Sunday, February 14, 2010

Boom-Bust, Part 2

In part I, I began discussing the Fed's response to the recent economic crisis as detailed in Chairman Ben Bernanke's recent statement to Congress. To better understand the causes of the crisis and evaluate Bernanke's proposed solutions, I used Dr. George Reisman's explanation of the inflation-depression cycle to briefly show that the current crisis is yet another instance of a well known process whereby government inflation of the money supply causes an artificial boom that sets the stage for a spectacular bust as soon as the credit expansion slows or stops. Dr. Reisman's explanation is consistent with what has become known as the theory of the Austrian business cycle.

To better understand the particulars of Bernanke's response and to better grasp the ultimate solution to the economic crisis, it is helpful to understand why it is we even have a central bank in the first place. If it is true, as I asserted, that central banking itself coupled with fractional reserve banking is largely responsible for the current crisis, why do modern economists believe a central bank is even necessary? Why does Bernanke think we need a central bank and what informs his actions as chairman?

Bernanke did his thesis on the Great Depression and is considered an expert on the subject. His formal conclusions from this work led to his nickname, "Helicopter Ben", since he famously claimed to be willing to drop freshly created paper money from helicopters if necessary to ward off a monetary crisis. Anthony Mueller, in a recent article, discussed "Helicopter Ben's" belief that inflation is always the solution to a monetary crisis:

Bernanke is an economist by trade, specializing in the study of the Great Depression. That was a bad omen from the beginning — because he has studied economics and the Great Depression in the framework of a particular, flawed paradigm. His studies make him believe that the central bank could have prevented the great economic decline of the 1930s if only it had more aggressively expanded the money supply. This was the lesson that Bernanke learnt from Milton Friedman. Apparently unfamiliar with alternative explanations, Bernanke has never doubted Friedman's thesis.

What has led Bernanke to this "flawed paradigm", a paradigm asserted to follow from the work of Milton Friedman? In the biggest picture terms, this paradigm follows from a flawed epistemological method and its logical consequence: flawed, or at best, incomplete conclusions.

First, Milton Friedman and Anna Schwartz authored a highly influential book, A Monetary History of the United States: 1867-1960. Bernanke no doubt adopted Friedman's interpretation of the economic history of the Great Depression including the view that the government could have prevented the Great Depression by creating massive amounts of paper money in the aftermath of the 1929 crash. In other words, instead of focusing on how the Federal Reserve's expansion of credit in the 1920's (along with a mountain of statist anti-business policies) set the stage for a bust in the early 1930's and thus caused the Great Depression, Bernanke focuses only on the more narrow question of the Fed's monetary response.

Such an approach derives from what Mueller refers to as Friedman's (and by implication Bernanke's) "positivist" approach to analyzing economic history. Positivism, in essence, is an extreme form of empiricism where one attempts to rely solely on empirical data. It is associated with "scientism" which is the view that the methods of the natural sciences can be applied to every field including economics. As part of this approach, Friedman argued that economics should be free of value judgments or so-called "normative" statements. In the introduction to Murray Rothbard's, A History of Money and Banking in the United States, Joseph T. Salerno contrasts Friedman's positivist approach with Rothbard's Austrian approach (known as praxeology):

Rather, the positivist methodology they [Friedman and Schwartz] espouse constrains them to narrowly focus their historical narrative on the observable outcomes of these actions and never to formally address their motivation. For, according to the positivist philosophy of science, it is only observable and quantifiable phenomena that can be assigned the status of "cause" in a scientific investigation, while human motives are intensive qualities lacking a quantifiable dimension. So, if one is to write a monetary history that is scientific in the strictly positivist sense, the title must be construed quite literally as the chronicling of quantitative variations in a selected monetary aggregate and the measurable effects of these variations on other quantifiable economic variables, such as the price level and the real output.

Salerno points out that such an approach leads Friedman and Schwartz to "forays into human history which are cursory and unilluminating, when not downright misleading." He states:

Friedman and Schwartz thus portray the drive toward a central bank as completely unconnected with the money issue and as only getting under way in reaction to the panic of 1907 and the problem with "inelasticity of the currency" that was then commonly construed as its cause. The result is that they characterize the Federal reserve System as the product of a straightforward, disinterested, bipartisan effort to provide a practical solution to a purely technical problem afflicting the monetary system.

