Thomas Humphrey recall Ricardo and Thornton on monetary policy and supply shocks

Williamson and Wright on sticky prices making sense

To avert a financial panic, central banks should lend early and freely to solvent banks against good collateral but at penal rates

First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.

Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business…

The great majority, the majority to be protected, are the ‘sound’ people, the people who have good security to offer. If it is known that the Bank of England is freely advancing on what in ordinary times is reckoned a good security—on what is then commonly pledged and easily convertible—the alarm of the solvent merchants and bankers will be stayed. But if securities, really good and usually convertible, are refused by the Bank, the alarm will not abate, the other loans made will fail in obtaining their end, and the panic will become worse and worse.

Walter Bagehot Lombard Street: A Description of the Money Market (1873).

The classical theory of the lender of last resort stressed

(1) protecting the aggregate money stock, not individual institutions,

(2) letting insolvent institutions fail,

(3) accommodating sound but temporarily illiquid institutions only,

(4) charging penalty rates,

(5) requiring good collateral, and

(6) preannouncing these conditions in advance of crises so as to remove uncertainty.

Did anyone follow these rules in the global financial crisis? The Fed violated the classical model in at least seven ways:

  1. Emphasis on Credit (Loans) as Opposed to Money
  2. Taking Junk Collateral
  3. Charging Subsidy Rates
  4. Rescuing Insolvent Firms Too Big and Interconnected to Fail
  5. Extension of Loan Repayment Deadlines
  6. No Pre-announced Commitment
  7. No Clear Exit Strategy

…{the Fed’s} policies are hardly benign, and that extension of central bank assistance to insolvent too-big-to-fail firms at below-market rates on junk-bond collateral may, besides the uncertainty, inefficiency, and moral hazard it generates, bring losses to the Fed and the taxpayer, all without compensating benefits. Worse still, it is a probable prelude to a severe inflation and to future crises dwarfing the current one.

Thomas Humphrey (2010)

Public policy fallacies and Stigler’s law of scientific epiphany-corrected

Economics under-supplies new ideas because it spends a lot of time rediscovering old ones.

Under Stephen Stigler’s law of scientific epiphany, the inventor of an idea is not the first to discover it, but the first to make sure that the idea stayed discovered and was not forgotten again and reinvented and recycled as new. Mentioning an under-developed idea in passing is not enough.

Stephen Stigler attributed his law to Robert Merton’s law of multiples, acknowledging that Stigler’s law obeys Stigler’s law.

His father, George Stigler gave his Noble Prize lecture was on how and when new ideas were slowly adopted by the body of knowledge of the economics profession.

Stigler said that Adam Smith founded economics because:

  • A considerable number of economists, and a few considerable economists, have emphasised the fact that Smith had many gifted predecessors and almost all or perhaps exactly all of his ideas are to be found expressed, and sometimes well expressed, by these predecessors.
  • Some economists therefore wish to give the title of founder of economics to earlier writers such as Cantillon. This line of argument, in my view, misses the point.
  • It was Smith who provided so broad and authoritative an account of the known economic doctrine that, henceforth, it was no longer permissible for any subsequent writer on economics to advance his own ideas while ignoring the state of general knowledge.

Knight’s 1937 scathing review of Keynes’ general theory was:

Many of Mr. Keynes’s own doctrines are, as he would proudly admit, among the notorious fallacies to combat which has been considered a main function of the teaching of economics.

Under Stigler’s rule of scientific epiphany, Keynes still deserves credit because he made sure that these old scattered fallacies stayed discovered, and they certainly did.

Another reason for the lack of new ideas – Stigler argued – is that if the problems of economic life changed frequently and radically, and lacked a large measure of continuity, there could not be a science of economics.

Stigler argued that an essential element of any science is a cumulative growth of knowledge. That cumulative character could not arise, in Stigler’s view, if each generation of economists faced fundamentally new problems that called for new methods of analysis. Stigler concluded that without the base of persistent theory and a set of fundamental and durable problems, there would be no body of slowly evolving knowledge to constitute a science. Without the challenges of unsolved, important problems handed down from economists in the past, the science of economics would become sterile.

An example of Stigler’s law of scientific epiphany is The Early History of the Phillips Curve by Thomas M. Humphrey (1985).

Humphrey found prototypal Phillips curve analysis in the writings of David Hume (1752), Henry Thornton (1801), and John Stuart Mill. Irving Fisher’s 1926 statistical analysis was republished, as I discovered the Phillips curve in 1973. Jan Tinbergen estimated the wage-change version of the Phillips Curve in 1936. Phillips was seen as the discoverer because, Humphrey concluded, he provided:

A ready-made justification for discretionary intervention and activist fine tuning, this interpretation helped make the Phillips curve immensely popular among Keynesian policy advisors.

Thomas Humphrey later wrote an excellent 250-year long literature survey of the rules versus discretion debate in the 1999 Richmond Fed Quarterly. He wanted to know if macroeconomics was a progressive science in the sense that superior new ideas relentlessly supplanted inferior old ones.

Humphrey found that:

  • Keynesian ideas about a lack of demand and their many antecedents gain currency when unemployment was the main concern.
  • Monetarist ideas tended to reign when price stability was the main problem.

The policy debate keeps being recycled because:

  • People forget the lessons of the past; and
  • For better or worse, politicians and the public have tended to believe that central banks – the focus of his studies – have the power to boost output, employment, and growth permanently.

Humphrey showed that stable policy rules are popular in good times to contain inflation. And when unemployment was rising, discretionary monetary policies became in vogue, once again.

A key role of economists in public policy is remembering that few policy ideas are new and they were often found wanting in a sufficiently distant past; those who knew these refutations have moved on. Humphrey concluded that:

The doctrinal historian knows that much of what passes for novelty and originality in monetary theory and policy is ancient teaching dressed up in modern guises…

Preoccupied by the pressing problems of the day, [policy-makers and the public] have neither the time, inclination, or training, nor indeed the duty to trace the history of the ideas they employ or endorse.

They have no reason to be aware of earlier policy debates in which sound theories were distinguished from fallacious ones.

The result is that policymakers may subscribe to old theories under the mistaken impression that those theories are new. Worse, they may unwittingly deploy policies whose underlying theory has been challenged and found wanting in earlier policy debates.

Every new idea needs both a market as well as alert intellectual entrepreneurs who seize the right moment to put their ideas forward.

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