Further Explanation of My Defense of Kling from Sumner
OK now that I have a little more free time, I clarified my response to Sumner (in defense of Kling on Recalculation). I am simply re-posting my long comment from Scott’s blog. (If you don’t know what the context is for this, just follow the link. Scott brings you up to speed in his original post.)
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Hi everyone,
I see this is still a lively topic. Mark and I went toe-to-toe in the comments at my post responding to Scott, but let me give a general reaction here, since I like away games as much as playing at home:
(1) Scott showed that housing starts dramatically fell from January 2006 through April 2008. However, during the same period, the national unemployment rate hardly moved. Scott said (possibly paraphrasing), “Looks like those construction workers found something else to do…” One would have thought that construction employment surged into 2006, then fell sharply, even while national unemployment didn’t move. So clearly the Recalculation Story was in jeopardy.
(2) I pointed out that, if this is what Scott and others inferred, they would be wrong. Construction employment peaked and held steady all through the period when the national unemployment rate held steady, and then when construction employment tanked, the national unemployment rate zoomed upward. So the basic Klingian story was back in play–it looked like we could explain the national unemployment problem, by the disgorging of construction workers out of that sector.
(3) OK, but there was an obvious problem: How to relate this to the housing boom? Arnold Kling and others (including me) who say the recession was “real” and not “nominal” often say to the layperson things like, “Too many workers and lumber went into housing. Workers lost their jobs in Nevada and it takes time for them to go somewhere else.” So the problem for us as Recalculation/Austrian theorists is, can we reconcile our original story with the new facts? I.e. we’re on solid ground with respect to total construction employment, but we’ve been talking as if all these workers were building houses. And yet, as Scott showed, housing starts started falling fast after January 2006, whereas we know construction employment held steady for a long time after that. What gives?
(4) Well, one thing is that houses aren’t made in a day. So when we switch to housing completions, we gain “a few” months. (I think it’s technically only “a couple of” months, but since it peaks in March I thought “three months after the start of 2006.”)
(5) Clearly two or three months isn’t going to cut it, because we need to explain the steady construction employment through April 2008 at least. So that’s why I went into the discussion about things that would be related to a massive surge in new home construction, such as adding decks and building shopping malls near the new developments.
(6) When writing up this argument, I made almost an offhand remark about the distinction between housing starts and completions, and then linked to the data. I said housing completions peaked “a few months” after housing starts. That is undeniably true (if you give me an out on “couple” versus “few”).
(7) In light of the above, I am still surprised that Scott thought I was hiding something in the link. Housing completions did exactly what I said they did. That data doesn’t “bolster” Scott’s case, because I’ve already shown that housing activity by itself didn’t mesh with overall construction employment.
(8) Finally: If it had turned out that all the people who were building houses in 2006 were picking vegetables and writing novels in 2007, then Scott would be totally vindicated: Rising NGDP solves all problems, and we don’t need to worry about labor skills matching up with consumer demands. But since Scott himself agreed that the former housebuilders moved into other construction projects–which may very well have been corollaries of the previous housing construction–I think Kling still has a leg to stand on. (Not surprisingly, so does Kling.)
This might be relevant to the puzzle: the Austrian story is about projects that start but are _not_ completed (because there are not enough real savings to complete them). This means that neither housing starts not housing _completions_ are a good indicator of employment in housing. To the contrary, what you’d expect according to ABCT is total employment in housing to drop _after_ housing starts and completions, because in the last period a lot of people were working on houses they will never be able to complete. So you would expect first housing starts and completions to drop, but employment to remain steady as the workers keep working on the houses they have started but will never complete. Only after, you would expect the drop in employment.
Bob,
Unless I am reading the data wrong, the issue I see is that construction employment did not remain steady through April, 2008. It peaked in April 2006, remained relatively stable (with a slight downward trend) over the next year, and then began to plummet in April, 2007. The sharp decline that began in April, 2007 coincided with continued growth in non-construction employment that persisted over the next year. In other words, as construction employment was plummeting between April, 2007 and April, 2008 employment elsewhere growing and apparently absorbing the displaced construction workers. This seems consistent with Scott’s story. More here.
OK I’ll take a look, thanks. If you are indeed reading it right (I haven’t checked it yet) I agree that is good for Scott. (I should say though that I am still vaguely uncomfortable about allowing him to have a theory that “explains” recessions by a fall in NGDP. I mean, I could explain sickness by reference to body temperature. “As long as your doctor keeps your temp at a steady 98.6, everything is fine. What, you thought that guy died because of the virus? Nope, it was because the doctors foolishly allowed the body temp to go to 110.”)
Since Scott argues that an NGDP collapse _causes_ RGDP to fall, I wonder what trasmission mechanism he has in mind.
Decline in aggregate demand leads to decline in aggregate sales revenues almost instantly.
Decline in aggregate demand also leads to decline in aggregate costs, but with a time lag, since current costs are a function of past productive expenditures.
Since aggregate revenues fall, but aggregate costs fall only with a time lag, it follows that aggregate profitability declines when aggregate demand (NGDP) declines. This results in an increase in unemployment, and with fewer workers working, there are fewer goods and services produced.
