From May 2009 to last month, the U.S. unemployment rate has been at 9 percent or above, the longest period of such high joblessness since the 1930s. Can anything be done? In a television debate on August 14 the Nobel economics laureate Paul Krugman complained that the Federal government had not been imaginative enough. He referred to the Second World War when, according to a widely shared view, the surge in military expenditure was the key influence on the decline in unemployment. Given that argument, Krugman appealed on television to “space aliens” to threaten life on earth and create an invasion scare. He suggested that, all being well, rearmament ahead of a War of the Worlds might eliminate high unemployment in 18 months.

Krugman’s belief in the reality of space aliens and interplanetary warfare is a new strand in his intellectual development. By contrast, one of his more familiar recent themes has been standard Keynesianism for decades. This is that increases in nondefense government spending and the budget deficit are the right answer to an unemployment problem. He was one of the main advocates, along with Joseph Stiglitz and Larry Summers, of the immense so-called “fiscal boost” engineered by President Obama at the start of the present administration. That boost, which meant an addition of almost $800 billion at an annual rate to the budget deficit, was thought to be a fool-proof way of checking the Great Recession.

Keynesian emphasis on the effectiveness of fiscal activism has been accompanied by repeated claims about the ineffectiveness of monetary policy. The weakness of monetary policy is said to be particularly obvious now that Federal funds rate has dropped to zero. Krugman has said that the “zero bound” on interest rates recalls the “liquidity trap” conceptualized by Keynes in his 1936 classic The General Theory of Employment, Interest and Money. Keynes qualified his discussion in The General Theory by admitting that he had never observed a liquidity trap in the real world. Krugman today sees himself not only as reinstating Keynes’s message in theory, but as doing so in a world where two major economies—the United States and Japan—have succumbed to the liquidity trap in practice.

Evidently, the debate about the relative potency of fiscal and monetary approaches to economic stimulus is rather more than a dry, technical, and esoteric sideshow to the contemporary political scene. It will be central to the clashes between the Democrats and Republicans in the 2012 presidential election. Although neither side pretends to have a macroeconomic silver bullet, the Republicans can readily pin the blame for the United States’ ballooning public debt on Obama and his advisors. In my recently published book Money in a Free Society, I argue that the Keynesians in general, and Krugman in particular, have misunderstood both Keynes and the liquidity trap. As a result, they have grotesquely underestimated the power of monetary policy.

I.

My critique of Krugman turns, to a large extent, on a misuse of words. The trouble goes back to Keynes himself, since he admitted at one point in The General Theory that he had “slurred over” problems in definition. Perhaps the most important of his verbal imprecisions related to the notion of “the rate of interest.”

The phrase could refer to several phenomena. People sometimes talk about “the rate of interest” on common stocks, by which they understand the dividend pay-out expressed as a yield on the market capitalization, or even “the rate of interest” on real estate investments, when they are thinking about the rental return. As we shall see, neither of these usages is silly, even if they may come across in highfalutin academic seminars as a little provincial. Usually in economics the phrase has one of two meanings. The first is the short-term money market rate, which serves as the building block of a much larger interest rate structure, including the interest rates charged on bank loans and paid on bank deposits. In the United States this money market interest rate is set by the Federal Reserve in operations with the commercial banks and is known as the “Federal funds rate.”[1] The second is the yield on bonds. This is a much trickier and more ambiguous idea than it looks. Bonds can have less than 50 weeks or over 50 years to redemption, be issued by governments or companies, and have a fixed payment coupon or a coupon payment that varies with other interest rates, with the inflation rate, or even a commodity price. (For example, Judy Shelton proposed gold-denominated bonds at the recent 29th Cato Institute annual monetary conference.)

Given the diversity of the alternatives, it might seem unwise to see “the rate of interest” as synonymous with bond yields. But without doubt this is what Keynes did in The General Theory. The point is clear and definite in the book’s chapter 15, which in one passage explained that banks could “purchase bonds for cash by bidding the price of bonds up in the market by a modest amount; and the larger the quantity of cash which they seek to create by [such] purchasing, the greater must be the fall in the rate of interest.” Further, the bond yield that concerned Keynes above all was the yield on long-dated bonds, as he thought it was particularly relevant to major investment decisions. He criticized the Federal Reserve’s activities in 1933 and 1934 when its operations had been limited to the short end of the yield curve and had “but little reaction on the much more important long-term rates of interest.”

Indeed, the logical coherence of Keynes’s liquidity trap hypothesis depended on the equivalence of the rate of interest and the bond yield in his work. As an active speculator in financial markets, Keynes was well aware that errors in judgment could lead to the loss of capital. (He almost went bust on two occasions.) He knew that, because bond prices and yields moved inversely, somebody who bought bonds at a high price (that is, a low bond yield) might suffer a hefty capital loss if the next major price move were downwards.

Fears of a capital loss could therefore deter investors from buying bonds at even higher prices, even if official operations increased the quantity of money in their hands. An increase in the quantity of money would therefore not depress bond yields or, Keynes saw it, the “rate of interest.” Once bond prices were at an unusually high level compared to long-run norms, a money injection engineered by the state could not reduce the rate of interest. In this sense the scope to conduct expansionary monetary policy had been exhausted.

In short, Keynes’s liquidity trap concerned the long-term bond yield and arose from the uncertainties facing investors as they balanced money holdings against bond investments. But here is the rub. This trap is not at all the one that bothers Krugman, despite his insistence on both the Keynesian lineage of his thinking and the “classic” character of his interpretation. In Krugman’s work monetary policy has become ineffective because the short-term money market rate cannot be lowered beneath zero by central bank operations. Frankly, Krugman says nothing in his articles and papers about the relationship between bond yields and the quantity of money. But the long-term bond yield and the short-term money market rate are not at all the same thing. It follows that Keynes’s trap and Krugman’s trap are very different ideas, and need to be clearly distinguished. (In essay 4 of Money in a Free Society I show that Krugman has devised at least three extra liquidity-trap formulae, on top of the two I have already discussed! They are all interesting and thought-provoking in their way, but not one of them is Keynes’s trap in The General Theory.)

II.

How do these issues—apparently so theoretical, abstract, and arcane—influence today’s policy debate in the United States? Can they in all seriousness be relevant to the next presidential election?

The answer is that Krugman has leapt from his misinterpretation of Keynes to two very dangerous assertions, while President Obama has unwisely translated these assertions into policy. The first assertion is that at a zero money market rate, Federal Reserve action cannot further lower “the rate of interest.” This claim has allowed Krugman to invoke the liquidity trap and to pooh-pooh monetary policy. The second assertion is that monetary policy has been made ineffective by “the” liquidity trap, which justifies the recommendation that government stimulus efforts must take the form of a yet larger budget deficit. Implicitly, there is one, and only one, notion of the liquidity trap.

But, as I have demonstrated above (and with more rigour in Money in a Free Society), economists have a proliferation of liquidity traps and have been careless in differentiating among them. Remember that Keynes’s trap was not about the responsiveness of the money market rate to central bank operations, but rather the effect on long bond yields of changes in the quantity of money. The United States would be in his liquidity trap today only if larger increases in the quantity of money had failed to drive down bond yields. Keynes did not doubt the ability of the state to create new money without limit. In that sense monetary policy was unlimited in his era, it remains unlimited today, and it will always be so. What then is happening to the quantity of money in the United States at present?

