In the meantime, courtesy of the folks at Division of Labor, here is a story of how bank regulations “help” small businesses.

In July 2010, the FDIC slapped Main Street with a 25-page order to boost its capital, strengthen its controls and bring in a new top executive. Regulators also said the bank was putting too many eggs in one basket. Mr. Depping says regulators wanted the bank to shrink its small-business lending to about 25% of the total loan portfolio, down from about 90%.

Sounds prudent right? However the bank was set up for the sole purpose of making small loans to local businesses. No commentary today and I encourage you to think of ways the regulators could be more helpful (if at all), we are headed out to Schoodic Point for a hike and a paddle.

(This presentation originally appeared in the Fall 2009 issue of the Mich-Matist of the Michigan State Numismatic Society.)

No mythology faces fewer challenges than the folktale of The Great Depression.  The Austrian economist, Ludwig von Mises, pointed out in Human Action that capitalists and socialists usually agree on the raw data, but then disagree on what the facts mean.  In 1929, the New York Stock Exchange recorded dramatic price collapses on October 24 (“Black Thursday”) and October 29 (“Black Tuesday”).  What is missing is a connection between the NYSE of October 1929 and the banks of Detroit in February 1933.  It was there, in Detroit, on February 14, 1933, 40 months later, and 600 miles away, that the bank failures of the Great Depression began.

To be sure, bank failures were common in the years before 1929-1933 – and so were bank openings. From 1884 to 1921, the number of banks had sextupled from 5000 to 30,000.  Not only were these generally small banks – some capitalized near the minimum $25,000 – but after 1921, the new operations were often branches.  The federal Comptroller of the Currency had opened the door to allow city banks to compete in towns and villages.  From that point, bank failures increased, as is to be expected from increased competition.  In January 1933, it seemed that the summer of 1931 had been the lowest point possible and that a recovery was unfolding.  Speaking to a United Press reporter in Dearborn, on February 1, 1933, Henry Ford called the period 1923-1929 “the real depression.”

At that time, two holding companies dominated finance in Detroit.  One was the Detroit Bankers Company Group.  The other was the Union Guardian Group, colloquially called “The Ford Group.”  When the Union Guardian Group experienced pressure from withdrawals, it turned to the federal government for a loan.  However, the Reconstruction Finance Corporation required that the Fords subordinate $7 million that the banks owed to them, which Henry Ford refused to do.  President Herbert Hoover set up a meeting with Ford, Arthur Ballantine (Under Secretary of Treasury) and Roy D. Chapin (Secretary of Commerce).  Chapin was a former Oldsmobile executive and co-founder of the Hudson Motor Car Company.  He appealed to Ford as a fellow manufacturer.  Ford replied that Hudson stock was traded on the NYSE, which Ford’s was not, and that a washout of the banking industry seemed inevitable.  Chapin replied that if people do not have money to buy cars, Ford was in for hard times himself.  Ford said that he felt young enough to start over from scratch.  Ford said that everyone else ought to be prepared to get up a little earlier and work a little harder.  He also said that he would withdraw his $25 million from the banks in the morning.  He did not get to do that.

The next morning, February 14, 1933, Michigan’s governor, William Comstock, declared a banking holiday.  The proclamation had been signed at 1:00 AM, published, and delivered to bankers when they arrived for the start of the business day.  Two weeks later, outgoing President Hoover hesitated to declare a national bank holiday, so the newly-inaugurated President Roosevelt did just that.  On March 21, 1933, the Michigan Legislature passed the McNitt-Green bill, granting the governor “dictatorial powers” over banks.  Unlike Hitler, Mussolini, and Stalin – to whom he was favorably compared by newspapers in those troubled times – Gov. Comstock had modest goals and eventually declined further powers to control the insurance industry as well.

Similarly, when folks discuss the problems with inflation (a general and sustained rise in all prices) and deflation (a general and sustained fall in all prices) they seem to think that people on only one side of the market matter. For example, one common defense of inflation is that if consumers expect prices to rise in the future, that will stimulate them to increase consumption today. Then, if one holds the erroneous view that consumption is what drives prosperity, you might conclude the expected inflation is a good thing because it acts like a regular economic stimulator.