Real GDP thus falls.
Free market economists say that the free market can facilitate falling prices, which can “clear the market” from the supply side at the lower aggregate demand.
Monetarists, and reluctant monetarists, say that it’s better for central banks to increase aggregate demand, so as to increase aggregate revenues and thus reverse the decline in aggregate profitability.
Dear Bob,
Much of this technical discussion is most likely way over my head as a non-economist. However, I am curious about one detail. The Rothbardian story as I understand it, is that depressions are not caused by a crash of one sector of the economy, but rather a general crash across many sectors of the economy. For example, in America’s Great Depression, Rothbard states: “Many economists, however, attribute general business depression to “weaknesses” caused by a “depression in building” or “farm depression”. But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression-a phenomenon of the true “business cycle”.
Maybe I have missed something fundamental, but it seems like at least the Rothbardian version of Austrian cycle theory differs from the story of Kling in some important aspects. Please be so kind as to enlighten me on this point.
One last point that I would like you to sincerely help me (and possibly other interested by-standers) understand. If Austrian cycle theory is primarily a story about what happens during booms, whey are you arguing over specific emperical data of the recession? With the many moving parts that occurred in this particular recession, including unprecedented monetary and fiscal measures, how can we deconvolute one piece of data in a very noisy system and take to arguing over it. Remember, this is a very non-linear system we are dealing with, and the individual components are incredibly noisy, and subject to all sorts of teleconnections from other places in the system. If I may risk a science analogy, it is sort of like back-casting the weather, and arguing whether a fall in humidity made it stop raining. It is a pointless excersize in a complex system.
But, it is very possible that I just don’t understand the argument sufficiently to chime in at all.
Bob, are we all sure that the Austrian recalculation theory requires aggregate unemployment to rise along with a rise in construction/housing unemployment? The Austrian theory makes no explicit or implicit mention that unemployment has to be concentrated in one specific sector and correlate with general unemployment.
I think K Sralla is right that it is incorrect to look at historical data in one specific sector and then seek to explain a general event like an economic recession.
I think this is why there appears to be more correlation between NGDP and the Great Recession, compared to “construction employment” and the Great Recession.
Yes, the Austrian theory is one of supply misallocation. But that doesn’t mean that misallocation has to be concentrated in one sector of the economy only such that movement in its data generates general economic movement in all other data.
You and Kling, and Sumner and Beckworth, all agree that it is monetary policy that is the fundamental culprit for the Great Recession. The only difference between you is that while you and Kling argue that the Fed’s manipulation of the economy should reveal itself in data showing construction and housing unemployment to be correlated with general unemployment and thus the recession, Sumner and Beckworth argue that the Fed’s manipulation of the economy should reveal itself in data showing NGDP to be correlated with general unemployment and the recession.
Sumner and Beckworth argue that if the Fed didn’t tighten monetary policy, then the Great Recession would not have happened.
You and Kling argue that if the Fed didn’t loosen monetary policy, then the Great Recession would not have happened.
Most Austrians would agree that a sudden, drastic collapse in aggregate money and spending will lead to a decline in aggregate profits, rise in aggregate unemployment, and decline in productivity.
This is because a decline in aggregate money and spending will generate an equivalent decline in aggregate revenues. But since aggregate costs can only fall with a time lag, since current aggregate costs are a function of PAST aggregate investment spending (when it was higher), it means aggregate profits must fall. This is what then generates aggregate unemployment.
As aggregate revenues decline, those areas of the economy with the highest relative debt investment, i.e. most debt compared to sales revenues, it follows that an aggregate decline in money and spending will hurt these sectors the most, for they will have the hardest time staying solvent.
Now, these facts above, while seemingly vindicating Sumner and Beckworth, actually support the Austrian position.
The Fed’s inflation does redirect real investment from where it would otherwise have gone if the Fed did not exist and we had a gold standard, or if the Fed targeted NGDP rather than CPI, or if the Fed targeted some other metric. This point I am sure everyone will agree on. If the Federal Reserve System increases the supply of money in the loan market thus making it greater than the supply of real investment directed savings, will lower interest rates from where they would have otherwise been.
This changes the real capital structure of the economy AND “locks in” a particular monetary demand trajectory associated with it. Just like a single individual or company will invest according to the particular monetary demand trajectory for its goods and services, so too will millions of individuals in the economy as a whole make investment decisions according to the particular monetary demand trajectory for their goods and services.
At the level of the economy as a whole, aggregate demand is not completely separate from real capital investment. I notice that you, Kling, and Sumner and Beckworth are all implicitly treating money as separate from the real economy. According to Sumner and Beckworth, this aggregate demand statistic can be, and, as long as the Fed exists, should be, controlled by a single consciousness. According to the Austrians, this is unwise because it generates real capital structure misallocation, which importantly is visibly manifested only after the Fed does not control money the way the Fed was supposed to, by either successfully targeting CPI, or NGDP, or mimicking gold (Gold standard is actually closer to NGDP than it is to CPI, which is why the more the economy deviates from gold, the more will deviate from NGDP targeting, which is why the data are more supportive of the theory of recessions being correlation with NGDP, rather than CPI). NGDP targeting theory is not an alternative to recalculation theory. It is an alternative to CPI targeting theory.
