The Skeptical Optimist

Austrians vs Keynesians: The Scoreboard

[After submitting this to a discussion group as my synopsis of the difference between those two schools of thought on monetary theory and policy, I decided to tweak it a little and post it here. If nothing else, it might clarify my stance on a few key issues for newer visitors to this blog.]

Keynesians 1, Austrians 0
The fundamental debate about monetary policy boils down to fiat money vs commodity money — and the question, "Which of those is a better system for ensuring a stable value of money?"

Before we can answer that, we need to agree on the definition of "stable money." In many minds, it means "money that does not suffer unanticipated inflation higher than 2-3%." In my opinion, that is only half of the proper definition; it should also include "money that also does not suffer deflation of any level." In short: Stable money is money that does not inflate or deflate.

Now, if you agree with my proposed definition, the flaw I see in the Austrian side of the monetary argument becomes easier to detect. As an experiment, try this: search any of their essays or texts on the subject, and count the number of occurrences of the word "inflation"; then count the number of occurrences of the word "deflation." I predict the ratio will be at least 100:1, if not 100:0 (infinite). Deflation is at best an afterthought in that ideology, even though it can produce worse consequences than inflation -- such as a downward-spiraling implosion of the real economy, which in the past has tended to end in the violent overthrow of governments.

An even harder-to-detect flaw in the commodity-money dogma (besides the "deflation? who cares?" attitude) is its shaky track record of actually preventing inflation itself, in spite of how plausible the theory sounds. As with any type of money, commodity money (eg, gold or silver) is inflationary whenever an increase in its supply outstrips the economy's ability to increase its production of real goods and services. The California gold rush produced inflation (arguably with excellent results for the real economy); on the other hand, Spain's obsession with bringing in silver from the new world caused a domestic inflation that removed Spain from the industrial revolution. In both cases, sudden increases in the supply of commodity money were inflationary — the same thing that happens to fiat money when its supply increases too quickly.

Moreover, some in the Austrian school define "inflation" differently from the way most people think of it these days. The (archaic, in my opinion,) definition is "any increase in the money supply." Contrast that with the way most people define inflation: "any increase in the general price level." To achieve stable prices, the money supply must increase roughly at the same rate as the supply of real goods and services. But to achieve the Austrians' version of "no inflation" the money supply must not increase -- which means prices and wages must fall as the real economy grows -- IF it grows *in spite* of the stagnant pool of money available to the economic participants. I have yet to see an essay proposing a politically-viable way of convincing the general public that falling nominal wages are no problem at all, because falling nominal wages are in fact constant or rising real wages in a real economy that's growing. And, as Lincoln said, "With public sentiment, nothing can fail; without it, nothing can succeed."

The Keynesians, in my judgment, have the upper hand in monetary theory: the proper goal is to prevent BOTH inflation AND deflation in the general price level. Deflation is partially-disguised as rising unemployment, but it is deflation nonetheless. (Reason it's disguised: When prices fall, businesses must reduce costs in order to survive. But hourly wage rates tend to be more rigid than prices; therefore, to reduce the cost of wages and salaries, businesses must reduce labor hours instead of labor $/hr. One full-time employee equals 2000 hrs/yr; you know the rest.) The Keynesians and neo-Keynesians seem to be the only ones genuinely concerned about preventing a deflationary spiral in unusual times like the ones we have been experiencing; the opposing viewpoint isn't much more than "Deflation? So what, who cares?" — and amounts to a hands-off policy of letting unemployment rise to whatever level we supposedly deserve because of prior excesses. I think that is an unacceptable mistake of ignoring money that's unstable in the downward direction.

Unanticipated inflation gives debtors an unfair advantage. Unanticipated deflation gives creditors an unfair advantage — that is, up until the debtors default, at which time everybody loses because of an accelerating downward spiral to oblivion. A "stable value of money" means preventing both inflation and deflation. The Keynesians have articulated both sides; the Austrian school has been vocal about inflation, but inexplicably silent about deflation. Makes me wonder if the Austrians could only see monetary theory from the creditors' viewpoint. In any case, on monetary theory, you can count me with the Keynesians, until something better comes along.

