29 Apr 2009

Another Aspect to the Mankiw Money Madness

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Taylor Conant emailed me his post bringing up a quote from Rothbard regarding “hoarding.” It raises a good point that I had originally meant to discuss regarding Mankiw’s negative interest rate column, but I ran out of room in my Mises Daily.

Anyway, the point is that people are increasing their demand for cash balances (or “velocity is falling”) for a reason. People are uncertain about the future, and so they are (trying to) stock up on their liquid purchasing power. Money provides a service when it is “idle” in your wallet or under your mattress.

So both the grad student’s suggestion (to deactivate 1/10 of the cash every year*) and Mankiw’s preferred technique of debasing the money with future inflation, are designed to reduce the ability of cash to serve this purpose. Mankiw doesn’t care why people are stocking up on cash, he just throws out ideas to get them “spending” again. For an analogy, it would be as if Americans kept buying cars from Japan. In order to get Americans spending money back on Detroit autos, Mankiw’s student suggests putting a venomous snake in every tenth import from Japan. Mankiw, the wizened veteran, thinks that idea shows promise but is a bit impractical. Instead, he suggests a 10% tariff. (Sure, the free market is nice in theory, but in the real world Detroit car prices wouldn’t fall quickly enough to clear the market, hence the need for government action.)

* Paul Nelson emailed me this, and I must confess I’m stumped. As a good Austro-libertarian economist, I favor the removal of all legal tender laws. So why am I mad at the grad student’s suggestion, which strictly speaking wasn’t to destroy 1/10 of the cash at the end of the year, but rather to remove its legal tender status? In other words, I (and the student and Mankiw) were assuming that taking away legal tender status for particular dollar bills was the same thing as literally seizing and destroying them. But is it?

=====================

On a completely unrelated matter, Taylor also asks me if there is any way to order signed copies of the new book. Sure, if you email me we can arrange it. I guess I would need to charge $25 per book to cover my shipping etc. (Obviously I’m giving the answer here in case anyone else wanted to know.)

29 Apr 2009

GDP Down 6.1% in 1st Quarter

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Here’s a depressing article…Some excerpts:

The U.S. economy contracted at a surprisingly sharp 6.1 percent rate in the first quarter as exports and business inventories plummeted.

The drop in gross domestic product…was much steeper than the 4.9 percent annual rate expected by economists and followed a 6.3 percent decline in the fourth quarter.

GDP…has now dropped for three straight quarters for the first time since 1974-1975.

The Fed, which has cut interest rates to almost zero and pumped about a trillion dollars into the economy to try and break its downward spiral, is expected to leave policy unchanged at the meeting.

The advance report from the Commerce Department showed business inventories plunged by a record $103.7 billion in the first quarter, as firms worked to reduce stocks of unsold goods in their warehouses.


Exports collapsed 30 percent, the biggest decline since 1969, after dropping 23.6 percent in the fourth quarter. The decline in exports knocked off a record 4.06 percentage points from GDP.

Investment by businesses tumbled a record 37.9 percent in the first quarter, while residential investment dived 38 percent, the biggest decline since the second quarter of 1980.

The Commerce Department said the government’s $787 billion rescue package of spending and tax cuts…had little impact on first-quarter GDP.


A separate report showed U.S. home loan applications fell last week to the lowest level since mid-March, even as mortgage rates clung to record lows.

I’m sure that medieval physicians had conversations like this too.

“How’s the patient doing?”

“Not well. He’s even weaker than when his wife brought him in. In fact, I’ve never seen someone this sick.”

“Hmmm. You’ve tried bleeding him, right?”

“Of course, that was the first thing we did. In fact, I’ve taken more blood out of this guy than any of my previous patients, but this is the toughest disease I’ve ever seen. He’s not responding to unprecedented treatment.”

28 Apr 2009

Answering Scott Sumner’s Questions About Austrians

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Scott Sumner asks some great questions about the Austrian view of the financial crisis. I’ll do my best to balance brevity against comprehensiveness in my answers.

1. Why did NGDP collapse late last year?

I’m not saying this is the whole story, and someone might plausibly say I’m confusing cause with effect, but I think the following were all involved:

(a) People panicked because they were told by “the authorities” that the entire world financial system was on the brink of collapse. So the demand for cash shot way up.