Aside from the macroeconomics being wrong here the microeconomics is wrong. What this idea forgets is that there is an entire half of the market whose behavior is likely to change if higher prices are to be expected. Remember the producers! If prices are expected to be higher next year than this year, it is entirely plausible to think that producers will want to build inventories and withhold selling some goods and services until the future when prices (and profits) would be higher. This would cause a decrease in supply today, putting even more upward pressure on prices and downward pressure on employment and economic activity. In the extreme, if producers were 100% confident that prices would rise considerably, it might even be profitable to fire all workers today, only to hire them in the future when profits will be higher. Not only would consumption fall, it would plummet to zero. So which is true? I don’t know, but the simple Keynesian idea that spending increases will necessarily come from inflation are again a big giant blinking red light that reads, “Warning: Priceless Economics Ahead.” Priceless here in the sense that they are ignoring how prices impact the other side of the market.

The same idea holds for deflation. The fear of many macroeconomists and those who read the modern popularizers of Keynesian ideas, is that if prices begin to fall, and consumers expect them to fall, that people will hold back consumption of goods and wait until prices are even lower in the future. This will leave (supposedly helpless) firms with no ability to sell goods, and the lack of consumption and sales will put the economy into a depressionary spiral. Leave aside the obvious problem with this fact from the consumers’ standpoint that expected declines in the prices of certain goods in the economy seems not to have limited the purchases of those goods. For example, my two year old laptop was twice as expensive and half-as-fast as a new model that could be had today. Same for my iPod, or even models of cars, bicycles, ice-skates, hockey sticks, and the like. But ignore that behavior. Once again, these deflation fears ignore the fact that when prices are expected to fall, producers have an even stronger incentive to unload their inventories today, and to sell as much as they can while prices are still higher than they expect them to be. Again, which effect is bigger, I have no idea. But it doesn’t follow from the fact that prices today are lower than in the past that the economy is set to go into a free-fall. That general improvements in economic productivity have not plunged economies into depressions seems to suggest that what is understanding what is happening on the producer side of the market is as important as how consumers react to changing prices.

I find it regularly puzzling that in certain applications producers are completely overlooked, while in others they receive the only attention (e.g. in trade discussions) while consumer desires and behaviors get completely ignored. Bonus points to any student who can advance a consistent theory that explains these attention deficits.

Of course, in a normal world, producers facing increased inventories would figure out a way to lower prices to get rid of the excesses, but in the Keynesian world, both prices and wages are sticky, so they cannot adjust downward fast enough to equilibrate supply and demand. Thus, we have a shortfall in “Aggregate Demand.” You know what comes next – governments should run massive deficits to make up for this demand shortfall. I do not intend to analyze this point, but rather I’d like you to think about the implications for this in terms of the monetary system we use.

The underlying problem according to the Keynesians is not that people hoard “money” per se, but rather that they are hoarding something that is not “produced.” Well, is that not a wee bit a function of the printing of money and even moving to a fiat system? Granted, even under commodity standards the amount of gold in circulation was small (because banks and their customers found it far more convenient to use bank notes and warehouse certificates that represented stocks of gold), but this does provide us with a framework for dealing with money demand increases without having to rely on the awesome omniscience of the fiscal authorities to stimulate the economy every time there is a downturn. So, perhaps one way to reform the system is to move to a currency that is backed by large percentage reserves of physical goods and services. I mean more than just gold. I mean beer, oak trees, maple syrup, bricks, and precious metals.

