Archive for the 'Hawtrey' Category

Keynes on the Theory of Interest

In my previous post, I asserted that Keynes used the idea that savings and investment (in the aggregated) are identically equal to dismiss the neoclassical theory of interest of Irving Fisher, which was based on the idea that the interest rate equilibrates savings and investment. One of the commenters on my post, George Blackford, challenged my characterization of Keynes’s position.

I find this to be a rather odd statement for when I read Keynes I didn’t find anywhere that he argued this sort of thing. He often argued that “an act of saving” or “an act of investing” in itself could not have an direct effect on the rate of interest, and he said things like: “Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income”, but I don’t find him saying that savings and investment could not determine the rate of interest are identical.

A quote from Keynes in which he actually says something to this effect would be helpful here.

Now I must admit that in writing this characterization of what Keynes was doing, I was relying on my memory of how Hawtrey characterized Keynes’s theory of interest in his review of the General Theory, and did not look up the relevant passages in the General Theory. Of course, I do believe that Hawtrey’s characterization of what Keynes said to be very reliable, but it is certainly not as authoritative as a direct quotation from Keynes himself, so I have been checking up on the General Theory for the last couple of days. I actually found that Keynes’s discussion in the General Theory was less helpful than Keynes’s 1937 article “Alternative Theories of the Rate of Interest” in which Keynes responded to criticisms by Ohlin, Robertson, and Hawtrey, of his liquidity-preference theory of interest. So I will use that source rather than what seems to me to be the less direct and more disjointed exposition in the General Theory.

Let me also remark parenthetically that Keynes did not refer to Fisher at all in discussing what he called the “classical” theory of interest which he associated with Alfred Marshall, his only discussion of Fisher in the General Theory being limited to a puzzling criticism of the Fisher relation between the real and nominal rates of interest. That seems to me to be an astonishing omission, perhaps reflecting a deplorable Cambridgian provincialism or chauvinism that would not deign to acknowledge Fisher’s magisterial accomplishment in incorporating the theory of interest into the neoclassical theory of general equilibrium. Equally puzzling is that Keynes chose to refer to Marshall’s theory (which I am assuming he considered an adequate proxy for Fisher’s) as the “classical” theory while reserving the term “neo-classical” for the Austrian theory that he explicitly associates with Mises, Hayek, and Robbins.

Here is how Keynes described his liquidity-preference theory:

The liquidity-preference theory of the rate of interest which I have set forth in my General Theory of Employment, Interest and Money makes the rate of interest to depend on the present supply of money and the demand schedule for a present claim on money in terms of a deferred claim on money. This can be put briefly by saying that the rate of interest depends on the demand and supply of money. . . . (p. 241)

The theory of the rate of interest which prevailed before (let us say) 1914 regarded it as the factor which ensured equality between saving and investment. It was never suggested that saving and investment could be unequal. This idea arose (for the first time, so far as I am aware) with certain post-war theories. In maintaining the equality of saving and investment, I am, therefore, returning to old-fashioned orthodoxy. The novelty in my treatment of saving and investment consists, not in my maintaining their necessary aggregate equality, but in the proposition that it is, not the rate of interest, but the level of incomes which (in conjunction with certain other factors) ensures this equality. (pp. 248-49)

As Hawtrey and Robertson explained in their rejoinders to Keynes, the necessary equality in the “classical” system between aggregate savings and aggregate investment of which Keynes spoke was not a definitional equality but a condition of equilibrium. Plans to save and plans to invest will be consistent in equilibrium and the rate of interest – along with all the other variables in the system — must be such that the independent plans of savers and investors will be mutually consistent. Keynes had no basis for simply asserting that this consistency of plans is ensured entirely by way of adjustments in income to the exclusion of adjustments in the rate of interest. Nor did he have a basis for asserting that the adjustment to a discrepancy between planned savings and planned investment was necessarily an adjustment in income rather than an adjustment in the rate of interest. If prices adjust in response to excess demands and excess supplies in the normal fashion, it would be natural to assume that an excess of planned savings over planned investment would cause the rate of interest to fall. That’s why most economists would say that the drop in real interest rates since 2008 has been occasioned by a persistent tendency for planned savings to exceed planned investment.

Keynes then explicitly stated that his liquidity preference theory was designed to fill the theoretical gap left by his realization that a change income not in the interest rate is what equalizes savings and investment (even while insisting that savings and investment are necessarily equal by definition).

As I have said above, the initial novelty lies in my maintaining that it is not the rate of interest, but the level of incomes which ensures equality between saving and investment. The arguments which lead up to this initial conclusion are independent of my subsequent theory of the rate of interest, and in fact I reached it before I had reached the latter theory. But the result of it was to leave the rate of interest in the air. If the rate of interest is not determined by saving and investment in the same way in which price is determined by supply and demand, how is it determined? One naturally began by supposing that the rate of interest must be determined in some sense by productivity-that it was, perhaps, simply the monetary equivalent of the marginal efficiency of capital, the latter being independently fixed by physical and technical considerations in conjunction with the expected demand. It was only when this line of approach led repeatedly to what seemed to be circular reasoning, that I hit on what I now think to be the true explanation. The resulting theory, whether right or wrong, is exceedingly simple-namely, that the rate of interest on a loan of given quality and maturity has to be established at the level which, in the opinion of those who have the opportunity of choice -i.e. of wealth-holders-equalises the attractions of holding idle cash and of holding the loan. It would be true to say that this by itself does not carry us very far. But it gives us firm and intelligible ground from which to proceed. (p. 250)

Thus, Keynes denied forthrightly the notion that the rate of interest is in any way determined by the real forces of what in Fisherian terms are known as the impatience to spend income and the opportunity to invest it. However, his argument was belied by his own breathtakingly acute analysis in chapter 17 of the General Theory (“The Properties of Interest and Money”) in which, applying and revising ideas discussed by Sraffa in his 1932 review of Hayek’s Prices and Production he introduced the idea of own rates of interest.

