Archive for the 'Earl Thompson' Category

Monetary Theory on the Neo-Fisherite Edge

The week before last, Noah Smith wrote a post “The Neo-Fisherite Rebellion” discussing, rather sympathetically I thought, the contrarian school of monetary thought emerging from the Great American Heartland, according to which, notwithstanding everything monetary economists since Henry Thornton have taught, high interest rates are inflationary and low interest rates deflationary. This view of the relationship between interest rates and inflation was advanced (but later retracted) by Narayana Kocherlakota, President of the Minneapolis Fed in a 2010 lecture, and was embraced and expounded with increased steadfastness by Stephen Williamson of Washington University in St. Louis and the St. Louis Fed in at least one working paper and in a series of posts over the past five or six months (e.g. here, here and here). And John Cochrane of the University of Chicago has picked up on the idea as well in two recent blog posts (here and here). Others seem to be joining the upstart school as well.

The new argument seems simple: given the Fisher equation, in which the nominal interest rate equals the real interest rate plus the (expected) rate of inflation, a central bank can meet its inflation target by setting a fixed nominal interest rate target consistent with its inflation target and keeping it there. Once the central bank sets its target, the long-run neutrality of money, implying that the real interest rate is independent of the nominal targets set by the central bank, ensures that inflation expectations must converge on rates consistent with the nominal interest rate target and the independently determined real interest rate (i.e., the real yield curve), so that the actual and expected rates of inflation adjust to ensure that the Fisher equation is satisfied. If the promise of the central bank to maintain a particular nominal rate over time is believed, the promise will induce a rate of inflation consistent with the nominal interest-rate target and the exogenous real rate.

The novelty of this way of thinking about monetary policy is that monetary theorists have generally assumed that the actual adjustment of the price level or inflation rate depends on whether the target interest rate is greater or less than the real rate plus the expected rate. When the target rate is greater than the real rate plus expected inflation, inflation goes down, and when it is less than the real rate plus expected inflation, inflation goes up. In the conventional treatment, the expected rate of inflation is momentarily fixed, and the (expected) real rate variable. In the Neo-Fisherite school, the (expected) real rate is fixed, and the expected inflation rate is variable. (Just as an aside, I would observe that the idea that expectations about the real rate of interest and the inflation rate cannot occur simultaneously in the short run is not derived from the limited cognitive capacity of economic agents; it can only be derived from the limited intellectual capacity of economic theorists.)

The heretical views expressed by Williamson and Cochrane and earlier by Kocherlakota have understandably elicited scorn and derision from conventional monetary theorists, whether Keynesian, New Keynesian, Monetarist or Market Monetarist. (Williamson having appropriated for himself the New Monetarist label, I regrettably could not preserve an appropriate symmetry in my list of labels for monetary theorists.) As a matter of fact, I wrote a post last December challenging Williamson’s reasoning in arguing that QE had caused a decline in inflation, though in his initial foray into uncharted territory, Williamson was actually making a narrower argument than the more general thesis that he has more recently expounded.

Although deep down, I have no great sympathy for Williamson’s argument, the counterarguments I have seen leave me feeling a bit, shall we say, underwhelmed. That’s not to say that I am becoming a convert to New Monetarism, but I am feeling that we have reached a point at which certain underlying gaps in monetary theory can’t be concealed any longer. To explain what I mean by that remark, let me start by reviewing the historical context in which the ruling doctrine governing central-bank operations via adjustments in the central-bank lending rate evolved. The primary (though historically not the first) source of the doctrine is Henry Thornton in his classic volume The Nature and Effects of the Paper Credit of Great Britain.

Even though Thornton focused on the policy of the Bank of England during the Napoleonic Wars, when Bank of England notes, not gold, were legal tender, his discussion was still in the context of a monetary system in which paper money was generally convertible into either gold or silver. Inconvertible banknotes – aka fiat money — were the exception not the rule. Gold and silver were what Nick Rowe would call alpha money. All other moneys were evaluated in terms of gold and silver, not in terms of a general price level (not yet a widely accepted concept). Even though Bank of England notes became an alternative alpha money during the restriction period of inconvertibility, that situation was generally viewed as temporary, the restoration of convertibility being expected after the war. The value of the paper pound was tracked by the sterling price of gold on the Hamburg exchange. Thus, Ricardo’s first published work was entitled The High Price of Bullion, in which he blamed the high sterling price of bullion at Hamburg on an overissue of banknotes by the Bank of England.

But to get back to Thornton, who was far more concerned with the mechanics of monetary policy than Ricardo, his great contribution was to show that the Bank of England could control the amount of lending (and money creation) by adjusting the interest rate charged to borrowers. If banknotes were depreciating relative to gold, the Bank of England could increase the value of their notes by raising the rate of interest charged on loans.

The point is that if you are a central banker and are trying to target the exchange rate of your currency with respect to an alpha currency, you can do so by adjusting the interest rate that you charge borrowers. Raising the interest rate will cause the exchange value of your currency to rise and reducing the interest rate will cause the exchange value to fall. And if you are operating under strict convertibility, so that you are committed to keep the exchange rate between your currency and an alpha currency at a specified par value, raising that interest rate will cause you to accumulate reserves payable in terms of the alpha currency, and reducing that interest rate will cause you to emit reserves payable in terms of the alpha currency.

So the idea that an increase in the central-bank interest rate tends to increase the exchange value of its currency, or, under a fixed-exchange rate regime, an increase in the foreign exchange reserves of the bank, has a history at least two centuries old, though the doctrine has not exactly been free of misunderstanding or confusion in the course of those two centuries. One of those misunderstandings was about the effect of a change in the central-bank interest rate, under a fixed-exchange rate regime. In fact, as long as the central bank is maintaining a fixed exchange rate between its currency and an alpha currency, changes in the central-bank interest rate don’t affect (at least as a first approximation) either the domestic money supply or the domestic price level; all that changes in the central-bank interest rate can accomplish is to change the bank’s holdings of alpha-currency reserves.

It seems to me that this long well-documented historical association between changes in the central-bank interest rates and the exchange value of currencies and the level of private spending is the basis for the widespread theoretical presumption that raising the central-bank interest rate target is deflationary and reducing it is inflationary. However, the old central-bank doctrine of the Bank Rate was conceived in a world in which gold and silver were the alpha moneys, and central banks – even central banks operating with inconvertible currencies – were beta banks, because the value of a central-bank currency was still reckoned, like the value of inconvertible Bank of England notes in the Napoleonic Wars, in terms of gold and silver.

In the Neo-Fisherite world, central banks rarely peg exchange rates against each other, and there is no longer any outside standard of value to which central banks even nominally commit themselves. In a world without the metallic standard of value in which the conventional theory of central banking developed, do the propositions about the effects of central-bank interest-rate setting still obtain? I am not so sure that they do, not with the analytical tools that we normally deploy when thinking about the effects of central-bank policies. Why not? Because, in a Neo-Fisherite world in which all central banks are alpha banks, I am not so sure that we really know what determines the value of this thing called fiat money. And if we don’t really know what determines the value of a fiat money, how can we really be sure that interest-rate policy works the same way in a Neo-Fisherite world that it used to work when the value of money was determined in relation to a metallic standard? (Just to avoid misunderstanding, I am not – repeat NOT — arguing for restoring the gold standard.)

Why do I say that we don’t know what determines the value of fiat money in a Neo-Fisherite world? Well, consider this. Almost three weeks ago I wrote a post in which I suggested that Bitcoins could be a massive bubble. My explanation for why Bitcoins could be a bubble is that they provide no real (i.e., non-monetary) service, so that their value is totally contingent on, and derived from (or so it seems to me, though I admit that my understanding of Bitcoins is partial and imperfect), the expectation of a positive future resale value. However, it seems certain that the resale value of Bitcoins must eventually fall to zero, so that backward induction implies that Bitcoins, inasmuch as they provide no real service, cannot retain a positive value in the present. On this reasoning, any observed value of a Bitcoin seems inexplicable except as an irrational bubble phenomenon.

Most of the comments I received about that post challenged the relevance of the backward-induction argument. The challenges were mainly of two types: a) the end state, when everyone will certainly stop accepting a Bitcoin in exchange, is very, very far into the future and its date is unknown, and b) the backward-induction argument applies equally to every fiat currency, so my own reasoning, according to my critics, implies that the value of every fiat currency is just as much a bubble phenomenon as the value of a Bitcoin.

My response to the first objection is that even if the strict logic of the backward-induction argument is inconclusive, because of the long and uncertain duration of the time elapse between now and the end state, the argument nevertheless suggests that the value of a Bitcoin is potentially very unsteady and vulnerable to sudden collapse. Those are not generally thought to be desirable attributes in a medium of exchange.

My response to the second objection is that fiat currencies are actually quite different from Bitcoins, because fiat currencies are accepted by governments in discharging the tax liabilities due to them. The discharge of a tax liability is a real (i.e. non-monetary) service, creating a distinct non-monetary demand for fiat currencies, thereby ensuring that fiat currencies retain value, even apart from being accepted as a medium of exchange.

That, at any rate, is my view, which I first heard from Earl Thompson (see his unpublished paper, “A Reformulation of Macroeconomic Theory” pp. 23-25 for a derivation of the value of fiat money when tax liability is a fixed proportion of income). Some other pretty good economists have also held that view, like Abba Lerner, P. H. Wicksteed, and Adam Smith. Georg Friedrich Knapp also held that view, and, in his day, he was certainly well known, but I am unable to pass judgment on whether he was or wasn’t a good economist. But I do know that his views about money were famously misrepresented and caricatured by Ludwig von Mises. However, there are other good economists (Hal Varian for one), apparently unaware of, or untroubled by, the backward induction argument, who don’t think that acceptability in discharging tax liability is required to explain the value of fiat money.

