I watched a pundit talk about money printing like it was a bad thing (when NGDP is still below the 1985-2007 trend and trending lower) yesterday on Bloomberg. [Click Here for the video]
After the disaster of 2008, gold standard proponents like Grant (guy in the link) and others gained a lot of ground. The problem being that many of their non monetary ideas are sound and that their monetary ideas seem plausible to people who haven’t seen the New Keynesian model derived in (Gali, 2008). As Sumner has pointed out, bad monetary policy hurts mainstream economics and opens the door for bad policy. Nowadays it seems it also opens the door for the gold standard arguments.
I have decided that the number one priority of this blog, at least for today, should be to undermine the notion that a dollar-gold peg is desirable as a long term policy, and that it would be disastrous in the short run. The goal will be to write for non economists. This will be hard. I will fail. But there are cool graphs at the end so keep reading.
Before I begin, I have a confession. I was once at least open to a gold-dollar peg, after all it worked to a greater to lesser extent for much of U.S. economic history. I was once also sympathetic to the “Austrian” business cycle theory. I have invested in gold and gold miners. I expect the gold price to continue rising. I dropped the Austrian view after about a week of reading Sumner’s blog. It is easy to fall in with the Austrians or others who espouse an anti paper money position because they have-an at first- compelling story which seems to explain the business cycle. To the average person the world of interest/exchange rates, stock markets, and recession is bewildering. The Austrians say that there is a “natural” market interest rate that will prevail if only we turn money creation over to gold mining companies.
The gist of the Austrian’s goldlove is that they think the systematic manipulation of interest rates by central banks tricks business into making bad investment decisions. The idea is that when the central bank drives interest rates from say 6% to 1% to stave off recession, that businesses reallocate capital away from short term projects (say buying milk for the office refrigerator) to projects that only pay off in the long term (say particleboard mansions in Arizona or condos in Valencia). Then when the central bank raises interest rates to slow inflation, these projects which were only profitable because of ultra low rates blow up and cause an even worse recession.
The problem with the Austrian story is that it assumes businessmen make bad decisions at the same time about the same thing, and build their operations around the idea that the recently lowered interest rates will remain so indefinitely. More than this though, the Austrian theory isn’t falsifiable. The Austrians can always say “Well at some point everything will blow up, and when it does it will be due to interest rate manipulation” this is what certain people has said since the ’70′s and it allows them to chronically play Chicken Little. If you are always Chicken Little that means there is always stock footage of you to play on CNBC when an economic crisis inevitable hits. This means the Austrians can take credit for any economic disturbance, because their theory doesn’t specify when a recession will start, or in which sector it will be.
The mainstream of economics has a different story. A story which is falsifiable. The mainstream says recessions are mostly due to a sudden drop in the amount of money spent. This story says that if (say) the Subprime Loan industry blows up, that those affected in that industry will spend fewer dollars. When they spend fewer dollars that means fewer dollars for healthy industries to spend, which means fewer dollars for other industries to use in paying back loans. This causes a chain reaction in the economy wherein everyone cuts spending. If the chain reaction is long enough, that it can cause enough loan defaults to bring down banks. In the modern top heavy banking system this can lead to a financial crisis if the loan defaults drag down enough major banks.
The good news is that because we use paper money, the central bank can hypothetically prevent the chain reaction from progressing. “All” they need to do is create more money so that the total amount of spending keeps growing at the rate it was when the loans were taken out. This is not Soviet style central planning, this is rule of law. The bedrock of capitalism is rule of law, the notion that the grounding rules of the economy are consistently applied in a manner conducive to longterm planning by independent agents. For example, courts should look to past rulings when handing down judgments so that everyone knows the rules of the game. Likewise when Bank of America lends it should feel confident that the total amount of spending in the economy will continue to grow as it has in the past, so that Bank of America’s average customer will have enough money to uphold their agreements. This removes what we can call monetary risk from my investment decision and leaves only business risk, or the risk that Bank of America will make bad business decisions independent of the amount of total spending.
It looks like I am writing like an economist again. Maybe there is no simple way of explaining monetary policy. Anyway lets plow on. Creating more money to offset spending shortfalls is not a panacea. If enough sectors run into hard times the drop in spending might be huge, it might mean that to keep spending up the central bank has to create a lot of money and promise to keep that money in the economy indefinitely, this will cause a rise in inflation which is a bummer but will prevent the rest of the economy from going under.
Let me give you two hypothetical choices: which would have been preferable, the 2008/2009 recession and weak 2010- recovery or the Great Depression? Which would have been preferable? 2008-2011 period of mild deflation and widespread unemployment or 6.5% unemployment and 5% inflation? Those are real choices in my view. If the Fed had not created as much money as it did in the early winter of 2008 we would have had a depression with maybe 20% unemployment (like Spain which cannot create its own money because it is on the
Deutsche Mark Euro).
