George Selgin on Average Inflation Targeting and "The Menace of Fiscal QE"

From Macro Musings comes this video in which David Beckworth interviews George Selgin about the Fed’s new policy framework and Selgin's recent book titled, The Menace of Fiscal QE. Specifically, David and George discuss the Fed’s quantitative easing evolution, and how the move to a floor system helped pave the way for fiscal QE to become a more popular policy in the present.

 

Macro Musings · George Selgin on Average Inflation Targeting and *The Menace of Fiscal QE*

George Selgin on "A Monetary Policy Primer, Part 11: Last-Resort Lending"

One of the few interesting bits of monetary policy is the central banks role as the lender of last resort.

For many, the "lender of last resort" role of central banks is an indispensable complement to their task of regulating the overall course of spending. Unless central banks play that distinct role, it is said, financial panics will occasionally play havoc with nations' monetary systems.

George Selgin's aim is to challenge this way of thinking. Its an interesting antidote to much of what you hear said about the importance of the lender of last resort role of central banks.

Worth a few minutes to read.

How the fed ended up fueling a subprime boom

Many people have argued that Fed fuelled the sub-prime boom by holding interest rates too low for too long after the dot-com crash. John Taylor, for example, has been saying "too low for too long" for a long time now. One question few, if anyone, has asked however is why the Fed did so.

Now George Selgin, David Beckworth and Berrak Bahadir have a paper in the Journal of Policy Modeling that offers an answer to this question. Fortunately George Selgin gives a brief discussion of their argument at the Alt-M blog. Selgin wites,

Our argument, in brief, is that the Fed blew it by treating the exceptionally high post-2001 productivity growth rate, not as warranting an upward revision of the Fed’s interest-rate target, as neoclassical theory would suggest, but as an opportunity to maintain a below-natural interest rate target without risking a corresponding increase in inflation.

We supply lots of evidence supporting our interpretation and, thereby, supporting the view that excessively easy Fed policy did indeed contribute substantially to the subprime boom. We also show how NGDP targeting would have prevented this outcome–and that it would have done so to an even greater extent than strict adherence to a Taylor Rule.

Readers familiar with my arguments favoring a “productivity norm,” as presented in Less Than Zero and elsewhere, will understand the claims made here here as a specific application of those more general arguments.

The "Less Than Zero" book referred to above is worth reading for its own sake not just because of its use in the above argument. The full tile is Less Than Zero: The Case for a Falling Price Level in a Growing Economy (pdf) and is written by George Selgin and published by the Institute for Economic Affairs in London. In it Selgin argues that

1. Most economists now accept that monetary policy should not aim at 'full employment': central banks should aim instead at limiting movements in the general price level.

2. Zero inflation is often viewed as an ideal. But there is a case for allowing the price level to vary so as to reflect changes in unit production costs.

3. Under such a 'productivity norm', monetary policy would allow 'permanent improvements in productivity...to lower prices permanently' and adverse supply shocks (such as wars and failed harvests) to bring about temporary price increases. The overall result would be '... secular deflation interrupted by occasional negative supply shocks'.

4.United States consumer prices would have halved in the 30 years after the Second World War (instead of almost tripling), had a productivity norm policy been in operation.

5. In an economy with rising productivity a constant price level cannot be relied upon to avoid '..."unnatural" fluctuations in output and employment'.

6. A productivity norm should involve lower 'menu' costs of price adjustment, minimise 'monetary misperception' effects, achieve more efficient outcomes using fixed money contracts and keep the real money stock closer to its 'optimum'.

7. The theory supporting the productivity norm runs counter to conventional macro-economic wisdom. For example, it suggests that a falling price level is not synonymous with depression. The 'Great Depression' of 1873-1896 was actually a period of '... unprecedented advances in factor productivity'.

8. In practice, implementing a productivity norm would mean choosing between a labour productivity and a total factor productivity norm. Using the latter might be preferable and would involve setting the growth rate of nominal income equal to a weighted average of labour and capital input growth rates.