Salerno goes on to show that this empirical approach fails to account for all the causal factors that give rise to a particular result in any given context. For example, he discusses their treatment of the panic of 1907 in which they observe that banks "restricted cash payments to their depositors within weeks after the financial crisis struck, and there ensued no large-scale failure" thus conjecturing that "when a financial crisis strikes, early restrictions on currency payments, work to prevent large scale disruptions of the banking system." They "test this conjecture" by observing that banks did not restrict bank depositors after the stock market crash of 1929 and there occurred a "massive wave of bank failures" from 1930 to 1933. Salerno summarizes the conclusion of Friedman and Schwartz:

The theoretical conjecture, or "counterfactual statement," that a timely restriction of cash payments would have checked the spread of a financial crisis, is therefore empirically validated by this episode because, in the absence of a timely bank restriction, a wave of bank failures did , in fact, occur after 1929.

Of course, unlike a natural science experiment, causal factors in this context can not be strictly "controlled." Salerno states:

Friedman and Schwartz do recognize that these theoretical conjectures cannot be truly tested because "there is no way to repeat the experiment precisely and to test these conjectures in detail." Nonetheless, they maintain that "all analytical history, history that seeks to interpret and not simply record the past, is of this character, which is why history must be continuously rewritten in the light of new evidence as it unfolds."

Salerno summarizes:

In rejecting the historical method of specific understanding, Friedman and Schwartz are led not by reason, but by a narrow positivist prepossession with using history as a laboratory, albeit imperfect, for formulating and testing theories that will allow prediction and control of future phenomena.

To narrowly focus on concrete quantitative data without accounting for potential causal factors applicable to varying degrees in varying contexts is a fundamentally flawed approach. Yet, not surprisingly, this is Bernanke's approach to monetary policy. Rather than being guided by universal principles of economics based on an integrated grasp of theory and history, modern economists like Bernanke are in a state of almost constant intellectual flux, awaiting the latest round of data in order to guide their actions. Quoting Mueller:

It is Bernanke's unwavering creed that central banking can be practiced as a science. If things don't work out as they are supposed to, it must be because of insufficient data and inadequate models. Thus, in his anguish, he decided to create a special "brain trust," a creation called MAQS: the Fed's "Macroeconomic and Quantitative Studies" unit. Bernanke wants this team to sift through as many models, projections, stats, and scenarios as possible.

Blinded by scientism, the chairman obviously is unable to see that no sound conclusion or reliable policy formulation can be reached this way. The more data the studies team collects and sifts, the more confusions and contradictions they will bring to light; the longer they collect and sift, the less relevant the data will become.

Of course, it is not only Bernanke that is mired in this kind of brute empiricism. The entire field of economics, excepting advocates of Austrian economics, consists of glorified statisticians unable or unwilling to offer any principled understanding of economics.

The argument made in Part I, that central banking is the problem, is an argument that has been made countless times for decades. Understanding the epistemological milieu of the economics profession is important in grasping why mainstream economists are so unable to grasp this. Once again, the solution was put forth in essentialized terms by Robert Klein and George Reisman in their recently published Barron's article, Central Problem: the Central Bank :

Lurching from crisis to crisis in boom-bust fashion is unacceptable and unnecessary. The Federal Reserve must stop juicing the economy with massive amounts of newly created money and move to a monetary system free of government-caused booms and busts. The only effective way to do this would be to remove control of our money supply from politicians and their appointees. We need to move to a money that is 100% backed by a commodity, such as gold. Only then can we rid the economy of the devastating effects of the creation of money and credit out of thin air.

I have observed that any criticism of central banking or advocacy of gold is virtually always met by a similar argument. In essence, the argument is made that even under a gold standard, reoccurring panics occurred that followed the same pattern as today's boom-bust cycles. I hold that only the positivist approach to economic history could account for such a complete misunderstanding of the events of the 19th century. In other words, the positivist observes that in the 19th century there was a gold standard and yet, there were boom-busts. Then, he sees no gold standard today but stills observes boom-busts. Ergo, he concludes, gold does not prevent boom bust.

