Category: History

Irish political economy seems to be falling apart in front of our eyes and the bond market isn't so happy, even after Ireland accepted the EU/IMF bailout.  That would appear to be political risk.  Maybe there won't be a happy ending even in the short run.

Here is Thomas Friedman, a number of years back, touting the wonders of the Irish model.  Cato and Heritage made similar claims.  What are we to make of this broader span of Irish history?  I see a few candidate views, not necessarily mutually exclusive:

1. The Irish had some excellent economic policies, but they needed to regulate their banks more.  They were simply too optimistic and too sloppy.

2. Irish troubles could have been contained, at some point over the last two years, had Ireland not been on the euro.  They would have devalued, defaulted, and had a rapid bounce back up, within the next three years.

3. Ireland never should have guaranteed the liabilities of its banking sector.  Indeed, Ireland (as New Zealand did long ago) should have encouraged larger, more diversified foreign banks to dominate its financial sector.

4. Irish troubles are intimately connected with low corporate tax rates.  Revenue starvation induced the Irish government to court and tolerate a real estate bubble.  One claim is that Ireland relied too much on property taxes.

5. The good and bad policies are a bundle of sorts, and Ireland needed the mix to rise from squalor and the dominance of anti-commercial interest groups, no matter how painful the present day may seem.  I recall vividly, growing up, that Ireland was thought of as not much more than a Third World country.

6. We are overreacting to the Irish failure.  It is one of the first European dominoes to fall, but over time many different policy models will look like mistakes.

What other candidate views are there?

In his response to my critique, Tyler calls the Federal Reserve the "saviour institution," a most un-Tyler like phrase although consistent with his earlier plea that all will be well if we just put our faith in the Fed.

Clearly, I am less of a true-believer than Tyler but lets turn from faith based argument towards substantive matters.

I said the case for the Fed is weak, Tyler responds that the case for free banking is weak–this is not a rebuttal.  The point is more than rhetorical since there are many alternatives to the Fed as we know it, Scott Sumner has relentlessly made the case for nominal-GDP targeting (with futures markets), Kotlikoff makes the case for limited purpose banking, Tyler and Randy Kroszner once made the case for a similar idea, mutual fund banking (Tyler is less favorable today), Selgin and White make the case for free banking, and of course there are also commodity standards such as a gold standard and the BFH system (e.g. see this piece by Bill Woolsey). Since the case for the Fed is weak, I see work on all these alternative institutions as important and valuable.

In the 1970s and 1980s there was a large literature on rules versus discretion at the Fed, that literature faded out with the great moderation. The great moderation today looks more like a combination of luck and structural change rather than discretionary wisdom.  The Selgin, Lastrapes, White paper can be read as an argument to put greater weight on rules.

Tyler argues (but compare here) that "Many of the Fed's most serious mistakes are sins of omission, not commission…" and then he seems to argue (it's not entirely clear) that alternative institutions are all omission and thus cannot do better.  The rules versus discretion debate shows us the falsity of this conjunction.  As Sumner has repeatedly reminded us a nominal GDP rule would have required more action not less. Moreover, it's quite possible that other alternative institutions such as free banking would also do better on avoiding sins of omission as well as commission.

Tyler says:

It takes a good deal of imagination to believe that the Fed's periodic overreaches outweigh the benefits it provides through countercyclicality.

If this were correct the benefits of the Fed in reducing variability would be obvious in the data. The benefits are not obvious in the data, why not? I see several possibilities.

1) As Milton Friedman showed, once we take into account lags and uncertainty it's quite easy to see how counter-cyclical monetary policy can backfire even when the case for monetary policy is strong.

2) As I suggested above, it could also be that alternative institutions performed about as well on counter-cyclicality as the Fed.  

3) It could also be that counter-cyclical monetary policy is not as important as we think. Tyler has argued strongly that the current recession is majority structural (e.g. here, here, here) and thus that neither monetary nor fiscal policy is very effective.  If a lot of recessions are structural then monetary institutions of any kind might not matter that much.

The Chinese central bank on Friday raised capital reserve requirements for its banks for the fifth time this year to “appropriately control” credit and liquidity.

Here is more.  From Ireland, here is "bondholder cannibalism."

Tyler's Case for the Fed (see below) has solidified my judgment that the case for the Fed is surprisingly weak.  I will draw out some of Tyler's comments.

I view 1929-1932 as a better illustration of "a world without a Fed" than "a world with a Fed," even though of course we had a Fed then.

I have learnt that the best response to this kind of reasoning is to say "please pass the nam tok, Tyrone" and move on. Be forewarned.

The Fed made the recent crisis much better than it otherwise would have been.  Without a Fed, we would have experienced something more like the Great Depression, including a frozen payments system.

It's wrong to evaluate a big institution like the Fed by assuming a world in which everything else is exactly the same, except for the Fed's absence. Tyler does a lot of this in his post but I am not enamored of this style of reasoning. This is why we need pre and post-Fed history.  Pre and post-comparisons are one of the few methods we have for understanding how entirely different institutional structures perform in equilibrium (looking at countries without a central bank is another possibility). Pre and post-comparisons have all kinds of problems, since other things are changing, but the facts do at least put some constraints on imagination.

By the way, as the Miron paper I linked to shows, comparing just the 25 years before and after the Fed (even if you exclude GD) also suggests that the Fed reduced stability.

Tyler says the Fed has been getting better. Ok, but that also illustrates the weakness of Tyler's approach. After 100 years we would have expected alternative institutions to have also gotten better.

In the 1950s, 1960s, 1980s, and 1990s, I see the Fed as bringing improvements, of unknown magnitude.

Tyler gives us his informed opinion but it's long on opinion and short on information. Would it be possible to be more vague?  "Improvements"? Compared to what? Compared to the Fed in the 1970s?  Unknown magnitude? As I said, Tyler's case for the Fed leaves me more solidified in my judgment that the case is weak. I will let the Straussians ponder that more.

Historically central banks have been essential in helping nations fight major wars.  The world's preeminent military power simply will have a Fed, for the same reason that it has lots of nuclear weapons.

I agree with this entirely.  Governments want central banks because they help to fuel war. Historically, this is why central banks were created. 

More generally, both Fed and Treasury are usually, in relative terms, voices of economic reason within government, even if they're not everything you wish them to be.  It is arguably counterproductive to lower their status.  Currently, the relevant alternative is a totally politicized Fed, not no Fed at all;

Like the points Tyler makes in the beginning of his post about who does or does not support deposit insurance this is sociology, irrelevant to the fundamental question of evaluation.

Moreover, as I pointed out earlier the case for "independent" central banks is also weak; central banks are always politicized, only the interest groups change.