Monthly Archives: January 2011

Does Trichet Understand Inflation? UPDATED

The Wall Street Journal reports:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent’s debt crisis.

In my previous post, I demonstrated that there is reason to believe that tight monetary policy by the ECB can potentially explain the downturn in the Eurozone and, potentially, the drastic declines on the periphery like Ireland. This performance is worse when coupled with the fact that the ECB strongly encouraged the Irish to prevent bank failures providing temporary liquidity and then laying the problem at the feet of the Irish taxpayer when it turned out that the problem was worse than previously imagined.

Nonetheless, putting past performance aside, the ECB is now fearful of inflation. Unfortunately for those in the Eurozone, it is not clear to me from the article that the ECB understands inflation. For example, consider the following excerpt:

In an interview with The Wall Street Journal ahead of this week’s annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don’t gain a foothold in the global economy.

So far, so good. Rising energy and food prices might be signs of inflationary pressures. However, this is the following paragraph:

Mr. Trichet’s warning comes at a time when inflation concerns are mounting among investors around the world. Fast-growing emerging markets such as China and Brazil are seeing rising inflation at home, and their demand for globally traded commodities is pushing prices higher elsewhere.

So which is it? Are prices rising because of increased demand in Brazil and China or because of inflation? It cannot be both. If prices of globally traded commodities are rising, it could be a sign of inflation, but it could simply be a relative price adjustment — even if it is a sustained relative price adjustment. In other words, rising commodity prices are a potential sign of inflation, not the cause of inflation. There is a difference between arithmetic and economics.

Nonetheless, it could be sloppy reporting by the WSJ, except that it is not. Here is Trichet:

“All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects” on domestic prices, said Mr. Trichet in his office overlooking Frankfurt’s financial district.

And here are the WSJ reporters:

Changes in food and energy prices are largely determined on world markets, and thus aren’t directly influenced by interest rates in any one economy. For that reason, central banks in many major economies, including the U.S., put greater weight on core inflation than on headline measures. For now, Fed officials don’t see much evidence that commodity prices are feeding broader inflation in the U.S.

The WSJ reporters clearly recognize the difference between relative price adjustments and inflation. So what does Trichet really believe? Does he believe that by raising interest rates in the Eurozone that he can reduce the demand for globally traded commodities in Brazil and China? Or, is he simply just trying to anchor inflation expectations? For everybody’s sake, I hope it is the latter.

UPDATE: Kantoos uses German inflation indexed bonds to calculate a TIPS spread of expected inflation in the Eurozone. Using these calculations inflation is expected to remain below 2% over the next 5 years and even below 1.5% over the next 2 years.

The Eurozone and NGDP

Several quasi-monetarist bloggers like Scott Sumner, David Beckworth, Bill Woolsey, and myself have all been making the claim that the recession can be blamed — at least in part — on tight monetary policy as reflected in the collapse in nominal spending.

As further evidence that this might be the case beyond the United States, Kantoos, a blog reader and fellow blogger, sent me a link to a recent post on nominal GDP of the Eurozone-15 from 1996 to the most recent data release. The graph shows the trend of NGDP for the Eurozone-15, the actual trajectory, and the percentage deviation from trend. As can be seen from the graph, in late 2008 NGDP began to fall significantly below trend. While NGDP has started to grow, it is still well below the trend line — nearly 10%.

Looking at this graph, I was struck by the fact that this is remarkably similar to situation in the United States. In addition, it raises serious questions about the monetary policy of the ECB — especially considering the severity of the collapse for some of the countries in the Eurozone.

Is David Beckworth Crazy?

Not to give away the conclusion, but the answer is ‘no’. Nonetheless, the title is provocative. (Perhaps, that is why Brad DeLong uses these types of headlines).

In all seriousness, I would like to address a recent criticism of David Beckworth. Those who have been reading the blog for the past couple of years will recognize that much of what has been written has been aimed at outlining a particular framework and addressing what that framework implies. At times, this has been done for the analysis of fiscal stimulus and at other times for monetary policy. Regardless, my goal in writing serious posts on this blog for the last couple of years has been in trying to engage readers in a serious discussion about particular topics. Specifically, I have tried to outline my preferred framework for analysis and challenge those who disagree to explain why. Unfortunately, this hasn’t been as successful as I had hoped. The lack of success is not because others have refuted particular ideas, but rather the fact that those who have engaged in the debate have often merely attacked straw man representations of the framework espoused herein — especially with regards to monetary policy.

Having said all of this, the subject of this post is something that was written by Robert Murphy regarding views espoused by David Beckworth regarding monetary policy and, in particular, quantitative easing.

