start to do better. [UPDATE: A paper by Anders Asland argues {pdf}, based on the experience of previous European currency union break-ups, that even a Greek exit would have disastrous effects, particularly for Greece.] Moreover, economic rigidity hardly explains the level of economic pain in the Great Recession—the UK is ranked 7, Ireland 10, USA 4 in difficulty of doing business. Nor does public debt on its own–even within the Eurozone, Spain has a lower level of public debt than Germany (pdf).

Compared to the ECB’s destructive monetary austerity, the Fed is more in the situation of having belted the US economy intoTKO,[iv] then helped it sit back up a bit, and offered some water, but resolutely refuses to help the punch-drunk economy stand, proclaiming that if it cannot stand up on its own, it is not fit to, while promising that it won’t let it fall to the matt again. Monetary policy matters.

Contractionary blindness
The great blindness involved in this inflationphobia is to think that inflation is the only significant monetary danger. Firstly, serious monetary-contraction deflation is worse than monetary-expansion inflation, even hyperinflation. Both undermine economic calculation, but inflation tends to promote transactions (as people spend before their money loses value), deflation to restrict them (as people defer using money that will buy more later, leading to falling spending and thus falling income). Generally, falling transactions, falling economic activity, is worse than rising.

There can be benign deflation; from expansion in supply of goods and services (pdf)[v]–a classic example is the falling price of information technology. But such expansion in output is quite different from deflation from monetary contraction.[vi]  (Inflation can also be disaggregated into supply and demand inflation.)

Unexpected inflation–inflation not already reflected in interest rates–tends to punish creditors, as their loans (denominated in money falling in value) lose value. Unexpected deflation tends to punish debtors, as their debt burdens (denominated in money rising in value) rise as money income falls. Both distort action across time, but monetary-contraction deflation does in a way that reduces economic activity and income while increasing debt burdens. Falling incomes and rising debts lead to increasing levels of insolvency and bad debts, which then puts pressure on the financial system. The worse the deflation from monetary contraction, the worse ensuring financial crisis is likely to be. An economic process that superficially improves the position of the holders of financial assets (i.e. debts) turns into a rolling disaster as those assets–being claims on the solvency of others[vii]–are devalued or destroyed as insolvency spreads.

Serious monetary-contraction deflation is not only worse in its economic consequences and suffering, it is also worse in its political and policy consequences. Deflationary spirals promote political extremism far more than inflationary ones do precisely because of the falling level of economic activity. (Weimar Germany survived hyperinflation; it was the Great Goldzone Deflation spending crash that killed it.) They also promote much more interventionist policies, as the market system fails for more and more people, so alternatives appeal more and more.

Inflation is much more common than monetary-contraction deflation. But that a danger is more common does not make it a worse threat. The historical evidence is quite clear: serious monetary-contraction deflation is much more to be feared.

Unexpected disinflation has similar effects to monetary-contraction deflation. Disinflation can be eminently desirable when it has a clear end point, being directed towards a desirable target (price stability). But the cost of dong so is greatly increased if the monetary authority fail to manage expectations effectively (i.e. fails communicates what it is doing), thereby leading to a plague of mis-specifed contracts and pricing through the central bank disinflating surreptitiously.

Secondly, it is perfectly possible to have monetary contraction with prices being relatively stable. Imposing monetary austerity–providing insufficient money to respond to demand to hold money without cutting back transactions, a process encouraged by failing to support income expectations–can be seriously contractionary, even without significant continuing effects on the price level. Indeed, unbalanced credibility–where confidence in the value of money is high (i.e. there is a nominal anchor for price expectations) but for future spending (and so income) is not (i.e. there is no complementary anchor for income expectations)–can drive economic activity well below capacity precisely because it drives money demand higher while the level of money in circulation spirals down with output. (Putting it in Aggregate Demand and Short-Run Aggregate Supply [SRAS] terms; if both curves move leftwards, output falls and the price level does not change–an entirely plausible possibility if the SRAS curve is sensitive to expectations about demand.) If central banks treat their inflation target as a ceiling and tighten at any sign of “inflationary” resurgence in activity–and are expected to keep doing so–then output can remain “stuck” at well below capacity, which means many people without jobs.

Expectations are crucial, and the constipated communications strategies of the Fed and the ECB represent failures to manage expectations. Expectations about prices and spending, about the value and use of money, both matter. The power of expectations can be seen in this dramatic example from economist Henry Thornton, writing in 1802 of events that had occurred in 1793:

when, through the failure of many country banks, much general distrust took place. The alarm, the first material one of the kind which had for a long time happened, was extremely great. It does not appear that the Bank of England notes, at that time in circulation, were fewer than usual. It is certain, however, that the existing number became, at the period of apprehension, insufficient for giving punctuality to the payments of the metropolis; and it is not to be doubted, that the insufficiency must have arisen, in some measure, from that slowness in the circulation of notes, naturally attending an alarm, which has been just described. Every one fearing lest he should not have his notes ready when the day of payment should come, would endeavour to provide himself with them somewhat beforehand. A few merchants, from a natural though hurtful timidity, would keep in their own hands some of those notes, which, in other times, they would have lodged with their bankers; and the effect would be, to cause the same quantity of bank paper to transact fewer payments, or, in other words, to lessen the rapidity of the circulation of notes on the whole, and thus to encrease the number of notes wanted. Probably, also, some Bank of England paper would be used as a substitute for country bank notes suppressed.