The rate of interest (as we call it for short) is, strictly speaking, a monetary phenomenon in the special sense that it is the own-rate of interest (General Theory, p. 223) on money itself, i.e. that it equalises the advantages of holding actual cash and a deferred claim on cash. (p. 245)

The huge gap in Keynes’s reasoning here is that he neglected to say at what rate of return “the advantages of holding actual cash and a deferred claim on cash” or, for that matter, of holding any other real asset are equalized. That’s the rate of return – the real rate of interest — for which Irving Fisher provided an explanation. Keynes simply ignored — or forgot about — it, leaving the real rate of interest totally unexplained.

Keynes and Accounting Identities

In a post earlier this week, Michael Pettis was kind enough to refer to a passage from Ralph Hawtrey’s review of Keynes’s General Theory, which I had quoted in an earlier post, criticizing Keynes’s reliance on accounting identities to refute the neoclassical proposition that it is the rate of interest which equilibrates savings and investment. Here’s what Pettis wrote:

Keynes, who besides being one of the most intelligent people of the 20th century was also so ferociously logical (and these two qualities do not necessarily overlap) that he was almost certainly incapable of making a logical mistake or of forgetting accounting identities. Not everyone appreciated his logic. For example his also-brilliant contemporary (but perhaps less than absolutely logical), Ralph Hawtrey, was “sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships”, according to FTC economist David Glasner, whose gem of a blog, Uneasy Money, is dedicated to reviving interest in the work of Ralph Hawtrey. In a recent entry Glasner quotes Hawtrey:

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.

This is a very typical criticism of certain kinds of logical thinking in economics, and of course it misses the point because Keynes is not arguing from definition. It is certainly true that “identity so established cannot prove anything”, if by that we mean creating or supporting a hypothesis, but Keynes does not use identities to prove any creation. He uses them for at least two reasons. First, because accounting identities cannot be violated, any model or hypothesis whose logical corollaries or conclusions implicitly violate an accounting identity is automatically wrong, and the model can be safely ignored. Second, and much more usefully, even when accounting identities have not been explicitly violated, by identifying the relevant identities we can make explicit the sometimes very fuzzy assumptions that are implicit to the model an analyst is using, and focus the discussion, appropriately, on these assumptions.

I agree with Pettis that Keynes had an extraordinary mind, but even great minds are capable of making mistakes, and I don’t think Keynes was an exception. And on the specific topic of Keynes’s use of the accounting identity that expenditure must equal income and savings must equal investment, I think that the context of Keynes’s discussion of that identity makes it clear that Keynes was not simply invoking the identity to prevent some logical slipup, as Pettis suggests, but was using it to deny the neoclassical Fisherian theory of interest which says that the rate of interest represents the intertemporal rate of substitution between present and future goods in consumption and the rate of transformation between present and future goods in production. Or, in less rigorous terminology, the rate of interest reflects the marginal rate of time preference and the marginal rate of productivity of capital. In its place, Keynes wanted to substitute a pure monetary or liquidity-preference theory of the rate of interest.

Keynes tried to show that the neoclassical theory could not possibly be right, inasmuch as, according to the theory, the equilibrium rate of interest is the rate that equilibrates the supply of with the demand for loanable funds. Keynes argued that because investment and savings are identically equal, savings and investment could not determine the rate of interest. But Keynes then turned right around and said that actually the equality of savings and investment determines the level of income. Well, if savings and investment are identically equal, so that the rate of interest can’t be determined by equilibrating the market for loanable funds, it is equally impossible for savings and investment to determine the level of income.

Keynes was unable to distinguish the necessary accounting identity of savings and investment from the contingent equality of savings and investment as an equilibrium condition. For savings and investment to determine the level of income, there must be some alternative definition of savings and investment that allows them to be unequal except at equilibrium. But if there are alternative definitions of savings and investment that allow those magnitudes to be unequal out of equilibrium — and there must be such alternative definitions if the equality of savings and investment determines the level of income — there is no reason why the equality of savings and investment could not be an equilibrium condition for the rate of interest. So Keynes’s attempt to refute the neoclassical theory of interest failed. That was Hawtrey’s criticism of Keynes’s use of the savings-investment accounting identity.

Pettis goes on to cite Keynes’s criticism of the Versailles Treaty in The Economic Consequences of the Peace as another example of Keynes’s adroit use of accounting identities to expose fallacious thinking.

A case in point is The Economic Consequences of the Peace, the heart of whose argument rests on one of those accounting identities that are both obvious and easily ignored. When Keynes wrote the book, several members of the Entente – dominated by England, France, and the United States – were determined to force Germany to make reparations payments that were extraordinarily high relative to the economy’s productive capacity. They also demanded, especially France, conditions that would protect them from Germany’s export prowess (including the expropriation of coal mines, trains, rails, and capital equipment) while they rebuilt their shattered manufacturing capacity and infrastructure.

The argument Keynes made in objecting to these policies demands was based on a very simple accounting identity, namely that the balance of payments for any country must balance, i.e. it must always add to zero. The various demands made by France, Belgium, England and the other countries that had been ravaged by war were mutually contradictory when expressed in balance of payments terms, and if this wasn’t obvious to the former belligerents, it should be once they were reminded of the identity that required outflows to be perfectly matched by inflows.