In Money in a Free Society I argue that the correct aggregate to use in macroeconomic analysis is one that is broadly defined to include virtually all bank deposits. This is consistent with Keynes’s approach in The General Theory, since his analysis relied on the nearest alternative to “money” being a non-monetary asset (that is, a bond). It also accords with the views of Milton Friedman and Anna Schwartz, who in their path-breaking A Monetary History of the United States blessed a broadly defined measure which included time deposits. (In my view the M3 measure is the ideal. The numbers for “the quantity of money” in the next paragraph are those estimated by the UK Shadow Government Statistics advisory service for M3. The Federal Reserve ceased publishing M3 data in 2006.)

In the three years to October 2008, the quantity of money soared from $10,032 billion to $14,186 billion, with a compound annual growth rate of just over 12 per cent. The money growth rate in this period was the highest since the early 1970s. Indeed, 1972 and 1973 had many similarities to 2006 and 2007, with bubbling asset markets, buoyant consumer spending and incipient inflationary pressures. On the other hand, in the three years from October 2008 the quantity of money was virtually unchanged. (It stood at $14,340 billion in October 2011.) In other words, in the three years of the Great Recession the quantity of money did not increase at all.

What would have happened to the long bond yield if the Federal government and the Federal Reserve had, in a programme of money creation far more aggressive than anything so far attempted, decided to pump up the quantity of money by 5, 10, or 20 per cent? We do not know. Because the quantity of money has been roughly constant in the Great Recession, we can only conjecture the sequel to a big burst of money expansion. We therefore cannot say anything about whether the United States is currently in a liquidity trap or not, as Keynes and not Krugman defined that concept.

May I go further? The salient feature of the numbers just given is the contrast between the boom in money growth in the three years to autumn 2008, when Lehman Brothers failed and the Great Recession began, and the stagnation of money subsequently. (I simplify. A drop in M3 in 2010 has been offset by renewed moderate growth in the last few quarters.) If one is looking for a convincing narrative and a cause-effect interpretation of the Great Recession, it seems to me that the quantity of money is the variable that should receive most attention. In this I am self-consciously trying to revive the intellectual legacy of Milton Friedman, who in a long and often turbulent intellectual career always insisted that “money matters.” Money has mattered in the Great Recession, just as it did in the Great Depression. (By common consent, the most searching analysis of the Great Depression was given by Friedman and Schwartz in chapter 7 of A Monetary History of the United States.)

III.

The United States is not in a liquidity trap today and never has been in one. The facts and data tell their own tale. Active fiscal policy has been useless as an antidote to the Great Recession, while money and monetary policy remain extremely powerful. Krugman and the Keynesians have misled the president. The surge in American public debt has failed to bring down unemployment, but it has led to the United States forfeiting its AAA credit rating. Astonishingly, Krugman, Stiglitz, Summers and company seem to have learned nothing from the last three years of disappointment with fiscal policy; they recommend yet more increases in government spending and another enlargement of the budget deficit. Given their indifference to evidence, one should perhaps not be surprised that the latest thinking envisages heavy expenditure on rockets and missiles to be fired at Martians and unidentified flying objects.

May I close with a few remarks on Keynes’s liquidity trap, the one that he proposed in The General Theory, but the details of which Krugman and his associates have forgotten? The validity of Keynes’s trap depended—in my view—on two assumptions that Keynes mischievously elided in his presentation of the argument. The first was the economy could be represented by a model which contained money, bonds, output, and employment—by a model, in other words, in which the only nonmonetary assets were bonds. The second was that, in books three and four of The General Theory, which developed the key ideas about money, bonds, and the rate of interest, wages per worker (and hence the price level) were held constant.

Let us think a little harder about Keynes’s model. Yes, in the real world investors are balancing money against bonds, but bonds are only part of their portfolios. Far more important in their decisions are the balancing of money against equities and real estate. In the United States today, as in most capitalist societies, bonds are only a fraction of the typical investment fund. And how plausible is the claim that never-ending expansion of the quantity of money would have no impact on the prices of equities and real estate? At highfalutin academic seminars economists might despise the possibility that unsophisticated investors compare “the rate of interest” available from bank deposits with “the rate of interest” on common stocks, equity-dominated mutual funds, real estate investment trusts, and so on. Well, the economists shouldn’t be so stuck-up. Bluntly, the viability of Keynes’s liquidity trap idea disintegrates when portfolio choice is not merely between money and bonds, but between money and a wide range of assets including equities and real estate. (This is one of the points in essay 2 of Money in a Free Society.)

And now let us also remove the assumption in books three and four of The General Theory that the price level is fixed. This assumption enabled Keynes to say that, normally, an increase in the quantity of money would lower “the rate of interest” and so stimulate investment. With the price level given, changes in the nominal and real interest rate would be identical. But nowadays alert investors form expectations about possible changes in the price level, and particularly smart investors watch trends in the quantity of money to anticipate big movements in inflation or deflation. Isn’t it possible that, if the Federal Reserve organized an enormous jump in the quantity of money (of, say, 50 per cent), investors would flee the bond market because of inflation worries? An increase in the quantity of money would then cause a rise, not a fall, in “the rate of interest.”

The troubles of the American economy today are not due to inherent weaknesses in capitalism, but to bad economic theories and poor economic advice. The Keynesians have had far too much influence since 2008. Their invoking of the liquidity trap notion in Keynes’s General Theory has been trebly unfortunate. It has been unfortunate, first, because they have misunderstood what Keynes himself said, secondly, because what Keynes said was rather foolish, and, finally, because the liquidity trap waffle has given an intellectual rationale for the disastrous budget deficits now being incurred. (And appeals to space aliens when the deficits don’t work does not help business confidence.)

American policymakers need to recall Milton Friedman’s key policy prescription over several decades, that a key condition of macroeconomic stability is stable growth of the quantity of money. The United States must never again experience the extremely volatile boom-bust in money growth of the last six years.

[1] Similar arrangements exist in other countries. In the European single currency area the bulk of the European Central Bank’s transactions with the banks are by means of “repurchase agreements” and so the main money market rate is “the repo rate.”

Tim Congdon covers a lot of ground in his essay on Keynes, Krugman, and the liquidity trap. I will narrow my focus to the current crisis and the relevance of Keynes to the policies being pursued.

First, it is important to focus on an issue where there should really be no grounds for disagreement: the size of the stimulus and its expected impact. Contrary to what Congdon states in his piece, the stimulus was closer to $300 billion a year (@ 2 percent of GDP) in 2009 and 2010, not $800 billion a year. The total stimulus package came in at close to $800 billion. Nearly $100 billion involved a technical fix to the alternative minimum tax, which is done every year and has nothing to do with stimulus. Approximately $100 billion was slated to be spent after 2010 in longer term projects. This leaves $600 billion, or roughly $300 billion to be spent in both calendar years, 2009 and 2010.

The expected impact of the stimulus can be determined by reading what the Obama administration was saying about it at the time. The projections in the paper by Christina Romer and Jared Bernstein, which outlined the original proposal, showed that they expected it to create just 3.7 million jobs. The package that they got through Congress was smaller and less oriented toward spending than their original proposal, so the number of jobs projected would have to be adjusted downward accordingly.

Finally, there is reason to believe that we did get roughly the number of jobs projected. James Feyrer and Bruce Sacerdote found in-state job multipliers that were comparable, albeit slightly smaller, than the national multipliers assumed by Romer and Bernstein. This is very positive from the standpoint of the success of the stimulus, since national multipliers will always be higher than in-state multipliers Many of the jobs created by spending in the state of Delaware will be in New Jersey or Pennsylvania, so if anything the Feyrer and Sacerdote paper suggests that the impact of the stimulus might have been somewhat larger than had been expected.

