It's private!

In the midst of my previous argument about the gold standard, a number of libertarians advocated private money. Perhaps it would work. But there's a big empirical hurdle to overcome, notably, why doesn't it already exist? There's no reason that you couldn't start your own currency now; sure, you couldn't pay your taxes with it, but assuming a reasonable exchange rate, even that wouldn't be a problem.

We already have credible currencies with pretty strong competition between them. Why would anyone adopt yours? If you think you have a good answer, you should start a bank.

Shhh! It's a secret

At least I hope so. Greg Mankiw points out that the Fed already seems to have let interest rates fall:

Robert Barro emails me:

Did you know that the average Fed Funds rate for August was 5.0%? That is, the Fed already cut rates by a quarter point--it just did not announce it.

He is right: The intended Federal Funds rate is still at 5.25, but the actual rate was 5.02 in August.

In the preceding 13 months, the Fed missed its target by no more than a single basis point. But then in August it misses by 23 basis points. Why? Is this an unannounced change in the target, or is the Fed getting worse at hitting its target?

Let us hope very much that the Fed is just foolin' us. Now would not be a good time to learn that monetary policy is getting more difficult to target.

There's gold in them thar standards!

Someone rather more partial to Ron Paul's arguments in favor of the gold standard than I am asks me to write a post outlining my objections to it. All right, here goes.

Money is a mysterious thing. It is a store of value, it is a medium of exchange. It is, in a fiat currency economy, worth only what people think it is worth, and what they think it is worth can be oddly affected by what they think it may be worth in the future, resulting in self-fulfilling feedback loops (at least in the short term). Even in non-fiat currencies, such as the gold standard, the value of the underlying asset can be changed by rising (or shrinking) demand for money. Economists studying this fascinating topic tend to suffer from migraines as they suffer from all the mysterious--hell, nearly mystical--attributes of money.

However, over the last fifty years, economists have settled on some very broad areas of consensus. The first is, as famous libertarian monetary economist Milton Friedman wrote, "inflation is always and everywhere a monetary phenomenon". When the supply of money outstrips the demand, prices rise. And this is by no means limited to fiat currencies; see the great Spanish inflation of the 16th & 17th centuries, thanks to the steady influx of gold from the New World. Or check out the price of basic commodities in mining towns during the Gold Rush, when all anyone had was gold.

The second is that a little bit of inflation is okay--possibly even beneficial, since it helps the economy to overcome the problem of sticky wages when the relative value of labour has fallen. But a lot of inflation is very, very bad. Exhibit A is Zimbabwe; Exhibits B-∞ are every other economy that has had inflation near or above the double-digit mark; the higher the inflation, the worse the economy did. The feeling that the currency will experience an unpredictable amount of inflation dampens the willingness of the citizens to save and invest, which is why so many third-world loans are denominated in dollars.

The third is that deflation is also bad, and at the lower percentage values, often even worse than inflation. This surprises/offends/meets with the frank disbelief of many "sound money" types, who think that, barring local shortage, in an ideal world everything ought to cost the same or less than it did when Grandpa was a boy. (These sorts of opinions are cemented further by the fact that Grandpa, who is often the source of them, is usually living on a fixed income, and therefore feels that he would make out better in a deflationary economy.) The problem is, deflation does rather devastating things to anyone who has debt, since they now have to repay what they borrowed in more expensive dollars. Deflation means that, thanks to the abovementioned sticky wages, the economy has to deal with demand shocks by lowering output. Deflation can result in what's known as a liquidity trap, a concept pioneered by liberal economist John Maynard Keynes and best elucidated by liberal economist Paul Krugman back before he left economics writing to focus on his hatred of George W. Bush. Deflation is what made the Great Depression so memorable. Deflation is so bad that almost everyone agrees that moderate inflation, in the range of 1-2%, is better than risking even a small amount of deflation.

Advocates of a gold standard dispute this. They argue that America experienced a long, slow deflation throughout most of the 19th century, without anyone getting hurt. What they neglect to mention is that people did get hurt, repeatedly, in the period's awful financial contractions. Though we don't have modern economic statistics for the period, it's pretty clear that recessions were longer and deeper than they are now.

