by Jeffrey Rogers Hummel and David R. Henderson
George Selgin posted a thoughtful critique of our Cato Briefing Paper on "Greenspan's Monetary Policy in Retrospect." His criticisms, rather than shaking our confidence in our evaluation, have strengthened our conviction that Greenspan's monetary policy is widely misunderstood by both detractors and apologists.
In some respects our disagreements with Selgin are not as severe as he believes. He devotes an early section of his critique to establishing the relationship between low interest rates during 2002 to 2004 and the growth of risky subprime mortgages. But we never denied that relationship and, indeed, think it was as important as he does. What we disagree about is the primary cause of the low interest rates during that period.
Nor does our paper argue, as Selgin asserts, that"Greenspan's Fed was innocent of any role in encouraging the housing boom [emphasis ours]." Indeed, we state:"Particularly alarming is the way the lender-of-last-resort function has been expanding the moral-hazard safety net and mispricing risk, a trend to which Greenspan no doubt contributed." We not only accept that the Federal Reserve's contributions to moral hazard may have been a major factor in the housing boom, but also stipulate at the end of our paper:"Minor blips in total reserves under Greenspan may have played some poorly understood role in any of these three events [the recessions of 1990 and 2001 and the current one]." Our disagreement is with the widespread and extravagant accusations that"easy Al" was conducting an exceptionally expansionary monetary policy after 2001.
Greenspan and Velocity
Before returning to the subject of the current crisis and its ultimate causes, let us take up Selgin's most serious challenge. Our Cato Briefing Paper argues that as a result of significant deregulation, the Fed lost most of its lingering control over the short-run movements of the broader monetary aggregates (M2, MZM, and M3), whose behavior therefore approximated what Selgin himself, along with Lawrence H. White and Steven Horwitz, contend would happen under a system of completely free, unregulated banking. Fluctuations in the money supply approximately responded to and offset fluctuations in money velocity, helping to stabilize the macroeconomy. Selgin correctly notes that a stable MV necessarily implies a stable nominal Gross Domestic Product (Py), as expressed in the equation of exchange (MV = Py). He then questions the actual stability of nominal GDP under Greenspan, buttressing his reservations with a graph (Chart 4 in his critique) showing the growth rate of final sales of domestic goods (nominal GDP minus changes in private inventories) from the recession of 2001 to the present.
Nominal GDP, however, is simply the product of real output and the price level. A decline in volatility of both output and inflation, therefore, strongly suggests that the volatility of nominal GDP has also declined. We never claimed that Greenspan's policies were perfect, and in fact our paper explicitly criticized them for being"too discretionary." After all, the Greenspan era did encompass two minor recessions, a decade apart. Yet surely Selgin does not wish to dispute the noticeable dampening of both business cycles and inflation variability during the Greenspan era, a dampening that macroeconomists now refer to as"The Great Moderation." Consider the follow two graphs.
Figure 1 (from the Federal Reserve Bank of San Francisco Economic Letter 2008-6, February 15, 2008) depicts the striking decrease after 1987, during the Greenspan era, in the volatility of real GDP (as measured by a five-year moving average of the growth rate's quarterly variance). Over the past twenty-five years, beginning in 1983, the U.S. economy has been in recession (as defined by the National Bureau of Economic Research) a mere 5 percent of the time, as compared with 22 percent of the time over the previous twenty-five years.
Figure 2 shows how this decrease affected the growth rate of quarterly nominal GDP (year-to-year annual rates). Notice that the major deviations of nominal GDP from trend after 1987 are during the three recessions (1990, 2001, and 2008) and are far less severe than previously. During the nineteen years from December 1986 to December 2005, nominal GDP growth averaged 5.6 percent, never varying from that in either direction by more than 2.5 percentage points. While this is not absolutely constant growth, it is about as close to constant as the U.S. economy has ever recorded.
What makes this decline in GDP's volatility particularly striking is that it occurred during a period in which most measures of monetary velocity were doing the exact opposite. Selgin acknowledges this well-known increase in velocity's variability, as it was the primary reason that macroeconomists--including most monetarists--abandoned the money supply as a way either to gauge inflation or to target central-bank policy. But if nominal GDP was becoming more stable at the exact same time that velocity was becoming more erratic, then the equation, MV = Py, ipso facto tells us that fluctuations of the money supply must have been offsetting fluctuations in velocity, at least partially.
The offset was reflected in the continuing or sometimes increasing volatility under Greenspan of the standard money measures, the very result that made central bankers despair of monetary targeting. Figure 3 shows the year-to-year annual growth rates of M1 (monthly, not seasonally adjusted), which after 1987 bounced around between 17 percent, higher than at any time during the 1960s and 1970s, and negative 5 percent.
Figure 4 shows the post-1987 growth rates of M2 and M3 (monthly, not seasonally adjusted) ranging between 0 and 13 percent, in a pattern not at all consistent with M1. Nor in either case does there seem to be any easily discernable correlation with the period's recessions.
This is what led Milton Friedman to marvel at Greenspan's performance in a Wall Street Journal article of April 19, 2003 (cited in our Cato Briefing Paper), where he displayed the graphs in Figure 5. They show how inflation remained relatively constant despite the M2 velocity bubble associated with the dot-com boom.
The counteracting decline of M2 growth shows up in Figure 4 above. (Our original paper regretfully did contain one bit of enthusiastic hyperbole in describing this outcome, which we can now correct. We stated that the M2 velocity bubble"was perfectly offset by the declining growth rate of M2." Obviously the word"perfectly" is too strong.) Normally an increase in the money supply's volatility would be associated with an increase in the volatility of nominal GDP, not the reverse. Clearly this development cries out for explanation. Our paper challenges the mainstream view among economists, which credits superb Fed discretion. We instead attribute it to a market process unleashed by financial deregulation.
Greenspan and the Productivity Norm
Selgin's critique goes further, maintaining that"final sales and other similar measures [of Py] would have been constant," rather than just growing at a constant rate, if the money stock had in fact adjusted for velocity. While literally true in the case where MV is absolutely fixed, this higher standard overlooks any growth of the labor force. Selgin's"productivity norm" as proposed in Less Than Zero (1997) requires only constant nominal GDP per capita, or something approximating that, which means that both Py and MV should be rising roughly at the rate of population increase.
Even adjusting for the moderate 1 percent annual growth of the U.S. population during the Greenspan era, Selgin's"productivity norm" conflates two separable goals, one long run and the other short run. His long-run goal, in which secular deflation at the rate of productivity growth yields a constant nominal GDP per capita, can be distinguished from his short-run goal of a money supply that is counter-cyclical with respect to velocity. While he would like to achieve both simultaneously, the economy can experience one without the other. Given a choice between (a) long-run mild deflation accompanied by wild oscillations in nominal GDP per capita around a zero growth path or (b) long-run mild inflation accompanied by no oscillations of nominal GDP per capita around a constant positive growth path, which goal would be Selgin's macroeconomic priority?
