“The Upside of Government Default,” where I discuss the state defaults of the 1840s.

George Selgin commented on my post, "Krugman and Macroeconomics," expressing reservations about my statement that his and Steve Horwitz's version of Austrian business cycle theory incorporates significant Keynesian elements. My belated reply, which follows, is long enough to warrant a separate post:

George, thanks so much for your comment, with which I mostly agree. I admit that many pre-Keynesian economists, Hayek, and some Monetarists all saw negative velocity shocks as one important source of depressions or recessions. But I still think it is fair to describe that view as Keynesian. After all, a Keynesian attack of "animal spirits" is nothing more nor less than a velocity shock. Indeed, I would identify this as the central proposition of Keynesian business cycle theory, although the Keynesian insistence upon referring to changes in velocity (i.e., money demand) as changes in "autonomous spending," or even worse, as a divergence between "planned saving and planned investment," often obscured this simple fact.

Three distinct positions on velocity seem to have dominated the debate after Keynes: (1) the traditional Keynesian view that autonomous falls in velocity were the only source of economic downturns because the money stock, for the most part, did not matter; (2) the orthodox Monetarist position, as exemplified by Milton Friedman, that the cyclical behavior of velocity was mainly a function of what was happening to the money stock, and that therefore, while in theory velocity shocks could cause economic fluctuations, in practice fluctuations are almost always driven by the money stock;  therefore velocity is unimportant as an independent causal factor; and (3) the view of many (but not all) Austrian economists that velocity shocks, to the extent that they arose from changes in people's preferences, could not cause business cycles, even in theory.

The third position, that velocity doesn't matter, is certainly the view of Rothbard, and I take it to have been the view of Mises as well, although it has been a long time since I read Mises closely, so correct me if I am mistaken. And Roger Garrison's version of Austrian business cycle theory, in contrast to your and Steve's version, assigns little role to velocity, apparently because he holds the orthodox Monetarist view. In his chapter included in Brian Snowden and Howard R. Vane's Modern Macroeconomics: Its Origins, Development and Current State (p. 491), Roger writes: "An exogenous change in money demand is rarely if ever the source of macroeconomic disruption. (Here the Austrians fall in with the monetarists.)" Ironically, a pure version of New Classical real business cycle theory also seems to agree with Rothbard that velocity doesn't matter. New Keynesian economists, on the other hand, have adopted significant Monetarist elements by giving monetary shocks equal billing with velocity shocks, which is one of several reasons why Greg Mankiw admits New Keynesians could just as accurately be labeled New Monetarists.

This raises one question that I may have asked you in the past, but if so, I've forgotten your answer. Given your position that negative velocity shocks can cause a recession or depression, doesn't that require that you also conclude that a positive velocity shock can cause a boom with its associated malinvestment? Yet every time I've suggested that possibility among Austrian economists, dating back to the summer of 1977, I have encountered vociferous objections.

Let me conclude by stating that I agree with you that if monetary shocks can cause business cycles, then it logically follows that velocity shocks can do so also. Because whether we call a shock one or the other depends on the slippery question of how we define the money stock. The banking panics of 1930-33, which made the Great Depression so severe, were a negative monetary shock if we are looking at M1 or M2 but a negative velocity shock if we use the base as the definition of money. However, I am not shy about conceding that this conclusion involves a significant Keynesian element.

"Correction: The US Has Defaulted Before and It Can Default Again." Of particular interest is Marc's pointing out the fiscal gains to the U.S. government from F.D.R.'s default by going off the gold standard.

Over at the Forbes blog, Timothy Lee of the Cato Institute has a good post criticizing what he calls "libertarian inflation hawks." But as David Henderson points out in an EconLog post entitled "Timothy Lee's Blunder," Lee is quite incorrect to state that Scott Sumner is the "lonely exception" to libertarians predicting rising inflation. As evidence, David cites our own joint article defending Greenspan, published by the Cato Institute, along with two of his previous posts. He also could have mentioned our earlier defense of Greenspan, appearing in the March 28, 2008, issue of Investor's Business Daily.

Even if Lee has in mind only libertarian inflation predictions since Bernanke's response to the financial crisis, he still has overlooked an article I wrote for the November 2010 issue of The Freeman, entitled "Government's Diminishing Benefits from Inflation," in which I make almost the same point as Lee: "most libertarians . . .  anachronistically harp on how the U.S. or European governments might cover significant fiscal shortfalls with the printing press, completely oblivious to how insignificant for such governments this hidden tax has become." Indeed, this article became the basis for an op-ed that I co-authored with Sheldon Richman and, like Lee's post, appeared on the Forbes blog.