In fact, this kind of thinking has led to a kind of mythical narrative of the 19th century. The narrative goes something like this:

Once upon a time, the United States had laissez faire and a totally free banking system based on a gold standard. This "free market" system led to reoccuring panics, runs on banks, and a volatile business cycle throughout the 19th century. Finally, after the 1907 panic, a group of wise businessmen and government officials got together and created the quasi-public Federal Reserve system to act as lender of last resort and to permanently eliminate reliance on the "barbarous relic" (gold) which stood in the way of economic progress by causing continual liquidity crises. With the banking system and money supply in the hands of wise and prescient central planners (like Ben Bernanke), the United States economy would live happily ever after. The End.

I hold that such a view betrays a complete disregard for cause and effect. To fully understand the monetary history of the United States and grasp the causal factors, economic and political, which led to the unfortunate advent of the Fed, would require a volume. Fortunately, much of that work has already been done by Murray Rothbard in the aforementioned, A History of Money and Banking in the United States. Other excellent volumes have been published that detail the effects of government inflation around the world from antiquity forward such as Money, Bank Credit, and Economic Cycles by Jesus Huerta De Soto, Peter Bernholz, Monetary Regimes and Inflation, and the recent volume, This Time is Different, by Reinhart and Rogoff.

In Part 3, I will attempt to address the specific history and detail my arguments including an explanation of the "tools" that Bernanke is proposing to use to reign in his recently created excess reserves, but the essence of my historical argument is as follows.

The government has been intimately involved in the monetary system since the inception of the country leading to one disaster after another. This involvement takes two general forms. The first form is direct intervention such as the First Bank of the United States (chartered in 1791), which pyramided paper money upon specie in the form of treasury notes and set the stage for destructive inflation-depression in the early 1800's. The second form of intervention represents a default by the government to perform its legitimate and necessary function as a protector of property - call it misintervention. I claim that this default took two primary forms. First, during various crises, it continually failed to uphold banks contractual obligations to redeem in specie. Second, through various court cases, it failed to legally define property in such a way as to effectively outlaw the practice known as fractional reserve banking, i.e., legally distinguish between a deposit and a loan contract.

In Part 3, I will discuss in detail my contention that it is government intervention (or misintervention) that caused the banking crises and panics of the 19th century, not the gold standard per se. In fact, it was gold that kept any semblance of price stability at all and led to phenomenal economic expansion. Ultimately, I will argue that the permanent solution is a 100% reserve specie standard and a complete separation of state and economy.


roadrage666 said...

enjoying the posts as always and glad to see you are writing again. question on the gold standard: you say, "We need to move to a money that is 100% backed by a commodity, such as gold. Only then can we rid the economy of the devastating effects of the creation of money and credit out of thin air." but isn't a gold standard pro-cyclical? how do the Austrians address this?

Doug Reich said...


What is "pro-cyclical"? Can you elaborate?

C.W. said...


The "science envy" of the economists last century took them from being wrong about how an economy works to being totally disconnected. Too bad they didn't actually know what science was. As you indicate, their positivism told them that it was mathematics that made science science. Today, that has brought them to statistics. Look at Bernanke's speech in January
( He trotted out his wizardary to show how innocent he was. Instead he showed that his "science" is designed to make it impossible to identify cause and effect. (my review:

I suspect that we will have some spirited discussions.


roadrage666 said...


happy to elaborate. by "pro-cyclical," i mean that a GS would result in deeper and more prolonged recessions. rather than use the anecdotal historical arguments of your positivist straw man, i'll just walk through the economic theory, as i understand it: when a recession occurs, the demand for money goes up. people don't want to buy big screen TVs or invest in swamp land in Florida or railroads in Shenzhen. so consumption and investment and imports fall, as people and corporations "go to cash." the effective money supply contracts (because the velocity of money falls) just as the demand for money increases (because the economy is deleveraging). deflation occurs as too few dollars are chasing goods and services and investments. money goes into mattresses. economic activity contracts, wealth is destroyed as asset prices fall. all things being equal, given that demand is increasing and supply is falling, these factors would cause the price of money (i.e. interest rates) to rise. under our current system of central/fractional reserve banking and fiat currency, this is the part of the story where the omniscient central banker turns on the printing press, creating money out of thin air, increasing the effective money supply in order to offset the deflationary forces at work. a counter-cyclical pump-priming occurs, which reduces the severity of the recession and reduces the volatility of the business cycle. or that's how the theory goes, at least. (i realize this is a very stylized description and not always what happens in reality, but i'm dealing strictly with how it works in principle here.)

