Monetary Fallacies Jude Wanniski December 4, 1998

Supply Side University Lesson #12

Memo To: Website Students
From: Jude Wanniski
Re: Monetary fallacies

In The New Yorker double-issue of Oct. 26/Nov. 2, the magazine's financial writer, John Cassidy, authored an extremely interesting piece about "The New World Disorder." Cassidy, a British economist who was imported two or three years ago to take the post, is not only a Keynesian, but also a devoted admirer of John Maynard Keynes and his teachings. The subhead on his essay tells us: "Facing the threat of an international economic crash, policymakers are searching for a new John Maynard Keynes to put things right. They should revisit the old one." It so happens that I also am an admirer of Keynes, who is considered "a monster" by some of my conservative friends, because he is associated with the idea that government deficits are what the doctor orders when an economy goes into recession. My major complaint with Keynes is his frivolous approach to monetary policy, no doubt stemming from his belief that the gold standard prevented a monetary "solution" to the Great Depression.

Fiscal policy is something else. As I've tried to make clear at SSU, I am not at all opposed to the national government or state and local governments borrowing in order to finance tax cuts or spending projects. But they must be designed to produce a positive return on the investments in the form of a bigger, more efficient economy. Spending for government safety nets may not have positive economic returns, but part of the government function is to sustain those who can't fend for themselves. I do part company with those Keynesians who argue that borrowing from the public during a recession and using it to dig holes and then fill them up will have positive multiplier effects. It is useful, though, to go through Cassidy's piece in order to note the Keynesian fallacies that have endured, some which Keynes himself might probably reject if he read today what is being attributed to him.

1. Cassidy writes that when Keynes came to Bretton Woods, N.H., representing Britain in the conference meant to design a post-war monetary and trading system, "The American government overruled Keynes on a number of points, and he didn't agree with every detail of the final plan. Still, he believed that the new system would be a great improvement over the chaos of the thirties and the gold standard of the twenties. (Under the gold standard, countries had fixed the value of their twenties. (Under the gold standard, countries had fixed the value of their currencies in gold, and the amount of money in circulation had been limited by their gold holdings.)"

Living in London at the time of the 1929 Wall Street Crash, Keynes never was aware of its connection to the Smoot-Hawley Tariff Act of 1930 as it was passing through the Senate in the last week of October 1929. Keynes's complaint about the "gold standard of the twenties" was iue to Britain's return to a sterling/gold peg in 1925 at the pre-WWI exchange rate — which caused a painful monetary deflation. He seemed io accept the idea that the return to gold by several countries was iomehow responsible for the Crash, an idea his followers embrace to this day.

Cassidy's note that under the gold standard the amount of money in circulation had been limited by their gold holdings is not true at all. The classical economists agreed that when the central bank had earned the trust of the people, it needed no gold to remain on a gold standard. Theoretically, every country in the world could be on a gold standard, with not one government possessing any as "reserves." As the Bank of England did from 1717 to 1933 (when it was still a private bank, by the way), it merely issued bank notes to meet the demand, no more no less, and earned the handsome seignorage by doing so with scrupulous recision. The actual specie it held in its vaults was a pittance.

The error is carried in almost all standard economics textbooks. In the 1984 edition of Economics by Byrns/Stone, a Scott, Foresman elementary textbook at college level, for example, we find that the gold andard ended at the time of WWI because "the supply of gold did not keep pace with the volume of transactions in rapidly growing economies, so countries everywhere in the world abandoned the gold standard and turned to fiat (paper) money." Of course this is entirely wrong. The dollar remained defined as a specified weight of gold until it finally was floated as fiat money. Fiat money is not paper money, as the authors of is book assert. It is paper money that has no definition in gold or silver and that can be issued regardless of the demand for it. The Bretton Woods agreement had gold at its core, with the dollar defined in terms of goId and all other currencies defined in terms of the gold dollar.