The big failing of the Obama administration was not in their stimulus package, but rather in their projections for the economy. Their baseline assumed that unemployment would peak at around 9 percent in the absence of the stimulus. Unemployment had already crossed this level at 9.4 percent in May, just as the first stimulus dollars were going out the door, and we were still losing more than 400,000 jobs a month. The administration had badly underestimated the severity of the downturn. In effect, they had gotten a stimulus package through Congress that was designed to create 3 million jobs in an economy that needed 10–12 million jobs.

Turning to Congdon’s theoretical points, he has seriously misrepresented my friend Paul Krugman’s position. Krugman has argued that conventional monetary policy, in the form of reducing the federal funds rate, has reached its limits. That seems uncontroversial; the federal funds rate is at zero and can’t go negative. However he has repeatedly pushed for the use of unorthodox forms of monetary policy, most notably targeting higher rates of inflation.

Krugman first wrote about the idea of targeting a higher rate of inflation in 1998, in reference to the slump in Japan. He has repeated this suggestion in reference to the current situation numerous times, both in his column and blog and in academic work.

The logic is straightforward. In the current downturn we would like to see much lower real interest rates. This is true for both the short-term rate, which is already at its nominal floor, and also the longer term rates that are more important for investment decisions. The latter are largely subject to the sort of liquidity trap conditions that Keynes described and Congdon references. The nominal long-term rate is unlikely to fall further because bondholders do not want to take the risk of capital losses.

In a situation where nominal interest rates have hit a floor, the only way that the Fed can reduce the real interest rate is if can credibly commit itself to sustaining a higher inflation rate. In addition to encouraging investment by lowering real interest rates, a higher inflation rate would also have the effect of reducing the debt burden that is weighing down tens of millions of households. That should have the effect of boosting consumption since heavily indebted households are likely to have a higher propensity to consume out of wealth than those who own the debt.

So contrary to Congdon’s contention, Krugman has been a vocal advocate of monetary policy. Of course this is a different monetary policy that Congdon’s suggestion that the Fed target M3. The level of M3 is not directly a policy variable under the control of the Fed. At a time when banks hold excess reserves of more than $1.6 trillion, it might be very difficult for the Fed to easily reach any target for either M2 or M3. And, since there are well-known definitional problems with both aggregates (which caused Milton Friedman to abandon his commitment to monetary targeting toward the end of his life), I am inclined to agree with Krugman’s policy over Congdon’s.

Of course, unlike Congdon, Krugman has also argued for fiscal policy, in addition to pushing for a lower valued dollar to boost net exports. The logic is that the government should be doing everything in its power at this point to restore the economy to full employment.

Many of the workers and their families who are suffering through spells of long-term unemployment are not going to recover from this trauma. The prospects for being rehired after an extended period of unemployment are poor, and the likelihood of finding a job that pays close to the same as the prior job after an unemployment spell of one to two years is extremely low.

Families who have seen their primary breadwinner laid off will be struggling to make ends meet, especially if the period of unemployment exceeds the period of benefit duration, which is increasingly common. Many will risk losing their home or apartment. Long spells of unemployment are often associated with family breakups and create an unstable environment for children in school.

The unemployed workers are not the ones whose mismanagement led to this economic crisis. Those in positions of authority have the responsibility to protect them from a disaster that is not their fault. In this context, Krugman and other Keynesians have argued for both fiscal and monetary policy to get the economy back toward full employment as quickly as possible. It is hard to see an economically or morally justifiable alternative position.

Tim Congdon earns sustained applause for helping us to better grasp what John Maynard Keynes had in mind with his notion of a liquidity trap. Applause is warranted also for Congdon’s clear account of why Keynes’s model—in which there are only two assets, bonds and money—distorts our understanding of the economy and of monetary policy.

Congdon’s mission is to shove Keynesianism off of the policymaking stage so that it might be replaced by Milton Friedman’s monetarism. This move would improve policy. Likewise, saving monetarism as an intellectual project from the misunderstandings that permeate the pronouncements of economists such as Paul Krugman is laudable.

Keynesianism’s record of success is more a matter of dogmatic conviction than of historical experience: the 1970s’ stagflation really did happen, as did the persistence of high unemployment in current-day America despite fiscal stimulus spending on a gargantuan scale. (I know that Krugman insists that this stimulus was insufficiently gargantuan. As Tino Sanandaji notes, though, “In this vulgar form, Keynesianism is turned into a non-falsifiable theory”[1]–which is to say, this sort of Keynesianism is an exercise of faith rather than of reason.) But while monetarism, at least as a guide to public policy, has stronger scientific creds than does Keynesianism, it suffers some of the same deep flaws that mar the works of Keynes and his followers.

Keynes’s Liquidity Trap and Monetarism

In my second essay, I will discuss what I see are the flaws shared by Keynesianism and monetarism. For the remainder of this essay, will I reflect on the observational similarity between three theses, each of which attempts to explain the inadequacy of investment: Keynesianism; monetarists’ insufficient-supply-of-money thesis (which is defended in this forum by Congdon); and Robert Higgs’s thesis of regime uncertainty.

Here’s the key passage in Congdon’s interpretation of Keynes’s liquidity trap:

As an active speculator in financial markets, Keynes was well aware that errors in judgment could lead to the loss of capital… He knew that, because bond prices and yields moved inversely, somebody who bought bonds at a high price (that is, a low bond yield) might suffer a hefty capital loss if the next major price move were downwards.

Fears of a capital loss could therefore deter investors from buying bonds at even higher prices, even if official operations increased the quantity of money in their hands.

Keynes’s famous focus on the instability of investment spending combines with his assumption that the economy’s only nonmonetary assets are bonds to recommend this interpretation strongly. As Congdon points out, if prices of the only assets (bonds) other than money are already unusually high—and if the purchasing power of money is fixed (as Keynes here effectively assumed it to be)—then even the most animal-spirited investors are unlikely to buy more bonds simply because the central bank gives them more money.

Better that your portfolio’s value remains stable (as it will if weighted down, in these situations, with money) than that it tumble (as it will likely do when it is loaded down with overpriced bonds).

While simplifying assumptions are necessary building blocks of all useful theories, simplifying assumptions are not sufficient to generate useful theories. The simplifying assumptions must be chosen and used wisely. (I know: “wise” is a non-quantifiable matter of judgment, but there’s no avoiding it.) Congdon is spot-on to criticize Keynes for making the simplifying assumption that an economy’s only assets are money and bonds. That assumption is unwise. As Congdon observes, “the viability of Keynes’s liquidity trap idea disintegrates when portfolio choice is not merely between money and bonds, but between money and a wide range of assets including equities and real estate.”

So the failure of looser monetary policy to spur investments in assets other than money (or precious metals) simply cannot be explained by Keynes’s liquidity trap, because that notion doesn’t apply to the real-world economy as we know it. It follows that the theoretical possibility of Keynes’s liquidity trap, even when combined with a Federal funds rate of zero, is insufficient to support the case for more vigorous fiscal stimulus.

Congdon argues that today’s inadequacy of investment is caused by what in fact really is an inadequate supply of money. He insists that the Fed has failed to increase the money supply—specifically, M3—to levels high enough to fuel a significant increase in private investment. Money-supply growth, not fiscal stimulus, is still the key.

Maybe. Monetarism does have a coherent theory to explain this observance: if people’s demand to hold larger money balances rises but is not accommodated by a sufficient fall in the price level (to make any given nominal stock of money larger in real terms), households will increase their money balances by reducing consumer spending and, especially, firms will increase their money balances by reducing investment spending. Investment won’t rise unless and until the higher demand for money is satisfied by an increased supply of money.

Regime Uncertainty

Perhaps, however, investors are today standing on the sidelines not because of too little fiscal stimulus or because of too little money creation but because of a problem not curable by mechanistic policy manipulations—namely, regime uncertainty. This uncertainty is the economy-chilling condition described by economist Robert Higgs as “a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns.”[2] (See also, for example, Higgs’s discussion here.)