The Independent Review also recently published my article "Ben Bernanke versus Milton Friedman: The Federal Reserve's Emergence as the U.S. Economy's Central Planner," in which I explicitly agree with parts of Sumner's analysis and contend that Bernanke's "policies were closer to a quantitative tightening" than to genuine quantitative easing. But enough self-promotion. George Selgin, although he rejects David's and my evaluation of Greenspan's monetary policy, is yet another libertarian who has endorsed much of Sumner's analysis  in a discussion at Cato Unbound (to which I also contributed).

One of my former students asked me about Pete Boettke's post over at Coordination Problem on a recent Paul Krugman presentation, "Mr. Keynes and the Moderns." Pete does not agree with Krugman, but he likes this particular piece and thinks it must be addressed. Perhaps I'm missing something, but I'm not entirely clear why.

Although I agree with Pete both (a) that it represents Krugman at his least intellectually dishonest and (b) that it makes a useful history-of-thought distinction between Keynesians who focus on Part 1 of The General Theory (Hicks and Samuelson) and those who focus on chapter 12 (essentially post-Keynesians and Leijonhufvud), most of the article merely reiterates the traditional textbook (IS-LM) exposition. There is almost nothing original there, not even with respect to providing an intuitive understanding of Keynesian theory. On the contrary, Krugman displays no explicit appreciation of the fact that a Keynesian divergence between total spending and total income can arise only through a change in the demand for money, or in more straightforward terms, through hoarding (or dishoarding) of cash--in short, through what monetarists refer to as changes in velocity.

Indeed, Krugman's presentation doesn't incorporate any of the more sophisticated arguments about the financial system of such old-line, hard-core Keynesians as James Tobin. He moreover completely ignores any possible complications arising from Ricardian Equivalence, essentially knocking down straw-men objections to fiscal policy. No other Krugman article has come closer to convincing me that John Cochrane is in fact right: Krugman doesn't actually know or understand much modern macroeconomics, as Krugman himself comes close to admitting at the article's beginning.

Which doesn't mean that there is any easy and obvious refutation of Keynesian business-cycle theory, or any short article that will answer Krugman. As I repeatedly point out in my macro classes, all general theories of the business cycle are wrong. None is entirely comprehensive and adequate, which is why economists are as far from a consensus on this issue today as they were during the Keynes vs. the Classics debates. Even some advocates of Austrian business cycle theory, such as George Selgin and Steve Horwitz, incorporate significant Keynesian elements, by giving velocity shocks equal billing with monetary shocks.

Nor do I think, if you really want to get a perspective on Krugman's article, that the way to go is to get into Talmudic distinctions between Say's Law and Say's Identity, as Pete suggests. Instead I would recommend slogging through Don Patinkin's massive classic, Money, Interest, and Prices: An Integration of Monetary and Value Theory, the second edition of which was published way back in 1965. It had become the standard fare in all graduate monetary theory classes before the New Classical revolution swept the profession with dynamic stochastic general equilibrium models. Patinkin actually considered himself a Keynesian, which is why his careful, rigorous, and exhaustive comparisons between classical and Keynesian approaches are so telling and insightful.

For a contrasting instance of Krugman at his most intellectually dishonest that still further confirms Cochrane's evaluation, you might take a look at Krugman's review (co-authored with his wife, Robin Wells) of Jeff Madrick's Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present in the latest (July 14) New York Review of Books. While Bethany McLean and Joe Nocera's All the Devils Are Here: The Hidden History of the Financial Crisis represents the best of what Arnold Kling has called "financial crisis porn," Madrick's book represents the worst. Most of the left-leaning economics writers for The New Yorker or the New York Review of Books usually understand economics, so even though I often disagree with their conclusions, I find their articles interesting and informative. Madrick, who writes regularly for the New York Review of Books, is the only one who seems to be totally ignorant of any serious economic theory or analysis. His book was even too much for the overly kind Tyler Cowen. And yet Krugman and Wells wax enthusiastic about Age of Greed.

Just to give you two examples of Krugman and Wells howlers: (1) "Madrick stresses a key point that is often forgotten or misunderstood to this day: the surging inflation of the 1970s had its roots not in some general problem of 'big government' but in largely temporary events--the oil price shock and disappointing crop yields--whose effects were magnified throughout the economy by wage-price indexation." Does Krugman honestly agree with Madrick that monetary policy played no role in the Great Inflation?

