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The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

by Mike Kimel

The Fed, Primary Dealers, and the Ineffectiveness of Monetary Policy

The Federal Reserve’s primary tool for monetary policy is buying or selling securities, in particularly US notes, bills and bonds.

But… it doesn’t buy and sell bonds to you and me. Instead, it deals with primary dealers – the complete list is here. The list includes reputable and scandal-free companies such as Citigroup, Bank of America (actually, it’s subsidiary Merrill Lynch, Pierce, Fenner & Smith Incorporated), Goldman Sachs, and UBS. What does it take to get removed from the list? Well, the most recent change to the list occurred when MF Global was removed on October 31, 2011. By coincidence, that was the day that MF Global declared bankruptcy after making almost $900 million of other people’s money disappear. Bear Stearns came off October 1, 2008, four months after the company imploded and sold itself to JP Morgan. Lehman came off a week after it declared bankruptcy.

Other past luminaries include Countrywide, Drexel Burnham Lambert, Continental Illinois and Salomon Brothers, which makes for an interesting list if you tend to be the kind of person who remembers financial scandals of times past. I have no idea what criteria the Fed uses in picking its primary dealers – clearly controlling massive quantities of financial assets is a requirement, but financial viability and being off the public dole are not.

In fact, being a primary dealer is a way of being on the public dole. When the Fed confers the primary dealer designation, it confers a large, recurring financial gift on the designee. Remember, the Fed won’t engage in securities transactions with the public, just with primary dealers. So if the Fed is planning to sell bonds for $X, and you want to purchase bonds for $X + $Y, the Fed won’t just sell you those bonds. Instead, the Fed sells the bonds to Bank of America, and making the perhaps unreasonable assumption that Bank of America is able to execute without massively screwing something up, the bank then turns around and sells you the bonds, pocketing $Y.

This convoluted and inefficient way of doing business made sense in the 1960s when the scheme was cooked up. Now, its just another infusion of cash from you, me, and the Fed to many of the same institutions that took a good run at taking down the world economy, and which regularly require other infusions of cash to survive. These days we have computers – any halfway decent programmer could set up an auction system for the Fed that wouldn’t require regular transfers from the rest of us to Goldman Sachs and UBS. Heck, I can do it and I’m not a halfway decent programmer.

Of course, if you give it some thought, there is no particular reason the Fed’s way to conduct monetary policy has to involve buying and selling Treasuries. It could just as easily be funding social security benefits, placing money in the bank accounts of each American, flinging it from trebuchets or buying geraniums. Buying and selling securities is an inefficient way to adjust the money supply in this day and age, even if it made sense in 1913 when the Fed was established.

What do I mean when I say that buying and selling Treasuries is an inefficient way to conduct monetary policy? Well, its simple. As noted above, the Fed’s current process is a way to transfer funds from you and me to the primary dealers. By selecting how money is put into and taken out of the system, the Fed selects how monetary policy affects the economy.

The haves are less likely to spend an extra dollar of income than the have nots (in economic parlance, the wealthy have lower marginal propensity to consume than the poor), and when the haves do spend money, they generally don’t do it as quickly as the have nots (in economic-ese, the velocity of money is slower when wealthy people have it).

The reason it matters… during a recession, people and companies become more cautious and reduce their spending. That leads to less stuff being produced, less people working, etc., making the economic downturn worse. By pumping money into the economy, theoretically the Fed makes money cheaper, which in turn leads to more money being spent. That’s the theory, anyway.

But because the Fed’s way of increasing the money supply is designed to place more of it in the hands of the primary dealers, the process often doesn’t work very well even leaving out the fact that periodically, another member of this august group turns out to be corrupt, antisocial or incompetent. The money the Fed has been putting into the economy has not been getting spent. Since it isn’t getting spent, it isn’t doing any good for the economy. Rather, its been accumulated, in large part by the very same sectors of the economy that played so big a role in causing the crash. I believe that’s what Lloyd Blankfein was talking about when he said he was doing God’s work.

It is long past time to change the way the Fed operates.

