Michael Bordo on Anna Schwartz, Financial Crises, and Life as a Monetary Historian

Michael Bordo is a professor of economics at Rutgers University where he is the director of the Center for Monetary and Financial History. Michael is also a distinguished visiting fellow at the Hoover Institution at Stanford University. He has been a visiting scholar at numerous central banks and is a research associate at the National Bureau of Economic Research. Michael has published widely in the field of monetary economics and monetary history and has many articles published in leading journals including the Journal of Political Economy, American Economic Review, The Journal of Monetary Economics, and the Journal of Economic History. Michael joins David to discuss his thoughts on the Great Recession, challenging the notion that financial crises like the one in 2007-2009 are necessarily followed by slow recoveries. David and Michael also chat about the history of American banking law and how restrictions on interstate-branch banking until the 1990s hindered economic growth. Finally, Michael gives some advice about how to be a successful monetary historian.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Michael, welcome to the show.

Michael Bordo: Well, thank you.

David Beckworth: Let's begin by asking, how did you get into macro economics and in, particularly, economic history?

Michael Bordo: Yes, I was a graduate student at the University of Chicago and I was a student of Milton Friedman and Robert Fogel. And I worked in both monetary economics and economic history and I got interested in monetary history, primarily through reading Friedman and Schwartz's A Monetary History of the United States. And so I wrote a dissertation under Friedman's direction with Fogel on the committee and it was dealing with an issue that was of great interest in the monetary policy debate at the time. This is in the late '60s, and that was the question of the first round effects of monetary change. Does it matter if the money supply increased through an open market operation, or did it increase through a gold discovery, or did it come through ... money produced inflation?

And that was the topic and what I did was I looked at different episodes in US monetary history where money came into the system through different channels and then I analyzed whether it really mattered and my results were sort of consistent with what Friedman was arguing at the time, that the first round effects were not that important. What really mattered was the amount of money that was being injected into the system. So that's how I got into it, and then all my research from then on sort of came out of that, but I worked both in monetary... current monetary issues, monetary theory and policy and I also work in economic history.

The other influence on me was that I started working with Anna Schwartz. The year after I left Chicago, I... Friedman arranged for me to go to the National Bureau of Economic Research where... in that time was in New York City to work with Anna on getting the data I needed for my dissertation. And spending four months with Anna really got me more into it. And then we started writing papers together. She had a paper that didn't have time to finish, she asked me if I would do it. I did and it worked out really well and then one thing led to another and then I had a whole series of papers I've done with Schwartz for 40 years and that was really extremely important in the development of my career.

David Beckworth: Well that's great you've had those incredible figures around you concerning your work and you've been very productive yourself. And I want to ask, for someone like me, maybe some of our listeners, we can go to FRED data, download our macro economic time series, stick them into a vector autoregression, spit out some cool results, but when you do monetary history, I mean you dig into the archives, right? I've seen a number of your papers where you've gone back and I'm guessing painfully constructed historical data. What is that experience like and how does it go for you?

Michael Bordo: It's a lot of fun. I don't feel it was that much. I do it, I've done it, but... and I did it obviously for my dissertation and a lot of the work that I did earlier in my career. It's a lot of fun. I mean, if you're digging and you're looking for data... in some cases, I remember just brushing off the dust from just opening up old books. But no, it's very useful.

I mean, what's happened today is that a lot of the data that we used to dig for through the control of the currencies annual reports and the US treasury reports and... which is the level I operated in. I didn't operate at the state level, was that... and that involves actually going to the library, getting the books, going through the stuff, okay... and I did all that and then I had research assistants to help me. But now, you've got FRED and they photocopied all of the reports that follow the currency and everything else. And so, for the kind of macro work that I do, it's gotten a lot easier and it's much, much easier.

That's not to say that the work that many younger economic historians do, which is largely at the micro level bank data, that's where all the advances and research in monetary history are going now. They're looking at bank level data and in the States and across countries and that takes a lot of work too.

But again, much of the data has been put online or it's on microfilm... in fact, data that I used was microfilm back then. So it was fun and it's nice that we've got these... the technological advances. That means it's a lot easier for everybody.

David Beckworth: Yeah, absolutely. I think even some of those documents you've mentioned are... some of them have been coded in the data. I know for example, that Balke and Gordon historical time series on GDP which goes back, I think at a quarterly frequency of the 1870s which is pretty awesome. I remember when I first saw that, I had to open up a big book and code it into Excel or some data spreadsheet and then run it through a program. But now, it's on Fred. Fred has it, you can actually download it directly into a program. So yeah, technology definitely has made our lives easier.

Michael Bordo: For me, Anna Schwartz was the pioneer because she was largely involved with putting together the data that was used in Friedman and Schwartz and that... but she did most of the dog work that monetary economists use. Balke and Gordon, if you look carefully, they just interpolate data that they got from other people. They didn't put together any original data. It's just a useful compendium.

