Home > Economics - General > The Unsustainability of Trade Deficits

The Unsustainability of Trade Deficits

November 22nd, 2005

I’ll be talking on this topic to the Economic Society of Australia (Queensland branch) on Thursday night at the Exhange Hotel, a well-known Brisbane cultural centre. I’m preparing a presentation and I found this graph of the US trade balance at the St Louis Fed

Bopbgs Max

The graph is in billions of dollars per quarter, unadjusted for inflation, so the pattern is exaggerated. Still it’s a good illustration of how the recent massive deficits are historically unprecedented, something which is true even when the more appropriate measure of percent of national income is used.

Australia’s experience is less dramatic, but we are, nonetheless hitting new records in terms of deficits and debts.

fn1. No animals were harmed in the preparation of this talk.

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  1. November 23rd, 2005 at 09:56 | #1

    The appropriateness of measuring it as a percentage of national income depends on what question you are trying to answer. That ratio is a good one to answer questions about how the trade deficit will affect the domestic economy in the future since we will eventually have to pay back the money we are borrowing and so will have to generate a surplus of appropriate size one of these days. However, if you are asking a different question you need a different measure. For example, suppose your question were how willing the various foreigners are going to be to keep absorbing our ever mounting need for credit (which the trade deficit is a major influence on). In that case you would want to divide the trade deficit by the foreigners’ GDP or some other measure of the size of their appetite. Or if you wanted to know what the trade deficit (or the current account) was doing the value of the dollar you might want to know how many dollars are already out there in the hands of the foreigners among other things.

    Bottom line, it looks bad for the US though the Chinese still seem to have a pretty healthy appetite for US paper. I expect pretty soon they will start buying up more concrete stuff like buildings, land and companies. That will start to get the attention of the public even if Congress seems immune to factual information from the real world.

  2. November 23rd, 2005 at 11:04 | #2

    John, can non ESA members come to your talk at the Exchange?

  3. jquiggin
    November 23rd, 2005 at 12:01 | #3

    I don’t think there would be a problem with that, Mark

  4. Razor
    November 23rd, 2005 at 16:57 | #4

    JQ, could you please post your speech on this site as I am interested to know why they are unsustainable.

  5. Terje Petersen
    November 23rd, 2005 at 23:44 | #5

    In the days when gold was the international currency, trade deficits couldn’t really exist. If you wanted to import more cheese from New Zealand you would have to export more gold. The effect would be a dampening of domestic price pressure. And if New Zealand was importing too much gold than the price of New Zealand goods would be rising.

    In other words the trade deficit was balanced by on the capital account and monetary policy was managed accordingly.

    Within a single currency zone this is pretty much how it works today. If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment. Intuitively we expect boom towns to have rising prices and depressed towns to have falling prices. The exception to the rule is when government transfers are involved (ie exporting votes) or when currencies float.

    The problem today is that the US dollar is the worlds preferred currency and the most dominant currency for international trade. 90% of pure currency trades involve US dollars on one side or the other. As the world economy grows there is a strong demand for US dollars. To counter balance this export of US dollars, goods must flow into the USA.

    One might question whether stable money is possible when you export paper in exchange for consumer goods. Long term it may be more prudent to export paper notes for assets like gold than can be used to defend the stability of your currency in a future crisis. Consumer goods get used up so they are available for resale to defend your currency. And government debt is not as risk free as some might assume. In a crisis governments may try to defend their debt paying ability by increasing taxation, only to find that in the process they kill the goose that lays the golden egg.

  6. James Farrell
    November 24th, 2005 at 00:43 | #6

    The US and Australia both have current account deficits around 6% of GDP. The big difference is that in the US case, the trade deficit by itself explains the current account deficit, whereas in Australia the lion’s share of the current account deficit is net investment income rather than the trade deficit.

    This could be seen in two ways. On the one hand, Australia’s problem is potentially much more intractable, whereas the US could in principle solve its problem with a few years’ fiscal austerity. By the same token, whereas Australia’s problem won’t worsen that quickly, the US’s position could deteriorate very fast.

    The weird thing about the US Balance of Payments is that net investment income has remained positive, despite the fact that the ‘net external position’ is by now a deficit worth about 25% of GDP. This is because for various reasons US investments abroad yield a higher return than the incoming investments. But that income surplus, though it has proved surprisingly persistent, will be reversed any day now.

    Combined with the already big trade deficit it will push the current account deficit toward 10 percent, precipitating a rapid acceleration of the US foreign debt. And since the world financial system could not countenance the prospect of the US getting into a debt trap, the only option will be a sharp monetary contraction to defend the dollar, and a severe recession. If it has to happen, let’s hope it’s on Bush’s watch.

  7. Standard Deviant
    November 24th, 2005 at 14:48 | #7

    “If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment.”

    If Dubbo (like the US or Aus) want to invest more than they save, then they will run a trade deficit (assuming no net income flow). Price adjustment will make it so, not “correct” it.

  8. Ian Gould
    November 24th, 2005 at 16:24 | #8

    In theory a trade deficit is sustainable indefinitely if economic growth in the country running the deficit increases the total capital stock at a sufficiently rapid pace that the sale of capital items can fund the deficit.

  9. November 24th, 2005 at 18:41 | #9

    James Farrell Says: November 24th, 2005 at 12:43 am

    http://johnquiggin.com/index.php/archives/2005/11/22/the-unsustainability-of-trade-deficits/#comment-37586

    “This is because for various reasons US investments abroad yield a higher return than the incoming investments. But that income surplus, though it has proved surprisingly persistent, will be reversed any day now.”

    I guess “incoming” means “RoW owned – US domiciled”. Conversely,
    “outgoing” means “US owned – RoW domiciled”. This implies that RoW investors earn less off the US than US investors earn off the RoW, per dollar invested.

    I am guessing that this is due to the relatively low rate of return on US bonds, shares and currency over the past few years. Why have so many RoW investors plunged into the US securities and equities market over the past few years if their returns were less than what US investors were earning in the RoW?

    And why will the US’s “income surplus…be reversed any day now”? I have been listening to “tunnels at the end of the light” stories for the whole naughties. I know that Stein’s Law states that “If something cannot go on forever, it will stop.” And yet the sky persistently refuses to fall.

    “Combined with the already big trade deficit it will push the current account deficit toward 10 percent, precipitating a rapid acceleration of the US foreign debt.”

    Can someone explain the mathematical economics (not too complex please!) of runaway debt traps once the CAD/GDP rises over the magic figure of 10%. Buffet and Gates* made the bet that the USD collapse would come this year, but they appear to have taken a bath.

    Obviously if we knew the answers to these questions we would not be idling away time on a blog. But no one seems to have a clue. If they dont know whats going on, who does?

    http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2005/11/24/ccfed24.xml&menuId=242&sSheet=/money/2005/11/24/ixcoms.html

  10. Razor
    November 24th, 2005 at 19:07 | #10

    Given the forecasts for US GDP growth exceeding 3.5% in the next year, falling government deficit, falling oil prices, improved consumer confidence, can someone please tell me why the current US trade deficit is unsustainable?

    I’ve studied a economics and finance at under-graduate level and read economic outlook reports almost everyday as part of work and I just ain’t seeing the picture being painted above where it matters – in the markets. Either you guys are a sh$t load smarter than the professionals or you have your own little axes to grind about the US.

    Terje – your analysis is almost intelligible to me and I don’t think I am that thick.

  11. Ian Gould
    November 24th, 2005 at 19:33 | #11

    “And why will the US’s “income surplus…be reversed any day nowâ€?? I have been listening to “tunnels at the end of the lightâ€? stories for the whole naughties. I know that Stein’s Law states that “If something cannot go on forever, it will stop.â€? And yet the sky persistently refuses to fall.”

    Jack, saying the US surplus will be reversed means that US income from overseas investment will no longer exceed the income paid to foreing investors on US investors.

  12. Ian Gould
    November 24th, 2005 at 19:46 | #12

    1. “US GDP growth exceeding 3.5% in the next year,”

    For the past several years (at least) US GDP growth has been driven by higher consumer demand which pushes up the current account deficit;

    2. “falling government deficit,”

    Medicare drug benefit kicks in January 1.

    3. “falling oil prices,”

    Assuming they continue -and even with the falls to date heating oil prices will be much higher in the US this year;

    4. “improved consumer confidence,”

    Seen the latest unemployment registration figures? how about the real estate prices and clearance rates. Actually as I noted previously, higher growth in the US tends to increase the CA deficit rather than reduce it so these make actually be positives;

    The US has been able to run large government deficits and CA deficits without significant economic pain (i.e. high interest rates and inflation) because East Asian countries have been intervening massively to push down the dollar by buying T-bills.

    This is as unsustainable as the policy those same states pursued in the 90′s of holding their own currencies artificially high.

    “Either you guys are a sh$t load smarter than the professionals or you have your own little axes to grind about the US.”

    That’d be the same market that took a bath on Enron shares, I assume.

    I just get very skeptical when I hear talk of a “new economy” or that a country- any country – can consume more than it makes on a continual basis.

  13. Terje Petersen
    November 24th, 2005 at 21:12 | #13

    The asian nations in question were not trying to hold their currencies high. They were trying to maintain a fixed exchange rate with the US dollar. Its just that the USA was running a “strong dollar” policy and the deflation was being transmitted by virtue of the fixed exchange rate.

    A fixed exchange rate is a good monetary policy (and fantastic trade policy) except when the target currency is not a stable reference in terms of value. The world would be better off with fixed exchange rates however the US dollar is too unhinged to server as a stable reference. The Malaysians had the right idea when they were promoting the Islamic Dinar a couple of years back.

  14. Andrew Reynolds
    November 24th, 2005 at 21:44 | #14

    Jack,
    Perhaps the answer to the problem of the persistence of this is the old market wisdom that the market can stay insane longer than you can stay solvent.
    Yes, this will probably reverse at some stage and the transition will be either painless or painful – but I, for one, will not bet a substantial amount on it happening soon. These things can continue for a long time. They normally reverse just after the last person betting on it goes bust.

  15. Ernestine Gross
    November 24th, 2005 at 22:32 | #15

    Terje,

    It is understood that the gold-standard provides an upper and lower bound on the variability of relative prices of currencies, called exchange rates. The bounds are given by ‘gold-points’, which are a function of the costs (in gold) associated with the prevailing transport technology.

    The gold-standard provides stability in a sense akin to an error control model. Fine.

    The central research question of economics, concerned with non-dictatorial resource allocation systems (with the assumption that people prefer to survive), is not concerned primarily with ‘error control’ of one set of relative prices but with the material (as distinct from spiritual) welfare of humans (see models of ‘competitive private ownership economies’ I’ve referred to in previous posts).

    [Parenthetically, the separation of material from spiritual welfare of humans may not be acceptable to all cultures or even to all people within one culture - but I am writing here merely from a position of what is conceivable rather than a position of extensive knowledge of cultural differences and their histories. In other words, there is an empirical question and I don’t have the answer to it.]

    The gold standard has nothing to offer regarding the primary question of interest in economics. To be more explicit, the gold standard has nothing at all to say on what is known as the ‘minimum wealth constraint’. That is, the error control system you are advocating can work very nicely until the world population is reduced to 2 people – everybody else died of starvation. This is an illustration by means of reasoning by the absurd, the purpose of which is to make a point on the properties of the system you are advocating rather than a prediction.

    You state: “If Dubbo runs a trade deficit with the rest of Australia then it tends to self correct through localised price adjustment. Intuitively we expect boom towns to have rising prices and depressed towns to have falling prices.”

    ‘A boom’ is characterised by rising prices. A characteristic of something (ie a definition) cannot be simultaneously an explanation of the something. I think this point has been made already on this tread.

    Your statement is an example of what I would call a hypothetical empirical result of ones choosing. ‘Adjustment’ is not through prices alone, as you suggest, but through quantities. People move! Within one currency area people are usually allowed to move from locations where incomes decline to locations where incomes rise. What would be the equivalent in the international arena? It would be the abolition of immigration laws, wouldn’t it? So, to advocate one but not the other is an error in ‘systems design’, setting everything else aside.