now let's compare this to what would happen (in theory) under a GS. as the demand for money rises, and the velocity of money falls, the nominal money supply would remain the same. this means the price of money (interest rates) would spiral higher even as the recession deepens and deflation becomes more powerful. a feedback loop of deflation and demand for money and higher interest rates would occur. so, effectively, a GS would cause interest rates to automatically rise into the teeth of a recession or bust.

in short, i fail to see how, in theory, this wouldn't aggravate every economic downturn. how do the Austrians address this issue?


Doug Reich said...


Under a 100% reserve gold standard, there would not be a boom-bust cycle. This can be shown logically and empirically.

Of course, there could be moderate swings in growth related to technological innovations, wars, supply shocks (gold rush), but these events would not dramatically affect the outstanding supply of gold since gold is difficult to produce unlike fiat currency. Again, prices were relatively stable in the 19th century and in fact, in aggregate went down.

Generally, productivity is greater than the rate of gold increases and so prices net tend to go down under a gold standard.

also, you said:

"given that demand is increasing and supply is falling, these factors would cause the price of money (i.e. interest rates) to rise"

Interest rates are fundamentally a function of the rate of profit in the economy. If the rate of profit is going down, and if money supply were contracting (deflation), I would expect rates to go down in this environment, not up.

roadrage666 said...

you wrote, "If the rate of profit is going down, and if money supply were contracting (deflation), I would expect rates to go down in this environment, not up." but this is precisely the opposite of what happened in the early 1930s, when adherence to the GS in the US, UK and Germany exacerbated the Great Depression by causing a huge increase in interest rates.

this is one of the key points made by Friedman & Schwartz in "A Monetary History of United States." you summarize their thesis by saying "the government could have prevented the Great Depression by creating massive amounts of paper money in the aftermath of the 1929 crash." this is not exactly what Friedman says. he does cite the 1928/29 Fed tightening cycle and rate hikes in late 1932 as policy mistakes, predicated on a misunderstanding of the distinction between real and nominal interest rates and how to measure them, that contributed to the GD. however, he makes a couple other points that are both crucial to the book's thesis and germane to the issue of GS pro-cyclicality described above.

specifically, friedman & schwartz cite the 1931 decision by the Fed to effectively double interest rates in order to protect the Dollar by stemming outflows of gold to the UK and maintain the GS as a policy mistake that exacerbated the GD. this seems a concrete historical example of the theoretical pro-cyclicality described above.

james hamilton cites some papers that touch on this idea here:

Doug Reich said...


You are following the playbook of the "positivist strawman" and missing the forest for the trees.

Saying that gold made the problem worse is like observing the symptoms of chemotherapy and concluding that it is making the cancer worse!

In other words, like most modern economists, you are focusing on these relationships out of context.

Hamilton is arguing not against gold per se, but making a historical-pragmatic argument that government's appear readily suscepitble to going on and off of them which causes chaos. For example, he states:

"Under a pure gold standard, the government would stand ready to trade dollars for gold at a fixed rate. Under such a monetary rule, it seems the dollar is "as good as gold."

"Except that it really isn't-- the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard, it can go off, and historically countries have done exactly that all the time. The fact that speculators know this means that any currency adhering to a gold standard (or, in more modern times, a fixed exchange rate) may be subject to a speculative attack."

He starts with the presumption that a gold standard would mean that the government stands ready to redeem in gold. I don't contemplate such a system. Instead, I am calling for private banking and a total separation of state and banking. The government's only role would be to protect contracts and person.

I think he is right, that in a given context, an attempt to maintain a gold standard while the government wildly inflates the paper currency is a recipe for disaster. But, this ignores the fact that it is the attempt to inflate the money supply that causes the problem in the first place.

