Wednesday, March 12, 2008

Copernicus and Monetary Policy

Arthur Schopenhauer famously opined: All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident. In the battle between heliocentrism and geocentrism one could argue that the second stage lasted more than 17 centuries. In the case of monetary policy, specifically the choice to define money in real terms, I hope we see a modification of Schopenhauer's path. For thus far, assuming specie money is a better choice, first it was accepted as being self-evident, then it was subverted.

Long before Copernicus drew his first breath, Aristarchus of Samos, in the 3rd Century BC, hypothesized that the earth revolved around the sun. Contemporaries argued that he should be indicted "on the charge of impiety" for disputing the work of Plato, Aristotle and others.

Four centuries later, Claudius Ptolemaeus (Ptolemy), systematized the geocentric hypothesis in the Almagest and Hypotheseis ton planomenon, the latter of which presents the view of the universe, later to bear his name, as a system of tightly-packed nested spheres with the earth at its center.

And so the matter rested for another 13.5 centuries. Fortunately, in this case, faith in the wrong model did not cause economic hardship for the people.

The impetus for this trip down Astronomical History was a read of Can monetary policy really be used to stabilise asset prices? by Katrin Assenmacher-Wesche and Stefan Gerlach.

Their view concludes: Whatever merits such a stabilisation policy has in theory, our research suggests that in practice, monetary policy is too blunt an instrument to be used to target asset prices – the effects on real property prices are too small, given the responses of real GDP, and they are too slow, given the responses of real equity prices. In particular, there is a risk that setting monetary policy in response to asset price movements will lead to large output losses that exceed by a wide margin those that would arise from a possible bubble burst.

My mind flashed to Copernicus while reading their view because it reminded me of the need to add more and more epi-cycles to the Ptolemaic System to make it work right. That is, it was not impiety to note that Ptolemy's system wasn't working right, just as it is not impiety today to note that monetary policy isn't working right. Those who opt for piety simply make the existing system more complex by adding epi-cycles, in the case of astronomy, or ever more arcanely derived rules, in the case of monetary policy. Impiety lies in challenging the basic assumption of the system, in the case of Copernicus, geocentrism and in the case of specie money proponents today, fiat money.

Why, I ask, should we assume that "monetary policy" refers only to the adjustments made within a system of fiat money? Is not specie money a "monetary policy?"

In the preface to Copernicus' seminal work, De Revolutionibus, Andreas Osiander argues:

There have already been widespread reports about the novel hypotheses of this work, which declares that the earth moves whereas the sun is at rest in the center of the universe. Hence certain scholars, I have no doubt, are deeply offended and believe that the liberal arts, which were established long ago on a sound basis, should not be thrown into confusion. But if these men are willing to examine the matter closely, they will find that the author of this work has done nothing blameworthy. For it is the duty of an astronomer to compose the history of the celestial motions through careful and expert study. Then he must conceive and devise the causes of these motions or hypotheses about them. Since he cannot in any way attain to the true causes, he will adopt whatever suppositions enable the motions to be computed correctly from the principles of geometry for the future as well as for the past. The present author has performed both these duties excellently. For these hypotheses need not be true nor even probable. On the contrary, if they provide a calculus consistent with the observations, that alone is enough. Perhaps there is someone who is so ignorant of geometry and optics that he regards the epicycle of Venus as probable, or thinks that it is the reason why Venus sometimes precedes and sometimes follows the sun by forty degrees and even more. Is there anyone who is not aware that from this assumption it necessarily follows that the diameter of the planet at perigee should appear more than four times, and the body of the planet more than sixteen times, as great as at apogee? Yet this variation is refuted by the experience of every age. In this science there are some other no less important absurdities, which need not be set forth at the moment. For this art, it is quite clear, is completely and absolutely ignorant of the causes of the apparent nonuniform motions. And if any causes are devised by the imagination, as indeed very many are, they are not put forward to convince anyone that are true, but merely to provide a reliable basis for computation. However, since different hypotheses are sometimes offered for one and the same motion (for example, eccentricity and an epicycle for the sun's motion), the astronomer will take as his first choice that hypothesis which is the easiest to grasp.

As humanity experiences the economic tumult that resulted, in part, from a system of undefined value money that allowed such massive imbalances to grow unchecked, that the virtues of specie money will become clearer.

Specie money, as history shows, won't stop the formation of asset bubbles, but this policy not only attenuates the excesses, but, far more importantly, provides a base to which the general price level can return. In the event of a global hyper-inflation, I suspect the virtues of such a feature will be clear.


STS said...

Nice historical context, but it doesn't really prove your point. The weaknesses (or epicycles) of the fiat money system are on daily display. What needs to be established -- if I understand your intention correctly -- is that a specie money system can avoid those weaknesses.

In reading history one often comes across references to things like "the panic of 1819" or "the panic of 1873" and unfortunately there isn't nearly as much literature on what exactly was going on economically in those episodes as there are narratives which merely gloss over them as spells of "bad weather" in order to get onto the "more interesting" discussion of whose political prospects were helped or hindered.

If you haven't already, I would recommend you read Barry Eichengreen's "Golden Fetters" for its treatment of the moderately well-functioning gold standard of the latter 19th century. I would value having your reaction to that.

I'm a fan of gold right now, but more on the basis of Keynes' "Old Maid" game theory than from a belief in its merits as currency.

Dude said...

I think in this case the proof will become empirically obvious, or not, depending on the way events unfold.

I don't think the use of specie money avoids bubbles altogether, the examples cited in MacKay's Extraordinary Popular Delusions and the Madness of Crowds, speaks to this. Credit fuels both real productivity advances and bubbles.

As I noted at the end of my piece, I think a key benefit to specie money is the preservation of a base to the general price level. The panics you note were much more quickly resolved then modern crises and prices returned to their old levels.

I'll read Golden Fetters and post on it.