By Lorenzo

What do the goldzone Great Depression (1929-3?) and the Eurozone Great Recession (2008-?) have in common? They were both created by European central banks with the US Federal Reserve (the Fed) as accessory during and after the fact. (Yes, the monetary shock which set off the Great Recession started in Europe though the responsibility of the European Central Bank [ECB] in that initial shock was a bit more indirect than that of the Bank of France in the Depression; the ECB was much more directly culpable in the subsequent monetary contraction.)

When Nobel laureate Thomas Sargent described the euro as an artificial gold standard he was zeroing in on common features–the goldzone and the Eurozone both being fixed exchange rate systems operating over institutionally divergent countries with limited labour flows, no fiscal union (so no significant fiscal transfers) nor common risk pool otherwise (in the case of the Eurozone, no lender of last resort). Having the Eurozone include Mediterranean economies was not (pdf) a monetary union that conventional Optimum Currency Area (OCA) theory supported. While economist Charles Goodhart is quite correct when he points out that OCA theory cannot explain the boundaries of existing currency realms–that being a result of the operation of state power–if OCA theory is seen as providing an analysis of whether currency realms should amalgamate, it turns out to be very powerful, as the travails of the Eurozone are proceeding to demonstrate.

This surprised-by-American-scepticism paper [pdf] by European economists–scepticism largely driven by OCA theory–reads rather differently now. Though labour mobility is supposed to be one of the key differences between the US and the Eurozone, yet land-rationing in the richer US cities is seriously reducing labour mobility, making the US more like the Eurozone and undermining its macroeconomic resilience.

Inflation phobia

Milton Friedman was famously an advocate of (pdf) floating exchange rates, Frederich Hayek an advocate of (pdf) fixed exchange rates. The latter seems an odd position for a free market thinker to take. Especially when Hayek was also an advocate for the gold standard, if one was going to keep the state money monopoly. A series of fixed prices (fixed exchange rates, fixed gold price) erected on monopoly provision seems a very odd position for a free market thinker to take.

The explanation is simple: fear of inflation. A fixed price of money in gold means–given gold’s scarcity–that the possibilities of inflation are greatly reduced. A fixed exchange rate means giving up the ability to domestically inflate (as Greece, Italy, Portugal and Spain are currently discovering). A monetary authority can control price stability or it can control the exchange rate, it cannot do both. Being in the goldzone means inflation will only occur if the price of gold is falling, which it is unlikely to do by much, given that stocks greatly outweigh new production.[i]

The experience of inflation is another feature in common between the goldzone Great Depression and the eurozone Great Recession. Both the great deflation of the former and the disinflation of the latter occurred after dramatic periods of inflation. In the case of the interwar goldzone; the wartime inflations, the German and Austrian hyperinflations, the French early 1920s inflation. Fear of inflation dominated the thinking of monetary authorities–indeed, paralysed their thinking.

In our own time, the Great Inflation from the late 1960s to the early 1980s has profoundly affected the thinking of monetary authorities; indeed, paralysed it. The success of inflation targeting in squeezing inflation out of Western economies has made it a policy fetish that central bankers cannot see beyond, just as the gold standard was a policy fetish monetary authorities in the early 1930s could not see beyond. Not even to make adjustments necessary to save it. To the extent that the Fed is paying people not to spend money. It has been a continuing pattern for central bank policy to respond more to the traumas of the past than the dilemmas of the present.

Been there, done that

It is a sad reflection on the ability of policy makers to find new ways of making old mistakes that if one reads either version of the paper (pdf) by Barry Eichengreen and Peter Temin, The Gold Standard and the Great Depression, and replaces ‘gold standard’ with ‘inflation targeting’, one gets an almost perfect description of the current failures of central banks and the mentality behind such. Particularly when the Eichengreen and Temin say (p.19 of the NBER paper):

policies were perverse because they were designed to preserve the gold standard, not employment.