In principle, I have no problem with such a use of accounting identities. There’s nothing wrong with pointing out the logical inconsistency between wanting Germany to pay reparations and being unwilling to accept payment in anything but gold. Using an accounting identity in this way is akin to using the law of conservation of energy to point out that perpetual motion is impossible. However, essentially the same argument could be made using an equilibrium condition for the balance of payments instead of an identity. The difference is that the accounting identity tells you nothing about how the system evolves over time. For that you need a behavioral theory that explains how the system adjusts when the equilibrium conditions are not satisfied. Accounting identities and conservation laws don’t give you any information about how the system adjusts when it is out of equilibrium. So as Pettis goes on to elaborate on Keynes’s analysis of the reparations issue, one or more behavioral theories must be tacitly called upon to explain how the international system would adjust to a balance-of-payments disequilibrium.

If Germany had to make substantial reparation payments, Keynes explained, Germany’s capital account would tend towards a massive deficit. The accounting identity made clear that there were only three possible ways that together could resolve the capital account imbalance. First, Germany could draw down against its gold supply, liquidate its foreign assets, and sell domestic assets to foreigners, including art, real estate, and factories. The problem here was that Germany simply did not have anywhere near enough gold or transferable assets left after it had paid for the war, and it was hard to imagine any sustainable way of liquidating real estate. This option was always a non-starter.

Second, Germany could run massive current account surpluses to match the reparations payments. The obvious problem here, of course, was that this was unacceptable to the belligerents, especially France, because it meant that German manufacturing would displace their own, both at home and among their export clients. Finally, Germany could borrow every year an amount equal to its annual capital and current account deficits. For a few years during the heyday of the 1920s bubble, Germany was able to do just this, borrowing more than half of its reparation payments from the US markets, but much of this borrowing occurred because the great hyperinflation of the early 1920s had wiped out the country’s debt burden. But as German debt grew once again after the hyperinflation, so did the reluctance to continue to fund reparations payments. It should have been obvious anyway that American banks would never accept funding the full amount of the reparations bill.

What the Entente wanted, in other words, required an unrealistic resolution of the need to balance inflows and outflows. Keynes resorted to accounting identities not to generate a model of reparations, but rather to show that the existing model implicit in the negotiations was contradictory. The identity should have made it clear that because of assumptions about what Germany could and couldn’t do, the global economy in the 1920s was being built around a set of imbalances whose smooth resolution required a set of circumstances that were either logically inconsistent or unsustainable. For that reason they would necessarily be resolved in a very disruptive way, one that required out of arithmetical necessity a substantial number of sovereign defaults. Of course this is what happened.

Actually, if it had not been for the insane Bank of France and the misguided attempt by the Fed to burst the supposed stock-market bubble, the international system could have continued for a long time, perhaps indefinitely, with US banks lending enough to Germany to prevent default until rapid economic growth in the US and western Europe enabled the Germans to service their debt and persuaded the French to allow the Germans to do so via an export surplus. Instead, the insane Bank of France, with the unwitting cooperation of the clueless (following Benjamin Strong’s untimely demise) Federal Reserve precipitated a worldwide deflation that triggered that debt-deflationary downward spiral that we call the Great Depression.

The Great, but Misguided, Benjamin Strong Goes Astray in 1928

In making yet further revisions to our paper on Hawtrey and Cassel, Ron Batchelder and I keep finding interesting new material that sheds new light on the thinking behind the policies that led to the Great Depression. Recently I have been looking at the digital archive of Benjamin Strong’s papers held at the Federal Reserve Bank. Benjamin Strong was perhaps the greatest central banker who ever lived. Milton Friedman, Charles Kindleberger, Irving Fisher, and Ralph Hawtrey – and probably others as well — all believed that if Strong, Governor of the New York Federal Reserve Bank from 1914 to 1928 and effectively the sole policy maker for the entire system, had not died in 1928, the Great Depression would have been avoided entirely or, at least, would have been far less severe and long-lasting. My own view had been that Strong had generally understood the argument of Hawtrey and Cassel about the importance of economizing on gold, and, faced with the insane policy of the Bank of France, would have accommodated that policy by allowing an outflow of gold from the immense US holdings, rather than raise interest rates and induce an inflow of gold into the US in 1929, as happened under his successor, George Harrison.

Having spent some time browsing through the papers, I am sorry — because Strong’s truly remarkable qualities are evident in his papers — to say that the papers also show to my surprise and disappointment that Strong was very far from being a disciple of Hawtrey or Cassel or of any economist, and he seems to have been entirely unconcerned in 1928 about the policy of the Bank of France or the prospect of a deflationary run-up in the value of gold even though his friend Montague Norman, Governor of the Bank of England, was beginning to show some nervousness about “a scramble for gold,” while other observers were warning of a deflationary collapse. I must admit that, at least one reason for my surprise is that I had naively accepted the charges made by various Austrians – most notably Murray Rothbard – that Strong was a money manager who had bought into the dangerous theories of people like Irving Fisher, Ralph Hawtrey and J. M. Keynes that central bankers should manipulate their currencies to stabilize the price level. The papers I have seen show that, far from being a money manager and a price-level stabilizer, Strong expressed strong reservations about policies for stabilizing the price level, and was more in sympathy with the old-fashioned gold standard than with the gold-exchange standard — the paradigm promoted by Hawtrey and Cassel and endorsed at the Genoa Conference of 1922. Rothbard’s selective quotation from the memorandum summarizing Strong’s 1928 conversation with Sir Arthur Salter, which I will discuss below, gives a very inaccurate impression of Strong’s position on money management.

Here are a few of the documents that caught my eye.