Nor do I think that Thompson’s tax-acceptability theory of the value of money can stand entirely on its own, because it implies a kind of saw-tooth time profile of the price level, so that a fiat currency, earning no liquidity premium, would actually be appreciating between peak tax collection dates, and depreciating immediately following those dates, a pattern not obviously consistent with observed price data, though I do recall that Thompson used to claim that there is a lot of evidence that prices fall just before peak tax-collection dates. I don’t think that anyone has ever tried to combine the tax-acceptability theory with the empirical premise that currency (or base money) does in fact provide significant liquidity services. That, it seems to me, would be a worthwhile endeavor for any eager young researcher to undertake.

What does all of this have to do with the Neo-Fisherite Rebellion? Well, if we don’t have a satisfactory theory of the value of fiat money at hand, which is what another very smart economist Fischer Black – who, to my knowledge never mentioned the tax-liability theory — thought, then the only explanation of the value of fiat money is that, like the value of a Bitcoin, it is whatever people expect it to be. And the rate of inflation is equally inexplicable, being just whatever it is expected to be. So in a Neo-Fisherite world, if the central bank announces that it is reducing its interest-rate target, the effect of the announcement depends entirely on what “the market” reads into the announcement. And that is exactly what Fischer Black believed. See his paper “Active and Passive Monetary Policy in a Neoclassical Model.”

I don’t say that Williamson and his Neo-Fisherite colleagues are correct. Nor have they, to my knowledge, related their arguments to Fischer Black’s work. What I do say (indeed this is a problem I raised almost three years ago in one of my first posts on this blog) is that existing monetary theories of the price level are unable to rule out his result, because the behavior of the price level and inflation seems to depend, more than anything else, on expectations. And it is far from clear to me that there are any fundamentals in which these expectations can be grounded. If you impose the rational expectations assumption, which is almost certainly wrong empirically, maybe you can argue that the central bank provides a focal point for expectations to converge on. The problem, of course, is that in the real world, expectations are all over the place, there being no fundamentals to force the convergence of expectations to a stable equilibrium value.

In other words, it’s just a mess, a bloody mess, and I do not like it, not one little bit.

Who’s Afraid of Say’s Law?

There’s been a lot of discussion about Say’s Law in the blogosphere lately, some of it finding its way into the comments section of my recent post “What Does Keynesisan Mean,” in which I made passing reference to Keynes’s misdirected tirade against Say’s Law in the General Theory. Keynes wasn’t the first economist to make a fuss over Say’s Law. It was a big deal in the nineteenth century when Say advanced what was then called the Law of the Markets, pointing out that the object of all production is, in the end, consumption, so that all productive activity ultimately constitutes a demand for other products. There were extended debates about whether Say’s Law was really true, with Say, Ricardo, James and John Stuart Mill all weighing on in favor of the Law, and Malthus and the French economist J. C. L. de Sismondi arguing against it. A bit later, Karl Marx also wrote at length about Say’s Law, heaping his ample supply of scorn upon Say and his Law. Thomas Sowell’s first book, I believe drawn from the doctoral dissertation he wrote under George Stigler, was about the classical debates about Say’s Law.

The literature about Say’s Law is too vast to summarize in a blog post. Here’s my own selective take on it.

Say was trying to refute a certain kind of explanation of economic crises, and what we now would call cyclical or involuntary unemployment, an explanation attributing such unemployment to excess production for which income earners don’t have enough purchasing power in their pockets to buy. Say responded that the reason why income earners had supplied the services necessary to produce the available output was to earn enough income to purchase the output. This is the basic insight behind the famous paraphrase (I don’t know if it was Keynes’s paraphrase or someone else’s) of Say’s Law — supply creates its own demand. If it were instead stated as products or services are supplied only because the suppliers want to buy other products or services, I think that it would be more in sync than the standard formulation with Say’s intent. Another way to think about Say’s Law is as a kind of conservation law.

There were two famous objections made to Say’s Law: first, current supply might be offered in order to save for future consumption, and, second, current supply might be offered in order to add to holdings of cash. In either case, there could be current supply that is not matched by current demand for output, so that total current demand would be insufficient to generate full employment. Both these objections are associated with Keynes, but he wasn’t the first to make either of them. The savings argument goes back to the nineteenth century, and the typical response was that if there was insufficient current demand, because the desire to save had increased, the public deciding to reduce current expenditures on consumption, the shortfall in consumption demand would lead to an increase in investment demand driven by falling interest rates and rising asset prices. In the General Theory, Keynes proposed an argument about liquidity preference and a potential liquidity trap, suggesting a reason why the necessary adjustment in the rate of interest would not necessarily occur.

Keynes’s argument about a liquidity trap was and remains controversial, but the argument that the existence of money implies that Say’s Law can be violated was widely accepted. Indeed, in his early works on business-cycle theory, F. A. Hayek made the point, seemingly without embarrassment or feeling any need to justify it at length, that the existence of money implied a disconnect between overall supply and overall demand, describing money as a kind of loose joint in the economic system. This argument, apparently viewed as so trivial or commonplace by Hayek that he didn’t bother proving it or citing authority for it, was eventually formalized by the famous market-socialist economist (who, for a number of years was a tenured professor at that famous bastion of left-wing economics the University of Chicago) Oskar Lange who introduced a distinction between Walras’s Law and Say’s Law (“Say’s Law: A Restatement and Criticism”).

Walras’s Law says that the sum of all excess demands and excess supplies, evaluated at any given price vector, must identically equal zero. The existence of a budget constraint makes this true for each individual, and so, by the laws of arithmetic, it must be true for the entire economy. Essentially, this was a formalization of the logic of Say’s Law. However, Lange showed that Walras’s Law reduces to Say’s Law only in an economy without money. In an economy with money, Walras’s Law means that there could be an aggregate excess supply of all goods at some price vector, and the excess supply of goods would be matched by an equal excess demand for money. Aggregate demand would be deficient, and the result would be involuntary unemployment. Thus, according to Lange’s analysis, Say’s Law holds, as a matter of necessity, only in a barter economy. But in an economy with money, an excess supply of all real commodities was a logical possibility, which means that there could be a role for some type – the choice is yours — of stabilization policy to ensure that aggregate demand is sufficient to generate full employment. One of my regular commenters, Tom Brown, asked me recently whether I agreed with Nick Rowe’s statement: “the goal of good monetary policy is to try to make Say’s Law true.” I said that I wasn’t sure what the statement meant, thereby avoiding the need to go into a lengthy explanation about why I am not quite satisfied with that way of describing the goal of monetary policy.

There are at least two problems with Lange’s formulation of Say’s Law. The first was pointed out by Clower and Leijonhufvud in their wonderful paper (“Say’s Principle: What It Means and Doesn’t Mean” reprinted here and here) on what they called Say’s Principle in which they accepted Lange’s definition of Say’s Law, while introducing the alternative concept of Say’s Principle as the supply-side analogue of the Keynesian multiplier. The key point was to note that Lange’s analysis was based on the absence of trading at disequilibrium prices. If there is no trading at disequilibrium prices, because the Walrasian auctioneer or clearinghouse only processes information in a trial-and-error exercise aimed at discovering the equilibrium price vector, no trades being executed until the equilibrium price vector has been discovered (a discovery which, even if an equilibrium price vector exists, may not be made under any price-adjustment rule adopted by the auctioneer, rational expectations being required to “guarantee” that an equilibrium price vector is actually arrived at, sans auctioneer), then, indeed, Say’s Law need not obtain in notional disequilibrium states (corresponding to trial price vectors announced by the Walrasian auctioneer or clearinghouse). The insight of Clower and Leijonhufvud was that in a real-time economy in which trading is routinely executed at disequilibrium prices, transactors may be unable to execute the trades that they planned to execute at the prevailing prices. But when planned trades cannot be executed, trading and output contract, because the volume of trade is constrained by the lesser of the amount supplied and the amount demanded.

This is where Say’s Principle kicks in; If transactors do not succeed in supplying as much as they planned to supply at prevailing prices, then, depending on the condition of their balances sheets, and the condition of credit markets, transactors may have to curtail their demands in subsequent periods; a failure to supply as much as had been planned last period will tend reduce demand in this period. If the “distance” from equilibrium is large enough, the demand failure may even be amplified in subsequent periods, rather than damped. Thus, Clower and Leijonhufvud showed that the Keynesian multiplier was, at a deep level, really just another way of expressing the insight embodied in Say’s Law (or Say’s Principle, if you insist on distinguishing what Say meant from Lange’s reformulation of it in terms of Walrasian equilibrium).

I should add that, as I have mentioned in an earlier post, W. H. Hutt, in a remarkable little book, clarified and elaborated on the Clower-Leijonhufvud analysis, explaining how Say’s Principle was really implicit in many earlier treatments of business-cycle phenomena. The only reservation I have about Hutt’s book is that he used it to wage an unnecessary polemical battle against Keynes.

