Friday, May 13, 2011

Hard Money Advocates are Their Own Worst Enemy

Hard money advocates have been taking a beating in the blogosphere over the past few days, complements of Matthew Yglesisas, Paul KrugmanMike Konczal, and Ryan Avent.  These critics make some good points about the hard money view.  Here is Avent's critique:
The hard money approach is atrocious economics. I don't think it's outlandish (or even particularly controversial) to say that the biggest difference in the outcome of the Great Recession and the Great Depression was the change in central bank approach to policy. An economic catastrophe was averted. What's more, hard money is a great force for illiberalism. Sour labour market conditions fuel anger at the institutions of capitalism and free markets. And when countries are denied the use of normal countercyclical policies, they quickly reach for illiberal alternatives like tariff barriers.
These points are often overlooked by hard money supporters.  There is, however, an even bigger problem for them.  Most hard money advocates are in the GOP which also happens to be calling for fiscal policy restraint.  The belief is that hard money and sound government finances are necessary for a robust recovery to take hold.  The problem is that the hard money approach--which means tightening monetary policy--makes it next to impossible to stabilize government spending.  It also makes it likely the economy will further weaken. 

How do we know this?  First, in almost all cases where fiscal tightening was associated with a solid  recovery  monetary policy was offsetting fiscal policy.  Last year there was a lot of attention given to a study by Alberto F. Alesina and Silvia Ardagna that showed large deficit reductions were often followed by rapid economic expansion.  Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates.  Fiscal tightening coincided with a recovery only because monetary policy was easing. 

Second, a key lesson of recent years is that monetary policy overwhelms fiscal policy.  Thus, from 2008-2009 when monetary policy was effectively tight the easing of fiscal policy didn't quite pack much of a punch.  Similarly, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.  

Third, another lesson from the recent crisis and the Great Depression is that if tight monetary policy is dragging down the economy it opens the door for more active fiscal policy.  Imagine if the Fed had been able to stabilize nominal spending more effectively and thus prevented the economic collapse in late 2008, early 2009. It would have been a lot harder to justify the large fiscal stimulus package. The same is true for 1929-1933.  Had the Fed not been passively tightening monetary policy at that time there would have been far less political support for fiscal policy and government intervention in the economy.

All of this indicates that calls for tight monetary and tight fiscal policy simply don't make sense for the GOP.  Such an approach would most likely cause the cyclical budget deficit to increase even if the GOP successfully lowered the structural budget deficit.  More importantly, with tight monetary policy there would probably be no recovery to show for the budget deficit cutting. This would make it politically tough to do further fiscal reforms. If the GOP wants to meaningfully address budget problems it needs to soften its stance on monetary policy.  Otherwise, it risks becoming its own worst enemy.

Update:  Paul Krugman comments on this post.  Here is  my reply to him.

15 comments:

  1. I wish the article would point out that the Great Recession is still ongoing and the full effects of current policy won't be known or understood for decades to come.

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  2. Hard money is a flat Earth religion - it defines money in terms of gold (as opposed to a transactional medium and a store of value) and rejects the notion that money can be tight when on a gold standard. Its appeal is that it is simple and easy to understand, and translates well in a political forum.

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  3. The GOP has no capacity for learning. Hard money was also their faith in the Great Depression. We all know how well that worked out for them last time, don't we.

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  4. Having a gold standard is like have a policy rule. The money supply will grow at the rate of gold production, say, 2% per year. And if there was a sudden change in the demand for money, the supply of money would not be able to adjust accordingly. This would lead to problems not unlike what we experienced during the great recession. But those who bust on hard money advocates should realize that the Federal Reserve has not been an improvement over pre-Federal Reserve macroeconomic volatility.

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  5. there are honest hard money advocates, and then there are people who will say absolutely anything to improve the bargaining power of capital.

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  6. One has to distinguish between hard money advocates who reject fractional reserve banking and those who accept fractional reserve banks but object to government control over the supply of base money in such a system.

    The former, who view any Fed action to increase the money supply as an artificial loosening, are subject to the empirical criticism leveled in this post.

