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Now We Know: Ethanol Caused the 2008 Financial Crisis and the Little Depression

In the latest issue of the Journal of Economic Perspectives, now freely available here, Brian Wright, an economist at the University of California, Berkeley, has a great article, summarizing his research (with various co-authors including, H Bobenrieth, H. Bobenrieth, and R. A. Juan) into the behavior of commodity markets, especially for wheat, rice and corn. Seemingly anomalous price movements in those markets – especially the sharp increase in prices since 2004 — have defied explanation. But Wright et al. have now shown that the anomalies can be explained by taking into account both the role of grain storage and the substitutability between these staples as caloric sources. With their improved modeling techniques, Wright and his co-authors have shown that the seemingly unexplained and sustained increase in world grain prices after 2005 “are best explained by the new policies causing a sustained surge in demand for biofuels.” Here is the abstract of Wright’s article.

In the last half-decade, sharp jumps in the prices of wheat, rice, and corn, which furnish about two-thirds of the calorie requirements of mankind, have attracted worldwide attention. These price jumps in grains have also revealed the chaotic state of economic analysis of agricultural commodity markets. Economists and scientists have engaged in a blame game, apportioning percentages of responsibility for the price spikes to bewildering lists of factors, which include a surge in meat consumption, idiosyncratic regional droughts and fires, speculative bubbles, a new “financialization” of grain markets, the slowdown of global agricultural research spending, jumps in costs of energy, and more. Several observers have claimed to identify a “perfect storm” in the grain markets in 2007/2008, a confluence of some of the factors listed above. In fact, the price jumps since 2005 are best explained by the new policies causing a sustained surge in demand for biofuels. The rises in food prices since 2004 have generated huge wealth transfers to global landholders, agricultural input suppliers, and biofuels producers. The losers have been net consumers of food, including large numbers of the world’s poorest peoples. The cause of this large global redistribution was no perfect storm. Far from being a natural catastrophe, it was the result of new policies to allow and require increased use of grain and oilseed for production of biofuels. Leading this trend were the wealthy countries, initially misinformed about the true global environmental and distributional implications.

This conclusion, standing alone, is a devastating indictment of the biofuels policies of the last decade that have immiserated much of the developing world and many of the poorest in the developed world for the benefit of a small group of wealthy landowners and biofuels rent seekers. But the research of Wright et al. shows definitively that the runup in commodities prices after 2005 was driven by a concerted policy of intervention in commodities markets, with the fervent support of many faux free-market conservatives serving the interests of big donors, aimed at substituting biofuels for fossil fuels by mandating the use of biofuels like ethanol.

What does this have to do with the financial crisis of 2008? Simple. As Scott Sumner, Robert Hetzel, and a number of others (see, e.g., here) have documented, the Federal Open Market Committee, after reducing its Fed Funds target rates to 2% in March 2008 in the early stages of the downturn that started in December 2007, refused for seven months to further reduce the Fed Funds target because the Fed, disregarding or unaware of a rapidly worsening contraction in output and employment in the third quarter of 2008. Why did the Fed ignore or overlook a rapidly worsening economy for most of 2008 — even for three full weeks after the Lehman debacle? Because the Fed was focused like a laser on rapidly rising commodities prices, fearing that inflation expectations were about to become unanchored – even as inflation expectations were collapsing in the summer of 2008. But now, thanks to Wright et al., we know that rising commodities prices had nothing to do with monetary policy, but were caused by an ethanol mandate that enjoyed the bipartisan support of the Bush administration, Congressional Democrats and Congressional Republicans. Ah the joy of bipartisanship.

Barro and Krugman Yet Again on Regular Economics vs. Keynesian Economics

A lot of people have been getting all worked up about Paul Krugman’s acerbic takedown of Robert Barro for suggesting in a Wall Street Journal op-ed in 2011 that increased government spending would not stimulate the economy. Barro’s target was a claim by Agriculture Secretary Tom Vilsack that every additional dollar spent on food stamps would actually result in a net increase of $1.84 in total spending. This statement so annoyed Barro that, in a fit of pique, he wrote the following.

Keynesian economics argues that incentives and other forces in regular economics are overwhelmed, at least in recessions, by effects involving “aggregate demand.” Recipients of food stamps use their transfers to consume more. Compared to this urge, the negative effects on consumption and investment by taxpayers are viewed as weaker in magnitude, particularly when the transfers are deficit-financed.

Thus, the aggregate demand for goods rises, and businesses respond by selling more goods and then by raising production and employment. The additional wage and profit income leads to further expansions of demand and, hence, to more production and employment. As per Mr. Vilsack, the administration believes that the cumulative effect is a multiplier around two.

If valid, this result would be truly miraculous. The recipients of food stamps get, say, $1 billion but they are not the only ones who benefit. Another $1 billion appears that can make the rest of society better off. Unlike the trade-off in regular economics, that extra $1 billion is the ultimate free lunch.

How can it be right? Where was the market failure that allowed the government to improve things just by borrowing money and giving it to people? Keynes, in his “General Theory” (1936), was not so good at explaining why this worked, and subsequent generations of Keynesian economists (including my own youthful efforts) have not been more successful.

Sorry to brag, but it was actually none other than moi that (via Mark Thoma) brought this little gem to Krugman’s attention. In what is still my third most visited blog post, I expressed incredulity that Barro could ask where Is the market failure about a situation in which unemployment suddenly rises to more than double its pre-recession level. I also pointed out that Barro had himself previously acknowledged in a Wall Street Journal op-ed that monetary expansion could alleviate a cyclical increase in unemployment. If monetary policy (printing money on worthless pieces of paper) can miraculously reduce unemployment, why is out of the question that government spending could also reduce unemployment, especially when it is possible to view government spending as a means of transferring cash from people with unlimited demand for money to those unwilling to increase their holdings of cash? So, given Barro’s own explicit statement that monetary policy could be stimulative, it seemed odd for him to suggest, without clarification, that it would be a miracle if fiscal policy were effective.