At about the same time that Clower and Leijonhufvud were expounding their enlarged view of the meaning and significance of Say’s Law, Earl Thompson showed that under “classical” conditions, i.e., a competitive supply of privately produced bank money (notes and deposits) convertible into gold, Say’s Law in Lange’s narrow sense, could also be derived in a straightforward fashion. The demonstration followed from the insight that when bank money is competitively issued, it is accomplished by an exchange of assets and liabilities between the bank and the bank’s customer. In contrast to the naïve assumption of Lange (adopted as well by his student Don Patinkin in a number of important articles and a classic treatise) that there is just one market in the monetary sector, there are really two markets in the monetary sector: a market for money supplied by banks and a market for money-backing assets. Thus, any excess demand for money would be offset not, as in the Lange schema, by an excess supply of goods, but by an excess supply of money-backing services. In other words, the public can increase their holdings of cash by giving their IOUs to banks in exchange for the IOUs of the banks, the difference being that the IOUs of the banks are money and the IOUs of customers are not money, but do provide backing for the money created by banks. The market is equilibrated by adjustments in the quantity of bank money and the interest paid on bank money, with no spillover on the real sector. With no spillover from the monetary sector onto the real sector, Say’s Law holds by necessity, just as it would in a barter economy.

A full exposition can be found in Thompson’s original article. I summarized and restated its analysis of Say’s Law in my 1978 1985 article on classical monetary theory and in my book Free Banking and Monetary Reform. Regrettably, I did not incorporate the analysis of Clower and Leijonhufvud and Hutt into my discussion of Say’s Law either in my article or in my book. But in a world of temporary equilibrium, in which future prices are not correctly foreseen by all transactors, there are no strict intertemporal budget constraints that force excess demands and excess supplies to add up to zero. In short, in such a world, things can get really messy, which is where the Clower-Leijonhufvud-Hutt analysis can be really helpful in sorting things out.

My Milton Friedman Problem

In my previous post , I discussed Keynes’s perplexing and problematic criticism of the Fisher equation in chapter 11 of the General Theory, perplexing because it is difficult to understand what Keynes is trying to say in the passage, and problematic because it is not only inconsistent with Keynes’s reasoning in earlier writings in which he essentially reproduced Fisher’s argument, it is also inconsistent with Keynes’s reasoning in chapter 17 of the General Theory in his exposition of own rates of interest and their equilibrium relationship. Scott Sumner honored me with a whole post on his blog which he entitled “Glasner on Keynes and the Fisher Effect,” quite a nice little ego boost.

After paraphrasing some of what I had written in his own terminology, Scott quoted me in responding to a dismissive comment that Krugman recently made about Milton Friedman, of whom Scott tends to be highly protective. Here’s the passage I am referring to.

PPS.  Paul Krugman recently wrote the following:

Just stabilize the money supply, declared Milton Friedman, and we don’t need any of this Keynesian stuff (even though Friedman, when pressured into providing an underlying framework, basically acknowledged that he believed in IS-LM).

Actually Friedman hated IS-LM.  I don’t doubt that one could write down a set of equilibria in the money market and goods market, as a function of interest rates and real output, for almost any model.  But does this sound like a guy who “believed in” the IS-LM model as a useful way of thinking about macro policy?

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

It turns out that IS-LM curves will look very different if one moves away from the interest rate transmission mechanism of the Keynesians.  Again, here’s David:

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Please do.  Krugman reads Glasner’s blog, and if David keeps posting on this stuff then Krugman will eventually realize that hearing a few wisecracks from older Keynesians about various non-Keynesian traditions doesn’t make one an expert on the history of monetary thought.

I wrote a comment on Scott’s blog responding to this post in which, after thanking him for mentioning me in the same breath as Keynes and Fisher, I observed that I didn’t find Krugman’s characterization of Friedman as someone who basically believed in IS-LM as being in any way implausible.

Then, about Friedman, I don’t think he believed in IS-LM, but it’s not as if he had an alternative macromodel. He didn’t have a macromodel, so he was stuck with something like an IS-LM model by default, as was made painfully clear by his attempt to spell out his framework for monetary analysis in the early 1970s. Basically he just tinkered with the IS-LM to allow the price level to be determined, rather than leaving it undetermined as in the original Hicksian formulation. Of course in his policy analysis and historical work he was not constained by any formal macromodel, so he followed his instincts which were often reliable, but sometimes not so.

So I am afraid that my take may on Friedman may be a little closer to Krugman’s than to yours. But the real point is that IS-LM is just a framework that can be adjusted to suit the purposes of the modeler. For Friedman the important thing was to deny that that there is a liquidity trap, and introduce an explicit money-supply-money-demand relation to determine the absolute price level. It’s not just Krugman who says that, it’s also Don Patinkin and Harry Johnson. Whether Krugman knows the history of thought, I don’t know, but surely Patinkin and Johnson did.

Scott responded:

I’m afraid I strongly disagree regarding Friedman. The IS-LM “model” is much more than just the IS-LM graph, or even an assumption about the interest elasticity of money demand. For instance, suppose a shift in LM also causes IS to shift. Is that still the IS-LM model? If so, then I’d say it should be called the “IS-LM tautology” as literally anything would be possible.

When I read Friedman’s work it comes across as a sort of sustained assault on IS-LM type thinking.

To which I replied:

I think that if you look at Friedman’s responses to his critics the volume Milton Friedman’s Monetary Framework: A Debate with his Critics, he said explicitly that he didn’t think that the main differences among Keynesians and Monetarists were about theory, but about empirical estimates of the relevant elasticities. So I think that in this argument Friedman’s on my side.

And finally Scott:

This would probably be easier if you provided some examples of monetary ideas that are in conflict with IS-LM. Or indeed any ideas that are in conflict with IS-LM. I worry that people are interpreting IS-LM too broadly.

For instance, do Keynesians “believe” in MV=PY? Obviously yes. Do they think it’s useful? No.

Everyone agrees there are a set of points where the money market is in equilibrium. People don’t agree on whether easy money raises interest rates or lowers interest rates. In my view the term “believing in IS-LM” implies a belief that easy money lowers rates, which boosts investment, which boosts RGDP. (At least when not at the zero bound.) Friedman may agree that easy money boosts RGDP, but may not agree on the transmission mechanism.

People used IS-LM to argue against the Friedman and Schwartz view that tight money caused the Depression. They’d say; “How could tight money have caused the Depression? Interest rates fell sharply in 1930?”

I think that Friedman meant that economists agreed on some of the theoretical building blocks of IS-LM, but not on how the entire picture fit together.

Oddly, your critique of Keynes reminds me a lot of Friedman’s critiques of Keynes.

Actually, this was not the first time that I provoked a negative response by writing critically about Friedman. Almost a year and a half ago, I wrote a post (“Was Milton Friedman a Closet Keynesian?”) which drew some critical comments from such reliably supportive commenters as Marcus Nunes, W. Peden, and Luis Arroyo. I guess Scott must have been otherwise occupied, because I didn’t hear a word from him. Here’s what I said:

Commenting on a supremely silly and embarrassingly uninformed (no, Ms. Shlaes, A Monetary History of the United States was not Friedman’s first great work, Essays in Positive Economics, Studies in the Quantity Theory of Money, A Theory of the Consumption Function, A Program for Monetary Stability, and Capitalism and Freedom were all published before A Monetary History of the US was published) column by Amity Shlaes, accusing Ben Bernanke of betraying the teachings of Milton Friedman, teachings that Bernanke had once promised would guide the Fed for ever more, Paul Krugman turned the tables and accused Friedman of having been a crypto-Keynesian.

The truth, although nobody on the right will ever admit it, is that Friedman was basically a Keynesian — or, if you like, a Hicksian. His framework was just IS-LM coupled with an assertion that the LM curve was close enough to vertical — and money demand sufficiently stable — that steady growth in the money supply would do the job of economic stabilization. These were empirical propositions, not basic differences in analysis; and if they turn out to be wrong (as they have), monetarism dissolves back into Keynesianism.

Krugman is being unkind, but he is at least partly right.  In his famous introduction to Studies in the Quantity Theory of Money, which he called “The Quantity Theory of Money:  A Restatement,” Friedman gave the game away when he called the quantity theory of money a theory of the demand for money, an almost shockingly absurd characterization of what anyone had ever thought the quantity theory of money was.  At best one might have said that the quantity theory of money was a non-theory of the demand for money, but Friedman somehow got it into his head that he could get away with repackaging the Cambridge theory of the demand for money — the basis on which Keynes built his theory of liquidity preference — and calling that theory the quantity theory of money, while ascribing it not to Cambridge, but to a largely imaginary oral tradition at the University of Chicago.  Friedman was eventually called on this bit of scholarly legerdemain by his old friend from graduate school at Chicago Don Patinkin, and, subsequently, in an increasingly vitriolic series of essays and lectures by his then Chicago colleague Harry Johnson.  Friedman never repeated his references to the Chicago oral tradition in his later writings about the quantity theory. . . . But the simple fact is that Friedman was never able to set down a monetary or a macroeconomic model that wasn’t grounded in the conventional macroeconomics of his time.

As further evidence of Friedman’s very conventional theoretical conception of monetary theory, I could also cite Friedman’s famous (or, if you prefer, infamous) comment (often mistakenly attributed to Richard Nixon) “we are all Keynesians now” and the not so famous second half of the comment “and none of us are Keynesians anymore.” That was simply Friedman’s way of signaling his basic assent to the neoclassical synthesis which was built on the foundation of Hicksian IS-LM model augmented with a real balance effect and the assumption that prices and wages are sticky in the short run and flexible in the long run. So Friedman meant that we are all Keynesians now in the sense that the IS-LM model derived by Hicks from the General Theory was more or less universally accepted, but that none of us are Keynesians anymore in the sense that this framework was reconciled with the supposed neoclassical principle of the monetary neutrality of a unique full-employment equilibrium that can, in principle, be achieved by market forces, a principle that Keynes claimed to have disproved.