The success of the remedy which the parliament administered, denotes what was the nature of the evil. A loan of exchequer bills was directed to be made to as many mercantile persons, giving proper security, as should apply. It is a fact, worthy of serious attention, that the failures abated greatly, and mercantile credit began to be restored, not at the period when the exchequer bills were actually delivered, but at a time antecedent to that æra. It also deserves notice, that though the failures had originated in an extraordinary demand for guineas, it was not any supply of gold which effected the cure. That fear of not being able to obtain guineas, which arose in the country, led, in its consequences, to an extraordinary demand for bank notes in London; and the want of bank notes in London became, after a time, the chief evil. The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency. This expectation cured, in the first instance, the distress of London, and it then lessened the demand for guineas in the country, through that punctuality in effecting the London payments which it produced, and the universal confidence which it thus inspired. The sum permitted by parliament to be advanced in exchequer bills was five millions, of which not one half was taken. Of the sum taken, no part was lost. On the contrary, the small compensation, or extra interest, which was paid to government for lending its credit (for it was mere credit, and not either money or bank notes that the government advanced), amounted to something more than was necessary to defray the charges, and a small balance of profit accrued to the public.

To summarise, if central banks have credibility on income but not price stability—we get the Great Inflation.[viii] If central banks have credibility on price stability but not income, and there is a sufficiently large economic shock—we get the Great Recession. The first does not stop until the central banks achieve credibility on price stability, the second until they do on spending. If central banks have sufficient credibility on both—we get the Great Moderation.

Grasping this pattern is harder when economists engage in pointless activities such as analysing monetary policy using dynamic stochastic general equilibrium (DSGE) modelling that abstracts away from key monetary elements. This study, for example, has no element of expectations in analysis (as they admit) and so concludes that monetary policy during the Great Inflation and the Great Moderation “were the same”. But if expectations and credibility are different, as they clearly were, then it is not “the same” monetary policy. Much of monetary policy is about policy instruments-as-signals and they work different depending on how expectations have been or are framed. Expectations matter.

For money cannot happen without expectations. Indeed, all future-directed action (so all action) is based on expectations because there is no information from the future; expectations are all we have to guide our actions. Expectations clearly based on past experience to be sure, but expectations nevertheless. Money is, however, particularly a matter of expectations, as its only value is due to expectations of future use in transactions, it has no utility beyond that. The combination of being of use only in transactions but being so across all monetised transactions makes money both expectation-driven and powerful in its short-run effects as the means by which aggregate demand is manifested.

Clearly, monetary policy is easier in some periods (such as periods with minor or benign supply shocks) than others (ones with strong, negative supply shocks). But that only makes it more important to get things right.

Obsessing over inflation wildly under-specifies how central banks can screw up. In particular, looking for causes of busts in preceding booms when dealing with highly abnormal events–as both the Great Depression and Great Recession are–is to profoundly mis-analyse what is going on. Abnormality has to be treated as abnormality, otherwise one will misunderstand both normality and abnormality. It is simply not the case that these wildly abnormal downturns can be “explained” by preceding booms when similar booms did not create equivalent output transaction collapses/goods and services gluts.

Fixed prices and constrained quantities
In any market, prices are the prime means of communicating changes in circumstances–they optimise and convey information. If there is a serious maladjustment, a serious collapse in output transactions, then the first suspicion has to fall on prices that do not, or cannot, adjust sufficiently.

In examining the dynamics of normal business cycles, things such as “sticky” wages are prime culprits; though for problems in adjustment rather than explaining the need to adjust. (I.e. why a given economic shock has the effect it does, not why the shock occurred.) But sticky wages are enduring features of modern economies, so not a good suspect for explaining wildly abnormal events.

Fixed prices in money are a much better culprit than even sticky wages, since money flows through every market in a monetary exchange economy. If there were, for example, fixed exchange rates before and after the downturn, they may be very much implicated in transmitting the relevant economic shock but less so in explaining abnormal economic downturns on their own. (Australia, for example, has found a floating exchange rate to be an excellent economic shock absorber.)

Markets are about both price and quantity. Quantity constraints coupled with fixed prices are an excellent mechanism for transmitting and worsening economic shocks. In particular, an increase in demand for money that is not compensated for by an increase in money supply is an excellent mechanism for turning an economic shock into economic downturn. Indeed, that may be the most common reason for economic downturns in societies with central banks as monopoly suppliers of money.[ix] A drop in confidence in income expectations (i.e. negatively construed uncertainty increases; Keynes’s “animal spirits” are just how people frame uncertainty) leads to increased money demand which supply does not expand to match which leads to a drop in transactions, so spending and so income, which drives down income expectations, and the spiral is on.

A prime mechanism for constraining quantity is a monopoly supplier. Which is precisely what modern central banks are–monopoly suppliers of money. Even if you think a government monetary monopoly is necessary for good public policy, that does not mean one should stop analysing it as a monopoly. (Though failing to do so can avoid the problem of justifying said monopoly.)

If a massive, continuing monetary contraction IS the economic shock, then fixed money prices plus monopoly provider(s) is an excellent mechanism (aggravated by “sticky” wages) for creating and transmitting, and blocking recovery from, a massive economic shock. This is the story of the Great Goldzone Deflation aka Great Depression. Unless and until the central bankers took responsibility for the disaster they caused, then the only way out was to rescue economies from their grip–in the case of Great Depression, by exiting the goldzone; the sooner countries did so, the sooner their (pdf) economies started to recover (absent further disastrous policies, such as NIRA).