Keynesians 1, Austrians 1
That said, I must qualify my objections to the Austrian school of thought: My objections are strictly limited to their 19th century thinking regarding monetary theory and money mechanics. I am an enthusiastic advocate of Hayekian ideas regarding the growth and vitality of the real economy in a free society. The Hayekian model for the real economy (as oppposed to the monetary side) is market- and rule-of-law driven, analogous to the biological model of natural selection and adaptation. By contrast, the central planning, government-knows-best model is analogous to Intelligent Design in biology. I most definitely do not subscribe to Intelligent Design in biology, nor do I subscribe to it in economics; the evidence in both cases is overwhelmingly in favor of the evolution model employing selection and adaptation. Hayek's brilliant essay, The Use of Knowledge in Society, explains why the market-driven model of selection and adaptation creates growing prosperity, and why Intelligent Design (a.k.a. central planning) fails.

So, I keep the money side of the economy well separated from the real goods and services side in my thinking. Money flows the opposite direction from real goods and services. Stable money is one of government's responsibilities, according to Adam Smith and most subsequent thinkers (...the other responsibilities being defense, justice, education, and infrastructure). After providing those, the government is NOT responsible for the real goods and services side of the economy. [That's why I support the Fed's monetary initiatives, but oppose the GM bailout and life-support programs. Stable money is the government's responsibility; automobile manufacturing is not.]

In short: It's all tied up: Keynesians 1, Austrians 1.

That's my interpretation, anyway, after a couple decades of research into the subject. And it's the reason I think Reaganomics is far from "dead," in spite of the wishful thinking on the left these days. Reaganomics is growth economics; what we've had to switch to is stop-the-bleeding economics. It's not an either-or choice, as I explained in more detail in this article a few months ago.

That's it. Happy Independence day, and have a safe and fun weekend.

The Fed vs the Politicians

Last Friday, the top story in the Wall Street Journal was all about how our esteemed politicians on Capitol Hill jumped all over Fed chairman Ben Bernanke the day before.

It was the harshest public grilling for a central bank chief since the late 1990s... The mounting controversy over the Fed's involvement risks subjecting the central bank to the kind of political pressure it has managed for decades to resist.

As usual, our esteemed politicians seem to disagree amongst themselves as to exactly what is so upsetting about the Fed's actions.

Critics on the right, especially House Republicans who have long been suspicious of the Fed's power, say the central bank intervened too aggressively into the private sector. Critics on the left say it has been too opaque in its actions and too easy on big banks.

Publicly, the politicians are split as to why the Fed irritates them. But I suspect a hidden agenda: politicians wish they had more control over the Fed -- but they don't, and that's why they were acting like spoiled kids last Thursday. Bernanke handled his grilling with admirable composure, and as I watched a recording of the session, I thanked my lucky stars that our country is, so far, still following Alexander Hamilton's advice to be sure that control of the central bank is kept AWAY from the politicians. If that condition changed and our esteemed politicians somehow gained a much larger measure of control over monetary policy, I'd have to triple or quadruple the odds of a deflationary depression or of high inflation — or both of those disasters taking turns in a perpetual cycle.

Obama should reappoint Chairman Bernanke in January, period. Bernanke knows how monetary policy should be handled in unusual times like these, he's doing it, he openly explains it to us in terms we can understand (unlike any past Fed chairmen), and he somehow maintains his composure when being grilled by grandstanding half-wit politicians. Those are valuable skills, especially the last one.

Inflation/Deflation watch
For now, the Fed continues its success at preventing both deflation and inflation. Here's the latest Inflation/Deflation chart.

[If the politicians ever gain direct control of monetary policy, I'll have to expand the Y-axis scale significantly upwards and downwards.]

Obama gets it: “Robust” growth is the solution

At last! We have a political leader who has found a way to say “Deficits don’t matter under the right conditions” without becoming the target of ridicule and partisan barbs as happened to Dick Cheney. I consider that a huge and important step in the right direction.