Replace ‘gold standard’ with ‘inflation target’ and that is exactly what has been happening in our own time.[ii] Indeed, it was worse than that, as the the Fed and the Bank of France were not even “doing” the gold standard properly (pdf). Just as the European Central Bank and the Fed are now not even doing inflation targeting properly. (To the extent that the IMF is now reporting a significant risk of deflation [pdf] in Mediterranean Eurozone countries.) Just to increase the similarities between the Great Depression and Great Recession, inflation targeting that implicitly or explicitly incorporates “headline” inflation which includes oil and commodity price shocks turns into a de facto commodity standard (since a rise in commodity prices leads to monetary tightening; so the value of money is tied to commodity prices).

As for the authors’ comment:

Central bankers continued to kick the world economy while it was down until it lost consciousness (p.2)

that is a fair description of the role of the ECB in the Eurozone crisis. With the added proviso that many think some beating is warranted: alas for such righteous monetary Calvinists, the policy of the beatings continuing until performance improves has long since degenerated into pointless and destructive monetary sadism.

Which makes Greece an enormously useful scapegoat for the ECB. While people are pointing at its obvious policy dysfunctions (a country rated by the World Bank as 100 out of 183 in difficulty of doing business has considerable capacity to improve its economic performance through its state simply stopping spending money and effort getting in the way of people transacting[iii]), and the undoubted economic rigidities in other Mediterranean Eurozone countries (Italy is rated 87, Spain 44 and Portugal 30 in difficulty of doing business compared to Germany at 19), the ECB is avoiding any accountability for its actions. (Which would make it the ultimate EU creation; the EU being a construction where power without accountability is not a bug, it’s a feature.)

Conversely, the worst thing for the Eurozone would be for Greece, or any other country, to leave–and promptly start to do better. [UPDATE: A paper by Anders Asland argues {pdf}, based on the experience of previous European currency union break-ups, that even a Greek exit would have disastrous effects, particularly for Greece.] Moreover, economic rigidity hardly explains the level of economic pain in the Great Recession—the UK is ranked 7, Ireland 10, USA 4 in difficulty of doing business. Nor does public debt on its own–even within the Eurozone, Spain has a lower level of public debt than Germany (pdf).

Compared to the ECB’s destructive monetary austerity, the Fed is more in the situation of having belted the US economy into a TKO,[iv] then helped it sit back up a bit, and offered some water, but resolutely refuses to help the punch-drunk economy stand, proclaiming that if it cannot stand up on its own, it is not fit to, while promising that it won’t let it fall to the matt again. Monetary policy matters.

Contractionary blindness

The great blindness involved in this inflationphobia is to think that inflation is the only significant monetary danger. Firstly, serious monetary-contraction deflation is worse than monetary-expansion inflation, even hyperinflation. Both undermine economic calculation, but inflation tends to promote transactions (as people spend before their money loses value), deflation to restrict them (as people defer using money that will buy more later, leading to falling spending and thus falling income). Generally, falling transactions, falling economic activity, is worse than rising.

There can be benign deflation; from expansion in supply of goods and services (pdf)[v]–a classic example is the falling price of information technology. But such expansion in output is quite different from deflation from monetary contraction.[vi] (Inflation can also be disaggregated into supply and demand inflation.)

Unexpected inflation–inflation not already reflected in interest rates–tends to punish creditors, as their loans (denominated in money falling in value) lose value. Unexpected deflation tends to punish debtors, as their debt burdens (denominated in money rising in value) rise as money income falls. Both distort action across time, but monetary-contraction deflation does in a way that reduces economic activity and income while increasing debt burdens. Falling incomes and rising debts lead to increasing levels of insolvency and bad debts, which then puts pressure on the financial system. The worse the deflation from monetary contraction, the worse ensuring financial crisis is likely to be. An economic process that superficially improves the position of the holders of financial assets (i.e. debts) turns into a rolling disaster as those assets–being claims on the solvency of others[vii]–are devalued or destroyed as insolvency spreads.

Serious monetary-contraction deflation is not only worse in its economic consequences and suffering, it is also worse in its political and policy consequences. Deflationary spirals promote political extremism far more than inflationary ones do precisely because of the falling level of economic activity. (Weimar Germany survived hyperinflation; it was the Great Goldzone Deflation spending crash that killed it.) They also promote much more interventionist policies, as the market system fails for more and more people, so alternatives appeal more and more.

Inflation is much more common than monetary-contraction deflation. But that a danger is more common does not make it a worse threat. The historical evidence is quite clear: serious monetary-contraction deflation is much more to be feared.