To the extent that mainstream economists pay attention to Higgs’s thesis, they typically dismiss it as being unscientific. Paul Krugman ridicules its adherents for appealing to the “confidence fairy“—an odd criticism coming from someone who champions a theory that famously explains investment demand as being heavily influenced by “animal spirits.”

In fact, regime uncertainty is a more substantive—and, hence, a scientifically more legitimate—idea than is “animal spirits.” “Regime uncertainty” highlights expectations regarding the security of property rights, future tax burdens, and other expected consequences of today’s policies and political attitudes that are understood by all but the most intransigent opponents of free markets to affect, in predictable ways, the level of private investment. “Animal spirits,” in contrast, highlights inexplicable swings in investors’s confidence.

Consider, in this light, a lament, from a business executive named “Mr. Young,” given to New Dealer Raymond Moley immediately following a 1939 hearing of the U.S. Temporary National Economic Committee:

Therefore, the extent to which adventurous men and adventurous dollars are discouraged or paralyzed, you will have idle dollars awaiting investment and idle men awaiting employment. Indeed, you will have more, you will have stagnation of spirit, you will have so-called realism, which for the most part, as now used, is another name for destructive cynicism, in place of productive imagination and daring action. If the success of men and dollars in productive enterprise is to be scorned, rather than honored, if it is to be penalized by taxation, other than for revenue purposes, or be blackened by suspicion, there will be no adventure and no spirit of adventure, and, consequently, restricted opportunity for savings.[3]

In the same setting, General Motor’s CEO Alfred Sloan told Moley that

Before that necessity or opportunity [for U.S. businesses to put private savings to productive use] can be capitalized, we must have a different attitude of mind with respect to private enterprise as it is affected by political and economic policies. The chief influence is the lack of confidence in the long-pull position of industry and business, in general, from the standpoint of the security of the investment and the opportunity to earn and retain a reasonable reward commensurate with the risk and success of the enterprise.[4]

Even Keynes seems to have worried about regime uncertainty. In his December 1933 “Open Letter to President Roosevelt,” Keynes gently reprimanded FDR for creating programs such as the National Industrial Recovery Act: “even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place.”

These are all complaints about Higgsian regime uncertainty.

It’s worth emphasizing that nothing about regime uncertainty—as understandably warned of here by Young, Sloan, and Keynes—will be mitigated by more government spending or by looser monetary policy.

My purpose here isn’t to “prove” that the inadequacy of investment during the Great Depression was—or today is—caused by regime uncertainty. Rather, my goal is the more modest one of pleading with scholars who set themselves the task of diagnosing the lingering stagnation of private investment spending to accord to regime uncertainty at least as much attention as they accord to Keynesian or monetarist diagnoses. Such attention to regime uncertainty seems to be warranted by both facts and theory.

Notes

[1] Tino Sanandaji, “Why Keynesianism Works Better in Theory Than in Practice,” The American, December 1, 2011.

[2] Robert Higgs,
>Depression, War, and Cold War (New York: Oxford University Press, 2006), p. 5.

[3] Quoted in Raymond Moley, “Business in the Woodshed,” Saturday Evening Post, 6 April 1940; reprinted in George Terborgh, The Bogey of Economic Maturity (Chicago: Machinery and Allied Products Institute, 1945), p. 28.

[4] ibid.

Tim Congdon takes up the 1960s/1970s monetarist/Keynesian debate over the efficacy of monetary policy in recession.[1] In recession, does the combination of low interest rates and high unemployment rates signal the impotence of monetary policy? If so, does the case for the potency of fiscal policy follow? As with all “journalistic” economics in which commentators impute causation from correlation in a “commonsense” way, the Keynesian affirmative responses to these questions could be correct, but their validity requires careful analysis within the framework of economics. Without a framework that allows one to address the issue of simultaneity between the two variables (the interest rate and the unemployment rate) and the nature of the original shock, the Keynesian responses lack substance.

In their discussion of the Great Depression, Friedman and Schwartz (1963, 300) noted the common belief that in the Depression monetary policy was impotent, as captured by the common expression about the inability to push on a string. They countered: “The contraction [Depression] is in fact a tragic testimonial to the importance of monetary forces.” Hetzel (2012) makes the case that the 2008–2009 recession offers another example in the spirit of the Friedman/Schwartz criticism.

To start, it is important to clear away the confusion surrounding the popular use of the term “liquidity trap” as a catchall phrase expressing the impotence of monetary policy. A liquidity trap is different from the zero-lower-bound problem, which expresses the fact that in a world of fiat money the nominal interest rate cannot fall below zero. The real interest rate (the nominal interest rate minus expected inflation) is the price that borrowers pay for transferring consumption from the future to the present. Alternatively, it is the price that lenders receive for deferring consumption from the present to the future. If individuals are sufficiently pessimistic about the future, the real interest rate could be negative. By itself, however, that fact is uninformative for policy without knowledge of the shock (monetary or real) that caused the pessimism.

The zero-lower-bound problem is different from a liquidity trap. The idea of a liquidity trap is that individuals will exchange assets with the central bank for money to an unlimited amount with no incentive to run down their increased money holdings through additional spending. As a result, the central bank loses its ability to influence the dollar expenditure of the public. Tim makes the monetarist argument that as long as the central bank buys illiquid assets, the public is left with a more liquid asset portfolio after the exchange. If the public was holding a balanced portfolio before, then it will try to run down its higher money holdings through bidding for other illiquid assets and, in the process, bid up their prices. Higher prices for illiquid assets like real estate and equities will make investment more attractive.

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.

The FOMC Minutes released after each meeting package the current policy action as optimal taken in the context of the contemporaneous state of the economy. As a matter of political economy, the FOMC can then attribute adverse outcomes to powerful real shocks originating in the private sector. In the event of inflation, as in the 1970s, it can blame the greed of powerful corporations. In the event of recession, as in the Great Depression and now with the Great Recession, it can blame the greed of bankers who made excessively risky, speculative bets. From this political-economy perspective, a “policy,” which requires a numerical objective, say, steady nominal expenditure, and an articulated strategy, say, a feedback rule running from a path for nominal expenditure to money creation, suffers two defects.

First, the explicitness of an objective communicates to the political system that the FOMC can take care of a problem that the FOMC considers to have been not of its making. A problem arising as a real shock should possess a solution coming from the political system, for example, through expansionary fiscal policy. Second, an explicit objective, by its nature, highlights misses. As a matter of accountability, however, that is the point. The FOMC must then explain rather than rationalize the miss by defending the miss as a real shock originating in the private sector rather than as arising from faulty policy based on a misunderstanding of the economy.

An alternative way of expressing Tim’s criticism of monetary policy in the Great Recession is to note the failure of central banks to maintain a steady rate of growth of nominal expenditure. In fact, central banks allowed nominal expenditure to decline in lock step with real expenditure. That behavior may have been appropriate. The appropriateness of the behavior depends upon the nature of the shock that pushed the economy into recession and that pushed the short-term interest rate to zero taken along with the nature of the failure of the price system that prevented it from offsetting the shock.

Central bank independence and accountability are indissolubly linked. The point made here, a point consistent with Tim’s criticism, is that accountability requires that the central bank move beyond the language of discretion, which historically has been the language of ex post rationalization, to the language of economics, which requires an explicit analytical framework linking numerical objectives to a strategy by the central bank for achieving those objectives. Within that framework and along with the debate that framework would permit with the economic profession, the central bank would have to evaluate its past behavior by comparing alternative possible shocks as the source of economic instability. Those shocks would include monetary shocks.

