Monthly Archives: December 2007

The Gold Standard and the Great Depression

Pete Boettke discusses the gold standard and the depression. My thoughts are in the comments.

UPDATE: Steve Horwitz chimes in with a follow-up post.

Inefficient Credit Booms

In a forthcoming paper, Guido Lorenzoni writes about inefficient credit booms. Here is the abstract:

This paper studies the welfare properties of competitive equilibria in an economy with financial frictions hit by aggregate shocks. In particular, it shows that competitive financial contracts can result in excessive borrowing ex ante and excessive volatility ex post. Even though, from a first-best perspective the equilibrium always displays under-borrowing, from a second-best point of view excessive borrowing can arise. The inefficiency is due to the combination of limited commitment in financial contracts and the fact that asset prices are determined in a spot market. This generates a pecuniary externality that is not internalized in private contracts. The model provides a framework to evaluate preventive policies which can be used during a credit boom to reduce the expected costs of a financial crisis.

Sounds a bit Austrian. Here is a link to a non-gated version of the paper.

Housing and Monetary Policy

John Taylor looks at housing and monetary policy:

Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.

Here is a non-gated version of the paper.

Frum, Again

Avid readers may recall that I had to correct David Frum in regards to the gold standard and the Great Depression. Frum is once again attacking the gold standard, but this time with an ad hominem attack of its main proponent in the political arena, Rep. Ron Paul:

But [Rep. Paul’s] core supporters also thrill to his self-taught monetary views, which amount to a rejection of everything taught by modern economists from Alfred Marshall to Milton Friedman.

While I am certainly no advocate of the gold standard, I am quite leery of with regards to discretionary monetary policy. It is my view that the purpose of the central bank should be to limit inflation and I would prefer that this be done through an explicit inflation target. In this respect, my view is quite similar to Milton Friedman’s and thus I am quite puzzled at David Frum’s assertions. Rep. Paul’s main reason for advocating the gold standard, at least to my knowledge, is a strong disregard for discretionary monetary policy and the inflation and distortions that it can create. In this way, Paul is very similar to the likes of Milton Friedman, despite the fact that Friedman did not advocate the gold standard (for more on this, see Peter Boettke’s stellar post on Frum).

The essential point is that the debate is not so much about the gold standard as it is about monetary policy carried out by individuals and thus the potential for error. Many influential economists including Friedman, F.A. Hayek, and Ludwig von Mises expressed strong doubts about the desirability of a central bank with discretionary power over monetary policy. Hayek’s Prices and Production explains in detail the distortions that can take place due to discretionary monetary policy. In addition, Friedman advocated monetary policy rules as favorable to individuals at a central bank. So perhaps such views aren’t as out of the mainstream as Frum would have you believe.

Imperfect Knowledge

This book seems intriguing.

The Muddles of Monetary Theory

The 75th Anniversary Lionel Robbins Conference took place this week in London. While I have only had a chance to give it a quick skim, Charles Goodhart has written an intriguing paper on monetary policy entitled, “The Continuing Muddles of Monetary Theory.” Here is the abstract:

Lionel Robbins was much concerned about the methodology of economic science. When he discussed the desirable relationship between theory and ‘reality’, two of the three examples that he presented where the theoretical analysis was not sufficiently based on a knowledge of historical fact were taken from monetary economics. Indeed, monetary theory has remained prone to such shortcomings ever since. Amongst the worst are:

(1) IS/LM: the monetary authorities set the monetary base, and the interest rate isdetermined in the market;

(2) The monetary base multiplier of bank deposits, and the role of reserve ratios;

(3) The current three equation neo-classical consensus, which not only assumesperfect creditworthiness for all agents, but also an essentially non-monetarysystem, e.g. no need for banks;
(4) The standard theory of the evolution of money.Monetary economics can only get better, but it has a long way yet to go.

Here is a link to the paper.HT: New Economist