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One question for Ben Bernanke

by Mike Kimel

The other day Ben Bernanke gave a speech in which he asked and answered five questions about the Fed:

1. What are the Fed’s objectives, and how is it trying to meet them?
2. What’s the relationship between the Fed’s monetary policy and the
fiscal decisions of the Administration and the Congress?
3. What is the risk that the Fed’s accommodative monetary policy will
lead to inflation?
4. How does the Fed’s monetary policy affect savers and investors?
5. How is the Federal Reserve held accountable in our democratic

I’d have asked only one question, similar to his first, albeit with a bit of prefacing. This is what I’d love to ask Bernanke.

The Fed has a very close relationship with the financial sector. Simple examples of this include:

a. Of the three advisory committees that advise the Board of Governors of the Federal Reserve directly, even in theory only one, the Consumer Advisory Council, has a non-zero number of members who don’t directly work for the financial sector. Regional Federal Reserve Banks are also, ahem, advised by similar committees made up entirely or almost entirely by financial institutions and/or their representatives.
b. By design, every one of the Fed’s methods for raising and lowering the money supply require direct interactions between the Fed and financial institutions. None of these methods even allow for any direct interactions between the Fed and members of the public. (Note that raising and lowering the money supply does not in any way constitute “regulating the banks.”)
c. Federally chartered banks and some state chartered banks are designated “members” of the Federal Reserve system – no similar appellation or roles apply to the public at large.
d. Federal Reserve banks serve as repository institutions for member banks, but none of the services performed by the Fed for banks are
available to the public at large.
e. And of course, there is something of a revolving door between the Fed and the financial sector.

Given all of this, what would the Fed’s objectives be, and how would it be trying to meet those objectives, if the interests of the public were given equal weight to the interests of the financial sector?

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The Main Point

Peter Dorman at Econospeak brings us another reminder about policy decisions on the economy.  Reposted from Econospeak:

The Main Point

Macroeconomics is complicated and political economy is devilish, so it is easy to get lost in the details. From time to time, it’s good to come up for air—to remember what the fundamental issue is. In a way, the debate over structural versus cyclical factors invites us to do just that.

Suppose the current recession/depression is mainly structural. Suppose it is due to an immense misallocation of capital and labor, a failure to foresee what our economy would really demand in the years ahead. According to this story, we have trained too many masons and anthropologists and invested in too many building cranes and liberal arts colleges, and it will take years to shift our human and produced resources to more valuable pursuits. (Actually, I think there continues to be an enormous misallocation of investment, but this will become apparent only when the threat of global warming is taken seriously.) If the structuralist story is right, the ongoing slump is necessary and unavoidable and will end only when we have fashioned the resources for producing the right stuff.

If the cyclical story is predominately true, however, we have neither the wrong people nor the wrong capital stock. We have all the ingredients it takes to have a vibrant economy that can fully employ our populations and generate a standard of living that surpasses what we had in the past and that keeps growing further. But think about it: if we have the wherewithal to resume prosperity, what holds us back? And why should rational people accept any excuses for policies that delay it?

Repeat: we have everything we need, right now, to restart our economies. All the unemployment, the hardship, the lost opportunities are unnecessary. That’s the main point.

The secondary point is about the why. There are ultimately two reasons why economies like ours get stuck in a cyclical rut. The first is that there is a reinforcing cycle of insufficient demand and insufficient investment. This is where standard countercyclical policy comes in: through fiscal deficits the government increases demand on its own initiative, and through monetary easing an impetus is added to investment. We are near the limit of what easing can do (diminishing returns to the QE’s), but not anywhere near the limit of fiscal expansion.

The second reason arises in balance sheet recessions: too much private borrowing has taken place, debtors find it difficult to sustain debt service, and both debtors and creditors retrench. In this case, which is ours, the essential problem is that fulfillment of claims on wealth—both credit claims and equity claims on debt-related assets—interferes with the conditions required for restarting growth. In other words, the shadow of past wealth creation is depriving new wealth creation of sunlight. While respecting wealth claims is desirable during normal times, since it supports long-term planning, there come episodes in which a choice must be made between the past and the future. This is such a time. Wealth claims need to be trimmed, quickly and sufficiently, in order to reduce leverage and permit economies to return to growth. We shouldn’t forget the main point, which is that economic growth produces the stuff of which real wealth is made, while satisfying the claims inherited from yesterday only allocates this stuff. (And in a slumping economy the claims can’t be honored anyway.)