As the Federal Reserve System creates new loanable funds ex nihilo and interest rates are lowered (from market), the real capital structure is altered AND, alongside this, money and spending for each individual human and each individual company, then become connected with this real capital structure. For example, the real capital structure changes in housing and construction that was caused by low interest rates and credit expansion (housing boom), then became insuperably connected with the spending and investment behaviors of home owners, MBS investors, construction workers, etc. As long as the money kept flowing into housing like the home owners, MBS investors and construction workers expect, then this part of the economy can be said to have been stable and capable of remaining integrated with the rest of the economy. But because the demand for housing was generated by the Federal Reserve System, and not endogenously from “within” the economy, it follows that the Federal Reserve System has now become “responsible” for the housing market’s “success”.
If the Fed stops increasing the supply of money and spending at a rate that each specific industry expected and invested in accordingly (planned for), then a recession will ensue as these investments are halted/liquidated.
The housing bubble popped (2007) a couple years after the Fed stopped increasing bank reserves as rapid as they had been or needed to to keep the bubble going (2005), rather than instantaneously, because after 2005 people started to dip into their mutual fund accounts to maintain monetary demand for housing (once the Fed induced housing bubble started, the Fed did not have to be the only entity to effectively increase the demand for housing, but once the Fed stopped, it was only a matter of time before the momentum stopped). Once those mutual funds depleted and the demand for housing stopped rising (2007), this is where Sumner and Beckworth blame the Fed for not keeping the money flowing, whereas you and Kling blame the Fed for generating labor and recourse misallocation.
You and Kling are right to hold that the “problem” is the requirements of the economy’s real capital structure, of real scarcity, and these real physical limits would have made it impossible for the Fed to keep creating new funds to maintain the existing capital structure without totally destroying the monetary system, but the reason why the data look more supportive to Sumner and Beckworth is because before that destruction point was reached, the Fed got jittery in 2005 about the prospect of rapidly rising consumer prices, and so they started to tighten monetary policy, thus slowing the demand for everything, thus pricking the housing bubble.
Sumner and Beckworth argue that the Fed should have kept monetary demand rising smoothly according to the aggregate metric NGDP, but because they did not, the Great Recession ensued. This argument is wrong, because NGDP is not an isolated statistic that is separate from the real capital structure of the economy, which is affected by interest rates. If Sumner and Beckworth argue that the Federal Reserve System should raise NGDP by continually increasing bank reserves at whatever amount is necessary so that the banks loan out enough money to result in NGDP rising at whatever % per year (terrible policy), then because the real capital structure becomes altered into an unsustainable configuration on account of artificially low interest rates, the rise in NGDP would have to *accelerate* in order for time preference and the resulting inter-temporal scarcity to prevent a market based correction from being fully manifested.
The Fed can keep the boom going by creating new money, but at some point, real world inter-temporal scarcity will eventually overcome it, and if the Fed fights THIS, then they will eventually destroy the currency. The Fed would rather the economy go into recession than losing control of the money supply.
THIS is why the historical data of the Great Recession, and of all other recessions/depressions, seem to be connected with NGDP (aggregate money and spending), and not “unemployment in bubble sector X”.
The Fed prints new money, which finds its way into the loan market. Interest rates fall, the real capital structure of the economy is altered into a real, physical, inter-temporal unsustainability in the long run. In order to keep the bubble going, aggregate demand would have to not just increase, but exponentially accelerate. This of course will result in eventual monetary breakdown, which the Fed does not want, which is why it always stops printing money so fast BEFORE the real, physical, capital structure discoordination does it for them, with catastrophic consequences. This is why the historical data concerning recession statistics (unemployment, profits, etc) appears to follow what the Fed does more so than what Austrian theory correctly predicts in the long run.
Austrian theory is a long term, inevitable theory that acts as a point of no return, to guide decisions NOW. But because the Fed would rather have a recession than allow the CPI to rise by more than target (which is what will result if the Fed tries to print more money to keep the bubble going), the data look as though “recessions are CAUSED by not enough money printing”.
Austrians hear that phrase and their long term brains cringe, correctly, and call that crazy talk. “You cannot print your way to prosperity”. “Printing new money does not create new capital goods”. Etc.
Monetarists like Sumner and Beckworth say that phrase because their brains are more short term oriented. They don’t understand that NGDP targeting cannot work, because artificially low interest rates, which is also created by the Fed when creating new money, requires an ACCELERATING NGDP, not a linearly increasing NGDP. But an accelerating NGDP will result in monetary breakdown.
Thus, if the Fed adopts targeting NGDP, then the economy will look as though it is going through a closely packed series of booms and recessions. Rather than long lived booms and thus long lived recessions (CPI targeting, which generates asset bubbles), there will be short lived booms and short lived recessions. There will be booms and recessions as soon as the Federal Reserve System creates more money that flows into investment than real savings generates, which will be always.
From David’s article:
>The housing boom peaked in early 2006 and yet the Great Recession does not really start to get going until mid-to-late 2008, when policymakers allow aggregate spending to collapse. Thus, the housing bust at best would have led to a mild recession. It was the failure of monetary policy that created the Great Recession.
