Right Reason

Wicksellian Rot in Greece: When Will Relief Come?

From NPR:

"There's no credit. How can you do business without credit?" he asks.

 

Greek banks have little money to lend out, while foreign lenders, which once flooded Greek businesses with loan offers, no longer want to do business in the country. The possibility that Greece might leave the eurozone, however slim, makes lending money there too risky.

It's a huge challenge for companies like Kir-Yianni, which have to import virtually all of the materials and equipment they use in their production. Kir-Yianni buys bottles from Italy, paper from Turkey, barrels from France and cork from Portugal.

 

What the NPR broadcast is describing, though it does not go into the economic details, is a phenomenon called Wicksellian Rot. Entrepreneurs in Greece are suffering from not having the money at hand to make their exchanges. This does not necessitate that what they are doing is economically unprofitable, indeed in the case of many it seems that they are plenty profitable, but that they suffer a want of physical money to complete their exchanges with other people. They know that they can make mutually beneficial trades with other people and they have done so in the past, but this exchange cannot be completed because of a lack of money. Thus parts of the Greek economy, which could otherwise be prosperous, are in a state of economic malaise due to a simple lack of cash.

 

The Euro is leaving Greece. As can be gathered from the broadcast, and which is corroborated by other reports, there is not enough Euros in Greece to fulfill the demand for money and so patterns of trade are grinding to a halt. This in turn is exacerbating the Greek economy as those few productive sectors in the economy are brought down as the Wicksellian rot brings down the economy. The natural process of this crisis is that capital will flee Greece into other parts of the world, and especially of the Euro-zone, until the overall price-level in Greece. This can be crudely shown with a basic supply-and-demand diagram, with the price-level on the ordinate and the quantity of money on the abscissa:

 

The right-ward sloping blue curve is the demand for money. It slopes that way because as the price level increases, each unit of cash will chase less goods hence to maintain their power to buy goods, in econ-speak their purchasing-power, people will demand more money. The purple line is the supply of money. It is vertical there because we shall assume here that the supply of money is endogenous, the product of the decisions of central-bankers and savers for reason outside of the model. Here, the initial price-level shown by the red dashed line no longer brings the demand and supply of money into equilibrium. Instead, the demand for money at that price-level exceeds the supply resulting in a large shortage of money whose effects we now see in Greece. The two can be brought back into equilibrium if the general price level in Greece decline by a process of systemic deflation; however, this is a process that has proved to be devastating for prosperity as shown by the British deflation of the 1920s after the Bank of England returned to the gold standard's pre-war parity even after half a decade of inflationary politices.

 

This can be avoided and there is a way to bring back monetary equilibrium without the price-level adjusting. This is possible if the Greek government were to expand the money supply as to bring it into equilibrium at the current price-level. This can be graphically represented as so:

Even though this would disturb the economy in its own ways, expanding the money supply would enable Greek entrepreneurs who have viable businesses to get the cash they need. In addition, since the Greek unit of money would have to decrease in value with respect to foreign monies, Greek goods would be less expensive than goods from other nations leading to a comparative advantage for Greek exports.

 

None of this is to happen soon, though. The Greek government has no control over their money and the nation is stuck in a union to the benefit of fiscally sound countries. Due to the loyalty of the EU to the idea of a united Europe and because the Euro is seen as an essential tenet of a united Europe, the Greek economy is simply left to go about the long process of deflation (while at the same time having to abide by austerity measures enforced by the EU). If Greece were to simply leave the Euro and adopt the Drachma, then Wicksellian rot could be avoided by expanding the money supply and the Greeks could use devaluation as a tool for getting out of the crisis.

In the short term, this is not to be for Eurocrats can continue to delude themselves that Greece can somehow remain in the Eurozone without loosing a decade of economic growth. In the long term, though, the Euro will leave Greece and the conditions of Wicksellian rot will worsen until finally the Greek government expands the money supply. What they use to initially expand the money supply may not be called Drachmas at first. They may very well be promises to pay Euros to the holders of the notes. However, they will be Drachmas in all but name and it is very likely that Greece will only formally sever its ties to the Euro after the informal ties had already cut themselves. This is all speculation, but what we can be certain of is that as long as Greece is in the Euro, there is no hope for the Greek economy. Until political hopes give way to economic reality, Wicksellian rot will worsen in Greece.