Apparently, Krugman felt compelled to revisit this argument of Barro’s because of the recent controversy about extending unemployment insurance, an issue to which Barro made only passing reference in his 2011 piece. Krugman again ridiculed the idea that just because regular economics says that a policy will have adverse effects under “normal” conditions, the policy must be wrongheaded even in a recession.

But if you follow right-wing talk — by which I mean not Rush Limbaugh but the Wall Street Journal and famous economists like Robert Barro — you see the notion that aid to the unemployed can create jobs dismissed as self-evidently absurd. You think that you can reduce unemployment by paying people not to work? Hahahaha!

Quite aside from the fact that this ridicule is dead wrong, and has had a malign effect on policy, think about what it represents: it amounts to casually trashing one of the most important discoveries economists have ever made, one of my profession’s main claims to be useful to humanity.

Krugman was subsequently accused of bad faith in making this argument because he, like other Keynesians, has acknowledged that unemployment insurance tends to increase the unemployment rate. Therefore, his critics argue, it was hypocritical of Krugman to criticize Barro and the Wall Street Journal for making precisely the same argument that he himself has made. Well, you can perhaps accuse Krugman of being a bit artful in his argument by not acknowledging explicitly that a full policy assessment might in fact legitimately place some limit on UI benefits, but Krugman’s main point is obviously not to assert that “regular economics” is necessarily wrong, just that Barro and the Wall Street Journal are refusing to acknowledge that countercyclical policy of some type could ever, under any circumstances, be effective. Or, to put it another way, Krugman could (and did) easily agree that increasing UI will increases the natural rate of unemployment, but, in a recession, actual unemployment is above the natural rate, and UI can cause the actual rate to fall even as it causes the natural rate to rise.

Now Barro might respond that all he was really saying in his 2011 piece was that the existence of a government spending multiplier significantly greater than zero is not supported by the empirical evidenc. But there are two problems with that response. First, it would still not resolve the theoretical inconsistency in Barro’s argument that monetary policy does have magical properties in a recession with his position that fiscal policy has no such magical powers. Second, and perhaps less obviously, the empirical evidence on which Barro relies does not necessarily distinguish between periods of severe recession or depression and periods when the economy is close to full employment. If so, the empirical estimates of government spending multipliers are subject to the Lucas critique. Parameter estimates may not be stable over time, because those parameters may change depending on the cyclical phase of the economy. The multiplier at the trough of a deep business cycle may be much greater than the multiplier at close to full employment. The empirical estimates for the multiplier cited by Barro make no real allowance for different cyclical phases in estimating the multiplier.

PS Scott Sumner also comes away from reading Barro’s 2011 piece perplexed by what Barro is really saying and why, and does an excellent job of trying in vain to find some coherent conceptual framework within which to understand Barro. The problem is that there is none. That’s why Barro deserves the rough treatment he got from Krugman.

My Paper on Hawtrey’s Good and Bad Trade

I have just posted my paper “Hawtrey’s Good and Bad Trade: A Centenary Retrospective” based on a series of blog posts this fall on SSRN. Here is a link to download the paper.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2369028

Comments on the paper will be gratefully accepted either as comments to this post or via email at uneasymoney@hotmail.com

OMG!

I just read this review/essay (“Lead Poisoning: The Ignored Scandal”) by Helen Epstein of the book Lead Wars: The Political Science and the Fate of America’s Children by Gerald Markowitz and David Rosner, in the March 21, 2013 issue of the New York Review of Books.. The story it tells is so outrageous – and on so many different levels — that it makes you want to cry, and to cry out in horror and disgust. And lest you think that it is an old story, think again.

In 1990, Leslie Hanes, another young black single woman, moved into an apartment that was supposed to have been fully stripped of lead paint years earlier. In 1992, she gave birth to a daughter, Denisa, and in the spring of the following year, she too joined the toddler lead study.3 The day before Hanes signed the consent form, the contractor found that her apartment was not in fact lead-free. The remaining lead paint was removed, but by the following September Denisa’s blood lead level had more than tripled and was now six times higher than that currently considered safe by the Centers for Disease Control.

Denisa’s mother was not informed of the blood test result for another three months, by which time it was nearly Christmas. The research assistant who told her about it wished her happy holidays and advised her to wash her front steps more carefully and to keep eighteen-month-old Denisa from putting her hands in her mouth. When Denisa eventually entered school, she had trouble keeping up and had to repeat second grade. This came as a surprise to her mother, a former high school honors student. As Hanes told The Washington Post‘s Manuel Roig-Franzia in 2001, sometimes Denisa came home crying because she thought she was stupid. “No, baby, you’re not stupid,” Leslie told her. “We just have to work harder.”

The effects of putting children at high risk of lead poisoning are tragic and appalling.

Long before the Baltimore toddler study was even conceived, millions of children had their growth and intelligence stunted by lead-contaminated consumer products—and some five million preschool children are still at risk today. One expert even estimated that America’s failure to address the lead paint problem early on may well have cost the American population, on average, five IQ points—enough to double the number of retarded children and halve the number of gifted children in the country. Not only would our nation have been more intelligent had its leaders banned lead paint early on, it might have been safer too, since lead is known to cause impulsivity and aggression. Blood lead levels in adolescent criminals tend to be several times higher than those of noncriminal adolescents, and there is a strong geographical correlation between crime rates and lead exposure in US cities.

In 2000, the two mothers sued the Johns Hopkins–affiliated Kennedy Krieger Institute, which employed the scientists. The mothers’ cases were thrown out by a lower court, but after an appeals court remanded the case to be heard, the mothers reached an undisclosed settlement with the institute. The ninety-six-page appeals court judgment compared the Baltimore lead study to the notorious Tuskegee experiment, in which hundreds of black men with syphilis were denied treatment with penicillin for decades so that US Public Health Service researchers could study the course of the disease.