On November 28 1927, Montague Norman wrote Strong about their planned meeting in January at Algeciras, Spain. Norman makes the following suggestion:

Perhaps the chief uncertainty or danger which confronts Central Bankers on this side of the Atlantic over the next half dozen years is the purchasing power of gold and the general price level. If not an immediate, it is a very serious question and has been too little considered up to the present. Cassel, as you will remember, has held up his warning finger on many occasions against the dangers of a continuing fall in the price level and the Conference at Genoa as you will remember, suggested that the danger could be met or prevented, by a more general use of the “Gold Exchange Standard”.

This is a very abstruse and complicated problem which personally I do not pretend to understand, the more so as it is based on somewhat uncertain statistics. But I rely for information from the outside about such a subject as this not, as you might suppose, on McKenna or Keynes, but on Sir Henry Strakosch. I am not sure if you know him: Austrian origin: many years in Johannesburg: 20 years in this country: a student of economics: a gold producer with general financial interests: perhaps the main stay in setting up the South African Reserve Bank: a member of the Financial Committee of the League and of the Indian Currency Commission: full of public spirit, genial and helpful . . . and so forth. I have probably told you that if I had been a Dictator he would have been a Director here years ago.

This is a problem to which Strackosch has given much study and it alarms him. He would say that none of us are paying sufficient attention to the possibility of a future fall in prices or are taking precautions to prepare any remedy such as was suggested at Genoa, namely smaller gold reserves through the Gold Exchange Standard, and that you, in the long run, will feel any trouble just as much as the rest of the Central Bankers will feel it.

My suggestion therefore is that it might be helpful if I could persuade Strakoosch too to come to Algeciras for a week: his visit could be quite casual and you would not be committed to any intrigue with him.

I gather from the tone of this letter and from other indications that the demands by the French to convert their foreign exchange to gold were already being made on the Bank of England and were causing some degree of consternation in London, which is why Norman was hoping that Strakosch might persuade Strong that something ought to be done to get the French to moderate their demands on the Bank of England to convert claims on sterling into gold. In the event, Strong met with Strakosch in December (probably in New York, not in Algeciras, without the presence of Norman). Not long thereafter Strong’s health deteriorated, and he took an extended leave from his duties at the bank. On March 27, 1928 Strong sent a letter to Norman outlining the main points of his conversation with Strakosch:

What [Strakosch] told me leads me to believe that he holds the following views:

  • That there is an impending shortage of monetary gold.
  • That there is certain to be a decline in the production by the South African mines.
  • That in consequence there will be a competition for gold between banks of issue which will lead to high discount rates, contracting credit and falling world commodity prices.
  • That Europe is so burdened with debt as to make such a development calamitous, possibly bankrupting some nations.
  • That the remedy is an extensive and formal development of the gold exchange standard.

From the above you will doubtless agree with me that Strakosch is a 100% “quantity” theory man, that he holds Cassel’s views in regard to the world’s gold position, and that he is alarmed at the outlook, just as most of the strict quantity theory men are, and rather expects that the banks of issue can do something about it.

Just as an aside, I will note that Strong is here displaying a rather common confusion, mixing up the quantity theory with a theory about the value of money under a gold standard. It’s a confusion that not only laymen, but also economists such as (to pick out a name almost at random) Milton Friedman, are very prone to fall into.

What he tells me is proposed consists of:

  • A study by the Financial Section of the League [of Nations] of the progress of economic recovery in Europe, which, he asserts, has closely followed progress in the resumption of gold payment or its equivalent.
  • A study of the gold problem, apparently in the perspective of the views of Cassel and others.
  • The submission of the results, with possibly some suggestions of a constructive nature, to a meeting of the heads of the banks of issue. He did not disclose whether the meeting would be a belated “Genoa resolution” meeting or something different.

What I told him appeared to shock him, and it was in brief:

  • That I did not share the fears of Cassel and others as to a gold shortage.
  • That I did not think that the quantity theory of prices, such for instance as Fisher has elaborate, “reduction ad absurdum,” was always dependable if unadulterated!
  • That I thought the gold exchange standard as now developing was hazardous in the extreme if allowed to proceed very much further, because of the duplication of bank liabilities upon the same gold.
  • That I much preferred to see the central banks build up their actual gold metal reserves in their own hands to something like orthodox proportions, and adopt their own monetary and credit policy and execute it themselves.
  • That I thought a meeting of the banks of issue in the immediate future to discuss the particular matter would be inappropriate and premature, until the vicissitudes of the Dawes Plan had developed further.
  • That any formal meeting of the banks of issue, if and when called, should originate among themselves rather than through the League, that the Genoa resolution was certainly no longer operative, and that such formal meeting should confine itself very specifically at the outset first to developing a sound basis of information, and second, to devising improvement in technique in gold practice

I am not at all sure that any formal meeting should be held before another year has elapsed. If it is held within a year or after a year, I am quite certain that it I attended it I could not do so helpfully if it tacitly implied acceptance of the principles set out in the Genoa resolution.

Stratosch is a fine fellow: I like him immensely, but I would feel reluctant to join in discussions where there was likelihood that the views so strongly advocated by Fisher, Cassel, Keynes, Commons, and others would seem likely to prevail. I would be willing at the proper time, if objection were not raised at home, to attend a conference of the banks of issue, if we could agree at the outset upon a simple platform, i.e., that gold is an effective measure of value and medium of exchange. If these two principles are extended, as seems to be in Stratosch’s mind, to mean that a manipulation of gold and credit can be employed as a regulator of prices at all times and under all circumstances, then I fear fundamental differences are inescapable.

