Scott Sumner  

The great sin, the even greater sin, and the enlightened path

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The title is my pathetic attempt to imitate Miles Kimball and Noah Smith, who sometimes post on religion. This won't be about religion; it's about monetary policy. Oh wait . . .

In the 1970s, US policymakers knew that inflation was too high, but weren't willing to bring it under control, as they worried about the effect on unemployment. And in some cases (such as 1972 and 1980) worried about the next election. Britain had the same problem, but far worse than the US. German policymakers did somewhat better (but still rather poorly in absolute terms) because they had more self-control than policymakers in the English-speaking world.

Thus the great sin of monetary policymaking is a lack of self-control. It's putting the "one marshmallow eaters" in charge of the central bank.

OK, if that's the great sin, then what is the even greater sin? The even greater sin is fear of a lack of self-control.

In the late 1920s and the early 1930s, policymakers feared what would happen if money was not backed by gold. They had seen the German hyperinflation, and not surprisingly had a rather low opinion of fiat money. The gold standard was seen as disciplining irresponsible policymakers. Something similar occurred in the 1990s in Argentina, when they set up their currency board. They also had memories of a hyperinflation about a decade earlier. And something similar happened when the euro was set up, without enough flexibility to easily prevent deflation, and without allowing the safety valve of devaluation. The architects of the euro recalled the irresponsible monetary policies of some of the Mediterranean countries, in the previous few decades. They wanted to make that sin impossible. And so like the greatest of the Mediterranean heroes, they tied their hands to the mast.

In each of those three cases, policymakers who feared a lack of self-control set up a policy apparatus that was extremely difficult to dismantle, with the euro coming closet to a true "doomsday machine." These regimes did successfully prevent high inflation, but they all had a fatal flaw. None of them could adapt to a circumstance that was not anticipated by the creators of their regime---a sharp increase in the demand for the medium of account (gold, the US$, the euro, respectively), which led to falling NGDP. And because nominal wages are sticky and debt contracts are in nominal terms, these regimes led to mass unemployment and severe financial crises.

Why is fear of a lack of self-control a worse sin than lack of self-control? After all, in ordinary life it would be a lesser sin. But monetary economics doesn't follow the rules of everyday morality. The damage of being "too responsible" is far greater than the damage of being "irresponsible." That's because wages are much stickier in the downward direction. Hence the German deflation of 1929-33 did more damage than the hyperinflation of 1920-23, even if one ignores the elephant in the room (Hitler.) The Great Inflation of 1965-81 did less damage than the Argentine deflation of 1998-2001 or the recent euro depression. That's just the way the world works.

Are those our only two choices? No, fortunately there is an enlightened path. The first step is to recognize our ignorance. (I believe NGDP level targeting is best, but might well be wrong.) In that case policy should be conducted from a "timeless perspective" and the policy regime should be occasionally updated to reflect new macroeconomic knowledge. Thus the policymakers of the 1970s should have realized that from a timeless perspective low inflation is better, because there is no long run trade-off between inflation and unemployment. But maybe that (natural rate model) is slightly wrong. Some studies suggest that below a certain level (say 2%) there is a permanent trade-off. So maybe you aim for 2% inflation rather than 0% inflation.

Then new knowledge might show that inflation is not the best target, NGDP is better. Which NGDP target is best? Consider the cost of transition. People made plans based on 2% inflation, at least in the long run. So have the changeover occur at a NGDP target path that is expected to produce 2% inflation, on average. Perhaps 4% NGDP growth. That way debtors and lenders won't feel robbed. You can write up models where those sorts of sunk costs don't matter, but those models only make sense if NGDP is the final policy adjustment. But it isn't. If you mess around with the average inflation rate this time, people won't believe your promises about NGDP.

Don't think of these policy changes as constantly changing direction, but rather as iterating in closer and closer to an optimal policy. Of course we will never arrive, it is always about making policy less bad. Money is useful for transactions, but monetary systems are always more or less harmful in a macroeconomic sense---they always move you at least some distance away from a frictionless world with a Walrasian auctioneer.

To summarize:

1. Show self-control; use a timeless perspective.
2. Don't show too much self-control, shift course when you discover your policy regime is fundamentally flawed.
3. Always recognize that your (and my) favorite policy is wrong, and always be on the lookout for "less wrong" policies. Just as Einstein's general relativity is less wrong than Newtonian mechanics.

PS. I am indebted to Eliezer Yudkowsky for the phrase "less wrong."

PPS. You might think this is hopelessly utopian; real world policymakers are not enlightened. I don't fully agree. We have moved from a bad rule (gold) to a discretionary policy regime (also bad), to a sort of Taylor Rule (better) and don't see why we can't then move to a NGDPLT policy (still better), and then perhaps a total nominal labor compensation target (if we were to assume that was still better.) Despite everything, I remain an optimist.


