In which a group of graying eternal amateurs discuss their passions, interests and obsessions, among them: movies, art, politics, evolutionary biology, taxes, writing, computers, these kids these days, and lousy educations.

E-Mail Donald
Demographer, recovering sociologist, and arts buff

E-Mail Fenster
College administrator and arts buff

E-Mail Francis
Architectural historian and arts buff

E-Mail Friedrich
Entrepreneur and arts buff
E-Mail Michael
Media flunky and arts buff


We assume it's OK to quote emailers by name.







Try Advanced Search


  1. Seattle Squeeze: New Urban Living
  2. Checking In
  3. Ben Aronson's Representational Abstractions
  4. Rock is ... Forever?
  5. We Need the Arts: A Sob Story
  6. Form Following (Commercial) Function
  7. Two Humorous Items from the Financial Crisis
  8. Ken Auster of the Kute Kaptions
  9. What Might Representational Painters Paint?
  10. In The Times ...


CultureBlogs
Sasha Castel
AC Douglas
Out of Lascaux
The Ambler
PhilosoBlog
Modern Art Notes
Cranky Professor
Mike Snider on Poetry
Silliman on Poetry
Felix Salmon
Gregdotorg
BookSlut
Polly Frost
Polly and Ray's Forum
Cronaca
Plep
Stumbling Tongue
Brian's Culture Blog
Banana Oil
Scourge of Modernism
Visible Darkness
Seablogger
Thomas Hobbs
Blog Lodge
Leibman Theory
Goliard Dream
Third Level Digression
Here Inside
My Stupid Dog
W.J. Duquette


Politics, Education, and Economics Blogs
Andrew Sullivan
The Corner at National Review
Steve Sailer
Samizdata
Junius
Joanne Jacobs
CalPundit
Natalie Solent
A Libertarian Parent in the Countryside
Rational Parenting
Public Interest.co.uk
Colby Cosh
View from the Right
Pejman Pundit
Spleenville
God of the Machine
One Good Turn
CinderellaBloggerfella
Liberty Log
Daily Pundit
InstaPundit
MindFloss
Catallaxy Files
Greatest Jeneration
Glenn Frazier
Jane Galt
Jim Miller
Limbic Nutrition
Innocents Abroad
Chicago Boyz
James Lileks
Cybrarian at Large
Hello Bloggy!
Setting the World to Rights
Travelling Shoes


Miscellaneous
Redwood Dragon
IMAO
The Invisible Hand
ScrappleFace
Daze Reader
Lynn Sislo
The Fat Guy
Jon Walz

Links


Our Last 50 Referrers







« Newspapers, R.I.P.? | Main | Architecture Linkage »

February 07, 2008

Gold Standards

Michael Blowhard writes:

Dear Blowhards --

Can anyone explain to me why putting the money supply on a gold standard is a bad idea?

I'm aware that all right-thinking people know that the gold standard is laughable, and that anyone who expresses enthusiasm for it is a rube -- a "gold bug." But why is this what the smart set believes? And why do they believe it's so smart?

I'm naught but an idiot, of course. But as far as I've been able to tell, the appeal of taking money off the gold standard is that doing so gives the expertise class near-infinite freedom to mess around with matters financial and monetary.

Upside: Perhaps the experts know what they're doing.

Downsides: Self-interest; temptation ("print more money"); rigging the game; stupidity; arrogance; outright mistakes; and "corrections" that only make things worse ...

Paul Krugman sneers at gold-standard fans. This video from the Mises Institute makes the case for a gold standard.

Plain English please -- and above all no math or charts. Well, except maybe those nice charts that show a squiggly line heading either up or down. I kind of like looking at those.

Tks and best,

Michael

posted by Michael at February 7, 2008




Comments

I am no economist (that's likely to be the understatement of the year here), and like MB I wonder what the anti-gold folks are up to. I recall being told, many years ago, that we'd sooner or later see another bout of depression, with the government coming after goldbugs with the following line: Gold is an irrelevance and an anachronism in a modern technological economy; now hand it over or we'll shoot you.

Posted by: Narr on February 7, 2008 6:34 PM



1. Having a gold standard does not mean ADHERING to it. A government on the gold standard can still print money on the sly.

2. A fractional reserve system is very good for averting liquidity crises, i.e. the classic case where one or more banks experience a run because of a false rumor and need a temporary handout to get back to normal. (Does nothing for SOLVENCY crises, where banks experience a run because of a TRUE rumor, though.)

3. There is so much materiel of value out there that valuing it solely in terms of gold would make the value of gold ridiculously high. The only way such a system is practical is basically if the central banks have all the gold and we only trade in gold notes. WHich for the average Joe would be "Note entitles bearer to .2 micrograms." And again, see #1.

4. Gold standard does not preclude governments from running deficits, nor banks from lending money to anyone with a pulse. And historically, the gold standard did nothing to reduce the frequency of speculative booms and panics.

Posted by: Omri on February 7, 2008 7:14 PM



What's especially amazing is that, in the early 20th-century texts you see arguing for irredeemable paper currencies, the writers (Keynes, Ezra Pound, and the like) sneer too. But they don't sneer at their opponents as cranks. They sneer at them as orthodox fuddy-duddies.

The irony is almost too brutal to observe.

I feel that anyone who opposes the gold standard should be required to answer not to me or MB or even anyone at the LvMI, but to John Stuart Mill. Don't talk to me about gold. Talk to Johnny. Write an essay that convinces J.S. Mill that he's a crank and a loon, that those crazy Attwood boys actually have it right, and that his "Currency Juggle" is in fact the best thing since sliced bread.

"You see, Mr. Mill," it might start, "while I understand your reasoning, in the 20th century, scientists found that..." Etc. You will have to supply the actual argument. Perhaps you can finish off by arguing for the "stimulus."

