Cliff Asness provides a qualified defense of a 2010 letter to Ben Bernanke he endorsed, warning that further QE would “risk currency debasement and inflation”. The piece boils down to the clash between priors that have not come to pass and observed reality. In theory, this is a fair defense: elevated risk of hyperinflation, if accompanied with a similar increase in risk of forever deflation wouldn’t alter the long-term expectation. Paul Krugman responds that Asness fundamentally misunderstood monetary theory – that when short-maturity debt substitutes perfectly for cash, an increase in money cannot increase prices.

That’s not necessarily sufficient. Expected inflation of 2% can be sustained if the entire market believes that inflation will, indeed, be between 1.5% and 2.5%. It would also be sustained if half the market thought inflation would average -2% and the other half thought it would hit 6% – except the Fed’s expected loss function is higher in any scenario of the latter world.

So the question we need to ask is whether the market price of inflation risk beyond some threshold increased because of quantitative easing. And because of the exciting market of inflation floors and caps, we can actually answer that question. Before we answer this question, it’s worth qualifying the value of this analysis, and explaining the nature of the market.

An inflation cap is effectively an out of the money call option struck at some inflation rate for some maturity. Normalizing the payoff at $1 per point, the we can denote this as C(10%, 5) = max{n – 10, 0} where n is the average inflation over 5 years. Then, at every moment in time, we can not just identify the expectation of inflation over a time period, but the probability density function thereof.

Various options pricing frameworks can be used to determine the implied PDF, though I think the partial derivative method using a forward measure is the most common. (This just means future cash flows are discounted by the yield curve of a well-traded bond, instead of a risk-free rate that you don’t know in advance).

Unfortunately, comparing the market for inflation caps with the TIPS (a standard estimate of inflation expectations) is tricky, since it’s far less liquid, and incredible new (introduced, conveniently, around 2008). Therefore, we need some sort of sanity check that the values generated from this data make sense without making huge adjustments for liquidity and risk premia. Looking for an answer, I came across a paper by Yuriy Kitsul and Jonathan Wright at the Fed that exploits a quirk in the TIPS payoff mechanism to see how well it matches the options data.

While you normally think that it’s only possible to infer an expectation from the TIPS breakeven, under reasonable assumptions, it’s actually possible to figure out the market’s expectation that there will be deflation (a cap of 0%) over some time period. The asymmetry that TIPS must payoff its entire nominal face value, even if there is substantial deflation, means that TIPS is actually a compound security: long pure TIPS and long a 0% inflation cap.

Therefore, we can compare the explicit inflation caps implied probability of deflation with the TIPS implied probability of deflation. And what researchers find is even if they don’t match perfectly, they are almost perfectly correlated suggesting that even if the level of the inflation caps market is distorted by liquidity concerns, the dynamics thereof are legitimate.

And now we can answer the question at hand: did the risk of high inflation increase after the Fed engaged in QE2? (Note this establishes a correlation, not causation). Per Kitsul and Wright:

Deflation Inflation

And you see two very interesting trends: the probability of high inflation (that above 6%, which is the largest traded strike) sharply increased over the latter half of 2010 and early 2011, the time period over which the effects of QE2 were priced in. This is a general trend across all maturities. While the 3, 5, and 10 year option follow a similar path afterwards, the 1-year cap is much more volatile (largely because immediate sentiments are more acute). Still, you see the probability of high inflation pic up through 2012, as QE3 is expanded.

The takeaway message from this is hard to parse. This market doesn’t exist in the United States before 2008, and isn’t liquid till a bit after that, so it’s tough to compare this with normal times. While the sharp increase in the probability of high inflation would seem to corroborate the Hoover Institution letter, that wouldn’t mean much if it simply implied a return to normalcy. That’s just a question we’ll have to leave for a later day.

What about the probability of deflation? We’ll the interesting point is that for the three higher maturity options, the probability for high inflation and probability of deflation were increasing at the same time. This was a time of relatively anchored 5 year implied inflation, but the underlying dynamics were much more explosive, as can be seen in the above charts.

The punctuated volatility of immediate, deflationary threat is interesting. Moving away from changes for a second, the risk of deflation was consistently higher than that of inflation (though we shouldn’t take this too seriously given liquidity issues) – but only over the span of one year. Over ten years, the likelihood of high inflation was much higher than that of deflation.

