Saturday, December 20, 2014

Huerta de Soto gets it Wrong on the Gold Standard

One can read this interview with the Austrian school economist Jesús Huerta de Soto in which he praises the “benefits” of deflation:
Jesús Huerta de Soto, “Deflating the Inflation Myth,” Cobden Centre, 7 December 14.
He makes an eyebrow raising comment here:
“[Interviewer:] Does that mean we should be happy about deflation?

[Huerta de Soto]: Certainly. It is particularly beneficial when it results from an interplay of a stable money supply and increasing productivity. A fine example is the gold standard in the 19th century. Back then, the money supply only grew by one to two percent per year. At the same time, industrial societies generated the greatest increase in prosperity in history.”
Jesús Huerta de Soto, “Deflating the Inflation Myth,” Cobden Centre, 7 December 14.
Really? The deflationary period of the 19th century generated “the greatest increase in prosperity in history”? What is the evidence for that?

Now it is true that there was in virtually all nations a long-run deflationary trend for most of the 19th century, even if punctuated by inflationary booms outside the 1873 to 1896 period (which was marked by almost persistent deflation).

Huerta de Soto’s statement can only mean that the gold standard era had an historically unprecedented real per capita GDP growth rate compared to all other eras both before and since.

Let us look at the average OECD real per capita GDP growth rate estimates and data for various periods over the past three centuries:
1700–1820 – 0.2%
1820–1913 – 1.2%
1919–1940 – 1.9%
1950–1973 – 4.9%
1973–1990 – 2.5%
(Davidson 1999: 22).
Uh oh.

This is what happens when an Austrian economist puts his foot in his mouth and makes statements in accordance with Austrian ideology but not backed by the empirical evidence.

As we can see, the industrial revolution of the 19th century under the gold standard most probably generated the greatest increase in real per capita wealth in history up to that time, but its record has since been surpassed. The best period of real per capita GDP growth was the 1950–1973 era: the time of Keynesian economics and modern macroeconomic management and also a much higher level of government intervention in the economy, both before and since.

But, the critic might counter-argue, didn’t Huerta de Soto really mean it was that specific deflationary period of the 19th century – which is normally taken to be the 1873 to 1896 era – that generated “the greatest increase in prosperity in history”? Possibly that is what he meant.

We can look at the data for the UK, the US and Germany below from 1873–1896 (with data from Maddison 2003):
UK Average per capita GDP Growth Rate 1873–1896: 1.057%
US Average per capita GDP Growth Rate 1873–1896: 1.422%
German Average per capita GDP Growth Rate 1873–1896: 1.495%.
Since these were the most advanced, fastest growing economies of the late 19th century, it is unlikely any other nations achieved an average per capita GDP growth rate higher than them, and certainly not in numbers large enough to affect the average for that era.

So even within the 1873 to 1896 era the figures do not seem deviate too far from the 1820–1913 OECD average. They were also inferior to the Keynesian golden age of capitalism from 1950–1973, which remains the best period in human history for real per capita output growth.

One can also note that the deflationary era of 1873 to 1896 produced deep business pessimism at the least in the UK (and possibly other nations too) resulting from the “profit deflation” or profit squeeze of that era, and there were also protracted economic problems in the 1870s and 1890s. In the US, this period coincided with the free silver movement and bimetallist political movement that opposed the gold standard, arising in part from the debt deflationary distress to debtors in that era.

In short, the idea that under the gold standard the industrial nations “generated the greatest increase in prosperity in history” at any time before or since is untrue, and is nothing but a libertarian myth.

BIBLIOGRAPHY
Davidson, P. 1999. “Global Employment and Open Economy Macroeconomics,” in J. Deprez and J. T. Harvey (eds), Foundations of International Economics: Post Keynesian Perspectives, Routledge, London and New York. 9–34.

Maddison, Angus. 2003. The World Economy: Historical Statistics. OECD Publishing, Paris.

Friday, December 19, 2014

The Inconvenient Truth about Interest Rates and Investment

Actually Post Keynesians are already well aware that the influence of interest rates on determining the level of investment is grossly overrated, but striking confirmation of the Post Keynesian view can be found in fascinating survey evidence in this Federal Reserve Finance and Economics Discussion Series paper:
Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf
In essence, Sharpe and Suarez conducted a survey of 550 corporate executives in nonfinancial industries directly asking them how their investment decisions are affected by a change in interest rates with other factors held constant in September 2012, and 541 responded (Sharpe and Suarez 2013: 3, 7–8).