QE3: A Look at the Micro-Foundations

 

To start off, any judgment of the new round of Quantitative Easing must make clear its own opinion on the problem that the Federal Open Market Committee hopes to alleviate with it: persistent unemployment that has been the norm over the past four years.

The problems the American economy is suffering from are neither supply-side nor demand-side problems. To even draw the two curves would to abstract away from most of the problems that we have suffered and are suffering from. The fundamental problem is an economy that has substituted debt for productivity in the past and that made serious malinvestments in the housing and financial sectors. To put it in terms of Arnold Kling’s language of Patterns of Sustainable Specialization and Trade: over the past decade (at least) the new patterns of specialization and trade (e.g. construction and financial jocks) that have driven the growth in spending in the American economy were driven by borrowing. Those patterns could only last as long as the credit was loose and the markets did not realize the house of cards they were built on.

Now that that house has collapsed, it is of no surprise that the patterns of specialization and trade it produced have been disrupted. A result of this has been that spending in the American economy has also plummeted along with those patterns. In addition, median households can no longer use cheap credit in order to expand their consumption beyond their disposable income, so this has also contributed to the fall in spending. These micro-foundations to the fall in spending in the American economy make me skeptical that NGDP could have even stayed on its historical average baseline in 2008. It seems to me like spending had to fall with the declining PSST and along with that NGDP. Any attempt to pump spending back into those sectors would have been patching the problem rather than addressing the serious long-term sustainability issues they had.  A nation simply cannot grow by credit forever.

Since the problems were debt and malinvestments, the only two solutions that would truly bring back economic health are deleveraging and economic recalculation (the reinvestment of malinvested assets to more productive uses). This is a process that no central banker can solve. Contra Keynes and Krugman, the problem of recession is not a problem about the insufficient use of technical knowledge on part of decision-makers in the government. Instead, it is a evolutionary process by which one of the most complex systems in the entire universe adapts to new conditions by the actions of millions of dispersed human beings, all with their own knowledge and vision of the world, guided by the mechanisms of the market. To interfere with that is to risk the entire process never truly adapting to those new conditions. As Joseph Schumpeter said in his article :Depressions: Can We Learn From Past Experiences?”:

(O)ur analysis leads us to believe that recovery is sound only if it does come of itself. For any revival which is due merely to artificial stimulus leaves part of the work of depressions undeone and adds, to the undigested remnant of the maladjutment, new maladjustments of its own which have to be liquidated in turn, thus threatening business with another crisis ahead.

 

The question of the day: what should this lead us to think about QE3?

For one thing, it should make us very suspicious of the FOMC’s decision to buy Mortgage-Backed Securities. Most of them are junk and should be treated as junk by policy-makers if policy is going to be neutral with respect to the process of recalculation in the housing sector. The Federal Reserve buying them does not correspond to that criterion of neutrality. Capital Economics has estimated that the Federal Reserve will have to buy $1 trillion in Mortgage-Backed Securities over the next three years to push unemployment down to 7 percent. This will have benefit those who have held onto those assets, a nefarious process that will reward failure rather than raising those up who made the best decisions over the years to the top. This contributes to the fragility of the markets and prevents the evolution of robust institutions that can endure through sudden changes in the economic data.

Then again, if the Federal Reserve were to buy $1 trillion in bonds from the US Treasury, that would also create perverse incentives in government budgeting. Perhaps there is no asset that Fed could buy while obeying the neutrality criterion, but to buy assets that are so connected with the 2008 Financial Crisis and the problems that caused it is an utter violation.

The greatest error of QE3, its designers and its advocates is that they are simply looking at spending. What they want is for monetary spending to simply stimulate spending in the economy to boost aggregate demand. However, there is no such thing as aggregate demand. There is only a variety of heterogeneous demands for many heterogeneous products, none of which are fungible. Aggregate demand is just a fiction of bad macroeconomics. By focusing on spending alone and not the channels of trade that spending flows through à la PSST, that perspective misses the entire process by which an economy crashes and that proceeds to recover.

