Archive for the 'Milton Friedman' Category

The Uselessness of the Money Multiplier as Brilliantly Elucidated by Nick Rowe

Not long after I started blogging over two and a half years ago, Nick Rowe and I started a friendly argument about the money multiplier. He likes it; I don’t. In his latest post (“Alpha banks, beta banks, fixed exchange rates, market shares, and the money multiplier”), Nick attempts (well, sort of) to defend the money multiplier. Nick has indeed figured out an ingenious way of making sense out of the concept, but in doing so, he has finally and definitively demonstrated its total uselessness.

How did Nick accomplish this remarkable feat? By explaining that there is no significant difference between a commercial bank that denominates its deposits in terms of a central bank currency, thereby committing itself to make its deposits redeemable on demand into a corresponding amount of central bank currency, and a central bank that commits to maintain a fixed exchange rate between its currency and the currency of another central bank — the commitment to a fixed exchange rate being unilateral and one-sided, so that only one of the central banks (the beta bank) is constrained by its unilateral commitment to a fixed exchange rate, while the other central bank (the alpha bank) is free from commitment to an exchange-rate peg.

Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.

For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed’s promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It’s asymmetric redeemability that gives the Bank of Canada its power over the Fed.

Absolutely right! Under these assumptions, the amount of money created by the Fed would be governed, among other things, by its commitment to maintain the exchange-rate peg between the US dollar and the Canadian dollar. However, the numerical relationship between the quantity of US dollars and quantity of Canadian dollars would depend on the demand of US (and possibly Canadian) citizens and residents to hold US dollars. The more US dollars people want to hold, the more dollars the Fed can create.

Nick then goes on to make the following astonishing (for him) assertion.

Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.

In other words, given the price level, the quantity of money adjusts to whatever is the demand for it, the price level being determined unilaterally by the unconstrained (aka “alpha”) central bank.

To see how astonishing (for Nick) this assertion is, consider the following passage from Perry Mehrling’s superb biography of Fischer Black. Mehrling devotes an entire chapter (“The Money Wars”) to the relationship between Black and Milton Friedman. Black came to Chicago as a professor in the Business School, and tried to get Friedman interested in his idea the quantity of money supplied by the banking system adjusted passively to the amount demanded. Friedman dismissed the idea as preposterous, a repetition of the discredited “real bills doctrine,” considered by Friedman to be fallacy long since refuted (definitively) by his teacher Lloyd Mints in his book A History of Banking Theory. Friedman dismissed Black and told him to read Mints, and when Black, newly arrived at Chicago in 1971, presented a paper at the Money Workshop at Chicago, Friedman introduced Black as follows:

Fischer Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.

Mehrling describes the nub of the disagreement between Friedman and Black this way:

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond.The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money casues prices to rise, as Friedman insisted, but it could also mean that an increase in prices casues the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (p. 160)

Well, we now see that Nick Rowe has come down squarely on the side of, gasp, Fischer Black against Milton Friedman. “Wonder of wonders, miracle of miracles!”

But despite making that break with his Monetarist roots, Nick isn’t yet quite ready to let go, lapsing once again into money-multiplier talk.

The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define “money”. Let’s say it’s 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada’s share in the total Canadian+US money supply. 1/1%=100.

Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn’t. But it doesn’t matter.

Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn’t matter.

The only thing that does matter is the Bank of Canada’s market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

The point of the money multiplier is to provide a rationale for saying: “sure, we know that banks create a lot of money, and we don’t really understand what governs the amount of money banks create, but whatever amount of money banks create, that amount is ultimately under the control of the monetary authority, the amount being some multiple of the monetary base. So it’s still as if the central bank decides what M is, so that it really is OK to say that the central bank can control the price level even though M in the quantity equation is not really produced by the central bank. M is exogenously determined, because there is a money multiplier that relates M to B. If that is unclear, I’m sorry, but that’s what the Monetarists have been saying all these years.

Who cares, anyway? Well, all the people that fell for Friedman’s notion (traceable to the General Theory by the way) that monetary policy works by controlling the quantity of money produced by the banking system. Somehow Monetarists like Friedman who was pushing his dumb k% rule for monetary growth thought that it was important to be able to show that the quantity of money could be controlled by the monetary authority. Otherwise, the whole rationale for the k% rule would be manifestly based based on a faulty — actually vacuous — premise. The post-Keynesian exogenous endogenous-money movement was an equally misguided reaction to Friedman’s Monetarist nonsense, taking for granted that if they could show that the money multiplier and the idea that the central bank could control the quantity of money were unfounded, it would follow that inflation is not a monetary phenomenon and is beyond the power of a central bank to control. The two propositions are completely independent of one another, and all the sturm und drang of the last 40 years about endogenous money has been a complete waste of time, an argument about a non-issue. Whether the central bank can control the price level has nothing to do with whether there is or isn’t a multiplier. Get over it.

Nick recognizes this:

The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks’ monies, otherwise it will be forced to redeem its money for other banks’ monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks’ responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.

It’s all about the public’s demand for money, and their relative preferences for holding one money or another. The alpha central bank may or may not be able to achieve some targeted value for its money, but whether it can or can not has nothing to do with its ability to control the quantity of money created by the beta banks that are committed to an exchange rate peg against  the money of the alpha bank. In other words, the money multiplier is a completely useless concept, as useless as a multiplier between, say, the quantity of white Corvettes the total quantity of Corvettes. From now on, I’m going to call this Rowe’s Theorem. Nick, you’re the man!

Hawtrey’s Good and Bad Trade, Part VI: Monetary Equilibrium under the Gold Standard

In Chapter 9 of Good and Bad Trade, Hawtrey arrives at what he then regarded as the culmination of the earlier purely theoretical discussions of the determination of prices, incomes, and exchange rates under a fiat currency, by positing that the currencies of all countries were uniformly convertible into some fixed weight of gold.

