Two Monetary Paradigms
April 26, 2009
I discussed in my book that history has given us two monetary paradigms, the Classical and the Mercantilist. We are now living in a Mercantilist period.
|“Hard Money”||“Soft Money”|
|“Rule of Law”||“Rule of Man”|
|Currency stability is highest goal||Adequate economy (low unemployment) is highest goal|
|Studiously avoids government manipulation||Constant government “management”|
|Gold link is best means to goal of currency stability||Gold link prevents government “management”|
|Currency instability causes problems||Monetary manipulation solves problems|
|Interest rates are the market’s business||Interest rates are the government’s business|
|Leave credit up to the bankers.||Manipulate credit for overall effect.|
|Fixed exchange rates are good||Floating exchange rates necessary for “adjustment”|
Sound familiar? Central bankers today pay a little lip service to the principles on the left, but, as we see so clearly today, they are really pledged to the list on the right. Also, we can see that the two are exclusive. You can’t have both.
The Mercantilist paradigm is so named because it reflects the thinking of the Mercantilist economists of the period roughly 1600-1750. From about 1750 onward, they were swept aside by the Classicals such as David Hume and Adam Smith. The Classical paradigm is the superior one. We need only look at the performace of the British economy during the Mercantilist period (a stagnant basket case, comparable to contemporary Spain before joining the euro), and its performance during the Classical period (industrial, technological, financial world leader with globe-encircling empire). From 1931 or so, Britain has adopted more of a Mercantilist approach again, and, outside of its hypertrophied financial industry, it is gradually reverting back to a Spain-like basket case.
But it was not only Britain. The entire globe embraced the Mercantilist paradigm in the 1930s, of course as a result of the economic difficulties of the time. John Maynard Keynes’ most famous work is called The General Theory of Employment, Interest and Money. The title alone explains his Mercantilist plan to solve the unemployment problem with monetary manipulation. It is important to recognize that Keynes was not really a revolutionary thinker, in the sense of introducing a new idea that was initially bewildering to most people. By the book’s publication in 1936, world governments had already been experimenting with currency devaluation for five years. He was riding a political tide. The change from the Classical to the Mercantilist paradigm was political, which is to say, somewhat irrational. The cry came out to “do something” and the politicians did something, in a clumsy, haphazard, ill-planned fasion. Sort of like today’s bank bailouts. Then, the academics came along to say how smart and wonderful the politicians were, which is what academics always do (especially in economics).
Keynes devotes a whole chapter in the book, Chapter 23, to celebrating the Mercantilist economists. Let’s see what he has to say about the Bank of England and the gold standard, which had racked up over two hundred years of success:
Under the influence of this faulty theory [Classical theory] the City of London gradually devised the most dangerous technique for the maintenance of equilibrium which can possibly be imagined, namely, the technique of bank rate [the means of adjusting the monetary base] coupled with a rigid parity of the foreign exchanges [the gold standard]. For this meant that the objective of maintaining a domestic rate of interest consistent with full employment was wholly ruled out.
Keynes even goes on and on, effusively, about the comical Silvo Gesell, a proponent of “stamped” or “demurrage” currencies during the period 1906-1930. The idea was that a currency steadily lost value, or had a “negative interest rate” (it had to have a stamp applied regularly, and the stamp cost money). Let’s see what Wikipedia has to say about that:
The major central banks’ post-WWII policy of steady monetary inflation as proposed by Keynes was influenced by Gesell’s idea of demurrage on currency , but used inflation of the money supply rather than fees to effect the goal of increasing the velocity of money and expanding the economy.
We are coming now, it seems to me, to a sort of final showdown, between the Classicals and the Mercantilists. The Mercantilists are dominant for now. But, I think they are in the process of blowing themselves up (along with everyone else). Perhaps we will just have a long, slow slide into Spanish irrelevance — but I think that the more dramatic outcome is more likely. If we change back to the Classical paradigm, it will ultimately be for political reasons. People will look for a solution to the problems that the Mercantilists got them into.
