Selgin on the Fed's Money Supply Process

George Selgin has a great post on the money supply process here.  

Romer on Macro

I am teaching Principles of Macro this semester as I frequently do.  What to make of Paul Romer's broadside against Macroeconomics?

I believe it was Williamson who said that what is taught in undergraduate macroeconomics has nothing to do with what real macroeconomists do.    So, I suppose I shouldn't worry too much that Romer believes that these "real" macroeconomists have gone off the rails.  

Still, I think Romer goes to far.

Romer calls out several famous economists by name.   His strongest criticism is for Prescott, though Lucas and Sargeant get some heavy criticism too.    What is Romer's problem with Prescott and the rest?   It seems mostly aimed at real business cycle theory.

I think real business cycle theory is a bit of an oxymoron.   Of course, if business cycle theory is supposed to explain fluctuations in real output around trend, then what I would prefer to call "supply-side" shocks must be taken into account.     From that perspective, real business cycle theory has done a service in correcting a view that potential output is on a continuous three percent growth path and any deviation of real output from that growth path should be understood as being due to shifts in aggregate demand--spending on output--imperfectly accommodated by changes in inflation of money prices and wages.

When the obvious is recognized, that there is little reason to expect potential output to always grow at a constant rate and that resource availability and productivity should be expected to at least grow at somewhat variable rates, then the problem of macroeconomic coordination is better understood--real output should grow not at three percent or some other "target" but rather at a rate that varies with potential output.

While slower than three percent growth in real output is entirely plausible, "supply-side" explanations of recessions--decreases in real output--are a more of a stretch.   However, it is actually quite easy to think of disasters that would have that consequence.   Natural disasters or man-made disasters like civil war would be examples.   And there are public policies that could also result in reductions in production.   These could be just foolish anti-capitalist policies.   But efficient policies could have that effect as well.   For example, even an efficient institution for protecting the environment could result in decreases in measured real output if starting from a highly polluted condition.   I think that a reduction in the production of various goods and services would be highly significant and worth measuring even if some more inclusive measure of human welfare increased on net.

The reason I think of real business cycle theory as an oxymoron is not that "real" recessions are impossible, it is rather that they are not interesting.   After a country suffers a major nuclear attack, it will produce less output.  Yes.   And aside from trying to make sure that doesn't happen, why is that interesting?

Now, I will grant that having slower growth in resource productivity cause reductions in output rather than just slower growth is interesting, though I doubt that it is at all likely.

The puzzle of recession is that even though we live in a word of scarcity, there are occasional periods where there is widespread idleness of scarce resources resulting in reduced production of many types of scarce goods and services.   These recessions are nearly always associated in broad-based reductions in sales of goods and services.   That is, many firms in many industries report what they perceive as weak sales and respond by curtailing production.   In other words, the problem to be explained is fluctuations in aggregate demand as well as the reason why these do not simply result in changes in money prices and wages so that scarce resources remain employed producing scarce goods and services.

What are sometimes called "growth recessions" would be a similar phenomenon.   Sales grow too slowly for firms to use all of their scarce resources to produce scarce goods and services, though the amount they do produce is greater than what they did before.   Real output grows, but less than potential output.   Since it is quite possible for potential output to grow more slowly, it is difficult to distinguish a failure of output to grow as fast as potential with a situation where real output remains equal to a more slowly growing potential output.

However, the real problem with real business cycle theory isn't that it has nothing interesting to say.   It is rather the research program of seeking to show that aggregate demand does not matter at all and that real output is always equal to potential output.   This is closely associated with the "new classical" emphasis on "market clearing."   Prices and wages are assumed to be sufficiently flexible that any shift in aggregate demand results in changes in prices and wages so that all scarce resources remain fully employed producing scarce goods.    Observed fluctuations in real output, employment, and unemployment around trend therefore must be due to optimal responses to real, or supply side, shocks.    Potential output?   Why have a special term for that?   Real output is potential output.  Or do you just mean trend?   It is that view that is the problem.

Romer's focus then is on the opaque methods real business cycle theorists have used in pursuit of this program.    In particular, their empirical work hides assumptions that makes unobserved real factors supposedly cause general fluctuations in output and employment.

One problem with Romer's essay is that the leading macroeconomists today are not the followers of Prescott but rather Woodford.   Where are the leading new Keynesians in his story?    They most definitely recognize the importance of aggregate demand and monetary policy.

Perhaps one issue is that the real business cycle approach has not been sufficiently stamped out.   I guess that there are still PhD dissertations accepted and papers published in major journals in this vein.   Romer seems to be arguing that this should be treated as so much trash.   Less of it should be published and it should be treated less seriously.