David Beckworth: I see, okay. ... no, that's interesting. You're at Rutgers and it happens that you have several other individuals, similar interest as you... economic historians who've looked at banking and money issues, you've got Hugh Rockoff which we had on previously, also Eugene White. So, that's an interesting arrangement you have there. Are there many other programs like that that have three well-known monetary historians working together? Because I know you've had projects with these individuals as well in the past. Are you a unique program in that regard?

Michael Bordo: Yes, we are. Nobody else does this. There're other places in the US that have concentrations of economic historians. We're pretty specialized and that was the design. I mean, first Hugh Rockoff joined Rutgers I think around 1970, and then Eugene White came a decade later and then they brought me in another decade after that, so... but the idea was for us to have this specialty. And we are unique.

David Beckworth: So, if you want to get your PhD and have a concentration in monetary history, you know where to go. Okay-

Michael Bordo: Exactly.

David Beckworth: Let's move onto some of your interesting work. And I want to move to the first general kind of theme and that's your work on a Great Recession we've been through and kind of slow recovery coming out of it. Raghuram Rajan had a book, Fault Lines in 2010 and in that book, he argued that a key force behind the build ups that eventually led to the collapse 2008, 2009 was rising inequality. And you've co-authored a paper in response to that. So what is his story and then what is your response to that? What did you find in your research?

Did Rising Inequality Help Drive the Great Recession?

Michael Bordo: Okay, well his story really simply was that growing inequality has been a big issue in the last many years really and go back maybe 30 or 40 years and that each administration regardless of whether it was democratic or republican felt that they wanted to tackle it, but they really couldn't tackle it directly through congress and so they dealt with it through... largely through housing policies to make it easier for people to own their own homes. And that these policies as well as encouraging institutions like Fannie Mae and Freddie Mac to ease up on their lending standards, that these policies led to the credit boom that led to the financial... the boom in real estate prices that led to the crisis in 2007.

I mean, it's very simple, I mean it's a simple argument. I gave it to you in three sentences. I mean, he goes through all the different administrations, it even goes back to Roosevelt. I mean, some of the... many of these institutions were first set up in the... during the Great Depression.

And so the implication of all of this is that inequality, rising inequality leads to financial crisis, okay? This is sort of the bottom line that came out of his book and I was skeptical of it. I read the book and I said I don't believe it, I got my friend and co-author, Chris Mizer involved in this project and we wanted to see what the evidence showed. And what we found was that for across country panel of 14 countries going all the way back through the 20th century, that there is a relationship between the growth of bank credit, that's called a credit boom, and banking crisis. And that this is a relationship that a lot of people have written about. So we find very strong evidence for that.

We could not find any statistical evidence that the rise in bank credit in... the credit boom was caused by inequality. We found some episodes where it was... there was a correlation like in the 1920s in the US, okay, and the case of... I think that one other case we found was Japan. But the other countries, it wasn't there, so that basically... we are, I was, and I still am skeptical of that story.

David Beckworth: Now is that story similar to the one that's been made about the 1920s? So before we even had the Great Recession, right, there's some historians who said 19... the Great Depression was a result of rising inequality in 1920s and I believe that story was largely... highly criticized in the literature. So, is Rajan's story similar to the one that was told about the 1920s?

Michael Bordo: It's the same story. It was brought up to date, but he's not the only one. There are a lot of people Atkinson in the UK, a very well known economist has been making this case. And there's a strong view out there that inequality causes financial crisis.

So work that Mizer and I did was not included in that article because we found that in general that we couldn't find much of a link between inequality and banking crisis, but we found there was some evidence with currency crisis in developing countries and there is a literature on that, that certain people gain and certain people lose when there's a big devaluation and generally, the affects tend to be worse for poor people. And so we corroborated that, but that didn't go into this article which is kind of- ...

David Beckworth: Okay.

Michael Bordo: ...  in a sense there is... so there's a lot of work out there on this, on debt crisis, currency crisis, et cetera, and we didn't talk about it so that... we had a very specific hypothesis and we didn't find the evidence consistent with it.

David Beckworth: Okay, how was that received? Did Rajan reply to it or anyone else?

Michael Bordo: No. I mean, there was some interest in it. I gave the paper at the summer institute at the NBER in 2013, and... but most people that were there kind of agreed with me. Most people I spoke to said that Rajan gave a nice story, but he hadn't really done his homework and that really they were not surprised at all. So in a sense... that paper did not lead to a lot of... it didn't get picked up much in the press, it sort of disappeared, but anyway, yeah- ...

