Dual Mandate

In the last couple of years I've enjoyed watching the YouTube videos of the annual Bogleheads conference. As I've blogged before, one thing I love about Bogleheads is how boring they (we?) are: the principles are very simple, and the whole point is to ignore the news and tune out the noise while staying the course. That said, the conference is good at reinforcing those simple rules; and, because a lot of the active members are very smart, curious and engaged, the second-order conversations they spark tend to be fascinating. In particular, in the last couple of years authors have joined the conference and presented on books that cover historical financial and economic topics.

 

 

I was intrigued by the presentation from Carola Binder, an economics professor, who spoke about the recent bout of high inflation in the US. I've since picked up her book "Shock Values: Prices and Inflation in American Democracy". It's been a really gripping read. In some ways it reminds me of the other recent book I discovered through the Bogleheads, Mark Higgins' "Investing in US Financial History". Both of these books are primarily historical, starting in America shortly before independence, and chronologically walk through time up to the present day, examining long-run trends and specific incidents that shaped the economy.

 

 

Of course, Binder's book has a more particular focus on prices and inflation, which intersects with but doesn't always overlap with other economic developments. In addition to history, Binder also examines the legal, political, economic and social dimensions of prices, in roughly that order of focus. There's a particular focus on the evolving legal decisions around what powers the government does and does not have related to influencing prices; among other things, this demonstrated how big an impact Supreme Court appointments have had for our entire history, as in multiple incidents the court established a ruling in one direction, and then a few years later reversed it after new appointments were made.

One specific legal area that repeatedly receives focus is contracts. There's language in the Constitution that the federal government cannot interfere in private contracts, and the 14th Amendment extended that restriction to state governments as well. This covers more ground than you might assume. For example, if the government sets a minimum wage, that restricts the terms of contract that an employer can offer an employee, and it potentially interferes in existing employment contracts by forcing a higher wage than was previously agreed on. Today there is broad acceptance that this is a legitimate government power, but there was significant disagreement over it for much of history. Similarly, for a long time purchase contracts would specify that a buyer would need to pay their debt in gold specie currency, as opposed to paper money or other forms of money. The government had a strong desire to make paper currency equivalent with specie and force people to accept them equally, but again, that potentially changes existing contracts between private parties, which is arguably unconstitutional.

As an aside, I was somewhat surprised to read a book that covers this country and time period and never mentions JP Morgan - I think that's a first for me. (But the book does frequently reference Bernard Baruch, which made me irrationally happy: I only knew that name as a punchline in Rocky & Bullwinkle.) While JP Morgan was a towering figure in finance and the economy, he didn't do much to influence prices. The biggest echo I see here has to do with the ongoing effort to get on, remain on or return to the Gold Standard during the 19th and early 20th century. In particular, this book describes how the US stretched itself during the interwar period between WW1 and WW2 to help the UK rebuild the gold reserves necessary to rejoin the standard. House of Morgan tells a great, more narrative story about the personal relationships and characters that drove that (mostly ill-advised) effort on both sides of the Atlantic.

On the other hand, this book had a lot more to say about farmers than any of the other economic books I've read covering this period. Which makes a sense: the US has primarily been a nation of farmers for most of its existence, and even up to the current day we continue to be a major exporter of food products; this was true even early in our history, when Europe was comparatively more industrialized and faced more frequent disruptive wars. I was fascinated to learn about the origins of the Grange Movement: I've been in a Grange Hall and vaguely associated it with rural agriculture, and loved learning about how it started, as a political force organizing against monopolistic price-fixing by railroads, and pushing for more accomodative monetary policy.

Zooming out for a moment: as I've learned from other books (most particularly Katarina Pistor's The Code of Capital), there's an inherent tension between debtors and creditors, and whatever helps one group necessarily harms the other. This includes topics like bankruptcy law and inflation. When inflation rises, it diminishes the real value of nominal debt and thus tends to benefit debtors and hurt creditors. For most of the US's history, while we were on the gold standard, deflation was a bigger specter, which harmed debtors and helped creditors. In general, farmers tend to be debtors: they borrow money to purchase land and buy seed, then pay back those debts after the harvest. So they are particularly sensitive to inflation. In fact, most of the major panics/depressions/recessions in our history have been triggered by economic pain in the farmland, to the extent that you could predict the month a recession would start based on the planting and harvesting schedule.

So this dynamic has played out many times, from the original Hamiltonian/Jeffersonian dynamic between Wall Street lenders and yeoman farmers, through the 1820s and 1840s land rush, through late-19th-century struggles against the railroads, and on into the modern day. Farming has shrunk as a share of the national GDP, but remains a huge business, and has retained an outsized influence thanks to our senatorial and electoral college representation, as well as an enduring cultural reverence towards farming as a profession.

