Tuesday, May 24, 2011

Great Crises of Capitalism (3)

This concludes my review of P. D. Jonson's (aka Henry Thornton) Great Crises of Capitalism. The first part is here, the second part is in my previous post.

Money offers
Jonson quotes the famous line of inflation as “too much money chasing too few goods” (p.203). I prefer to talk in terms of money offers (Py or M/k), since money that is not spent has no inflationary effect. Base money aggregates can surge in either deflationary or inflationary situations. In the former, it represents money being hoarded (a rise in k). In the latter, it is part of a much wider monetary expansion (and can even represent a fall in k). Money aggregates can be as misleading an indication of monetary conditions as interest rates. (Jonson notes problems with interest rates as indicators [p.244].)

It is nonsense, for example, to suggest that low interest rates are a sign of “loose money”: if interest rates are zero, then that often implies negative money risk – that is, people are expecting the value of money to rise: this is not a sign of loose money. Just to confuse matters, it can also mean, if conditions are sufficiently peculiar, that there are inflationary expectations, these are just being overwhelmed by negative opportunity costs for capital: such a flood of capital in excess of demand that people are willing to pay to put it somewhere. (This is the situation Japan has found itself in.) The nonsense slogan that interest rates are “the price of money” leads to misreading of interest rates. What you can buy with money (goods, services, assets) is its (barter) price, its nominal price is 1. Interest rates include an element for expected changes in the price of money (money risk), so clearly are not the price of money. Interest rates are, at best, the price of capital (not the same thing as money, since capital has an across-time element to it).

All of which is to say I am a Sumnerian (or “quasi-monetarist”): I believe the crucial thing is Py (or nominal GDP). Consider this chart of change in nominal GDP with change in employment. Do you think that they might be connected? More precisely, the key thing is expectations about Py (what people expect about the overall level of economic activity in nominal terms) since they will drive their money holding (k) and their transacting. (Such as, for example, what wages will be agreed in contracts: so an unexpected deflation, or even disinflation, will lead nominal wages to "overshoot", discouraging employment.)

That monetarism needed to include the notion of ‘variable lags’ due to the disconnect between changes in monetary aggregates and price-level changes is an indicator of basic problems with the theory: use of such a “fudge factor” takes the power out of the theory – hence the rise of ‘quasi-monetarism’, focussing on expectations and nominal transactions.

Dot coms and Asian busts
Jonson moves on to a quick history of Japan from Commodore Perry onwards, recommending Ruth Benedict’s excellent Chrysanthemum and Sword, and noting some of the similarities in Japan’s postwar “miracle economy” with China’s recent economic rise. This culminated in Japan’s 1980s “bubble economy” and a spectacular 1991 bust from which Japan has still not fully recovered. The Bank of Japan “pricked” the bubble by raising interest rates but the failure to deal seriously with insolvent banks meant problems lingered: indeed, some of the more bizarre lending practices continued. Jonson holds that Richard Koo’s concept of a ‘balance sheet recession’ should be taken seriously (Pp209ff).

Many economists are puzzled by Japan’s fiscal policy of massive deficit spending – to the extent that it now has the world’s highest public debt to GDP ratio – coupled with the Bank of Japan’s policy of monetary restriction, thereby nullifying whatever stimulatory effect there might be from fiscal policy. (On of the basic policy principles is that ‘the monetary authorities move last’: i.e. they can respond much more quickly than fiscal policy.) The combination of fiscal stimulus and monetary restriction results in a flat economy and a mountain of public debt. (That Japan’s politicians have been coping with the new experience of competitive Party politics may be a factor in the mix.) Koo’s theory, an updated version of Irving Fisher’s debt-deflation analysis, at least explains the fiscal policy.

