All Currencies Are Backed By a Promise

Yglesias notes that many Americans wish to return to the gold standard because they are worried about excessive inflation.  Some states have even been discussing plans to print new forms of state money which are based on the gold standard:

For example, ...North Carolina:

Cautioning that the federal dollars in your wallet could soon be little more than green paper backed by broken promises, state Rep. Glen Bradley wants North Carolina to issue its own legal tender backed by silver and gold. The Republican from Youngsville has introduced a bill that would establish a legislative commission to study his plan for a state currency.

A similar measure already passed in Utah. But this reflects, among other things, a fundamental misunderstanding of the relationship between currency and promises. It’s actually a gold-backed currency that’s backed by nothing but promises. When America was on the gold standard, that meant that the government promised to give you such-and-such an amount of gold in exchange for a dollar. When FDR came into office, he decided the government needed expansionary monetary policy so he changed the price of gold. Under the Bretton Woods system, similarly, the government’s promise to convert dollars to gold lasted a few decades and then it went away. It’s a gold standard that represents a government promise that can (and will) be broken. Fiat currency is a government that’s being honest with you. It’s not pretending the money is anything other than what it is.
The practical response for Americans who question the forward-looking strength of the US dollar is just to buy another currency. Europe is run almost exclusively by center-right governing coalitions right now, so you can trust your money to them. Or maybe since all Europeans are socialists by definition you’d prefer to trust your money to the Canadian or British governments. You can buy Korean won or Australian dollars or Brazilian reals. You can even go out and buy actual bars of gold. I personally have a bunch of Chinese paper money in my sock drawer left over from my trip last year and held in that form in anticipation of future RMB appreciation. You can even buy gold. But whatever you do, don’t entrust your money to promises by the North Carolina state government to give you gold in the future. That’s just a sucker move that’s going to leave you get stuck holding the bag next time there’s a budget crisis.

I would not expect the new state money to catch on unless people begin to trust the North Carolina government more than the US federal government.  I certainly don't trust North Carolina politicians as much.

Yglesias » Households and States

Yglesias » Households and States:

In response to my claim that public understanding of fiscal policy is dominated by fallacious analogies between a national government and a household, MF asks for an explanation “Why is that analogy deceptive or misleading?”

Glad you asked. There are a number of reasons, but the main one concerns money. A household typically measures its wealth in terms of money. So many assets and so many liabilities. And it doesn’t just do this as an accounting convention. An influx of extra dollars into your bank account is a real increase in your wealth. Mo money mo purchasing power.

The United States of America also uses dollars as a unit of account for tallying up assets and liabilities, but the wealth of the United States is properly measured not by how many dollars there are but by what real production we’re engaged in and what real stock of assets we possess. We have the I-95 and the aircraft carrier Ronald Reagan and the Hollywood movie studios and Yale University and the casinos of the Las Vegas strip and the Mayo Clinic and fertile farmland and many detached single-family homes. Unlike a household, if we as a country want more dollars, we can just print more dollars. But also unlike a household, if we as a country want more stuff we actually have to make more stuff not just obtain more currency. This means that to say we’re “broke” or “running out of money” is nonsense. The relevant issue is are we running out of productive capacity? If we try to boost demand faster than we can produce, we’ll end up with inflation. But if our level of demand is well below our potential for production, then we’ll get richer (have more stuff, more production) merely by increasing our demand to something closer to our potential.

Brad DeLong: IS-LM model of recessions

What Must Be the Case for the Economy to Be at Full Employment?

(1) Given the current price level, the long-term real risky interest rate must be such that total planned nominal spending is equal to the full employment level. In general the lower the long-term real risky interest rate, the higher is total planned nominal spending--this is the "IS" curve: the curve that corresponds to equilibrium in the market for "bonds".

(2) Given the current price level, the short-term nominal safe interest rate must be such that when nominal spending and incomes are at their full-employment level that planned holdings of liquid cash money are equal to the existing money stock--this is the "LM" curve: the curve that corresponds to equilibrium in the market for "money".