In the 1910s people were surprised to discover that prices under the gold standard fluctuated based on the quantity of gold. But that's exactly what Adam Smith was writing about in The Wealth of Nations 150 years earlier! And Alexander Hamilton wrote about the impact of the quantity of precious metals in his first report as Treasury Secretary. As in Investing In US Financial History, I'm struck by how we as a society can learn stuff, and then even the experts forget it after a few generations and are amazed to rediscover these facts... which weren't even obscure facts but are in our foundational texts.

Somewhat similarly, there's been a lot of angst in the last two decades over the Federal Reserve's quantitative easing program (QE), and the Bogleheads forums and other online financial spaces I follow have been aghast at how the Fed has abandoned its traditional tools of the discount rate. But from what I've read now in Shock Values, it sounds like historically the Fed used similar tactics when they were first founded: they initially managed the money supply by purchasing government securities and private bonds, even before they created the Discount Window and began the modern process of influencing inflation and prices via interest rates. The system used to be all based on the Fed regional banks choosing to buy up government debt or to sell it, and so you could say that QE is a return to the Fed's roots and not an unprecedented shift.

Throughout the book, Binder describes different high-level approaches that the government has taken to try and manage price stability. I mentally sort these into three buckets: monetary policy (controlling the amount of money in the economy), fiscal policy (taxing and spending), and controls (directly mandating prices). The forms have changed over the centuries, but there are lots of similarities between different attempts, which I think is a big part of why Binder was inspired to write this book, as the debates of the last few years have very strong echoes of actual experiments we've conducted in the past.

On the monetary policy side: back when we were a colony, Britain forbade trade in pounds, so the only hard currency Americans held were foreign coins, which we then sent to Britain to pay taxes. During the Revolutionary War and the Civil War the government deployed paper currency, Continentals and Greenbacks respectively, to expand the monetary supply. These days monetary policy is primarily conducted through the Federal Reserve, which is the main focus of the last third or so of the book. By requiring banks to keep a certain amount of money in reserve and encouraging or discouraging lending, the Fed can grow or shrink the amount of money in the economy.

On the fiscal front, increasing government spending and cutting taxes tend to increase economic activity and are generally inflationary. Raising taxes and cutting spending does the opposite. The early US federal government had a very minimal footprint in the economy: it only raised revenues through tariffs and excise taxes, and outside of wartime it had very minimal spending. Over the years the scope of the government has steadily grown, and today it can make a major impact in the economy through its decisions. This drove one of the major recent debates, whether the spending in recent stimulus bills was responsible for the large rise in inflation.

Controls are regulations around acceptable prices that sellers can charge in the private market. Sometimes they are straightforward, like declaring that you can't charge more than $4 for a gallon of gas or pay a wage less than $7.25 per hour. Other times they have been more nuanced, like limiting the amount of profit a seller can make, pegging prices to the average or maximum in a historic range, or limiting the rate at which prices can increase.

All of these three levers have been used since the Revolutionary War. The various discussions on controls were probably the most interesting to me. As noted above, these are a form of the government "interfering" in private contracts, and thus have come under constitutional scrutiny. While various courts have ruled various ways in various cases, we've ended with a system where the government tends to have significant latitude in controls during emergency situations like wars or natural disasters: anti-gouging laws (which are state and not federal laws) punished people who jacked up gasoline prices after Hurricane Katrina or who overcharged for PPE in the early days of the COVID-19 pandemic. But as Binder writes, we've also come to increasingly rely on "emergencies" - the average "emergency" now lasts for 9.6 years - and this can have distorting effects on markets. In a laissez-faire system, high prices would send a signal for more sellers to enter the market, increasing production and lowering prices. If supply falls and prices can't rise, shortages almost always result, leading to long gas lines in the 1970s or empty supermarket shelves in 2020. As she notes in a grim aside, many people spent longer time in markets searching for N-95 masks, and thus were exposed to the virus and died. 

Price fixing was originally tried in the Revolutionary War but wasn't very effective - the state wasn't strong enough to enforce it. It wasn't even considered during the Civil War as the earlier memories were strong. There were some attempts at it in WW1, and a very strong push in WW2. It's interesting to see how it played out. Early on industry was on board with price controls a show of patriotism. But it's inherently hard to manage: different companies have different expenses, and you can either control profits or prices but not both. If you control prices then you will drive some companies out of business. The administrative state enabled enforcing prices, but the FDR administration also rolled out a broad-based distributed network of civilian volunteers, who monitored, educated and reported on pricing activities in their own community. It sounds a bit like the Gestapo, but benevolent.

The book also shows how the parties have grown less ideologically diverse over the years. Particularly during the stretch from the Civil War to the Roaring Twenties, party positions on topics like protectionism, tariffs, the gold standard, free silver, etc. tended to be driven much more by the biases of party leaders than the party membership, so it could radically swing from one election to the next, or have cases where a trifecta would disagree or a divided government would push something through. There's a quote along the lines of "People aren't Republican because they are protectionist, they are protectionist because they are Republican." Party loyalty was big, and (as in our time) economic issues, especially technical ones, tended to play second fiddle to social issues, so people would tend to go along with the direction of their party, even when it changed.

