1937, the Fed, the stock market, and the Treasury

Sitting on cash when people want cash drives up interest rates. High interest rates discourage investment. They discourage investment even more when investors are already predisposed against expanding operations to provide for future demand that they're uncertain about. They discourage investment even more if there are arithmetic barriers to relief on interest rates (like a nominal price floor and weak inflation).

As far as the economy is concerned, it doesn't matter who does it: households increasing savings, businesses demanding and retaining higher profits, central bankers mandating higher reserves, or fiscal authorities sitting on money. As far as history is concerned, of course, sometimes one entity is more to blame than another.

Paul Krugman recently wrote a post on the "recession within a depression" of 1937, which he says eerily parallels the discourse we see today. He says (citing Friedman and Schwartz) that in 1936-1937 the Federal Reserve started getting concerned about the inflationary potential of the large growth in excess reserves. These concerns are not unlike those we are hearing today. They responded by raising reserve requirements, a decision which Friedman and Schwartz consider to be the source of the 1937 downturn. Krugman raises doubts about how important this policy really was, citing the Romers. Recent research looking at Federal Reserve member banks by Calamoris, Mason, and Wheelock (2011) confirms Krugman and the Romers' suspicion that Friedman and Schwartz were too quick to blame the Fed. They demonstrate that the reserve requirement rules were non-binding. This is all in the spirit of Krugman's own mentor, James Tobin, who said of the 1936-37 Fed policy that "raising reserve requirements may have been a mistake but it was probably a relatively harmless one."

Jonathan Catalan presents a response that ties Krugman to Friedman and Schwartz (which seems a little odd to me). Aside from the question of what Krugman thinks fo the Friedman and Schwartz argument, Jonathan does identify the common thread between the three economists, that "the point Krugman is trying to make is that tight monetary policy will definitely set a recovery back". Jonathan, of course, disagrees - a position which he has staked out earlier in his Mises Daily article on the 1937 recession. He blames the stock market crash for the contraction of the money supply. Falling stock prices increased precautionary demand for money, leading to a contraction in the money supply.

This is a little confusing to me. As I understand it, the stock market crashed in August of 1937, the monetary base started falling at the beginning of 1937, and output started falling earlier in the spring. How does Jonathan get the causality going from the stock market to the monetary base? I don't entirely understand the argument.

So barring an explanation from Jonathan, he seems to be wrong in pointing to the stock market (and thus businesses and households) as the source of the reduction in the money supply. Friedman and Schwartz are wrong that the Fed is to blame (according to Jonathan, Krugman, Calamoris, Mason, Wheelock, Tobin, Romer, and Romer). So what happened in 1937?

Well once again we can look to Calamoris, Mason, and Wheelock (2011), who suggest that the real culprit may have been the U.S. Treasury. In 1936 the Secretary Morgenthau decided to play central banker and sterilize billions of dollars of incoming gold by stock-piling it and paying for it by selling government securities (rather than by depositing it at the Federal Reserve). This is just as contractionary as it would be if the Federal Reserve had engaged in open market sales.

Of course taxes were raised and the deficit was cut too - that doesn't help. But the gold sterilization point is interesting because you don't hear people talking about it as much.

Does this history make sense? I'm no expert on the depression, but the literature seems to point to this explanation. Perhaps Friedman and Schwartz defenders can reinvigorate the case for the impact of reserve requirements or Jonathan could explain how the stock market is causal here.

Lee strikes again

Lee has a new post on Modus Tollens on quantitative easing that makes a point I had never thought of before and that I don't think I've read anywhere else (he's probably made it a million times and it's just finally clicking for me).

I've noted elsewhere that I see three arguments for QE2 - all good ones, I might add. It can:

1. Lower long-term rates to boost investment demand (classic Keynesian)
2. Boost nominal expenditures (classic monetarist, widely adopted Keynesian)
3. Increase inflation to deal with wage and price rigidties (New Keynesian)

One thing I haven't comprehended, though, is how simply increasing nominal income guarantees any substantial impact on employment. To put it bluntly "we're in a liquidity trap" (I think we probably are), but to put it more accurately and less controversially, we simply have very high liquidity preference - which will do the trick of getting you below full employment even if you're not in a liquidity trap. What does handing people money really do when liquidity preference is a problem? It might help, but there's no guarantee even a substantial portion of it is going to be put to work.