(3) The expected inflation rate, expectations of future shifts in short-term nominal safe interest rates, the amount of financial risk in the economy, and the financial risk tolerance of wealth holders must be such that the spread between the long-term risky real interest rate and the short-term nominal interest rate is equal to the gap between those respective interest rates' full-employment values. The spread corresponds to equilibrium in the market for "quality."

Recessions happen when:

(1) A shortage of savings vehicles to transfer purchasing power from the present into the future induces spenders to cut back spending and save more. Even if the money stock (and thus the LM curve) and the spread remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.

(2) A shortage of liquid cash money leads spenders to cut back spending to try to build up their liquid cash money balances. Even if the relationship between spending and real interest rates (and thus the IS curve) and the spread remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.

(3) A shortage of high-quality assets or expected deflation or expected future monetary contraction leads the spread between the short-term nominal safe interest rate and the long-term real risky interest rate to rise. Even if propensities to spend, to hold money, and the money stock remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.

And, of course, a shortage of any of these three classes of financial assets--savings vehicles ("bonds"), liquid cash ("money"), or high-quality assets ("quality")--relative to its full-employment balanced macroeconomic level can arise ither becasue of a reduction in the supply of such assets or an increase in the demand for such assets. In 2008 we had a fall in the supply and a rise in the demand for high-quality assets with the financial crisis. In 2001 we had a fall in the supply of savings vehicles with the collapse of the dot-com boom. In 1982 we had a fall in the real supply of liquid cash with the Volcker disinflation.

Is there a presumption that a recession that arises out of derangement in any of these three financial markets--for bonds, for money, or for quality--is best cured by a strategic government intervention to repair the supply-demand full-employment imbalance in that particular market? Yes, if you thought that the macroeconomy was in balance before the recession--that the long-term risky real interest rate and the spread were at their right value before. Otherwise? It is pretty clear to me that you do not want to reattain full employment with spreads that are 'too low' or 'too high', or with a long-term real risky rate of interest that is either 'too low' or 'too high'. But what the appropriate values are of those variables is not something I would claim to have strong evidence-based views on.

Model the macroeconomy as a household

Yglesias :

Public understanding of fiscal policy is hazy, inaccurate, and dominated by fallacious analogies between a national government and a household. What’s more, voters believe that deficits are primarily driven by wasteful government spending. So when a recession strikes the deficit spikes, and people complain.

This is completely true. Ironically, the very name 'economics' means the study of a household. And sadly, it is easy to think about a recession in an extended household. Suppose that the Swiss Family Robinson household is self-sufficient and that the members have completely specialized in doing what each does best. One fishes, another makes tools and shelter, and a third only gathers plants. Suppose there is a supply shock in fishing because of El Nino. That means the fisherman has less to trade with the other two. If they spend less (meaning they produce less), then total output decreases and there is a major recession. If they spend more, then output could stay the same, but with a different composition (more fruits and equipment for fishing). That will cause inflation in fish and deflation in the other two sectors, but the overall price level will stay fairly constant and they will end up with more capital for being more productive in the long run.

Suppose it is a recession that is caused by a financial crisis. The vegetable guy loaned food to the fisherman to allow him to buy more equipment from the tools guy. During this period, the vegetable guy and the tool guy worked extra hard. But the equipment didn't make the fisherman more productive and now the fisherman cannot earn more fish to pay the vegetable guy back. Instead, he will have to buy less equipment than usual from the tool guy in order to pay back the veggie guy. Meanwhile, the tool guy has less food unless he can convince the veggie guy to buy more tools than usual. This causes a recession because the tool guy will have less fish and the fisherman will have less fish and the veggie guy will have more food than usual.

Good Inflation, Bad Inflation

Krugman - NYTimes.com:

FTAlphaville reports that some people believe that surging commodity prices might be good for Japan, because they will make deflation go away.