If you accept the cyclical story, and the evidence certainly weighs in its favor, you should not accept another month, much less year after year, of excuses for austerity.

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Paul Krugman is Very, Very Wrong

by Mike Kimel

Update …Since this post has gotten a lot of attention, jump here for my
final word
on this topic.

I’m sure I’m missing something here, because Paul Krugman is so often extremely perceptive, but I think here he is very, very wrong. He writes:

The naive (or deliberately misleading) version of Fed policy is the claim that Ben Bernanke is “giving money” to the banks. What it actually does, of course, is buy stuff, usually short-term government debt but nowadays sometimes other stuff. It’s not a gift.

To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.

Um, I dunno. Perhaps on specific day to day operations Ben B. is not giving money to the banks, but things look very different with a 30,000 foot view. (I suspect “the banks” most people mean if they say there are giveaways going on are not all banks but rather a small subset of basket cases.) Remember the toxic asset purchase? When the Fed spends over a trillion bucks paying the face value for securities whose real worth has declined to a fraction of that face value, to me that is both an expansion of the money supply and a give-away to those from whom one “purchases” those assets. There have been any number of similar, er, programs the Fed has run in the last few years which have had the same purpose: injecting money into a small number of entities that made extremely bad lending decisions in ways that specifically avoid making those entities pay any sort of market or reasonable price for that money.

That isn’t the only error in Krugman’s post. He also tells us this:

Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread, either by persuading investors that it will keep short rates at zero for a longer time or by going out and buying long-term assets. These are actions you would expect to make bankers angry, not happy — and that’s what has actually happened.

Yes, the Fed is sending a message that it well keep short rates at zero for a while longer. But which short rates and which long rates is Krugman talking about? Because banks can borrow at one rate – the effective federal funds rate, and they loan money to the public at a number of other rates.

I wandered over to FRED, the economic database of the St. Louis Fed and downloaded the Effective Federal Funds rate and the Average 30-Year Mortgage rate, which should be a good representation of a long rate used in loans by banks to the public.

The thirty-year mortgage is first reported on 5/7/1976 and is reported weekly thereafter. The FF tends to be reported a day or two earlier or later depending on the week, holiday schedules, and the like. Here’s what the 30-year Mortgage less the Fed Funds rate looks going back that far:

As is evident from the graph, whatever the Fed has been doing since the recession began in December of 2007, it isn’t compressing the spread between the 30-year mortgage rate and the Fed Funds rate.

Perhaps things might look different if the Fed followed more of a Banco do Brasil model, where the public could borrow directly from the Central Bank. But as things stand, pace Krugman, the Fed’s interventions since the recession began have only increased the spread between the rate at which banks can borrow and the rate at which they can loan out money.

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The Scariest Graphic I Made All Week, or, Still More on Excess Reserves and "Money"

One of the nice things about the Kauffman Foundation’s Blogger Conference is the time to let the mind wander and look at data after having your brain scoured.

One of the worst things is realizing too late that you’ve got a Really Ugly Graphic, and most of the people who could help with it are gone.

Four hours ago at dinner, I was sitting between Brad DeLong and Tim Duy (who pointed out some good contemporary performers of Real Country Music), but I didn’t have this graphic with me. Now Tim is on a plane and Brad is teaching students, and my best option is to ask the AB commentariat if the following graphic scares them as much as it does me.

Even given my hobby-horse attitude toward Excess Reserve (i.e., the Sheer Unmitigated Contempt with which I treat the idea that reserves in general—let alone Excess Reserves—should “earn” interest), the dropping-off-a-cliff impression (and the overall downward trend, even keeping in mind that we do not Seasonally Adjust Excess Reserves, and therefore Seasonal Effects are clear) almost seems to explain why the 32nd month of the “recovery” feels as if it’s just possibly starting something.