    But this is not all, there are ‘boom towns’ where the boom is a bubble – and some of these bubbles are no more than financial bubbles (ie created by debt in its various forms). Moving to one of those boom towns would not help much, would it? – the hypothetical emigrants from the proverbial Dubbo would ‘buy expensive’ and ‘sell cheap’.

    What happens to the debts of people in the proverbial ‘Dubbo’? (A trade account deficit usually entails debt although it is conceivable that the financing of the trade account deficit is done via equity shares or trade credits). Assuming the banks in Dubbo operate like those in Auckland, Birmingham, …, Sydney, the amount of debt (face value) does not ‘adjust’, while the prices of houses, farms, tractors, horses, cows, fruit, machinery may decline along side with wages in the adjustment process you are talking about. So, one of the many possible reasons for people to emigrate from the hypothetical Dubbo is because they have gone bust – can’t pay their debts.

    Finally, a known source of potential financial instability in theoretical models of ‘competitive private ownership economies with securities markets’ is due to an ‘unboundedness’ problem. There is no natural limit on short selling of securities. These models do not contain a government – hence you can’t blame ‘the government’ for the outcomes you may not like. ‘Securities markets’ involve things like options, shares, debentures, IOYs, etc., issued by ‘private’ agents.

    So, how can we get stability in financial markets? By deregulating labour markets? I suppose there would be little wrong in some people’s mind if a medical doctor would cut off the left leg if the right leg is gangrenous, right?

    I don’t have a panacea for the world’s problems. However, I can refer to Oliver Hart’s 1974 and 1975 papers in Journal of Economic Theory. Hart provides two conditions (strict risk aversion on part of all members of the society and price expectations being not ‘too different’; ie in a closed cone) under which it can be shown that the model of a ‘competitive private ownership economy with securities markets’ has a solution without requiring an externally determined bound. Hart’s results were published before the financial markets were ‘deregulated’. To the best of my knowledge of the literature at the time of financial deregulations in the early 1980s, the deregulation proceeded on the assumption that an institutional environment which works well for the manufacture of cars and sausages also works for the manufacture of financial contracts (ie another example of moving forward to the past; substitute the believes of the 18th and 19th century for knowledge available in the mid-20th century). The sector was re-regulated rather quickly, wasn’t it? Not the same regulation as before, true, but a more complex system of bounds was introduced (eg Basel III) and the process is going on.

    The only reason I can think of for anybody to advocate the gold standard is if they are ‘long in gold’.

    And, the reason why I respond in detail is because Economics is in a sense a very difficult area – everybody is part of ‘the economy’ but not everybody is an ‘economist’, and, speaking primarily for myself, not every ‘economist knows everything’ in relation to Economics.

    I have some difficulties with the word ‘economist’. In contrast to a chemist or a pharmacist, who can apply his or her knowledge to material of which he or she is not part of, ‘everybody’ is part of ‘the economy’, including ‘the economists’. It seems to me there is a very fine line between ‘applying economic knowledge’ and becoming dogmatic or dictatorial. To illustrate the difficulty, Milton Friedman is ‘an economist’ and Nobel Prize (Bank of Sweden) winner. Gerard Debreu is ‘an economist’ and a Nobel Prize (Bank of Sweden) winner. Milton Friedman toured the world to tell governments and the public (TV) what to do. Gerard Debreu toured the world and did not tell governments (or the public) what to do. He presents his research findings and leaves it to the public to decide what to do with it. Who of the two is more credible when it comes to ‘freedom of choice’, and ‘freedom’ in general and ‘democracy’ and other big words?

    I prefer to be a permanent student of Economics rather than ‘an economist’.

  16. James Farrell
    November 25th, 2005 at 05:21 | #16

    Jack

    1. Foreign owners of shares in US companies get capital gains instead of divdends, and capital gains aren’t counted as investment income in the balance of payments. I don’t think the return on US bonds is particularly low, however. In fact the discrepancy applies more to direct rather than to portfolio investment. This is probably because the outbound direct investment is perceived as riskier and therefore requires a higher rate of return. But it might also be due to transfer pricing by multinationals.

    2. The above reasons explain why the US can still maintain an investment income surplus despite having negative net foreign assets. But it is only possible because foreigners’ claims on US citizens don’t exceed US citizen’s claims on foreigners by too much. Very approximately, the returns on the former and the latter are 3% and 4% respectively. Therefore the flow of income to Americans will exceed the flow from Americans to foreigners only as long as the foreigners’ claims don’t exceed the Americans’ claims by more than one third. It will only take a few more big current account deficits, and this threshold will be crossed. Net investment will become negative, and strongly so.

    3. Everything that Andrew says above is right, but I’d rather be wrong than equivocal.

    Ernestine

    I don’t find you argument against ‘economists’ convincing. Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot. Friedman, by contrast is interested in fixing real economic problems. You may not like his particular suggestions or his tone – I sure don’t – but that doesn’t mean we shouldn’t try to work out how to fix inflation and unemployment.

  17. James Farrell
    November 25th, 2005 at 05:23 | #17

    Damn. For ‘Net investment will become negative…’, read ‘Net investment income will become negative…’

  18. Terje Petersen
    November 25th, 2005 at 06:37 | #18

    Ernestine,

    The length of your piece makes it hard to be conversational in style. However you are an academic so I will forgive you and persist.

    QUOTE: The gold-standard provides stability in a sense akin to an error control model. Fine.

    RESPONSE: Which is pretty much what “Inflation Targeting” attempts to do with CPI numbers and Internest rate targets.

    QUOTE: The central research question of economics, concerned with non-dictatorial resource allocation systems (with the assumption that people prefer to survive), is not concerned primarily with ‘error control’ of one set of relative prices but with the material (as distinct from spiritual) welfare of humans (see models of ‘competitive private ownership economies’ I’ve referred to in previous posts).

    RESPONSE: When you have paper fiat money, the supply of which is dictated by the policy of a dictatorial entity (ie government central bank) then its no longer a question of free markets. You could advocate a government retreat from the money business, and I could see ways to make that work, however it is a larger question than the choice between “Inflation Targeting”, “A fixed US dollar exchange rate policy”, “a gold standard” etc. My concern is one of policy by a dictatorial entity.

    QUOTE: The gold standard has nothing to offer regarding the primary question of interest in economics. To be more explicit, the gold standard has nothing at all to say on what is known as the ‘minimum wealth constraint’. That is, the error control system you are advocating can work very nicely until the world population is reduced to 2 people – everybody else died of starvation. This is an illustration by means of reasoning by the absurd, the purpose of which is to make a point on the properties of the system you are advocating rather than a prediction.

    RESPONSE: In essence you are saying that the gold standard might cause us all to starve. I think you would need to ellaborate. “Inflation Targeting” might also cause us all to starve. So long as we have fiat money we still need to make a choice about monetary policy. Are you saying that the gold standard is inferior to the other policy options and causes starvation?

    QUOTE: ‘A boom’ is characterised by rising prices. A characteristic of something (ie a definition) cannot be simultaneously an explanation of the something. I think this point has been made already on this tread.

    RESPONSE: We had rising prices in the 1970s even as we had economic contraction. In the middle ages during the plague prices rose as large swags of people died and output plummeted. China had falling prices in the 1990s even as production output was growing at 10% pa. Without monetary adjustments (ie money flows) contractions are in fact inflationary and expansions are in fact deflationary. So I think you are off the mark.

    QUOTE: What would be the equivalent in the international arena? It would be the abolition of immigration laws, wouldn’t it? So, to advocate one but not the other is an error in ‘systems design’, setting everything else aside.

    RESPONSE: I do advocate free immigration laws with many other economies. I think we should negotiate reciprocal work rights in nations such the USA, Europe, Japan etc in the way we have done with New Zealand.

    QUOTE: But this is not all, there are ‘boom towns’ where the boom is a bubble – and some of these bubbles are no more than financial bubbles (ie created by debt in its various forms).

    RESPONSE: Bubbles are a fanciful concept. I have yet to find a useful analysis based on the concept. The followin article on the Dutch Tulip Bubble is worth a read.

    http://www.slate.com/id/2103985/

    QUOTE: Finally, a known source of potential financial instability in theoretical models of ‘competitive private ownership economies with securities markets’ is due to an ‘unboundedness’ problem. There is no natural limit on short selling of securities. These models do not contain a government – hence you can’t blame ‘the government’ for the outcomes you may not like. ‘Securities markets’ involve things like options, shares, debentures, IOYs, etc., issued by ‘private’ agents.

    RESPONSE: More info please.

    QUOTE: So, how can we get stability in financial markets? By deregulating labour markets? I suppose there would be little wrong in some people’s mind if a medical doctor would cut off the left leg if the right leg is gangrenous, right?

    RESPONSE: Such a doctor would have a poor reputation. However I don’t know how we suddenly lept to labour market regulation after discussing alternatives for monetary regulation.

    QUOTE: The only reason I can think of for anybody to advocate the gold standard is if they are ‘long in gold’.

    RESPONSE: I advocate it because I think gold is a stable reference. Not one prone to rising rapidly in value. I own less than a gram of gold in an e-gold account and I wear a wedding ring. Other than that your logic of imputed motives fails.

    QUOTE: And, the reason why I respond in detail is because Economics is in a sense a very difficult area – everybody is part of ‘the economy’ but not everybody is an ‘economist’, and, speaking primarily for myself, not every ‘economist knows everything’ in relation to Economics.

    RESPONSE: Yes.

    QUOTE: He presents his research findings and leaves it to the public to decide what to do with it. Who of the two is more credible when it comes to ‘freedom of choice’, and ‘freedom’ in general and ‘democracy’ and other big words?

    RESPONSE: The world has always need advocates and academics. To suggest that one is superior to the other is naive.

    ASIDE: e-gold now has 2.5 million account holders. Each day people buy and sell things with e-gold. The value of such purchases is approaching US$10 million daily. And use of the private currency grows at 40% per annum. http://www.e-gold.com

  19. Katz
    November 25th, 2005 at 08:17 | #19

    Terje: “In the days when gold was the international currency, trade deficits couldn’t really exist. If you wanted to import more cheese from New Zealand you would have to export more gold.”

    In the days when the gold stardard existed major countries cheated.

    During the 1920s the US and France refused to reflate to reflect the trade surpluses they were experiencing.

    Milton Friedman discusses the final demise of the gold bloc in 1934:

    “From January 1933 to September 1934 the rise [against the US dollar] was 70 per cent for [France and several other continental currencies], and less than 50 per cent for the pound sterling. … The differential appreciation measured the special impact of [the US] gold-price support program on the position of the gold standard countries. The fact that they lost gold meant that they bore, as it were, a larger part part of the effect of the expansion of US exports and contraction of US imports other than gold than other countries did…”

    [Milton Friedman, "A Monetary History of the United States, 1867-1960".]

    The insuperable problem of any attempt to fix currencies against any stardard, whether gold or tulip bulbs, is that the temptation to “cheat” is irresistable, both in “good” times, as during the 1920s and during “bad” times, as during the 1930s.

    When the power to cheat is given to governments, the temptation to maintain conditions of full employment in the short term (i.e., between now and the next election) is much stronger than the enlightened self interest desire to maintain freedom of the movement of goods and services and capital across international boundaries. The latter may be better for the voters in the long term, but in the short term the government will be voted out of power.

    It is therefore much more elegant for governments to allow private entrepreneurs and arbitrageurs to assume the risk of capital movements across international boundaries.

    Moreover, the power of private capital markets provides governments with two very potent weapons:

    1. A motive to discipline credit creation and currency policy which blunts the demand for inflationary policies that are favourable to debtors, which is most of us.

    2. A common enemy to complain about when unfavourable exchange rate movements throw into question an admittedly atavistic sense of national virility (vide, repeated references to the Aussie $ as the Pacific Peso.)

    In a reasonable world the gold standard would work, but in a reasonable world we wouldn’t need any rules at all.

  20. Ernestine Gross
    November 25th, 2005 at 10:46 | #20

    James,

    “I don’t find you argument against ‘economists’ convincing.”

    I don’t think I put forward an argument against ‘economists’ in the sense of an argument against people who choose this title. My point was that the role of people in society, who are knowledgeable in the area of Economics, is more complex than that of say practising chemists. For example, how do ‘economists’ avoid being put into an ideological box in the public arena? It seems to me it is with great difficulty. So, my problem is with the word ‘economist’ – and I don’t have a better one.

