Tag Archives: monetary policy

Bitcoin and Endogenous Nominal Rigidities

One supposed problem with Bitcoin taking over the world, critics say, is that lack of a central bank precludes countercyclical monetary policy. When aggregate demand grows more slowly than expected, you want the central bank to increase the money supply in order to induce people to spend. The argument is fair enough as far as it goes, but it is undercut somewhat by the growing literature on endogenous nominal rigidities.

At the core of New Keynesian models of monetary non-neutrality is price stickiness: how quickly do firms and workers update prices and wage demands in light of new information about nominal shocks? Most models follow Calvo in assigning producers an exogenous frequency of price changes.

But the endogenous nominal rigidities literature asks an important question: what if instead of changing prices according to an assigned schedule, firms can choose how often they update their prices? Furthermore, what if they make that choice in response to monetary policy? When monetary policy focuses on price stability, firms will choose to update their prices less frequently, conserving on the resource costs of changing prices (menu costs, as Mankiw calls them). When monetary policy focuses on the output gap (or, by extension, when monetary policy is erratic, which is important for analysis of Bitcoin), they will choose more price flexibility in spite of the higher menu costs. More price flexibility means both that nominal shocks have less bite and that monetary policy is less effective.

What does this mean for Bitcoin? If we simply model the Bitcoin money supply as set by an incompetent central banker, it means that in a world in which Bitcoin rules the currency roost, firms and workers will choose nearly complete wage and price flexibility and nominal shocks won’t matter as much.

That’s not such a bad world. The big downside is the menu costs—people will need to adopt systems that ensure complete pricing flexibility—but with improvements in information technology, menu costs are lower than ever before. For long-term contracts, people would index to a basket of goods, or as I’ve suggested, to GDP.

This world is also not unprecedented: for most of human history, we have not had central banks, and therefore humans have taken steps to decrease price rigidity. Consider Polonius’s advice, “neither a borrower or a lender be,” or the prohibitions on lending in the Abrahamic religions. These make sense when there is an erratic (or no) central banker. If cryptocurrencies displace fiat currencies, then we’ll say, “always index your debt contracts,” which is approximately an update of Polonius.

The bottom line is that recent advances in monetary economics somewhat undercut the macro-stability argument against Bitcoin. I would like to see this basic point acknowledged more widely, especially by people who style themselves the defenders of conventional economics against Bitcoin crackpottery.

Replies to My Critics

Last week, I argued that the short run is short—that there is good reason to believe that we’re now past the point where monetary stimulus can do much to help the economy. Again, I am broadly friendly to market monetarism and not especially hawkish on inflation. I am not so much against QE3 as skeptical that it will work. I think that the broad facts and a lot of mainstream macro theory back me up.

My post garnered a fair bit of criticism around the blogosphere. Let me make one quick empirical point to get everyone on the same page, and then I will try to respond to my critics point by point.

The empirical point is summed up in the graph below. NGDP grew around 5 percent per year until around 2008, and then it fell, and then it grew at around 5 percent—or slightly less—per year again beginning in mid 2009. These facts are well known, but I bring them up here because they do constrain the kind of stories we can tell about the economy. Any story you tell has to contain a one-time shock that ended years ago, and it has to be consistent with NGDP that has grown at about the same rate over the last 3 years as it did before the shock arrived.

OK, now with that out of the way, let’s take the criticisms one by one.

Bryan Caplan and ADP unemployment

Bryan cites Akerlof, Dickens, and Perry on long-run unemployment as a reason why QE3 might boost employment in spite of the fact that we are out of what we would conventionally call the short run. The ADP model assumes heterogeneous firms and workers with money illusion. At any given time, some firms need to cut real wages, and since nominal cuts hurt morale, higher inflation helps those particular firms cut wages instead of jobs. Consequently, in a low-inflation environment, monetary stimulus can help lubricate the employment market.

This argument is a good one as far as it goes. Unfortunately, I don’t think it goes very far given the stylized facts. As I noted above, NGDP is growing at a rate of 4-5 percent per year, not that different from before the crash. So any long-run ADP-style unemployment should be about the same now as it was before the crash unless there was a structural change in the economy. You can’t have it both ways—if we’re in a low-inflation environment for ADP purposes now, then we were in a low-inflation environment for ADP purposes before the crash as well.