Bob, it appears that according to David, he concedes that the Fed induced housing collapse would have led to a recession. Thus he hasn’t completely rejected Austrian theory. He is just failing to reject Milton Friedman’s and Ben Bernanke’s theory of the Great Depression, which is that “tight money” after a sudden collapse makes the economy worse. He is “right” that tight money makes the economy worse, but the economy that is made worse is not a free market economy, but rather a Fed manipulated economy. The economy that the Fed “failed” to control in terms of sufficient aggregate demand is its own demand manipulated economy. The Fed cannot make the economy prosper in the long run.
Captain Freedom:
Finally, something we can agree on. Yes, in my view, the Fed’s did play a pivotal role in creating an unsustainable housing and credit boom. There are many moving parts to what happened–a perfect financial storm of sorts–but I am convinced that had the Fed kept the federal funds rates closer to the natural interest rate level then many of other problems related to the crisis would have been minimized. Given this understanding–and the fact that this was more than just a housing boom, it was a much broader credit boom–there was going to be some correction. I just don’t see it requiring the Great Recession.
Several other things to note. First, I believe that the Fed’s role was not limited to just the U.S. economy. It is a monetary superpower and its policies get exported to the rest of the world. Thus, we had a global housing and credit boom. (See my Cato Journal article where I make this argument more fully.)
Second, my long-run goal for NGDP is closer to George Selgin’s Productivity Norm rule . His NGDP target would allow productivity to be reflected in the price level. However, we have to transition ourselves there over time.
Third, while I believe the Fed kept interest rates well below the natural rate level 2002-2004, it is not clear to me they are doing so today. Back in 2002-2004 we had a productivity boom which implies a higher natural interest rate. Now we don’t and given the state of the economy it is reasonable to believe the natural rate is very low. Thus, my view for more monetary stimulus is rooted, in part, on the belief that the natural rate is much lower than normal.
David:
I would like to think that there are LOTS of areas of agreement between us. It’s just not as fun to always agree than to know personally what one agrees with and then publicly find disagreement and then hopefully resolve it. Order out of chaos?
>Given this understanding–and the fact that this was more than just a housing boom, it was a much broader credit boom–there was going to be some correction. I just don’t see it requiring the Great Recession.
Fully accepted. I would expect that almost all Austrians would also agree that such prolonged corrections are not “necessary”. The key question, which I think separates us, is the optimal “means” to accomplish the desired goal of ending a recession. If I were to agree with your solution in 2008 that the Fed should have engineered a larger increase in demand, to avoid turning a true Austrian recession into an “unnecessary” Great Recession, then the only kernel of truth to this would be if, as you said, we are compelled to live in a Fed world, and, more importantly, generations of regular people have become so used to generally rising prices and wage rates, that even when monetary shocks occur and require falling prices, the tendency is for people to nevertheless “hold out” and inefficiently insist on higher prices and wage rates, which prolongs the recession.
Would you agree that the perceived need for inflation would not exist, or would at least not exist to the extent that it does now, if prices and wage rates gradually fell over time due to us being on a more sound monetary system like gold, and generations of people become accustomed to falling prices and wage rates, while nevertheless experiencing rising prosperity, such that should any monetary shocks occur, prices would adjust downward much more rapidly?
I’m sure that you have heard of the Austrian emphasis on the 1921 depression and how within a year or so the economy was corrected, and this was in the absence of Fed inflation or government deficits. Perhaps the quickness was in part due to people being accustomed to falling prices and wage rates, or, at least constant prices and wage rates, for generations prior to that time? I mean, how many businessmen and workers would be able to understand that falling prices or falling wage rates can be made consistent with rising prosperity?
Perhaps if the Fed in 2005-2007 announced something like “We are hereby strongly committed to a very tight monetary policy. We will not create any more reserves (or we will create new reserves at a much slower pace), and so investors and other market participants should expect falling prices and wage rates”, and then STUCK with that plan thereafter, the necessary correction after the rapid decline in NGDP in 2007 may have been more rapid.
It’s hard to tell now of course, but if you say that should the Fed not have loosened at all after they raised the fed funds rate in 2005, and continued to tighten, and hence the recession/correction would have been even worse, then I will agree with you, as would most Austrians. Yes, the price system naturally adjusts, but if people expect rising prices, then Austrians cannot say the market will in fact adjust prices downward, completely removing what you and Sumner call an excess demand for money. We must take what people think at face value and then go from there. Yes, it would be nice if people thought to lower prices voluntarily because the new monetary conditions require it, but it’s another to say that people WILL do such and such if say the Fed tightens. If everyone expects constantly rising prices, and they see almost 90 years of rising prices in history, and they see the Fed saying “we will not tighten”, then it’s hard to expect people to decrease prices and wage rates right away. When each individual, the Fed included, all want and expect prices to rise, but for some reason or another the banks are not lending as much as they would have to be in order to maintain demand and thus prices, then I don’t think I would agree with you if you say that the Fed could have made NGDP higher if it wanted. After all, the Fed can increase bank reserves till the cows come home, but it is also true that the banks, and even the borrowers, and everyone else for that matter, have to decide to actually increase their spending as well before you can say the Fed “succeeded” or “failed”.