    “Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot.” Friedman, by contrast is interested in fixing real economic problems. You may not like his particular suggestions or his tone – I sure don’t – but that doesn’t mean we shouldn’t try to work out how to fix inflation and unemployment.

    Which ‘real economic problem’ did Friedman fix? Did Friedman fix the asset market bubbles? Bankruptcies? Corporate fraud? Did Friedman fix the unemployment problem? I am not convinced by Friedman because he has not produced a coherent theoretical model from which his policy advice follows logically. That is all.

    If the ‘real economic problem’ of the day is whether or not the Reserve Bank should increase the discount rate by 0.5%, leave it unchanged, or reduce it by 0.5%, then I would agree that ‘pure research’, like Debreu’s, is of no assistance at all. However, if the ‘real economic problem’ of the day are major changes in the institutional environment (eg micro-economic reform) then I would suggest Friedman’s work is entirely useless (because of the absence of a theoretical framework; one has to ‘believe’). By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge. Empirical data has limitations in providing guidance in situations of ‘system changes’. Long term data is of limited usefulness if one wishes to maintain the argument that there has been ‘technological progress’ and one takes note of historical records of past ‘system changes’. Short term data is of limited usefulness because it belongs to a system which one is about to change.

    I would have thought Mandelbrot’s work is particularly relevant for complex processes.

    .

  21. Terje Petersen
    November 25th, 2005 at 11:12 | #21

    Are you saying that under the current monetary regime governments can’t cheat?

  22. Katz
    November 25th, 2005 at 11:20 | #22

    Of course governments try, but when they are found out (vide Nigel Lawson) the taxpayer is punished.

    Retribution comes swifter and surer than under any system of managed exchange rates.

    Then it’s up to the taxpayer, when she puts her voter’s hat on, to decide whether such cheating should be punished.

  23. conrad
    November 25th, 2005 at 11:20 | #23

    Terje : I presume you haven’t lived in a country with a fixed currency that has had ridiculous sized bubbles as a result. If you think that, say, the average small apartment costing $800,00 isn’t a bubble (HK in 1997), then I wonder what you would call it ? Or if you think this isn’t bad economic policy, then you might like to dig up the HK goverment criticizing itself over these problems.

    It also isn’t just deflation after bubbles which is a pain, but inflation too. For instance, I think you’ll find that the average persons who actually wants to live in the place they buy finds it quite a pain to find out things like the apartment they were going to buy went up 20% in the month they proscrastinated over buying it (or the week, for that matter). Having a fixed currency might not be responsible for all of these annoyances, but it is certainly a decent part.

  24. Ernestine Gross
    November 25th, 2005 at 11:33 | #24

    Katz,

    “In a reasonable world the gold standard would work, but in a reasonable world we wouldn’t need any rules at all.”

    I should think it is very reasonable to have road traffic light rules. These rules communicate information efficiently among road traffic participants and resolves conflicting interests without requiring individually negotiated settlements at every intersection. True, sometimes the participants “cheat” with horrific consequences.

    May I ask for a reference in Friedman’s writings where he deals with trade restrictions in the form of market segmentation and transfer pricing by multinational firms? I can’t find any.

  25. Katz
    November 25th, 2005 at 12:28 | #25

    EG, Friedman’s “Monetary History” was almost entirely concerned with political and central banking decisions.

    Not even US tariff policy is discussed in any detail.

    The actions of private corporations, such as transfer pricing, therefore, lie beyond the purview of Friedman’s “Monetary History”.

    Of course traffic signals are reasonable, given the *unreasonable* nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.

    (I’m not suggesting this as public policy.)

  26. Terje
    November 25th, 2005 at 13:35 | #26

    Katz,

    Under a gold standard it is exceedingly simple to see if the government is cheating. All you do is open a newspaper and look at the gold price. If it is still within the range defined by the gold window then you are still on a gold standard. If it is outside the gold window range then they are cheating. Any deviation is immediately obvious. Governments that commit to a gold standard are highly accountable for that commitment because there is simply nowhere to hide.

    Contrast this with “Inflation Targetting”. Consumer prices have such an institutionalised component that monetary errors may not show up for a year or two. They can play mischief with Interest rates in the short term and only the very perceptive might notice. Even then the perceptive can be dismissed as being merely of a different opinion. The current system is heavily lacking in accountability compared to a gold standard or an exchange rate standard.

    The only valid criticism that I can see for a gold standard is that the value of gold may prove to be unstable. However having reviewed the empiracle history of golds value, and considering the natural stabilisers in the global production and trade in gold, I find this complaint to be without much practical basis. During the 1800s in Britian the gold standard (or metalic standards) meant a gentle and mostly benigh deflation such that the price level halved over a century. A gold based currency did cause a localised inflation in Europe during the plague in the middle ages but the recovery was quick and the circumstances extreme.

    Regards,
    Terje.

    P.S. I agree with Ernestine that Friedman did not contribute much to the world. The quantity based rules that he advocated for monetary policy were discredited extensively during the 1970s and 1980s and even the man himself admits that he was wrong in this arena. I suppose he did make a valuable contribution in advocating a role for the private sector and private action when such a view was out of favour.

  27. Razor
    November 25th, 2005 at 16:01 | #27

    Ian Gould – what the hell has the fraudulent activities at Enron and macro-economics got in common?? And if you held Enron as part of a well diversified portfolio, then the impact should not have been huge.

    And who is talking about a ‘new economy’? Last time I heard that type of talk was 1999-2000.

    You also said:

    “East Asian countries have been intervening massively to push down the dollar by buying T-bills.”

    I generally avoid being nit-picky but you have redefined demand and supply economics – perhaps a Nobel Prize is in order! Demand for a thing pushes it’s price up. In your example demand by non-US investors for T-Bills would increase demand for USD, which pushes the price up. At the same time, you don’t buy T-Bills if you are trying to move currency prices – you buy the currency, or futures or options or swaps or some other derivative. Do you think there is some sort of international conspiracy to keep the USD down? This is not in the interest of those who export to the US – they want a high dollar. Demanding T-Bills would also push their price up and therefore decrease interest rates. This would be logical if you expect inflation to decrease, however the yield curve at the moment ain’t showing that.

    As you can see – my normal understanding of demand and supply and financial markets puts me at a loss to understand your claims that “East Asian countries have been intervening massively to push down the dollar by buying T-bills.” Please expand so that I can see the light.

  28. Ernestine Gross
    November 25th, 2005 at 16:54 | #28

    Terje,

    The length of my post in reply to yours is the outcome of adopting a conversational style rather than an academic one.

    To illustrate the difference. In reply:

    1. In previous posts (concept of money) I have provided all necessary information for you to find the article where the ‘unboundedness problem’ shows up.

    2. Bubbles: Look for “Sun-spot equilibria” models.

    3. I don’t accept the blanket statement that governments are dictatorial. (See for example Katz’ post on another thread on the complexities introduced by ‘advocates’)

    4. Reputational effects may at most (ie not necessarily) prevent unlimited repeats of the same action by the same person or, with a bit of luck, for one successor generation (didn’t work with Milton Friedman). There is no assurance that intergenerational learning is linear. I think we have been on this topic before in an earlier sequence of posts.

    5. Are you saying Milton Friedman is not an academic?

    6. I suspect the trade unions will be pleased to hear that you recognise a demand for advocates.

    7. May I suggest that if you allow for information asymmetries (which we both recognised some time ago), then my statement that “the only reason I can think of for people to advocate the gold standard is if they are long in gold� does not necessarily entail your inference.

    8. There is no government I know of which prevents you from conditioning your price expectations on what is happening in the gold market.

  29. Ian Gould
    November 25th, 2005 at 17:22 | #29

    “I generally avoid being nit-picky but you have redefined demand and supply economics – perhaps a Nobel Prize is in order! Demand for a thing pushes it’s price up.”

    I should have written “to keep the dollar up”.

  30. Terje
    November 25th, 2005 at 18:02 | #30

    Ernestine,

    1. Yes but I thought you had said that it was limited to an economy that was purely market driven with no public sector so I was not sure that it would apply.

    2. I’ll try and do that.

    3. Governments are dictatorial to those people that don’t agree with government policy and would act otherwise if free to do so.

    4. Granted.

    5. In the context of your comparison and in relative terms he was an advocate. But in practice nobody is purely one thing. It would certainly be appropriate to refer to Friedman as an academic. And just to be sure please don’t think that I use the word in any derrogator manner. Academia is a most worth path to take in life. Its just that I am not an academic and the style of writing and thinking that I encounter with academics is sometimes curious and foreign.

    6. I am glad that trade unions will be pleased. I have no reason to regret their satisfaction. I have no general desire to outlaw or persecute cartels.

    7. I was seeking to expand your horizons. Perhaps you might try and imagine other motives.

    8. No but many laws insist that I keep my books in dollars, pay my taxes in dollars etc. As a business man who needs to deal with cash flow it is not really practical to use any unit of account other than the one dictated by the authorities. Although at times I do use other measures for strategic thinking.

    Let me seek clarity with a question that cuts to the heart of what I find most interesting in your comments. In your view is “inflation targeting” (as practiced by central banks in Australia and elsewhere) more or less dictatorial than a gold standard? And what is your reasoning?

    Regards,
    Terje.

  31. Andrew Reynolds
    November 25th, 2005 at 18:43 | #31

    Terje,
    Is there any reason, other than the historical, why you suggest gold as the standard for value? Why not silver (the old Islamic standard) or platignum (slightly less bulky for value) or some other commodity?

  32. Razor
    November 25th, 2005 at 20:02 | #32

    OK – have a good weekend.

  33. Ernestine Gross
    November 25th, 2005 at 20:16 | #33

    Terje,

    1. I mentioned two authors at one stage. You asked for the reference of one. I gave to you. For the ‘unboundedness problem’ the second author is relevant (Radner, 1972, Econometrica)

    2. —

    3. Interesting but not helpful.

    4. –

    5. — Terje, I am going to venture a guess – I might be totally wrong but I’ll state my guess. You are working through introductory economics textbooks and you put the stuff on blog sites. You then get refutations or comments. The outcome should be an interesting book.

    6. –

    7. I don’t understand your response to my response. I did not draw the inference which you drew.

    8. Yes, but how would you know whether you would have a business at all without there being a government?

    You write:
    ” Let me seek clarity with a question that cuts to the heart of what I find most interesting in your comments. In your view is “inflation targetingâ€? (as practiced by central banks in Australia and elsewhere) more or less dictatorial than a gold standard? And what is your reasoning?”

    Response: I recall you have shot down your own strawman quite well.

    Regards
    Ernestine

  34. James Farrell
    November 25th, 2005 at 20:50 | #34

    Ernestine

    “I am not convinced by Friedman because he has not produced a coherent theoretical model from which his policy advice follows logically.”

    Isn’t this asking a bit much, especially in macro. As I said, I’m not a fan of Friedman, but I’m willing to concede that he did a pretty good job of pulling together a number of threads – his Phillips curve, his quantity theory and his consumption theory – into a coherent story that laid a foundation for policy. Keynes did the same sort of thing. In a fast-changing environment, theories will always be constructed on the hop.

    “By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge.”

    Sure, general equilibrium theory is useful in the negative sense that it can strip the Friedmans of this world of their pretensions to having a solid theoretical grounding for their claims. But that’s not the same thing as generating plausible, constructive proposals.

    I’d say something similar about chaos theory. It is a useful caution against interpreting the patterns we observe in terms of the equilibrating processes in our models, and also a caution against assuming that a deterministic process will be predictable. But again that’s different from furnishing useful solutions for concrete problems.

  35. Terje Petersen
    November 25th, 2005 at 22:04 | #35

    Ernestine,

    1. -
    2. -
    3. helpful in defining the word dictatorial. However I suspect you have a differing meaning for the word that I have not yet fathomed.
    4.—
    5. I am not working through introductory economics textbooks and putting the stuff on blog sites. Although that might be fun.
    6.—
    7. You originally state that you could think of only one reason for somebody to advocate a gold standard. I just think that with imagination you might imagine other reasons. I would think that if somebody was “long on gold” that might be a good reason to argue against a gold standard.
    8. Interesting comment but kind of off the topic.

