Though in the public mind, all of economics is a war between Keynesians and Friedmanites, this wasn't particularly controversial between left and right (though people on both fringes disagreed). A generation of PhD candidates built their burgeoning careers on writing about "The Great Moderation"--the kinder, gentler business cycle we seemed to have discovered in recent decades. Financial regulators certainly bought it--indeed, who wouldn't love a theory that told them that the world no longer suffered through crippling economic declines because they'd just gotten so darned good at their jobs? That confidence was the genesis of the 2004 SEC rule allowing investment banks to lever up to 30-to-1 and other follies--many of them merely mirroring similar developments in Europe.
Alas, the pundits and the professors and the regulators all turned out to be wrong. We were wrong in part because we thought the theory was much better than it actually was at recognizing and preventing disaster. But as Matthew Yglesias points out, we were also wrong because central bankers can't always do the right thing:
But the central banker who holds sway over the largest economic unit is no longer the Fed Chair. Rather, it's the head of the European Central Bank, Jean Claude Trichet. His decisions have vast influence over the fate of the entire global economy. And he seems to not be doing a very difficult job, arguing confidently that there's no risk of deflation and maintaining the ECB's lifelong obsession with inflation.This is a problem for Europe. But it's a problem for us, too. American households are increasing their savings rates which is macroeconomically counterproductive in a downturn. Counterproductive but probably unavoidable considering the past years of dissavings. But the world needs someone to be reducing savings and generating demand. And many of the people in a position to do that live in Germany. But absent a central bank that appreciates the gravity of the situation and is interested in stimulating demand, it won't happen. And all of us around the world will suffer for it. I think confidence had developed over the past few decades that whatever might come to pass, policymakers wouldn't just repeat the blunders of the Great Depression era. But that confidence seems to some extent misplaced.
Indeed--just look at the rising pressure for protectionist measures a la Smoot-Hawley. History may not repeat itself, exactly. But it stammers.
The ECB's inflation hawkery is partly just contagious German nuttiness. The German government attempted to inflate its way out of the heavy reparations exacted for World War I. The result was a grotesque hyperinflation, with workers famously being paid twice a day to counteract the daily upward march of prices. Inflation got so bad that a loaf of bread cost more than 100 million marks, and workers hauled their paychecks around in wheelbarrows. This episode has gripped the national imagination at least as powerfully as guilt over the Holocaust, leaving a powerful legacy of anti-inflationary sentiment that borders on mania. The entire northern European central banking culture is noticeably more conservative about inflation than its counterparts elsewhere.
Some of it is understandable. The ECB wants to establish credibility as an inflation hawk, because that credibility is a lot easier to maintain than to regain--just as Paul Volcker. And the Euro has several profligate members with a history of inflating their way out of debt problems or export woes--the ECB wants to keep it crystal clear that this will not be tolerated.
But even with the most sympathetic view of their actions, Europe is dropping the ball here. The euro area is being notably stingy with bost fiscal and monetary stimulus, and I'm not the only one who's stonkered by it. If fiscal policy remains too tight, it threatens the very union they're supposed to be protecting--how long can Greece and Italy, Ireland and Spain, suffer under a tight regime before one of them pulls out? And if one of them pulls out, the other weak sisters will pay sharply higher interest rates to compensate for currency risk, probably forcing them out as well.
It may be as simple as not wanting to face an outraged public. In which case, the theory of the Great Moderation, the independent central bank, may be even weaker than we thought.
Well, inflation is a concern because, just like in Germany and WWI, there is excessive debt in the system. Government debt causes inflation, and you can have inflation and recession going on at exactly the same time. It hasn't started yet, but it will. This deflation talk is a lot of hooey. We're headed for an inflationary recession.
Were the reparations really quoted in Deutschmarks? Otherwise how could they deflate their way out of it? Did the Allies really not see that?
They printed money to cover all of their other obligations because their hard cash went to the allies.