Furthermore, assuming QE3 is a temporary policy, then if unemployment is long-term ADP unemployment, the effect of QE3 on unemployment will be temporary. I would regard a temporary dip in unemployment as a result of QE3 as good but underwhelming, given the claims of many market monetarists. There may of course be interactions between short-run unemployment and ADP unemployment, and for that reason, the dip in unemployment may not literally be temporary, but I would be surprised if QE3 could fix the economy through this channel.

Bryan makes an interesting linkage between my views on the ZMP hypothesis and ADP unemployment. If there is a decreasing secular trend of low-skill labor productivity, then ADP unemployment will become more serious over time. I think this is a good point, and it pushes me at the margin to favor a higher long-run NGDP target than I otherwise would. I was previously inclined to believe that the exact value of the target doesn’t matter once you get to levels of around 3 percent, but now I see more merit in a higher target.

Insider-outsider models

Bryan and some of the commenters at MR say that it is a mistake to focus on the wage demands of the unemployed. Rather, it is the wage demands of the employed that are especially sticky. The failure of insider wages to adjust downward to long-run levels means that there’s no ability to hire outsiders at below long-run levels, either because companies can’t afford to do it or because they are afraid of hurting insider morale.

The problem is that even if this story is true, we are probably, again, out of the short run. NGDP is almost 10 percent higher now than it was at the pre-crash peak. The number of people employed, even with population growth, is still below the pre-crash peak. Even assuming that insider nominal wages are totally inflexible, nominal output per worker has grown fast enough that insider real wages have probably adjusted. Furthermore, in five years, a non-trivial fraction of insiders retire or change jobs.

More generally, I’ve never been a fan of insider-outsider models, at least not for the United States in recent times. Maybe it makes sense as a model of Europe or Detroit in the union heyday. But today in the US, “labor” is less homogeneous than ever, private sector unions have declined, and fewer workers have an expectation of lifetime employment. Yet the past three recoveries have been increasingly jobless! How can you square the fact that at a time when the insider-outsider distinction is weaker than ever, labor hoarding has basically ended and labor market adjustment has become more difficult? I do it by assuming that the insider-outsider mechanism does not play that big of a role.

But again, even if the insider-outsider story was true at the beginning of the recession, there is little reason to believe that it is still true.

Ryan Avent and corporate profits

At the Economist, Ryan Avent focuses on my point that corporate profits are at record highs.

Firms could be enjoying high profits simply because revenues have stabilised while costs are low, perhaps because low expectations for future nominal spending growth have discouraged investment.

First, note that in the series I cited, corporate profits are adjusted for inventory valuation and capital consumption. The purpose of these adjustments is to make the series less responsive to exactly the kind of behavior Ryan posits. If firms decide not to invest in production and simply sell out of inventory instead, that can increase profits, but it doesn’t increase profits adjusted for inventory valuation. Likewise, a firm can temporarily increase profits by making inefficient use of existing equipment, which could lead to faster depreciation. Are these adjustments perfect? No. But they do offset some of Ryan’s concerns. Corporate profits are high even when you subtract some of the temporary gains firms get from not investing. The unadjusted series is here, by the way; I avoided it because I anticipated Ryan’s argument.

Second, whatever firms’ expectations were, as I’ve said repeatedly, nominal spending growth has not been especially low in the last three years. A better story, if you are trying to resist structural theories, might be that firms are wary of investing due to fears of shocks from Europe or Asia, which monetary easing now does little to help. It would be great if the Fed would commit now to keeping NGDP growing at 4-5 percent when those shocks do hit, but in the meantime, I am not expecting a lot out of QE3.

Ryan also makes a couple of other points, but none of them cut to the heart of my critique of QE3 optimism. He gestures to the New Keynesian literature, but of course even the New Keynesians don’t argue that the short run lasts forever. And Mankiw, who is one of the authors Ryan cites, is a well-known proponent of the unit root hypothesis. I do not read Mankiw as expecting a return to trend, no matter what monetary policy is, although I of course do not speak for him and am happy to be corrected. Ryan also quotes Weitzman on how increasing returns creates unemployment, which is true, but tautologous: if there were no increasing returns, anyone who was unemployed could start his own firm and be just as productive as when he was employed.