Unexpected disinflation has similar effects to monetary-contraction deflation. Disinflation can be eminently desirable when it has a clear end point, being directed towards a desirable target (price stability). But the cost of dong so is greatly increased if the monetary authority fail to manage expectations effectively (i.e. fails communicates what it is doing), thereby leading to a plague of mis-specifed contracts and pricing through the central bank disinflating surreptitiously.

Secondly, it is perfectly possible to have monetary contraction with prices being relatively stable. Imposing monetary austerity–providing insufficient money to respond to demand to hold money without cutting back transactions, a process encouraged by failing to support income expectations–can be seriously contractionary, even without significant continuing effects on the price level. Indeed, unbalanced credibility–where confidence in the value of money is high (i.e. there is a nominal anchor for price expectations) but for future spending (and so income) is not (i.e. there is no complementary anchor for income expectations)–can drive economic activity well below capacity precisely because it drives money demand higher while the level of money in circulation spirals down with output. (Putting it in Aggregate Demand and Short-Run Aggregate Supply [SRAS] terms; if both curves move leftwards, output falls and the price level does not change–an entirely plausible possibility if the SRAS curve is sensitive to expectations about demand.) If central banks treat their inflation target as a ceiling and tighten at any sign of “inflationary” resurgence in activity–and are expected to keep doing so–then output can remain “stuck” at well below capacity, which means many people without jobs.

Expectations are crucial, and the constipated communications strategies of the Fed and the ECB represent failures to manage expectations. Expectations about prices and spending, about the value and use of money, both matter. The power of expectations can be seen in this dramatic example from economist Henry Thornton, writing in 1802 of events that had occurred in 1793:

when, through the failure of many country banks, much general distrust took place. The alarm, the first material one of the kind which had for a long time happened, was extremely great. It does not appear that the Bank of England notes, at that time in circulation, were fewer than usual. It is certain, however, that the existing number became, at the period of apprehension, insufficient for giving punctuality to the payments of the metropolis; and it is not to be doubted, that the insufficiency must have arisen, in some measure, from that slowness in the circulation of notes, naturally attending an alarm, which has been just described. Every one fearing lest he should not have his notes ready when the day of payment should come, would endeavour to provide himself with them somewhat beforehand. A few merchants, from a natural though hurtful timidity, would keep in their own hands some of those notes, which, in other times, they would have lodged with their bankers; and the effect would be, to cause the same quantity of bank paper to transact fewer payments, or, in other words, to lessen the rapidity of the circulation of notes on the whole, and thus to encrease the number of notes wanted. Probably, also, some Bank of England paper would be used as a substitute for country bank notes suppressed. The success of the remedy which the parliament administered, denotes what was the nature of the evil. A loan of exchequer bills was directed to be made to as many mercantile persons, giving proper security, as should apply. It is a fact, worthy of serious attention, that the failures abated greatly, and mercantile credit began to be restored, not at the period when the exchequer bills were actually delivered, but at a time antecedent to that æra. It also deserves notice, that though the failures had originated in an extraordinary demand for guineas, it was not any supply of gold which effected the cure. That fear of not being able to obtain guineas, which arose in the country, led, in its consequences, to an extraordinary demand for bank notes in London; and the want of bank notes in London became, after a time, the chief evil. The very expectation of a supply of exchequer bills, that is, of a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas, created an idea of general solvency. This expectation cured, in the first instance, the distress of London, and it then lessened the demand for guineas in the country, through that punctuality in effecting the London payments which it produced, and the universal confidence which it thus inspired. The sum permitted by parliament to be advanced in exchequer bills was five millions, of which not one half was taken. Of the sum taken, no part was lost. On the contrary, the small compensation, or extra interest, which was paid to government for lending its credit (for it was mere credit, and not either money or bank notes that the government advanced), amounted to something more than was necessary to defray the charges, and a small balance of profit accrued to the public.

To summarise, if central banks have credibility on income but not price stability—we get the Great Inflation.[viii] If central banks have credibility on price stability but not income, and there is a sufficiently large economic shock—we get the Great Recession. The first does not stop until the central banks achieve credibility on price stability, the second until they do on spending. If central banks have sufficient credibility on both—we get the Great Moderation.