The executives were asked these questions:
(1) “By how much would your borrowing costs have to decrease to cause you to initiate, accelerate, or increase investment projects in the next year?” and

(2) “By how much would your borrowing costs have to increase to cause you to delay or stop investment projects?” (Sharpe and Suarez 2013: 3).
They could choose from these responses:
(1) not applicable;

(2) 0.5 percentage point;

(3) 1 percentage point;

(4) 2 percentage points;

(5) 3 percentage points and

(6) more than 3 percentage points (Sharpe and Suarez 2013: 3–4).
The findings were as follows:
The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points. Strikingly, 68% did not expect any decline in interest rates would induce more investment. In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.” (Sharpe and Suarez 2013: 4).
We can put this in graph form below.


The findings are pretty stark: 68% of CFOs said that they would not expect “any decline in interest rates would induce more investment.” Of the firms in this category many were insensitive to interest rates changes because they finance investment out of retained or current earnings (Sharpe and Suarez 2013: 20).

Curiously, some 139 respondents answered “not applicable” (Sharpe and Suarez 2013: 7–8). Presumably this was because such firms also finance investment through retained or current earnings or do not have easy access to credit anyway (Sharpe and Suarez 2013: 20).

It would appear that many firms that invest via retained or current earnings or just do not have borrowing plans in a coming investment period are relatively unaffected by interest rate hikes – or at least the interest rate hike has to be pretty large to make them cut investment plans (Sharpe and Suarez 2013: 4).

Overall, however, businesses are more sensitive to rate rises than rate reductions.

Furthermore,
“… firms that expected their investment plans to be unresponsive to any conceivable decrease (or increase) in borrowing cost were given the space to provide a reason, and most offered one. The most commonly cited reason for insensitivity was the firm’s ample cash reserves or cash flow. Two other popular reasons were: (i) interest rates are already low (absolutely, or compared to firm’s rate of return); and (ii) the firm’s investment was based largely on product demand or long-term plans rather than on current interest rates. Only about 10% of firms providing a reason for not responding to a decrease cited a lack of profitable opportunities, and only a handful offered high uncertainty as a reason” (Sharpe and Suarez 2013: 5).
The fact that many firms make investment decisions “largely on product demand or long-term plans rather than on current interest rates” should cause no surprise.

Crucially, one year after this survey the respondents were questioned again when longer-term interest rates happened to be 100 basis points higher, and the new answers confirmed that their behaviour had been in line with what they said earlier (Sharpe and Suarez 2013: 5, 23–24).

There is of course one caveat about this survey: interest rates were very low in 2012 and low interest rates may have increased business insensitivity to interest rate changes (Sharpe and Suarez 2013: 20–21). While that is true, it is still quite likely that even this factor has not skewed the survey results so badly that the findings are not generalisable.

In fact, the discovery that most businesses do not regard interest rate changes as a major factor determining investment was already a fundamental finding of the Oxford Economists’ Research Group (OERG) in the 1930s in their survey work: they found that uncertainty was an overriding factor in the investment decision, not interest rates (Lee 1998: 88). Other empirical evidence seems to corroborate this (see Caballero 1999).

A final point can be made about interest rate rises. If interest rates are raised very sharply and severely (as in, say, the “Volcker Shock”), I do not think that anybody disputes that this is most likely to cause recession in a market economy.

But mild to modest rate rises do not necessarily have to depress economic activity. Why? The reason is that many mark-up firms actually include interest payments as part of overhead costs, and many firms will raise their profit mark-up if interest rates are increased (Godley and Lavoie 2007: 265). If demand for a firm’s product is still strong, and a firm then faces an interest rate rise, it can simply raise its prices to recover the cost of higher interest payments.

Further Reading
“Louis-Philippe Rochon on What Should Central Banks Do?,” January 31, 2012.

“Post Keynesian Policy on Interest Rates,” March 12, 2013.

BIBLIOGRAPHY
Caballero, Ricardo J. 1999. “Aggregate Investment,” in John B. Taylor and Michael Woodford (eds.), Handbook of Macroeconomics (vol. 1B). Elsevier, Amsterdam.

Godley, Wynne and Marc Lavoie. 2007. Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth. Palgrave Macmillan, New York, N.Y.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sharpe, Steve A. and Gustavo A. Suarez. 2013. “The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs,” Finance and Economics Discussion Series, Federal Reserve Board, Washington, D.C. December 3
http://www.federalreserve.gov/pubs/feds/2014/201402/201402pap.pdf