To be fair—and a hearty “thank you” to Jeff Miller of A Dash of Insight for reminding me that most people believe the Fed concentrates on M2, not M1—the broader index shows an upward trend (again, discounting the recent decline as a Seasonal Effect):

Otoh, an overall ca. 5% increase in “Net M2,” as it were, over a year in which the dollar has increasingly appeared to be the only reasonable “Safe Haven” doesn’t seem all that large either.

I’ve yet to play with the data beyond this, so I leave it to the AB comentariat:

  1. Do you believe there is something here?
  2. If so, any guesses what it is? Or anything you want to know about it?
  3. If not, what else should we be looking at where Excess Reserves may/should/will (depending upon your degree of certainty) affect the value of the data and/or Real Economic Growth?

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Must-Read of the Day, non-NBER edition

Tim Duy body-slams St. Louis FRB President James Bullard:

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources. The backbone of the CBO’s estimates is a Solow Growth model. So I don’t think that Noah Smith is quite accurate when he says:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model – and all models like it – are wrong. He’s saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

Bullard can’t be saying the Solow growth model is wrong because he doesn’t realize that such a model is the basis for the estimates he is criticizing. [first and last link in the original; Noah Smith link copied from elsewhere in the original post]

Go Read the Whole Thing. For those of you too lazy to do that without incentive, here’s the conclusion:

Bottom Line: Bullard really went down an intellectual dead end last week. He criticized the focus on potential output, but revealed that he doesn’t really understand the concept of potential output either empirically or theoretically. He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path. And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating. I just don’t see where Bullard thinks he is taking us.

It’s Worse Than You Think.

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Deja Vu All Over Again, or On the Whole…

The President of the Federal Reserve Bank of Philadelphia:

We have been putting out credit in a period of depression, when it is not wanted and could not be used, and will have to withdraw credit when it is wanted and can be used.

But this is not Charles I. Plosser, no matter how similar the sound. It’s from September of 1930,* presumably George W. Norris (PDF; see page 4).**

Indeed, reviewing the Calmoris and Wheelock article from which I pulled that quote, we find the same mistakes being made: excess reserves confused with circulating money and therefore treated as harbingers of inflation, squealing for austerity,*** sterilization of shifts in reserves in a desperate attempt to avoid non-visible inflation.

As Owen Wilson’s Gil says in Midnight in Paris, we have antibiotics; the people in Fin de siècle Paris didn’t. It’s just one of our other “sciences” that appears not to have advanced.

*Michael D. Bordo;Claudia Goldin;Eugene N. White. The Defining Moment: The Great Depression and the American Economy in the Twentieth Century (National Bureau of Economic Research Project Report) (p. 36). Kindle Edition.

**Not to be confused with George W. Norris, the Nebraska Senator discussed in Profiles in Courage

***The Norris quote above begins:

We believe that the correction must come about through reduced production, reduced inventories, the gradual reduction of consumer credit, the liquidation of security loans, and the accumulation of savings through the exercise of thrift. These are slow and simple remedies, but just as there is no “royal road to knowledge,” we believe there is no short cut or panacea for the rectification of existing conditions.

Chancellor of the Exchequer George Osborne, not to mention EC President Herman von Rompuy, would be proud.

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The ECB is Plugging Holes

by Rebecca Wilder

The ECB is Plugging Holes

Today the ECB released its monthly data on monetary developments in the Euro area (EA), as measured by M3 and its components. The market usually focuses on the marketable assets portion of M3, M3-M2, as a representation of funding access – here’s an FT Alphaville post highlighting as much. In December 2011, M3-M2 declined 0.2% over the year, its first annual decline since early 2010. What’s going on here? The ECB’s plugging holes.

There’s an evolution in marketable debt that is telling a very interesting story regarding bank funding through December 2011. As each private funding market shuts down, the ECB compensates by relaxing its lending facilities and collateral rules, effectively shoring up bank liquidity.

