The other day I praised Lars Christensen’s survey of the new Market Monetarism School. Apparently, Lars was a bit overwhelmed by my comparison of his survey to Friedman’s 1956 restatement of the quantity theory and the 1976 paper by Johnson and Frenkel on the monetary approach to the balance of payments. In fact, Lars, in some respects at any rate, outdid both Friedman and Johnson and Frenkel. After all, he avoided making any remark even remotely comparable to Friedman’s infamous reference to a non-existent Chicago oral tradition or even the gross error made by Johnson and Frenkel of citing David Hume as a forerunner of the monetary approach based on his exposition of the price-specie-flow mechanism when the monetary approach implies that the price-specie-flow mechanism is not how the gold standard operated (as demonstrated by McCloskey and Zecher in their paper in the volume edited by Johnson and Frenkel in which their paper was the opening chapter). But the point of my comparison was more contextual than a comparison of the papers as such. The common characteristic of the three papers is how they provide a clear summary of and introduction to the key issues raised by a new literature along with an account of the historical origins of the new theory. Such a survey paper serves a really important rhetorical (to use McCloskey’s idea) role in propagating new set of ideas and making them accessible and attractive to a broader group of readers than those actively involved in developing those ideas. Well done, Lars.
But despite my genuine admiration for Lars’s accomplishment, I did not agree with everything he wrote, so in this post, and perhaps some future posts as well, I will explain why I look at things a bit differently from how Lars does, though it is not clear whether what Lars writes always reflects his own views or actually reflects those of some or all of the Market Monetarists whose views he is surveying.
So I shall begin my commentary with the first substantive section of Lars’s paper under the heading “Recessions are always and everywhere a monetary phenomenon.” The discussion in this section concerns the idea that an aggregate excess supply of goods (which is how economists often characterize an economy in recession) must be matched by an excess demand for money. Now that way of thinking about recessions is well-established and not really very controversial, but I have serious reservations about it. First, it treats all money as if it just came into existence out of thin air and not as the result of a voluntary economic transaction with a supplier and a demander. In other words, most money has come into existence as the result of a banking transaction in which a deposit (the bank’s liability) was created in exchange for an individual’s liability, the liability of the bank, unlike that of an individual, being generally acceptable in exchange.
Lars (pp. 3-4) then quotes Nick Rowe as follows:
In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.
Nick is here giving formal expression to the old idea of money as a hot potato, once created it is there and can only be passed from one pair of hands to another; it can’t be gotten rid of. Following Jim Tobin’s classic paper (“Commercial Banks as Creators of Money”) I reject that view of bank money. Bank money is created by banks in the course of economic transactions designed to satisfy a demand, and can be extinguished by a corresponding transaction in the opposite direction. So I don’t accept the proposition that an excess demand for (supply of) bank money necessarily corresponds to an excess supply of (demand for) real goods. There is a market for money backing services in which an excess demand for (supply of) money finds its counterpart in an excess supply of (demand for) money backing. The price that is determined in this market for bank money is the interest paid on deposits, which adjusts as needed to equilibrate the supply of deposits with the demand to hold deposits.
That’s why I believe, unlike traditional (and Market) Monetarists, that the price level and associated macroeconomic variables like employment and output should be viewed as being determined strictly in terms of government currency, with any disequilibrium between the supply of and demand for bank money being viewed (at least as a first approximation) as triggering an adjustment in the interest paid on deposits rather than on the excess demand for real goods. (Bill Woolsey and I had an exchange on this point a few weeks ago in the comments to my post “Are Recessions Efficient?”). I have the impression (perhaps mistaken) that Scott Sumner actually may be closer to my position than to Nick Rowe’s and Bill Woolsey’s on this point, but Scott can weigh in for himself on this.
The policy significance of this disagreement may actually not be that great, because an equilibrium view of money creation by banks does not imply that monetary policy is ineffective as Tobin mistakenly concluded, inviting the everlasting (and in my view completely misguided) hostility of Monetarists to his understanding of money creation by banks. At any rate, in my view of the world, the price level is determined in a market for currency and (when it is not interest-bearing) bank reserves. There is a supply of and demand for bank money convertible into currency whose equilibrium determines the interest paid on bank deposits. And finally, the money multiplier is cast into the theoretical dustbin as a useless and hopelessly senseless confusion of supply and demand concepts.