A run on central banks?

When I see what commodity prices are doing, I don’t think “low interest rates” or “skyrocketing demand”. I think about a loss of confidence.

There is that old saw about gold, that it is the only money that is no one’s liability. Wheat is no one’s liability, and neither is corn. Oil is no one’s liability.

It is common to invest in commodities as an “inflation hedge”. If the central bank prints too much money, you need wheelbarrows to buy bread. If you have a sack of wheat, you will have your bread whatever the central bank does. But if everyone buys wheat, the price of grains will rise, even if the central bank does nothing at all.

Just as the fear of a bank’s insolvency can precipitate a run that drives a bank to ruin, loss of confidence in a central bank can provoke a great inflation. The Federal Reserve, much I might criticize it, has not gone on a printing spree. It has lowered interest rates, and altered the composition of bank assets by replacing less liquid with more liquid securities. But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid. The Fed’s actions are best described as antideflationary, not inflationary.

But confidence is a funny thing. Central bankers are supposed to be dour and dependable. The current crop is not. Rather than “taking away the punchbowl“, central bankers have become the life of the party. Japan’s central bankers hand out Yen like free acid. China’s guy will give you a microwave oven and a DVD player if you draw him a picture (and sign Henry Paulson’s name to it). Our man Ben is an Amadeus-cum-Macguyver, he’s brilliant, unpredictable, he’ll improvise a Delaware company from paper clips and vacuum up your derivative book with a toenail clipper. Even the ECB’s Trichet, who at first comes off like a sourpuss, turns out to be alright, when you’ve got some Spanish mortgages to pawn.

Some of us think that something’s wrong, and these guys we’re drinking with aren’t serious enough to fix it. We know that trillions of dollars in presumed housing wealth have disappeared, but we don’t know who’s ultimately going to bear the loss. Americans know that as a nation, we cannot afford our clothes, furniture, or gas, unless the people who are selling it to us lend us our money back. Economists fret about “imbalance” and “adjustment”, but we’ve yet to see a serious plan, other than let’s-keep-this-party-going.

So, we lose faith. When we lost faith in Northern Rock, Bear Stearns, Citigroup, or Lehman, the central bankers stepped into the fray, and stood behind them. So, we ask, who stands behind the central bankers? We take a peek, and all we see is our own money. Which we quickly start exchanging for something else.

Although commodity prices have been increasing for years, you’ll notice that the very sharp run-up began last summer, at roughly the same time as the credit crisis. Commodities soared when interest rates were still high, but predicted to fall. Commodities are soaring today, even though US interest rates are now predicted to rise. Commodities have soared in euro terms, despite the ECB’s refusal to drop interest rates.

I can’t tell you where the inventories are, except to wonder why anyone would put them where they would be counted. Hoarders tend to get nervous, and not advertise their hoards. (But this is pretty obvious.) Perhaps producers of storable commodities who lose faith in paper quietly hold back production. Interestingly, people who no longer trust the very core of the financial system remain comfortable with collateralized, centrally-cleared futures exchanges. These are well designed to manage credit risk, but they can default, have defaulted, and will default in extremis. I heartily endorse Cassandra’s suggestion that they step up their margin requirements, ASAP.

None of this is any good at all. Capital devoted to precautionary storage would be better employed building new enterprises, laying a foundation for tomorrow’s prosperity. But claims on future money are only promises, easily broken or devalued. A run on central banks, a flight from financial assets to stored goods, sacrifices the hope of future abundance for certain present scarcity. Governments can shut futures exchanges, confiscate gold, ban “hoarding, profiteering, and price-gouging”. People will hoard anyway if they don’t believe in the paper. People are losing faith in financial assets for good reason. Rather than organizing productive economies, the machinery of finance has recently functioned as an anesthetic, masking the pain while resources were mismanaged and stolen. We need a solid financial system, but confidence cannot be imposed or legislated. It will have to be earned. There has to be a plan. Earnest promises to do better soon won’t suffice. Nor will yet another drink from the punch bowl.


38 Responses to “A run on central banks?”

  1. JKH writes:

    Gold, wheat, and oil have become somebody’s liability via their “securitization” through various financial instruments: futures, ETFs, etc. If commodity prices have become both the cause (price indices) and the consequence (central bank non-confidence) of inflation fears, this is a feedback loop that is inherently unstable. And underlying strong fundamental demand with constrained supply doesn’t mean pricing can’t become manic. Assuming that the Fed’s actions are correctly anti-deflationary, the punch bowl may move away under its own dynamics.

  2. Steve:

    Welcome aboard! Enjoy the ride!

  3. joebhed writes:

    Fervent free-enterpriser, anti-capitalist here.

    A run on central banks?

    Hang on taxpayer!

    Conventional wisdom sees the CBs as nothing more than cheap money-purveyors, seen as handing out “liquidity” from the punch bowl.

    To me they are the opposite.

    They are debt-purveyors.

    And, the long-term function of that debt is the opoosite of liquidity.

    Wanting to avoid the lesson of double-entry bookkeeping, my view is the private central bankers do nothing more than chattel all the world’s worth with increasing volumes of unpayable debt, setting up the contraction-phase wealth grab for the financial survivors.

    Coming soon to an economy near you.

    Always the same group.

    There ought to be a law.

    Given that the mountain of debt is actually unpayable in the declining economy, a run on the CBs does rise to the fore.

    Most likely, we will soon see a trans-national “consortium” proposal from the CBs and the IBs, ostensibly aimed at backstopping that run.

    Hang on to your Constitutional rights, Americans.

    If we ever want to see a CB in this country acting in the interests of the American taxpayer rather than the private bankers, we need a truly sovereign entity that takes away from from the private bankers their gilded right to create the nation’s money.

    The Jeffersonian view of economic democracy.

    The Chicago Plan for money creation.

    The post-financial-apocalypse solution.

    Private banks lend their own money.