But to be fair, I should also observe that missing from Krugman’s take down of Friedman was any mention that in the original HIcksian IS-LM model, the price level was left undetermined, so that as late as 1970, most Keynesians were still in denial that inflation was a monetary phenomenon, arguing instead that inflation was essentially a cost-push phenomenon determined by the rate of increase in wages. Control of inflation was thus not primarily under the control of the central bank, but required some sort of “incomes policy” (wage-price guidelines, guideposts, controls or what have you) which opened the door for Nixon to cynically outflank his Democratic (Keynesian) opponents by coopting their proposals for price controls when he imposed a wage-price freeze (almost 42 years ago on August 15, 1971) to his everlasting shame and discredit.

Scott asked me to list some monetary ideas that I believe are in conflict with IS-LM. I have done so in my earlier posts (here, here, here and here) on Earl Thompson’s paper “A Reformulation of Macroeconomic Theory” (not that I am totally satisfied with Thompson’s model either, but that’s a topic for another post). Three of the main messages from Thompson’s work are that IS-LM mischaracterizes the monetary sector, because in a modern monetary economy the money supply is endogenous, not exogenous as Keynes and Friedman assumed. Second, the IS curve (or something corresponding to it) is not negatively sloped as Keynesians generally assume, but upward-sloping. I don’t think Friedman ever said a word about an upward-sloping IS curve. Third, the IS-LM model is essentially a one-period model which makes it difficult to carry out a dynamic analysis that incorporates expectations into that framework. Analysis of inflation, expectations, and the distinction between nominal and real interest rates requires a richer model than the HIcksian IS-LM apparatus. But Friedman didn’t scrap IS-LM, he expanded it to accommodate expectations, inflation, and the distinction between real and nominal interest rates.

Scott’s complaint about IS-LM seems to be that it implies that easy money reduces interest rates and that tight money raises rates, but, in reality, it’s the opposite. But I don’t think that you need a macro-model to understand that low inflation implies low interest rates and that high inflation implies high interest rates. There is nothing in IS-LM that contradicts that insight; it just requires augmenting the model with a term for expectations. But there’s nothing in the model that prevents you from seeing the distinction between real and nominal interest rates. Similarly, there is nothing in MV = PY that prevented Friedman from seeing that increasing the quantity of money by 3% a year was not likely to stabilize the economy. If you are committed to a particular result, you can always torture a model in such a way that the desired result can be deduced from it. Friedman did it to MV = PY to get his 3% rule; Keynesians (or some of them) did it to IS-LM to argue that low interest rates always indicate easy money (and it’s not only Keynesians who do that, as Scott knows only too well). So what? Those are examples of the universal tendency to forget that there is an identification problem. I blame the modeler, not the model.

OK, so why am I not a fan of Friedman’s? Here are some reasons. But before I list them, I will state for the record that he was a great economist, and deserved the professional accolades that he received in his long and amazingly productive career. I just don’t think that he was that great a monetary theorist, but his accomplishments far exceeded his contributions to monetary theory. The accomplishments mainly stemmed from his great understanding of price theory, and his skill in applying it to economic problems, and his great skill as a mathematical statistician.

1 His knowledge of the history of monetary theory was very inadequate. He had an inordinately high opinion of Lloyd Mints’s History of Banking Theory which was obsessed with proving that the real bills doctrine was a fallacy, uncritically adopting its pro-currency-school and anti-banking-school bias.

2 He covered up his lack of knowledge of the history of monetary theory by inventing a non-existent Chicago oral tradition and using it as a disguise for his repackaging the Cambridge theory of the demand for money and aspects of the Keynesian theory of liquidity preference as the quantity theory of money, while deliberately obfuscating the role of the interest rate as the opportunity cost of holding money.

3 His theory of international monetary adjustment was a naïve version of the Humean Price-Specie-Flow mechanism, ignoring the tendency of commodity arbitrage to equalize price levels under the gold standard even without gold shipments, thereby misinterpreting the significance of gold shipments under the gold standard.

4 In trying to find a respectable alternative to Keynesian theory, he completely ignored all pre-Keynesian monetary theories other than what he regarded as the discredited Austrian theory, overlooking or suppressing the fact that Hawtrey and Cassel had 40 years before he published the Monetary History of the United States provided (before the fact) a monetary explanation for the Great Depression, which he claimed to have discovered. And in every important respect, Friedman’s explanation was inferior to and retrogression from Hawtrey and Cassel explanation.

5 For example, his theory provided no explanation for the beginning of the downturn in 1929, treating it as if it were simply routine business-cycle downturn, while ignoring the international dimensions, and especially the critical role played by the insane Bank of France.

6 His 3% rule was predicated on the implicit assumption that the demand for money (or velocity of circulation) is highly stable, a proposition for which there was, at best, weak empirical support. Moreover, it was completely at variance with experience during the nineteenth century when the model for his 3% rule — Peel’s Bank Charter Act of 1844 — had to be suspended three times in the next 22 years as a result of financial crises largely induced, as Walter Bagehot explained, by the restriction on creation of banknotes imposed by the Bank Charter Act. However, despite its obvious shortcomings, the 3% rule did serve as an ideological shield with which Friedman could defend his libertarian credentials against criticism for his opposition to the gold standard (so beloved of libertarians) and to free banking (the theory of which Friedman did not comprehend until late in his career).

7 Despite his professed libertarianism, he was an intellectual bully who abused underlings (students and junior professors) who dared to disagree with him, as documented in Perry Mehrling’s biography of Fischer Black, and confirmed to me by others who attended his lectures. Black was made so uncomfortable by Friedman that Black fled Chicago to seek refuge among the Keynesians at MIT.

On a Difficult Passage in the General Theory

Keynes’s General Theory is not, in my estimation, an easy read. The terminology is often unfamiliar, and, so even after learning one of his definitions, I have trouble remembering what the term means the next time it’s used.. And his prose style, though powerful and very impressive, is not always clear, so you can spend a long time reading and rereading a sentence or a paragraph before you can figure out exactly what he is trying to say. I am not trying to be critical, just to point out that the General Theory is a very challenging book to read, which is one, but not the only, reason why it is subject to a lot of conflicting interpretations. And, as Harry Johnson once pointed out, there is an optimum level of difficulty for a book with revolutionary aspirations. If it’s too simple, it won’t be taken seriously. And if it’s too hard, no one will understand it. Optimally, a revolutionary book should be hard enough so that younger readers will be able to figure it out, and too difficult for the older guys to understand or to make the investment in effort to understand.

In this post, which is, in a certain sense, a follow-up to an earlier post about what, or who, determines the real rate of interest, I want to consider an especially perplexing passage in the General Theory about the Fisher equation. It is perplexing taken in isolation, and it is even more perplexing when compared to other passages in both the General Theory itself and in Keynes’s other writings. Here’s the passage that I am interested in.

The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. This is the truth which lies behind Professor Irving Fisher’s theory of what he originally called “Appreciation and Interest” – the distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of exiting goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of the money lent. For the dilemma is not successfully escaped by Professor Pigou’s expedient of supposing that the prospective change in the value of money is foreseen by one set of people but not foreseen by another. (p. 142)

The statement is problematic on just about every level, and one hardly knows where to begin in discussing it. But just for starters, it is amazing that Keynes seems (or, for rhetorical purposes, pretends) to be in doubt whether Fisher is talking about anticipated or unanticipated inflation, because Fisher himself explicitly distinguished between anticipated and unanticipated inflation, and Keynes could hardly have been unaware that Fisher was explicitly speaking about anticipated inflation. So the implication that the Fisher equation involves some confusion on Fisher’s part between anticipated and unanticipated inflation was both unwarranted and unseemly.

What’s even more puzzling is that in his Tract on Monetary Reform, Keynes expounded the covered interest arbitrage principle that the nominal-interest-rate-differential between two currencies corresponds to the difference between the spot and forward rates, which is simply an extension of Fisher’s uncovered interest arbitrage condition (alluded to by Keynes in referring to “Appreciation and Interest”). So when Keynes found Fisher’s distinction between the nominal and real rates of interest to be incoherent, did he really mean to exempt his own covered interest arbitrage condition from the charge?

But it gets worse, because if we flip some pages from chapter 11, where the above quotation is found, to chapter 17, we see on page 224, the following passage in which Keynes extends the idea of a commodity or “own rate of interest” to different currencies.

It may be added that, just as there are differing commodity-rates of interest at any time, so also exchange dealers are familiar with the fact that the rate of interest is not even the same in terms of two different moneys, e.g. sterling and dollars. For here also the difference between the “spot” and “future” contracts for a foreign money in terms of sterling are not, as a rule, the same for different foreign moneys. . . .

If no change is expected in the relative value of two alternative standards, then the marginal efficiency of a capital-asset will be the same in whichever of the two standards it is measured, since the numerator and denominator of the fraction which leads up to the marginal efficiency will be changed in the same proportion. If, however, one of the alternative standards is expected to change in value in terms of the other, the marginal efficiencies of capital-assets will be changed by the same percentage, according to which standard they are measured in. To illustrate this let us take the simplest case where wheat, one of the alternative standards, is expected to appreciate at a steady rate of a percent per annum in terms of money; the marginal efficiency of an asset, which is x percent in terms of money, will then be x – a percent in terms of wheat. Since the marginal efficiencies of all capital assets will be altered by the same amount, it follows that their order of magnitude will be the same irrespective of the standard which is selected.