9. Achieving a predetermined growth rate of nominal income would be easier under a free banking regime which tends automatically to stabilise nominal income.

10. Many countries now have inflation rates not too far from zero. But zero inflation should be recognised not as the ideal but '... as the stepping-stone towards something even better'.

This argument makes the point that not all deflation is necessarily bad. It would be interesting to know what effect a productivity norm would have on New Zealand's inflation history given its somewhat dismal post-WW2 productivity experience.

Selgin v. Summer

Over at the Free Banking blog the ever interesting George Selgin has a post discussing why Austrian cycle theory and monetarist explanations of booms and busts are not mutually exclusive. Selgin writes,

Having learned my monetary economics from both the great monetarist economists and their Austrian counterparts, I've always chafed at the tendency of people, including members of both schools, to treat their alternative explanations of recessions and depressions as being mutually exclusive or incompatible. According to this tendency, a downturn must be caused either by a deficient money supply, and consequent collapse of spending, or by previous, excessive monetary expansion, and consequent, unsustainable changes to an economy's structure of production.

During the 1930s and ever since, this dichotomy has split economists into two battling camps: those who have blamed the Fed only for having allowed spending to shrink after 1929, while insisting that it was doing a bang-up job until then, and those who have blamed the Fed for fueling an unsustainable boom during the latter 1920s, while treating the collapse of the thirties as a needed purging of prior "malinvestment." As everyone except Paul Krugman knows, the Austrian view, or something like it, had many adherents when the depression began. But since then, and partly owing (paradoxically enough) to the influence of Keynes's General Theory, with its treatment of deficient aggregate demand as the problem of modern capitalist economies, the monetarist position has become much more popular, at least among economists.

It is, of course, true that monetary policy cannot be both excessively easy and excessively tight at any one time. But one needn't imagine otherwise to see merit in both the Austrian and the monetarist stories. One might, first of all, believe that some historical cycles fit the Austrian view, while others fit the monetarist one. But one can also believe that both theories help to account for any one cycle, with excessively easy money causing an unsustainable boom, and excessively tight money adding to the severity of the consequent downturn. I put the matter to my undergraduates, who seem to have little trouble "getting" it, like this: A fellow has an unfortunate habit of occasionally going out on a late-night drinking binge, from which he staggers home, stupefied and nauseated. One night his wife, sick and tired of his boozing, beans him with a heavy frying pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by the ruckus, pokes his head into the doorway, sees our drunkard lying unconscious, in a pool of puke, with a huge lump on his skull. "What the heck happened to him?," he asks. Must the correct answer be either "He's had too much to drink" or "I bashed his head"? Can't it be "He drank too much and then I bashed his head"? If it can, then why can't the correct answer to the question, "What laid the U.S. economy so low in the early 1930s?" be that it no sooner started to pay the inevitable price for having gone on an easy money binge when it got walloped by a great monetary contraction?

This not just a good piece of marriage advise, it is also a good piece of economic advise, one which is missed by many economists who see the Austrian and monetarist views as mutually exclusive.

Selgin goes on to argue that modern economists, including Scott Sumner, have been sucked into a false dichotomy:

Sumner basis his position, not merely on the claim that prices are more flexible upwards than downwards, but on a dichotomy erected in the literature on asset price movements, according to which upward movements are either sustainable consequences of improvements in economic "fundamentals," or are "bubbles" in the strict sense of the term, inflated by what Alan Greenspan called speculators' "irrational exuberance," and therefore capable of bursting at any time. Since monetary policy isn't the source of either improvements in economic fundamentals or outbreaks of irrational exuberance, the fundamentals-vs-bubbles dichotomy implies that monetary policy is never to blame for changes in real asset prices, whether those changes are sustainable or not. If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary policymakers shouldn't be concerned about booms" crowd are right, and the Austrians, Schwartz, Taylor, and others, including Obama and his advisors, who would hold the Fed responsible for avoiding booms, are full of baloney.