In the case of the Great Recession, the failure to respond to the increased demand for money interacted with the lack of income credibility to send income expectations spiraling down. While the central banks refuse to take responsibility for their failings, and so do nothing to revive income expectations, the only way out is to rescue economies from their grip; either by exiting the Eurozone (or from their control in some other way) or by forcing a change in policy goal on them. (Which the Cameron-Clegg Government could do for the UK by simple direction of the Bank of England, thereby greatly improving its economic and political situation.)

As the global financial crisis was unfolding, the Feb failed to respond to increased demand for dollars from the Eurozone. The difficulties in getting hold of the primary reserve currency showed up in a dramatic increase in European demand for gold. These difficulties and failures have since been exacerbated by the ECB’s tight money policies and the refusal of both the ECB and the Fed to take responsibility for the level of aggregate spending aka aggregate demand. Reading two analyses of the Global Financial Crisis (GFC) written by then or former central bank “insiders”, one sees either concern for rising inflation (pdf) framing the analysis or a lack of any sense that (pdf) monetary policy mattered in understanding the GFC.

Diverted by debt
Part of the problem with grappling with such abnormal economic disasters, even just analytically, is that many things are happening as the disaster unfolds and it is easy to fixate on one of more of them and ignore or discount the underlying cause. (Also, since the dynamics of a system often become much clearer after massive failure–since its weaknesses and stress points are exposed–the revealing information about affected systems and institutions adds to the distraction effect.)

As policy-makers thrash around trying to find solutions, whatever expediences they fix upon can get some or all of the blame (and they may act to delay recovery). As underlying weaknesses are revealed under serious economic stress, they can also be pointed to.

In particular, as spending and so income crashes, the debt burden rises and the collapse in income expectations means people seek to reduce debt. But this “deleveraging” is response more than cause. This is particularly obvious in the Eurozone Great Recession, as public debt burdens have surged since 2008.

Spending crunch means debt surge which means debt crisis

As GDP falls and unemployment rises, the fiscal balance shifts against government and debt burdens rise. But to concentrate on the increased burden of debt, and consequent “de-leveraging” (whether private or public), is to elevate symptom over cause.

If one has an asset price crash, the loss of wealth is hardly likely to make people want to work less. It is only if one has a spending crash that there is a problem for economic activity. As 1987 proved, it is perfectly possible to have one without the other, especially when asset prices have become predicated on expected future income rather than current income. It is any spending crash that causes the real damage.

If we look at the economic indicators for the Eurozone (pdf), we not only see the surge in public debt, we can also see an amazing crash in M3, consumer spending, wage growth, investment … In other words, a dramatic crash in spending, in output transactions. That is what has done the damage.

Having taken absolutely no responsibility for the spending crash, the ECB is now taking no responsibility for the continuing poor income expectations, and so no steps to fix it. It is, at most, seeking to minimize the stress to the financial system that its policies caused and which will continue while Eurozone countries continue to be in the grip of the ECB’s monetary austerity; stress that only resurgent economic activity can fix and the lack of which extends the danger of a further collapse in the financial system.

Just as the Fed, having inflicted surreptitious disinflation on the US economy, is refusing to take responsibility for restoring spending expectations after passively engineering the biggest peacetime crash in US national income since 1937-38. If the Great Depression is a story of unexpected monetary contraction causing disastrous deflation and income/spending crash, the Great Recession is a story of unexpected monetary contraction causing disastrous contractionary price “stability” mixed in with unexpected disinflation and income/spending crash.

“Sticky” wages and debt are two nominal (as in denominated-in-money) rigidities that affect macroeconomic stability. The third rigidity typically identified (pdf) is hitting the “zero bound” aka liquidity trap of zero interest rates. Clearly, this has effects but it does not make monetary policy impotent. Not only have prominent economists such as Paul Krugman (pdf) and Lars Svensson (pdf) explained how to exit such a trap but Fed Chair Ben Bernanke has reiterated that the Fed is not out of “policy ammo”. It is perfectly possible to analyse monetary policy without discussing interest rates. In monetary policy terms, interest rates are primarily a policy signalling device whose affects vary depending on how expectations are framed. The Reserve Bank of Australia (RBA) shifting interest rates is a different act to the Fed doing so because the framing expectations are different. Think about money and monetary policy in supply, demand and expectations terms, and the so-called “zero bound” looks like nothing more than a policy phantasm from over-relying on a specific signalling device.

Diagnose, then deal with
Contractionary monetary policy by monopoly central banks over large fixed exchange rate areas (the goldzone, the Eurozone, the USA) can create abnormal economic downturns. Accepting that leaves two broad policy options.

(1) Force central banks to take policy responsibility for both price and income stability (i.e. the value and level of use of money across time). This can be done either in the way the RBA does–with an average inflation target over the business cycle, so it responds to the business cycle in a smoothing (i.e. not actively or passively procyclical) way–or by explicit NGDP targeting. Either way, central bank policy becomes smoothing rather than following (or even driving) output down.

(2) End the central bank money monopoly. Introduce free banking, or even the complete denationalisation of money (pdf). (As economist Peter Klein reasonably asks, do we want so much of the world economy to depend on the personality of the Fed Chair or, extending the point, the dynamics of two committees–the FOMC and the ECB Executive Board?)