The answer is quite obvious in retrospect. Longer term bonds don't simply have higher rates that have more flexibility to be pressed down. Longer term bonds don't simply play a role in long-term inflation expectations. The other thing about longer-term bonds that gives a boost to nominal expenditures traction is that long-term bonds aren't all that great for satisfying liquidity preference - they are not as close substitutes for money as short-term bonds. Lee writes:

"Short term bonds with near zero interest rates are extremely close substitutes for money, and so purchasing short term bonds may increase the money supply, but is also likely to increase money demand in proportion, and so any excess demand for money will remain unchanged. Purchasing longer term bonds with higher interests rates, however, exchanges quite different assets. Households and firms that sell long term bonds are unlikely to hold their new money, but instead they will begin spending it on various consumer and capital goods. (Initially, they likely will be reluctant to lend for the same reasons as banks)."

OK - one more (probably dumb) question. Long-term bonds are not like cash in the way short-term bonds are (and even short-term bonds, as Scott Sumner regularly points out, aren't perfect substitutes). But long-term bonds do afford a liquid market. If the problem is a demand for liquidity - an increase in liquidity preference - might it be plausible that people who sell their long-term bonds were still holding them for liquidity purposes, and therefore would still be unlikely to go out and spend? Or am I still misunderstanding something.

Anyway - I've inched closer to the "eh - fiscal policy seems to be more trouble than it's worth" position. Not there yet. But an inch closer.

H. Vernon Eney - Goldbug

On a few occasions I've talked about my great-grandfather, H. Vernon Eney, and his work as president of Maryland's 1967-68 Constitutional Convention. The Constitution failed, but it was an important reform effort that tried to make the state government more efficient and more responsive to the needs of modern society. I've previously called his work an example of a non-reactionary case for states rights.

Well, one thing I don't share as often (that I haven't shared at all) is that in the thirties, Eney also played a small role in pushing back against the Roosevelt administration's most important policy of monetary stimulus: the demonetization of gold. I was reminded of this recently by a Peter Klein post about the "gold clause" cases in 1935. Eney argued a less famous gold case before the Supreme Court in 1937 (I believe this was ten years after he passed the bar). To be honest, the argument on the part of Eney's client (Machen) and two other petitioners was a little contrived. All three petitioners were arguing that they deserved interest payments on their Liberty Loans from after a 1935 redemption call. The argument was that the call was made null because it was a call on the initial bonds but did not stipulate that payment would not be made in accordance with the language of the initial bonds (i.e., in gold). They argued that "the payment that it [the call for redemption] promises is not the payment owing under the letter of the bond", and so was not valid.

The court ruled that the call for redemption was simply a notice that must be construed in the context of current law, and current law had stated that gold would not be paid out by the Treasury (this was the issue at stake in the earlier, more controversial rulings). The notice wasn't nullified by the fact that it didn't explicitly note that payment would be in a manner different than what was laid out in the language of the bond and so the petitioners were unjustified in demanding interest payments after the call.

Riveting stuff, huh? Anyway - I've always thought the small part that Eney had to play in monetary policy during the Great Depression was interesting, and this post by Klein today reminded me of it. It would probably be a stretch, I suppose, to say that if he had won it would have worsened the "depression within a depression" of 1937!

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Note: Justice Cardozo, who delivered the opinion of the court in this case, is pictured above. Cardozo was appointed by Hoover in 1932, and was generally considered to be a liberal justice. He has also been said to look like Conan O'Brien, but I personally don't see it.

What exactly do Selgin, Lastrapes, and White expect me to think about this?

