Sunday, December 18, 2011

Andolfatto vs. Ron Paul

Given our discussion of him yesterday, and the increasing strength of his campaign, I think it's worth reprinting the post that David Andolfatto had up earlier this spring criticizing Ron Paul's grasp of monetary. The circumstances are worth recounting too. David Andolfatto works at the Federal Reserve as a research economist. He wrote this post criticizing the sitting chairman of the House committee that oversees the Federal Reserve, Ron Paul, and pointing out that the emperor has no clothes. I don't think I need to point out how that takes a lot of guts.

The supporters of Ron Paul, the Congressman who calls Obama authoritarian and who recently suggested that he's doing well in the polls because his opponents don't have principles, took deep offense at the fact that Andolfatto let his blood boil a little and called Ron Paul a "pinhead". Yes, the people who love the guy that throws around "authoritarian" got outraged at "pinhead". Andolfatto got so overwhelmed by the rage over the post that he took it down. Here it is:

"I can appreciate Ron Paul’s libertarian philosophy. And because this is so, it pains me all the more to say what I am about to say. The guy can be a real pinhead at times. And this is never so evident as in his persistent “attacks” against the Fed.

Now, of course, I work at the Fed, so maybe you think I’m just complaining for the sake of defending my employer. If you think that, I can understand why you do. It is because you do not know me.

There are legitimate arguments one could make against the Fed as an institution and/or about the conduct of Fed policy. And then there are the stupid arguments, for example, the one contained on pg. 25 of his book End the Fed:

"One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy."

One might indeed say that, Mr. Congressman. But if one did, one would behaving like an opportunistic politician, which I know you are not.

Now, let us examine what is wrong or misleading in the statement above.

First, with the exception of the last sentence (which he weasels around with his “one might say”), there is nothing factually incorrect. Indeed, the data source cited by Paul is (ironically enough) the Federal Reserve Bank of St. Louis. (I’m glad he trusts us enough for some things.)

So the question is not whether he has his facts straight on this matter. The question is whether these facts matter at all.

There is this old idea in monetary theory called money neutrality. Money neutrality means that larger quantities of money ultimately manifest themselves in the form of higher nominal prices (and wages), and not on real quantities. No serious economist disputes the idea of long-run money neutrality.

Yes, what cost $1 in 1913 now costs $20. But so what? Money neutrality states that if you were earning $1 per hour in 1913, you are now earning $20 per hour (and even more, if labor productivity is higher).

So there you go, the Fed is responsible for increasing your nominal wage by a factor of 20. How do all you workers out there like them apples? Ron Paul wants to rob you of these wage increases!

Here is another example of the Congressman misleading the public (perhaps unintentionally); see his recent interview here with CNBC’s Larry Kudlow: Fed Under Fire.

At the 3:50 mark, Kudlow asks Paul: “Would oil be at $102 a barrel now if we had a sound dollar policy?” Paul’s reply is that, if Bretton Woods had not been abandoned (in 1971), oil would now be trading closer to $5 a barrel.

I ask you…how embarrassing of an answer is that? I mean, maybe oil would be trading at $5 a barrel. But what he is implicitly suggesting is that your nominal wage would not be scaled back in proportion. That is, he is suggesting that by cutting the value of paper, the Fed has somehow diminished the purchasing power of your labor over the past 100 years. Can he be serious?

The Congressman evidently suffers from money illusion. It is an affliction that can be forgiven in most people. But not one who likes to think of himself as a person learned in the finer principles of monetary theory.

And, as an aside, am I the only one who chuckles whenever he berates the Fed for creating money “out of thin air?” (I reiterate, there may be many legitimate complaints one could make against the Fed, but the “out of thin air” charge…well, let’s just say it…lacks substance).

Is it not true that the Treasury also creates its debt “out of thin air?” Do you think getting rid of the Fed (which, in conducting monetary policy, is simply swapping one form of thin air for another) will prevent Congress from issuing its own thin air? Do you really believe that a gold standard would mitigate the government’s ability to tax? (Seigniorage revenue for the U.S. is peanuts as a fraction of total taxation. Moreover, keep in mind that the inflation tax is collected off of foreigners as well.)

