Broken by the fix

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. To the extent that the Fed is paying people not to spend money.
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. 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. 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 into a TKO,[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.

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

Going for gold: perils of entering the goldzone

Who would want the global monetary system to be at the mercy of the Bank of China?  Not conservative, free market types in the United States and elsewhere, one guesses.

Actually, it turns out lots of them do; all the people who support some sort of return to the gold standard, who think that the US (and other countries) should recreate the goldzone. Let me explain.

Gold shines
Some folk are quite impressed by the way the price of gold has shot up in recent years (all gold statistics are from the World Gold Council website).

Gold price in US$: on the up and up

As the price has shot up, so has gold's attraction as an investment. It is a striking illustration of the mystique of gold that folk who, if any other asset quadrupled in price in 6 years, would call "bubble", see the surge in the gold price as saying something profound about the global economic situation and monetary system.

Mined and recycled gold increasingly flows into (private) vaults

While industrial and dental use of gold has remained fairly constant, there has been a strong shift from demand for gold being dominated by jewellery to increasing interest in coins and bullion. With investment hitting 40% of mined and recycled gold, it is likely at about the levels that flowed into monetary gold at the height of the gold standard; movement between monetary and non-monetary uses of gold being an important feature (pdf) of the 1873-1914 gold standard.

After surging in price in 1979-80, gold was actually losing value as an investment in real terms until 2005, when it began a price surge which has seen it storm past its 1980 highpoint: but low real interest rates make gold a better investment (pdf). While Asian demand had tended to dominate the market, the striking change in demand for gold as an investment has been the dramatic European (particularly German) embrace of gold from 2008 onwards.

Investment gold, in tonnes

A certain Euro-nervousness perhaps.  Looking at jewellery and investment demand together, the way Asian demand dominates the gold market is clear.

Big in Asia: demand for gold for jewellery and investment in 2011, in tonnes.

India has long been a strong market for gold and, as they and the Chinese are getting richer; this (along with the aforementioned Euro-nervousness) is reflected in the demand for gold. For all the (largely American) goldbug chatter, Americans are not nearly as in love with gold as others are.

Still, there are voices calling for us all to enter the goldzone, to "go back to gold" as the basis for the international monetary system. But doing so would have implications they may not have considered fully.

Entering the goldzone
Money is a transaction good: the value of money is what it can be swapped for. In a monetary exchange economy, the price level (P) is the average swap value of money in circulation for goods and services. Using the Fisher-Friedman equation of exchange (money stock x rate of turnover of money for goods and services = prices x output: i.e. MV = Py), then P = MV/y.

The cost of production of money is merely a minimum constraint on its supply. For notes, this clearly not much of a constraint. (For coins, some premium over metal value for transaction utility can also be a factor.) In the case of a monopoly provider of non-convertible notes, there is no other constraint on its supply except that adopted by the monopoly provider. In economist George Selgin's words:

The disadvantage of fiat money [.i.e. non-convertible money], relative to commodity money, rests precisely in the fact that its scarcity, being thus contrived, is also contingent. A matter of deliberate policy only, it is subject to adjustment at the will of the monetary authorities or, if those authorities are bound by a monetary rule, at that of the legislature. Consequently, although a fiat money can be managed so as to not only preserve its purchasing power over time, but also so as to achieve the greatest possible degree of overall macroeconomic stability, there is no guarantee that it will be so managed, and market forces themselves offer no effective check against its arbitrary mismanagement.

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

The RBA is not the Fed, thank goodness

This is based on a comment I made here.

At the Bubbles and Busts blog, there is a post criticising Marcus Nunes' post positively contrasting Australia's economic performance over New Zealand for failing to deal with Australian economist Steve Keen's warnings over the Australian housing bubbles and their debt-deflation implications.

That impending crunch is a long time coming. I agree completely that Australian housing prices are a series of bubbles and that many Australian households are highly leveraged on bureaucratic approval. But the air was out of the various American housing bubbles before the Global Financial Crisis or Great Recession hit. The former was a result of (1) some bizarre evolution in financial instruments, (2) poor prudential regulation, (3) a pattern of the destruction of prudence by intervention and the (4) US Fed deciding to go with specific credit management (pdf) rather than general liquidity support. It then proceeded to (5) disinflate by "passively" tightening monetary policy in what Matt Yglesias rightfully calls a massive failure in monetary policy while (6) entirely fail to anchor income expectations (giving it what I have called unbalanced credibility).

