About the welfare state

This comment provoked the thought that modern welfare states are systems for replacing private saving with public debt. With large health costs and retirement income guaranteed, much of the incentive for private saving is undermined. Meanwhile, the political incentive to pay for present goodies to hand out to voters by pushing the cost into a future that the office-holder may well not have to deal with encourages high levels of public debt.

Given rising per capita incomes, people should be increasingly able to manage their own health and retirement costs, yet the clear tendency has been for this process of replacing private saving with public debt to accelerate.

There are exceptions in various directions. For example, the Singaporean system of compulsory saving, the Australian system of compulsory superannuation, the Japanese combination of high private saving and mountainous public debt. Nevertheless, in adopting an inappropriate common currency--the euro--the eurozone EU may have revealed this basic contradiction in the post-1960 welfare state by cutting off a major mechanism for dealing with the consequences of replacing private saving with public debt, currency devaluation (both against other currencies, making one's products cheaper and imports more expensive, and future value, reducing the value of debts denominated in one's own currency). Add in collapsing fertility rates (and so lack of future taxpayers to pay these mounting debts) and one can see that the post-1960 massive income-transfer welfare state is not likely to be a long-lasting historical form.

There is no limit to the good, alas

This is based on comments I made here.


If the purpose of government is to "do good", then there is no limit to government, for there is always more "good" to do. The more absolute the claim of "the good", the more total the therefore-legitimate ambit of government. The most complete manifestations of this logic is in totalitarian regimes, for the more complete the transformation of human society to be achieved, the more total the control. The Soviet Union sought to transform human beings, the Third Reich to give Aryans Lebensraum, the Fascist state to create a united, powerful and confident Italian nation. Each aim was more total than the next one, so the peace time Soviet state was more completely totalitarian than the Nazi state which was more totalitarian than Fascist Italy.

Democratic government points in both directions. As legislators are the elected representatives of The People, their authority is sanctified by popular sovereignty. On the other hand, their authority comes from said people, so controls which seem to too restrictive on said people also contradict popular sovereignty.

One sees this tension particularly clearly in US politics, where the left tends to take it as read that government acts across a wide range of issues to support the Good and manifest popular sovereignty while the right tends to take it as read that government is a dangerous delegated authority whose overweening ambition threatens popular (in the sense of individual) sovereignty.

This comes out particularly strongly in economic issues, where one sides sees property rights as manifestations of popular sovereignty and the other as them being various levels of impediments thereto.

It also comes out in that folks on the left tend to see private interests as something the political order can "sit over" and control while the right tends to see government as something that will be gamed by, or otherwise manifest, private interests. (To put it another way, one regulates in the hopes of restricting lobbies and private interests, the other is more likely to see lobbying as the predictable result of intrusive regulation.)

To complicate matters, there are "the claims of God" conservatives who are happy to use the state to do "God's will". Also, the default attitudes to state coercion tend to reverse when considering the physical coercive arms of governments (police and military forces). The left tends to be suspicious of legitimated official violence (while being terribly keen on all sorts of other official coercion) since criminals and angsty foreign powers are just misunderstood/have legitimate concerns (but corporate interests are, of course, evil), while the right wants social order to be protected (even while being generally sceptical of state coercion elsewhere).

So US politics is divided into two Parties who can both accuse the other of "not getting" the American Revolution and both are correct.

All of which makes the question of "yes, but what actually works?" an excellent one. It, more than anything else, was the question which led to liberalising economic reforms being adopted by both sides of Australian politics. Legislation normally has wonderfully "good" intentions. But intentions are easy, anyone can spout them, it is consequences that really matter.

Another way to think about the modern addiction to legislating is: what incentives constrain politicians to pay attention to consequences? And which consequences are they going to pay attention to? Thinking about those questions leads to rather more scepticism about the modern mania for lawmaking.

Changes in technology may also have affected the propensity to legislating. Looking at the stats on pages of legislation passed by the Australian federal Parliament, I suspect the photocopier helped expand the amount of legislation by making it easier for Parliament to process it.

As for the notion that purpose of legislators is to legislate, Pitt the Elder is reputed not to have shepherded a single Act through Parliament in his entire Parliamentary career.

Law can also repeal law. By the late C19th, British politics had a reputation for high levels of probity. This was not the case in the C18th. The British Parliament, from the late C18th on, spent much time repealing laws and regulations. By so dramatically reducing official discretions, it dramatically reduced the potential market for corruption (corruption being the market for official discretions) and so greatly improved the probity of British politics.

If one dislikes all the corporate lobbying, less intrusive regulation (particularly less complex tax systems) would be a great way of reducing the amount of lobbying. Complex tax laws and intrusive regulation attracts lobbying the way faeces attracts flies. It is a major cost of an excessive propensity to legislate.

A political order that is addicted to legislating should not have its addictive behaviour facilitated by a presumption of doing Good. Consequences are what really matter, because they are what people actually live with. Not justifying intentions.

Of labour income and shifts in income inequality

This is based on a comment I made here.


There are a host of issues with inequality: of the significance of income versus consumption inequality, for example. But that income inequality in the US has been increasing in recent times, (on some indicators) back towards the levels of the “Gilded Age”, is fairly clear. The effect is particularly concentrated at the very top of incomes.

Paul Krugman divides the history of C20th income inequality in the US into the “long Gilded Age” until about 1938, “middle class America” of the Great Compression from then until the mid 1980s and the “Great Divergence” since. A pattern he has tied it to political polarisation and financial deregulation.

Krugman is arguing that it is basically a creation of public policy. That the New Deal deliberately compressed incomes until the “supply side” policies of the 1980s reversed the effects. I suspect that public policy has less effect than Krugman claims.

It is worth noting, for example, that the US federal income tax is wildly progressive. The top 5% of income taxpayers pay over half of total federal income tax receipts. The top 20% of income taxpayers pay over 80% of total federal income tax receipts. Even given that the income figures cited above are about market (i.e. pre-tax) incomes, the income transfers of the US government work in the reverse direction to that which Krugman is indicating. So, for the “public policy did it” explanation to work, it must be overwhelmed by other aspects of public policy. For example, Krugman might have a point about the finance industry.

Still, there could be other factors are at work driving up capital and driving down labour incomes (relative to each other).

It is easy to nominate social changes that could be increasing income inequality.

(1) Immigration: widening skill differentials and driving down labour income (and therefore putting upward pressure on capital income).
(2) Increased life cycle inequality with the expansion in higher education, as poor students become highly paid professionals later in life, and increasing skill differentiation.
(3) Women entering the workforce, putting downward pressure on labour income (and thus upward pressure on capital income) and increasing household differentiation as high-income women marry high-income men.

In the C19th, there were temperate and tropical zone labour flows. A vital interest of labour politics in North America and the Antipodes was to block tropical zone labour flows competing with them. (Hence the White Australia policy and anti-Chinese immigration sentiment in both regions.) But even within the temperate zone labour flows, a lot was fairly low skill. The effect of the mass immigration to the US was to increase skill differentials and put downward pressure on labour income (and upward pressure on capital income): hence the inequality of the "Gilded Age".