The Federal Reserve has what is called a "dual mandate", to maintain price stability and to pursue full employment. Price stability wasn't initially an explicit goal of the Fed, and over the years bills were proposed to make it an explicit or sole goal. In the short term there is a tension between these two goals, because tighter monetary policy will be deflationary but hurt economic growth and thus employment. However, over the long run the goals do align. As we learned during the Great Inflation, once inflation expectations become unanchored and it becomes self-reinforcing, inflation harms budgets (consumer, business and government) without giving any benefit to employment.

When there is a sudden change in the price level, it's usually due to either a supply shock or a demand shock, and Binder makes a nuanced point about the asymmetry of these types of shocks. If demand spikes, prices will tend to increase; if demand collapses, prices will decrease. Supply is more complex. If there's a shortage, that good will tend to be more expensive, but it can have ripple effects through the economy. If there's an oil shortage, then gas gets more expensive; but there may be less demand for cars, so those will get less expensive. Fed reserve actions are very effective at managing demand shocks, either cooling down overly enthusiastic growth or calming fears. But it's much less effective for supply shocks. Monetary policy is a powerful but very broad tool, and can't be targeted at a specific good. These days the Fed tries to "look through" supply shocks: they will do some damage but conditions will right themselves, because markets will signal sellers to enter or leave the industry. Trying to address a recession due to high oil prices might cause inflation elsewhere without really helping oil prices, for example. Actually addressing supply shocks is better handled by Congress or maybe the Executive: trade treaties, fiscal stimulus or taxation. 

In the last chapter covering the Greenspan years and beyond, Binder introduces the phrase "Techno-populism". I tend to think of a continuum from populism through representative democracy to technocracy. But recently the technocratic institutions and populism have become more aligned, bypassing democracy. One example she gives is direct appeals from technocratic bodies to populist goals, as in the "Fed Listens" series. It seems benign in this case, making the operations of these important bodies more transparent. But broadly it's concerning. The direct appeal to populism reflects declining trust in democratic bodies, a perceived or real inability for democracy to fix problems, and a weakening of our constitutional order and separation of powers. Article 1 of the constitution gives Congress the ability to control the currency; that authority has been delegated to the executive, and from the executive to an independent body. There are reasons for that independence, but it's also at tension with our rule of law, and feeds discontent with the broader political system.

There's a quote on page 274 that I really liked: "American policy makers' and institutions' attempts to stabilize prices have reflected, shaped, and sometimes come into conflict with our political values. As American political values are neither homogeneous nor static, the legitimacy of a wide variety of state interventions in prices has been litigated and relitigated in the courts and the courts of public opinion". Things are complicated! Political movements have risen and shifted over time, and actions that once seemed unthinkable (setting a minimum wage, leaving the gold standard) now are our normal. There is no natural law when it comes to the economy: it's us, our opinions and actions, that shape it. We can and often do change over time.

Near the end Binder mentions her own preferred approach of targeting the Nominal GDP (NGDP) instead of the inflation rate. So if the long-run desired inflation rate is 2% and the real GDP growth rate is 2.5%, the Fed could target an average annual nominal GDP growth rate of 4.5%. One appeal of this is that it explicitly focuses on both sides of the dual mandate: if there is a recession and the GDP drops (or seems likely to drop), the Fed would pursue looser money and more inflationary policy until it is back on track. She's an economist and I'm not; on reading this, my mind goes to a few places. First, from my understanding, a long-term real GDP rate of 2.5% feels ambitious for a fully developed economy. The real GDP rate tends to be the population growth rate plus the productivity growth rate, with productivity largely dependent on advances in technology. My understanding (which may be wrong) is that since 1820 or so the long-run per-capita growth rate in the most advanced economies has tended to be near 1%. So you take that and add any population growth you can get. I'd be curious to hear if Binder's thinking has changed in the last two years; if the US continues to pursue an anti-immigrant agenda, we're likely to see flat or even declining population over the long term; if we continue our anti-science and anti-higher-education agenda, we'll probably start to lag the 1% per capita real GDP growth. That might mean pursuing a 4% annual inflation rate instead of 2% over the long term. Which might be fine, as long as that expectation stays anchored, but I think the expectation behind targeting NGDP is to accommodate short-term and temporary shocks rather than long-run changes in real growth.

Anyways! This book was even better than I expected. Even though I've read a decent amount of economic books covering this era, most of the information was new to me, and I really appreciated the focus in the writing. It deepened my understanding of inflation specifically and price levels more broadly. This book fits in nicely alongside some other ones: where The Code of Capital focuses on private law (contracts, trusts, bankruptcy, etc.), Shock Values focuses on public law (statutory law and court challenges to private laws). Where The Birth of Plenty looks at the reasons for growth, Shock Values looks at the reasons for price changes. Where Investing In US Financial History details events in the stock market, Shock Values details events in the currency market. I'd definitely recommend this book to any money nerds like me, and it could also be a good entry point to anyone who has a particular interest in learning more about why we had that large inflation a few years ago and what history tells us about efforts to combat inflation.