Comment Rescue: Advantage and the breakdown in Bretton-Woods

This is a long comment by Ramblin’ Rod, that really belongs on the frontpage. JamesK and anyone else who wants to give a sustained reply to this can reply here instead of adding to the comment thread in the original post.

by Ramblin’ Rod

Here’s my  big post on trade, as promised. I’m a huge fan of both trade and free markets. Sure would like to see me some. While I agree in principle with the libertarian ideal of no tariffs, quotas, etc., I’d also like to see them pay some attention to the huge subsidies we currently lavish on foreign imports. It’s all about money and the Federal Reserve. To understand where I’m coming from, let me develop the argument:

Ricardian Comparative Advantage is basically a theory of barter. English cloth for Portuguese wine. Each country’s comparative advantage lay in a combination of natural advantages such as climate and developed expertise in the respective industries. These advantages are really differential advantages in productivity. TMK, it didn’t address the question of absolute advantages in such things as wage levels. And, as noted above, it didn’t really address the issue of trade conducted through the medium of money.

Smith, on the other hand, explicitly addressed the latter issue and the concerns of mercantilists who worried about all the money going overseas due to trade deficits. It’s important to note that Smith was a strict metallist about money. To him, money was gold and gold was money, full stop. So in a sense, Smith’s theories were also about barter with gold serving as the universal trade commodity. It’s often claimed that Smith definitively proved that trade deficits didn’t matter. That’s not really the case. Actually, Smith’s thesis was that trade surpluses and deficits were self-correcting and therefore no governmental intervention was necessary. The mechanism was fairly simple. If country A was running a trade surplus with country B then money (gold) would pile up in country A and become relatively scarce in country B. This would cause the general price level to rise in country A and fall in country B, which would then make exports from B to A more attractive until a new balance was achieved. A second part to his argument was that trade is never really just bilateral and so it’s silly to worry about trade balance with any particular country since gold can and would be repatriated by more circuitous routes.

Of the two arguments, the second is the most sound. Just as you’re not going to lie awake nights worrying that the grocery store that you’re constantly spending money in rarely if ever buys anything from you, there’s no reason to worry about the balance of trade with any particular country (i.e., China). However, there’s a big problem with this first argument. Perhaps he didn’t understand the dynamics or just chose to ignore them* but, to put it succinctly, deflation sucks. Big time. As a corrective mechanism it’s fairly brutal, causing an economy to plunge into punishing bouts of recession and depression. When money is becoming more valuable and prices are falling, consumers are incentivized to hoard cash in the hopes that the price of whatever they may want to buy will be cheaper next week, next month, or next year. Consumer demand drops, production falls off, unemployment rises, even fewer people have money to spend, and it just all goes into a death spiral. Eventually, prices bottom out and the economy recovers, but in the meantime a lot of people suffer.

 

Recognizing that this dynamic was less than ideal, yet desiring the gains from international trade, the major industrial economies of the world entered into a post-WWII agreement, largely devised by Keynes, called the Bretton-Woods accords. It established a system of fixed exchange rates relative to the dollar which, in turn, was pegged to gold at a value of $35/ounce. This also established the IMF which served as a mechanism for smoothing out imbalances in trade and currency flows. I’d be lying if I said I totally understood exactly how this all worked. But the result was that from the signing of BW, until it’s eventual repudiation by Nixon in 1973, the U.S. maintained an overall trade balance, with only little temporary blips of surplus and deficit.

Was it a good plan? In the sense of doing what it was designed to do, yes. During that time we experienced no major deflationary recessions, certainly nothing like what we’ve seen since then. But my sense of it is that it was unsustainable long-term, and many (most? all?) economists believe it was responsible for restraining growth. Personally, I think it’s a case of right diagnosis, wrong cure. And that wrong cure was motivated by a continuing belief in “sound”, metallic-based, currencies, a belief that almost no reputable, mainstream, economist currently holds.