Some Austrian School economists, following in the monetary tradition of Ludwig Mises and Murray Rothbard, utterly reject Selgin's short-run goal. They contend that there is no need for the money stock to compensate for any shifts in money demand, whether arising from velocity shocks or output growth. All such shifts, in their view, can easily be accommodated by price adjustments. Selgin's Theory of Free Banking (1988), in contrast, built on Friedrich Hayek's focus on MV to introduce a Keynesian element into Austrian analysis. He predicted that an unregulated banking system would eliminate cyclical fluctuations in velocity (or in what Keynesians call"autonomous expenditures") and implied that such was necessary to avoid macroeconomic disturbances. Despite our initial reservations, we were persuaded of the validity of at least Selgin's prediction about the operations of free banking, which, ironically, is crucial to our analysis of Greenspan's monetary policy.
The validity of Selgin's long-run productivity norm is another matter. Although he offers it as policy prescription, it may not even be an accurate description of the way an ideal commodity money would operate in practice. White's Theory of Monetary Institutions (1999) lucidly elaborates on how changes in either the supply of or demand for gold as money would affect gold production and consumption in a way tending toward long-run price stability, not secular deflation. As a result, the market for gold as a commodity would dominate the long-run equilibrium path of the price level under a commodity standard. Depletion of gold sources might deliver mild deflation, but technological improvements in the extraction and recycling of gold or in the development of gold substitutes might deliver mild inflation. Recall that the introduction of the cyanide process for extracting gold helped cause a 2 percent annual inflation from 1896 until World War I.
Whatever the most desirable macroeconomic goal, whether an inflation target, a nominal GDP target such as Selgin's productivity norm, or no target whatsoever, our paper readily admits that Greenspan could have delivered"a constant price level or even secular deflation over the last two decades." He would have had to tighten up on growth of the monetary base, which would have caused a steady decrease in total reserves. This could have counteracted the declining reserve ratios of the monetary aggregates, a decline, as we explained, that resulted from a combination of financial deregulation and innovation and that was the main source of the period's 2.5 percent average inflation. But none of these long-run factors speaks to our observation that the short-run fluctuations in the money supply dampened the short-run fluctuations in velocity.
Selgin counters that financial deregulation was insufficient to achieve the result we observe. Freezing the monetary base will not work if"banks cannot issue currency and are subject to legal reserve requirements. . . . Consequently, the prevailing regime is one in which the avoidance of monetary excess or shortages calls for frequent changes to the monetary base, that is, for adherence to some more elaborate monetary rule, if not for monetary discretion [emphasis ours]." But as our article points out, reserve requirements are now virtually non-binding within the U.S. and on the road to extinction, whereas base increases after 1987 went entirely into currency (much of it going abroad), substituting for the currency that banks would have issued in the absence of legal restrictions. (See Figure 6, reprinted from our original paper.) Thus, Greenspan's unintentional freezing of total reserves approximated a freezing of the monetary base in a more deregulated world.
We detect a certain ambivalence in Selgin's objections. He condemns the freezing of total reserves for failing both to induce price deflation and to provide enough currency. Moreover, his rejection of simple monetary rules, unless accompanied by further deregulation, would also mean that he would, if consistent, oppose such other interim reforms as currency boards, which are supported by at least some advocates of free banking. Undoubtedly complete free banking, along with the elimination of the Fed and fiat money, would have yielded an even better outcome. Nonetheless, the decrease in the variability of nominal GDP during the Great Moderation is undeniable. Why an opponent of the Fed would seemingly attribute this improvement not to deregulation and free markets but to successful central-bank discretion is perplexing.
To be fair, perhaps Selgin wishes only to insist that as long as the economy has a central bank, it will always suffer some distortion of interest rates and inevitable self-reversing booms. That may very well be true. Yet does it follow that all central bank policies are equally harmful? A claim that malinvestment is constant and pervasive, but only revealed randomly with sudden depressions and recessions, of varying intensity and timing, sometimes back-to-back and sometimes separated by a decade, hardly qualifies as a complete theory of the business cycle. Unless the theory accounts for the timing and intensity of the downturns, it really has explained little.
Greenspan and the Current Crisis
Because our paper was concerned with monetary policy over the nearly two decades beginning in 1987, we made no effort to sketch out a complete explanation for the current financial crisis. It formed only a part of our analysis, although we did write an earlier op-ed on the subject for Investor's Business Daily, and one of us (Jeff) has recently discussed this question at the Liberty & Power blog. Our Cato Briefing Paper did, however, attribute"the unusually low interest rates early this decade mainly to a massive flow of savings from emerging Asian economies and elsewhere," supporting that claim with an extended footnote scratching the surface of the vast literature, both pro and con, on the global savings-glut thesis. As many, including Greenspan, have asked, how can Federal Reserve policy starting in 2001 be the primary cause of a housing boom that began in 1997 and was worldwide, with higher percentage price hikes in the U.K., the Netherlands, and Ireland than in the U.S.? This alternative hypothesis has been widely discussed among mainstream economists.
Selgin briefly alludes to John Taylor's rejection of the global savings-glut thesis, reporting correctly that global savings"declined as a share of world GNP from 25 percent in the 1970s to 21 percent between 2003 and 2005." This comes from a talk Taylor gave, "Housing and Monetary Policy," in September of 2007 (cited in our footnote). But this statistic is hardly decisive, given that it is net of any private savings covering government borrowing, that world savings has risen in absolute amount with only the world economy growing faster, that investment demand relative to world GNP also fell, and that the statistic says nothing about flows of savings between countries. Chapter 2 of the International Monetary Fund's World Economic Outlook for September 2005, which reports the statistic Taylor cites, discusses this decline at great length without rejecting the idea that a relative rise in Asian savings caused a fall in world interest rates. And everyone admits that whatever happened to world levels compared to world GNP, the period of low interest rates witnessed the unprecedented anomaly of savings flowing from less developed countries to more developed. Because the housing boom was international, this would seem to be relevant. For Selgin to invoke as definitive what is practically a throwaway line in a Taylor speech is a bit of a stretch.
For further documentation that has appeared since we wrote our footnote on the savings-glut thesis, we recommend a recent Financial Times article by Martin Wolf, "Asia's Revenge," and his new book from which it is drawn, Fixing Global Finance (although we hastily add that we do not endorse all of his conclusions). The cause of the worldwide fall in interest rates is still a debated question, and we invite readers to explore arguments on both sides. But that just reinforces the importance of evidence from the monetary measures, something that Selgin tends to dismiss. After all, to offer a monetary explanation for the current crisis, invoking some indicator of monetary policy is necessary. Austrian economists have long rejected the price level or inflation rate as the proper indicator, which is why Rothbard devoted so much of America's Great Depression (1962) to defining the appropriate money stock and documenting its increase over the 1920s.
Selgin rejects monetary measures because velocity has become erratic, and our paper agrees that he is mostly right with respect to the broader monetary aggregates. But to turn exclusively to interest rates is hardly a solution. One must have some idea of what the natural rate would have been without central bank interventions. Yet market rates are subject to so many influences from both demand and supply that no economist has been able to articulate a full explanation for their past, much less their current, levels. Forgive us if we remain skeptical of those who declare that interest rates alone tell the direction and magnitude of Fed distortions.