The obvious practical difficulty with (2) is that government is by far largest transactor, so has largest stake in monetary system. Coercive power gives government the ability to exercise that stake and provides it with means to shift consequences onto others. The more so if it has monopoly power over issuing of currency; so accepting competition in provision of money seriously constrains government–that is much of the point of doing so. Though the utility for  modern states of access to commercial debt gives them an interest (pdf) in price stability too. It depends whether voters as citizens want to have a monopoly provider they have varying degrees of control over (and whose performance they are significantly at the mercy of) or competing suppliers they can choose between.

Citizens can exercise the power to restrain the state regarding maintaining the value of money. For centuries from 1284 onwards, some commercial polities did so. Where propertied-with-inheritance commercial elites dominated the government, they valued the stability of money for private transactions over government revenue from seigniorage, an effect reinforced by their long time-horizons. Competitive money is a way of getting the same effect while also counteracting the risk of money supply not responding to money demand.

As an aside, those who are seriously critical of the RBA’s performance in recent years are–absent some serious reform suggestions–effectively conceding the argument for the abolition of central banks, since the RBA’s performance has been far better than that of the Fed, ECB, Bank of England or the Bank of Japan.[x]

Whatever response is decided upon, disastrously contractionary monetary policy by monopoly central banks over large fixed exchange rate areas can create abnormal economic downturns. They have now done so twice in less than a century. Can we just accept that and move on to what to do about it? In particular, we need to stop pointing fingers elsewhere (particularly on the various scapegoats and fears raised to avoid accountability) and force accountability on the relevant central banks for their failures.


[i] The huge surge in the gold price in recent years may fall back, as did the surge in the late 1970s and early 1980s.

[ii] Though I would say transaction/spending/income levels, rather than employment; though the former clearly have an impact on the latter.

[iii] Putting it in Aggregate Demand (AD) and Aggregate Supply (AS) terms, supply-side reforms move the AS curve continuously rightwards, allowing output to increase without any movement of the AD curve. Of course, if demand is being further constrained (i.e. the AD curve is moving leftwards), then the benefit of reform is felt merely as a failure to go backwards as fast, rather than as an increase in living standards.

[iv] There is an arguable case that Fed and US Treasury intervention made the GFC worse, including through perverse signalling. Chairman Bernanke seems to have used the Global Financial Crisis to prove (pdf) that Prof. Bernanke was right about the “credit channel“ (pdf) for the Great Depression even though his own analysis of the Great Depression said that monetary shock was the underlying driver, financial crises an aggravating transmission mechanism.

[v] Recent papers have had an amusing division of deflation into the good (increased supply), the bad (monetary contraction) and the ugly (extreme monetary contraction).

[vi] Putting it in Aggregate Demand (AD) and Aggregate Supply (AS) terms, benign deflation comes from the AS curve shifting continuously rightwards, driving down prices while output increases. Contractionary deflation comes from the AD curve shifting continuously leftwards, driving down both prices and output. Failing to differentiate these two very different cases is an instance of the Sumner analytical principle–never reason from a price change. The 1873-1895 goldzone deflation was a shifting mixture of both elements. The 1929-32 deflation was entirely the latter and has become the canonical example of deflation.

[vii] Solvency rather than income because creditors typically have a claim on assets as well as income.

[viii] Even within a supply-shock analysis of Stagflation, it is clear that the lack of monetary policy credibility on price stability was a major factor in the inflation of the period.

[ix] I am ignoring issues of wider monetary aggregates. In a country with a monopoly supply of monetary base, they are all derivations of same.

[x] Alas, the only person in the Fed with a strong Australian connection–Dallas Federal Reserve President Richard Fisher–has fairly disastrous views on monetary policy, obsessing about fighting inflation when inflationary expectations are low and falling; the exact corollary of worrying about inflation during the 1930s, which economist R. G. Hawtrey (who predicted the potential [pdf] for deflationary catastrophe from countries re-entering the goldzone) characterised as shouting “fire!, fire!” in Noah’s flood.


  1. TerjeP
    Posted July 30, 2012 at 1:48 pm | Permalink

    I think you presume that the monetary authority should do all the heavy economic lifting. Greece has options although clearly political paralysis seems to impede them from choosing any that make sense. It can default. It can do a fiscal devaluation by shifting away from payroll taxes. It can engage in microeconomic reform.

    A lot of these problems would have been avoided if the notion that central banks would bail out government debts was avoided from the get go. That Greek debt was at a similar interest rate to German debt right up until their debt crisis suggests that the markets had an expectation that the central bank would do the heavy lifting when push comes to shove. As such it seems that the market wants to believe in the world you advocate but that does not mean people can’t learn of alternatives. Or that they shouldn’t.

  2. derrida derider
    Posted July 30, 2012 at 3:40 pm | Permalink

    Unexpected inflation … tends to punish creditors, … [u]nexpected deflation tends to punish debtors

    Indeed, which tells you all you need to know about why respectable people such as the ECB are inflation-phobic but far too relaxed about the risk of deflation. The Germans are suppsoed to be so inflation-phobic because of the trauma of hyperinflation in the mid 1920s, but actually it was tight money in the face of depression that brought the Nazis to power. Such selective memories people have.