Since the collapse of B-W in 1973 at the unilateral hand of Nixon (dubbed the Nixon Shock), the U.S. has run a perpetual and growing trade deficit. That’s also the exact point, that I term the Great Divergence**, where a number of important indicators suddenly shifted. Wages, which had previously closely tracked productivity growth, stagnated. The overall CPI, which had for the entire post-war period ran at a pretty consistent 2.3% rate of inflation, suddenly shifted permanently to 4.3%. This is also the point at which the CPI for professional services–medical, legal, educational, financial, etc.–diverged sharply from the overall CPI. I’ve posted the graphs before and they’re stunning. Just this really sharp knee-bend from one constant rate to a different subsequent constant rate. Inequality, as expressed by the GINI coefficient, which had been steadily declining over the twentieth century started to sharply rise in the ’80s. The correlation with the Nixon shock isn’t as clear, but given all the other indicators I find it hard to believe that it isn’t a lagging indicator from the same root cause.

So what’s the mechanism that ties all this together? Well, it’s interesting to note that the latter half of the ’70s were characterized by an economic phenomenon that had the econ professors scratching their heads. Stagflation. A period of relatively high inflation and high unemployment, despite high interest rates (typical mortgage rates were in the low teens). These aren’t supposed to go together. It wasn’t until Volker took over the Fed under Reagan, clamping down on the system with high Fed funds rates and triggering the ’82 recession that inflation was brought under control. I’m not entirely sure what all the Fed was doing in that period (since the Fed’s operations are notoriously opaque) and subsequent that’s different from earlier eras, but the result has been relatively modest base interest rates combined with a strong dollar policy.

This strong dollar policy is precisely the stealth subsidy to imports that I referred to way, way, way up above (sorta gave up on me getting back to that, huh?). Have we had stronger growth? Maybe. That’s not clear. But we sure have had bubbles, huh? My own pet theory here is that the Fed is managing money basically the same way it always used to without really taking advantage of the fact that our currency is now fiat. But that failure isn’t accidental, since the Fed is owned by banks and our financial sector (Wall Street) has done very well under this new regime, thank-you very much.

So what would real free trade look like under a fiat currency regime assuming the goals of B-W still operated (i.e., avoiding punishing deflationary recessions)? Simply allow dollars to flow overseas and make up the difference through deficit spending without calling it that. Just spend whatever extra you need from printed dollars to keep the domestic money supply stable (with a modest inflation bias) and don’t figure it as debt that has to be repaid. Because it doesn’t need to be.

The result of such a policy would be dollar devaluation overseas which would make imports more expensive and exports more competitive, realizing the mechanism outlined by Smith oh so many years ago, while avoiding the harsh medicine of domestic deflation. You couldn’t do something like that with gold-backed currency but there’s no reason not to do it with fiat money.

* Smith was pretty plugged into the moneyed elite of his day. Deflation is great for creditors like banks, so it’s easy to understand if he had a blind spot for that.

** Various writers use this term to describe the divergence between productivity and wage growth and others use it to describe the subsequent rise in inequality that became evident in the ’80s moving forward.

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17 thoughts on “Comment Rescue: Advantage and the breakdown in Bretton-Woods

  1. Isn’t that already your current policy? The fed already prints more money in order to stave off deflation right?

    I think the problem happens when you don’t have a mechanism to stave off excessive inflation if money ever decides to come back home. In Singapore, we absorb excess money by increasing taxation or reducing spending. This keeps price levels on a constant to very modest inflation rate.

    • Thanks for posting this to the FP Murali. I have no idea if Rod is OK with this, of course, but it’s a pretty damn good comment. It’s one of those comments I often read where I’m saying to myself “yes! of course!” or “excellent point!”, but am completely incapable of articulating why I’m so enthusiastically agreeing. I’m hoping some discussion might help me figure that out.
    • Isn’t that already your current policy? The fed already prints more money in order to stave off deflation right?

      Well, as far as I can tell, not really. There were quite a few breathless prophecies of hyper-inflation when the Fed announced a round of “quantitative easing” back in 2009(?), so I have to assume that was a more-or-less unprecedented move.