The toxic effects of lead poisoning were known long ago

The problem began in the early twentieth century when a spate of lead-poisoning cases in children occurred across the United States. The symptoms—vomiting, convulsions, bleeding gums, palsied limbs, and muscle pain so severe “as not to permit of the weight of bed-clothing,” as one doctor described it—were recognizable at once because they resembled the symptoms of factory workers poisoned in the course of enameling bathtubs or preparing paint and gasoline additives. One Dupont factory was even nicknamed “the House of the Butterflies” because so many workers had hallucinations of insects flying around. Many victims had to be taken away in straitjackets; some died.

By the 1920s, it was known that one common cause of childhood lead poisoning was the consumption of lead paint chips. Lead paint was popular in American homes because its brightness appealed to the national passion for hygiene and modernism, but the chips taste sweet, and it could be difficult to keep small children away from them. Because of its well-known dangers, many other countries banned interior lead paint during the 1920s and 1930s, including Belgium, France, Austria, Tunisia, Greece, Czechoslovakia, Poland, Sweden, Spain, and Yugoslavia.

In 1922, the League of Nations proposed a worldwide lead paint ban, but at the time, the US was the largest lead producer in the world, and consumed 170,000 tons of white lead paint each year. The Lead Industries Association had grown into a powerful political force, and the pro-business, America-first Harding administration vetoed the ban. Products containing lead continued to be marketed to American families well into the 1970s, and by midcentury lead was everywhere: in plumbing and lighting fixtures, painted toys and cribs, the foil on candy wrappers, and even cake decorations. Because most cars ran on leaded gasoline, its concentration in the air was also increasing, especially in cities.

Lead paint was the most insidious danger of all because it can cause brain damage even if it isn’t peeling. Lead dust drifts off walls, year after year, even if you paint over it. It’s also almost impossible to get rid of. Removal of lead paint with electric sanders and torches creates clouds of dust that may rain down on the floor for months afterward, and many children have been poisoned during the process of lead paint removal itself. Even cleaning lead-painted walls with a rag can create enough dust to poison a child. Gut renovating the entire house solves the problem, but this too may contaminate the air around the house for months.

The sheer magnitude and duration of those effects is mind-boggling, and the suffering has not ended.

There is no way of knowing how many children were harmed over the past century by America’s decision not to ban lead from consumer products early on, but the number is somewhere in the millions. The most accurate national survey of lead poisoning was probably the 1976–1980 National Health and Nutrition Examination Survey, which found that 4 percent of all children under six—roughly 780,000—had blood lead concentrations exceeding thirty micrograms per deciliter, which was then thought to be the limit of safety.

Black children, the survey found, were six times more likely to have elevated lead than whites. The number of children with lead levels over five micrograms per deciliter—or for that matter over one or two—was obviously much higher, but there’s no way of knowing how high it was. The 1985 leaded gasoline ban and the gradual renovation of slum housing have since reduced the number of poisoned children, so that today, the CDC estimates that some 500,000 children who are between one and five years old have lead levels over five micrograms per deciliter.

As the scale and horror of the lead paint problem came to light, the lead companies played down the bad news. When popular magazines like Ladies’ Home Journal began publicizing the dangers of lead poisoning in the 1930s and 1940s, lead and paint manufacturers placed cartoons in National Geographic and The Saturday Evening Post celebrating the joy that lead paint brought into children’s lives. Advertisements for Dutch Boy paint—which contained enough lead in one coat of a two-by-two-inch square to kill a child—depicted their tow-headed mascot painting toys with Father Christmas smiling over his shoulder.

See below

dutch_boys_hobby

The companies also hired a public relations firm to influence stories in The Wall Street Journal and other conservative news outlets, which characterized Needleman as part of a leftist plot to increase government spending on housing and other social programs. So, just as the tobacco industry deliberately obfuscated the dangers of cigarettes until skyrocketing smoking-related Medicaid costs finally led state governments to sue the companies, and just as oil company–backed scientists now downplay the dangers of greenhouse gases, the lead industry also lied to Americans for decades, and the government did nothing to stop it.

During the 1980s, government officials finally agreed that the lead paint crisis was real, but they were conflicted about how to deal with it. In 1990, the Department of Health and Human Services developed a plan to remove lead from the nation’s homes over fifteen years at a cost of $33 billion—a large sum, but half the estimated cost of doing nothing, which would incur a greater need for special education programs, Medicaid and welfare payments for brain-damaged and disabled lead-poisoning victims, and other expenses. But the plan was opposed by the lead industry, realtors, landlords, insurance companies, and even some private pediatricians who objected to the extra bother of screening children. The plan was soon shelved, and instead, the EPA, looking for a cheaper way around the problem, commissioned the Baltimore toddler study.

Since then, the US government has spent less than $2 billion on lead abatement. This money has supported a number of exemplary state and nonprofit programs that work in inner cities, but it’s a tiny fraction of what’s needed, and about twenty times less than US spending on the global AIDS crisis since 2004 alone. It’s worth asking why both Republican and Democratic administrations appear to have cared so little about this threat to America’s children.

And the horror continues

Lead-poisoning prevention once had its partisans too, but they were marginal and rapidly stifled. During the 1960s, the Black Panthers and the Puerto Rican activist group the Young Lords set up community health clinics and carried out screening programs for tuberculosis and sickle cell anemia as well as lead poisoning. The historian Alondra Nelson’s excellent Body and Soul: The Black Panther Party and the Fight Against Medical Discrimination (2011) describes how these groups maintained that new civil rights laws and Great Society programs alone would never meet the needs of the poor unless the poor themselves had a voice in shaping them. The Panthers espoused violence and called for a separate black country. They certainly weren’t right about everything, but when it came to lead poisoning, they probably were.