    9. You recall you I shot down your own strawman quite well. I think I must of missed it. So let me ask again:-

    As a monetary policy choice do you think that a “gold standard” is inferior to “inflation targeting”?

    Regards
    Terje.

  36. Terje Petersen
    November 25th, 2005 at 22:31 | #36

    QUOTE: Is there any reason, other than the historical, why you suggest gold as the standard for value? Why not silver (the old Islamic standard) or platignum (slightly less bulky for value) or some other commodity?

    RESPONSE: Partly it’s because gold is an easy talking point given its history. I would actually be content to let the market decide after withdrawing and restructuring certain laws that inhibit a free choice. I would be happy enough to have a standard based on a commodity basket of goods. Almost any commodity based standard would be better than a price basket based on consumer goods (ie CPI based inflation management).

    E-Gold started in 1996 and it has always offered the following varients:-

    e-gold
    e-silver
    e-platinum
    e-palladium

    Duirng that time the gold variant has always proved more popular and been massively more liquid.

    If you read your Islam then you will know that it proscribed dinar and dirham. The first was gold and the latter silver. The weight of each was fixed but the market value of each was flexible relative to the other. As such it proscribed a market place where gold and silver could compete for the role of most monetary commodity.

    I suppose I also advocate gold because after lots of charting I have come to the view that its a stable reference. Certainly more stable than something like the US dollar.

    I think that the current monetary policy with its targeting of interest rates is inheriently disruptive.

  37. Ernestine Gross
    November 26th, 2005 at 00:14 | #37

    Terje,

    Your question: “As a monetary policy choice do you think that a “gold standardâ€? is inferior to “inflation targetingâ€??

    My answer: Any monetary policy choice presupposes an adequate concept of ‘money’. I say we don’t have one.

  38. Terje Petersen
    November 26th, 2005 at 07:39 | #38

    Ernestine,

    Given that we have to live in ignorance what is your hunch as to which is better.

    Terje.

  39. November 26th, 2005 at 15:04 | #39

    For practical reasons, silver makes more sense as a standard than gold or platinum (it would be easier to use for transaction purposes). That aside, there would be transitional costs of going onto a bullion standard, and these might be endemic if some countries/areas did and others did not. Since current stocks and production of bullion (more particularly gold) is effectively a government monopoly, the transition would favour governments at private expense as they diversified their holdings out of gold into a more productive asset base – they would be acquiring the assets from present holders. It would take a long time for that to wash out.

  40. Terje Petersen
    November 26th, 2005 at 19:52 | #40

    Central banks don’t need to buy any gold to go onto a gold standard. They just need to conduct open market operations (OMO) in such a manner that the exchange rate between their fiat currency and gold are essentially fixed within a narrow band. An efficient central bank could in fact go onto a gold standard and have no gold at all.

    Lets say that the RBA decided to keep the Australian dollar worth between 49 milligrams of gold (mgg) and 51 mgg. It would no longer be able to use OMO to achieve an interest rate target so interest rates would need to float (as they should in a market economy). If the value of the dollar was drifting up towards 51 mgg then the RBA would need to reduce the dollars value by using OMO to buy assets (ie a monetary loosening). It could use freshly printed currency to buy gold or instead it could buy government bonds or foreign currency and leave gold out of it. If the value of the dollar was drifting down towards 49 mgg then it would need to sell assets to redeem aussie dollars (ie a monetary tightening).

    There is a lot of M0 base money in existance so some people figure that a gold standard is unachievable because gold needs to replace the base and there is not enough. However this is not necessary at all. And a lot of M0 base money is simply sitting in a foreign central bank whilst we hold some of their M0 in our central bank. If the whole world went to a gold standard a lot of currency that is notionally in circulation could be simple returned home in exchange for us returning foreigners currency to them.

    The only requirement for a gold standard is that a specific weight of gold becomes the national unit of account. And this is most readily achieved by using OMO to fix the domestic currency exchange rate with gold. Australia could do it in the blink of an eye if the political will existed. Likewise the entire world.

  41. Ernestine Gross
    November 26th, 2005 at 23:37 | #41

    James, I’ll post my response tomorrow.

    Terje, yes, we all have to live in ignorance and yes, I make hunches but this is not an ocasion when I wish to do so. I refer to my post in the thread on Bernanke a little while ago which puts my comment on this thread into perspective.

    Regards
    Ernestine

  42. Terje Petersen
    November 27th, 2005 at 16:01 | #42

    Ernestine,

    Yes we have been over this before. However I still don’t fully understand the basis or essence of your hunches/theories/notions and so I will probably probe you again in future.

    Regards,
    Terje.

  43. Standard Deviant
    November 27th, 2005 at 18:44 | #43

    Terje Petersen: “Central banks don’t need to buy any gold to go onto a gold standard. They just need to conduct open market operations (OMO) in such a manner that the exchange rate between their fiat currency and gold are essentially fixed within a narrow band.”

    Such a soft peg would be highly susceptible to speculative attack. In fact, without trading directly in gold, or at least in some foreign currency, I doubt the RBA would be able to keep within a 4% band during the turbulence of a fully-fledged speculative attack, even if wanted to.

  44. Uncle Milton
    November 27th, 2005 at 19:02 | #44

    “Gerard Debreu is engaged in interesting but pointless pure research. He is no more likely to come up with useful policy suggestions than, say, Benoit Mandelbrot.”

    Gerard Debreu isn’t engaged in anything. He died on December 31 2004.

  45. Terje Petersen
    November 27th, 2005 at 22:17 | #45

    Standard Deviant,

    A peg is a peg. Its softness is determined not so much by the technical ability of a central bank to defend it so much as it depends on the political will to defend it.

    A central bank that was on a gold standard would probably be prudent to hold some gold. However that would be more to do with a potential decline in the value of other asset classes (eg foreign currencies).

    A central bank has very little to fear from a fully-fledged speculative attack so long as it has a single clear objective target for open market operations. Central banks fail to defend their monetary target when they are caught between multiple objectives and they blink.

    Malaysia had no difficulty fending of the speculators in 1997 despite some heated words between Mahathir (then Malaysian PM) and Soros (a prominant currency speculator).

    The RBA currently targets interest rates even though it’s lending represents only a tiny proportion of lending in the broader market place. Whilst it is single minded about this target even well funded speculators have little chance of shifting the market interest rate off target.

    When China fixed its exchange rate to the US dollar not even the might of the US Federal Reserve could have used a speculative attack to shake the peg so long as the Chinese remained commited.

    In summary I disagree with you. The RBA would have no difficulty maintaining a 4% price band even without trading gold.

    Regards,
    Terje.

  46. Ernestine Gross
    November 27th, 2005 at 23:14 | #46

    James,
    Quote: “As I said, I’m not a fan of Friedman, but I’m willing to concede that he did a pretty good job of pulling together a number of threads – his Phillips curve, his quantity theory and his consumption theory – into a coherent story that laid a foundation for policy.�

    Response: How do you know that M. Friedman produced a coherent story? How would you prove that it is a coherent story?

    Quote: “Keynes did the same sort of thing. In a fast-changing environment, theories will always be constructed on the hop.�

    Response: No, because:
    1. Keynes (1930s) advanced knowledge. His work gave rise to many more questions and many more results (eg non-Walrasian equilibrium theory, monetary economics, the role of governments in a democratic society). Friedman went backward in time, back to 19th century neo-classical economics. IMHO, Friedman had not achieved by the middle of the 20th century what L. Walras had achieved about 100 years earlier.
    2. Keynes policy advice was concerned with an imminent crisis of monumental proportions affecting huge numbers of people. His policy advice worked. Which economic crisis did Friedman solve? Indeed, what exactly is the problem to which Friedman offered a solution that is useful and in which sense is it useful?
    3. To the best of my knowledge, Keynes never aimed at fixing the world’s problems once and for all. “In the long run we are all deadâ€?, he said, for the benefit of those who wanted to hear that it is the material welfare of humans – not just as a species but as individuals, each one of them having a finite life – that is the subject matter of economics. I cannot find anything in M. Friedman’s writings which would tell me what his understanding of the fundamental research question of economics is.
    JF quotes EG: “By contrast, the ‘pure research’ program, of which Debreu’s work is part, (Walrasian and non-Walrasian general equilbrium theory, applications of game theory) is mighty helpful in reducing the risk of confusing wishful thinking with theoretical knowledge.�

    Quote of JF: “Sure, general equilibrium theory is useful in the negative sense that it can strip the Friedmans of this world of their pretensions to having a solid theoretical grounding for their claims. But that’s not the same thing as generating plausible, constructive proposals.�

    Response: I fail to see how ‘something’ that has been revealed as being ‘nothing’ (because “it has been stripped away of its pretensions�) can generate plausible constructive proposals. See questions in 2. above.
    The first result of a (Walrasian) model of a competitive private ownership economy, which in a sense is consistent with Keynes writings, is the ‘pseudo-equilibrium’ in Radner (1972). The institutional change made, relative to Arrow-Debreu model, consists of introducing a sequence of markets for commodities and financial securities. Markets did not clear. Only the value of excess supply was minimized. I am using this example to substantiate my earlier remark that Keynes advanced knowledge, Friedman did not. The mid-1980s outcome of this research program is mentioned in my earlier post (Bernanke).
    Do you know what the economic rationalists were reading all these years?

    Quote: “I’d say something similar about chaos theory. It is a useful caution against interpreting the patterns we observe in terms of the equilibrating processes in our models, and also a caution against assuming that a deterministic process will be predictable. But again that’s different from furnishing useful solutions for concrete problems.�

    Response: Suppose you are alive when ‘the economy’ goes through a state of turbulence. What would you prefer, a government that takes advice from economists whose primary research question is the ‘material welfare of individuals under alternative institutional environments’ or the advice of someone who says we are not sure whether the data shows us that we are going through an equilibrating process and we don’t know what will happen tomorrow but we believe competition and free markets is good for ‘the economy’?

    Regards
    Ernestine

  47. Ernestine Gross
    November 27th, 2005 at 23:20 | #47

    Terje,

    That’s fine. It makes the point that private individuals can also have a voluntary dialogue of the deaf.

  48. Terje Petersen
    November 27th, 2005 at 23:24 | #48

    I think competition is over rated. However we have a lot of institutions (eg ACCC) who are tasked with creating and maintaining it.

    QUOTE: Suppose you are alive when ‘the economy’ goes through a state of turbulence. What would you prefer, a government that takes advice from economists whose primary research question is the ‘material welfare of individuals under alternative institutional environments’ or the advice of someone who says we are not sure whether the data shows us that we are going through an equilibrating process and we don’t know what will happen tomorrow but we believe competition and free markets is good for ‘the economy’?

    RESPONSE: Either way I think that the government would find a way to screw us.

  49. Razor
    November 28th, 2005 at 16:56 | #49

    Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).

  50. Standard Deviant
    November 28th, 2005 at 17:09 | #50

    Terje,
    Quote: “Its softness is determined not so much by the technical ability of a central bank to defend it so much as it depends on the political will to defend it.�

    In practice this is probably generally true. I say this because the technical ability to maintain a peg is not usually a problem, but central banks don’t usually try to maintain a fixed exchange rate without (at least the option for) any foreign exchange market intervention. However, the softness also depends on the practical ability of the central bank (and on that of the government of the day) to abandon the peg quickly and easily.

    Quote: “A central bank that was on a gold standard would probably be prudent to hold some gold. However that would be more to do with a potential decline in the value of other asset classes (eg foreign currencies).

    “A central bank has very little to fear from a fully-fledged speculative attack so long as it has a single clear objective target for open market operations. Central banks fail to defend their monetary target when they are caught between multiple objectives and they blink.�

    There are two different issues. The first is the technical feasibility of a peg. I agree that there is generally no technical barrier to maintaining a peg, provided the central bank has the ability to buy back its money base, which would best be ensured by holding sufficient gold or gold denominated assets (because of, as you point out, the potential depreciation of other assets). How narrow a band they can keep is probably not as clear, though.
    The second issue is that of time consistency and credibility. Even if a fixed gold peg is considered optimal ex ante, short-term incentives to depreciate may be strong, particularly when the peg is not credible. The incentive to gain a reputation may be stronger, making the peg more credible, and reducing the problem, but it is hardly guaranteed. Yes, the problem is multiple objectives, but simply realising and acknowledging this does nothing to fix the problem. Wanting to be committed is not the same thing as being committed. Nobody could be blamed for not caring about only the gold price and nothing else (quite the opposite). A monetary authority not willing to defend a peg to gain credibility could be accused of short-sightedness and/or lacking political courage, but a time consistency problem could occur even if their preferences were perfectly aligned with those of the general population (which, of course, won’t be homogeneous in reality…). A possible solution is to impose further practical constraints (i.e. make it more difficult to abandon the peg quickly). There is a reason they brought in the Euro, rather than those countries just keeping narrow pegs. Of course if the technical ability to defend the peg is (perceived to be) jeopardised then it loses credibility, so the two issues are related.