      This really gets into how money is created and put into circulation. Normally, base money is “created” when the Fed loans money to member banks. (I guess since it’s a loan it doesn’t count as “printing” money.) The bulk of our money supply (M2) is created by commercial banks through the extension of loans to customers. Almost all, like 95% or so, of our money supply is created that way.

      That’s right. Almost our entire money supply is earning interest for the banking system simply by existing. There’s simply no other way to interpret this system.

  2. I’ve been mulling over this post Rod, and I have a few thoughts.

    First off, this is a bit nit-picky but you have a few historical details wrong, and while they don’t affect the thrust of your argument, I thought I’d clear them up before I addresses the substance of your post:

    1)

    That’s not really the case. Actually, Smith’s thesis was that trade surpluses and deficits were self-correcting and therefore no governmental intervention was necessary. The mechanism was fairly simple. If country A was running a trade surplus with country B then money (gold) would pile up in country A and become relatively scarce in country B. This would cause the general price level to rise in country A and fall in country B, which would then make exports from B to A more attractive until a new balance was achieved.

    While Smith did believe this, he didn’t invent it. It’s called the Price-Specie Flow Mechanism and was invented by David Hume, a close friend of Smith’s.

    2)

    Smith was pretty plugged into the moneyed elite of his day. Deflation is great for creditors like banks, so it’s easy to understand if he had a blind spot for that.

    Not really, Smith was an academic, and at this point in history the primary money interested were the guilds and the aristocracy, nether of which Smith had any fondness for.

    3)

    It’s important to note that Smith was a strict metallist about money. To him, money was gold and gold was money, full stop

    Technically he would have though of Silver as begin synonymous with money, not gold as Britain was on the silver standard. And the primary reason Smith was a metallist is because that was the only kind of money there was in the late 18th Century.

    OK, with the pedantic stuff out of the way, I can talk to your key points.

    A)

    However, there’s a big problem with this first argument. Perhaps he didn’t understand the dynamics or just chose to ignore them* but, to put it succinctly, deflation sucks. Big time. As a corrective mechanism it’s fairly brutal, causing an economy to plunge into punishing bouts of recession and depression. When money is becoming more valuable and prices are falling, consumers are incentivized to hoard cash in the hopes that the price of whatever they may want to buy will be cheaper next week, next month, or next year. Consumer demand drops, production falls off, unemployment rises, even fewer people have money to spend, and it just all goes into a death spiral. Eventually, prices bottom out and the economy recovers, but in the meantime a lot of people suffer.

    In theory this could be a problem, but in practice the movement of money would prevent the imbalance from getting very large in the first place, so I don’t think this is something to worry about.

    B)

    I’ve posted the graphs before and they’re stunning. Just this really sharp knee-bend from one constant rate to a different subsequent constant rate. Inequality, as expressed by the GINI coefficient, which had been steadily declining over the twentieth century started to sharply rise in the ’80s. The correlation with the Nixon shock isn’t as clear, but given all the other indicators I find it hard to believe that it isn’t a lagging indicator from the same root cause.

    Attempting to determine causation is one of the most difficult and dangerous things one can attempt in the social sciences. In this context, it can only be performed with any hope of success through the use of complicated statistical techniques. There were so many things going on at that point of time that obvious explanations are mostly likely very badly wrong. For instance, my guess as to the cause of the Great Divergence is actually the cost of providing healthcare.

    C)
    And then there’s your primary argument – that the Fed is deliberately pushing the value of the dollar up for some unknown reason. I simply don’t see it:
    i) First off it would be a first. I’ve never heard of a government trying to make it’s currency stronger before, political pressure is always in the other direction.
    ii) The Fed’s behaviour is wrong. You make a currency stronger by having high interest rates, and while interest rates were pushed up in the 1980s to fight inflation, the Fed has been playing monetary policy very loose for a decade.