David Beckworth: Well, it confirmed what a lot of people were probably thinking, that they were skeptical that inequality can drive a crisis this big. All right, well let's move to another paper of yours which is very similar. Again, this is within the theme of the Great Recession and this is a paper you wrote that addressed whether financial crises inevitably lead to long weak recoveries, and this question has been, at least in the popular view a kind of a general consensus is, the answer is yes. But there's been a number of papers including the one that you co-authored that raised some questions about this. Ryan Hart and Rockoff probably the best known who said definitely, after there's a financial crisis you're going to have these slow weak recoveries. But you found evidence pointing the other direction, so can you speak to us about that?

Do Financial Crises Inevitably Beget Slow Weak Recoveries?

Michael Bordo: Yes, so this paper of ours did go viral. It was written up in all the press, it was a big deal. So,  Ryan Hart and Rockoff came out with these facts in their book... what's the book? I forgot the name. Anyway, in their book that came out in 2009, arguing that big financial crisis almost always lead to slow recoveries, so they lead to deep depressions and slow recoveries. And their evidence came from looking at history from a panel across a large number of countries.

And so, I was skeptical of this too because I, as a student of Milton Friedman, remembered that Friedman used to talk in his class about this model he called the plucking model. And it was an analogy for the US economy and his analogy was think of a board that's sort of held at an angle of 20 degrees or 30 degrees and you got a string suspended underneath the board at each end. And then you pull the string down and it bounces back, okay? And he said that the further... the more you pull it down, the faster it bounces back, okay?

And so that was his analogy for that if you have a deep recession, you're going to have a faster recovery, okay? And not only was it a story, but he had a lot of evidence in his work and Victor Zarnowitz who was one of the great NBER researchers in a very famous book on business psycho also documented that fact. And furthermore, what Zarnowitz showed was that many of these recessions in US history also had ... panics in them, okay?

And so given that I knew this, I knew this from my Chicago background, I got involved with Joe Haubrich at the Cleveland to see if we could systematically analyze this for the US. And we did and we did a lot of work and what we found was that Friedman's hypothesis held up very well, that the plucking model held up and that moreover, that having a banking crisis would be associated with a faster recovery, okay?

Now, there was a huge amount of push back against this because it was believed by everybody that... including the Obama administration at the time that it's inevitable if you have a big crisis, the recovery's going to be slow. And what we said was that looking at the US record, that the recent recession was definitely an exception to the pattern. And we didn't... in the paper, we didn't give any answer, but what we thought at the time was it had a lot to do with how... it had a lot to do with the collapse of residential investments. And we also thought at the time that it had a lot to do with policy uncertainty, and now I'm more convinced of the second argument than I was at the time... when we first wrote the paper.

So, the key thing though is... and of the push back we got, it took us a long time to get the paper published because every referee that Ryan Hart wrote ... the push back was to try to make the point that the results were strongest based on the pre World War two evidence which is true because there were no big banking panics since World War two. We've had FDIC, there was only one big banking crisis and that's the one we just had. And so when you account for all this stuff, we still get the result, okay, but it's not as strong.

So, if you take into account the recent periods that it's not as strong as what you get for pre World War two. So we qualified ourselves, we did a lot of sensitivity analysis, we went through three journals and we finally got it out and... but the paper itself went viral and as you know, it was a debate, it was discussed in every major newspaper and the Wall Street Journal did an editorial on it and I did an article for the Wall Street Journal.

So, the Wall Street Journal went... really went to town with it, as did John Taylor, but as you would expect, the newspapers from the different... slightly different persuasions went the other way, okay? So yes, so that was a lot of fun.

David Beckworth: Well, that's the mark of a great paper though, right? It gets widely cited even if it doesn't get published right away, you know you did... it got the discussion going, it raised some interesting questions. I remember reading Ryan Hart and Rockoff's response, they weren't very happy about it, but in general, I think it was a fun conversation and an important one because it helped us step back and kind of not be so caught up in the moment of the crisis we're in and say hey, what does history teach us? What is the systematic evidence teach us?

Now, you mentioned a reason why this recovery has been slow, it's not because it was inevitable, but you mention policy failures and in particular, policy uncertainty as a key reason. Gerald Dwyer and a co-author, I believe Atlanta Fed wrote a piece that came to similar conclusion. I don't think their paper was as extensive as yours, but they also argue these... a slow recovery is not inevitable after a financial crisis and they also pointed to policy failure. And they mention policy uncertainty as well as just maybe a tepid response, right? So which of those two do you think really mattered more? Was it more of a tepid response by macro economic policy or was it more the policy uncertainty that explains the slow recovery?

Michael Bordo: I'm thinking it's policy uncertainty. I mean, if you think what was the policy response? So looking back over the years... and I've written a lot about this too, I mean, I think the Fed did some... made some very big mistakes. I mean, they were... had a lot to do with causing... fueling the house price boom by keeping interest rates too low for too long. But then during the crisis, they engaged in lender of last resort policy most of which worked, but they had a disaster in the case of Lehman, they got that one completely wrong.

