An Error in the Opposite Direction is Still --- AN ERROR!

David Rose and Larry White explain why Fed Chairman Ben Bernanke has committed a significant policy error.

Comments

[martinf]

Some authors, within the Austrian tradition but with other influences as well (Benjamin Anderson, Melchior Palyi, Antal Fekete...), claim that the Quantitative theory of money is not enough to explain the value of money. Rather, we should pay attention to the QUALITY of money.

Philipp Bagus and Markus Schiml did a great job showing that: "concentrating exclusively on the quantity of money is not sufficient to evaluate the condition of a currency. Qualitative issues can be even more important than mere quantities"
http://mises.org/story/3281

But these kind of articles only deal with the quantitative side of it.

What do you think?

[bill woolsey]

I disagreed with just about everything in the White and Rose op-ed. Spending on consumer and capital goods dropped at more than a 6.4% annual rate at the end of last year. (Total spending dropped 6.4%. What did happen to private sector spending?) How was this possible with base money doubling? Well, the money mulitplier has dropped, with reserves being over 100% of checkable deposits (as measured.) And uncertainty about the economy has caused caused a scramble to hold FDIC insured bank deposits, much of which is money. So, the increase in the broader measures of the money supply are only partly accomodating additional money demand. It is certainly likely that the increase in the demand by banks to hold reserves and by people to hold bank deposits is only temporary. At some point, the reserves and the money supply will need to drop.

But, what about the increase in the CPI in January? There was also a report of an increase in retail sales for February. Perhaps the recovery is starting.

Looking at the CPI figures, the increase in January is hardly noticable against the drop since last July. However, White and Rose's point about the CPI being higher than a year ago is points to something interesting.

I favor a stable price level in the long run, and so a growth path of final sales at 3% per year. However, fear of deflation resulted in the Fed aiming for a low inflation rate. The trend growth rate of the CPI between 1994 and today is about 2.4%. The CPI remained above trend in 2007. In 2008 the increases became larger, peaking at 4.7% above trend in July 2008. The deflation since then was mostly a return to trend, though it was .9% below tend in December and .6% below trend in January.

While I favor price level stability, I don't favor disinflation at this time. Perhaps the large increase in the monetary base has "worked," even with the payment of interest on reserves. I can only hope so. Anyway, along with the rise in retail sales, this increase in the CPI is evidence that it is perhaps time to reverse course.

[Peter Boettke]

Bill,

I usually defer to you on issues of monetary theory and policy, but I have to disagree with you here. Even John Taylor and Anna Schwartz have pointed out that our current monetary policy has been (a) wrong for our current situation, and (b) long term inflationary.

This isn't an "Austrian" point, it is a point that can and has been made by several different stripes of economists.

Also, I am more persuaded than ever that the policy cycle of deficits, debts and debasement is set loose by Keynesian hegemony in policy, with the consequences that threaten the long term viability of the polity and the economy.

Do you think we suffered a "deflationary" period in 2008, or a period of regime uncertainty caused by the government policies that were introduced?

Pete

[Lawrence H. White]

I agree with just about everything in the Woolsey comment above, so I’m puzzled by the first sentence where he says he disagreed with just about everything in the White and Rose op-ed. Obviously the money multiplier has dropped and so has velocity. Given that, and putting aside the option of cutting the payment of interest on reserves to bring the money multiplier back up, anyone who (in the context of our current monetary regime) favors having the Fed produce a stable growth path of nominal final sales will agree that a certain expansion of the monetary base was warranted over the past year to keep MV from shrinking. The question is whether the Bernanke Fed has gone too far. We think they have. The op-ed makes Woolsey’s point that “It is certainly likely that the increase in the demand by banks to hold reserves and by people to hold bank deposits is only temporary. At some point, the reserves and the money supply will need to drop.” At some point, too, the drop in velocity will begin to reverse. The Fed will need an exit strategy. The main point of the op-ed is to emphasize what he concludes with, that “along with the rise in retail sales, this [recent] increase in the CPI is evidence that it is perhaps time to reverse course.”

[bill woolsey]

Pete,

Thanks for the response.

During the 4th quarter of 2008 nominal consumption fell 9%. This included a 27% drop in nondurable consumer goods and a 2.3% increase in consumer services. Nominal investment fell 20%. These are all at nominal rates.

In my first remark, I said that retail sales had risen in February. Well, I must have dreamed that. They fell. (But they did rise in January.) I think maybe I was remembering a report from the WSJ and it was showing a rise in general merchandise. Auto sales were very negative in February.

Anyway, I think we are seeing a deflation because of an increase in the demand for money.

I think the demand for money increased after Lehman Brother's failed. I think that it did create a lot of regime uncertainty. Those who were betting that they will all be bailed out always, were proven wrong. Who will be bailed out was very uncertain for a time, and now it is looking more and more like--everyone always.

But I don't think it matters why money demand increased. I think monetary institutions need to operate in a way that accomodate changes in the demand to hold money regardless of why they happen--including regime uncertainty.

If the natural interest rate drops because regime uncertainty causes people to not want to invest, then monetary institutions should not keep the market interest rate higher than the natural interest rate. If people want to hoard money because they don't know what will happen next and they want to "wait", then monetary institutions need to work so that either they are detered from holding money or else the supply rises to accomodate their demand.

By the way, I think the natural interest rate was low during the period of very low Federal Funds rates. Hummel and Henderson are right. But, with hindsite we now know that the market interest rate was too low, maybe for too long, as White and Schwartz have pointed out. We know because nominal income grew faster than trend.

I believe that now (or at least last fall) the natural interest rate was very low--at least for short and low risk assets. And, even though base money increased a lot, it failed to meet the demand.

I am much less confident of our situation today. The CPI went up in January. We will see what happens in February.

I make no claim to be able to run a central bank. I don't know the demand for money or the natural interest rate better than anyone else.

I still hope for some kind of free banking reform that will put all of these in the hands of market forces. Of course, then any remaining nominal income instability would be entirely a market failure.

[Lawrence H. White]

In response to martinf:
I certainly agree that, in considering alternative monetary regimes, we should pay attention to the quality of money. Antal Fekete, however, is an advocate of the fallacious Real Bills Doctrine in monetary policy and thus not one I’d cite as an authority. (I don’t know about Anderson or Palyi.) Yes, my op-ed with Rose deals only with the quantitative side. It takes the current fiat money regime for granted. Within a fiat regime, the quantity theory of money (exogenous M drives P) applies. In a gold-based regime, M is endogenous.

[Danny Shahar]

It's funny...I haven't been hearing a lot of people talking about how the government's constantly changing, ad hoc policy-making generates an atmosphere of uncertainty which hinders the entrepreneurial actions of the market actors who will drive the needed economic reorganization. I mean, I know that it's not a new point, and I'm sure there's been some stuff written on it. But most of what I've been hearing is criticism of the policy measures themselves, rather than explanations of how the approach to policy-making which our overlords are taking makes it impossible for people to make coherent plans for the future. You guys are all much better on this stuff than me...how about it?

[Barkley Rosser]

There is an old joke about the rational expectations economist who goes hunting. He fires at the deer and misses it by two feet to the right. Then he fires again and misses it by two feet to the left, thereby declaring, "I got it!"