2. In his article, Cassidy says Bretton Woods fell apart when its "framework came under increasing pressure as the United States, the anchor country in the system, printed more and more dollars to pay for the Vietnam War." If an American economist made this statement it would be laughable, but we chalk up to this silly error the fact that Cassidy was in England at the time and somehow assumes the U.S. blew up Bretton Woods to pay for Vietnam with fiat money. Even our Keynesians know the Bretton Woods framework came apart because President Nixon wanted the economy to grow faster to ensure his re-election in 1972. It was at this time Robert Mundell noted the impossibility of hitting two targets with one arrow. By trying to maintain the $35 gold price and at the same time trying to increase the size of the Gross Domestic Product, Nixon failed at both. The unwanted dollar liquidity force-fed into the banking system produced no economic growth, but created such turbulence as it flooded into the European economies that on August 15, 1971, Nixon closed the "gold window" to Europe's central banks — which meant they could no longer expect to convert the surplus dollars into gold or the special U.S. Treasury bonds we were selling as gold substitutes.

3. Cassidy writes that Keynes may not have "folly achieved his theoretical objectives, but in practical terms he emerged triumphant. Ever since the publication of The General Theory, governments have turned to 'Keynesian' policies to guide the course of their economies. Much of the terminology he devised in the book still is used. It is generally agreed, for example, that the Japanese economy now is stuck in a 'liquidity trap' — a situation in which consumers and businesses are so depressed that no amount of monetary expansion by the central bank can persuade them to start spending. (In a sign of increasing desperation, the Tokyo government is considering handing out gift vouchers worth about two hundred and fifty dollars to each of Japan's hundred and twenty-five million inhabitants.)"

Note Cassidy's reference to the Keynesian "liquidity trap" and how "it is generally agreed" that the Japanese economy now is stuck in one. The "liquidity trap" was the excuse Keynes developed to explain why a monetary expansion might not work. Because Cassidy and his fellow Keynesians cannot understand how Japan's central bank can have lowered interest rates to rock bottom, and yet the economy still stagnates, it is oh so convenient to dredge out the excuse of the "liquidity trap." There has been no "monetary expansion" in Japan, which is why the yen price of gold is at Y34,000 when it belongs closer to Y44,000. Cassidy and the Keynesians equate "ease" with low interest rates, refusing to revive the classical argument that money is easy when creditors are eager to lend to borrowers who are eager to acquire debt. For that to occur, the unit of account must be stable in terms of real goods. Because Keynes never developed a theory of the global political economy as a closed system, his writings are replete with loopholes such as the "liquidity trap" to explain why his theories sometimes did not work in practice. He essentially developed a theory of a closed national economy and applied it to each country one at a time. As Art Laffer once explained it to me, Keynes took his single national units and smooshed them together to make an international model. One wonders how Cassidy could write of Japan's "desperation" in handing out spending vouchers to its citizens hoping to get them to spend. This is pure Keynes, which the bureaucrats of Japan's Ministry of Finance learned straight out of the Samuelson textbooks. If printing more yen doesn't work, borrow money from the citizens and give it back to them, hoping they will spend it to get the economy moving.

4. Next we see Cassidy describing Keynes's 1942 discussion of the need  to control world capital movement as a farsighted description of the "hot money" problem that afflicts the world today. That is, Lord Keynes is calling us from his grave to institute an international system of capital controls that would direct capital to those countries that need it, not those with the best investment opportunities. No kidding: "Keynes was convinced that the movement of 'hot money,' as it is now called, has been immensely damaging during the period between the two wars. Speculative capital, instead of flowing from North America to Europe, which needed help in rebuilding itself, had flowed in the opposite direction, much of it ending up in the United States, which was running a large trade surplus. This became, in the end, the major cause of instability, Keynes claimed in a September 1941 paper, which first outlined his proposals for the postwar era. 'Nothing is more certain than that the movement of capital fluids must be regulated,' he wrote. If this didn't happen, the whereabouts of "the better ole" ' — the best place to stash one's money — would 'shift with the speed of the magic carpet and these movements would have the effect of disorganizing all steady business.'"

Cassidy goes on to say this 57-year-old passage is, "of course, a pretty good description of what has been happening in Asia for the past eighteen months." He says South Korea, Indonesia, Malaysia, the Philippines and Thailand in 1996 received about $90 billion in foreign investment. No kidding, folks, Cassidy says: ''This money wasn't really needed by these countries, which already had high savings rates and plentiful sources of capital, and a great deal of foreign capital was misused." Capital should not go to a destination chosen by the market, but by Cassidy and his Keynesian friends. If you can't see the shadow of the Soviet Union in these comments, please look again. The Soviet model, after all, was transported to Moscow from Keynes's communist followers in the London School of Economics, after Keynes died in 1947. A diluted model showed up in the United States in the early 1950s when Lawrence Klein, one of the Marxist followers of Keynes at the London School of Economics, showed up at the University of Pennsylvania. (Nowhere in Cassidy's piece does he relate the story of how Keynes, prior to his death, allowed that the world probably needed a dose of classical economics.)