Let me conclude by saying that I think that America is, on the whole, well-served by having a voice like Ron Paul in Congress. I’d like to invite him to the SL Fed for lunch one day. I’d ask him to tone down his rhetoric and present his (frequently very good) arguments in a more sober manner.

But maybe this is too much to ask of a politician. Even a libertarian one

Andolfatto had a follow up post here.


  1. On the "out of thin air" portion of the quoted material:

    Just where does the Fed get the money for its purchases?

  2. "There is this old idea in monetary theory called money neutrality. Money neutrality means that larger quantities of money ultimately manifest themselves in the form of higher nominal prices (and wages), and not on real quantities. No serious economist disputes the idea of long-run money neutrality."

    Ooof. The Austrians would seem to disagree. In the short run, there is a redistributive process, and while in the long run people's wages will have increased, there still is a permanent redistribution of income based on how the new money is spent (certain factor's DMVPs will have permanently increased, e.g. military contractors). And since we never reach the long run, and the Fed is continually printing money, there is a serious "inflation tax" on wages.

  3. "Yes, what cost $1 in 1913 now costs $20. But so what? Money neutrality states that if you were earning $1 per hour in 1913, you are now earning $20 per hour (and even more, if labor productivity is higher)."

    Really? I guess we live in Wonderland where all these things happen simultaneously right? Prices and wage must automatically adjust in Andolfatto's world. What kind of elementary justification is this?

    I have read some very thoughtful critique's of the Austrian opposition to central banking (on this site none the less) but this was rather embarrassing.

    Thank you for posting this though Daniel, I was looking for something to skewer today.

  4. OK - Let me know when you get around to skewering him.

  5. Ha! I will try to remember but the fact that he implies that wage and prices adjust automatically to new money entering the economy is enough to show his reasoning is lacking. My grandmother who complains about near-0% interest rates certainly doesn't agree. Didn't Keynes build a career off of proving that assertion incorrect anyway (sticky wages and such)?

  6. Every time the fed increases the money supply and causes price inflation the real value of its debts decrease.

    I assume this is what Ron Paul is alluding to and the neutrality of money has nothing to do with that.

    In addition: how does the author of the quoted blog think the money supply did increase 2000% if the fed had not created the new money "out of thin air"? He switches the subject to taxation which is clearly irrelevant to the creation of new money.

  7. James, it is effectively impossible to compare price levels from 90 years ago and price levels today.

    Did commercial flights, video-cameras, or technical support exist in 1920? No. Can you compare what those things cost today and what those things cost yesterday? No.

    If inflation is about rise in cost of living, relative to the same standard of living, we can not compare, because standard of living has also risen.

    There is no way for us to tell how much purchasing power was "lost" over nine decades.

  8. Prateek,

    So if you can't compare prices, is there no point to looking at purchasing power of currency? Why not inflate by 15% a year then? How about even more, say 50% a year. After all, we can't compare prices right? If a loaf of bread cost $1.00 in 1970 and costs $5.83 today (using BLS calculator), then that clearly means nothing using your logic.

    Sure it wasn't 90 years ago, but then again, where is your cut off point for comparison?

    I agree you are right to a certain extent in that prices aren't only affected by the purchasing power of money (increased production, invention of substitutes, etc.) but to throw out the baby with the bath water and declare that prices can't be compared at all seems a bit much.

    The effect on prices by monetary debasement and increased production are two different things. Looking at loss of purchasing power doesn't tell us everything but it sure does tell us something.

  9. A loaf of bread does not form as large a part of a person's diet today as it did then. People's diets have changed. As it is, food forms a smaller percentage of household expenditures today.

    Anyway, just consider.

    In a given society, 50% of the annual steel production is purchased by government and 50% of it by the private sector. Government prints money to buy steel. Steel prices don't rise, and government purchases 75% of annual steel production and private sector just 25%. Alternatively, steel prices soar upwards and private sector incomes adjust faster due to rise in money supply and circulation of new money. Government still purchases 50% of steel and private sector 50%.