HT on Image to Jeffrey Ellis

This reform would have two benefits:

1. For those who find fractional reserve banking unstable and undesirable, the large reserve requirements would provide a strong measure of insurance for the safety and soundness of the payments system.
2. When demand for “money” increases in this world what we would see is not a decrease in “Aggregate Demand” as the Keynesians argue, but instead a shift in consumption from some goods (like cars and TVs) and toward other goods (like beer and maple syrup). The shift toward the beer and syrup would happen naturally since the increase in money demand would require an increase in the amount of base commodities supporting these new holdings of paper. And, if you like in the Keynesian world, such a reform should be seamless – after all, for the Keynesians, it does not matter where the demand is directed, just so long as it is there. If you wish to dispute that last point and you claim to be a Keynesian, then you are going to have an awfully tough time defending fiscal stimulus that is not perfectly targeted to the industries where demand has been declining for irrational reasons.

In summary, a high reserve commodity backed currency would contain an implicit “aggregate demand” stimulator in it without having to rely on the fiscal side to do our bidding. This sort of thing should be attractive to Keynesians, who, after all, support the idea of government welfare programs as counter-cyclical fiscal policy measures that obviate the need for additional stimulus during “normal” business cycle down-turns.

And that leaves us with an open question: in the Keynesian mind, is there ever just a “normal” downturn that does not require stimulus beyond the automatic stabilizers?

Without getting into the details, I wanted to react to what requirements the classical gold standard imposed on countries. Each country on the standard had to relinquish direct control of its domestic money supply (imagine the Fed for example saying that, “we’ll leave it up to gold flows to determine prices in our country”). It did this by fixing the price of gold in relation to its domestic currency unit, and standing ready to redeem its notes and obligations for gold upon demand. If each c0untry did this, then it follows that this is a system of fixed exchange rates. To illustrate one of the many fixed bilateral rates, the dollar price of gold was $20.67 per ounce and the pound price of gold was £4.25 (I think) per ounce. Hence the $/£ exchange rate was fixed at $4.86. Americans with dollars could, whenever they wished, present them to issuing banks in exchange for specie, and this specie could then be used to purchase foreign currencies at the specified rates.

For the system to work (perhaps I’ll diagram some mechanics in a future post) it required that many (all?) countries participated. It also required that each participant rigidly stick to the rules. If for some reason your banks or central bank were being careless with their note issuance (and hence domestic prices would rise) they had to permit customers to convert their notes into specie and use those funds outside the country. This action would result in gold outflows in the inflationary country (which forces banks to contract and hence prices to fall back down) while it would result in gold inflows to the other countries. So, for this system to work, the “other” countries had to allow the gold inflows to come in and allow domestic prices to rise as a result.

Similarly, there could very well be an outflow of gold from a country that was behaving quite well, if for example, there was an improvement in productivity driving prices lower in other countries (or if they were experiencing true deflations). This latter requirement is particularly painful, as there are a variety of mechanisms through which allowing deflation in your country could lead to serious problems in the real economy. One such possibility is debt-deflation induced bankruptcies putting serious pressure on the solvency of underlying financial institutions, leading to serious credit tightening, and a downward spiral of reduced aggregate demand and prices (let’s discuss that another day). My point is that countries had to swallow hard and bite the bullet as these sorts of events were staring them down.

Yet, the classical gold standard seemed to work remarkably well for that 40+ year period. And such a standard could only have worked well with incredible amounts of global cooperation AND discipline in the face of some potentially unpleasant circumstances that were perhaps no fault of your own, and with interest group pressures breathing down policymakers necks. That it worked as long and as well tells me two things. First, that is simply a remarkable achievement, and it showed a remarkable faith in allowing market forces to determine the “right” amount of money across countries. Second, this seems to demonstrate that massive global coordination to deal with hard problems is possible.

Let me repeat that – nearly 150 years ago we lived in a world where extremely disparate countries that could not communicate well with one another given the technologies of the day were able to commit to a challenging, sometimes painful, global monetary arrangement that ended up contributing to an enormous flourishing of global trade and prosperity. My take on this is that when there is a good idea out there, sometimes it is possible to defeat nationalistic tendencies.