This is not only due to the gold standard; the era's primitive financial system and its approach to financial regulation, which often ranged between lighthearted and foolhardy, also played substantial roles. But the gold standard also has to stand up and take a bow. There's a strong correlation, for example, between how long a country hewed to the gold standard, and how badly it suffered from the Great Depression.

The gold standard cannot do what a well-run fiat currency can do, which is tailor the money supply to the economy's demand for money. The supply of gold grows--or not--depending on how much of the stuff is mined. Demand also fluctuates for non-economic reasons; gold has uses besides being money, like industrial components and jewelry.

The lone advantage of a gold standard--and it is a real advantage--is that it prevents governments from inflating the currency. The problem is, this is only moderately true. The government, after all, can always modify its gold standard. Yes, you say, but it will pay a price in the markets, and this is true, but this is the same price it pays when it prints more fiat currency. Such practices do not go unnoticed for long.

As James Hamilton has pointed out, gold-backed currencies, like all money with a fixed exchange rate, are subject to speculative attacks whenever the government's financial position looks weak. Such speculative attacks often require punitive economic measures to fight off, which is one of the reasons that America suffered so nastily from the Great Depression--it raised interest rates in the middle of a recession in order to defend the credibility of its currency.

Also, since devaluations tend to produce sharp changes in the values of currencies, rather than smooth appreciations or declines, the economic dislocations are magnified. Imagine you're a company with a contract denominated in dollars. If the value of the dollar gradually declines, you lose a little, but not too much, since you periodically renew the contract, giving you time to adjust the amounts. If, on the other hand, the devaluation pressure builds up over a period of years, and then all at once the government has to devalue by 20%, you end up badly hurt. You might go out of business. Now multiply that all across the country, and you can see why recessions used to last for years.

In short, you don't get anything out of a gold standard that you didn't bring with you. If your government is a credible steward of the money supply, you don't need it; and if it isn't, it won't be able to stay on it long anyway. (See Argentina's dollar peg). Meanwhile, the limitations on the government's ability to respond to fiscal crises, the necessity of defending against speculative attacks in times of crises, and the possibility of independent changes in the relative price of gold, make your economy more unstable. It's a terrible idea, which is why there are so few economists willing to raise their voices in support of it.

Rah, rah, Ron?

Most of my libertarian friends seem to love Ron Paul. Their descriptions of his presidential campaign have a wistful "If only . . . " quality to them that I haven't seen in a political discussion since the write-in campaign by the girl's field-hockey team to elect Christian Slater president of the student council.

After my much-regretted decision to vote for George W. Bush in 2004, I've kind of been sitting on the political sidelines. I'm pretty sure I'll hate whoever gets elected. Rudy might be funny just to see the ACLU get all misty and nostalgic about the current administration, but that probably won't make up for having to wear uniforms and go to bed at 10 o'clock every night. John McCain lost me at the execrable McCain-Feingold finance reform, and has not exactly covered himself in glory since. I'm not even sure what one calls his peculiar politics: popuwafflism? Mitt Romney's specialty seems to be a blandness so total that I have difficulty recalling what he looks like, broken by inexplicably revealing stories about, for example, his penchant for strapping dogs to the roofs of cars.

Vote Democrat, you say, then. John Edwards teeth sure are pretty, but his economic polices sure aren't. Hilary Clinton . . . even if I were disposed to vote for her vintage 1967 earnest technocratic policies, I'd be more than a mite uncomfortable with a political lineup that went Bush, Clinton, Bush, Clinton. Which means I'm probably going to end up voting for Obama just because I like his senior economic advisor, Austan Goolsbee . . . and then regretting it as soon as he actually starts doing things.

But I digress. The point being that, having pretty much opted out of paying attention to politics, I've just kind of assumed that I would like Ron Paul to be president, if only the thing weren't totally impossible.

