Greenspan, gold & government

[Warning: long post about economics]

Back in 1967 Greenspan wrote an article called “gold and economic freedom” in which he supports the gold standard, and he also supports fractional-reserve banking (though he didn’t use those words). But the part I found particularly interesting was the discusion of government borrowing.

When a bank creates credit for a private loan this leads to an expansion in broad money supply. If nothing else changes, an increase in broad money will lead to inflation (too much money chasing too few goods).

However, the bank will only provide the loan if they expect to get a good return. Which means the borrower will need to increase their wealth in the future by enough to pay back the loan + interest. In this way, the monetary system only increases broad money roughly in line with national production. If future production does not rise then some of the loans will not be repaid… this will decrease the assets of the bank and the bank will have to reduce the amount of credit it offers. So broad money and production move together.

This avoids the problem of inflation.

But the same does not apply when the government takes a loan. From the bank’s perspective, the government is a “good bet” because in the future they can always repay the loan simply by taxing the people. So the banks will create credit and broad money will increase. So far the story is the same.

However, in contrast with the private sector (which needs to expand production to pay back the loans) the government has no market dicipline to ensure that their spending increases national production. Indeed, government spending often decreases national production though distorted incentives, deadweight loss, administrative and compliance costs, waste and corruption. This means that there will be more money chasing the same (or fewer) goods… leading to inflation.

Greenspan suggests that only a gold standard can prevent this. But he is wrong. All of these problems still exist with a gold standard. If the government is still allowed to borrow and tax, then even under a gold standard banks will have an incentive to create credit for the government without ensuring an equivalent increase in production.

The only way to ensure a stable monetary system is either to (1) remove the government’s power to tax; or (2) remove the government’s right to borrow; or (3) allow them only to borrow when the future repayments on the loan do not come from tax revenue.

The current system in Australia

In the current system we do not try to have a stable monetary system. Instead the government distorts the market in many different ways and tries to ensure that these distortions all off-set each other. So to offset the inflationary effects of their borrowing the government (or their agents, such as the RBA) would increase interest rates, which will decrease the money base.

The virtue of this system is that at least the government is trying to do the right thing. They are aiming to keep the value of money stable (ie low inflation) and to some degree they have done a decent job. This is a substantial step forward compared to other systems which attempt to use monetary policy to create growth or employment (the most dramatic recent example being Zimbabwe). This step forward represents the victory of the Monetarists over the Keynesians.

But the current system has a major problem. It relies on the judgement of a few people about the nature of a few very difficult-to-assess economic variables. And it is always possible that political pressure re-introduces a Keynesian element to the equation (which is often demanded by financial traders, politicians and economic journalists).

These problems are avoided if we have an asset-based currency. The most popular version is the “gold standard”, though there are other options, such as silver, whiskey, cigarettes, property, shares, shells, etc.

I’m not going to dwell on which is the best asset to use. I would prefer that we had free banking and let the market decide which type off currency would prevail. But the main point I’m making here is that all of these systems can still be destabilised by the government if they retain the power to both borrow and tax.

Restrictions on government borrowing

My preferred solution to this problem is to remove the government’s right to tax.

But a more moderate option would be to restrict the government’s ability to borrow. The government should not be allowed to use tax revenue to pay off their loans. Instead, a loans should only be repaid from the profits made from whatever was done with that same loan. This effectively limits government borrowing only to infrustructure projects, and only those projects where the government gets a return on its investment.

Government spending that doesn’t get a return (like welfare), or where the government chooses not to attempt to get a return (like a new freeway without a toll), should be paid for through taxation or previously saved money.

Some will argue that it is only important that the government could get market return on their investment, and it doesn’t matter whether they actually collect or not. Theoretically this is true. However this is also true of any private investment — and we don’t provide all private investors with access to taxpayer money (or at least, we shouldn’t). The problem is that people do not always correctly assess the viability of their own projects. The goverment, like all groups seeking debt, would argue that all of their projects produce huge benefits… but the only way to assess the merits of these projects is by exposing them to the scrutiny of the financial markets.

To argue otherwise is to suggest that the government knows best where the capital markets should allocate their money. This is, without exageration, exactly what lead to the inefficiencies and eventual collapse of socialism.

Under the above system, government infrastructure projects which genuinely do meet market criteria for a loan can proceed on debt. Not only does this remove the monetary distortion, but it also ensures that government infrastructure spending is not wasted. Banks will not simply be loaning money on the basis that the government can always repay (though tax), but instead will be assessing the risk and expected return from the project and only loaning the money if the project is viable.

Final objections

I expect two final objections: A final resort to Keynes; and a humanitarian plee.

The Keynesians will argue that in a deep recession it may be necessary to pursue deficit spending to “pump-prime” the economy. At the heart of this argument (often not well understood by those making the argument) is the suggestion that in a deep recession the banks aren’t simply refusing to create credit to give to businesses. This reduction in the “credit multiplier” leads to a monetary contraction which leads to deflation. As some prices are “sticky” (ie they don’t adjust quickly) this can lead to imbalances — the most important example is in the labour market where deflation and sticky prices would lead to unemployment.

There are four points to note here. First, without the pre-existing monetary distortions there would be fewer deep recessions. Second, deflation is not necessarily a bad thing and prices don’t stay sticky forever. Third, with a stable monetary system banks would be more likely to correctly manage and quickly adjust their distribution of credit. And finally, while it is theoretically possible for the perfect intervention to improve the market outcome, this has to be weighed against the probability that the government will get it wrong and the many consequences from those mistakes.

This leaves me with only the humanitarian objection. This argument would be that in a down-turn there is less tax to pay for social services, but more demand on social services. True. However there are various alternative way to deal with this without government borrowing. First, the government could save during the good years, and then draw down on this saving during the bad years. This is how most responsible adults manage their lives. Second, the government could borrow against the returns on a pre-existing assets (for example, the “Future Fund”). Third, the government could cut spending on other projects which weren’t aimed at the poor (such as the arts, sports, corporate welfare, middle-class welfare, defence, etc). And finally, perhaps we shouldn’t have such a big welfare state anyway.

In refusing this humanitarian argument it must be remembered that we are not choosing between a “good” and a “bad” outcome, but between two bad outcomes. Active fiscal policy is not “money from heaven”, but brings its own set of problems — such as potential inflation, future debt, crowding out, ricardian equivalence and inefficient spending.


Phew. That post was longer than I expected. My conclusion is that the major cause of monetary instability is the government, and that even in the best monetary system the government will still create distortions unless you restrict either their right to tax or the right to borrow.

So the choices are, in my order of preference: (1) abolish tax; (2) restrict government borrowing; or (3) accept monetary instability. Oh… and a distant last in my order of preference is (4) ban banking.

77 thoughts on “Greenspan, gold & government

  1. John
    They’re not going to remove the power to tax. That just isn’t going to happen

    I disagree with a few points you made:

    I don’t think the inflation rate has been stable, as I don’t think the CPI is even close to a decent measure of inflation. The CPI failed to measure what was going on in the asset markets. We had the situation where the financial market was mis-pricing risk to an alarming degree. In some instances risky proposals were able to access loans at only a few basis points over the risk free rate of return.

    Targeting interest rates is a grossly inadequate way to manage monetary policy as relying on a committee to hit the rate note is impossible. In fact it’s basically like asking the politburo to set monetary policy.

    I really don’t think we could ever go back to the gold standard or a commodity based monetary system. That system suited an earlier time when an economic and political philosophy was forming and the world was a lot different in the 19th century. There is nothing to stop people transacting in gold right now yet people haven’t exactly voted for it since Nixon floated the Dollar.