We have shown that the rate of exchange tends to represent simply the ratio of the purchasing power of the two units of currency, and that when this ratio is disturbed, the rate of exchange, subject to certain fluctuations, follows it.

But having elucidated this point we can now pass to the much more important case of the international effects of a fluctuation experienced in a country using metal currency common to itself and its neighbours. Practiaclly all the great commercial nations of the world have now adopted gold as their standard of legal tender, and this completely alters the problem. (p. 102)

Ah, what a difference a century makes! At any rate after providing a detailed and fairly painstaking account of the process of international adjustment in response to a loss of gold in one country, explaining how the loss of gold would cause an increase in interest rates in the country that lost gold which would induce lending by other countries to the country experiencing monetary stringency, and tracing out further repercussions on the movement of exchange rates (within the limits set by gold import and export points, reflecting the cost of transporting gold) and domestic price levels, Hawtrey provides the following summary of his analysis

Gold flows from foreign countries ot the area of stringency in response to the high rate of interest, more quickly from the nearer and more slowly from the more distant countries. While this process is at work the rates of interests in foreign countries are raised, more in the nearer and less in the more distant countries. As soon as the bankers’ loans have been brought into the proper proportion to the stock of gold, the rate of interest reverts to the profit rate in the area of stringency, but the influx of gold continues from each foreign country until the average level of prices there has so far fallen that its divergence from the average level of prices in the area of stringency is no longer great enough to cover the cost of sending the gold.

So long as any country is actually exporting gold the rate of interest will there be maintained somewhat above the profit rate, so as to diminish the total amount of bankers’ loans pari passu with the stock of gold.

At the time when the export of gold ceases from any foreign country the rate of exchange in that country on the area of stringency is at the export specie point; and the exchange will remain at this point indefinitely unless some new influence arises to disturb the equilibrium. In fact, the whole economic system will, the absence of such influence, revert to the stable conditions from which it started. (p. 113)

In subsequent writings, Hawtrey modified his account of the adjustment process in an important respect. I have not identified where and when Hawtrey first revised his view of the adjustment process, but, almost twenty years later in his book The Art of Central Banking, there is an exceptionally clear explanation of the defective nature of the account of the international adjustment mechanism provided in Good and Bad Trade. Iin the course of an extended historical discussion of how the Bank of England had used its lending rate as an instrument of policy in the nineteenth and earl twentieth centuries (a discussion later expanded upon in Hawtrey’s A Century of Bank Rate), Hawtrey quoted the following passage from the Cunliffe Report of 1918 recommending that England quickly restore the gold standard at the prewar parity. The passage provides an explanation of how, under the gold standard, the Bank of England, faced with an outflow of its gold reserves, could restore an international equilibrium by raising Bank Rate. The explanation in the Cunliffe Report deploys essentially the same reasoning reflected above in the quotation from p. 113 of Good and Bad Trade.

The raising of the discount rate had the immediate effect of retaining money here which would otherwise have been remitted abroad, and of attracting remittances from abroad to take advantage of the higher rate, thus checking the outflow of gold and even reversing the stream.

If the adverse conditions of the exchanges was due not merely to seasonal fluctuations but to circumstances tending to create a permanently adverse trade balance, it is obvious that the procedure above described would not have been sufficient. It would have resulted in the creation of a volume of short-dated indebtedness to foreign countries, which would have been in the end disastrous to our credit and the position of London as the financial centre of the world. But the raising of the Bank’s discount rate and the steps taken to make it effective in the market necessarily led to a general rise of interest rates and a restriction of credit. New enterprises were therefore postponed, and the demand for constructional materials and other capital goods was lessened. The consequent slackening of employment also diminished the demand for consumable goods, while holders of stocks of commodities carried largely with borrowed money, being confronted with an increase in interest charges, if not with actual difficulty in renewing loans, and with the prospect of falling prices, tended to press their goods on a weak market. The result was a decline in general prices in the home market which, by checking imports and stimulating exports, corrected the adverse trade balance which was the primary cause of the difficulty. (Interim Report of the Cunliffe Committee, sections 4-5)

Hawtrey took strong issue with the version of the adjustment process outlined in the Cunliffe Report, though acknowledging that ithe Cunliffe Report did in some sense reflect the orthodox view of how variations in Bank Rate achieved an international adjustment.

This passage expresses very fairly the principle on which the Bank of England had been regulating credit from 1866 to 1914. They embody the art of central banking as it was understood in the half-century preceding the war. In view of the experience which has been obtained, the progress made in theory and the changes which have occurred since 1914, the principles of the art require reconsideration at the present day.

The Cunliffe Committee’s version of the effect of Bank rate upon the trade balance was based on exactly the same Ricardian theory of foreign trade as Horsely Palmer’s. It depended on adjustments of the price level. But the revolutionary changes in the means of communication during the past hundred years have unified markets to such a degree that for any of the commodities which enter regularly into international trade there is practically a single world market and a single world price. That does not mean absolutely identical prices for the same commodity at different places, but prices differing only by the cost of transport from exporting to the importing centres. Local divergences of prices form this standard are small and casual, and are speedily eliminated so long as markets work freely.

In Ricardo’s day, relatively considerable differences of price were possible between distant centres. The merchant could never have up-to-date information at one place of the price quotations at another. When he heard that the price of a commodity at a distant place had been relatively high weeks or months before, he was taking a risk in shipping a cargo thither, because the market might have changes for the worse before the cargo arrived. Under such conditions, it might well be that a substantial difference of price level was required to attract goods from one country to another.