    One-hundred percent reserves for all speculative lending.

    Free enterprise.

  4. Alessandro writes:

    Steve, great piece! The run on the central bank is something that not even Roubini in his ’12 steps to financial disaster’ saw coming.

    In the rush to protect the world financial system the world CBs have now put at stake the very existence of the fiat money they oversee. If some form of unofficial gold standard emerge from this commodity run the world CBs are toasted.

  5. RueTheDay writes:

    “But the most these measures should do is bring us back, monetarily speaking, to the status quo ante, back to a year ago when asset-backed securities were liquid.”

    I’m not sure they can even do that, unless they are massively devalued and some floor under the price of houses emerges to stem the foreclosures and stabilize expectations around future cash flows for the MBSs.

    It all comes down to the fundamental uncertainties of future cash inflows from investment versus the certainty of current and past commitments to cash outflows on debt contracts. It affects everything from capital asset prices to economic output to employment. All of Minsky’s books are back in print folks, read them. There’s a lot more to it than the hedge/speculative/ponzi financing positions that everyone associates with him. He has formulated an all-encompassing theory of macroeconomics with integrated financial markets and provides complete microfoundations for everything.

  6. RueTheDay writes:

    Regarding the commodities runup: IMO, it’s a bubble that is going to burst, but probably not for awhile. I see the equities bubble popping first, then a significant deterioration in economic fundamentals (output and employment), and then finally the commodities markets come crashing down as income declines cause demand to evaporate. The longer the polyannas continue the “everything is ok, the credit crisis is behind us” propaganda (with full support from the Treasury and the Fed) the worse the ultimate crash will be.

  7. Nemo writes:

    Re: Where the inventories are

    Jeff Frankel has a suggestion.

    He suggests that the “missing inventory” is still in the ground. If long-dated futures prices are high, a rational producer of oil will tend to delay production, especially if dollar interest rates are low. (As a producer, should you keep your oil and sell it in the future, or should you sell it now and pocket the dollars? The right answer depends on the future price of oil and the current interest rate on dollars…)

    Thus the run-up in oil could certainly be the result of low interest rates and futures speculation, even if no inventories are accumulating above ground.

    Thus, speculators plowing money into oil futures can actually reduce current supply.

  8. Desmond writes:

    Hi Steve!

    Regarding the run up in commodity prices, you’re spot on. Central bankers print all these money and they have to go somewhere.

    Do you know what’s happening right now? You may want to take a look at this article, Who is to blame for surging food and oil prices? This blog reported that two days ago, at a Senate Committee inquiry, senators grilled some witness on whether institutional investors are contributing to the run up of food and oil prices. The most eye-opening testimony was from Michael Masters, who is a hedge fund manager. He explained that a lot of what’s happening was due to the rise of Index Speculators (basically the SWF, pension funds, government pension funds, university endowment funds, etC), who distorted the commodities futures market through a loop hole, which in turn distort the spot prices. The rise of these Index Speculators was a recent phenomenon and they distort the market through their sheer quantity of liquidity.

    Michael Masters’s testimony is eye-popping!

  9. a writes:

    It’s deja vu all over again. At the beginning of the Great Depression the Fed lowered rates until, because of a weak dollar, it had to raise them. This time around, CBs will eventually panic about commodity prices and then begin to raise rates.

  10. sivere writes:
  11. William Steding writes:

    Steve: nice post.

    As long as we tolerate 140+ currencies that populate the world riding on the back, one way or another, of the dollar – we will observe increasing volatility. Central Banks, who manipulate their currencies to serve domestic interests, are like rogue traders in the $3.2 trillion (daily) foreign exchange market.

    Monetary Unions are an interim step to contracting the number of currencies and central banks to a long-term path to a common currency. The dollar, for so long a source of economic and political power for the US, has become a source of weakness. The days of “the dollar is too big to fail” are over. It’s time to trade primacy for systemic stability.

    This all requires extraordinary political will. Oops, therein lies the problem.

  12. rob writes:

    And don’t forget:

    $400+ trillion of derivitives risk; $50 trillion in unfunded liabilities/obligations of the US gov alone; pending insolvency of SS and Medicare in the US.

    What will people do when they realize that: they can’t work enough to buy food? There is no SS? There is no medicare? It takes $100 to buy a peso?

    Smells of riots begetting revolution, IMHO.

  13. joebhed writes:

    To WS

    Maybe I am missing something in Steve’s post. Probably so.

    But if the problem is the number of money-changers and currency-speculators out there “messing-about” with the precious US dollar in a free competitive market, then maybe what we need to do is to close that market.

    Joining a monetary union just increases the scale of one source of market power to the currency traders.

    Fewer traders in larger markets.

    Ah, efficiency.

    Less competition.

    If you really want less competition in currency exchange, why not try cooperation?

    That would be the value of a monetary union. To keep the currencies of all countries that want to join away from the money speculators.

    Each of those countries represented mas o menos by its CB is a sovereign entity, meaning that its laws and its currencies are under the control of their respective governments.

    Each of them must be just as eager as we to do everything possible to prevent the volatility of their respective currencies.

    So, why not do it cooperatively?

    Thus preventing, rather than enabling, unnecessary and unwanted speculation by the money changers of our precious, sovereign currencies.

    It seems to me it is either government cooperation or private competition.

    I would rather see all currencies exchanged via rational, cooperative agreement than hidden international market competition.

  14. Spectator writes:

    Beautiful post. So this is what the talking heads have euphemistically called inflation expectations. A much overdue loss of faith in Helicopter Ben and the pack of Wall Street sycophants that pass for central bankers today. Only Volcker can restore any integrity to this breed of civil servant.

  15. William Steding writes:

    In reply to Joebhed:

    Each currency creates a new exchange rate against every other currency, increasing the number of options for speculative activity. Monetary unions, which are excellent examples of cooperation, reduce the number of options to speculate and vastly increase the economic pool that supports the common currency.The common currency is also “managed” by a common central bank, which also reduces the number of chefs fouling the financial system stew.