Look at the chart below: it maps out the dynamics of the components of marketable instruments in the EA, M3-M2, in levels of seasonally adjusted billion €. See Table 1 of the release, or download the data here. Since September 2011, the level of repo lending dropped 21%, or – €107 billion. Not coincidentally, the ECB started to introduce longer-term refinancing operations starting with the 1-yr in LTRO October. Holdings of debt instruments <2 years increased €40 billion, as banks use the securities for collateral under the ECB’s lending operations.

The ECB is offsetting, at least partially, the crunch in private repo funding markets.

This policy behavior is evident throughout 2010. Spanning the period January 2010 to August 2011, money market securities fell -€ 108 billion while private repo lending rose € 179 billion. The ECB offset fully the dropoff in funding from mutual fund shares by flushing private repo markets with liquidity.

The Table below describes the dynamics of funding through marketable assets more succinctly.

It’s pretty clear what the ECB is doing: plugging up the bank funding holes left exposed by private capital markets. What’s next?

originally published at The Wilder View…Economonitors

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How Keynesian Policy Led Economic Growth In the New Deal Era: Three Simple Graphs

by Mike Kimel

In this post, I will show that during the New Deal era, changes in the real economic growth rate can be explained almost entirely by the earlier changes in federal government’s non-defense spending. There are going to be a lot of words at first – but if you’re the impatient type, feel free to jump ahead to the graphs. There are three of them.

The story I’m going to tell is a very Keynesian story. In broad strokes, when the Great Depression began in 1929, aggregate demand dropped a lot. People stopped buying things leading companies to reduce production and stop hiring, which in turn reduced how much people could buy and so on and so forth in a vicious cycle. Keynes’ approach, and one that FDR bought into, was that somebody had to step in and start buying stuff, and if nobody else would do it, the government would.

So an increase in this federal government spending would lead to an increase in economic growth. Even a relatively small boost in government spending, in theory, could have a big consequences through the multiplier effect – the government hires some construction companies to build a road, those companies in turn purchase material from third parties and hire people, and in the end, if the government spent X, that could lead to an effect on the economy exceeding X.

This increased spending by the Federal government typically came in the form of roads and dams, the CCC and the WPA and the Tennessee Valley Authority, in the Bureau of Economic Analysis’ National Income and Product Accounts (NIPA) tables it falls under the category of nondefense federal spending.

Now, in a time and place like the US in the early 1930s, it could take a while for such nondefense spending by the federal government to work its way through the economy. Commerce moved more slowly back in the day. It was more difficult to spend money at the time than it is now, particularly if you were employed on building a road or a dam out in the boondocks. You might be able to spend some of your earnings at a company store, but presumably the bulk of what you made wouldn’t get spent until you get somewhere close to civilization again.

So let’s make a simple assumption – let’s say that according to this Keynesian theory we’re looking at, growth in any given year a function of nondefense spending in that year and the year before. Let’s keep it very simple and say the effect of nondefense spending in the current year is exactly twice the effect of nondefense spending in the previous year. Thus, restated,

(1) change in economic growth, t =
f[(2/3)*change in nondefense spending t,
(1/3)*change in nondefense spending t-1]

For the change in economic growth, we can simply use Growth Rate of Real GDP at time t less Growth Rate of Real GDP at time t-1. The growth rate of real GDP is provided by the BEA in an easy to use spreadsheet here.

Now, it would seem to make sense that nondefense spending could simply be adjusted for inflation as well. But it isn’t that simple. Our little Keynesian story assumes a multiplier, but we’re not going to estimate that multiplier or this is going to get too complicated very quickly, particularly given the large swing from deflation to inflation that occurred in the period. What we can say is that from the point of view of companies that have gotten a federal contract, or the point of view of people hired to work on that contract who saved what they didn’t spend in their workboots, or storekeepers serving those people, they would have spent more of their discretionary income if they felt richer and would have spent less if they felt poorer.

And an extra 100 million in nondefense spending (i.e., contracts coming down the pike) will seem like more money if its a larger percentage of the most recently observed GDP than if its a smaller percentage of the most recently observed GDP. Put another way, context for nondefense spending in a period of rapid swings in deflation and inflation can be provided by comparing it to last year’s GDP.