    The latter, however, argue that a system of fractional reserve free banking allows for the adjustment of the total money supply (including banknotes and demand deposits) to meet money demand even when the monetary base comprises a commodity money. They therefore acknowledge that if we must have a central bank, its best policy, which is the policy that would best simulate monetary conditions under a free banking system, requires money supply increases in the face of increasing money demand (insofar as such demand can be detected).

    I'm sure you, David Beckworth, realize this given your previous references to the work of free bankers like George Selgin, but it deserves clarification in this post.

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  7. 1.The Great Recession is not ongoing. There may be another recession, but global recovery, whether slow or weak, has commenced.
    2.The end of fractional Reserve banking was the goal of socialists and populist in the hope of taking money creation away from private finance. Some hard currency advocates try and use the same line, but it doesn't work. Hard currency and a non-fractional reserve banking system don't jive. Even Hayek basically admitted this
    3.Fractional Reserve banking leads toward a "central bank" because of transfer payment crisis associated with fractional Reserve banking. By 1907 America simply couldn't politically handle it anymore. So populists dropped their anti-fractional Reserve crusade in a comprise that lead to the Federal Reserve System. People like Selgin live a fantasy. One that does not exist in nature.

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  8. LowerRates=/=EasyPolicyMay 17, 2011 at 6:59 AM

    Dr. Beckworth:

    You said

    "Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates. Fiscal tightening coincided with a recovery only because monetary policy was easing."

    Why are you conflating lower interest rates with easy monetary policy? They don't necessarily coincide. You cannot claim that monetary policy was easier *because* interest rates were falling. It does not follow. Hey, isn't it you quasi-monetarists who keep harping on this point?

    Wouldn't it be more accurate to focus on Treasury purchases made by the Federal Reserve, or some aggregate money stock measure like M1/M2/MZM/etc?

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  9. Last commentator,

    Yes,lower nominal interest rates do not necessarily mean easier monetary policy. My own preference for the stance of monetary policy is looking at the growth of nominal spending.

    Unfortunately, the IMF study I cited above only looks to short-term interest rates as the stance of monetary policy and so I mentioned their measure of the stance of monetary policy in the post. I should have been more clear on that.

    With that said, short-term nominal interest rates in normal circumstances (i.e. not in zero-bound settings like the present)do an adequate job indicating the stance of monetary policy. The time period in the IMF study is for the most part normal times.

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  10. LowerRates=/=EasyPolicyMay 17, 2011 at 9:51 AM

    David,

    Yes,lower nominal interest rates do not necessarily mean easier monetary policy. My own preference for the stance of monetary policy is looking at the growth of nominal spending.

    Fair enough, but that is NOT what you said in this post. In this post, you definitely equated lowering interest rates with loosening monetary policy. You did so by favorably referring to a study that considers only lowering interest rates.

    Unfortunately, the IMF study I cited above only looks to short-term interest rates as the stance of monetary policy and so I mentioned their measure of the stance of monetary policy in the post. I should have been more clear on that.

    But then you cannot use the study as evidence that declining fiscal deficits lead to recovery only if monetary policy is loosened! It appears that you just jumped on the conclusions made by the IMF because it serves as a relief, a vindication, that your nominal GDP theory can remain alive.

    But by favorably citing the IMF's "lowering interest rate" study, as alleged evidence that austerity cannot "work" unless it is accompanied by loosening monetary policy, you are clearly giving the impression that you yourself equate lowering interest rates with loosening monetary policy, which contradicts everything you have said about interest rates and monetary policy.

    If you say that we cannot look to interest rates to know monetary policy looseness, then you cannot refer to the IMF study as if it vindicates the nominal GDP theory!

    Only if the IMF study referred to money stock aggregates, or nominal spending, can you say that it serves to undercut the "fiscal austerity works regardless of nominal GDP" story.

    With that said, short-term nominal interest rates in normal circumstances (i.e. not in zero-bound settings like the present)do an adequate job indicating the stance of monetary policy.