OK, this is a failure to understand the principle.

Why does deflation have a depressing effect on the economy? Two reasons. First, it reduces money incomes while debt stays the same, so it worsens balance sheet problems, reducing spending. Second, expectations of future deflation mean that any borrowing now will have to be repaid out of smaller wages (if the borrower is a household) or smaller profits (if the borrower is a firm.) So expected future deflation also reduces spending.

So, does a rise in food and energy prices do anything to alleviate these problems? No. In fact, it makes them worse, by reducing purchasing power. So while the commodity surge may temporarily lead to rising headline prices in Japan, the underlying deflation problem won’t be affected at all.

In a way, this is another illustration of the need to differentiate among inflation measures. It’s not exactly the same as the usual case for focusing on core inflation, but it’s related. And once again, the point is that looking at “the” inflation rate is a bad guide for policy.

How Different Bubbles Work

Almost by definition, bubbles are conditions where prices temporarily soar.  A crash is when prices temporarily drop.  The financial "bubble" of 2006-2007 was actually a crash.  The price of money (interest rate) dropped and the mortgage market was awash with so much extra money that they were giving mortgages away to dogs and dead people.  The housing bubble, in turn, was caused by the crash in the cost of borrowing money.  That was a bubble that was caused by an irrational, unsustainable temporary increase in demand for housing fueled by increased borrowing.   This is unsustainable for the same reason that a Ponzi scheme is unsustainable.  Prices can only rise as long as new money keeps flowing in which cannot continue forever.  Current prices are always based on expectations of future prices.  If people think that future prices will go up because of a momentum strategy (what has been going up in the past will likely continue to go up in the future), then that creates an inherent instability in markets. 
Some bubbles are caused by a decrease in supply that are caused by hoarding.  Hoarding creates an unsustainable increase in price unless there really is a permanent decrease in supply.  Amartya Sen argues that this was the main reason for the 1943 famine in the Bangladesh region of British India.

We need better definitions of bubbles.  There are Ponzi-demand bubbles caused by expectations of higher future prices and new money flowing into a market. There are hoarding-supply bubbles caused by suppliers raising their current stocks.  And then there are "bubbles" like the "financial bubble" that are misnamed and are really crashes in price which I will analyze another time and probably have very different causes. 
Krugman dismisses the ability of financial markets to create bubbles if there isn't an increase in stocks, but that only looks at hoarding-supply bubbles and there certainly could be a financial Ponzi bubble that causes a bubble without hoarding.  The problem is in how to measure a financial Ponzi bubble.  The hoarding-supply bubble is easy to measure if we have measures of stocks, but do we have any measures of monetary inflows into markets?  In the short-run supply is very inelastic and too many dollars chasing a nearly fixed supply of anything will raise its price. 

Economic growth & Inequality

Economic growth: Why the rich must get richer | The Economist:

“The value of a rising standard of living lies not just in the concrete improvements it brings to how individuals live but in how it shapes the social, political and ultimately the moral character of a people.” Growing prosperity, history suggests, makes people more tolerant, more willing to settle disputes peacefully, more inclined to favour democracy. Stagnation and economic decline are associated with intolerance, ethnic strife and dictatorship.

It is not obvious that this should be true, so why has this tended in practice to happen? Mr Friedman's explanation is that people's sense of well-being is essentially relative. They become accustomed to any fixed standard of living, rich or poor. They are happiest if they feel their standard of living is rising (something that, in principle, all members of a society can experience at once), or if they feel that they are better off than their peers (which is divisive and not an aspiration that everyone can realise at once).

The key thing is the way these two standards of comparison—the potentially harmonious and the socially self-defeating—interact. If people are becoming better off relative to their own past standard of living, they will care less about where they stand in relation to others. If they are not growing better off relative to their own past standard of living, they will care more about their placing in relation to others—and the result is frustration, intolerance and social friction. Growth, in short, has moral as well as material benefits.