We do not need to become totally agnostic about Federal Reserve policy. But analyzing it requires a subtle examination of many factors, with assorted monetary measures receiving prominence. If Greenspan's policy was as unrestrained as commonly reported, you would think it would have left a monetary footprint somewhere. Our paper reported the inconvenient fact that the rate of growth of all the broader monetary aggregates was falling during the period when the Federal funds rate was unusually low. A few of our critics have replied:"So what? The decline was from earlier growth rates for M3, M2, MZM, M1, and even the base that were higher." Yes, but the Federal funds rate is not, like the price level or real output, a magnitude affected by the money supply with long and variable lags. It is the Fed's daily operating target, so the impact of an expansionary monetary policy should be instantaneous. Interest rates should fall at the exact same time that monetary growth rises. The fact that we instead observe money growth rates falling during 2002 and 2003, when the Federal funds rate was at its lowest, is a serious, unresolved problem for those who reject the global savings-glut thesis.
The attempt to blame Greenspan for the crisis actually has two variants. The simplistic version points to the low Federal funds rate from the end of 2001 to mid-2004 as evidence of a spouting monetary gusher worse than anything since before Paul Volcker took over the Fed. A quick perusal of Figures 3, 4, and 6 dramatically refutes the simplistic version. Selgin adheres to a more nuanced version, again citing the macroeconomist Taylor. According to the Taylor Rule, the Fed--after lowering the target Federal funds rate at the beginning of 2001-- should have begun raising it in the second quarter of 2002 (or a bit earlier if you change the specifications of Taylor's equation). This already reduces the dispute to technical issues of how much the Fed should have tightened and when. Moreover, it rests the case against Greenspan on a dubious tool of central bank discretion.
No one has written a pithier exposé of the Taylor pseudo-Rule than Roger Garrison, in correspondence with Liberty Fund that he shared with one of us: It"is not really a rule at all. Taylor, in effect turns an 'is' into an 'ought' by (a) describing the Fed's past actions in terms of its responses to changes in unemployment and inflation and then (b) telling the Fed how to make sure that its future responses are consistent with its past responses: 'If you like what you've done so far, here's how to keep doing it.'" Those who appeal to the Taylor Rule as proof of loose Fed policy after 2001 almost never mention that the same rule condemns Fed policy during the mid-1990s for being too tight, that is, for holding the Federal funds rate up too high by almost as many basis points as it later supposedly pushed the rate down.
As our paper fully concedes, the monetary measure that we believe has become the most informative--total reserves--is the one measure whose growth rate does indeed show"a slight uptick into 2003, when interest rates were down." Greenspan's policies thus may have been slightly more expansionary after 2001, making a minor contribution to a housing boom already in progress. We can quibble over how large that minor contribution was. But to make Greenspan's policies the sole or even primary cause of the current financial upheaval, international in scope, is just placing far too much weight on what, at worst, was a small discretionary misstep.
Selgin concludes his critique of our Greenspan retrospective with a question:"Why two anti-central bank libertarians would bother to undertake such a defense"? It has an interesting answer. The genesis of our paper dates to long before the current financial turmoil. Jeff wrote the first draft back in June 2004, while Greenspan, still chairman of the Fed, was being hailed as a financial maestro. Everyone recognized that the U.S. macroeconomy had become more stable after 1987, with respect to both inflation and recessions, and our motivation was to figure out why. As libertarians, we were suspicious of the dominant explanation that credited Greenspan's wise discretion. Only the onrush of recent events has converted what began as an unequivocal rejection of the need for any government monetary manipulation into a qualified defense of Greenspan's record.
And let us be clear: our defense is qualified. To use an analogy: as much as we loath the Drug Enforcement Agency and everything it does, we would be wary of any hypothesis that blamed the DEA for the explosion of subprime mortgages. If we then published an article about the weakness of the evidence linking the DEA to the subprime crisis, it would certainly not entail any diminution in our ardor for the DEA's abolition. Or to alter the analogy slightly, imagine a scenario in which marijuana, psychedelics, and cocaine are all fully legalized, but the DEA still enforces laws against opiates and other drugs. If we were to celebrate this limited legalization and its beneficial effects, it would hardly constitute an endorsement of the DEA's remaining activities in the war on drugs.
No one yet knows how the current financial turmoil will play out. There is still a chance it will generate a recession as mild as those in 1990 and 2001, despite everything the government has done to make matters worse. Or it could become as severe as the recession of 1982, signaling an end to the Great Moderation. Either way, the macroeconomic stability of the Greenspan era remains a puzzle. Some of our critics have suggested completely non-monetary explanations based upon the dramatic transformations in the American economy over the last two decades. For instance, the Internet and other innovations may have so significantly reduced transaction costs in the labor market that the high unemployment during recessions has been mitigated for reasons unrelated to monetary shocks. Greenspan himself, in his memoirs, gave much credit to globalization for the economy's two-decades increased resilience.
But none of these non-monetary explanations can account for the second piece of the puzzle. Why was the Great Moderation accompanied with greater instability of the broader monetary measures and their velocities? That instability should have been jolting the economy with frequent monetary shocks throughout the twenty years of the Greenspan era (unless you retreat into a theoretical fairyland of complete monetary neutrality, where nothing that happens to the money supply has any real impact). So far only two alternatives have been put forward to explain both pieces of the paradox: intentional monetary discretion or unintended monetary rules. Despite Selgin's criticisms, we still opt for our invisible-hand alternative.
As our paper indicated, we believe that government fiat money is untenable in the long run. The current economic crisis confirms our belief, particularly the under-explored role played by fickle capital flows under a fiat regime, as suggested by the global savings-glut thesis. Minimizing the discretion of the Fed by chaining it to a monetary rule, so as to formalize what Greenspan inadvertently did for the most part during his tenure, is only a short-run improvement as long as the Fed exists. The ultimate solution is free banking, among whose foremost champions is George Selgin.
[Cross-posted at EconLog.]
Although Cassidy tries to survey Bernanke's responses to the current crisis, it is clear Cassidy is a little beyond his depth. He misses completely what financial developments caused Bernanke to hit the panic button after September 17, as well as the extent to which Bernanke then amped up Fed policy.
But the profile has a chilling ending, when Cassidy reports that"Bernanke, in a search for inspiration and guidance, has been thinking about two Presidents": not only F.D.R., as already widely reported, but even worse, Abraham Lincoln. Let me quote in full:
"From the former he took the notion that what policymakers needed in a crisis was flexibility and resolve. After assuming office, in March, 1933, Roosevelt enacted bold measures aimed at reviving the moribund economy: a banking holiday, deposit insurance, expanded public works, a devaluation of the dollar, price controls, the imposition of production directives on many industries. Some of the measures worked; some may have delayed a rebound. But they gave the American people hope, because they were decisive actions.
"Bernanke's knowledge of Lincoln was more limited, but one morning the man who organizes the parking pool in the basement of the Fed's headquarters had given him a copy of a statement Lincoln made in 1862, after he was criticized by Congress for military blunders during the Civil War: 'If I were to try to read, much less answer, all the attacks made on me, this shop might as well be closed for any other business. I do the very best I know how the very best I can; and I mean to keep doing so until the end. If the end brings me out all right, what is said against me won't amount to anything. If the end brings me out wrong, ten angels swearing I was right will make no difference.'