George Selgin, William Lastrapes, and Larry White recently released a Cato Institute working paper looking at economic performance before and after the Fed which concludes that the Fed has been bad for the macroeconomy on all kinds of measures. The sort of people you'd expect to blog on a Cato working paper have fulfilled their duties in praising the piece: Cafe Hayek, Coordination Problem, and Econ Log. I'm not sure exactly what there is to be so impressed about. It's when I see things like this that I'm glad I came up through the labor economics/econometrics side of economics first before developing an interest in macroeconomics, because methodologically this paper has very little to offer and I'm not sure why that's not being pointed out by more people.

The paper is essentially a century and a half long pre-post test of the Federal Reserve, an approach to performance evaluation that simply wouldn't fly in, say, the labor economics literature. The question of how macroeconomic performance and volatility have changed over time may be an interesting question to answer, but simply comparing a century with the Fed to a century without the Fed isn't really a test of the impact of the Fed at all.

The problem is (as Arnold Kling does point out in his post) that things change over time that have nothing to do with the Fed, and those changes are being picked up and attributed to the Fed by Selgin, Lastrapes, and White. What's worse is that we are likely to have substantial endogeneity in this case. It's not simply that other changes that are going on may be falsely attributed to the Fed - it's that the Fed was created precisely to address these changes in the economy that were occuring! It's the same problem that you have when you regress output or employment on federal spending to get at the impact of fiscal policy - it doesn't work because you implement fiscal policy precisely when the economy is weak. The pre-Fed period was an agrarian period where the United States largely followed other technological leaders, where we still had a frontier, and when growth was extensive: applying standard production techniques to more land, more people, and more capital. The Fed was established at a time of transition, precisely because of the volatility that that transition was expected to usher in: we emerged as an industrial economy that was a technological leader, not a follower. The frontier was closed and the low hanging fruit of extensive growth was no longer available. Instead, we grew intensively - by innovating on the production processes that we had been using. This road is inherently rockier, which is precisely why you saw a growth in macroeconomic management at this time. Selgin, Lastrapes, and White see a more volatile 20th century and attribute it to the Fed - I see a more volatile 20th century and say "well isn't that why we made the Fed in the first place? Wasn't this precisely what we were expecting when we were having these discussions about another central bank between 1907 and 1913?".

I've been doing program analysis at the Urban Institute for four and a half years now, and I haven't once done a pre-post test like the one Selgin, Lastrapes, and White present here. We could never get that kind of assessment published, and if we were producing it for a client, we would probably get it sent back to us with an angry note and lots of red ink. It's not like these points should be lost on monetary or macroeconomists. It's precisely these concerns with identification problems that lead Barro and Romer to do their innovative work trying to isolate the effect of fiscal policy. Macroeconomists do know about this stuff. But sometimes I feel like they are less attuned to the problem than labor economists and econometricians. A lot of people looked at the Selgin, Lastrapes, and White paper and thought it was pretty interesting and compelling. I just thought "What the hell do they expect me to think of this? This is fluff. I can't make heads or tails of this."

Read critically, people.

UPDATE: Looking at what happens before and after a policy change can be improved by a lot of different methods. One is to compare the pre-post change to a pre-post change from a comparison group that did not experience the policy change (this is called difference-in-differences). This allows you to subtract out the change over time that wasn't associated with the policy. People also trust pre-post tests if they look at change in a very short time period as a result of a very sharp policy change where nothing else in the system has changed (this is called a natural experiment or a regression discontinuity design, depending on how it's implemented). Intuitively we can also put more weight on pre-post observations in a shorter time period (for example, in my 1920-21 paper I point out a rise in economic activity after the Fed finally cut rates and argue that this is consistent with the idea that monetary policy is stimulative - it's not a rigorous test, but the tight time frame makes it more plausible as an illustration). A dicier method that I'm usually skeptical of is called "instrumental variables", which uses an exogenous proxy to measure the impact of an endogenous policy change. These have to be very, very well justified.