Note

[1] The ideas expressed here are those of the author, not the Federal Reserve Bank of Richmond or the Federal Reserve System.

References

Hetzel, Robert L. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

Friedman, Milton & Anna Jacobson Schwartz. A Monetary History of the United States 1867-1960. Princeton: Princeton University Press, 1963.

First of all, I must thank the Cato Institute for hosting this blog discussion on the liquidity trap and its role (if any) in current policy-making, issues which are considered at more length in my new book Money in a Free Society. Secondly, I am also very grateful for the interesting and thought-provoking comments from Dean Baker, Donald Boudreaux and Robert Hetzel, and will cover them each in turn.

But, before that, may I note one point of apparent agreement? We all seem to believe that, when the short-term money market rate (set by the central bank) is zero and monetary policy in that sense is exhausted, the state can still conduct a range of expansionary operations that will boost economic activity. My interpretation is that we also believe that such expansionary operations do not require a widening of the cyclically adjusted budget deficit.

I think Dean and, to a lesser extent, Donald would nevertheless like to involve “fiscal policy” as well. Well, I wouldn’t. In fact, I would like the phrase “fiscal policy” banished from the lexicon of macroeconomics. We do, however, share the view that unemployment is a tragedy, both for the individuals concerned and for society at large, but I would like to avoid rhetoric.

1. Dean Baker

Dean has tripped me up about the meaning of the Obama $800 billion fiscal package. I was wrong to say that the package by itself added $800 billion at an annual rate, and I apologize. Was I talking through my hat? I had in fact taken the trouble to check the data, to be precise, to check the International Monetary Fund’s website with its estimates of the change in the “structural” (i.e., cyclically adjusted) budget position, normally taken to a good summary measure of “fiscal policy.” (On the website the estimates are said to be part of the September 2010 World Economic Outlook database.) The numbers for the period in question are as follows:

We can see that between 2007 and 2010 the U.S. structural budget deficit increased by over $770 billion, with the bulk of the increase occurring in 2008 (before Obama) and 2009 (in Obama’s first year). If Obama and his advisers had made it a priority to bring U.S. public finances under control, they would have avoided any further enlargement of the structural budget deficit in 2009. But in fact they went ahead with a so-called “expansionary” package. In that sense they did endorse a fiscal boost that amounted to almost $800 billion, at an annual rate, relative to the last recession-free year of 2007.

Dean claims that the package did create jobs, citing work on multipliers by Feyrer and Sacerdote. Like Milton Friedman, I reject this sort of analysis. As Friedman said in a 1996 interview (as I quote on p. 192 of Money in a Free Society), “I believe it to be true…that the Keynesian view that a government deficit is stimulating is simply wrong. A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.”

This may be a little sweeping. I wouldn’t deny that an increase in the budget deficit financed by new money creation increases equilibrium national income. (And in fact I am pretty sure Friedman would not have denied this either, when he was being careful.) But that means the value of the fiscal multiplier must depend on the pattern of financing. The multiplier may be positive if the deficit financing is entirely monetary, but a smaller multiplier (perhaps even a multiplier under one) is to be expected when the extra deficit is financed at the long end of the bond market (i.e., exclusively from non-banks). The emphasis should not be on the balance between Federal and state expenditure, but on the balance between monetary and non-monetary financing.

Dean says that the Obama administration’s mistake lay not in their fiscal policy, but in their underestimation of the severity of the recession. That then raises the question of why the recession was so deep. In my opening contribution I concentrated on the money numbers. In particular, I highlighted the contrast between the rapid money growth in the three years to October 2008 and the stagnation of money in the following three years. I submit that the source of the Obama administration’s miscalculation lay in its advisers’ lack of interest in monetary data, their prejudice against monetary activism, and their contempt for monetary economics and monetary economists. Having been on the receiving end of this contempt for most of my career, I say this with some feeling.

Incidentally, I am dismayed that Dean seems to think that the underestimation of the recession’s severity justified a stimulus package calibrated to the creation of 10 – 12 million jobs instead of the 3 million jobs that Obama’s planners had in mind. No, this is what the debate is all about. I deny without reservation the effectiveness of fiscal policy. As I say in the four essays in part three of Money in a Free Society, unless budget deficits are monetized, fiscal policy just doesn’t work.

The Great Recession—like the Great Depression—was the result of adverse monetary trends. The Great Depression was caused by a crash of one third in the quantity of money; the Great Recession was caused by a sudden halt in money growth in late 2008. That sudden halt was due to central banks’ and regulators’ misplaced zeal as they hurried to make the bankers much safer (i.e., with fewer risk assets, leading to a fall in bank deposits) and better-capitalized (i.e., so that banks’ deposit liabilities were replaced with non-money liabilities in the form of bonds and equities).

Dean says I have got Krugman wrong. I would welcome Professor Krugman’s intervention in this exchange, so that he can try to refute me and to sort out the matter more definitely. But let me be blunt. Krugman’s invocation of a change in the inflation rate, as a policy shift of some sort, is a red herring. The inflation rate is not a policy instrument. If it were a policy instrument, such that central banks could determine it by proclamation or even mere assertion, we could chuck out hundreds of textbooks and monographs and go home. Moreover, most economic agents in real-world business and financial markets know that the central bank is not staffed by magicians. Since they know that, a pronouncement from on high that “inflation over the next six months will be x” or “the change in the price level in 2014 will be y” does not change inflation expectations by itself.

My position on monetary control is much the same as that of Keynes and Friedman, and—if I may say so—all of the classic authors in this field. Dean says that M3 (i.e., the quantity of money) is not “directly a policy variable under the control of the Fed.” Check The General Theory, Dean. (And perhaps Krugman should do the same.) Keynes said—consistently and repeatedly—that “the authorities” could control the quantity of money in order, as he saw it, to influence “the rate of interest.” On February 21, 1936, just as The General Theory was being prepared for printing, someone wrote a letter to the Times of London observing, “…no question is more important than the principles on which the Bank of England and the Treasury should fix the quantity of bank money. It has not been discussed lately as much as it deserves to be.” Who was the author of that letter? None other than John Maynard Keynes. At any rate, the quantity of money comes much closer to being a variable susceptible to policy actions (and hence “a policy instrument”) than the rate of inflation or deflation.

Having said that, I agree that understanding The General Theory is not easy. In essay 4 in Money in a Free Society I try to remove some of the “slurring” of definitions that Keynes admitted he had done in his book. That led me to distinguish between different kinds of liquidity trap and different formulae for open market operations. I appreciate Dean’s remarks on my essay, but he seems to have missed the significance of those distinctions altogether.

2. Donald Boudreaux

I don’t have much to say about Donald’s comments on money and the liquidity trap, as we are singing from the same hymn sheet. But Donald really does take the discussion forward with his reference to Higgs and the relationship between regime uncertainty and property rights. This is hugely important, particularly for banking systems. Banks have been unpopular in the United States ever since the early republic, with Jefferson the first and most distinguished in a long line of bank-bashers. The current regulatory assault on the banks has hit their profitability, so that on the stock market they are now typically trading at under book value. But the Federal government and the Federal Reserve want banks to be more highly capitalized, which has meant that some banks have been under pressure to raise extra capital in the market. Unfortunately, shareholders don’t like buying more stock in a business if they will immediately suffer a loss on the investment. (And they will suffer such a loss in bank stocks today. That is the implication of market capitalizations being less than book value.)

There is a great deal to say here. If regulatory officialdom wants banks in the United States (or indeed in any country) to be both strongly capitalized and privately owned, it must be careful not to overload the banks with regulations and to wipe out banks’ profits. Investors buy shares either for income or because over time the market capitalization comes to exceed the sum invested. If regulators overcook the regulation, so that market capitalizations are routinely less than the sums invested in banks, banks will not be able to raise new capital.

