The Great Depression and Austrian Economics

Bruce Bartlett opines on the Great Depression and Austrian economic theory:

Representative Paul is here reciting the “Austrian” theory of the Great Depression. It says that even though there was no inflation during the 1920s, somehow or other inflation nevertheless caused the Great Depression. According to the Bureau of Labor Statistics, prices were either flat or falling throughout the 1920s – i.e., deflation.

 

But the Austrian school believes there was actually some sort of double-secret inflation because the money supply increased. They believe the same thing is happening right now.

One curious feature of the Austrian argument that Fed intervention is always undesirable is the fact that the Austrians who promote it never seem to ask the most basic economic question: might intervention be justified in cases where the costs of inaction are extraordinarily high?  In other words, why not think of government intervention in plain old cost/benefit terms as Friedman/Schwarz did in concluding that the Fed’s mistake was one of doing far too little to prevent the economic collapse in the 1930s?  Perhaps the Austrians do this and conclude that the benefits of intervention never outweigh the costs, but that seems highly implausible in scenarios like the Great Depression (if not then, when?).

And Bartlett is right – there was no inflation in the 192os to speak of.  Here’s the chart of CPI from 1920 to 1929 (from measuringworth.com):

The more troubling criticism for the Austrian theory of crises has long been articulated (most clearly by Bryan Caplan).  The Austrian theory relies on an unexplained irrationality among businessmen who are continually fooled by the Fed into believing that “artificially” low interest rates are the actual market interest rates.

As Caplan noted,

Even if simple businessmen just use current market interest rates in a completely robotic way, why doesn’t arbitrage by the credit-market insiders make long-term interest rates a reasonable prediction of actual policies? The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can’t persist forever) they wind up making malinvestments. But why couldn’t they just use the credit market’s long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates?

There are other objections, of course.  See Marginal Revolution here and Paul Krugman here.

Inflation Phantoms Again

The New York Post’s John Crudele thinks we have inflation and that it’s all to be blamed on the Fed (here’s the article):

The actions taken so far by the Fed should have gotten the economy booming. Interest rates this low should have caused a resurrection in the housing industry. And companies should be more than confident enough to hire tons of workers.

 

Instead, all that Bernanke has really accomplished — aside from getting stock prices higher — is to raise inflation levels. It’s funny but no matter how hard I look I don’t see any mention of inflation, and especially rising gasoline prices, in Bernanke’s speech yesterday to the Conference.

 

Yet inflating gas prices — and other signs of Ben-flation — are what’s clearly causing the most disruption in the household economy today.

I suppose evidence does not really matter, but here it is anyway.  According to the Cleveland Fed, 10-year expected inflation rates are averaging 1.4 percent (here’s a description of the model they use).

The University of Michigan’s inflation expectations index is a bit higher at 3.3 percent, but even that does not quite get us into galloping inflation territory:

Other measures of expected inflation tell the same general story but even if the expectations are somehow wildly underestimating future inflation, there is no indication of Ben-flation in the actual historical inflation data.  I’m starting to wonder if those who have been sounding the alarm on inflation have missed the decimal point…the latest year-over-year change in the all-items CPI was 2.9 percent, not 29 percent:

And wage growth (a big part of firm costs) remains practically nonexistent:

Yes, we all know that gas prices have recently spiked (here is James Hamilton’s “rational reason for high oil prices”) but it is bizarre to blame that recent jump in the price of one particular commodity solely on Fed policy that started 4 years ago.  And if Ben-flationary practices are the true culprit, why did oil prices drop by 70 percent between June 2008 and February 2009, just as all the monetary aggregates were skyrocketing?

Bernanke and his Critics

Bloomberg correctly reports today that “Bernanke Economy Proves Critics Clueless on Fed.”  As I noted in an earlier post, inflation remains historically low and inflation expectations are suggesting more of the same – just what we would expect in an economy with high unemployment rates and slowly rising unit labor costs.  From the Bloomberg article:

The criticism about the Fed being inflationary is not fact-based,” saidMark Gertler, an economics professor at New York University who has co-written research with Bernanke. “In terms of an inflation record, the facts are the Fed has been as close to impeccable as you can possibly get.

 

During Bernanke’s tenure, the U.S. consumer price index has risen an average of 2.4 percent, lower than the 3.1 percent average for Alan Greenspan and 6.3 percent for Paul Volcker. Greenspan was chairman from 1987 to 2006; Volcker was Fed chief from 1979 to 1987.

 

“There’s been an extraordinary amount of misinformation about inflation circulating,” Gertler said. “We have not had any sign of sustained inflation.”

 

In January, Fed officials lowered their projections for price acceleration, with inflation ranging from 1.4 percent to 1.8 percent this year, and 1.4 percent to 2 percent in 2013. In November, they predicted inflation of 1.4 percent to 2 percent in 2012, and 1.5 percent to 2 percent next year.

Should Bernanke Get a Pink Slip?

The Federal Reserve has been receiving quite a lot of heat these days both from the political right (Newt Gingrich, for example, recently called for Bernanke’s “firing” and labeled him a “disaster”) and from the political left (the Occupy Wall Streeters are no fans of Wall Street bailouts).  While there’s plenty to criticize about some of the Fed’s actions, the most reasonable way to determine success or failure is the way we normally do that – by looking at measures of job performance.  The Congressionally mandated job requirements for the Fed and its chairman are to use monetary policy to achieve maximum employment and stable prices.