    While the foreign exchange markets provide a clearing mechanism for disequilibria between currencies they do so while creating no economic value: it’s a zero-sum event – win/lose. This means no contribution to economic development occurs. Many predicted the euro’s failure. Now, states stand in line to join because, among other things, we have witnessed participating states enjoying increased trade, reduced costs, and increased asset values.

    For more information, there is a repository of research on this issue at singleglobalcurrency.org.

  16. Stedling:

    Before 1914 we had a single global currency: gold!

  17. joebhed writes:

    To WS

    Thanks for the note.

    I tried to imply that I understand the “efficiency” of the monetary union concept, but I do not support it as the means to the common end of more stable currency relationships.

    As I said, I favor a cooperative framework among the nations, as opposed to the CBs, in bringing that stability forward.

    I am familiar with Mr. Volker’s proposal for a single global currency, having long ago taken the poll as “strongly-against” the concept.

    I have a lot of respect for his tenure at the helm, and I am thankful for his more recent comments on the Fed’s BS-JPM bailout actions being inappropriate without a true ‘government” position in the deal.

    But I am not a one-world-order guy.

    And I am especially not a one-world-capitalist-monetary-order guy.

    Internationally, I believe that what we need first is monetary reform, where the peoples of the world, acting through their respective governments, have actual control over both their currencies and their economies.

    And, my ideas of how this monetary reform would manifest itself are contained in the following sentence:

    Sound monetary reform requires the issuance of all money (legal tender) by the State, exclusively; in amounts calculated to stabilize the general price level; without debt obligation to private persons; with all lending to be performed by private legal persons, exclusively; while safeguarding the widespread ownership of private property.

    -taken from M. Friedman’s Principles for Monetary Reform.

    I am not one who believes that the biggest economic/financial problems we have are caused by the volatility of the dollar. Rather I see that as a symptom – a symptom of a lack control of the money-creation function of a government, cured only by the reforms needed to get the people back in control of their currency and their economy.

    Maybe then the people, rather than the bankers, can decide if they want one world order, or not.

  18. William Steding writes:

    To Joebhed:

    I don’t disagree in principle with your point of view; however, I will suggest that a common currency enables, rather then encumbers states, multinational corporations and other non-state actors to realize their free-enterprise objectives – removing the inevitable manipulations of currency that arise in a multi-currency/political environment.

    I think we have to ask ourselves what factors contribute to value creation in any given economy to understand what it is that we should focus on to “control” that economy. Currencies? Factors of production (capital and labor)? Ideas and resources? Removing the noise/friction in the system created by foreign exchange, capital account imbalances, etc. – all a product of multiple currencies and central banks – actually enhances the capacity of more important economic factors to be the focus of participating actors.

    As “IA” points out, we had gold as a common currency although, for obvious matters of inconvenience, other currencies were developed consistent with a state-centric world where the velocity of commerce increased beyond gold’s capacity of facilitation. Now, we’re evolving away from the Post-Westphalian, state-centric world through globalization. The stability of the global financial system has provided a number of warning signs including several regional financial crises in the 90s (Russia, SE Asia, Mexico, Brazil, etc.) and now, the BS (all-around) global debacle. Any “cooperative framework” (which you suggest we contemplate as opposed to central banks) requires an organizing principle, codification, enforcement, and a capacity for adaptation/flexibility to deal with the unknowns the future (always) provides. If we don’t like central banks, the administrative challenges remain.

    I am suggesting that we can enable much more free enterprise, focused on those economic factors that actually contribute to the wellspring of the economy if we stabilize every economy’s most important attribute: its medium of exchange. This does not produce “one world order”, as you fear; on the contrary, it supports independence to develop economic plans and activities around those things that matter, rather then the artificial trappings of iconic currencies that all-too-often become the playthings of statesmen at the expense economic development and stability.

    I too was reared under the influence of Mr. Friedman. If he were still with us today and observed the effects of globalization, I would like to think he would agree with the concept of a ubiquitous currency, allowing economic champions across the global system to do what they do best without incurring the costs of currency mismanagement. Our medium of exchange, unit of account and store of wealth should not be an ideological battleground. It should be a stable utility that facilitates wealth creation.

  19. Benign Brodwicz writes:

    I’m not sure I understand what a run on a central bank is but the idea certainly connotes the loss of confidence that’s going around quite well…. Seems Gresham’s Law applies with good money being commodities and bad money all the burgeoning fiat monies in the world today…. Is barter the next stage, with a failure to find a numeraire commodity?

  20. Teddy Taura writes:

    Hi I came by this nice blog via an aggregator, but I like your post very much.

    One related issue could be that this could be somewhat related to what, in “Human Action”, von Mises says will eventually, inevitably happen when central banks try to prolong a credit cycle by lowering interest rates, the flight into “real” values, “the crack-up boom”…

    Just a thought.

    We are virtually trapped by central banks all over the world and with their money and credit manipulation, unless we take flight into hard assets, such as gold.

  21. WS writes:

    Commodities are, and will continue to be, an alternative store of wealth to currencies, but there’s another on the rise: sovereign wealth funds. States faced with currency risk are organizing rapidly to form their own venture capital funds, in many cases, fund-to-funds.

    China dropped a few billion in Blackstone Group. Dubai is very active. Countries like Norway are on the leading edge of this trend.

    While they tend to be subject to objection by classic-sovereignists who fear political effects, sovereign wealth funds represent a big step forward in the deployment of savings toward developmental assets as opposed to static assets like currencies that only feed the FOREX speculation game.

    As states like China, whose reserves now exceed $1.5 trillion, diversify away from US Treasuries and other financial instruments, the economic landscape across the global system will change dramatically. States and multinationals who learn to embrace sovereign wealth funds will likely flourish. Those who cling to traditional notions of sovereignty, as a wall of protection from an anarchical world, will not.