There was a dramatic drop off in migration in the interwar period. After some lag, there was consequently downward pressure on capital income and upward pressure on labour income. In the postwar period, there was high productivity growth and immigration was largely from Europe, and the more educated and industrialised parts thereof. Capital growth more than compensated for labour force growth, so there was upward pressure on labour incomes and downward pressure on capital incomes (relative to each other) with little or no widening of skill differentials. Hence the "great equalising".

Then productivity growth died away, migration became much more "tropical zone", women flooded into the workforce. There was downward pressure on labour income, widening skill differentials and upward pressure on capital income (due to increased relative scarcity). Combine that with increased life cycle inequality (due to mass higher education) and high-income women marrying high-income men and you get flat labour income and increased income inequality. (And yes, I am aware of the claims that the net effect of migration is to increase per capita incomes. Maybe, but it does not increase specifically labour income, which is my point.)

So how much public policy changes drove, or responded, to these underlying patterns, a fascinating question. But I am sceptical how much public policy can counteract these effects.

I also disagree with Krugman’s take on the wider the effect of Reagan. There is little point in comparing Reagan’s performance with the period of high productivity growth. The interesting comparison is with other developed democracies at the same time as his term in office. The "supply side" reforms that started under Carter led to the US pulling away from European countries in per capita income, after the post war decades of convergence in per capita income as European countries got over the effects of Dictator’s War and technology spread in “technological catch up”. Reagan did well under the comparison that counts—similar countries in the same general context.

A lot of factors affect both relative economic performance and trends in income inequality: analysis needs to carefully consider the complete context, rather than focusing on what seems congenial to blame or credit.

The protection of the public eye

Blogging in Cuba is not the safest of occupations. Here is a request, received by email, by and on behalf of such bloggers:

Many people want to do something to help the bloggers directly. The most important thing is to read them, talk about them, comment on their blogs, share their blogs with others, keep them IN THE PUBLIC EYE, which is a shield that helps to protect them.

So, here are some blogs to follow:

Generation Y

Sin Evasion/Without Evasion

Laritsa's Laws

Octavo Cerco

Dimas's Blog

The Birth of the Nazis: the Freikorps

Nigel Jones' splendid A Brief History of the Birth of the Nazis: How the Freikorps Blazed a Trail for Hitler is an excellent rendering of the turbulent period in German history from the abdication of the Kaiser on 9 November 1918 to failure of the Beer Hall Putsch of 8/9 November 1923. So a period of precisely five years, but a very exciting five years.

The collapse of the Kaiserreich in defeat and hunger left a gap in legitimacy and authority that the proclamation of a German Republic did not solve. No part of the borders of the Reich had been breached when Germany sued for peace, so it was easy to deny that Germany had "really" been defeated--leading to the "stab in the back" myth, a phrase first coined by a puzzled British general in conversation with Ludendorff (p.171). Ludendorff comes across as a wholly odious character--physically brave but an appalling moral coward who avoided any responsibility for the military outcomes he was more responsible for than any other German officer. He was an entirely pernicious influence in the new post-Imperial Germany.

Large parts of the judiciary, civil service, Reichswehr, academe, police and other "pillars" of order where hostile, or otherwise unreconciled, to the new Republic. Something that showed up dramatically in the derisory sentences (or even acquittals) handed out to right wing political killers and violent plotters and contrasted with the severity that left-wing equivalents were treated to.

With well-entrenched enemies on the right, the shaky German Republic had also to contend with territorial ambitions of new neighbours in Poland and the Baltic States, revolutionary outbreaks inspired by the success of Lenin's Bolsheviks in Russia and vengeful Western Allies who imposed a dictated peace treaty on the new Republic.

Though the Treaty of Versailles was not as vicious as the Treaty of Brest-Litovsk that the Ludendorff and the Second Reich had imposed on its defeated Russian and Romanian enemies. Indeed, both Treaties were failures. Brest-Litovsk meant that significant German forces (particularly its cavalry) were busy trying to secure what turned out to be empty gains in the East and so were not available to exploit Germany's initial gains in the Ludendorff offensive, an offensive launched without any arm of exploitation. (As one historian has noted, Ludendorff the politician defeated Ludendorff the general.) While the Versailles Treaty, as an imposed diktat, was one no Germans felt in anyway committed to; except as an unfortunate burden to be shed as soon as practicable. The aristocrats and gentry of the Congress of Vienna a century earlier did much better than the democrats at Versailles. (But then, as a hereditary elite, they and their children had to live with, and manage, the consequences.)

In order to defend against revolutionary outbreaks and aspirations at home and territorial intrusions on the borders, the new Republican government turned to the Freikorps, paramilitary formations formed of refugees from the demobilised Reichswehr officers and troops and right-wing students. Violent and contemptuous of the new Republic and its politicians, the Freikorps were dangerous and unreliable instruments. Gustav Noske, the new SDP Defense Minister, was ruthlessly determined to put down any signs of revolution so that the new Ebert Government did not suffer the fate of Kerensky's in Russia.

In this he succeeded, at considerable cost in blood and by feeding the ambitions of the Freikorps, which culminated in the Kapp Putsch. This was defeated by the passive resistance of most of the civil service and a general strike. The latter manifestation of successful worker power then led to another round of revolutionary alarms, forcing the Republic to once again call upon the Freikorps.

Eventually, the Republic stabilised, particularly with the widespread revulsion against the murder of the Republic's Foreign Minister, the urbane and cultured wealthy cosmopolitian Walther Rathenau. But large parts of the working class were alienated from the Republic, giving the KPD a solid voting base and creating a Reichstag bloc in permanent opposition which, as it grew, made forming a majority government increasingly difficult.

The Freikorps also faded away, but left a legacy of violent paramlitarism that was to feed into the new Nazi Party. Its Beer Hall Putsch was both the final surge in Freikorps activity and expressed much of the trends of the period (including Ludendorff's consistently awful political judgement: the Putschists having successfully captured the key figures in the Bavarian Government, Ludendorff released them on their word--as soon as they were free, they promptly organised the violent suppression of the Putsch). The Putsch itself was a deliberate emulation of Mussolini's March on Rome, but aimed at a regional capital (Munich) and was too little too late, since the greatest fears of revolutionary collapse had subsided, as all such attempts have been successfully (and brutally) repressed.

Its failure both gave the new Nazi Party a myth of martyrs and blood sacrifice while convincing Hitler that power was going to have to come via the ballot box. After his release from fortress confinement, he concentrated on organising an effective movement which was already consolidating its dominance of the violent right of German politics when the 1930s Depression gave them the crisis opportunity they needed.

Nigel Jones' prose is clear and vivid. This is history which is both exciting and perceptive. It is an excellent rendition of the violent, and deeply flawed, birth of the Weimar Republic, and the prehistory of the Nazis.

Property rights for animals

This is based on some comments I made here on a proposal to give animals property rights in order to protect habitats.


