Let’s get Europe off the Gold Standard. Again.

Bear with me for a second – I obviously do not mean that literally. But at the same time, it wasn’t really strictly literally back then either. As Christina Romer puts it, what we needed back then and what we need now is a regime shift – while the precise nature of that regime shift is considerably less important. What the gold standard did was essentially limit the ability of central banks – which in many cases back then hadn’t even existed for all that long – to ease monetary policy when times most required it. In other words, it was a monetary regime that might work fairly well as long as everything else works fairly well. Put differently, it works at times when we might be just fine having no central bank at all to begin with. In that sense, the current strict inflation target by the ECB in particular (but also inflation targeting in general, as many other central banks around the world face similar issues) is actually remarkably similar, even if it does represent a vast improvement. The Fed’s fairly sluggish action in late 2007 and the beginning of 2008 was in large part due to fears of rising headline inflation. The ECB’s failure to act now is largely due to overall inflation in Europe remaining fairly stable – even while unemployment keeps rising and rising. Back in the 30s, central banks were held back by the supply of a metal the worth of which, for most intents and purposes, has baffled economist for centuries. Today’s central banks are held back by a basically randomly chosen number linked to a just as arbitrary basket of goods and services that is supposed to stabilize the overall economy – and yet has proven not to do so when needed the most.

As such, today, just as in the 1930s, what we need is for central banks to get rid of the chains that prevent them from doing their job when we need them the most. Let’s get off the gold standard. Not literally, of course – but it’s time, once again, to face the fact that our current way of doing things means, just as it did back then, strongly restrictive monetary policy when monetary policy should be loose. As pointed out by Katharina in the comments to one of my previous posts, having countries leave the Euro would of course be an option. I don’t think we have to go with the nuclear one though. Giving the ECB at least a dual mandate like that of the FED would be a start, if only a timid one. Nominal GDP targeting would certainly help as well.

The importance of overshooting monetary policy

The general concept that monetary policy should react in a strong fashion to try and bring an economy back on track is fairly widespread. In fact, it makes up a big part of how even John Taylor, nowadays on the very hawkish side of things when it comes to monetary policy, thinks central banks should proceed when they feel the need to act. In particular, the Taylor principle states that in order for a central bank to cool an economy it perceives to be overheating, it needs to raise interest rates by more than the expected rise in inflation. If inflation, for instance, deviates from the central bank target rate by 1%, the central bank should raise interest rates by something like 1.5%. Of course this basic prescription follows the idea that the real interest rate equals the nominal interest rate minus (expected) inflation. If you want to reduce economic activity by raising real rates, you clearly have to raise nominal rates by more than expected inflation. But the importance of this basic notion goes far beyond this almost trivial explanation, and more so in the case of current policy. Kugman’s concept of “credibly promising to be irresponsible” (.pdf) is also aimed in this direction. Overshooting, or “doing more than strictly necessary”, is essential not only for monetary policy to be truly effective, but also for it to remain effective in the future. Ryan Avent over at The Economist discusses the issue with regards to the current debate surrounding the FED’s “tapering”:

I understand that the Fed is generally uncomfortable with unconventional monetary policy and has concerns about the side-effects from large-scale QE. That’s eminently reasonable. The trouble is that the Fed seems not to have learned that aiming to overshoot on the pace of employment growth and inflation is the safer, more conservative route. Overshooting maximises the chance that monetary policy will maintain its potency the next time trouble hits. Overshooting provides the best means to safely and quickly end growth in the balance sheet. Overshooting is the sustainable route to healthy increases in interest rates. But overshooting, the Fed has made entirely clear, is the one thing the American economy should not expect.