    Quote: “The RBA currently targets interest rates even though it’s lending represents only a tiny proportion of lending in the broader market place. Whilst it is single minded about this target even well funded speculators have little chance of shifting the market interest rate off target.�

    I see the RBA’s cash rate targeting as somewhat different to a gold peg (or exchange rate peg generally) with respect to the issues we’re talking about. For one thing, the RBA only commits to its target for one month out (or two months after its December meeting). If something happens that makes the RBA want to change its target then it would only have to wait less than a month before it could do so without losing any credibility. Also, I don’t see how speculation on the cash rate could cause close to the amount of economic discomfort as speculation on the exchange rate could. Not to mention that funds from RBA open market operations flow more directly into the interbank funds market than the gold market.

    Quote: “When China fixed its exchange rate to the US dollar not even the might of the US Federal Reserve could have used a speculative attack to shake the peg so long as the Chinese remained commited.�

    If the Fed remained committed as well then there would be trouble. China imposes restrictions on international capital flows (as I understand, but I’m not aware of the details), so it’s a different kettle of fish.

    Quote: “The RBA would have no difficulty maintaining a 4% price band even without trading gold.�

    I don’t dispute that standard OMO, without direct gold market intervention, would always allow the RBA to push the gold price up or down (again provided they don’t run out of assets to conduct those OMO). I was disputing that they would necessarily be able to do so very precisely, especially in extreme circumstances. I imagine that OMO would affect the gold price only at a lag, as well as somewhat imprecisely. I am not an expert though, so perhaps I shouldn’t be commenting on specific band widths, but plus or minus 2% still sounds a bit narrow in particularly turbulent circumstances.

  51. Ian Gould
    November 28th, 2005 at 17:26 | #51

    >Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).

    Certainly current account deficits of, say, 2-3% of GDP are sustainable and have been sustained by Australia, and other coutnries, for extended periods.

    However this does not prove that any level of deficit is automatically sustainable.

    As I noted early in this disucssion. You can only consistently import more than you export if you borrow or if you sell assets. IN both cases, the higher the percentage of GDP you need to cover the more you need ot borrow or the more assets you need to sell.

    You can’t borrow an ever-increaing percentage of your GDP without incurring debt servicing costs which become crippling and you can only sell assets at a rate slower than the formation of new assets or you’ll eventually run out.

  52. Terje Petersen
    November 28th, 2005 at 20:09 | #52

    Standard Deviant,

    Thanks for a thoughtful response.

    An easy way to visualise how the RBA could maintain a tight grip on the gold price without trading gold might be illustrated thus.

    Lets say the RBA trades in US dollars. Hence it can very accurately target any particular US dollar exchange rate that it desires so long as it does not try and mix objectives. Lets say then that its target for the US dollar exchange rate is defined as:-

    USD / AUD = K x (USD / GG)

    Where K is some constant and GG is a gram of gold.

    By using this dynamic target for the US$ exchange rate the arbitrage of third parties ensures that AUD / GG will remain very close to constant.

    I find the prospect of a significant lag unlikely given that it would leave profit on the table for those that arbitrage in currency.

    OMO does not ensure that the RBA always hits its interest rate target. In practice there is a tiny amount of jitter. And a gold price target is no different. However I see a 4% price band as being very achievable at least in a technical sence.

    I would agree that being on a gold standard and refusing to own or trade gold is a very contrived notion. However I merely use this notion to show that gold reserves are not an essential precondition for a gold standard.

    Regards,
    Terje.

    P.S. Likewise a central bank could target a commodity price index without owning any of the commodities.

  53. Ernestine Gross
    November 29th, 2005 at 11:49 | #53

    Razor says: “Still no information on why Trade deficits are Unsustainable for either the US or Australia. Maybe they are sustainable (well, they have been so far).”

    It seems to me the answer hinges upon the enforceability of ownership rights of incorporated assets owned in foreign countries, the ownership of transportation technology, the composition of assets owned in foreign countries in terms of commodities (natural resources and produced) relative to those demanded in the ‘home country’ and feasibility of transportation in relation to environmental pollution. I am assuming those who draft national and international laws aren’t getting themselves entangled in contradictions. Convertibility of currencies would not constitute a limiting factor.

    I am not suggesting this is how it’ll pan out – at least not in my lifetime. I am not suggesting this is how the world should look like. I am saying these would be sufficient conditions for a country to export {0} and, in the limit, import all transportable commodities (in the sense of Arrow-Debreu) sold in the same country.

    I am not sure whether I would call such a ‘global economy’ a ‘non-dictatorial one’ because it relies on a theoretical model of a ‘competitive private ownership economy with partially segmented markets and multinational firms’ and the welfare properties of the solution of this model are not quite the same as that of the Arrow-Debreu model (Gross, 1988).

    The move from a central wage fixing system toward Enterprise Agreements is a move consistent with the model of partially segmented markets and multinational firms’. But no prediction follows because this move is also consistent with a misunderstanding of the role of prices in coordinating decentralised decisions.

  54. Terje
    November 29th, 2005 at 11:52 | #54

    QUTOE:But no prediction follows because this move is also consistent with a misunderstanding of the role of prices in coordinating decentralised decisions.

    RESPONSE: Can you expand on this point. It sounds interesting but I don’t really understand it.

  55. Ernestine Gross
    November 29th, 2005 at 12:04 | #55

    Terje,

    I continue to rely on you being interested in convergence in conversations – I don’t want to have another AVAROO media management experience.

    Which bit do you wish me to expand on?

  56. Terje
    November 29th, 2005 at 12:45 | #56

    Convergence is good. Lets work on it.

    What do you regard as the role of prices in coordinating decentralised decisions? I have always seen price as a form of communication. It is a summation statement made by one party to another about costs, willingness and alternatives.

  57. Ernestine Gross
    November 29th, 2005 at 18:20 | #57

    “What do you regard as the role of prices in coordinating decentralised decisions? I have always seen price as a form of communication. It is a summation statement made by one party to another about costs, willingness and alternatives.”

    The role of prices in coordinating decentralised decisions is to convey the relative value (in exchange) of commodities (in the sense of Arrow-Debreu) and securities (in the sense of Radner) to all member of an economy.

    A feel for the absence of the coordinating role of open markets might be obtained if one imagines an open market (stock exchange) for shares would not exist and all trades (primary and secondary) would have to be done via over-the-counter markets. This might also help to see the limitations of Enterprise Agreements.

  58. Standard Deviant
    November 30th, 2005 at 00:02 | #58

    Terje,

    Quote: “Lets say the RBA trades in US dollars.�

    Well, I did qualify my initial remarks with “or at least [trading] in some foreign currency�. I do imagine that trading in US dollars would be much more effective than trading Australian government securities (which you have suggested would be adequate, unless you were referring only to foreign government bonds), for instance. I’m not sure how using only US dollars would compare to trading gold directly, but I’ll concede that it’s probably good enough. You can’t trade Australian government securities directly for gold (not in a liquid market with prices easily observable to the RBA, anyway), as you can with US dollars. In fact, you would probably have to go back via Australian dollars, which means you’re trading in the same market the RBA would be trading in. This complicates things, and is why I think standard open market operations would not have too precise an effect on the gold price.

    Quote: “I find the prospect of a significant lag unlikely given that it would leave profit on the table for those that arbitrage in currency.�

    I’m not sure if you’re referring here only to simple cross rate arbitrage, or also to “arbitrage� based on expectation that the RBA will make the gold price return to its target value. With respect to the latter, there is only an arbitrage opportunity if it is certain that the RBA will maintain its peg, which presumably precludes a speculative attack. With respect to the former (which I think is what you meant), as I have argued above, this would probably not work very well when the central bank trades in government bonds. I would not generally take “standard open market operations� to include changes in holdings of foreign reserves.

  59. Terje Petersen
    November 30th, 2005 at 07:11 | #59

    Standard,

    Even with government bonds I doubt that the RBA would have any trouble meeting its target. Although as you point out the trassmission factors are not as direct.

    I was refering to cross rate arbitrage in the example of trading in US dollars. However in a pure bond trading OMO setup then “arbitrage� based on expectation would no doubt be significant in short circuiting any lags. Not that I think such lags would be significantly large.

    In the case of OMO targeting interest rates I would guess that “arbitrage� based on expectation is also significant.

    If I loosened my original assertion and said that a central bank only needs a small proportion of OMO trades to be directly in gold (to smooth lags) then would you accept that the bulk of the OMO trades could be in government securities.

    And of course if a government was commited to a gold standard then it might deepen that commitment by denominating its bonds in physical gold weights such that a direct cross market between bonds and gold did emerge.

    In Australias case given the recent reduction in government debt I would expect that if the RBA went onto a gold standard it would want to trade in gold and currencies. I suspect that if the Australian dollar was on a gold standard there would be strong demand for the currency anyway and we would need to expand the base money supply to accomodate foreigners who want to hold a gold standard currency. What the RBA buys as it expands the money supply would not be insignificant.

    Regards,
    Terje.

  60. Terje Petersen
    November 30th, 2005 at 07:13 | #60

    Ernestine,

    Can you illuminate me with the difference between an “open market” and an “over-the-counter market”.

    Regards,
    Terje.

  61. Ian Gould
    November 30th, 2005 at 08:19 | #61

    Terje,

    In an open market, goods are effectively auctioned to all comers with everyone having access to bid and offer prices.

    In an over-the-counter market, one or mroe brokers/market-makers quote buy and sell prices for goods.

  62. Katz
    November 30th, 2005 at 09:21 | #62

    Terje,

    On the issue of the inflexibility and fragility of foreign exchange fixed to any standard, may I recommend Andrew Boyle, “Montagu Norman. A Biography,” Weybright and Talley, New York, 1967.

    Boyle’s argument is that a successful fixed exchange rate regime required more than competence; it required good will between the central bankers of the leading financial powers. Mutual suspicion was the inevitable consequence of central bankers who were required to promote divergent and ultimately contradictory priorities.

    Thus, [in 1927] Emile Moreau, Governor of the Bank of France, recognised that Norman, Governor of the Bank of England, had pegged the pound too high against gold:

    “By going daily into the market and purchasing with francs large amounts of foreing currencies [Moreau was able to secure a vice-like grip on the London money market]. The tenacious Frenchman had now got his hands on big sterling balances. If he sent further and converted these into gold, he could squeeze British credit, upset Norman’s wider plans and gradually deplete the Bank of England’s gold reserves. ‘This was a situation,’ as Benjamin Strong’s [Chairman of the US Federal Reserve] biographer aptly comments, ‘calling for mutual understanding andclose co-operation. But relations between Norman and Moreau were … strained …’” (pp. 226 -7)

    Boyle concludes:

    “[Strong and Moreau] so abused the inordinately great power that was temorarily theirs, converting their respective prejudices and weaknesses into principles of action and thus opening a fresh chapter of mistrust, that when Britain was confronted with financial ruin in 1931 the continued intransigence of the Bank of France helped to precipitate the collapse of the gold standard.” (p. 238)

    Thus reasonable selfishness and unreasoning prejudice were combined in a witches brew that helped embroil the world in utter financial and economic chaos.

    Today, Alan Greenspan is often called the most powerful man in the world. Yet he has only a tiny proportion of the power of central bankers who had access to the financial levers provided to them by the gold standard.

    It seems to be quite rash to set up a system that gives a small number of individuals more power than Alan Greenspan.

  63. Terje Petersen
    November 30th, 2005 at 14:24 | #63

    Katz,

    I accept that when Sterling was returned to the gold standard in 1925 with a deflationary stance then this of course put pressure on debtors and created a benefit for creditors. In essence sterling debts were going up in value with a net transfer of wealth from debtors to creditors.