    Lastly allowing the government to fund infrastructure projects is highly dangerous especially with the proposal you’re suggesting. If the government were forced to use infrastructure projects to finance their borrowing they would do their best to create monopoly situations to protect their turf.

  2. “This is a substantial step forward compared to other systems which attempt to use monetary policy to create growth or employment (the most dramatic recent example being Zimbabwe)”.

    Wrong. Zimbabwe is not “attempt[ing] to use monetary policy to create growth or employment”. There are quite other purposes at work there – and, in terms of those, the policy is a success.

  3. PML — not sure which other purposes you’re referring to, but the Zim govt says they’re trying to boost growth. Maybe they’re lying. Either way, their actions are consistent with other countries which have used expansionary monetary policy for supposed economic gain and have ended up with inflation. They are certainly not inflation-targetting!

    JC — I think Australian inflation has been more stable in the last 20 years than it was for the 20 years before that. And more stable than those countries which have more activist monetary policy (eg America). I agree that there are many difficult to measure variables that reserve banks often get wrong. Indeed — I wrote that in my post.

    Interest rates aren’t the target. They are the mechanism. The target is an inflation rate of 2-3%. I agree it’s difficult, but with a fiat currency the money supplier has to use some mechanism for controlling money supply and whatever they do will be imperfect. The only solution to that is to replace fiat currency with asset-backed currency. And even then, the money supply will be imperfect.

    I think you misunderstand my point about infrustructure loans and I’ve tried to improve the wording. I’m not saying that current debt should be repaid from the proceeds of infrastructure projects. I’m saying that the debt from an individual infrastructure project should be repaid from the proceeds of that infrastructure projects.

    The government already can borrow to fund infrastructure projects. This puts more discipline on their borrowing.

    Your statement “use infrastructure projects to finance their borrowing” doesn’t make any sense. It’s the other way around… they “use borrowing to finance their infrastructure projects”.

    The government already has some monopolies, and there is nothing in my suggestion that would give them an incentive to have more. I’m effectively suggesting that government infrastructure projects be fully corporatised, or else they cannot borrow for that project.

  4. Just thinking aloud here so don’t be too surprised if I say something a bit fluffy or disjointed.

    John – Your analysis does not seem to differentiate between a closed economy scenerio and an open economy scenerio. Perhaps you don’t think it matters much.

    In my view the easiest way to achieve your outcome is to prohibit governments from borrowing. They could then build infrastructure via private equity deals. So instead of banks lending money to the government the banks (or private borrowers) take an equity position with the infrastructure perhaps returning to public ownership debt free after 30 years or some such thing.

    Perhaps we could have a law that says that all government loans and bonds are cancelled at the time of an election. The EU imposes borrowing limits on Eurozone members however I don’t know if this rule will stick long term.

    When Argentina broke the fix between it’s currency and the US dollar in the 1990s loads of people said it had to or else the government would go broke. I agreed with the counter view that it would do no harm for the government to go broke and that in fact it would be better than the subsequent inflation. There was no reason that the governments problems should be used as a reason to drag down society in general. A broke government simply means the government can’t get anybody to lend it money. Yipee!!

    If all nations on the planet were back on a gold standard (or a Euro style single currency) then we would in essence have a single global currency and a common broad money pool of funds. Interest rates would be essentially pretty flat across the entire domain and would differentiate mainly on risk. What the Australian government borrowed or didn’t borrow would be largely irrelevant to general interest rates. However governments collectively might still destabilise the global monetary system and Australia may end up in the same boat irrespective of domestic borrowing discipline. However I don’t see much merit in floating exchange rates as some sort of insulating factor.

    JC – It was illegal for US citizens to own gold bullion when Nixon floated the dollar and it continued to be illegal until 1975. It was illegal for Chinese citizens to own gold bullion until 2005. And everywhere there are institutionalised incentives to use the national unit of account rather than some alternative (otherwise inflation in the Zim would be irrelevant to the lives of those living in Zimbabwe). The calculation of tax liabilities in the national unit of account and the need to pay taxes in the national currency being the most significant factor. Even if the Aussie dollar is superior to the Kiwi dollar you would still expect most New Zealanders to stick with the Kiwi dollar. The fact that we don’t all use gold simply says that the market follows the government on currency. Either that or national governments provide their people with the most perfect currency possible.

  5. Interest rates aren’t the target. They are the mechanism. The target is an inflation rate of 2-3%. I agree it’s difficult, but with a fiat currency the money supplier has to use some mechanism for controlling money supply and whatever they do will be imperfect. The only solution to that is to replace fiat currency with asset-backed currency. And even then, the money supply will be imperfect.

    An asset-backed fiat currency is just another money supply management mechanism. You could just as readily adjust the supply of the fiat currency directly (ie use it as a mechanism) to fix the value of the currency with respect to some assett (such as gold).

    I’m probably splitting hairs on terminology but if you fix the currency to gold to keep a lid on inflation then is the gold price a target or a mechanism? I’d contend that adjusting M0 is nearly always the monetary mechanism and something such as interest rates, the gold price, exchange rate or otherwise is just an intermediate target.

  6. I like the idea of government borrowing less (indeed, not at all). But the argument here does not include a balanced budget proposal. “Saving” in the good years implies running a structural budhet surplus which means over-taxation. James Buchanan argues that (public) borrowings should only be used to finance very long-lived assets, but now with sophisticated financial markets and better pricing technology it is possible for the private sector to finance that sort of thing. So the ‘demand’ for public borrowing should decline over time.

    One of the ‘benefits’ of the Howard years was a strong aversion to public debt (that economic vandals are working to undermine). That needs to be augmented with a balanced budget rule and constitutional restraints on spending. And taxing powers being devolved to lower levels of government.

  7. You’re right Terje — I think you’re splitting hairs. 🙂 Though I’m also happy with the term “intermediate target”, so long as people understand that interest rates are not the ultimate target.

    You’re right that the government could still raise money through the equity markets, even if they were denied the right to borrow.

    My point was that there is no need to make this distinction with regards to the effect on money. So long as the government investment is corporatised (ie held away from the taxing powers of government and actually getting a return) then debt for such investments will not destablise the monetary system.

    I think the argument for a blanket ban on government borrowing rests on the simplicity of that approach as well as the fact that it would encourage greater private involvement in infrastructure, which would hopefully lead to more efficient investments. Those issues were outside the scope of my article (which was about monetary stability).

    Finally, if we had a world currency and all governments of the world could borrow and use tax money to repay those loans then we would see world inflation. Leading to mal-investment & the consequent corrections (ie recessions).

  8. Sinclair — when you say the demand for public borrowing should decline you’re looking at the economic argument. I suspect public choice theory would tell us something different. Unless we have a rule against borrowing, the government will always find an excuse to borrow.

    A balanced budget proposal is outside of the scope of the issue I was trying to address here. But my 2 cents…

    I’m against having a welfare state at all. But if we are going to have a welfare state then I think it is reasonable for the government to inter-temporally shift “their” resources. That is, have a consistent tax system, but distribute relatively more money in the times when it is relatively more needed. That would involve what you call “over-taxing” during the good times. I think that’s the only sensible way to manage a welfare state.

    I have another argument for building government funds, using them as the only source of revenue for government activities (one fund per type of activity) and then privatising those funds with a strict constitution. Anarchy by stealth. But that’s a totally different discussion. 🙂

    For the moment all I’m saying is that the monetary system cannot be stable unless you either restrict government borrowing or stop tax.