In the case of Australia, (1) does not apply anywhere to the same degree (2) is likely rather better (but as yet not seriously tested by a domestic crisis rather than an imported one) (3) does not really apply (4) is not something the Reserve Bank of Australia (RBA) is likely to do, (5) it won't do and (6) it does the reverse.



Like Keen, I admire Fisher's Debt-Deflation analysis (pdf) of the Great Depression. But that analysis was in the situation of massive deflation imposed on the goldzone by the Bank of France abetted by (pdf) the US Federal Reserve. You need seriously destructive monetary policy to get the effect.



Yes, it will be ugly when the bubbles burst but better monetary policy than the Fed managed will make things a lot less ugly in Australia when and if the housing bubbles burst (rather than subsiding).

There is no such thing as just money

I have been doing a fair bit of reading in the history of money and monetary theory to try and understand money, particularly its origin and use. A thing reveals its nature through history, to understand the history of something is to much better understand it.

I was aware that modern macroeconomics is bedevilled by a lack of a common analytical language in talking about money. But the problem goes deeper than that; money is a multi-dimensional phenomenon.

I am not talking here about debates over monetary base (coins, notes and bank reserves with the central bank) and the various monetary aggregates (M1, M2, M3 etc). These debates are even less interesting than they appear, not least because expectations matter so much.

Nor even that when economists talk of the "demand for money" they mean the demand to hold money, not the willingness to spend money (which, in a monetary exchange economy, is the demand for goods and services; and money actually spent on goods and services is aggregate demand). Though one way of thinking of money held is as a proportion of money passing through, and shifts in the proportion of money held rather than spent can be very important in its macroeconomic effects. Especially if the money supply does not adjust accordingly, because then an increase in the demand to hold money can lead to a fall in transactions and hence (since one person's spending is another person's income) a fall in incomes, spiralling down into those transaction crashes/goods-and-services gluts we call recessions or depressions.

The problem in talking about money qua money, is that there are so many institutional possibilities with money. Let us just consider the situation were notes exist, so cost of production is not an effective constraint (and ignoring coins and the history of money before notes).

A "theory of money" has to consider to following dimensions:
(1) Is there a monopoly supplier of local notes or are there competitive suppliers?
(2) Are the notes convertible into gold, silver or some other commodities?
(3) If not convertible, are the notes backed in some other way?
(4) If not, is the supply of notes limited in some other way beyond cost of production?

If (2) is true, then the price level (P) is determined by the ratio of monetised backing (for example, gold if a gold standard is operating) to output (y), since notes can always be "swapped out" for gold, so the level of monetised gold (mG) sets the swap value of notes for output. (So P = mG/y.) So, if monetised gold rises faster than output, prices rise. If monetised gold rises slower than output, prices fall.

Note that if (2) applies, then the swap value of the notes (in terms of gold) is set, but their supply is not.[i] This setting of the swap value by a fixed price in gold leads to considerable price stability, as the gold/output ratio generally changes fairly slowly.[ii]  Changes in the rate of turnover of notes (i.e. in the demand to hold money) can easily be accommodated by changes in the supply of notes.

This price stability tends to lead to low levels of fluctuations in the rate of turnover/proportion of notes held--in Sweden, for example, in its gold standard era from 1873 to 1914, there was a steady decline (pdf) in the rate of turnover of notes/proportion of notes held.

If (2) does not apply, then the above is not how things work. So convertible or not convertible becomes a vital issue for effective analysis.

If you have a monopoly supplier of notes that are not convertible nor backed nor otherwise supply limited--so (2), (3) and (4) do not apply--then you have hyperinflation, for the reasons explained nicely here (pdf) using the example of the German 1922-3 hyperinflation:

throughout the hyperinflation episode the Reichsbank’s president, Rudolf Havenstein, considered it his duty to supply the growing sums of money required to conduct real transactions at skyrocketing prices. Citing the real bills doctrine, he refused to believe that issuing money in favor of businessmen against genuine commercial bills could have an inflationary effect. He simply failed to understand that linking the money supply to a nominal variable that moves in step with prices is tantamount to creating an engine of inflation. That is, he succumbed to the fallacy of using one uncontrolled nominal variable (the money value of economic activity) to regulate another nominal variable (the money stock).

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]