UPDATE 2: So I asked Don Boudreaux to humor me and let me know what he thought of my critique. He writes: "I'll satisfy your curiosity. First, you ought to pay more attention to public choice; your 'the Fed was created with good intentions' assumption is naive. Second, given your reasons for dismissing as 'fluff' Selgin's, Lastrapes's, and White's conclusions, what evidence have you that the Fed succeeded? Third, I see no reason why the economy of the twentieth century - or the economy that those mythical wise and well-meaning technocrats of a century ago thought they foresaw - was destined to be inherently more volatile than was the economy of the 19th century. Why, for example, you presume that the closing of the geographic frontier is economically significant is beyond me. Were not, say, the economic frontiers pushed outward by electrification, by telecommunications, by inexpensive transoceanic steamships, by the Internet less important than the Wm. Jackson Turner's geographic frontier? If your criticism of Selgin-Lastrapes-White is the harshest that there is, their paper is destined to become a celebrated classic." And odd and telling reply, isn't it? The public choice point is strange - I don't deny the incentives associated with the founding of the Fed, but there's nothing in public choice theory that requires an entirely myopic perspective on public actions either. I also never said that there was evidence succeeded. In fact I said quite the opposite, didn't I? He makes a big fuss over the frontier point too, which I re-explain in the comment section here. Notice anything missing in Don's response? Oh yeah - no mention at all of the massive methodological problems with this paper that formed the crux of my criticism. Now Don's not dumb. He understands the argument. He makes the same argument when cautioning people against being too sanguine about empirical fiscal multiplier estimates. So he understands the concept perfectly. Which is why when he fails to mention it, it's pretty transparent what it means - he knows I'm right, that he was overzealous in praising the paper, and he doesn't want to admit it.

A question to readers on QE2...

What is the purpose of quantitative easing?

It's not as simple a question as it may first appear, especially from a Keynesian perspective. I can think of at least two legitimate answers from a Keynesian perspective, and then one more from a New Keynesianish perspective.

What do you think the purpose of quantitative easing is? I honestly am analytically agnostic (or perhaps it's better to say I'm receptive to several of these explanations), and just hoping for the best.

I see the following purposes:

1. Lower long-term rates to boost investment demand (classic Keynesian)
2. Boost nominal expenditures (classic monetarist, widely adopted Keynesian)
3. Increase inflation to deal with wage and price rigidties (New Keynesian)

And of course a lot of these imply each other.

I know Lee Kelly will be especially receptive to the second one. My concern is that if we're just shoveling money at people with excessive demand for money, we may eventually satisfy that demand, but we're not really addressing the root cause of the excessive demand for money: the lack of demand for goods and services. Number one seems to be the best at addressing that "root cause", but this is second-best solution in the Keynesian playbook to fiscal policy. And I think while the third explanation doesn't hurt to tack on, it's not even clear that price rigidities are the real problem here (except perhaps for the zero lower bound on interest rates).

Open Thread on QE2

I have not had time to really think about the Fed's announcement yesterday or digest the various reactions. My stance on this has always been that this is a good idea, but don't expect miracles, and strong fiscal policy is where we should expect to get the most traction when we're so far below full employment. But then again, I often feel out of my depths in monetary discussions.

There's been lots of good blog posts and thinking on this - please feel free to use the comment section to share those as well as your own thoughts. I'm interested in hearing them even though I don't really have any of my own.

Who you calling John Law?

Alternative titles considered for this blog post:

1. Austrians say the darndest things, and
2. Silly Austrians, BPS are for Keynes!

Anyway - Jonathan Catalan seems to think the move from LM2 to LM3 in Figure 1 and from LM1 to LM2 in Figure 2 are the same thing. I'm not sure why he would think such a thing. I mean just look at them! They look really, really different, right? What's the deal Jonathan?

Jonathan's Liquidity Trap Article

I've gotten a chance to read Jonathan's Mises Daily article on the liquidity trap, and I certainly don't regret recommending it in previous posts - it's very good. I jotted down thoughts as I was reading it, so I think the best way to present it in a blog post is just to go through the points the caught my eye, quoting him and then posting my response to him. It might be hard to follow this without reading the article, but I'm not sure how else to organize my essentailly bullet-point response.

JFC: “Broadly speaking, the economics profession is divided into two camps. One side is made up of "liquidationists" and "deficit hawks," supporting tight monetary policy and low — or no — government spending. The other group is composed of those fearing a fall in prices, who support easy credit and expansive fiscal policy to combat it.”

