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Lost In Translation

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Tags Booms and BustsThe FedInterventionism

01/26/2007C.J. Maloney

"To understand the Great Depression is the Holy Grail of macroeconomics." — Ben Bernanke[1]

The Great Depression, more than any other event in the history of these United States, still brings a collective shudder to Americans in the same way the Black Death stills tugs at the fears of Europe. It was, hands down, the most devastating economic crisis in our history.

In that vein, Ben Bernanke released a collection of previously published writings on the subject. Essays on the Great Depression is just that, a collection of essays. Each one, therefore, should be able to stand on its own merits now as it did in the past. This review looks at the book up to and including its first essay, "The Macroeconomics of the Great Depression: A Comparative Approach."[2]

Unfortunately, Essays triggers one of my pet peeves with econometric texts: they read with all the flow and warmth of a DVD's instruction manual.[3] Despite clocking in at only thirty pages, this first essay felt far longer because it reads like all econometric writings do — like a math book.

The tedious writing style is not Mr. Bernanke's fault. He was brave enough to try to reach an unreachable star — math can be a useful tool but it's never fun to read a math book. Who brings a math book to the beach? Ever settle blanket-wrapped before a warm fire, Advanced Algebra for Undergraduates open in your lap?

This is not to imply that Mr. Bernanke has nothing interesting and of the utmost importance to say; he does. He is a man of such power that his opinions about economics mean more than any other man's. Unlike me, whining impotently at the end of the bar, he can Do Something About It.

Or at least try.

Mr. Bernanke's main argument is that "the evidence that monetary shocks played a major role in the Great Contraction, and that these shocks played a major role in the world primarily through the working of the gold standard, is quite compelling" (6). And it was that gold standard that caused the Great Contraction that caused the Great Depression because "in particular, the evidence for monetary contraction as an important cause of the Depression, and for monetary reflation as a leading component of recovery, has been greatly strengthened" (34) and "this monetary collapse was itself the result of … the gold standard" (viii).

He states "I am a Great Depression buff, the same way some people are Civil War buffs" (vii), and the book's impressive list of sources say he's not lying. He's done the grunt work and has earned a respectful listen, so here we are. And with all due respect, I believe his essay is loosely written, built on a foundation of poor data, and ultimately rests on a refutation of one of the most basic of economic laws.

Please allow me to explain.

The Gold Standard, in a Kinda Sorta Way

"Nobody knows what the gold basis or gold standard really is." — President Roosevelt, March 8, 1933

Agree with his support of a paper standard or not, no reasonable man can deny Mr. Bernanke's intellectual honesty on the subject of fiat currency. Unlike his predecessor, there are no embarrassing skeletons in his closet jabbering away about the sanctity of a gold standard. Yet in an essay whose main purpose seems to be a warning against it, Mr. Bernanke does a poor job defining exactly what it is he means by the gold standard. His loose terminology in the essay reflects this failure.

Reference to the "gold standard" makes its first appearance on page six, without any definition. I assume he is referring to the gold standard as it stood before World War I destroyed it. The "gold standard" appears again on page eight, also without any definition of what it is or what it was designed to do when, out of the blue, he's referring to an "international gold standard" within the same page then onto the "strict gold standard" on page nine.

We're back to an "international gold standard" in the very next sentence, and we hold steady until page ten brings us the "gold exchange standard." Page twelve gives us "the gold standard as it was practiced at that time" then page fifteen brings us back to the "international gold standard." And so on…

I have a moment of hope when Mr. Bernanke refers to another study that compares "the classical and interwar gold standard periods" which were different due to the latter period displaying a "lack of effective international cooperation" among central bankers and a reduced "perceived likelihood that the exchange rate would be defended at the cost of higher unemployment." Yet he never explains why peoples' perception of whether or not the central bankers would "defend the exchange rate" changed, so he fails to  explain clearly the profound difference between the workings of the gold standard versus the gold exchange standard that prevailed post-1914.[4]

In my opinion, Mr. Bernanke's failure to pin himself down to a firm definition of exactly what he means when referring to the gold standard leaves his essay flawed from a scientific standpoint. Science requires exactitude, consistency, and clarity; all are inseparable from its very nature. You don't mix kinda this many oxygen molecules with sorta that many hydrogen molecules to create water. Science is exact; labels don't change: ten is always called ten. Science defines its terms clearly and sticks to them — if you can't do that then it isn't science.

The gold standard is the essay's whipping boy, its harmful effects his main warning, yet like "enemy combatant" it is loosely defined, at best. His use of multiple terms[5] when referring to the gold standard is something none of my college professors would have accepted.

Be that as it may, he does make his opinion known clearly enough. Whether he condemns the "gold standard" or the "gold exchange standard" or the "gold standard as it was practiced at that time" doesn't really matter — gold is in there somewhere and it is to be feared and shunned.