But I also think Romer believes that the bad technique generated by that wrongheaded approach has infiltrated into the mainstream of new Keynesian macroeconomics.    If an idea cannot be characterized within a rigorous and calculable DSGE model using rational expectations, then it isn't worthwhile.    The mechanism for sticky prices (or wages) must be sufficiently rigorous and allow for a calculation of results in a rigorous model.   Why?   Because that is the standard insisted upon by Prescott and company, when really, according to Romer, their approach was fundamentally fraudulent.

Further, if the model implies that aggregate demand has only small and transitory effects on real output, then real business cycle theory must be mostly correct and monetary policy really doesn't matter.   I think Romer's point is if the Calvo model of price-stickiness doesn't result in large fluctuations in output, then the problem is in the Calvo model and not a reason to think that monetary policy doesn't matter much in the real world.

Market Monetarists favor a stable growth path for spending on output.    If this were accomplished perfectly, then there would be no problem with fluctuations of aggregate demand.   That doesn't mean that there would be no fluctuations in real output.    The fluctuations would be due to supply side factors.   In such a world, researches would hopefully find that all fluctuations in real output were caused by "real" factors.   Would that mean that aggregate demand and monetary policy does not matter?   Not at all.   It would rather be that monetary policy was perfect and stabilized aggregate demand.  

Further, what would researches discover about the quantity theory of money?   Well, it is likely that the quantity of money would grow as would nominal income over the long run.   However, a careful consideration of short run fluctuations would show appreciably no relationship between the quantity of money and inflation.   Instead, the quantity of money would be inversely related to velocity and systematically related to anything that causes changes in velocity--perhaps real interest rates.  Changes in inflation, on the other hand, would be almost entirely shown to be determined by the same real factors causing fluctuations in real output.     But to conclude from such evidence that a new monetary institution that involved rapid exogenous growth in the quantity of money would not generate more rapid inflation would be foolhardy.

The Constitution Party: An Alternative?

Libertarian critics of the Johnson/Weld ticket sometimes suggest that the Constitution Party's candidate, Darrel Castle is a "more libertarian" alternative.   I certainly disagree with that evaluation.

Conservative critics of Trump have proposed that Castle is a better alternative for them than Johnson/Weld.   They have a stronger argument than the libertarian critics, though I would suggest that they stay away from Castle as well and seriously consider Johnson.

The key problem with Castle is that he is plainly a candidate of the paranoid conspiratorial far right.   His campaign platform focuses on the dark fantasies of the John Birch Society.     Many years ago, the John Birch Society claimed that communists held key positions in the U.S. government and they were working on behalf of their foreign masters.   There was an element of truth to this claim.   There were plenty of communists in the U.S. in the forties and fifties who were taking orders from Stalin's Russia and some of them were in senior government positions.  

The John Birch Society went wrong by first claiming that pretty much every center-left politician and bureaucrat in the U.S. was taking orders from Stalin, and then going further and claiming that the same was true of center right politicians like President Eisenhower and Nixon    Before long, if you didn't agree with the John Birch Society, you must be part of the international communist conspiracy.  

And if that wasn't crazy enough, by the sixties, it was no longer the KGB and the Soviet Union giving the orders, but rather it was a secret cartel of "globalist" bankers giving orders to both the Soviet leadership and pretty much all U.S. politicians conspiring to impose one-world big government.

Key issues in Castle's campaign platform are the struggle against the United Nations and Agenda 21.   The problem isn't that the United Nations is particularly valuable or that there is something good about Agenda 21.   It is rather that these are big red flags that Castle is not connected with reality.   They have no place as key issues facing the U.S. today.

Interestingly, one of the negative aspects of Trump's campaign has been his close ties to conspiracy theorists and really, what seems to be a willingness to take them seriously.   That is one key reason why Castle will not get much traction as a practical matter and why it is not desirable that he get any traction.

From a libertarian perspective, the best parts of Castle's campaign platform are his call to abolish the Fed and his support for the U.S. Constitution.   The section of his campaign platform that calls for the abolition of the Fed is pretty good.   It emphasizes allowing people to use alternative monetary instruments, including Bitcoin.   It mentions in passing that dollars would be redeemable in gold.   While I think a gold or silver standard is a mistake, many libertarians strongly support a return to the gold standard.   

The problem is the audio file linked by Castle to this text that explains why he favors abolishing the Fed.   He rapidly heads into bad economic analysis that has a long pedigree in far right conspiracy theory.   The Federal Reserve is private.   Our money is based on debt.   This creates problems because there can never be enough debt-money to pay the interest on the money.   Wrong, confused, and paranoid.  

Personally, I am more interested in reforming the Fed than abolishing it, though if I had a magic wand, I would abolish it.   In the broader libertarian movement, support for reforming the Fed by constraining it with rules has had many important advocates--like Milton Friedman.    (I favor replacing the Fed with a rule-constrained monetary authority, so for me the difference between reform and abolition is a matter of a fresh start.)