So there's a big debate about lender of last resort. I think monetary policy was too tight in 2007, 2008 especially before the Lehman crisis. That might have ... that might have something to do with the recession. But then the recovery... so there's a debate about there wasn't enough fiscal policy. There's a debate that QE could have been done more and I think that QE was the right policy, but they did some things that really didn't make it as effective as otherwise could have been.

I mean, I have a new paper which compares the 1932 open market operation at the Fed ... with this one, and actually even though it was very short lived, okay, and much smaller in many respects, actually had a bigger impact on the economy. So things like paying interest on excess reserves, okay, and in a sense thinking of QE affecting the term structure rather than working directly through a quantity theory mechanism probably meant that it wasn't going to be as effective as it could have been, okay?

But that said, I don't think that's the cause for the slow recovery and I don't think... the other issue that most people bring up is fiscal policy and Obama... the big Obama fiscal package wasn't enough. I'm skeptical of that too, okay. I mean, I'm not saying it's not true, but I think the evidence is not overwhelming that it was that effective, okay? So maybe the policy response could have been more, but I think there are other issues that are more on the supply side and this issue of policy uncertainty.

I have a paper I've just... we're just publishing now with two guys at the Dallas Fed which is getting a lot of attention too and that's showing that the policy uncertainty had a significant effect in reducing bank lending after the crisis, okay? And a significant effect on real growth. It reduced the growth rate since the recession by 0.5%, okay? So that's not... I mean, seeing as we're growing at less than 2%, that would have made a difference- ...

David Beckworth: Right. Big difference.

Michael Bordo: ... and others like Baker and ... showed that it really affected investment. So my gut feeling is the policy uncertainty story and various regulations that have been put in or in addition to those that have been put in in the financial sector, but those that are impending, I think that's really had a bad effect on restricting than lending investment, okay?

And then there's the story about productivity and I don't think that's necessarily a Great Recession story, but low productivity is a good part of it.

David Beckworth: Yeah, I'm very sympathetic to the earlier point you made about the Fed 2007, 2008 effectively being too tight. I would also mentioned QE even though QE arguably may have helped, it was very ad hoc, right? QE1, QE2, QE3 a sense of make it up as we go along, and I think the uncertainty that itself created probably wasn't the most useful or helpful as well.

Michael Bordo: Exactly-

David Beckworth: And also going back to your quantity theory versus kind of the credit easing approach, I marvel when I go back and look at the Fed response in 2007 where they kept their balance sheet stable, they were selling off... they were lending to banks and for every dollar loan they made, they sold their treasury so they were effectively sterilizing their monetary injections. Where Friedman was much more if you're going to help out in a crisis, you increase the monetary base, you don't sterilize it.

So there's a lot of interesting things I think to be said about what the Fed failed to do in their early part of the period, but I also appreciate your point about policy uncertainty. And I look forward to reading your paper on QE. Is that out already, the one comparing the '30s to the present?

Michael Bordo: We're putting it out as a working paper this week. I finished it and it's being submitted to a jounral so I guess... so it will be NBER working paper within a week or two.

David Beckworth: Fantastic. Yeah, I look forward to reading that. Well, let's go to one other interesting case relating to the Great Recession and that's Canada. And you have a paper that's titled “Why Didn't Canada Have a Banking Crisis In 2008 (or in 1930, or 1907, or...)”. So they've had this remarkable experience avoiding some of the problems we've had in the US, so tell us about that and why is that the case?

The Canadian Experience with Financial Crises

Michael Bordo: Sure. Well, this is a big research project that I've been engaged in for a long, long time with my colleagues ... she was a UBC in Canada and Hugh Rockoff here, and we've looked at this question of why the Canadian banking system was so stable in the last two centuries, and the US wasn't. And the main answer we came up with was branch banking, was nationwide branch banking, the fact that the US had unit banking. And other people have said the same thing, but we documented that pretty closely.

So as I said, we did a number of articles in the 1990s on this which got a lot of attention. So the recent... what happened was I thought we could extend this to the recent episode and we did, and we found that in a sense, there were... not only was it the bank structure story, but there were other issues of regulation and so one of the key differences between US and Canada is the Canadian financial system consolidated itself in the period from the 1980s until the present.

And so what we would call the shadow banking system in the US and that includes mortgage finance industry and investment banks, these two sectors became absorbed into the Canadian banking system, okay? And so it meant that Canada had a... developed a universal banking system. In addition to that, you had one regulator over the banks. So in other words, in the US you've got more than a dozen regulators over different parts of the shadow banking system and then you've got national banks, state banks, the federal reserve, you've got control over the currency, we've got the Fed, FDIC, blah, blah, blah.

Canada, it's a lot simpler. I think that... we think that had a lot to do with it, okay? So it's bank structure plus that, and also historically, what happened was when we wrote our papers in the '90s, we thought that the US was going to go in the Canadian direction, it was going to consolidate and create nationwide branch banking. And this was the time of Gramm... what is Bliley-Leach... I think it was 1996 which kind of allowed banks to have interstate branching and also when they got rid of Glass-Steagall. So we thought that the US would move in the Canadian direction.