And here is a third document in a similar vein that is also worth looking at. It is a memorandum written by O. E. Moore (a member of Strong’s staff at the New York Fed) providing a detailed account of the May 25, 1928 conversation between Strong and Sir Arthur Salter, then head of the economic and financial section of the League of Nations, who came to New York to ask for Strong’s cooperation in calling a new conference (already hinted at by Strakosch in his December conversation with Strong) with a view toward limiting the international demand for gold. Salter handed Strong a copy of a report by a committee of the League of Nations warning of the dangers of a steep increase in the value of gold because of increasing demand and a declining production.

Strong responded with a historical rendition of international monetary developments since the end of World War I, pointing out that even before the war was over he had been convinced of the need for cooperation among the world’s central banks, but then adding that he had been opposed to the recommendation of the 1922 Genoa Conference (largely drafted by Hawtrey and Cassel).

Governor Strong had been opposed from the start to the conclusions reached at the Genoa Conference. So far as he was aware, no one had ever been able to show any proof that there was a world shortage of gold or that there was likely to be any such shortage in the near future. . . . He was also opposed to the permanent operation of the gold exchange standard as outlined by the Genoa Conference, because it would mean by virtue of the extensive credits which the exchange standard countries would be holding in the gold centers, that they would be taking away from each of those two centers the control of their own money markets. This was an impossible thing for the Federal Reserve System to accept, so far as the American market was concerned, and in fact it was out of the question for any important country, it seemed to him, to give up entirely the direction of its own market. . . .

As a further aside, I will just observe that Strong’s objection to the gold exchange standard, namely that it permits an indefinite expansion of the money supply, a given base of gold reserves being able to support an unlimited expansion of the quantity of money, is simply wrong as a matter of theory. A country running a balance-of-payments deficit under a gold-exchange standard would be no less subject to the constraint of an external drain, even if it is holding reserves only in the form of instruments convertible into gold rather than actual gold, than it would be if it were operating under a gold standard holding reserves in gold.

Although Strong was emphatic that he could not agree to participate in any conference in which the policies and actions of the US could be determined by the views of other countries, he was open to a purely fact-finding commission to ascertain what the total world gold reserves were and how those were distributed among the different official reserve holding institutions. He also added this interesting caveat:

Governor Strong added that, in his estimation, it was very important that the men who undertook to find the answers to these questions should not be mere theorists who would take issue on controversial points, and that it would be most unfortunate if the report of such a commission should result in giving color to the views of men like Keynes, Cassel, and Fisher regarding an impending world shortage of gold and the necessity of stabilizing the price level. . . .

Governor Strong mentioned that one thing which had made him more wary than ever of the policies advocated by these men was that when Professor Fisher wrote his book on “Stabilizing the Dollar”, he had first submitted the manuscript to him (Governor Strong) and that the proposal made in that original manuscript was to adjust the gold content of the dollar as often as once a week, which in his opinion showed just how theoretical this group of economists were.

Here Strong was displaying the condescending attitude toward academic theorizing characteristic of men of affairs, especially characteristic of brilliant and self-taught men of affairs. Whether such condescension is justified is a question for which there is no general answer. However, it is clear to me that Strong did not have an accurate picture of what was happening in 1928 and what dangers were lying ahead of him and the world in the last few months of his life. So the confidence of Friedman, Kindelberger, Fisher, and Hawtrey in Strong’s surpassing judgment does not seem to me to rest on any evidence that Strong actually understood the situation in 1928 and certainly not that he knew what to do about it. On the contrary he was committed to a policy that was leading to disaster, or at least, was not going to avoid disaster. The most that can be said is that he was at least informed about the dangers, and if he had lived long enough to observe that the dangers about which he had been warned were coming to pass, he would have had the wit and the good sense and the courage to change his mind and take the actions that might have avoided catastrophe. But that possibility is just a possibility, and we can hardly be sure that, in the counterfactual universe in which Strong does not die in 1928, the Great Depression never happened.

Trying to Make Sense of the Insane Policy of the Bank of France and Other Catastrophes

In the almost four years since I started blogging I have occasionally referred to the insane Bank of France or to the insane policy of the Bank of France, a mental disorder that helped cause the deflation that produced the Great Depression. The insane policy began in 1928 when the Bank of France began converting its rapidly growing stockpile of foreign-exchange reserves (i.e., dollar- or sterling-denominated financial instruments) into gold. The conversion of foreign exchange was precipitated by the enactment of a law restoring the legal convertibility of the franc into gold and requiring the Bank of France to hold gold reserves equal to at least 35% of its outstanding banknotes. The law induced a massive inflow of gold into the Bank of France, and, after the Federal Reserve recklessly tightened its policy in an attempt to stamp out stock speculation on Wall Street, thereby inducing an inflow of gold into the US, the one-two punch knocked the world economy into just the deflationary tailspin that Hawtrey and Cassel, had warned would result if the postwar restoration of the gold standard were not managed so as to minimize the increase in the monetary demand for gold.

In making a new round of revisions to our paper on Hawtrey and Cassel, my co-author Ron Batchelder has just added an interesting footnote pointing out that there may have been a sensible rationale for the French gold policy: to accumulate a sufficient hoard of gold for use in case of another war with Germany. In World War I, belligerents withdrew gold coins from circulation, melted them down, and, over the next few years, exported the gold to neutral countries to pay for food and war supplies. That’s how the US, remaining neutral till 1917, wound up with a staggering 40% of the world’s stock of monetary gold reserves after the war. Obsessed with the military threat a re-armed Germany would pose, France insisted that the Versailles Treaty impose crippling reparations payments. The 1926 stabilization of the franc and enactment of the law restoring the gold standard and imposing a 35% reserve requirement on banknotes issued by the Bank of France occurred during the premiership of the staunchly anti-German Raymond Poincaré, a native of Lorraine (lost to Prussia in the war of 1870-71) and President of France during World War I.