So, when people ask, “when will there be another gold standard?”, the answer is: when people beg for it. It is possible that certain insightful leaders could go there before things reach such a state, but I really don’t see any such insightful leaders around these days.
I am most amused by the recent op-ed by Greg Mankiw in the New York Times:
By N. GREGORY MANKIW
Published: April 18, 2009
WITH unemployment rising and the financial system in shambles, it’s hard not to feel negative about the economy right now. The answer to our problems, however, could well be more negativity. But I’m not talking about attitude. I‘m talking about numbers.
Let’s start with the basics: What is the best way for an economy to escape a recession?
Until recently, most economists relied on monetary policy. Recessions result from an insufficient demand for goods and services — and so, the thinking goes, our central bank can remedy this deficiency by cutting interest rates. Lower interest rates encourage households and businesses to borrow and spend. More spending means more demand for goods and services, which leads to greater employment for workers to meet that demand.
The problem today, it seems, is that the Federal Reserve has done just about as much interest rate cutting as it can. Its target for the federal funds rate is about zero, so it has turned to other tools, such as buying longer-term debt securities, to get the economy going again. But the efficacy of those tools is uncertain, and there are risks associated with them.
In many ways today, the Fed is in uncharted waters.
So why shouldn’t the Fed just keep cutting interest rates? Why not lower the target interest rate to, say, negative 3 percent?
The idea of making money earn a negative return is not entirely new. In the late 19th century, the German economist Silvio Gesell argued for a tax on holding money. He was concerned that during times of financial stress, people hoard money rather than lend it. John Maynard Keynes approvingly cited the idea of a carrying tax on money. With banks now holding substantial excess reserves, Gesell’s concern about cash hoarding suddenly seems very modern.
N. Gregory Mankiw is a professor of economics at Harvard. He was an adviser to President George W. Bush.
Be sure to read the whole thing.
Now, it is not so surprising that some nutjob somewhere says something. There are always nutjobs. The important thing is that this is in the op-ed page of the New York Times, which serves as sort of a discussion agenda for the left-leaning political elements in the U.S., specifically the Democratic Party. Which, you will have noticed, holds the White House presently.
The second thing is that Greg Mankiw is a professor at Harvard. Professors are intensely aware of politics, because that is basically the means by which they climb their career ladders. (This is also largely why they are bad economists.) And, Harvard professors are not only aware of politics, they are very good at it. So, when a professor of Harvard not only thinks such a thing — it has obviously passed his self-censor — but proudly splatters it all over the newspaper, that’s telling you something.
Mankiw is not only an educator of 18-21 year olds, he is the author of a leading textbook and overall part of the tippy-top class of establishment economists in the United States.
I especially like the first couple lines:
“What is the best way for an economy to escape a recession? … Until recently, most economists relied on monetary policy.” (I’m not sure how this is any different than what has been going on recently.)
Think about that. No matter what happens — whether the cause of the recession is related to exploding taxes, as in the 1930s, or mass credit stupidity recently, or a mania for terrible investment in “tech” as was the case in 2001-2002, or currency events such as has been going on in Eastern Europe, or whatever else including trade effects of things that happen in different countries — the solution is “monetary policy.”
You can see why it is important for the Classical camp to have, at the very least, a good explanation for the current events, and a plan to do something about it. The Classical types really blew it during the Great Depression, because they did two things: first, they advocated enormous tax hikes worldwide (including tariff hikes), which were a big disaster. Second, they didn’t really have either an explanation for the event, or a solution except to say “maybe it will get better later.” This was wholly insufficient, which is why they all got broomed to make way for the Mercantilists’ more sexy-sounding solutions. Unfortunately, very few people are familiar with the history of these ideas, and their rather poor track record over the past five hundred years.