(b) The real economy was due for a serious correction after the housing boom. In this article written in September 2007 (which itself was based on an analysis I made in July 2007), I was calling for the worst recession since the early 1980s. That clearly hadn’t “hit” as of last summer, so I was not surprised that things finally started falling apart. I don’t know why it happened late last year, except to say that the Fed and Treasury had been doing unprecedented things (TAF etc.) to keep the plates spinning. Once people realized that Paulson and Bernanke were bluffing, and that they had no clue what they were doing, panic set in and people understood that there would be no magic undoing of the malinvestments of the boom years by “injecting liquidity” or other such crankish schemes.

2. Could a suitably expansionary monetary policy have stopped NGDP [nominal Gross Domestic Product] from collapsing?

Of course. What was the growth rate in Zimbabwe’s nominal GDP? (I actually don’t know but I’m assuming >> 0%.)

3. Wouldn’t Hayek have favored enough monetary expansion to keep NGDP from collapsing?

You mean Friedrich, right? If so, I’m not sure. I believe the mature Hayek thought the Fed should have prevented M1 from falling during the Great Depression, but that’s not the same thing as propping up NGDP. The best single paper on Hayek (and Robbins’) changing views of “liquidationism” in the 1930s I’ve seen is this one [pdf].

4. Hayek originally thought that the Depression was a needed corrective for the excesses and misallocations of the late 1920s. He later changed his mind and argued that the Fed should not have allowed NGDP to collapse. Was he right to change his mind?

No. Read the book.

5. If monetary policy could not have prevented an NGDP collapse, what is your story? Is it the Keynesian liquidity trap? (I assume the answer is no.)

I do not fear NGDP collapses. I eat units of food, not dollar bills.

6. If a suitably expansionary monetary policy could have prevented an NGDP collapse, should the Fed have tried to do this?

No. Please don’t ask me again.

7. If the answer is no, why not? Wouldn’t that have prevented the collapse in manufacturing in Asia late last year? What is the structural imbalance corrected by having 10s of millions of Chinese loose jobs making stuff like shoes? (Presumably there was no shoe bubble.) Are Austrians worried about the U.S. trade deficit?

Are you comparing shoemakers to prostitutes?

The world economy was in an unsustainable configuration during the boom years of 2002-2005. The flow of consumption goods (including durable goods like housing) coming out of the capital structure pipeline increased, but at the expense of necessary maintenance. See this article for a very simple, yet numerical, model of what I’m talking about.

I think he sometimes overshoots into too much “commonsense” simplicity, but I think Peter Schiff is dead right when he ridicules the notion that Asia needs US consumers to fuel their economic growth. The idea seems to be, if Asia didn’t have fat lazy Americans grabbing iPhones and plasma screens, then the Asians would be thrown out of work. That’s the crudest of…well something, I don’t know what. I wanted to say Keynesianism but I think it’s older and more primitive than that.

During the boom years, the Chinese and other net exporters were willing to ship Americans consumption goods, in exchange for a growing stockpile of claims on future income. This was clearly unsustainable. So yes, the expansion of Chinese export sectors–to the extent that they were catering to purchases made by Americans who were falsely believing themselves to be rich because of rising house and stock values–was indeed a “bubble.” If American real estate had grown at a “proper” rate, then those Chinese exporters wouldn’t have seen their demand grow so quickly.

People often ask me, “OK so what sectors were starved for capital, if you think housing, Wall Street quant departments, etc. expanded too much?” I don’t know, but if we believe in scarcity and moderately full employment of resources during 2002-2005, then there must have been such sectors. I’m a lover, not an applied economist.

I get why we needed housing to decline for eight straight quarters from mid-2006 to mid-2008, but I don’t get why we then needed to violate Hayek’s maxim to keep NGDP from falling, and let NGDP fall sharply—causing massive output declines in sectors completely unrelated to the housing bubble. Recall that those non-housing sectors held up well during the first two years of unwinding the housing bubble–so we are not just talking about manufactured goods like rugs and furniture.