A long time ago I wrote a paper “An Evolutionary Theory of the State Monopoly over Money” (which was reworked as chapter two of my book Free Banking and Monetary Reform and was later published in Money and the Nation State) in which, relying on an argument made by Earl Thompson, I suggested that historically the main reason for the nearly ubiquitous state involvement in supplying money was military not monetary: monopoly control over the supply of money enables the sovereign to quickly gain control over resources in war time, thereby giving states in which the sovereign controls the supply of money a military advantage over states in which the sovereign has no such control. Subsequently, Thompson further developed the idea to explain the rise of the gold standard after the Bank of England was founded in 1694, early in the reign of William and Mary, to finance rebuilding of the English navy, largely destroyed by the French in 1690. As explained by Macaulay in his History of England, the Bank of England, by substantially reducing the borrowing costs of the British government, was critical to the survival of the new monarchs in their battle with the Stuarts and Louis XIV. See Thompson’s article “The Gold Standard: Causes and Consequences” in Business Cycles and Depressions: An Encyclopedia (edited by me).

Thompson’s article is not focused on the holding of gold reserves, but on the confidence that the gold standard gave to those lending to the state, especially during a wartime suspension of convertibility, owing to an implicit commitment to restore the gold standard at the prewar parity. The importance of that implicit commitment is one reason why Churchill’s 1925 decision to restore the gold standard at the prewar parity was not necessarily as foolish as Keynes (The Economic Consequences of Mr. Churchill), along with almost all subsequent commentators, judged it to have been. But the postwar depreciation of the franc was so extreme that restoring the convertibility of the franc at the prewar parity became a practical impossibility, and the new parity at which convertibility was restored was just a fifth of its prewar level. Having thus reneged on its implicit commitment to restore the gold standard at the prewar parity, impairing its ability to borrow, France may have felt it had no alternative but to accumulate a ready gold reserve from which to draw when another war against Germany came. This is just theoretical speculation, but it might provide some clues for historical research into the thinking of French politicians and bankers in the late 1920s as they formulated their strategy for rejoining the gold standard.

However, even if the motivation for France’s gold accumulation was not simply a miserly desire to hold ever larger piles of shiny gold ingots in the vaults of the Banque de France, but was a precautionary measure against the possibility of a future war with Germany – and we know only too well that the fear was not imaginary – it is important to understand that, in the end, it was almost certainly the French policy of gold accumulation that paved the way for Hitler’s rise to power and all that entailed. Without the Great Depression and the collapse of the German economy, Hitler might well have remained an outcast on the margins of German politics.

The existence of a legitimate motivation for the insane policy of the Bank of France cannot excuse the failure to foresee the all too predictable consequences of that policy – consequences laid out plainly by Hawtrey and Cassel already in 1919-20, and reiterated consistently over the ensuing decade. Nor does the approval of that policy by reputable, even eminent, economists, who simply failed to understand how the gold standard worked, absolve those who made the wrong decisions of responsibility for their mistaken decisions. They were warned about the consequences of their actions, and chose to disregard the warnings.

All of this is sadly reminiscent of the 2003 invasion of Iraq. I don’t agree with those who ascribe evil motives to the Bush administration for invading Iraq, though there seems little doubt that the WMD issue was largely pretextual. But that doesn’t mean that Bush et al. didn’t actually believe that Saddam had WMD. More importantly, I think that Bush et al. sincerely thought that invading Iraq and deposing Saddam Hussein would, after the supposed defeat of Al Qaeda and the Taliban in Afghanistan, establish a benign American dominance in the region, as World War II had done in Japan and Western Europe.

The problem is not, as critics like to say, that Bush et al. lied us into war; the problem is that they stupidly fooled themselves into thinking that they could just invade Iraq, unseat Saddam Hussein, and that their job would be over. They fooled themselves even though they had been warned in advance that Iraq was riven by internal ethnic, sectarian, religious and political divisions. Brutally suppressed by Hussein and his Ba’athist regime, those differences were bound to reemerge once the regime was dismantled. When General Eric Shinseki’s testified before Congress that hundreds of thousands of American troops would be needed to maintain peace and order after Hussein was ousted, Paul Wolfowitz and Donald Rumsfeld could only respond with triumphalist ridicule at the idea that more troops would be required to maintain law and order in Iraq after Hussein was deposed than were needed to depose him. The sophomoric shallowness of the response to Shinseki by those that planned the invasion still shocks and appalls.

It’s true that, after the Republican loss in the 2006 Congressional elections, Bush, freeing himself from the influence of Dick Cheney and replacing Donald Rumsfeld with Robert Gates as Secretary of Defense, and Gen. George Casey with Gen. David Petraeus as commander of US forces in Iraq, finally adopted the counter-insurgency strategy (aka the “surge”) so long resisted by Cheney and Rumsfeld, thereby succeeding in putting down the Sunni/Al-Qaeda/Baathist insurgency and in bringing the anti-American Shi’ite militias to heel. I wrote about the success of the surge in December 2007 when that provisional military success was still controversial. But, as General Petraeus conceded, the ultimate success of the counter-insurgency strategy depended on implementing a political strategy to reconcile the different elements of Iraqi society to their government. We now know that even in 2008 Premier Nouri al-Maliki, who had been installed as premier with the backing of the Bush administration, was already reversing the limited steps taken during the surge to achieve accommodation between Iraqi Sunnis and Shi’ites, while consolidating his Shi’ite base by reconciling politically with the pro-Iranian militants he had put down militarily.