So Keynes in chapter 17 explicitly allows for the nominal rate of interest to be adjusted to reflect changes in the expected value of the asset (whether a money or a commodity) in terms of which the interest rate is being calculated. Mr. Keynes, please meet Mr. Keynes.

I think that one source of Keynes’s confusion in attacking the Fisher equation was his attempt to force the analysis of a change in inflation expectations, clearly a disequilibrium, into an equilibrium framework. In other words, Keynes is trying to analyze what happens when there has been a change in inflation expectations as if the change had been foreseen. But any change in inflation expectations, by definition, cannot have been foreseen, because to say that an expectation has changed means that the expectation is different from what it was before. Perhaps that is why Keynes tied himself into knots trying to figure out whether Fisher was talking about a change in the value of money that was foreseen or not foreseen. In any equilibrium, the change in the value of money is foreseen, but in the transition from one equilibrium to another, the change is not foreseen. When an unforeseen change occurs in expected inflation, leading to a once-and-for-all change in the value of money relative to other assets, the new equilibrium will be reestablished given the new value of money relative to other assets.

But I think that something else is also going on here, which is that Keynes was implicitly assuming that a change in inflation expectations would alter the real rate of interest. This is a point that Keynes makes in the paragraph following the one I quoted above.

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – insofar as the rate of interest rises, the stimulating effect is to that extent offset) but to its raising the marginal efficiency of a given stock of capital. If the rate of interest were to rise pari passu with the marginal efficiency of capital, there would be no stimulating effect from the expectation of rising prices. For the stimulating effect depends on the marginal efficiency of capital rising relativevly to the rate of interest. Indeed Professor Fisher’s theory could best be rewritten in terms of a “real rate of interest” defined as being the rate of interest which would have to rule, consequently on change in the state of expectation as to the future value of money, in order that this change should have no effect on current output. (pp. 142-43)

Keynes’s mistake lies in supposing that an increase in inflation expectations could not have a stimulating effect except as it raises the marginal efficiency of capital relative to the rate of interest. However, the increase in the value of real assets relative to money will increase the incentive to produce new assets. It is the rise in the value of existing assets relative to money that raises the marginal efficiency of those assets, creating an incentive to produce new assets even if the nominal interest rate were to rise by as much as the rise in expected inflation.

Keynes comes back to this point at the end of chapter 17, making it more forcefully than he did the first time.

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest – namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of of Wicksell’s “natural rate of interest,” which was, according to him, the rate which would preserve the stability of some, not quite clearly specified, price-level.

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus, it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. . . .

If there is any such rate of interest, which is unique and significant, it must be the rate which we might term the neutral rate of interest, namely, the natural rate in the above sense which is consistent with full employment, given the other parameters of the system; though this rate might be better described, perhaps, as the optimum rate. (pp. 242-43)

So what Keynes is saying, I think, is this. Consider an economy with a given fixed marginal efficiency of capital (MEC) schedule. There is some interest rate that will induce sufficient investment expenditure to generate enough spending to generate full employment. That interest rate Keynes calls the “neutral” rate of interest. If the nominal rate of interest is more than the neutral rate, the amount of investment will be less than the amount necessary to generate full employment. In such a situation an expectation that the price level will rise will shift up the MEC schedule by the amount of the expected increase in inflation, thereby generating additional investment spending. However, because the MEC schedule is downward-sloping, the upward shift in the MEC schedule that induces increased investment spending will correspond to an increase in the rate of interest that is less than the increase in expected inflation, the upward shift in the MEC schedule being partially offset by the downward movement along the MEC schedule. In other words, the increase in expected inflation raises the nominal rate of interest by less than increase in expected inflation by inducing additional investment that is undertaken only because the real rate of interest has fallen.

However, for an economy already operating at full employment, an increase in expected inflation would not increase employment, so whether there was any effect on the real rate of interest would depend on the extent to which there was a shift from holding money to holding real capital assets in order to avoid the inflation tax.

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.

I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Two Reviews: One Old, One New

Recently I have been working on a review of a recently published (2011) volume, The Empire of Credit: The Financial Revolution in Britain, Ireland, and America, 1688-1815 for The Journal of the History of Economic Thought. I found the volume interesting in a number of ways, but especially because it seemed to lend support to some of my ideas on why the state has historically played such a large role in the supply of money. When I first started to study economics, I was taught that money is a natural monopoly, the value of money being inevitably forced down by free competition to the value of the paper on which it was written. I believe that Milton Friedman used to make this argument (though, if I am not mistaken, he eventually stopped), and I think the argument can be found in writing in his Program for Monetary Stability, but my memory may be playing a trick on me.

Eventually I learned, first from Ben Klein and later from Earl Thompson, that the naïve natural-monopoly argument is a fallacy, because it presumes that all moneys are indistinguishable. However, Earl Thompson had a very different argument, explaining that the government monopoly over money is an efficient form of emergency taxation when a country is under military threat, so that raising funds through taxation would be too cumbersome and time-consuming to rely on when that state is faced with an existential threat. Taking this idea, I wrote a paper “An Evolutionary Theory of the State Monopoly over Money,” eventually published (1998) in a volume Money and the Nation State. The second chapter of my book Free Banking and Monetary Reform was largely based on this paper. Earl Thompson worked out the analytics of the defense argument for a government monopoly over money in a number of places. (Here’s one.)

And here are the first two paragraphs from my review (which I have posted on SSRN):

The diverse studies collected in The Empire of Credit , ranging over both monetary and financial history and the history of monetary theory, share a common theme: the interaction between the fiscal requirements of national defense and the rapid evolution of monetary and financial institutions from the late seventeenth century to the early nineteenth century, the period in which Great Britain unexpectedly displaced France as the chief European military power, while gaining a far-flung intercontinental empire, only modestly diminished by the loss of thirteen American colonies in 1783. What enabled that interaction to produce such startling results were the economies achieved by substituting bank-supplied money (banknotes and increasingly bank deposits) for gold and silver. The world leader in the creation of these new instruments, Britain reaped the benefits of efficiencies in market transactions while simultaneously creating a revenue source (through the establishment of the Bank of England) that could be tapped by the Crown and Parliament to fund the British military, thereby enabling conquests against rivals (especially France) that lagged behind Britain in the development of flexible monetary institutions.

Though flexible, British monetary arrangements were based on a commitment to a fixed value of sterling in terms of gold, a commitment which avoided both the disastrous consequences of John Law’s brilliant, but ill-fated, monetary schemes in France, and the resulting reaction against banking that may account for the subsequent slow development of French banking and finance. However, at a crucial moment, the British were willing and able to cut the pound lose from its link to gold, providing themselves with the wherewithal to prevail in the struggle against Napoleon, thereby ensuring British supremacy for another century. (Read more.) [Update 2:37 PM EST: the paper is now available to be downloaded.]

In writing this review, I recalled a review that I wrote in 2000 for EH.net of a volume of essays (Essays in History: Financial, Economic, and Personal) by the eminent economic historian Charles Kindleberger, author of the classic Manias, Panics and Crashes. Although I greatly admired Kindleberger for his scholarship and wit, I disagreed with a lot of his specific arguments and policy recommendations, and I tried to give expression to both my admiration of Kindleberger and my disagreement with him in my review (also just posted on SSRN). Here are the first two paragraphs of that essay.

Charles P. Kindleberger, perhaps the leading financial historian of our time, has also been a prolific, entertaining, and insightful commentator and essayist on economics and economists. If one were to use Isaiah Berlin’s celebrated dichotomy between hedgehogs that know one big thing and foxes that know many little things, Kindleberger would certainly appear at or near the top of the list of economist foxes. Although Kindleberger himself never invokes Berlin’s distinction between hedgehogs and foxes, many of Kindleberger’s observations on the differences between economic theory and economic history, the difficulty of training good economic historians, and his critical assessment of grand theories of economic history such as Kondratieff long cycles, are in perfect harmony with Berlin.

So it is hard to imagine a collection of essays by Kindleberger that did not contain much that those interested in economics, finance, history, and policy — all considered from a humane and cosmopolitan perspective — would find worth reading. For those with a pronounced analytical bent (who are perhaps more inclined to prefer the output of a hedgehog than of a fox), this collection may seem a somewhat thin gruel. And some of the historical material in the first section will appear rather dry to all but the most dedicated numismatists. Nevertheless, there are enough flashes of insight, wit (my favorite is his aside that during talks on financial crises he elicits a nervous laugh by saying that nothing disturbs a person’s judgment so much as to see a friend get rich), and wisdom as well as personal reminiscences from a long and varied career (including an especially moving memoir of his relationship with his student and colleague Carlos F. Diaz-Alejandro) to repay readers of this volume. Unfortunately the volume is marred somewhat by an inordinate number of editorial lapses and mistaken attributions or misidentifications such as attributing a cutting remark about Paganini’s virtuosity to Samuel Johnson (who died when the maestro was all of two years old). (Read more) [Update 2:37 PM EST: the paper is now available to be downloaded.]

What Kind of Equilibrium Is This?