Nevertheless it was fallacious ot explain the adjustment wholly in terms of the price level. There was, even at that time, an approximation to a world price. When the difference of price level attracted goods from one country to another, the effect was to diminish the difference of price level, and probably after an interval to eliminate it altogether (apart from cost of transport). When that occurred, the importing country was suffering an adverse balance, not on account of an excess price level, but on account of an excess demand at the world price level. Whether there be a difference of price level or not, it is this difference of demand that is the fundamental factor.

In Horsely Palmer‘s day the accepted theory was that the rate of discount affected the price level because it affected the amount of note issue and therefore the quantity of currency. That did not mean that the whole doctrine depended on the quantity theory of money. All that had currency so far tended to cause a rise or fall of the price level that any required rise or fall of prices could be secured by an appropriate expansion or contraction of the currency that is a very different thing from saying that the rise or fall of the price level would be exactly proportional to the expansion or contraction of the currency.

But it is not really necessary to introduce the quantity of currency into the analysis at all. What governs demand in any community is the consumers’ income (the total of all incomes expressed in terms of money) and consumers’ outlay (the total of all disbursements out of income, including investment).

The final sentence seems to be somewhat overstated, but in the context of a gold standard, in which the quantity of currency is endogenously determined, the quantity of currency is determined not determining. After noticing that Hawtrey anticipated Cassel in formulating the purchasing power parity doctrine, I looked again at the excellent paper by McCloskey and Zecher “The Success of Purchasing Power Parity” in the NBER volume A Retrospective on the Classical Gold Standard 1821-1931, edited by Bordo and Schwartz, a sequel to their earlier paper, “How the Gold Standard Worked” in The Monetary Approach to the Balance of Payments, edited by Johnson and Frenkel. The paper on purchasing power parity makes some very powerful criticisms of the Monetary History of the United States by Friedman and Schwartz, some of which Friedman responded to in his formal discussion of the paper. But clearly the main point on which McCloskey and Zecher took issue with Friedman and Schwartz was whether an internationally determined price level under the gold standard tightly constrained national price levels regardless of the quantity of local money. McCloskey and Zecher argued that it did, while Friedman and Schwartz maintained that variations in the quantity of national money, even under the gold standard, could have significant effects on prices and nominal income, at least in the short to medium term. As Friedman put it in his comment on McCloskey and Zecher:

[W]hile the quantity of money is ultimately an endogenous variable [under fixed exchange rates], there can be and is much leeway in the short run, before the external forces overwhelm the independent internal effects. And we have repeatedly been surprised in our studies by how much leeway there is and for how long – frequently a number of years.

I’ll let Friedman have the last word on this point, except to note that Hawtrey clearly would have disagreed with him post, at least subsequently to his writing Good and Bad Trade.

Why Hawtrey and Cassel Trump Friedman and Schwartz

This year is almost two-thirds over, and I still have yet to start writing about one of the two great anniversaries monetary economists are (or should be) celebrating this year. The one that they are already celebrating is the fiftieth anniversary of the publication of The Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz; the one that they should also be celebrating is the 100th anniversary of Good and Bad Trade by Ralph Hawtrey. I am supposed to present a paper to mark the latter anniversary at the Southern Economic Association meetings in November, and I really have to start working on that paper, which I am planning to do by writing a series of posts about the book over the next several weeks.

Good and Bad Trade was Hawtrey’s first publication about economics. He was 34 years old, and had already been working at the Treasury for nearly a decade. Though a Cambridge graduate (in mathematics), Hawtrey was an autodidact in economics, so it is really a mistake to view him as a Cambridge economist. In Good and Bad Trade, he developed a credit theory of money (money as a standard of value in terms of which to discharge debts) in the course of presenting his purely monetary theory of the business cycle, one of the first and most original instances of such a theory. The originality lay in his description of the transmission mechanism by which money — actually the interest rate at which money is lent by banks — influences economic activity, through the planned accumulation or reduction of inventory holdings by traders and middlemen in response to changes in the interest rate at which they can borrow funds. Accumulation of inventories leads to cumulative increases of output and income; reductions in inventories lead to cumulative decreases in output and income. The business cycle (under a gold standard) therefore was driven by changes in bank lending rates in response to changes in lending rate of the central bank. That rate, or Bank Rate, as Hawtrey called it, was governed by the demand of the central bank for gold reserves. A desire to increase gold reserves would call for an increase in Bank Rate, and a willingness to reduce reserves would lead to a reduction in Bank Rate. The basic model presented in Good and Bad Trade was, with minor adjustments and refinements, pretty much the same model that Hawtrey used for the next 60 years, 1971 being the year of his final publication.

But in juxtaposing Hawtrey with Friedman and Schwartz, I really don’t mean to highlight Hawtrey’s theory of the business cycle, important though it may be in its own right, but his explanation of the Great Depression. And the important thing to remember about Hawtrey’s explanation for the Great Depression (the same explanation provided at about the same time by Gustav Cassel who deserves equal credit for diagnosing and explaining the problem both prospectively and retrospectively as explained in my paper with Ron Batchelder and by Doug Irwin in this paper) is that he did not regard the Great Depression as a business-cycle episode, i.e., a recurring phenomenon of economic life under a functioning gold standard with a central bank trying to manage its holdings of gold reserves through manipulation of Bank Rate. The typical business-cycle downturn described by Hawtrey was caused by a central bank responding to a drain on its gold reserves (usually because expanding output and income increased the internal monetary demand for gold to be used as hand-to-hand currency) by raising Bank Rate. What happened in the Great Depression was not a typical business-cycle downturn; it was characteristic of a systemic breakdown in the gold standard. In his 1919 article on the gold standard, Hawtrey described the danger facing the world as it faced the task of reconstructing the international gold standard that had been effectively destroyed by World War I.