  22. JoeSchmoe writes:

    To WS,

    I like joebhed’s ideas but for different reasons. Concentration of power will become abused, just as the concentration of power at the FED has become abusive as well as being an anti-Constitutional institution. A one-world currency leads to a one-world government that can more easily be usurped by a one-world leader (strongman). You will get what you wish for and it will (eventually) turn into your worst nightmare. The Bible has predicted this very thing to come to pass. Do you really want to see it happen under your watch? Volker not withstanding (and to his credit a responsible CB chairman), I do not see a Paul Volker running the show when that happens. Generally, I find the ignorance of people to be equal to their arrogance and that is why the Founding Fathers wrote the Constitution the way they did. They were all rich people who knew how corrupt they themselves could become if given unfettered power.


  23. Adan Lerma writes:

    really good really important article, thanks!

    also the comments re thomas jefferson, returning control of our money away from the bankers and to ourselves, and the questions re one currency, all really good to see being brought up

    trust, i believe, is foundational before all else

    we will need to trust ourselves more to eventually claim control of our currency

    we will need to trust ourselves more to accept and want one currency

    literally, we cannot drive down a two lane road without trust, or sample a grape at the produce counter, or say hello to a stranger

    and when it becomes apparent that our trust as individuals has been manipulated as a group for the benefit of a self-selected few, it’s very hard to listen – to avoid hollering our own personal concerns at the other person simultaneously shouting his (or hers)

    i hope your article stirs more writings re trust and our financial system

    thank you much

  24. WS writes:

    To: JoeSchmoe

    The Bible predicts many things…like a kaleidescope, if you don’t like what it reveals, just turn the lens and a whole new world appears, as if by magic, er, excuse me, scripture.

    And, the Bible had much to say about money changers.See the Gospel according to John. Jesus wouldn’t be so high on the idea of FOREX.

  25. Average Joe writes:

    Ok, Ok. I’ve heard enough. What I want to know is a)how do I protect the meager net worth of $200K I’ve managed to scape together, and b)is there anyway to take advantage of the current situation, like buying land in foriegn countries? I would like to read about some suggestions on what to do.

  26. joebhed writes:

    In reply to William Steding:

    Suffice to say that we agree that we should be doing everything we can to protect the value of the US dollar.

    All the benefits that you claim can come from a common currency/ monetary union would come from having as stable a currency as we could manage.

    You see the Monetary Union as the unfolding answer.

    I do not, except in the manner I have described as fortuitous to the American people and taxpayer, whose dollar it is.

    I prefer that governments at all levels issue the currencies of their states, and that they make laws about who can and who cannot exchange that currency, and at what values.

    “Only the Congress shall have power to coin money, regulate the value thereof, and of foreign coin”, sayeth the United States Constitution.

    Now, turning to Milton Friedman, again.

    I would presume that you know he agrees with me.

    Writing on the need for monetary reform, he lays out in one sentence the solution to the unsoundness of today’s currency/credit crisis:

    “Sound monetary reform requires the issuance of all money (legal tender) by the State, exclusively; in amounts calculated to stabilize the general price level; without debt obligation to private persons; with all lending to be performed by private legal persons, exclusively; while safeguarding the widespread ownership of private property.”

    In further defining that government money issuance parameter, he states the following corallaries:

    a. this implies the prohibition of all

    private money creation;

    b. this implies the prohibition of

    fractional reserve banking;

    c. this implies the requirement of

    full reserve banking;

    d. this implies withdrawal from

    international banks with credit/

    reserve-creating authority (such

    as the IMF SDRs);

    Such a withdrawal negates the potential for monetary unions with banks such as the ECB and others.

    The bottom line to me is this: Until we act in the manner described by Mr. Friedman above, we are collectively cats chasing our own tails.

    Monetary reform is demanded by the financial crisis unfolding today, and I do not mean higher reserve/margin levels, and I do not mean more transparency.

    As soon as the EconBloggers start talking in a straightforward manner about doing what is both necessary and possible, we will begin the greatest transformation of economic power this country, or the world, has ever seen.

    The widespread ownership of private property. Free enterprise.

    Not confiscatory contraction.

    It is long overdue. And, it is coming.

    Because, we know.

  27. Steve, I wanted to respond to RueTheDay’s comment on your last post, that he (she?) entered May 17th at 8:14 am. I hope you don’t mind if I do so here. I wasn’t able to get to it until now.

    RueTheDay, you write, “because once you acknowledge real balance effects, you have to either keep the hoarding part and explain why the price mechanism doesn’t work (sticky wages/prices) or discard the hoarding”.

    But the whole point is that wages and prices are sticky. Information doesn’t disseminate and become ubiquitous and acted upon instantly. This is the big strength of Keynesian or New Keynesian economics; the assumptions that it depends on are far more realistic than the assumptions that real balance arguments and rational expectations arguments, and the like depend on.

    It’s far more realistic to assume, as Keynesian type theories do, that everyone in the world does not have every bit of information everywhere in the economy and cannot analyze all of it perfectly, with perfect expertise, instantly when it comes to price and wage setting, and many other things.

    It’s much more realistic to assume that people severely lack information, and they acquire it relatively slowly, and don’t analyze it perfectly with Ph.D. techniques, and that it takes time (which is money), and effort to analyze information, and there are costs and risks to changing prices and wages, and therefore prices and wages adjust relatively slowly and imperfectly.

    These are much more realistic assumption to make about the economy, and that’s why the empirical evidence is immensely stronger for Keynesian type theories, and for the effectiveness of Keynesian type prescriptions.

