Important Article on the Global Monetary Order

Take a minute and read this important article by Paul Nathan on the changing role of the IMF's fake currency, the SDR, or special drawing rights.

I'll have more to say on this article shortly.

Ah, Krugman!

To sum up: A few months ago the U.S. economy was in danger of falling into depression. Aggressive monetary policy and deficit spending have, for the time being, averted that danger. And suddenly critics are demanding that we call the whole thing off, and revert to business as usual.

The above is a quote from the marvelous Paul Krugman. I love him; and yet, he's so wrong right now.

Let's be clear: aggressive monetary and fiscal policy have not averted any danger to the economy. The danger is not inflation, nor is it deflation. The danger is economic distortions. That is, massive investment in unproductive economic activity (retail, advertising, finance, etc.). This kind of economic activity does not produce anything, and hence it is the major threat to the economy.

Why are there economic distortions? Why should it be the case that the market, which often gets things right, ought to be disastrously wrong? What causes the distortions is the massive inflation of the money supply. That may lead to inflation or it may even lead to stable prices, even deflation for a time. It all depends on how the extra dollars are used. If they are saved, no inflation in consumer prices. If dollars are spent elsewhere in the world, no inflation (at least in the US). If those extra dollars are spent in the US, expect to see some inflation.

Rising or falling prices is not the danger. The danger is that there is a prolonged period of confusion: what are my assets worth? Is my business viable? Should I start this business? What is the market saying?

If the answers to these questions are unusually obscure for a long period of time, the result will be stagnation, low growth, and unemployment. This is the danger. And it's in full bloom now. More aggressive monetary and fiscal policy will worsen the situation, not make it better.

GDP Plunges, Unemployment Remains High

The Bureau of Economic Analysis reports that GDP contracted at an annual rate of 6.1% last quarter (the first quarter of 2009), following on a 6.3% rate of decline the quarter before.

Meanwhile, unemployment seems to be headed for further increases. The latest number from the Bureau of Labor Statistics is 8.5% for the headline unemployment statistic, which the BLS calls U-3. If workers who are "marginally attached" and underemployed (that is, they have given up searching for work, or they would like full time work but are working part time) are counted you get an unemployment rate of 15.6%. Incredible.

What ought to be done?

Given the circumstances unique to this recession, we ought to cut government spending, remove subsidies, cut taxes, refuse to prop up failed and insolvent corporations and banks, and simply allow the market to reach equilibrium.

Creating a system of sound honest money that is tied to a commodity (I favor gold) would stabilize the international monetary order, though it would cause some immediate pain in the short term. Abolishing fractional reserve banking would immediately solve the banking crisis, allowing banks to begin lending.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

Did the Gold Standard Cause the Great Depression?

(I'll be out of town until 4/12, so I won't be blogging. Can you live without me?)

A fascinating 1997 paper by Barry Eichengreen and Peter Temin argues that the gold standard caused the Great Depression. (Well, at least that the gold standard 'mentalite' was part of a set of factors that caused the Depression.) Eichengreen (UC Berkeley) and Temin (MIT) are top-notch economists; each has published a slew of articles on economic history. They represent the mainstream orthodox neoclassical-Keynesian synthesis on this point.

In this view, which is really more Keynesian than classical, sound money tends to tie the hands of government during a recession. Sound money is 'inelastic', you see, and cannot be made to do what government officials want it to do. The government often wants the impossible: lots of spending, while at the same time cutting taxes.

Eichengreen and Temin's paper is good to read alongside Murray Rothbard's America's Great Depression. (Freely available in its entirety at the previous link). Rothbard essentially argues the opposite: it was the rapid expansion of bank credit during the 1920s which caused the inevitable contraction in the money supply as banks rushed to cover; the government's response in the form of stimulus made things far worse by lengthening the time of adjustment.

Fed "Quarterbacking"

If you want something that will turn you against the study of monetary economics forever, read a series of experts debating what the Fed should've done and how what they did affected the economy. For example, The Wall Street Journal's recent symposium, Did Alan Greenspan Cause the Housing Bubble?

What a tiresome parade of simplistic reasoning and confusion, with the exception of Judy Shelton's piece, "Loose Money and the Derivative Bubble." (She has another great article published on 2/11 called Capitalism Needs a Sound-Money Foundation. (Ms. Shelton is the author of Money Meltdown, which I confess I have not yet read.)

To blame the Chair of the Fed for supposedly disastrous Fed policies is "quarterbacking", as in, how might have that game played out if the quarterback had acted differently? A speculative exercise at best, quarterbacking ignores the interconnected nature of events, supposing that we could go back in time and change one thing, leaving all other things unchanged.

The other problem with Fed quarterbacking is that the Fed is in an impossible position. The Fed's stated mission is to maintain price stability, full employment, and financial stability. Each of these is a sham. Price stability? The Fed issues a fiat currency, and has recently increased the number of Federal Reserve Notes (aka dollars) by several trillion (most of it in electronic form). The Fed is the primary engine of inflation, not price stability.

That the Fed can use wise monetary stimulus to ensure full employment is Keynesian dogma, and it's more or less true during the credit-fueled boom. But when that boom ends, as it must, the Fed becomes ineffective, for the contraction in bank lending tends to counteract the Fed's lowering of the interbank lending rate. This is where we are now, and the Fed's efforts to re-inflate the bubble are likely to create inflation, which will surely interfere with the economic adjustments necessary to begin recovery.

As for financial stability, the Fed presides over a fractional reserve banking system, which is inherently unstable. Like building on a river delta, a flood will periodically come and wash out the banking system, causing banking failures and bank runs, which the system cannot endure.

The housing bubble isn't Alan Greenspan's fault. But it is the fault of the Fed system, which generates credit bubbles which must inevitably pop. Greenspan should've known better. He has long advocated the gold standard. But he just did what everyone wanted him to do: he spiked the punch so we could all get drunk at a decades-long party. Now we're sobering up and cursing the man who sold us the drinks we demanded.