What we can learn from the deflation PDFs is that long-term deflation was never a concern in the US (it would be interesting to conduct a similar analysis on the UK and EU, something I’d be happy to do if anyone knows where this option pricing data is – help!) The immediate dynamics are a whole different game. QE2 seems to drastically reduce the chance of deflation, to basically nil, but this isn’t persistent and there’s a lot of volatility. Though it does look as if QE3 was responsible for the death blow, with the likelihood around 10% by the time purchases peaked at $85 billion.

So where does this bring us on Krugman v. Asness?

An important argument the money manager made in his essay is that this question may be decisively settled for the short-run, but we still haven’t successfully exited from this period of weird, unconventional policy regime: the risk of inflation still exists seems to be the message. Markets agree with this: with the 10-year inflation cap probability of high inflation nearing its peak. That said, there’s a good chance, that 2008-2010 represented the trough of high inflation probability – the increases afterwards seem to be a return to normal more than anything else. A 20% chance of inflation above 6% isn’t too bad – and it’s important to keep in mind that the levels of this market are probably biased by selection, risk, and liquidity.

More importantly, the probability of deflation, and variability thereof, moderated. But here’s the end result:

PDFs

The probability that we’re going to have 2% inflation over the long-run decreased from around 70% in 2010 to 40% in 2012. There’s been a marked increase in the standard deviation of the PDF, which is cause for concern.

Again, I don’t want to put too much stock in these numbers – until we have reads from more normal times (again, anyone, data? I would love to replicate this for 2014 USA, or Europe).

These numbers neither provide a roaring endorsement for QE nor one for some crazy increase in the risk of inflation. While you can defend your use of the word “risk” against failed expectations – there’s a distribution, after all – it’s hard to protest when the increase in risk itself, as priced by the market, has been so modest.

That said, the QE can’t increase inflation in a liquidity trap argument is also unconvincing. There’s little theoretical reason to believe that once the growth rate picks up and overnight bonds are once-again priced at a discount, the exit from unprecedented stimulus wouldn’t cause inflation to increase as the monetary transmission mechanism kicks in, and the money multiplier roars back to life. There is good reason to think that this isn’t going to cause any hyperinflation (not the least that the Fed wouldn’t let it), and “debasement” was certainly too alarming a description.

This letter suffers more from some of its signatories, like Niall Ferguson, who go on to defend its claims with dubious nonsense from Shadowstats than pure content it self. It was wrong, but derivatives markets suggest that inflation risk has increased.

The big departure I’d take is in arguing this increase wasn’t enough to flush out the debt overhang. Though, one ought to ask, whether a better way to get there was moving the distribution to the right, or increase its standard deviation.

About these ads

Tyler Cowen links to Scott Sumner’s skeptical notes on secular stagnation. As frequent readers know, I’ve been very skeptical in the past myself, but I think the argument has a lot more merit than Sumner gives credit for – i.e. that this is an open question that economists can more decisively accept or reject in ten years.

Sumner:

It seems to me that the Krugman/Summers view has three big problems:

1. The standard textbook model says demand shocks have cyclical effects, and that after wages and prices adjust the economy self-corrects back to the natural rate after a few years. Even if it takes 10 years, it would not explain the longer-term stagnation that they believe is occurring.

2. Krugman might respond to the first point by saying we should dump the new Keynesian model and go back to the old Keynesian unemployment equilibrium model. But even that won’t work, as the old Keynesian model used unemployment as the mechanism for the transmission of demand shocks to low output. If you showed Keynes the US unemployment data since 2009, with the unemployment rate dropping from 10% to 6.1%, he would have assumed that we had had fast growth. If you then told him RGDP growth had averaged just over 2%, he would have had no explanation. That’s a supply-side problem. And it’s even worse in Britain, where job growth has been stronger than in the US, and RGDP growth has been weaker. The eurozone also suffers from this problem.

The truth is that we have three problems:

1. A demand-side (unemployment) problem that was severe in 2009, and (in the US) has been gradually improving since.

2. Slow growth in the working-age population.

3. Supply-side problems ranging from increasing worker disability to slower productivity growth

Only the last two can explain the slowing long run trend rate of RGDP growth, as well as the low real interest rates on 30 year T-bonds.