Presuming that the point of the exercise is not simply a green power grab (which is what it looks like) but to change people’s behaviour, then adding to people’s future possibilities rather than threatening their present ones seems a better way to go.

In his Economic Analysis of Property Rights Yoram Barzel notes differences between UK and US habitat law, which I summarized as:

Another striking Barzel example is property rights in wildlife (Pp145-7). In the UK, farms tend to be larger than habitats, so property rights to wildlife are largely held privately as habitats are largely encompassed within private holdings. In Canada and the US, farms tend to be smaller than habitats, so the state assumes much more control over wildlife, as habitats generally extend across several, or even many, holdings.

A famous example of giving people a stake in preserving wildlife is giving local people ownership rights over their local elephants rather than just banning poaching. The former means that live elephants are a continuing source of income, the latter means the only profitable elephant is a dead elephant.

If live possums or whatever a boon for the farmer, then there will be more live whatevers. There is no such thing as an endangered profits-from-owning species.

Property rights evolved as a way of creating productive boundaries. Harold Demsetz, in his classic 1967 article Towards a Theory of Property Rights uses the example of beavers in North America. As the fur trade developed, Amerindians developed property rights in beaver dams. An example of productive interactions, considered by Steven Cheung, is bee-keepers and apple farmers. (Coase’s classic The Problem of Social Cost (pdf) considers these sorts of interactions.)

The proposal to give animals property rights, does not create productive boundaries, it creates anti-productive boundaries; it does not increase human possiblities, it lessens them. Not a clever idea.

Property-rights environmentalism has a lot to be said for it, but precisely because it increases human possibilities, not because it undermines them.

As for the comment in the above-linked thread from an advocate of the proposal

Why do so many land holders react with hostility to the idea of having to talk to others about their land use decisions? I might be an optimist but considering all the other supposed regulatory burdens upon land holders, is what I’m suggesting all that more demanding?

Because there are only so many ours in the day? Because it is their livelihood one is talking about? Because their experience of other examples is not a happy one?

Discretionary controls by officials inevitably become dominated by the politically well-connected. The notion that this would be a reliably benign process is belied by an enormous amount of experience.

As for “talking to others”, once one shares control of some attribute, one raises transaction costs, lowering the number and return on such transactions. To quote Michael Kirby, then High Court Justice, certainty is the central demand of land law. Clear boundaries allow productive trades. Unclear boundaries undermine such: sometimes profoundly. If a way exists to eliminate the problem (such as eliminating the problematic animals), it is likely to be taken.

Here is a question: would landholders be compensated for their loss of rights, or a we talking about simple theft here? A property right is a right of control up to a boundary. If you create “property rights” for animals, then any previously existing right of control in that boundary is eliminated. Someone else — the landowner in this case — loses rights. So, will there be payment for such loss or is it going to be simple theft?

As for appealing for “good intentions” by landlords, incentives matter. They matter a great deal. Given the potential power over land use this proposal gives, one must expect that people will politically organise to gain control over that power.

This is one of those basic analytical differences. Libertarians and others presume that private interests are endogenous to the political process and will game it according to the incentives generated. Progressives of various stripes presume that political processes can somehow be made exogenous to private interests and “control them” from outside. This is nonsense on stilts, and pernicious nonsense at that.

The more proponents argue for this proposal, the more alarming I find it. The issue is not the intention, but the means suggested.

Markets with clear rules have shown excellent ability to trade attributes to their most efficient holders. For example, we pay to have the attribute ‘liable to catch fire’ allocated to insurance companies according to rules which work fairly well. The trick is being able to define boundaries to the attributes and to trade them to mutual benefit.

If one does not have such defined boundaries, one just has a mess. And the experience of officials (actual or quasi) having joint control over attributes with private property owners is not a happy one. (Such as aiding and abetting NIMBY and BANANA — build absolutely nothing anywhere near anyone.)

It is not a lack of imagination that leads to the scepticism about this proposal, it is the application of experience against comforting theories about good intentions.

Money and expectations

I recently listened to talk by a former Chief Economist for the Reserve Bank of Australia. He was speaking to a lay audience and gave a nice rendition of the basic intuition of monetarism, presenting its central idea as being based on the Fisher equation of MV = PT and, assuming V (number of transactions money goes through in a given time period: often converted into k = 1/V or the proportion of money held as cash) and T (total number of transactions: often simplified to total production of goods and services in a given time period, ‘y’) do not change much, then a rise in M (money supply) will lead to a rise in P (price level).

Basically, in monetarism, it is all about the quantities. Hence monetarism relies on the notion of ‘long and variable lags’ to make this quantity story work: in other words, it invokes a ‘fudge factor’.

Monetarism does accept that a short run effect of rising money supply can be a rise in production (as discussed below) but, in the long run, the rate of inflation is determined by the rate of money expansion in excess of the rise in production, but with "long and variable lags".

The historical evidence on the fundamental claims of monetarism is not as cooperative as it might be. As one economic historian notes:

From my own studies of monetary and price history over the past four decades, I offer these observations, in terms of the modernized version of Fisher's Equation of Exchange, for the history of European prices from ca. 1100 to 1914. An increase in M virtually always resulted in some degree of inflation, but one that was usually offset by some reduction in V (increase in "k") and by some increase in y, especially if and when lower interest rates promoted increased investment. Thus the inflationary consequences of increasing the money supply are historically indeterminate, though usually the price rise was, for these reasons, less than proportional to the increase in the monetary stock, except when excessively severe debasements created a veritable "flight from coinage," when coined money was exchanged for durable goods (i.e., another instance in which an increase in M was accompanied by an increase in V).

The quantity story is not enough for several reasons, starting with the flexibility of supply mattering (as monetarism itself acknowledges). For example, in the C16th and C17th, Asian goods coming into Europe was an upward supply response that would have dampened the inflationary effect of the Central European and American silver flows and the various debasements of coinage (notably the English debasements of 1526, 1542 and 1553 – the total reduction in silver content of coins reaching 83%, though Elizabeth’s recoinage of 1560 reduced the loss to 25%, a further debasement in 1601 bringing the total loss of silver content to 36% – while the silver coinage of the Southern Low Countries was debased 12 times from 1521 to 1644, totalling a 49% reduction in the silver content of coins).

But if the responsiveness of aggregate supply matters, that gets in the way of telling a quantity story. Hence the “long and variable lags”.

The quantity story is, however, also not enough because one has to look at people’s expectations, for that will affect their holding of money (i.e. k) and so how much money is in circulation (i.e. the level of spending: Py). The upward responsiveness of aggregate supply of goods and services to any increase in spending determining how much the response is in prices (P) and the downward responsiveness of prices determining how much any fall in spending is reflected in falling production (y). (Or, to put it another way, whichever of prices or production is more constrained will lead the effect of any change in spending to be greater in the other.)