Bill Woolsey

Bill Woolsey cordially welcomes me, despite my heterodoxy, to the market monetarist club. I am glad to make the cut.

I think that I failed to make myself clear in my original post. Bill says, “Dourado’s version of how shifts in nominal GDP impact real output and employment is based upon an assumption of market clearing.” This is not what I intended to convey. I think that part of the effect of nominal shocks propagates through market-clearing monetary misperceptions (Lucas islands), and the rest through non-market-clearing nominal rigidities, or as I wrote in the original post, “because some wages, prices, and contracts don’t adjust instantaneously.” I am not as New Classical as Bill seems to think. I like some elements of the New Classical school, but in the end I think the correct theory of macro for now is pluralism.

In the long run, I do think that markets mostly clear. And I think that Bill must agree, for he writes at the end of his post:

On the other hand, most of us do believe that firms eventually cut prices and wages in the face of persistent surpluses of output and labor. Most of us remain puzzled by the slow adjustment.

This is my point. If our problems were purely cyclical, “eventually” would have happened already, so our problems must not be purely cyclical. Time to start looking at structural explanations.

Scott Sumner and cutting-edge research

I was pleased to get a reply from the high priest of market monetarism himself, Scott Sumner.

I addressed the plausibility of sticky wages here, and in numerous other posts in reply to Tyler Cowen and George Selgin. I’d also point out that there is lots of cutting-edge research that tells us that the “common sense” approach to the wage stickiness hypothesis is not reliable. By common sense I mean; “Come on, wouldn’t the unemployed have cut their wage demands by now.” Yes, they would have, but that doesn’t solve the problem.  This is partly (but not exclusively) for reasons discussed in this recent Ryan Avent post.

Well ok, I followed the first link, which gives the usual argument and then ends with the line, “Until we get a more plausible theory of unemployment, I’m sticking with stickiness.” This is honest, and it certainly is a common view, but I don’t think it’s a good idea to rely so heavily on a theory just because we don’t understand competing theories well yet. Macro of the gaps, I call it.

We have a long way to go in macro, so I’m glad that Scott brings up the issue of cutting-edge research. If he has particular examples of recent work that undermines the common sense approach, he should write about them at greater length. I assume that when he says “cutting-edge” he is not referring to the papers cited in Ryan’s post, since those are both from the 1980s.

Speaking of cutting edge research, let me point everyone to a paper, “Countercyclical Restructuring and Jobless Recoveries,” by David Berger, a new PhD from Yale, and now a professor at Northwestern. Berger creates a model in which firms grow fat during expansions and respond during recessions by laying off their least productive workers. His model creates jobless recoveries and matches the new stylized facts (they have changed since the 1980s) about business cycles pretty well.

One thing that I like about the Berger paper is that it shows why some nominal shocks, if not addressed immediately, are not easily reversible by monetary authorities. Once a firm has fired its least productive workers, it is not going back. If the monetary authority wants to prevent a recession, at least post-1984, it needs to act before firms lay off their workers. This perspective actually bolsters the case for NGDP targeting, because it means that the Fed should have an apparatus in place now so that the economy will be automatically stabilized when the next shock hits. Here is Tyler on Berger.

My question for Scott, since he’s so interested in cutting-edge research, is: “What do you think about Berger’s paper?” I assume that Scott is familiar with the changes in business cycles that Berger documents. Does he not think that Berger’s model accounts for some significant fraction of our current unemployment better than simply sticky wages forever?

The bottom line

None of my critics seem to be willing to make any sort of broadly falsifiable claim about how long the short run lasts. (I should say that Bryan is not arguing that we are necessarily in the short run in the bulk of his post). There is a lot of assuming trend stationarity, talk about output gaps, and pointing to literature I am well aware of—in short, a lot of question begging.

I would like to see a greater emphasis in the blogosphere on understanding stylized facts about recessions, a greater willingness to explore micro phenomena (even if we are not using fully microfounded models), and more macro-ecumenicism. No one school of macro has it all figured out, and that includes market monetarism. There is enough ambiguity in our current situation that reasonable people can disagree about what is going on. But I don’t think that reasonable people can be totally certain that all we need is more nominal stimulus.