If the Fed had created even more money and promised to Foie gras money into the economy so spending grew at the trend of 5% per year [which prevailed on the average year after year, month after month-from about 1985 to 2007] we would have had high inflation. However unemployment would have been lower, there would never have been a TARP or a stimulus or unemployment extension in the U.S. Tax revenue would never have collapsed and the U.S. would be 20 years away from a debt crisis instead of five.
I am confident that this story is right because the mainstream model is falsifiable. If the financial crisis was not created by a short fall in spending caused by Fed and ECB inaction we should have seen high inflation during the crisis. If the entire economy was a house of cards created by easy credit then the productive apparatus should have collapsed along with the housing sector. The productive capacity of healthy businesses like Walmart and Metro should have gone down with housing. The extra liquidity pumped in by the Fed (remember the gold crowd say this was artificial stimulus) should have only resulted in rising prices, not new production. That means inflation should have been high during the recession, but prices actually fell across the whole economy and inflation was well below normal up until this spring. High inflation would have told me that the physical structure of the economy was the problem, I would have known that the conventional view of recessions was wrong in this instance. The Austrians on the other hand get to claim any set of circumstances as vindicating their view and can always say “An inflationary depression is just around the corner!”.
Finally, let me pull out the workhorse of Quasi Monetarism, the Nominal GDP plot:
This plot shows the total number of dollars spent in America at a yearly rate. The gray bars show recessions. See how total spending slows down in the 1991 and 2001 recessions? See how it actually falls in 2008? See how it never gets back to trend in 2009-2010? Every economist, banker, investor worth his salt would agree that the Fed can control this value with high precision by printing money and telling markets how it will print money in the future. The Fed wont do this because that would take away the mystery of central banking. It would turn them into the post office. Instead the Fed likes to talk about inflation. If the Fed simply stabilized spending and kept it growing steadily even during times like the dot com bust or the Subprime Crisis we would see times of 5% inflation, which is evidently the worst thing in the world.
Now lets see how U.S. policy compares to Australia, which hasn’t had a recession since 1992/93 despite being a munch smaller economy and thus buffeted far more than the U.S. by events overseas. Fist NGDP (total spending) in America along with the average trend from 1985-2007, along with that trend advanced through to 2011Q1:
And now Australia:
This doesn’t constitute proof of the demand side hypothesis, just illustrates the idea. Australia is a rather more flexible economy than the U.S. which might explain part of their success. That said it does fit my story, the Fed did a (slightly) better job than the Bank of Australia in stabilizing spending before the crisis but has failed spectacularly these last three years. Spending in the U.S. continues to fall further and further below trend. At this point it seems the Fed is targeting a new lower trend, which after the economy works through the past 25 years of loans which built in 3% inflation and 5% nominal spending growth will give lower inflation. That is, if the U.S. Federal government doesn’t go broke and blow up the world economy first.
How does this tie in with gold? Under the current system of paper money, central banks can set nominal spending to be anything they want, just by printing more or less, and signaling to financial markets about their plans for money printing in the future. If we used gold as money total spending would be very hard to predict, it would depend on 1. new gold production 2. demand for gold; both of which are essentially unpredictable. Gold production has been falling for years, and most of the new gold finds are in Mongolia and The Congo. Gold demand is also tricky to predict.
A gold standard could “work”. It would require a generation of adjustment though and would introduce new uncertainty into the economy. It would lead to more recessions and higher average unemployment. A better alternative would be a legal requirements for central banks to stabilize NGDP. That would take the risk out of the economy that nominal spending would behave weirdly and leave us with only business risk.
I’m about halfway through watching the 2011 Russia Forum discussion. Those wishing to hear a fresh interpretation of economic life (a little dated now as the talk was in March) should check it out. I don’t know yet if I have learned much from the talk, but as it is hosted by the eminently entertaining (and completely mad) Marc Faber and features applied statistician, trader and philosopher Nassim Taleb and the speculator Hugh Hendry, I recommend it without reservation.
This is just a highlight, click the video to move to the full youtube page for links to the full talk.
It was great to hear Hugh Hendry talk about NGDP.
This headline caught my eye: Maoist Rebels Kill 15 Security Personnel in India
I add this to my pile of evidence in the on going debate over who will be the country of The Future: China or India. My view is that China will remain, and even grow in its Super Power credentials over India. A big reason behind this is that China doesn’t have anything like this, while insurgency and random violence is almost routine in at least parts of India. The occasional protest or violent flare up in Xinjiang or Tibet are nothing compared to the ideological, cast, and ethnic tensions in India.
I have not yet traveled in India, so take my view with a grain of salt. From what I read though, India doesn’t feel like a “natural state”, and if history is any guide, you really need a natural state in the beginning and middle part of the industrialization process. I like India, I like Raj English and the country has a lot going for it. I am sure it will reach (current) Brazilian levels of development within 20 years, which combined with stead population growth should put its GDP around the (current) level of the U.S. That said, I am also sure that China will reach (current) Taiwanese levels of development [in addition to absorbing Taiwan], which combined with a shrinking workforce will still put it between three and four times the (current) U.S. level of GDP. No contest.