  9. John

    The cpi was stable ove the past 20 years. Inflation wasn’t, otherwise prices of hard assets wouldn’t have gone through the roof and the cost of credit wouldn’t have been so narrowly spread to the risk free rate of return.

    Interest rate targeting is an awful way to run monetary policy, especially when CPI is used as the marker because as I maintain, CPI doesn’t measure the real inflation rate in the economy.

    The world went through a period where prices in the goods sector was greatly influenced by the industrialization of China which to a large degree disguised what was really going on in the world economy.

    Take the other extreme. US CPI was quite well behaved during the past 70 years with monetary policy pretty much aligned to the CPI. It’s not an explicit marker in the US but it certainly influneces the Fed in policy direction. The current crisis there is a direct result of an inflationary monetary policy.


    A small economy linking to gold makes no sense.

  10. One other thing. We also need to be casreful that we’re not tighting the fiscal levers in the economy during a slowdown, which means we shouldn’t be that concerned with running a dificit in a recession. That’s what unemployment benefits are about.. to give one example.

  11. JC — I expected the Keynesian criticism in my post, and responded to it there.

    But note that I’m not arguing against the welfare state and active fiscal policy here. You can still do that through saving in the good times and spending in the bad times. I’m just pointing out that if the government pursues active fiscal policy through debt-financing then they are distorting the monetary system.

    As I pointed out, our system is not “inerest rate targetting”. And most people accept that inflation targetting (albeit imperfect) is better than not even trying to target inflation. You keep saying that it’s difficult. I wrote that in my original post. But some sort of arbitrary mechanism for controlling money supply, and some sort of feedback mechanism, will always be necessary in every fiat money system. And they will all be imperfect because the relevant variables are hard to assess.

    If you think the monetary policy during the 1970s was better than now, then I disagree.

    You have argued against every system so far, but at the end of the day we’re going to have some sort of monetary system. You’ll need to work out which one you think is least-worst.

  12. Governments can raise money by issuing bonds this ties in with your article as the money raised will need to make a profit to pay the bond holders at maturation.

    Debentures can be issued by banks to raise money, this combined with a gradual raising of holdings by banks would eventually finish off fractional reserve lending.

    I also wonder why banks like FR lending as the increase in inflation devalues the money they have loaned to customers.

    I recently read about a businessman in Germany just after WW1, he predicted the currency would inflate, purchased a lot of businesses like steel mills and coal mines then after the inflation paid the loans from his petty cash.

    I support a Gold Standard it would take the G20 or some such organisation to start it rolling again.

    When Australia had a surplus of 40 Billion dollars I wondered what would happen if we had purchased that much gold.

  13. John

    Of course it’s interest rate targeting even if they are using CPI as the marker. They use short term interest rates to guide monetary policy to the “ideal” point. In other words by trying to control the price of credit they are attempting to control the quantity of credit in the economy, which of course they can’t. (The US is exhibit A) They come unstuck because they are unable to control the quantity through price as you can’t do both at the same time.

    If we are to continue with a socialist meonetary model I would support a control on credit and letting the market determine the price.

    In reality the only reason why we/the US did away with this system in the 80’s was because governments didn’t like the volatility in the interest rate markets and not because targeting the Ms was problematic. It was only problematic to governments and their never ending desire for “stability”.

    I haven’t suggested an altnerative? Okay here goes.

    Perhaps they could target commercial bank balance sheet footings, or we target M1 again.

    Perhaps even targeting the slope of the yield curve by objectively trying to aim for a flat yield curve.

    I disagree with you that they are not applying an interest rate target otherwise the quantity of money would be targeted. (They can’t do both and as stupid as they are they know this).

    No of course I don’t think the 70’s was a great period when there were all sorts of restrictions such as interest rate and foregin exchange controls, which were an attempt to internalize the economy so they could control it.

  14. I’m sorry I should have said targeting M1. The word “again” shouldn’t have been there are they weren’t targeting M1 in the 80’s.


    I don’t have too much of a problem with a gold standard if the big economies move towards one , but certainly shouldn’t by ourselves as we are too small to monetize gold.

    It would also be probematic for the world to move to a full gold standard as there simply isn’t enough gold around.

    China for instance doesn’t have any gold to speak of, so they would have to go to the market and buy it with their 2 $trillion in reserves. You can of course imagine what would happen to the gold price and the effect that would have on those that already have the gold and linked to it.

    It would be a shambles.

    Imagine the effect if the US linked to gold and China/India had to go out and buy it. The inflation rate in the US would sky rocket.

    The best case would be to simply allow free banking, remove all restrictions over a period of say a decade and let the marke decide what it wanted.

    I would bet the system wouldn’t be all that different than we have no in the sense that we would still be using fiat currency, backed by banks that would simply specialise in currency issuance. The system of course would be far less leveraged than it is now.

    Here’s my gentlman’s bet. The limitless guarantee granted by these economic vandals will cause us to lose 10% of GDP in the next decade as a result of losses sustained in the banking system.

    Amongst other reasons I’m an economic libtertarian because I can’t abide by the sheer stupidy of government.

    We have arrived at this crisis as a result of huge government caused imbalances in the system including moral hazard and the government has now increased moral hazard to unlimited degree with the guranatee to all small and large baking institutions in the country.

    Now a tiny credit co-op has soverign credit rating while say BHP which has little to no debt would have to borrow at higher rates. They have bascially distorted credit risk stratification in the economy.

    Meanwhile people like Charles would think that a good thing.

  15. John, you are inconsistent. You say that you are not against welfare and active fiscal policy. If I am being pedantic, snip me. How can you justify your position of no taxes and limited borrowing?

    I have an abiding faith in govt issuing debt to support projects where there may be initial or ongoing free market failure, something which is not adressed. I doubt whether the roads you drive on, the public transport you use or the bitimun outside of your place was financed by a private dude – and if it was, it is probably in the headlines for being in the red.

    Also national defense and border security, our judicial system, police and especially education. There are many other examples, like health and utilities (the latter two being mixed).

    My main gripe with extremist positions such as Johns (I reckon that he is adopting a normative stance rather than a positive one, as many of the statements made are slogans not backed up by analysis) is that the benefits of positive externalities which the free market is unable to capture is underestimated (or just glossed over and/or completely ignored) by about here to the moon by the believers.

    For example – compassionate welfare is manifestly a good thing for our western culture. Is it anyones wish that people through no fault of their own find themselves in trouble and with no means of support? It may be said that so why do not churches provide? [I cannot comment on Mosques or Synagogues] The distortions involved in private charity are astounding, and anyone who does not know that is ill-informed.

    On topic, Greenspin also was clearly inconsistent without acknowleging it. Duh!

  16. Angie:

    Government intetventionism in nearly all its forms save catastrophic welfare support has been and continues to be a disaster. Not just a simple disaster but an imitigated disaster.

    John is clear and in no way inconsistent in what he’s said.

  17. My main gripe with extremist positions such as Johns (I reckon that he is adopting a normative stance rather than a positive one, as many of the statements made are slogans not backed up by analysis) is that the benefits of positive externalities which the free market is unable to capture is underestimated (or just glossed over and/or completely ignored) by about here to the moon by the believers.

    What are these f*cking benefits? Where are they? If you’re sick of these ‘positive externalities’ being overlooked then point them out. Show us silly ‘believers’ where they are, because I’m pretty sure they only exist in your head and the head of the average true believer leftist.