- I don’t think deflation is the primary concern – although it is an important one. Depressed output is the primary concern, and deflation is a concern because of the complicating factors it introduces to a depressed environment. The fact that this is not the major bone of contention is made clear by Hayek and Rothbard’s insistence that deflation is problematic, as well as recent expressions of the Austrian School’s allegedly close relationship to monetary disequilibrium theory.

- We need to appreciate how Jonathan goes on to delve deeply into the literature that provides context to this debate. For example, Krugman’s treatment of the Austrian school in 1998 isn’t strictly necessary for understanding his view of the liquidity trap. I’m not personally familiar with the details of this exchange, but Jonathan has done impressive due diligence by providing all these references here.

- On Krugman’s recent treatment of Hayek – I think the critique of Krugman has been overdone. I agree with Jonathan that Krugman doesn’t really seem to demonstrate an understanding of the macroeconomics of the capital structure (although he’s closer than many suspect – he does the sort of sub-sector analysis in his critiques that I’ve never seen an Austrian do thoroughly. I complain often on here about the lack of empirical verification of Austrian theory – Krugman’s blog comes closer to doing that than mises.org does). But he does correctly summarize what Hayek has said: that a “slow process of adapting the structure of production” is necessary. That sure sounds like we have to just wait and suffer through unemployment to me. Didn’t Mises call this purging the rot out of the system? I think we’re being disingenuous if we don’t accept that the Austrian school sees high unemployment as, to a certain extent, functional.

But later, Jonathan seems to agree with Krugman! He writes:

JFC: “This [the "Misesian-Hayekian" malinvestment framework] suggests — like Krugman accuses — that following a boom of malinvestment there will be a period of relatively high unemployment.”

If he really thought that, he shouldn’t have said that Krugman was “erroneous”.

Jonathan zeroes in on what I agree is the important point:

JFC: “As a general concept, the liquidity trap is legitimate in the sense that we are currently in a situation in which, despite the extreme provision of liquidity on the part of the Federal Reserve, there has not been a substantial increase in real private investment. As such, any Austrian rebuttal to Krugman should concede this point.

The real debate is whether or not fiscal stimulus can effectively revive an economy (or pull it out of a "liquidity trap") or if fiscal stimulus contributes to the existence of a liquidity trap — there is the distinct possibility that this so-called liquidity trap is the product of regime uncertainty, which may or may not be aggravated by government policy.”

- And it’s about more than just that. Does monetary policy work? The original purpose of highlighting the liquidity trap was to demonstrate a circumstance under which it wouldn’t. But is that really the case? A lot of people don’t think that is the case. I’m not sure what I think, but I’ve been content to say that “monetary policy is less effective in a liquidity trap than it would otherwise be”

- When he describes the liquidity trap here, he’s really describing the symptoms rather than the underlying cause. That’s fair enough, but it would have been nice to explain exactly what a liquidity trap is near the beginning: it is a situation where cash and bonds become interchangeable. How that is depicted in a model has been debated, but that’s the fundamental point.

JFC: “Keynes believed that such a situation occurs out of a change in the "state of expectation."[10] In other words, an increase in uncertainty leads to an increase in the demand to hold money and a decrease in investment,[11] based on the belief that money's relatively riskless qualities makes it more desirable to hold than bonds and assets”

- Yes, there’s that – but presumably the risk premium can be compensated for. The point is, at low interest rates there is no longer any compensation for the risk. So I think the key here is the interest rate, not the relative risk.

JFC: “Given a "virtually absolute" liquidity preference, monetary policy becomes ineffective at stimulating "aggregate demand" since an increase in the supply of money cannot increase wage-earners' incomes.”

- Does monetary policy stimulate aggregate demand by increasing wage-earners’ incomes or by lowering the interest rate? I always thought it was lowering the interest rate.