"Bernanke keeps the statement on his desk, so he can refer to it when necessary."
The current financial turmoil is very complex, and no one knows the whole story yet. Anyone who claims otherwise is oversimplifying. The historian in me would like to wait five to ten years, until the dust has settled, to dispassionately analyze the causes. After all, not until Milton Friedman and Anna Schwartz published their MONETARY HISTORY OF THE U.S. in 1963 did we get a relatively complete understanding of the Great Depression, and economic historians are still debating details. All considered, I think a bit of epistemic humility is in order.
Moreover, no economist in my opinion has yet come up with a fully satisfactory theory of business cycles. If someone had, there would be more consensus within the profession, as there is today with respect to what causes sustained inflation. Sadly every one of over half a dozen theories that macroeconomists have put forward, including Austrian business cycle theory, have serious empirical or analytical weaknesses. David Friedman once commented that someone teaching business cycles in macro had a choice between a tour of a graveyard or a construction site.
Yet the economist in me has to do the best with the limited information and theoretical apparatus available. What we do know is that the two central precursors of the financial turmoil were (a) the housing boom and bust and (b) the widespread underpricing of risk. The mispricing of risk obviously generated malinvestment of some form. It is also a malinvestment that everyone agrees took place; they just disagree about the cause.
For those who are skeptical of explanations relying on irrational asset bubbles or pervasive market failure, there are three primary alternatives: (1) monetary expansion under Greenspan generating a self-reversing boom as in Austrian business cycle theory or something similar; (2) government-induced moral hazard from some combination of subsidized risky mortgages, implicit government guarantees, leaking deposit insurance, and the infamous"Greenspan put," which promised to use monetary policy to prevent any collapse of asset prices and bailout institutions too big to fail; or (3) a savings-glut coming from abroad, particularly China, that then started to recede. Notice that these three alternatives are not mutually exclusive, and two of them place some blame on Greenspan's monetary policy.
David Henderson and I do not believe that monetary expansion under Greenspan gets us very far. First, the behavior of the monetary measures cannot bear the weight that this explanation puts on them. Second, as many including Greenspan have asked, how can Federal Reserve policy starting in 2001 be the primary cause of a housing boom that began in 1997 and was worldwide, with higher price hikes in the U.K., the Netherlands, and Ireland than in the U.S.? We do not deny that Greenspan's monetary policy may have been SLIGHTLY more expansionary after 2001, making a MINOR contribution to a housing boom already in progress. As we state toward the end of our Cato Briefing:"Minor blips in total reserves under Greenspan may have played some poorly understood role in any of these three events [the recessions of 1990 and 2001 and the current one]." In fact, we go further within the body of the briefing, admitting:"Total reserves are also the one monetary measure that show a slight uptick into 2003, when interest rates were down."
But monetary expansion made at most a trivial contribution to the housing boom and underpricing of risk. I would put heavier emphasis on the Greenspan put as a potential source of moral hazard. Articles (here and here) by Cato economist Jerry O'Driscoll combine these two avenues through which monetary policy may have played a role, not always distinguishing between the two. Our Cato Briefing fully acknowledges the role of the second avenue. As we state on the first page:"Particularly alarming is the way the lender-of-last-resort function has been expanding the moral-hazard safety net and mispricing risk, a trend to which Greenspan no doubt contributed."
But even the Greenspan put, by itself, cannot be the entire story. Not only do you have to throw in the CRA, Feddie and Frannie, deposit insurance, past bailouts, capital requirements too rigid on the downside, misguided bankruptcy changes, and an array of other domestic interventions. But since the housing boom was international, the widely observed anomaly at the turn of the twenty-first century of savings flowing from poor to rich countries, opposite of its usual direction, also has to be brought into the mix. In other words, my full account would combine elements from the second and third alternatives above. If there is a traditional Austrian malinvestment story in this brew anywhere, I suspect the culprit will end up being Chinese monetary policy, not that of the Fed.
On top of all this, the actions of Ben Bernanke and Henry Paulson have been making matters worse, right from the outset of the subprime crisis, as Anna Schwartz has suggested in recent interviews (here and here). My own reasoning for this charge was sketched out in my post on"Recent Fed Machinations." Nonetheless, within this broad framework, there is much we do not understand, especially with respect to apportioning relative importance.
Correction: Originally I attributed the quotation above on"graveyard or construction site" to the wrong Friedman. David advised me that it was he rather than his father who made the comment, and so I have corrected that sentence.
Many believed that Ben Bernanke had begun pumping up the money supply as early as the end of last year in response to the financial situation. But in fact, the Fed did not actually open the monetary spigots until a little over a month ago. Up until then, Bernanke effectively sterilized all his monetary injections, either by directly trading Treasuries from the Fed's portfolio for riskier financial securities, or by indirectly loaning to financial institutions with money recouped by selling Fed-held Treasuries on the open market. Either way, there was no major impact on the monetary base. As a result, the annual rate of growth of the monetary base remained in the neighborhood of 2 percent through August 2008, whereas total bank reserves remained virtually constant.
Indeed, one of the problems with the Fed's early response may have been Bernanke's fear of potential inflation, as the RELATIVE prices of oil and other commodities headed upward. He therefore tried to do the impossible: simultaneously avoid inflation by holding the line on monetary growth, while warding off a potential deflationary bank panic by injecting liquidity into selected institutions. The market's confusion over these cross purposes seems to have actually prolonged and deepened financial difficulties. In fact, a desire to achieve both goals simultaneously was a primary motive behind the dreadful Treasury Bailout. At least Bernanke didn't make the mistake of the European Central Bank, which with its rigid inflation targeting, tightened monetary growth in response to rising commodity prices, exacerbating the supply-side shock (and incidentally helping the Euro to remain temporarily strong against the dollar).
But now, all that has changed. After September 17, when the interest on T-bills briefly went negative, Bernanke opened the monetary floodgates. The reversal of commodity prices probably made him more comfortable about doing so. In any case, back in August the monetary base was $847 billion with total reserves constituting $72 billion of that (all figures are not seasonally adjusted and not adjusted for changes in reserve requirements). The Fed's latest H.3 Release (October 22, 2008) puts the base at $1,149 billion, a 40 percent jump over a year ago. What has exploded even more is total bank reserves, where the base increase is concentrated. Reserves have increased by an astonishing factor of about FIVE over the last month, and are now somewhere between $343 and $358 billion.
And that is not all! Federal Reserve Bank Credit (as reported in the weekly H.4.1 release) has doubled in the last month to around $1.8 trillion. Although Federal Reserve Bank Credit used to mirror the monetary base closely, that is true no longer--not since the Fed activated its U.S. Treasury supplementary financing account, which you can find reported in the same release. These are additional Treasury deposits at the Fed, which have gone from zero to approximately $560 billion.