    Tell me which option is worse. Low prices accompanying expansion of money supply? Or high prices accompanying expansion of money supply?

  10. James: you may be correct that there are short-term costs. prices don't all adjust simultaneously and immediately and I David knows this. however, this is much different than David's point. Over a 100 year horizon prices do adjust. So it is disingenuous to suggest that purchasing power has fallen by so much. if you want to think of this all as a tax, comparing it to other taxes it is pretty small. and this tax is levied on foreigners too. i really don't understand why people get so angry about this. the government does a lot worse things, why don't we focus on those?

  11. Prateek- a loaf of bread was a random example, I could have picked anything. I don't know about you but bread plays a pretty big role in my diet still, I don't know if there would have been that dramatic of a difference if I was alive 40 years ago.

    Your example assumes that the private sector doesn't attempt to bid for steel at the same rate as the government increases spending on it. But say your example follows like it does, being that bureaucrats are incapable of economizing the way individuals who spend their own limited funds do(they don't have printing press as you allege the government does), one would assume that the 75% the gov't spends on steel isn't allocated as efficiently. But I am sure you know this argument already.

    Why would private sector incomes adjust faster? Are you saying that it would be instantaneous, as all income for everyone is affected at once? Did you mean private steel industry incomes? If so, aren't you admitting that the steel industry benefited at the expense of the rest of the public first through essentially political spending? Sorry, I don't take this example as very realistic the way you portray it.

    Whether prices are affected one way or another with the expansion of money supply depends on whether time preferences and demand for money change with it. Your question doesn't account for these nuances.

    Anon- Yes, over 100 years these things do adjust but even now the monetary base continues to expand, thus perpetuating discoordination as money continues to enter the economy in different sectors.

    It may be disingenuous to suggest that purchasing power decreased without mentioning that how incomes and wages adjust, but the fact remains that the dollar used to have a higher purchasing power.

    The government does some pretty crappy things (killing civilians, denying due process, etc.) but the reality that new money hits Wall Street first through open market operations is pretty horrible as the system is pretty much rigged in its favor.

  12. James, how are we to retain the purchasing power of a dollar without necessarily creating a severely contractionary policy? There are far more people alive and in the workforce today than even ten years ago; even Paul's theory should admit that fewer dollars chasing more goods and services is a bad situation. Krugman's analysis of the liquidity trap seems to make the most sense, here.

    I do have sympathy with the view that more money can and does, sometimes, lessen the purchasing power of a savvy investor's holdings; but aside from the point that it's supposed to be invested, not hoarded (another point Lincoln makes in his Sub-Treasury speech), the evidence that too little liquidity also can degrade the purchasing power of your dollar seems pretty clear, through the experience of bank runs and the current liquidity trap situation. Put simply: If the banks are showing signs of failure, you're going to draw out your holdings, if possible; other holders of money will be harmed if they don't get their money out in time, as will the FDIC; and you're less likely to release any of your hard-fought greenbacks back into the market (speaking of the generalized person - I admit I have been transferring some of my bank accounts into items of value, but the CDs weren't doing anything for me, and this isn't a full-on market crash either).

    Following that, I think you have it backwards, if we were asking to describe a good government policy (which is, of course, not necessarily the policy being designed or followed today): The expansion of the money supply should not be (and, unless I am missing something critical here, actually is not) a driver but a response to demand for money, and I would assume for time preferences as well (an actual example would help me here, though I won't demand anything as obviously I need to read up on that).

  13. Edwin- not sure why you are implying "we" when you and I really have nothing to do with dictating monetary policy in this country. I assume you are referring to central bankers. But you must realize that severely contractionary movements in money supply are often the result of previous inflationary policies. They are the necessary market correction for previous distortions brought by arbitrarily increasing the monetary base.

    You are correct that there are more people living in the world, but I am not advocating a fixed amount of currency indefinitely. I want a market based money which would most likely be gold/silver that is mined at a slower rate than can be printed You don't acknowledge how purchasing power increases during monetary contractions (prices drop), thus incentivizing spending.

    If banks are showing signs of failure, than they should see bank runs as they are obviously using money and resources inefficiently. What makes bank runs a problem is fractional reserve banking itself- a phenomena I won't get into now for everyone else's sake.