I’m not sure if this answers your question, but here goes: If in August 2007 the Fed hadn’t starting cutting rates (the discount rate at the time, following next month by fed funds target rate cut), and if the government had said, “Well we live in a profit and loss economy, boys, I guess you’ll all be filing Chapter 11,” then there would have been a horrendous quarter or two. But all of the remaining assets owned by the insolvent banks and other financial institutions would have been sold off to the highest bidder, we would have had functioning asset markets, and there would have been no “credit crunch” because everybody would know exactly what the derivatives were worth, and who was holding what.

But that’s not what happened. The government made bolder and bolder moves every month, leading the insolvent firms to believe that if they could just string their investors and creditors along, eventually they would be bailed out. And they were right.

So the Austrian business cycle theory explains why there needs to be a depression following an unsustainable boom. But if the government minds its own business (or better yet, cuts spending and taxes) then the economy can recover fairly quickly.

For example, during the 1920-1921 depression, the government cut the budget outrageously (at least 30% in one year, and I believe even more from 1919 to 1920 I believe) and the NY Fed jacked its discount rate up to a record high for the 1913-1931 period. (I think the record would extend beyond 1931 but I know the above is true for sure.) You had prices fall more than 15% in one year.

So if the Keynesian or monetarist explanation of the Great Depression is right, the 1920s should have been a decade of stagnation.

And yet they weren’t; they were the Roaring Twenties. That’s because Harding didn’t do squat, and so unemployment peaked at 11.7% in 1921 and then was down to 2.4% in 1923. (See this article for more.)

I think Friedman and Schwartz were totally wrong in blaming the “inaction” of the Fed for the 1930s. Was the Fed more inactive then, compared to when it didn’t exist pre-1913? How could it possibly be that the worst depression in US history was the fault of a timid Fed, when there were several bad (but not “Great”) depressions that occurred before the Fed was created?

Oh, and one other question: As you know I am completely contemptuous of those (mostly Keynesians) who use interest rates as an indicator of monetary policy. Interest rates were very low in American in 1931; and very high in Germany in 1923. I believe that interest rates tell us precisely nothing about whether money is too easy or too tight, especially short term rates. The key variable is NGDP growth (which I believe Hayek also favored targeting.) Do you agree with my view that the 1% (short term) interest rates of 2003 were a totally meaningless indicator of the stance of monetary policy?

I agree that interest rates need not indicate the tightness or looseness of monetary policy. But since prices were falling more quickly in the 1920-1921 depression than in any single year from 1929-1933, I think the NY Fed’s discount rate of 7 percent in the first period, versus 1.5 percent in the second period, shows that the Fed was halting money growth in the first period while at least being more liberal in the second. (I didn’t have access to a consistent series on monetary aggregates for the whole period.)

So yes, the mere fact that Bernanke Greenspan brought the target down to 1% (in June 2003) by itself doesn’t prove anything, but I have argued that he allowed the base to grow at rates that were almost as high as any point in the 1970s. So if we think that the Fed was too loose in the 1970s, then I think we can agree the Fed was too loose in the early 2000s.

Also, if we adjust for actual price inflation, then the real fed funds rate went negative in the early 2000s, something that hadn’t happened since the 1970s. (See here.) Since I don’t think the technical productivity of roundabout processes went negative (on the margin), this is a clear indication to me that Greenspan was pushing rates down, rather than passively responding to real changes in the supply and demand of loanable funds.

28 Apr 2009

Think Twice News, on the Tea Parties

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My old college / grad school buddy Jason Osborne is producing a series on the Tea Parties. Here is the first episode. Note: I’m not embedding it here, because if you go to YouTube and click the HD in the bottom right corner, you get a much nicer picture. I had recorded some audio comments on the event, and they worked a few into the episode.

28 Apr 2009

"Charles Krauthammer Day"

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I have to admit, the leftists are more clever than their right-wing opponents. It’s too bad they don’t know how market economies work.

This guy celebrates “Charles Krauthammer Day” (HT2 Brad DeLong) because back on April 22, 2003, Krauthammer said:

DR. KRAUTHAMMER: Hans Blix had five months to find weapons. He found nothing. We’ve had five weeks. Come back to me in five months. If we haven’t found any, we will have a credibility problem. I don’t have any doubt that we will locate them. I think it takes time. They’ve obviously been deeply hidden, and it will require that we get the information from people who know where they are.