... we were also wrong because central bankers can't always do the right thing ...
You don't say!
Too bad your (along with most everybody else's) prescription of "stimulating demand" is also exactly wrong.
Mike, actually at the time they were called papiermarks and the allies knew that Germany might try this and thus demanded that the reparations be paid in material, gold, and foreign currency.
Germany didn't have enough gold or foreign currency to meet those demands, and thus they effectively printed currency to try and get them.
"In which case, the theory of the Great Moderation, the independent central bank, may be even weaker than we thought."
MM,
maybe? only maybe?
Please, be kind, stick to positive Economics, it'll be easier for anyone involved..
or, differently, maybe you could post your recipe for this brand of high-grade Prole Feed? did you open a can? pull it from a tree? or, were they brazen enough to leave an electronic trail?
Just to liven up this dullness:
http://exiledonline.com/cnbc-bitch-slaps-santelli-into-line-freedomworks-admits-it-organized-grassroots-tea-parties-jon-stewart-cancels-santelli-megan-mcardle-queefs-on-our-founding-fathers/
I’m going to ask the dumb question that has been bouncing around in various forms for a while now. Why are you assuming that inflation is preferred to deflation?
It seems to me that the EU central bank is acting rationally for a central bank that represents an area with a mentality of saving. In the US there is clearly little worry about inflation unless it reaches huge values. Since we don’t collectively save we don’t loose stored value. On the other hand Europe, on average, does save at least a little. Even without the memory of hyperinflation it seems clear that a nation of people who have something to loose in an inflationary environment would have more fear of it.
Your making this all way to complicated. The crises is actually quite simple if you recognize that both Keynes and Friedman were wrong and von Mises was right. In Human Action you will find a perfect theoretical model for what is going on right now, including even a little philosophical background.
If you, however, cling to the spoon fed academic version of economics, monetary phenomenon will continue to be "weird" to you, and nothing will make sense.
Thanks to Milton Friedman, we knew what had caused the Great Depression: the Fed's inappropriate tightening in the wake of a financial panic.
Really? Says Milton? Even if he was right about that, he was wrong about a lot of other things about the Great Depression. Also, I can't help but mention "B-52" Ben's remarks to Friedman at some gathering honoring Friedman a few years back. And the speech is the first thing you get in Teh Google if you type in "Bernanke Friedman". To wit: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." That is a direct quote. I bet Ben would like to have that back now. He's starting to be like Bill Kristol. Has he been right about anything?
Thanks to Milton Friedman, we knew what had caused the Great Depression: the Fed's inappropriate tightening in the wake of a financial panic.
No, "we" don't know that. Monetarists know that, but they are wrong. Rather, the Austrians are right: the Fed created a boom via its inflationary policy in the 20s. The Great Depression was the inevitable fallout from that. You simply cannot divert vast quantities of wealth into the production of things people don't need indefinitely.
Trichet will cave, which means that you should start buying commodities _now_.
@intj:
I think I can answer that for you.
In case of inflation, prices and wages creep up. This makes savings worth less (unless they earn more than inflation), and gives people incentive to spend money.
In case of deflation, prices and wages drop. Thus, it gives everyone incentive to save, and no incentive to spend. It basically turns money into collectors items, which will be worth more tomorrow than they are today. No investment will happen in this situation. After all, why invest money in a factory, that will be worth less tomorrow, when you can keep the money under your mattress, where it will be worth more tomorrow.
Inflation can be adjusted (if it is predictable) by having the savings earn at the same pace as inflation. In order to adjust for deflation, savings accounts will have to have a negative return rate. While that is possible, your mattress will always offer you flat 0% return, which will beat any savings account. In addition, instead of annual raises, people will have to take annual pay cuts as the economy grows.
Summation: Inflation can be dealt with as long as it is predictable. Deflation cannot be dealt with at all.