(2) "The transformation of American banking initiated by Wriston arguably began as early as 1961, when First National City began offering negotiable certificates of deposit--CDs that could be cashed in early, and therefore served as an alternative to regular bank deposits, while sidestepping legal limits on interest rates. First National City's innovation--and the decision of regulators to let it stand--marked the first major crack in the system of bank regulation created in the 1930s, and hence arguably the first step on the road to the crisis of 2008." So we could have prevented the financial crisis by going back to a world in which rigid interest-rate ceilings prevented bank depositors from earning market rates of return and in which an entire generation was taught that putting their money in a bank was equivalent to throwing it away? Amazingly, this second sentence runs counter to the more sober analysis Krugman and Wells offered in a prior article for the New York Review of Books of last September 30: "The Slump Goes On: Why?"

Ellen Green, "Why Banks Aren't Lending: The Silent Liquidity Squeeze," is an excellent article on the consequences of paying interest on reserves, despite its proposed policy at the end. I stumbled on it because it favorably quotes me. Particularly important is its discussion of the impact on interbank lending, the ramifications of which hadn't occurred to me. David Henderson has a stimulating post on the article over at Econ Log.

To understand why, we need to look more closely at the relationship between the flows in the Fed’s income statements and the stocks reported in the Fed’s balance sheet. The Fed’s income primarily consists of interest earnings (and any capital gains) on its assets, whether Treasury securities, loans, or private securities. That income is used to cover the Fed’s operating expenses and to pay a fixed dividend of 6 percent on the “shares” owned by member banks, with most of the residual kicked back to the Treasury. Thus, during calendar year 2009, the Fed’s total income was $63.1 billion. Of that, operating expenses (including interest paid out) accounted for $9.7 billion, dividends paid to member banks for $1.4 billion, increases in the Fed’s capital account (about which more later) for $4.6 billion, and remissions to the Treasury for $47.4 billion (or 75 percent of the total).

What makes these transactions unlike those of any private firm or household is that they are nearly all conducted in the Fed’s very own liabilities: dollar-denominated notes and Fed deposits. Moreover, these are not genuine liabilities, being only claims to more of the same. Assume for a moment that the Treasury pays any interest it owes to the Fed in the form of dollar bills it has just received as taxes from the general public. Because those dollars when outstanding were listed as liabilities on the Fed’s balance sheet, the payment will have no impact on the total balance sheet, so long as the Fed takes no further action. Outstanding Federal Reserve notes along with the monetary base will fall by the amount of the payment, and the Fed’s capital account rises by the same amount. Total assets remained unchanged on one side of the balance sheet as will total liabilities plus net worth on the other side. Only if the Fed employs this income to purchase further assets does the balance sheet increase, with assets rising on one side by the same amount as the capital account on the other, while total outstanding liabilities (and the monetary base) remain constant. This later scenario is analogous to what usually happens in the short run to the balance sheet of private firms, whose dollar income is obviously not in the form of their own liabilities. Yet in either scenario, the flow of income to the Fed initially shows up as an increase in its capital account.

Of course, the Treasury does not pay interest to the Fed with actual dollar bills, much less ones that it has just acquired. When the Fed earns any interest on assets that have been privately issued, the payment is in the form of a check, or its equivalent, written against some bank. But the check is a claim on bank reserves, which are interchangeable with currency, so the process works out pretty much the same as above, with any initial decline appearing in the reserve component of the monetary base rather than the currency component. Although the Treasury, like private parties, has what are called “tax and loan” accounts at private commercial banks, these accounts are used mainly for the deposit of tax revenue rather than for Treasury payments. The rationale for the tax and loan accounts is to diminish the impact of tax payments on the total reserves of the banking system.

Treasury payments, in contrast, are made from Treasury deposits maintained at the regional Federal Reserve banks. Funds are routinely funneled out of the tax and loan accounts into these deposits before they are paid out to cover Treasury expenditures. These deposits, however, are just another liability of the Federal Reserve, although in this case one that does not count as part of the monetary base. So with no further action by the Fed, much as in the first scenario above, a Treasury interest payment would cause its deposits to fall by the same amount that Fed capital rises, with no change either in the Fed’s balance sheet totals or the monetary base. If the Fed on the other hand uses the payment to acquire a net asset, as in the second scenario above, the balance sheet totals and the monetary base go up by the amount of the payment. Except for the differing impact on the monetary base, everything else therefore works out the same as if the payment had been made in dollar bills.