3. Robert Hetzel

Again, in some senses Robert and I are singing from the same hymn sheet, and I don’t have much to add. We agree 100% that the zero bound problem and the liquidity trap are separate phenomena. But there is one point worth highlighting. Robert talks of the central bank’s ability to create both money and monetary base (“…the central bank can conduct monetary policy as a strategy” etc.), and emphasizes the central bank’s responsibility for monetary policy and macroeconomic outcomes. I agree, but with a reservation. The point is that the government also can create money by borrowing from banks and using the loan proceeds to buy any asset from private sector non-banks. In fact, in the original version of the paper that has become essay 4 in Money in a Free Society I said that very expansionary open market operations (which involve the state buying assets from non-banks and what I call “debt market operations”) could only be carried out by the government.

That original version was sent by a friend to Milton Friedman for comment. Friedman came back with the devastating criticism that the central bank, too, could buy assets from non-banks and create money, and so my distinction between different types of open market operation was overstated. Robert—who I believe was taught by Friedman—is in much the same intellectual position, perhaps not surprisingly!

They both are right. The central bank can buy assets from non-banks and create money directly. Indeed, the operations that have become known as “quantitative easing” in the current cycle have been conducted by central banks, not governments. Nevertheless, I believe that government creation of money has the advantage that it would avoid the controversial ballooning of central bank balance sheets that we have seen in the last three years. (The subject is discussed on pages 76–81 of Money in a Free Society.) Again, this is a huge topic, of great contemporary importance to public policy in the United States and other leading economies.

Once again, may I thank everyone for their comments and criticisms?

After Tim Congdon’s response to my earlier piece, I am a bit confused what we are debating. First, to finish up the simplest point, Congdon’s original post expressed unhappiness about President Obama’s $800 billion a year fiscal stimulus. I pointed out that it was actually closer to $300 billion a year. Now Congdon has come back with data from the International Monetary Fund showing the structural deficit was almost $800 billion higher in 2011 than in 2007.

That’s fine, except that most of the increase in the structural deficit (measured as a share of GDP) came in 2008, under President Bush’s watch. Fiscal 2009 began in October of 2008, which means that one-third of the fiscal year was over before President Obama entered the White House. I don’t work for President Obama, and furthermore I am not troubled by someone raising the deficit in response to an economic collapse, but I just don’t understand the logic of his assertion: “In that sense they [the Obama administration] did endorse a fiscal boost that amounted to almost $800 billion, at an annual rate, relative to the last recession-free year of 2007.” Most of this boost was the result of President Bush’s policies.

I referred in my original note to research that indicated the stimulus was as effective as, or even somewhat more effective than, had been predicted. Congdon responds by saying:

Like Milton Friedman, I reject this sort of analysis. As Friedman said in a 1996 … “I believe it to be true…that the Keynesian view that a government deficit is stimulating is simply wrong. A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, on spending.”

Here Congdon seems to telling us as an article of faith that a stimulus can’t be effective, and thus he rejects the evidence that finds substantial job creation.

But the next paragraph gives us a somewhat more measured, “I wouldn’t deny that an increase in the budget deficit financed by new money creation increases equilibrium national income.” Okay, so now we do have a fiscal stimulus adding jobs, when done in conjunction with monetary policy. Of course I don’t know any Keynesians who were not advocating aggressive monetary policy in conjunction with the fiscal stimulus, so I fail to see the point of the objection that Congdon apparently considers so important. When we have people who are suffering from involuntary unemployment, the government should use every tool at its disposal to get them back to work.

I would argue that in the conditions we had in 2009–10 a fiscal stimulus even without further monetary expansion by the Fed would have been expansionary, but obviously it would be more expansionary with the additional boost from the Fed. Of course we do run into a problem here in what we consider expansion by the Fed.

By increasing loan demand, the stimulus would have reduced the $1.6 trillion in excess reserves held by the banking system leading to an increase in M1, M2, M3 and any other monetary aggregates that we might care to invent. I suppose we could call this expansionary monetary policy, but in reality this is the endogenous response of the money supply to growth in the economy.

This gets back to the point that Congdon asserts:

The Great Recession–like the Great Depression–was the result of adverse monetary trends… the Great Recession was caused by a sudden halt in money growth in late 2008. That sudden halt was due to central banks’ and regulators’ misplaced zeal as they hurried to make the bankers much safer .

My recollection was that the halt in money growth was due to banks collapsing because they were insolvent. I suppose that we could have suspended banking regulations completely and regulators could have shown even more forbearance than they did, but the proximate cause of the “halt in money growth” was the fallout from the collapse of the housing bubble, not the evildoing of the Fed. (My story of the Fed’s evildoing was that it did not take steps to burst the bubble in the years 2002–06, before it became so dangerous, but that is another story.)

Finally we are having a strange debate about what is an outcome variable and what is directly under the control of the Fed. Congdon argues that M3 is directly under the control of the Fed but dismisses the idea that an inflation target can be. In fact, the relationship of the two is similar. The Fed controls the monetary base, and how this translates into M2 or M3 depends on the willingness of the banking system to make loans. Of course the Fed can counteract an unwillingness to make loans by enlarging the monetary base to the point where it will eventually hit its target.

Similarly, the Fed can keep throwing money into the system until it hits an inflation target. The idea of inflation targeting should not sound that strange; most central banks in the world now formally do it. The only issue is whether it makes sense to deliberately set a higher inflation target to lower real interest rates and alleviate debt burdens. If there is a serious downside to this policy, I haven’t heard it.

I agree with Tim Congdon that Robert Higgs’s work on regime uncertainty is quite useful to the larger exploration of why unemployment sometimes remains stubbornly high for long periods of time. It’s true that Higgs pays little attention to fiscal and monetary policies and to aggregate demand. That’s not to say that the phenomena that do command his attention are not justifiably classified as “macroeconomic.” But those phenomena also happen to be ones that neither monetary nor fiscal policies in the usual sense are capable of curing.

F.A. Hayek correctly warned that “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.”[1] This warning applies also to monetarists’ focus on the role of the aggregate spending M*V (money supply times velocity of spending) in driving recovery.

Before getting to the heart of my argument that Higgs’s regime uncertainty thesis supplies at least as plausible an explanation for the length of the current recession as do theories that appeal to the (alleged) inadequacy of aggregate demand, I wish to prevent a possible misunderstanding. I don’t at all intend to deny that a sudden reduction in M*V—whether it be caused by falling M, falling V, or a combination of both—can result in a serious and troublesome decline in real economic activity. Nor do I deny that, should such a decline materialize, the monetary authorities should take whatever steps are necessary to combat it. Like many economists, and unlike Joseph Stiglitz,[2] I find Milton Friedman’s and Anna Schwartz’s account of the depressing consequences of the 1930–33 “great contraction” of the U.S. money supply to be quite compelling.[3]

But to recognize that a recession can be triggered or worsened by a collapse in spending, and to understand also that the problems destined to be unleashed by such a fall are better avoided by increasing the nominal stock of money rather than by waiting for the price level to fall, does not commit one to look exclusively, or even chiefly, to inadequate spending as the cause of any prolonged bout of sluggish economic activity and high unemployment. (Indeed, compelling as Friedman’s and Schwartz’s thesis is in accounting for the bottoming out of U.S. economic activity in 1933, it hardly suffices—as Friedman and Schwartz themselves fully recognized—to account for the prolonged period of unemployment that followed.)