Actually, as bad as interwar inflation became in Germany, I doubt they needed wheelbarrows for the paychecks (at least until after they cashed them)!
Sorry; gallows humor.
Maybe the Germans are paying attention to Hayek and not to Friedman . . . and, as a result, following policies that approximate a more hardcore libertarianism than yours.
I wrote "how could they deflate their way out" above. Obviously I meant inflate.
So they printed money in order to buy gold and foreign currency to meet reparations, but didn't that immediately tank their currency's ability to purchase those items? Was there enough lag time in those days that they thought they could get some purchase on it? Did it work (even a little)?
Well, Beelzebub is wearing a parka today, or at least a wool sweater, since Matthew Yglesias has openly stated that central planning carries with it some inherent and predictable poor outcomes. None that apply to health care delivery, of course.
I do think that there's a pretty good chance that various constituencies will force an abandonment of the Euro in some counrties. That'll make for some more interesting times.
The PIIGS won't leave the euro - not after they've larded up on so much euro-denominated debt. I know for sure that the Irish government doesn't want to pay off its bonds in worthless new punts. Yes, Trichet is a bit too anxious about inflation, but he's been cutting rates since October and is going to cut more. You can say he's not going fast enough, but he seems to have absorbed the macro-lesson here. Personally, I'm not looking forward to the explosion of the inflation bomb in a few years. I'm one of those crazy people with little debt and growing savings. Obviously we need to be punished.
intj, read anything that Krugman has written about liquidity traps. In short, deflation can be quite self-fueling, and conventional monetary policy can't fight it.
Niall Ferguson addresses the reasons for the (hyper)inflation in Germany in The Pity of War. Important German politicians saw it coming. Essentially there was a three part political split with the creditors losing out. And many Germans were creditors having bought German War Bonds. Also, there was not the political will to overcome immediate social benefits in Germany to pay off the debt which had been reduced; Keynes was influential in having been brought over to the 'poor Germans' point of view. He had not been in favor of Britain fighting Germany in the first place.
I wonder if in theory, we could have the best of both worlds: while financial assets evaporate into nothingness (deflate), inflate the currency in job-creation spending. In theory, would these two "opposites" cancel out, and we get a stable currency, while creating jobs and writing off bad assets? I'm sure this is easier said than done!
It's interesting how Europe's crisis is different from America's, and how China and India are different as well. I suppose if we could stimulate demand in India and China, that would be the deux es machina that would get us out of this mess.
Unfortunately, Europe not only has a history of hyperinflation. Europe has a 20th-century history of falling apart completely. And this time, there won't be a Marshall Plan to save the continent.
As the equity markets continue to tank, etc., one wonders whether anyone is wise enough to call what someone else does a mistake.
Maybe Trichet is right. Maybe what is being done in the US is wrong.
Or the other way around.
Time will tell. It's only been 6 months, barely, and the effects of both schools of thought won't have an effect for another year.
Derek
Time will tell. It's only been 6 months, barely, and the effects of both schools of thought won't have an effect for another year.
What will time tell? What are your metrics for success, specifically?
Given the results we're getting from our stimulus (which seems to be zero), isn't the EU getting the same thing a lot cheaper?
(Megan - I'd like to hear your take on the huge increase in US money supply (specifically M0), especially if you're not worried about inflation.)
I guess I'm just too focused on the individual level. I've read plenty about liquidity traps. I can follow Ken's logic. Yet it still doesn't seem to completely work.
Deflation will tend to limit investment as you say but if an investment has a good return it should still get acted upon (if its rate of return is more then the rate of deflation it is still a good deal). Somehow it doesn't seem that bad to say that in a deflationary environment only the most rewarding investments are made.
Alex s:
I don't know whether to laugh or cry at your point. Its a good one.
intj:
What about all those businesses that don't post fantastic returns their first quarter? Or, what about any sort of consumer spending? Or, if you are of a liberal mindset, imagine the social inequality that would result. Older people would be tremendously more wealthy just by virtue of being old.