    Better still, rather than using force to make people pay for your socialism to get these ethereal ‘positive externalities’, demonstrate to us how this can be done by going and starting a commune or some other voluntary society of leftists. Let your ideas run wild then demonstrate to the world the superiority of your left-wing ways. Then us silly free marketeers will be able to see all the wealth, peace, happiness and social capital you have created and immediately offer up our worldly possessions and labour to join your society.

    What, you don’t think it would work like that ? I didn’t think so either.

  18. JC – I could comment but your grammar and punctuation makes your comment ambiguous.

    Mr Sutcliffe – I do not respond in a meaningful manner to anyone who employs the word fucking in their first sentence. I suggest that you read my post, as I do not repeat myself.

  19. EricH — you ask why the banks would support FR-banking. The answer is that FR-banking effectively is banking. That is where banks add value to the economy and that is where they make their profits. And it doesn’t cause inflation. It would be insane to ban banking, that’s why I put that option at a distant number (4).

    JC — it’s called “inflation targetting” by everybody except you. You say yourself that they use interest rates to guide money to the right point, and that point is where inflation (as measured, imperfectly, by CPI) is between 2-3%. So interest rates are the tool and inflation is the target. This is just semantics anyway. It’s possible to re-write any article using your semantics, but I prefer to use the standard approach used in monetary economics.

    I’m not sure what you mean by “control on credit”. That sounds dangerous. But I think you are saying that you would prefer the RBA to use base money adjustments as their mechanism, and still target inflation. If so — I agree that might be an improvement over the status quo. However, this approach seems inconsistent with your earlier complaints about inflation-targetting.

    Or perhaps you are saying that the target (not the mechanism) should be base money. If so — I think that is dangerous as it fails to adjust for the variations in GDP growth, volatility and changes in the credit multiplier.

    This sort of confusion is why it’s important to distinguish between the “mechanism” and the ultimate “target” being used with fiat currency. I urge you to use the standard monetary economics semantics to avoid confusion.

    Regarding a gold-standard, I think Terje would suggest that you only have to keep your dollar pegged to gold, you don’t actually have to own it. So China wouldn’t need to buy any gold.

    But I agree we should just leave it to free banking. And I agree that fiat currency may continue to play a role, at least in the short-medium term.

  20. John

    Look, let’s go through this again. They use a marker to set the interest at a level where they think is the most appropriate (which is the CPI). If they set the price they therefore can’t control the level of funds demanded at that rate of interest.. So even if they are using the CPI as the marker they are unable to control the money supply, as they have to meet any demand at the rate they target. Call it what you like, call it CPI targeting if you want, however if they are setting the price to target the marker it’s just basically interest rate targeting by another name.

    To see this in action let’s set an example. CPI goes up over the target range of 3% and they raise rates by 25 basis points. The banking system is short of funds over and above the day to day money market needs that is determined at 11 am. In order to maintain the rate at the new higher target (not above) they only have one choice. The RBA has to make a permanent add to the system by buying securities and meeting demand otherwise the rate would rise above their target. The net effect is that they cannot control the demand for money at a given rate of interest. They may be able to guess it right, but as with anything it’s only a guess. This works both ways by the way, which is why interest targeting is so dangerous.

    This isn’t semantics as you call it, but a pretty important facet of the system. Calling it inflation targeting is not really describing what the hell these idiots are doing.

    “Controlling credit” is nothing to do with what you’re implying you think I was saying. That’s what you thought I was implying, right? Well I’m not of course.

    What I’m saying is they ought to target the quantity of money supplied to the system, which as I mentioned earlier would mean the market determines the price of short-term credit rather than the central bank.

    CPI is a dangerous way to measure inflation, as inflation may not show up in the price of goods and services. The traditional measure of inflation was the money supply.

    On the gold standard:
    Okay so you’re suggesting a gold targeting system that used to be called I think the gold exchange standard. So it’s not really a bullion standard at all in the sense that the public may not be able to go and exchange their currency for assayed bullion. The problem with a gold target is that governments wouldn’t be trusted and at the first sign of trouble people would begin to doubt their intentions especially after what Nixon did to the French.

    I also can’t see how they avoid banning the ownership of private gold holdings like they used to, as people would simply go and buy bullion if they thought the target couldn’t hold putting further pressure on the system. The obvious implications of that are that a gold target (gold exchange standard) can never really work, as governments will eventually walk away as they have always done in history.

    So if you’re going to have a commodity standard and gold is going to be used then straight bullion standard is the method to use, but they won’t as there isn’t enough gold in the world for a bullion standard.

    John, be a little patient as I can’t recall the exact terms I learned in monetary economics. It was quite a few years ago.

  21. Angie — I wrote you a long reply, but my computer just ate it. I’ll now just mention the basics.

    You misunderstand me. I didn’t say that I supported the welfare state & active fiscal policy. I simply said that this post did not argue against the welfare state & active fiscal policy. That’s because this post is about monetary policy. In fact I do not support the welfare state, but that’s a different topic. I think your accusaiont of inconsistency is based on this misunderstanding.

    You say that you support big government and the welfare state. I disagree, but that’s a different topic. Everything you mentioned could be funded through tax, and does not necessarily require borrowing.

    You say that my article is normative. The main point of my article is clearly positive (that a stable monetary system cannot include unrestricted government tax & borrowing). Though I do also include my opinion. You provide no rebuttal to my positive point, nor do you provide a useful critique of my normative opinion.

  22. @John Humphreys

    I am not convinced FR banking is not inflationary.

    For example if the government suddenly decided that the banks could hold 5% reserves instead of 10% they could double the amount of money loaned. Money created due to a policy change. Banks would do it of course as governments around the world declare major banks too big to fail so there is no risk to the bank only the taxpayer.

    It is probably too hard to put the genie back in the bottle as regards FR lending. but the rate of cash holding can be raised to help lessen problems in the future.

  23. Eric – the reserve requirement for banks in Australia is zero. Always has been.

    JC – I agree that interest rate volatility was and would be a major cause of political angst. In spite of that I still think that a floating interest rate is the most appropriate one and so do you based on the system you advocate.

    A gold standard is any system in which the currency has a fixed value with respect to gold. A bullion backed currency is feasible but we would need to allow promisory notes (ie bank promises not unlike demand deposits) for day to day currency which strictly speaking would mean an expansion of M1 and a contraction of M0 but roughly the same amount of notes in our wallets. A gold exchange standard would continue to fill our wallets with fiat currency but we could trade it for gold at any time via the gold market. A government can break it’s promise on either system as history has shown.

    Also don’t forget that if every nation went to a gold bullion standard no central bank would hold foreign currency as a reserve asset so a lot of foreign currency would return home and be liquidated. In the process reducing the amount of currency that needs to be backed by gold. The world currently needs a lot more currency than it would on a gold bullion standard.

  24. Yea , terje. I think the market ought to set the interest rate.

    Look, quietly the US Fed has gone to a quantity target right now. Although the funds rate isn’t that volatile at present, obviously because it near zero, that’s what the fed has done. It’s now managing the quantity of money in the system and essentially letting the market determine the interest rate to some degree.

  25. Eric – when Australia changed our capital adequecy ratios from 25% down to 8% in 1983, we did not see 300% inflation – but somewhere between 5-10%, which also was the rate narrow money was being created.

    You have a huge problem with your theory and should be utterly convinced that it is wrong.

  26. JC – There are some arguments against returning to a gold standard that I think have merit. However the notional that we are too small an economy to “monetarise gold”, as you suggest in one of the comments above, doesn’t stack up in my view. If New Calidonia can fix it’s currency to the EURO and Jersey can fix to Pound Sterling then I don’t think being small has anything much to do with it. Fixing our currency to gold would not require the monetisation of gold because gold is already well monetised.