Obama said the following in a recent interview with Bloomberg (...and thanks to William B. for the tip):

One of the biggest variables in this whole thing is economic growth.

And, most importantly…

If we are growing at a robust rate, then we can pay for the government that we need without having to raise taxes.

I give that sentence an A-minus. That puts Obama way, way ahead of all other politicians, who deserve D-minuses and F’s in the category of understanding and communicating the overwhelming importance of “robust economic growth.”

Mind you, I’m not complaining, but if I could have tweaked that sentence just a little, it would have read as follows (my tweaks are in boldface):

If the private sector is growing at a robust rate, then we can pay for the government that we need without having to raise anybody’s tax rates.

Presumably, we can all agree that "growing" means "creating new jobs, products, and services"; I hope at least that is nearly unanimous. But tweaks aside, this is very encouraging; we’re making important headway, at least rhetorically. Now all we have to do is make “robust growth” happen in reality—which requires a lengthy and important debate, to which I will be happy to contribute.

For now, however, I’d like to enjoy the moment. “Robust growth” is at last out there for us to think about and talk about with our family, friends, and neighbors, thanks to President Obama's communications skills. He's a great talker, and that's an indispensable first step.

Jobs "saved"? Great, but let's see the math.

Apparently, someone in the administration knows how to keep track of the number of jobs that would have been lost if the this administration's policies hadn't been in effect.

Gee, I think that's just great... but I'd like to see the math, please. Social scientists would call it "quantifying the counterfactual" -- an oxymoron. Regular people just call it "making up data for political posturing" -- a tactic that fools only morons.

Here's an excerpt from the Wall Street Journal's article, The Media Fall for Phony 'Jobs' Claims:

...the inability to measure Mr. Obama's jobs formula is part of its attraction. Never mind that no one -- not the Labor Department, not the Treasury, not the Bureau of Labor Statistics -- actually measures "jobs saved." As the New York Times delicately reports, Mr. Obama's jobs claims are "based on macroeconomic estimates, not an actual counting of jobs." Nice work if you can get away with it.

Let's see the macroeconomic estimates, and the math behind them. It would enable us to add some important additional data to the excellent chart below (one that I wish I'd though of) which I borrowed from the Innocent Bystanders blog. It shows three sets of unemployment numbers: the actual results, and the results the administration projected with and without their recovery plan.

Click to enlarge:

Obviously, the administration's plan isn't delivering the results their experts had projected four months ago. Yet we keep hearing about all the jobs "created and saved" by that same plan. Something isn't adding up. Maybe an unveiling of the math behind the estimates would clear things up(?).

Maybe, but I won't hold my breath.

Does Obama subscribe to The Economist?

I hope so. If he doesn't, there's not much chance his advisors will alert him to the latest edition's lead article:

"Piling on: In his zeal to fix capitalism, Barack Obama must not stifle America’s dynamism."

(A ray of hope: maybe Austan Goolsbee can slip him a copy when the others aren't looking.)

This is a must read. It summarizes my main fear that the "temporary" fiscal package for stimulating the private economy is permanent, not temporary, and will stimulate politicians and bureaucrats, not entrepreneurs and innovators. (Outsourcing the package to Nancy Pelosi certainly didn't help matters, as the article points out).

A few excerpts:

America has experienced a failure of finance, not of capitalism... Even in boom times, 15% of American jobs disappear each year. Their places are taken by new ones created by start-ups and expansions... Americans are adept at finding opportunity in adversity...

Yet Mr Obama—and, even more, his Democratic allies in Congress—could do lasting damage to this marvellous [economic] machine. [Outsourcing rule-writing is risky because] Congress is much more likely than the executive branch to let special interests or demagoguery shape the outcome...

America’s free-market capitalism has always been a model for the rest of the world. By all means fix its flaws, Mr Obama; but do not take its dynamism for granted.