Once we take our eyes off of the golden calf of aggregate demand and stop thinking purely in terms of fungible “spending”, we can truly focus at the problems at hand:  the PSST within the economy and the institutions that facilitate them. This is no my last word on the subject and for lack of time (as well as trying not to take on too much for a single post) I'm unable to consider concerns about debt-deflation found in Irving Fisher's great paper: “The Debt-Deflation Theory of Great Depressions.” Of course, that is no mere lacuna so treat this all as merely a process of getting the true, yet forthcoming, understanding.

 

QE3: Some Initial Thoughts

This is not my last words on the subject, but these are some of my initial thoughts on QE3. From The Economist:

Earlier this year, the Federal Reserve reached a crossroads. It had lowered short-term interest rates to zero and promised to keep them there until 2013, and then 2014. It had undertaken multiple rounds of bond purchases to lower long-term interest rates. Yet the recovery was actually losing steam; unemployment had stopped falling. Was there anything left to try?

The answer, it turns out, is yes. The Fed made one of its most consequential announcements yet today. The detailed actions were, in themselves, similar to previous steps: it will buy $40 billion of mortgage backed securities per month, and extend the period of short-term rates near zero until at least mid-2015. But the game changer was what it said: it will keep buying bonds until, and beyond, when the recovery is firmly established.

All other attempts have failed and now the Fed is reaching for the kitchen sink. Despite my cynicism, this is certainly a victory for market monetarists throughout the blogosphere. They have argued that money has been too tight over the past couple of years and it now seems that the Federal Open Market Committee agrees with them.

However, I must emphasize the “seems”. I myself look at this as less an intellectual victory for the market monetarists and more of a correlation between what the FOMC is now willing to do and their own beliefs. The market monetarists could have won the intellectual debate in 2008 and yet I do not think that the course of monetary policy would have changed. What we now see is less of a paradigm-shift in policy than a reflexive reaching towards bigger guns after the smaller ones failed to do the job.

That gives me a very Japanese feeling about all of this. Just as in Japan, for better or for worse, it is events that are leading the Federal Reserve down policy routes rather than its choice of policy determining the events that affect it.  That alone gives cause for pessimism.

 

Another problem, one that I wrote about before, is that the Federal Reserve has no means of committing itself to this policy. What gives people reason to believe that the Fed will actually abide by what it says today? Especially with the racketing up of Fed policy each year, it is a very good bet that when recovery does not come this year, that the FOMC will reach for an even bigger gun next year. Scott Sumner over at The Money Illusion may want the Fed to abide by results-based policies rather than basing its policies on tools like loosening credit. However, the Federal Reserve cannot simply will a recovery into existence. This in turn must leave us wondering what will happen when a strong recovery doesn’t happen over the coming year, and I have a feeling that the FOMC will simply continue its reaction to events by ratcheting up its policies.

Without commitment, words are wind. The only way that the Federal Reserve could truly commit itself to NGDP in a manner I see affecting expectations across the entire economy is by law. Either the Federal Reserve is completely willing to target NGDP, or it is not. If the former, then it would be willing to have that be legislated and would want Congress to legislate that in order to send the strongest signal possible. If not, well then I see this as simply a case of trying out a new policy and then being willing to leave it by the wayside if things don’t go well.

 

Another feature of the announcement that provides cause for pessimism is the decision of the FOMC to buy mortgage-backed securities. This to me will provide incentives that will hamper what must happen if the economy is to truly recover from the havoc of 2008: resources that were misdirected under the bubbly conditions of the boom must be reallocated to more productive uses. There simply will not be any recovery worth having. It’s not a matter of simply how many Legos we have, it’s a matter of how well those Legos fit together and whether anything can be done with them.

I do not know where recovery will come from, what will be the next big jump in productivity that expands the American recovery (though many have estimated that the new iPhone 5 alone may contribute 0.5% to GDP growth this year). However, it will not come from housing. Don’t get me wrong, I believe there are places in the country in which the housing market is strong and will continue to be strong, but there are other places where we must accept that much of the market must be liquidated. This has largely been done, but housing policies and the purchase of mortgage-backed securities work against this aspect of the recovery.