    I can’t see any logic in the story of Moreau. I think it likely that he is merely a scapegoat for the deflation created by Churchill.

    When Churchill decided that the target price for gold would be the same as the pre WWI target then he ensured two things.

    1. The central bank would loose collateral (ie gold reserves) in the process of draining Sterling liquidity from the markets in its efforts to hit Churchills target. This is a basic reality of open market operations. If you want your currency to appreciate you must sell collateral.

    2. The sterling zone (which included Australia and most of the commonwealth) would suffer deflation.

    All of this was a logical consequence of Churchills decision. Blaming other market participants is futile because the facts of the matter could have been predicted ahead of time and in fact where by many of Churchills critics.

    Regards,
    Terje.

  64. Terje Petersen
    November 30th, 2005 at 14:29 | #64

    The point is that in 1927 the problem with the gold standard was not its existance but the choice of entry that Churchill chose in 1925. His choice played a significant part in creating the great depression. Although the advent of American protectionism and the European backlash was also crucial.

    All this could have been avoided if:-

    a) Britian did not leave the gold standard during WWI.
    b) Churchill in 1925 did not try to re-enter the gold standard at the pre-WWI price.

    Using this piece of history to judge the gold standard is a little like saying that “inflation targeting” would be awful if the central bank put interest rates up to 30% tommorow just on a whim.

  65. Katz
    November 30th, 2005 at 17:55 | #65

    “Using this piece of history to judge the gold standard is a little like saying that “inflation targetingâ€? would be awful if the central bank put interest rates up to 30% tommorow just on a whim.”

    Not correct Terje. These circumstances are different in kind and are therefore not analogous.

    The decision of a Central Bank unilaterally to raise domestic interest rates has a direct effect only domestically. (I recognise that raising interest rates, especially to the ridiculous extent that you use as an example (30%) would have the effect of attracting capital inflows.) But this would happen at the cost of locking the wheels of the domestic financial and credit systems. Greenspan, for example, could do this tomorrow. But by the next meeting of the Fed Board he’d be gone. And in the meantime, private currency speculators and hedgers would remake the market in US$ in the light of this bombshell news. Spot dollar and dollar future markets would whipsaw around as a consensus is forged about the (bleak) future of the US dollar.

    Moreau’s manoeuvres and manipulation of the exchange in 1927, on the other hand, involved direct intervention into the supply of sterling and potentially gold in British credit markets. A Central Banker could, and did, exploit the commitment of the Central Banker of another country to keep the value of sterling steady against gold. This kind of manipulation is possible regardless of at what level the currency ispegged against gold.

    Moreau’s manipulation was possible *because* Norman was commited to keeping the value of sterling steady against gold.

    In other words, the Central Banks were the risk-takers in this transaction, rather than allowing distibution of risk by means of floating exchange rates and a liquid fx market.

  66. Andrew Reynolds
    November 30th, 2005 at 19:17 | #66

    Katz,
    All I think he was saying was that to judge the gold standard by one stupid action would be like to judge inflation targetting by a different stupid action and not trying to look too deeply into it from there.

  67. Terje Petersen
    November 30th, 2005 at 21:03 | #67

    Andrew is spot on.

    The errant thinking so often evident in modern monetary policy discussions is the notion that our currency has two unrelated values. One is the domestic value (measured in baked beans) and the other is the international value (measured by foreign currencies).

    The fact that we can devalue our currency on international markets and see no domestic consumer price movement is taken as proof of the concept. However this ignores the institutional nature of consumer prices, wages, office leases etc. Such an inflation immediately sets of a chain of events within the domestic economy even if it does not get reflected in consumer goods for months or years. It is however reflected in domestic spot markets. The domestic price of gold will change as rapidly as the exchange rate with US dollars or Pesos. The stock market will also respond rapidly.

    A monetary policy decision to target a 30% interest rate would be highly deflationary. Anybody holding Australian currency could anticipate a significant capital gain (barring a change of policy). This would cause others to pile in buying the aussie dollar. To suggest that the effect would be domestic only is simply wrong. People piled in buying YEN all through the 1990s precisely because errant monetary policy had put the YEN in a deflationary cycle.

    You recount that in 1927 Britian was losing gold reserves. Blaming this on the French (or else giving the French credit for causing this) is not credible. This was something that was simply going to happen regardless the minute that Churchill choose the gold price fix that he did. It was inevitable.

    The British hate the French so the story is not surprising. It is also consistent with the host of stories that get told about monetary errors. For instance when Nixon stuffed up US monetary policy in the 1970s they blamed the Arabs for causing US inflation. In Ghana where inflation is in double digits today it is common for people to blame foreigners for putting up the price of imports. In the 1970s in Australia lots of people routinely blamed the unions for causing inflation, while lots of other people routinely blamed retailers.

    What gets missed is that the players in a wage price spiral (upward or downward, inflation or deflation) are reacting to forces bigger than themselves. They may be easy targets for blame but they are not the source. Likewise blaming the French may have let the British wash their hands of guilt or responsibility for their situation but it does not change the fact that it was Churchills fault.

    You suggest that if Greenspan put interest rates at 30% he would be gone tomorrow. Perhaps. Paul Keating survived the recession we had to have even if only for the short term. A flawed gold standard such as Churchills effort also unleashed strong political forces. In fact consequences and pain was such that within less than a decade the political forces were busy dismantling the gold standard and large slabs of the neoclassical system. And not long after than the world was engaged in the bost bloody war in all history. Had it not been for a certain toughness of character during the military hardship Churchill may be remembered somewhat less favourable.

  68. Katz
    November 30th, 2005 at 21:05 | #68

    AR, I understood what Terje was arguing.

    I disagree with your premise about Moreau’s act being “stupid”.

    Moreau’s actions in 1927 were not “stupid”. They were very much in France’s national interest. Poincare, the French PM and the bulk of the French political nation applauded his actions.

    Under the hypothetical jointly constructed by terje and myself, on the other hand, Greenspan’s action in raising interest rates on a whim to 30% would be seen by all sane people as “stupid”.

    Thus, to restate the concept enunciated in my post above, the Gold Standard (or for that matter any fixed exchange rate system) encourages “cheating” of the kind exemplified by Moreau in 1927. Moreau wasn’t being “stupid” he was being tough and smart.

    Interestingly, the French threatened to do the same thing to US gold reserves in 1968 as they threatened against the British in 1927 when the French National Bank started to worry about rapidly growing deposits of US$ fuelled by US consumer expenditure and the financial demands of the Vietnam War. Again, the French were being smart and tough.

    And it worked.

    This crisis set the stage for the end of the Bretton Woods system some years later.

    So we can thank the French to some extent for our free floating exchange rate environment.

  69. Katz
    December 1st, 2005 at 07:51 | #69

    “You suggest that if Greenspan put interest rates at 30% he would be gone tomorrow. Perhaps. Paul Keating survived the recession we had to have even if only for the short term.”

    The comparison between Alan Greensspan and Paul Keating is not useful.

    Alan Greenspan holds his chairmanship of the Federal Reserve Board at the pleasure of the President of the US and subject to the confidence of the members of the Board.

    The Federal Reserve Board is composed of members appointed for terms of 14 years. Board members are in theory above politics. But they are political appointees nominated by the President and ratified by the Senate. The political cycle being what it is, it is highly likely that a range of views will be represented on the Federal Reserve Board.

    According to Bob Woodward, “Maestro. Greenspan’s Fed and the American Boom”, Paul Volcker, Greenspan’s predecessor, lost the confidence of his own Board.

    In 1986 the Reagan administration wanted a cut in official interest rates. Volcker disagreed. A Reagan appointee, Manuel H. Johnson Jr., informed Volcker that he demanded a vote on the question.

    Volcker lost the vote.

    “‘Good-bye,” [Volcker] announced to the Board after the vote was taken. “You’re going to havve to do it on your own.” He got up and walked out, slamming the door. Hard.” (p. 18.)

    Of course Volcker could have stayed on. But pride and ego, and no doubt a sizeable family trust account, argued against it.

    Paul Keating, and any other popularly elected prime minister, on the other hand, lead for the duration of their elected term. When that term comes to an end, or the PM prematurely ends it to go to the people on what s/he believes to be the propitious time, s/he appeals to the people on a wide range of issues.

    If the people vote against a PM (i.e., the PM fails to construct a working majority in Parliament), s/he necessarily is stripped of authority.

    Thus, the Chairman of the Fed and a popularly elected PM hold authority on two entirely different bases. Therefore there are few useful grounds for comparison of the means by which they may have that authority removed.

  70. James Farrell
    December 2nd, 2005 at 01:13 | #70

    Ernestine

    A belated and very brief respone to your detailed reply to me, for which I’m grateful.

    Friedman’s legacy is mixed as far as useful advice is concerned. The emphasis on the money supply and monetary targetting was unhelpful, and has long been repudiated by orthodox macroeconomics. On the other hand, his contribution coincided with a revolution in thinking about expectations, central bank credibility and so on, which seems to have contributed to the current era of price stability. And of course Hahn was right that no one ever ‘ground out’ a natural rate of unemployment from a Walrasian system, but I think the concept at least drew attention to the limits of demand management as a cure for unemployment, and the inflationary risks associated with exclusive reliance on it.

    I don’t know if I dare cross swords with you on the topic of GE, but for what it’s worth, my feeling about Walras’ contribution was that he solved a particular formal problem in the theory of value, and that’s about all. He found a way to reconcile cost- and utility-based explantions of price, by showing that you can tell a coherent story in which everything depends on everything else. But I don’t see that this formal solution took us far beyond Adam Smith in terms of our understanding of the day-to-day workings of markets. I defy you to read, say, a typical Industrial Organisations textbook, and not conclude that Smith would find it more interesting than Arrow and Debreu. Though it’s obvious that the participants are having plenty of fun, I just don’t see that the GE research project has yielded much by way of testable hypotheses or policy implications.

  71. Terje
    December 2nd, 2005 at 10:44 | #71

    * Thus, the Chairman of the Fed and a popularly elected PM hold authority on two entirely different bases. Therefore there are few useful grounds for comparison of the means by which they may have that authority removed.

    I agree. However there are few other comparable precidents for the example we are discussion.

    In any case it does not change my position that the loss of gold reserves (and national pride) suffered by Britian in 1927 was as a direct result of Churchills 1925 decision to overvalue Sterling relative to gold.

  72. Ernestine Gross
    December 3rd, 2005 at 15:43 | #72

    James,

    Thank you for giving your assessment of the usefulness and influence of Friedman’s advice in the area of monetary policy. I am aware of ‘schools of thought’ and associated debates between and among members of ‘schools of thought’ and I accept your opinion on Friedman’s influence on the thinking of schools of thought. Using the broad brush we are using, I would agree with your summary of Walras’ work. So we seem to differ in the information we share on the Arrow-Debreu model and all subsequent theoretical models since the 1950s.

    You ask me to read a typical Industrial Organisation textbook and to reach a conclusion on whether or not Adam Smith (1776) would find it [the Industrial Organisation textbook] more interesting than Arrow-Debreu. Furthermore, depending on my conclusion, you would defy me or not. If I would be silly enough to engage in such an exercise, I would be putting words into Adam Smith’s mouth – more than 200 years after his death! What would be the purpose? Debreu’s (1959) book states right at the beginning that the area of Industrial Organisation is not treated. Typical Industrial Organisation books, (eg Tirole, 1988), state right at the beginning that its content [applications of game theory to analyse the interaction of a ‘small’ number of decision makers, each one them being self-interested and aware that the outcome of its decision depends on the decisions of the others] is not suitable for welfare questions [for ‘the economy as a whole’ - as distinct from ‘the economy as a hole’; ie where the individual decision makers aren’t considered at all] and it refers to general equilibrium theory for the latter. The methodology of general equilibrium theory is the same as that of game theory (and the theory of the core and dynamic agent models). There is no ‘competition of schools of thought’ involved; no crusaders and persuaders. This methodology was not available in 1776 – how on earth would anybody know what Adam Smith, who wrote in 1776, would think of it?