These new deposits result from what the Treasury calls its Supplementary Financing Program, initiated a month ago to try to staunch the growing demand for Treasury securities manifested in falling T-bill rates. What essentially has been going on is that the Treasury is now issuing extra securities to borrow money from the economy, then loaning the money to the Fed in these special deposits so that Bernanke can re-inject it to make his bail out purchases of various securities, all without increasing the base. In other words, what the infamous Bailout Act permitted the Treasury to do directly is something it had already started doing indirectly through the Fed to the tune of half a trillion. And all in the name of easing a tight Treasury market. This partly explains why Treasuries fell in price after the Bailout passed, along with stocks, contrary to what usually happens.
It also means that the total bailout is not the $700 billion that Congress appropriated but at least $1.2 trillion. Nor does this count the Fed's recently promised $540 billion bailout of money market funds, which if not covered by the Fed's sale of other assets, will require either further monetary increases or further Treasury borrowing. Thus we now have the worst of both worlds: a massive bailout financed BOTH by Treasury borrowing, in order to avoid inflationary pressures, and a monetary base increase, heralding future inflation anyway.
There will be a lag before the explosion of the base works its way fully into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent. Bernanke's plan is undoubtedly to pull liquidity back out before this process heats up. But that will entail dumping around $300 billion of Fed-held securities back on the market (or still more if base expansion continues). Now that the Fed is paying interest on bank deposits at the Fed, it can also induce banks to hold more reserves, dampening the money multiplier. It has already jacked up the interest it pays, not on required reserves, but on excess reserves.
Notice further that when you combine the Treasury's Supplementary Financing Program with the Bailout, you have a $1.2 trillion increase in federal government borrowing, at least half of which has already taken place within the space of a month. This sudden 25 percent increase in the outstanding national debt qualifies as the most dramatic peacetime experiment in fiscal stimulus the U.S. government has ever implemented. If Keynesian theory were correct, we should already be well beyond any potential recession. But how many economists are going to acknowledge this striking empirical refutation of fiscal policy's efficacy?
Indeed, I suspect that this enormous increase in government debt at least partly explains the sudden stock market collapse after the Bailout passed. Government borrowing represents a future tax liability, and expected future taxes affect the value of equities. Some argue that this new borrowing may not increase taxes at all because it merely finances the purchase of earning assets that the government can later resell. While certainly possible in the long run, no one knows the true value of those assets in the short run. After all, the market's anxiety about their worth was the justification for the Bailout in the first place. So now the government transfers that uncertainty from private financial institutions to the general taxpayer. Just in case markets failed to notice, Bernanke--rather than calming them as you might expect the Fed to do--combined forces with Treasury Secretary Henry Paulson and President George W. Bush to scare hell out of the American people in order to ram their ill-advised Bailout through Congress. Is it any wonder that stock prices took a nosedive? In short, current events seem to have not only refuted Keynesian theory but also dramatically demonstrated the validity of the approximate Ricardian Equivalence between government expenditures financed with present taxes and those financed with future taxes.
And as icing on the national debt cake, the Bailout Act, by allowing the Fed to pay interest on bank reserves, has in effect converted that portion of the monetary base into still more Treasury securities. Reserves held as vault cash obviously cannot earn interest, but this change still adds another $325 billion to the growth of federal debt over the last month. Future historians may someday refer to this sad episode as the Bernanke-Paulson Recession, concluding that it was the policies of those two individuals, more than any other factors, that turned what was not even a mild recession into a major economic downturn.
A CORRECTION FOR PERFECTIONISTS (added Oct 27): I realize now that my claim above, in the last paragraph, that interest on reserves increases the national debt by $325 billion is not completely accurate. Here is the reason. Unless it sells goods and services on the market like a private firm, the government has only three ways of financing its expenditures: (1) current taxes, (2) borrowing (i.e., future taxes), or (3) printing money (a.k.a seigniorage). With a central bank, Treasury borrowing is divided between (2) and (3), with the amount borrowed from (that is, monetized by) the Federal Reserve generating seigniorage. Before the Fed paid any interest on reserves, the recent $300 billion increase in the monetary base would have constituted seigniorage. So the future taxes required by the new $1.2 trillion Treasury debt would have been REDUCED by $300 billion. Instead, by simultaneously paying interest on reserves, the Fed completely eliminated this seigniorage deduction, requiring future taxes for the entire sum of $1.2 trillion. Not only that, the Fed began paying interest on reserves the banks were already holding, adding merely about $25 billion (not $325 billion) to the $1.2 trillion. (This may seem complicated enough, but I haven't adjusted for the interest differential between what the Fed pays on reserves and what the Treasury pays on its securities. That differential represents a smidgen of lingering seigniorage that reduces the $25 billion somewhat.) Of course, to the extent that the banks or public convert reserves into currency, Treasury debt will be converted into seigniorage.
"But this hardly indicates a liquidity trap, for at least four reasons: (1) Base money can only be held as reserves or currency, and the allocation of a massive base increase between the two tells you absolutely nothing about the overall demand for base money. (2) At the same time that the Fed stomped on the monetary accelerator, it began paying interest on bank deposits at the Fed, obviously increasing the demand for reserves. (3) A sudden SHIFT outward in the demand for base money does not in and of itself demonstrate a liquidity trap, as the history of bank panics teaches us. (4) You must allow for lags to see whether this incredibly sudden base increase works its way into the broader monetary aggregates. The year-to-year annual growth rate of M1 has already risen from 0 to over 7 percent, whereas that of M2 is up slightly from 6 to 7 percent."
Bryan also questioned whether all of the base increase was indeed going into reserves. Again, my comment:
"Accurate numbers on bank reserves are devilishly difficult to get and interpret, because the official figures are often adjusted for changes in reserve requirements and do not include excess vault cash, required clearing balances, and Fed float. But you can tease out recent estimates by going to the Fed's weekly H.3, H.4.1, and H.6 releases and by checking against how much of the base increase has ended up as currency in the hands of the general public. Using these means, I put total reserves for the entire banking system (not adjusted for changes in reserve requirements and not seasonally adjusted but counting all vault cash and clearing balances) at $72 billion in August. Currently, as of October 22, total reserves are somewhere between $343 and $358 billion. Notice how close this comes to matching the corresponding increase in the base, from $847 billion to $1,149 billion. The remaining increase constitutes currency in circulation."
1. The myth that bank lending to nonfinancial corporations and individuals has declined sharply.
2. The myth that interbank lending is essentially nonexistent.
3. The myth that commercial paper issuance by nonfinancial corporations has declined sharply and rates have risen to unprecedented levels.
4. The myth that banks play a large role in channeling funds from savers to borrowers.
The paper is reported on in two blogs, those of Alex Tabarrok and Arnold Kling, and they both provide links to a pdf copy of the paper itself.
Hat tip to David Henderson for alerting me to this major development.
"You refer twice in this post to a tightening of credit last week. I am wondering about what evidence of such tightening you have in mind. . . . Consulting the Fed's website, I see that issuances of commercial paper increased last week from roughly $179 billion on Monday and Tuesday to roughly $205 billion on Thursday and Friday. This 14 percent increase would not seem to comport with a situation of 'credit tightening.'"