Not that John Stuart Mill is infallible, like the Pope. Of course, he is also dead. I am no J.S. Mill. But I'm certainly quite willing to take a stab at answering in his place.

Posted by: Mencius on February 7, 2008 7:23 PM



Narr -- Funny musings and lines!

Omri -- Thanks for your points. If you can bear a little more querying ...
1) But isn't the key question whether govt is more or less likely to print paper? Does anyone know if it's more likely to print money under a gold standard or as fiat money?
2) Which assumes, of course, that the people in charge know what they're doing, and can act quickly enough to have the desired effects. Any reason to think that either one is likely to be the case?
3) Does that really make a difference? I own (I think) two shares of Berkshire Hathaway, which is worth some absurd amount per share. What's the prolem with that?
4) But the important question whether booms and panics happen more or less often under gold or fiat? Not whether they happen at all, but whether they happen more or less often?
Thanks again for tips, ideas, and advice -- much appreciated.

Mencius -- Go for it, dude! Explain away!

Posted by: Michael Blowhard on February 7, 2008 7:36 PM



The founding fathers required that ONLY gold and silver COIN should be circulated as money--NOT paper bills that were receipts for gold and silver! Of course the government can counterfeit these paper bills and print them to the moon--but they cannot counterfeit gold and silver itself. A "gold standard" behind cirulating paper is bound to fail (from counterfeitting the paper receipts) as is any unbacked fiat money divorced from gold and silver. Paper is trash money, period. Get over it.

Modern banks run a fraudulent business--they create credit fiat money out of thin air and loan it to people at interest. They hold your savings, CD's, and checking accounts as reserves, but that has nothing to do with the money they create ab nihilo and loan out. The great credit booms and busts are created by these funny money loans, so having a fiat money supply is no cure for the problem--the problem is the money system itself.

How sad that under a real money system the bankers would only be able to loan out 1/10 of their deposits instead of 10 times their deposits, and collect interest. Poor babes. I guess equity (in the form of stock shares of new businesses) would have to substitute for funny money bank notes and loans. Then money creation would be based on equity (or real value and ownership of some tangible asset) instead of debt, and money creation would go hand in hand with production, as it always should. Not perfect, but much much better than centralization and debt enslavement-- that's for sure.

And hey, think about this--if gold and silver were again money, we would have a great deflation of prices, so your gold and silver savings would appreciate in value with our technological advances. Being in debt would suck, but there would be a whole lot less of that around anyway under a real money system. Pity the poor, poor lenders.

PS If you doubt that gold and silver coin could be used as money again, silver is about $17 an ounce now. For about a dozen of these, you could easily buy a week's worth of groceries for a family. Silver coins circulated in the US up until the 1970's. Its doable.

Posted by: BIOH on February 7, 2008 8:58 PM



Mike,

I am both an economist and a former employee of a certain interest-rate-cutting central bank, so I hope you'll excuse my biases.

The number one reason we're not on the gold standard is that it's completely ridiculous to let one's monetary policy be driven by fluctuations in the global supply of gold. In the 1800s, new gold strikes would trigger inflation, while lulls in gold mining would trigger deflation. Deflation, in particular, is worrying because wages are sticky downward; that is, people suffer from short-term money illusion. When nominal wages go up 2% each year, even if inflation is 3%, people don't seem too upset. But if nominal wages go up -1% and inflation is -2%, wage stickiness tends to lead to high unemployment. (This is why most countries aim for inflation between 1 and 2% - deflation is worse than inflation if you adjust a bit wrong). Further, the gold strikes and gold lulls don't correlate with the business cycle, so you could have contractionary policy during a recession (a lessening of the money supply, which can lead to a liquidity trap), or expansionary policy during a boom (which leads to inflation).

In general, since 1980, or roughly since we began with a new guard of Fed economists not from the Gold Standard era, inflation and unemployment are both much less variable - this is often called the "Great Moderation". It is evident around the world in countries that left the gold standard. You may not realize it, but booms and busts were *far* deeper during the Gold Standard era. Today's "recession" wouldn't even have been noticed back then.

Now, let's say you're a small country, and you don't trust your central bank to be independent (i.e., you think politicians will force expansionary policy in election years, increasing inflation, as in much of South America in the 1980s). There's a simple solution that doesn't involve gold: just peg your currency to a basket of foreign currencies that represent your trading partners. Many, many small countries do this already (Ecuador, Panama, etc.) If you're a large country? Well, why would you give up the moderated business cycle that can be achieved when you can control monetary policy?

Finally, as a poster noted above, a gold standard doesn't prevent inflation; in fact, it can make it (and speculative bubbles) worse as people anticipate a devaluation of the currency. Look at how the Mexican govt. tipped off key bankers during the Peso Crisis, letting the bankers make out like bandits.

Bottom line: the gold standard just isn't a sensible way to run an economy now that we understand modern monetary economics (aka "rational expectations" economics). Feel free to ask any questions you have.

Posted by: cure on February 7, 2008 10:25 PM



"The number one reason we're not on the gold standard is that it's completely ridiculous to let one's monetary policy be driven by fluctuations in the global supply of gold." But it's ridiculous, or worse, to let one's monetary policy be driven by Mr Magoo at the Fed. Hayek recommended the adoption of competing currencies - modern electronics would make that practical. Then if Joe Bloggs turns out to prefer a gold-backed currency, so be it. Or oil-backed. Or chocolate-backed.