JFC: "Between 1940 and 1970, the liquidity-trap theory went through major changes and reformulations, only for Hicks to recant, suggesting that, "[w]hile one can understand that large balances may be held idle for considerable periods, for a speculative motive, it is harder to grant that they can be so held indefinitely."[24]"

- I’ve always been suspicious of this “recantation” by Hicks. Whoever said they would be held indefinitely? I know Hicks’s change of heart was broader than this and perhaps there was more to it than this, but this particular quote never struck me as particularly convincing. He seems to be recanting a strawman, in other words. I don't see the later Hicks making a convincing argumetn against the earlier Hicks, in other words.

JFC: “Where Krugman parts ways with Keynesian precedents is in applying a theory of intertemporal expectations, where monetary policy is ineffective because of the expectation of future deflation — the public believes monetary policy to be only temporary, as opposed to sustained.”

- This is actually probably better put as “Krugman parts ways with Hicksian precedent”. Keynes actually uses these expectations arguments quite frequently in the General Theory. Hicks put it into a static model, so a lot of the original Keynesian discussions of expectations were forgotten. I don’t mean to be argumentative with Jonathan on this point – I actually mean to deflate Krugman’s originality a little bit and give more credit to Keynes (who may not deserve original credit himself, in all likelihood).

JFC: “While Keynes and Hicks would have perhaps shied away from massive monetary stimulus, operating with the understanding that monetary policy was ineffective during a liquidity trap, New Keynesian theory puts much more importance on a growing money supply.”

- This is what I’ve always thought as well, and that’s the impression I get from the General Theory, but what’s interesting is that Keynes does express a very similar monetary prescription in an open letter he wrote to Roosevelt – I believe in 1938. He said two things were needed: fiscal stimulus, and the reduction of long-term interest rates. Presumably one would reduce long-term interest rates with the sort of quantitative easing policies being proposed today.

JFC: “Austrians instead see the resulting fall in the price level as the cure for deflation (or fall in the money supply).[54] Recognizing the problem as the result of a fall in profit, due to the deceleration of credit expansion, the problem of demand necessarily stems from the inability to pay for products demanded. The solution is a fall in prices of relevant goods and services, to the point where demand for them can once again rise.[55] In other words, conceding that a fall in the money supply will lead to a decline in spending, the only method by which spending can rise is through a fall in the price level.”

- I could see why a falling price level as a "solution" would result in re-equilibration. I don’t see how it addresses the fundamental dynamics of the deflationary spiral. The whole point of the deflationary spiral is that deflation further constricts the money supply, which causes more deflation. At some point, one may think that a real balances effect would put a brake on this. I am more persuaded by the idea that at some point the need to replace capital will put a brake on this. Either way – simply letting prices fall alone doesn’t seem to provide a solution to a problem that is caused by falling prices, unless you reject the logic of a deflationary spiral in the first place (which Jonathan doesn’t seem to).

JFC: “The alternative method, or the Keynesian "solution" of inflation, can lead to a temporary "recovery."[56] Nonetheless, such a policy would inevitably result in greater malinvestment and a greater net loss of wealth.[57]”

- This is probably an instance where it would have been better to distinguish between Keynes and Krugman explicitly. Not that inflation didn’t play an important role for Keynes, but it plays a much more important role for Krugman. However, I think even for Krugman this is only the monetary half of the story.

JFC: “However, rising uncertainty and low expectations for the future, brought about by economic depression, can be considered legitimate factors behind a liquidity trap. In this case, we define a liquidity trap as a situation in which private investment stagnates despite the readjustment of the structure of production. One such situation of this occurring was during the Great Depression. This topic is tackled by Robert Higgs, in which he attaches the blame to "regime uncertainty," or uncertainty caused by a general antibusiness climate produced by the government.[58]”

- The policy uncertainty argument always seems odd to me. Empirical evidence suggests that the policy uncertainty is of minimal concern to businesses relative to other uncertainties (i.e. – demand uncertainty). The arguments of Higgs and others always strike me as a case of post hoc ergo propter hoc. The policy reacts to the business climate, not vice versa. This at least seems to be what we see in the business confidence data.

