As inflation rates continue to fall across the Eurozone one might expect Austrian economists to rejoice. After all, inflation reduces our purchasing power and acts as a hidden form of taxation. Failure to control inflation caused some of the greatest social and political disturbances of the twentieth century, and attempts to centrally plan the monetary system are destined to failure. George Selgin’s “Less than Zero” is the seminal account of how deflation can be beneficial, and why central banks should be willing to tolerate it. However it also provides a useful, and highly relevant distinction between “good” and “bad” deflation. The underlying point that needs to be expressed is that not all deflation is ghastly. Indeed the readily available examples of falling prices – such as the Great Depression – are not representative. Allowing a fear of deflation to prevent deflation in any circumstance will commit monetary policy to steady and suboptimally high inflation. The Great Moderation is perhaps the best example of the harm that can be done when we fail to allow increases in productivity to manifest themselves in falling prices. But the relevant point is whether this is the situation we find ourselves in right now.
Austrians tended to be ahead of the expectations revolution therefore to some extent it isn’t inflation or deflation per se that matters, but how it ties into expectations. If the inflation rate is falling, and especially if it’s falling more than expected, we have problems. If inflation is 2% a year, but this is anticipated, then the costs of inflation are reasonably low. If it’s -2% a year, and anticipated, ditto. The problems occur if we transition from one to the other.
Inflation in the Eurozone is currently 0.3%, and the rate has been steadily falling since early 2012. There’s two main reasons why we may expect falling pressure on prices. One is that the underlying capacity of the economy has increased. Positive productivity shocks will increase the potential growth rate, make it easier to produce output for a given amount of inputs, and make things cheaper. In terms of Dynamic AD-AS analysis, it constitutes an increase in the Solow curve. This is good deflation. But it also implies that real GDP will be rising.
Alternatively, prices might be falling because of a reduction in what Keynesians call “aggregate demand”, Monetarists call “nominal income”, or what Austrians call “the total income stream”. These are all various ways to refer to total spending. This could fall as a result of a monetary contraction, or an increase in the demand for money. It’s important to realise that whilst central banks are the prime culprits of the former, they are also a key instigator of the latter. Keynesians might blame it on “animal spirits”, but we can also think of this as “regime uncertainty”. These are two ways to treat confidence as a meaningful concept, and something that can be negatively affected by central bank policy.
Many commentators attribute low inflation to low oil prices. On the surface this seems like a positive supply shock and hence the reason for low prices is a good one. However the reason oil prices are low is because of increases in supply and decreases in demand. The former is a result of IS getting the keys to the pumps. The latter is due to a slowdown in China. Neither of these bode well for the global economy. Both of them have reduced confidence.
We can see this negative AD shock in the data. With GDP growth of just 0.7% this means that total spending is just 1%. This is significantly lower than where we would like it to be in a world with a greater rate of achievable growth and a 2% inflation target.
So what needs to be done? Austrians are loathe to advocate monetary activism and for good reason. But the goal of monetary policy is not inactivism, but neutrality. The issue comes down to the costs of adjustment. If aggregate demand remains at 1% then people will adjust their expectations, prices will adjust, and output will return to normal. During the Great Depression Hayek advocated this path, even though he recognised that prices take time to adjust, and whilst they do so unemployment would rise. His reasoning was that increasing the load on price adjustments will increase their flexibility. In a time of chronic wage and price inflexibility it was a moment to bust the unions. However he later came round to the idea that those costs were too high. The collateral damage of using a downturn to put more emphasis on nominal wage adjustments was unfair. For the mass unemployed, nominal wage rigidities isn’t their fault. So instead of placing the burden on wage adjustments, central banks have the option of maintaining a certain level of total income. This avoids the necessity of a nominal wage adjustment, in part because inflation allows real wages to adjust.
The fact that we are starting to see inflation expectations fall implies that this is only the beginning of an economic adjustment. If the total income stream continues to grow at a less than expected (and possibly even a negative) rate then we will have plenty new problems to worry about. This isn’t just the economy responding to the pre 2007 boom. This is the economy responding to fresh problems being introduced by central bank incompetence.
The difficulty for the ECB – and possibly the explanation for why things are so much worse in the Eurozone than in the US or UK – is that they don’t have the same tools available. But let’s leave a debate over tools for another time. The bottom line is that the ECB should be striving to give clear guidance and generate credibility for pursuing a steady increase in a target nominal variable. Monetary policy cannot generate wealth – all it can do is buy time for governments to sort out their competitiveness and improve their public finances. The fact that they aren’t making use of the breathing room provided by central banks is their fault. But monetary policy can destroy wealth, and a failure to maintain a steady total income stream is contributing to those competitiveness and public finance problems. I would love to believe that this impending deflation is the good sort, or that Eurozone labour markets were flexible enough to allow prices to do all the heavy lifting. But I fear that we’re seeing an impending catastrophe, and the ECB needs to take bolder action to prevent making things even worse.
