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Austrians on Deflation

January 30, 2014 1 comment

A commenter on an older post about hyperinflation says the following:

“deflation is not the end of the world, and there are different kinds of deflation, too.”

Then he posts links to a bunch of Austrian posts about inflation and deflation. They are highly confused and I want to go through them point by point. First though, let me say that I agree there are different types of deflation. This is what I have been trying to say all along. If money were an organic and decentralized phenomenon, then there would most likely be steady mild (price) deflation at most times. This is altogether different from what happens when we have a central bank regime which encourages a highly leveraged society and then tightens monetary policy (or fails to loosen it sufficiently to keep the leveraging going). I’m not confusing these two, Austrians are confusing them. When they say “deflation is not the end of the world” they (seemingly) are talking about the first kind. But they say this in contexts which have nothing to do with that type of regime.  They don’t see the difference.  Deflation in a highly leveraged economy is the end of the world.  Read more…

More on Hyperinflation

January 14, 2014 Leave a comment

There is a piece on Mises.org that sums up the confusion among Austrians and conservative more generally about hyperinflation.   For those of you who don’t know me I am a libertarian and don’t like the idea of a central bank but I think this hyperinflation stuff is seriously misguided and bad for the liberty movement.  There is a lot deal with here.

First, the article clearly states what the author means by hyperinflation.

Hyperinflation leads to the complete breakdown in the demand for a currency, which means simply that no one wishes to hold it. Everyone wants to get rid of that kind of money as fast as possible. Prices, denominated in the hyper-inflated currency, suddenly and dramatically go through the roof.

This is important to point out because there is a standard sequence that these arguments usually follow in which the hyperinflation side changes their definition in the middle, talking about what a dollar bought a hundred years ago and claiming that we have actually had hyperinflation all this time (look at the comments to see what I mean).  But steady single-digit inflation over decades is clearly not what they have in mind when they talk about hyperinflation so let us get that out of the way up front.

Now I will concede that if the Federal Reserve secretly wanted to create a hyperinflation, it is possible that they could.  But the argument here seems to be that they will do so accidentally because they “do not understand the true nature of money and banking.”  The narrative put forth begins when foreigners suddenly decide they don’t want to hold dollars any more.  I don’t think this is likely to happen in the near future but it is possible so let’s take that as a starting point and evaluate the hyperinflation case.  I will take it one step at a time.

Is it possible that the Fed could prevent a hyperinflation?

Simply put, the answer is yes.  The Fed inflated the money supply in the first place by buying financial assets (mainly government debt).  They can take money out simply by doing the opposite.  There is no reason to believe that they could not reign in inflation in this way if it were running higher than they wanted.

Would the Fed accidentally create a hyperinflation?

The author doesn’t even argue that it would be impossible for the Fed to prevent a hyperinflation.  Rather, he argues that they would mistakenly compound the inflation because of their commitment to low interest rates.

Committed to a low interest rate policy, our monetary authorities will dismiss the only legitimate option to printing more money — allowing interest rates to rise.

Frankly, this betrays a total ignorance of the Fed’s stated policy goals.  They are not committed to low interest rates.  They are essentially committed to a certain inflation rate and they change interest rates to try to hit their inflation target.  They have been keeping rates low and doing quantitative easing because they are falling short of that target.  If inflation suddenly shot up, they would be thrilled to let rates rise.  This way of thinking opens up a big can of worms including such Scott Sumner classics as “never reason from a price change” and “low rates don’t mean easy money” but you don’t even have to start down that path before the hyperinflation argument falls apart on this count.

Inflationary recession?

This claim is very peculiar.

Only the noninflationary investment by the public in government bonds would prevent a rise in the price level, but such an action would trigger a recession.

Presumably, the investment in government bonds to which he is referring here would be due to the bonds the Fed would have to sell to soak up the excess liquidity which was driving the inflation.  But this would not cause a recession in an environment of hyperinflation.  It is true that if the Fed did this when inflation was not running above trend it would likely cause a recession.  To understand why this is (and why the hyperinflation argument is mistaken) see this post.  But the premise is that there is a bunch of new money flooding domestic markets driving prices up which we need to take out of the system to prevent a hyperinflation.  This produces a lot of slack for the Fed to contract the money supply without causing a recession.

Also this makes no sense.

