There Is No Lassez Faire in Fiat Money

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Scott Sumner

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December 14, 2010 4:00 A.M.

Monetary policy has always been the Achillesâ?? heel of conservative economics. Weâ??ve repeatedly seen conservative policymakers work hard to create a successful free-market economy, only to have their efforts undone by a devastating period of deflation. In the 1920s, the U.S. economy did well with all levels of government spending only about 10 percent of GDP. All those efficiencies were lost in the subsequent decade. Nominal GDP fell by half between 1929 and 1933, opening the door to big-government statism. Similarly, the neoliberal reforms in Argentina during the 1990s were discredited by the deflation of 1999â??2001. In each case, markets got blamed for what was actually the fault of a dysfunctional monetary regime.

Unfortunately, many conservative economists are too dismissive of the costs of deflation. They claim that wages and prices can adjust to any increase in the value of money. But if this were so, there is no reason to believe that wages couldnâ??t adjust to any decrease as well â?? and high inflation would also be of no concern. In fact, deflation tends to be far more costly than the sorts of mild inflation that we tend to see in the U.S.

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Once the devastating costs of deflation are acknowledged, one can no longer imagine an earlier age when the dollar was â??as good as gold.â? A gold standard stabilizes the price of one good, gold itself, at the cost of allowing instability in the overall price level. Long-term inflation was near zero under the 19th-century gold standard, but like the man who drowned in a lake with an average depth of three feet, long-term price-level stability can mask a great deal of short-term instability. Prices were at about the same level in 1913 and 1933, for example.

Nor can we avoid the pitfalls of previous gold-standard regimes by getting government out of the picture. If governments did not hold gold reserves for monetary purposes, the value of gold would be even more closely tied to fluctuations in the industrial demand for the metal. In recent years, almost all metals prices have become highly unstable, as rapid industrialization in Asia has pushed up their prices relative to those of other goods. Fixing the nominal price of gold will not lead to price stability.

For better or worse, conservatives need to acknowledge that we live in a fiat-money world, and we need to figure out a way of managing paper money that does the least damage to the broader economy. That means we canâ??t dodge the hard questions of macroeconomics and blithely assert that we oppose the Fedâ??s â??meddlingâ? in the economy.

There is no laissez faire in fiat money. If the Fed holds the money supply constant, it will be changing the interest rate and the price level. And if it holds interest rates constant, it loses control over the price level and money supply. As a result, many economists now favor some sort of inflation-targeting regime. The most famous example is the Taylor Rule, which did keep inflation tolerably low and stable for two decades. But inflation targeting has several defects that in my view make nominal income (or GDP) stabilization a better goal.

One well-known argument against inflation targeting is that there are times when price-level fluctuations are desirable. George Selgin pointed out that during a productivity boom, it might be better to have a mild deflation in order to prevent labor markets from overheating. Conversely, a negative supply shock ought to make inflation rise: We donâ??t want to force all non-energy prices to fall to make up for an oil embargo.

Most of the problems that are believed to flow from an unstable price level actually result from nominal-income instability. The aggregate nominal income in the economy is the sum of each personâ??s income, measured in current dollars. Since most debts are nominal (i.e. not indexed to inflation), nominal income is the best measure of a personâ??s ability to repay their debts. In 2009, the U.S. saw the biggest fall in nominal GDP (NGDP) since 1938. It is thus no surprise that we had a debt crisis: Borrowers almost always have trouble repaying debts when nominal income comes in much lower than was expected when the debts were contracted.

Some people overlook this problem because they focus on the most spectacular debt problems, the cases where borrower behavior would have been irresponsible regardless of the future path of NGDP: the subprime mortgages in America, the government borrowing in Greece, or the decision by the Irish government to absorb the liabilities of irresponsible banks. But those cases are merely the tip of the iceberg; the sort of systemic debt problem now faced by the Western world goes far beyond these isolated cases, and can be explained only by the fall in nominal income.

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fijiaaron

12/15/10 12:36

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There are two types of conservatives:

The ignorant, hairy, unwashed, superstitious, violence prone voters.

And those who believe they are so much smarter than the rest of us that it's they're solemn duty to trick us into letting them rule over us.

Which group do you think Scott places himself in?

Greg

12/15/10 12:35

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Doesn't this targeting of ngdp have huge potential problems? What if we are targeting ngdp growth of 3% but the economy can only produce 2% long term growth? Who's to say that the fed can pick the right number?

And won't this plan lead to an incredible amount of currency printing during bad recessions, creating dangerous inflation and imbalances incentives?