Both (1) and (2) don’t get to the heart of what Krugman/Summers believe and are implicitly embedded with false assumptions. The “standard textbook model” is a nebulous concept. Even within many of the workhorse, New Keynesian, models the economy will not return to full employment without some external push if the natural rate to which it must correct is below 0%. This is very different from the old Keynesian permanent slump, which suggested that if wages are flexible, downward adjustment would further increase the real interest rate and tempt a vicious, deflationary cycle.

Krugman has definitely agreed before that to the extent that falling prices are expected to be temporary, they can also be expansionary.

More importantly, disregarding the fact that a fall in unemployment to 6.1% doesn’t adequately capture the whole labor market, if you showed Keynes a chart of US unemployment since 2007, he wouldn’t have expected rapid growth if you also told him inflation has consistently been well-below its long-term average every year thereof. Sumner’s suggestion that productivity growth is to blame (while perhaps true) does nothing to change the fact that, if anything, declining supply-side fundamentals should have increased the price level.

In fact, that’s specifically the conundrum that secular stagnation attempts to address. It’s not a comment on the financial crisis and recession as much as a meditation on the decade that preceded it. How could a rapid increase in wealth, credit creation, construction, government spending, and accommodative monetary policy not result in above-average inflation?

John Taylor loves pointing out that the housing bubble was caused by discretionary policy that deviated from his eponymous rule. Not only does that ignore the fact that the target FFR pretty much followed the implied Taylor Rule if one looked at the Fed’s inflation forecast instead of current inflation (which is both noisy and laggy), but also assumes that the equilibrium rate of interest was constant over this period. That deviation from Taylor’s version of the Taylor Rule begat a housing bubble , and not any inflationary pressures suggests this is false.

So if you told Keynes that the unemployment rate had been cut in half without any associated increase in inflation, he’d probably ask you to look at a different metric.

More peculiarly, Sumner seems to be missing the Krugman/Summers point entirely by prescribing policies that they would both advocate:

I mentioned that there was a third problem with the Krugman/Summers view. They favor big government Keynesian demand-side remedies for what they see as a sort of permanent liquidity trap. This fits with the newly fashionable anti-neoliberal views on the left. Thomas Piketty’s new book made the wildly implausible claim that neoliberal reforms had not helped countries like Britain. However the countries least likely to be mentioned in discussion of “The Great Stagnation” are precisely those countries that have pretty good supply-side fundamentals, and/or relatively small government. Here’s the Heritage Foundation’s list of the top 10 countries for Economic Freedom [...]

Now I don’t want to oversell this list. Many of the top 6 countries have fast population growth. It’s hard for any country to completely overcome the slowdown in the rate of global productivity growth. But I think any fair observer would note that (with the exception of Ireland) the “usual suspects” in the stagnation discussion (Japan, the US, Britain, the 18 eurozone members, etc) are conspicuously missing from that list. And while Ireland undoubtedly was hammered by a big demand shock, their RGDP rose 7.7% over the past 12 months, a rate the US could only dream about. So while the top ten countries are not perfect (Denmark’s performance has been mediocre) they’ve clearly done better than most developed countries. That doesn’t provide much support for the progressives’ claim that the eurozone is doing really poorly because while they have the biggest governments on Earth, their governments need to be even bigger to overcome the Great Stagnation.

There’s pretty much nothing exclusive in those two paragraphs with what Summers and Krugman believe, except perhaps for any credibility assigned to the Heritage Foundation. If you read Summers’ introduction to the definitive ebook on the subject, he notes the following as some of the most promising avenues out of secular stagnation:

  • “Removing barriers for labor mobility between firms by trimming down employment protection legislation.”
  • “Increasing incentives for low-skilled workers to participate on the labor market.”
  • “Simplifying procedures for starting up businesses.”
  • “Applying anti-monopoly policies to reduce the profit margins in new IT industries”.

In fact, the central thrust of the secular stagnation argument is that falling productivity growth, a chief determinant of the prevailing natural interest rate, has fallen to a point where there is a vicious cycle between lower potential growth and lower actual growth.