    But this contradicts the argument you use to chastise others, say the Austrians, who refer to lowering interest rates as signalling easy monetary policy "in normal times." But chastising them is exactly what you have done on many occasions in the past for doing exactly that. You have on many occasions said with conviction that it is wrong to refer to interest rates when discussing matters of how loose or tight the Fed is running monetary policy. Now you are saying it's OK to do that? Come on Dr. Beckworth, you're using the same thing to argue two different conclusions.

    On the one hand, you said that we should not look at nominal interest rate alone if we want to know how loose monetary policy really is. That's when you want to refute theories that are contra your nominal GDP theory.

    But on the other hand, you say that it's OK to look at lowering interest rate alone if we want to make judgments on how loose monetary policy really is. That's when you want to undercut the austerity theory and provide support for your nominal GDP theory.

    You can't have it both ways. If your position is that the targeted interest rate does not necessarily show us anything with regards to how loose monetary policy really is, then you cannot use the IMF study as a gotcha against the pro-austerity anti-nominalGDP crowd.

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  11. You can't have it both ways. If your position is that the targeted interest rate does not necessarily show us anything with regards to how loose monetary policy really is, then you cannot use the IMF study as a gotcha against the pro-austerity anti-nominalGDP crowd.

    No, in this case I can have it both ways. The reason being is, as you note above, that though interest rates do not necessarily always reveal the true stance of monetary policy sometimes they do an adequate job. In the IMF study case that is true for most of the period examined. Only the last year in the study (2009) is it potentially problematic.

    Most issues in life are more nuanced than an either or outcome. This one is no different.

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  12. LowerRates=/=EasyPolicyMay 17, 2011 at 7:06 PM

    No, in this case I can have it both ways. The reason being is, as you note above, that though interest rates do not necessarily always reveal the true stance of monetary policy sometimes they do an adequate job. In the IMF study case that is true for most of the period examined.

    So if the Fed lowers interest rates in "normal times," and they fall from say 7% to 5%, would you characterize this as "easy monetary policy," even if nominal GDP was flat or even falling?

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  13. LowerRates=/=EasyPolicyMay 18, 2011 at 9:39 AM

    One more point Dr. Beckworth:

    It is expected that fiscal austerity would be accompanied by falling interest rates, but not because of action by the Fed, but because of the very nature of austerity.

    By reducing deficits, the government reduces the "crowding out" of private investment, which means there are more financial resources available for private investment, which will, all else equal, reduce interest rates.

    So it should not be surprising that fiscal austerity throughout history correlates with falling interest rates!

    Combine this with your own previous position (before you completely reversed course and contradicted yourself) that one cannot use interest rates alone to determine how expansive monetary policy actually is, then I think it's pretty clear that austerity works and explains why austerity economies recovered.

    Have you even considered whether or not all the episodes of austerity in the Alesina paper, that the IMF considered, were indeed followed by monetary expansion to offset the fall in government spending, such that nominal GDP increased? Or are you just staying in the "contradict myself" land of focusing only on interest rates?

    Falling interest rates do NOT imply expansionary monetary policy. You accept this, and yet you contradict yourself when you refer to the falling interest rates as per the IMF as showing expansionary policy! You say you can have it both ways, but no, you cannot. You're contradicting yourself and for some reason you think you can do this and still make a reasonable argument.

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  14. It strikes me that few people ever mention Estonia, which was one of the fastest-growing countries in Europe, and I believe the fastest-growing former Soviet state before 2008, and a perfect example of hard money, tight fiscal policy. Tight money policy via a currency board. Tight fiscal policy, they've had to dramatically cut spending because they do not have the ability to run deficits constitutionally. Unemployment is 13-14% as a result. Deflation appears the only way out.
    Recent elections seem to indicate the public likes sticking to these guns-- Estonia is a different place.
    But conservatives who advocate hard money right now need to point to an Estonia and say "I'm okay with 13-14% unemployment."

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  15. Interestingly these arguments are made by the Eric Dennis with almost no factual evidence or data backing the claims.

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