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December 27, 2006

Was WIN A Loser? Part 2

I closed my previous post asking this question:  Is there anyway to characterize President Gerald Ford's "Whip Inflation Now" campaign as anything other than a waste of effort wrapped up in a bad idea?

One answer might be: "Yes, if you are willing to extend a little sympathetic goodwill toward those doing a tough job at a tough time."  For some time I have been in a sporadic but ongoing informal debate about the record of Arthur Burns, the Chairman of the Federal Reserve Board during the Ford (and most of the Nixon) administration.  I have become increasingly drawn to the possibility that many of the mistakes attributed to the Burns-era Fed -- sometimes with the added charge of overtly political manipulation by Burns himself -- were the inevitable consequence of trying to learn how to conduct monetary policy in the aftermath of the collapse of the Bretton Woods global monetary system.  A generous interpretation might be that the right thing to do was only obvious with the benefit of hindsight.  And if so great an economist as Arthur Burns struggled with how to get inflation under control, can you really blame Gerald Ford for not getting it quite right?

Even so, you might say, the WIN button publicity campaign was a ridiculously naive misfire.  But I wonder.  Consider this thoroughly modern idea, described by Lawrence Christiano and Christopher Gust:

An expectations trap is a situation in which an increase in private agents. expectations of inflation pressures the central bank into increasing actual inflation. 

There are different mechanisms by which this can happen. However, the basic idea is always the same. The scenario is initiated by a rise in the public's inflation expectations. Exactly why their inflation expectations rise doesn't really matter. What does matter is what happens next. On the basis of this rise in expectations, private agents take certain actions which then place the Fed in a dilemma: either respond with an accommodating monetary policy which then produces a rise in actual inflation or refuse to accommodate and risk a recession. A central bank that is responsive to concerns about the health of the economy could very well wind up choosing the path of accommodation, that is, falling into an expectations trap.

Christiano and Gust continue:

In an appearance before the House of Representatives, Committee on Banking and Currency, July 30, 1974, Burns said:

One may therefore argue that relatively high rates of monetary expansion have been a permissive factor in the accelerated pace of inflation. I have no quarrel with this view. But an effort to use harsh policies of monetary restraint to offset the exceptionally powerful inflationary forces of recent years would have caused serious financial disorder and economic dislocation. That would not have been a sensible course for monetary policy.

What is the way out?  There are two possibilities.  One, a change of heart, policymakers, or circumstances that alters the perceived trade-off between inflation and the real consequences of monetary restraint.  Two, change expectations. 

In the end, we took the first route, but it would be the end of the decade before the right circumstances, the right public mood, and the right people would arrive to get the job done.  Changing expectations would surely have been the less painful route, but how to do that?  The idea of institutionalizing a commitment to price stability -- by way of inflation targets, for example -- was essentially unthinkable at the time.  (It was, in fact, viewed as barely respectable in 1991 when I took up residence at the Cleveland Fed, one of the few places in the United States where such ideas were taken seriously.)  And when it gets right down to it, what do today's inflation targets really amount to beyond public statements that we think inflation is bad, and we really, really mean it?

Maybe President Ford's anti-inflation PR initiative was indeed hopelessly naive, and it certainly didn't work.  But the basic idea was arguably on the right track.  And in the context of the times, wasn't it worth a shot? 

UPDATE: William Polley has items on the situation Ford inherited (also emphasizing the collapse of Bretton Woods) and an extensive discussion of the proposals in the WIN speech.  He also has links to others, including a sympathetic post from King at SCSU Scholars (who also notes that policy credibility then ain't what it is now) and pgl at Angry Bear (who also noticed that Ford called for monetary restraint without a restriction in credit).   

UPDATE II: pgl has more thoughts, at Angry Bear.  I like to think he is right when he says I would have counseled for more monetary restraint had I been asked at the time, but in truth I'm not so sure.  As pgl says, "the 1970’s was a very difficult period for policy makers and their economic advisors."

December 27, 2006 in Inflation, This, That, and the Other | Permalink

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Comments

Had me scared for a minute. Read that as "Christopher Guest."

You forget that it was easy to make fun of the button (see also, tripping); the button itself undermined the policy idea (save that it provided jobs for some button makers).