The comments on the Eurozone are also tough to confirm. While Germany was definitely the success story of the decade, it worked largely because the rest of the world was able and willing to absorb its excess savings, thereby masking instability in the periphery. Instead, the real question is why did the periphery grow so slowly, despite a rapid inflow of capital from Germany and subsequent fall in borrowing rates.

The German model, by the unfortunate but inevitable requirement that international assets and international liabilities must sum to zero, could not have been applied everywhere to similar effect.

This post mischaracterizes what progressives actually believe. The conversation on secular stagnation most certainly does not, at least by itself, advocate “anti-neoliberal” viewpoints. If anything, this is a much stronger case for supply-side reforms than the Reaganites were ever able to produce in the 80s.

Vox reports (but makes no editorial comment on) a Census Bureau chart showing a steep decline in middle class wealth between 2005 and 2011. This is a sensitive topic, and on the heels of Piketty, who advocates a global wealth tax, one that may fuel progressive criticism of increasing wealth inequality. While the economic malaise of the poor is something we need to address, thinking through the lens of wealth is the wrong way to go about it.

For one, median household wealth tells us less than a lot about living standards, inequality, or economic power. 

wealth

At least among OECD countries, non-income factors account for a majority of the variation in median wealth. (The relationship is stronger for the per capita counterpart, but that is skewed by a long, right tail.) Income does clearly determine a good bit of wealth, but no one would walk away convinced that the median Slovenian or Spaniard is actually richer than the American. That isn’t to say income per se is an effective measure of living standards either: wealth provides a sense of security and certainty for bad times, but that is surely of second order importance. 

But the more important point is, if there’s a measure in which a country like Israel is almost as rich as America, it’s a bad measure. At least to measure median economic prosperity. And the problem comes in measuring wealth. While we may think of it in its accounting reality, assets less liabilities, its better to think of trends through a more fundamental definition: that is a claim on future output. Wealth, after all, is the discounted present value of the future cash flows from your net position.

That makes a big difference. Not all wealth is created equal. A good amount of the returns from wealth sitting in the hands of the one percent will be taxed between 15 and 55%. A good amount of the returns from wealth sitting in the hands of everyone else will be taxed more or less at 0%. 

There’s a bigger angle to this as well. Healthcare is going to be a large part of future output, and that’s something we kinda sorta socialized between 2005 and 2011, supposedly the time period over which middle class wealth plummeted. And yet, as we each have a more equal claim on what will be a growing component of future output, implicit wealth inequality falls. Nor does this include social security and disability, which surely represent a big chunk of middle class wealth. 

Wealth, unlike income, is intertemporal. Measures of wealth inequality, unfortunately, are not as nuanced. I would venture to say, however, that anyone who thinks the utility of middle class consumption over the discountable future actually fell by 35% in absolute terms better prepare for armed revolution. 

Rather, implicit claims of more progressive taxes and even more progressive expenditures will probably keep the Bolsheviks at bay. For now. 

Pranjul Bhandari and Jeffrey Frankel argue that the case for nominal income targeting over inflation targeting is stronger in developing countries than their advanced counterparts. The crux of this argument relies on the increased frequency of supply-side shocks in poorer countries, which require perverse policy under an inflation targeting regime.

I’m ambivalent about both the relevance and efficacy of this proposal. It’s a debate we desperately need to have, but it’s not like two of the most important emerging markets (India and China) follow any target to begin with. However, I think nominal income targeting has a few critical benefits the authors (at least in the VoxEu summary) do not cite.

Inflation is hard to define, let alone measure, in rich countries. And a lot harder in poor ones. A common measure of inflation in the United States, the Consumer Price Index, considers the price level a representative agent faces. In places like the US and Europe, it’s pretty easy to outline the parameters that define a representative agent, and the basket of goods he consumes. With a bit of econometric handiwork, the Bureau of Labor Statistics (BLS) has developed sophisticated tools to update the CPI to keep it relevant with a modern consumer. 

Inequality in America may be high, but the overwhelming number of citizens care about the same things: price at the pump, the cost of bread, and so forth. A broad consumption-driven middle-class buys the same stuff. In India, as in many other developing countries, the urban middle-class lives a world apart from its poorer, rural cousin. This has an important macro dimension. The cost of tradables (and hence the exchange rate) matters a lot more for an IT worker in riding a scooter to work than a casual laborer in the heartland of Haryana. 