The Short Run is Short

I’m a fan of Scott Sumner, NGDP level targeting, and many of the ideas of market monetarism in general. However, unlike many of those who support these ideas, I am pessimistic that QE3 will fix the economy, and I worry that too much celebration by market monetarists over the structure of easing will only serve to undermine what remains good in market monetarism if and when the economy fails to recover quickly. In particular, I think that many commentators fail to appreciate the mainstream macroeconomic distinction between short run and long run analysis, and that many economists overestimate how long the short run lasts.

The case for stimulus is based in monetary non-neutrality. If we double the money supply, the real productive capacity of the economy does not increase—real productive capacity has nothing to do with monetary factors. However, because people are tricked, and because some wages, prices, and contracts don’t adjust instantaneously, output may go up briefly. Business owners see an increase in nominal demand for their products and mistakenly assume that it is an increase in real demand. They see this as a profit opportunity, so they expand production. As prices, wages, and contracts adjust to the new money supply and their assumption is revealed to be false, they cut back on production to where they were before.

If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

Obviously, there is no signal that is fired to let everyone know that the short run is over, so reasonable people can disagree about how long the short run lasts. But I think there is good reason to think that the short run is over—it is short, after all.

My first bit of evidence is corporate profits. They are at an all time high, around two-and-a-half times higher in nominal terms than they were during the late 1990s, our last real boom.

If you think that unemployment is high because demand is low and therefore business isn’t profitable, you are empirically mistaken. Business is very profitable, but it has learned to get by without as much labor.

A second data point is the duration of unemployment. Around 40 percent of the unemployed have been unemployed for six months or longer. And the mean duration of unemployment is even longer, around 40 weeks, which means that the distribution has a high-duration tail.

Now, do you mean to tell me that four years into the recession, for people who have been unemployed for six months, a year, or even longer, that their wage demands are sticky? This seems implausible.

A third argument I’ve heard a lot of is that mortgage obligations have remained high—sticky contracts—while income has gone down. Garett Jones endorses this as a theory of monetary non-neutrality, and I agree. In fact, I beat him to it. But just because debt can make money non-neutral in the short run does not mean that we are still in the short run.

In fact, there is good evidence that here too we are out of the short run. Household debt service payments as a percent of disposable personal income is lower than it has been at any point in the last 15 years.

Yes, this graph includes mortgage payments.

So what is the evidence that we are still in the short run? I think a lot of people assume that because unemployment remains above 8 percent, we must be in the short run. But this is just assuming the conclusion. There are structural hypotheses for higher unemployment, but even if unemployment is cyclical, it doesn’t mean that monetary adjustment has failed to occur—real sector recalculation may just take longer than monetary recalculation.

Again, I favor NGDP targeting, but it is most effective when it is done simultaneously with the nominal shock. Evan Soltas points to the case of Israel, and indeed, the Israelis did it right. But it seems like wishful thinking to assume that four to five years after a nominal shock, you can fix the economy with monetary stimulus.

I would be delighted to be wrong. And I wouldn’t be surprised to see a slight decrease in unemployment as the result of QE3. But I would be surprised if we experience a plummeting of unemployment in the next two years down to what we previously thought of as “normal” levels of around 5 percent. Yes, it is good that the Fed is now using the expectations channel, but it did it four to five years too late, and there’s little theory or evidence its failure can be easily reversed.

UPDATE: I reply to my critics here.

Replies to Interfluidity

Steve Randy Waldman, aka Interfluidity, is wicked smart. So it was with mild trepidation that I read Nicholas Weininger’s request:

I’d like to see your take on Interfluidity’s posts about inflation-averse influencers, flights to safety, wealth as a positional good for insurance purposes, and the effects thereof on productivity. Relevant links:

http://www.interfluidity.com/v2/3487.html
https://plus.google.com/112482032780181267192/posts/5ATAa1ckps9
http://www.interfluidity.com/v2/3212.html

Alright, let’s see what I can do.

On inflation-averse influencers, I agree with a lot of the post. I’d quibble with the assumption that our current recession is 100% demand-driven. I favor NGDP targeting, and I think our problems would be less acute if we had more monetary stimulus, but I still think a lot of our problems are structural. NGDP targeting is not going to bring back the 90s.

That quibble aside, I think Waldman is totally right that we have a public choice problem. The way I think about it is that there is a public choice curve.