JFC: “Wealth-producing investment relies on two underlying factors: that there exists a demand for the product and that the producer can satisfy that demand at a profit or by receiving greater satisfaction in return. That government cannot satisfy another's demand at a profit can be extrapolated empirically, because if it could, there would be no need for deficit spending — the capital necessary to fund these programs would come from received profits.”

- I think this whole statement is problematic. I could probably agree with the first part of the definition – that there exists a demand for the product. I don’t see what profits have to do with it. What about a competitive situation where economic profits are driven to zero? What about non-profit institutions – do they not produce wealth? Profit seems to me to be important because it provides an incentive and information on consumer demand. It doesn’t seem to me to be definitionaly essential to wealth. I’m also having a hard time understanding what deficit spending has to do with it. Firms finance projects in a variety of ways – why should the government be any different? The share of government financing coming from debt can easily be explained by the unique qualities of the government – its status as a sovereign guarantor of currency, its longevity, etc. I really would have preferred that Jonathan defend this understanding of wealth more sufficiently.

JFC: “Fulfillment of satisfaction is dependent on individual subjective evaluations and voluntary exchange. Government, instead, distributes capital towards otherwise unwanted ends, taking it away from the private sector and "producing" at a net loss.”

- This seems to assume complete property rights. Otherwise, how else could Jonathan conclude that capital is moved to “unwanted” ends. Whether the ends that government moves capital towards are “unwanted” or not is indeterminate unless you are assuming complete property rights. Therefore, I’m forced to conclude that Jonathan is assuming complete property rights. It’s a bad assumption.

JFC: “The difference between Hayek and Krugman is that Hayek was not a utopian, and realized that economic growth can only once again take place if the structure of production adapts to society's time preference — there is no formula by which government can centrally plan wealth creation.”

- The non-utopianism is a quality of Hayek, but I don’t see how it is a point of difference between Hayek and Krugman. Hayek and Krugman are simply different kinds of non-utopian. Krugman certainly doesn’t believe there is a formula by which government can centrally plan wealth. They both think that there is a course which is closer to an ideal than an alternative course. If that belief alone is utopian, then they are both equally utopian – but I don’t think that simple belief is enough to qualify someone as a “utopian”.

I think one of the biggest liabilities of this piece is that it goes from a reasonably relevant Krugman v. Hayek discussion, to the liquidity trap, and then on to questions of deflation in general, ABCT, etc. I think the transition from the liquidity trap to deflation was perhaps appropriate given the important of inflation and deflation to Krugman's version of the liquidity trap, but I think it gets a little farther afield when it gets into the deflationary spiral - which it seems to me is quite different from the liquidity trap.

Part of the problem is that the liquidity trap is hard to incorporate into a theory like the Austrian School's, which for the most part doesn't incorporate anything like liquidity preference. Hayek's "loose joint" of money was the passage of time. For Keynes, the loose joint was more than that, and it came from liquidity preference (Garrison calls it a "broken joint" for Keynes - I think "looser joint" is probably more accurate). Without a well incorporated concept of liquidity preference, it's hard for Austrians to engage the liquidity trap. Policy uncertainty is invoked to explain what we see empirically and the concern with low rates and the capital structure is invoked to address the theoretical symptoms of the liquidity trap. But the real heart of it - the indifference between cash and bonds - is left completely untouched.

Khan and Caplan on Savings

Razib Khan, at the Discover blog, has an interesting post up on a Jonah Lehrer post about early childhood investments, reviewing a recent Heckman paper on preschool. Khan brings in an older paper that looked at the cognitive and non-cognitive impact of early childhood education. The cognitive impact apparently wore off over time, but the non-cognitive impact persisted. Khan relates the non-cognitive effect to the adoption of "bourgeois values", including what he mentions as a lower time preference. He goes through an interesting discussion of the results: is the impact a result of actually changing the brain at a critical point (much like how young children can acquire languages easier than older children), or does it have to do with peer groups? He also links to an interesting former post of his discussing genes and saving behavior as well as culture and saving behavior (both are important).

It's not all that strange to think that time preference is culturally informed. That's the Weber thesis. It's also not all that strange to think of it as genetically determined - low time preference is a fantastic trait to evolve if you want to set up your ancestors for success (granted, first you have to evolve an ability to think abstractly about time in the first place).