So let’s rewrite equation (1) as follows:

(2) Growth in Real GDP t – Growth in Real GDP t-1
f[(2/3)*change in {nondefense spending t / GDP t-1},
(1/3)*change in {nondefense spending t-1 / GDP t-2}]

Put another way… this simple story assumes that changes in the Growth Rate in Real GDP (i.e., the degree to which the growth rate accelerated or decelerated) can be explained by the rate at which nondefense spending as a perceived share of the economy accelerated or decelerated. Thus, when the government increased nondefense spending (as a percent of how big the people viewed the economy) quickly, that translated a rapid increase in real GDP growth rates. Conversely, when the government slowed down or shrunk nondefense spending, real GDP growth rates slowed down or even went negative.

Note that GDP and nondefense spending figures are “midyear” figures. Note also that at the time, the fiscal year ran from July to June… so the amount of nondefense spending that showed up in any given calendar year would have been almost completely determined through the budget process a year earlier.

As an example… nondefense spending figures for 1935 were made up of nondefense spending through the first half of the year, which in turn were determined by the budget which had been drawn up in the first half of 1934. In other words, equation (2) explains changes in real GDP growth rates based on spending determined one and two years earlier. If there is any causality, it isn’t that growth rates in real GDP are moving the budget.

Since there stories are cheap, the question of relevance is this: how well does equation (2) fit the data? Well, I’ll start with a couple graphs. And then I’ll ramp things up a notch (below the fold).

Figure 1 below shows the right hand side of equation (2) on the left axis, and the left hand side of equation (2) on the right axis. (Sorry for reversing axes, but since the right hand side of the equation (2) leads it made sense to put it on the primary axis.)

Notice that the changes in nondefense spending growth and the changes in the rate of real GDP growth correlate very strongly, despite the fact that the former is essentially determined a year and two years in advance of the latter.

Here’s the same information with a scatterplot:

So far, it would seem that either the government’s changes to nondefense spending growth were a big determinant of real economic growth, or there’s one heck of a coincidence, particularly since I didn’t exactly “fit” the nondefense function.

But as I noted earlier in this post, after the first two graphs, I would step things up a notch. That means I’m going to show that the fit is even tighter than it looks based on the two graphs above. And I’m going to do so with a comment and a third graph.

Here’s the comment: 1933 figures do not provide information about how the New Deal programs worked. After all, the figures are midyear – so the real GDP growth would be growth from midyear 1932 to midyear 1933. But FDR didn’t become President until March of 1933.

So… here’s Figure 2 redrawn, to include only data from 1934 to 1938.

While I’m a firm believer in the importance of monetary policy, for a number of reasons I don’t believe it made much of a difference in the New Deal era. As Figure 3 shows, changes in nondefense spending – hiring people to build roads, dams, and the like, explain subsequent changes in real GDP growth rates exceptionally well from 1934 to 1938. This simple model explains more than 90% of the change in real GDP growth rates over that period.

Of course, after 1938, the relationship breaks down… but by then the economy was on the mend (despite the big downturn in 1938). More importantly (I believe – haven’t checked this yet!), defense spending began to become increasingly important. People who might have been employed building roads in 1935 might have found employment refurbishing ships going to the Great Britain in 1939.

As always, if you want my spreadsheet, drop me a line. I’m at my first name (mike) period my last name (kimel – note only one “m”) at

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Scaling to New Depths* with Scott Sumner

by Mike Kimel

Scaling to New Depths* with Scott Sumner

I’ve been having a bit of back and forth with Scott Sumner. Here is his latest post, helpfully entitled: “A suggestion for Mike Kimel.”

His key suggestion:

“Please take a close look at the data from the Great Depression, before doing more posts claiming I don’t know the facts.”