 

On top of all of that, this policy comes four years too late. It certainly would have been an improvement over the initial round of Quantitative Easing and would have fought the decline in Nominal GDP over that period. It still would not have been enough to prevent this terrible economy, though, for this economy is not a problem of too tight money, but a problem of massive malinvestments, an economy that was too leveraged and that thought it was richer than it really was.

 

NGDP over the yeays, note the collapse in 2008.

That would have been four years ago. Today it may very well be a move in the right direction, but it will have nowhere near the decisive effect proponents of NGDP targeting hope for. Nor should the necessity of NGPD targeting in face of economic downturns be the lesson of what we now experience. Instead, the lessons should be about the real side of the economy.

It was not the money illusion that created 2008 nor is it the money illusion that will raise the world from its economic malaise. Let that be known.

Forbes on the Gold Standard

Over at Forbes, the eponymous editor-in-chief has recently provided the second most convincing argument for the gold standard:

In order to work properly and productively markets need a reliable pricing mechanism. By manipulating interest rates on such an unprecedented scale the Federal Reserve has effectively destroyed the ability of our credit markets to genuinely price the borrowing and lending of money. Does anyone really believe a 10-year Treasury should yield little more than 1.5% or a 30-year government bond just under 3%?

This point is critical: The Fed’s forced suppression of organic interest rates has made the pricing of credit impossible to figure. And guess what? If you can’t determine the real prices of products and services, you get less–or none–of them. It’s Soviet-style economics.

Say we had market-determined interest rates again. Banks might then have to pay 3% or more on your deposits. Unable to get virtually free money, banks would more actively seek customers for loans. And regulators, who in their current bout of unreasonableness have also suppressed lending impulses, would be more vigorously resisted.

A problem with how Mr. Forbes phrases the argument is his focus on the rate of interest payed to deposit accounts. How much the Fed actually affects the rate of interest that banks in the market pay on deposits is an easier question to ask than answer. A handy, though slightly dated guide to this issue has been published by the St. Louis Federal Reserve here. However, with the Bernank throwing everything he's got to get spending back up, I would expect that the effect of the market rate of interest on deposits has been higher than normal. Still, Mr. Forbes should have focused more on the market for Treasuries rather than wandering off on a point that is far more questionable.

 

This brings me to the best argument for the Gold Standard. The best argument is that would prevent the money supply from being manipulated in order to provide perverse incentives to the government. What do I mean by this? An example would be best: Just last yeas, as a part of Operation Twist, the Federal Reserve bought 61% of the United States debt, and as such have been subsidizing the massive deficit that the United States has been running (an article from the Wall Street Journal on the issue is here). In Europe the ECB now intends to directly buy sovereign bonds in order to indirectly bail-out the countries teetering on the edge of crisis. These policies directly provide incentives for governments to continue to live beyond their means and to continue to pile up debt for other people to deal with. If we want a constitutional arrangement that provides incentives for governments to guard the public purse and the soundness of their balance sheets, then there must be an institutional arrangement that prevents actions like these in the economy. By limiting the amount of money in existence and limiting the extent of central bank's actions by the amount of gold held in reserve, a gold standard would help provide that institutional arrangement.

 

Of course, all of these arguments for the gold standard assume that central banks will actually obey the rules of the gold standard, which they did not after 1929, as Milton Friedman and Anna Schartz note in The Great Contraction:

The international effects (of the rise in the U.S. gold stock in the two years after the 1929 crash) were severe and the transmission rapid, not only because the gold-exchange standard has rendered the international financial markets more vulnerable to disturbances, but because the United States did not follow gold-standard rules. We did not permit the inflow of gold to expand the U.S. Monetary stock. We not only sterilized it, we went mcuh further. Our money stock moved perversely, going down as the gold stock went up. In August 1929, our money stock was 10.6 times our gold stock; by August 1931, it was 8.3 times the gold stock. (Friedman and Schwarz, pg. 109)

When the costs of not obeying the rules are negligible, then they will not be obeyed. Just as Greece, Spain, Portugal and Italy continued to run massive deficits despite being obligated by the rules of the Euro not to, we ought to expect governments to do the same. And then when crisis approaches and the rules seem to determine that events must go that way, politicians and central bankers will simply get rid of the rules. Worked for them in 1931, 1971, and in 2010, so why expect events to go differently in the future? Promises to do better?