There is also a lot of uncertainty around the portion of rural transactions that are even monetary in nature, with informal markets and even non-money exchange an important part of life. 

So in the United States, when inflation unexpectedly jumps, it’s a little hard to say who the winners and losers are. In India, to the large extent perishables drive prices, jumps in inflation largely reflect higher wages in rural districts reflected as higher prices in urban fringes. 

There is no representative basket.

Measurement in India is also confounded by tricky conflicts of interest. The bureaucrats that estimate inflation have wages expressly indexed to the CPI-IW. This probably is an order of magnitude or two less important than the more philosophical problems with inflation, but given its slight upward bias over the past decade not something to ignore altogether either. 

Unlike inflation, price level, and real GDP, nominal GDP is something we can estimate pretty well and, more importantly, have an extremely clear definition to work with. This is an enormous advantage in favor of a NGDP based anchor. 

But currently, India doesn’t target anything, and there’s probably good reason for that. Monetary operations in developing countries are in many ways more complex, if less consequential, than those in advanced markets. For example, the Indian economy is far more sensitive to the exchange rate than most rich countries (especially the United States) are. Sensitive both because of institutional arrangements (such as fuel subsidies) whereby the terms of trade are important and because of volatility in capital flows, particularly short-term debt. 

Specifically because India imports certain dollar-priced goods (oil, but other minerals too) the exchange rate affects not only demand, as in most countries, but also supply. A depreciation can lead to unsustainable deficits and infectious inflation much quicker than in advanced countries. 

Fiscal dominance, or at least political interference, is a much larger concern. As Raghuram Rajan noted not long before he was tapped as the RBI chief, by imposing high liquidity requirements on banks – held through Indian government debt – the RBI was effectively financing artificially-cheap borrowing by the Centre. 

So one may ask – a nominal income target, but in what? Nominal rupees or nominal dollars? Or nominal trade-weighted units? It’s a bit like whack-a-mole. A nominal income target in a foreign currency, while something I definitely need to think more about, comes dangerously close to certain worries of competitive devaluation. However, it does at least intuitively deal with most of the problems of just an inflation target, or just a nominal income target.

A final problem with rules-based, as opposed to ad hoc, monetary policy is low labor mobility and dearth of a strong fiscal transfer system. If America is booming, but Alabama is sagging, a deep social safety net via food stamps, unemployment insurance, and social security ensures that an inflation-targeting Fed doesn’t harm Alabama too much with monetary tightening. And wages will move towards equality as Alabamans move out, reducing local supply. But that’s not the case in India, suggesting monetary moves have far more political implications, the rural-urban divide key among these.

I find any sort of long-run target that doesn’t consider exchange rates to be worrisome in the world of free and fickle capital. I’ll be writing more about a dollar-denominated nominal income target for emerging markets in the days to come, but am curious to see what people think about this. However, given the problems with measuring inflation I think we can be sure that were India to choose between the two, it should chart its own course instead of copying the Reserve Bank of New Zealand. 

Evan Soltas thinks so. With both inflation and unemployment figures finally pointing in the direction of a rate hike, only meek housing numbers portend any extended period of low interest rates. This is important because, as Evan notes, housing has consistently been a key driver of monetary policy and the crash in construction leaves a big dent to this day. 

I’m a little less convinced this is cyclical factor deserving monetary nourishment as much as a structural change in the housing market itself. This isn’t something I’m too sure about, and this is largely a note for my benefit. While Evan says “It [the weak recovery] is no less apparent if you include multifamily housing”, I’m not so sure. 

Housing

Now, single-family houses are definitely the most important part of the market, which is why a weak recovery in 1-unit structures will persist in a graph of the market as a whole. But the consistent improvement in 5-unit housing starts, that is apartment buildings, is curious.

It tells us a little bit about where the recovery is and is not. People in New York City live in apartments, people in Tennessee do not. It tells us a little bit about the changing structure of home ownership. People rent apartments but own houses. And surely enough, rental vacancy has fallen over a third from its double-digit peak in 2009. The divergence in housing starts is just the market responding the a change in consumer preferences.