"Niall Ferguson addresses the reasons for the (hyper)inflation in Germany in The Pity of War."
I believe he borrowed the phrase "The Pity of War", incidentally, from this poem by Wilfred Owen:
Some might think Milt had the last word. Those would be people with closed minds.
http://www.frbatlanta.org/filelegacydocs/erq304_tallman.pdf
The evidence is mixed.
Well there is a deeper problem with this whole formulation. It pretty much ignores the cause of the stock market crash. A crash which immediately started to destroy credit.
It is insane if Milt actually said the "cause" of the depression was monetary actions after the crash. It's like concluding the cause of a plane crash was the ground. (I know this is a not entirely fair summary of Milts thesis but let's face it, this shorthand version is the conventional wisdom and Marie just repeated it)
Poor Trichet was stuck with a far more difficult situation than any Fed Chairman since the Euro Zone has so much more variation and thus complexity. Both political and practical. Trichet used to sound like a responsible central banker compared to Greeny or Ben, who will sit # 1 and #2 ahead of John Law as histories worst central banker. He talked a good game but too many things were out of his hands
Ken Magalnik writes, "In order to adjust for deflation, savings accounts will have to have a negative return rate. While that is possible, your mattress will always offer you flat 0% return, which will beat any savings account. In addition, instead of annual raises, people will have to take annual pay cuts as the economy grows."
The latter point seems to come straight out of Chapter 1 of Keynes's General Theory, which I've started reading, on the theory that I ought to be better informed about a system of ideas I disagree with. Keynes in fact says that in a period of economic contraction, workers need to take pay cuts to keep working, but mostly won't be willing to do so, and thus will be stuck in persistent unemployment . . . but if you inflate the currency and raise the general price level, you are in fact giving them a pay cut in terms of real output, but they'll be fooled into accepting it by the fact that their money wages stay the same. That's a rather breathtakingly cynical approach to economic policy and it's hard to see how it's justified as helping the disadvantaged.
As to negative interest rates, that looks like a static analysis. What I would in fact expect is that as funds are taken out of the loan market and put into mattresses, many businesses will either shut down or figure out how to operate without loans . . . but some will instead offer to pay at a higher interest rate. So the supply and demand curves will end up intersecting at a positive money interest rate, or at a real interest rate that more than compensates for the deflation rate. That will result in business activity being concentrated in businesses that have a high productivity of investment, while less productive ones will contract or shut down. But that's exactly what Austrian capital theory says is needed to correct for the damage caused by inflation and easy credit. Deflation simply speeds the process up. I find it hard to see that as a bad thing.
All I know is that I'm best off loading up on debt to buy cheap, income producing assets, and I should fix those interest rates.
It's what worked in the 1970s.
William:
Thanks for a thoughtful reply. I think the general dangers of deflation is the undershoot. As I understand it, Keynes central idea is that the markets have a certain inertia, and, as far as I know, Friedman never disagreed with that.
So as deflation sucks up available capital, profitable businesses, that could potentially operate in this environment would close shop prior to being able to make the transition, leaving their employees and owners with no income. Those in turn would be added to the large number of unemployed people who worked for the not so profitable businesses, and the whole system would settle to a much lower equilibrium. Eventually it would climb out, but how long would that take?
Personally, I don't much care for Keynes approach of the gov'ts being the lender/purchaser/employer of last resort, but I see no market method for controlling monetary policy. If you do, please share.
Megan, you'd better file the 'Eurozone falls apart' theory next to the 'Eurabia' theory (2005) and the 'Russia takes over Europe' theory (2007-8) as another US-origin EUtastrophe that isn't going to happen. Separation from the Euro is a non-starter - it would require a referendum in each of the countries mentioned above and the printing of new currencies for the express purpose of making them worthless - not something that is likely to go down well anywhere. At most, noises will be made about separation in an effort to exert pressure on the ECB - but no major political party is likely to run on separation.