Grasping this pattern is harder when economists engage in pointless activities such as analysing monetary policy using dynamic stochastic general equilibrium (DSGE) modelling that abstracts away from key monetary elements. This study, for example, has no element of expectations in analysis (as they admit) and so concludes that monetary policy during the Great Inflation and the Great Moderation “were the same”. But if expectations and credibility are different, as they clearly were, then it is not “the same” monetary policy. Much of monetary policy is about policy instruments-as-signals and they work different depending on how expectations have been or are framed. Expectations matter.

For money cannot happen without expectations. Indeed, all future-directed action (so all action) is based on expectations because there is no information from the future; expectations are all we have to guide our actions. Expectations clearly based on past experience to be sure, but expectations nevertheless. Money is, however, particularly a matter of expectations, as its only value is due to expectations of future use in transactions, it has no utility beyond that. The combination of being of use only in transactions but being so across all monetised transactions makes money both expectation-driven and powerful in its short-run effects as the means by which aggregate demand is manifested.

Clearly, monetary policy is easier in some periods (such as periods with minor or benign supply shocks) than others (ones with strong, negative supply shocks). But that only makes it more important to get things right.

Obsessing over inflation wildly under-specifies how central banks can screw up. In particular, looking for causes of busts in preceding booms when dealing with highly abnormal events–as both the Great Depression and Great Recession are–is to profoundly mis-analyse what is going on. Abnormality has to be treated as abnormality, otherwise one will misunderstand both normality and abnormality. It is simply not the case that these wildly abnormal downturns can be “explained” by preceding booms when similar booms did not create equivalent output transaction collapses/goods and services gluts.

Fixed prices and constrained quantities

In any market, prices are the prime means of communicating changes in circumstances–they optimise and convey information. If there is a serious maladjustment, a serious collapse in output transactions, then the first suspicion has to fall on prices that do not, or cannot, adjust sufficiently.

In examining the dynamics of normal business cycles, things such as “sticky” wages are prime culprits; though for problems in adjustment rather than explaining the need to adjust. (I.e. why a given economic shock has the effect it does, not why the shock occurred.) But sticky wages are enduring features of modern economies, so not a good suspect for explaining wildly abnormal events.

Fixed prices in money are a much better culprit than even sticky wages, since money flows through every market in a monetary exchange economy. If there were, for example, fixed exchange rates before and after the downturn, they may be very much implicated in transmitting the relevant economic shock but less so in explaining abnormal economic downturns on their own. (Australia, for example, has found a floating exchange rate to be an excellent economic shock absorber.)

Markets are about both price and quantity. Quantity constraints coupled with fixed prices are an excellent mechanism for transmitting and worsening economic shocks. In particular, an increase in demand for money that is not compensated for by an increase in money supply is an excellent mechanism for turning an economic shock into economic downturn. Indeed, that may be the most common reason for economic downturns in societies with central banks as monopoly suppliers of money.[ix] A drop in confidence in income expectations (i.e. negatively construed uncertainty increases; Keynes’s “animal spirits” are just how people frame uncertainty) leads to increased money demand which supply does not expand to match which leads to a drop in transactions, so spending and so income, which drives down income expectations, and the spiral is on.

A prime mechanism for constraining quantity is a monopoly supplier. Which is precisely what modern central banks are–monopoly suppliers of money. Even if you think a government monetary monopoly is necessary for good public policy, that does not mean one should stop analysing it as a monopoly. (Though failing to do so can avoid the problem of justifying said monopoly.)

If a massive, continuing monetary contraction IS the economic shock, then fixed money prices plus monopoly provider(s) is an excellent mechanism (aggravated by “sticky” wages) for creating and transmitting, and blocking recovery from, a massive economic shock. This is the story of the Great Goldzone Deflation aka Great Depression. Unless and until the central bankers took responsibility for the disaster they caused, then the only way out was to rescue economies from their grip–in the case of Great Depression, by exiting the goldzone; the sooner countries did so, the sooner their (pdf) economies started to recover (absent further disastrous policies, such as NIRA).