A reasonable doubt may be that consumers are starting to rent precisely because the recovery is so week, and that I am diagnosing a symptom, not the disease. However, that is unlikely to dismiss this theory. Homeownership rates have been in persistent decline since well before the crisis, and the recession didn’t really accelerate the trend.

This is a trend that will certainly become more important in years to come. While Evan is worried that the housing market remains depressed, the rental market is headed towards steamy recovery.

shelter

That kind of “v” recovery in rental prices is exactly the kind economists love to see. Unfortunately it’s not for the economy as a whole, confirming a longer term shift in underlying economic dynamics, towards a nation of renters. While single-family housing starts may be underwhelming, apartment creation will be necessary for affordable housing over the next decade.

And while the consensus that the taper didn’t affect the overall recovery, but did slam housing, seems to be true, lumber futures – a good gauge of where markets think housing will go – have been going strong. 

It’s clearly true that tapering, and tightening in general, will slow the recovery of housing relative to recovery of the economy as a whole. But that’s not necessarily a bad thing. Rents are a superior gauge of economic activity as they are more reactive to underlying labor market indicators – like job creation, consumer confidence, and employment – than home prices which ultimately reflect an asset and hence are sensitive to the magnitude of the initial drop in price. 

Sure, single-unit construction dominates the market. Yet homebuilder ETFs have shown a stronger recovery than housing prices in general, or one-unit construction in specific, would suggest. The market, I think, is pricing in the eventual need to vastly improve America’s multifamily apparatus, as there are no signs a decline in home ownership will halter. 

And, as I’ve written before, the argument that student loans reflective of inadequate demand is holding back housing is not strong. Fact is, an overwhelming number of students want to live in places where they can’t afford to buy a home.

But more importantly, those jumping at the correlation between student loans and home ownership over a few years of data are not paying enough attention to large, structural shifts in economic geography over the past fifty years. For nearly a century, suburban growth eclipsed urban. Millenials, the fraught group in question, are changing that. Two-thirds of young graduates now want to move to cities for a better job, compared to a fraction not too long ago. Not to mention the more than 80% that are willing to move to any city if needed.

Dad is no longer a company man, nor mom a housewife. Rather, graduates are likely to vie for shorter commitments focused on training and, in a number of cases, with a higher probability of relocation in the future. Not to mention the logistical, locational difficulty of maintaining a dual-income family (specifically outside of urban centers).

And that’s the demand side. Jobs that cater to college graduates are slowly disappearing from middle America toward coastal centers that capitalize on economies of scale and network effects. Vox notes that the age at which graduates first purchase a house is becoming later. True, but not necessarily relative to household formation itself – something happening later across the country driven by graduates. (Not to mention, as a commenter on Twitter mentions, the increasing necessity of a post-Baccalaureate degree).

So if the argument is that further monetary accommodation will improve the housing market, I’d buy. However, that’s different from the argument that high investment in single-unit housing is the weakest link in the recovery. And the Fed shouldn’t be making choices about structural trends.

I’m in favor of keeping rates lower for longer only as an insurance that the left tail of doing too little is worse than the expectation of doing too much. Not all labor market indicators are decidedly healthy – employment of 25-54 year olds, for example – and current levels of inflation aren’t overwhelming enough that we can be sure they’re here to stay. We can afford to be a little behind the curve. 

Tyler Cowen has an excellent column suggesting that while the past thirty years has indeed been tough for the American middle class, it has also realized astonishing improvements in the living standards of the global poor. Primarily China, and to a lesser extent its neighbor India, have together brought hundreds of millions out of poverty and malnourishment. Surely this is more important than the stagnation of (an already extraordinarily high) income in the western world.

In any way you slice it, the world is becoming a more egalitarian place. Indeed, it is probably the single-fastest restructuring of international economic hierarchy in the modern era. China’s urban upper-middle class is effectively as well-off as America’s lower-middle class. There used to be a time, not so long ago, that the United States could boast it would be better to be born dirt poor here than with a silver spoon anywhere else.

Tyler posits the story as the tension amid between and within country inequality. And he at least implies the enlightened western mind should focus on the success of the former as at least an order of magnitude more important than the failure of the latter. I am not inclined to disagree.