And the risks involved in not overshooting have become even more clear in the aftermath of the recent crisis, as discussed by Yichuan Wang, who seems to hit the nail on the head with this statement with regards to how the FED got stuck in the liquidity trap in the first place:

It is important to remember the sequence of these events. It is easy to think that the downward pressure on interest rates was the inevitable consequence of financial troubles. […] The Fed’s sluggishness to act is even more peculiar given that there were already serious concerns about economic distress in late 2007. [T]he decision to wait three months to lower interest rates to zero was a conscious one, and one that helped to precipitate the single largest quarterly drop in nominal GDP in postwar history. The chaos in the markets did not cause monetary policy to lose control. Rather, the Fed’s own monetary policy errors forced it up against the zero lower bound.

In a way monetary policy (and not just by the FED) made the same mistake as fiscal policy in the aftermath of the crisis – it tried to be optimistic, “on the safe side” of things, and ended up providing stimulus that ended up being massively inadequate. Not only does this mean it now faces a much deeper slump than necessary, making its job much more difficult. It also means that the very ability of it to do its job is put in question. Just like the “failure” of the Obama stimulus plans to keep unemployment in the single digits has been the main argument against fiscal stimulus in general, monetary policy being stuck in a “liquidity trap” that it to some degree helped create in the first place has also been the main argument for those who say monetary policy can’t do anything more either!

Politicians should have less, not more power to fight economic crises

A big issue I personally have with the concept of Keynesian economics is that, in practice, it involves way too much discretionary action by people who often really shouldn’t have the kind of economic power they do. The whole thing is part of a wider discretionary vs. rules-based economic policy debate, and something on which I find myself in remarkable agreement with the freshwater school in economics, who often don’t seem to make much sense on other grounds. There is a good argument to be made that when stuck in a liquidity trap (as long as something like that is even the big problem it is often portrayed to be) fiscal policy is the go-to economic tool to help get the economy back on track. Most of the standard arguments against this generally move somewhere between the either claiming it is totally ineffective or that it is so effective that the stimulus always proves to become permanent after a while. Both arguments are mostly wrong. But the real issue I see is that discretionary fiscal spending is, basically by definition, highly uncertain. The recent crisis has shown that when push comes to shove, politicians of all stripes will dig up their own copy of The General Theory and start throwing money at the problem. Yet, even though in theory it would be fairly easy to imagine a fixed rule which would be followed in these situations, in practice both the size and the direction of this throwing of money is highly arbitrary.

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Conspicuous Consumption and Poverty

For something new, here’s a guest post by Katharina Allinger, currently studying at the University of Warwick. Developmental economics is definitely something I would want to cover more on this blog.

The first time I heard the term „conspicuous consumption“ was in a lecture given by Omer Moav at Warwick. He was presenting one of his papers on the topic.  For the non-native speakers among you, the term „conspicuous consumption“ describes the purchase of a good or service that is mainly motivated by showing off one’s wealth. We could take the example of buying a car. Maybe I need the car, because my home and my work place are far away from each other and so I determine what characteristics are important and buy a sensibly priced car to drive to work everyday. On the other hand, I might already have a car, but I want to show off to my friends that I earn a lot of money and therefore buy a luxurious and expensive sports car. The latter would be a definite case of conspicuous consumption.

While this is definitely an interesting topic related to developed countries and maybe elites in poor countries (see article below) a lot of research recently focused on „conspicuous consumption“  of „the poor“. (I’m putting „the poor“ in brackets because certain academics tend to like to talk about „the poor“ as if they were some kind of different and mysterious species of humans) Researchers have put a lot of effort into showing that “the poor” do not spend their money rationally. Instead of spending everything they have on food or health care or the education of their children they ACTUALLY go to weddings and festivals. And drink alcohol. In BARS! – How conspicuous! To go to a bar to show off that you can afford having a beer out instead of just having a beer at home…

Maybe some of you have the reaction I was hoping for. How did we get from sports cars to beers?

What exactly is “conspicuous” about having a beer with friends? Isn’t that just “normal” consumption? Of course, what constitutes a „luxury“ depends on your income, but at the same time, we shouldn’t DEFINE people by their income. Taking a more psychology or sociology based view of human beings, there is nothing weird about the poor not spending all their income on things with high future return (like education or a new agricultural machine). Like everyone else, poor people also want to enjoy life a little bit – and go to a bar to have drink. Should we really worry about this and try to encourage them to save more and enjoy less? Personally, I doubt that this is a very great approach to development. (Please note, that I’m not trying to say that we should not help the poor to save more and more effectively at all!)