Future entrepreneurs and innovators would grow the economy (i.e., create real jobs)  faster if given sufficient incentives, but I'm afraid Mr. Obama doesn't know much about them, let alone what motivates them. That's the reading I'm getting so far, anyway. A long conversation at the White House with someone who does understand the growth engine, such as recent Nobel winner Edmund Phelps, might help cover that blind spot, but that's just wishful thinking on my part.

Anyway, be sure to read the article in The Economist. Here's the link again.

Inflation Watch

Some people think deficits cause inflation; some don't. I'm in the latter group, because I think inflation is almost always a result of monetary policy, and seldom if ever of fiscal policy.

But whichever it is, the numbers should start swinging one way or the other reasonably soon, given the unprecedented deficits we're running (...and will continue to run for several years). Either deficits will pull away from the low inflation numbers, or the inflation numbers will start rising with the deficits. It might be a good idea to start watching all the key numbers in one place on a regular basis, so here they are:

The CPI says we're deflating; the other three say we are safely in low-inflation territory.

Another way of saying that: all four indicators say that inflation is not a problem yet. Neither the deficits we have, nor the deficits we know are coming, nor the trillion dollars the Fed has "printed up" are causing any inflation so far. Why? In my judgment, deficits don't cause inflation, so that narrows the mystery down to all that money the Fed printed up. Reason that's not causing inflation yet is because almost all of it is just sitting there, in "excess reserves" in the banking system. (If the Fed printed up a *hundred* trillion dollars and set it down in an inaccessible nook at the bottom of the Grand Canyon, that wouldn't be inflationary either.)

So here's this week's conclusion:

Nothing but a low, safe inflation level so far. If the high-inflation demon is out there, it's still hiding just around the next corner, as it has been for the several decades I've been paying attention.

============

End note regarding the four inflation indicators I picked:
My two personal favorites are the so-called TIPS spread, and the "trimmed-mean" PCE. The TIPS spread is the worldwide bond market's daily judgment on inflation, and the most popular "spread" is the difference between the interest rate on 10-year Treasury notes and the rate on 10-year Treasury inflation-protected securities. The trimmed-mean PCE is the Dallas Fed's massaging of the components in the personal consumption expenditures numbers, and it's a second cousin of "core" PCE.

The Consumer Price Index (CPI) is a must have because it's always in the headlines. The GDP deflator is a bit more comprehensive than the others, but it's also more delayed (...it's more of a rear-view-mirror indicator).

Here are the links to the sources:

Trimmed-mean PCE

TIPS spread components:
 10-year T-Notes, daily
 10-year TIPS, daily

CPI-U

GDP deflator

The Guantanamo solution? Easy.

The Sunday talk shows (ABC, CBS) spent a lot of airtime today on President Obama's Guantanamo dilemma: (1) he promised a million times during the campaign that he'd shut it down, and dutifully signed an order on day 2 to do just that within one year; but (2) unfortunately, no other country, and no state within our country, wants any of the remaining bad guys in their back yard; consequently, $80 million in funding to do it was overwhelmingly blocked by Congress.

What should the President do to save face?

I don't think it's difficult at all—and I can't understand why nobody has suggested it. Maybe it's so simple it's too easy to overlook. The solution is this: Shut down the name "Guantanamo" — then immediately start calling it "Camp Progressive" or "Niceville South." It wouldn't take anywhere near $80 million to do that; a few hundred thousand for new signs and emblems should do it.

Obama could then chalk that up as twin accomplishments, ready for the bumpersticker printing presses:

"Not only did he shut down Guantanamo, he reduced the deficit in the process."

(It's overdue for a name change anyway — now that the "war on terror" is over.)

Back to Clinton-era debt burdens

Anyone nostalgic for Clinton-era fiscal results has something to look forward to. Net interest on the federal debt in the mid- to late-1990s was just under 3% of GDP, and consumed 15% of tax receipts. Investor's Business Daily says it will be returning to (or exceeding) those levels in a few years, based on the White House and CBO projections of Obamanomics. (Interest fell to about half those levels in Bush's second term.) The chart at right is from the IBD article; be sure to read the whole thing.