    • James, you suggest the cause of the Great Divergence is due to the cost of healthcare. Is there evidence for that? What happened in other countries when they went to Uni HC models? Have other countries suffered a Divergence and is possible to locate a cause for that? I know, I know its a Friday night, can’t i think of more econ questions. Well no.
      • I was overstating a bit. I think it might be a significant part of it (it would take a full-blown research project to be sure). The thing that led me to wonder was a piece Cato did a while ago (which I’ve had terrible trouble locating again) suggesting that wages growth wasn’t at all stagnant if you accounted for the values of people’s benefits, rather than just their cash incomes. And what’s the most expensive benefit most people have?

        But other Anglo-Saxon countries have had some divergence at least. There are two other factors that are likely in the mix somewhere – the Superstar Effect (globalisation had given some people the ability to make money of a much larger group of people), and the lowering of tax rates since the 1970s leading to people hiding less of their income.

    • In theory this could be a problem, but in practice the movement of money would prevent the imbalance from getting very large in the first place, so I don’t think this is something to worry about.

      Don’t you mean the inverse: that in practice this could be a problem, but in theory not? I mean, there’s evidence of this, isn’t there? Which is Rod’s point, I take it.

      Attempting to determine causation is one of the most difficult and dangerous things one can attempt in the social sciences. In this context, it can only be performed with any hope of success through the use of complicated statistical techniques. There were so many things going on at that point of time that obvious explanations are mostly likely very badly wrong. For instance, my guess as to the cause of the Great Divergence is actually the cost of providing healthcare.

      If causes are hard to determine without lots of statistical modeling, and most explanations are badly wrong, then why do you feel comfortable saying it’s caused by the healthcare? That seems inconsistent with your previous statements on the topic.

      And then there’s your primary argument – that the Fed is deliberately pushing the value of the dollar up for some unknown reason.

      I thought his primary argument was that the Fed was doing monetary policy as if the dollar wasn’t fiat currency when it in fact is. That’s the real insight of this post, it seems to me. The one I’m most curious about, and hope people comment on.

      • Don’t you mean the inverse: that in practice this could be a problem, but in theory not? I mean, there’s evidence of this, isn’t there? Which is Rod’s point, I take it.

        Not in any country with a floating currency.

        If causes are hard to determine without lots of statistical modeling, and most explanations are badly wrong, then why do you feel comfortable saying it’s caused by the healthcare? That seems inconsistent with your previous statements on the topic.

        Fair point. When I say “guess”, I mean that it’s a working hypothesis. I’m not confident I’m right, but it’s worth further study. In practice it will probably be a lot of things working together, because that’s how these things usually turn out. I just think healthcare is an under-appreciated part of that.

        I thought his primary argument was that the Fed was doing monetary policy as if the dollar wasn’t fiat currency when it in fact is.

        But you can’t really do monetary policy with non-fiat currencies.

    • For the primary arguemt, I think the Fed is doing what Rod wants them to do already, though with a bit too low of an inflation target for my tastes. I’d like to see them hitting 4ish instead of 2.

      On the great divergence thing, there is just so much going on over the same period that I think it’s very specious to put it on the collapse of B-W. The assimilation of women into the workforce over the same period comes to mind as a more obvious reason for a major change to wage levels, and one that happens gradually over the course of the divergence.

      Health care costs are a consequence, not a cause IMHO, of the vast increases in productivity.

    • Thanks for the comments. Let me reply by number:

      1. I confess I haven’t read Hume, so I assume you’re correct. As you say, it makes no difference to my thesis. Simply means I read it in Smith.

      2. Okay, maybe. Whatever. It’s not the impression I got from other readings but again, doesn’t matter much either way.

      3. It’s been awhile, he may have said something like ‘quantity of gold or silver by weight’. Depending on time constraints I may try to look that up again. It’s possible that I’m remembering a passage from his chapter on trade where a statement like that would sort of make sense. A Spaniard, for instance, taking English coins for payment could easily be seen accepting them on the basis of their metal content alone since Pounds per se wouldn’t have any particular value in Spain. Maybe. Commodity money just worked different from modern money which is a central part of my argument.

      A. You really need to flesh out what you mean by “movement of money”. For what purpose and what manner of transaction between which parties?