Why not just try to keep the money level stable so that people have a reliable currency with which to conduct business? Anything else seems dangerous and utopian to me.

Scott Sumner

12/14/10 19:47

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Gregor, I've generally thought that a nominal aggregate wage target is best in theory, but for all sorts of practical reasons it is not feasible. So I thought NGDP was a good compromise. If there was some weird shock where the two cases diverged sharply, then NGDP might not work. For instance, if the population suddenly grew by 20%, then it might be better to stabilize per capita NGDP, or per capita final sales.

Greg, It's a given that real world gold standard policies won't be in accordance with the gold standard ideal. If governments were that competent then we wouldn't need a gold standard, we'd just run a fiat regime and stabilize NGDP. People used to argue the gold standard prevented government mischief, now they argue it can only work if the government follows arbitrary rules. But I don't even agree it would work in that case. Asian demand for gold could still cause problems.

By the way, no one agrees on how the gold standard should work, and the pre-WWI regime had many of the same flaws as the post-WWI regime.

Banking crises led to currency hoarding, which is deflationary under a gold standard but not deflationary under a fiat money regime. So that's another argument against a gold standard. I agree the branching laws were a big problem, but if you insist a gold standard can only work in a pure laissez-faire economy, then don't bother proposing it for a modern economy.

Kevin, I'm talking about a 5% NGDP growth target, but a 4% NGDP/capita growth target would be almost identical, and indeed might be slightly better.

Contemplationist 30922 /?p=30922

12/14/10 18:03

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Kevin hes talking about NGDP GROWTH. The trend rate of NGDP growth in the US has been 5%. This obviously captures population growth, productivity growth etc etc

KevinH

12/14/10 16:57

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I've got two questions. Are you talking about per capita NGDP? It seems like you would have to be otherwise you'll have to end up with large deflation to account for population growth. If so are we talking about median or mean NGDP/capita?

Second, I'm now sure exactly how you would do this without enforcing wages or massive redistribution

Gregor

12/14/10 09:52

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Greg, If the Fed chooses to stabilize the general price level (or have it increase along some agreed upon path) or general inflation this doesn't prevent overinvestment in one sector of the economy. Nor should it. Ensuring that there is never overheating or overinvestment in a particular sector of the economy is impossible. But as long as the whole economy wasn't overheating - and it wasn't because the Fed was (roughly)targeting inflation - that must mean that some other sector of the economy was underperforming (manufacturing, for example) as housing boomed. The appropriate course of action was to offset the effect of the housing bubble bursting by easing policy to keep the overall price level growing along it's pre-recession path. If it had done that, housing still would have declined but previously underperforming sectors such as manufacturing would have outperformed.

There's no reason that overinvestment in one sector needs to results in a plunge in activity in all sectors of the economy. So my preferred policy is to stabilize growth in the overall price level or stabilize growth in NGDP. What is your preferred monetary policy objective? Stabilizing nominal gold prices? What happens when there is a sharp increase in the relative price of gold?

Greg

12/13/10 16:57

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The deflationary discoordination -- if it exists -- is put into play by a prior artificial malinvestment boom sponsored by the Fed and pathological gov. housing mortgage policies. The inevitable bust revealed massive insolvency and projects which made no sense at a price which would sustain solvency by those who were dependent on continued pathological Fed interest rates.

Scott has nomsolution for this problem -- and untilhe honestly confronts it, he has no real solution to the problem of monetary stability

Greg

12/13/10 16:48

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Scott is deeply misleading on the "gold standard" -- as George Selgin points out, post WWI money policies were NOT in accord with an international gold standard regime.

Scott also should have learned from Selgin and others that pre WWI instability came from the ban on branch banking in an economy dominated by farming seasons.

So Scott just isn't being honest about the facts.

Not a good start for a productive conversation.

Gregor

12/13/10 16:32

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Scott, The other day you mentioned that Bill Woolsey's idea of nominal final sales was a better target for small open economies. Are there any other cases where you would change the target or any other potential pitfalls?

Also, how do you see this actually happening given the current composition of the Fed? Don't you think that a slow evolution from inflation targeting to price level targeting to CPI futures to NGDP futures is more likely? And given that the US has yet to even adopt an inflation target, don't you think it's more likely to happen somewhere else first?

Bill Woolsey

12/13/10 11:23

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I'm convinced.

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fijiaaron

12/15/10 12:36

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There are two types of conservatives:

The ignorant, hairy, unwashed, superstitious, violence prone voters.

And those who believe they are so much smarter than the rest of us that it's they're solemn duty to trick us into letting them rule over us.

Which group do you think Scott places himself in?

Greg

12/15/10 12:35

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