Institutions also matter: what forms of money there are, how available credit is. So, changes in institutional structures will change the significance of various monetary aggregates. One of the notorious problems of monetarism is trying to work out which monetary aggregates to follow and when. Money is a tool of human action, so what happens to it and what it does is about human behaviour which change as institutional structures change and vice versa: a quantity story is never going to be enough.

Money complexities
It is easy to go wrong in thinking about money as it is so central to so much economic behaviour. One of the basic things money does is that it simplifies. Without money, people are stuck with barter price(s) – price in terms of goods and services. Money prices are much simpler to deal with: everything for sale then has a money price in terms of a unit of account, a single number. (Money has barter price(s) – what it buys in terms of goods and services: what economists call ‘real price’ is some average barter price across a “basket” of goods and services at some point or period in time expressed in numerical – i.e. “money” terms – to make it manageable.)

Money – as the medium of account: that is, a medium of exchange that embodies the unit of account – also connects across time. We accumulate existing obligations from past actions, obligations that are specified to be paid in the medium of account. We also have future spending intentions, making us attentive to money as a store of value. Our expectations about the future path of money as a store of value will affect our current holding and spending patterns; our use of money as something to hold (k) or something to spend (Py) in the current time period. So, if we expect money to seriously lose value, the incentive is to spend it; if we expect it to gain value, the incentive is to hold on to it.

These simplifying and cross-time aspects of money means that money matters in its own right, it is not simply a “transparent” connector to the “real economy” of goods and services. (So monetarism is correct in that.) Particularly as we are not immediately aware of all shifts in the barter price(s) of money: money is a response to a real information problem (keeping track of all those relative prices) yet, while it hugely reduces the information problem, it does not abolish it (since there is still the issue of becoming aware of shifts in the average barter price of money).

(I keep using the term ‘barter price(s)’ because I have come to dislike the terms ‘real price’ or ‘real wages’ as they skate over the information problem that money exists to solve and which is fundamental to how people use and think about money. So using ‘real price’ or ‘real wage’ becomes actively misleading even though talking of the 'barter price(s)' for money sounds a bit odd. Though surely no more odd than calling statistical artifacts 'real prices' and 'real wages'.)

While money does therefore matter in its own right, it is still just a means for human action. The constraints and expectations it is embedded in matter: there is no simple quantity story to tell. So, the level of money offers (i.e. money spent rather than held) matters, but whether any increase in spending will be inflationary or not (and how much) depends also on the responsiveness of aggregate supply.

Hence, as it is the nature of assets that they cannot respond as quickly to increased spending as goods and services can, it is easier to get much bigger inflationary surges in asset prices than in goods and services prices: surges which will be bigger the more constrained supply is. But the shift from using the Fisher ‘T’ to the Friedmanite ‘y’ diverts attention away from spending effects on asset prices.

The level of spending cannot, however, be inferred from M, since people’s expectations matter, as they will affect k. If people have low or negative inflationary expectations, then that is a reason to hold on to money. If they also have negative (i.e. pessimistic) uncertainty, that will be even more reason to hold on to money as a safety measure. If they wish to reduce debt (i.e. are “de-leveraging”), then that will also be a reason to hold on to money. So the combination of debt, negative uncertainty and low or negative inflationary expectations is likely to lead to a dramatic lowering in spending. Even while “base money” surges: relying on such quantity measures will not merely be uninformative, they will be actively misleading. Hence ‘quasi-monetarism’ [now Market Monetarist (pdf)]: monetarism with the addition that expectations matter.

So, the worst thing a central bank can do in a situation of high debt and negative uncertainty is to reduce liquidity (and so both the availability of money and the expected path of money supply); thereby creating expectations of low or negative inflation, leading to a “flight to cash” and a dramatic drop in spending leading to a dramatic fall in Py (i.e. nominal GDP, GDP in straight money terms), with the drop in y (economic activity/output) being bigger the more downwardly constrained prices are.

This debt-and-deflation story is basically Irving Fisher's story (pdf) about the Great Depression. It is also what happened with the recent Global Financial Crisis and Great Recession (see this chart of changes in nominal GDP and employment).

An example of downwardly constrained prices are wage contracts operating across time incorporating significantly higher inflationary expectations than actually occur, so that the price of wages in terms of goods and services – their barter prices – rise as demand for what they produce is falling. With such wages being downwardly “sticky” since cutting wages means breaking the agreed contract, creating a trust-and-future dealings problem: particularly as people have already acquired obligations to pay in terms of the medium of account, so are resistant to receiving less of such regardless of what is happening to the barter price of money.

There is a long-running critique of central banking with fiat money that fiat money central banks are inflation-addicted. But they seem to do their worst damage when they become inappropriately inflation-phobic. The question is whether these are soluble problems, or they are a manifestation in monetary policy of the classic problem of central planning – the destructive and chaotic combination of poor incentives and information problems.

Still, one can be a quasi-monetaristMarket Monetarist in macroeconomic analysis without thereby being committed to any particular position on fiat money and/or central banking. (For those interested, George Selgin has recently posted a nice defense of fractional reserve banking [via].)

So, yes inflation is “always and everywhere a monetary phenomenon” but it is not a simple matter of measuring (and manipulating) monetary quantities: one has to include constraints and expectations. Indeed, expectations are where the real game is. So targeting stable growth in Py (nominal GDP) incorporates responsiveness of aggregate supply to money offers (i.e. output to spending), works to both stabilise and respond to expectations while not being constrained by institutional changes in money. It also optimises use of a policy instrument (monetary policy) which is a lot quicker in responding than fiscal policy without the nasty debt consequences (which is to say, fiscal policy is more rigid in both operation and consequences).

So, quasi-monetarists Market Monetarists of the world unite! There is nothing to lose but misleading obsessions with monetary aggregates!

ADDENDA I have amended the post to use the term 'spending' and 'output' more and 'money offers' less and incorporate the new name of 'Market Monetarists'.

Cosmology matters (or why Jews make the stupidest queer-haters)

Economist Deepak Lal usefully divides cultures—interwoven ways of doing things passed across generations by learning—into their material and cosmological aspects. In his words (pdf):

The former relate to ways of making a living and concerns beliefs about the material world, in particular about the economy. The latter are related to understanding the world around us and mankind’s place in it which determine how people view their lives—its purpose, meaning and relationship to others

Material beliefs are more amenable to changing circumstances, cosmological beliefs are more persistent. As Lal continues:

There is considerable cross-cultural evidence that material beliefs are more malleable than cosmological ones. Material beliefs alter rapidly with changes in the material environment. There is greater hysteresis in cosmological beliefs on how, in Plato’s words, “one should live”. Moreover, the cross-cultural evidence shows that rather than the environment it is the language-group which influences these world-views.

Since language provide cognitive maps, it is not surprising that language group might matter. (So Islam’s insistence on Arabic as its sacred language probably aids its consistency, its recurring patterns.)

Sex and gender – how sex is to be conceived, what genders there are, how are they to be conceived – are classic concerns of cosmological aspects of culture, since they are so important to being human and human purposes. The most important single reason why conservative Christian perspectives have been losing grand moral arguments within Western civilisation has been the improvement in the status of women. Giving women control over their own fertility, the right to exit marriage and full economic and property rights has involved basic shifts in some fundamental presumptions.