      B. The shifts in the overall and sectoral CPI numbers, as well as the divergence of wage growth from productivity gains, is all at exactly the same time. Not “the 70′s” but 1973. Drawn at the scale of 50 years or so, the graphs look like two practically straight lines that meet at that year. Like a bullet ricocheting off a rock.

      Your point about the hazards of ascribing the rise in income inequality to this phenomenon is well taken. I’m actually attempting to move away from the standard liberal explanations (demise of unions, free-er trade agreements, lowering of top marginal tax rates, etc.) that irritates libertarians so much by proposing an alternate causal chain. Not saying it’s right necessarily; just that it’s possible and worthy of consideration. Also, income inequality isn’t the primary focus of my thesis, just one of many possible (probable?) eventual consequences of the breakdown of B-W.

      The story I propose goes like this. For whatever reason, good, bad, or indifferent, B-W collapses under Nixon and the U.S. repudiates the gold standard. Our balance of trade turns immediately, and so far at least, permanently to deficit territory. The immediate consequence of this unique and unprecedented event is a similarly unique and unprecedented phenomenon, stagflation*, characterized by both high unemployment and high inflation. Paul Volker apparently gets the inflation situation under control by seriously raising the Fed funds rate. Then we enter a period, that we’re still “enjoying” of a bubble-fed economy. It’s not really the Fed’s fault, since they have a mandate and it’s the only way to meet that mandate, since they’re not getting any help on the fiscal side for political reasons. The alternative is to let the economy slide into prolonged doldrums ala Japan’s lost generation.

      C. It’s only partly a matter of policy. The status of the dollar as the primary world reserve currency, as well as the primary currency for the oil market, has served to keep the dollar unnaturally strong. Foreign banks are perfectly willing to hold dollars regardless of opportunity to spend them on U.S. goods.

      Keep in mind, though with your point (i) you’re assuming something of a mercantile trade policy. The political pressure in the U.S., since the ascendancy of the Reagan conservatives has been the exact opposite ever since the money guys realized how much scratch was to be had from outsourcing. Don’t underestimate the extent of jingoistic feelings here. A “strong” dollar equals a strong country in many minds.

      Your point (ii) is correct in theory but is offset by the strength of the dollar as a consequence of its reserve currency status as I mentioned above. It’s been a balancing act to keep the dollar strong overseas which makes Wall Street happy since our major corps are primarily import companies while injecting enough liquidity into the domestic economy to stave off deflation.

      Without making any moral judgments or whatever, the fact is that our trade deficit is simply unsustainable. When it crashes it’s gonna hurt like hell for a long time.

      * How did the Nixon shock cause stagflation? IDK, does anyone? Seriously I’ve never heard a good explanation for that.

      • On point A – the exchange rate shifts to corrects for any imbalances as they happen. If a country imports more than it exports then money starts to flow out of the country, and exchange rates change to make the money that is left in the country more expensive to any foreigner wishing to obtain it. This slows the flow of money out an encourages more money back in. The flows of money in and out have to balance (with one exception, which I’ll get to below), since a country’s currency is only good for anything inside that country. A country can only run a trade deficit if some other source of money is flowing in, like investment capital.

        The exception is if foreigners want to hold your currency as an asset. If this is the case, you have turn your printing presses into an export market, with the government as the beneficiary. Your Budget deficit is a little lower than it otherwise would be thanks to your country having the world’s reserve currency.

        Without making any moral judgments or whatever, the fact is that our trade deficit is simply unsustainable. When it crashes it’s gonna hurt like hell for a long time.

        Son long as people see the US as a desirable place to invest, it can be sustained indefinitely. Otherwise, it will end at some point. How bad that is depends on how long it takes for the investment flow to die away. The slower that happens, the easier things will be.

        How did the Nixon shock cause stagflation? IDK, does anyone? Seriously I’ve never heard a good explanation for that.

        Stagflation was a product of Old Keynesian fiscal and monetary policy, Nixon was just the point were it came to a head. The trouble is that policy makers at the time were operating under the original Phillips Curve, which said that high inflation = low unemployment. The trouble is that this only works if people don’t expect the inflation, and as Friedman predicted the whole thing spiralled out of control as policy makers had to keep pushing inflation higher and higher just to forestall a crash. The only solution was to take the hit and then squash inflation totally. After that things were a lot more stable.