    Ironically you seem to also argue that because of a lack of gold large nations can’t fix to gold. So it seems you think most nations fall into the too large of the too small camp.

    Fixing to gold would however entail accepting an exchange rate that fluctuates differently against the big currencies than it does at the moment. Which may or may not be worse than what we have today. This is a line of argument against a gold standard that you have offered previously and I think it has more merit than the “too small” or “too large” argument. Of course we could do away with a lot of exchange rate fluctuations by fixing to one of the big currencies such as the US dollar or the Euro. To do it properly we would need to allow the free flow of capital and to surrender any government control over interest rates. Of course it wouldn’t be a gold standard unless the larger currency was linked to gold.

  27. Mark – The difference isn’t that they have a bigger economy than Australia. There in lays my point.

  28. Terje

    New Cal and Jersey are basically dependencies. I think the examples are wrong whereas Aust. is a first world major industrial economy.

    We can link to the Dollar or the Euro, but I think it would be wrong. We’ve already linked to the Dollar and that basically came unstuck primarily because our labor market didn’t resembles the US’s more liberal one.

    The dangers of linking to the Dollar when you don’t have a labor market resembling the host is that you can end up like Argentina did in the earlier part of the decade. It was flattened as a result of its internal rigidities.

    HK can of course manage the dollar peg because it’s a free port and the labor market is about the most free in the world.

    My humble opinion is that we shouldn’t link unless everyone else does.

    I still maintain an example I gave you sometime ago showing the potential folly of linking to gold alone.

    If we linked to gold when the gold price was $US260 and the Aussie was 53 cents we would have had the following combination over the course of a decade.

    When gold went to $US1,032 oz the aussie would have been around A/US1.57.


    In other words we would have been smoked by a higher aussie. We would have been doubly smoked by the fact that our labor market is being made far less responsive to external pressure by the present government. In other words it would be a disaster.

    If you want to unilaterally tie up with gold you would have remove all major impediments in the economy. The labor market has to be totally freed up, no regulatory crap like a two airlines policy ec…. very limited regulations on M&A.
    It has to basically be a free port. I’m all for that by the way, but if you want to unilaterally go to gold you have to ensure all that beforehand.

  29. JC — saying something is semantics doesn’t mean the underlying issue isn’t important. If you decided to swap the meaning of “cat” and “dog” you could still make coherent sentences about animals. Your point about animals wouldn’t be changed, but the words would be. It would be only a semantic distinction.

    It is useful to use a consistent (and robust) semantics to ensure we understand what the other person is trying to say.

    I understand that you want the government to manage the stock of money and not the price of credit (ie interest rates)… but you didn’t tell me what rule you would use to manage the stock of money. It is pretty much impossible to know the correct amount of money supply growth… just as it’s impossible to know the correct interest rate. You need some sort of feedback information to let you know when you should adjust your money supply.

    Most monetary economists suggest using some measure of inflation (CPI or GDP deflator) as this feedback… and adjusting money supply (whether through stock or price controls) to “target” a set level of inflation.

    I understand that CPI is an imperfect measure. I’ve said this in the original post and in every response to you. But you haven’t told me which alternative you’re going to use to give you information about the “correct” level of money supply growth. This leaves me to think you want a fixed money supply growth rule — which theoretically doesn’t make sense and was a spectacular failure when it was tried previously.

    The money supply is not a useful definition of inflation. Inflation is about changes in prices. If the amount of money stayed constant and the amount of production halved, you would have inflation.

  30. I told you we could say target M1 or use say the asset side of commerical bank balance sheets to target a growth rate of the money stock that works its way through the banking system.

    I actually don’t believe targeting the money supply was as a spectuclar failure as you seem to think. It was only after the fed began messing about with which agregate to use that it became problematic. There was also the issue that interest rate volatility became an issue.

    The fed used M3 as the target and therefore was too broad and unreliable to target.

    Fistly, in order the target something you need to define money. Money fits in pretty well with M2 or even the austrian definition of money supply.

    I disagree that inflation is about changes in prices and this is where it becomes most dangerous in terms of relying on the CPI. The US CPI was mostly well behaved in a good part of the decade causing the Fed to err on the easy side of things letting it rip.

    Inflation is as far as I’m concerned a material increase in the money supply causing rises in the general price level… Note… I said the general price level not just comsumer prices.

    I can’t see outside of war how or what would cause a constant level of money while production halved. Are you thinking that perhaps there could be some huge government policy error to cause this? What exactly could cause such a thing to happen?

  31. @ Mark Hill #26
    I may be mistaken of course. I am new to Austrian Economics. My first thought when reading your comment about the rate of inflation is that banks are not the entirety of Australia’s GDP so inflation my not hit the 300 percent extra the banks will loan out but it will increase.

    If a bank issues easy credit, money created by changing the amount in someone’s bank account as opposed to money loaned out from depositors savings, does this not cause inflation?

    when new money is created the person who first uses it does not suffer immediate problems with inflation. The person at the end of the economic path, those on fixed incomes like pensioners suffer the most. So the banks are ok as they are the point of new money creation.

    This from Planning for Freedom by Ludwig Von Mises

    Credit expansion may lower real wages and spark a boom.

    But credit expansion, whether it is effected by issuing additional banknotes or by granting additional credits on bank accounts subject to check, does not add anything to the nation’s wealth of capital goods. It merely creates the illusion of an increase in the amount of funds available for an expansion of production. Because they can obtain cheaper credit , people erroneously believe that the country’s wealth has thereby been increased and that therefore certain projects that could not be executed before are now feasible. The inauguration of these projects enhances the demand for labour and for raw materials and makes wage rates and commodity prices climb. An artificial boom is kindled.

    Under the conditions of this boom, nominal wage rates which before the credit expansion were too high for the state of the market and therefore created unemployment of a part of the potential labour force are no longer too high and the unemployed can get jobs again. However this happens only because under the changed monetary and credit conditions prices are rising or, what is the same expressed in other words, the purchasing power of the monetary unit drops. Then the same amount of nominal wages, i.e. wage rates expressed in terms of money, means less in real wages, i.e. in terms of commodities that can be bought by the monetary unit. Inflation can cure unemployment only by curtailing the wage earners real wages. But then the unions ask for an increase in wages to keep pace with the rising cost of living and we are back where we were before, i.e, in a situation in which large scale unemployment can only be prevented by a further expansion of credit.

    My apologies for the length of that, I did not want to edit the passage.

    I remember a quote attributed to Keynes saying “The best thing about inflation is that it gives a pay cut to the working class without their being aware of it.”

    The Mises extract above really describes the housing boom.

  32. I’d have said Mugabe’s priority was to keep himself in power and/or keep his own in group at the top of the food chain (the two are somewhat blurred, in terms of those tribal cultures). From that perspective he is doing a fairly thorough job, and the casualties falling all around don’t much matter. He isn’t hurting his people, in a properly understood sense of the term.

  33. With this being a libertarian site and assuming that the commenters would likely consider themselves to be libertarians too I wonder if there is then anyone who would disagree with John’s conclusion that the best solution to all this would be to abolish government taxation (setting aside any considerations of “what is practical for the moment” and/or “what people would go for”).

    I would be interested to hear if there could be any justification from a libertarian standpoint to take any other position on this issue.