We have already observed that the displacement of vast quantities of gold from circulation in Europe has greatly depressed the world value of gold in relation to commodities. Suppose that in a few years’ time the gold standard is restored to practically universal use. If the former currency systems are revived, and with them the old demands for gold, both for circulation in coin and for reserves against note issues, the value of gold in terms of commodities will go up. In proportion as it goes up, the difficulty of regaining or maintaining the gold standard will be accentuated. In other words, if the countries which are striving to recover the gold standard compete with one another for the existing supply of gold, they will drive up the world value of gold, and will find themselves burdened with a much more severe task of deflation than they ever anticipated.

And at the present time the situation is complicated by the portentous burden of the national debts. Except for America and this country, none of the principal participants in the war can see clearly the way to solvency. Even we, with taxation at war level, can only just make ends meet. France, Italy, Germany and Belgium have hardly made a beginning with the solution of their financial problems. The higher the value of the monetary unit in which one of these vast debts is calculated, the greater will be the burden on the taxpayers responsible for it. The effect of inflation in swelling the nominal national income is clearly demonstrated by the British income-tax returns, and by the well-sustained consumption of dutiable commodities notwithstanding enormous increases in the rates of duty. Deflation decreases the money yield of the revenue, while leaving the money burden of the debt undiminished. Deflation also, it is true, diminishes the ex-penses of Government, and when the debt charges are small in proportion to the rest, it does not greatly increase the national burdens. But now that the debt charge itself is our main pre-occupation, we may find the continuance of some degree of inflation a necessary condition of solvency.

So 10 years before the downward spiral into the Great Depression began, Hawtrey (and Cassel) had already identified the nature and cause of the monetary dysfunction associated with a mishandled restoration of the international gold standard which led to the disaster. Nevertheless, in their account of the Great Depression, Friedman and Schwartz paid almost no attention to the perverse dynamics associated with the restoration of the gold standard, completely overlooking the role of the insane Bank of France, while denying that the Great Depression was caused by factors outside the US on the grounds that, in the 1929 and 1930, the US was accumulating gold.

We saw in Chapter 5 that there is good reason to regard the 1920-21 contraction as having been initiated primarily in the United States. The initial step – the sharp rise in discount rates in January 1920 – was indeed a consequence of the prior gold outflow, but that in turn reflected the United States inflation in 1919. The rise in discount rates produced a reversal of the gold movements in May. The second step – the rise in discount rates in June 1920 go the highest level in history – before or since [written in 1963] – was a deliberate act of policy involving a reaction stronger than was needed, since a gold inflow had already begun. It was succeeded by a heavy gold inflow, proof positive that the other countries were being forced to adapt to United States action in order to check their loss of gold, rather than the reverse.

The situation in 1929 was not dissimilar. Again, the initial climactic event – the stock market crash – occurred in the United States. The series of developments which started the stock of money on its accelerated downward course in late 1930 was again predominantly domestic in origin. It would be difficult indeed to attribute the sequence of bank failures to any major current influence from abroad. And again, the clinching evidence that the Unites States was in the van of the movement and not a follower is the flow of gold. If declines elsewhere were being transmitted to the United States, the transmission mechanism would be a balance of payments deficit in the United States as a result of a decline in prices and incomes elsewhere relative to prices and incomes in the United States. That decline would lead to a gold outflow from the United States which, in turn, would tend – if the United States followed gold-standard rules – to lower the stock of money and thereby income and prices in the United States. However, the U.S. gold stock rose during the first two years of the contraction and did not decline, demonstrating as in 1920 that other countries were being forced adapt to our monetary policies rather than the reverse. (p. 360)

Amazingly, Friedman and Schwartz made no mention of the accumulation of gold by the insane Bank of France, which accumulated almost twice as much gold in 1929 and 1930 as did the US. In December 1930, the total monetary gold reserves held by central banks and treasuries had increased to $10.94 billion from $10.06 billion in December 1928 (a net increase of $.88 billion), France’s gold holdings increased by $.85 billion while the holdings of the US increased by $.48 billion, Friedman and Schwartz acknowledge that the increase in the Fed’s discount rate to 6.5% in early 1929 may have played a role in triggering the downturn, but, lacking an international perspective on the deflationary implications of a rapidly tightening international gold market, they treated the increase as a minor misstep, leaving the impression that the downturn was largely unrelated to Fed policy decisions, let alone those of the IBOF. Friedman and Schwartz mention the Bank of France only once in the entire Monetary History. When discussing the possibility that France in 1931 would withdraw funds invested in the US money market, they write: “France was strongly committed to staying on gold, and the French financial community, the Bank of France included, expressed the greatest concern about the United States’ ability and intention to stay on the gold standard.” (p. 397)

So the critical point in Friedman’s narrative of the Great Depression turns out to be the Fed’s decision to allow the Bank of United States to fail in December 1930, more than a year after the stock-market crash, almost a year-and-a-half after the beginning of the downturn in the summer of 1929, almost two years after the Fed raised its discount rate to 6.5%, and over two years after the Bank of France began its insane policy of demanding redemption in gold of much of its sizeable holdings of foreign exchange. Why was a single bank failure so important? Because, for Friedman, it was all about the quantity of money. As a result Friedman and Schwartz minimize the severity of the early stages of the Depression, inasmuch as the quantity of money did not begin dropping significantly until 1931. It is because the quantity of money did not drop in 1928-29, and fell only slightly in 1930 that Friedman and Schwartz did not attribute the 1929 downturn to strictly monetary causes, but rather to “normal” cyclical factors (whatever those might be), perhaps somewhat exacerbated by an ill-timed increase in the Fed discount rate in early 1929. Let’s come back once again to the debate about monetary theory between Friedman and Fischer Black, which I have mentioned in previous posts, after Black arrived at Chicago in 1971.