Given the subject's import, I've decided to make my reply to Bob a separate post:
Bob: I agree with you entirely that current reports about credit markets"freezing up" and"melting down" are grossly exaggerated. Which is why I used the term" credit tightening," which can encompass fairly minor changes in the credit markets, including your scenario of risky borrowers having more difficulty finding lenders. The credit tightening that had been bothering the Fed over the past year was the increase in the Treasury-Eurodollar (TED) spread and the LIBOR-OIS (overnight index swap rate) spread. The first reflects a market shift from riskier to less risky assets and the second reflects a shift from intermediate maturity lending between banks (one to three months) to overnight lending. Then on September 18, the increasing demand for liquidity caused the T-bill rate to go temporarily negative, which is when Bernanke and Paulson hit the panic button. T-bill rates can only go negative so far before it pays to flee into base money.
Last week's concern over commercial paper was not with respect to total volume. It was over the enormous increase in the spread between A2/P2 and AA thirty-day nonfinancial commercial paper, reported here. In other words, lenders were shying away from the riskier commercial paper. As a result, the total volume of A2/P2 paper outstanding fell by over one-third from August to October. While an A2/P2 rating is not the highest, in order for firms to get it and be able to issue commercial paper that sells on a secondary market at all, they must be fairly well qualified. (In short, it is nowhere near analogous to a subprime rating on a mortgage.) You also saw the drying up of issues maturing in 80 days or more (remember that commercial paper can legally have a maturity of up 270 days) and the bunching of maturities at the shorter end. (See this Fed chart, particularly the monthly averages for A2/P2 non-financial and AA-financial paper.) Borrowers could only issue shorter term paper than they would have liked. All that this reflects, of course, is not any total interruption of the flow of savings, but a redirecting of savings into different channels, causing a re-pricing of financial assets. This certainly does not qualify as the catastrophe that newspapers were screaming about. But it does result in some economic stringency for the firms affected, and therefore I think the mild phrase" credit tightening" is not inappropriate.
The long-run rationale for this change is to permit the Fed to hit its target Federal funds interest rate more reliably, and other central banks throughout the world have already implemented this reform. The short-run rationale is that troubled banks will now be earning interest on their reserve assets, which previously earned no interest.
But I am concerned that in the midst of a potential liquidity crisis, this change can have unintended negative consequences. I can think of four:
1. During a liquidity crisis, banks tend to increase their reserves and thereby decrease their lending to the general public. On top of reducing the flow of savings, this puts deflationary pressure on the money stock. Because banks now receive interest on reserves, they have an incentive to do more of this, accelerating the scramble for liquidity. Indeed, bank anticipation of this change may have been a factor in the tightening of U.S. credit markets last week, after passage of the Bailout Bill.
2. Any particular day, the interest rates on actual Federal funds loans between banks are distributed all round the Fed's target, above and below, with the average not even being on target sometimes. Paying interest on reserves eliminates the lower tail of this distribution, so now banks will no longer lend on the Federal funds market at any rate below what they receive on their reserves. This may be good for the flush banks lending reserves but possibly not so good for the cash-starved banks borrowing reserves, some of which will now end up paying a higher interest rate on the Federal funds market, or curtailing their own lending. Both of these results seem to be the opposite of what the Fed would want in this situation and again could have contributed to last week's credit tightening.
3. Paying interest in effect converts bank reserves into Treasury securities. Any interest the Fed pays will reduce the seigniorage it earns, which by itself is good. But since there is no overall change in total federal expenditures, the reduction in seigniorage also increases the government debt by an equivalent amount. The present value of future tax payments therefore undergoes a one-shot increase by the total amount of reserves receiving interest, which is now approaching $150 billion (not counting banks' vault cash, for which the Fed will not pay interest). If Ricardian equivalence holds, meaning investors correctly anticipate future tax liabilities, this increase could have been one factor helping to initiate last week's stock market decline.
4. Although paying interest on reserves leaves the entire size of the monetary base unchanged, it also at one fell swoop reduces how much of the base qualifies as true outside money that is an asset only, paying no interest. (This is the flip side of point 3.) And it is the supply and demand of outside money ALONE that anchors the price level. (A point that Don Patinkin taught economists years ago.) Of course, paying interest on reserves simultaneously reduces bank demand for outside money by an equal amount, so the immediate effect should be entirely neutral. But at a time when regulators are worried about deflation and a flight into outside money, does it seem wise to hit the economy with a sudden shock, reducing the quantity of outside money by 15 percent, even with a hopefully offsetting 15 percent fall in demand? Could this sudden fall in the quantity of outside money at a period when otherwise demand is rising have been another factor contributing to the events of last week? That is a very complicated question, and I don't pretend to know the answer.
If the current liquidity scramble warranted accelerating any future change, you would have thought that the Bailout would instead have permitted the Fed to eliminate all reserve requirements, something it can do beginning in 2011. Perhaps that might have appeared too much like deregulation at a politically inopportune moment. Perhaps the Fed is more interested in centrally planning interest rates. Or perhaps it felt such a change unnecessary since it can under current law eliminate reserve requirements on a temporary emergency basis.
Hat tip to my former student, Christian Warden, for calling this provision of the act to my attention.
CDS are essentially a form of insurance against default on debt securities. The insured party pays premiums in exchange for a payoff upon a debt default. The contract usually lasts for five years and payoff is triggered by such events as a bankruptcy, failure to pay, or debt restructuring on the part of the institution issuing the underlying debt security. The seller of this protection will either take delivery of the defaulted debt for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the debt (cash settlement). Good descriptions of CDS are at Wikipedia and Pimco.
The amount of credit default swaps now outstanding is reported to be an astonishing $45 trillion. (This number refers to the par value of debt insured and not the trading value of the contracts themselves.) Compare that with $22 trillion for the U.S. stock market or $13 trillion for mortgages. Because you do not have to hold the protected security to purchase CDS insurance, and because the contracts are negotiable on both sides, they have created a very liquid market in default-risk. It is analogous to me being able to take out fire insurance on your house and then re-sell it at a profit when a heat wave increases the likelihood of fire.
Here is a brief discussion of one way of speculating or hedging with CDS, and here is a report on the recent decline in the CDS premiums (or spreads) on the debt (not covered by deposit insurance) of major commercial and investment banks. As this Bloomberg article from over a month ago reveals, you can even purchase CDS protection in this over-the-counter market for U.S. Treasury bonds, which will be a great way to short Treasuries as that glorious day of federal government default finally approaches. :-)
Some of the media have been raising a hue and cry over the alleged dangers from credit default swaps and calling for government regulation. See these articles from the NEW YORK TIMES and TIME MAGAZINE.
Yet credit default swaps should help increase market efficiency in an unregulated and unsubsidized market. The problem, however, is that commercial banks are among the biggest players in this market, both as insurers and insured, to the tune of an estimated $14 trillion. Of that, JPMorgan Chase accounts for $7.8 trillion, Citibank for $3 trillion, and Bank of America for $1.6 trillion. To the extent that banks are providing the insurance, this constitutes a major avenue through which the moral hazard caused by deposit insurance can spread the under-pricing of risk well beyond the banking system. At the same time, this exposure is off balance sheet, evading much regulatory scrutiny. Not to mention that among the debts insured by CDS are mortgage-backed securities, although I haven't been able yet to find out how much.