    Real balances arguments, rational expectations arguments, and the like, only really work and are the whole story if it’s true, or close to true, that that everyone in the economy has perfect information about everything, perfect expertise and education about everything, perfect rationality, and the ability to analyze and update all information constantly and instantly in their brains (although some of these make an exception for one or a few things like job search time). Obviously, we don’t fit this bill with a majority almost picking W. in 2000, and actually picking him in 2004!

    Here is Krugman on this (from his book “Peddling Prosperity”, page 47):

    When Keynes published his theory of the business cycle, some conservative economists argued that there was no need for government policy to combat recessions because recessions would be self correcting. Their argument went as follows: In the face of high unemployment, wages and prices will tend to fall. This fall in wages and prices will increase the real money supply – that is the given stock of money in circulation will have steadily rising purchasing power. And this expansion in the real supply of money will in turn lead to an economic expansion.

    Keynes did not deny the logic of this so-called classical argument; he was willing to concede that in the long run economic slumps would be self-correcting. But he regarded this self-correcting process as very slow, and as he pointed out in a widely quoted but rarely understood remark, “In the long run we are all dead.” What he meant was: Recessions may eventually cure themselves. But that’s no more a reason to ignore policies that can end them quickly than the fact of eventual mortality is a reason to give up on living.

    On page 214, Krugman more specifically discusses what happens once you realistically take into account that it’s far from the truth that all people are instantly calculating machines with perfect and constantly updated knowledge about every single bit of information in the economy:

    Suppose now that in this imperfect world we once again play the Keynesian experiment of posting an increase in the desire of people to hold cash. Recall that in Chapter 1 we saw how an attempt by everyone at once to increase cash holdings leads to a general fall in employment and incomes. The same will be true here.

    At this point, the monetarist says that wages and prices will fall, increasing the real value of the cash in circulation and curing the recession. But will wages and prices really adjust?

    What if firms are reluctant to cut their prices, either because there are measurable costs to putting on new price tags (menu costs in the jargon of the new Keynesians) or because they just don’t want to be bothered with rethinking their pricing schemes? (The difference between real costs of changing stickers and subjective costs of thinking is actually quite blurry – that’s why near rationality may in a way be regarded as a higher form of true rationality.) If markets were perfect, a firm that charges too high a price would lose all its business. In a world of highly imperfect markets, a firm that charges a price a little too high gains almost as much from that higher price as it loses in sales; a firm that fails to cut wages has a gain in higher leverage over its workers that almost compensates for its higher cost; and so on. In other words, the costs to an individual firm of being a little less than totally rational and not cutting wages and prices may be quite small, small enough that reasonable people just don’t do it.

    And yet the individually reasonable decision not to cut prices in the face of a recession can have collectively disastrous results. If prices don’t fall when people decide to hold more cash, then the slump in output and employment is not self-correcting. In an imperfect world, senseless things can happen to groups of people who behave sensibly as individuals.

    The case for active monetary policy is now obvious. Suppose that we have slid into a recession, just as described. There is an easy way out: put more money into circulation, and spending, incomes, and employment will rise…

    In addition to menu costs, information gathering and analysis costs and time, efficiency wages, and other non-behavioral (non-psychological) imperfections, there are also strong behavioral causes of sticky or relatively slow price adjustment. For example, many businesses are reluctant to cut prices until they can really be sure that they will be able to keep the price at that lower level for a while, because (especially for certain products) customers don’t like price increases or jumpy prices. That kind of thing can hurt customer goodwill and loyalty. It is also well documented that managers facing substantial competition often put off raising prices because they don’t want to be the first to do so.

    One very interesting, important, and widespread behavioral phenomenon is that workers are much less resistant to taking a real paycut if it doesn’t involve a nominal paycut. In other words, the empirical evidence shows overwhelmingly that most workers are far more resistant to a 3% paycut when inflation is 0, than they are to a pay freeze when inflation is 3%, even though they are basically the same thing.

    Krugman notes this in his 1996 Economist article, “Fast Growth and Stable Prices: Just Say No”:

    Messrs Akerlof [Nobel Prize winner], Dickens, and Perry have produced compelling evidence that workers are indeed very reluctant to accept nominal wage cuts: the distribution of nominal wage changes shows very few declines but a large concentration at zero a clear indication that there are many workers whose real wages ‘should’ be falling more rapidly than the inflation rate but cannot because to do so would require unacceptable nominal wage cuts.

    This nominal wage rigidity means that trying to get the inflation rate very low impairs real wage flexibility and therefore increases the unemployment rate even in the long run. Consider the case of Canada a nation whose central bank is intensely committed to the g
    oal of price stability (the current inflation rate is less than 1%). In the 1960s Canada used to have about the same unemployment rate as the United States. When it started to run persistently higher rates in the 1970s and 1980s many economists attributed the differential to a more generous unemployment insurance system. But even as that system has become less generous the unemployment gap has continued to widen: Canada’s current rate is 10%. Why? A Canadian economist Pierre Fortin points out that from 1992 to 1994 a startling 47% of his country’s collective-bargaining agreements involved wage freezes. Most economists would agree that high-unemployment economies like Canada suffer from wage inflexibility; Mr. Fortin’s evidence suggests however that the cause of that inflexibility lies not only in structural microeconomic problems but also in the Bank of Canada’s anti-inflationary zeal.

    It can also take a while for a person looking for work to understand and/or admit that the equilibrium wage in his field has dropped, and he has to accept less. It’s not just bad luck that he’s getting lower offers than were common last year, and instead the market has, in fact, changed. It can take a while for an individual to discover this with all of the complication and random factors in the labor market. This is known as the Misperceptions theory.