It is not gold's fault that it represents reality, and the government attempts to evade that reality by printing phony currency.

With respect to your particular argument re the 1930's - you should check out Dr. Reisman's hypothesis on p. 940-941 of Capitalism in the section titled:

Gold Clauses and Prospective Inflation of paper as the Cuase of Deflation in Gold

He advances "the hypothesis that the depression was intensified by the Federal reserve's efforts to expand the quantity of money in order to reduce intereest rates and finance large-scale government budget defiicts. These efforts had the effect of creating the prospect of a devaluation of the dollar against gold and thus of making the honoring of gold-clause contracts correspondingly more difficult, with the result that they precipitated greater credit contraction and thus a larger number of immediate bankruptcies and bank failures, and, because of this last, a decline in teh quantity of money."

The causes of the GD and its aftermath must be evaluated in a larger context. The expansion of credit in the 1920's by our Fed to keep the dollar low to the pound, the effect of Britain's desire to return to the pre-war pound/gold rate, the massive inflation in Europe post WWI, protectionist and anti-business legislation passed in the 1920's and 30's, the prospect of the devaluation of the dollar vis-a-vis gold clauses, etc.

Also, the solution must take into account the framework of the entire banking system including consideration of central banking in and of itself vis-a-vis private banking, fiat vs. gold, etc.

These economists seem to take the Fed or central banking as a metaphysically given fact, then discuss the effect of the various monetary policy levers at any given time in a rationalistic construct rather than discerning the essential principles involved.

Doug Reich said...


I want to follow up with some more related to your point.

A statement of the kind you quoted to the effect that "gold exacerbated the GD" is exactly the kind of conclusion following from bad epistemology that I claim is destroying the profession of economics (or rendering it useless as a science.)

It is a claim made completely out of context on the basis of a statistical observation that fails to take into account all the causal factors.

Let me quote Rothbard from his book "America's Great Depression" which is essentially an Austrian account of the GD as contrasted to Friedman or a more positivist account.

"Most writers on the 1929 depression make the same grave mistake that plagues economic studies in general-the use of historical statistics to "test" the validty of economic theory. We have tried to indicate that this is a radically defective methodology for economic science...statistics can prove nothing because they reflect the operation of numerous causal forces. To "refute" the Austrian theory of the inception of the boom because interest rates might not have been lowered in a certain instance, for exampole, is beside the mark. It simply means that other forces-perhaps an increase in risk, perhaps expectation of rising prices-were strong enough to raise interest rates. But the Austrian analysis, of the business cycle continues to operate regardless of the effets of other forces. For the important thing is that interest rates are lower than they would have been without the credit expansion. From theoretical analysis we know that this is the effect of every credit expansion by the banks; but statistically we are helpless-we cannot use statistics to estimate what the interest rate WOULD HAVE BEEN. Statistics can only record past events; they cannot describe possible but unrelized events."

"If we were writing an economic history of the 1921-1933 period, our task would be to try to isolate and explain all the causal threads in the fabric of statistical and other historical events. We would analyze various prices, for example, to identify the effects of credit expansion on the one hand and of increased productivity on the other. And we would try to trace the processes of the business cycle, along with all the other chaning econoimc forces (such as shifts in the deman for agricultural products, for new industries, etc.) that impinged on productive activity...our to pinpoint the specifically cyclical forces at work, to show HOW THE CYCLE WAS GENERATED AND PERPETUATED DURING THE BOOM, AND HOW THE ADJUSTMENT PROCESS WAS HAMPERED AND THE DEPRESSION THEREBY AGGRAVATED. Since government and its controlled banking system are wholly responsible for the boom (and thereby for generating the subsequent depression) and since government is largely responsible for aggravating the depression, we must necessarily concentrate on these acts of government intervention in the economy. An unhampered market would not generate booms and depressions, and, if confronted by a depression brought about by prior interveiont, it would speedily eliminate the depression and partiuclary eradicate unemployemnt. Our concern, therefore, is not so much wiht studying the market as with studying the actions of the culprit responsible for genrating and intensifying the depression-government."