I also think that, except for some very extreme cases like stories about a poor Indian guy winning money in the lottery and spending it all on a helicopter ride, we should be very careful when applying the term „conspicuous consumption“ to poor countries and people.

In his article Why Pay More? Peter Singer  writes about the origins of the term „conspicuous consumption“:

 “Thorstein Veblen knew the answer. In his classic The Theory of the Leisure Classpublished in 1899, he argued that once the basis of social status became wealth itself – rather than, say, wisdom, knowledge, moral integrity, or skill in battle – the rich needed to find ways of spending money that had no other objective than the display of wealth itself. He termed this “conspicuous consumption.”

Thus, unless we want to argue that for poor households the „basis of social status is wealth itself“ we should maybe think twice about applying Thorstein Veblen’s concept to „the poor“.

If you are curious about a very interesting and appropriate use of the phrase, please read Peter Singer’s article, which deals with corruption among Ukrainian officials.

The delusions of central bankers

Mario Draghi’s responses to questions at the press conference held in Frankfurt on June 6th are for the most part nothing short of terrifying. I could probably make several posts covering the different levels of shortcomings, but will at the moment only discuss one and link to another very obvious and disheartening one which has been dealt with already by Krugman and Sumner. Yet what struck me as well is that apparently Draghi is making the same mistake that Joan Robinson, otherwise certainly an excellent economist, made all the way back in 1938 by claiming that the hyperinflation in the Weimar Republic could not possibly have been caused by loose monetary policy because interest rates were “high” during the time. At least since Friedman pointed it out clearly in 1968 (.pdf) I thought everyone should be aware of the problems involved in trying to draw conclusions regarding the stance of monetary policy by simply looking at current rates. Draghi states that

“I think that all in all we are currently taking a much more conservative stance, although our monetary policy remains accommodative and, as I said, it will stay accommodative for as long as needed.”

of which the first part is unfortunately true yet a mistake on a policy level, and the second one is plain and simply wrong. Which leads me to the article by Friedman, in which he mentions that

“As an empirical matter, low interest rates are a sign that monetary policy has been tight […]; high interest rates are a sign that monetary policy has been easy.”

Again, low interest rates are a result of a depressed economy, and a depressed economy is more often than not (and I would argue both Japan’s lost decades as well as the current situation in the US and the Eurozone proves this) a result of inadequate monetary policy to begin with. The current level of interest rates is generally a dismal indicator when trying to assess the current stance of monetary policy. So equating low interest rates with easy money is missing the point conceptually, but even if it were not, by any measure that matters, interest rates at the moment are not “accommodative” in a sense that they are helping boost the economy either. The current level of interest rates set by the ECB is the prime reason the economy is being held back, not that it is recovering! A more accurate description of current ECB policy would be something along the lines of

“I think that all in all we are currently taking a much more conservative stance, which is deeply regrettable but whatever. Our monetary policy remains deeply contractionary and, as I said, it will stay contractionary because…SQUIRREL!”

The science of bubble spotting

Even before the collapse of the housing bubble in the United States and around the world there was a substantial debate in the field of macroeconomics concerning whether central banks should take asset prices into account when deciding on the course of their monetary policy. I would like to suggest that the appropriate answer here should be yes. The failure to do so became abundantly clear somewhere around the end of 2008, even though I can sympathize with the view that it was not the housing crash that brought down the worldwide economy, but rather failures of central banks to do their jobs by allowing nominal GDP to crash almost 2 full years after the housing bubble burst. Think about it, not much happened between 2006 and 2008. In any case, it is pointless to debate whether or even what central banks should do to try and limit the effects of asset bubbles if we don’t have a way to tell when such a bubble is present to begin with.

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