These changes are intimately connected with expanding knowledge and growing technology that has not only downgraded any premium on upper body strength (an area of male advantage), it has also made mental abilities more salient (men have no advantage over women in average intelligence) while making pregnancy much safer (so reduced greatly the risk that investment in educating women will be lost in early death) and child-raising more readily compatible with higher income work: both factors being strengthened by greatly increased average life spans. Capitalism promotes the spread of technology by encouraging use of its benefits, including in its hiring patterns. As women have become more competitive, they have been hired more. As they have become more broadly economically useful, so legal restriction have been removed, each process helping the other along.

Longer life spans and fertility-control technology encourage separation of sex from reproduction, weakening the ability to define sex in terms of reproduction: the fundamental sex-and-gender premise of monotheism since, in monotheism, sex separates us from the divine apart from procreation. (Clearer in Judaism and Christianity than in Islam, since in Islam the principle of status is so much stronger and more pervasive.)

Changing conceptions of gender, sex (and sexual possibilities) have knock-on effects. It is a nice historical resonance that John Stuart Mill and Harriet Taylor’s The Subjection of Women was published in the same year the term ‘homosexual’ was coined. The more equal in status men and women are, the less one man providing another with sexual pleasure involves “betrayal” of male status.

Sex and gender also involve intense, roiling emotions. Which makes it ripe for exploitation in all sorts of ways.

Religion-as-excluding
An important role of religion is to give you people to despise, to separate the righteous from the unrighteous. A sense of one’s own virtue (or possible virtue) is so much easier if combined with a sense of other people’s viciousness.

Monotheism, with its conception of a single, authoritative, definitive view of truth, and reviling of false gods and their worship, generally finds it easy to generate people to despise. Combine this status claim (believers as profoundly morally superior to unbelievers) with sex as only being validated by its procreative role, and you have a rich field of intense emotion to exploit. (It also counts for monotheism’s fun allergy, since almost any form of worldly enjoyment can be characterised as separating or diverting us from the divine.)

Controlling women
If sex is only validated by procreation, obviously queers (anyone who does not fit in the binary male/female sex-for-procreation framing) are anathema. But it also makes it much easier to insist on the motherhood-box as normative for women – a religiously-sanctified sex-and-gender role only permitted to be exited for religious reasons. Any attempt to escape the motherhood-box easily becomes an immoral transgression involving a profound loss of status.

[Read the rest at Critical Thinking Applied.]

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.

Considerations
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.

Great Crises of Capitalism (2)

This continues my review of P. D. Jonson (aka Henry Thornton) has written Great Crises of Capitalism. The first part is in my previous post.


History matters
After the first three chapters (on the GFC, role of crises in capitalism, plus war, peace and capitalism) set the stage, the fourth chapter is engagingly, and provocatively, titled The Dutch Tulip Boom of 1636; with Brief Comments on the Modern Market for Art. Taking us through the Dutch Republic’s success, particularly its role in financial innovation, Jonson summarises the Tulipmania as described in Charles McKay’s cultural classic Memoirs of Extraordinary Popular Delusions and the Madness of Crowds and then a more recent examination of the episode by Peter Garber, examining the difficulty of defining a ‘bubble’ in a way that is genuinely informative at the time, rather than only in retrospect (Pp79ff).

This is a genuine difficulty, since the point of asset price bubbles is that their turning points are not systematically predictable: if they were no one would get caught in them. It is the lack of predictability which makes bubbles possible in the first place.

Jonson makes the point that the prices of assets of different classes tend to rise and fall together, particularly in general crashes (p.94). The more fundamental lesson this suggests is to limit one’s debt exposure. Jonson’s point that likely the worst effect of Tulipmania was its undermining of ‘trust and honour’ is surely a powerful one.

His discussion of the booms in art prices associated with wider booms is rather whimsical in tone. As an activity of the extraordinarily rich, he does not think it a public policy problem – particularly as the pieces often end up on public display in museums (Pp91ff).

Then it is on to the South Sea and Mississippi bubbles of the early C18th. This is an amazing pair of stories. In both England and France the state was burdened with massive public debts it could barely manage to service. An able economist, gambler and scallywag, John Law, proposed to the French Regent a system of note issue to improve liquidity and thus economic activity: in effect, creating a central bank. This worked so well that the Regent decided more was clearly better. One thing led to another, and there was an enormous bubble followed by a dramatic crash.

England already had a central bank, the Bank of England: indeed, the original [second] central bank. That the English central bank, far from being a participant in the English bubble, was engaged in a struggle against those at the centre of the South Sea bubble, limited the damage; though there was great rage against those felt to be culpable when the bubble burst.

In England, there was to be improved management of a consolidated national debt that was to permit the United Kingdom to fight major wars, successful (War of the Austrian Succession, Seven Years War), unsuccessful (War of American Independence) and long and eventually successful (French Revolutionary and Napoleonic Wars) while maintaining sound finances. Improvement in public finances in France from John Law’s innovations was temporary, and accompanied by much economic and social damage. As Jonson observes:

a leading edge in innovation can so easily become a bleeding edge (p.81).

The failure to deal with the underlying fiscal problems was to result in the Bourbon monarchy eventually being effectively bankrupted by a successful war (War of American Independence) and collapsing in revolution (Pp97ff).

A pop culture aside: Terry Pratchett’s Making Money is a splendid fictional take on some of these issues, with protagonist Moist von Lipwig likely being partly based on John Law, but one working for a competent autocrat, not a silly and greedy one.

The grand century
We then move onto the nineteenth century, concentrating on the UK and the US and a potted history of economic cycles in the US and UK, with supporting graphs and table focusing on the interaction between the gold standard, credit and railway speculation in particular. There seems to be a quasi-Austrian malinvestment theory behind Jonson’s analysis, except he points out that the railway investments turned out to be economic boons. I find the Austrian concept of malinvestment unpersuasive. There does not seem to be any useful general concept of ‘malinvestment’ that is independent of the level of economic activity. Sure, businesses fail but they do so all the time, even in the height of booms, and this discovery process is surely much more about exploring boundaries of what is or is not profitable (boundaries which shift as the level of economic activity shifts) than displaying some inherent characteristic. Yes, one can get inappropriate construction (e.g. empty housing estates in post-bust Ireland or various US cities) but they were the result of very specific forms of perverse incentives, not indicative of some general phenomenon, even in housing construction (even if you add in various complications).

Our author does fall into a common flaw of works of economic history, in failing to explain important features to readers. Specifically, a paragraph, or even a sentence or two, explaining why the Bank of England raised the Bank Rate (merely defined in the text as ‘a key contributor to economic stability under the gold standard’ [p.123]) in crises would have been very useful. There is a useful glossary of terms, which tells us what the bank rate is, but does not explain this crucial dynamic (Pp121ff).