By the early 1980s, the movements to achieve social justice led by Martin Luther King Jr., Malcolm X, and the Black Panthers had largely subsided, and with them, grassroots advocacy for the health of poor black children. Some scientists continued to raise the alarm about lead poisoning, including Herbert Needleman, Jane Lin-Fu of the US Children’s Bureau, Philip Landrigan of Mount Sinai Hospital in New York, and Ellen Silbergeld, the editor of the journal Environmental Research, but they lacked a strong social movement to take up their findings and fight for children at risk. Although there were some desultory campaigns against lead poisoning, neither the powerful women’s health movement nor environmental groups took up the issue in a sustained manner. The Obama administration has invested no more in this problem than George W. Bush’s did. Lead poisoning isn’t even on the CDC’s priority list of “winnable public health battles.”

Hawtrey’s Good and Bad Trade, Part IV: The Inherent Instability of Credit

I don’t have a particularly good memory for specific facts or of books and articles that I have read, even ones that I really enjoyed or thought were very important. If I am lucky, I can remember on or two highlights or retain some general idea of what the book or article was about. So I often find myself surprised when reading something for the second time when I come across a passage that I had forgotten and experience the shock and awe of discovery while knowing, and perhaps even remembering, that I had read this all before once upon a time. That is just the experience I had when reading chapter 7 (“Origination of Monetary Disturbances in an Isolated Community”) of Good and Bad Trade. I think that I read Good and Bad Trade for the first time in the spring of 2009. On the whole, I would say that I was less impressed with it than I was with some other books of his that I had read (especially The Art of Central Banking and The Gold Standard in Theory and Practice), but reading chapter 7 a second time really enhanced my appreciation for how insightful Hawtrey was and how well he explained the underlying causes for what he called, in one of his great phrases “the inherent instability of credit.” He starts of chapter 7 with the following deceptively modest introductory paragraphs.

In the last two chapters we have postulated a perfectly arbitrary change in the quantity of legal tender currency in circulation. However closely the consequences traced from such an arbitrary change may correspond with the phenomena we have set out to explain, we have accomplished nothing till we have shown that causes which will lead to those consequences actually occur. . . .

At the present stage, however it is already possible to make a preliminary survey of the causes of fluctuations with the advantage of an artificial simplification of the problem. And at the outset it must be recognized that arbitrary changes in the quantity of legal tender currency in circulation cannot be of much practical importance. Such changes rarely occur. . . .

But what we are looking for is the origination of changes not necessarily in the quantity of legal tender currency but in the quantity of purchasing power, which is based on the quantity of credit money. . . . For example, if the banker suddenly came to the conclusion that the proportion of reserves to liabilities previously maintained was too low, and decided to increase, this would necessitate a reduction in deposits exactly similar to the reduction which in the last chapter we supposed them to make in consequence of a reduction in the actual stock of legal tender currency. Or there might casual variations in their reserves. These reserves simply consist of that portion of the existing supply of cash [i.e., currency] which happens for the moment not to be in the pockets, tills, cashboxes, etc., of the public. The amount of money which any individual carries about with him at any time is largely a matter of chance, and consequently there may very well be variations in the cash in circulation and therefore contrary variations in the reserves, which are really in the nature of casual variations . . . (pp. 73-74)

After explaining that the amount of cash (i.e., currency) held by the public tends to fluctuate cyclically because increasing employment and increasing wage payments involve an increasing demand for currency (most workers having been paid with currency not by check, and certainly not by electronic transfer, in the nineteenth and early twentieth centuries), so that banks would generally tend to experience declining reserves over the course of the business cycle, Hawtrey offered another reason why banks would be subject to cyclical disturbances affecting their reserve position.

[W]henever the prevailing rate of profit deviates from the rate of interest charged on loans the discrepancy between them at once tends to be enlarged. If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. A parallel phenomenon occurs when the profit rate, through some chance cause, drops below the market rate; the consequent curtailment of loans and so of purchasing power leads at once to a greater and growing fall in profits, until the bankers intervene by reducing the rate of interest. It appears, therefore, that the equilibrium which the bankers have to maintain in fixing the rate of interest is essentially “unstable,” in the sense that if the rate of interest deviates from its proper value by any amount, however small, the deviation will tend to grow greater and greater until steps are taken to correct it. This of itself shows that the money market must be subject to fluctuations. A flag in a steady breeze could theoretically remain in equilibrium if it were spread out perfectly flat in the exact direction of the breeze. But it can be shown mathematically that that position is “unstable,” that if the flag deviates from it to any extent, however small, it will tend to deviate further. Consequently the flag flaps. (pp. 76-77)

Hawtrey also mentions other economic forces tending to amplify fluctuations, forces implicated in the general phenomenon of credit.

Credit money is composed of the obligations of bankers, and if a banker cannot meet his obligations the credit money dependent upon him is wholly or partly destroyed. Again, against his obligations the banker holds equivalent assets, together with a margin. These assets are composed chiefly of two items, legal tender currency and loans to traders. The solvency of the banker will depend largely on the reality of these assets, and the value of the loans will depend in turn on the solvency of the borrowers. (p. 77)

Hawtrey describes one of the principal assets held by English commercial banks in his day, the mercantile bill, with which a dealer or wholesaler making an order from a manufacturer obligates himself to pay for the ordered merchandise upon delivery at some fixed time, say 120 days, after the order is placed. The IOU of the dealer, the bill, can be immediately presented by the manufacturer to his banker who will then advance the funds to the manufacturer with which to cover the costs of producing the order for the dealer. When the order is filled four months hence, the dealer will pay for the order and the manufacturer will then be able to discharge his obligation to his banker.