In the case of the Great Recession, the failure to respond to the increased demand for money interacted with the lack of income credibility to send income expectations spiraling down. While the central banks refuse to take responsibility for their failings, and so do nothing to revive income expectations, the only way out is to rescue economies from their grip; either by exiting the Eurozone (or from their control in some other way) or by forcing a change in policy goal on them. (Which the Cameron-Clegg Government could do for the UK by simple direction of the Bank of England, thereby greatly improving its economic and political situation.)

As the global financial crisis was unfolding, the Feb failed to respond to increased demand for dollars from the Eurozone. The difficulties in getting hold of the primary reserve currency showed up in a dramatic increase in European demand for gold. These difficulties and failures have since been exacerbated by the ECB’s tight money policies and the refusal of both the ECB and the Fed to take responsibility for the level of aggregate spending aka aggregate demand. Reading two analyses of the Global Financial Crisis (GFC) written by then or former central bank “insiders”, one sees either concern for rising inflation (pdf) framing the analysis or a lack of any sense that (pdf) monetary policy mattered in understanding the GFC.

Diverted by debt

Part of the problem with grappling with such abnormal economic disasters, even just analytically, is that many things are happening as the disaster unfolds and it is easy to fixate on one of more of them and ignore or discount the underlying cause. (Also, since the dynamics of a system often become much clearer after massive failure–since its weaknesses and stress points are exposed–the revealing information about affected systems and institutions adds to the distraction effect.)

As policy-makers thrash around trying to find solutions, whatever expediences they fix upon can get some or all of the blame (and they may act to delay recovery). As underlying weaknesses are revealed under serious economic stress, they can also be pointed to.

In particular, as spending and so income crashes, the debt burden rises and the collapse in income expectations means people seek to reduce debt. But this “deleveraging” is response more than cause. This is particularly obvious in the Eurozone Great Recession, as public debt burdens have surged since 2008.

As GDP falls and unemployment rises, the fiscal balance shifts against government and debt burdens rise. But to concentrate on the increased burden of debt, and consequent “de-leveraging” (whether private or public), is to elevate symptom over cause.

If one has an asset price crash, the loss of wealth is hardly likely to make people want to work less. It is only if one has a spending crash that there is a problem for economic activity. As 1987 proved, it is perfectly possible to have one without the other, especially when asset prices have become predicated on expected future income rather than current income. It is any spending crash that causes the real damage.

If we look at the economic indicators for the Eurozone (pdf), we not only see the surge in public debt, we can also see an amazing crash in M3, consumer spending, wage growth, investment … In other words, a dramatic crash in spending, in output transactions. That is what has done the damage.

Having taken absolutely no responsibility for the spending crash, the ECB is now taking no responsibility for the continuing poor income expectations, and so no steps to fix it. It is, at most, seeking to minimize the stress to the financial system that its policies caused and which will continue while Eurozone countries continue to be in the grip of the ECB’s monetary austerity; stress that only resurgent economic activity can fix and the lack of which extends the danger of a further collapse in the financial system.

Just as the Fed, having inflicted surreptitious disinflation on the US economy, is refusing to take responsibility for restoring spending expectations after passively engineering the biggest peacetime crash in US national income since 1937-38. If the Great Depression is a story of unexpected monetary contraction causing disastrous deflation and income/spending crash, the Great Recession is a story of unexpected monetary contraction causing disastrous contractionary price “stability” mixed in with unexpected disinflation and income/spending crash.

“Sticky” wages and debt are two nominal (as in denominated-in-money) rigidities that affect macroeconomic stability. The third rigidity typically identified (pdf) is hitting the “zero bound” aka liquidity trap of zero interest rates. Clearly, this has effects but it does not make monetary policy impotent. Not only have prominent economists such as Paul Krugman (pdf) and Lars Svensson (pdf) explained how to exit such a trap but Fed Chair Ben Bernanke has reiterated that the Fed is not out of “policy ammo”. It is perfectly possible to analyse monetary policy without discussing interest rates. In monetary policy terms, interest rates are primarily a policy signalling device whose affects vary depending on how expectations are framed. The Reserve Bank of Australia (RBA) shifting interest rates is a different act to the Fed doing so because the framing expectations are different. Think about money and monetary policy in supply, demand and expectations terms, and the so-called “zero bound” looks like nothing more than a policy phantasm from over-relying on a specific signalling device.