However.

The real story here is really not about inequality. It’s about living standards, and that tells us something about the futile conversation America has had on inequality within its own borders. For example, the research behind Tyler’s column, suggests that global Gini inequality did indeed fall: from 72.2 to 70.5.

Sure that’s something – especially given that North-South inequality had been increasing for the years before – but it’s certainly nothing incredible. Because two big things happened over that time: the international poor crawled into the middle class, and the global one percent pulled further away.

The former still dominates the latter, but the net effect is a lot less impressive. That can mean one of two things. Either the last thirty years have not been as amazing as everyone thinks, or a change in inequality is not the correct lens through which to view the transformation.

I don’t think anyone would go with the former. But this can be extended to the United States as well. I don’t pretend that inequality doesn’t matter, but the real question America has to deal with is an erosion of living standards at the fringes.

And many times these have nothing to do with economic inequality. For example, consider the incredible disutility caused by America’s racist, aggressive, expensive, and futile criminal justice system. Indeed, incarcerating millions of black people every year for smoking crack and pot, and forcing them into penal labor, isn’t pretty far from modern-day slavery.

Or what about the post-industrial ghost towns scattered across Appalachia where unemployed families bond over crystal meth? This contributes to inequality, but only analogously to the poor Indian farmer of 1980. That is to say, the more the only even remotely-sensible political platform in town (the Democratic Party – whether you want to accept it or not) keeps screaming about increasing taxes on the one percent by one percent, as a solution to everything from runaway deficits to inequality, those who are truly suffering miss out on any and all political representation.

America’s criminal justice system has been a heinous crime – and that is blatantly obvious to anyone with a heart – for over a decade. But it takes a libertarian and a man who lived in the Newark slums to do something about it. Democrats, the supposed party of opportunity and progress, have had basically nothing to say about the clearest cause of systematic suffering in the country.

And immigration reform is a close second, yet the party’s effective nominee has clearly hawkish views about sending kids who came into this country back to gang-ridden Central America.

They still have the audacity to claim they champion the poor man’s cause.

To the extent the narrow definition of inequality is the primary avenue to achieve this end, maybe they do. After all, Democrats have had basically nothing new to say about the subject than increasing the capital gains tax, and adding a new top rate at 40%. Or was it 50%?

It’s time that we started talking about living standards. And this may alleviate inequality in the long-run, but just like the reduction of the global Gini by 2 points, that won’t be the main story. Instead, over the next thirty years we’ll see an increasingly large share of the income go towards those the top quartile. And before we talk about taxing them more, let’s talk about how we want to spend that revenue most effectively in improving the broad welfare of the country.

Call be a tax-and-spend liberal, but let’s at least start talking about the “spend”.

In Battle for Bretton Woods, Benn Steil is a storyteller first, economist second. But that doesn’t mean this intriguing account of the two men who made the international monetary world sacrifices on the tricky, technical implications thereof.

Following the tradition of Liaquat Ahmed’s wildly-successful Lords of Finance, Steil writes the financial history following the life of an economic great, John Maynard Keynes, and his rogue rival, Harry Dexter White.

For a book discussing the most important economic event of the century, Steil is working in a surprisingly uncompetitive market. There seem to be no other books aimed at a popular audience describing the brilliant exploits of this Soviet spy. It turns out that White – the American economist who taught not at Harvard or MIT but Appleton, Wisconsin – was Red. As Steil noted from his essays,

“Russia is the first instance of a socialist economy in action,” the bureaucrat wrote in an unpublished essay that Mr. Steil discovered in White’s papers. “And it works!”

But perhaps what sets White apart from his undercover counterparts is, we learn, his zeal to secure unquestionable American dominance in the new world order. By any measure, the debate between the two men was hardly ideological. Indeed the ultimate result largely matched the expectations of both parties – discouragement of competitive devaluations, stability in exchange rates, control of cross-border capital flows nestled in the spirit of never-before-seen international cooperation in economic affairs.

Rather, the differences derived entirely from the relative position of an emerging behemoth to a fading empire decades past its prime. Where Britishers wanted to think, until the last minute, that Bretton Woods was a landmark conference between two great equals, the Americans saw it as a way to end British dominance forever.