    You talk about the “current era of price stabilityâ€?. I don’t understand. It does not seem to match observables. A huge industry (finance) thrives on price instability. Between Friedman’s time of influence and now there were ‘stock exchange crashes’ (1987) in the ‘western world’. There was another series of such discontinuities in share prices and relative currency prices that affected South East Asia in the 1990s, and Argentina, among others, defaulted between Friedman and now. Again, I am using a broad brush to pick out the ‘big’ items from the ‘real world of how markets work’ that seem to contradict your statement.

    Given the above mentioned information asymmetry and the different methodologies, it seems to me a bit too much to expect to get agreement on the usefulness of the GE (and GT) research programs. As for your impression that participants in the GE research program are having plenty of fun – maybe you are right; I don’t know. On a lighter note (it is Saturday after all) would you give me a pass for my answer to ‘Smith in relation to IO’?

  73. Standard Deviant
    December 3rd, 2005 at 17:29 | #73

    Terje,

    Quote: “If I loosened my original assertion and said that a central bank only needs a small proportion of OMO trades to be directly in gold (to smooth lags) then would you accept that the bulk of the OMO trades could be in government securities.�

    Trading in government securities could certainly reduce, up to a point, the gross amount of gold trading needed to be done. Over a long enough time horizon it could probably reduce the required net trade of gold to zero. So I would not really disagree with your statement. However, I wouldn’t really know what proportion of trading would still have to be done in gold to maintain a peg within a given band, and it would depend on many variable factors (including market expectations) anyway. So I can’t categorically agree with your statement either.

  74. Terje Petersen
    December 4th, 2005 at 09:59 | #74

    Standard Deviant.

    In any case there is no law against central banks buying and selling gold. My original point was merely that it is not overly necessary for the purposes of maintaining a gold standard.

    Regards,
    Terje.

  75. Ernestine Gross
    December 5th, 2005 at 00:12 | #75

    Terje,

    Re: Gold standard.

    I’ve been following more or less consistently your posts on the gold standard. Perhaps it is helpful to distinguish between the gold standard, as an international monetary system, and historical records on the empirical details of its implementation and practice. Sometimes historical detail can make it quite difficult to see the underlying logic of the system.

    There is a book by Krugman and Obstfield on international economics, which is quite detailed on ‘the mechanism’; that is the rules of the game, which make up the international monetary system, known as the gold standard. For example, one rule was that national ‘monetary authorities’ had to settle net balance of payments positions in gold. The gold points (see earlier post) are of interest to arbitrageurs (approximately risk free arbitrage). The book by Krugman and Obstfield should be in all University libraries. There are various editions. Amazon may offer it.

    It seems to me your usage of the term gold standard is not consistent with its originl meaning.

    My message is not to be understood as me being in any way in support of the gold standard. It is simply meant to clarify the term ‘gold standard’.

  76. Terje Petersen
    December 5th, 2005 at 04:25 | #76

    I have read enough Krugman articles on the topic to be inclined towards “no thankyou”. I find his analysis of the gold standard (and most things) to always be overly selective and biased.

    There have been various versions of a gold standard. The only rule that I think defines a gold standard is a monetary rule that ensures a near fixed price of gold. That is not to say that the underlying mechanisms are not interesting or relevant.

    A gold standard is not without faults. And elsewhere I have argued with gold bugs about the faults surrounding the historical institutions and rules associated with the gold standard. I am happy to acknowledge the weaknesses of various systems. However like democracy a gold standard is generally better than all the alternatives that have been tried.

    Which monetary system do you think is superior to a gold standard? And by what measure do you find the results superior?

    P.S. I am still inclined towards tracking down the earlier book that you recommended (when time in the vicinity of a library permits).

  77. Katz
    December 5th, 2005 at 07:50 | #77

    Terje,

    When you say “monetary system” in your last post, do you mean:

    1. The bases upon which central banks and currency issuing authorities vouchsafe the value of the currency they issue

    or

    2. The bases upon which the changing relative purchasing power of different currencies is controlled/negotiated

    or

    3. Something else

    or

    4. Some aspects of the above

    or

    5. All of the above.

    Was there a period when foreign exchange transactions worked satisfactorily?

    If so, what forces militiated against the persistence of this system?

    Can you explain how the defenders of this system failed to protect it from the actions of those who had no desire to protect it?

  78. Ernestine Gross
    December 5th, 2005 at 08:37 | #78

    Treje,

    Re Krugman: In your opinion, does the result of 2+2 depend on who writes it?

  79. Terje Petersen
    December 5th, 2005 at 15:04 | #79

    Ernestine,

    Of course not. However in my experience having read several Krugman articles, having followed several Krugman debates and having skimmed his website previously I find that he often asks me to believe that 2+2 is only sometimes four. He tends to start his analysis of issues with a set of a-priori assumptions that I simply don’t share.

    If you wish to quote Krugman then I will happily play the ball. However I am not likely to put his book at the top of my list of things to read. I know he is a pin up boy for the Keynesians but I don’t share their enthusiasm.

    Regards,
    Terje.

  80. Terje Petersen
    December 5th, 2005 at 15:14 | #80

    QUOTE KATZ: When you say “monetary systemâ€? in your last post, do you mean…

    RESPONSE: I was being open ended. I was asking Ernestine to name an alternative to the gold standard and to define why he found it superior. It may be that he finds all monetary systems (as he chooses to define monetary systems) to be equally flawed. He has stated previously that he has a hunch as to which might be better but to date he has been pretty tight lipped about which alternative he prefers. I am just interested in which he prefers and the reasons why.

    Can Katz tell me which system he prefers and why?

    My definition of monetary system would be any set of rules that defines the managment objectives and processes used by a central bank (or some such government body) to regulate the distribution of additional national currency and/or the reduction of national currency in circulation.

    In other words a monetary system is any system of rules that encodes the circumstances and means for changes to M0.

  81. Katz
    December 5th, 2005 at 17:47 | #81

    Terje, I have no objection to your “M0″ definition of currency. Domestic currency issuing authorities all over the world issue currency according to financial and prudential criteria. In some places this is corrupt and/or imprudent. I guess I ould point to Zimbabwe as an example. Such corruption or imprudence is almost always a sign of deeper-seated crisis. I’m aware of no country that links its M0 to gold or any other stoe of value. (I may be wrong and would be happy to be corrected). In other words, domestically, as ar as I know, all currencies are fiat currencies.

    Thus, in terms of domestic currency creation, there seems to be nothing to prefer. The world has voted with its feet.

    More interesting and more important are the mechanisms that determine the relative value of all of these fiat currencies.

    As I write there are thousands of fx dealers hedging and speculating in trillions of dollars negotiating the exchange rates of all of these currencies. This is a zero sum game. For every winner in a transaction there is a loser. Governments and Central banks are also involved in this game. I recall that a year ago the RBA announced an annual $200m profit from open market transactions. Good luck to them, but they may have lost too. However, the value of the $A is negotiated with or without the intervention of the RBA or any other Australian government body.

    These hedgers and speculators pay greater or less attention to the conditions of the country issuing currency. Knowledge is often rewarded. Ignorance is often punished. But not always. Whatever, the $A is assigned a value based on the perceived self-interest of all these speculators and hedgers, and not according to the determination of our government andd central bank to spend the nation’s tax revenues to defend a certain value.

    This system distributes power, it uses greed and fear to maintain relative stability. It does not demand active intervention by national politicians who are driven by a set of non-financial imperatives.

    It isn’t perfect, but it is predictable. And it imposes discipline on national currency and credit-creation agencies.

    This is the system I prefer.

  82. Terje Petersen
    December 5th, 2005 at 19:47 | #82

    Katz,

    You seem to be saying that the absents of a gold standard is a system. This seems somewhat naive.

    M0 is the amount of national currency in circulation. It includes coins and notes but not bank deposits etc.

    M0 is currently regulated in Australia with the objective of meeting short term interest rate targets and longer term CPI targets.

    For historical data on M0 the following is useful:-
    http://www.rba.gov.au/Statistics/Bulletin/D03hist.xls

    It shows for instance that in September 2000 there was A$25.6 billion worth of our aussie fiat currency in circulation. However 5 years later in September 2005 this figure had been increased to A$34.0 billion.

    In other words in five years the amount of currency in existance was 33% higher (ie 6% more per annum). Or to put it another way the reserve bank had during this period printed A$8.4 billion in new currency and spent it.

    Hopefully you know all this.

    You seem to be saying that the correct policy dictating how they grow or shrink M0 is to just print as much new currency as they please as long as its consistent with not being like Zimbabwe and consisten with ensuring that the currency does not maintain any form of parity with gold.

    In essence what you advocate is a non-system. You think that there should be no significant restraint on the printing presses other than at the absolute extremity.

    Now why do you think such an approach would be superior in it’s outcome?

    Regards,
    Terje.

  83. Katz
    December 5th, 2005 at 21:22 | #83

    Terje, I didn’t know the figures, but they don’t surprise me.

    Presumably, the folks who map out strategies for dealing the $A in fx markets are much more aware of these figures than I am. And the enormous weight of money they handle are exhanged with tose underying realities in mind.

    And look at what has happened to the value of the $A in the same time frame.

    The $A has appreciated significantly in value against most major currencies.

    In other words, this weight of money is happy with the numbers you quote.

    Now consider what might happen if these same dealers learned that Australian public institutions were commited to protecting the value of the $A against any other store of value, including gold. Very quickly the latterday Geore Soroses of this world would devise strategies to take advantage of this determination and take those public institutions, and Australian taxpayers, down.

    Now I’d be interested in your answers to the questions I posed further up.

  84. Ernestine Gross
    December 5th, 2005 at 23:25 | #84

    Terje,

    Paul Krugman is, IMHO, not a member of the set of ‘crusaders and persuaders’ who produce rhetoric suitable for ‘quoting’.

    Paul Krugman’s academic background is in analytical economics. It is the antithesis of rhetoric.

    You mentioned on a previous post that your background is in engineering (electrical?). Would it make sense to engineers to try to work out something by means of quoting rhetoric?

    Please do give me a list, if it exists, of all electrical egineers who are in the ‘quoting of rhetoric business’ for I surely would like to avoid them. The same applies for civil engineers (and I, like many others, apply it also to Economics).

    For all I know some people may have a picture of Krugman on the wall next to a picture of Picasso and a picture of Einstein. Who cares.

  85. Ernestine Gross
    December 6th, 2005 at 00:00 | #85

    Katz Says: November 25th, 2005 at 12:28 pm : “Of course traffic signals are reasonable, given the unreasonable nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.”

    I read your qualification re policy. But policy is not the issue.

    I accept that local conventions can emerge and native language may be an example. I take this as given for the purpose of the following. However, I am not convinced that your analogy with the development of languages answers my point that traffic lights provide an efficient way of communicating traffic rules to road users. I am sceptical because:

    Even if people would be ‘reasonable’ enough to think through a coherent set of rules, there are multiple possible coherent sets of rules (eg drive on the left hand or on the right hand side, etc, etc). Suppose the degree of ‘reasonableness’ (computational abilities) is such that each person works out all possible coherent sets of rules. It still would not solve the problem because each person would not know which of the possibly many alternative coherent sets of rules would be used by any one of the other members in society (‘equilibrium selection problem’) and each person would not know whether each of the other members of society has worked out all possible coherent sets of rules (absence of common knowledge). Enter your analogy with learning a language. O.k. suppose this is an example of the emergence of conventions (unwritten rules). But it is not convincing for the traffic light rule. While it may be the case that historically the introduction of traffic rules evolved with the increasing number of people and vehicles of one sort or another, there is another problem, namely not all conceivable coherent sets of traffic rules are equally ‘efficient’. One of the possible sets of coherent rules is ‘opportunities to move approximately in the direction you want to go at whatever speed is possible, given the opportunities that are taken up by all other traffic participants to move approximately in the direction they want to go’ – something close to this seems to have been (or still is) operating in New Delhi. It works, true, but it is inefficient in terms of traffic volume. India has many developed languages and, I understand, European languages have borrowed from one or several Indian languages. The population of the proverbial New Delhi has solved an equilibrium selection problem for traffic rules but has not selected any one of a number of relatively more efficient coherent sets of rules. (I am saying ‘proverbial New Delhi’ because my information on the traffic conditions in this city might be very much out of date.)

    I would say that traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria. (I won’t go through an analogous argument in a dynamic context – takes too much time and space).