  3. Posted July 30, 2012 at 6:35 pm | Permalink

    DD@2 Indeed. I am less and less surprised how often one has to remind folk that, as I note above, the Weimar Republic survived hyperinflation, but not (ugly) deflation.

    TP@1 If Greece had never entered the Eurozone, there would still be a Eurozone crisis. The markets may indeed have expected that the system being set up had to have an implied lender of last resort, even though it did not officially.

    The ECB is running a monetary policy that is disastrous for the Mediterranean countries. That is not their fault. If you drive down people’s income, of course their debt problem gets worse. This is not rocket science. Such an effect will, however, get reflected in interest rates.

    The markets appear to be reflecting the mix of how much there is a lender of last resort and how much ECB policy is driving down the income of the Mediterranean countries.

    No central bank can fix supply side problems; but it has near complete control over the demand side.

  4. Posted July 30, 2012 at 8:22 pm | Permalink

    DD@2 On your comment in a previous thread about Japan being the future of the developed world, this piece looks at deflation/strong yen as a boon to elderly retirees. Given much of EU policy is already anti-young people, it would fit.

  5. Posted July 30, 2012 at 8:49 pm | Permalink

    TP@1 We have a calculation of what is required to stabilise Spain’s Debt-to-GDP ratio calculated here. The importance of growth in nominal GDP is clear.

    For a depressing dissection of ECB President Draghi’s latest comments, see here.

  6. Posted July 30, 2012 at 9:06 pm | Permalink

    It is a complete absurdity for the CBs to be focused on capping inflation at a very low level after a severe recession, considering that even if they didn’t provide monetary stimulus, inflation would temporarily be higher during recovery because of the idling of production capacity during the downturn.

    But since the CBs in the western world are intent on doing just that, it doesn’t matter what Greece did or didn’t do from a public policy perspective because the ECBs policy of 2% inflation, including headline, acts as a productivity redistributor – which is why Germany isn’t in near as much trouble. It was simply the stronger economy when the crisis hit, not because it has some magic formula of supply side measures that make it resilient to monetary shocks. By those standards the US should be flying right past all of them and we could have money as tight as we want. Nope – doesn’t work that way and eventually the broken monetary policy will bring Germany down as well because no one can survive that kind of cap on demand..

  7. JC
    Posted July 31, 2012 at 12:32 am | Permalink

    Replace ‘gold standard’ with ‘inflation target’ and that is exactly what has been happening in our own tim

    Actually i wouldn’t agree with that. Certainly the individual countries can’t increase the money supply, but the ECB can and has, even more so that the Fed, obviously counting the long term repo programs. It’s a dysfunctional monetary union in the same way WA has to live with a monetary union with the rest of Australia. You can’t create money in a gold standard unless the markets decide to exchange for gold.

    TP@1 We have a calculation of what is required to stabilise Spain’s Debt-to-GDP ratio calculated here. The importance of growth in nominal GDP is clear.

    Dunno about Spain in terms of getting a bailout. i think they will. However I think Italy does slink out of their problems better than the rest. I bought a little of their 10 year the other day selling France 10 year as a short protection and I also traded their stock market.

    Italy’s short term position is actually better than France and Italy has made some pretty significant reforms including labor market reforms. I don’t quite get how Italy is considered a high risk and France is a safe haven when they refuse to even consider their own plight.

  8. Posted July 31, 2012 at 2:29 pm | Permalink

    JC@7 The crucial similarity is the monetary contraction/austerity of both systems stifling output. Merely printing money is not the issue–base money got to extraordinary heights in the Great Depression too, for the same reason, the value of money had far more credibility than did expectations of income. But if, in the name of inflation targeting, the central bank jumps down on any sign of “inflationary” pressure, then the economy remains squelched.

  9. Benjamin Cole
    Posted August 1, 2012 at 9:48 am | Permalink

    Very thoughtful blogging.

    I am beginning to wonder if the Fed should not be lodged within the Treasury Dept, as proposed by then-Secy of Treasury Don Regan, back int he Reagan days.

    This would mean central banks would have to worry about performance across the full spectrum of the responsibilities, or get voted out.

    Why not have voters decide if inflation is too high, or employment is too low?

    Are the risk of popular control over a central bank greater than the risks of popular control over the vast and lethal arsenal of the Defense Dept?

  10. TerjeP
    Posted August 1, 2012 at 11:40 am | Permalink

    But the ECB is only supposed to jump on inflation if it is general across the eurozone. There is plenty of scope for variations in inflation from country to country. Money will flow into a region, and may even cause inflation within that region, when the economic conditions are right. If money is not flowing into the Mediterranean countries right now it is due to concerns about whether the euro will endure in these areas, whether wealth will be effectively expropriated, whether borrowers are credible, whether investment options are viable given the mix of tax policy, property rights, labour laws and the usual suspects.

  11. Posted August 1, 2012 at 8:28 pm | Permalink

    TP@10 What the ECB is supposed to do seems to have little to do with it, see here. The sort of monetary contraction makes just about every economic problem worse, which was my point.

  12. Posted August 1, 2012 at 8:30 pm | Permalink

    BC@9 Thanks, and the accountability issue seems to work fairly well in Australia via upfront public agreement between the RBA Governor and the Treasurer.

  13. JC
    Posted August 2, 2012 at 12:14 am | Permalink

    the central bank jumps down on any sign of “inflationary” pressure, then the economy remains squelched.