The Fed has lots of power yes, but it does not have infinite power. Even if the rules were changed and the Fed stopped granting interest on excess reserves, and even if the banks started to lend more money, all this does not mean that aggregate demand will rise. The only way you can ensure that NGDP will rise the way you want it to is if there was full control over the individual’s spending patterns.
Are you absolutely certain that the Fed could have prevented a fall in NGDP if they instead kept increasing bank reserves in 2005, or thereafter? How do you know? What if their increasing of reserves resulted in the CPI going way above target? What if the CPI would have had to increase by 10% or more during 2005 (or 2007 depending on when one considers the Fed to have “tightened”) in order to stave off the expected decline in NGDP?
The economy is so unbelievably complex that even if the Fed targeted NGDP, then increasing/decreasing the speed of bank reserve creation would also be economically disruptive to the extent that the concomitant rate of credit expansion exceeded the rate of voluntary savings.
If you agree that artificially low interest rates generates unsustainable bubbles, which appears to be the case, then how can targeting NGDP avoid recessions? Or are you just presenting a solution that would minimize, rather than eliminate, Fed induced disruptions? If the latter, then I will agree that NGDP is SUPERIOR to CPI targeting, but that’s only because targeting NGDP is closer to what a gold standard, the most stable system, would look like. Targeting NGDP is targeting a gradual rise in true aggregate demand, but since the target is still estimated and enforced by violence, it cannot be “the” best.
Just like targeting the price of potatoes is an inferior monetary policy compared to targeting CPI, and just like targeting CPI is inferior to targeting NGDP, it is also true that targeting NGDP is inferior to targeting gold, which of course means just a gold standard.
I will treat your work and Selgin’s work as an IMPROVEMENT over CPI, but I will not treat it as superior to the Austrian “rigid” solution of gold standard or go home. Your solution will minimize economic calamity compared to CPI targeting, but there will still be problems, and if you are successful in convincing policy makers to target NGDP, us fringe Austrians will be there to explain why it didn’t work the best.
>First, I believe that the Fed’s role was not limited to just the U.S. economy. It is a monetary superpower and its policies get exported to the rest of the world. Thus, we had a global housing and credit boom. (See my Cato Journal article where I make this argument more fully.)
That is definitely true.
>Second, my long-run goal for NGDP is closer to George Selgin’s Productivity Norm rule . His NGDP target would allow productivity to be reflected in the price level. However, we have to transition ourselves there over time.
I can’t help but think that you and Selgin are doing so much hard work trying to get central planners to act like they don’t actually exist. To mimic the free market (in money) as closely as possible, without being a free market in money.
I like your work compared to current Fed policy, it is a definite improvement, but I don’t see you taking into account INTEREST RATES anywhere. Thankfully, you do mention interest rates in your third point:
>Third, while I believe the Fed kept interest rates well below the natural rate level 2002-2004, it is not clear to me they are doing so today. Back in 2002-2004 we had a productivity boom which implies a higher natural interest rate. Now we don’t and given the state of the economy it is reasonable to believe the natural rate is very low. Thus, my view for more monetary stimulus is rooted, in part, on the belief that the natural rate is much lower than normal.
THIS is, I believe, the fundamental issue that makes or breaks any agreement between yourself and Sumner on the one side, and the Austrians on the other.
Would you agree that it is IMPOSSIBLE for any central planner of money, no matter how intellectually sophisticated, to be able to put interest rates where the market would have put them absent the central planning?
You are saying that it is clear that the Fed kept interest rates below the natural rate from 2002-2004 (I will quibble and argue 2001-2005), and so far I will agree. But you go on to say that a productivity boom implies a higher natural rate. Are you sure of that? The Austrian view is that the natural rate of interest is due to time preference, not physical productivity per se. The natural rate is borne out of a difference between valuation of future goods as against present goods. A constant time preference, provided it is low enough to facilitate enough savings and investment to not only replace used up capital goods, but add to them over time, is consistent with a constant interest rate and rising productivity. As long as the monetary demand for output and the monetary demand for inputs remains the same, which generates the same aggregate nominal rate of profit and interest, then the economy could produce more over time, practically indefinitely.
It seems that you are invoking the productivity theory of interest. Has that not already been rejected? Productivity can only increase if there is an adequate amount of savings and investment, and when people add to savings and investment, the rate of interest falls, all else equal. It does not rise. This is because a nominal rise in savings and investment relative to aggregate sales revenues will generate an increase in aggregate costs relative to aggregate revenues. That will make nominal profits, and thus nominal interest rates, fall.
A rise in interest rates is consistent only with a rise in aggregate demand and thus rise in aggregate sales revenues, and/or a decline in savings and investment and thus decline in aggregate costs. A constant rate of profit/interest of say 10%, provided this rate reflects a level of savings and investment that not only merely replaces, but more than replaces used up capital goods, is fully consistent with rising productivity in the physical sense. As long as aggregate sales revenues in money generate 10% profit on aggregate capital (costs) in money, then 10% will stay as the rate of interest and real productivity will rise on account of a higher productivity of labor.