Scott Summer not surprisingly sees it differently,

I’m happy to reassure George that I do not believe the things he claims I believe. I believe the Fed often creates booms, and that these booms often lead to recessions. So in that sense my views are quite Austrian. I am particularly surprised by his claim that I don’t believe that monetary policy affects real asset prices, as he recently commented on a post that was devoted to exactly that proposition:

Now here’s where I part company with Keynesians who might have been with me so far. Although short term interest rates are one of those “asset prices” that cause the money market to achieve near instantaneous equilibrium, even as the goods and labor markets are in disequilibrium, they actually have very little role in moving NGDP and prices to the level necessary to restore long run macro equilibrium (and to move interest rates back to their original level.) In my view 60% of the heavy lifting is done by what Keynes called “confidence” and I call “expectations of NGDP growth” and Ford Motors economic forecasters call “expected nominal incomes in 2014 available to buy Ford cars.” Another 35% of the transmission is done by asset markets like stocks, forex, commodities, real estate prices, junk bond yield spreads, etc. And maybe 5% by risk-free short term rates. At most.

So I just claimed that 35% of the transmission effect of monetary policy works through changes in real asset values, and have been saying similar things all along. George is a smart guy, so clearly something I said was misleading, or created a false impression. Perhaps it’s my denial of “bubbles.” I believe in the EMH (i.e. no bubbles), but only for asset markets. Because goods and labor markets have sticky wages and prices, they are not efficient, and monetary stimulus creates booms and busts in terms of output. In some cases, such as the 1970 recession, the blame is almost 100% the preceding boom. Indeed the preceding boom also played a big role in the next few recessions. Where I differ from some Austrians is that I believe the preceding booms in 1929 and 2007 were not major factors in the subsequent slump. In those two cases I think tight money is mostly to blame, perhaps 90% or more. It’s hard to be more precise as the trend line is a judgment call (in the absence of NGDPLT.)

Summer goes on to say that he sees booms and bubbles as unrelated phenomenon. If by boom we mean "excessive nominal spending" then he doesn't see a strong correlation between booms and bubbles.

The rise and fall of the gold standard

There is a new Cato Policy Analysis piece out on The Rise and Fall of the Gold Standard in the United States (pdf) by George Selgin. The executive summary reads,

There is, in informal discussions and even in some academic writings, a tendency to treat U.S. monetary history as divided between a gold standard past and a fiat dollar present. In truth, the legal meaning of a “standard” U.S. dollar has been contested, often hotly, throughout U.S. history, and a functioning (if not formally acknowledged) gold standard was in effect for less than a quarter of the full span of U.S. history.

U.S. monetary policy was initially founded upon a bimetallic dollar, convertible into either gold or silver. Although officially committed to bimetallism, from 1792 to 1834 the United States was functionally on a silver standard. From the Civil War until 1879, a fiat “greenback” standard predominated with the exception of a few states, such as California and Oregon, where a gold standard continued to operate.

Between 1870 and 1879 numerous countries embraced gold monometallism. France ended the free coinage of silver in 1873, while the rest the Latin Monetary Union followed in 1876. But it was above all Germany’s switch to gold that prompted the United States to demonetize silver and embrace gold. Thus began the era of the Classical Gold Standard in the United States.

The Classical Gold Standard Era lasted until about War World I, when as common in times of war countries abandoned their commitment to convertibility. What followed World War I was the Gold Exchange Standard, whose failure resulted from its dependence upon central bank cooperation. Post World War II, the Gold Exchange Standard was replaced by the Bretton Woods System and its reliance on a fiat dollar. Bretton Woods finally came to an end when President Nixon closed the “gold window” on August 15, 1971.

This paper reviews the history of the gold standard in the United States, explaining both how that standard came into being despite having been neither formally provided for nor informally established at the nation’s inception, and how it eventually came to an end. It concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.