But then every time I hear about his actual policies, I'm pretty thoroughly appalled. He voted against CAFTA and wants us to withdraw from the WTO. Perhaps unsurprisingly, he's also hardline on immigration. He favors the stupid Cuba travel ban even though the Communist Menace evaporated almost two decades ago. And last week, sitting with one of his supporters at a wedding, I found out that he wants to move America back onto the gold standard. I cannot, in good conscience, even entertain the hope of electing a man who wants to outsource our monetary policy to Anglo-American.

Fast and loose

Over at Felix Salmon's place, guest-blogger Yves Smith chastises Alan Greenspan:

Remember, a central banker actually has very few policy tools, and monetary policy is a blunt instrument. Moral suasion is one of their powerful but often not effectively used instruments. Greenspan, unfortunately, was an enabler, fond of impenetrable statements that left everyone perplexed but not worried since in the end he'd open the money tap in times of trouble. It was a hollowing out of the role of the central banker who, as William McChesney Martin famously remarked, was supposed to take the punch bowl away just when the party was getting good. Greenspan didn't merely help create widespread asset inflation via overly aggressive rate cuts in 1998 and 2002, but also set a tone that makes it hard for his successor Bernanke to deliver tough messages.

If there were ever any doubts about Greenspan's willingness to rock the boat, they were dispelled, irrevocably, on December 6, 1996. Greenspan, the evening before, had used the now famous phrase, "irrational exuberance," as a question rather than a statement about a recent runup in the equity markets. The Nikkei fell 3% overnight. European markets traded down 2-3%. The Dow dropped 145 points before rallying late in the day.

And Greenspan took the trouble to clarify his remarks and retreat from any implication that stocks were too high.

Now readers might think this confirms Greenspan's power, but actually it shows the reverse. The stock markets are not the Fed's job. And worse, a Fed chairman should not try to talk the markets up. This revealed how Greenspan was hostage to the markets, and that attitude may have taken root at the Fed.

I'm not sure I'd cite William McChesney Martin as an example of a fellow who took the punchbowl away when the party got going; during the last five years of his twenty-year fed term, he allowed inflation to spike from 1.6% in 1965 to 5.7% in 1970, rather higher than is thought fitting by today's central bankers.

I think it's justified to fault Mr Greenspan for concern with the stock market . . . only most of the people mad that he worried about falling prices were also mad that he didn't pop the stock bubble by raising rates. As a friend reports, he once saw Greenspan heckled by one Punchbowl Paul, who demanded to know why he hadn't done something about the speculative bubble.

Greenspan blinked, then said "If you're asking whether we know how to use the tools of the central bank to deflate a stock market bubble, the answer is yes." He then stood silently while the various financial types in the room pondered just how high he would have had to raise rates, and margin requirements, in order to pop that particular bubble, and the fairly hideous economic effects that would have resulted from such an action.

But I don't think that the world would have been a happier place if Greenspan had kept the lid on the punchbowl in 1998 and 2002. We haven't had a really bad, deep recession in 26 years, and it seems reasonable to think that the Fed's willingness to control inflation, while releasing liquidity as necessary, are very much responsible for that change. Had Greenspan not opened the taps when times got tough and markets were unhappy, we might well have had some really nasty fallout.

The problem really is that central bankers, like most government institutions, are equipped to fight the last war. Alan Greenspan (and now Ben Bernanke) had excellent tools to deal with price inflation and liquidity problems. But our central bankers don't have much on tap to deal with asset price inflation, i.e. speculative bubbles. Nor do they have any way to keep a flood of capital from flowing into our markets and lifting all boats, so to speak . . . nor from flowing back out and leaving us to deal with the mess. In the latter case, I don't think that they should have those tools. But that means they can't protect us from all bad financial events.

Roundabout

The next question about higher Chinese wages is, what does it mean for us?