Productivity 2001-2005 “boomed”, and interest rates rose, because of the Fed’s inflation. It’s just that the Fed controls the economy so much that inflation has become synonymous with productivity. The concurrence of rising productivity and rising interest rates 2001-2005 does not mean that rising productivity implies rising natural interest rates. The NOMINAL rate of interest rose, but the real rate cannot be said to have risen. We don’t know what it did, because it was unobservable. We can only guess, and my guess is that since the rate of savings in the US was very low during that time, the natural rate would have been very high, since a low savings rate would have made aggregate investments and thus aggregate costs very low compared to aggregate revenues.
David Beckworth,
Ayoy from someone else here in the Lonestar state.
I’m not sure how the Fed ever differentiates effectively between “good deflation” and “bad deflation”? Many of George’s views are very intelligent, and he is certainly correct that deflation in the face of a growing economy is a good thing, *however*, if the Fed cannot tell the difference between good and bad deflation (and I’m convinced that it can’t), it will always err on the side of inflation. The fact that it is not clear to you today whether policy is too loose or too tight, tells me that the Fed probably does not know either. By default, it will err on an inflationary path. This provides the fuel for errant fiscal policy, and hence we risk getting a debt-inflation cycle, where bad monetary and fiscal policy feedback on themselves to create an accelerating path toward Mises’s crackup boom. This is a very real danger IMO, especially when the Fed sets precedent of acting outside any type of Bagehot rule, which it has done in this last crises.
This point is being made by Peter Boettke to many of the guys in your camp, but nobody seems to be listening. The real problem with your argument as I see it is not it’s strict technical merrits, but the unintended consequences from a political economy/ public choice standpoint.
P.S. I wish “Captain Freedom” would use his real name, because that was an excellent and thoughtful (albeit long) post. Somehow “Captain Freedom” does not go with the level of discourse that he presented.
Captain Freedom & K Sralla:
Let me respond briefly to some of your questions.
(1) No, I am not 100% certain the Fed could have prevented the fall in NGDP if they had desired to do so in 2008. I would be more confident if they had had in place an NGDP regime in the first place that would anchor expectations. Anchoring NGDP expectations would go along way in keeping aggregate spending from soaring or collapsing. Even so, they let NGDP fall as early as June, 2008 and then outright collapse in late 2008, early 2009. Surely, they could have done something more than they did. For example, they could have adopted an explicit nominal target to help stabilize expectations and not paid interest on excess reserves. They didn’t and thus they failed.
(2) The standard macro story, which I accept, for the natural interest rate is that it is a function of productivity, time preference, and population growth. I thought Austrians believed this too, but maybe I am wrong. I focused on the productivity part in my above reply because that seemed to be factor with that had the most change in the early-to-mid 2000s. This productivity surge is widely attributed to technological gains and the opening up of Asia.
(3) Yes, I am familiar with the 1921 recession. My take, not original, is that indeed prices were more flexible back then. In my thinking, I take a pragmatic approach that accepts this fact that we now have more rigid prices. Thus, a negative aggregate spending shock can be slow and painful to work out given prices don’t adjust quickly. Best to minimize those demand shocks. An example of this is the gold hoarding by the US and France during the late 1920s, early 1930s that helped usher in global deflation via the interwar gold standard. Because prices were sticky by then, this hoarding of gold (i.e. money demand shock) caused much global economic pain.
(4) Speaking of the gold standard, the reason it fell apart during the 1920s and 1930s is because some countries were not playing by the rules of the international gold standard (i.e. Hume’s price specie flow mechanism). Yes, it would have worked better had the US and France not hoarded gold then. But what makes you confident that even if we had a gold standard today countries would play by the rules of the game? If countries back then could not stop themselves from manipulating the gold standard, why would they behave any better today? See my counterfactual question on this issue.
(5) No, I don’t think central banks will ever be able to perfectly put their policy interest rates at the natural rate level. That is one reason I would have them move to a NGDP rule–don’t fret over interest rates, focus on stabilizing aggregate spending instead. And if done right, as in following Selgin’s rule, then actual interest rates should gravitate toward the natural rate level. The right kind of NGDP targeting can be consistent with keeping actual interest rates close to their natural rate level.
(4) K Sralla–Selgin’s productivity norm (see the link above to his piece) does not require the central bank to distinguish between good and bad deflation. I agree that would tough to do a priori. It simply requires the central bank to grow aggregate spending at the expected growth rate of factor inputs (e.g. labor, capital). If there is a productivity surge deflation will automatically occur. If there is no surge no deflation will occur. For example, say the Fed has NGDP growing at 3% since that is the expected factor input growth rate. Suddenly productivity surges and pushes up real GDP growth to 5%. Since the NGDP growth rate equals RGDP growth rate plus inflation rate, this development would cause deflation of 2%. Note, though, that the Fed never had to worry about differentiating between good and bad deflation.