Superimpose the public choice curve over a dynamic AS/AD diagram, properly situated, and you will see why we are stuck. The public choice curve is meant to bolster the argument that recession is ultimately what the polity chooses, but keep in mind also one encouraging and one discouraging thought. The encouraging one is that having a polity that places a ceiling on the rate of inflation it will tolerate is actually an achievement when compared to the alternative. I lived in Brazil in the early 1980s, and while I was too young to really understand the value of money, I remember dropping a few million cruzeiros on a pack of gum. We might rightly call our current public choice curve inverted because there is an inflation ceiling rather than an inflation floor, which is much more common. Again, this is not to deny that we should have more monetary stimulus now.

The most discouraging part of the public choice curve is the bound on growth. There is a lot that a moderately-enlightened dictator could do to increase the growth rate of the economy from the supply side. I wish that people would get as incensed over the political failure on the supply side as they do on the demand side.

On the other post on the insurance value of wealth, I really disagree, not with the proposition that wealth is a kind of insurance for the wealthy, but that this has a significant real effect on employment. I think Waldman elides differences between the real and financial sector and between long and short runs.

Let’s say that Scrooge McDuck goes to his bank, withdraws his billions in $100 bills and puts them in a vault somewhere, as insurance against some improbable bad event. Aside from this, he spends only enough to keep himself alive. What are the real effects of McDuck’s insurance “purchase”? Putting aside any short-run distortions, all he is doing is leaving more real resources for everyone else to consume. Because the money in his vault is not circulating, it has no real long-run effect, at least not to a first approximation. Waldman needs to find some way to reconcile his argument, at least in the long run, with Steve Landsburg’s point about misers.

If you want to say, “OK, the insurance function of wealth does not distort the real economy in the long run, but it has an effect in the short run,” you still have a lot of work to do. First, Waldman needs to walk back the article I referred to in the first half of this post, in which he argues that depression is a choice. Assuming, arguendo, that the wealthy disrupt the circular flow of payments somehow with their insurance demands, why can’t monetary policy fix that? On top of this, I’m not sure that the comparative statics of anything we might plausibly consider insurance work out: you would expect wealthy people to “buy insurance” during good times and “collect a payout” during bad times. But isn’t the problem the reverse, that we observe hoarding in bad times? Finally, inequality is procyclical, so it’s not as if recessions are caused by sudden outbreaks of inequality.

I’m totally willing to consider the possibility that inequality adversely affects the real economy; indeed, I share the sense that most economists probably have that a highly unequal society likely has something wrong with it. I guess I am just an inequality traditionalist who thinks more in terms of plutocracy, unholy alliances between business and government, and standard public choice. While I’m not persuaded by Interfluidity’s account of the inequality-unemployment channel, I’d be eager to read other economists discussing this question.

Forensic Semantics: The Meaning of Liquidity Trap

I promise not to do too many more posts about a) macro or b) Paul Krugman. I don’t just love macro, these are not my most popular posts, and Krugman is too shrill to read on a regular basis. Nevertheless, I think I can sort through some of the recent disagreement about liquidity traps.

The term “liquidity trap” comes from Keynes. He described it as a theoretical possibility under which monetary policy would be ineffective; it would be unable to stimulate an economy in recession. Consequently, fiscal policy would be needed. To my knowledge, Keynes was not claiming that the economy ever has been in a liquidity trap; it’s simply a possibility that occurs under very specific conditions. Those conditions define “liquidity trap,” but there is disagreement over when they hold.

What is at stake here is the status of fiscal policy. If the economy sometimes experiences liquidity traps, then that is perhaps a good reason to keep fiscal policy in our toolbelt. If the economy never experiences a liquidity trap, then monetary policy strictly dominates fiscal policy: it is faster, less wasteful, and does not increase sovereign debt. It’s sometimes hard to say whether advocates and detractors of fiscal policy take those sides because of their position on liquidity traps or vice versa.

Krugman is among those who think that the world does experience liquidity traps, that we are in one now, and that we need more fiscal policy. Why does he think this? Arnold Kling does some of the forensic work and uncovers an old and a recent statement from Krugman on liquidity traps. Arnold says they are inconsistent, but I think they are perfectly consistent. The old statement:

My view … is that the liquidity trap is real: no matter how much the Fed increases the monetary base, it has no effect, because it just substitutes one zero-interest asset for another.

The new statement:

The economy is in a liquidity trap when even a zero nominal interest rate isn’t enough to restore full employment. That’s it.