The failure of the Iraqi government to consolidate and maintain the gains made in 2007-08 has been blamed on Obama’s decision to withdraw all American forces from Iraq after the status of forces agreement signed by President Bush and Premier al-Maliki in December 2008 expired at the end of 2011. But preserving the gains made in 2007-08 depended on a political strategy to reconcile the opposing ethnic and sectarian factions of Iraqi society. The Bush administration could not implement such a strategy with 130,000 troops still in Iraq at the end of 2008, and the sovereign Iraqi government in place, left to its own devices, had no interest in pursuing such a strategy. Perhaps keeping a larger US presence in Iraq for a longer time would have kept Iraq from falling apart as fast as it has, but the necessary conditions for a successful political outcome were never in place.

So even if the motivation for the catastrophic accumulation of gold by France in the 1928-29 was merely to prepare itself to fight, if need be, another war against Germany, the fact remains that the main accomplishment of the gold-accumulation policy was to bring to power a German regime far more dangerous and threatening than the one that would have otherwise confronted France. And even if the motivation for the catastrophic invasion of Iraq in 2003 was to defeat and discredit Islamic terrorism, the fact remains that the invasion, just as Osama bin Laden had hoped, was to create the conditions in which Islamic terrorism could grow into a worldwide movement, attracting would-be jihadists to a growing number of local conflicts across the world. Although bin Laden was eventually killed in his Pakistani hideout, the invasion of Iraq led to rise of an even more sophisticated, more dangerous, and more threatening opponent than the one the invasion was intended to eradicate. Just as a misunderstanding of the gold standard led to catastrophe in 1928-29, the misconception that the threat of terrorism can be eliminated by military means has been leading us toward catastrophe since 2003. When will we learn?

PS Despite some overlap between what I say above and what David Henderson said in this post, I am not a libertarian or a non-interventionist.

Repeat after Me: Inflation’s the Cure not the Disease

Last week Martin Feldstein triggered a fascinating four-way exchange with a post explaining yet again why we still need to be worried about inflation. Tony Yates responded first with an explanation of why money printing doesn’t work at the zero lower bound (aka liquidity trap), leading Paul Krugman to comment wearily about the obtuseness of all those right-wingers who just can’t stop obsessing about the non-existent inflation threat when, all along, it was crystal clear that in a liquidity trap, printing money is useless.

I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen. Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right.

But no — it’s a complete puzzle. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves (Japan never paid such interest). Anyway, inflation is just around the corner, the same way it has been all these years.

Which surprisingly (not least to Krugman) led Brad DeLong to rise to Feldstein’s defense (well, sort of), pointing out that there is a respectable argument to be made for why even if money printing is not immediately effective at the zero lower bound, it could still be effective down the road, so that the mere fact that inflation has been consistently below 2% since the crash (except for a short blip when oil prices spiked in 2011-12) doesn’t mean that inflation might not pick up quickly once inflation expectations pick up a bit, triggering an accelerating and self-sustaining inflation as all those hitherto idle balances start gushing into circulation.

That argument drew a slightly dyspeptic response from Krugman who again pointed out, as had Tony Yates, that at the zero lower bound, the demand for cash is virtually unlimited so that there is no tendency for monetary expansion to raise prices, as if DeLong did not already know that. For some reason, Krugman seems unwilling to accept the implication of the argument in his own 1998 paper that he cites frequently: that for an increase in the money stock to raise the price level – note that there is an implicit assumption that the real demand for money does not change – the increase must be expected to be permanent. (I also note that the argument had been made almost 20 years earlier by Jack Hirshleifer, in his Fisherian text on capital theory, Capital Interest and Investment.) Thus, on Krugman’s own analysis, the effect of an increase in the money stock is expectations-dependent. A change in monetary policy will be inflationary if it is expected to be inflationary, and it will not be inflationary if it is not expected to be inflationary. And Krugman even quotes himself on the point, referring to

my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

So the question whether the monetary expansion since 2008 will ever turn out to be inflationary depends not on an abstract argument about the shape of the LM curve, but about the evolution of inflation expectations over time. I’m not sure that I’m persuaded by DeLong’s backward induction argument – an argument that I like enough to have used myself on occasion while conceding that the logic may not hold in the real word – but there is no logical inconsistency between the backward-induction argument and Krugman’s credibility argument; they simply reflect different conjectures about the evolution of inflation expectations in a world in which there is uncertainty about what the future monetary policy of the central bank is going to be (in other words, a world like the one we inhabit).

Which brings me to the real point of this post: the problem with monetary policy since 2008 has been that the Fed has credibly adopted a 2% inflation target, a target that, it is generally understood, the Fed prefers to undershoot rather than overshoot. Thus, in operational terms, the actual goal is really less than 2%. As long as the inflation target credibly remains less than 2%, the argument about inflation risk is about the risk that the Fed will credibly revise its target upwards.

With the both Wickselian natural real and natural nominal short-term rates of interest probably below zero, it would have made sense to raise the inflation target to get the natural nominal short-term rate above zero. There were other reasons to raise the inflation target as well, e.g., providing debt relief to debtors, thereby benefitting not only debtors but also those creditors whose debtors simply defaulted.

Krugman takes it for granted that monetary policy is impotent at the zero lower bound, but that impotence is not inherent; it is self-imposed by the credibility of the Fed’s own inflation target. To be sure, changing the inflation target is not a decision that we would want the Fed to take lightly, because it opens up some very tricky time-inconsistency problems. However, in a crisis, you may have to take a chance and hope that credibility can be restored by future responsible behavior once things get back to normal.