If you’re looking for anthrax and VX gas, which can be hidden in a basement or a closet, in a country the size of Germany, you can understand how in five weeks we might not have stumbled across them.

I understand that from the Austrian point of view, Americans appear rather naive. I can assure you that from the American point of view, Austrians appear rather cynical.

[Laughter.]

I do not want to get sucked into a foreign policy debate; feel free to call me an idiot or a French-loving commie in the comments. I just want to remind everyone that we were clearly told that Saddam HAD WMD IN HIS POSSESSION, and that that’s why we had to invade Iraq pronto. After the weapons didn’t turn up, there was a lot of optimistic revisionist history going on, a la “Bush never said Saddam had WMD, he said he was developing the capacity for them. So I guess you think we should have sat back and let Saddam butcher those people?”

So to repeat, maybe it was a good idea to invade, maybe not. (Personally, I think not.) But what is NOT up for debate is whether the official reason was the clear and present danger of existing stockpiles of WMD. If you doubt that, then please explain why Krauthammer said the above.

28 Apr 2009

Fed Misled By Libertarian Dogma

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So argues Henry Kaufman in FT:

The Federal Reserve has been hobbled by at least two major shortcomings that were primarily responsible for the current and several previous credit crises. Its failure to spot the importance of changing financial markets and its commitment to laisser faire economics were big mistakes and justify a fundamental overhaul of the Fed.

Kaufman actually comes close to my own view near the end of his piece:

Ironically, the problem was made worse by the fact that the Fed was inconsistently libertarian. The central bank stuck to its hands-off approach during monetary expansion but abandoned it when constraint was necessary. And that, in turn, projected an unpredictable and inconsistent set of rules of the game.

We should, therefore, fundamentally re-examine the role of the Fed and the supervision of our financial institutions. Are the current arrangements within the Fed structure adequate – from its regional representation to its compensation for chairman and governors to its terms of office for governors? How can the Fed’s decision-making process be improved? If we were to create a new central bank from the ground up, how would it differ? At a minimum, the Fed’s sensitivity to financial excesses must be improved.

That’s right Mr. Kaufman, the Fed was entrusted to do all the things you discuss in your article, and the Fed screwed up horribly. But rather than tinkering with it and getting it j-u-u-u-u-st right, let’s be consistently libertarian. No central bank with a monopoly on money production, no legal tender laws, no special regulations on banking. And if a bank gets overleveraged and blows up, Go Straight to Bankruptcy Court. Do not pass Paulson, do not collect $700 billion.

27 Apr 2009

Mankiw Doesn’t Realize When He Has Been Beaten…

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…and portrays me as an unrealistic ideologue. (In fairness, I implied Mankiw was crazy in my original Mises.org critique to which he was responding, so he handled it with class.) Mankiw first quotes me, saying that future inflation is not necessary to clear the market, because another solution would be for current prices to fall. (Thus, even if it’s true that the “equilibrium real interest rate” is very negative, butting up against the nominal zero rate barrier, then you still get market clearing because the large drop in present prices gives you room for a steep price inflation back up to “normal” levels in the future.) To this Mankiw replies:

I think this analysis is correct, under the maintained assumption that prices (including wages) are completely and instantaneously flexible. But if prices are sticky, then the immediate deflation and concurrent increase in expected inflation won’t occur painlessly. Instead, it would take a while for the price level to fall, and as we wait, the economy would suffer through a period of depressed economic activity.

According to conventional new Keynesian analysis, sticky prices are the ultimate market imperfection that makes aggregate demand matter. If you deny that prices are sticky and assume they can instantaneously jump downward to new equilibrium levels, many macroeconomic problems become much easier to solve. Indeed, you don’t need to solve them at all, as the market would do it.

I wish we lived in the world that Mr Murphy describes, but my reading of the evidence is that we don’t.

[Bold in original]

OK hang on a second. I didn’t say prices would “instantaneously” drop down to new equilibrium levels (where “equilibrium” isn’t even really a good term because Mankiw means something different from what Hayek or Garrison would in this context). Rather, I said that the market isn’t so impotent because of the zero-nominal-interest-rate barrier as Mankiw and others seem to think. The market is trying to adjust to the shocking realizations that have set in after the housing collapse–and this includes the huge increase in the demand to hold cash–but Bernanke won’t let it. So as usual, we have Mankiw et al. blaming the market for something that their own prior interventions are causing.