Furthermore, by failing to explain exactly what the gold standard was designed to do, Mr. Bernanke makes the error of holding up the "Great Contraction" as terrifying and inexplicable — when it was nothing more than the gold standard's protective mechanism kicking in. When Keynes & Friends rail against the "fetters of gold" they are exactly correct: the gold standard's natural operation puts an end to counterfeiting; it disallows the political class to have, in Mr. Bernanke's words, "autonomy in its domestic monetary policy."[6]

By not taking a few paragraphs to explain to the reader how the gold standard of pre-1914 was different from the gold exchange standard that prevailed post-1914 (or how either system was designed to operate), he mistakenly condemns gold-based money for performing the very function it was designed to do — destroy counterfeit currency.

He is condemning the frog for its hop.

Garbage In — Garbage Out: Is There Some Data in the House?

"If central bankers threw out all the data that was poorly measured, there would be very little information left on which to base their decisions." — A former research director at the Fed, quoted by Caroline Baum

Whether or not you agree with the logic behind econometrics, you have to admire Mr. Bernanke's meticulous and wide-ranging quest for data. He feels that mathematics is essential to the study of human behavior and acts aggressively; he's gathered quite a harvest. He touts his expansion of sample countries to twenty-four as the "comparative approach," meaning he's added X data points where before there was Y-X data points. He specially refers to the essay as empirical "in the strict econometric sense" (5)[7], in other words, Mr. Bernanke's argument rests purely on mathematics.

Yet, how reliable the data he must use is anyone's guess — it comes with a long list of disclaimers. By expanding the number of countries studied, he's "bought with it data limitations" (26) necessitating he use "annual rather than monthly data" (26) and a further "lack of data" forces them to "confine their analysis to the effects of banking panics" (26). So they add in a dash of "dummy variables" (needed due to the lack of a "consistent quantitative measure" of banking instability) and a sprinkle of "arbitrarily assumed" banking crisis that last one year — no more, no less — and we come to the conclusion that here is a man so desperate to flex his econometric muscles he'll sleep with any data point that'll buy him a drink.

We should not lose sight of a widely known and widely talked about fact: economic data is  arbitrary and unreliable. Even using big, speedy computers so smart they could beat Stephen Hawking in Trivial Pursuit, the data today's econometricians must put into those computers are murky, at best. For example, in a speech last November Dallas Fed president Mr. Fisher stated that the Fed miscalculated its favored "core PCE" inflation gauge by 0.5% in early 2003, causing them to create more money and credit then they otherwise would have.[8]

How reliable, then, is a constellation of data collected over 70 years ago and penciled into ledgers by the bureaucratic predecessors of the good people who run FEMA?[9] Maybe not terrible, but doubtless not better than what we collect today, and even that leads us to miscalculate one single measure of inflation.

Mr. Bernanke stated in a recent speech "one should clearly acknowledge that the results can be sensitive to various statistical and modeling assumptions"[10] and he lives up to his words here; his disclaimers are prominently displayed.

And it's not only his reliance on poor data but also his choice of when to start harvesting them that strikes me as flawed. All his monetary data points start in 1929[11]. Starting a scholarly review of the Great Depression from the standpoint of empirical numbers, using 1929 as your starting point, is like starting your book on World War II with "On September 3, 1939 the Germans invaded Poland" and onward to 1945 without a backward glance, leaving the reader ignorant as to why the Germans wanted to beat up on the Polish.[12]

Mr. Bernanke needs to explain why 1929 should be the level of optimum monetary stock. Maybe it should be, but he doesn't explain why. Otherwise, the monetary levels of 1929 are in his opinion optimum, but I can find people who feel otherwise. Many contemporaries of Keynes, like Irving Fisher and FDR, liked 1926, and personally I'm partial to 1920.[13]

Mr. Bernanke's insistence on using mathematics to study human behavior — backed up by arbitrarily chosen data of admittedly poor quality — has led him  not only to condemn gold-based money for doing exactly what it is supposed to do, but also to trumpet a rather odd solution to the problem of curing depressions.

It has led Mr. Bernanke into a wonderland where rising prices are used to stimulate demand.

Lost In Translation

"Forget all the econometric models for a minute and focus on the logic." — Caroline Baum

Because prices fell at the beginning of the Great Depression — and the numbers sure seem to say so, and, more important, economic science tells us they will during periods of monetary contraction — Mr. Bernanke therefore feels falling prices led to the Great Depression. I believe Mr. Bernanke has fallen for a fallacy whose existence we were all warned about in our introductory statistics class — things can be linked mathematically yet make no sense in the real world. There are times, to be blunt, when our econometric models, constructed with great care and detail, will tell us with a straight face that the world is flat.

We all learned the Fable of the Lecherous Ice Cream to avoid giving credence to logically backwards results from our econometric models. To wit, sales of ice cream rise in the summer, and so do the number of rapes. Therefore, ice cream sales cause rape.

Now that's just silly. It shows how using math to study human beings can lead people to conclusions that are so illogical only the unwary would give them the compliment of belief. The belief in a need to "reflate prices" in order to "stimulate aggregate demand" is a case in point. It is a belief that springs from the linkage of falling prices with economic distress. It is a belief rampant amongst econometricians.