Posted by: Ken Houghton | December 28, 2006 at 04:33 PM

"It was, in fact, viewed as barely respectable in 1991 when I took up residence at the Cleveland Fed"

That's nonsense, Dave. In fact, the opposite was true. Milton Friedman's presidential address made it all very clear even to non-economists in 1968, and he won the Nobel Prize in 1976.

Posted by: Jeff Hallman | December 29, 2006 at 11:12 AM

Hi Jeff --

Maybe I should be clear that I meant two things -- 1) I was talking about the view that price stability ought to be the dominant goal of the central bank, and that this goal was consistent with the broader goal of sustaining growth; and 2) I was thinking about opinions within the Federal Reserve(and academics who were tightly aligned with the Fed). I should probably include Minneapolis in the group of forward-looking places. But you were there during the Lee Hoskins days, so you surely must remember that the zero-inflation zealotry of the day was much like a voice crying out in the wilderness. Having come to Cleveland from the land of the die-hard Keynesian Phillips-curvers, I'd think that would have been your impression as well.

Posted by: Dave Altig | December 30, 2006 at 09:31 AM

Hi, Dave. I don't mean to be disagreable, but among the MA economists, I think that only a few could be thought of as die-hard Keynesian in 1990. It's true that they tended to be senior people, but even among the senior people, many were not that way (e.g., Dave Lindsey and Dick Porter). And Greenspan himself thought price stability very important.

Where he differed from us Cleveland folk was in how he defined it: we tended to think price stability meant a mean-reverting price level, while Greenspan thought of it as inflation low enough and predictable enough to not enter into economic decisions.

As I recall, most of us in Cleveland thought that was a pretty fuzzy definition, and suspected that it would prove so flexible as to not constrain the Fed at all. That still could turn out to be the case someday, but probably not anytime soon. In the event, it seems Greenspan was more hawkish on inflation than we had thought.

(I still think targeting a specific path for the expected price level would be a good thing, and that it wouldn't be hard to come up with automatic, or nearly automatic rules that would work along this line. A central bank following a rule by definition is more predictable than one that isn't, and the Fed has too often been a source of uncertainty. But the last 25 years have purchased the Fed a lot of credibility, so the issue is not as important as it used to be.)


At any rate, I agree with you that the Cleveland Bank was ahead of the rest of the Fed in advocating price stability. But I don't think the Board was as far behind as it seemed to us at the time.

Posted by: Jeff Hallman | January 02, 2007 at 04:02 PM

Fair enough, Jeff. (Hope all is well with you.)

Posted by: Dave Altig | January 03, 2007 at 09:25 PM

What about inflation´s non-monetary consequence?

"People today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise." Ludwig von Mises - "Inflation: An Unworkable Fiscal Policy".

All prices do not rise. Only the prices of variable real value non-monetary items while many constant real value non-monetary items are not fully updated and many are not updated at all.

The second inevitable consequence of inflation is the tendency of many constant real value non-monetary items NOT to rise at all - during the Historical Cost era while some constant real value non-monetary items are not fully updated.

Inflation today has and always had a second consequence during the 700 year old Historical Cost era.

Inflation has a monetary consequence, called cash inflation refered to above by Ludwig von Mises and defined as the economic process that results in the destruction of real economic value in depreciating money and depreciating monetary values over time as indicated by the change in the Consumer Price Index.

Inflation´s second consequence is a non-monetary consequence defined as Historical Cost Accounting inflation which is always and everywhere the destruction of real economic value in constant real value non-monetary items not fully or never updated (increased) over time due to the use of the Historical Cost Accounting model or any other accounting model which does not allow the continuous updating (increasing) in constant real value non-monetary items in an economy subject to cash inflation.

Inflation´s second consequence is solely caused by the global stable measuring unit assumption.

The stable measuring unit assumption means that we regard the annual destruction of a portion of the real value of our monetary unit by cash inflation in low inflation economies as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

This results in the destruction of at least $31bn in the real value of Dow companies´ Retained Income balances each and every year. Globally this value probably reaches in excess of $200bn per annum for the real value thus destroyed in all companies´ Retained Income balances.

The International Accounting Standards Board recognizes two economic items:

1) Monetary items: money held and "items to be received or paid in money" – in terms of the IASB definition.

2) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

Historical Cost items valued at cost in terms of the stable measuring unit assumption are also included in non-monetary items. This makes these HC items, unfortunately, equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies without well located and well maintained land and/or buildings or without other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

The stable measuring unit assumption thus allows the IASB and the Financial Accounting Standards Board to conveniently side-step the split between variable and constant real value non-monetary items. This is a very costly mistake in low cash inflation economies - or 99.9% of the world economy.

Retained Income is a constant real value non-monetary item, but, it has been in the past and is, for now, valued at Historical Cost which makes it, very logically, subject to the destruction of its real value by cash inflation in low inflation economies - just like in cash.

It is an undeniable fact that the functional currency's internal real value is constantly being destroyed by cash inflation in the case of low inflation economies, but this is considered as of not sufficient importance to adjust the real values of constant real value non-monetary items in the financial statements – the universal stable measuring unit assumption which is the cornerstone of the Historical Cost Accounting model.

The combination of the implementation of the stable measuring unit assumption and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and very company in the world with Retained Income for any given period.

Everybody agrees that the destruction of the internal real value of the monetary unit of account is a very important matter and that cash inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non-monetary item – the change in the real value of money is regarded as of not sufficient importance to update the real value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important! All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals devote thousands of columns to the discussion of the fight against inflation.

But, when it comes to constant real value non-monetary items:

No sir, inflation is not important! We happily destroy hundreds of billions of Dollars in Retained Income real value year after year after year.

However, when you are operating in an economy with hyperinflation, then we all agree that, yes sir, you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies: Variable and constant real value non-monetary items.

But ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% - the rate required for the implementation of IAS 29. Once you are not in hyperinflation anymore (for example, Turkey from 2005 onwards), then, with an annual inflation rate anywhere from 2% to 20% for as many years as you want, you are prohibited from updating constant real value non-monetary items. Then you are forced by the FASB´s US GAAP and the IASB´s International Accounting Standards and International Financial Reporting Standards to destroy their value again – at 2% to 20% per annum - as applicable!

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil’s accounting of their Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of their implementation of the stable measuring unit assumption in the valuation of their Retained Income. (Dec 2005 values).

Revoking the stable measuring unit assumption is actually allowed this very moment by IAS 29 but ONLY for companies in hyperinflationary economies. At 26% per annum for three years in a row, yes! At any lower rate, no!

It is prohibited by US GAAP and IASB International Standards for companies that are operating in a low inflation economy.

That means the following at this very moment in time: Today all companies in, most probably, only Zimbabwe (1000% inflation) are allowed to update all their variable real value non-monetary items as well as all their constant real value non-monetary items.

But not the rest of the world.

The rest of the world is forced by current US GAAP and IASB International Standards to destroy their/our Retained Income balances each and every year at the rate of inflation because of the implementation of the stable measuring unit assumption whereby we are all forced to regard the change in the value of the unit of account - our low inflation currencies - as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

We are forced to destroy them year after year at the rate of inflation till they will reach zero real value as in the case of Retained Income and the issued share capital values of all companies with no well located and well maintained land and/or buildings at least equal to the original real value of each contribution of issued share capital.

The 30 Dow companies destroy at least $31bn annually in the real value of their Retained Income balances as a result of the implementation of the stable measuring unit assumption. Every single year.

Retained Income can be paid out to shareholders as dividens. Poor Dow company shareholders. They will never see that $31bn of dividens destroyed each and every year.

We have all been doing this for the last 700 years: from around the year 1300 when the double entry accounting model was perfected in Venice.

When we do this at the rate of 2% inflation ("price stability" as per the European Central Bank and as per Mr Trichet, the president of the ECB) we are forced to destroy 51% of the real value of the Retained Income balances in all companies operating in the European Monetary Union over the next 35 years - when that Retained Income remains in the companies for the 35 years - all else except cash inflation being equal.

Each and every one of those 35 years will be classified as a year of "price stability" by the ECB and Mr Trichet. Mr Trichet will not be the president of the ECB in 35 years time.

I think we will do ourselves a great favour by revoking the stable measuring unit assumption as soon as possible.

FREE DOWNLOAD : You can download the book "RealValueAccounting.Com - The next step in our fundamental model of accounting." on the Social Science Research Network (SSRN) at http://ssrn.com/abstract=946775


--------------------

Nicolaas J Smith
http://www.realvalueaccounting.com/

Posted by: Nicolaas J Smith | January 07, 2007 at 10:25 PM

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