Jonson has a nice eye for a good quote:

’A currency system which in difficult times,’ says Clapham, ‘depends on the chance occurrence of nuggets in gulches and gold dust in river sands lack stability (p.134)’.

Gold standard enthusiasts point to the stability of (goods and services) prices under the gold standard, but it is a stability which can lead to considerable instability in employment and economic activity, a factor that gains increased force given there is reason to believe that the degree of “stickiness” in prices and (particularly) wages has increased over time. The gold standard has also been compatible with wild swings in asset prices.

Leaving the nineteenth century in US and UK with praise of innovation and the warning that:

Prosperity often leads to over-exuberance and is often accompanied by fraud and incompetence, which helps to explain why prosperity often turns out to recession or depression (p.142).

Jonson moves on the “Marvellous Melbourne” and the extraordinary story of the Victorian land boom.

Antipodean occurrences
We start with a refreshingly (generally) positive portrayal of the energy, innovation and progress of the period, including Australia’s role as a pioneer of representative democracy, interspersed with references to Jonson family history (Pp143ff). In the midst of this (mostly) positive economic history, there was a land boom-and-bust in the late 1830s and early 1840s as wool prices surged then collapsed.

What Jonson labels – with an explicit invocation of recent American experience – as the ‘sub-prime land boom of the 1880s’ was built on two pillars: a plethora of building societies and a belief that it was impossible to lose money by investing in land. (This should sound very familiar.) What made things worse was that Victorian building societies were permitted to invest in real estate themselves. Prices surged: land prices in the CBD could double in price in a matter of months. When the boom busted, the crash was spectacular. Suburbs were built that remained untenanted for years; 20 major financial institutions closed, 120 public companies failed, high levels of fraudulent behaviour were revealed, there was massive unemployment accompanied by deprivation, misery and death (Pp151ff). It is hardly surprising that Melbourne became a bastion of labour and protectionist politics.

This is followed by a short economic history of Australia, where the period from 1900 to 1972 is covered rather more briefly than the period from the Whitlam Government on, interspersed with references to the author’s family and personal history. But the public policy history from 1972 onwards is very usefully covered, by someone who was a senior ‘econocrat’ for much of that time, concluding with a survey of current issues. That housing seems both clearly overvalued but has potential for future housing shortages just reminds us of the unknowability of the future (Pp161ff).

Income and expectation
My take on that is that rental prices tell the supply-and-demand story and value above a reasonable capitalisation of current rental (i.e. income) value tells the “bubble” story. (If a good return on an asset is 6%, take the annual rental value, divided by 6, multiply by a 100: that is the reasonable capitalisation of current rental value.) Except, of course, some of the excess price over said capitalisation may be (reasonable) expectation of future rental rises: that little difficulty of the unknowability of the future again. Still, one can do the check in reverse: take the current price, divide by 100, multiply by 6 – is that a reasonable expectation of future rents? If not, then there is in the price of the asset an expectation of capital gain beyond reasonable expectations of its future income value and we are in bubble territory.

That part of the price which is based on expectations of pure capital gain beyond income value can vanish astonishingly quickly if those expectations go away: which they do as soon as prices start falling sufficiently. Hence the sudden asset price “busts”. Which is unfortunate: it only becomes a disaster if it was the basis for debts, for one is then left with the debt without the asset value that was backing it. It becomes a catastrophe if lots of folk are in that position and suddenly financial institutions have a massive surge in “bad debts” – loans people cannot pay back and which are not covered by realisable assets. The loss of income and assets can destroy financial institutions and devastate capital markets leading to a dramatic drop in economic activity as people lack the funds to engage in transactions, or take their money out of the financial system, or simply stop transacting for prudential or anticipated rising-value-of-money reasons (since money in circulation is becoming more scarce).

A proposal
So, the truly risky form of debt is debt beyond the income value of an asset. Hence my suggestion that people simply be banned from borrowing against an asset beyond its capitalised income value. If people want to bet on capital gains beyond that, fine: but they can do it (only) with their own money, not on credit.

This is not some puritanical dislike of “speculation”, just a prudential concern to minimise systemic risk in the financial system. It would also take a lot of the “heat” out of asset price booms, as it would effectively eliminate the use of credit to generate expectations of capital gain beyond income value. It is not a proposal for perfection, merely of prudence. There would be some cost at the margin (that problem of reasonable expectations of future income gain) but the benefits would surely greatly outweigh that: the most one can hope for in any regulation. Moreover, it would actually increase information in the market, by forcing attention to how much of a price is current income value and how much expectations of capital gain (the problem with much regulation is that it either destroys or distorts information).

Roaring boom, savage bust
Jonson then moves back to wider economic history with his next chapter The Roaring Twenties and the Great Depression. The chapter has many quotes from Galbraith’s (highly quotable) The Great Crash, an account Jonson labels “sardonic and authoritative”, while Milton Friedman and Anna Schwartz’s magisterial A Monetary History of the United States only gets a role in the commentary towards the end.

The public policy question Jonson concentrates on is the proper role of a central bank in the face of a boom in asset prices. One of the major speculators, Charles E. Mitchell, became a director of the New York Reserve of New York, a blatant conflict of interest (p.172). Raising the rediscount rate was proposed to cool speculation (since it would have reduced the profit on broker’s loans) while controlling margins (what proportion of cash had to be put up to buy stocks) could also be used to discourage speculative borrowing. The Reserve merely issuing a statement in February 1929 caused the share market to drop and then stall, particularly as the attitude of the new President (Hoover) was unclear.

Then Mitchell stepped in and made it clear his bank would support what the Reserve had warned against. The market rallied, the Reserve was silent: as Galbraith wrote, it had decided not to be responsible for a market crash and the share price boom restarted (Pp173-5). This is a basic problem: what central bankers wish to be responsible for a crash? The post-Depression joke – the role of a central banker is to take the punch away just as the party is getting started – is not a counsel of popularity. And the further away the memory of the last big boom-and-bust is, the less credence there is likely to be that the alternative is worse. Particularly as technological and financial innovation can so easily feed the delusion that “this time is different”.

The market surged on the belief that there was a “shortage of securities”, which much human ingenuity went into addressing, the use of credit to buy stocks surged (such loans being safe – as long as the market continued to rise) and various commentators supported the siren song “this time is different”. Prof. Irving Fisher, who Milton Friedman regarded as the US’s greatest economist, made his infamous statement that ‘stock prices have reached what seems like a permanently high plateau’, while doomsayers were sharply criticised (Pp176ff). The discrediting of free commerce advocates by their spruiking of the boom and the severity of the subsequent bust was to have major political, public policy and intellectual consequences.

Fisher himself was to develop his debt-deflation analysis (pdf) of the subsequent Depression, which was largely ignored at the time but, decades later, was to become more influential.

Then the stock market crashed, with expectations of gain being replaced by fears of loss and lack of information (such as the ticker falling behind, or Sunday market closure) becoming an increaser of fear:

After the Great Crash came the Great Depression which lasted, with varying severity, for ten years. In 1933, America’s Gross National Product was nearly a third less than in 1929. Not until 1937 did the physical volume of production recover to the levels of 1929, and then promptly slipped back again. In 1933, nearly thirteen millions were out of work, or about one in four of the labour force. In 1938 one person in five was still out of work (Pp180-1).