  34. JC – With regards to fixing our currency to gold I think the exchange example you cite has merit as an empirical line of argument. I may not agree with your conclusion and I could add some counter points to explain why, but it doesn’t mean I don’t recognise the merit of your point. I do however get frustrated when you introduce other points that seem like meaningless distractions. Such as saying our economy is too small. Our economy is not too small to fix to gold or the euro or to yen or to the US dollar. These may not be the best policies to adopt but the size of our economy isn’t the reason. In fact smaller economies have more reason to anchor their currency in one of these ways. If you have good lines of argument as to why we shouldn’t adopt a gold standard then you should be able to cease referencing bad reasons that simply don’t bear even casual scrutiny.

  35. Yes, terge our economy would be too small to hold onto the the gold standard as we would be buffeted around by the gold price no matter what was happening in the domestic economy.

    And the example I gave illustrates precisely why it would be a serious issue.

    If we wanted to go to gold on our own we would have to ensure that the demestic price level in every important sector was able to withstand sudden price changes. it would mean that the labor market for instance would need to be sufficiently flexible to withstand sudden pay cuts and pay rises. Pay rises wouldn’t be so much of a problem. However pay cuts would be.

  36. The prices that would bear the adjust process would be import prices and export prices. Most exports are commodities so a link to gold would see the price of these items stabilised in domestic currency terms more so than they are today. Exporters such as miners and farmers would see a decline in income volatility. Volatility in import prices would probably be higher for goods such as finished consumer goods, machinery and computers etc but lower for commodity goods such as petroleum. However volatility in import prices would not necessitate significant changes to domestic production prices such as wages which are determined by export income or domestic factors. And we have already agreed that the price of capital would be relatively low as we would inherit the interest rate currently applicable to gold.

    However even if you are right that price volatility would make an Australian gold standard unviable it has nothing to do with being too small to “monetise gold”.

  37. The only way to ensure a stable monetary system is either to (1) remove the government’s power to tax; or (2) remove the government’s right to borrow; or (3) allow them only to borrow when the future repayments on the loan do not come from tax revenue.

    I’ll take options 1-2 please!

  38. Back on topic.

    John – are you suggesting that central banks can’t deal with an excessive inrease in M1 (due to excessive government borrowing) by simply contracting M0 (base money)? Logically the latter response will tend to increase interest rates and hence decrease private sector borrowing. In which case we simply have the crowding out of the private sector in accessing capital and potentially lower rates of economic growth but no net inflationary effect.

  39. Terje — no. I specifically said that the government could offset more govt borrowing with a contraction in the monetary base. But then I made the point that this involves a series of difficult judgements about difficult-to-assess variables (specifically, future inflation). Mistakes will be made.

    I’m not arguing that government borrowing necessarily leads to inflation. I’m arguing that it stops the monetary system from being stable.

    JC — I didn’t say “consumer prices”. I just said “prices”. My example of GDP halving was just a thought experiment. If you need a more realistic thought-experiment, consider a situation were GDP was reduced by 10%. The same point holds. As for targetting a more narrow definition of money, that simply means that broad money (ie what matters) will be under even less control… leading to an even more unstable monetary system.

    Jaz — While I prefer no tax, the argument for tax is that it is a “necessary evil” which produces more benefits than costs. I don’t believe that… but I think it’s an understandable position. Liberty is not the only virtue in life. People also care about the outcome (generally measured in utility).

  40. Eric – you are confused. Please read Human Action thoroughly. Mises gives free banking his approval, which is a system which has certain conditions and phenomena which contradict the wishes and goals of the Rothbard-school of “100% backing”.

    Mises was a far better economist than Rothbard as well.

    There is nothing in the quantity relationship that infers that an increase in money will necessarily lead to inflation.

    MV = PY. Money growth is optimally matched to output growth. That is what free banking does, *perfectly managed* central banking does but what Rothbard et al., say you shouldn’t do.

  41. @ Mark Hill
    Please read Human Action thoroughly.

    Now there is an evenings light reading. 🙂

    I do have a copy and I have downloaded the study guide but I am about to start reading Bureaucracy next although I am torn between Bureaucracy and Prosperity through Competition by Ludwig Erhart.

    I do not know enough yet to continue this discussion intelligently so I will have to leave it there I guess unless of course you want frothing at the mouth and rabid denunciation. 🙂

  42. Jaz, the word ‘libertarian’ simply means someone who believes in freedom of thought, behaviour, et cetera. It is a broad word. Politically, it tends to mean people who want less government in their lives. we often disagree on how little there should be. ‘Libertarian’ covers a wide range of views. Some might want to limit governments to no more than ten per cent tax rates. (With our current tax rates, that would be a drastic reduction in Government!) Some extreme libertarians embrace Anarcho-Capitalism- no governments at all! Roads would be toll-roads, privately owned. you defend yourself- no cops. you get the idea.
    I am a Libertarian who goes for minarchism- local councils should be the strongest level of government, but confined to ruling ‘public’ properties, and offering services.
    No taxes would be one example of libertarian thought, but not the only one. (And you’d want to curtail government powers in other ways- because I don’t think that Communist societies have things like Income Tax, but they control the people through ration cards, and wage levels! So Taxation might not stop your local would-be-dictators.)

  43. Thanks John and Nicholas for your replies. John, you say on one hand you prefer no tax and then on the other hand you say that liberty is not the only virtue and people care about the outcome etc. So which one is it?

    My concern is that while everyone here would agree in principle on taxation (nil or very little) all we are doing by suggesting “tweaks” to the current policy is serving to legitimatize the current system.

    I think it would be common to see this type of compromise and pragmatism on a blog/site connected to one of the major political parties but I am surprised to find it here.

  44. This argument makes perfect sense – for the American economy.

    America is much further down the road than we are when it comes to central banking wizardry. Their government has been issuing incredible amounts of debt in exchange for newly created money from the Fed.

    But I’m a bit confused here as to whether our government is doing the same. Haven’t we had a balanced budget for quite a while ? No deficits to speak of = no new treasury bonds being exchanged for newly created money.

    I thought the driving force behind our inflation, defined as the expansion of our money supply, is banks expanding their credit by huge amounts over the past decade. Thus I see this as a big problem.

    I’m not proposing solutions here, just trying to understand the nature of inflation.

  45. John aren’t you contradicting yourself:
    Quote #1:
    ” However, the bank will only provide the loan if they expect to get a good return. Which means the borrower will need to increase their wealth in the future by enough to pay back the loan + interest.

    This avoids the problem of inflation.”

    Quote #2:
    “If the government is still allowed to borrow and tax, then even under a gold standard banks will have an incentive to create credit for the government without ensuring an equivalent increase in production.”

  46. @Mark Hill
    I forgot to add my copy of Planning for freedom is the 2008 Liberty Fund edition in which all essays not by mises were removed, so the earlier passage was written by him.

  47. Terge

    If say the US and the EU decided they were going to a gold targeting system they would be able say hold the gold price between a target range without too many problems.

    We can’t, which is why i say we would have a hard time going to gold on our own.

    You mention that some sectors such as miners would see a deline in pices vol. Why?

    Have you seen the relative move of gold to other commodities and just how volatile it is?

    Sorry, but I disagree with you that the only sectors feeling the differences are the external sectors. That just isn’t the case. Even a state public servant would feel the effects of the aussie going to 1.57. Chances are s/he would be out of a job as a result of the depression such an action would bring.

  48. John

    Even your example of a 10% gap would be indicating that was the result of some inflationary caused monetary disequilibrium in the system.

    You just simply can’t present a scenario without asking how we got there first.

  49. Jaz — my preferences aren’t inconsistent. I want no tax and I believe that liberty isn’t the only virtue. I am a utilitarian anarchist.