Back to Regime Uncertainty

Without denying that a prolonged slump in economic activity could be caused by deficient aggregate demand, Higgs looks beyond this conventional macroeconomic variable for other possible explanations. Why else might investors hesitate to invest, and entrepreneurs hesitate to plan to produce more output, especially when the economy has an unusual number of idle resources available to be put to productive use?—this is one way to frame the question Higgs asks. Just because macroeconomic textbooks and journal articles focus overwhelmingly on changes in aggregate demand as the chief cause of changes in the vigor of economic activity is no reason for a scholar not to search for some other cause, especially if another identifiable cause is solidly grounded in economic theory.

Higgs argues that he has found some such other cause: regime uncertainty. A good deal of investment and entrepreneurship that would have occurred under a different policy regime will not occur under a regime perceived to be hostile to wealth accumulation, hostile to profits higher than some politically trumpeted norm, hostile to creative destruction, and hostile to many of the other elemental features of dynamic market capitalism. As Higgs himself describes it, “regime uncertainty … has to do with widespread inability to form confident expectations about future private property rights in all of their dimensions.”[4]

Who can doubt that (1) government is capable of creating such fears regarding the security of “private property rights in all of their dimensions”; (2) if such fears are sufficiently widespread, private investment and entrepreneurial activity will slow significantly regardless of consumers’ current and future propensity to spend; and (3) among the symptoms of such curtailed investment and entrepreneurial activity will be deficient aggregate demand and high and lasting unemployment?

Unless one is ready to jettison most of microeconomics—or be prepared to insist that microeconomic factors such as a falling expected rate of return on each of many long-term business plans are simply inadmissible in discussions of conventional macroeconomic troubles if these falling expected rates of return are caused by something other than falling aggregate demand—regime uncertainty must be reckoned with as possibly supplying an explanation for prolonged slumps.

Some Evidence

So what’s the evidence?

Among Higgs’s evidence that regime uncertainty played a prominent role in prolonging the Great Depression is the yield curve on bonds. Here’s Higgs:

My most striking financial evidence for the New Deal episode pertains to the yield curve for corporate bonds, that is, to the spreads between the effective yields on high-grade corporate bonds with various terms to maturity. I found that this yield curve became suddenly much steeper sometime between the first quarter of 1934 and the first quarter of 1935 (a period when the New Deal lurched from its first, or business tolerant, phase to its second, or business hostile, phase) and remained very steep until sometime between the first quarter of 1941 and the first quarter of 1942 (a period when the New Deal handed over the reins to the military and the big businessmen who, along with the president himself, ran the war-command economy for the duration). I interpreted these extreme spreads as risk premiums on longer-term investments caused by regime uncertainty.[5]

Higgs finds a similar yield pattern for the current recession:

Thus, corporate bond yields have exhibited three distinct periods: pre-crisis stability with a shallow yield curve; extreme volatility of the yield curve, including some inversions in the latter part of 2008; and post-crisis stability with a much steeper yield curve since mid-2009.

Thus, just as the steep yield curve for the New Deal years corresponds precisely with the so-called Second New Deal, when Roosevelt and his leading subordinates and advisers went on the warpath against investors as a class, the recent transition corresponds to the volatility associated with the period of frenetic government action and financial market fluctuations between September 2008 and the middle of 2009, leaving in its wake a much steeper yield curve.[6]

Higgs isn’t alone in finding evidence in support of the regime uncertainty hypothesis. Consider the following from Stanford University’s Scott Baker and Nicholas Bloom, writing with the University of Chicago’s Steven J. Davis:

[T]he data refute the view that economic uncertainty necessarily breeds policy uncertainty. In the last decade, however, policy became a larger source of movements in overall economic uncertainty and an increasingly important concern for businesses and households. … [T]he persistence of policy uncertainty … reflects deliberate policy decisions, harmful rhetorical attacks on business and “millionaires,” failure to tackle entitlement reforms and fiscal imbalances, and political brinkmanship…

When businesses are uncertain about taxes, health-care costs and regulatory initiatives, they adopt a cautious stance. Because it is costly to make a hiring or investment mistake, many companies will wait for calmer times to expand. If too many businesses wait, the recovery never takes off. Weak investments in capital goods, product development and worker training also undermine longer-run growth.

So how much near-term improvement could we gain from a stable, certainty-enhancing policy regime? We estimate that restoring 2006 levels of policy uncertainty would yield an additional 2.5 million jobs over 18 months. Not a full solution to the jobs shortfall, but a big step in the right direction.[7]

As Higgs himself admits, none of this proves that regime uncertainty plays any role in prolonging the current recession. But I submit that the economic logic of the regime uncertainty thesis combines with available evidence to render regime uncertainty at least as plausible an explanation for our continuing economic sluggishness as any explanation offered by Keynesianism or monetarism.

Notes

[1] F.A. Hayek, “Reflections on the Pure Theory of Money of Mr. J. M. Keynes,” Economica 1931.

[2] Joseph E. Stiglitz, “A Book of Jobs,” Vanity Fair, January 2012.

[3]Milton Friedman and Anna J. Schwartz, A Monetary History of the United States: 1867-1960 (Princeton: Princeton University Press, 1963).

[4] http://blog.independent.org/2011/09/05/regime-uncertainty-pirrong-debunks-the-keynesian-debunking/

[5] “Regime Uncertainty: Are Interest-Rate Movements Consistent with the Hypothesis?” blog post, August 24, 2010.

[6] ibid.

[7] Baker, Bloom, & Davis, “Policy Uncertainty is Choking Recovery,” Bloomberg, Oct. 5, 2011.

Don raises several interesting issues about the role of regime uncertainty, however one important piece of evidence against it being a major issue in the current downturn is that investment is not depressed. Non-residential investment is back to its pre-recession level of GDP.

What is down is residential investment and consumption. The former is more likely due to the massive overbuilding of the housing bubble years and the resulting record vacancy rates. The fall in consumption is most obviously explained by the wealth effect associated with the loss of $8 trillion in housing bubble wealth. If we are trying to explain a falloff in investment by regime uncertainty then we are trying to explain an event that did not happen.

I’m mystified by Dean Baker’s claim, in his latest entry, that “Non-residential investment is back to its pre-recession level of GDP.”

According to figures available here (through 2010, the latest figures that I can find), inflation-adjusted net non-residential investment in 2010 was down 68 percent from its 2006 level, and down 72 percent from its 2007 level.

I’m mystified also by Dean’s claim that consumption spending is still down. Adjusting for inflation, and using the data available here, real personal consumption expenditures in the third quarter of 2011 (the latest period for which such data are available) were slightly higher than they were during the third quarter of 2007 (the final full quarter before the start of the recession).

Don, I was referring to shares of GDP. In the case of consumption, the savings rate was almost zero in the years from 2004 to 2007. (There are some issues with the data related to the statistical discrepancy. We find evidence that capital gains income was erroneously counted as ordinary income, leading to an overstatement of the savings rate during these years). It had been over 5.0 percent for in 2009 and 2010, although it slipped down to 3.8 percent in the most recent quarter. The gap between a saving rate of 5.0 percent and a saving rate of zero corresponds to $500 billion in lower annual demand.

I did refer to gross non-residential investment. It is more common to use gross rather than net figures both because gross is what determines demand and net is not very well measured. I should have also specified investment in equipment and software. There was huge overbuilding in most categories of non-residential construction in the pre-recession period as there was a bubble in non-residential construction that followed on the heels of the bubble in residential real estate. This measure on investment stood at 7.5 percent of GDP in the most recent quarter. It averaged 7.9 percent of GDP in 2007. The gap corresponds to a shortfall in demand of roughly $60 billion a year.