He then goes on to point out he’s been studying the 1933 period for 20 years. From there he goes on to explain my first mistake:

He insists that FDR’s dollar depreciation program began in October 1933, even though all economic historians agree in began in mid-April 1933, when the exchange rate for the dollar began declining (against gold and against other currencies.) He insists prices began rising before FDR took office off, which is not true. He presents a graph that he claims shows prices rising before FDR took office, but his graph shows inflation rates, not the price level. In fact, the graph actually supports my argument that inflation didn’t turn positive until after FDR took office. There’s a difference between the rate of inflation and the price level.

OK. Let’s redo the graph showing not inflation but rather the price level. And I’ll keep it very simple… I will limit it to two points. Well, three, though the third is not exactly on the curve so to speak. As before, I’m still using PPI because its the publicly available source most closely related to the prices Sumner seems to be discussing, and I’ll use the graphics tool at the Federal Reserve Economic Database (FRED)

Figure 1.

The graph shows the PPI for February and March of 1933. FDR took office in March 1933.

As I noted in my previous post,

You can see the decline in prices halt and start reversing even before he took office.

Now, I don’t remember arguing that inflation didn’t turn positive before then. To me, its a big deal that PPI hit rock bottom and reversed itself. Getting out of free-fall was in itself a big deal. Here’s a graph for 1929 to 1934 to give you an idea:

Figure 2.

Note that February 1933 happened to be the low point for PPI during its entire history, and the PPI had been calculated since 1913.

But there’s another important point in the quote I provided above, namely this:

He insists that FDR’s dollar depreciation program began in October 1933, even though all economic historians agree in began in mid-April 1933, when the exchange rate for the dollar began declining (against gold and against other currencies.)

This isn’t quite right. As I’ll make clear, I don’t think the dollar actually depreciated against gold until January 1934. Sumner was so insistent on this depreciation occurring before then that I spent a bit of time on google and found a story by Jesse Jones, head of the Reconstruction Finance Corporation, about how FDR had him and soon to be Treasury Secretary Morgenthau help him (FDR) revalue the price of gold.

Now, I am not an economic historian, and I’m not sure I know any these days, so for all I know, Sumner is correct about what all economic historians agree happened. I am, instead a data guy. I like data. Scratch that. I love data. I go through data in my spare time. Most of the stuff I do at this blog, for instance, has absolutely nothing to do with my day job. Nothing. But its an opportunity to play with data. My wife usually scratches her head wondering why I do this kind of thing, but everyone needs a hobby and I don’t watch tv.

One thing I’ve learned with data is that its generally important to go back as close to the original source of data as possible. Another is to know something about your sources. Go through the data. Read footnotes.

So in that spirit, I decided to try see what I can learn by looking for data from the era or thereabouts, ideally coming directly from the folks who collect it. I have not succeeded in finding a series that shows what Sumner claims. In fact, data from around that era, particularly on gold prices, isn’t easy to come by. But I have found a few examples.

For instance, Table Number 230 of the 1936 Statistical Abstract of the United States shows the supply of gold in the United States on June 30 of each year (going back annually to 1887, and with selected years before then). The data seems to originate with the Treasury and the Fed, though I haven’t been able to locate the contemporaneous originals.

Footnote 1 reads in part:

By a proclamation of the President dated Jan. 31, 1934 the weight of the gold dollar was reduced from 25.8 to 15 5/21 grains of gold, 0.9 fine. The value of gold is therefore based on $35 per fine ounce beginning June 1934; theretofore it is based on $20.67 per fine ounce.

In other words a couple months after Sumner and other economic historians believe the dollar had started losing value against gold, the Fed and/or the Treasury were reporting to the Census (which publishes the Statistical Abstract) that the price of gold was still exactly the same as it had been.)

Now, its possible the Census or the Fed or the Treasury made a mistake and it went uncorrected by the time of the 1936 Statistical Abstract. So one source is not enough, especially when Sumner and “all economic historians” agree it is wrong.

Which leads to a Fed document called Banking and Monetary Statistics 1914 – 1941. This is from the section on gold (bottom paragraph, left hand column, page 522)

All figures are in dollars, calculated at the rate of $20.67 per fine ounce of gold through January 1934 and $35 per fine ounce thereafter (except that the figures for the year 1934 in Table 159 are based upon the $35 gold price). The change in rate results from the fact that on January 31, 1934, the dollar was devalued by 40.94 per cent in terms of gold in accordance with a proclamation issued by the President.