In other words, the Classicals need a recession plan. (They could also use a what-do-I-do-if-there’s-a-bubble plan, and I’ve touched on that.) I’ve been promoting tax cuts not only because they would geniunely help, but because it gives politicians something to do when they are told to “Do Something.” Tax cuts are not too popular today, but, since we’re going to run a deficit of 20%+ of GDP anyway, mostly so bank bondholders don’t have to take a well-deserved haircut, there was no particular reason why there couldn’t have been big tax cuts. I don’t think tax cuts cause deficits, but even if I was wrong about that it would have been better than what we’ve got. And, even if the tax cuts are the sort of irrelevant little nonsense that wouldn’t have any sort of meaningful effect whatsoever, at least it fills the legislative agenda and allows some time to pass, during which the economy could really improve if it is not being bombarded with some other sort of destructive policy. In other words, it is a surreptitious way of doing nothing.
Indeed, Britain is going the other way by raising its top income tax rate from 40% to 50% in the latest budget, a trend that should be watched. And, it appears that progress is being made on a new government healthcare plan in the U.S., which would probably mean higher taxes. It will likely amount to a further scam perpetrated on the U.S. citizen, this time by the healthcare industry instead of the financial industry. But, what do you expect when 80%+ of the graduates of the top universities become doctors, lawyers and bankers? (A proper healthcare reform would offer universal government coverage using the 8% or so of GDP that the government is already paying for healthcare. Then, we would have at least a Cuban level of public healthcare with no more taxes, and corporations would enjoy huge relief in terms of their healthcare costs. The losers would be the healthcare industry, which would have to slim down from its 16%-and-growing share of GDP.)
The Western World has their head so far up their Mercantilist behinds that they can probably only be extracted via a painful and cathartic event. However, I can tell that the newbies — Russia, China, and the Middle East, along with some other Asian countries and maybe Brazil (is Lula a hard money guy???) — don’t quite buy into the nonsense. Since a fair number of readers from those regions visit this site, I hope this will give them some idea of what the alternative looks like.
* * *
After the experience of the 1970s, full-strength Keynesianism is a little unpopular. Today’s Mercantilists talk about “price stability,” which sounds similar to the Classical goal of stability of currency value, but it’s not the same. Prices fell quite a bit during the Great Depression of course, not because of monetary factors but because the economy was falling apart. In other words, for the same reason that the price of zinc or the price of shipping dry goods or containers (the Baltic indexes), or the price of commercial real estate, took a tumble recently. What the “price stabilizers” really mean here is that they want to be able to counteract this price-decline-in-recession effect with a big dose of currency devaluation, which is also what happened in the early 1930s. So, “price stability” is really an excuse for currency devalution, which is the opposite of “stability of currency value” although it sounds similar enough to fool people.
Supposedly, at some future point, when there has been enough currency devaluation to tip the scales toward rising general prices, the central bank will step in and, following their “price stability” mandate, take restrictive steps to reduce the inflation. This is considered to be very sophisticated modern central banking, but actually it is following the Mercantilist playbook in exactitude. People in those days also knew you couldn’t just print money willy-nilly into the indefinite future.
This quote from the Mercantilist author James Denham Steuart, in 1767, sums up the Mercantilist thinking of the time. It’s from my book. (Obviously I am a little lazy about finding some new material. It’s hard work!):
He [the monetary bureaucrat] ought at all times to maintain a just proportion between the produce of industry, and the quantity of circulating equivalent [money], in the hands of his subjects, for the purchase of it; that, by a steady and judicious admininstration, he may have it in his power at all times, either to check prodigality and hurtful luxury, or to extend industry and domestic consumption, according as the circumstances of his people shall require one or the other corrective, to be applied to the natural bent and spirit of the times. …
A statesman who allows himself to be entirely taken up in promoting circulation, and the advancement of every species of luxurious consumption, may carry matters too far, and destroy the industry he wishes to promote. This is the case, when the consequences of domestic consumption raises prices, and thereby hurts exportation.
A principal object of his attention must therefore be, to judge when it is proper to encourage consumption, in favor of industry, and when to discourage it, in favor of a reformation upon the growth of luxury.
Do you see how ancient this is? Also, do you see that it basically doesn’t work, or we would all know who James Denham Steuart is, instead of his contemporary Adam Smith, who thought Steuart was a nut case?
So, what happens down the road when, supposedly, we will have “enough” inflation?