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (Mehrling, Fischer Black and the Revolutionary Idea of Finance, p. 160)

So Black obviously understood the possibility that, at least under some conditions, it was possible for prices to change exogenously and for the quantity of money to adjust endogenously to the exogenous change in prices. But Friedman was so ideologically committed to the quantity-theoretic direction of causality from the quantity of money to prices that he would not even consider an alternative, and more plausible, assumption about the direction of causality when the value of money is determined by convertibility into a constant amount of gold.

This obliviousness to the possibility that prices, under convertibility, could change independently of the quantity of money is probably the reason that Friedman and Schwartz also completely overlooked the short, but sweet, recovery of 1933 following FDR’s suspension of the gold standard in March 1933, when, over the next four months, the dollar depreciated by about 20% in terms of gold, and the producer price index rose by almost 15% as industrial production rose by 70% and stock prices doubled, before the recovery was aborted by the enactment of the NIRA, imposing, among other absurdities, a 20% increase in nominal wages. All of this was understood and explained by Hawtrey in his voluminous writings on the Great Depression, but went unmentioned in the Monetary History.

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Of course, whether the private sector is stable is itself a question too complicated to be answered with a simple yes or no. It is one thing for a car to be stable if it is being steered on a paved highway; it is quite another for the car to be stable if driven into a ditch.

Leijonhufvud on Friedman

Before it was hijacked by Paul Krugman, Scott Sumner and I were having a friendly little argument about whether Milton Friedman repackaged the Keynesian theory of the demand for money as the quantity theory of money transmitted to him via a fictitious Chicago oral tradition, as I, relying on Don Patinkin and Harry Johnson, claim, or whether Friedman was a resolute anti-Keynesian, as Scott claims. We have been trading extended quotations from the literature to try to support our positions.

I now offer some additional quotations, all but one from Axel Leijonhufvud’s wonderful essay “The Wicksell Connection: Variations on a Theme,” published in Leijonfuvud’s volume Information and Coordination (Oxford University Press, 1981). By some coincidence, the quotations tend to support my position, but, more importantly, they shed important light on problems of interpreting what Keynes was really talking about, and suggest a way of thinking about Keynes that takes us beyond the sterile ideological debates into which we tend lapse at the mere mention of the name John Maynard Keynes, or for that matter, Milton Friedman. Of course, the main lesson that readers should take away is: read the whole essay.

Herewith are a few extracts in which Leijonhufvud comments on Friedman and his doctrinal relationship with Keynes.

Milton Friedman has emphatically denied that the elasticity of LM is at issue [in the Monetarist v. Keynesian controversies]. At the same time his use of what is basically an IS-LM structure in presenting his own theory, and his oft-repeated insistence that no theoretical issues but only questions of empirical magnitudes within this shared theoretical frame separate him from his opponents, have apparently fortified others in their belief that (whatever he says) this elasticity must be crucial. Furthermore, Friedman has himself played around with elasticities, for example in advancing the notion of a horizontal IS curve. (p. 144, fn. 22)

The troubles with keeping track of the Wicksellian theme in its Keynesian guises and disguises go far back in time. The original “Savings-equals-Investment” debate did not reach a clear-cut collective verdict. As Lipsey ["The Foundations of the Theory of National Income: An Analysis of Some Fundamental Errors"] has recently shown, confusion persists to the present day. The IS-LM framework did not lend itself too well to a sharp characterization of the question whether the excess demand for bonds or the excess demand for money governs the interest rate. It was concluded that the distinction between the Loanable Funds and Liquidity Preference hypotheses was probably either pointless or misleading and that, in either case, the issue could safely be left unresolved. Correspondingly, Hansen found, Keynes’ insistence that saving and investment determine income while money stock and liquidity preference determine the rate of interest (rather than the other way around) makes no sense once you realize that, in IS-LM, everything simultaneously determines everything.

In Hansen’s reading Keynes’ interest theory was “indeterminate” – money supply and demand could not determine the interest rate, as Keynes would have it, but only give you the LM curve, etc. This way of looking at it missed the issue of which excess demand governs the interest rate.

One is reminded of Hansen’s indeterminacy charge by Friedman’s more recent argument that Keynes’ theory suffered from a “missing equation” – and should be completed by adding an exogenously determined price level. Keynes’ theory . . . was of the dynamic-historical variety. In describing the state of the system at some point in the sequential process, such theories make use of information about the system’s initial (historical) state. Static models do not use historical information, of course, but have to have equations for all endogenous variables. Reading a dynamic-historical theory on the presumption that it is static, therefore, is apt to lead to the mistaken impression that it lacks equations and is indeterminate. (pp. 180-81 and fn. 84)

Friedman, like so many others, filters Keynes and Keynesian theory through the IS-LM model and, consequently, ends up where everyone else ends up: bogged down in the Neoclassical Synthesis, which is to say, with the conclusion that exogenous fixity of money wages was Keynes’ explanation of unemployment. His discussion is notable for a sophisticated treatment of Keynes’ demand for money function and for its sweeping endorsement of the Pigou-effect. . . . (p. 189)

I break off from the final quotation, which is just a small part of an extended discussion of Friedman, because the argument is too dense to summarize adequately, and the entire lengthy passage (pp. 187-94) has to be read to grasp its full import. But I close with one final quotation from Leijonhufvud’s essay “Schools, ‘Revolutions,’ and Research Programmes in Economic Theory,” also contained in Information and Coordination (pp. 291-345).