The whole value of the manufacturer’s efforts in producing the goods depends upon there being an effective demand for them when they are completed. It is only because the dealer anticipates that this effective demand for them will be forthcoming that he gives the manufacturer the order. The dealer, in fact, is taking the responsibility of saying how £10,000 worth of the productive capacity of the country shall be employed. The manufacturer, in accepting the order, and the banker in discounting the bill, are both endorsing the opinion of the dealer. The whole transaction is based ultimately on an expectation of a future demand, which must be more or less speculative. But the banker is doubly insured against the risk. Both the dealer and the manufacturer are men of substance. If the dealer cannot dispose of the goods for £10,000, he is prepared to bear the loss himself. He expects some of his ventures to fail, and others to bring him more than he counted on. Take the rough with the smooth he will probably make a profit. . . . And if the dealer becomes insolvent, there is still the manufacturer to save the banker from loss. . . . Where bills are not used a banker may lend on the sole credit of a dealer or manufacturer, relying on the value of the business to which he lends as the ultimate security for the loan.

Now if a contraction of credit money occurs, the consequent slackening of demand, and fall in the prices of commodities, will lead to a widespread disappointment of dealers’ expectations. At such a time the weakest dealers are likely to be impaired. An individual or company in starting a manufacturing business would usually add to the capital they can provide themselves, further sums borrowed in the form of debentures secured on the business and yielding a fixed rate of interest. . . . But when the general level of prices is falling, the value of the entire business will be falling also, while the debenture and other liabilities, being expressed in money, will remain unchanged. . . . [D]uring the period of falling prices, the expenses of production resist the downward tendency, and the profits are temporarily diminished and may be entirely obliterated or turned into an actual loss. A weak business cannot bear the strain, and being unable to pay its debenture interest and having no further assets on which to borrow, it will fail. If it is not reconstructed but ceases operations altogether, that will of course contribute to the general diminution of output. Its inability to meet its engagements will at the same time inflict loss on the banks. But at present we are considering credit, and credit depends on the expectation of future solvency. A business which is believed to be weak will have difficulty in borrowing, because bankers fear that it may fail. At a time of contracting trade the probability of any given business failing will be increased. At the same time the probability of any particular venture for which it may desire to borrow resulting in a loss instead of a profit will likewise be increased. Consequently at such a time credit will be impaired, but this will be the consequence, not the cause of the contracting trade. (pp. 79-80)

Finally, Hawtrey directs our attention to the credit of bankers.

We have already seen that the banker’s estimate of the proper proportion of his reserve to his liabilities is almost entirely empirical, and that an arbitrary change in the proportion which he thinks fit to maintain between them will carry with it an increase or decrease, as the case may be, in the available amount of purchasing power in the community. If a banker really underestimates the proper amount of reserve, and does not correct his estimate, he may find himself at a moment of strain with his reserve rapidly melting away and no prospect of the process coming to an end before the reserve is exhausted. His natural remedy is to borrow from other banks; but this he can only do if they believe his position to be sound. If they will not lend, he must try to curtail his loans. But if has been lending imprudently, he will find that on his refusing to renew loans the borrowers will in some cases become bankrupt and his money will be lost. It is just when a banker has been lending imprudently that his fellow-bankers will refuse to lend to him, and thus the same mistake cuts him off simultaneously from the two possible remedies. (pp. 81-82)

Interestingly, though he explains how it is possible that credit may become unstable, leading to cumulative fluctuations in economic activity, Hawtrey concludes this chapter by arguing that without changes in aggregate purchasing power (which, in Hawtrey’s terminology, means the total quantity of fiat and credit money). The problem with that formulation is that what Hawtrey has just shown is that the quantity of credit money fluctuates with the state of credit, so to say that economic activity will not fluctuate much if aggregate purchasing power is held stable is to beg the question. The quantity of credit money will not remain stable unless credit remains stable, and if credit is unstable, which is what Hawtrey has just shown, the quantity of credit money will not remain stable.

Keynes on the Fisher Equation and Real Interest Rates

Almost two months ago, I wrote a post (“Who Sets the Real Rate of Interest?”) about the Fisher equation, questioning the idea that the Fed can, at will, reduce the real rate of interest by printing money, an idea espoused by a lot of people who also deny that the Fed has the power to reduce the rate of unemployment by printing money. A few weeks later, I wrote another post (“On a Difficult Passage in the General Theory“) in which I pointed out the inconsistency between Keynes’s attack on the Fisher equation in chapter 11 of the General Theory and his analysis in chapter 17 of the liquidity premium and the conditions for asset-market equilibrium, an analysis that led Keynes to write down what is actually a generalized version of the Fisher equation. In both of those posts I promised a future post about how to understand the dynamic implications of the Fisher equation and the relationship between Fisher equation and the Keynesian analysis. This post is an attempt to make good on those promises.

As I observed in my earlier post, the Fisher equation is best understood as a property of equilibrium. If the Fisher equation does not hold, then it is reasonable to attribute the failure to some sort of disequilibrium. The most obvious, but not the only, source of disequilibrium is incorrectly expected inflation. Other sources of disequilibrium could be a general economic disorder, the entire economic system being (seriously) out of equilibrium, implying that the real rate of interest is somehow different from the “equilibrium” rate, or, as Milton Friedman might put it, that the real rate is different from the rate that would be ground out by the system of Walrasian (or Casselian or Paretian or Fisherian) equations.

Still a third possibility is that there is more than one equilibrium (i.e., more than one solution to whichever system of equations we are trying to solve). If so, as an economy moves from one equilibrium path to another through time, the nominal (and hence the real) rate of that economy could be changing independently of changes in expected inflation, thereby nullifying the empirical relationship implied (under the assumption of a unique equilibrium) by the Fisher equation.