    Jono — no contradiction. In fact, the two quotes you provide are exactly my point. Credit provided to the market results in increased productive capacity. Credit provided t the government does not. Therefore the former doesn’t lead to inflation and the later does.

    JC — of course I can present an example without explaining how we got there. It’s a hypothetical. Not all recessions are caused by monetary disequalibrium. All you need to admit is that GDP growth is not constant (whether it goes up or down by 50%, 10% or 1.438% is not important to the concept). Once you admit that, then you effectively admit that constant money supply growth is not stable. And GDP fluctuations is only one problem. You also have changing velocity and changing credit multiplier. If your mechanism and your target is simply the amount of base money then you are almost guaranteed to get the broad money supply wrong — and have an unstable system. Very likely less stable than the current system.

    I would be very suprised if you could find any monetary economists who support such a system.

  50. You can of course present any example you like, but if you present an example where GDP falls by 1/2, the qunatity of money remains constant and argue that is an example of inflation without considering the background in terms of how we got there and what is happening to prices, then I would have argue that is being silly.

    We have had one example of soemthing like that in the US between 1929 and 32. Industrial production was cut in half but they expereienced the opposite of inflation. the general price level was down 30% during this time. In other words there was a serious delationary event happening.

    So no, i’m going to call your example unlikely in the estremeas it can’t happen in real life.

    I never talked about targeting base or broad money, John. Take a look.

    There has been an example of a country doing quite well targeting money supply after a deep inflationary induced recession.

    mexico ran a quantitative system for years after the currency crash in the early 90’s. they were advised to do so by Chicago school economists. the reason was that the central bank was not trusted by the market otherwise.

    Switzerland to some degree has run a monetary policy based on quantity of money.

    So I wouldn’t be calling it a failure so quickly if I were you.

  51. John, thankyou for you kind response #21. I apologise if I was unable to provide a worthy criticism, however I guess that my point was about positive externalities, which clearly are not understood judging from comments. It is easy to misunderstand. I am with, say, Nicholas #45. Me a fan of big govt? NO WAY – just responsible and prudent govt, stepping in where the free market fails (and now I am repeating myself).

    It is with some glee that I note that you mention velocity in post #52.

    I note that Helicopter Bernanke is scheduled to speak tonight. Giggles, sighs, or a cold sweat?

  52. JC — I think you misunderstand the purpose of hypotheticals. The ideas isn’t that they are literally true. The idea is that it makes you think about a concept. Inflation comes from “too much broad money chasing too few goods”. You can get inflation from (1) increasing the amount of broad money; or (2) decreasing the amount of goods. If you have a policy of always increasing the base money by a fixed amount it is very unlikely that you are going to keep money & goods in balance.

    If you want to use base money as a mechanism then I’m sympathetic. But you need another feedback mechanism to guide the money growth decisions. I imagine both Mexico & Switzerland have a feedback mechanism, and without checking I would assume it is an inflation target.

    This is where the distinction between mechanism and target becomes so important. It totally changes what sort of monetary system we’re talking about.

    Angie — I understand externalities very well. You suggested that the market doesn’t capture positive externalitites and that the government should therefore subsidise certain activities. That’s a common conclusion from a basic understanding of economics. There are two problems there.

    First, the above discussion has nothing to do with externalities. Unless you are suggesting that there is a marginal difference in the externalities that result from debt-funded spending vis-a-vis tax-funded spending. I find that very unlikely and would be suprised if anybody took it seriously.

    Second, your treatment of externalities is overly simple and doesn’t factor in the massive complexities of externalities and the common inability of the government to either correctly measure or respond to those externalities.

    All activities involve externalities… often they involve several positive and several negative ones. People who want to justify a government program will often hunt around for something to call “externality”. It is the most over-used and abused part of economic theory. For instance, there is no reliable evidence that suggests the net positive externalities from education, or welfare, or health, or nearly all other government programs are higher than the average net positive externalities from other market and civil society behaviour. The only externality arguments that are taken seriously by good economists are (1) environment; and (2) knowledge (ie R&D).

    Even then… I spent quite a bit of time looking at the literature for knoweldge spillovers (ie externalities) and the argument for government action is not strong. And theory aside, in reality it is clear that the total government policy in this area creates more costs than benefits.

    More often than not, externality aguments are just biases dressed up as theory, and not backed by empirics.

  53. No I don’t think Mexico had an inflation target in the early 90’s, John. But I’ll try to check.

    Furthermore the US has gone to quantitative easing at the present moment and the they don;t have an inflation target.

  54. It seems Germany may have taken your advice with regards to your second preference:

    The coalition also agreed to amend the constitution, making it illegal for any government to raise the state’s public deficit above 0.5 per cent of gross domestic product “in normal economic times”. European fiscal rules ban deficits above 3 per cent of GDP.

    but unfortunately, in the same article, the cycle continues:

    “This is an extraordinary situation and we must respond with extraordinary measures,” she told journalists. “This means we will have to borrow more. But we must also be credible vis-à-vis future generations when we say we intend to repay this debt quickly.”


    My question is: do you want this type of limitation on government behaviour in your constitution? Is it possible to leave this option open to government but somehow make sure there are checks and balances ensuring it is a wise decision, considering that it’s not too hard to think of those rare situations where government borrowing can be a good thing? Is ‘normal economic times’ a sufficient check? (I suspect not!)

  55. Steve, #58, I am a huge fan of Dr Ron Paul who, in hindsight and also with foresight, clearly needed advice about how to explain his thoughts to the lowest common denominator. I do not agree that your Think Libertarian link does any favours to your coy attempt to label libertarians as intellectual. Maybe Intelligensia.


  56. JohnH – I’m glad that these days you are going on about targets and mechanisms. I think an understanding of feedback and how feedback works and how it is used to create stability or instability in a system is fundamental to monetary policy. I think it is worth reading a good book on Engineering control theory because it provides an extremely valuable intuitive feel for lots of dynamic systems.

    In particular it is good to get an intutive handle on damping and the merits of underdamping, overdamping and critical damping.

    Not because I think monetary policy can be conducted with the same precision that heat seeking missiles or amplifiers or steam engine governors achieve using well tuned feedback but simply because it increases the insight into how feedback systems can go wrong.

    Personally I think that a gold standard is a bit like a critically damped system (ie following a disturbance it returens to the settling point quickly and cleanly) whilst inflation targeting with interest rates ends up being an under-damped system (ie following a disturbance the system is prone to lots of oscillations before the final settling point is achieved).

  57. You know, Terje, I have often thought there must be a way for a smart economist to model an economic system along the lines of control theory but I just don’t know where to start in terms of equating aircraft stability characteristics and the general economy! Even more so, I think in time we will be able to model the social characteristics of a society based on this type of thinking where we assign a potential value according the ability to influence to each actor, and their statistical propensity to use that potential, and the accuracy of the information they are acting on. You will actually be able to prove mathematically that socialism does not work (thereby eliminating the need to, say, look out your window or turn on the news!)

  58. This reminds me of a very notable Japanese economist.'s_theorem


    “Nobuo Okishio proved this generally, which can be interpreted as a refutation of Marx’s law of the tendency of the rate of profit to fall. This proof has also been confirmed, if the model is extended to include not only circulating capital but also fixed capital. The introduction of labour saving techniques does not lead to falling, but to increasing rates of profit.”*

    So basically, a key assumption of Marxian economics is mathematically impossible.

  59. The effects of competition were also missed by Marx- all that discussion of monopolies missed the reality that most enterpreneurs need to make good products to survive. And an employee could be hired by a factory offering better wager and/or conditions! If you get workers who let you take advantage of them, you must have ended up with the dregs! Intra- and inter- company competition was ignored.
    Whilst he got some things right, like alienation feelings, and some factory conditions really were appalling, he seems to have missed the big picture.