The most widely known “monetarist,” Professor Milton Friedman, has for a long time consistently voiced the position that “monetarists” and “(neo)-Keynesians” share essentially the same theory and that their differences all derive from contrasting hypotheses concerning certain crucial empirical magnitudes. (He has also, however, persistently denied that the issues can be defined as a “simple” matter of the magnitude of the interest-elasticity of the excess demand for money – an otherwise oft-repeated contention in the debate.) In his recent attempts to provide an explicit representation for his theory, accordingly, Friedman chose ot use the “Keynesian” so-called “IS-LM” framework as his language of formal discourse.

In my opinion, there are “hard core” differences between the two theories and ones, moreover, that the “IS-LM” framework will not help us define. Not only are these differences at the “cosmological” level not accurately represented by the models used, but they will also lead to divergent interpretations of empirical results. (pp. 298-99, fn. 10)

The last paragraph, I suspect, probably sums up not just the inconclusiveness of the debate between Monetarists and Keynesians, but also the inconclusiveness of the debate about whether Friedman was or wasn’t a Keynesian. So be it.

Sumner Sticks with Friedman

Scott Sumner won’t let go. Scott had another post today trying to show that the Cambridge Theory of the demand for money was already in place before Keynes arrived on the scene. He quotes from Hicks’s classic article “Mr. Keynes and the Classics” to dispute the quotation from another classic article by Hicks, “A Suggestions for Simplifying the Theory of Money,” which I presented in a post last week, demonstrating that Hicks credited Keynes with an important contribution to the demand for money that went beyond what Pigou, and even Lavington, had provided in their discussions of the demand for money.

In this battle of dueling quotations, I will now call upon Mark Blaug, perhaps the greatest historian of economics since Schumpeter, who in his book Economic Theory in Retrospect devotes an entire chapter (15) to the neoclassical theory of money, interest and prices. I quote from pp. 636-37 (4th edition).

Marshall and his followers went some way to move the theory of the demand for money in the direction of ordinary demand analysis, first, by relating money to net output or national income rather than the broader category of total transactions, and, second, by shifting from money’s rate of turnover to the proportion of annual income that the public wishes to hold in the form of money. In purely formal terms, there I nothing to choose between the Fisherian transaction approach and the Cambridge cash-balance approach, but the Cambridge formulation held out the potential of a genuine portfolio theory of the demand for money, which potential, however, was never fully exploited. . . .

The Cambridge formulation implies a demand for money equation, D_m = kPY, which contains no variable to represent the opportunity costs of holding cash, namely the rate of interest or the yield of alternative non-money assets, analogous to the relative price arguments of ordinary demand functions.
Yet a straight-forward application of utility-maximizing principles would have suggested that a rise in interest rates is likely to induce a fall in k as people strive to substitute interest-earning assets for passive money balances in their asset portfolios. Similarly, a fall in interest rates, by lowering the opportunity cost of holding money, is likely to cause a rise in k. Strangely enough, however, the Cambridge monetary theory never explicitly recognized the functional dependence of k on either the rate of interest or the rate on all non-monetary assets. After constructing a framework highly suggestive of a study of all the factors influencing cash-holding decisions, the Cambridge writers tended to lapse back to a list of the determinants of k that differed in no important respects from the list of institutional factors that Fisher had cited in his discussion of V. One can find references in Marshall, Pigou and particularly Lavington to a representative individual striking a balance between the costs of cash holdings in terms of interest foregone (minus the brokerage costs that would have been incurred by the movement into stocks and bonds) and their returns in terms of convenience and security against default but such passages were never systematically integrated with the cash-balance equation. As late as 1923, we find the young Keynes in A Tract on Monetary Reform interpreting k as a stable constant, representing an invariant link in the transmission mechanism connecting money to prices. If only Keynes at that date had read Wicksell instead of Marshall, he might have arrived at a money demand function that incorporates variations in the interest rate years before The General Theory (1936).

Moving to pp. 645-46, we find the following under the heading “The Demand for Money after Keynes.”

In giving explicit consideration to the yields on assets that compete with money, Keynes became one of the founders of the portfolio balance approach to monetary analysis. However, it is Hicks rather than Keynes who ought to be regarded as the founder of the view that the demand for money is simply an aspect of the problem of choosing an optimum portfolio of assets. In a remarkable paper published a year before the appearance of the General Theory, modestly entitled “A Suggestion for Simplifying the Theory of Money,” Hicks argued that money held at least partly as a store of value must be considered a type of capital asset. Hence the demand for money equation must include total wealth and expected rates of return on non-monetary assets as explanatory variables. Because individuals can choose to hold their entire wealth portfolios in the form of cash, the wealth variable represents the budget constraint on money holdings. The yield variables, on the other hand, represent both the opportunity costs of holding money and the substitutions effects of changes in relative rates of return. Individuals optimize their portfolio balances by comparing these yields with the imputed yield in terms of convenience and security of holding money. By these means, Hicks in effect treated the demand for money as a problem of balance sheet equilibrium analyzed along the same lines as those employed in ordinary demand theory.

It was Milton Friedman who carried this Hicksian analysis of money as a capital asset to its logical conclusion. In a 1956 essay, he set out a precise and complete specification of the relevant constraints and opportunity cost variable entering a household’s money demand function. His independent variable included wealth or permanent income – the present value of expected future receipts from all sources, whether personal earning or the income from real property and financial assets – the ratio of human to non-human wealth, expected rates of return on stocks, bonds and real assets, the nominal interest rate, the actual price level, and, finally, the expected percentage change in the price level. Like Hicks, Friedman specified wealth as the appropriate budget constraint but his concept of wealth was much broader than that adopted by Hicks. Whereas Keynes had viewed bonds as the only asset competing with cash, Friedman regarded all types of wealth as potential substitutes for cash holdings in an individual’s balance sheet; thus, instead of a single interest variable in the Keynesian liquidity preference equation, we get a whole list of relative yield variables in Friedman. An additional novel feature, entirely original with Friedman, is the inclusion of the expected rate of change in P as a measure of the anticipated rate of depreciation in the purchasing power of cash balances.