The first thing that would happen, most likely, is that the excess bank reserves would be “mopped up” and short-term interest rates would rise to some nonzero level, but likely below 1%. The Bank of Japan did this a few years ago. As long as the banks don’t actually want excess reserves (sometimes they do in times of stress), this will have no particular effects. Some people would have a panic about the abrupt decline in the “money supply” but nothing much would come of it if the currency’s value doesn’t change much.
Then, it is most likely that the Fed will return to its previous interest-rate target format, and begin to raise its interest rate target.
Aha! — thinks the more perceptive reader of this site. First of all, raising interest rates is not particularly popular. Certainly not with Easy Ben. Consider the insane fascination that Bernanke-like economists have with the irrelevant little lift in U.S short-term interest rates in 1931. (This was related to reductions in the monetary base to support the dollar, which was under pressure due to the devaluation of the British Pound in September 1931, and fears that the U.S. would go a similar route — which indeed it did, in 1933.) It is only popular when there is enough economic activity that it seems like we can give up a little bit. Second, the level of interest rates that is normally associated with a “hawkish” anti-inflation policy is quite high, over 6%. Consider that against the present policy of cramming down the long end of the yield curve as low as possible to help property (and equity) valuations. The third thing is: it probably won’t work. The interest-rate target system is not a reliable method of stabilizing or increasing the value of the currency, which is what actually tempers or reduces perceived “inflation.”
Notice how all of this is completely contrary to the Classical goal of a stable currency.
So, I suspect that although some sort of more hawkish policy may be in the future, it will likely be “behind the curve” consistently due to economic and political considerations — which is exactly what happened in the 1970s as well. It wasn’t until the political consensus shifted more towards the Classical paradigm, with Paul Volcker, that real progress was made.
So, the future of “price stability” is likely a “hawkish” policy of higher interest rates — much higher, possibly exceeding 8% — that won’t actually succeed in tempering the inflationary trend any more than the 8%+ rates that prevailed during the Carter administration. But it will succeed in blowing up what’s left of the economy.
* * *
Back to Glass-Steagall: After this “stress test” charade, at some point the government might have to finally step in and clean up this mess at the big banks. Besides swapping the debt for equity, one thing they could do is to effectively reinstate Glass-Steagall by separating the regular banking operations from all the broker-dealer type operations. This would help resolve the second problem, which is the derivatives mess. JP Morgan Chase would go back to being JP Morgan and Chase. Goldman Sachs and Morgan Stanley would no longer be “bank holding companies.” The bank portions — now amply capitalized — would be allowed to sail along their merry way. The broker-dealer portions, including the derivatives book, would also be sent along with a big slug of capital, to fend for themselves. If they disappear in a puff of smoke when the CDS neutron bomb goes off, then too bad. They could head back to government receivership, to at least run off their prime broking units and other such things without making too much of a mess. It’s really the combination of the BD risk with the commercial banks that is causing a lot of systemic risk, which is of course why Glass-Steagall was imposed in the first place. There wouldn’t be too much risk of a post-Lehman style problem because the banks would by then be amply capitalized and free of their BD activities. The problem with Lehman was that, at the time, everybody else also looked like Lehman, including the big banks such as JP Morgan Chase, BofA and Citibank.
* * *
Change of Government: We in the U.S. are not much accustomed to changes in government. Consider France: after the fall of the Ancien Regime, it had a First Republic (1792-1804), a First Empire (1804-1814), a Restoration (1814-1830), a July Monarchy (1830-1848), a Second Republic (1848-1852), a Second Empire (1852-1870), a Third Republic (1870-1940), a Vichy government (1940-1944), a Provisional Government (1944-1946), a Fourth Republic (1946-1958), and finally the Fifth Republic (1958-present).
* * *
Effective tax rates in China: China has a tax code, and it is actually not too different from typical West European tax codes, with highish income tax rates and a substantial VAT or sales tax. However, I hear that, in practice, taxes in China are very low to nonexistent. Can someone explain what’s going on there? Thanks! (Apparently there are no property taxes in China in most cities, which is intriguing to say the least.)