Mr. Bernanke warns of the "economic damage inflicted by falling prices," (34) which have entered (as the great Keynes praised it) "those laboratories in the Harvard economic departments" and through an intelligent, judicious use of regression analysis, log changes, and least-squares analysis, have been shown to cause a collapse in economic activity, as proven by the bankruptcy of IBM, Dell, HP, and Microsoft caused by the large fall in the price of home computers over the last decade.[14]

Mr. Bernanke's recommendation to inflate the money supply in order to "reflate prices" to boost aggregate demand is based upon the belief, wildly popular amongst the Roosevelt set in the early 1930s, that rising prices stimulate economic activity and are, in fact, a sign of economic health.

The belief that aggregate demand needs to be stimulated by raising the price level is as absurd as believing that filling a rowboat with water will keep it from sinking — it defies one of the most basic laws of economics. And defying that law is at the heart of Mr. Bernanke's argument.

Probably the only thing that I can remember from my college years was that Holy Cross of the economics professor, the Supply and Demand curve.[15] The demand curve is downward sloping as against a rising price — meaning the lower the price the more will be demanded. If this holds for one item it certainly holds for a basket of items, and I've made note during my life that stores in my city always seem to lower prices to stimulate demand for their products.

Under a gold-based money, Mr. Bernanke states in this essay, "I believe that there is overwhelming evidence that the main factor depressing aggregate demand was a worldwide contraction in money supplies" (viii) and "the behavior of price levels corresponded closely to the behavior of money stocks" (22).

To buttress this statement, Mr. Bernanke turns to the results of his econometric models, which show the gold standard's greatest benefit to the working masses — a falling price level during periods of economic depression. Mr. Bernanke decries this as an economic calamity, yet a falling price level brings demand back in line with supply, as a lower price boosts aggregate demand, or at least every lecturer I listened to  in college thought so, as does Mr. Bernanke's textbook Macroeconomics, which states on page 343 that an "increase in the price level reduces the aggregate quantity of goods demanded."

So why, then, would we want to "reflate" or raise prices to kick-start an economy?

In order for Mr. Bernanke's line of inquiry to hold logically, it must be that the law of economic science that states that a falling price leads to a greater demand (and a rising price to lower demand) is not a law of our science any longer, else his argument against gold-based money falls apart.

If the law does hold, then the gold standard's causing the Great Contraction (which it did) was not a cause of the Great Depression (which it wasn't) because it could not be the cause of a fall in aggregate demand since the falling price level it caused triggers higher demand.

"And here at Wal-Mart we're raising prices to serve you better!" — Consumer ad you will never see

In Rome's Greatest Defeat, the historian Adrian Murdoch chides the archeologists of Germany for their "precedence of methodology over analysis, and of description over interpretation." Much the same accusation can be leveled at this essay. Despite the cascade of numbers, it leaves the reader as bereft of any answer to the question tackled as when he started, because we have forgotten that the science of economics was born of philosophy, not mathematics.

The inability to explain the underlying data and the ability to get confused by that same data is a trait common to all econometric writings. You cannot use math to measure human beings' behavior; you certainly can't explain us using math, and economic activity is human behavior.

Mr. Bernanke has the best intentions at heart. Unfortunately, this first essay failed to shine any light in the darkness because he is using advanced mathematics — econometrics — in an attempt to explain human beings.

He has chosen the wrong tool for the job.

"It is often said of econometrics textbooks that their readers miss the forest for the trees. This is inevitable — the terminology and techniques that must be taught do not allow the text to convey a proper intuitive sense of 'What's it all about?' and 'How does it all fit together?' All econometrics textbooks fail to provide this overview." — Dr. Peter Kennedy, A Guide to Econometrics, 4th Edition


[1] All page citations taken from Ben Bernanke, Essays on the Great Depression, (New Jersey: Princeton University Press, 2000).

[2] Meaning the introduction and the first essay. That's as far as I've gotten to date. All I can say in my defense is that the book digests slowly.

[3] Maybe that's too harsh. Mr. Bernanke does display a notable affection for t-scores.

[4] FDR made note of this difference in a press conference on March 8, 1933 where he said, "for a good long time as a matter of actual fact the United States has been the only country on the gold standard."

[5] I stopped counting at six.

[6] Autonomy is my favorite Buzzcocks song of all time. I thought you should know.

[7] Emphasis mine.

[8] Oops.

[9] And not only must we account for the ever-present sloppy sloth of the bureaucrat. Again displaying his intellectual honesty, Mr. Bernanke speaks clearly on page 32 to the possibility that "actual wages paid fell relative to reported or official wages rates." In other words, people was lyin'.

[10] March 20, 2006 before the Economic Club, New York City, New York.

[11] He does the same thing when showing economic data in my copy of his Macroeconomics text from college. All the numbers start at 1929.

[12] Answer: They were conveniently located.

[13] F. Scoot Fitzgerald's first novel came out. It was a good year.

[14] Before you send that email, please know that I'm aware IBM, Dell, HP, and Microsoft are all still in business.

[15] The Supply and Demand curve — I can draw it in my sleep. And you can too for a mere $100,000 or so!!!


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