A little Keynesian leaven goes a long way

Scott Sumner

This week Professor Scott Sumner over at his blog The MoneyIllusion gave readers some of his pearls of wisdom on the gold standard.  A self-proclaimed monetary expert, Sumner seems to be rather muddled up about the whole issue.

His piece has shades of nuance and indeed some truth, but misses the mark in so many ways.  Basically his argument boils down to (and this is pure paraphrase): the ability of people to freely buy and sell gold under a gold standard means that gold can be hoarded in times of economic distress, which in turn creates painful deflationary recessions.  Gold is basically too volatile in its price to be a stable monetary solution, and would lead to untold economic havoc as prices fluctuate wildly.  Moreover, industrial demand for gold makes its price inherently unstable.  Therefore, ‘conservatives’ calling for a gold standard should be careful what they wish for.

Before I go into the Prof’s logic, here’s his bio from his blog:

“…I have spent 25 years researching the Great Depression, liquidity traps, and forward-looking monetary policy (especially policies that utilize market forecasts.) Last October I noticed that the Fed (and other central banks) had lost credibility, allowing market expectations for growth and inflation to fall far below their implicit target. In other words, the severe economic slump seemed to be caused by tight money–not tight in any absolute sense…but relative to what was needed to meet the Fed’s objectives. To my great frustration, I found few if any macroeconomists who saw things that way, even though it seemed a logical implication of mainstream macro theory. A blog is not the place for a lengthy dissertation, and so here I’ll merely list three views that underlie my unusual take on the current recession: Premise 1: The only coherent way of characterizing monetary policy as being either too“easy” or “tight” is relative to the policy stance expected to achieve the central bank’s goals. Premise 2: “Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.” Premise 3: After mid-2008, and especially in early October, the expected growth in the price level and nominal GDP fell increasingly far below the Fed’s implicit target. In plain English, the first premise means the Fed should adopt the policy stance most likely to achieve its goals… The second is a quotation from Mishkin’s best selling monetary economics text (p. 607), i.e. it’s what we have been teaching our students. And I have encountered few if any economists who disagree with my third assumption. Indeed, if this were not so, why would Bernanke be calling for fiscal expansion? The logical implication of these three premises is that the Fed has the ability to boost nominal growth expectations, and if they let those expectations fall far below target (as they did last fall) the subsequent recession (depression?) is their fault. Why does almost no one else see things that way?
[HA Emphasis]

That puts things into some perspective for us.  Basically Prof Sumner is a ‘Liquidity Trapper’ or ‘Krugmanite’ as defined in our post on inflation and deflation.  As we said back in September 2010,

The Liquidity Trappers worry that the private sector, due to fear, lack of confidence, and falling employment, cannot provide the ‘aggregate demand’ required to keep businesses profitable, and that until such private sector demand is restored, the government and central bank must make up the deficiency in demand through deficit spending and ultra-loose monetary policies.

Some of the more ardent members of this group advocate not only zero% interest rates when ‘required’ to boost growth and employment, but sometimes argue for negative interest rates (as Nobel Laureate Paul Krugman has done) and considerable new money creation by the central bank with which it should buy government bonds and other assets, thereby pumping more money into the economic system.  Because savings rates rise during a recessionary period and people tend to pay down debt, the Liquidity Trappers worry that the lack of demand will force companies to shed staff in order to remain profitable due to falling sales.  Those newly unemployed people lose purchasing power, creating a downward spiral of job losses and diminishing aggregate demand that leads to utter economic ruin.

Sumner is part of that group of economists who talk about ‘expectations’ as though they are something to be manipulated by our fiscal and monetary masters.  According to Sumners own words he believes that the Fed ‘let’ growth expectations fall below it’s targeted levels, and if it had just been more willing to print it up, growth expectations would not have fallen and the recession could have been averted.

I don’t know what kind of research the professor has done for 25 years, but it is a sad indictment on myopic ivory-tower academia that such an obviously intelligent man can distil the essence of economic prosperity into such nebulous concepts as “managing growth expectations”.  As if we’re a bunch of drones having our growth expectations dictated to us by a central authority and then making our individual economic choices from there.