    What is the empirical evidence that there is a substantial amount of stickiness in prices, and especially wages? It’s pretty obvious if you’re willing to look at it objectively. Have you ever heard of anyone signing a contract for their job for a year or more? Have you ever noticed that unions only negotiate new contracts every few years? Have you ever thought about how difficult it would be to attract workers if instead of offering them a wage that’s relatively steady and guaranteed, you started jumping it up and down constantly in perfect tune to aggregate demand in the economy (even assuming that all managers had the expertise to do that and the cost of the huge amount of time they would spend doing this was zero). The empirical evidence for nominal (and real) wage rigidity is vast. A good start is Fehr and Goettes 2005 paper in the Journal of Monetary Economics (volume 52, pages 779-804), “Robustness and Real Consequences of Nominal Wage Rigidity”.

    To sum it up from Krugman’s text “Macroeconomics” with Robin Wells (2006), “Wages do not fall quickly in the face of labor surpluses or rise quickly in the face of shortages. Almost all macroeconomists agree that wages adjust slowly to surpluses or shortages of labor.” (page 381). And from the other Paul, Samuelson, you know the legendary Nobel prize winner, “Keynesian economists point to much evidence suggesting that prices and particularly wages move slowly in response to shocks, and few economists believe that labor markets are in constant supply-demand equilibrium. When the assumption of perfectly flexible wages and prices is abandoned, policy will regain its power to affect the real economy in the short run.” (From Samuelson’s text, “Macroeconomics”, 18th edition, 2005, with William Nordhaus of Yale, page 364.)

    The bottom line is that you can’t take simple Austrian or classical models literally, that is you can’t assume the actual economy is identical to the simple model. These models, and similarly simple ones are just useful as a first step. An actual economic situation may have 10 major factors and many smaller, but still important, noisy ones. It’s usually harder to understand such a situation if you just look at it as a whole. It can be useful instead to just first look at a few of the factors in isolation, to understand better how those few factors work. But that’s only the first step. You don’t say from there, “Oh that’s how the economy with the many more factors works too”. No, instead you next look at what happens when you add a few more factors. How much, and how, does this change things? Next you add more factors, and keep re-evaluating, until you have considered all of the significant factors. And then to help screen out mistakes you may have made in your analysis, you look at the real world data with lots of empirical studies to see how well it fits your analysis. This a lot more complicated than just acting like simple models are identical to reality, but this kind of in-depth and logical thinking has lead to great advances in our quality and quality of life.

    With regards to Keynes’s views on wage decreases: Keynes’ writings can be hard to interpret. The style of English is formal, artsy, and complicated, but there’s no dispute among experts on Keynes that he thought in the long run prices and wages would adjust to an equilibrium (until the next disequilibriating shocks) where normal unemployment was restored ending a recession or depression, but as Keynes said, “In the long run, we’re all dead” (so why wait, suffer, and lose wealth unnecessarily for a long time).

    In the short run (without smart action by a central bank) funny things could happen like the “Widows Curse” or “The Paradox of Thrift”, but these are not long run equilibriums, and some of them are very unlikely. Most of all, they can all easily be stopped by smart action by a central bank (and/or fiscal action). For more on this I recommend Krugman’s 1997 Slate article, “Vulgar Keynesians”.

    Richard H. Serlin

    Blog: http://richardhserlin.blogspot.com/

  28. RueTheDay writes:


    Keynes’ writings are not all that difficult to understand if people would only READ them. I’ve read the General Theory cover to cover, along with some of his earlier works. His views did in fact change over time, and by the time the General Theory was published, his model was most certainly NOT one of sticky wages and prices (though no one really doubts that wages/prices are somewhat sticky, that is not the heart of his theory). As I said in my previous post, Keynes was adamant that a fall in wages during the Great Depression would have made matters WORSE not better, thus it would be illogical to conclude that his theory was one of sticky wages. The Neoclassical Synthesis proponents and the New Keynesians both have it precisely wrong.

    There’s a reason that Keynes called his magnum opus The _GENERAL_ Theory. In Keynes’ view, the Classical (and Austrian) theories of the macroeconomy represented a _SPECIAL_ case, that of an economy operating on the boundary of the production possibilities frontier. Keynes claimed that it was certainly possible for an economy to be operating there, in which case the classical view was correct, but that it was also possible for an economy to be operating anywhere _INSIDE_ the PPF as well. It would take me several pages to explain how an economy could reach an equilibrium inside the PPF, but the gist of it is this – savings are not necessarily invested, the degree to which savings are invested is determined by the difference in the money interest rate on the one hand and the profit opportunities faced by firms on the other hand, both of these values are determined largely by expectations surrounding an uncertain (using the Knightian definition of uncertainty) future, and the degree of investment that takes place determines the overall income level which then determines the level of consumption and savings. One key property of an economy operating inside the PPF is that consumption AND investment can both increase simultaneously, and this is represented by movement towards the frontier. Keynes’ viewed consumption as being relatively stable, whereas investment was unstable (due to the uncertainty mentioned above) and virtually all of his policy recommendations were centered around stabilizing investment demand by reducing uncertainty and lowering the rate of interest on money (you won’t find anything about countercyclical fiscal policy in the GT – the word “deficit” is only mentioned twice in the entire book, and the paragraphs on “burying bottles and building pyramids” was Keynes being sarcastic towards the views of the classical economists). Like I said, READ the GT, and then tell me if anything in it remotely resembles the IS-LM model of the “Keynesians” or the sticky wage models of the “New Keynesians”.

  29. Benign Brodwicz writes:

    You academic economists are so lame, twiddling your monetary and fiscal dials and arguing about such chestnuts as wage rigidity. There are so many other ways to mitigate the human costs of cyclical fluctuations, e.g, as old-timer Lester Thurow pointed out years ago, DON”T SPEND EVERY FRIGGIN’ CENT YOU MAKE (i.e., Japanese large spring bonus, precautionary balances, and [somwhat-erstwhile] commitment to employment), or, HAVE A LIVEABLE DOLE FOR RECESSIONS so that AgD doesn’t take such a big hit and people get a [constrained] mini-vacation as a reward for being an inflation-fighter (or failure-of-confidence-scapegoat, as I see it).