Murphy begins by labeling Beckworth’s views as “monetarist Keynesianism.” I would call this an oxymoron, but it seems far beyond such a simple description. The term seems to refer to the use of “Keynesianism” by certain economists of the Austrian persuasion as synonymous with “interventionism”, but I digress. I would hope that we can dispense with labels as they are often, as this example illustrates, misused and distract from the substance of the conversation.

Now, on to the substance. David wrote an article for the National Review Online attempting to justify quantitative easing. Why does the economy need quantitative easing? David Beckworth explains in the article:

[QE2] is about fixing a spike in the demand for money that has significantly hampered spending.

He then goes on to detail the behavior of aggregate nominal spending in the U.S. economy and demonstrate how it has fell short of its long-run trend and that it can be explained by tight monetary policy (excess money demand). Robert Murphy then replies:

And there you have it, clear as a bell. Paul Krugman couldn’t have said it any better. According to Beckworth, the problem with our economy is that people aren’t spending enough.

This simple idea is very powerful; it permeates our financial press when they wring their hands and wonder if “the consumer” will buy enough Tinkertoys this holiday season “to pull the economy out of recession.” But of course, if spending were really the trick to having a growing economy, then the world would have eliminated poverty long ago. No, it’s production that is the real obstacle; consumption can take care of itself.

This critique sounds harmless enough, but it misses the point. David’s argument is not predicated on the belief that more and more nominal spending will generate prosperity and eliminate poverty. Rather, David’s point is that falling nominal spending reflects excess money demand and therefore implies that monetary policy is too tight. This view is based on the concept of monetary disequilibrium. Although I have detailed this concept on a number of occasions, it seems important to resurrect this framework again; not only to demonstrate the underlying framework for David’s argument, but also to show that this view is consistent with the Austrian business cycle theory.

The concept of monetary equilibrium is rather simple. Monetary equilibrium is defined as the case in which desired money balances are equal to actual money balances. Let’s begin in equilibrium and then describe monetary disequilibrium.

Recall the equation of exchange:

MV = PY

where M is money, V is velocity, P is the price level, and Y is real output.

The two major sources of monetary disequilibrium are changes in the money supply (M) and changes in the demand for money (V). If M or V decline it is because of a decline in the money supply or an increase in money demand, respectively. This results in an excess demand for money — desired money balances are below above the actual supply. Ceteris paribus a reduction in M or V will result in a reduction in PY, or nominal spending. Since prices are not infinitely flexible, this also implies that at least part of the reduction in nominal spending will be a reduction in real GDP. Thus, it is not that David Beckworth thinks that evermore nominal spending would create prosperity, eliminate poverty, cure cancer, and turn Bob Murphy into a monetarist, but rather that the reduction in nominal spending reflects an excess money demand problem.

How can excess money demand be eliminated?

Excess money demand is reflected in a reduction in M and/or V. In a world with a central bank, monetary policy can eliminate excess money demand by reversing the reduction in M or offsetting the reduction in V. In either case, the central bank is increasing the money supply so that actual money balances increase to equal desired money balances. This is the point that David Beckworth is making.

An alternative way of thinking about monetary equilibrium is to use the interest rate rather than the money supply as a guidepost. If we define the interest rate that reflects the underlying preferences and real factors of the economy as the natural rate of interest and the interest rate that actually exists in everyday activity the market rate of interest, we can then define monetary equilibrium as the case in which the natural rate of interest is equal to the market rate.

So why is the equivalency important? Allow me to quote, at length, a wise monetary economist that I know:

The monetary equilibrium tradition is largely a European one. Much of the work on the doctrine prior to Keynes was in the hands of Swedish, British, and Austrian economists. Arguably, the whole approach begins in Sweden with the work of Wicksell, an in particular his development of the concepts of the natural and market rates of interest.

[...]

Wicksell saw himself as rescuing the Quantity Theory from what he saw as overly simplistic treatments that ignored the process by which monetary changes manifested themselves both in the price level and in real effects…

Wicksell’s work had a clear Austrian connection in its reliance on Bohm-Bawerk’s theory of capital in developing the concept of the nature rate of interest.

[...]

Hayek’s relationship with monetary equilibrium theory was also somewhat ambiguous. In some of his early writings, he defended a constant supply of money and appeared to agree with Mises’ claim that the creation of fiduciary media would disequilibrate the real capital market. On the other hand, as Selgin (1988a: 57) points out, there are numerous passages in Hayek where is recognizes that the nominal money supply should adjust to changes in the demand to hold money balances…in the second edition of Prices and Production, as we shall discuss later on, Hayek clearly call for changes in the money supply that offset movements in velocity so as to stabilize the left side of the equation of exchange. He was skeptical of the ability of any banking institution to actually accomplish this task, but he does indicate that this is desirable norm. Even as late as his 1978 book The Denationalisation of Money, he argued that:

A stable price level…demands..that the quantity of money (or rather the aggregate value of all the most liquid assets) be kept such that people will no reduce or increase their outlay for the purpose of adapting their balances to their altered liquidity preferences.