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COMMENTS (21 to date)
D.F. Linton writes:

The work of Prof. Selgin pretty much shows that the Fed era has been substantially worse by most measures than the gold standard era that preceded it. Why then do you characterize the gold standard as "bad".

Nick Rowe writes:

Yep. This pretty much reflects my perspective too.

There is a danger of us NGDPers being seen to dump too hard on inflation targeting. Inflation targeting was not a bad policy. It was better than what went before. It just wasn't as good as some of us had hoped. We have learned from experience.

Barry "The Economy" Soetoro writes:

Scott,

Let me say I've read you for a long time and have enjoyed your work. However, I cringed reading this. It is pure fantasy that the Fed has maintained self control since August 1971. That's when gold was really ended, hence the points about the 30's don't really apply. If you look at nearly EVERY major negative trend in America, they all started in the mid to late 70's and progressively have gotten worse.

http://thecurrentmoment.files.wordpress.com/2011/08/prod_wedge-1960-2000.gif

http://research.stlouisfed.org/fred2/series/TOTALSL/

First graph here
http://www.cbpp.org/cms/?fa=view&id=3629

To me, the evidence is overwhelming that a major shift happened in the 70's and I think the answer is obvious.

"On 15 August 1971, the United States unilaterally terminated convertibility of the US dollar to gold, effectively bringing the Bretton Woods system to an end and rendering the dollar a fiat currency."

http://en.wikipedia.org/wiki/Bretton_Woods_system

To pretend fiat currency has been a great success for the average joe is laughable.

The Fed prints money and literally hands it to those who own financial assets, most of which are the top 5%. Since prices are made by the marginal buy, who the FED IS, the Fed is basically giving the rich a sliver of wealth everytime it makes an asset purchase, while the rest of us get nothing.

Barry "The Economy" Soetoro writes:

Also, Scott, I KNOW you KNOW that dollars were still effectively convertable to gold by central banks until Nixon, and so to say that we ended the gold standard in the early part of the century is Krugmanesque. You're better than that.

Barry "The Economy" Soetoro writes:

Hmm.. what trend changes suddenly in the early 70s??

http://marginalrevolution.com/marginalrevolution/2004/03/income_inequali.html

Philo writes:

"[T]he [monetary] policy regime should be occasionally updated to reflect new macroeconomic knowledge." Yes, there is no escape from dependence on (the macro wing of) the economics profession as a whole. And did it not take a step backwards in 2008? Why, then, should one be optimistic about the future?

Also, policy would be more effective if the market thought it knew what the policy was going to be far into the future. But that won't happen if the market is aware that the policy regime is *flexible*, subject to unexpected updating. *Flexibility* introduces an undesirable element of uncertainty.

Sam Haysom writes:

This is a pretty naive view of self control. Libertarians like to stress the imperfection and inevitable ignorance of man right up until their favored policy choices require Herculean efforts of virtue and restraint. At that point people are suddenly near perfect.

Self-control works because people over-correct against potential flaws. Self-control isn't rational and it isn't a product of reflection. It is it's own impulse. The second reflection leaks into self-control you no longer have self control you have bargaining. You can't program a self-control algorithm into people. Laxity like decay is the default setting in man. Of course that predisposition to laxity has served libertarians well when it comes to their support for the permissive society so it's hardly surprising they don't acknowledge it. "No that's not moral laxity that's expanding freedom."

That said I would genuinely like to see this kind of analysis applied to Bryan Caplan's immigration policies. Caplan doesn't just think his preferred policies are right he thinks he's owed an apology.

bill writes:

Excellent.

CMA writes:

"shift course when you discover your policy regime is fundamentally flawed."

Could we apply this principle to asset purchases? For example if the MB had to increase massively and targets arent being reached should we than change course to maybe heli's instead of purchasing evry asset out there?

Andrew_FL writes:

Oh boy, where to begin. There's more that I disagree with than agree with here, unfortunately.

We have moved from a bad rule (gold) to a discretionary policy regime (also bad), to a sort of Taylor Rule (better) and don't see why we can't then move to a NGDPLT policy (still better), and then perhaps a total nominal labor compensation target (if we were to assume that was still better.)

In the first place, your history here suffers from a flaw of not tracing back far enough. Let's push back a little further, to prior to the Gold Exchange Standard (which roughly corresponds to your "gold rule" which was "bad"-I'd note, though, that the rule followed by the fed at the time of the Great Depression was the Real Bills Doctrine) To the Classical International Gold Standard from before the first World War. This ought to be classified as "good, but hampered by bad banking regulations"-which can be seen from the superior performance of the contemporary Canadian system. We then turned not to an "also flawed" system but to an "objectively worse system"of the Gold Exchange Standard. Then what you call Discretion, which was either better or worse (you say "also bad" so I can't tell where you stand. Then Taylor Rule which is better than discretion. And then suggest NGDPLT as better still. So here's the heirarchy as I see it:

FBGS>RBGS>GES/RBD~DP is less than TR is less than NGDPLT

Dang, can't use the less than sign.