What we didn't take into account was that regulation would not move in the Canadian direction, okay? And the other factor that was different about Canada from the US and also from the UK which has a banking system that's not that different from Canada's is that there was a major financial center in Canada's .... It's not a global financial center. And the Canadian banks, okay, were not really big players on the global financial scene.

And one thing that happened... and we only mentioned this in passing in the paper, but something I've been thinking about even more is that with growing global competition across universal banks, okay, and financial integration, okay, there's pressure being placed... this is occurring in the '90s and the 2000s, in the US and the UK to weaken the rules, to reduce capital requirements, to make it easier to do financial innovation.

In Canada, they didn't allow the banks to do it, okay? There's an apocryphal story about Toronto-Dominion Bank which operates down here that wanted to go and set up an SIV and engage in NBSs and the Bank of Canada... David Dodge who was ... he was a friend of mine, he just said no, you can't do it. Just like that, no. Okay, so these things... so there is this regulation and bank structure and these are the main factors.

David Beckworth: It's striking to me that what you just mentioned a minute ago, that the US did not really have full interstate branch banking until the '90s. Is that right?

Michael Bordo: That's correct-

David Beckworth: It's hard to believe. So in other words, before that point in time, at most, a bank could have branches within a state, but not beyond a state line. And you think of all the problems that creates for diversification of a bank's assets, for financial stability, it took us that long to get interstate branch banking, it's mind blowing. I mean, what's the history behind it? Why did it take us so long to get to that point?

Michael Bordo: Okay, that's a very big... and by the way, I should tell you that... so we were talking at the beginning about research in monetary history, so there's a lot of work being done by young people and probably the first one, the pioneer in this field is Eugene White who looked at the data on unit banks. Because most states didn't allow branching either, okay? Only a few did, California was one. ... so not only is it a problem of lack of diversification, but unit banking, okay, makes things even worse, okay? So there's a lot of work that's been done on unit banking and on the mechanisms that were devised to get around these regulations like the use of the correspondence system and the use of clearing houses, okay?

But all of these US innovations, clever though they were, were not as efficient as nationwide branch banking, okay. Now, to get to your question, okay, it's a politically economy question. Okay, it goes back to Alexander Hamilton really. At the time of the American revolution, the revolution did not want to have any part of the system, the British system and that included the Bank of England which had a monopoly over the issue of fiduciary money and also a monopoly over banking. And so US didn't want that.

Hamilton comes along and he realizes that the Bank of England is a good plan, okay, and so his original plan in 1790 had created the first bank of the United States. And it was a chartered bank, okay, it was a government chartered bank which had branches in every state, okay? It was like the Canadian banks, okay? And there was a lot of push back by states rights people, by populous against the first bank and it was shot down, okay, in 1811 as charter was not renewed.

Then they set up the second bank in 1816 and it did a pretty good job, okay? I've written a paper on that, okay, but yet it was shot down too by Andrew Jackson on exactly the same grounds. So there was this fear of the concentration of power, okay, in having these nationwide branch banks. And especially if they were government chartered. And even more so if it was seeming to be a central bank.

And so this opposition to the concentration of power and even more so on the east coast is deep seeded in the United States, it goes through everything. We still hear it today. It's in the election campaign, break up the bank, Wall Street, blah, blah, blah. That's the story that goes back to ... century.

Canada didn't have that system, okay? In Canada, the Confederation, the Articles of Confederation gave the Federal government the control of the chartering of banks, okay, not the states, not the provinces. And the US, okay, after the break down of... well, actually I should back up the tape. The congress gave the power to create money... oh, sorry, the congress got the power to create money and regulate it, right? But they did not say anything about banking, okay? And one reason the second bank was shot down and the first, was it wasn't in the constitution.

So what that meant was... by the way, the constitution works, the delegation of powers, that banking went to the states, okay. Once you set up an industry, okay, like banking, okay, there are a lot of forces that come into play, political forces that try to correct... try to create barriers to entry from outside. Now the book by Calomiris and Haber goes in great detail into that story, okay, about rent seeking. And so I think that that really was part of the story, that had Canda... had the provinces got the power to charter and regulate the banks, we could have had an outcome, Canada could have had an outcome like the States.

David Beckworth: Interesting. I mean, I think we see that also, kind of the state power in terms of we have... each state has their own insurance regulator as well as opposed to one Federal regulator insurance. So the state rights is a reason... state right emphasis is the reason for this unit banking laws combined with rent seeking by, I imagine individual banks.