Cassidy, of course, knows my arguments on how Alan Greenspan and the Fed were the source of the turbulence in Thailand and the rest of Asia. I've been sending him stuff ever since he arrived at The New Yorker at Tina Brown's behest. He even knows my argument on how Thailand was the most vulnerable of the Asian countries because MIT's Paul Krugman sold the Bangkok government on a policy of capital controls to manage the "hot money." In other words, Thailand weakened itself by taking Krugman's advice, and Krugman now is boasting that he predicted the crisis he helped initiate. The monetary fallacy is that Thailand was not importing hot capital at all, but creating more liquidity in its own currency than its domestic market was demanding — as it valiantly attempted to keep the baht tied to the dollar. In other words, it imported not hot money, but the monetary errors of a Federal Reserve that permitted the dollar to lose 10% of its value against gold between late 1993 and early 1994 by not withdrawing surplus liquidity from the U.S. banking system.

5. The need to make sure international capital goes to the right places leads Cassidy to next dredge up Lord Keynes's idea of a world central bank, which would have a new money, the bancor, which it would use "to keep the world economy expanding in much the same way that the Federal Reserve manipulates the supply of dollars to try and prevent recessions in the United States." Cassidy goes on to say: "Politically, this idea may be difficult, but economically it makes even more sense than it did when Keynes suggested it. If the Asian contagion has shown anything, it is the need for an international institution that can extend credit to developing countries when private investors are threatening to stampede for the exits." (No kidding, Cassidy really wrote this and The New Yorker published it with a straight face.) There's more: "The I.M.F., by contrast, usually arrives in a country when the stock market and the currency have already collapsed and the economy is in deep trouble. One of the invaluable lessons Keynes taught is that it is a lot easier for makers of policy to prevent an economy from falling into a deep recession than it is for them to get an economy out of a slump." WHAT? We thought Keynes was supposed to have the key to getting economies out of a recession! Now that we find it is very hard to do, Cassidy & Co. tells us Keynesianism works best when it is applied to economies that are working well.

6. Next, Cassidy solemnly asserts: "The last twenty-five years have demonstrated that in a world of unrestricted capital movement no exchange-rate regime — fixed or floating — can survive unscathed for long." Whoa... easy there, Hopalong. In the last 25 years, there has been no fixed exchange-rate regime. Either currencies floated against each other or they tried to fix to another floating currency. You can see here what I mean by Keynes being frivolous in his approach to exchange rates, thinking that as long as they were scientifically fixed, they did not need to be fixed to the real world through gold. Cassidy seems oblivious to how nonsensical his statement seems to a classical economist who knows any currency must be tied to reality to serve the interests of the world of commerce.

7. In explaining the Asian crisis, Cassidy writes: "A number of developing countries, including Indonesia, South Korea and Thailand, attempted to keep their exchange rates fixed by linking them to the dollar. This seemed like a good idea at the time, but when the value of the dollar rose sharply, between 1995 and 1997, the Asian currencies appreciated with it, and this made Asian goods more expensive on world markets. Countries in the region started to run ever-larger trade deficits as their imports outstripped their exports." This is a mish-mash. The problem was that because the Asians had linked their currencies to the dollar, they inflated when the dollar inflated against gold between September 1993 and early 1994. The dollar did not strengthen between 1995 and 1997. It did not begin to strengthen (deflate against gold) until November 1996, when the demand for dollar liquidity began to rise and was not met with increased supply by the Fed. The Asian crisis was simply a matter of importing the Fed's inflationary error, then its deflationary error. Cassidy's remark about countries in the region running larger trade deficits is factually incorrect, but he fuzzes it over because it is part of Keynesian theory that you will run a trade deficit when your currency strengthens. Japan has had the strongest currency in the world in the last 30 years and has had nothing but trade surpluses — one of the many areas where the Keynesians cannot explain why their theory breaks down.