In my previous post, I suggested that Stephen Williamson’s views about the incapacity of monetary policy to reduce unemployment, and his fears that monetary expansion would simply lead to higher inflation and a repeat of the bad old days the 1970s when inflation and unemployment spun out of control, follow from a theoretical presumption that the US economy is now operating (as it almost always does) in the neighborhood of equilibrium. This does not seem right to me, but it is the sort of deep theoretical assumption (e.g., like the rationality of economic agents) that is not subject to direct empirical testing. It is part of what the philosopher Imre Lakatos called the hard core of a (in this case Williamson’s) scientific research program. Whatever happens, Williamson will process the observed facts in terms of a theoretical paradigm in which prices adjust and markets clear. No other way of viewing reality makes sense, because Williamson cannot make any sense of it in terms of the theoretical paradigm or world view to which he is committed. I actually have some sympathy with that way of looking at the world, but not because I think it’s really true; it’s just the best paradigm we have at the moment. But I don’t want to follow that line of thought too far now, but who knows, maybe another time.

A good illustration of how Williamson understands his paradigm was provided by blogger J. P. Koning in his comment on my previous post copying the following quotation from a post written by Williamson a couple of years on his blog.

In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe – I looked up Benassy and he is still hard at work. However, most of the mainstream – and here I’m including New Keynesians – sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don’t have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it’s not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with “disequilibrium.” In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.

I actually agree that departing from the assumption of equilibrium can involve a lack of discipline. Market clearing is a very powerful analytical tool, and to give it up without replacing it with an equally powerful analytical tool leaves us theoretically impoverished. But Williamson seems to suggest (or at least leaves ambiguous) that there is only one kind of equilibrium that can be handled theoretically, namely a fully optimal general equilibrium with perfect foresight (i.e., rational expectations) or at least with a learning process leading toward rational expectations. But there are other equilibrium concepts that preserve market clearing, but without imposing, what seems to me, the unreasonable condition of rational expectations and (near) optimality.

In particular, there is the Hicksian concept of a temporary equilibrium (inspired by Hayek’s discussion of intertemporal equilibrium) which allows for inconsistent expectations by economic agents, but assumes market clearing based on supply and demand schedules reflecting those inconsistent expectations. Nearly 40 years ago, Earl Thompson was able to deploy that equilibrium concept to derive a sub-optimal temporary equilibrium with Keynesian unemployment and a role for countercyclical monetary policy in minimizing inefficient unemployment. I have summarized and discussed Thompson’s model previously in some previous posts (here, here, here, and here), and I hope to do a few more in the future. The model is hardly the last word, but it might at least serve as a starting point for thinking seriously about the possibility that not every state of the economy is an optimal equilibrium state, but without abandoning market clearing as an analytical tool.

And Now Here’s a Kind Word for Austrian Business Cycle Theory

I recently wrote two posts (this and this) about the Austrian Theory of Business Cycles (ABCT) that could be construed as criticisms of the theory, and regular readers of this blog are probably aware that critical comments about ABCT are not unprecedented on this blog. Nevertheless, I am not at all hostile to ABCT, though I am hostile to the overreach of some ABCT enthusiasts who use ABCT as a justification for their own radically nihilistic political agenda of promoting the collapse of our existing financial and monetary system and the resulting depression in the expectation that the apocalypse would lead us into a libertarian free market paradise. So, even though I don’t consider myself an Austrian economist, I now want to redress the balance by saying something positive about ABCT, because I actually believe that the Austrian theory and approach has something important to teach us about business-cycle theory and macroeconomics.

The idea for writing a positive post about Austrian business-cycle theory actually came to me while I was writing my latest installment on Earl Thompson’s reformulation of macroeconomics. The point of my series on Earl Thompson is to explain how Thompson constructed a macroeconomic model in many ways similar to the Keynesian IS-LM model, but on a consistent and explicitly neoclassical foundation. Moreover, by inquiring deeply into the differences between his reformulated model with IS-LM model, Thompson identified some important conceptual shortcomings in the Keynesian model, perhaps most notably the downward-sloping IS curve, a shortcoming with potentially important policy implications.

Now to be able to construct a macroeconomic model at what Thompson called “a Keynesian level of aggregation” (i.e, a model consisting of just four markets, money, output, capital services and labor services) that could also be reconciled with neoclassical production theory, it was necessary to assume that capital and output are a single homogeneous substance that can either be consumed or used as an input in the production process for new output. One can, as Thompson did, construct a consistent model based on these assumptions, a model that may even yield important and useful insights, but it is not clear to me that these minimal assumptions provide a sufficient basis for constructing a reliable macroeconomic model.

What does this have to do with ABCT? Well, ABCT seeks to provide an explanation of business cycles that is built from the ground up based on how individuals engage in rational goal-oriented action in market transactions. In Austrian theory, understanding how market actions are motivated and coordinated is primarily achieved by understanding how relative prices adjust to the market forces of demand and supply. Market determined prices direct resources toward their most highly valued uses given the available resources and the structure of demand for final outputs, while coordinating the separate plans of individual households and business firms. In this view, total aggregate spending is irrelevant as it is nothing more than the sum total of individual decisions. It is the individual decisions that count; total spending is simply the resultant of all those individual decisions, not the determinant of them.  Those decisions are made in light of the incentives and costs faced by the individual decision-makers. Total spending doesn’t figure into their decision-making processes, so what is the point of including it as a variable in the mode?

This mistaken preoccupation of Keynesian macroeconomics with aggregate spending has been the central message of Austrian anti-Keynesianism going back at least to Hayek’s 1931 review of Keynes’s Treatise on Money in which Hayek charged that “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.” But the assertion that aggregates are irrelevant to individual decisions is not necessarily valid. Businesses decide on how much they are going to invest based on some forecast of the future demand for their products. Is that forecast of future demand independent of what total spending will be in the future? That is a matter of theoretical judgment, not an issue of methodological malpractice.  Interest rates, a quintessential market price, the rate at which one can transform current commodities or money units into future commodities or future money units, are not independent of forecasts about the future purchasing power of the monetary unit. But the purchasing power of the monetary unit is another one of those illegitimate aggregate about which Austrians complain. So although I sympathize with Austrian mistrust of overly aggregated macroeconomic models, I am not sure that I agree with their specific criticisms about the meaningfulness and relevance of particular aggregates.

So let me offer an alternative criticism of excessive aggregation, but in the context of a different kind of example. Suppose I wish to explain a very simple kind of social interaction in which a decision by one person can lead to a kind of chain reaction followed by a rapid succession of subsequent, but formally, independent, decisions. Think of a crowd of people watching a ball game. The spectators are all seated in their seats.  Suddenly something important or exciting happens on the court or the field and almost instantaneously everyone is standing. Why? As soon as one person stands he blocks the vision of the person behind him, forcing that person to stand, causing a chain reaction. For some reason, the action on the field causes a few people to stand. If those people did not stand, no one else would have stood. In fact, even if the first people to stand stood for reasons that had nothing to do with what was happening on the field, the effect would have been the same, because everyone else would have stood; once their vision is  blocked by people in front of them, spectators have to stand up to to see the action.  But this phenomenon of everyone in a crowd standing when something exciting happens on the ball field happens only with a crowd of spectators of some minimum density.   Below that density, not everyone will be forced to stand just because a few people near the front get up from their seats.

A similar chain reaction, causing a more serious inefficiency, results when traffic slows down to a crawl on an expressway not because of an obstruction, but just because there is something off to the side of the road that some people are slowing down to look at. The effect only happens, or is at least highly sensitive to, the traffic density on the expressway. If the expressway is sufficiently uncrowded, some attention-attracting sight on the side of the road will cause only a minimal slowdown in the flow of traffic.

The point here is that there is something about certain kinds of social phenomena that is very sensitive to certain kinds of interactions between the individuals in the larger group under consideration. The phenomenon cannot be explained unless you take account of how the individuals are interacting. Just looking at the overall characteristics of the group without taking into account the interactions between the individuals will cause you to miss something essential to the process that you are trying to explain. It seems to me that there is something about business-cycle phenomena that is deeply similar to the crowd-like effects in the two examples I gave in the previous paragraph. Aggregation in economic models is not necessarily bad, even Austrians routinely engaging in aggregation in their business-cycle analyses, rarely, for example, discussing changes in the shape of the yield curve, but simply assuming that the entire yield curve rises or falls with “the interest rate.” The question is always a pragmatic one, is the increased tractability of the analysis that aggregation permits worth the impoverishment of the model, by reducing the scope for interactions between the remaining variables. In this respect, it seems to me that real-business cycle models, especially those of the representative-agent ilk, are, by far, the most impoverished of all.  I mean can you imagine, a representative spectator or representative-driver model of either of the social interactions described above?

So my advice, for whatever it’s worth, to Austrians (and non-Austrians) is to try to come up with explanations for why aggregated models suppress some type of interaction between agents that is crucial to the explanation of a phenomenon of interest.  That would be an more useful analytical contribution than simply complaining about aggregation in the abstract.

PS  Via Mark Thoma I see that Alan Kirman has just posted an article on Vox in which he makes a number of points very similar to those that I make here. For example:

The student then moves on to macroeconomics and is told that the aggregate economy or market behaves just like the average individual she has just studied. She is not told that these general models in fact poorly reflect reality. For the macroeconomist, this is a boon since he can now analyse the aggregate allocations in an economy as though they were the result of the rational choices made by one individual. The student may find this even more difficult to swallow when she is aware that peoples’ preferences, choices and forecasts are often influenced by those of the other participants in the economy. Students take a long time to accept the idea that the economy’s choices can be assimilated to those of one individual.