Now in the canonical Fisherian theory of interest, there is, at any moment of time, a unique equilibrium rate of interest (actually a unique structure of equilibrium rates for all possible combinations of time periods), increasing thrift tending to reduce rates and increasing productivity of capital tending to raise them. While uniqueness of the interest rate cannot easily be derived outside a one-commodity model, the assumption did not seem all that implausible in the context of the canonical Fisherian model with a given technology and given endowments of present and future resources. In the real world, however, the future is unknown, so the future exists now only in our imagination, which means that, fundamentally, the determination of real interest rates cannot be independent of our expectations of the future. There is no unique set of expectations that is consistent with “fundamentals.” Fundamentals and expectations interact to create the future; expectations can be self-fulfilling. One of the reasons why expectations can be self-fulfilling is that often it is the case that individual expectations can only be realized if they are congruent with the expectations of others; expectations are subject to network effects. That was the valid insight in Keynes’s “beauty contest” theory of the stock market in chapter 12 of the GT.

There simply is no reason why there would be only one possible equilibrium time path. Actually, the idea that there is just one possible equilibrium time path seems incredible to me. It seems infinitely more likely that there are many potential equilibrium time paths, each path conditional on a corresponding set of individual expectations. To be sure, not all expectations can be realized. Expectations that can’t be realized produce bubbles. But just because expectations are not realized doesn’t mean that the observed price paths were bubbles; as long as it was possible, under conditions that could possibly have obtained, that the expectations could have been realized, the observed price paths were not bubbles.

Keynes was not the first economist to attribute economic fluctuations to shifts in expectations; J. S. Mill, Stanley Jevons, and A. C. Pigou, among others, emphasized recurrent waves of optimism and pessimism as the key source of cyclical fluctuations. The concept of the marginal efficiency of capital was used by Keynes to show the dependence of the desired capital stock, and hence the amount of investment, on the state of entrepreneurial expectations, but Keynes, just before criticizing the Fisher equation, explicitly identified the MEC with the Fisherian concept of “the rate of return over cost.” At a formal level, at any rate, Keynes was not attacking the Fisherian theory of interest.

So what I want to suggest is that, in attacking the Fisher equation, Keynes was really questioning the idea that a change in inflation expectations operates strictly on the nominal rate of interest without affecting the real rate. In a world in which there is a unique equilibrium real rate, and in which the world is moving along a time-path in the neighborhood of that equilibrium, a change in inflation expectations may operate strictly on the nominal rate and leave the real rate unchanged. In chapter 11, Keynes tried to argue the opposite: that the entire adjustment to a change in expected inflation is concentrated on real rate with the nominal rate unchanged. This idea seems completely unfounded. However, if the equilibrium real rate is not unique, why assume, as the standard renditions of the Fisher equation usually do, that a change in expected inflation affects only the nominal rate? Indeed, even if there is a unique real rate – remember that “unique real rate” in this context refers to a unique yield curve – the assumption that the real rate is invariant with respect to expected inflation may not be true in an appropriate comparative-statics exercise, such as the 1950s-1960s literature on inflation and growth, which recognized the possibility that inflation could induce a shift from holding cash to holding real assets, thereby increasing the rate of capital accumulation and growth, and, consequently, reducing the equilibrium real rate. That literature was flawed, or at least incomplete, in its analysis of inflation, but it was motivated by a valid insight.

In chapter 17, after deriving his generalized version of the Fisher equation, Keynes came back to this point when explaining why he had now abandoned the Wicksellian natural-rate analysis of the Treatise on Money. The natural-rate analysis, Keynes pointed out, presumes the existence of a unique natural rate of interest, but having come to believe that there could be an equilibrium associated with any level of employment, Keynes now concluded that there is actually a natural rate of interest corresponding to each level of employment. What Keynes failed to do in this discussion was to specify the relationship between natural rates of interest and levels of employment, leaving a major gap in his theoretical structure. Had he specified the relationship, we would have an explicit Keynesian IS curve, which might well differ from the downward-sloping Hicksian IS curve. As Earl Thompson, and perhaps others, pointed out about 40 years ago, the Hicksian IS curve is inconsistent with the standard neoclassical theory of production, which Keynes seems (provisionally at least) to have accepted when arguing that, with a given technology and capital stock, increased employment is possible only at a reduced real wage.

But if the Keynesian IS curve is upward-sloping, then Keynes’s criticism of the Fisher equation in chapter 11 is even harder to make sense of than it seems at first sight, because an increase in expected inflation would tend to raise, not (as Keynes implicitly assumed) reduce, the real rate of interest. In other words, for an economy operating at less than full employment, with all expectations except the rate of expected inflation held constant, an increase in the expected rate of inflation, by raising the marginal efficiency of capital, and thereby increasing the expected return on investment, ought to be associated with increased nominal and real rates of interest. If we further assume that entrepreneurial expectations are positively related to the state of the economy, then the positive correlation between inflation expectations and real interest rates would be enhanced. On this interpretation, Keynes’s criticism of the Fisher equation in chapter 11 seems indefensible.

That is one way of looking at the relationship between inflation expectations and the real rate of interest. But there is also another way.

The Fisher equation tells us that, in equilibrium, the nominal rate equals the sum of the prospective real rate and the expected rate of inflation. Usually that’s not a problem, because the prospective real rate tends to be positive, and inflation (at least since about 1938) is almost always positive. That’s the normal case. But there’s also an abnormal (even pathological) case, where the sum of expected inflation and the prospective real rate of interest is less than zero. We know right away that such a situation is abnormal, because it is incompatible with equilibrium. Who would lend money at a negative rate when it’s possible to hold the money and get a zero return? The nominal rate of interest can’t be negative. So if the sum of the prospective real rate (the expected yield on real capital) and the expected inflation rate (the negative of the expected yield on money with a zero nominal interest rate) is negative, then the return to holding money exceeds the yield on real capital, and the Fisher equation breaks down.