Words are wind. When betting on either incentives that tempt or promises that hold true, my bet will be on the former. So, even though I do believe that it is a good thing that the gold standard is in the news if for no other reason it provides a foil for our current system, I do not think that the gold standard will accomplish what its advocates desire.

That is why I would much prefer we do away with the government's monopoly over money and let the free decisions of individuals decide the dominant currency (just as the free market decided on gold rather than silver being the dominant currency in the 18th century).

Monetary Policy: A Matter of Institutions

Will the Federal Reserve, or any Western central bank for that matter, be able to provide monetary stimulus to the economy? No, for a reason why, look to the recent post from Professor John Crochrane's blog, “The Grumpy Economist”:

The deep, intractable problem with this idea is commitment. This occupies the bulk of Mike's analysis, but I don't think he, or others advocating these policies, successfully solves it.

Every day I promise that tomorrow I'm not going to have dessert. Every tomorrow I change my mind. Because I can. Tomorrow, if inflation breaks out, the Fed will want to raise rates sharply.

How can the Fed promise today to do something it will very much regret tomorrow, and get people to believe that promise?  More deeply, how does the Fed commit to allowing "just a bit" of inflation in the future, and not starting down the path of the 1970s again?

Simply put, no informed person will actually believe that a central bank would be willing to actually grab the inflation tiger by the tail and risk another '70s scenario.

Central banks may roar as loud as they can, they can do all of the open-mouth operations they want and announce that they are willing to see some mild inflation to get spending back up to the historical NGDP baseline. However, no one will, or should for that matter, listen. After all, no central bank within the Occident would now be willing to commit to taking on the great political costs such a policy would have and without commitment those words are little more than exhaled breath.

If central banks want to get more spending, expectations are what matter. For monetary stimulus to work, they have to convince all of the companies and banks now sitting on cash that they have better start spending it if they don't want to see a good portion of the assets of their balance sheets. The point shouldn't be to blind-side the economy with a flood of new money and money-substitutes, but to gently prod savers into spending their held assets. However, if the central bank wanted to create expectations of inflation, open-mouth operations would not be enough, it would have to prove its mettle first. That exercise of power would almost necessitate unleashing unexpected inflation. 

Turning back to why those open-mouth operations are so impotent, the reason has to do with the institutional evolution especially over the past half decade, though certainly acting on previous precedents, of central banks involving themselves more and more with politics outside of the regulation of the rate of interest and monetary aggregates. What we see today are central banks that are becoming more and more institutions that are an active part of their respective government's economic policies. Take two examples: the Federal Reserve and the European Central Bank. After the Dodd-Frank Act, the Federal Reserve Chairman now sits on a regulatory council, the Financial Stability Oversight Council, (the loss of independence was implicitly accepted by the bill when it included a partial audit of the Fed). This was after the sitting Chairman overstep his explicit authority by bailing out companies and even urging on the Federal government to pass TARP. This, though, doesn't come close to matching the statecraft that is now being practiced by the decision-makers within the ECB who are using all tools within their disposal in order to salvage the European Union.

When central banks are so tied to the political workings of their nations, as the Fed and the ECB are now, they are vulnerable to shifts in public opinion. The very same shifts that unexpected inflation would doubtlessly cause. Those shifts of public opinion would effect not only the means that the central banks have adopted, but also the ends that they now strive after. Why would the Federal Reserve risk its future ability to pursue polices independent of Congress by stirring up more anti-Fed sentiment within the United States. Why would the ECB risk their attempts to help the EU survive the ongoing Euro Crisis by the undermining the current German government and reinforcing anti-EU sentiment within nations like Finland, the Netherlands, and the UK already teetering on leaving the Eurozone?

Yes, one could argue that they do so by betraying any hope of swift economic recovery, but I still find it hard to believe it is still not in their long-term interest to follow those strategies. And when it is within their interest to do so, open-mouth policies will not provide any monetary stimulus for they would not be willing to shoulder the costs of following through with those announcements.