But going back to Canada, I mean, in your article on it, it's a striking paragraph where you talk about how dire the circumstances were in the US, the Federal government got involved, there was TARP, all this intervention. But in Canada... I want to quote your words here, "In Canada, there were no bank failures or government bank bailouts and the recession has been less severe than either that of the early 1980 or 1990s." That's just amazing. I mean, no government intervention to help the banks and just overall economic activity did not slow down anything near what it did in the US. So it sounds like we have something to learn from the Canadians.

Michael Bordo: Oh, yes-

David Beckworth: Based on what you're saying though, I don't see it happening any time soon, though.

Michael Bordo: Look, whenever Canada is brought up in comparisons to the US and when it comes to economic policy, it never goes anywhere. ...

David Beckworth: Well, it's interesting though, it provides a benchmark for us at least to aim for, so-

Michael Bordo: Yeah.

David Beckworth: Well, let's talk about another paper of yours. Let's move over to Europe and the eurozone crisis and you've talked about that. And you've written a paper, it was real interesting, it's called “A Fiscal Union for Euro: Some Lessons From History.” And you address some of the issues behind the eurozone crisis, in particular you talk about is the eurozone truly a optimal currency area? And many observers would say no, they don't have a true fiscal union. There's nothing like a US treasury equivalent over there. So tell us what your paper attempts to do and what does it show from its findings?

Is the Eurozone an Optimal Currency Area?

Michael Bordo: Right, so I did this paper with Lars Jonung and another co-author, and Lars Jonung and I had worked together for many, many years. We had written a very influential paper and a book in 1999 on monetary... on the history of monetary unions. And we speculated on would... the question was would monetary... would EMU work like a national monetary union like the US, or would it work like an international monetary union like the Latin monetary union?

So anyway, so that paper ... something we said in that paper was that one of the major aspects of creating a monetary union was that it was... in nation states, was that it was associated with the creation of the state and that not only do you need a monetary union, but you need a fiscal union, okay?

And I was always thinking about the Alexander Hamilton story, again, that he understood this and he knew that the only way to get the United States to work was to have a Federal government that had a funded debt, he learned that lesson from Great Britain and he created a Federal bond. And he also resolved the ongoing debt crisis that the US states had and the Federal government after the American revolutionary war. And so he created a fiscal union. He created the foundations of it. It took until Roosevelt to really create a fiscal Federal system, okay?

So what we did in this paper was we looked at US history, Canada and a number of other countries, okay? Countries that were successful... that we said had a successful fiscal unions and those that didn't. And the ones that didn't where the Latin countries where they couldn't work out a deal whereby the states... in a sense strained from running too large fiscal deficits, that one of the key things that Hamilton... that came out of Hamilton and came out of the US experience in the 1830s when there was ... 10 states defaulted on their debt, was the no bail-out clause, the Federal government in a sense, the congress said no, we will no bail out the states, and the states defaulted.

And so that idea of the no bail-out clause and the fact that there had to be constraints on the member of governments in a fiscal Federal system, okay that we said had a lot to do with why some countries were successful and others were not. So then we applied this to Europe and we said the framers of the EMU debated this, many of them, the Germans especially thought a monetary union could not work without a fiscal union because once you take away... you create a monetary union, you take away the instrument of monetary policy at the national level, okay, that's the main instrument of stabilization .... And unless you have a fiscal Federal system where you can transfer resources from those countries that win... that don't do too badly in a recession, to those countries that do badly, okay, through the tax system like we do in the US through the income tax and through unemployment insurance, unless you can do something like that, a monetary union is not going to work. It's going to break down and it's going to be dysfunctional.

And of course, that exactly happened, okay? And also the issue of the no bail-out clause and the issue of credibility. All these issues were discussed in the case of the United States and Canada and these other countries. So we, basically, applied the lessons from history to Europe and so we were not surprised by what happened. And I'm still a strong advocate that if the European monetary union wants to succeed, it's going to have to move in that direction okay, even though the forces... the political forces right now are going in the other direction. And so the opposition... so the fact that you have to give up sovereignty to do this suggests that the future of EMU is definitely not too good.

David Beckworth: Yeah, I was going to say your diagnosis, your outlook doesn't seem very bright for the eurozone given that it needs a fiscal union to survive.

Michael Bordo: Yeah, but we're not original. I mean, look back in the '90s okay, Marti Feldstein said it would break down the EMU and it'll end up in war, okay. So he was a little-

David Beckworth: ... foreign affairs article he wrote, yeah.

Michael Bordo: But Milton Friedman said it wouldn't last, it wouldn't last for more than 15 years and his arguments were the same. Anna Schwartz, same story. I mean, so the old monetarist and Marti wasn't a monetarist, but it's pretty close, were very skeptical.