What Paul is saying is that the economy is in a liquidity trap when the nominal interest rate on short-term Treasuries is zero. When the Fed tries to expand the money supply by buying up short-term Treasuries, it is swapping cash for Treasuries. Normally, cash and Treasuries have different properties: cash has a nominal interest rate of zero and Treasuries bear some positive nominal interest rate. However, when Treasuries bear an interest rate of zero, they are basically the same as cash. They are backed by the US Government and they don’t carry interest. Why should swapping one asset for an identical asset make any real difference in the world? On this narrow point, Krugman is clearly correct: it wouldn’t make a difference at all.

Krugman is wrong, however, that this constitutes a liquidity trap, either in the sense that Keynes meant it or in the looser sense that monetary policy is ineffective, because swapping cash for short-term Treasuries is not the only (or even necessarily the best) way to conduct monetary policy. First of all, it is important to recognize that there is not just one nominal interest rate. There is an infinity of nominal interest rates. If the interest rate on short-term Treasuries is zero, the Fed can swap cash for longer-term Treasuries. It could in theory buy private bonds, or stock, or mortgage-backed securities, or even non-financial assets. In any of these cases, the Fed is increasing the amount of money in circulation, and it is removing less liquid assets. This is expansionary except in extraordinary circumstances I’ll discuss below.

Incidentally, the Fed can also conduct monetary policy by other means. It can simply print money and distribute it, the infamous “helicopter drop.” It can buy foreign currency. It can lower the interest rate or raise the penalty on excess reserves that banks hold at the Fed. It can promise to inflate more in the future. All of these actions are expansionary, again except perhaps in extraordinary circumstances.

What are the extraordinary circumstances in which all monetary policy is ineffective? Keynes got it right. Monetary policy is ineffective when people want to hoard whatever cash they can get their hands on. In technical terms, the demand for money is infinitely elastic. The point is that increasing liquidity in the system (buying illiquid assets with liquid assets, say) does not translate into more spending because people soak up whatever liquidity there is.

When is demand for money infinitely elastic? Basically never. This is what Tyler is saying in his most recent post on liquidity traps. In Tyler’s terminology, there are multiple margins on which people express preferences for liquidity. There is the money-bonds margin, and in fact, there are multiple money-bonds margins. When the nominal interest rate on short-term Treasuries is zero, that is one margin on which people are expressing a preference for liquidity. But as I argued above, there are other bonds, and people are generally willing to sacrifice liquidity for a non-zero rate of return. There is also the money-goods margin. People are generally willing to sacrifice liquidity for stuff. That is, if you give them money, they spend some of it. But since Keynes is all about aggregate spending, you can see how it would be the case that if people infinitely preferred liquidity to goods (they were unwilling to spend even if you gave them more money), then it would be desirable to have the government to engage in direct spending (fiscal policy) to boost aggregate demand.

So why does Krugman fixate on only one interest rate, on only one particular money-bonds margin? I think that it’s just a lack of imagination about what monetary policy consists of. Traditionally, monetary policy in the US has consisted primarily of open market operations on short-term US Treasuries. But there is nothing special about this particular kind of monetary expansion. If Krugman wants to call it a liquidity trap when the nominal interest rate on short-term Treasuries is zero, he needs to abandon the conclusion that fiscal policy is called for in a liquidity trap. I prefer to retain Keynes’s original meaning and conclusions by defining a liquidity trap as an infinitely elastic demand for money.

Miscellaneous Thoughts on the Fed

Everyone is interested in monetary policy and the Fed all of a sudden, so, what the hell, I’ll chime in too.

Here is my ranking of monetary regimes:

  1. Depoliticization and denationalization of money. Free banking. The market selects a currency and banking is “regulated” in court under the common law of contract.
  2. The Fed is a Sumnerian robot. It runs a market in quasi-velocity futures and a computer uses the market price to decide whether to expand or contract the money supply.
  3. The status quo.
  4. Congress itself “coin[s] money and regulate[s] the value thereof.”

Most people who want to abolish the Fed think that we can go from number 3 to number 1, but more likely, if we End the Fed, we’ll go to number 4. For all the exaggerated claims about how the Fed is turning us into Zimbabwe, number 4 would go much further in that direction than number 3 has.