For a more detailed explanation of the ideas expressed in this post, take a look at my new textbook on Austrian Economics.
I’m delighted to announce that my Austrian economics textbook is now available.
The book is aimed at time poor but economically curious people. It is based on lecture material from my courses on Managerial Economics and covers a lot of ground. The writing style is intended to be engaging but not patronising. My website contains some additional resources, including videos and reading lists:
If you have any questions I’d be delighted to receive feedback. Here’s the blurb:
[Editor's note: now that Steve Baker MP is on the Treasury Select Committee, it should be of interest to all Austrianists, and those interested in monetary reform in general, to re-visit Anthony Evans and Toby Baxendale's 2008 paper on whether there is room for Austrian ideas at the top table. Within the paper they also reference William White, of the BIS, who has made several comments in the past that are sympathetic to the Austrian School. The recent BIS Annual Report, at least relative to individual, national central banks, shows some consideration of the distorting effects of monetary policy, and the cleansing effects of liquidation (note that the BIS does not face the same political pressures as supposedly independent national central banks). It will be of major importance to followers of the Austrian School around the world to follow the progress of Steve as things develop. Below is the introduction to the paper, the paper in its entirety can be downloaded here aje_2008_toptable]
At a speech in London in 2006 Fynn Kydland surveyed ‘the’ three ways in which governments can achieve credible monetary policy: the gold standard, a currency board or independent central banks. After taking minimal time to dismiss the first two as either outdated or unsuitable for a modern, prosperous economy the majority of the speech was focused on the latter, and the issue of independence. However, the hegemony of this monetary system belies the relative novelty of its use. Indeed the UK presents an especially peculiar history, given the genesis of independence with the New Labour government of 1997. A decade is a short time and two large coincidences should not be ignored. First, independence has coincided with an unprecedented period of global growth, giving the Monetary Policy Committee (MPC) a relatively easy ride. Second, the political system has been amazingly consistent with the same government in place throughout, and just two Chancellors of the Exchequer (Gordon Brown and Alistair Darling). These two conditions have meant that from its inception the UK system of central bank independence has not been properly tested.
Our main claim in this article is that monetary policy has converged into a blend of two theoretical approaches, despite there being three established schools of thought. We feel that there is room at the top table of policy debate for more explicit attention to Austrianideas, and will survey emerging and prevailing attention amongst policy commentary.
Troubling times to be a central banker
Current economic conditions are proving to be of almost universal concern. In the UK general price levels are rising (with the rise in the consumer price index (CPI) hitting 3.8% and in the retail price index reaching 4.6% in June 2008) whilst output growth is falling (with GDP growth slowing to 0.2% in quarter two 2008), raising the possibility of stagflation. This comes after a serious credit crunch that has led to the nationalisation of Northern Rock and an estimated £50 billion being used as a credit lifeline. Most of the prevailing winds are global and are related to two recent financial bubbles. From late 2000 to 2003 the NASDAQ composite index (of primarily US technology stocks) lost a fifth of its value. This was followed with a bubble in the housing market that burst in 2005/06 leading to a liquidity crisis concentrated on sub-prime mortgages. Although the UK has fewer sub-prime lendings, British banks were exposed through their US counterparts and it is now widely acknowledged that a house price bubble has occurred (the ratio of median house prices to median earnings rising steadily from 3.54 in 1997 to 7.26 in 2007) and that a fall in prices is still to come. Also worrying, we see signs that people are diverting their wealth from financial assets altogether and putting them into hard commodities such as gold or oil.
Although academic attention to developing new models is high, there seems to be a request on the part of central bankers for less formal theory building and more empirical evidence.
Alan Greenspan has ‘always argued that an up-to-date set of the most detailed estimates for the latest available quarter are far more useful for forecasting accuracy than a more sophisticated model structure’ (Greenspan, 2007), which N. Gregory Mankiw interprets to mean ‘better monetary policy . . . is more likely to follow from better data than from better models’. But despite the settled hegemony of theoretical frameworks, there is a genuine crisis in some of the fundamental principles of central bank independence. Indeed three points help to demonstrate that some of the key tenets of the independence doctrine are crumbling.