In other words, Hayek is arguing that in response to change in the demand for money (liquidity preferences), the monetary authority ought to adjust the supply of money so as to head off a scramble to obtain, or rush to get rid of, money balances.

That lengthy quote is taken from Microfoundations and Macroeconomics: An Austrian Perspective by Steven Horwitz (p. 75 -79). Thus, it is curious that Murphy would write:

As I mentioned in the introduction, this is why intellectually consistent conservatives are defecting to the Austrian camp. They can’t listen to their favorite AM radio hosts or TV pundits blast away at the stupidity of Keynesian deficit spending, and then turn right around and champion Bernanke’s attempt to stimulate aggregate demand.

What David Beckworth is arguing is that we must maintain monetary equilibrium, which is precisely what Hayek suggested was the optimal type of monetary policy not only in Prices and Production, which articulates in great detail the Austrian business cycle theory, but also in his work nearly a half-century later.

So what precisely is the Austrian critique? Murphy seems to be suggesting that any increase in the money supply generates inflation and distorts the capital structure. That view might fly with a certain band of Austrians, but it is not consistent with Hayek’s articulation of the Austrian business cycle theory and it is not even consistent with a free banking system in the absence of a central bank. Under a free banking system, banknotes would be redeemable in terms of a particular commodity. It follows that banks would routinely vary their level of reserves in accordance with the demand for money.

My objective in discussing this issue is merely to point out that David’s argument is not that more nominal spending is always better. Rather, it is the concept of monetary equilibrium that is at the center of David’s claim that quantitative easing is necessary. Accordingly, rapid declines in nominal spending reflect a deviation of desired money balances from actual money balances and, as a result, require monetary expansion to correct. In addition, this concept is not only at the core of David’s argument, but also at the core of the Austrian theory of the business cycle as articulated by Hayek and others.

Thus, Robert Murphy is free to support (or oppose) whatever policy he desires. The astute reader will note that I have not advocated a particular policy in the post. I have not done so because the purpose of the post, as with so many since the recession began, is to explicitly outline a framework rather than a caricature thereof. If one is to advocate the Austrian position and argue that David is wrong, the argument must take seriously the concept of monetary equilibrium and recognize that this concept was also at the core of Hayek’s thinking. Such an advocate would therefore have to explain why Hayek’s policy prescription was not consistent with the business cycle theory that he contributed so much to developing; or, alternatively, that we are not currently in a state of monetary disequilibrium.

Commodity Money: A Primer

Much has been said recently about commodity money.  Unfortunately, a number of the things that have been said have been misleading or misinformed.  Similarly, it is fairly strange that so many people assert the benefits OR the costs of a commodity standard as evidence for or against.  A careful analysis would suggest a comparison of benefits AND costs.  Given that the commodity money research cupboard has laid bare – for the most part – for some time, it might be useful to dust off the theory and address it in a meaningful fashion.

In order to discuss the gold standard, I will address the specific case of a pure gold standard.  Under this scenario, it is true that either gold coins circulate as money or that bank notes are backed 100 percent by gold.  If we neglect the costs associated with coining, deterioration, and debasement, these are essentially equivalent from a macroeconomic perspective.  Once this framework is discussed I will proceed to a discussion of a fractional reserve gold standard (perhaps in a subsequent post).

Suppose that resources can be used to produce consumer goods and gold.  For a given amount of resources, Rfixed, we can write a production possibilities frontier:

Rfixed = R(C, G)

Where C is consumer goods and G is gold.  The marginal productivities can be of producing consumer goods and gold are, respectively, Rc > 0 and Rg > 0.

Resource owners earn income:

Y = (Pc/Pg) C + G

Where Y is income and P­c and Pg are the prices of consumer goods and gold, respectively.

Equilibrium necessarily requires that

Rc/Pc = Rg/Pg

Or

Rc/Rg = Pc/Pg

This implies that the price of consumer goods in terms of gold is equal to the marginal opportunity cost (marginal rate of transformation).  Price changes in either industry would lead to resources shifting from one industry to another.

Under a gold standard, the price of gold is fixed.  In addition, we will assume that there is free coinage provided that the individual pays the resource cost.  With the price of gold fixed, there is a corresponding price level for consumer goods.  This highlights the main benefit of a gold standard.  With the price of gold fixed, the purchasing power of gold is fixed.  Holding everything else constant, this implies that the purchasing power of money in terms of consumer goods is fixed as well.  In other words, absence changes, the price level for consumer goods is constant.

Given this basic framework, we can summarize the mechanisms of the gold standard.