What’s the deal with Gaia? Well, if one subscribes to the view that the only way to save the Earth from destruction is to massively reduce global carbon emissions, then such a plan would require a global commitment not unlike what we saw a century and a half ago. For some countries the commitment would be less of a burden than for others. But every country would face the temptation to shirk on their agreement, much like countries during the classical gold standard had the regular temptation to devalue their own currency (for example, if London had devalued the pound, say by allowing the domestic price of gold to rise to say £6 per ounce that would have led to a surge in exports as citizens from other countries would be able to secure more British currency for any particular amount of domestic currency they started with – this would lead to the UK piling up gold while selling lots of stuff to foreigners for low prices … sound familiar?). Such shirking could easily lead to beggar-thy-neighbor responses and a large global inflation to follow. But it did not happen. World War I changed things.

The nations of the world at the time overwhelmingly saw the benefits of adhering to such a program and they committed to it. In order to get global cooperation on global warming action, my sense is that the benefits are going to have to be even more apparent than offering up a stable monetary system that prevented global inflations from causing problems. Even for the most hard-core “alarmist” I think the writing should be on the wall. It’s very unlikely that this will happen in any foreseeable future especially considering that the best course of action is not a massive global tax on carbon, but instead something else, something that we are perhaps unaware of.

I am not much interested in policy complications and what is really “needed” to get global cooperation, but I am very interested in understanding what our choices reveal about our values and expectations – and this applies to “countries” as much as individuals.

What is wrong with this story? Well, it confuses a change in relative prices with a rise in the overall level of prices. Given a fixed amount of goods and ability to produce, the only way the price of everything can rise is if there is an increase in the amount of purchasing media available to purchase the same stock of goods. If there is no more money around, then it is not possible for prices to rise.

However, if the stock of money is unchanged, and somehow it becomes more difficult to produce the goods and services we desire (say, for example, by having some benevolent organization increase regulations required to be met when you decide to produce), then certainly prices will rise across the board.

But my suspicion is that when you hear a comment like, “increases in oil prices will lead to inflation” people do not have either of these stories in mind. They simply believe in a weird “cost-price” spiral that spins out of control and we are all forced into crazy starvation unless the government comes in an puts on some price controls, or starts producing the oil and broccoli itself.

So what is wrong with the simple cost-price spiral story?

Well, it conflates the idea of relative prices with nominal prices. Put simply, if there is a fixed stock of goods around and a fixed stock of money, if the price of oil increases, it has to be the case that the price of something else must fall. Why? Well, if consumers continue to buy the same amount of oil, that leaves them with less purchasing media to buy the remaining stocks of other goods, meaning the purchasing power of the remaining media are higher – leading to lower prices outside of oil. In other words, unless the government runs the printing presses when oil prices increase, it would be odd to expect the prices of other things to increase. I am definitely leaving out important parts to this story however.

To make the point clearer, suppose the world was limited to two goods: oil and broccoli. And that one hour of work effort produced ten units of broccoli and one hour of work produced one unit of oil. In other words, the “price” of one broccoli is 1/10th of a unit of oil while the “price” of oil is 10 broccoli’s in the very real sense that if I dedicate an hour of work to one, I am giving up an hour of work where I could have produced the other. So, what does it mean if oil gets more expensive? It would mean that with an hour of work effort, I could secure less oil than before (there are many reasons this might happen). Imagine this happens. Now, with one hour of effort, I can produce only 1/2 a unit of oil but with that same effort I still could have produced 10 broccolis.

What has happened to prices after this oil shock?

Now, the price of oil has indeed risen. It has risen from 10 broccolis to 20 broccolis, just as “conventional wisdom” would suggest. But now, what has happened to the price of broccoli? It has fallen. With the time required to get one broccoli, you are now only sacrificing 1/2oth of a unit of oil instead of 1/10th of a unit. In other words, relative prices change.

Note however that this does not imply that the oil price increase makes us better off. But what it does mean is that not all prices increase because the oil price increases. If they do, that is a sign that Santa Claus is not playing nice. But we would never expect that to happen, right? So it just has to be the case when we see an adverse shock, that markets must make then worse, allowing the chaotic, no one in control market to fend for itself would result in some crazy, anarchic price spiral of everything, where Uncle Sam the cowboy must come in a lasso it back for the good of the world.