Instead, the government will demand and the Fed will acquiesce in even further expansions to the money supply via direct purchases of these government bonds, formerly held by our overseas trading partners. This will produce even higher levels of inflation, of course.

Buying government bonds is normal expansionary monetary policy but he gives no reason whatsoever explaining why the Fed would do this in the midst of a sudden dramatic inflation, he just arbitrarily says that they would.  There is no logical connection here, he’s basically just saying “then the Fed will create some more inflation for no apparent reason.”

Feedback effects?

In addition to the strange response assumed by the Fed, the author imagines a lot of reinforcing feedback effects which layer more inflation on top of the original inflation but these also make no economic sense.  For instance:

State and local governments will also be under stress to increase the pay of their public safety workers or suffer strikes which would threaten social chaos. Not having the ability to increase taxes or print their own money, the federal government will be asked to step in and print more money to placate the police and firemen.

This is profoundly confused.  He starts by saying that the domestic economy is flooded with currency previously held by foreigners.  This extra money drives prices up.  Then he claims that people demand higher prices (wages are a price) and so the government has to print more money to pay them and that causes more inflation.  Here is another example.

 Goods will disappear from the market as producer revenue lags behind the increase in the cost of replacement resources.

There is no reason to think that producer revenue would lag behind the increase in the cost of replacement resources.  The extra money would cause increased demand for final goods and services which would increase their price.  This would increase the demand for intermediate goods and services and raise their prices but it is silly to think that it would somehow raise them so much that downstream buyers would not be able to afford them.  This is the kind of classic confusion that kids in introductory econ get into when they say “demand increases which increases price which decreases demand.”  There seems to be no concept of market equilibrium underlying this, it’s “reasoning from a price change” on steroids.

Similarly, it is arbitrary and incorrect to say that state and local governments would “not have the ability to raise taxes.”  If the price of everything doubles, property taxes double, income taxes double, they would automatically raise twice as much in taxes.  No need to print more money here.

An alternate story

The thing that is so frustrating about this hyperinflation myth is that most of the story would go from making no sense at all to making perfect sense if you just took out inflation and replaced it with deflation.  Think about it.

Either because of or in spite of Fed policy, demand for money suddenly increases and velocity and prices go down.

Workers in both government and the private sector refuse to alter their union contracts to reduce their compensation.

Companies are forced to lay off workers because they can’t pay them less.  Many can’t find work because of minimum wages, government mandated benefits etc. (“sticky wages” in Keynesian speak) and end up on the government dole.

State and local governments lose tax revenue but their government workers–and more importantly their debt–is just as expensive as ever so they have to be bailed out by the Federal government.

Workers who maintain work but at lower wages can’t pay their mortgages which are as expensive as ever so they have to be bailed out.

As people realize that prices are falling, they stop borrowing money which causes the money supply to contract further.

Eventually, the Federal government has to basically buy everything with newly printed money to keep the whole country from collapsing.  It is seen as the absolutely necessary, proper, patriotic, and ethical thing to do…..

The reason I think that Austrians can’t see this is that they are committed to arguing that inflation is bad and deflation is not.  A hundred years ago they made this argument against creating the Federal Reserve and they were right then.  But now that we have had the Federal Reserve for a century, things are different.  They are still trying to mash that old argument together with the current facts and what they end up with is totally incoherent.

But you don’t have to believe in hyperinflation to think the Federal Reserve is a bad idea.  The reason that deflation is dangerous is because of the Federal Reserve (here’s how, in case you missed it above).  We’ve got a fever and the only cure is more government.  We got the fever from the Federal Reserve.  But we (conservatives/libertarians) are in denial about having the fever.  The medicine is killing us slowly but if we stop taking it the disease will kill us quickly.  The first step is to admit we have a problem

 

 

A New Direction

January 9, 2014 6 comments

When I started this blog, it was basically just for me to practice writing down things I was thinking about.  I had a lot to say about liberty and property rights and stuff like that.  But lately, these things have been under such constant assault and it should be so obvious to anybody who thinks about them, that I have had little motivation to come on here and rant about the same things everyone else is ranting about.

Meanwhile, libertarian ideas have been on the rise.  This is good.  Unfortunately, this movement is mired in some serious economic confusion.  In short, the reliance on Austrian economics is leading to a sort of conservative/libertarian orthodoxy which is not only misguided but increasingly isolated and disconnected from all other academic thought on economics that has taken place over the last century.  We seem to think that everything worth knowing about economics Austrians have known for fifty years and all other schools are just attempting to obscure that reality to support some alternate ideology.  This attitude stands in the way of any intellectual progress as well as any hope of communicating with non-Austrians.