    • For instance, my guess as to the cause of the Great Divergence is actually the cost of providing healthcare.

      If by the “Great Divergence” you’re referring to the rise of income inequality in the ’80s (which is the standard usage for that term) then our disagreement boils down to me claiming Nixon Shock –> persistent trade deficit enabled by Fed/strong dollar –> consequent effects including apparent increase in health care inflation over and above the base CPI vs. you claiming rising health care costs as an endogenous cause for an apparent stagnation of wages.

      For your claim, which to your credit you hold weakly, to hold:

      1. What then caused health care costs to suddenly diverge sharply from the overall CPI precisely subsequent to the Nixon Shock?

      2. And to do so in lockstep with legal services, financial services, and education services?

      I also question the logic of assigning increased health care costs borne by employers to the employees as increases in wages. Isn’t the idea of real vs. nominal wage growth to discount such inflationary effects?

      This breaks open, in my mind, an entirely separate discussion about our definitions and measures of inflation. You see, what I see happening here is costs rising in one sector while falling in others. Now, a priori, I see no reason to assume that costs and prices would necessarily rise and fall in lockstep with little motion relative to each other. But the assumption behind the discussion of health care costs is that there’s something really, really, wrong when health care (or education, for example) rises faster than the general rate of inflation. But it’s all yippee! cheaper shit at Wal-Mart when talking about free trade. I mean… if a third of the stuff you spend money on is getting cheaper, and another third is staying about the same, and another third is getting more expensive then the weighted CPI is naturally going to reflect the price level of that middle third. And of course, you’re going to see the prices of the last third of spending increasing faster than inflation. But it’s all just a consequence of the way you put together your CPI and that some things are more amenable to cost/price reductions due to productivity and gains from trade than others. We talk about inflation in terms of movement in the value of the currency but we measure it backwards in terms of what that currency can purchase.

      So here’s my theory… what we’re really seeing is a base or shadow rate of inflation that’s actually several points higher than reported in the official numbers because the way we calculate those official numbers combines that base rate with deflation in other sectors. There is no actual health care cost crisis. It’s completely an artifact of the way we measure inflation combined with deteriorating wages for the lower and middle classes caused by the persistent trade deficit.

      Furthermore, the Social Security “crisis” is wholly a symptom of deteriorating wages for precisely those workers that contribute the bulk of the SS revenues. If wages had kept pace with inflation since 1973 at the same rate they did for the entire post WWII period up to that year, someone like me would be currently making about twice as much as I currently do. In fact, someone like me did make twice as much in real wages back in the ’70s. Without the wage stagnation from the trade deficit how much more would currently be sitting in that SS trust fund? We wouldn’t even be discussing it.

      • It’s also worth asking whether it’s a “cost crisis” or merely a spending increase. People spend a lot more money on telecommunications services in 2012 than they did in the 1970s, but nobody considers that to be a crisis because it’s obvious that there’s simply more to buy in that area.
      • That’s a great point, Duck. It’s amazing to consider that only a hundred years ago, you were fairly likely to die of the most routine infections because antibiotics hadn’t yet been invented. My wife was born in 1963, three months premature, and she was considered a miracle baby because infants that preemie hardly ever survived. Now it’s considered fairly routine to save such kids.

        Sometimes we forget really basic things like why we’re supposed to care about productivity in the first place. Because being more productive in making A, B, and C allows us more labor and resources to producing D, E, and F. And then D, E, and F are just naturally, according to fundamental laws of economics, going to be precisely those products and services which are least amenable to industrial productivity gains. The fact that we’re spending a higher portion of our incomes on things like healthcare and education isn’t a problem to get all strung out about. It’s actually a result that we should be cheering as a happy result of an advancing economic system! Yeah, Capitalism! All we have to work on is the distribution angle.

      • You make some good points, and you’re right there are clearly other forces at work here. I don’t have the answers to most of the questions you raise, and I think this definitely an area where more research is needed.

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