Do you see the problem here? First, your Whiggish Historiography of monetary policy is wrong, policy can get worse as well as better, and in fact it's done so probably at least as frequently.

But more importantly, the above heirarchy is ambiguous. We can tell from it that both NGDPLT and Free Banking on a gold standard (or, if we have a mind toward reconstructing in the future, on a frozen or rule controled monetary base) are better than the Gold Exchange Standard or Discretionary Policy, but not which of the two is better than the other! They're two ideas history has not ever put head to head, so our only option is theory.

Next, the virtue of a laissez faire system is that you don't have to worry about either sin, as no one is empowered to commit either of them.

On the idea of a permanent trade off, by their very nature these studies are on societies conditioned to expect inflation-condition essentially synonymous with living under Central Banking. So I find it unconvincing that in the very long run, you couldn't shift that 2% value downwards with a carefully managed transition.

Finally, a system of barter wouldn't be like the Walrasian fiction, either, so it's wrong to measure money against it and find it wanting in general.

I think that covers everything, may be back with more complaints later though. All the best!

[to use a less-than sign, type &lt; --that is, ampersand, the letters "lt", and then a semi-colon. It will look like this: 6 < 7.--Econlib Ed.]

This is not a very helpful perspective.

There is nothing "overly responsible" about keeping a few million people out of work to prevent the price of groceries of rising for the others. It is not responsible, period.

The ECB is the anorexic overly thin young woman who is afraid of getting fat. She is not eating "overly healthy," she is killing herself. Perhaps in a way that shows self-control, but not responsibility.

Scott Sumner writes:

DF, I've spent most of my life studying the damage done by the gold standard in the early 1930s. George doesn't believe the US was on a true gold standard in the early 1930s. That explains part of the difference. Unfortunately we lack the sort of good macro data for the pre-WWI period that would allow us to definitively settle this issue.

But if the 1930s were not a true gold standard, then why not claim 1965-81 was not a true inflation targeting period? Since 1982 the inflation rate has been fairly low and fairly stable, not much of a problem in a welfare sense. If you compare inflation targeting to gold, even classical gold, it comes out reasonably well. I don't view low trend inflation as a problem, although George actually prefers mild deflation (assuming productivity is growing.)

BTW, I think George's paper on this topic is excellent, but that doesn't mean I have to accept his conclusions 100%.

Thanks Nick, I agree.

Barry, You said:

"It is pure fantasy that the Fed has maintained self control since August 1971."

You misread me, I said the Fed LOST self-control in 1971 (actually 1968 is when we left gold, and is the better date to use.)

So we agree.

You said:

"Also, Scott, I KNOW you KNOW that dollars were still effectively convertible to gold by central banks until Nixon, and so to say that we ended the gold standard in the early part of the century is Krugmanesque. You're better than that."

This is getting kind of comical. First DF trashes me for assuming we were on the gold standard in 1931, when any American could redeem dollars for gold on demand (his argument implies we weren't), then you trash me for saying we were not on the gold standard in September 1968, when even foreign individuals could not redeem dollars, and the free market price of gold had diverged from the official price ($35), and the US was leaning on foreign central banks to not redeem dollars. I can't win. Yes, we were on a quasi-gold standard February 1934-April 1968. Doesn't change my argument at all.

Oh, and money is roughly super-neutral at modest expected inflation rates.

Philo, Good question. If Delta finds that 10 of its pilots are drug users, you fire them and try to find better pilots. You don't fire them and replace them with plumbers. What other choice do we have than to use macroeconomists? Even if most screwed up, a Fed board of 12 plumbers probably would have screwed up worse. And if you say abolish the Fed and replace it with X, who writes the law setting up the X regime? Macroeconomists.

Sam, If your argument was correct, then inflation targeting would have failed after it was adopted in the 1980s. Many people with your point of view predicted it would fail. But it succeeded almost everywhere it was tried, in bringing inflation down to low rates close to the target. This suggests the assumption that central banks lack self-control is a false hypothesis. They may lack self control, and did in the 1970s, but improved monitoring regimes have proven modestly successful. (Of course inflation is the wrong target, but that's a different issue.)

CMA, Agree that QE is not the best policy, but I'd prefer shifting to either level targeting of P, or better yet NGDP targeting. I oppose helicopter drops.

Andrew,

I agree with two points you made:

1. Our banking regs were a big problem in the old days.

2. The pre-WWI gold standard was better than the post WWI standard.

But I still think even the pre-WWI standard was far worse than inflation targeting.