Posted by: dearieme on February 8, 2008 5:50 AM



Cure hits the nail on the head.
I'd add a little bit more. You need to expand the money supply as the economy expands. More people doing more things means you need more money around. There's no particular reason to think that the amount of gold being mined each year and thus being added to that money supply is going to be the correct amount to encompass the growth we're getting.
Indeed, at least twice we've seen that changes in the amount of metal being mined have been greater than the desired expansion of that money supply.
16th century Spain (silver rather than gold really) as they stripped Latin America andthen again with gold in the late 19th as the South African mines came on stream.
Another very non-complicated way of putting it.
We may or may not want to have more money around at some point. We may or may not want to have more efficient gold mining. But there's no actual link between those two things.

Posted by: Tim Worstall on February 8, 2008 5:58 AM



Michael - sorry to pursue a tangent, but how is it possible not to be sure whether or not you own 2 shares of BRK.A? $270,000 is a lot to be indifferent to.

Posted by: robert on February 8, 2008 9:53 AM



Megan McArdle has a good post on this.

Posted by: Thursday on February 8, 2008 10:45 AM



cure,

I notice that your comments aren't directed to John Stuart Mill. Care to explain why? Perhaps you could respond to George Bancroft while you're at it.

Your issue #1 is a red herring, for the following three reasons.

One: while it is certainly the case that gold mining (or more accurately, gold discovery, because discovered but unmined the monetary base as well, as it is capitalized into the equity of gold miners) dilutes the monetary base, the dilution is extremely small (2% a year) compared to the rate at which fiat currency and promises equivalent to it are being produced (difficult to measure, but certainly 10-20% per year). To put it differently, the BWII monetary system has outsourced monetary production not to the extremely predictable (given modern geology) profession of gold mining, but to the People's Bank of China.

Two: I don't think any reputable (ie, Austrian School) economist would argue that the gold standard is perfect. In fact, the core conclusion of Austrian monetary theory, which you'll note is exactly the conclusion reached by Mill, Hume, Bancroft, and other cranks and loons, whom you can mock and ignore only because they happen to be dead, is that any supply of money is adequate.

The gold standard would be theoretically ideal if there was zero unmined gold in the earth's crust, and the money supply was fixed. Gold mining in a metallic standard is the economic equivalent of counterfeiting. Fortunately, physical reality makes this very difficult.

What I want to hear from you is a clear and rational explanation of why a productive economy should be dependent on continuing monetary dilution.

In other words, I want you to either (a) renounce, or (b) explain and defend Tim Worstall's argument: "You need to expand the money supply as the economy expands." Um, sure, dude. Why? If you can't put your explanation in terms that would be intelligible to Hume, Mill, and Bancroft, why not?

(And I can't believe you're still talking about the "Great Moderation." Do you guys, um, read the newspaper?)

Three: as anyone with an even tangential involvement with the financial system is now aware, the so-called "business cycle" (a better term would probably be "banking cycle") is caused by the ubiquitous mismatching of maturities, ie, the issuance of liabilities which are not backed by cash or projected cash flow at the same point in time at which they mature. Issuing more notes redeemable for gold on demand (ie, with a term of zero) than you have actual gold to deliver is a textbook trivial case of maturity mismatching. The financial crises of the 1930s, in which the sorely abused gold standard finally collapsed, were all "gold runs" in which schemes of this sort dissolved.

The appropriate response would have been terminating the gold standard, but devaluing so that all liabilities were actually matched by assets. If a gold standard does not mean that "money" is simply defined as a weight of metal, it should at least correspond to a 100%-reserve currency board. Devaluing is the right response to any breakdown of a currency peg: don't overvalue the freakin' currency in the first place.

Posted by: Mencius on February 8, 2008 12:39 PM



Cure is right. The problem with a gold standard is that you are basing the value of your money on a single commodity - gold. Even if you used a basket of commodities (such as gold, silver, platinum, etc.) the supply of these commodities can fluctuate wildly as new mines open and old mines close.

Fiat currency was invented for the purposes of stabilizing these wild fluctuations. The problem with fiat currency is the moral hazard associated with deficit spending of the government and artificial inflation of the money supply, which is the cause of all of our current problems. We must think of ways to reduce this moral hazard while preserving the benefits of fiat currencies.

Much of the power and, therefor, moral hazard of the FED comes from the fact that they set the interest rate. Why should the FED set the interest rate? This should be determined by the marketplace itself, not the FED.

The other source of moral hazard results from the FED playing around with the CPI calculation. Here again, the FED should not calculate the CPI and, hense, declare the inflation rate to be such and such. The bond and stock ratings agencies such as Moody's and S&P are more than capable of calculating CPI and, therefor, inflation. Let them do it. Having several competing definitions of CPI (one from Moody's, another from S&P) would be beneficial in that it would allow financial institutions and individuals to choose which one they think is more accurate and, therefor, relevant.

The problem of the FED is that it is a monopoly. Monopolies have never worked. They don't work for cars, airlines, or semiconductors. Why would anyone think that monopoly works for the finance industry?

The FED should be reformed such as to remove its monopoly functions. The marketplace itself can set the interest rate and the rating agencies can calculate the going rate of inflation.

Posted by: Kurt9 on February 8, 2008 12:44 PM



I suspect 2Blowhards readers might also enjoy this discussion of the actual modern-day gold market.

The mysterious "Cassandra" (who is a hedge-fund manager, not an "economist") and I disagree about everything, as you can easily see. Obviously, she is wrong and I am right. But if you care at all about finance and you're not reading CDT, you missin' out.

Posted by: Mencius on February 8, 2008 12:45 PM



Mencius,

Well, very smart people in the 19th century were wrong about a lot in economics - look at the number of respected political economists who didn't understand the water-diamond paradox and who believed in the Labor Theory of Value. Without knowing more about Mill's exact position, I can't respond further, but I think it's safe to say that while we respect people like Mill and Newton for their contributions, the last 150 years have also produced worthwhile additions to their research.