Now just reverse all these transactions when the Fed remits its residual earnings to the Treasury. Treasury deposits at the Fed will go up with an equal and offsetting decline in the Fed’s capital account. If the Fed takes no further action, balance sheet totals are unchanged. If the Fed sells off assets decreasing the monetary base, balance sheet totals fall by the amount of the remittance. However, decisions about monetary policy dominate changes in Fed assets and the base, with the Fed easily offsetting any perturbations arising from earnings and remittances, leaving no discernable impact on the base. To top that off, since excess earnings are distributed to the Treasury on a weekly basis, the amounts involved are trivial, when compared to the size of the Fed’s $2 trillion plus balance sheet, and never amount to more than a few billion dollars.

Which brings us finally to the January 6 announcement. It has brought about two related changes in the accounting procedures, neither of which seems at first glance to be significant. First, the residual earnings slated to go to the Treasury are now listed not as surplus capital but instead as a separate liability, somewhat misleadingly labeled “Interest on Federal Reserve notes due to U.S. Treasury.” (The label is misleading because Federal Reserve notes actually earn no explicit interest for the Fed, nor does the Fed’s remittance to the Treasury bear any direct relationship to the amount of Federal Reserve notes outstanding.) This new liability gets its own line toward the bottom of the H.4.1 release in the “Statement of Condition of Each Federal Reserve Bank,” which gives individual balance sheets for each of the twelve Fed district banks, but is lumped into the category of “Other liabilities and accrued dividends” in the “Consolidated Statement of Condition of All Federal Reserve Banks,” which combines the balance sheets over all districts and sits just above in the release. In other words, a trivial item that once showed up as fluctuations in the capital account now shows up as a fluctuating liability.

The second change in the January 6 announcement requires a closer look at the Fed’s capital account. Both before and after the announcement, the account has been subdivided into three categories: “Capital paid in,” “Surplus,” and “Other capital accounts.” The last of these three is where the residual earnings to be remitted to the Treasury used to show up, but now that they have been shifted into a liability, the amount in “other capital accounts” has so far stayed at zero. “Capital paid in” refers to the nominal shares, mentioned above, that member banks hold in the district Fed where they are located. These shares are fixed in value and cannot be resold on a secondary market; and the amount each member bank must purchase is required to equal 3 percent of the bank’s own capital. So rather than representing true ownership, it is more accurate to think of these shares as a bond-collateral requirement once removed. The banks must invest in the Fed, which in turn buys Treasury securities. The banks then get a fixed 6 percent dividend out of the Fed’s earnings. Whether that return is a good deal or not depends on prevailing interest rates and where the banks that are members of the Fed might have invested their funds otherwise.

As banks change in size or join and leave the Fed, the number of such shares can grow (or shrink), and consequently so does the amount of “capital paid in.” But the Federal Reserve Act further required the total capital of each district Fed to be twice the amount of capital paid in by member banks, and that additional amount is listed in the Fed’s capital account as “surplus.” In essence, this represents retained earnings, a small part of the Fed’s income that does not cover operating expenses and yet is not remitted to the Treasury. Prior to the January 6 announcement, the amount of surplus capital was only adjusted to exactly equal (as required by law) the amount of capital paid in at year’s end, so the two could vary slightly from week to week. But as a result of the January 6 change, these two amounts are being equalized on a daily basis. And doing so necessarily alters slightly the liability shown as owed to the Treasury. For some of the Fed’s twelve districts, therefore, the category of “Interest on Federal Reserve notes due to U.S. Treasury” can temporarily appear as negative, although this washes out for the system as a whole. In short, both of these changes result only in minor shifts in where the flows of Fed income and payments temporarily show up on the balance sheet.

It is true that these two changes could affect how the Fed’s balance sheet reports any losses. What if the Fed’s portfolio of mortgage-backed securities and other risky assets reduces its income so low that its residual earnings completely disappear and turn negative? Such losses conventionally would cause first a decline in the Fed’s surplus capital, and when that is wiped out, a decline in the paid-in capital of member banks. The worry is that the January 6 change will now permit the Fed instead to book losses as a negative liability, appearing to leave the capital account untouched. However, if the Fed can now permanently carry a negative liability on its balance sheet, it could have just as easily permanently carried a negative entry for “other capital accounts,” with the same result: no decline in paid-in and surplus capital. Admittedly, total capital would still have registered a decline. But the reason the Fed can easily get away with either form of accounting legerdemain is because its income and payments are in its own liabilities. Consequently, the Fed cannot de facto go bankrupt (at least unless the Treasury or the entire U.S. government does as well). It can continue to cover its operating expenses, to buy more assets, or even to make subventions to the Treasury simply be increasing the monetary base, ad infinitum.