>(1) No, I am not 100% certain the Fed could have prevented the fall in NGDP if they had desired to do so in 2008. I would be more confident if they had had in place an NGDP regime in the first place that would anchor expectations. Anchoring NGDP expectations would go along way in keeping aggregate spending from soaring or collapsing. Even so, they let NGDP fall as early as June, 2008 and then outright collapse in late 2008, early 2009. Surely, they could have done something more than they did. For example, they could have adopted an explicit nominal target to help stabilize expectations and not paid interest on excess reserves. They didn’t and thus they failed.
Yes, it would go a long way, and is certainly an improvement over CPI and interest rate targeting. Not only will targeting NGDP not be biased against asset prices and biased for consumer prices, it will also more closely mimic a commodity standard that tends to generate a gradual rising aggregate demand.
>(5) No, I don’t think central banks will ever be able to perfectly put their policy interest rates at the natural rate level. That is one reason I would have them move to a NGDP rule–don’t fret over interest rates, focus on stabilizing aggregate spending instead. And if done right, as in following Selgin’s rule, then actual interest rates should gravitate toward the natural rate level. The right kind of NGDP targeting can be consistent with keeping actual interest rates close to their natural rate level.
I mentioned interest rates in my previous post, but I think I failed to make clear what I was referring to. I was not referring to fed funds rate manipulation on the part of the Fed, which allegedly affects all other interest rates. I was referring to the fact that the indirect means by which the Fed traditionally increases aggregate demand (regardless of what statistic it targets), is by increasing bank reserves (buys assets from banks).
This constant addition to bank reserves allows the banking system to engage in the maintaining of credit expansion ex nihilo, which all else equal reduces the interest rate on debt of all maturities to be below the natural rate of interest. The Austrian position is not that a lower fed funds rate directly affects all other interest rate maturities. It’s the way the Fed lowers the fed funds rate that generates lower interest rates.
So if you say that the new rule should be for the Fed to target NGDP rather than fretting over interest rates (which presumably means fed funds rate), then you cannot but help admit that the way the Fed will inevitably target NGDP is by increasing bank reserves such that the banks expand credit, such that the aggregate demand in the economy increases by a particular rate conditional on some other metric, for example productivity.
So yes, targeting NGDP will almost certainly be more stabilizing for aggregate demand, but it will not avoid the inevitable malinvestment that would ensue on account of the artificially lower interest rates that inflating bank reserves and credit expansion would generate. You say that the resulting interest rates will be “close” to the natural rate, but I am not so sure about this, because the natural rate is that rate which results from a free market in money production, which has unpredictable aggregate demand, and unpredictable interest rates. For inflating reserves and expanding credit ex nihilo are the means by which you argue the Federal Reserve System should influence aggregate demand, yes?
Now, if you argue that under a gold standard, any increase in supply of money that enters the loan market first would also tend to reduce interest rates. But this reduction would only be fleeting, and only to the extent that new gold production kept getting injected into the loan market. So just as the market would “adjust” to the Fed targeting NGDP, so too would the market adjust to gold production.
If you argue that the Fed would inflate as if it were under a gold standard, then we may as well have one, “just to be sure”, no? You say you don’t trust other countries to stick with gold, well, I don’t trust this country’s central bank to act as if paper money were gold. If I say gold will work, and you say no because we can’t trust people, then I could use that same argument against paper money printers.
>(2) The standard macro story, which I accept, for the natural interest rate is that it is a function of productivity, time preference, and population growth. I thought Austrians believed this too, but maybe I am wrong. I focused on the productivity part in my above reply because that seemed to be factor with that had the most change in the early-to-mid 2000s. This productivity surge is widely attributed to technological gains and the opening up of Asia.
Well, to be fair to you, there is some disagreement in the Austrian camp as to what determines the market rate of interest, which seems to be partly what you are referring to, but there is definitely universal agreement that the natural rate of interest is fundamentally and primarily a result of time preference, and there is universal rejection of the standard macro story of interest coming together as a result of many different concurrent factors such productivity, population growth, etc.
Productivity may, to the Austrians, indirectly affect the difference in people’s preference between future goods and present goods. For example a radical explosion in say the electronics industry may influence a person to buy more funky electronics gadgets now and save and invest less in future production. But there is no mathematical or inevitability to this such that it can be said to always “cause” a higher rate of time preference, and thus higher interest rate. The only mathematical certainty here is that the market rate of profit/interest is determined by the difference between the monetary demand for output and the monetary demand for factors of production that go into producing that output. As long as this monetary difference is unchanged, productivity can rise or fall and there would be no pressure on the market rate of profit/interest. The natural rate, of course being unobservable in our Fed controlled world, is the difference in subjective valuation between present goods as against future goods.
Productivity and population, insofar as they do not affect this subjective preference difference, do not affect the natural rate of profit/interest.
(3) Yes, I am familiar with the 1921 recession. My take, not original, is that indeed prices were more flexible back then. In my thinking, I take a pragmatic approach that accepts this fact that we now have more rigid prices. Thus, a negative aggregate spending shock can be slow and painful to work out given prices don’t adjust quickly. Best to minimize those demand shocks.