However, libertarians seem to be drawn to Austrian economics because there is essentially no other school of thought out there that embraces decentralized, free-market economic policies.  That is understandable.  But I find myself on an intellectual island.  Here are some of the things I believe.

1.  Free markets are good.

This is both a moral and practical belief.  Morally, I believe that a system where property rights are protected and people are otherwise free to do what they want with their lives and their property is the most just system and most harmonious with natural human rights.  In addition to this, I believe that free markets and property rights generate more prosperity than any other system.  This does not mean that they are perfect but once you start allowing the government to arbitrarily meddle with markets in the name of efficiency, or “equality” or whatever, you start down a road that always ends up doing more harm than good.

2.  Central banks are bad.

This is also both a moral and practical belief.  Morally, I don’t think you have a free economy (see belief #1) when there is a centralized authority manipulating the money supply and financial markets.  Most people, frankly, don’t care about this as long as the system works fairly well.  Practically, I don’t think this system will work well in the long run.   This is because I believe it requires the Federal Government and central bank to be constantly taking over more and more of the economy and this will eventually crush the free-market system which is the source of all of our prosperity.  But this is difficult to explain and can’t be shown by pointing to historical data because it is largely a prediction about things that haven’t happened yet.

3.  “Mainstream” economics is not that bad.

There are a lot of issues tied up in this one.  For one thing, many Austrian criticisms of mainstream economics derive from a misunderstanding of mainstream economics.  Utility is one glaring example.  When it comes to macro, mainstream economics does a much better job of describing how the economy actually behaves. (I particularly think Market Monetarism does the best job of this.)  Of course, macroeconomics is a really complicated thing and they are certainly not perfect.  The main shortcoming of “mainstream” economics is that it is nearly entirely focused on describing the current system and almost never deals with questions like “is this system a good idea?”  Austrian economics, on the other hand, is still using arguments that were used a hundred years ago to argue that the system we have now was not a good idea to argue, not that we should have a different system, but that we should have tighter monetary or fiscal policy within the current system.  That makes no sense and this causes Austrians to be mostly dismissed by people who understand mainstream economics.

[Note: There are, no doubt, some Austrian economists out there who would consider my characterization of them inaccurate, and maybe it is.  However, it is an accurate description of the popular arguments which I encounter frequently on the internet/TV/etc. and are often associated with that school.  For what it’s worth, I do think Austrian economics has made some meaningful contributions, I just don’t think it is nearly as perfect as many other libertarians seem to.]

These are essentially the three pillars of my macroeconomic beliefs though there are a lot of more specific details related to them.  So what school do I belong to?  Seemingly, the only school that believes in the second one is the Austrians but they are completely turned around on number three.  In short, there seems to me to be an intellectual hole in the blogosphere.  There has to be room for people to question the efficacy of central banking without throwing out all of mainstream economics.

It is my intention to refocus this blog to meet that need.  I have been deriving a macroeconomic model which I think can ultimately explain, in “mainstream” terms, the threat that central banking poses.  It is not quite complete and I certainly don’t claim to have everything figured out but I think we have to start making intellectual progress on these issues which means we have to start discussing them in an open-minded way.

This puts me in a strange position where I will be arguing mainly with the people who agree the most with my values (conservatives and libertarians).  In some ways I would rather be arguing with progressives.  However, right now, I think we need to get our own house in order before we will be able to make further progress so I see no way around it.  To this end, I intend to basically dive in and spend the next couple weeks identifying the biggest economic misconceptions conservatives have.  I hope this will be taken in the spirit intended.

[First misconception: hyperinflation/money isn’t backed by anything]

Banks Can Lend Out Excess Reserves

January 4, 2014 21 comments

In the comment section of a post by Scott Sumner on EconLog, a commenter made the claim that banks cannot lend out excess reserves and cited this paper.   While most of the details discussed in the paper are correct, the conclusion that banks can’t lend excess reserves is not.  I will try to explain the confusion.