His bio also highlights the sheer narcissism of the mainstream economic fraternity.  People like Sumner think that ‘policy makers’ have to ’steer’ the economy away from ruin, like big benevolent gods.  “Sure individuals may know what’s best for themselves”, these people quip, “but the ‘macroeconomy’ requires a whole new level of ‘coordination’ to avoid disaster.”

Yip, pretty much what the Soviets thought as well.

This God-complex among the modern intellectual economic fraternity also comes through in Sumner’s justifications for his three core premises.  In simple terms he’s saying, basically, premise number 1 is self-evident (it isn’t), premise number 2 must be true because some big best-selling (i.e. because lots of state funded universities bought it) Keynesian textbook says so, and number 3 is true because economists generally agree it to be so.

So on this rock-solid intellectual foundation, Prof Sumner proceeds to tell us what’s wrong with the gold standard, which is made all the more odd by the fact that we here at Human Action ALSO reject the gold standard, at least in the way Sumner characterises it… or at least in the way we think he’s thinking about it, or something like that.

But overall, as you might expect from a Keynes/Krugman disciple, Sumner goes intellectually wonky on the whole gold-as-money thing and pretty much gets lost in his own pretzel-twist.

Let’s go through is piece:

There has been a recent upswing in conservative articles discussing the idea of going back to some sort of gold standard.  I don’t think people realize how dangerous this idea is.  You can’t just “give it a shot” and see how it works out.  It’s like marrying the daughter of a Mafia chieftain–you need to be very sure you are willing to commit.

First off we agree with statement at face value.  Many of the calls for a ‘gold standard’ come from deeply ignorant places and largely don’t understand the full implications of what it would look like and how it would be administered.  In this sense yes, going guns blazing into a gold standard is “dangerous”, even if, as we’ll discuss, for different reasons than Sumner advances.

A true gold standard (not Bretton Woods) allows Americans to buy or sell gold.  If you are not 100% committed to staying on gold, but instead hint you might devalue the dollar at some point, people will dump dollars and buy gold.

This is of course true, but rather than it being a vice of the gold standard, it is its virtue, for it allows people to seek monetary protection from paper debasement, and as a result keeps government honest as monetary debasement is quickly exposed once markets start showing gold prices rising above the mandated exchange rate.

The increase in demand for gold will raise its value, or purchasing power.  This is deflationary under a gold standard, where the nominal price of gold is fixed.

 What the prof is saying here (I think) is that basically you can debase the paper, but because gold will hold its value, and the gold standard has mandated a fixed ratio of paper to gold, the paper must soon deflate in order to restore that ratio.  This is just a restatement of the discipline of the gold standard: it forces government to quickly rein in an episode of profligate monetary debasement.

Of course we can understand why Sumner thinks this is a problem because his Keynesian/Krugmanite framework causes him to think that a recessionary episode is a) bad, b) the fault of ‘deflationary psychology’, and c) solved only by inflating back to the pre-existing ‘happy’ time.

It probably doesn’t occur to Sumner (I don’t think) that the real problem is the initial inflation, not the resulting and necessary deflation, like saying a drug addict’s withdrawal symptoms are bad instead of the drugs.  Or maybe he does understand but is trying to sort of imply that governments will do what governments will do, so we need to remove any impediments that will spoil the party.

Nor is this merely a theoretical problem.  There were large bouts of private gold hoarding during four periods of the Great Depression, all associated with devaluation fears; the last half of 1931, spring 1932, February 1933, and late 1937.  All four were associated with economic distress, falling stock and commodity prices, etc.  And there is event studies-type evidence showing causation going from gold hoarding to deflation.

This is factually correct, but again Sumner seems to be re-emphasising that this is a BAD thing, when in reality it is a protective and rational response to a) paper debasement (dealt with above) and b) uncertainty and lack of confidence about where and how to deploy cash balances.