In Australia, whose governments had run up massive public debts, the surge in unemployment was likely even worse than in the US and the struggle to service the debt as incomes crashed dominated politics (Pp178ff).

Jonson wrestles with the question of what caused the Great Depression without coming up with a clear answer: as there is no scholarly consensus on this subject, this hardly surprising. He notes that Friedman and Schwartz’s analysis of severe contraction in money supply is the generally accepted explanation for the severity of the Depression. Ben Bernanke, the current Chair of the Fed, provided evidence for a severe contraction in credit whose effect was even greater than the money supply contraction. The Smoot-Hawley tariff increases and increases in taxes did not help (Pp182ff). As well:

There was an irrational fear of inflation while the country was experiencing the most violent deflation in the nation’s history (p.186).

A pattern we have seen replicated in recent times.

Meanwhile, in Australia, tariffs were raised, quotas and foreign exchange restrictions were imposed, limiting trade. But there was also a massive currency depreciation and a 10% nominal wage cut while the options of default, deficit spending or balancing the budget dominated politics. Jonson feels it is likely that the currency depreciation and wage cut, plus business unhappiness with FDR’s Administration, were the prime reasons why Australia recovered from the Depression quicker than the US (Pp186ff). As for lessons learnt since, the Greenspan view that it is not the job of central bankers to act against asset bubbles (as distinct from cleaning up afterwards) became widely accepted. When the GFC and Great Recession crisis hit, the response – cutting interest rates, swapping private assets for cash (‘quantitative easing’), bailouts and fiscal stimulus – were all adopted “with almost religious fervour”, a dramatic contrast to the policies of the early 1930s (Pp188-9).

Stagflation
Then we are on to “the Age of Aquarius” and the rise of stagflation – inflation with unemployment – and a period where the author can rely more on personal experience. Inflation is denounced:

Misery is inevitable in any economy as inflation erodes the value of people’s investments, raises their cost of living and makes contracts difficult to adjust and in some cases impossible to enforce (p.191).

Made worse if people also lose their jobs and others fear doing so. Since this was the time when the Phillips Curve had appeared to provide a clear trade-off between (goods and services) inflation and unemployment, the conjunction of inflation with unemployment – which reigning theory said was impossible – caused confusion and conflict in policy circles (Pp191-3).

The analytical breakthrough was to add expectations about inflation into the analysis. As inflation rose without effective counter action, so did inflationary expectations:

both rose largely independent of the state of the economy as measured by unemployment (p.194).

The link between unemployment and inflation was broken, with rising costs of inflation driving up unemployment. (More precisely, the ‘equilibrium point’ of unemployment.) There was an extra complication:

It is a basic theorem of economics that small open economies with a fixed exchange rate will import the global rate of inflation (Pp195-5).

The last effectively meant the US rate of inflation. On August 15, 1971 President Nixon broke the last link between gold and the US dollar, so there was no ‘anchor’ for inflationary expectations beyond people’s expectations about the actions of the US Federal Reserve (and their effects).

This point was not as widely understood at the time as it might have been. The battle between “cost push” and monetary explanations was fought out, being (mostly) won by the monetarists. The new Chair of the Fed, Paul Volcker, changed the Fed’s operating procedures. This led to the Federal Funds rate rising to 20% in June 1981: unemployment surged, but the recession was short and (goods and services) inflation collapsed to 3% p.a. Appointed by President Carter, re-appointed by Reagan, Jonson labels Volcker:

history’s greatest central banker, its most effective inflation fighter (p.197).

It took other countries rather longer to catch up, requiring as it did flexible exchange rates and abandonment of the hope of painless solutions. Jonson covers the arguments over floating the Australian dollar, which the author supported against the objections of then Treasury Secretary John Stone, who was opposed on the grounds that loss of financial reserves was a stronger constraint on fleckless government (Pp197-8).

The rest of the chapter is devoted to a lengthy discussion of the costs of inflation, the costs of stopping inflation and judging the balance thereof. Jonson is firmly of the inflation-as-scourge view, which policy needs to be constantly alert against: one of the costs of persistent inflation being the drop in household saving (Pp198ff). Expectations of capital gain in house prices become an alternative “saving” strategy: one using credit and dependant on what goes up not coming down.

[This review will be concluded in my next post.]

Great Crises of Capitalism (1)

P. D. Jonson (aka Henry Thornton) has written Great Crises of Capitalism, a history of economic crises in capitalism since the C17th and a jeremiad against inflation. It is clearly provoked by the Global Financial Crisis (GFC) of 2007-08, which the book begins with a survey of, and the subsequent Great Recession whose consequences Australia largely avoided but the US and other major Western economies are still suffering the effects of.

Jonson notes that financial booms and busts have recently been getting generally greater in amplitude (as measured by change in asset prices from height of boom to depth of bust). He also argues that, with the rising economic significance of China and India, goods and services inflation has been restrained, so easy money has spilled over into asset booms. (That is, global supply has continually responded to increases in money offers so as to keep inflation low: the weakness in this argument is many goods and services are not globally traded, though the range of these is diminishing – and non-traded goods and services are considered later [Pp235ff].) Jonson faults Alan Greenspan in particular for encouraging the notion that Central Banks should ignore asset price booms (p.18).

Follow the money
Another way of looking at this is that Jonson is, in effect, taking the classic Fisher equation of MV = PT (money x velocity [average number of transactions money goes through in a given time period] = price x transactions [in that time period]) and saying the restriction of T to current transactions (thereby leaving out asset transactions), so using CPI or some derivative thereof as the measure of P, and thereby ignoring asset prices, is a fundamental error. (Jonson points out that Milton Friedman’s model implicitly assumed a single good and a single asset, money, leading to inflation being defined in terms of goods and services [Pp17-8].)

A recent review of Earl J. Hamilton’s classic American Treasure and the Price Revolution in Spain, 1501-1650 nicely sets out the basic economics of the Fisher equation:

Most economics students are familiar with Fisher's Equation of Exchange, to explain the Quantity Theory of Money in a much better fashion than nineteenth-century Classical Economists had done: namely, MV = PT. If many continue to debate the definition of M, as high-powered money, and of P — i.e., on how to construct a valid weighted CPI — the most troublesome aspect is the completely amorphous and unmeasurable "T" — as the aggregate volume of total transactions in the economy in a given year. Many have replaced T with Q: the total volume of goods and services produced each year. But the best substitute for T is "y" (lower case Y: a version attributed to Milton Friedman) — i.e., a deflated measure of Keynesian Y, as the Net National Product = Net National Income (by definition).[note 55: For various reasons, too complex to discuss here, I prefer to use the Gross National Product - as many economic historians, in fact do, in the absence of reliable figures for Net National Product.]