Monetary policy is not independent of political pressures
The UK government grants operational independence to the Bank of England, but sets the targets that are required to be hit. This has the potential to mask inflation by moving the goalposts, as Gordon Brown did in 1997 when he switched the target from the retail price index (RPIX) to the narrower CPI. Although the relatively harmonious macroeconomic conditions of the first decade of UK independence has created little room for conflict, the rarity of disagreement between the Bank of England and Treasury also hints at some operational alignment. On the other side of the Atlantic the distinction between de facto and de jure independence is even more evident, as Allan Meltzer says,
Monetary policy is not merely a technical exercise
The point of removing monetary policy from the hands of politicians was to provide a degree of objectivity and technical competence. Whilst the Treasury is at the behest of vested interests, the Bank of England is deemed impartial and able to make purely technical decisions. In other words, the Treasury targets the destination but the Bank steers the car. But the aftermath of the Northern Rock bailout has demonstrated the failure of this philosophy. As Axel Leijonhufvud says,
As these political judgments are made, there will be an increasing conflict between politicians and central bankers.
Inflation targeting is too simplistic
The key problem with the UK is that a monetary system of inflation targeting supposes that interest rates should rise to combat inflation, regardless of the source. Treating inflation as the primary target downplays conflicting signals from elsewhere in the economy. In an increasingly complex global economy it seems simplistic at best to assume such a degree of control. We have seen productivity gains and cheaper imports that should result in falling prices, but a commitment to 2% inflation forces an expansionary monetary policy. As Joseph Stiglitz has said, ‘today inflation targeting is being put to the test – and it will almost certainly fail’. He believes that rising commodity prices are importing inflation, and therefore domestic policy changes will be counterproductive. We would also point out the possibility of reverse causation, and instead of viewing rising oil prices as the cause of economic troubles, it might be a sign of capital flight from financial assets into hard commodities (Frankel, 2006). Underlying this point is a fundamental fallacy that treats aggregate demand as being the main cause of inflationary pressure. This emphasis on price inflation rather than monetary inflation neglects the overall size of the monetary footprint, which is ‘the stock of saved goods that allow entrepreneurs to invest in more roundabout production’ (Baxendale and Evans, 2008). It is actually the money supply that has generated inflationary pressures.
The current challenges have thus led to an increasingly unorthodox use of policy tools, with the British government making up the rules as it went along over Northern Rock, and the Fed going to the ‘very edge’ of its legal authority over Bear Stearns. Paul Volcker made the accusation that ‘out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank’, McCallum’s rule and Taylor’s rule fall by the wayside as the New York Times screams out, ‘It’s a Crisis, and Ideas Are Scarce’.
The recent update to the MA compilation method revealed a sudden reduction in the growth rate. However this was driven by a mysterious “improvements in reporting at one institution”, which saw £85bn vanish in January 2014. I made a shadow M’ series which added this back in, but that’s not ideal.
I’ve just tried an alternative response, which is to strip MFI deposits from the measure. We can call this MAex, and here’s the series from April 1991:
If you want to see a more recent look, here it is from January 2001:
I’m continuing efforts to improve the measure.
I owe a debt of obligation to my fellow Cobdenites for kickstarting a debate about money and banking amongst the UK Austrian community. As a participant in that debate – both on this blog and on the Cobden Centre mailing list – I decided to write up a working paper on the sound money debate. I’m delighted that it has now been published, and those with institutional access can find it here (PDF).
The abstract is:
If you don’t have access, please email me and I’ll be glad to send you a copy.
Readers of The Cobden Centre blog may be interested in the recent report from Kaleidic Economics. It focuses on an analysis of Japan’s “lost decade”, and how this relates to the UK. In particular, it assesses some of the academic literature – especially from the Austrian school perspective – about whether the lost decade is a myth or reality, and what the root causes were.
You can download the report here (PDF).
I don’t think I’m adding anything original but as I understand things, George’s position rests on two claims. (1) In an “ideal” system (i.e. free banking) there would be an increase in the money supply in response to an increase in the demand to hold it. In other words the banking system would ensure that MV is stable. (2) In the present system, the costs of attempting to “do nothing” are higher than the costs of attempting to simulate a free banking system, even though you can’t do this perfectly. Therefore if V increases the Fed should increase M. Hence there is “a case” for QE.
Many Austrians deny the first point, and so it is obvious that they would reject the second. Peter Boettke is right to say that the second point doesn’t necessarily follow from the first (although I’m not totally sure if he fully agrees with the first point himself). But – and let’s take it as given that the first point is accepted – here are a few things to consider when thinking about the second point:
Finally, I sense that Pete (and many other Austrians) accept the basic arguments put forward above but just can’t bring themselves to be seen to be endorsing any action of a government agency. The analogy I use here is that the state is like a wife beater. We all see the damage being done but for whatever reason the person being beaten always offers forgiveness and a belief that things will improve over time. In which case the bystander/economist has two options. You could try to minimise the harm being caused. Or you could try to engineer an event so catastrophic she finally confronts the problem.