You don’t need to take my word for it. I will quote someone whom Mankiw presumably respects to make my case:

In this post the economist gives a “Deflation Alert.” So presumably deflation is possible. Oh darnit, on second thought that’s not really such a decisive point in my favor, because people who worry about deflation might mean long-term deflation. In contrast, I was arguing that prices could fall fairly rapidly in order for the market to clear, without the need for Mankiw’s own suggestion of promised massive future inflation.

Ah, but that’s why this blog post from last November is relevant. The author reports with worry that, “The CPI drops 1 percent. Even the core CPI is falling.” Now this is quite interesting. From September to October 2008, general consumer prices fell one percent–and that’s the actual fall, mind you, not an annualized figure (which would have been in excess of 12 percent deflation per year). What’s even more extraordinary is that this price drop of 1 percent occurred while the stock of money held by the public (M1) rose by more than 2 percent (and again, that’s the monthly figure).

Hang in there folks, we’re almost there: Now if prices fell by (more than) 1 percent in one month, at the same time that the quantity of money rose by (more than) 2 percent, we’re looking at a 3 percent monthly drop had Bernanke merely held the money stock constant. If the CNBC pundits are right, and what the economy “needs” right now is a negative 5 percent real rate of interest, and if nominal interest rates are zero, then that means it would take the market economy all of 50 days to achieve the necessary price deflation to clear. (Again, this calculation assumes that Mankiw’s diagnosis of the problem, and his prescription of negative real interest rates, is correct.) The economy has officially been in recession since December 2007, meaning that the interventionist approach has not fixed things in at least 16 months. Note that 50 days << 16 months. To sum up, in case my cutesy-ness has lost some readers: Mankiw admits that my proposal of allowing prices to fall would work, if only prices in a market economy could quickly fall. But alas, in the real world, market prices don’t fall quickly enough, and so that’s why Mankiw thinks Bernanke needs to promise to dump massive amounts of inflation on us in the future.

Yet I am claiming that the only reason prices haven’t been falling very rapidly is that Bernanke has been pumping in money like there’s no tomorrow. We all know he’s increased the monetary base at an absurd pace, but even the M1 money stock rose 17% during 2008. So if the overall CPI was roughly flat for the year, while the money stock rose by 17%, imagine what would have happened had Bernanke merely pumped in enough base just to maintain M1, let alone had Bernanke truly done nothing and let things play out.

I will leave you with this final quote from Mankiw. Again, does the following sound like a guy who thinks that the market can’t give us price deflation in a timely enough fashion?

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed’s target price path.

So there you have it, folks. The Fed needs to credibly promise to inflate in the short run, in order to prevent prices from falling. And then the Fed needs to credibly promise to inflate in the long run, because in the imperfect market economy, prices don’t fall in the short run.

UPDATE: I realized I had left one gaping hole in my response. Mankiw might say, “Sure, gasoline and stock prices can fall very rapidly, but the one really sticky price is the wage rate. So you might get housing markets and commodity markets clearing, but you’d still have incredibly high unemployment if we followed your crazy advice and let the CPI drop, say, 17% in 2008.”

It’s true that wages are stickier than many other prices, but that’s largely due to other interventions in the market (unions etc.). But fine, let’s take all those as given. It still doesn’t follow that the market is as fragile as Mankiw believes. It’s not that people in particular jobs would have to take a 20% pay cut, but rather that laid off workers would need to settle for much lower pay in order to get hired someplace else. So if a former quant at a hedge fund that blew up used to make $200,000 a year, and now is driving a cab for $50,000 (I don’t know what cabbies make), that’s a 75% wage cut right there. Were it not for Paulson and Bernanke’s bailouts, there would be plenty of huge cuts like that to be thrown into the national averages.

27 Apr 2009

Another Northern Female Political Leader

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Though this one is indisputably cool, as all partisans must agree. If you’re really important and work at a law firm or something, it’s probably not worth watching the whole thing, but be sure to listen to her discussion of the city’s financial situation. (Thanks to my wife Rachael for the link.)