The variable "V" thus becomes the income velocity of money (rather than Fisher's Transactions Velocity) — of the unit of money in the creation of the net national income in the course of a year. It is obviously derived mathematically by this equation: V = Py/M (and Py of course equals the current nominal value of NNI). Almost entirely eschewed by students (my students, at least), but much preferred by most economists, is the Cambridge Cash Balances equation: whose modernized form would similarly be M = kPy, in which Cambridge "k" represents that share of the value of Net National Income that the public chooses to hold in real cash balances, i.e., in high-powered money (a straight tautology, as is the Fisher Equation). We should be reminded that both V and k are mathematically linked reciprocals in that: V = 1/k and thus k = 1/V

Thus kPy equals the demand for money and changes in k for a given level of M will lead to changes in Py. So, for example, if people expect deflation (and so wish to delay purchases and increase their k since they expect money to increase in value) then the withdrawal of money means either prices must fall or national product must fall, or both (with the balance depending on how downwardly responsive prices are). Conversely, if people expect inflation (and so wish to bring forward their purchases, and decrease their k, since they expect money to decrease in value) then either prices must rise or national product must rise, or both (with the balance depending on how upwardly responsive supply is – hence Jonson’s point about rising Indian and Chinese production reducing global inflationary pressures).

Clearly, expectations matter: for example, the belief that one has to get into the housing market as soon as you can because prices will keep rising faster than income is classic inflation-expectations behaviour.

As an historical aside, one can see how the flow of silver from the Americas in the C16th and C17th would have had price effects on its own, since the silver did not appear everywhere instantaneously, but passed through a series of hands; so there would be a lag in k responses, leading to an increase in P given that the silver kept flowing in and did so in patent excess of the ability of supply (y) to respond to the increased money offers (M/k=Py) within the European economy. Conversely, since only about a third of the silver went to purchase goods and services from the (much larger) Asian economy, and transport costs and official monopolies blocked convergence in prices (pdf), any price effect in Asia would have been much smaller, leading to European goods being priced out of Asian markets (except where they had no competitors) and Asian goods being priced into European markets.

About assets
Even in the explanation quoted above, we can see that there has been a move from considering all transactions and all prices to considering consumer prices only (and thus ignoring asset prices: even that part of National Product spent as investment). But money can be used to purchase consumer goods or assets. So our author has a plausible point.

Not that these macro considerations means that the characteristics of different specific markets do not matter. On the contrary, they matter a great deal. For example, money will clearly be attracted to assets where people have high expectation of income or capital gains (that is, downside risks are discounted). Such as housing markets with constricted supply; financial instruments where there has not (yet) been experience of problems or weaknesses or financial markets where explicit or implicit government guarantees have undermined prudence. The US brought all these things together in a “perfect storm” of (land) supply-restricted housing bubbles, sub-prime mortgages and Fannie Mae and Freddie Mac (as usefully discussed in this review of and also this review of a recent book on the matter).

Jonson notes that, in Australia:

By March 2007, compared to June 1986, consumer prices had slightly more than doubled, implying annual goods and services inflation of 3.8%. Over the same 21 years, average house prices had risen by 450%, the share price index had risen by a similar 480% while shares in BHP Billiton haqd soared by a massive 1150%. While the out-performance of BHP Billiton shares were in part, perhaps in large part, due to the ‘China boom’, other asset prices had risen by an order of magnitude faster than prices of goods and services (p.17).

Jonson’s argument about asset prices does point to a lacunae in mainstream economic thinking. But I disagree with some of his economic history, particularly his dismissal of the medieval economy. Jonson writes:

The strong inflows of Spanish gold and silver gave a pronounced stimulus to economies that had stagnated for centuries (p.40).

First, the dramatic increase in silver production from central Europe (based on technological advances) began well before the arrival of Spanish and Portugese gold and silver. Second, the medieval economy was far from stagnant: on the contrary, it was a highly adaptive economic system which created the first mass machine economy. The cathedrals were not signs of a stagnant economy. The Serene Republic of Venice in 1330 had more sophisticated capital markets than Qing China in 1830 (bonds were invented by the Serene Republic in 1171): indeed, financial innovation was likely at least as important in explaining the Great Inflation of the C16th and C17th as Central European and American silver.

Historical infelicities
There are also some simple historical errors in the book, such as that East Germany was not the People’s Republic of Germany (p.47), it was the German Democratic Republic. The Spanish influenza killed about the same number as killed in the fighting in the First World War, not half (p.48). I think one can reasonably claim that Japan joined the modern world before the A-bombing of Nagasaki and Hiroshima (p.209). There is also the odd failure of editing, such as:

When President Nixon devalued the US dollar against gold in 1971, the Japanese yen was set at ¥308 per $1, which compares to around 50 cents per US dollar at the start of the twentieth century (p.211).

This makes no sense, presumably ‘cents’ should have been ‘yen’. While in a sense the US won the Cold War due to much greater wealth than its Soviet rival (p.61), that was a result of a superior economic system, not some freestanding fact.

Jonson’s story about Sir Francis Drake’s looted Spanish treasure setting off a series of investments culminating in the East India Company being the source of England’s foreign investment (p.58) is a “lucky happenstance” analysis that is a completely inadequate explanation of why England (and the Dutch Republic) proved so much more successful than Spain and Portugal at taking long term advantage of the commercial opportunities of the European global commercial expansion. Massive flows of silver were not an asset, they were a long-term disaster. But if you have a dismissive attitude to medieval Europe, such a “they were lucky” analysis gains spurious plausibility. Jonson also keeps referring to Spanish gold (e.g. ‘vast gold fleets’, p.62) when silver was much more important.

Jonson is not adverse to some rather un-pc observations – such as ethnic Chinese integrate into democratic capitalist countries rather better than Muslims typically do (p.61): one of those embarrassing truths folk are not supposed to mention.

Jonson provides a brief potted history of great power struggles from the C16th to C20th, relying on Kennedy’s Rise and Decline of Great Powers (a study which sadly concluded by claiming that late 1980s America was suffering worse “imperial overstretch” than the Soviet Union) and Blainey’s The Causes of War (a much better book which Jonson relies rather more on) (Pp60ff).

Sometimes, one could wish for more economic history. Jonson’s:

There is clearly something deep in human character that is driven towards expansionism (p.68)

is not a helpful analysis. That people like wealth and rulers-cum-states like revenues are pretty straightforward reasons for both the expansion of farming (which has been going on for 10,000 years, since farming first began) and for imperialism (which has been going on since rulership first established itself, so at least 5,500 years).

Jonson raises the hardy perennial of how much ideological conflicts reflect underlying economic interests or tensions (Pp71ff). His suggestion that the American South could have won independence in the American Civil War by using insurgency tactics (p.74) seems to be based on the common Vietnam War-era misconception that insurgencies are naturally successful (most insurgencies fail) and is deeply implausible given an occupying North would have had the black population in support. But Jonson’s wider discussion of the connection between war and economies is nicely nuanced and thought-provoking (Pp74ff).

[This review continues in my next post.]