As for the notes about the CPI and the Great Moderation...the Great Moderation is simply an empirical regularity. There are dozens of papers discussing it, by researchers all over the world, affiliated with private industry, academia and central banks. I don't know that "opening a newspaper" would change my view on the subject. As for the CPI, there are in fact many competing definitions of inflation - PCE, CPI, GDP deflator, stats collected by the IMF, stats from the OECD, etc. They all have different uses, which explains their slightly different number. I know people distrust inflation numbers because "core" inflation doesn't include food and energy. There is a very good reason for using core numbers when setting policy: the Fed can't do anything about the vagaries of oil price changes and crop failures. When examining long-run success, though, of course economists all use standard inflation numbers than include food and energy. As for the strange conspiracy theory that the US govt. changed how we process inflation in the 80s in order to make the numbers sound better, I see no evidence of that, since the current method of estimating inflation (allowing for substitution of goods) matches my idea of the welfare effect of a price change much better than the old method. And, of course, when comparing today's inflation to inflation in, say, 1950, know that the CPI and PCE numbers were updated so that they all reflect the current definition.

Posted by: cure on February 8, 2008 1:31 PM



Ah, Tim Worstall and Cure, acolytes in the religion of monetarist economics!

In science, you can't break the law--that's why its a law! The "laws" of economics are broken all the time, like the "law of supply and demand". Real science is also predictive. If economics were a science, all economists would be rich and retired. Yet they aren't. Proof positive that economics isn't a science.

Economics is more like a a religion, with competing factions and belief systems, carried on amongst partisans. In reality its not a very complicated subject at all. That's why I don't have such great regard for economic schools or sects. They are nothing more than propagandists for their own credo. The current Church propaganda is that of a fiat credit money system, run by the banks, with the backing of the government to make the system monopolistic. Its the biggest scam ever pulled in all of human history.

Let's take the monetarist "arguments" one by one.

1) Gold is bad because sometimes there isn't enough of it and prices go down (deflation of the money supply is bad).

How in the world is a reduction in prices bad for the consumer? So-called "economists" widely hail the price decreases of products due to improved technology all the time--the big increase in "productivity" we always hear about! Yet in this case its bad bad bad. But for whom? Deflation is bad for debtors. If the amount of money you can make goes down, and your debts stay the same, then the loan gets harder to pay back. Bad for the money lendors and debtors, good for the workers, savers, and consumers! WE MUST HAVE NONE OF THAT!

So what, there are cases of overproduction, and sometimes there is higher unemployment and sometiemes less? Oh well, things move in cycles. Big deal. Its never a big deal when American workers get laid off and the factories move overseas, is it? That's good--when labor prices DEFLATE and people get laid off. Its good when labor prIces DEFLATE due to illegal alien labor. That makes us more "productive", right? But there shall be no layoffs in the BANKING SECTOR! We can't have bankers being laid off. There is no oversupply of bankers. There shall be NO DEFLATION in the BANKING SECTOR! What a joke.

2) Gold is limited in supply, the supply fluctuates too much, and there isn't enough of it really.

Then use other metals too. LIke silver. Like platinum. Hell, the nickels I have in a jar are made of actual nickel. That seemed fine. There are plenty of metals that are used for money, have been used for money, and always will be used for money. Metal is a real thing that takes real effort to make and is intrinsically valuable as metal. Fiat credit money is not.

You see, the bankers are tricky. They talk about a "gold standard", where paper certificates can be called money because they are tied to gold--only gold, no other metals! Then they print far more paper certificates than there is gold. Then the inevitable collapse comes, and they whine about the supply problems of gold. Its all a false choice. A "gold standard" is a rip-off mechanism of artificially constrained choices. If you can make something like pieces of paper money, then why not other things too, like other metals besides gold? There is no constrained supply at all. The bankers will do anything to make pieces of paper that they control money. The last thing they want is for the weight of a certain amount of metal to have a certain value and to be called money. That truly limits money's supply, and takes it out of their hands.

3) We need a central bank to control the money supply because the free market is too messy, and there are toomany booms and busts.

Hahahahaha! Ever heard of the Great Depression, or the great stock market booms of the 1920's and 1990's, oh venerable economists? Alan Greenspan and Ben Bernanke both agree that the Fed caused the Great Depression. All the greatest booms and busts were the result of massive amounts of money and credit creation, malinvestment (fast money over real production), and the subsequent collpase.

Oh, and I thought monopolies only caused lowered innovation and high prices? Big Bankers afraid of a little competition in the creation of money? Poor babies! There shall be all kinds of competiton for the workers, businesses, and consumers, but none for the big bankers! Fiat credit money--the only legal monopoly in town! What a joke that is!

You guys have turned yourselves into the most pathetic of propagandists. Why can't you see that?

Posted by: BIOH on February 8, 2008 1:53 PM



"You need to expand the money supply as the economy expands." Um, sure, dude. Why?

One simple argument is wage stickiness. At least, it's an argument that a layman like myself can understand -- not sure if it lines up with the economists' understanding, but hopefully they can correct me if this is wildly inaccurate.

If you hold the supply of money constant (or roughly constant), but, crudely speaking, increase the number of goods produced (expand the economy), then each unit of money will purchase more goods. A monetary unit's purchasing power will increase.

However, the wages we pay the producers of each good will remain roughly constant, because people get mad when you reduce their wages. A worker may have produced five widgets/week before, and now he still produces five widgets/week, albeit in a larger economy (widget-manufacturing isn't the source of the economy's expansion here). But now that the economy has expanded, those widgets will bring in a lower facial amount of money, because prices have fallen, so we ought to slash wages, since the same value is now represented by smaller fractions of the currency. But we won't. Or will do so only to a limited extent. Because wages are "sticky." We see a little of this during recessions today -- businesses will just fire workers, rather than slash wages.