I am vary wary of conspiracy theories, but Gretchen Morgenstern in the NEW YORK TIMES intriguingly suggests that JPMorgan Chase may have had a good deal of CDS exposure to Bear Stearns before the recent bailout. Bear in mind (no pun intended) that JPMorgan Chase is a bank holding company, owning (1) JPMorgan Chase Bank, National Association, with branches in 17 states; (2) Chase Bank USA, National Association, a credit-card issuing bank; and (3) JP Morgan Securities, an investment bank. The first two, of course, enjoy the pernicious and insidious deposit-insurance subsidy.
Now two of the most prominent libertarian economists on the blogosphere have started to discuss government default as well, possibly arising from other causes. Tyler Cowen wrote:"When it comes to the mortgage agencies, there is no real choice but to bail out the debt holders. The alternative is a run on the dollar and collapse of faith in U.S. government securities and the end of the world." This inspired Arnold Kling to consider the potentiality of such a government default in two successive posts: here and here.
There seems to be a certain tension between Tyler's argument for bailouts and some of his other opinions. He wrote in a subsequent post that although"I have very much favored the 'bailouts' to date [,] I don't favor that they were necessary." The statement is difficult to interpret. If it means anything more than that Tyler prefers utopia if possible, it suggests that he wishes the U.S. had a macroeconomic regime in which the alternative to bailouts was not"the end of the world." Yet Tyler has also dismissed free banking and/or a gold standard as providing no significant benefits over the current system of central bank-managed fiat money. But isn't fiat money managed by a central bank a major feature of what, in Tyler's opinion, links the future of the mortgage agencies to the future of the U.S. dollar?
More important, would a U.S. government default indeed be"the end of the world"? Tyler's scenario contains many implicit assumptions that require examination. The first is that saving Freddie Mac and Fannie Mae decreases the probability of U.S. default. As Mark Brady pointed out to me, one could plausibly argue just the opposite. In fact, a firm refusal to bail out the mortgage agencies would establish a strong barrier between U.S. Treasuries and the fortunes of not only the mortgage agencies themselves but also the myriad other institutions that we can imagine receiving similar treatment. Wouldn't that in fact help maintain confidence in U.S. government securities?
A second assumption in Tyler's scenario is that what happens to U.S. Treasuries and what happens to the dollar are inextricably intertwined. It is true that fiat money makes it harder than would a gold standard to separate the fate of a government's money from that of its debt; but it is certainly not impossible to do so. Treasury securities are second-order claims to central bank-issued dollars. Although both may be ultimately backed by the government's power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution the U.S. repudiated its paper money and yet successfully honored its debt (in gold). What in theory prevents it from doing the reverse in the future?
That the U.S. in fact would do the reverse is implied by some of the observations (with which I generally agree) that Tyler has made about the recent record of the Fed and other central banks. Seigniorage has become a trivial source of revenue in developed countries with widespread fractional reserve banking. Yet Tyler seems to blithely assume that a major fiscal crisis would lead the U.S. government to resort to inflationary finance. If the double-digit inflation experienced by the U.S. during the 1970s covered no more than 2 percent of central government expenditures, imagine the hyperinflation that would be necessary to cover even a two-thirds increase in total federal expenditures, a conservative projection of what current Social Security and Medicare benefits would require over the next half century. Central bank independence, moreover, permits the Fed to isolate the dollar from such a fiscal crisis. And given a choice between only default on its debt, and both default on its debt and collapse of its currency, I expect the Treasury and the Congress would gratefully acquiesce.
But my major disagreement with Tyler and Arnold is that I believe that a U.S. government default, rather than being "the end of the world," could possibly be a good thing. I even advocated repudiating the national debt in a 1981 issue of CALIBER (the newsletter of the California Libertarian Party), long before predicting a default. My arguments were moral, economic, and political, and I would only soften them slightly today.
The moral argument for repudiation is easiest to follow although by itself says nothing about the practical results. Treasury securities represent a stream of future tax revenues, and investors have no more just claim to those returns than to any investment in a criminal enterprise. I favor total repudiation of all government debt for the same reason I favor abolition of slavery without compensation to slaveholders.
The economic argument depends on whether Ricardian Equivalence holds. Repudiating government debt eliminates future tax liabilities. To the extent that people correctly anticipate those liabilities, the value of private assets (including human capital) should rise over the long run by the same amount that the value of government securities falls. Thus, people will gain or lose depending how closely their wealth is associated with the State. If on the other hand, people underestimate their future tax liabilities, they suffer from a fiscal or "bond illusion" in which Treasury securities make them feel wealthier than they actually are. Debt repudiation will bring their expectations into closer alignment with reality, which should increase saving.
When I survey students in my classes, most of them claim to have no realistic expectation that social security will be there for them when they retire. If they are being honest, and they act on this belief as they earn income, then Ricardian Equivalence should hold for those liabilities, making any default less painful. These of course are all long-run effects, and the current market hysteria about the subprime crisis leaves me far less sanguine than I once was about the short-run financial turmoil following a Treasury default.
The political consequences are the trickiest to analyze. A government default is certainly a balanced-budget amendment with real teeth. Moreover, government defaults in the past, when not obviated by bailouts from other governments, seem to have had positive political consequences. Compare the widespread defaults of American state governments in the 1830s, with their cascading benefits--reluctance of states to set up government-owned railroads the way they had government-owned canals, balanced-budget constitutional amendments at the state level which even today impose lingering constraints, a general state retrenchment in a period of increasing laissez faire, among others--with the baleful consequences of the failure to repudiate the Revolutionary War debt, the most notorious of which was replacement of the Articles of the Confederation with the U.S. Constitution. During the late 1830s, President Martin Van Buren blocked any national bailout of the states, and yet the world did not end, and indeed the U.S. continued on the path of sustained growth that it had only recently started down. Unfortunately nowadays, with the U.S. and assorted international agencies stepping in to stave off sovereign defaults, we don't have good recent comparisons.
The greatest potential political benefit of a future government default would be the end of the democratic welfare state. In fact, nearly all the social democracies seem to be approaching similar fiscal crises at the same time. Even though the U.S. started its pay-as-you-go social insurance later than most of the rest, it has caught up with them because, rather than rationing medical services with national health care, it subsidizes medical services. Nor is it likely that the U.S. government will be able to turn to any combination of explicit taxes and siegniorage to stave off the crisis. I've already explained the futility of relying exclusively on seigniorage. Federal taxes as a percent of GDP have been roughly constant since 1960, bumping up against 20 percent. That is an astonishing statistic when you think about it. There have been numerous tax changes over what is nearly half a century, with rates sometimes rising and sometimes falling, and still the total bite out of the economy has not changed much. The chances that Americans would put up with a doubling of that bite strikes me as close to nil. Look at the problems Governor Arnold Schwarzenegger faces with only a minor tax increase in the face of California's fiscal straits.