In other words, if r + dP/dt < 0, where r is the real rate of interest and dP/dt is the expected rate of inflation, then r < -dP/dt. But since i, the nominal rate of interest, cannot be less than zero, the Fisher equation does not hold, and must be replaced by the Fisher inequality

i > r + dP/dt.

If the Fisher equation can’t be satisfied, all hell breaks loose. Asset prices start crashing as asset owners try to unload their real assets for cash. (Note that I have not specified the time period over which the sum of expected inflation and the prospective yield on real capital are negative. Presumably the duration of that period is not indefinitely long. If it were, the system might implode.)

That’s what was happening in the autumn of 2008, when short-term inflation expectations turned negative in a contracting economy in which the short-term prospects for investment were really lousy and getting worse. The prices of real assets had to fall enough to raise the prospective yield on real assets above the expected yield from holding cash. However, falling asset prices don’t necessary restore equilibrium, because, once a panic starts it can become contagious, with falling asset prices reinforcing the expectation that asset prices will fall, depressing the prospective yield on real capital, so that, rather than bottoming out, the downward spiral feeds on itself.

Thus, for an economy at the zero lower bound, with the expected yield from holding money greater than the prospective yield on real capital, a crash in asset prices may not stabilize itself. If so, something else has to happen to stop the crash: the expected yield from holding money must be forced below the prospective yield on real capital. With the prospective yield on real capital already negative, forcing down the expected yield on money below the prospective yield on capital requires raising expected inflation above the absolute value of the prospective yield on real capital. Thus, if the prospective yield on real capital is -5%, then, to stop the crash, expected inflation would have to be raised to over 5%.

But there is a further practical problem. At the zero lower bound, not only is the prospective real rate not observable, it can’t even be inferred from the Fisher equation, the Fisher equation having become an inequality. All that can be said is that r < -dP/dt.

So, at the zero lower bound, achieving a recovery requires raising expected inflation. But how does raising expected inflation affect the nominal rate of interest? If r + dP/dt < 0, then increasing expected inflation will not increase the nominal rate of interest unless dP/dt increases enough to make r + dP/dt greater than zero. That’s what Keynes seemed to be saying in chapter 11, raising expected inflation won’t affect the nominal rate of interest, just the real rate. So Keynes’s criticism of the Fisher equation seems valid only in the pathological case when the Fisher equation is replaced by the Fisher inequality.

In my paper “The Fisher Effect Under Deflationary Expectations,” I found that a strongly positive correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year Treasuries) and asset prices (approximated by S&P 500) over the time period from spring 2008 through the end of 2010, while finding no such correlation over the period from 2003 to 2008. (Extending the data set through 2012 showed the relationship persisted through 2012 but may have broken down in 2013.) This empirical finding seems consistent with the notion that there has been something pathological about the period since 2008. Perhaps one way to think about the nature of the pathology is that the Fisher equation has been replaced by the Fisher inequality, a world in which changes in inflation expectations are reflected in changes in real interest rates instead of changes in nominal rates, the most peculiar kind of world described by Keynes in chapter 11 of the General Theory.

Friedman’s Dictum

In his gallant, but in my opinion futile, attempts to defend Milton Friedman against the scandalous charge that Friedman was, gasp, a Keynesian, if not in his policy prescriptions, at least in his theoretical orientation, Scott Sumner has several times referred to the contrast between the implication of the IS-LM model that expansionary monetary policy implies a reduced interest rate, and Friedman’s oft-repeated dictum that high interest rates are a sign of easy money, and low interest rates a sign of tight money. This was a very clever strategic and rhetorical move by Scott, because it did highlight a key difference between Keynesian and Monetarist ideas while distracting attention from the overlap between Friedman and Keynesians on the basic analytics of nominal-income determination.

Alghough I agree with Scott that Friedman’s dictum that high interest rates distinguishes him from Keynes and Keynesian economists, I think that Scott leaves out an important detail: Friedman’s dictum also distinguishes him from just about all pre-Keynesian monetary economists. Keynes did not invent the terms “dear money” and “cheap money.” Those terms were around for over a century before Keynes came on the scene, so Keynes and the Keynesians were merely reflecting the common understanding of all (or nearly all) economists that high interest rates were a sign of “dear” or “tight” money, and low interest rates a sign of “cheap” or “easy” money. For example, in his magisterial A Century of Bank Rate, Hawtrey actually provided numerical bounds on what constituted cheap or dear money in the period he examined, from 1844 to 1938. Cheap money corresponded to a bank rate less than 3.5% and dear money to a bank rate over 4.5%, 3.5 to 4.5% being the intermediate range.

Take the period just leading up to the Great Depression, when Britain returned to the gold standard in 1925. The Bank of England kept its bank rate over 5% almost continuously until well into 1930. Meanwhile the discount rate of the Federal Reserve System from 1925 to late 1928 was between 3.5 and 5%, the increase in the discount rate in 1928 to 5% representing a decisive shift toward tight money that helped drive the world economy into the Great Depression. We all know – and certainly no one better than Scott – that, in the late 1920s, the bank rate was an absolutely reliable indicator of the stance of monetary policy. So what are we to make of Friedman’s dictum?

I think that the key point is that traditional notions of central banking – the idea of “cheap” or “dear” money – were arrived at during the nineteenth century when almost all central banks were operating either in terms of a convertible (gold or silver or bimetallic) standard or with reference to such a standard, so that the effect of monetary policy on prices could be monitored by observing the discount of the currency relative to gold or silver. In other words, there was an international price level in terms of gold (or silver), and the price level of every country could be observed by looking at the relationship of its currency to gold (or silver). As long as convertibility was maintained between a currency and gold (or silver), the price level in terms of that currency was fixed.