An expanding money supply helps keep the price of goods and wages stable in an expanding economy. More money to chase more goods, and to keep the facial denomination of wages roughly constant, rather than having wages appear to collapse in stagnant or slower-growing sectors of the economy.

I don't know whether Mill would accept this as an explanation, but it does play off an observable phenomenon that -- in Mill's day -- I don't think we knew about. It's possible that the modern worker's sensitivity to the (arbitrary) denomination of his wage is a product of historical circumstances, and limited to the current historical aera -- that is, that it may not apply in future economic periods when workers' and managers' perceptions of the significance of the currency are different. But whatever the reason, I think it does point to at least one reason why a fixed monetary supply for an expanding economy might be problematic at this juncture.

Posted by: Taeyoung on February 8, 2008 2:25 PM



Oh, and I thought monopolies only caused lowered innovation and high prices? Big Bankers afraid of a little competition in the creation of money?

Doesn't the Fed have rivals in the creation of "money," already, thanks to extensive eurodollar markets abroad? I'm pretty sure that foreign banks can and do engage in fractional reserve lending on dollar-denominated deposits outside of the United States, without any Fed oversight. And without, in some cases (or so I understand), there ever having been actual American dollars involved in the first place. In practice, I think LIBOR or whatever eurodollar loans key off of is sensitive to the Fed rate, so the Fed still has a certain amount of control. But the eurodollar market is still huge.

I mention the Fed here only because the comment I respond to seemed to be about central bankers, not the ordinary banks -- the ordinary banks, obviously, compete against each other.

That said, in re: BIOH's post, I found the following a bit striking:

There is no constrained supply at all. The bankers will do anything to make pieces of paper that they control money.

Like, what, secured debt? Equity? Derivatives? Swaps? I sense BIOH's outrage, but I'm not sure what he expects a gold standard to do about it. Is he going to ban ordinary people from purchasing things with credit? Ban banks from selling credit card debt and debt instruments? Ban banks from engaging in fractional reserve lending?

As soon as you allow Person A to borrow money from Person B, you've increased the apparent money supply. Person A takes the money he borrowed and buys something. Person B can sell his contract (to receive repayment from A) to Person C, in exchange for something else. Are you suggesting we ban that set of transactions?

Posted by: Taeyoung on February 8, 2008 2:52 PM



cure,

In other words, Mill is dead, so he's wrong. I'm glad you think this question is important enough to deserve your full attention.

If you ask a modern physicist what Newton was wrong about, he will tell you. If you ask a modern economist what Mill was wrong about, all you get is contempt, condescension and stonewalling. Perhaps this is a clue that 20th-century macroeconomics is a very different thing from 20th-century physics. A cuckoo is not a robin.

There are only two possibilities. Either Mill was on crack, or modern macroeconomics is institutionalized charlatanry. If you find the second option insulting, I suggest that you devote a little more energy to convincing us of the first.

As for your "Great Moderation," I am well aware of the numbers. Note that exactly the same phenomenon was observed in the 1920s - stable price levels and apparent prosperity. There is a famous quote on the matter from Irving Fisher, the inventor of modern price indexing, whom you probably think of as a pioneer of 20th-century "economics."

If newspapers are not your forte, I suggest you enjoy your permanently high plateau while you have it. Perhaps you have some unopened portfolio statements from 2006 that you can dig up and smile at. Or perhaps you are so wealthy that asset-price fluctuations mean nothing to you.

In reality, what was happening in the 1920s was exactly the same thing that was happening in the quarter-century from 1982 to 2007. A large volume of unpayable debt was building up. This debt was priced incorrectly by the financial markets, which overestimated the probability that it would be repaid.

This was not a case of "market failure." The chief motivation for this overestimate was the so-called "Greenspan put," essentially an informal option or loan guarantee, which made the spread between Treasury securities and the AAA ratings produced by the NRSROs minimal. When AAA-rated securities began to default, the crunch was on. I think you'll find that this problem can only be resolved by widespread monetization, ie, more loan guarantees.

I suspect the monolines will be effectively converted into GSEs, for example. Note that a loan guarantee from the Fed (eg, the informal protection enjoyed by the GSEs) is risk-free to the extent that it is formal, since a Fed liability and a dollar are one and the same thing.

If you "open a newspaper," at least to the financial section, you can read all about these events. You can find out what a GSE and an NRSRO and a monoline and an SIV and a CDO and a CPDO are. Furthermore, I have made predictions. You can follow these predictions. If they don't come true in the next few months, something else certainly will.

But let's go back to this "Great Moderation" thing for a moment. It's hardly your fault that you were not taught "literary economics," and you don't have the moves to take on John Stuart Mill any more than I could go one-on-one with Kobe Bryant. So perhaps this essay [PDF] by Greg Mankiw, summarizing the state of modern macroeconomics, is more to your taste.

As Mankiw puts it, "economists like to strike the pose of a scientist." Indeed. Of course, so do charlatans. Our task here is to figure out which is which. Mankiw is of course an economist, and as I would argue a charlatan. But he did not invent the profession, and he strikes me as a relatively honest and responsible thinker for a Presidential advisor.

The theoretical nut of Mankiw's piece is this:

All modern economists are, to
some degree, classical. We all teach our students about optimization, equilibrium, and
market efficiency. How to reconcile these two visions of the economy—one founded on
Adam Smith’s invisible hand and Alfred Marshall’s supply and demand curves, the other
founded on Keynes’s analysis of an economy suffering from insufficient aggregate
demand—has been a profound, nagging question since macroeconomics began as a separate
field of study.