Castle's devotion to the U.S. Constitution is a positive.   I certainly support constitutional restraints on government, and the U.S. Constitution is what we have.   But the dominant approach in the modern libertarian movement has been to seek to strengthen the U.S. Constitution, rather than hold it up with an almost religious devotion.   And that relates to a fundamental problem with the paranoid right.   In their view, the fundamental problem is that the communist (or globalist) traitors have not kept their oath to follow the U.S. Constitution and that is the source of all of our problems.    It is part and parcel of their conspiracy theory.   Libertarians, on the other hand, have mostly understood that the mainstream of U.S. politics have driven through massive loopholes that were always part of the U.S. Constitution.  

Now, in the sixties, the dominant voices in the libertarian movement were all for closing off the loopholes in the U.S. Constitution and providing more express language to protect economic and personal liberties.   Later, largely due to the influence of Murray Rothbard, opposition to the U.S. Constitution became more important.   Rather than holding up pro-Constitution founders like Madison, other pro-Constitution founders like Hamilton were attacked as advocates of "big-government."   Constitution-skeptics among the Founders, the "anti-Federalists" like Patrick Henry, were more in favor.   And then there are the anti-Constitution abolitionists of the nineteenth century, chiefly Lysander Spooner that were held up as libertarian heroes.   The "radicals" in the libertarian party were strongly influenced by "anarcho-capitalism" and so critics of the general project of constitutionally limited government.    These perspectives on the U.S. Constitution remain today as important strains among libertarian scholars and intellectuals.

The tremendous success (by libertarian standards) of Ron Paul's Presidential primary efforts in 2008 and 2012 has greatly strengthened "pro-" U.S. Constitution rhetoric and approach within the libertarian movement.   That is because Ron Paul always emphasized his support for the U.S. Constitution.   As someone who supported Congressman Paul in those efforts, there is no doubt that there was both a libertarian wing and a conspiracy wing among campaign volunteers.

Is Darrel Castle more libertarian than Gary Johnson?   I don't think so.   I must admit that Ron Paul's approach has been somewhere between that of Castle and Johnson.  Is Ron Paul closer to Castle than to Gary Johnson.   I think it depends on what parts of Ron Paul's message you find most important.

Another of Castle's key platform positions is his anti-abortion stance.   He shares that view with Ron (and Rand) Paul.   Johnson is "pro-choice" on abortion, though he has supported leaving the issue to the states and as a state leader supported some restrictions on late term abortions.   In my opinion, Johnson comes closer to the libertarian mainstream on the issue.   The Paul's are outliers as are those libertarians whose views on the issue are similar to Clinton.

So, Castle isn't much of a libertarian and while he is a conservative of sorts, I think sensible conservatives should steer clear of the paranoid conspiracy nonsense.

Is the Constitution Party something that should be supported?   Not by libertarians, though perhaps some conservatives might find it compatible with their views.

The Constitution Party has seven principles on its website.   The first is anti-abortion.   In many ways, the Constitution Party has historically been focused on opposition to abortion.   There is, of course, a relationship to the U.S. Constitution, since the Supreme Court blocked states from outlawing (or hardly regulating) abortion based upon a Constitutional "right to privacy."

Now, on the whole, libertarians would like to see the Supreme Court protect more liberties, both personal and economic.   Still, many libertarians are critical of Rowe vs. Wade.   My view is that "grey areas" like abortion are the last place the Supreme Court should be overturning state and local government action.

The second principle is described as liberty and includes personal and religious liberty.    It is quite good.   Interestingly, it does not speak to so-called "religious liberty" statutes.

The third principle is about the family and is plainly inconsistent with any kind of libertarian approach.   Here the Constitution Party plainly states that the the laws should be based upon Christian (and Jewish) scripture.   In particular, marriage is ordained by God to be one man and one woman.   They claim that state and local governments have the right to restrict offensive sexual behavior.   Of course, this is more or less what some conservatives (say Ted Cruz) ran upon, so this might be a positive for some conservatives considering the Constitution Party.  (At least the Constitution Party does not support federal legislation to persecute gay people.)

The fourth principle is private property rights.   It mostly involves 4th and 5th Amendment protections.  In my view it is quite good.   Though I am not sure that privacy legislation to prevent private entities from requiring social security numbers is really a priority.

The fifth is interpretation of the U.S. Constitution according to the intentions of the Founders.  That is good.  The link on the website is broken.

The sixth is states rights.   It is a strong statement regarding the 10th amendment.    I like it, though I don't like the term "states rights," given its use by advocates of slavery and segregation.   I think "federalism" is the better term.   And, like many libertarians, I agree with Ayn Rand's statement that states don't have rights, only individuals have rights.   Rather than speak of "state's rights," I would say that the U.S. Constitution provides for federalism, which is a good way to protect individual rights.  