Maybe if the Fed tried to “do nothing” in 2008 there would have been such a crisis that faith in central banking would be completely shattered, and we would usher in a new era of free banking. In which case maybe +10% unemployment and a breakdown in monetary calculation “would be worth it”. But holy shit! Maybe if that had occurred it’d have been used as a reason to have an even more centrally planned economy, because instead of putting forward the ideas of liberty in a pragmatic, policy-oriented public debate, our best and brightest are too busy seeking the luxury of irrelevance!
I say this as someone who’s turned down opportunities to discuss the evils of central banking on TV because I know full well an uncharitable audience would fail to understand that you simply cannot spent 10 minutes defining terms and explaining caveats in a brief live interview. Bravo to anyone who has the courage to state their case publicly.
I can sleep at night because although people may mistake me as a Keynesian, a Monetarist, an endorser of monetary socialism, etc, my criticisms are more effective if they are informed criticisms; I find common ground with intellectual opponents where it exists; I have “spoken truth to power”; and I’m staying true to “good” monetary theory as I understand it. Such attacks say more about deficiencies in their knowledge than it does mine.
I have great respect for Joe Salerno and have learnt a lot from him. But I think George is right to say “there is a case for QE” and I think that needs to be opened up and discussed, not shouted down.
In light of recent events, we’re bringing forward this proposal from June 2010.
There’s two ways to view the financial meltdown that occurred in 2008. The first is that it was a rare and unfortunate blip that can be remedied with calm and enlightened improvements in the regulatory framework. The second is that it exposed a serious flaw in the entire monetary system, and is likely to be repeated unless a radical transition takes place.
It’s no surprise that politicians, bankers and regulators – the architects of the banking industry – favour the first idea. This is why their response has skirted around the edges instead of dealing with the core. Even supposedly extreme measures such as nationalising banks are in fact attempts to preserve the status quo.
For those of us who favour the second idea, 2008 provided a golden opportunity to join the public debate and present a credible alternative. Perhaps we missed it. But if indeed another crisis is coming, this article attempts to outline a 14-point plan that could be implemented quickly and genuinely reform the institutions that create financial instability.
The key aspects of this proposal have been made previously, notably by economists Kevin Dowd and Richard Salsman. It could be implemented in three phases:
Over 2 days the aim is to ensure that all operating banks are solvent
Over 2 weeks the aim is to monitor the emergence of free banking
Over 2 months the aim is the end of central banking
You can download a copy of the plan in pamphlet form here.
In my City AM column on September 4th 2012, I discussed the resource costs of a gold standard. This was triggered by reading Lawrence White’s estimate that the benefits of a commodity standard outweigh the costs once inflation hits around 4%. Due to space constraints, the calculations were not included in that article. I thought I’d provide them here. The basic analysis is (White, 1999, p.42-50).
Following Friedman and White we first need to know the ratio of gold to money. This is equal to the typical reserve ratio (like White I used 2%) multiplied by the ratio of currency notes and demand deposits to M2 (52.7%), plus the ratio of coins to M2 (0.18%).
Assuming the marginal reserve ratio is equal to the average reserve ratio, the resource cost is equal to this ratio (1.2%) multiplied by the change in money supply that would keep the price level unchanged, multiplied by the ratio of M2 to GDP.
I used 4% for the former (as a rule of thumb), and 176% for the latter (from the World Bank). All in this suggests that a gold standard would cost 0.085% of GDP, which amounts to around £31bn, or £512 per capita.
Back of the envelope calculations, to be sure. I encourage others to give it a better stab.
This article was previously published at Kaleidic Economics
Readers of the Cobden Centre may be interested in a new book by Paul Knott. “Ouch!: Ignorance is Bliss, Except when It Hurts – What You Don’t Know About Money and Why It Matters (More Than You Think)” is written for ordinary people, but provides an extraordinary overview of the financial system and why it matters to everyone.
Amongst the swathes of books released following the financial crisis, this is both readable and full of sound economics. It explains fractional reserve banking, introduces readers to Austrian economics and to behavioural finance, and is done so in a highly engaging style. It will make you laugh out loud and shake your fist in anger.
I strongly recommend it, and indeed was lucky enough to read several drafts of the manuscript. At under a tenner it’s the perfect gift for people who moan at bankers and politicians, but want to understand a bit more about the monetary system.