    Yea, Sumner made an excellent point similar to this in that the fed is undermining itself by doing QE and when expectations are beginning to build it starts to squelch it by signalling rejection if the inflation rate nears 2%.

    However I think there is a great deal left out here though with the administration’s actions of creating supply shocks through the economy with bad policy and awful signals itself.

  14. Posted August 2, 2012 at 5:09 am | Permalink

    JC@13 There is something in what you say (see here). But, while the stock market rallies at any hit that the Fed might loosen, I will continue to go with there being an ongoing demandside problem.

  15. Posted August 2, 2012 at 8:07 am | Permalink

    JC@13 Continuing my previous point, Evan Soltas has documented what an appalling bad job the Fed does at achieving its own forecasts/forecasting accurately. Perhaps their model is broken?

  16. Posted August 2, 2012 at 1:30 pm | Permalink

    TP@10 David Beckworth puts it in perspective in a vivid graph. Driving down spending/income like that inevitably drives up debt-to-income ratios, as expressed in the graph in my post, which is then worsened by the knock-on increases in risk premiums.

  17. Rien Huizer
    Posted August 5, 2012 at 4:04 pm | Permalink


    Well written, but you ignore one important fact: the ECB is not authorized to most of the things CBs with broader mandates can do. What it is doing now is already questionable. Since expectations matter, the ECB, operating under well known constraints and close to being in conflict with Germany (which in turn is constrained constitutionmally). In looking for the boundaries the ECB is also incurring a lot of silly credit risk which its policies cannot (unlike the FED (with its MBS portfolios) to some extent) modify. It is simply a greater fool and that cannot be good for tis longer term credibility.

    Maybe it would be appropriate for central banks to operate like the RBA (lucky as well as competent and treated decently by politicians, but that can change), maybe not. I am not entirely convinced that dual mandates are sustainable unless CB’s as per Lars Christensen, are replaced by an NDGP targeting robot, which is unthinkable in a democracy. Democraric politicians like fall guy CB.s, not robots that destroy vote buying capacity. Within the EUR area there is a case for starving peripheral rent seeking politicians (as Germany and a few others are trying to do)in certain states and forcing them to do supply side reforms before they get to eat again. Ireland is obedient and gets rewarded. Greece is difficult and being punished. Spain is being tested. Italy too important to fail but not immune to pain. The problem is that the obvious solution would be a return to the “two speed” approach once promoted by Germany and France (more so by the latter). But that would lead to more countries (former EUR members with quasi EUR-ized economies) adopting parasitic exchange rate policies a la Sweden (that could be construed as NDGP targeting or even touted as examples of virtue; but with a mercantilistic bent). From Germany’s point of view, this is the best of all possible worlds: lots of bargains for for the corporate sector within the EUR zone and a very attractive exchange rate.. What could make them change their game?

  18. Posted August 5, 2012 at 4:29 pm | Permalink

    RH@17 In terms of being a lender of last resort, yes the ECB is twisting itself into rather strange shapes to deal with a hole in the architecture of the Eurozone. A hole which notionally shouldn’t have existed if everyone had played by the rules, but that clearly did not (and probably wasn’t going to) happen.

    But that still does not excuse the level of monetary austerity the ECB has been engaged in. Nor am I convinced that the ECB is precluded from managing income expectations. It, in effect, already is by making clear it won’t.

    I support targeting NGDP, and the experience of the RBA suggests that dual credibility (on price stability and spending) is achievable. I am not at all sure why stable demand management should be such a big problem for democratic politics.

    The only reason Northern Europe cannot keep going as is indefinitely is the sovereign risk danger to its financial system. Hence the ECB doing the strange things it is.

    I am just doubtful how much institutional pain the Mediterranean economies will tolerate just to keep the euro; though some sense of an attainable benefit at the other end of the process would help. There is also the small problem that the people suffering most are often those with limited capacity to influence events.

  19. Posted August 6, 2012 at 5:35 am | Permalink

    Some of us economics grad students at Berkeley are doing a summer book club of Barry Eichengreen’s book “Golden Fetters.” Our discussions of the gold standard always lead to discussions of the past few years. It is very interesting.

    I don’t think DSGE models necessarily preclude taking expectations into account. See e.g. this paper. But I agree it is really important for macroeconomists to be aware of history and narrative and think beyond the model!

  20. TerjeP
    Posted August 6, 2012 at 6:25 am | Permalink

    Lorenzo@16 – nice graph. The gap can be closed with a 10% inflation spike, 10% real growth spike or some mix of the two. In fact a 10% shrinkage in the economy coupled with 20% inflation spike would also close the gap. As such I don’t see indifference to inflation being useful in charting this course. NGDP targeting is consistent with both good outcomes and shocking outcomes. For it to be effective you would need to target NGDP with an eye on inflation. And I don’t think central banks are that accountable, or successful when they have multiple targets. By all means pump up the money supply but only in so far as it is consistent with the inflation mandate.

  21. Rien Huizer
    Posted August 6, 2012 at 3:56 pm | Permalink


    “I support targeting NGDP, and the experience of the RBA suggests that dual credibility (on price stability and spending) is achievable. I am not at all sure why stable demand management should be such a big problem for democratic politics.”