    What do you mean by ‘reasonable’?

  86. Terje Petersen
    December 6th, 2005 at 05:28 | #86

    Katz,

    It is true that the value of the aussie dollar has not be adversely effected as M0 has grown over the last 5 years (at least not as adverserly as in earlier periods). No doubt the demand for aussie dollars has grown at a similar rate to this increase in supply.

    Soros could never shake Australia from a gold standard just as he would never have shaken the Chinese from their dollar standand (which they ended themselves just recently). You underestimate the power of central banks.

    However you have avoided the question which was what type of “monetary system” do you think is superior to the gold standard.

    Let me try and answer your questions which I missed:-

    Q1. Was there a period when foreign exchange transactions worked satisfactorily?

    A1. No. However some periods were more satisfactory than others. The 1950s and the 1960s were more satisfactory than the 1970,1980s and 1990s.

    Q2. If so, what forces militiated against the persistence of this system?

    A2. Fashion and politics.

    Q3. Can you explain how the defenders of this system failed to protect it from the actions of those who had no desire to protect it?

    A3. Brenton Woods was structurally flawed because it depended on a single nation to hold good to the cause (ie the USA). This was why Keynes had argued for an independent reserve currency (the Bancor). The IMF was intended to evolve into the custodian of such a reserve currency but it never happened.

    The breakdown of the pre WWI gold standard was heavily dictated by the decisions of the UK. Lots of Commonwealth Countries like Australia were never really on a gold standard but were in fact on a Sterling standard. When the Pound Sterling was taken off gold it effected a much bigger economic space than just Britian.

    Leaving the gold standard to fund a war was an example of inflation financing. It happened during the US civil war also. Whilst such a decision might seem necessary in desparate times it rarely proved effective.

    Other choices could have been made. And given hindsight at the consequences I think that many of the proponents who caused the system to come to an end might have chosen differently.

    The system was further weekend by the creation of central banks in places like the USA (1913) and Australia (1912). A notion called socialism was becoming popular and it called for new ideas and institutions.

    Regards,
    Terje.

  87. Terje Petersen
    December 6th, 2005 at 05:37 | #87

    Ernestine,

    QUOTE: Paul Krugman is, IMHO, not a member of the set of ‘crusaders and persuaders’ who produce rhetoric suitable for ‘quoting’.

    RESPONSE: Then we disagree.

    Krugman is a New York times columnist. He routinely has vocal opinions about government policy and he is well and truely engaged in public debate. He is quite busy in the persuasion business.

    Regards,
    Terje.

  88. Katz
    December 6th, 2005 at 07:57 | #88

    EG,

    Note how you conflate “reasonable” and “efficient”.

    The core or my argument is that a means of communicating information about the behaviour of traffic, or anything else for that matter, can be “reasonable” without being “efficient”.

    If traffic lights were installed and working to some discernible pattern, persons would, inefficiently but reasonably, come to a consensus about what they may signify and moderate their behaviour according to the consequences of this consensus.

    The most efficient means of communicating this meaning might be to have snipers posted at every light. Any infraction would result in a fatality for the wrongdoer. But is this “reasonable”?

    During my residence in the Southern States of the US, I noticed the effects of an analogous system. Afro-American motorists drove with infinite care. They were fastidious in their observance of “Stop” signs, to such an extent that I could be certain of the race of the driver of a car at the distance of a city block. There was no written traffic rule that dictated this behaviour, only fear of the consequences of any collision with a white driver, even though the Afro-American may have been in the right, from the point of view of the letter of the traffic law. This was “reasonable” but not “efficient” behaviour on the part of the Afro-American.

    For example, it is no more “reasonable” for cars to travel on the left or on the right. Luxembourg could declare a law to that effect tomorrow.

    However, given the size and location of Luxembourg locked between France and Germany, such a law would be very inefficient for reasons that I don’t need to elaborate.

    On the other hand, it wasn’t “reasonable” for cars in Sweden to be left-hand drive and yet drive on the left, as they did until the late 1960s. Nor was it “efficient”, given the increased number of catastrophic accidents that this state of affairs allowed.

    And again, it was “reasonable” for the Japanese to adopt driving on the left, which had the effect of protecting the nascent local car industry from American competition. However, forcing Japanese car owners to pay a premium for inferior local product (how times have changed!) could not be called “efficient”.

  89. Ernestine Gross
    December 6th, 2005 at 09:45 | #89

    Terje,

    Thanks for your reply. If you consider Krugman’s articles in the NY Times contain rhetoric, then I’ll take this as your perception, with which I might or might not agree.

    My point relates to his acadeic writing, including the textbook, which I had mentioned.

    .

  90. Katz
    December 6th, 2005 at 12:42 | #90

    Terje,

    Thanks for your responses to my questions. Allow me time to digest them.

    Meanwhile an answer to your question:

    “However you have avoided the question which was what type of “monetary systemâ€? do you think is superior to the gold standard.”

    My short approximation at an answer: from the perspective of domestic currency creation: prudent opportunism that takes aims to take intelligent advantage of the lags and enthusiasms of the floating exchange rate regime.

  91. Terje Petersen
    December 6th, 2005 at 13:55 | #91

    Katz,

    So do you agree or disagree with the short term targeting of interest rates? Do you think a government authority should essentially regulate the price of credit risk in this manner?

    The problem with a system called “prudent opportunism” is that we can’t say much about it as a system. It is not open to objective analysis. It is like arguing in fiscal policy that the correct tax rate for Australia would be the one that is optimal. Its hard to disagree with that statement but it does not cast much light on the topic.

    If we were to assume that Australia had been on a system of “prudent opportunism” since 1984 then I would wonder in what way you think the result has been better than a gold standard. If these are the apples that we are to compare then I think that the historical record would show that a gold standard would be better for Australia. If we have been on a system of “prudent opportunism” since 1971 then the gold standard definitely wins in my book.

    I will be the first to admit that a gold standard is flawed. However before dismissing it you have to propose an alternate system that is less flawed. That is why I advocate a gold standard.

    If you really want to just leave it to the market place then you would need to advocate that the government repeal the Notes Act of 1910, cease printing currency and really leave the currency business to private interests. However even then our tax laws have a powerful pull on the choice of our national “unit of account”, so you would probably not be able to truely leave it to the market unless you re-wrote all our tax laws and made the “unit of account” and “means of settlement” completely optional for tax purposes. That would be no minor undertaking.

    Regards,
    Terje.

  92. Ernestine Gross
    December 6th, 2005 at 14:23 | #92

    Katz,

    Thanks for your reply.

    No, I do not conflate ‘reasonable’ and ‘efficient’.

    My initial post read: “I should think it is very reasonable to have road traffic light rules. These rules communicate information efficiently among road traffic participants and resolves conflicting interests without requiring individually negotiated settlements at every intersection.”

    We agree on policy (roughly speaking: traffic lights should not be removed) but we don’t agree on the reason for agreeing on the policy.

    You argue that traffic light signals are a reasonable solution to the problem of people being unreasonable (“Of course traffic signals are reasonable, given the unreasonable nature of our species. The red lights you mention could exist and work without any rules being enunciated. Reasonable people could arrive at appropriate behaviour in regard to the operation of these signals without ever being informed of any rules. This is how people learned their native language for millennia before the invention of formal laws of grammar.”).

    In my reply I give reasons for rejecting the hypothesis that it is the unreasonable nature of humans which is the cause of the agreement on policy regarding traffic lights. I found myself having to reject your statement that the same outcome that can be achieved with traffic light rules could be achieved but for the unreasonableness of humans. On the contrary, I reached the conclusion that “traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria.”

    You may know a higher-order intelligence than that which I have assumed people to have. If this were the case then my conclusion might have to change. However, your reply does not contain such information. Your reply gives examples of situations which you judge to be ‘reasonable’ and ‘efficient’. Irrespective of how much I would respect your personal points of views, it would not change my conclusion.

  93. December 6th, 2005 at 23:14 | #93

    Terje, inflation financing (as you describe it) is in fact a splendid way to loot someone else’s economy (in the short run) or to mobilise its resources in your own interest (in the longer run), provided only that the area is sufficiently advanced already that you don’t have to create the cash economy in the first place. The French did the former to countries it “evacuated” during the revloutionary wars, as did the Nazis to Vichy France, and the Dutch did the latter in setting up their culture or cultivation system in the East indies, though they in fact used a depreciation of a copper coinage which limited how far inflation could go.

  94. Terje Petersen
    December 7th, 2005 at 07:00 | #94

    If you control the finances of a foreign nation then there are lots of ways to loot the wealth. That is bad enough but all to often national governments have used such policies to loot the wealth of their own citizens at home.

  95. Katz
    December 7th, 2005 at 07:57 | #95

    EG we agree that traffic signals represent a more efficient means of traffic control than a traffic signal-free regime.

    I now acknowledge that the language/traffic signal parallel is by no means perfect.

    Both are systems of communication of information. Language is much richer than red/amber/green. But that isn’t the most important difference.

    Language is a positive sum game. The acquisition of new language skills by one individual or collectivity does not restrict the access of others to those new resources. On the contrary, it encourages enrichment.

    Traffic systems are different. From the point of view of traffic controllers who can impose various algorithms on traffic flow to optimise traffic movement in the entire system, they aim for the most efficient traffic solution, given certain parameters. However, from the point of view of the many drivers, traffic flow looks like a zero sum game at best. Either the lane of traffic is “winning” or it’s “losing”.

    Thus, your comment:

    ‘I reached the conclusion that “traffic signals are a reasonable solution to a social equilibrium selection problem in a society where its members want to have a road traffic communication system that is efficient with respect to a set of criteria.’

    presupposes a large number of drivers accepting as true the proposition that those traffic controllers have established “a road traffic communication system that is efficient with respect to a set of criteria”. Now this is what these drivers might “want” but how do they know they have got it?

    These drivers may accept that the traffic system is reasonable. But they have no way of knowing it is efficient.

    Thus, this acceptance by a multitude of drivers is not based on knowledge. It is based on trust, or to use an old-fashioned word, on faith.

    Drivers use a set of rough and ready rules of thumb to decide whether this faith is well founded. So long as they don’t experience intolerable delays or danger they are prepared to play along with these rules.

    But there comes a time when all drivers are provoked to abandon their faith. Last evening we had storms in Melbourne. Unusually, I was driving my car at the time. The traffic lights at several intersections were not operating. There was a wide range of rule-breaking behaviour that signified that many drivers had lost faith that the normal rules of traffic flow would be restored.

    Unreasonable behaviour suddenly became reasonable as many individual drivers sought the most efficient solution for themselves.

  96. Terje Petersen
    December 7th, 2005 at 08:03 | #96

    In Italy stopping at a red traffic lights is only required if the driver or pedestrial who has the green light looks assertive. If you are riding a scooter then a red traffic light means “swerve as required”. The rules for round-abouts also seem to be different.

  97. Ernestine Gross
    December 7th, 2005 at 11:07 | #97

    Terje,

    Re: Traffic in Italy.

    Are you talking about a small country town or are you talking about ROMA, MILANO, PALERMO, FIRENZE, eh?? Or maybe VENEZIA where GONDOLA traffic is the attraction?

    What is your sample size? 1?, 2?, ? What was the sampling method used? When did the sampling take place? 1950s? 1960s? last year?

  98. Terje Petersen
    December 7th, 2005 at 14:15 | #98

    The sampling took place in Rome in 1997. I think that in the time we were there we probably observed several hundred traffic light controlled intersections although to be honest our record keeping was non existent.

    I don’t trust their taxi drivers either.

    I must admit that my study has not been peer reviewed but we won’t let that get in the way.

  99. Ernestine Gross
    December 7th, 2005 at 15:56 | #99

    Katz,

    Thank you for your detailed reply. It is, if I may say, a magnificent example of an attempt to substitute your premise for not wishing to abolish traffic lights, namely the unreasonable nature of humans, for my premise for not wishing to abolish traffic lights, namely the reasonable nature of humans. The word ‘impose’ in your paragraph 5 does not follow from what I had written. All your subsequent paragraphs suffer from this.

    Unrelated to the traffic light signal example, I agree that languages are a good example of ‘commons’.

  100. Katz
    December 7th, 2005 at 20:46 | #100

    I enjoyed it too EG.

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