  60. Michael – models are a great way to get a feel for things. However given that most social and economic systems are probably neither linear nor time invariant and not even deterministic I think modelling the economy with the same success that we model heat seeking missiles isn’t going to happen. However I do think we could make a fair crack at trying with monetary policy (we would still fail but we might learn a thing or two).

    Our input into the monetary system is the amount of base money. In a fiat system control of this input is quite straight forward using open market operations. Of course instantaneous changes in the amount of base money are not possible so we immediately have a lagging effect inherient in our system. Not critical but worthy of note.

    Next we need to choose the most appropriate output signal. External disturbances to the state of the system that are outside our control need to be compensated for (analogous to the wind blowing our heat seaking missile off course). This is where it gets interesting. Some things that we care about in our economy (eg CPI inflation) respond slowly to changes in the input (ie lagging response). Some things such as commodities respond quicker. A lot also depends on expectations about what will happen next. Given that those with expectations are part of the system then we don’t have a completely deterministic system. Deciding which signal to use as our output signal for feedback purposes isn’t straight forward. Personally I put a lot of weight on commodities because their prices are set in spot markets free from lots of institutional barriers that slow change.

    When I look over the events that preceded the inflation of the 1970s (ie the end of the gold standard in 1971) the charts just scream “step response” at me. And the oscillations in commodity prices and everything else after that point look to me like somebody screwing with the feedback on a crude amplifier circuit and turning the thing into an oscillator. In some instances it looks like the feedback turned positive.

    However at the end of it all I don’t think the macro level concerns of economics can be stitched together with a couple of neat Laplace Transform equations. Even if things such as signal lag and system feedback are still of critical importance.

  61. However at the end of it all I don’t think the macro level concerns of economics can be stitched together with a couple of neat Laplace Transform equations. Even if things such as signal lag and system feedback are still of critical importance.

    Fair enough, but I’m not so sure it isn’t going to come. The model won’t be the same as a missile, or as comfortably exact, but it will still be just as meaningful and useful. Economics is a junior science and it’s going to produce some good things. My personal opinion is that, unlike the hard sciences, economists can never seem to agree because of the social aspects – and open and clear models will address this (and shut the f*ck up to the ones who base their science on sentiment, emotion and ‘the common good’).

  62. Michael,

    Based on his books George Soros seems quite at odds with your view. He thinks that attempts to model social systems and economies in the same way that we model physical systems is deeply flawed. The quality that social systems exhibit that cause the problem is what he refers to as ‘reflexivity’. Although he is not the first to offer this observation.

    Reflexivity and the status of the “Social Sciences”
    Flanagan (1981) and others have argued that reflexivity complicates all three of the traditional roles that are typically played by a classical science: explanation, prediction and control.

    The fact that individuals and social collectivities are capable of self-inquiry and adaptation is a key characteristic of real-world social systems, differentiating the social sciences from the physical sciences.

    Reflexivity, therefore, raises real issues regarding the extent to which the social sciences may ever be ‘hard’ sciences analogous to classical physics, and raises questions about the nature of the social sciences.

    If electrons had personal theories about how electrons ought to behave, and are likely to behave, and if electrons then acted on those personal theories by changing their own behaviour I think we would also have problems modeling electricity. And actual electrons would have an even harder time modeling electricity. These problems go beyond the statistical nature of electrons as given by quantum physics to something all together more impossible to pin down. Luckily for electrical engineers it seems that electrons don’t have personal beliefs about the behaviour of electrons, or if they do they lack the free will to act on those personal beliefs.

    On a personal note (why the heck not) I think beliefs can create a hugely powerful self fulfilling effect. Try believing that you are gregatious and kind (not just saying it but actually doing what it takes to believe it) for a while and pretty soon you will discover that you are gregatious and kind. Try believing that you are stupid and clumsy (not just saying it but actually doing what it takes to believe it) and pretty soon you will have all the evidence you need. In such matters belief can precede evidence and belief can produce evidence. In the arena of hard science belief is never supposed to precede evidence.

    Of course if you believe that personal beliefs are of little relevance in determining the type of outcomes you produce in life then maybe you won’t see any evidence to support my position. 😉

    This gets us into the arena of culture. Culture is merely a set of shared beleifs. If our cultural belief is that people are typically selfish and cunning cheats then we will create the necessary evidence. If our cultural belief is that people are kind and genereous we will create a different kind of evidence. These two alterant cultures will create quite different societies. And both will have the evidence they demand.

  63. p.s. When it comes to quantum physics and relativity even the hard sciences have run up against the limits of causality. In spite of this a belief in causality is still central to our culture.

  64. I believe that personal beliefs are the overriding factor in determining the outcomes you produce in life. I believe that once you acknowledge the objective nature of reality (i.e. the primacy of reason, and the hard sciences and the causal nature of the world) humanity survives and prospers or otherwise according to their values (and this is not contradictory as some may assert, or simply due to a self fulfilling effect).

    Wouldn’t reflexivity be part of the feedback loop, quantified by the actors ability to adapt, the actors propensity to adapt, and the accuracy of his inquiries?

    BTW, is Soros thinking credible? Even though he must be doing something right isn’t he the guy who predicted 21 out of the last 3 financial downturns?

  65. TerjeP, in the spirit of lovingkindness, I will help you by correcting your spelling. I think you mean ‘gregarious’, as in ‘sociable’. Gregatious does not appear in my dictionary.
    An interesting thing, like your idea, TerjeP, is that scientists have found that visualisation works! If a Tennis player first imagines playing well, the act of imagination helps tone the muscles, by sending energy to the nerves, even if no action occurs. It probably works like a fire drill, a dress rehearsal being better than nothing, though the real thing is better than visualisation. I don’t think you can use it to visualise victory, and then guarantee victory, but you can improve your own performance.

  66. Mick — we’ve had models in economics for a long time. Economics is not much the junior of physics or biology in terms of it’s history. It is “junior” only in the sense that it cannot ever be properly modelled.

    About 100 years ago there was a great belief in the ability to model the economy and use that information to better manage the allocation of resources. This approach is associated with Pareto & Walras — both socialists. This approach to economics was loved by socialists until (and even after) it was destroyed by Mises & Hayek who showed that the economy is too dynamic for a model to be useful for more than a general vibe.

    Non-economists occasionally suggests that economists should try to be more empirical. But the literature is full of empirical information — with a range of answers for every question. I’m not saying the empirical work isn’t important (and sometimes it does give a clear answer), but excessive trust in the ability to effectively model the economy is generally only found in naive socialists circles.

  67. There is always going to be a problem if there are people who think that the creation of ponzi-money creates real wealth. This superstition is just ubiquitous. Is there anyone here other than myself who doesn’t believe it?

  68. This is a deeply frustrating situation. Not unlike the global warming fraud. In that people adhere with furious fidelity to this irrational belief. Yet they refuse to justify it. They will not argue for it in an honest fashion. And if you argue against it you will be swarmed or censored.

    This has got to stop Humphreys. This is one of your pet religious beliefs that you spend an incredible amount of time being obstructive over.

  69. Ponzi-money is where you run out of a supply of suckers, and the whole thing crashes. It involves fraud and lying. Factional reserve systems are out in the open, and don’t collapse if everyone knows about them.
    I don’t see how you can compare them.

  70. He doesn’t understand it, Terje. He gives no clue of understanding the implications of the gold standard, so the link is pretty worthless.

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