Again, Sumner’s Keynesmanite paradigm tells him that the symptom (hoarding) is bad rather than the root cause, and that investors’ very lack of certainty and confidence is the very reason why ‘aggregate demand’ is falling and why the policy authorities should be able to step in and guide this bunch of headless chickens toward economic salvation.

But of course the lack of entrepreneurial certainty (i.e. the demand for hoarded cash balances), is a rational and necessary response to uncertainty and confusion THAT HAS ALREADY BEEN CREATED by the monetary debasement and the misallocation of capital that it caused.  The inevitable bust is the process of CAPITAL RE-ALLOCATION, and that process requires entrepreneurs to reassess their economic environment, pause before acting, and carefully consider where opportunities lie.

It’s not easy to know which price of gold would be appropriate.  Perhaps market gold prices would go to the right level after an “announcement” of a return to gold, but even that depends on the announcement being 100% credible.  But after you re-peg, the real value of gold can change due to industrial demand shifts, even if there is no monetary hoarding of gold.  Furthermore, all countries are not likely to follow the US back on gold, so you might have monetary gold hoarding in Europe, as people feared for the euro.  Booming Asia might increase the industrial demand for gold, just as it has raised the demand for many other metals.

Here Sumner is picking up on an important point, namely that ultimately any re-pegging to gold involves and entirely arbitrary assessment of value at a point in time.  Given that no form of money ever can or will remain ’stable’ in value this is hardly a worthy objection to having gold as the anchor as compared to anything else.  After all, conventional fiat currency exchange rates are wildly fluctuative are they not?

It seems that Sumner has two basic objections here:

1. That pegging gold incorrectly can exert unnecessarily deflationary forces
2. That Gold is inherently an “unstable” value anchor

Point 1 we agree with at face value, but at least in such a scenario there is a once-off deflation or inflation and then an end to the boom cycle caused by monetary debasement (if the gold standard is honoured properly).

Point 2 is a strange objection.  Seeing as all values are relative and shifting due to market dynamics, why would gold or paper money or anything else be any different.  Moreover, why would we want it to be any different, since shifting valuations of some goods against others signals marginal economic opportunities upon which decisions are made?

However, to speak specifically to Sumners objection that gold prices would fluctuate wildly, that is an assumption I presume gleaned from the current way gold prices fluctuate in currency terms.  But it ignores a world using gold as money, which would increase greatly gold’s liquidity and limit marginal influences on is value.  It also ignores the fact that golds seeming volatility of price is driven by the instability of the dollars chasing after it, not the gold itself.  We could just as easily say that the dollar is hugely volatile when priced in gold.

And there is little room for error.  A 10% increase or decrease in the real value of gold seems very small when it is just a commodity.  But under a gold standard that sort of shift can be accommodated only by changing the overall price level by 10%.  A sudden 10% rise or fall in the price level is very destabilizing to the economy.

This is exactly the regime we currently have in the global fiat system, except that it is way worse.  How destabilising is the world of dirty-floating fiat currencies on trade and investment flows?  Moreover, to repeat what was said above, gold would need to be able to move in value anyway in response to market conditions.

Even if the government is committed to gold, investors may fear the next government won’t be (remember FDR?)  In that case the promise to stay on gold may not be credible.  In the old days there was a powerful emotional attachment to gold, as paper money was feared as inevitably leading to hyperinflation.

A fear proven correct countless times in history, most recently in Zimbabwe, and soon to come in Venezuela.

Only then will voters be willing to suffer austerity to stay on gold.  A modern analogy is the long painful struggle of Argentina to stay on its currency board during the 1998-2001 deflation, attributable to a fear they would return to hyperinflation.  But we now know that fiat money can produce modest inflation rates, so our voters won’t undergo the pain of the mid-1890s, or early 1930s, just to stay on gold.  And if you aren’t willing to undergo that pain, the system won’t work.

Again, pain brought about by prior profligacy.