Thompson’s Reformulation of Macroeconomic Theory, Part IV

It’s time for another installment, after a longer than expected hiatus, in my series of posts summarizing and commenting on Earl Thompson’s path-breaking paper, “A Reformulaton of Macroeconomic Theory.” In the first three installments I described the shift on modeling strategy from the conventional Keynesian IS-LM model adopted by Thompson, and the basic properties of his reformulated model. In the first installment, I explained that Thompson’s key analytic insight was to ground the model in an explicitly neoclassical framework, exploiting the straightforward and powerful implications of the neoclassical theory of production to derive the basic properties of a macroeconomc model structurally comparable to the IS-LM model. The reformulated model shifts the analytic focus from the Keynesian spending functions to the conditions for factor-market equilibrium in a single-output, two-factor model. In the second installment, I explained how Thompson drew upon the Hicksian notion of temporary equilibrium for an explicit treatment of Keynesian (involuntary) unemployment dependent on incorrect (overly optimistic) expectations of future wages. While the model allows for inefficient (relative to correct expectations) choices by workers to remain unemployed owing to incorrect expectations, the temporary equilibrium nevertheless involves no departure from market clearing, and no violation of Walras’s Law. In the third installment, I described the solution of the model, deriving two market-equilibrium curves, one a locus of points of equilibrium (combinations of price levels and nominal interest rates) in the two factor markets (for labor and capital services) and one a locus of points of money-market equilibrium (again in terms of price levels and nominal interest rates) using the standard analytic techniques for deriving the Keynesian IS and LM curves.

Although not exactly the same as the Keynesian LM curve (constructed in income-interest-rate space), the locus of points of monetary equilibrium, having a similar upward slope, was assigned the familiar LM label. However, unlike the Keynesian IS curve it replaces, the locus of points, labeled FF, of factor-market equilibrium is positively sloped. The intersection of the two curves determines a temporary equilibrium, characterized by a price level, a corresponding level of employment, and for a given expected-inflation parameter, a corresponding real and nominal interest rate. The accompanying diagram, like Figure 4 in my previous installment, depicts such a temporary-equilibrium solution. I observed in the previous installment that applying Walras’s Law allows another locus of points corresponding to equilibrium in the market for the single output, which was labeled the CC curve (for commodity market equilibrium) by Thompson. The curve would have to lie in the space between the FF curve and the LM curve, where excess demands in each market have opposite (offsetting) signs. The CC curve is in some sense analogous to the Keynesian IS curve, but, as I am going to explain, it differs from the IS curve in a fundamental way. In the accompnaying diagram, I have reproduce the FF and LM curves of the with reformulated model with the CC curve drawn between the FF and LM curves. The slope of the CC curve is clearly positive, in contrast to the downward slope normally attributed to the Keynesian IS curve.

In this post, I am going to discuss Thompson’s explanation of the underlying connection between his reformulated macroeconomic model and the traditional Keynesian model. At a formal level, the two models share some of the same elements and a similar aggregative structure, raising the question what accounts for the different properties of the two models and to what extent can the analysis of one model be translated into the terms of the other model?

Aside from the difference in modeling strategy, focusing on factor-market equilibrium instead of an aggregate spending function, there must be a deeper underlying substantive difference between the two models, otherwise the choice of which market to focus on would not matter, Walras’s Law guaranteeing that anyone of the n markets can be eliminated without changing the equilibrium solution of a system of excess demand equations. So let us look a bit more closely at the difference between the Keynesian IS curve and the CC curve of the reformulated model. The most basic difference is that the CC curve relates to a stock equilibrium, with an equilibrating value of P in the market for purchasing the stock of commodities, representing the equilibrium market value of a unit of output. On the other hand, the Keynesian IS curve is measuring a flow, the rate of aggregate expenditure, the equilibrium corresponding to a particular rate of expenditure.

Thompson sums up the underlying difference between the Keynesian model and the reformulated model in two very dense paragraphs on pp. 16-17 of his paper under section heading “The role of aggregate spending and the Keynesian stock-flow fallacy.” I will quote the two paragraphs in full and try to explain as best as I can, what he is saying.

All of this is not to say that the flow of aggregate spending is irrelevant to our temporary equilibrium. The expected rate of inflation [as already noted a crucial parameter in reformulated model] may depend parametrically upon the expected rate of spending. Then, an increase in the expected rate of spending on consumption or investment (or, more generally, an increase in the expected future excess demand for goods at the originally expected prices) would, by increased Pe [the expected price level] and thus r [the nominal interest rate] for a given R/P [the ratio of the rental price of capital to the price of capital, aka the real interest rate], shift up the FF curve. In a Modern Money Economy [i.e., an economy using a non-interest-bearing fiat money monopolistically supplied by a central bank], this shift induces a movement out of money [because an increase in the nominal interest rate increases the cost of holding non-interest-bearing fiat money] in the current market (a movement along the LM curve) and a higher current price level. This exogenous treatment of spendings variables, while perhaps most practical from the standpoint of business cycle policy, does not capture the Keynesian concept of an equilibrium rate of expenditure.

It is worth pausing here to ponder the final sentence of the paragraph, because the point that Thompson is getting at is far from obvious. I think what he means is that one can imagine, working within the framework of the reformulated FF-LM model, that a policy change, say an increase in government spending, could be captured by positing an effect on the expected price level. Additional government spending would raise the expected price level, thus causing an upward shift in the FF curve, thereby inducing people to hold less cash, leading to a new equilibrium associated with an intersection of the new FF curve at point further up the LM curve than the original intersection. Thus, the FF-LM framework can accommodate a traditional Keynesian fiscal policy exercise. But the IS-LM framework suffers from a difficulty in specifying what the equilibrium rate of spending is and how that equilibrium can be determined, the problem being that there does not seem to be any variable in the model to equilibrate the rate of spending in the way that the price level equilibrates the market for output in the reformulated model. Now back to Thompson:

In order to obtain an equilibrium rate of expenditures – and thus an equilibrium rate of capital accumulation [aka investment, how much output will be carried over to next period] – a corresponding price variable must be added. The only economically natural price to introduce to equilibrate the demand and supply of next period’s capital goods. [In other words, how much of this period's output you will want to hold until next period depends on the relationship between the current price of the output and the price expected next period.] This converts Pe into an equilibrating variable. Indeed, Section III below will show that if Pe is made the equilibrating price variable, making the rate of inflation an independently equilibrating variable rather than an expectations parameter determined by other variables in the system and extending the temporary equilibrium to a two-period equilibrium model in which only prices in the third and later periods may be incorrectly expected in the current period, the Keynesian expendiutres condition, the equality of ex ante savings and investment, is indeed achieved. However, Section III will also show that the familiar Keynesian comparative statics results that are based upon a negatively sloped IS curve fail to hold in the extend model just as they fail in the above, single period model.

The upshot of Thompson’s argument is that you can’t have a Keynesian investment function without introducing an expected price for capital in the next period. Without an expected price of output in the next period, there is nothing to determine how much investment entrepreneurs choose to undertake in the current period. And if you want to identify an equilibrium rate of expenditure, which means an equilibrium rate of investment, then you must perforce allow the expected price for capital in the next period to adjust to achieve that equilibrium.

I must admit that I have been struggling with this argument since I first heard Earl make it in his graduate macro class almost 40 years ago, and it is only recently that I have begun to think that I understand what he was getting at. I was helped in seeing his point by the series of posts (this, this, this, this, this, this, this, and this)  that I wrote earlier this year about indentities and equilibrium conditions in the basic Keynesian model, and especially by the many comments and counterarguments that I received as a result of those posts. The standard Keynesian expenditure function is hard to distinguish from an income function (which also makes it hard to distinguish investment from savings), which makes it hard to understand the difference between expenditure being equal in equilibrium and being identical to savings in general or to understand the difference between savings and investment being equal in equilibrium and being identical in general. There is a basic problem in choosing define an equilibrium in terms of two magnitudes so closely related as income and expenditure. The equilibrating mechanism doesn’t seem to be performing any real economic work, so it hard to tell the difference between an equilibrium state and a disequilibrium state in such a model. Thompson may have been getting at this point from another angle by focusing on the lack of any equilibrating mechanism in the Keynesian model, and suggesting that an equilibrating mechanism, the expected future price level or rate of inflation, has to be added to the Keynesian model in order to make any sense out of it.

In my next installment, I will consider Thompson’s argument about the instability of the equilibrium in the FF-LM model.

Thompson’s Reformulation of Macroeconomic Theory, Part III: Solving the FF-LM Model

In my two previous installments on Earl Thompson’s reformulation of macroeconomic theory (here and here), I have described the paradigm shift from the Keynesian model to Thompson’s reformulation — the explicit modeling of the second factor of production needed to account for a declining marginal product of labor, and the substitution of a factor-market equilibrium condition for equality between savings and investment to solve the model. I have also explained how the Hicksian concept of temporary equilibrium could be used to reconcile market clearing with involuntary Keynesian unemployment by way of incorrect expectations of future wages by workers occasioned by incorrect expectations of the current (unobservable) price level.

In this installment I provide details of how Thompson solved his macroeconomic model in terms of equilibrium in two factor markets instead of equality between savings and investment. The model consists of four markets: a market for output (C – a capital/consumption good), labor (L), capital services (K), and money (M). Each market has its own price: the price of output is P; the price of labor services is W; the price of capital services is R; the price of money, which serves as numeraire, is unity. Walras’s Law allows exclusion of one of these markets, and in the neoclassical spirit of the model, the excluded market is the one for output, i.e., the market characterized by the Keynesian expenditure functions. The model is solved by setting three excess demand functions equal to zero: the excess demand for capital services, XK, the excess demand for labor services, XL, and the excess demand for money, XM. The excess demands all depend on W, P, and R, so the solution determines an equilibrium wage rate, an equilibrium rental rate for capital services, and an equilibrium price level for output.