When you tell me that I don't understand monetary history (after spending almost my entire adult life studying the gold standard), it just tells me that you don't understand monetary history. The price level was fairly volatile prior to WWI, although unfortunately we lack good data, so it may have been less volatile than the data suggests, we just don't know how much less.

Scott Sumner writes:

Luis, Perhaps I should have used scare quotes for "responsible."

Andrew_FL writes:

@Scott- I did not say you don't understand monetary history, I said your account here is flawed. Big difference, in my opinion. But sorry for the misunderstanding.

Second, to the volatility of the price level:in the short term, yes, the price level varied significantly. But for the fotmation of long term contracts, it's the long term predictability that matters. That's worse now than it was then. The prevalence at the time of 100 year bonds attests to this.

Third, I don't believe I've contradicted the claim that

IT>RBGS

That's consistent with my heirarchy.

Scott Sumner writes:

Andrew, Long term price level predictability is not worse now, it's better (under IT). The price level was roughly a random walk under the gold standard. (Check out Barsky's research.) And in any case short run volatility is far more important for social welfare than long run predictability. Employment shocks and debt problems are the big problem.

Andrew_FL writes:

@Scott- I did not say you don't understand monetary history, I said your account here is flawed. Big difference, in my opinion. But sorry for the misunderstanding.

Second, to the volatility of the price level:in the short term, yes, the price level varied significantly. But for the fotmation of long term contracts, it's the long term predictability that matters. That's worse now than it was then. The prevalence at the time of 100 year bonds attests to this.

Third, I don't believe I've contradicted the claim that

IT>RBGS

That's consistent with my heirarchy.

Andrew_FL writes:

Okay I didn't mean to resend that comment.

Anyway part of what I'm contending is that the short run price volatility under the pre WWI Gold Standard was due to banking regulations. Not gold per se.

I'll look into what you're saying about Barsky, though I will say i base my claims about the long run stability during that period on Selgin, White, and Lastrapes' paper about the Fed. I would be interested to know where you think they err because as I recall the do claim inflation was more predictable under the classical gold standard.

At any rate I'm glad there are no hard feelings (right?) about my unintentional insult to your expertise.

Scott Sumner writes:

Andrew, Their claim is correct for the entire fiat money period. But here I am just talking about the IT period, since about 1990. PCE inflation has average 1.98% over the past 24 years, while the Fed's PCE target has been 2%. The gold standard didn't come close to that level of stability, and it wasn't just banking. Prices trended down 1879-97, then up 1897-1914. That wasn't banking.

Andrew_FL writes:

For some reason I can't comment on your most recent post, and I suspect others cannot either. Did something with the formatting mess things up? Big ol' numbers and all that? Anyway, I'll reproduce here the comment I wanted to make there:

Scott, to point 2, those were exactly the dates I had in mind for comparison.

To point one, fair enough, I'll concede that under the system the US had from 1879-1914, things were inferior to under inflation targeting. I'll concede it because it seems to me that it's true. Also, I will concede it because I never directly disputed it, though I may have implied otherwise.

To your last point on the previous post:

It's true, there was, in the US, first a period secular deflation then secular inflation. You suggest this wasn't a banking system (or rather, regulatory) problem. I'm not so sure about that: While it doesn't cover the whole of both periods, it's interesting to compare the behavior of the Canadian and US stocks of Banknotes in the late 19th Century: see figure 2 here. The period of Price deflation roughly corresponds to the period when regulations imposed a decreasing trend in M, and price inflation roughly to when M began to turn around (although actually a while later). It would be interesting to know what Canadian prices did contemporaneously though on a quantity theory basis I have a hard time imagining they were as unstable as the US's.

That being said, I'm not an unreconstructed Goldbug. I could be persuaded that you need some kind of rule to manage the stock of the reserve commodity. In fact, my feeling, a priori, is that it would be preferable to have a fixed stock of the reserve commodity, which is not achievable under gold.

One alternative is a Bitcoin-style computer program to manage the reserve commodity stock. This could be designed so that, with a deregulated banking system, the rule would in fact act like NGDPLT. Which might make you ask "why bother when we can just have NGDPLT" to which I suppose my answer would be that it would be preferable to have something that achieves it automatically than to trust the Government to follow a rule.

[I think I've fixed the mismatched format codes on the other post now.--Econlib Ed.]

Eliezer Yudkowsky writes:

I'm indebted to Nick Bostrom for the name 'Less Wrong', and I'm damned sure he got it off someone else who had said something along the lines of, "We never become right in science, we only become less wrong."

Philo writes:

I did not suggest that we had a choice other than relying on macroeconomists. I merely wanted to sound a more pessimistic tone about this forced choice of ours than what I detected in your post.

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