First, the author makes the important point that “A key distinction to bear in mind (hinted at in the last previous paragraph) is between individual banks and banks in aggregate.”  But then he goes on to “prove” his claim that banks can’t lend out excess reserves by showing that they can’t change the quantity of aggregate reserves.  This is true but an individual bank can lend out excess reserves.

Consider the bank’s balance sheet as represented in the paper.

Reserves (R) + Loans (L) + Bond holdings (B) = Deposits (D) + Equity (E)

When a bank makes a loan, they create additional deposits and additional loans (initially keeping their reserves unchanged).  However, people don’t just take out loans to keep the money in a deposit account at the bank who gave them the loan.  Usually they spend these deposits.  When they do this, they become deposits in someone else’s account, possibly at another bank (some may become cash held by the public).  When this happens the other bank settles with the first bank and reserves are transferred.  This decreases reserves and deposits at the first bank, keeping the above equation intact.  It’s true that this doesn’t change the total quantity of reserves in the economy but it does change the quantity of reserves held by that individual bank.  They have been traded for loans (notice that this still keeps the above equation intact, it has just changed the composition of the left-hand side.

If a bank does this, it will increase the money multiplier because while the total reserves in the economy remain unchanged (they have just changed banks) the total amount of loans and deposits has increased (those deposits ending up on the balance sheet of the other bank which got the reserves which left the first bank).

Note that even if you assume that when a bank makes loans, it increases its own deposits only and does not decrease its reserves at all, the minimum reserve requirement will still be a constraint on lending because as it increases lending, L and D will increase but R will remain the same.  Obviously, at some point, this will cause the ratio L/R to hit the minimum.

Now the claim that banks are not constrained by reserve requirements in normal times is mystifying.  Again, this is a case of making an argument about aggregates and extrapolating (erroneously) to the behavior of individual banks.  Here is the claim.

The money multiplier view of the world envisages the central bank creating reserves and the reserves multiplying into new lending. That is, reserves constrain bank lending. That would seem compelling. If banks are subject to minimum reserve requirements (requiring them to hold reserves in a certain proportion to their deposits, and deposits are the balance-sheet counterpart to loans at the point of credit creation), then, by restricting the amount of reserves that the central bank supplies, it should be able to control the amount of credit.

But modern central banking doesn’t work this way. Central banks don’t constrain the amount of bank reserves they supply. Rather they supply whatever amount of reserves that the banking system demands given the reserve requirements and the amount of deposits that have been created.

This seems to indicate a deep confusion about what it means to be “constrained.”  It’s true (or at least I will accept the premise) that the central bank sets an interest rate target and provides whatever amount of reserves are necessary to hit that target.  This does not mean that banks are not constrained by reserves! 

This fact I think is indisputable: a legal minimum requirement for reserves exists.  This means that if a bank has a ratio of loans to reserves which is equal to that minimum level, they cannot make more loans.  When banks make loans in the way described above (which is the same way described in the paper), they increase aggregate loans and deposits without changing the aggregate quantity of reserves.  This means that for a given quantity of reserves, there is a maximum amount of loans and deposits that the banking system is capable of creating and this maximum is determined by the minimum reserve requirement.

The author seems to claim that this technical constraint is meaningless because if a bank runs into it, the Fed just creates more reserves.  This is not true for an individual bank.  A bank cannot hit the minimum level of reserves, want to keep making loans, and just call up the Fed and say “give me more reserves, I want to keep making loans.”  They have to trade some other asset for more reserves (this may include attracting deposits) or else they cannot make more loans.   This means that the reserve requirement is a binding constraint if the bank is in that situation.

Furthermore, and more importantly, this claim that Fed just supplies whatever reserves the banking sector “demands” given the reserve requirements and deposits being created is complete nonsense.  He is just saying that, instead of the Fed determining the amount of reserves (money base) and this leading to some amount of deposits which is determined by the reserve requirement (which is a constraint on the creation of deposits), there is some exogenously given quantity of deposits and the Fed just mindlessly fills in the reserves which this amount of deposits requires.  That’s completely upside down.  The amount of deposits depends on the amount of loans.  The amount of loans and interest rates are determined in the market.  Yes the Fed tries to target an interest rate but how do they do this?

A bank has the ability to trade assets of one kind for assets of another kind at certain prices which are determined in the market.  Different assets have different rates of return.  Barring any other constraints on their behavior, they will choose the quantities of these assets (and the market prices will adjust) in such a way that the rate of return (net of risk premiums and other such considerations) is equal.  Reserves usually have a low or zero rate of return.  This is fixed by the rate of interest on reserves.