You might also note that the (independent) Bank of England has also slashed inflation rates to the lowest in history in an effort to encourage greater lending - cutting it from 5% last October to 1% now. Important in the case of the bank of England is the high interest rate of the late 70s/80s, brought in for the purpose of fighting recession, but which actually produced little in the way of results. Memories of 'stagflation' are quite present.
I think that John Hulsman and Will Schirano said it best four years ago in the National Interest. “The European Union is Dead.”
And this is simply more evidence of why it is dead. On the crucial question underlying political integration — whether or not one is prepared to ‘die for the EU,’ the largest and most pro-EU member has said no.
And for good reason, because Germany knows that there is a shitstorm coming from the East and they’re going to need cash to survive it.
Damned if they do and damned if they don’t. There’s no way they have (or the rest of the West) has the money to prop up the East…and if they let them collapse, it’s going to be brutal.
Trust me, I don’t want Europe to fail…To be honest, they’ve been a net benefit for the United States since the dawn of the ECM. But for many years now, Europhiles have been telling us to ignore the facts and pretend that there was nothing that could stop the EU. I recall many a meeting where we were told of the bike that always continued forward. Well, that bike is continuing forward, off of a cliff.
We were right, they were wrong.
Now it’s time to figure out what to do about it.
Just to review.
Thanks to Milton Friedman, we knew what had caused the Great Depression: the Fed's inappropriate tightening in the wake of a financial panic. "
This Feds action after the "financial panic" as a cause of the Depression is not a settled issue. It is settled in many peoples minds but that does not make it so. Just look
http://www.frbatlanta.org/filelegacydocs/erq304_tallman.pdf
Then there is the issue of the Feds actions before the crash, the financial panic. What was the Feds role in the stock bubble and its collapse?
Should it not be considered possible that the very scale of the financial panic caused the severity of the economic contraction called the Depression? Yes it can.
Which brings us to today and Bernanke's and Greenspan's insistence that monetary measures will clean up the mess and everything will just be great. What happened after the 29 crash and is happening now is a classic debt deflation. Huge amounts of debt are going to be defaulted on. Currently the rate of default is probably higher than the rate of credit expansion. The banking system cannot function under these conditions.
Freidman's monetarism became a narrow monetarism. Narrow in scope because it ignored financial processes and among other things refused to acknowledge that asset price rises were just as much inflation as other price increases. Trillions of Treasury dollars are being committed to propping up asset prices. A fools errand that is an affront to markets. Most importantly it isn't working.
If I were a Milt explained it all and a Ben Greenspan and the Fed will make it right partisan I would start to back away slowly. For they are in the process of being thrown into histories scrap heap.
A year ago, if you had asked me, or most economics journalists, or most economists, if America would have another Great Depression, I would have said no.
A year ago, in March 2008, a large number of economists and economics journalists were predicting a historic-level recession at least and possibly worse. But Megan wasn't...she was still parroting glibertarian talking points.
FYI, the crisis was pretty well advanced in March 08, Bear Stearns went under in mid-March. Yet another example of Megan not even bothering to pay attention.
Ken: It's not obvious to me that deflation is dragging interest rates down to zero or negative in the real economy. If that is so, then why is the Federal Reserve making such a point of setting interest rates as low as possible? I would think that if the market would go there anyway, no manipulation of interest rates would be needed to take us there. Why couldn't negative interest rates be avoided simply by having the Fed let the market find its own level?
Ed Smithe: "And for good reason, because Germany knows that there is a shitstorm coming from the East and they’re going to need cash to survive it.
Damned if they do and damned if they don’t. There’s no way they have (or the rest of the West) has the money to prop up the East…and if they let them collapse, it’s going to be brutal."
What the heck are you talking about, about Eastern Europe? This problem of Eastern Europe debt is overrated.