First, consider the case of a growing economy in which all industries are growing at the same rate as the overall economy.  In this case, there would be no change in the ratio of productivities.  Equilibrium implies that the ratio of prices would remain unchanged as well.  Since the price of gold is fixed, this means that the price level would remain constant.

Second, suppose that there is technological progress in gold mining, the discovery of a new mine, or that the gold mining industry is growing at a faster rate than that of consumer goods.  If we imagine a production possibilities frontier with gold on the x-axis and consumer goods on the y-axis, this implies that the production possibilities frontier gets flatter.  This implies that Rc/Rg rises as the opportunity cost of producing gold relative to consumer goods declines.  This necessarily requires that Pc/Pg rises as well.  Since the price of gold is fixed, this means that consumer prices will rise.

Third, it follows that if the rate of technological progress in consumer goods outpaces that of gold mining or if there is simply a lack of gold discoveries to keep the pace of gold mining in line with the rate of growth in consumer goods, the opposite change would occur.  In this case the opportunity cost of producing consumer goods would fall relative to that of producing gold.  This implies that Pc/Pg would fall.  With the price of gold fixed, consumer prices decline.

Each of these three examples described above concerns a change in flows.  It is possible, however, that a change in stocks might also have influence on the gold standard.  In order to discuss the role of stocks in this analysis we need to extend the framework as follows.  First, define the quantity of gold as the sum of monetary and non-monetary gold:

G = (M/Pg) + Gnm

Where G is gold, M is the quantity of money, and Gnm is the quantity of non-monetary gold.

In addition, monetary equilibrium is defined as when the supply of monetary gold (M/Pg) is equal to the demand for monetary gold:

M/Pg = L[Y, (Pc/Pg)]

Now, suppose there is an increase in the demand for money.  The effects can be considered in the context of stock/flow equilibrium.  An increase in the demand for money is an increase in the demand for the stock of monetary gold.  The increase must be offset by a reduction in the demand for non-monetary gold, consumer goods, or a combination of both.  If the increase in money demand corresponds with a reduction in the demand for non-monetary gold, there is no further adjustment necessary.  The individual essentially just takes non-monetary gold to the mint.

If, however, the increase in the demand for gold corresponds with a reduction in the demand for consumer goods, the prices of these goods decline thereby increasing the purchasing power of gold.  It follows that an increase in the purchasing power gold encourages an increase in gold production.  However, since gold production is (usually) a small proportion of the existing stock of gold it takes an extended period of time for the adjustment to take place.

This adjustment likely results in reduced total output and lower prices, which is to some extent why deflation has been considered a poor outcome.  It is important to note, however, that in the first three examples we were concerned with flows rather than stocks.  In the case of flows, the fact that gold production is a fraction of the total stock of gold makes the adjustment process smoother.  Thus, when there is an increase in productivity in the consumer goods industry relative to the gold industry, the prices of consumer goods fall and deflation is associated with economic growth rather than economic contraction.

Finally, the last possible change to consider is a change in the price of gold.  As the model has been written, an increase in the price of gold would not affect the real side of the economy and therefore would only result in a corresponding increase in the price level of consumer goods.  In reality, however, the increase in the price of gold would result in a relative price change making consumer goods cheaper, which would increase the demand and production in consumer goods.  This would therefore entail temporary real effects that would ultimately result in a higher price level for consumer goods.

This discussion of commodity money, while somewhat long-winded, should highlight several important concepts.  First, it should be clear that the primary advantage of commodity money is that by setting the price of gold (or any such asset), the price level remains constant – absent any changes.  If gold production and consumer goods production grow at the same average rate over a period of time, the average price level will remain unchanged.  Second, the demand for money is important because if changes in the demand for money correspond with changes in the demand for consumer goods, these changes produce changes in the price level of consumer goods.  Since the gold mining is small relative to the stock of gold, this implies a long adjustment process.  Finally, changes in relative productivity across industries induce changes in the flow of consumer goods and the flow of gold.  These similarly entail an adjustment process, but that process is mitigated to some extent by the fact that the flow of newly mined gold is a fraction of the total stock.

A careful discussion of commodity money would require consideration of the costs and benefits.  Since much of the framework that I described above was based on that found in Niehans’s The Theory of Money, I would conclude the post with a quote from that text (p. 140):

“Commodity money does not exist today.  It is also not ideal in the sense that it is relatively easy to imagine non-commodity systems that are intellectually more satisfying than commodity money.  In fact, a non-commodity system, since it gives monetary policy more freedom, can if it is ideally managed, always do at least as well as any commodity money system and probably better.  Commodity money has therefore been denounced as a ‘barbaric relic’ from less enlightened stages of human society.  Yet, from a practical point of view, commodity money is the only type of money that, at the present time, can be said to have passed the test of history in market economies.”