There's a lovely psychic benefit to thinking of Chinese workers getting wealthier, happier and healthier, all while supplying us affordable HDTVs. Some analysts, however, are worried that this benefit will come at a stiff cost to us: inflationary pressure from Chinese exports. For some years now, the falling price of goods from China has helped hold down inflationary pressure in industrialised nations. But with wage and commodity bottlenecks appearing, Mervyn King, the governor of the Bank of England, fretted publicly last year that rising Chinese export prices would reverse that pressure upward. As Chinese inflation has gotten stronger, other analysts have joined him.

This would be a particularly bad time for that to happen, as the central bankers, particularly America's, would like some room to cut rates if there are liquidity or other economic problems. If Chinese goods are getting more expensive, that will be harder.

But as my former employer wrote earlier this month, these fears are overblown. Much of the inflation is in local goods such as prepared food. And while wages are rising, productivity is rising even faster, holding down the price of the goods shipped. To the extent that export prices are rising, this is more a result of China's looser yuan policy than an outflow of domestic inflation.

Of course, to Americans shopping for electronics and other China-made gear, the difference is theoretical; price pressure is still up. But we could fight that by backing off the Congressional obsession with a weak-dollar policy. As the article concludes: "The real threat to America's inflation is not that Chinese export prices start to rise modestly, but that Congress is short-sighted enough to impose protectionist measures which prevent American consumers from continuing to buy cheap Chinese imports."

Dont panic!

I am trying not to read any significance into the fact that just as I leave The Economist for this shiny new blog at The Atlantic Monthly, the financial markets melt down. Sure, the timing may be correct . . . the market began tanking about a week before my last day, which is par for insider trading deals. But it would be paranoid to take this as any sort of an omen. Wouldn't it?

Not that this is stopping anyone else in the market from looking for inauspicious auguries. Over the last few weeks, I've heard the situation compared to any number of financial crises that preceded really nasty recessions: the 1929 stock market crash, of course, but also more recent debacles, such as Japan and Sweden in the 1990s. Sweden's economy contracted for years, while Japan is only now, just-maybe-barely-we-hope?, pulling out of a slump that lasted for more than a decade. This was very amusing for anyone who owned a copy of Rising Sun, but somewhat less so for the Japanese people.

But for all the ponderous proclamations, the parallels between those economic disasters and our current situation are less than compelling. Don't get me wrong: what is happening in the markets is bad. Very bad. Now is not a fun time to be either a homeowner, or a hedge-fund manager, and from what I can tell I am the only person left in the United States who isn't at least one of those things. The stock market may fall for a longish time, some people will be thrown out of work, and the economy, which has been flirting with recession for quite some time now, may finally decide to go all the way.

But that does not mean that you should start pricing apple-carts or prime spots beneath bridges to pitch your cardboard box. Having a nasty market contraction does not mean that your economy automatically goes down the tubes. It particularly does not mean this in a large, diversified, fully developed economy such as ours.

The dire economic problems in Sweden and Japan, and America in 1929, were only touched off by financial crises. It was central banking errors that turned them into full-fledged disasters. As private markets were collapsing, the central banks kept money too tight. So what had been a temporary situation in a single market spread out in concentric ripples, until the resulting waves had pretty thoroughly scuttled the entire economy.

There were various reasons that this happened. Sweden was trying to defend its exchange rate; America was trying to stay on the gold standard; and Japan . . . well, Japan had a lot of weird reasons for what it did. But none of them apply in America now. Ben Bernanke is known, among those who follow the Fed, as "Helicopter Ben" for famously saying that he'd drop money out of a helicopter onto Americans if more traditional methods for goosing the money supply failed. He's acted pretty quickly to move liquidity into the markets, and pretty clearly stands ready to deliver more if he thinks it's necessary.

Even less appropriate are comparisons to developing countries. We have robust, deep financial markets; an independent central bank; a (no, seriously) fairly modestly sized debt and budget deficit; and most importantly, we all borrow in our own currency. We are not going to turn into [insert developing country that had a financial panic] even if Helicopter Ben falls asleep at the joystick.

So while I wouldn't say you should be exactly sanguine about the mess in the markets, it's not time to panic yet. Save that for the Yankees' pitching lineup.