Some supporters point to Bretton Woods, but that “worked” in direct proportion to the extent that the gold constraints were ignored.  Gold was highly overvalued after the 1933 devaluation, and then the US grabbed a huge share of the world’s gold in the run-up to WWII.  After the war those two factors gave us an unprecedented amount of slack, where we could mildly inflate until gold was no longer overvalued.  Once we reached that point in the late 1960s, the system immediately fell apart.

In plain English: The gold price was overvalued at Bretton Woods, allowing the US to print up a storm for 25 years, after which gold exerted its discipline on the US, who didn’t like said discipline, and therefore dumped gold outright.

It would have collapsed even sooner if Americans had been allowed to own gold.  And if LBJ had tried to deflate to stay on gold, Americans (if allowed to) would have hoarded gold in the (correct) expectation that the next president would devalue the dollar, putting expediency ahead of principle.  That hoarding would have had the same effect as the hoarding of the early 1930s–deflation and depression.

Sadly once again Sumner conflates two separate issues.  His assessment here is actually quite sharp, but then he laments the pesky old problem of hoarding.  In essence I think what Sumner is saying is that a gold standard begets a kind of cat and mouse game between the public and the politicians, where monetary debasement begets gold hoarding, gold hoarding necessitates a monetary deflation, the pain of the deflation begets a politician that will appease the people by inflating again, which in turn begets gold hoarding, another round of deflation, fresh calls to ease the pain via paper inflation,  a new round of gold hoarding, and on and on and on.

So basically it all starts with the state reneging on its promised gold-paper ratio.

Thus, strangely, in a roundabout way, via a labyrinth of fallacious Keynesian logic, Sumner kind of comes to a proper conclusion: that the state controlled classical gold standard is doomed to fail.  We agree.  Indeed that is exactly why it DID fail!

But note the subtle differences here.  While the prof acknowledges to his credit that governments will eventually renege on the gold-paper ratio, he doesn’t lament this act and call it what it is: fraud.  Nonetheless, his recognition that governments will probably cheat on the gold-paper ratio is a profoundly libertarian one.  Which makes it strange when he then conflates this view with Keynesian logic about the ‘disutility’ of hoarding and the creation of harmful deflationary recessions.

In a way then (and I’ve admittedly only arrived at this point now after trying to think through how Sumner is thinking), Sumner is basically recognising that a classical gold standard is doomed from the start (a profoundly libertarian position), that governments start the rot by debasing the paper (also an Austrian-libertarian view), that rational gold hoarding will create a deflation episode and recession (a sound monetary understanding), and that the deflation will cause calls to come for a new round of inflation to ease the pain of the recession (a distinctly Austrian understanding of the political economy of deflationary episodes).

So where on earth does Sumner miss the boat?

1. Sumner’s Keynesian paradigm dictates to him that deflation is bad and therefore that we need a system that does not hold the potential to encourage hoarding, and this basically leads him to the idea that we need to keep inflating fiat money and live with “modest inflation rates” that dull the pain.  In control of unbridled fiat paper creation the state no longer has to worry about the pesky discipline of gold, and can mitigate hoarding by pumping new money into the economy and make previously unattractive investments attractive again, thereby boosting much-needed ‘aggregate demand’.
2. Sumner cannot seem to comprehend a world of FREE MARKET MONEY.

So for all Sumner’s surprising libertarian insights, whether accidental or not, he ideas fall short because of his lack of understanding of the nature of business cycles, the cathartic process of recession, and the basic functions of money.  It goes to show that a little bit of Keynesianism acts like leaven in the formation of ideas about how the world works.  It also seems to corrupt any acknowledgement of the possibility of free market money, a monetary system where money production and administration is totally out of the hands of the state and where gold, silver, copper, seashells or paper can compete freely as monetary commodities within an unhampered system of economic exchange.

So yes Professor Sumner, the classical gold standard is a system that cannot last, but your alternative of creeping insidious paper debasement is no substitute for the gold standard.  Instead, how about we allow people to trade in the money they choose, abolish authoritarian legal tender laws, and let the best money show itself in a free market?