In this vein, I am reminded of the 1930 exchange between Hawtrey and Hugh Pattison Macmillan, chairman of the Committee on Finance and Industry, when Hawtrey, testifying before the Committee, suggested that the Bank of England reduce Bank Rate even at the risk of endangering the convertibility of sterling into gold (England eventually left the gold standard a little over a year later)

MACMILLAN. . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY. I do not know what orthodox Central Banking is.

MACMILLAN. . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Of course the best evidence for the effectiveness of monetary policy at the zero lower bound was provided three years later, in April 1933, when FDR suspended the gold standard in the US, causing the dollar to depreciate against gold, triggering an immediate rise in US prices (wholesale prices rising 14% from April through July) and the fastest real recovery in US history (industrial output rising by over 50% over the same period). A recent paper by Andrew Jalil and Gisela Rua documents this amazing recovery from the depths of the Great Depression and the crucial role that changing inflation expectations played in stimulating the recovery. They also make a further important point: that by announcing a price level target, FDR both accelerated the recovery and prevented expectations of inflation from increasing without limit. The 1933 episode suggests that a sharp, but limited, increase in the price-level target would generate a faster and more powerful output response than an incremental increase in the inflation target. Unfortunately, after the 2008 downturn we got neither.

Maybe it’s too much to expect that an unelected central bank would take upon itself to adopt as a policy goal a substantial increase in the price level. Had the Fed announced such a goal after the 2008 crisis, it would have invited a potentially fatal attack, and not just from the usual right-wing suspects, on its institutional independence. Price stability, is after all, part of dual mandate that Fed is legally bound to pursue. And it was FDR, not the Fed, that took the US off the gold standard.

But even so, we at least ought to be clear that if monetary policy is impotent at the zero lower bound, the impotence is not caused by any inherent weakness, but by the institutional and political constraints under which it operates in a constitutional system. And maybe there is no better argument for nominal GDP level targeting than that it offers a practical and civilly reverent way of allowing monetary policy to be effective at the zero lower bound.

Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

Imagination and Identity

Before continuing my summary of the key points of Richard Lipsey’s important paper, “The Foundations of the Theory of National Income,” I want to clear up a point that the deliberately provocative title may have obscured. The accounting identities that I am singling out for criticism are the identities between income and expenditure (and output) and between savings and investment. It is true that, as Scott Sumner points out in a comment on my previous post, every theory has to define its terms in some way or another, so there is no point in asserting that a definition is wrong. Scott believes that I am a saying that it is wrong to define investment and savings as the same thing, but I am not saying that. I am saying that, in the context of the basic income-expenditure theory of national income, it makes the theory incoherent, so that there is a mismatch between the definition and the theory.

It is also true that sometimes identities follow directly from basic definitions. Such identities are like conservation laws in physics. For example, purchases must equal sales, because purchasing and selling are reciprocal activities; to assert that purchases are, or could be, unequal to sales would be self-contradictory. Keynes, when ridiculed by Hawtrey for asserting that a) savings and investment are equal by definition, and b) that the equality of savings and investment is achieved by variations in income, responded by comparing the equality of savings and investment to the equality of purchases and sales. Purchases are necessarily equal to sales, but prices adjust to achieve equality between desired purchases and desired sales.

The problem with Keynes’s response to Hawtrey is that to assert that purchases are unequal to sales is to misconstrue in a really fundamental way the meaning of the terms “purchase” and “sales.” But when it comes to national-income accounting, the identity of “investment” and “savings” does not follow immediately from the meaning of those terms. It must be derived from the meaning of two other terms: income and expenditure. So the question becomes whether the act of spending (i.e., expenditure) necessarily entails an immediate and corresponding accrual of income, in the same way that the act of purchasing necessarily entails the act of selling. To assert that expenditure and income are identical is then to assert that any expenditure necessarily and simultaneously entails a corresponding accrual of income.

Before pursuing this line of thought further, let’s just pause for a moment to recall the context for this discussion. We are talking about a fairly primitive model of an economy in which there are households that are units of consumption and providers of factor services. Households purchase consumption goods and provide factor services to business firms. Business firms are units of production that combine factor services provided by households with raw materials purchased from other business firms, and new or existing capital goods produced now or previously by other business firms, to produce raw materials, consumption goods, and capital goods. Raw materials and capital goods are sold to other business firms and consumption goods are sold to households. Business firms are owned by households, so profits earned by business firms are remitted, along with payments for factor services, to households. But although the flow of payments from households to business firms corresponds to a flow of payments from business firms to households, the two flows, which can be measured separately, are, at not identical, or at least not obviously so. When I bought a tall Starbucks coffee just now at a Barnes & Noble cafe, my purchase of $1.98 was exactly and necessarily matched by a sale by Barnes & Noble to the guy who writes for the Uneasy Money blog. But expenditure of $1.98 by the Uneasy Money blogger to Barnes & Noble did not trigger an immediate and corresponding flow of $1.98 to households from Barnes & Noble.

Now I grant that it is possible for income so to be defined that every act of expenditure involves a corresponding accrual of income to providers of factor services to the firm, and of profit to owners of the firm. But expenditure entails simultaneous accrual of income only by virtue of an imputation of income to providers of factor services and of profit to owners of firms. Mere imputation does not and cannot constitute an actual flow of payments by firms to households. The identity between purchases and sales is entailed by the definition of “purchase” and “sales,’ but the supposed identity between expenditure and income is entailed by nothing but an act of imagination. I am not criticizing imagination, which may often provide us with an excellent grasp of reality. But imagination, no matter how well attuned to reality, does not and cannot establish identity.

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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