The seventh principle is American sovereignty.   Here there is a very strong support for nonintervention in foreign affairs.   It also proposes the withdrawal of the U.S. from just about every international agreement, organization, or treaty.    I imagine this goes a bit far for most conservatives, though many libertarians would have no problem with anything in this section.   It is too "isolationist" for me.  I prefer Rand Paul and Gary Johnson's foreign policy realism in general.   And I think some international treaties and agreements are desirable--that is why the Constitution expressly allows the Senate to adopt them.   I am not worried much about international organizations.  To me, the Constitution Party's focus on them shows paranoid worries about the secret international global conspiracy to imposes one world government.  

If you go to the Constitution Party Platform, there are plenty of problems, making it unacceptable for any libertarian.  For me, one deal killer is:

"Article I, Section 8 provides that duties, imposts, and excises are legitimate revenue-raising measures on which the United States government may properly rely. We support a tariff based revenue system, as did the Founding Fathers, which was the policy of the United States during most of the nation’s history. In no event will the U.S. tariff on any foreign import be less than the difference between the foreign item’s cost of production and the cost of production of a similar item produced in the United States. The cost of production of a U.S. product shall include, but not be limited to, all compensation, including fringe benefits, paid to American workers, and environmental costs of doing business imposed on business by federal, state, and local governments."

Talk about protectionism!   This implies that tariffs must be used so that there is no specialization based upon comparative advantage.   The tariffs on bananas sure will be high.   Is it based on the cost of operating a banana plantation in south Florida or growing them in hothouses in Alaska?
   

It goes on:

"Tariffs are not only a constitutional source of revenue, but, wisely administered, are an aid to preservation of the national economy. Since the adoption of the 1934 Trade Agreements Act, the United States government has engaged in a free trade policy which has destroyed or endangered important segments of our domestic agriculture and industry, undercut the wages of our working men and women, and totally destroyed or shipped abroad the jobs of hundreds of thousands of workers. This free trade policy is being used to foster socialism in America through welfare and subsidy programs.We oppose all international trade agreements which have the effect of diminishing America’s economic self-sufficiency and of exporting jobs, the loss of which impoverishes American families, undermines American communities, and diminishes America’s capacity for economic self-reliance, and the provision of national defense.We see our country and its workers as more than bargaining chips for multinational corporations and international banks in their ill-conceived and evil New World Order."

I told you it was conspiracy nonsense.  The "ill-conceived and evil New World Order," and capitalized!   Economic self-sufficiency?   It all started going downhill after the repeal of Smoot-Hawley.  Yikes!

And, of course, there is immigration:

"We affirm the integrity of the international borders of the United States and the Constitutional authority and duty of the federal government to guard and to protect those borders, including the regulation of the numbers and of the qualifications of immigrants into the country.Each year approximately one million legal immigrants and almost as many illegal aliens enter the United States. These immigrants – including illegal aliens – have been made eligible for various kinds of public assistance, including housing, education, Social Security, and legal services. This unconstitutional drain on the federal Treasury is having a severe and adverse impact on our economy, increasing the cost of government at federal, state, and local levels, adding to the tax burden, and stressing the fabric of society. The mass importation of people with low standards of living threatens the wage structure of the American worker and the labor balance in our country.We oppose the abuse of the H-1B and L-1 visa provisions of the immigration act which are displacing American workers with foreign.We favor a moratorium on immigration to the United States, except in extreme hardship cases or in other individual special circumstances, until the availability of all federal subsidies and assistance be discontinued, and proper security procedures have been instituted to protect against terrorist infiltration."

The immigrants are going to take our jobs and lower our wages.   For libertarians, this is all just wrongheaded.   Of course, many conservatives probably support this.

The Constitution Party is all in favor of banning gambling, drug abuse, and pornography.   Though they thankfully seem to understand that it is up to state and local governments to carry it out, though the Federal government is going to keep drugs from entering the U.S.   This is all anti-libertarian.   Of course, conservatives may like this better than libertarian tolerance.

The platform also calls for outlawing fractional reserve banking.   Thankfully, it does no more than mention in passing that the Federal Reserve is private before calling for it to be banned.   They call for a debt free and interest free monetary system.    While not anti-libertarian like banning fractional reserve banking, it is plainly pointing to bad monetary theory as Castle also discusses in his audio file.   

As for taxes, they are all about the "tax patriot" nonsense, expressly claiming that the 16th amendment does not do what it plainly was meant to do--allow for a personal income tax.  They support a corporate income tax.  Why?  More tax patriot nonsense.   Is such a tax good?   Who cares?  The Supreme Court decision allowing such a tax plays a role in the wacky theories that wages are not subject to income tax.

Frankly, when I read the Constitution Party website, I begin to wonder if Donald Trump hasn't been reading it too.