Jonson then discusses the 1997 Asian crisis, then the ups and downs of post-Soviet Russia, whose gyrations brought down the (spectacularly erroneously named) Long Term Capital Management. Then it is on to the Shanghai Stock Exchange bubble (the Cultural Revolution is a long way away now: modern China is far closer to Chiang Kai-shek’s vision than Mao’s) followed by an extended consideration of the dot.com booms and busts (Pp209ff).

Considering capitalism
Having started with three general chapters framing the issue, Jonson concludes with three chapters considering the history of boom and bust covered in the middle seven chapters. The first of the final three chapters examines how capitalism works, its strengths and weaknesses.

This is a matter of “myriad of transactions” with the great divide in macroeconomics being those who hold that all markets (eventually) clear (i.e. those who rely on equilibrium analysis) and:
a school of economics – based on simple facts – that asserts that economies develop irrational financial instability, with runaway asset and credit inflation followed by a reaction that leaves many resources unemployed or underemployed (p.230).
Jonson has considerable respect for Keynes, who grappled with these large questions and whose efforts “have not yet been bettered” (p.230).

While the facts of asset booms and busts, so engagingly covered by the author, are clear, I am less inclined to throw around terms like ‘irrational’, ‘mania’ and ‘animal spirits’. It seems to me one is dealing with patterns of reinforcing expectations in a situation where all we can have about the future are expectations (admittedly, based on available information including past experience), not direct information.

But any price one can sell at is economic reality, and so therefore are any expectations of capital gain they are based on: reality until, that is, they are not. Expectations are driven by information and experience but also frame how information (or its lack) is treated. Where there is a general expectation of rising prices, for example, lack of information is treated very differently than when expectations of falling prices have set in.

Still, one takes his point about dealing in reality. One just needs to expand rationality analysis to take account of the limits of time and information – including for cognition itself.

Jonson discusses the work of Keynes, Friedman and Minsky in the course of making some general policy recommendations, including “leaning into” asset booms (Pp229ff). His discussion of the continuing relevance of Hume’s analysis of monetary economics (Pp233-4) is reminiscent of Friedman’s comment that in the last two centuries monetary economics has only managed to go one derivative beyond Hume. Part of the problem is adding in a non-monetary asset to simple basic models of open economies quickly lead to very complicated mathematics (p.235). (See my previous point about limited information.)

Jonson then gets to the heart of his macroeconomic analysis, discussing what happens when one adds in a non-monetary asset to economic models in a world where China is massively expanding its production of goods and services – money expansion will be reflected in rises in prices of non-traded good and services and assets, with the (eventual) impact on traded goods and services potentially taking decades (Pp233ff).

The implication of this is that:
When analysts write of ‘global imbalances’ they are usually writing about an incomplete adjustment in which one country or group of countries have an external deficit (or a falling exchange rate), and another country has an external surplus (or a rising exchange rate) with incomplete price adjustment. The great modern example as the USA and other developed countries in deficit and China and similar nations in surplus (p.236).
As well,
goods inflation is slow to adjust to monetary contraction, the same approach predicts asset deflation (p.236).
Jonson cites then Chancellor of the Exchequer Churchill’s 1925 setting the gold value of sterling too high as a classic example.

Monetary economist Scott Sumner clearly takes the Fed’s recent disinflation as a similar example. When critiquing the inflationary habits of the Fed, it is well to remember it did its greatest damage by monetary contractions and managed to do so both on (1929-33, 1937-8) and off (2007-8) the gold standard.

Jonson discusses the main competing explanations of stagflation, the range of monetary regimes across history and the virtues of the gold standard and the problems and opportunities of booms and busts for asset management, citing some seminal texts on the way through. He is particularly exercised by the debt and inflation problems that emerge after banking crises and busts and is informative on the pervasive problems of lack of predictability of events (Pp229ff).

Lessons of up and downs
Then it is on to the lessons of booms and bust. Jonson regards attempting to stop booms and busts happening as likely impossible to begin with and having high costs – vitiating the achievements of booms and the punishing of poor or misguided behaviour of busts. He then proceeds to tease out lessons for governments, central banks and investors, with a helpful one-page summary at the end of the chapter (Pp247ff).