Indeed. Basically, what Mankiw is saying is that the quantitative models of 20th-century economics - Keynes, Fisher, Samuelson, even Friedman - are derived from thin air and chewing gum. What do all these acronymous numbers mean? It is not exactly clear. Note that this is not at all inconsistent with the picture of modern macroeconomics as astrology.

Here's another quote which is not inconsistent with said picture:

So let’s ask: Have
the developments in business cycle theory over the past several decades improved the
making of economic policy? Or, to set a more modest goal, have the advances in
macroeconomic science altered how economic policy is analyzed and discussed among
professional economists who are involved in the policy process?

I will spare you Mankiw's answer, which is lengthy. It boils down to "no." Of course, he hardly believes that his profession should be abolished. Here is his conclusion:

The resulting insights are being incorporated into the new synthesis that is now
developing and which will, eventually, become the foundation for the next generation of
macroeconometric models. For those of us interested in macroeconomics as both science
and engineering, we can take the recent emergence of a new synthesis as a hopeful sign that
more progress can be made on both fronts. As we look ahead, humble and competent
remain ideals toward which macroeconomists can aspire.

Note that if you replace "macroeconomics" with "astrology" in this paragraph, its meaning remains remarkably consistent. This is the line of argument that astrologers have always used. "Your Majesty, with all due respect, your present astrologers are quacks. They don't know a comet from an asteroid. Whereas with my new Venus-centric approach, future battles, sexes of unborn children, and winners of American Idol are, yea, as an open book to me."

Keeping this interpretation in mind, let's go back to your CPI and PCE and GDP deflator, and answer Mankiw's question. What do all these numbers mean?

I will tell you what these numbers mean if you can answer one simple question. How much better a car is the 2008 Mustang than the 1968 Mustang? I know it's faster, it brakes better, etc, etc. But all I want is a unitless number. Is the 2008 Mustang twice as good? Three times as good? 4.7 times as good?

I would like to think that 2Blowhards readers, unless perhaps they are "economists" - and perhaps even if - will agree with me that there is no objective procedure that can construct a meaningful number that tells us how much the Mustang has improved since 1968. If it has improved. I suspect Donald Pittenger might say it's gotten worse. It is certainly uglier.

But actually, 2Blowhards readers would be wrong. There is an objective procedure. It's called "index chaining." Late in 1968, there was a short period during which both the 1968 Mustang and the 1969 Mustang were on sale. The latter was more expensive. So we can take the price ratio between the 1969 Mustang and the 1968 Mustang, the '70 and the '69, and so on all the way up to 2008, when we arrive at our number. Perhaps it's 7.5 or 3.1 or 9.127. I really have no idea.

Now, what would John Stuart Mill say if this procedure was described to him? I have to imagine he would laugh until he was red in the face and his belly was sore. His was a stern time, but he was by no means a humorless man.

Yet this procedure is followed faithfully as we speak, down at the Bureau of Astrological Statistics, and has been for decades. And it is from numbers of precisely this type that your "Great Moderation" emerges.

Yes, the Boskin Commission did revised the CPI formula in the '90s. It's on Wikipedia. It can't be a conspiracy theory. But the problem is much larger than that. It is not that the Carter-era CPI was more meaningful. Quite the contrary. Both numbers are equally accurate.

As any pre-20C economist would have agreed, price indexes are numerological garbage. There is simply no way to compare prices across the time domain. The goods are different and the supply of money is different.

Imagine if you were trying to compare prices on Venus with prices on Earth. We can observe Venus with telescopes, we know their currency is the Venusian dollar, and they even have many of the same exact goods - such as, of course, gold. Venusian gold is exactly the same as Earth gold. So what is the exchange rate between the Venusian dollar and the US dollar?

The question remains nonsensical. There is no exchange rate, because there is no market and no exchange. This number is a pseudo-price. It pretends to be a price in exactly the way that economics pretends to be a science.

Likewise, there is no exchange rate between the 1968 dollar and the 2008 dollar, because 2008 cannot trade with 1968 any more than Venus can trade with Earth. You can come up with any number of supposedly objective procedures for producing this number, and this is precisely the problem. Like the ratio between 2008 and 1968 Mustangs, it is subjective nonsense.

Meanwhile, back on Earth, here is what actually happened in the last 50 years. The US's productive industries disappeared, its cities decayed and became uninhabitable, and it became a massive net borrower. Call it the "Great Squandering."

So this is 20th-century macroeconomics. It feeds meaningless numbers into meaningless formulas, computes the result, and uses it to abet an irresponsible government in ignoring reality. Nice job if you can get it. I'm afraid the rest of us will just have to stick with John Stuart Mill.

Posted by: Mencius on February 8, 2008 3:37 PM



Taeyoung,

I don't know whether Mill would accept [wage stickiness] as an explanation, but it does play off an observable phenomenon that -- in Mill's day -- I don't think we knew about.

Actually, Mill specifically answers this argument:

Mr. Attwood’s error is that of supposing that a depreciation of the currency really increases the demand for all articles, and consequently their production, because, under some circumstances, it may create a false opinion of an increase of demand, which false opinion leads, as the reality would do, to an increase of production, followed, however, by a fatal revulsion as soon as the delusion ceases.

Price and wage stickiness is precisely Mill's "false opinion." Attwood is referring to price stickiness, but a wage is just a labor price. Read the article - I suspect you'll start thinking of Keynesianism as "Atwoodism." Of course I'm sure Attwood was not the true inventor, either. The Juggle springs eternal.

As soon as you allow Person A to borrow money from Person B, you've increased the apparent money supply. Person A takes the money he borrowed and buys something. Person B can sell his contract (to receive repayment from A) to Person C, in exchange for something else. Are you suggesting we ban that set of transactions?

No. I'm suggesting we ban maturity transformation, which is the process by which an infinite stream of cash flows from the future into the present.