David Beckworth: Yeah-

Michael Bordo: And were-

David Beckworth: We talked about this a little bit with Hugh Rockoff and I mentioned to him there was an article that came out in Econ Journal Watch, I believe, and it written in 2009 by two European economists and they went through and kind of cataloged all the American skeptics of the eurozone project including yourself and others who's saying it won't work, it won't work unless you get all these things checked off. And they wrote it in 2009 and they said see, it's worked. You guys should have listened to us, this... we make the currency union and we turn it on and endogenously it's going to grow into a true optimal currency area. Of course, the next year 2010, a eurozone crisis blows and one of... probably the most poorly timed articles published ever.

Michael Bordo: Yeah. You know who wrote that paper? My co-author Lars Jonung and he sent it to me. I remember, I was- ...

David Beckworth: Really?

Michael Bordo: He sent it to me and I said, Lars, I said I would be very cautious about putting that paper out and of course Krugman took it up, but anyway, yeah, Lars was a-

David Beckworth: And that was your... okay, that's interesting.

Michael Bordo: Lars Jonung, yeah, he's my buddy, yeah. He was the one. I had nothing to do with it. I warned him about it. I didn't believe it.

David Beckworth: Well, do you guys ever like over drinks ever talk about that article, get a good laugh out of it now?

Michael Bordo: Oh, yeah, we definitely do. I just saw him this summer. I was at his ... oh yeah, definitely.

David Beckworth: Yeah, no one can say economists don't have a sense of humor. You guys can laugh over that article. Well, that's great. Okay, I want to switch gears and talk about a paper you've written that I actually cited in some work that I did, but I found very interesting. And this was work that you did with Angela Redish on the post ... deflation period as to what it tells us about deflation, right? So kind of the standard view is deflation is always in everywhere a horrible thing, but you have something else to say about that and that period. So, please share with the listeners what you found.

Deflation and Inflation

Michael Bordo: So that paper... we did a couple of papers on that and basically, the point we made was that you got to distinguish between good versus bad deflation. And again, a lot of my ideas go back to my Chicago days and Friedman stories he told about the national banking era, the pre 1914 period that we had a period of 20 years from 1879 until '96 where we had falling prices by about one or two percent per year and the economy grew pretty rapidly by three to four percent per year. And then we had a period of rising prices from 1897 to 1914 and the economy grew about the same amount, okay?

And so his point was that the growth rate of output is determined by these long run, deep fundamental real forces and that the behavior of prices depends upon how fast money is growing relative to the real economy. And so if you have... if deflation is expected, it's not going to be that much of a problem, okay?

And so picked up on that and we did some empirical work which kind of backed that up, okay? I mean, the thing is that... and there's a huge debate on this, but we backed that up for the US. And then there were... I did a paper once which you didn't cite by... with Andy Filardo in 2004. It was an economic ... which looked at a big panel of countries for both the 19th and 20th centuries. And we found the evidence backed this up, okay, that really there was this significant difference good versus bad deflation.

And that by bad deflation, we met the Great Depression, okay? And that's what people think about. When they think of deflation, they think of a period where prices are falling by 10/15% a year and with nominal rigidities in place, the output falls too, okay? And we said there are many examples in history and many example of other countries' histories which show that you can have low inflation and rapid economic growth, okay?

I still stand by that. I mean, obviously a lot of people focus on the Japan case in the '90s and the 2000s. That's a story of stagnation and it's not really a story about deflation. They've conflated these two things and I really am not convinced that it's because prices fall once in a while that their growth rate is low. I think there are other really important real factors that explain that and these things have been conflated.

The Federal reserve is paranoid about Japan and they're paranoid about the Great Depression. And once of the reasons why they messed up and gave us the credit boom... helped give us the credit boom from 2003 to 2006 was they were worried about deflation in 2002 and 2003, they were worried about... and so the Fed was unwilling to tighten.

David Beckworth: No, I completely agree with that. I've worked with ... who has a strong view on this as well and he stresses... and I think similar to what you mentioned in your papers is that deflation that's driven by rapid productivity gains, as long as demand is stable, you can have stable demand, stable spending and still have a gentle fall in the price level if there's rapid supply side changes, rapid productivity growth. The type of deflation you want to avoid is when there's sudden unexpected drops in spending, when spending is not stabilized like the Great Depression.

But you're right, it's hard for people to see that distinction because as economist ... brought up... taught the horrors of the 1930s, never to repeat them again without kind of distinguishing them. But hopefully your work and others will help people better delineate the difference between a benign and malign deflation.

In the few minutes we have left, you have so many interesting papers, there’s one more I want to touch on and that's a question about using inflation as a solution to excessive national debt. This is a paper you've written on this topic and right now, that doesn't seem to be a pressing problem for the US, maybe in the future with our unfunded liabilities, and right now there seems to be a huge appetite for our debt, interest rates are at all time lows. In fact the number of countries that have safe assets there seems to be almost an insatiable demand for our securities. But this is a issue, right? Long term, there's unfunded liabilities, there's always this issue about debt burdens and there's always the temptation to inflate them away with the printing press.