All of this meshes very well with Keynes's assertion that savings behavior is as much about psychology as it is a response to economic incentives.

I would also highlight that although Khan only mentions time preference as it relates to savings - it will also relate to investment and the sorts of investments we make. A lot of very important public investments: space colonization, basic research, addressing climate change, etc. are hampered by a high discount rate and short time horizons.

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Bryan Caplan also has a post on savings, specifically addressing the critique that expansionary monetary policy and tax cuts won't work because "people will save it". He accepts the liquidity preference justification for the increased savings, and then essentially says "well what's so wrong about satisfying that preference"? I have three thoughts:

1. He does raise a good point that eventually consumer demand could be augmented by satisfying consumer's liquidity preference, but

2. The real glitch isn't consumption - it's investment demand. Now, maybe once corporate liquidity preference is satisfied, they'll start investing because they feel safer. But they're not going to start investing in response to lower interest rates - that's the essential point of the liquidity trap. When cash and bonds become interchangeable because interest rates are so low, further expansion is not going to stimulate activity through lowering the interest rate. Could it stimulate activity through satiation of liquidity preference? Perhaps. But,

3. Wouldn't it be a whole lot quicker, and wouldn't it avoid the risk of substantial inflation after the recovery, if we just augmented demand with fiscal policy? This might not be as attractive if we didn't have a bunch of potential public investments, but... ummm... we do have a bunch of public investments.

I've been fairly agnostic about the monetary policy route - I don't think it holds a ton of promise right now, but I haven't put a lot of effort into shooting it down either. Caplan presents a plausible case for how it could work, but it just seems like it would take so damned long.

Cowen on substitutes and the liquidity trap

Regular readers know that I think the liquidity trap is intriguing and certainly relevant right now, but more of a theoretical curiosity than a hugely important factor. Tyler Cowen makes much the same case in this post, which thinks through the zero lower bound argument by reviewing the importance of substitutability in other markets.

Cowen argues that adjustment can be slow for very close substitutes, but that it will happen - and many other factors are important than just the substitutability of cash and Treasuries for the adjustment process. That's all well and good, but the fact remains that the adjustment process is considerably slower for closer substitutes than it is for substitutes that are much less close. It is precisely the close substitutability of cash and Treasuries that makes all the other issues that Cowen talks about relevant right now, and that is the sense in which the liquidity trap is meaningful. Cowen uses the example of the close substitutability of grapes and pluots to talk about the liquidity trap, and he says that substitutability alone does not explain the adjustment. His appetite, for example, is also a factor. I would only add that we're only even talking about "appetite" as a factor because what is introduced is more food (pluots). If Cowen's house guest had brought, say, a bottle of wine we might think of the wine and the grapes as complements rather than substitutes. "Appetite" in the sense of how much food you feel like eating is no longer a constraint at all, because it might be very nice to have wine and grapes together. The close substitutability of grapes and pluots is disconcerting precisely because it introduces the relevance of other constraints like appetite.

That's largely how I think about the liquidity trap. It makes things problematic that wouldn't be problematic under other circumstances. Other than that, it's hard to stretch this metaphor much farther. Grapes and pluots aren't media of exchange, stores of value, or opportunities for speculation, after all - so I'm not sure how much mileage Cowen thought he was going to get out of this. I suppose it works as an explanation for portfolio adjustment, which is what he claims he's talking about. But since when is the importance of the liquidity trap derived from balancing the composition of your portfolio between cash and bonds? That's not really the major point. The point is the demand for liquidity as well as the impact (or lack of impact) of monetary expansion on the interest rate.

I guess I'd offer one more interpretation to push this metaphor a little further. If you were Cowen's house guest and you knew about his grapes/pluots dilemma, it would probably make more sense for you to bring that bottle of wine that would complement grape consumption, rather than those pluots which would be close substitutes for grapes, right?

What could possible complement liquidity preference right now - what could encourage households and firms to work through their liquidity preference - rather than exascerbate it? Probably some additional aggregate demand, right?