Person B can sell his contract. But he cannot change it from a contract to deliver money one year later, into a contract to deliver money now. Under present financial regulations, however, a bank can issue present liabilities against future assets. That is, it can treat its ownership of Person A's promise to deliver money in one year, as if it actually had that money now. Iterated, this alchemy has created quite a number of dollars.

Maturity transformation only works if the transformer (bank) is the beneficiary of a loan guarantee issued by an authority with the power to print money. Ie, it has "deposit insurance." You may think of this as a gift from Uncle Sam to you, but it is actually a gift to the bank. Without this protection, there will be a "bank run" and all the promises of money now will be worth just that.

No, I don't think Mill had a clear understanding of maturity transformation. But I think I could explain it to him.

Posted by: Mencius on February 8, 2008 3:50 PM



Kurt9,

The problem with a gold standard is that you are basing the value of your money on a single commodity - gold.

Actually, a single commodity is ideal. You cannot have stable exchange rates between multiple competing monetary commodities. I know Hayek believed in a multiple-commodity standard, but Hayek, frankly, is overrated.

Until the late 19th century the world was on a bimetallic standard - gold and silver. This collapsed into the gold standard, and I guarantee you that the event made silver holders quite unhappy. The bimetallic standard only existed in the first place because ancient China and India were on the silver standard, and the West used gold.

A multicommodity standard is like a pen balanced on its point. As soon as it tips in one direction, momentum will accelerate its decline. If your standard is gold and silver, you cannot prevent a fluctuating price between gold and silver, and if this market starts to move in the direction of one metal it will keep moving until the other is effectively demonetized.

This is a good thing, not a bad thing. Any good that is used as money will be vastly overpriced relative to a world in which is an industrial commodity. Gold as an industrial commodity today would surely be under $50 an ounce, perhaps under $20. There is a large stockpile. And think of the ratio between the cost of dollars and the cost of paper and green ink.

Even without the unstable game theory, a world in which the effect of monetary demand is limited to one commodity is more stable and less distorted than a world in which it is tied to a basket. Furthermore, the fewer ulterior uses the monetary good has, the better, because its high price will seriously discourage those uses.

The ideal money would be some element created by alien technology that humans could not produce at all. Gold is not quite there. But there are 150,000 tons of mined gold in the world, and only about 2000 more are extracted - at significant expense - every year. A gold-dollar exchange rate of 10x the present would not change these numbers much.

Posted by: Mencius on February 8, 2008 4:04 PM



Taeyoung,

I love the economic word "sticky"--very scientific! The hard science of economics strikes again!

How about the situation where the worker in a deflationary environment keeps his job because he is producing more goods through technological procuctivity increases, and company profits actually stay the same or increase? Seems to me a deflationary environment only hurts those who don't innovate and become more productive. Nice try though.

One more time for the hard of hearing crowd--I DO NOT ADVOCATE A GOLD STANDARD! I advocate hard money and competing types of hard money! A gold standard is just a phony screen to prop up paper money printers!

Also, bonds, stocks, CMO's, blah blah blah aren't new forms of money, since their value is all denominated in dollars. Another nice try!

Keep swinging guys, you might actually hit something!

Posted by: BIOH on February 8, 2008 4:06 PM



This is without a doubt the 2Blowhards thread that I can contribute the least to. I can only hope those who think about this stuff and have some control over it are right!

Posted by: JV on February 8, 2008 4:33 PM



Price and wage stickiness is precisely Mill's "false opinion." Attwood is referring to price stickiness, but a wage is just a labor price. Read the article - I suspect you'll start thinking of Keynesianism as "Atwoodism." Of course I'm sure Attwood was not the true inventor, either. The Juggle springs eternal.

Mill can suppose stickiness to be a false opinion, but it's been empirically observed too. no? Or are those studies finding wage stickiness (or price stickiness) simply lies? I'm not an economist, and I'm not deep in the literature, of course, so maybe there's some fundamental flaw causing them to find wage stickiness where there is none, but I'm a little suspicious there. It seems like a pretty straight empirical question -- are workers willing to accept nominally lowered wages?

Person B can sell his contract. But he cannot change it from a contract to deliver money one year later, into a contract to deliver money now. Under present financial regulations, however, a bank can issue present liabilities against future assets. That is, it can treat its ownership of Person A's promise to deliver money in one year, as if it actually had that money now. Iterated, this alchemy has created quite a number of dollars.

I think follow you up to this point.

To make sure I'm thinking of the same thing you are let me go through that in laymanspeak:

B has a receivable against A, and B exchanges the receivable with C for present money. But the money is just a notation in C's accounts at Bank D, saying that B's account at D now has X additional cash in it and C's account has X less. B can then pull that cash out into currency, if, for some reason, it wanted to. Or it could just continue using that as money by transferring it to a counterparty's accounts at Bank D or something, or using an interbank exchange, the banks' accounts at the fed, or whatever to work the transactions.

Is that right?

Maturity transformation only works if the transformer (bank) is the beneficiary of a loan guarantee issued by an authority with the power to print money. Ie, it has "deposit insurance." You may think of this as a gift from Uncle Sam to you, but it is actually a gift to the bank. Without this protection, there will be a "bank run" and all the promises of money now will be worth just that.

I'm not sure I see how the deposit insurance is necessary. The guarantee reduces the risk, certainly. But it's not like the risk of default would be infinite otherwise. I only see how the guarantee gives you a floor -- the actual valuation is typically a lot bigger than that. Why wouldn't banks (or individual lenders, or businesses selling their receivables or whatever) just factor in the increased risk factor, reduce the expected value / exchange value of the debt a little bit, and continue on as they have done before?

