Monthly Archives: July 2014

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“Russia is the first instance of a socialist economy in action,” the bureaucrat wrote in an unpublished essay that Mr.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.

I don’t think Paul Krugman is very convincing in his argument that repeated calls for higher interest rates derive from class interest:

You’re living in a fantasy world if you don’t think this has something to do with the diatribes against currency debasement and all that.

Krugman’s argument is simple, and fair at first approximation: the rich earn a disproportionate share of their income from interest-bearing assets and have the most to loose from “artificially low” interest rates.

Similarly, to the extent low interest rates create inflationary pressures, the rich have more to loose given a net surplus position in nominal assets. However, as I remember the story, the economists making this argument made a fundamental error in assuming simple asset swaps (i.e. QE) could somehow cause hyperinflation. Arguing against hyperinflation may be a straw man, but it’s still a fair worry (for rich and poor alike). I don’t think you had many rich people militate in favor of deflation.

But that’s not the most puzzling part of this argument. A side-effect of the Fed’s stimulus have been elevated asset prices. There’s no voodoo behind this: the price of an asset is the discounted value of its future cash flows, and this necessarily increases as the interest rate falls. Since the rich own a disproportionate share of real assets across the country – primarily real estate and equities – they stand to benefit from this program. Indeed the stock market has been setting record highs for the past few years.

Krugman’s tandem argument that high interest rates/low inflation portend a redistribution from the young to the old is also tenuous. (Sure, if there was a long-term increase in expectations this would act like a one-off capital levy. But that hasn’t been the case.) Note that wealth is just a claim on future income, and since Fed policy has increased asset prices and therefore P/E ratios, capital gains will fall in the future, ceteris paribus. To think about it another way, the Fed has moved future returns into the present to stimulate consumption. Or, equivalently, low interest rates increase asset prices redistributing consumption from the future to the present. (Or young to the old, contra Krugman).

Magnitudes matter. Nothing Krugman is saying is inherently false, but seems to be guided more by intuition than data. I’m just pointing out a number of other effects. His primary source indicates that the ratio of interest-bearing income to debt increases as we move up the income distribution. But even at the latter end, debt is twice as important. Krugman is probably right that were the last group to be spliced further, those at the tippy-top may have more even portfolios.

But at the tippy-top you also have a diverse group of people without homogenous incentives. For example, the private equity industry has made a killing financing large, leveraged buyouts at throwaway prices. This similarly stimulates demand for mergers and acquisitions which is one of the few profit centers left for investment banks. These people surely fall among the rich.

On this note, observe that to the extent the data Krugman presents holds to any significant magnitude, we’re talking about 0.01% of the population. Sure, class interests matter for this group, but more effective avenues (even if low interest rates were a huge problem for them) would include lobbying for specific subsidies and tax breaks, which actually works, rather than have discredited economists spill ink in the Wall Street Journal.

Another overlooked consideration is that the United States is somewhat unique. Despite a large current account deficit and soaring obligations, we earn more in foreign income than foreigners earn here. And in fact, the ratio of GNP/GDP has only been increasing. This derives from a large long position by (rich) American investors in emerging markets. To the extent the the dollar is debased (something Krugman suggests the rich are very worried about), the US claim on the rest of the world’s future income increases. (And, conversely, foreign reserves across the world would plummet).

None of this is to say that any of the noisemakers clamoring about money printing and debasement are right. I’m just suggesting that class interest may not be nearly as relevant as Krugman suggests. Occam’s Razor would demand a simpler explanation: these people are simply ignorant or want to sound serious.

But hey, which one percenter among us hasn’t dumped our net worth into the money market.

The National Association for Business Economics recently published Larry Summers’ remarks on secular stagnation earlier this year. The conversation picked up after his speech at the IMF conference last year, though has been floating around for some time. Excluding gloomy prognostications from Alvin Hanson in the 1930s, I can trace back the idea that the US has fallen into a secular trap back to Paul Krugman at the Munk Debates in 2011.

Though Summers is seen today as the ringleader of the stagnationistas, Krugman’s formidable opponent was none other than Larry Summers. Summers has since undergone, as I’ve documented before, a remarkable intellectual evolution making very similar claims to Krugman in 2011 (though with more rigor and a stronger platform). While even the chance of a somewhat permanent slump is sobering, there are reasons to doubt both the theory and evidence behind this claim.