The rate of return on loans is determined by the supply and demand.  The demand is beyond the control of the banks.  The aggregate supply of loans is essentially flat (maybe not perfectly flat but at least pretty flat) at (or near) the rate of IOR (abstracting from risk premiums) for quantities up to the maximum quantity of loans which is possible for the given quantity of total reserves and the minimum reserve requirement.  At that point, it becomes perfectly inelastic (vertical) because there is no way that the banking system can make more loans without the Fed either increasing the total reserves or lowering the reserve requirement. (In other words it is constrained by these two things!)

In normal times, interest rates on loans are high enough that the return on them dominates the return on holding reserves so banks try to make more loans and they do this until they hit the reserve requirement constraint and the market interest rate is determined by where this quantity of loans hits the demand for loans.

Market For Loans

loans market normal

Here i* is the market interest rate R is total reserves and r is the minimum reserve requirement and I am assuming there is no currency held by the public just for simplicity. (I don’t know why it’s blurry I’m not very good at blogging…)  Now if the Fed were to increase the total amount of reserves in the economy, this supply curve would shift to the right which would lower interest rates (of course there could be some effect on demand from changing expectations about the stance of monetary policy but that isn’t important for our purposes).  The Fed can increase or decrease the quantity of total reserves to try to hit its interest rate target but this doesn’t mean that banks aren’t constrained by reserves.  On the contrary, it is because banks are constrained that this works.  By increasing the total quantity of reserves (money base) they are relaxing the constraint and this allows banks to make more loans until the constraint becomes binding again.

The quantity of reserves (money base) is a tool the Fed uses to manipulate interest rates to the supposed target.  The reason this works is that the expansion of credit is constrained by this quantity.  This means that the quantity of base money determines the quantity of credit created and the interest rate.  You can say that the quantity of reserves the Fed has to create is determined by the interest rate target and the demand for loans and the reserve requirement but this is not saying something different from the “fractional-reserve banking theory of credit creation,” it is just saying it in a different order.  It is still a fact that the Fed controls the size of the monetary base and that this puts a constraint on the total amount of loans and deposits banks can create.

“Zero” Lower Bound and Interest On Reserves

If for some reason the quantity of base money becomes high enough relative to the demand for loans that the demand hits the supply to the left of the maximum quantity of loans which can be created, then this constraint will cease to be binding and instead bank behavior (on an individual level) will be equating the marginal return on loans to the marginal return on reserves (recall that while banks as a whole cannot reduce their reserves, individual banks can).  The reserve-requirement constraint still exists but it is not binding.  When this happens banks could make additional loans but they are choosing not to because the rates at which they would have to make those loans are not worth it.  This is not a criticism of banks.  So while the imagery of reserves being parked at the Federal Reserve instead of being loaned out may seem misleading, this is only because if banks made more loans, the reserves in the aggregate would still be parked there.  This does not mean that the presence of those reserves, however they are described, does mean that banks have the ability to make more loans.

In this environment, increasing the money base does not relax the constraint on lending because it is not binding and therefore, it does not have the usual effect on interest rates and borrowing/lending.  (This is not to say it has no effect since it still affects inflation expectations which affect the demand).  On the other hand, lowering the IOR would lower the rate of return on reserves (obviously) which would make loans relatively more attractive.  In other words, it would shift supply downward, which would increase the quantity of loans and further reduce interest rates.

Market for Loans

loans market zlb2

Now if demand suddenly increased in this environment, banks would start making more loans and this could cause inflation if the Fed did nothing to restrain it.  However, I agree with the author that the Fed would have no difficulty reigning this in by reducing the base if such a thing occurred.  Indeed, I believe the Fed would love to have that problem instead of the current one.  However, just because the Fed can change the constraint by changing the total quantity of reserves does mean that it isn’t a constraint.

The claim that “banks can’t lend out reserves” seems to be purely a semantic argument.  He doesn’t want to call it “lending out reserves” but his reasoning for this–that an individual bank’s reserves don’t decrease when they lend more–is not correct since, even though they may trade deposits for loans, those deposits are usually quickly transferred, along with reserves, to other banks.  This means that individual banks can’t change the total quantity of reserves but they most certainly can change the quantity of their own reserves.