Book Highlights: The Midas Paradox (Part 5)

And in 2001 there was a similar inconsistency in statements made by officials at the Bank of Japan, who warned that quantitative easing would be ineffectual, but also that such a policy might lead to runaway inflation.

Fed adopted money supply targets in 1979, inflation fell to relatively low levels, where it has remained ever since.

Part of the problem was beyond their control. The “interest rate approach” to monetary policy is much easier to understand than the quantity of money approach—in fact it’s virtually the only approach used by the general public and the news media.

Monetarists understood at a theoretical level that what mattered was not so much the current change in the money supply, but rather the expected change in the future path of the money supply.

But monetarism was developed before the rational expectations revolution, and hence this insight was never fully incorporated into empirical monetarist analyses such as the Monetary History.

New Keynesianism is distinguished by its more sophisticated understanding of the potency of monetary policy and also its awareness that long-run wage and price flexibility give the economy a self-correcting mechanism.

Both of these insights can be seen as a belated recognition that Keynes misinterpreted both the apparent failure of the Fed’s 1932 open market purchases, and also the chronically high interwar unemployment rates triggered by policies such as the NIRA.

I believe that there is a much simpler explanation: Japan did not experience a liquidity trap but was instead successful at maintaining an inflation target of roughly 0 to -1 percent per annum.

Twice during the past decade, the Bank of Japan tightened monetary policy as the (core) inflation rate was approaching zero, from below.

When Ben Bernanke was asked in 2009 why the Fed didn’t aim for a higher inflation target, he didn’t claim the Fed was unable to generate higher inflation but rather argued that it would be undesirable.

In my view, this crisis has been misdiagnosed in a very similar way to the Great Depression. As in the 1930s, the current recession was associated with a severe drop in nominal spending (relative to trend), caused by excessively tight money. Of course, the mainstream view is that the recession was caused by a financial crisis, and that monetary policy was actually relatively expansionary.

More research needs to be done to explain why mar kets seemed to respond more bearishly to vague and uncertain fears of future devaluation than to expectations of imminent devaluation.

Virtually any neoclassical labor market model would predict that the announcement of a mandated 22 percent wage increase would reduce output sharply.

One would like an explanation that is rooted so deeply in the interwar political and economic systems that in retrospect, the Depression seems almost inevitable. But we would also like an explanation that would not have been obvious to the financial markets in mid-1929. This is not easy to do.

If there is a root cause to the Great Depression, it lies somewhere in the painful birth of the modern world, the difficulty that societies had in letting go of their emotional attachment to the “barbarous relic,” and moving to a more mature, and interventionist, monetary policy regime.

Temin is probably right that even had the interwar gold standard been relatively well managed, its eventual demise was both inevitable and desirable.

Capitalism was widely discredited by 1932.

During the 1932 campaign, even Hoover was discussing the need for a program like the National Industrial Recovery Act (NIRA)—and without the policy being accompanied by currency depreciation.

The fast-moving and extremely complex events of the interwar period simply do not allow us to resolve the age-old dispute between the “great man” and “deep historical forces” views of history, a debate that may tell us more about historians than it does about history.

Had either alternative strategy been followed, and a modest depression resulted, that alternative would have almost certainly received historical censure.

Here I should emphasize that not just my analysis of 1933, but the entire narrative in Chapters 2 through 10 hinges on monetary policy strongly impacting both prices and output almost immediately. If I am wrong, if policy has little or no immediate impact, then this entire narrative is essentially worthless.

I have found repeated links between policy shocks and contemporaneous movements in financial market prices, commodity prices, the WPI, and monthly industrial production. We know that all of these variables (with the possible exception of the policy shocks that I tried to identify) were highly correlated during the Depression. It makes no sense to argue, for instance, that monetary policy shocks had an immediate impact on stock and commodity prices but only impacted the WPI and industrial production with a long and variable lag. The series are simply too closely entangled.

At the risk of seeming to contradict myself, however, I continue to find much merit in Eichengreen and Temin’s view that the gold standard constrained U.S. policymakers in the early 1930s. But I would emphasize the psychological aspects of those constraints more than the technical aspects.

Previous studies have focused on the debate over the extent to which the international gold standard “constrained” monetary policymakers. This study adds several new perspectives to that analysis. First, policymakers do have some discretion, but only to the extent to which they can impact the world gold reserve ratio in the long run.

When there is too little money, monetary tightness doesn’t seem to be the problem. Interest rates are low and the public may be hoarding lots of cash. It’s much easier to argue that depressions are the inevitable hangover from a preceding bout of speculation. Today, most economists agree with Cassel; when nominal GDP falls in half, monetary policy has been far too tight, regardless of the level of interest rates.

And gold flows between any two countries might reflect either an expansionary policy in the country losing gold or a contractionary policy in the country receiving gold.