So what did you find in that paper titled “Under What Circumstances Can Inflation Be A Solution To Excessive National Debt? Some Lessons From History.”

Michael Bordo: I mean, I think I did that paper for a conference in Germany about four or five years ago and I wanted to make the point that if you... okay, I'm trying to remember what my arguments where back then. Okay, so there were a number of ideas that I was thinking about. One was what happens when you run really large deficits? And I was thinking in terms of the fiscal theory, the price level, and I was also thinking in terms of ... arithmetic and they both come out to the same conclusion, although using different methods. And that is that if you run large fiscal deficits, ultimately, you're going to have inflation, okay? Because you're going to end up having to deal with this huge... you're either going to have a default, like an emerging country or you're going to inflate it away.

And so then... so starting with that, I then looked at history and I said well, what's the really... the really bad story is the German hyper inflation, okay? But there were other cases where... like I was focusing on France in the 1920s where you had high inflation because you couldn't work out this fiscal deal, okay? And then eventually the inflation became such a problem that they had a currency crisis and then ... came in and there's a whole story about the politics of it, but he stabilized the system and he returned France to the gold standard.

And so I was arguing that in most cases, you got to be careful not to have run up big fiscal deficits because they can lead to these problems at the other end. In war time, obviously, you need... the inflation tax is a way of funding government expenditure and it's a way of smoothing taxes and creating revenue. And there was a paper once by ... on revenue smoothing.

So I've argued there and in a few papers that if you have a mix of issue of ... money, inflation tax, taxation on labor income and bond finance that may actually be optimal.

And then I think the last point that I might have mentioned in that paper was after World War two in the United States and I argued that what happened here was that we came out of the war with huge debt, well over 250%... well over 200% of GDP and how did we get rid of it? Well, the way we got rid of it over 20 years was by growth, rapid growth, okay, so that raised the denominator of the debt to GDP ration. And secondly, we had low inflation, okay? The average inflation rate over the whole period between say 1947 or '48 and 1961 or '62 was about two or three percent per year, okay?

So those two things together, growth of the economy in a sense, meant they didn't have to do any type of fiscal consolidation. So those are the points that I made in that paper, but I mean, the audience that I was talking to didn't... wanted me to basically say inflation's bad, debt's bad, and I basically said in most cases it is, but in war time you need the debt and you need the inflation, okay? But then in the post war period, you need to work it off. And so our experience, US experience and that of other countries, UK, is that it got worked off in the UK more by inflation than here, okay?

David Beckworth: Interesting, so it's a more nuanced story... you got to be careful about how you understand these episodes of debt and inflation. Well, we have a few minutes left and I thought I'd ask this last question. What would you tell to an aspiring economic historian, let's say a monetary historian, someone who's listening to this show and they want to be the Michael Bordo, what would you recommend they do?

Michael Bordo: Well, I recommend that... two things. They don't be like me, they become really good econometricians and secondly, they learn about how to work with big data and how to do archival research with data because I think most of the advances that we're seeing in economic history, not just monetary history and financial history, involved innovative... use of innovative statistical tools, the tools that have come out of labor economics. And I think that that is... that's the way it's going and I think that's one direction you have to go. I mean, the times have changed.

The other thing that I think about is I think that having a good background in monetary theory and macro economics is really important. And I think that the kind of work that are done by people like ... and his crowd, even though I don't agree with everything they do, it shows that you can really use these models, okay, the model based approach... you can get a lot out of that too.

So I'm not a skeptic of technique, nor am I a skeptic of theory. I'm a strong believer in those... in economists having those tools, but I also think that historians have a lot to teach us, okay? They teach us about narrative, they teach us about ... they teach us about archives. And one of the things that I've learned over the years is that any paper you do, no matter what kind of fire power you throw at it... and I work with other guys who are better than me in econometrics, okay, or modeling, is you got to have a story. You got to have a narrative and it's got to be consistent with what happened. And that... as time goes by, I think that's the most important thing.

Whenever I write a paper now or maybe it's always been that way, I always have the story thought out first. I don't go scrambling around in a bunch of data to see what I'm going to get and then go oh yeah, well, we can put some story... I think it through and it's got to make sense with me, okay, and I learned that from Anna and Friedman, but mainly Anna. Anna, she had this ability to listen to the most complicated papers and do the snoof test. She could always smell when it didn't hang together, okay? And that's something that young people can't figure out, but it's something you learn by being doing this for a long, long time. Is you just look at it, you read a paper, it doesn't make sense.

When I referee stuff, I get asked to referee things, that's what I do. I go through it and I'll often write a one paragraph saying it doesn't make sense. The identification strategy here, blah, blah, blah, that the idea is very complicated, very cool, but it doesn't make... I don't believe it, okay?

David Beckworth: Well, thanks for sharing those insights. Our guest today has been Michael Bordo. Michael, thank you for being on the show.

Michael Bordo: Okay, you're very welcome.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.