8. Because the Keynesians are embarrassed at the IMF failures in dealing with Asia — opening itself to charges that it should be abolished altogether — Cassidy notes that some Keynesians are now criticizing other Keynesians. Indeed, on Thursday of this week, the NYTimes had a page one article by David E. Sanger headlined: "U.S. AND IMF MADE ASIA CRISIS WORSE. WORLD BANK FINDS." The Cassidy piece in last month's New Yorker foreshadowed this bit of nonsense — nonsense because the World Bank criticizes the IMF for not ANTICIPATING the terrible effects of capital flowing into a country that does not deserve to get it. Here is how Cassidy puts it: "Joseph Stiglitz, the chief economist at the World Bank, and Paul Krugman, of M.I.T., are both echoing Keynes by advocating direct measures to restrict the movement of speculative capital. 'There are big risks attached to short-term capital flows, and the benefits are ambiguous,' Stiglitz told me from his office in Washington. Since sudden changes in the direction of capital flows can easily precipitate a recession, governments may be justified in taxing them the same way they tax factories that cause pollution, Stiglitz said."

This also is the thrust of the December 3 NYTimes article. Those conservatives who have become conditioned to realizing the IMF is a destructive institution now are asked to feel all warm and fuzzy toward the World Bank, because it criticizes the IMF. You actually have to read the article with some skepticism to realize Stiglitz wants the IMF to raise taxes on capital inflows before there is a crisis instead of after the crisis. This is what Krugman persuaded Thailand to do in 1996, when he toured Asia spreading the word that capital inflows are bad for developing countries. David Sanger of the Times, who displays a high degree of intelligence when he covers the physical sciences, turns to jelly when he confronts this nonsense in high places. It comes as close to conspiracy as anything I've ever run across of this kind, as all the World Bank and IMF players who are supposedly "criticizing" each other are all old pals. They are all pointing toward reforms giving them the power to subvert economic growth before it occurs. In his article, Sanger tells us that Stanley Fischer, the IMF economist supposedly on the receiving end of criticism from the World Bank's Stiglitz, is on record sharing Stiglitz's view: Several months ago the first managing director of the [IMF], Stanley Fischer, said, 'In most cases governments call us in only after they discover they are in a mess, usually because they didn't do things they needed to do long ago.' " Like tax capital inflows.

9. Having advised us that Keynesian stomping out of speculative capital is the answer to all our prayers, Cassidy tells us this is not likely to happen because "The American government, and the Treasury Department in particular, remain committed to the idea that unrestricted capital flows are a good thing, and this commitment occasionally leads to absurdities. At one point earlier this month, President Clinton called for a policy that enabled 'capital to flow freely without the crushing burdens the boom-bust cycle brings.' Since it is precisely the free flow of capital that causes the boom-bust cycle, it was, perhaps, not surprising that the President has some difficulty translating his aims into practical policy proposals."

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What do you make of all this as students of SSU? What I'd like you to come away with is an understanding of the power of ideas, good and bad, when they are at the center of a belief system. At the end of his life, Lord Keynes disavowed many of the ideas being peddled in his name — just as Karl Marx on his deathbed insisted he was not a Marxist. In the present day, the IMF and the World Bank are institutions that have evolved to serve the interests of bankers. If it were not for the support of the multinational banks, the IMF and World Bank would have dried up long ago. The agents of these institutions look for justification anywhere they can when their blunders become as obvious as they have recently. They escaped by the skin of their teeth in the 105th Congress when the Republican leadership caved in to arguments from the big banks and the Treasury Department that the taxpayers had to pay for their mistakes and ante up another bundle for the next round.

When there is failure, those who fail contrive arguments to reduce risk on the next round. If you do not want to fail, you should arrange to take no risks. If you want to prevent bettors from losing on long shots, tax their winnings sufficiently to discourage people from betting on longshots and sticking with the favorites. This is "speculative hot money." These are the people who inhabit the international financial institutions. If you don't want failure, you must prevent success. This is the core idea of the communist experiment, which attempted to smooth out "the business cycle" by replacing markets with "wise men." The aversion to risk is a normal human attitude among those whose plans and ideas have failed again and again. To drag John Maynard Keynes out of mothballs to discourage the essence of capitalism explains a lot about the decline and fall of Keynesianism.

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