Clearly, we do not have “maximum employment,” so we could give a low grade on this measure although it’s not clear how much of the employment problem is due to monetary policy and how much more the Fed could feasibly do.  But this is beside the point since the one thing the Fed’s critics on both the left and the right would agree on is that that Fed should not be pursuing more aggressive policy.  Their main complaint has been that the Fed has done far too much, not too little.  The only way for Bernanke to improve on the maximum employment front would be to pursue an option that the Fed’s critics have said should be off the table.

That overactive Federal Reserve then must be failed miserably in containing inflation, right? That’s the implication of the criticism, but the data suggest nothing of the sort.  Here’s the Bernanke Fed’s inflation record during his tenure at the helm:

Fed's Inflation Record

The average inflation rate over this period using the all-items CPI was 2.5 percent and the more reliable core-CPI inflation was a mere 1.9 percent. By comparison, the Greenspan Fed had an all-items CPI inflation rate of 3.3 percent on average and a core inflation rate of 3.0 percent.

So Bernanke has not been recklessly generating rapid price inflation but what about the potential for inflation down the road?  There are no crystal balls to gaze into but we do have evidence that inflation inflation expectations remain low by historical standards.  Here’s the University of Michigan’s Inflation Expectation index (the latest reading on that measure is 3.5 percent):

University of Michigan's Inflation Expectation Index

Wages and labor costs remain low, as Greg Mankiw pointed out here, which do not suggest any significant inflation risks going forward.

Finally, the spread between nominal Treasury bond rates and rates on Treasury Inflation Indexed Securities (TIPS) is one way to measure expected inflation.  Here’s the graph, which again suggests that markets are not anticipating rapid inflation either:

Spread between nominal Treasury bond rates and rates on Treasury Inflation Indexed Securities

The primary function of the Fed, aside from these Congressional mandates, is to act as a lender-of-last-resort. The economic history is useful to keep in mind here: the Fed was the product of the National Monetary Commission (if you’re as odd as I am, you might find the NMC documents fascinating and they are all online here), which was formed in response to the 1907 panic to fulfill just this function.  Now, it hasn’t always done that (as Friedman and Schwarz famously pointed out, the Fed contributed to the Depression by being too inactive as it sat by and watched banks collapse in the early years of the Depression).  But even before messing things up by abandoning its post as backstop to the American banking system in the Depression, the U.S. clearly needed a lender-of-last resort.

In the gilded age alone, the U.S. experienced panics in 1873, 1884, 1890, 1893 and 1907. Between 1825 and 1929, there were as many as seven major bank panics and 25 minor panics, so the NMC finally decided to do what Alexander Hamilton had tried (successfully for a while) to create well over a century earlier.

Hamilton proposed and created something that looked a lot like a central bank way back in 1791.  Hamilton’s bank was modeled after the much older Bank of England (created in 1694), which did not endear him to those who abhorred all things British.  But, the First Bank of the United States was chartered anyway and was a success story in American economic history.  Unfortunately, its economic success was obscured, as these things often are, in the politics of the day and its charter was not renewed.  Only five years later, we backtracked and decided that Hamilton may have been right after all!  Thus, the Second Bank of the United States was chartered in 1816 but it too died a political death under President Jackson’s “Bank War.”  The U.S. was without a true central bank until 1914 when, for the third time, we decided it might be a good idea and created the Federal Reserve.

So the U.S. has gone through these anti-central bank sentiments before.  Ron Paul notwithstanding, I don’t think there’s much chance of a second Jackson Bank War but I do believe it is important to keep in mind why the Fed was created in the first place.

Despite its mistakes and despite any number of squabbles one might have with specific Bernanke Fed strategy, he has not been disastrous. If nothing else, the Bernanke Fed, when faced with a massive financial crisis, acted decisively to prop up the system; in short, it did in 2008 precisely what it should have done from 1929 to 1933. I think Hamilton, and Friedman, would be satisfied.

Friedman on Quantitative Easing

Via Marginal Revolution, an old interview with Milton Friedman on monetary policy at the “lower bound”:

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy. The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasirecession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?” It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

Operation Twist

So the Fed adjusts the duration of securities on its balance sheet, long-run interest rates fall, and consumers and/or businesses get a kickstart.  That’s the plan, but I have my doubts about whether it will do much.  It’s better than nothing, but there is evidence (Shiller here and Glaeser here) that house prices do not respond much to changes in interest rates – the extent to which this helps the housing market is very unclear.  Households remain credit constrained and many remain underwater on their mortgages, so it is not clear that they would be able to take advantage of the lower rates even if they wanted to.

Historical data show a weak connection between interest rates and house prices.  For a bit of context, here is Shiller’s data on long-run interest rates and home prices going back to 1890:

Long Interest Rate vs. Home Price

In a separate study using the FHFA index between 1980 and 2008, Glaeser, Gottlieb and Gyourko foundhome prices only rose by barely 7 percent even with a 100 basis point drop in interest rates.

The cost of capital will drop with the lower interest rates, which could help spur business investment spending although it’s not entirely clear how sensitive that spending is to interest rates.

I don’t expect a big impact but I do appreciate the name “Operation Twist.”  For some reason, Chubby Checker’s song keeps repeating in my head….