If anti-Fed steps are to be taken, they should be along the lines of Ron Paul’s Free Competition in Currency Act, which weakens the Fed by eliminating legal tender laws and eliminates capital gains for alternative currencies. The capital gains issue is important because money is half of every transaction, and even if the value of money is stable such that there are minimal capital gains and losses, the amount of record-keeping that is needed to use an alternative currency is prohibitive. The bill doesn’t go far enough, though; the optimal currency may be none of the things that are exempted from capital gains taxes under the bill, and really the only solution is to eliminate taxation of capital gains entirely. Can you imagine the political uproar from our friends on the left?

People complain that since the inception of the Fed, 95% of the purchasing power of the dollar has been inflated away, but this is looking at the wrong derivative. When inflation is consistent and expected, rates of return adjust to compensate for it. As long as you are not holding most of your assets in currency or non-interest-bearing dollar-denominated accounts, steady inflation doesn’t matter. Inflation is a tax on people who hold literal dollars, which is probably not you unless you are a crime lord or a foreign dictator.

QE2 brings us slightly closer to the number 2 monetary regime above, and I support it on those grounds and those grounds only. If we had had the Sumnerian infrastructure in place in early 2008, it would be telling us to expand the money supply now, and therefore expanding it now is what we should do. I regret that it is being done on a discretionary basis, but you give policy advice in the policy environment you’ve got.

By the way, QE1 was not really QE, as Alex Tabarrok explained in 2008. The Fed started paying interest on reserves, which has the effect of massively decreasing velocity. The Fed needed to increase M to offset the decrease in V. Why the Fed would take such velocity-decreasing action in the middle of a crisis, I do not know.

Tyler Cowen writes this morning that if you want a countercyclical money supply, you must have a central bank. Tyler, this is false! I had a discussion once with a different Tyler in which we traced the effects of using shares of the S&P 500 as currency. Since the stock market is cyclical, money would appreciate in booms and depreciate in busts, just as it would if you had a decent central bank. The big downside would be a long-term deflationary trend, but nevertheless as a proof-of-concept it shows quite clearly that a countercyclical money supply is possible under a commodity currency.

For those who are opposed to monetary central planning, the real story is not QE2, but the looming disaster in the Eurozone, which is quite obviously not an optimal currency area. If they can get past the current crisis somehow, they will just be inviting the next one if they do not do something radical like banning all languages other than English. I’m still hoping that if the Greek collapse comes, it comes when I am in Greece next month.

The bottom line is that whether the Fed has been a failure depends on what you think the alternative is. The Fed made some big mistakes in the 1930s and in 2008-2009, but at least (1) we’re not Europe and (2) Congress is not in charge. I think that if we give in to populism, we are likely to get something worse than the Fed, not better, though if the populists want to start getting serious about monetary theory, I would welcome that.

Ireland Tells Us Nothing About Austerity

In 2008, the Keynesians emerged from hiding, where they had been since the mid-1980s. It was nice to see them, catch up, and so on. But now they won’t go away.

This week’s Buttonwood column in The Economist considers whether fiscal austerity is expansionary or contractionary. A sentence caught my eye.

Keynesian economists are also likely to counter the Canadian example [in which fiscal austerity was followed by prosperity] with that of Ireland today, where a willingness to appease the bond markets with budget cuts has been accompanied by a fall in nominal GDP of almost a fifth.

Last week in the New York Times, Christy Romer’s debut column claimed:

Ireland, Greece and Spain have all had rising unemployment after moving to cut deficits.

OK, I can agree that Ireland, Greece, and Spain all cut their deficits, and that they all had rising unemployment. I will leave aside, for this post, the question of what their unemployment rate would have been if they had not appeased the bond market, because in the US context it is irrelevant. The US is not yet on the immediate verge of a sovereign debt crisis.

What is important in the US context? Ireland, Greece, and Spain differ from the US in a way that is so inescapably essential in theory that it makes me want to revoke the credentials of any economist who cites them as evidence. Yes, dear reader, you guessed it, none of them runs its own monetary policy.

The monetary authority moves last. It incorporates the actions of the fiscal authority into its choices. If the fiscal authority decides to be austere, the monetary authority can be loose. The friendly Keynesians who cite the experiences of countries without their own currencies as evidence of the evil of austerity during a recession are trying to trick you.