In contrast, the standard Keynesian model includes a bond market instead of a market for capital services. The excluded market is the bond market, with equilibrium determined by setting the excess demands for labor services, for output, and for money equal to zero. The market for output is analyzed in terms of the Keynesian expenditure functions for household consumption and business investment, reflected in the savings-equals-investment equilibrium condition.

Thompson’s model is solved by applying the simple logic of the neoclassical theory of production, without reliance on the Keynesian speculations about household and business spending functions. Given perfect competition, and an aggregate production function, F(K, L), with the standard positive first derivatives and negative second derivatives, the excess demand for capital services can be represented by the condition that the rental rate for capital equal the value of the marginal product of capital (MPK) given the fixed endowment of capital, K*, inherited from the last period, i.e.,

R = P times MPK.

The excess demand for labor can similarly be represented by the condition that the reservation wage at which workers are willing to accept employment equals the value of the marginal product of labor given the inherited stock of capital K*. As I explained in the previous installment, this condition allows for the possibility of Keynesian involuntary unemployment when wage expectations by workers are overly optimistic.

The market rate of interest, r, satisfies the following version of the Fisher equation:

r = R/P + (Pe – P)/P), where Pe is the expected price level in the next period.

Because K* is assumed to be fully employed with a positive marginal product, a given value of P determines a unique corresponding equilibrium value of L, the supply of labor services being upward-sloping, but relatively elastic with respect to the nominal wage for given wage expectations by workers. That value of L in turn determines an equilibrium value of R for the given value of P. If we assume that inflation expectations are constant (i.e., that Pe varies in proportion to P), then a given value of P must correspond to a unique value of r. Because simultaneous equilibrium in the markets for capital services and labor services can be represented by unique combinations of P and r, a factor-market equilibrium condition can be represented by a locus of points labeled the FF curve in Figure 1 below.

The FF curve must be upward-sloping, because a linear homogenous production function of two scarce factors (i.e., doubling inputs always doubles output) displaying diminishing marginal products in both factors implies that the factors are complementary (i.e., adding more of one factor increases the marginal productivity of the other factor). Because an increase in P increases employment, the marginal product of capital increases, owing to complementarity between the factors, implying that R must increase by more than P. An increase in the price level, P, is therefore associated with an increase in the market interest rate r.

Beyond the positive slope of the FF curve, Thompson makes a further argument about the position of the FF curve, trying to establish that the FF curve must intersect the horizontal (P) axis at a positive price level as the nominal interest rate goes to 0. The point of establishing that the FF curve intersects the horizontal axis at a positive value of r is to set up a further argument about the stability of the model’s equilibrium. I find that argument problematic. But discussion of stability issues are better left for a future post.

Corresponding to the FF curve, it is straightforward to derive another curve, closely analogous to the Keynesian LM curve, with which to complete a graphical solution of the model. The two LM curves are not the same, Thompson’s LM curve being constructed in terms of the nominal interest rate and the price level rather than in terms of nominal interest rate and nominal income, as is the Keynesian LM curve. The switch in axes allows Thompson to construct two versions of his LM curve. In the conventional case, a fixed nominal quantity of non-interest-bearing money being determined exogenously by the monetary authority, increasing price levels imply a corresponding increase in the nominal demand for money. Thus, with a fixed nominal quantity of money, as the price level rises the nominal interest rate must rise to reduce the quantity of money demanded to match the nominal quantity exogenously determined. This version of the LM curve is shown in Figure 2.

A second version of the LM curve can be constructed corresponding to Thompson’s characterization of the classical model of a competitively supplied interest-bearing money supply convertible into commodities at a fixed exchange rate (i.e., a gold standard except that with only one output money is convertible into output in general not one of many commodities). The quantity of money competitively supplied by the banking system would equal the quantity of money demanded at the price level determined by convertibility between money and output. Because money in the classical model pays competitive interest, changes in the nominal rate of interest do not affect the quantity of money demanded. Thus, the LM curve in the classical case is a vertical line corresponding to the price level determined by the convertibility of money into output. The classical LM curve is shown in Figure 3.

The full solution of the model (in the conventional case) is represented graphically by the intersection of the FF curve with the LM curve in Figure 4.

Note that by applying Walras’s Law, one could draw a CC curve representing equilibrium in the market for commodities (an analogue to the Keynesian IS curve) in the space between the FF and the LM curves and intersecting the two curves precisely at their point of intersection. Thus, Thompson’s reformulation supports Nick Rowe’s conjecture that the IS curve, contrary to the usual derivation, is really upward-sloping.

Thompson’s Reformulation of Macroeconomic Theory, Part II: Temporary Equilibrium

I explained in my first post on Earl Thompson’s reformulation of macroeconomics that Thompson posited a model consisting of a single output serving as both a consumption good and as a second factor of production cooperating with labor to produce the output. The single output is traded in two markets: a market for sale to be consumed and a market for hire as a factor of production. The ratio of the rental price to the purchase price determines a real interest rate, and adding the expected rate of change in the purchase price from period to period to the real interest rate determines the nominal interest rate. The money wage is determined in a labor market, and the absolute price level is determined in the money market. A market for bonds exists, but the nominal interest rate determined by the ratio of the rental price of the output to its purchase price plus the expected rate of change in the purchase price from period to period governs the interest rate on bonds, conveniently allowing the bond market to be excluded from the analysis.

The typical IS-LM modeling approach is to posit a sticky wage that prevents equilibrium at full employment from being achieved except via an increase in aggregate demand. Wage rigidity is thus introduced as an ad hoc assumption to explain how an unemployment “equilibrium” is possible. However, by extending the model to encompass a second period, Thompson was able to derive wage stickiness in the context of a temporary equilibrium construct that does not rely on an arbitrary assumption of wage stickiness, but derives wage stickiness as an implication of incorrect expectations, in particular from overly optimistic wage expectations by workers who, upon observing unexpectedly low wage offers, choose to remain unemployed, preferring instead to engage in job search, leisure, or non-market labor activity.  The model assumptions are basically those of Lucas, and Thompson provides some commentary on the rationale for his assumptions.

One might, however, reasonably doubt that government policy makers have systematically better information than private decision makers regarding future prices. Such doubting would be particularly strong for commodity markets, where, in the real world, market specialists normally arbitrage between present and future markets. . . . But laws prohibiting long-term labor contracts have effectively prevented human capital from coming under the control of market specialists. As a consequence, the typical laborer, who is not naturally an expert in the market for his kind of service, makes his own employment decisions despite relative ignorance about the market. (p. 6)

I will just note parenthetically that my own view is that the information problem is exacerbated in the real world by the existence of many products and many different  kinds of services. Shocks are transmitted from sector to sector via complicated and indirect interrelationships between markets and sectors. In the process of transmission, initial shocks are magnified, some sectors being affected more than others in unpredictable, or at least unpredicted, ways causing sector-specific shocks that, in turn, get transmitted to other sectors. These interactions are analogous to the Cantillon effects associated with sector-specific variations in the rate of additional spending caused by monetary expansion.  Austrian economists tend to wring their hands and shake their heads in despair about the terrible distortions associated with Cantillon effects caused by monetary expansion, but seem to regard the Cantillon effects associated with monetary contraction as benign and remedial.  Highly aggregated models don’t capture these interactions and thus leave out an important feature of business-cycle contractions.

Starting from a position of full equilibrium, an exogenous shift creates a temporary equilibrium with Keynesian unemployment when there is an overall excess supply of labor at the original wage rates and some laborers mistakenly believe that the resulting lower wage offers from their present employers may be a result of a shift which lowers the value of their products in their present firms relative to other firms who hire workers in their occupations. As a consequence, some of these laborers refuse the lower wage offers from their present employers and spend their present labor service inefficiently searching for higher-wage jobs in their present occupation or resting in wait for what they expect to be the higher future wages.

Since monetary shifts, which are apparently observed to induce inefficient adjustments in employment, also change the temporary equilibrium level of prices of current outputs, we must assume that some workers do not know of the present change in the price level. Otherwise, all workers, in responding to a monetary shift, would be able to observe the price level change which accompanied the change in their wage offers and would not make the mistake of assuming that wage offers elsewhere have not similarly changed. . . . (p. 7)

The price level of current outputs is only an expectation function for these laborers, as they cannot be assumed to know the actual price level in the current period. This is represented . . . by allowing labor’s perception of current non-labor prices to depend only on last period’s prices, which are parameters rather than variables to be determined, and on current wage offers. (p. 8)

Because workers may construe an overall shift in the demand for labor as a relative shift in demand for their own type of labor, it follows that future wage and price expectations are inelastic with respect to observed increases in wage offers. Thus, a change in observed wages does not cause a corresponding revision of expected future wages and prices, so the supply of labor does not shift significantly when observed wages are higher or lower than expected.  When wages change because of an overall reduction in the demand for labor destined to cause future wages and prices to fall, workers with slowly adjusting expectations inefficiently supply services to employers on the basis of incorrect expectations. The temporary equilibrium corresponds to the intersection of a demand curve and a supply curve.  This is a type of wage rigidity different from that associated with the conventional Keynesian model.  The labor market is in equilibrium in the sense that current plans are being executed. However, current plans are conditional on incorrect expectations. There is an inefficiency associated with incorrect expectations. But it is an inefficiency that countercyclical policy can overcome, and that is why there is potentially a multiplier effect associated with an increase in aggregate demand.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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