Diagnose, then deal with

Contractionary monetary policy by monopoly central banks over large fixed exchange rate areas (the goldzone, the Eurozone, the USA) can create abnormal economic downturns. Accepting that leaves two broad policy options.

(1) Force central banks to take policy responsibility for both price and income stability (i.e. the value and level of use of money across time). This can be done either in the way the RBA does–with an average inflation target over the business cycle, so it responds to the business cycle in a smoothing (i.e. not actively or passively procyclical) way–or by explicit NGDP targeting. Either way, central bank policy becomes smoothing rather than following (or even driving) output down.

(2) End the central bank money monopoly. Introduce free banking, or even the complete denationalisation of money (pdf). (As economist Peter Klein reasonably asks, do we want so much of the world economy to depend on the personality of the Fed Chair or, extending the point, the dynamics of two committees–the FOMC and the ECB Executive Board?)

The obvious practical difficulty with (2) is that government is by far largest transactor, so has largest stake in monetary system. Coercive power gives government the ability to exercise that stake and provides it with means to shift consequences onto others. The more so if it has monopoly power over issuing of currency; so accepting competition in provision of money seriously constrains government–that is much of the point of doing so. Though the utility for modern states of access to commercial debt gives them an interest (pdf) in price stability too. It depends whether voters as citizens want to have a monopoly provider they have varying degrees of control over (and whose performance they are significantly at the mercy of) or competing suppliers they can choose between.

Citizens can exercise the power to restrain the state regarding maintaining the value of money. For centuries from 1284 onwards, some commercial polities did so. Where propertied-with-inheritance commercial elites dominated the government, they valued the stability of money for private transactions over government revenue from seigniorage, an effect reinforced by their long time-horizons. Competitive money is a way of getting the same effect while also counteracting the risk of money supply not responding to money demand.

As an aside, those who are seriously critical of the RBA’s performance in recent years are–absent some serious reform suggestions–effectively conceding the argument for the abolition of central banks, since the RBA’s performance has been far better than that of the Fed, ECB, Bank of England or the Bank of Japan.[x]

Whatever response is decided upon, disastrously contractionary monetary policy by monopoly central banks over large fixed exchange rate areas can create abnormal economic downturns. They have now done so twice in less than a century. Can we just accept that and move on to what to do about it? In particular, we need to stop pointing fingers elsewhere (particularly on the various scapegoats and fears raised to avoid accountability) and force accountability on the relevant central banks for their failures.

[i] The huge surge in the gold price in recent years may fall back, as did the surge in the late 1970s and early 1980s.

[ii] Though I would say transaction/spending/income levels, rather than employment; though the former clearly have an impact on the latter.

[iii] Putting it in Aggregate Demand (AD) and Aggregate Supply (AS) terms, supply-side reforms move the AS curve continuously rightwards, allowing output to increase without any movement of the AD curve. Of course, if demand is being further constrained (i.e. the AD curve is moving leftwards), then the benefit of reform is felt merely as a failure to go backwards as fast, rather than as an increase in living standards.

[iv] There is an arguable case that Fed and US Treasury intervention made the GFC worse, including through perverse signalling. Chairman Bernanke seems to have used the Global Financial Crisis to prove (pdf) that Prof. Bernanke was right about the “credit channel” (pdf) for the Great Depression even though his own analysis of the Great Depression said that monetary shock was the underlying driver, financial crises an aggravating transmission mechanism.

[v] Recent papers have had an amusing division of deflation into the good (increased supply), the bad (monetary contraction) and the ugly (extreme monetary contraction).

[vi] Putting it in Aggregate Demand (AD) and Aggregate Supply (AS) terms, benign deflation comes from the AS curve shifting continuously rightwards, driving down prices while output increases. Contractionary deflation comes from the AD curve shifting continuously leftwards, driving down both prices and output. Failing to differentiate these two very different cases is an instance of the Sumner analytical principle–never reason from a price change. The 1873-1895 goldzone deflation was a shifting mixture of both elements. The 1929-32 deflation was entirely the latter and has become the canonical example of deflation.

[vii] Solvency rather than income because creditors typically have a claim on assets as well as income.