If you’re curious, $35 – $20.67 = $14.33. $14.33 happens to be 40.94% of $35.

The document is chock full of tables that show, including other things, the monthly value of US gold holdings. Where dollar figures are involved, those tables also carry a helpful note indicating the price as $20.67 an ounce through January 1934, and $35 an ounce thereafter. Note that the Fed valued monthly holdings at $20.67 an ounce in April, May, June, July, August, September, October, November and December of 1933 when, all along, according to Scott Sumner who spent 20 years studying the era and “all economic historians,” insist the price of gold had been rising at the time.

I’ve stumbled on a few other sources as well but they don’t look any different. I’m just not seeing the series that shows the dollar price of gold rising during the months from April 1933 to January 1934.

So what is going on? I’m going to split the baby here and suggest that both Scott Sumner and “all economic historians” are right that there was a devaluation, and the Fed and the Treasury and the Statistical Abstract of the United States were (and are) right that there wasn’t. But the way in which they are right is very definitely not a good thing for Scott Sumner and “all economic historians.”

See, as I said above, I’m not an economic historian, but I did spend my formative years in South American in the 1970s and 1980s. As anyone who spent roughly the same years in the region as I did could tell you, or as any Zimbabwean can do today, during times of turmoil (which can last decades) the official exchange rate can come to bear no relationship with the actual price at which a currency trades against something that is considered more stable and more desirable to hold. Heck, you don’t have to track down someone from Arrgentina or Zimbabwe – ask any European who ever visited the Soviet Block and traded in some Western currency at the airport or the border about how unrealistic official exchange rates could be. In many an economic basket case, the likelihood that a transaction takes place at anything resembling the official exchange rate is similar to the probability that someone walks into a Chevrolet dealership and pays the MSRP, in cash.

And like the MSRP, the official exchange rate has a purpose. Yes, there’s always someone clueless or coerced enough to pay that price. But for the most part, its a fiction that either serves as a baseline for something or papers over something the government wants to really do, usually printing money. Its a handy excuse to get from point A to point B, and if the excuse doesn’t fly, another one will do.

My guess, and I’ll repeat that I’m not an economic historian, is that when FDR and Jones and Morgenthau were picking prices out of the air, it was in that vein. The country was in turmoil when FDR took office, and there were fears that if things got worse there would be an armed insurrection. It wasn’t a time for half measures. My guess is the mood in the White House at the time was best summarized by a quote decades later from the immortal John Candy, “There’s a time to think, and a time to act. And this, gentlemen, is no time to think.”

So what did the fiction of changing the price gold accomplish if nobody else believe that the price had actually changed? I suspect it meant, in practice, that the Reconstruction Finance Corporation could pay more than $20.67 an ounce for gold. And why would the RFC (which, I note, could borrow outside the budget) want to pay more than $20.67 an ounce for gold if that was the price everyone was accepting?

Think of the RFC the way you think of the Fed trying to bail out banks in recent years – loaning money at below market rates to banks who then used the money to buy Treasuries which paid higher rates. In effect, paying more than $20.67 an ounce was a way to funnel riskless profits to banks. (Of course, the RFC often replaced management, but things have gotten permissive as well as more sophisticated in recent decades.)

Which brings us back to Sumner and “all economic historians” being right, at least technically. Yes, the currency was being devalued throughout much of 1933, but no, it wasn’t. Not really. There were a series of fictional devaluations that served a specific purpose, but which nobody else made believe was real (and its possible which almost nobody else was aware were happening – don’t ask me, I’m not an economic historian). Pretending otherwise, and using that fictional data to do an analysis is the equivalent of trying to understand the East German economy in 1974 using the exchange rates a traveler would have received at Checkpoint Charlie during that year.

* The title comes from a book put out by Mad Magazine in the 1970s or 1980s. Sorry I can’t be more specific – it has been a while

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