If we want to take a net measure, net investment in equipment and software was 1.5 percent of GDP in 2007. It was 0.5 percent in 2010, the last period for which we have data. This would imply a gap of 1.0 percentage point of GDP, or roughly $150 billion a year. However, given the growth in gross investment in the last four quarters, it is likely that close to half of this gap would be eliminated by the third quarter, leaving a gap in net investment in equipment and software of around 0.5 percent of GDP, roughly the same as the gap in gross investment.

In short, I don’t see that we have any real shortfall of investment to explain. If anything, given the unusually low rates of capacity utilization, investment in equipment in software is surprisingly high. The downturn is caused by the lack of consumption demand associated with the loss of $8 trillion of housing wealth and the loss of construction demand (both residential and non-residential), which is attributable to the overbuilding of the bubble years.

John Tamny is the editor of Forbes Opinions and RealClearMarkets.com, a Senior Development Associate for the Cato Institute, and a senior economic advisor to both H.C. Wainwright Economics and Toreador Research & Trading. He sends us the following letter, which we are pleased to publish in response to our December, 2011 issue.

“The sole use of money is to circulate consumable goods” – Adam Smith, The Wealth of Nations

The debate about monetary policy has taken an improper turn in recent decades, prompted by a very unfortunate misunderstanding about what money is. To some, the creation of money itself is a driver of economic growth, by putting paper in people’s pockets. To others, money only works if philosopher kings from the Commanding Heights are allowed to attempt to control its quantity. To still others, the central bank that oversees money’s issuance should ignore its value, instead seeking to manage the cost of accessing it.

Each philosophy misses the point. Money is not a commodity. It is a concept that facilitates the exchange of goods, all the while serving as a measuring rod that enables economic actors to place value on investments.

Money decidedly is not wealth. In truth, money is a method that enables the trading of actual wealth. Reducing to the basics what is already very basic, my employers pay me to write, to edit, to aggregate the work of other writers, and to raise funds. My earnings then allow me to enter into contracts with landlords who put a roof over my head, carmakers who provide me with transportation, and clothiers whose skills with the needle make me appear presentable. I trade the products of my labor for the products of the labor of others.

But when money’s value is unstable, the above description of wealth-enhancing trade loses its basic harmony. That’s because while I may agree with my landlord to pay $3,000/month in rent, that same landlord will not get $3,000 in value if the measure of wealth—the dollar itself—regularly changes. Simply put, if the dollar declines in value given an absurd belief that the “tickets” used to facilitate exchange should float, the contract agreed to between the landlord and me is broken. The landlord will get 3,000 “dollars,” but they will be greatly reduced in value.

Conversely, if the value of the dollar rises, those 3,000 dollars I hand to the landlord will be worth more than what we agreed to, which means I lose out in the exchange. It should be no wonder that trade among the world’s producers became much less harmonious with the emergence of floating currencies in the aftermath of President Nixon’s decision to sever the dollar’s link to gold. Whereas trade was once the wondrous exchange of wealth between two individuals, in modern times it has become warlike to some degree, since floating money values ensure winners and losers where there used to be only winners.

Looking at investment, the same applies. To state the obvious, there are no companies and there are no jobs without savings and investment first. As Joseph Schumpeter so correctly noted, there are no entrepreneurs without capital, hence entrepreneurs are wholly reliant on the willingness of individuals to forgo consumption in order to put wealth earned to work with an eye on creating something new.

To simplify a bit, investors are buying future income streams; in our case they are measured in dollars. But when money is allowed to float in value, those presumed future returns take on a perilous quality. Assuming my willingness to forgo consumption leads to actual investment returns, if the dollar is in decline I will get returns greatly reduced in real value. That’s why inflation—meaning a decline in the value of the unit of account—regularly coincides with subpar economic growth. Inflation, which is once again currency devaluation, is a process whereby currency issuers make the act of investment a very risky proposition. Again, investment is about the purchase of future income streams, and inflation devalues those streams.

In that sense, money must be stable in value. That is so because absent stability, the investment and trade that produces all economic advancement becomes less frequent. Economic thinkers of the classical era seemed to agree.

As John Maynard Keynes wrote in his Tract On Monetary Reform, the “Capitalism of to-day presumes a stable measuring rod of value, and cannot be efficient – perhaps cannot survive – without one.” Or, to quote David Ricardo, “A currency, to be perfect, should be absolutely invariable in value.”

And while there’s no way to ensure complete stability in monetary values, money defined in terms of gold is the best way to achieve a reasonable facsimile. Gold hasn’t been used as a measure of exchange for thousands of years by accident; rather gold was used because it’s the most stable commodity known to mankind.

As John Stuart Mill put it in his Principles of Political Economy, “In order that the value of the currency may be secure from being altered by design, and may be as little as possible liable to fluctuation from accident, the articles least liable of all known commodities to vary in their value, the precious metals, have been made in all civilized countries the standard of value for the circulating medium; and no paper currency ought to exist of which the value cannot be made to conform to theirs.”

Mill went on to note that gold and silver are the commodities “so little exposed to causes of variation” thanks to the total quantity in existence “so great in proportion to the annual supply.” In short, gold’s real value doesn’t change very much, thus making it a great money measure.

Sadly, in modern times we have digressed on the monetary front. Our present Fed Chairman, Ben Bernanke, presumes that the mere creation of money stimulates economic growth. This turns monetary history on its head. Not wealth itself, money is a facilitator. So to simply create it when there’s no demand for it is to devalue it, and in the process retard the investment and trade that stable money values foster.

Monetarists, though they claim to be for free markets, presume that wise minds know what the proper quantity of money is. Ignored by them is that no central bank and no bureaucrat could ever control the quantity of dollars (presently two thirds of all dollars are overseas), plus implicit in their thinking is that bright minds could possibly know what the proper quantity should be. This is the equivalent of McDonald’s promising to limit the creation of Big Macs to a set number per year. The latter would be easy for planning purposes, but assuming demand for Big Macs rises or falls, McDonald’s would either have a great deal of unsold inventory (devaluation) on its hands, or a severe shortfall relative to what consumers desire. Instead, McDonald’s adjusts quantity to consumer demand.

Those who believe in interest rate targeting presume that those same wise minds know what the proper price of credit should be. Lots of luck there, and as confirmed by the folly of price controls anywhere else, the end result is too little or too much credit. Better it would be to let markets set the price of credit so that the demands of both creditors and debtors are met by those same market forces through an interest rate achieved in the marketplace.

All of which brings us back to gold-defined money. No human could ever have a clue as to the proper supply of money. Gold serves this function and is the only market based money because it’s through the market price of gold that the currency issuer knows what economic actors desire.

Assuming a dollar defined as 1/1000th of an ounce of gold, if the price of the yellow metal falls in dollars, that’s a market signal that demand for dollars has risen and that the issuer must buy interest-bearing assets in order to increase the dollar supply. Assuming the reverse—if the price of gold rises—that’s a market signal telling the issuer that dollars are too plentiful, and that the issuer must sell interest-bearing assets in order to reduce the supply. In short, it’s through the gold price set in markets that the proper supply of dollars is arrived at.

After that, the dollar price stability achieved under such a scenario ensures the greatest amount of trade and investment possible. Investors will know that delayed consumption will be rewarded with dollars returned that have held their value. As for those seeking near-term consumption and trade, they’ll know that the dollars they receive for the goods offered will not be lower in value after the transaction occurs.

Since 1971 the United States and the rest of the world (no matter what people say, we remain on a dollar standard of sorts) have suffered the constant uncertainty wrought by gyrating currency values that has predictably led to frequent financial crises driven by the malinvestment that always results when money has no definition, as predicted by the Austrian School. To fix this we must return to stable monetary values, and while gold is not perfect as the definer of money, it’s the best we have.