    So do I. The reason I do not believe democratic (=competitive, self interested) politicians would tolerate some form of locked automatic pilot for demand side policymaking is that it constrains their opportunity set. And without politicians there is no democracy. Tactically they may support an independent central bank (a great fall guy) but whenever their incentives are no longer aligned with such an approach, they have the power to change, at least in regimes without constitutional guarantees around CB independence and an unambiguous mandate that leaves very little discretion.

    That situation is intrinsically unpopular with politicians (who must offer incentives to prospective voters) because it reduces their opportunity set. Sometimes though they subscribe to a “virtuous” consensus (as appears to have been the case in Australia until now (not so sure about the likely next gvt though) and agree to forgo current opportunities in exchange of access to greater rents in the future (as most Australians do when visiting their newsagents). But that is not a stable situation.

    However the German alternative (a CB that considers employment/economic activity as a random walk and is used to operate with limited discretion (not always, see the reunification period) recently enhanced by a constitutional device aiming at balancing the budget regardless of the status of the business cycle… Is basically an approach that eliminates politicians from demand management. Some would call that undemocratic, others in the interest of preserving the fragile plant of democracy in a non-Westminster system against extremist politicians. Of course Germany relies on a large state controlled banking sector for intervention, controlled by local politicians as a soft budget-type shock absorber.

  22. Posted August 6, 2012 at 7:24 pm | Permalink

    CC@19 Thanks for the link to the paper, I found it enlightening. Yes, clearly DGSE modelling can incorporate expectations, but it is still pretty silly to model monetary policy without relevant key features.

    TP@20 How is inflation targeting leading to years of entrenched mass unemployment not an appalling outcome?

    And NGDP targeting is going to have an inflation level no higher than the target, unless output falls, which seems unlikely.

    Rien@21 Good policy is always a trade-off. The experience in Australia is that good demand management means more resources for everyone, including politicians. I did not notice, for example, US politicians complaining much during the Great Moderation. I suspect your pessimism is overdone.

  23. TerjeP
    Posted August 6, 2012 at 7:37 pm | Permalink

    And NGDP targeting is going to have an inflation level no higher than the target, unless output falls, which seems unlikely.

    You find stagflation to be improbable? How quaint.

  24. Posted August 6, 2012 at 9:17 pm | Permalink

    TP@23 Stagflation is clearly possible. It is very unlikely in the current circumstances however.

  25. Posted August 6, 2012 at 9:49 pm | Permalink

    TP@23 Moreover–going back to my post–the combination of negative supply shocks with central banks credible on spending but not price stability is what produced Stagflation. The entire point of NGDP targeting is not to have unbalanced credibility. Price stability is simply not the only thing that matters in monetary policy; the current travails of the US, UK and Eurozone come precisely from thinking that it is.

  26. JC
    Posted August 6, 2012 at 10:55 pm | Permalink

    You find stagflation to be improbable? How quaint.

    I don’t. Sumner doesn’t. What I find incredible especially on the right is how people believe that having a hardened monetary policy could be helpful in the current climate.

    I tell you, I agree with Sumner. I’d rather have a period of stagflation that dis-inflation we’re currently experiencing now.

  27. JC
    Posted August 6, 2012 at 11:04 pm | Permalink

    Lorenzo@16 – nice graph. The gap can be closed with a 10% inflation spike, 10% real growth spike or some mix of the two. In fact a 10% shrinkage in the economy coupled with 20% inflation spike would also close the gap.

    Huh? You have an inflation rate of 10% and real growth of 10% that means nominal GDP in 20%, no? If the RBA is running a target of 5% NGDP how would that be possible unless it allowed NGDP to go over the target. There’s no way in hell the Fed would allow NGDP to rise by 20%. At the worst of it NGDP was 11% in the 70′s.

    In fact a 10% shrinkage in the economy coupled with 20% inflation spike would also close the gap

    So real GDP is -10% and the inflation rate is 20%. This would be an impossible combo under NGDP targeting. How would you possibly arrive at that combo?

  28. TerjeP
    Posted August 7, 2012 at 5:07 am | Permalink

    You have an inflation rate of 10% and real growth of 10% that means nominal GDP in 20%, no?

    I said “or” not “and”. A combination of the two obviously implies any numbers against each variable such that the combination add to 10%.

    I don’t think you looked at the chart or the associated article so I think you are missing the context of my comment. Obviously proponents of NGDP targeting propose something more like a steady growth in NGDP of 5% or so. However the proposition in the article was that we have a gap between current NGDP and trend line NGDP which the central bank could announce it will close. The gap is 10%.

  29. TerjeP
    Posted August 7, 2012 at 5:09 am | Permalink

    Price stability is simply not the only thing that matters in monetary policy; the current travails of the US, UK and Eurozone come precisely from thinking that it is.

    I thought they came from reckless borrowing and poor lending practices coupled with malinvestment.

  30. JC
    Posted August 7, 2012 at 9:22 am | Permalink

    You mean this chart?

    It shows a gap of around 8.5%. That would be about right or close to it. So they would be buying securities to bring NGDP back to target.

    I don’t think you quite understand the mechanics. If the central bank sets a target of say 5% they would be (selling) conducting reverse repo operations to drain the system in order to maintain the target.

  31. JC
    Posted August 7, 2012 at 9:33 am | Permalink

    oops that may not be clear.