    Americans will do anything but look human need in the face. We’d rather imprison it, use ridiculously gameable macro policies to “attack” it (while enriching those who know how to play the game), or just plain ignore it (the declining life expectancy of the bottom income brackets of the American population).

    As I’ve said before, we live in an age of larcenous financial tricksters in America today, and the more we play foolish games, the more the tippy-top of the income distribution is going to game the central bank and financial system (which some would say they control by Wall Street prox[imit]y) and suck the rest of us dry.

    Get real, guys. America is fracturing. What we need to policies directed at PEOPLE.

  30. To Benign Brodwicz,

    I agree that it’s also very important that we save more, and that we crack down on corruption and increase transparancy, and that we deal with income inequality by making high return social investments. In fact I think that the best thing we can do to improve the quality of life of just about everyone is to increase taxes on the wealthy and costly externalities like carbon production greatly, and then invest the money in very high return projects such as alternative energy, basic scientific and medical research, education, infrastructure, universal health insurance, etc.

    And no, the wealthy are not going to suddenly work far less. Look up the old and totally accepted income and substitution effects in any intermediate college microeconomics text. The gist is this if your wage per hour goes from $8/hour to $12, you might (in the short run) want to work 45 hours per week instead of 40, because you get an extra $4 for an hours work, but if your income went from $40/hour to $1 million per hour, you’d probably cut your hours to like 40 per year! That’s the income effect kicking in big time.

    Taxes generally don’t seriously affect work hours in the long run unless they hit a very high extreme that we’re far from. Cornell Economist Robert Frank has an excellent discussion of this in a book of his you would like, “Luxury Fever”. For something quicker, however, please read his New York Times Economic Scene article from April 12th, 2007, “In the Real World of Work and Wages, Trickle-Down Theories Don’t Hold Up”. A quote:

    Trickle-down theorists are quick to object that higher taxes would cause top earners to work less and take fewer risks, thereby stifling economic growth. In their familiar rhetorical flourish, they insist that a more progressive tax system would kill the geese that lay the golden eggs. On close examination, however, this claim is supported neither by economic theory nor by empirical evidence.

    The surface plausibility of trickle-down theory owes much to the fact that it appears to follow from the time-honored belief that people respond to incentives. Because higher taxes on top earners reduce the reward for effort, it seems reasonable that they would induce people to work less, as trickle-down theorists claim. As every economics textbook makes clear, however, a decline in after-tax wages also exerts a second, opposing effect. By making people feel poorer, it provides them with an incentive to recoup their income loss by working harder than before. Economic theory says nothing about which of these offsetting effects may dominate.

    If economic theory is unkind to trickle-down proponents, the lessons of experience are downright brutal. If lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. According to trickle-down theory, then, the cumulative effect of the last century’s sharp rise in real wages should have been a significant increase in hours worked. In fact, however, the workweek is much shorter now than in 1900.

    Trickle-down theory also predicts shorter workweeks in countries with lower real after-tax pay rates. Yet here, too, the numbers tell a different story. For example, even though chief executives in Japan earn less than one-fifth what their American counterparts do and face substantially higher marginal tax rates, Japanese executives do not log shorter hours.

    Trickle-down theory also predicts a positive correlation between inequality and economic growth, the idea being that income disparities strengthen motivation to get ahead. Yet when researchers track the data within individual countries over time, they find a negative correlation. In the decades immediately after World War II, for example, income inequality was low by historical standards, yet growth rates in most industrial countries were extremely high. In contrast, growth rates have been only about half as large in the years since 1973, a period in which inequality has been steadily rising.

    The same pattern has been observed in cross-national data. For example, using data from the World Bank and the Organization for Economic Co-operation and Development for a sample of 65 industrial nations, the economists Alberto Alesina and Dani Rodrick found lower growth rates in countries where higher shares of national income went to the top 5 percent and the top 20 percent of earners. In contrast, larger shares for poor and middle-income groups were associated with higher growth rates. Again and again, the observed pattern is the opposite of the one predicted by trickle-down theory.

    Another common objection of conservatives is that governemnt spending on basic scientific and medical research, infrastructure, alternative energy, education and training, etc., would be wasteful. If it was so good the free market would do it better, but this is far from the truth and based on simple-minded slogan economics. These are the kinds of things that the free market will grossly underprovide and/or provide less efficiently due to very well proven and accepted in economics market problems like externalities, inability to patent, assymetric information, giant economies of scale/monoploy power, and many more which you can find in any intermediate college economics text (usually micro).

    So increasing taxes on negative extrenalities and the wealthy and spending a lot more on high social return investments is the most important thing, but other things, like monetary policy, are important too. Doing that well would have avoided the Great Depression. Optimally we should have at least some people thinking about it. My job involves it in part, so I should.

  31. Benign Brodwicz writes:


    What a kind response to a rant! Thank you for your support.

    However, the theme of our host’s last post was a “run” on central banks, and the attendant loss of confidence therein (and in their monies). I do think Investment Banker Ben has instituted the Imperial Fed Chairmanship–which, on top of the Imperial Presidency, should give pause. A general falling off of trust in monetary policy is perhaps justified.

    On the fiscal policy front, I read in Forbes the share of Federal personal income taxes paid by the bottom half of households is about 3%, so there really isn’t much tax-cutting available there, and increased transfers, perhaps directed at health, training and education, might be necessary. Funding? I have no problem raising taxes (including the payroll ceiling) on upper income groups. And of course stopping stupid and useless military spending, of no strategic value in the 21st century (see John Robb’s Global Guerillas blog) would help.

    But until we get a Congress that isn’t indentured to Big Money, we will get no useful legislation. Looks to me like the Military-Industrial complex is calling the shots in a way to line their pockets.


  32. Steve,

    I was looking at some of your personal posts. My long time girlfriend was born in Budapest and lived there until she was 14, when her family moved to one of your homes, Baltimore. What are/were you doing in Romania?