This formulation of the money demand function was offered in a paper entitled “The Quantity Theory of Money: A Restatement.” Friedman claimed not only that the quantity theory of money had always been a theory about the demand for money but also that his reformulation corresponded closely to what some of the great Chicago monetary economists, such as H.C. Simons and L. W. Mints, had always meant by the quantity theory. It is clear, however, from our earlier discussion that the quantity theory of money, while embodying an implicit conception of the demand for money, had always stood first and foremost for a theory of the determination of prices and nominal income; it contained much more than a particular theory of the demand for money.

Finally, Blaug remarks in his “notes for further reading” at the end of chapter 15,

In an influential essay, “The Quantity Theory of Money – A Restatement,” . . . M. Friedman claimed that his restatement was nothing more than the University of Chicago “oral” tradition. That claim was effectively destroyed by D. Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman, JMCB, 1969 .

Well, just a couple of quick comments on Blaug. I don’t entirely agree with everything he says about Cambridge monetary theory, and about the relative importance of Hicks and Keynes in advancing the theory of the demand for money. Cambridge economists may have been a bit more aware that the demand for money was a function of the rate of interest than he admits, and I think Keynes in chapter 17, definitely formulated a theory of the demand for money in a portfolio balance context, so I think that Friedman was indebted to both Hicks and Keynes for his theory of the demand for money.

As for Scott Sumner’s quotation from Hicks’s Mr. Keynes and the Classics, I think the point of that paper was not so much the theory of the demand for money, which had already been addressed in the 1935 paper from which I quoted, as to sketch out a way of generalizing the argument of the General Theory to encompass both the liquidity trap and the non-liquidity trap cases within a single graph. From the standpoint of the IS-LM diagram, the distinctive Keynesian contribution was the case of absolute liquidity preference, that doesn’t mean that Hicks meant that nothing had been added to the theory of the demand for money since Lavington. If that were the case, Hicks would have been denying that his 1935 paper had made any contribution. I don’t think that’s what he meant to suggest.

To sum up: 1) there was no Chicago oral tradition of the demand for money; 2) Friedman’s restatement of the quantity theory owed more to Keynes (and Hicks) than he admitted; 3) Friedman adapted the Cambridge/Keynes/Hicks theory of the demand for money in novel ways that allowed him to develop an analysis of price level changes that was more straightforward than was possible in the IS-LM model, thereby de-emphasizing the link between money and interest rates, which had been a such a prominent feature of the Keynesian models. That of course is a point that Scott Sumner likes to stress. In an upcoming post, I will comment on the fact that it was not just Keynesian models which stressed the link between money and interest rates. Pre-Keynesian monetary models also stressed the connection between easy money and low interest rates and dear money and high interest rates. Friedman’s argument was thus an innovation not only relative to Keynesian models but to orthodox monetary models. What accounts for this innovation?

Who Sets the Real Rate of Interest?

Understanding economics requires, among other things, understanding the distinction between real and nominal variables. Confusion between real and nominal variables is pervasive, constantly presenting barriers to clear thinking, and snares and delusions for the mentally lazy. In this post, I want to talk about the distinction between the real rate of interest and the nominal rate of interest. That distinction has been recognized for at least a couple of centuries, Henry Thornton having mentioned it early in the nineteenth century. But the importance of the distinction wasn’t really fully understood until Irving Fisher made the distinction between the real and nominal rates of interest a key element of his theory of interest and his theory of money, expressing the relationship in algebraic form — what we now call the Fisher equation. Notation varies, but the Fisher equation can be written more or less as follows:

i = r + dP/dt,

where i is the nominal rate, r is the real rate, and dP/dt is the rate of inflation. It is important to bear in mind that the Fisher equation can be understood in two very different ways. It can either represent an ex ante relationship, with dP/dt referring to expected inflation, or it can represent an ex post relationship, with dP/dt referring to actual inflation.

What I want to discuss in this post is the tacit assumption that usually underlies our understanding, and our application, of the ex ante version of the Fisher equation. There are three distinct variables in the Fisher equation: the real and the nominal rates of interest and the rate of inflation. If we think of the Fisher equation as an ex post relationship, it holds identically, because the unobservable ex post real rate is defined as the difference between the nominal rate and the inflation rate. The ex post, or the realized, real rate has no independent existence; it is merely a semantic convention. But if we consider the more interesting interpretation of the Fisher equation as an ex ante relationship, the real interest rate, though still unobservable, is not just a semantic convention. It becomes the theoretically fundamental interest rate of capital theory — the market rate of intertemporal exchange, reflecting, as Fisher masterfully explained in his canonical renderings of the theory of capital and interest, the “fundamental” forces of time preference and the productivity of capital. Because it is determined by economic “fundamentals,” economists of a certain mindset naturally assume that the real interest rate is independent of monetary forces, except insofar as monetary factors are incorporated in inflation expectations. But if money is neutral, at least in the long run, then the real rate has to be independent of monetary factors, at least in the long run. So in most expositions of the Fisher equation, it is tacitly assumed that the real rate can be treated as a parameter determined, outside the model, by the “fundamentals.” With r determined exogenously, fluctuations in i are correlated with, and reflect, changes in expected inflation.