    I needed to say:

    If the central bank sets a target of say 5% they would be (selling) conducting reverse repo operations to drain the system in order to maintain the target if NGDP is over the ceiling (expectations suggest it is)

  32. TerjeP
    Posted August 7, 2012 at 10:36 am | Permalink

    I understand the mechanics. And the arithmetic.

  33. JC
    Posted August 7, 2012 at 10:48 am | Permalink

    It’s not clear you do Terje, otherwise you wouldn’t be coming up with silly combinations ignoring the fact that NGDP targeting has both an implict floor and ceiling at which point the central bank mus take action.

    Out of the two, you obviously consider the present inflation/ interest rate targeting to be a superior model to NGDP targeting. Why so?

  34. TerjeP
    Posted August 7, 2012 at 1:48 pm | Permalink

    Out of the two, you obviously consider the present inflation/ interest rate targeting to be a superior model to NGDP targeting. Why so?

    NGDP is compatible with stagflation and if you get there then there is no real way out. So it seems to me that NGDP is a policy for some times but not for other times. As such you would need a meta policy to decide when to switch policies. Also as an ongoing policy strategy it’s not really tested.

    A lot hinges on whether you think monetary stimulus will end a recession. I discount the efficacy of this approach. I think fiscal stimulus and monetary stimulus are not a general treatment for recession and for it’s avoidance.

    However I think inflation targeting is also flawed. One flaw is that interest rates are limited by the zero boundary. In deflationary times you need to flip to quantitative easing. Which essentially looks a lot like NGDP targeting. In that context there is some merit.

    I’m a bit cynical about whether it would work now or whether it should be the permanent policy platform. But I’m not entirely opposed just cynical.

  35. Posted August 7, 2012 at 3:53 pm | Permalink


    I thought they came from reckless borrowing and poor lending practices coupled with malinvestment.

    Sigh, I am not convinced you actually read my posts. That is just the tired re-run version of what “caused” the Great Depression. Friedman is right, you cannot get a serious and prolonged economic downturn without significant monetary contraction. That turns investments into “malinvestments”. And, before the monetary contraction, there was nothing extraordinary about the level of public borrowing and there is no correlation between the level of borrowing before the contraction and one’s travails after. (Greece is not nearly important enough to have caused anything.)

  36. TerjeP
    Posted August 7, 2012 at 4:24 pm | Permalink

    I read them. I even enjoy them. I just don’t agree with everything you assert.

  37. JC
    Posted August 7, 2012 at 5:54 pm | Permalink

    NGDP is compatible with stagflation and if you get there then there is no real way out.

    I don’t thinks so. We may, as Sumner claims experienced had a bout of staflation with the GFC and unemployment peaking at 6% in the US before things stabilized and the economy turned back around. Frankly anything would be better than what happened and how the economy is flatlining now.
    I don’t quite get why you think it would mean stagflation for protracted period of time when there is a ceiling and a floor to the target.

    So it seems to me that NGDP is a policy for some times but not for other times. As such you would need a meta policy to decide when to switch policies. Also as an ongoing policy strategy it’s not really tested.

    No, i think it ought the be the policy going forward for all time.

    A lot hinges on whether you think monetary stimulus will end a recession. I discount the efficacy of this approach. I think fiscal stimulus and monetary stimulus are not a general treatment for recession and for it’s avoidance.

    Yea, I think it would. Consider how the Fed really fucked up policy by tightening too hard and causing the GFC. Monetary policy does work even in the current framework.

    However I think inflation targeting is also flawed. One flaw is that interest rates are limited by the zero boundary. In deflationary times you need to flip to quantitative easing. Which essentially looks a lot like NGDP targeting. In that context there is some merit.

    Actually they are hugely different.

  38. TerjeP
    Posted August 8, 2012 at 3:52 am | Permalink

    I share the sentiment expressed in this article:-

  39. TerjeP
    Posted August 8, 2012 at 3:56 am | Permalink

    I don’t quite get why you think it would mean stagflation for protracted period of time when there is a ceiling and a floor to the target.

    I don’t see why you think that is relevant. So what if growth in NGDP falls withing your target range. That target range is still perfectly compatible with stagflation. You can have your monetary policy target perfectly aligned and still have the economy in a crappy place with low or negative real growth and high inflation. And if you then remained true to your monetary policy the economy would stay screwed.

  40. Posted August 8, 2012 at 4:28 am | Permalink

    TP@36 Not a subscriber, so can’t read the link. But, from the couple of lines I could read, anyone who thinks the situation described in this post can be ignored by invoking Friedman hasn’t actually read Friedman in any serious sense; the man who held that monetary contraction was always behind any serious and prolonged economic downturn.

    Your stagflation arguments all are presuming that aggregate demand has nothing to do levels of output. Part of the point of NGDP targeting is precisely to smooth out output fluctuations.

  41. TerjeP
    Posted August 8, 2012 at 5:15 am | Permalink

    Your stagflation arguments all are presuming that aggregate demand has nothing to do levels of output.

    You can’t inflate your way out of a recession. The exception being a deflation induced recession.

  42. Posted August 10, 2012 at 12:14 pm | Permalink

    TP@41 You can monetary expand your way out of a monetary contraction downturn. If the problem is a collapse in aggregate demand, then the solution is an expansion in aggregate demand. Which is saying the same thing in a different way.

    There is more to monetary policy than “price stability” and turning ‘inflation’ and ‘deflation’ into the dominant descriptive categories obscures the underlying reality.

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