Jonson is not a fan of Greenspan or his successor Ben Bernanke and fears that the recent “quantitative easing” will release high inflation down the track. He is particularly concerned with the mounting levels of public and private debt, pointing out that large government debt leads to default, inflation or a squeeze on services (p.249). While very keen on policing of fraudulent behaviour and separation of investment banking from commercial or deposit banking, and use of anti-monopoly laws to stop any institution being “too big to fail”, he also suggests it is desirable if the broader citizenry was educated in basic principles of finance to try and reduce the level of public credulity (Pp250-1). Jonson also feels that some version of Keynes’ Bancor proposal is likely superior to Taylor rule targeting (Pp257ff).

Scott Sumner is eloquent on the pitfalls of a gold standard. The implication is that a monetary system that had the discipline to run a gold standard would also have the discipline to run a fiat money system, unless there is some very strong threshold effect in entering into the gold standard. Some version of Keynes’ Bancor might, through the international commitment involved, have such a threshold effect. One of the benefits of such agreements is, after all, providing an excuse to stand up to domestic interests – thus the structure and processes of the GATT-cum-WTO does not make much sense in terms of economic theory, but a great deal of sense as an international forum to deal with domestic political pressures.

Future shocks
In the final chapter, Jonson attempts to look forward, based on the principle that:
In the absence of some great catastrophe, the future will be like the past, only more so (p.263).
A survey of trends and possibilities is followed by a critique of the ‘two-speed’ Australian economy with rising interest rates and $A undermining small businesses, particularly small exporters: he judges that a classic “bust” is the likely outcome (Pp272-3). Brief considerations of issues of the economically disadvantaged and corporate power is followed by the suggestion of a continuing “regulatory pendulum” which Jonson judges as likely to swing towards more regulation (Pp276-7).

In contrasting the US policy of using “every form of stimulus known to man” with the British strategy of austerity, Jonson is inclined to think the latter will work better, as it forces focus on basics such as “thrift, hard work and smart ways to do things” (p.277). Jonson then makes various “modest suggestions” for reforming capitalism and reiterates his fear of financial instability spiralling out of control due to misguided attempts to stop the process of boom and bust (Pp278ff). He concludes, however, with a basic optimism about the possibilities before us.

I enjoyed Great Crises of Capitalism a great deal. Jonson has an engaging writing style and a refreshing confidence that the facts matter. While taking his points about public debt, “too big to fail”, inevitability of booms and busts, the problems of ignoring asset inflation, I am less convinced by some of his assertions about monetary policy. As this post eloquently puts the case (with revealing graphs), disinflation by inflation hawks have (and continue to do) great damage.

If central bankers have a persistent tendency to be too sanguine about inflation much of the time, but disastrously over-concerned with it on some searing occasions, this surely raises the issue of the value of central banking in the first place. “But they just have the wrong theory” is always a suspect move in trying to explain away problems of central control. The pattern looks more like the perennial problems for central control of dubious incentives and information limitations.

But this is not a book for the ideologically pure and is mostly the better for it. Though a framework can be so open-minded that it lacks the constraints required for intellectual rigour. The diffidence of the author does leave a feeling that the heart of things has not quite been captured.

Talking of the failure of Long Term Capital Management (rarely has a major financial institution been more incorrectly named), Jonson writes:
these bright but naïve men used a short run of history in developing their models, the sort of silly mistake this book is dedicated to discouraging (p.242).
However one might quibble about this assertion or that implication, Great Crises of Capitalism succeeds very well at putting boom and bust into a deeply sensible perspective. It is not a book of answers so much as warnings, questions and examples: but that too serves. Far better than do the spruikers of the latest unending boom, who are not possessors of some new truth but mere purveyors of recurring delusions.

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