In this respect, the Fed is like the Treasury, which issues that part of the monetary base consisting of coins. Indeed, it is at least conceivable that the Treasury, on its own, could generate severe inflation by minting lots of quarters and dollars. Despite the fact the pennies and nickels now cost more to produce than their face value, the U.S. Mint’s operations overall still generate positive seigniorage, which shows up in the U.S. government’s budget as a receipt. Because most of the national government’s assets consist of uncertain future tax revenue, the government never compiles or reports a complete balance sheet for itself. In fact, future revenue is the only ultimate asset that backs up all the Treasury securities in the Fed’s portfolio. Consequently, the asset that corresponds to the Treasury’s “liability” of outstanding coins is never directly reported. But you can indirectly figure it out from the Fed’s H.4.1 release. The weekly release not only provides the consolidated balance sheet for the Federal Reserve System standing alone, but the release’s first section, “Factors Affecting Reserve Balances of Depository Institutions” has always combined the Fed’s balance sheet with the monetary accounts of the Treasury in order to present a full picture of all the factors affecting the monetary base.

This is why “Treasury currency outstanding” in that section of the release is a “factor supplying reserves” to the banking system. In effect, it is an “asset” in the combined monetary accounts. The vaults of the Fed hold a small amount of coin, which is therefore listed in the balance sheet for the Fed alone as an asset. But most Treasury coin is included with Federal Reserve notes as “Currency in circulation” as a “factor absorbing reserves,” or a “liability,” in the release’s combined monetary accounts. This total, which includes the vault cash of banks as well as cash held by the general public, is consequently always slightly larger than the liability “Federal Reserve notes” in the balance sheet for the Fed alone. The difference between the two is the estimated amount of coin being held by the public (minus the small amount of cash that the Treasury holds in the form of actual Federal Reserve notes, which is listed in the combined monetary accounts as another “factor absorbing reserves”). The net effect is that in the combined monetary accounts, most Treasury coin appears as both a liability in the hands of the general public and a fictive asset.

The reason this sounds complicated, if not totally abstruse, is because it is. Since the Fed was created, it has combined its own balance sheet with the monetary accounts of the Treasury in a confusing fashion, originally driven in part by the real-bills doctrine and genuine misunderstanding at the time about how the Fed affects the money stock. Milton Friedman and Anna Jacobson Schwartz sorted out these accounting obscurities in their Monetary History of the United States, 1867-1960, at the very end of Appendix B (pp. 797-98), where they show how to consolidate the Fed and Treasury balance sheets in a simple, straightforward fashion. For anyone interested in working through the intricacies of this part of the Fed’s H.4.1 Release, I highly recommend those passages in their classic work. But for our purposes, the important conclusion illustrated by Friedman and Schwartz is that the only actual asset backing up most of monetary base—whether it takes the form of Treasury coin, Federal Reserve notes, or commercial bank deposits at the Fed—is a “book entry to balance,” or as they put it more succinctly, “fiat.” And just as the Treasury can issue coins to cover government expenses without acquiring any asset of market value, so too can the Federal Reserve. After all, that is what fiat money is about.

Admittedly, pure fiat does not back up the entire monetary base. Both the Treasury and the Fed hold some genuine assets. For instance, the Fed still holds gold certificates, an asset of the Fed and liability of the Treasury, which in turn owns the actual gold at Fort Knox. The certificates are valued on the Fed’s balance sheet at the historical price of $42.22 on once. At current market prices, this asset would jump from $11 billion to around $340 billion, surely enough to cover a lot of Fed losses on other assets. I do not know whether the Fed could conduct such a revaluation entirely on its own authority or whether it would require the cooperation of the Treasury and Executive or even of Congress. But the ease with which this asset can be revalued, and the very fact that it does not show up in the Fed’s balance sheet at its current market value, underscores the ultimate irrelevance of Fed profits or losses.

In essence, the Fed functions—as do nearly all of the world’s central banks—like a giant legalized counterfeiter. It generates revenue the same way as any counterfeiter, by issuing money that imposes an implicit tax on the general public’s real cash balances. Therefore, it can no more be driven insolvent de facto than a successful, undetected, and illegal private counterfeiter. This is not to deny that Congress, having established the Federal Reserve System and the rules by which it operates, could decide that the Fed has somehow violated those rules and is nominally insolvent. But Congress can just as easily alter such rules to allow the Fed to continue operation. The future viability of the Fed, in short, is entirely a political decision, with absolutely no necessary economic relationship to any losses the Fed may suffer on its portfolio of assets.

Hat Tip: Less Antman, Warren Gibson, David Henderson, Bob Murphy, and Bill Woolsey.