Let’s start with the labor force. Summers is understandably unhappy about the recent decline in participation rate. He controls for demographic factors by looking only at working age (25-54 yo.) men which should account for an older population and students staying in school longer:

But that is not the largest part of the story. Even if one looks at 25-to-54 year-old men, a group where  there is perhaps the least ambiguity because there is the greatest societal expectation of work, Figure 3 shows that the employment/population ratio declined sharply during the downturn, and only a small portion of that decrease has been recovered since that time. The recovery has not represented a return to potential; and, according to the best estimates we have, the downturn has cast a substantial shadow on the economy’s future potential.

With the graph:


While there is certainly a sense in which this has not recovered to trend level, there is also an argument that the crash just accelerated an already fermenting labor force. While Summers argues this is due to features of the recovery, and not structural or technological issues, the data may suggest otherwise:


For example, the graph above demonstrates that the rough participation rate of those with a college degree or higher fluctuates within a very narrow band and has, if anything, continued on an increasing trend. This militates in favor of a skills-biased technological change hypothesis which is inconsistent with secular stagnation (of output at least).

The evidence is stronger still. Take these two charts from JP Morgan:

lfpr lfpr2

Discouraged workers are peripheral to the question of labor force participation. Nor is “working age men” the representative statistic it once was, as Summers analysis makes it out to be. If anything, females are obtaining college degrees at higher rates and are employable in a wide array of increasingly-important occupations, prominently healthcare and education. Traditionally male fields, on the other hand, are in largely tradable sectors and probably not coming back. This has worrisome implications for the distribution of income and the underlying social structure itself. And we should do something about that. But robots and cheap, Chinese goods are not “secular stagnation”.

This brings us to our next point:

Third, changes in the distribution of income, both between labor income and capital income and between those with more wealth and those with less, have operated to raise the propensity to save, as have increases in corporate-retained earnings. These phe- nomena are shown in Figures 9 and 10. An increase in inequality and the capital income share operate to increase the level of savings. Reduced investment demand and increased propensity to save operate in the direction of a lower equilibrium real interest rate.

This sounds good in theory, but in reality the very period over which income inequality has increased the most, total savings rates have fallen precipitously:


Gross private saving is the broadest measure of saving and accounts for increased savings in the form of corporate profits. Government saving, to nobody’s surprise, has also fallen over this period. While richer people most certainly do have a lower propensity to consume, the magnitude of this effect is clearly dwarfed by forces like the Asian saving glut and potentially overvalued dollar. Luxury markets are booming: and it may not be to a good liberal’s taste, but demand for chauffeurs and butlers creates employment just like that for apparel and electronics. Indeed, to the extent richer people consume at the margin on non-tradable services, the leakage is also lower.

But Summers’ grander point here remains: real interest rates have been on a secular decline. This strikes at what may be the heart of the problem: low investment demand. While low equilibrium interest rates have other problems, like increasing the risk of a liquidity trap, the structural impact isn’t necessarily felt in investment. The interest-rate elasticity of investment has always been tough to measure and Treasury yields may not be the best gauge: lets look at the corporate bond market once yields start to diverge. This isn’t too important (yet).

Rather, advanced economies currently function on what Paul Krugman has called a “bicycle model”. Firms invest on the expectation of higher returns in the future due to economic growth. The accelerator model of output, therefore, frames investment demand as a function of long-run potential growth. When this expectation falls, so does investment. In other words growth is necessary for growth. If long-run growth expectations fall substantially the US is by the principle of recursion screwed. But the bicycle doesn’t have to fall if we transition to a steadier, consumption driven model. And that’s just what we’ve been doing:


So long as we’re able to keep consumption growth to meet a lower steady-state investment rate, the economy won’t self-implode (though, definition, will grow slower). Given that the largest projected increases in future private and public spending come from education, healthcare, and a geriatric economy this transition will be rather easy for the United States to make. (Not to mention the ample space for public investment, something I know Summers is on board with).