  33. Steve,

    Sorry, I glazed at your personal posts too quickly. I looked again and see that your family is from Romania, or at least owned property there. I also probably should have left my comment at that post, but I wasn’t sure you’d see it. Anyway, I’ll do so next time. By the way, beautiful photography. I don’t know if it’s yours, but I just decided to get into photography and am about to buy a Nikon D300.

  34. Richard — Those photos were an ad, so I made ’em as snazzy as I could. The backdrop to Interfluidity is a Black Sea sunrise. Enjoy the Nikon!

    Benign & All — Your “host” is incredibly gratified by the quality of comments here, even when he neglects to wade in and respond. As a reader, I’ve often found blog comments as informative as the headline posts. I’m certain that Interfluidity readers have much more to gain from commenters than from my occasional rants.

    RTD — That was a particularly nice way of describing Keynes’ General Theory. Which, to my shame, I’ve not read cover to cover — yet. I did enjoy Chapter 12, though. Taking another look at that, I should have included the following in a recent post:

    Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

  35. RueTheDay writes:

    Steve – Speaking of apropos quotes, you might want to have a look at page 337 of Hyman Minsky’s Stabilizing An Unstable Economy, where he describes the very subject of this entry, a run on the Federal Reserve.

    I have this little heuristic that I use in judging the emerging popularity of everything from different programming languages to exercise regimes – I note the shelf space dedicated to the particular topic at the big box book stores like Borders and B&N. I spent last week in Denver (I live on the East Coast), visited a few bookstores (I’m a nerd, I know) and couldn’t help but notice the proliferation of Minsky’s books. One store had multiple copies each of all three of his in-print works: JM Keynes, Stabilizing an Unstable Economy, and Can It Happen Again.

  36. RTD — Not a bad heuristic. I certainly have used it for programming languages, but haven’t so much with economics, yet.

    I mean to read the Minsky books. Have just begun Hayek’s Denationalization of Money, but will really need to go cold turkey from the b-sphere for a few week or two to read actual books. It’s probably worth doing, despite my addiction to the breathless immediacy of this medium…

  37. Steve,

    I’m not expert on commodity inventory estimates, so I look to people like Krugman, a man who has obviously shown himself to be immensely intelligent, competent, well connected, and well intentioned.

    Yves Smith, in his profile, says ideas should stand on their own merits and not on the messenger, and this is true to a large extent, but the messenger is still usually important for a number of reasons including:

    First, ideas often depend on raw facts and data that the reader doesn’t know, so the messenger could be lying or mistaken about them. If the messenger is highly credible and competent, this can greatly increase the odds that the facts and data are essentially correct.

    Second, ideas are often complex. You can make a mistake in evaluating them at first blush. If you agree with the idea, and the messenger of the idea is one you know to be highly competent and trustworthy, then you know the odds are greatly decreased that you have made a mistake and there’s actually something very wrong with the idea.

    So the messenger matters, although many great ideas and insights come from those who have not yet established a reputation, so you should try to give them a hearing to the extent that it’s reasonable.

    In any case, for things like commodity inventories, I’m not an expert, so I demur to the ultra-intelligent Krugman, who over his vast career has become an expert on a great number of things, and is also super connected and resourced with Princeton, the New York Times, etc., etc., to find things out.

    He doesn’t see excess inventories and actually responds to Yves Smith in his May 12th post, “Why oil isn’t gold”:

    Here’s the key fact: as nearly as I can tell, private gold stocks — gold held as a store of value and/or for speculation — are equal to about 50 years’ worth of production.

    Meanwhile, private stocks of crude oil are equal to about 50 days’ worth of production. Yes, we should also add stocks of refined products; and there may also, as Yves Smith likes to remind us, be some additional unrecorded stocks (in 1979, I remember, everyone was filling their gas tanks as often as possible, adding to the speculative demand); but the fact remains that oil prices are much more closely tied to the flow of production and consumption than gold, or any other good that is mainly held as an asset rather than actually consumed.

    With regard to just keeping oil in the ground, I haven’t researched this thoroughly, but I am an avid daily reader of the New York Times, Washington Post, etc., and over the last couple of years I don’t remember reading anything about OPEC significantly cutting production. I actually seem to remember them somewhat increasing it.

  38. mike Jr writes:

    I was reading this and it was interesting..I had a thought just now. It is argued that a gold standard cannot work today because of the velocity of money..I disagree. In all systems or chemical reactions there is a limiting factor..If there is a limited amount of gold, growth cannot occur more quickly than miners can create more gold. That puts a foundation and limit on sustainable growth and resource use worldwide. In the fiat twilight zone that we currently live in, it is difficult to rationally price anything. Thus much mal-investment occurs. We tear down perfectly good sports stadiums and buildings to build another one in its place before the first one was paid for. We build bridges to nowhere, we ues massive amounts of fuel to ship products and materials all over the world. It is not rational or efficient. In a gold standard, a lot of this waste is taken out since the amount of money is more limited and it must do actual work for its owners to profit. Sure growth would be less,if tied to metals, but there would be some constraint on use of resources, food, water,land, national and private savings, even on government spending. I tend to see that the poor will suffer in such a system, but I doubt it can be any worse than what is currently happening as Chopper Ben and his friends allow the price of commodiites like grains to rise so rapidly that half of the worlds population may be outbid in the marketplace called economic Darwinism. If the central banksters go bust, and the fiat toilet paper currencies of the world reset to their true worth, (insulation material?) then let the games begin. I remember a French queen who lost her head after she told the starving masses who were begging her for affordable bread to “go eat cake” These banksters and their friends are charting a very dangerous path for the continued peaceful co-existance of the different social classes around the world. Sadly, I cannot see a peaceful end to the mess they have created. The pundants who predict a global depression and war in the not distant future are missing another important step in this process..the abandonment of fiat currencies will happen again (as they always have before).