So when the default occurs, I expect it to happen very fast, much like the sudden collapse of the Soviet Union. While the Social Security and Hospital Insurance trust funds only provide the verisimilitude of full funding, that is enough to create a seeming firewall between the Treasury debt and social insurance obligations. All that is required for investors to change their expectations is some signal that the firewall is an illusion, such as Congress dipping into general revenues to finance Social Security or Hospital Insurance. (The other parts of Medicare are already financed partly out of general revenues.) Suddenly investors will realize that the enormous $70 trillion unfunded liability (Kotlikoff's estimate) does affect the Treasury's ability to honor its debt. Once a default risk premium appears on Treasuries, with the need to constantly roll over of the debt, things will be over quickly. The Fed won't have the time, much less the ability, to inflate the Treasury out of its problems, even if it wanted to.
The social-democratic welfare State will come to end, just as socialism came to an end. Socialism was doomed by the calculation problem identified by Mises and Hayek. Mises also argued that the mixed economy was unstable, and the dynamics of intervention would inevitably drive it towards socialism or laissez faire. But in this case, he was mistaken; a century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above political reproach and beyond economic salvation. Fully funded systems could have survived, but politicians had little incentive to enact fully funded systems, and much less incentive to impose the huge costs of converting from pay-as-you-go.
Whether the inevitable collapse of social democracies will be a good or bad thing depends on what replaces them. The travails of post-Communist countries can be a source of either optimism or pessimism, depending on where you look. But the lesson libertarians should take away from all this is to stop wasting their time on social insurance reforms that have no chance of implementation and small chance of working, even if implemented. Most of them are half-way measures that reduce only a portion of the unfunded liability with tax increases or benefit decreases, and try to cover the remainder with either smoke-and-mirror cuts in other government programs or hand-waving about higher growth rates. Libertarians instead should be helping people to accept the inevitable by explaining why government intervention dooms social insurance and why only voluntary alternatives are viable over the long run. This is the best way to ensure that what comes after the democratic welfare State is something better.
Bryan returned to the subject of my lecture, discussing a question he had posed to me during the seminar's recorded Q & A:"Agree or disagree: In developed countries during the last 10-15 years, central banks have become (close to) the most efficient state enterprises." After some hesitation, I had to reluctantly agree, despite my unequivocal advocacy of the Fed's abolition. But I throw the question open to discussion: what is your candidate for the least inefficient state enterprise?
Bryan of course approves of my answer, which is why he posed the question. But his reasons are somewhat different than mine. He gives two in his post: (1) the public's exaggerated fears of inflation partially offset the time-inconsistency problem that would otherwise cause central banks to generate higher inflation; (2) central bank independence allows them to rely more on economists, who do a better a job than mere mortals.
I have already questioned the claim that the public exaggerates the danger of inflation relative to economists in an ECON JOURNAL WATCH article. Economists only consider inflation's deadweight loss, ignoring inflation's transfer, which bothers the public just as much and just as reasonably as the transfer from the income tax. Does it really make sense to say that the public hates taxes too much because most of the extracted revenue is just a transfer?
Bryan's second reason really combines two points, one with which I agree and one with which I disagree. I do think central bank independence is important but not because it results in employing more economists. The economists I know seem to be just as susceptible to incentives as the general public. They may cast more intelligent votes, where as Bryan argues incentives are weak, but I don't see how it follows that they will make more public-spirited (i.e., welfare enhancing) decisions when faced with the temptations of power.
Here are my three reasons, given somewhat sporadically in my lecture, for the better performance of central banks in developed countries since the 1980s:
1. Highly developed financial systems with widespread fractional reserve banking have reduced government seigniorage, even at double-digit inflation rates, to a trivial source of revenue. (During the Great Inflation of the 1970s, direct seigniorage never covered more than 2 percent of the U.S. government's outlays.) This greatly diminishes the incentive for central banks to generate high inflation.
2. Globalization and international competition have approximated Hayek's world of competing private banks issuing fiat money. The major difference is that we have competing central banks. Investors can fairly easily move from one currency to another, which means the market immediately prices changes in central bank policy and punishes them when necessary. Central banks are still the major noise traders in the interest-rate and foreign-exchange markets. But whenever a central bank goes up against speculators and tries to seriously misprice its currency, the central bank almost always loses and the speculators almost always win. This tends to discipline central banks.
3. Central banks are freer to respond sensibly to this growing international competition and market discipline because of their political independence.
But truly exceptional is Dyson's assessment of the second book he reviews: GLOBAL WARMING: LOOKING BEYOND KYOTO, edited by Ernesto Zedillo, head of the Yale Center for the Study of Globalization. At the heart of the book is a debate about the effects of global warming between Stefan Rahmstorf, a German professor of physics of the oceans representing the mainstream, and Richard Lindzen, professor of atmospheric science at MIT, who"does not deny the existence of global warming, but considers the predictions of its harmful effects to be grossly exaggerated." Here is Dyson's assessment of the debate:
"These two chapters give the reader a sad picture of climate science. . . . Their conversation is a dialogue of the deaf. The majority responds to the minority with open contempt. In the history of science it has often happened that majority was wrong and refused to listen to a minority that later turned out to be right. It may--or may not-- be that the present is such a time. The great virtue of Nordhaus's economic analysis is that it remains valid whether the majority view is right or wrong."
Dyson goes on to add that"all the books that I have seen about the science and economics of global warming, including the two books under review, miss the main point. The main point is religious rather scientific. There is a worldwide secular religion we may call environmentalism, holding that we are stewards of the earth. . . . The ethics of environmentalism are being taught to children in kindergartens, schools, and colleges all over the world. Environmentalism has replaced socialism as the leading secular religion."
Dyson himself believes that"the ethics of environmentalism are fundamentally sound." Yet he admits that"unfortunately, some members of the environmental movement have also adopted as an article of faith the belief that global warming is the greatest threat to the ecology of our planet." However, many of the global-warming skeptics themselves"are passionate environmentalists. . . . Whether they turn out to be right or wrong, their arguments on these issues deserve to be heard."
This is noteworthy both for Dyson's intellectual honesty and for the fact that his review appeared in such a prestigious and widely read establishment publication. I cannot wait to see the firestorm of letters the review generates in future issues of THE NEW YORK REVIEW OF BOOKS.
During the Civil War, Foster was the most prominent of fifteen abolitionists who signed the antiwar "Standing Protest of the New England Non-Resistant Abolitionists." He was married to the better-known Abby Kelley, a founder of the women's movement. Kelley was subsequently written out of feminist history by Susan B. Anthony and Elizabeth Cady Stanton because of her Garrisonian hostility to voting, which continued even after the Civil War ended, while the feminist movement generally became almost exclusively obsessed with women's suffrage.
More details on Stephen Foster can be found scattered in Dorothy Sterling, AHEAD OF HER TIME: ABBY KELLEY AND THE POLITICS OF ANTISLAVERY (New York: W. W. Norton, 1991); Lewis Perry, RADICAL ABOLITIONISM: ANARCHY AND THE GOVERNMENT OF GOD IN ANTISLAVERY THOUGHT (Ithaca: Cornell University Press, 1973); and Richard H. Sewell, BALLOTS FOR FREEDOM: ANTISLAVERY POLITICS IN THE UNITED STATES, 1837-1860 (New York: W. W. Norton, 1976).