As usual, GDP growth makes a big difference; IBD made that point at the end of their article:

The biggest difference in the CBO and White House assumptions appears to be economic growth. By 2019, the White House expects that GDP will be 9% higher than the CBO forecast.

The higher growth would generate an extra $480 billion in tax revenue. That would trim budget deficits and, thus, interest payments.

"Protecting jobs": good politics, but...

...it always backfires, and ends up costing jobs. Trade wars tend to break out. But what do politicians care? "Protecting jobs" gets them elected, and that's what it's all about, isn't it?

Supposedly, someone in the administration is keeping track of the number of jobs being "created" -- no doubt for use in the next political campaign. Do you think they'll be properly tracking and deducting the jobs destroyed by the Buy American mantra? Probably not. But I'm confident that objective journalists such as Lou Dobbs will call them on it.

Just kidding. Replace "confident" with "not holding my breath" in the sentence above, and scratch the word "objective."

Read about the "outrage in Canada" in today's Washington Post.

[Many thanks to commenter Harun for pointing this out. I lifted this from the comments under the previous article.]

Fiscal responsibility, and the Obamanomics Report for May 2009

"Fiscal responsibility" is a term nobody ever defines — until today.

I gave it a shot a couple years ago, in an article titled “'Fiscal Responsibility' defined at last" -- but even that definition turned out to be too mushy for my taste. If I had it to do over again, I'd add two words to the end of the title: "...sort of."

If you've read more than a few articles at this blog, you already know my position: Growing debt is nothing to fear as long as the economy is growing at or near the same pace as the debt. The proper measure for that was the debt-to-GDP ratio. Recently, I've had to amend that position: It is ALSO nothing to fear as long as we are using it in the short term to get the economy back on the growth track.

But the problem with using the debt/GDP ratio as the measure is that nobody can say how much is too much (or too little); consequently, nobody knows how much runway we have left. Debt/GDP was 120% after WW2, but would that be too much now? Or would we still have some slack even at that level? Who knows? (Not economists, I can tell you that with a lot of confidence.)

I found a measure I like better than debt/GDP. It's the "Net Interest share of Federal Spending." If our monetary policy is successfully controlling inflation, but we are not being fiscally responsible, the interest share of spending will grow in the long run, crowding out things like defense, justice, social security, and health care.

Some things that put upward pressure on the interest share of spending are:

• increasing federal debt
• increasing interest rates on the debt
• "investments" that don't boost the economy

Some things that relieve the pressure are:

• increasing GDP (by far, the best way)
• decreasing interest rates on the debt
• "investments" that succeed in boosting the economy

[I intentionally left "running surpluses" off the second list; for an explanation why, see this article from four years ago.] 

How much is "too much"? I think we have a better indicator with this new statistic. Interest required 15% of federal outlays in the Clinton years, which are loudly touted as a good example of fiscal responsibility. Because of falling interest rates and growing tax receipts during the Bush years, it fell to an even more fiscally-responsible range of 7%-9%. Now the Obama budget calls for a combination of spending, growth, deficits, and interest rates that will take it back up to the Clinton-era level of 14%. No sweat, in my judgment, IF the budget comes true. (Big if, huh?)

So, here's the new chart. I plan to update this one monthly.

Pay no attention to the huge drop in the last six months; it's temporary, and it's due to the huge spending increase that will soon cause the interest payments on the debt to rise, just as the budget predicts. We need to watch how the red line tracks against the budget line.

I will say that if it does level off at 14% in a few years, that will be sustainable, and it will match the level achieved in the Clinton years. But it will require most of the "investments" in the Obama budget to pay off in enhanced growth. We'll see it unfold fairly soon, in any case.

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Data sources:
Monthly Treasury Report

Treasury Debt Position Report

Obama budget[*]

[*] The only assumption I had to make was this: The avg interest rate "budgeted" for paying net interest on the publicly held debt will be the midpoint between the budget's forecasted rates for 3-mo T-bills and 10-yr T-notes.