However, we should still be uncertain about the extent to which potential growth has fallen. As Summers notes:

Ponder that the leading technological companies of this age—I think, for example, of Apple and Google— find themselves swimming in cash and facing the challenge of what to do with a very large cash hoard. Ponder the fact that WhatsApp has a greater market value than Sony, with next to no capital investment required to achieve it. Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars. All of this means reduced demand for investment, with con- sequences for equilibrium levels of interest rates.

It is valuable here to think in terms of inputs and outputs. We need less “debt” to achieve a similar valuation that once required tons of borrowing. What Summers is describing is technological, if not economic, progress. Indeed the interest-rate elasticity of demand has probably fallen, but only in a small segment of the economy. I’ve written about this in some detail before:


While he’s right that there are secular trends toward cheaper capital, I’m not sure we can attribute much of that to the information technology era. Even granting that the magnitude of technology is substantial, something I’ll get back to in a minute, it’s important to explore the consequences. I would argue that the information era doesn’t reduce the demand for investment, as Summers proposes, as much as the interest rate elasticity of demand – that is to say firms are less sensitive to changes in the cost of capital. The reason isn’t obvious. Interest rates matter a lot for long-term, capacity building investments—like opening a huge new factory. But software is usually rented on a monthly basis from the firm’s own cash—so interest rates matter a lot less. (Reduced demand and reduced need mean the same thing in English, but not economese).

But that’s coming from the same cash pile Summers is talking about—and it’s still investment. In general it’s not that there’s a lot less investment as much as the factors that affect its demand are changing. This is where we get back to magnitudes. Take a look at software’s share of total private investment:


There are two stories here. One, in sheer magnitude, software (the blue line) is still only 15 percent of private investment and not significantly higher than points in the past two decades when interest rates were a lot higher. On the other hand, residential investment as a share of private investment, hasn’t changed much in structure since the mid-’60s and is still very sensitive to changes in the interest rate.

The point here is that while WhatsApp didn’t need any real investment, a lot of the economy does, and as sexy as Silicon Valley is, main street America is not irrelevant. There’s another point here, and I’d file it under, as Scott Sumner might say, “never reason from a price change.” The Silicon Valley story tells us that the returns on very small investments can be huge and, under competitive markets, this would imply that the marginal return on capital is falling rapidly after a certain level. However, that isn’t consistent with the broad increase in capital’s share of income we’ve noticed over the past decade or so. In a simple (but empirically powerful) Cobb-Douglas production function, the exponent on capital is its share of total income, and the higher the exponent, the larger the marginal product at any given point (other things equal).

Of course, other things are never equal, and that’s Sumner’s point.

Summers is right, that to the extent software is significant, there are important implications for the equilibrium interest rate. As the elasticity falls (that is, as the demand curve becomes more vertical) changes in the supply of loanable funds will be felt entirely through interest rate adjustment. So an increase in supply has a lot more potential to keep the economy under a low interest rate environment than before.

Ultimately, this is all pretty speculative. Calculating the importance of interest rates, as an empirical phenomenon, is notoriously difficult (studies disagree, for example, on whether higher interest rates even increase savings)—and observing shifts in the shape of the determining curves is harder still. While interest rates are low for a number of reasons, technology per se may not be one.

The practical point here is that since long-term interest rates are what drive the kind of investment Summers says is dwindling, it’s ever more incumbent that the Fed doesn’t let the term premium on long bonds rise too much. That is, keep quantitative easing hard.


Lower interest rates and interest-rate elasticity of demand pose a real threat to the current model of monetary policymaking. These are good arguments for a slightly higher inflation target.

But maybe the most important problem with secular stagnation is the cyclical recovery, which to some extent are mutually exclusive. While the economy is still really tough for those at the bottom, there are signs of life with increasing quits, inflation, and pressure in the market in general. There’s a lot more we can and should be doing, but these should perhaps be considered for redistributive and supply-side – rather than purely demand-side – reasons.

Of course, until we do get consistently sufficient inflation, demand is still lacking. The question is whether that seems impossible, and I think it would be difficult to answer in the affirmative. Unfortunately, my post has none of the optimism with which Larry Summers and Ian Bremmer challenged Paul Krugman in the Munk Debate. The Depression was the last time we were in such a bad position. As horrific as that was, it was no secular stagnation.