Maybe the most fascinating part of the book, especially for someone of Indian-descent, is the extent to which the socialists in FDR’s administration advanced the anti-colonialist cause, dismantling imperial preference and hence empire itself.

Steil recounts this drama as the magical coincidence of far left and far right. On the one hand, the State department was filled with hardcore free marketers that wanted a world without any tariffs or subsidies, something at odds with imperial preference (which in effect provided Britain’s otherwise uncompetitive exporters captive demand). On the other hand, the socialists advising FDR (not the least White himself) saw the British empire as a grotesque invasion of national sovereignty and axiomatically hated imperialism.

I was always taught that the Americans, despite their lip service towards democracy, always did too little, too late when it came to expediting the end of European Colonialism. While White’s role does not definitively challenge this, it does provide evidence that the Americans went well out of their way by ending a system that would cripple Britain and only benefit American exporters modestly at best.

The central debate between White and Keynes concerned the relationship between creditor and debtor nations, and the role of the American dollar. While Keynes wanted a system that placed the burden of responsibility on creditors to sap their trade surplus, White insisted on a less forgiving system that wouldn’t require very accommodative monetary policy. This is where the latter question comes in: Keynes advocated for the creation of an international reserve currency that would help deficit countries to settle their balances, the bancor, with an elastic supply from a fund towards which all countries would contribute, splitting the austerity between creditor and debtor nations. White, instead, wanted a system where all countries were pegged to the dollar at a fair rate and only the dollar would be convertible to gold, in which debtor countries may only obtain a limited loan from an international fund (the IMF), and where debtor countries may devalue their currencies only 10% (and another 10% if needed). White won the day.

Thus was born the gold-exchange standard where foreign currencies were pegged to the dollar which in turn was convertible to gold to qualified parters (as opposed to the classical standard where all currencies were convertible at any time, by anyone).

As promised, the economics is less interesting than the intrigue thereof, and Steil does a wonderful job telling the tale of deceit and drama that wrought Bretton Woods. We learn of the carefully orchestrated conference agenda in which Keynes was relegated to the debate of a relatively irrelevant institution (the World Bank) while White carefully controlled the creation of the Fund.

The timing of this book couldn’t be better. We are today living through the logical conclusion of a system that was bound to break. As the sole producer of an international reserve currency, it became necessary for the United States to run persistent trade deficits to ensure adequate supply of liquidity abroad. However, the fixed exchange rate system exported American monetary policy, and hence inflation, abroad. The mad irony then is that America is today the world’s largest debtor, a paradox otherwise known as the Triffin dilemma.

Published earlier this year is Eswar Prasad’s The Dollar Trap which discusses the impossibility of a dollar standard in a world with free capital flows, but the lack of any viable alternative. The irony comes from the fact that both official and unofficial American attitudes towards the situation echo Keynes, not White (again reflecting its relative position in the world).

More than anything else, Steil paints the picture of a rich intellectual, nationalistic, and ideological drama between a technocrat and an economist that set the tides for economic policy in the twentieth century. It was economists more than army generals or foreign diplomats that defined geopolitics. This is a trend that continues to this day. Indeed, whereas American-led peace talks secured by the Security Council may seem like a century-old anachronism, the international affairs office of the Treasury department continues to be an exceedingly important component of our foreign policy.

And, people don’t even know about it. When Ben Bernanke opened American credit lines of over half a trillion dollars to a select-few countries and rebuked the requests of others, he arguably made more important geopolitical decisions than Hillary Clinton ever did as Secretary of State. Indeed, the Indonesian Prime Minister once even personally requested Clinton to open a swap line between its reserve bank and the Fed. Unfortunately, that’s not a question over which she much control.

As we move towards a G-Zero world, as international relations superstar Ian Bremmer likes to call it, the United States dollar still represents an overwhelming majority of foreign exchange transactions and is the primary reserve currency. To this end, American monetary policy is exported worldwide and will continue to create dramatic tensions with other countries.

Battle for Bretton Woods is first an epic story (even for those with little interest in economics). But it’s also a reminder how economic policy dominates geopolitics.

Follow

Get every new post delivered to your Inbox.

Join 2,208 other followers