Do you see the self-reverential logic here? The Fed has habitually targeted a relatively stable consumer price level, which is what the majority of income earners now take into account to a large extent when forming preferences for nominal wages and prices. Granted there are sources of wage and price rigidity from Congress’ regulatory side as well, but there is no doubt that when the average wage earner is considering a wage, the most important thing he takes into account is his standard of living, which is related to purchasing power, and thus prices. So, the logic goes, because prices are more rigid now, the Fed is to do even more to prevent demand and hence prices from falling, by inflating more and making prices as rigid as they are supposed to be, because, well, they’re rigid.
Is it not the case that you reject the gold standard, in part, because it makes prices too volatile? Now here you are saying that prices are unfortunately not as flexible! If flexibility in prices is what you think is desirable, then gold would do that job.
>An example of this is the gold hoarding by the US and France during the late 1920s, early 1930s that helped usher in global deflation via the interwar gold standard. Because prices were sticky by then, this hoarding of gold (i.e. money demand shock) caused much global economic pain.
That is one interpretation of history, but I do not think it is correct. It appears to only serve to justify the pre-existing theory that hoarding money is inherently bad.
Then there are the inner contradictions of the “gold standard” of that day, the resulting economic problems of which was NOT a result of the inability of central banks to inflate, but rather because the European countries, and later the US, went OFF the gold standard, initially in order to finance the great war effort, most of them doubling and even quadrupling their supply of money, and then later on in a vain attempt to enforce a pre-war monetary exchange rate. Germany was the worst of course, and we all know what happened there. The inflation in Europe was masked by exchange controls. The US, which entered the war late (it’s weird to even type that now), inflated less, and was thus the only country that remained on a de jure gold standard. De jure because the US banned gold export. After the first war, the exchange controls were lifted, and the mess was exposed. The British Pound Sterling for example depreciated around 35% from pre-war value. It was in this post-WWI world of volatility, inflation, and currency blocs that made the world, for the first time, abandon a true gold standard.
Britain tried to go back to the pre-war gold exchange rate while still inflating. This contradiction could not last. The rest of Europe also kept inflating their currencies, and, in combination with a more rigid supply of gold, and pre-war exchange rates, Europe kept complaining of “shortages” of gold during the late 1920s. This made it seem as though the problem was gold “hoarding”, when in reality it was too much paper inflation at the pre-war enforced exchange rates.
Because Britain inflated so much and yet enforced a pre-war, pre-inflated exchange rate, England saw gold starting to flow out of the country. The “gold standard” was doomed to fail in Europe precisely because the gold standard was abandoned.
Just like a fiat money standard is doomed to fail if central banks abandon a low inflation target and print too much, i.e. Zimbabwe, so too will the gold standard fail if countries enforce and abandon free money production and enforce a fiat standard.
Trust cannot be used AGAINST my preferred system any more than it can be used FOR your preferred system. If you don’t trust people to do X, then I don’t trust those same people to do Y.
>(4) Speaking of the gold standard, the reason it fell apart during the 1920s and 1930s is because some countries were not playing by the rules of the international gold standard (i.e. Hume’s price specie flow mechanism).
So too will the present paper money standard collapse because countries are not “playing by the rules”. Dot com bubble, stock market bubble, real estate bubble, bond bubble, etc, etc, etc
>Yes, it would have worked better had the US and France not hoarded gold then.
Those are myths. France suffered from hyperinflation during and after WW1. The Franc went from 19.3¢ under the old gold standard to 1.94¢ by 1926. Riots broke out, and after the debacle in England, France went back to gold at a realistic par. This established confidence, foreign capital returned, and France decided to peg the Franc at 3.92¢ even though the foreign exchange market valued it much lower. This caused a huge flood of Franc purchases in the foreign exchange market, causing the Bank of France to sell tremendous quantities of Francs in exchange for foreign currencies, including British Pound Sterling. Britain threatened France to go off gold if France kept redeeming the inflated Pound Sterling for gold, which they eventually made good.
In the US, they wanted to PREVENT an inflow of gold from Britain, to help their inflated currency. They did this by inflating US dollars by massive quantities and lowering the rediscount rate. This of course only added to the great stock market speculative boom that had already been created by the mid to late 1920s. The further inflation in 1927, coupled with a historically low “call rate” of just 10% (as opposed to over 100% which is what existed prior to the Fed), made the stock market skyrocket. Inflationary Britain loved this, because gold did not flow out from there as fast.
It was inflation, NOT “hoarding gold” that generated economic calamity during the inter-war years.
>But what makes you confident that even if we had a gold standard today countries would play by the rules of the game?
A country that adopts a unilateral 100% reserve gold standard is better off, and best off, even if other countries inflate and violate the gold standard.
If you don’t trust countries to play by the rules of the game, then there is no reason to believe that the Fed will play by the rules of YOUR game, which is targeting NGDP. What makes you confident that the Fed will not print money to finance an operation overseas that does not get tallied in domestic NGDP?
If you don’t trust other countries to play by the rules of the game, and I don’t trust the Fed to play by the rules of your game, or anyone else’s game for that matter, then
>If countries back then could not stop themselves from manipulating the gold standard, why would they behave any better today? See my counterfactual question on this issue.
If countries today could not stop themselves from manipulating the paper standard, why would they behave any better in the future?