Now there’s an obvious problem with the Fisher equation, which is that in many, if not most, monetary models, going back to Thornton and Wicksell in the nineteenth century, and to Hawtrey and Keynes in the twentieth, and in today’s modern New Keynesian models, it is precisely by way of changes in its lending rate to the banking system that the central bank controls the rate of inflation. And in this framework, the nominal interest rate is negatively correlated with inflation, not positively correlated, as implied by the usual understanding of the Fisher equation. Raising the nominal interest rate reduces inflation, and reducing the nominal interest rate raises inflation. The conventional resolution of this anomaly is that the change in the nominal interest rate is just temporary, so that, after the economy adjusts to the policy of the central bank, the nominal interest rate also adjusts to a level consistent with the exogenous real rate and to the rate of inflation implied by the policy of the central bank. The Fisher equation is thus an equilibrium relationship, while central-bank policy operates by creating a short-term disequilibrium. But the short-term disequilibrium imposed by the central bank cannot be sustained, because the economy inevitably begins an adjustment process that restores the equilibrium real interest rate, a rate determined by fundamental forces that eventually override any nominal interest rate set by the central bank if that rate is inconsistent with the equilibrium real interest rate and the expected rate of inflation.

It was just this analogy between the powerlessness of the central bank to hold the nominal interest rate below the sum of the exogenously determined equilibrium real rate and the expected rate of inflation that led Milton Friedman to the idea of a “natural rate of unemployment” when he argued that monetary policy could not keep the unemployment rate below the “natural rate ground out by the Walrasian system of general equilibrium equations.” Having been used by Wicksell as a synonym for the Fisherian equilibrium real rate, the term “natural rate” was undoubtedly adopted by Friedman, because monetarily induced deviations between the actual rate of unemployment and the natural rate of unemployment set in motion an adjustment process that restores unemployment to its “natural” level, just as any deviation between the nominal interest rate and the sum of the equilibrium real rate and expected inflation triggers an adjustment process that restores equality between the nominal rate and the sum of the equilibrium real rate and expected inflation.

So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about? The Fed has no legal power to set interest rates; it can only announce what interest rate it will lend at, and it can buy and sell assets in the market. It has an advantage because it can create the money with which to buy assets. But if you believe that the Fed cannot reduce the rate of unemployment below the “natural rate of unemployment” by printing money, why would you believe that the Fed can reduce the real rate of interest below the “natural rate of interest” by printing money? Martin Feldstein and the Wall Street Journal believe that the Fed is unable to do one, but perfectly able to do the other. Sorry, but I just don’t get it.

Look at the accompanying chart. It tracks the three variables in the Fisher equation (the nominal interest rate, the real interest rate, and expected inflation) from October 1, 2007 to July 2, 2013. To measure the nominal interest rate, I use the yield on 10-year Treasury bonds; to measure the real interest rate, I use the yield on 10-year TIPS; to measure expected inflation, I use the 10-year breakeven TIPS spread. The yield on the 10-year TIPS is an imperfect measure of the real rate, and the 10-year TIPS spread is an imperfect measure of inflation expectations, especially during financial crises, when the rates on TIPS are distorted by illiquidity in the TIPS market. Those aren’t the only problems with identifying the TIPS yield with the real rate and the TIPS spread with inflation expectations, but those variables usually do provide a decent approximation of what is happening to real rates and to inflation expectations over time.

real_and_nominal_interest_rates

Before getting to the main point, I want to make a couple of preliminary observations about the behavior of the real rate over time. First, notice that the real rate declined steadily, with a few small blips, from October 2007 to March 2008, when the Fed was reducing the Fed Funds target rate from 4.75 to 3% as the economy was sliding into a recession that officially began in December 2007. The Fed reduced the Fed Funds target to 2% at the end of April, but real interest rates had already started climbing in early March, so the failure of the FOMC to reduce the Fed Funds target again till October 2008, three weeks after the onset of the financial crisis, clearly meant that there was at least a passive tightening of monetary policy throughout the second and third quarters, helping create the conditions that precipitated the crisis in September. The rapid reduction in the Fed Funds target from 2% in October to 0.25% in December 2008 brought real interest rates down, but, despite the low Fed Funds rate, a lack of liquidity caused a severe tightening of monetary conditions in early 2009, forcing real interest rates to rise sharply until the Fed announced its first QE program in March 2009.

I won’t go into more detail about ups and downs in the real rate since March 2009. Let’s just focus on the overall trend. From that time forward, what we see is a steady decline in real interest rates from over 2% at the start of the initial QE program till real rates bottomed out in early 2012 at just over -1%. So, over a period of three years, there was a steady 3% decline in real interest rates. This was no temporary phenomenon; it was a sustained trend. I have yet to hear anyone explain how the Fed could have single-handedly produced a steady downward trend in real interest rates by way of monetary expansion over a period of three years. To claim that decline in real interest rates was caused by monetary expansion on the part of the Fed flatly contradicts everything that we think we know about the determination of real interest rates. Maybe what we think we know is all wrong. But if it is, people who blame the Fed for a three-year decline in real interest rates that few reputable economists – and certainly no economists that Fed critics pay any attention to — ever thought was achievable by monetary policy ought to provide an explanation for how the Fed suddenly got new and unimagined powers to determine real interest rates. Until they come forward with such an explanation, Fed critics have a major credibility problem.

So please – pleaseWall Street Journal editorial page, Martin Feldstein, John Taylor, et al., enlighten us. We’re waiting.

PS Of course, there is a perfectly obvious explanation for the three-year long decline in real interest rates, but not one very attractive to critics of QE. Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate. The real interest rate might have adjusted more rapidly to the reduced equilibrium rate, but that would have required expected inflation to have risen. What that means is that sometimes it is the real interest rate, not, as is usually assumed, the nominal rate, that adjusts to the expected rate of inflation. My next post will discuss that alternative understanding of the implicit dynamics of the Fisher equation.

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.]


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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