And what about secured debt? Secured debt has a guarantee -- enforced, yes, by the government, but through the courts, not through the deposit insurance mechanism. The underlying assets in a secured debt transaction aren't money -- they're a house or a boat or whatever, or a factory or inventory or something -- but the debt can be converted into present money through the same mechanism, even though the security remains in the possession of the debtor, up until he defaults.

Posted by: Taeyoung on February 8, 2008 5:01 PM



Also re: Deposit Insurance -- I couldn't remember for certain, but googling around it looks like in the UK, the insurance amount is only equivalent to a couple thousand dollars. And they do maturity transformation anyway. For eurodollar deposits at UK banks, the insurance limit is 0, and again, I'm pretty sure they engage in maturity transformation on those amounts too.

Posted by: Taeyoung on February 8, 2008 5:18 PM



Mill can suppose stickiness to be a false opinion, but it's been empirically observed too. No?

That's not quite what he means. Mill means that the "money illusion" caused by the systemic change of monetary dilution is not lasting, and is not an effective way to manipulate prices in the long term. He doesn't deny that markets are imperfect and prices are sticky. He just notes that they will adjust.

In real life, "wage stickiness" tends to be not the result of market imperfections, but of inflexible labor contracts enforced by the barely concealed strong arms of unions. While strong, unions are not dumb, and when you start diluting the money supply in an attempt to surreptitiously decrease their wages, they tend to start asking you for regular wage hikes.

B has a receivable against A, and B exchanges the receivable with C for present money. But the money is just a notation in C's accounts at Bank D, saying that B's account at D now has X additional cash in it and C's account has X less. B can then pull that cash out into currency, if, for some reason, it wanted to. Or it could just continue using that as money by transferring it to a counterparty's accounts at Bank D or something, or using an interbank exchange, the banks' accounts at the fed, or whatever to work the transactions.

Yup, dat's da money multiplier. Like magic it is.

I'm not sure I see how the deposit insurance is necessary. The guarantee reduces the risk, certainly. But it's not like the risk of default would be infinite otherwise. I only see how the guarantee gives you a floor -- the actual valuation is typically a lot bigger than that. Why wouldn't banks (or individual lenders, or businesses selling their receivables or whatever) just factor in the increased risk factor, reduce the expected value / exchange value of the debt a little bit, and continue on as they have done before?

The loan that will default (at least at first) is not the bank's loan to A, but X's loan to the bank.

The bank's checking "deposits" are in fact liabilities for present money, continuously renewed. Suppose the bank is solvent, ie, the sum of its liabilities exceeds the market value of its assets, which consist largely of future money flows (eg, loans to A).

If all of the people who are owed present money demand it, refusing to renew their loans to the bank, the bank has to sell its assets to fulfill its liabilities. If the market for future money is reasonably frictionless, it can do so - perhaps instantly.

So if the bank is the only financial structure with mismatched maturities, no problem. It sells the loans from A and the ATM still works.

If it is part of an entire financial system which is mismatched, however, the dreaded "contagion" ensues. The bank must sell future money to pay the present money it owes. The problem is equivalent to that of finding new lenders. If mismatched banks cannot find new lenders at the price at which they carry the future money on its books, that price must drop. Ie, the interest rate must rise.

And when the price of future money in present money drops, the banks become insolvent. And now you actually have a reason to go to the ATM! Hopefully before everyone else does.

And what about secured debt? Secured debt has a guarantee -- enforced, yes, by the government, but through the courts, not through the deposit insurance mechanism. The underlying assets in a secured debt transaction aren't money -- they're a house or a boat or whatever, or a factory or inventory or something -- but the debt can be converted into present money through the same mechanism, even though the security remains in the possession of the debtor, up until he defaults.

Again, it is not that the loan to A will default. At least not at first. As we're seeing in the housing market, however, the prices of the assets that act as security (eg, houses) are not immune to the banking cycle. And when the price of the asset falls below the balance on the loan...

I discuss maturity transformation in a fair bit more depth here. No previous knowledge of finance, economics or accounting is required. I know you'd think it couldn't be this simple, but it is.

The dynamics of a bank run are not even one of the issues on which mainstream and Austrian economists differ - if you're looking for the former's take, google "Diamond-Dybvig."

Posted by: Mencius on February 8, 2008 5:31 PM



Also re: Deposit Insurance -- I couldn't remember for certain, but googling around it looks like in the UK, the insurance amount is only equivalent to a couple thousand dollars. And they do maturity transformation anyway. For eurodollar deposits at UK banks, the insurance limit is 0, and again, I'm pretty sure they engage in maturity transformation on those amounts too.

They changed the rules on this after Northern Rock. I think the old limit was around 30,000 quid.

It turned out to be the case that depositors above the limit had no need to worry, anyway. If I'd had money in Northern Rock, I'm not sure I would have even bothered lining up. The real protection is political, and quite predictable.

It's the same with the FDIC. FDIC "insures" US dollar deposits up to $100K. But a bank run is not a genuine insurable risk, and FDIC as a private financial structure would make Ambac look healthy. It simply does not have the money to guarantee all those deposits. But deposit insurance in the US works nonetheless, and it works because everyone assumes that the Fed would bail out FDIC and/or the failed banks. Because everyone assumes this, it is a political reality and can be taken for granted.

Similarly, the bonds of GSEs (Fannie and Freddie) trade at a negligible premium to Treasuries, even though these so-called companies are financial monstrosities, with balance sheets that look like the aftermath of a Khmer Rouge killing spree. Why? For the same reason that Treasuries themselves are "risk-free." The Fed has no formal legal obligation even to Treasury. But their political connection is strong enough that the financial markets treat them as identical.


Posted by: Mencius on February 8, 2008 5:36 PM






Post a comment
Name:


Email Address:


URL:


Comments:



Remember your info?