    You say expansion of money supply isn't a driver when in fact it really is as previous inflationary policies cause downturns and thus perpetuate more inflationary responses.

    You are right on the time preference aspect but again, markets are capable of clearing. The fundamental difference between Keyensians and Austrians is whether or not this clearing, when people stop saving and start spending, happens quick enough.

  14. James, don't mention the MB unless you're understanding of how that translates into deposits (or, the disappearance thereof). MB is not circulating money, but it is often helpful to understand how MB turns into circulating money.

    No doubt, MB is inextricable to how the banking system works, but it only represents potential, it isn't money in exchange. However, if AD were to increase, MB would be quite a honeypot of base money on which to multiply deposits, and thus the circulating money supply.

    Certainly, this is not a consideration that is in the minds of most main stream economists. And, if AG were to increase and the MB were to leak into deposits, then Keynesians would only know about it when the last data set was released.

  15. I should also mention that most of this "leakage" would take place in the higher stages of production, especially considering the current rates of interest.

  16. Joe- Yes, I should have differentiated between monetary base and circulating money. My bad on not making that distinction.

  17. James E. Miller:

    Yes, of course I'm referring to CBs above.

    It seems to me one of the major divides between our thoughts appears where you focus on inflationary policies, which are "often" the cause of a contraction - but not always. At this juncture, the question I think we ought to ask is whether a "market driven," contractionary reality of the liquidity trap is what we should be concerned about, or setting up a 'solid currency.'

    On that point, I would argue that the oft-overlooked preference that must be reflected in any monetary system is that of the electorate (represented, however imperfectly, by their government and government policies). The market by itself isn't guaranteed to create demand quickly enough to get us out of the current slump, which represents a very low opinion indeed on the part of those arguing this policy of the productivity and forward track of the young college graduate and the unemployed.

    I agree with you when you say that is the fundamental difference between Austrians and Keynesians, but I think the points marshalled against the Keynesian response are weak and unconvincing when we can be sure that there is, in a considered policy, no risk of inflation from introducing liquidity.

    Inflationary policies might have been a driver in, say, Richard Nixon's time, and in other cases, but there doesn't seem to be any evidence of inflationary policy at the present time. As has been mentioned elsewhere, as far as money is concerned the Bush and Obama Administrations have pursued a policy of lowering the dollar value (esp. in relation to the yuan).

    I'll agree to stay away from fractional reserve banking, but your mention of it suggests the question of whether FRB is actually a typical market creation used to leverage assets. As John Corzine's MF Global proved once again, the incentive structure continues to entice investment bankers to leverage assets irrationally; just because we can enshroud one policy with a cloak of institutional legitimacy does not mean that it is somehow not representative of market shenanigans.

    You raise a valid point to me when you point out I was not forthcoming in acknowledging increased purchasing power during a contraction (I think I actually did, but it was buried in the middle of my dancing around the point).

    I've made use of this purchasing power, but that's mainly because my preferences were to get the things I bought and to use them as a kind of investment, due to a lack of faith in the money. This, however, is not enticing if a person is worried about using that money to pay bills; we are no longer in a barter economy and the banks have been all too willing to exercise foreclosure on buyers who have too little liquidity. Even if prices drop, this alone is not enough to drive the market out of a liquidity trap. The market doesn't fix this situation in an equitable and timely way (in my opinion).

    I also question which mechanism, or if your model actually allows a mechanism, to expand the monetary supply to keep up with population and demand. You mention mining it at a rate slower than paper, but without more details it's unclear whether you advocate reserving this power to the government (where it becomes a fiat system but without the benefit of flexibility and timeliness) or to peg it to the market somehow (and expose it to the usual market-driven speculations and other shenanigans).

    I am sure you realize that your system does not allow any elasticity of the monetary supply, which I believe is one of the policies that has contributed to the "great moderation" since the end of the Bretton Woods system (somebody more familiar with that period can correct me if I am wrong there). Monetary policy can be, and has been, used effectively to moderate market-driven or emergency discontinuities in demand.


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