If a central bank changed its bank rate, as long as convertibility was maintained (and obviously most changes in bank rate occurred with no change in convertibility), the effect of the change in bank rate was not reflected in the country’s price level (which was determined by convertibility). So what was the point of a change in bank rate under those circumstances? Simply for the central bank to increase or decrease its holding of reserves (usually gold or silver). By increasing bank rate, the central bank would accumulate additional reserves, and, by decreasing bank rate, it would reduce its reserves. A “dear money” policy was the means by which a central bank could add to its reserve and an “easy money” policy was the means by which it could disgorge reserves.

So the idea that a central bank operating under a convertible standard could control its price level was based on a misapprehension — a widely held misapprehension to be sure — but still a mistaken application of the naive quantity theory of money to a convertible monetary standard. Nevertheless, although the irrelevance of bank rate to the domestic price level was not always properly understood in the nineteenth century – economists associated with the Currency School were especially confused on this point — the practical association between interest rates and the stance of monetary policy was well understood, which is why all monetary theorists in the nineteenth and early twentieth centuries agreed that high interest rates were a sign of dear money and low interest rates a sign of cheap money. Keynes and the Keynesians were simply reflecting the conventional wisdom.

Now after World War II, when convertibility was no longer a real constraint on the price level (despite the sham convertibility of the Bretton Woods system), it was a true innovation of Friedman to point out that the old association between dear (cheap) money and high (low) interest rates was no longer a reliable indicator of the stance of monetary policy. However, as a knee-jerk follower of the Currency School – the 3% rule being Friedman’s attempt to adapt the Bank Charter Act of 1844 to a fiat currency, and with equally (and predictably) lousy results – Friedman never understood that under the gold standard, it is the price level which is fixed and the money supply that is endogenously determined, which is why much of the Monetary History, especially the part about the Great Depression (not, as Friedman called it, “Contraction,” erroneously implying that the change in the quantity of money was the cause, rather than the effect, of the deflation that characterized the Great Depression) is fundamentally misguided owing to its comprehensive misunderstanding of the monetary adjustment mechanism under a convertible standard.

PS This is written in haste, so there may be some errors insofar as I relying on my memory without checking my sources. I am sure that readers will correct my lapses of memory

PPS I also apologize for not responding to recent comments, I will try to rectify that transgression over the next few days.

My Milton Friedman Problem

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

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

PPS.  Paul Krugman recently wrote the following:

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

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

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

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

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

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

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

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

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

Scott responded:

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

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

To which I replied:

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

And finally Scott:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

What’s with Japan?

In my previous post, I pointed out that Ben Bernanke’s incoherent testimony on the US economy and Fed policy last Wednesday was followed, perhaps not coincidentally, by a 2% intraday drop in the S&P 500 and by a 7% drop in the Nikkei average. The drop in the Nikkei was also accompanied by a big drop in long-term bond prices, and by a big jump in the yen against all major currencies (almost 2% against the dollar).

For the past six months or so, ever since it became clear that Shinzo Abe and his Liberal Democratic party would, after two decades of deflation, win the December elections on a platform of monetary expansion and a 2% inflation target, the Nikkei average has risen by over 50% while the yen has depreciated by 25% against the dollar. The Japanese stock-market boom also seems to have been accompanied by tangible evidence of increased output, as real Japanese GDP increased at a 3.5% annual rate in the first quarter.

The aggressive program of monetary expansion combined with an increased inflation target has made Japan the poster child for Market Monetarists, so it is not surprising that the tumble in the Nikkei average and in the Japanese long-term bonds were pointed to as warning signs that the incipient boom in the Japanese economy might turn out to be a flop. Scott Sumner and Lars Christensen, among others, effectively demolished some of the nonsensical claims made about the simultaneous drop in the Japanese stock and bond markets, the main point being that rising interest rates in Japan are a sign not of the failure of monetary policy, but its success. By looking at changes in interest rates as if they occurred in vacuum, without any consideration of the underlying forces accounting for those changes – either increased expected inflation or an increased rate of return on investment – critics of monetary expansion stumble into all sorts of fallacies and absurdities.

Nevertheless, neither Scott nor Lars addresses a basic problem: what exactly was happening on Black Thursday in Japan when stock prices fell by 7% while bond prices also fell? If bond prices fell, it could be either because expectations of inflation rose or because real interest rates rose. But why would either of those be associated with falling stock prices? Increased expected inflation would not tend to reduce the value of assets, because the future nominal value of cash flows would increase along with discount rates corresponding to the expected loss in the purchasing power of yen. Now there might be some second-order losses associated with increased expected inflation, but it is hard to imagine that they could come anywhere close to accounting for a 7% drop in stock prices. On the other hand, if the increase in interest rates reflects an increased real rate of return on investment, one would normally assume that the increased rate of return on investment would correspond to increased real future cash flows, so it is also hard to understand why a steep fall in asset values would coincide with a sharp fall in bond prices.

Moreover, the puzzle is made even more perplexing if one considers that the yen was appreciating sharply against the dollar on Black Thursday, reversing the steady depreciation of the previous six months. Now what does it mean for the yen to be appreciating against the dollar? Well, basically it means that expectations of Japanese inflation relative to US inflation were going down not up, so it is hard to see how the drop in bond prices could be attributed to inflation expectations in any event.

But let’s just suppose that the Japanese, having experienced the positive effects of monetary expansion and an increased inflation target over the past six months, woke up on Black Thursday to news of Bernanke’s incoherent testimony to Congress suggesting that the Fed is looking for an excuse to withdraw from its own half-hearted attempts at monetary expansion. And perhaps — just perhaps — the Japanese were afraid that a reduced rate of monetary expansion in the US would make it more difficult for the Japan to continue its own program of monetary expansion, because a reduced rate of US monetary expansion, with no change in the rate of Japanese monetary expansion, would lead to US pressure on Japan to prevent further depreciation of the yen against the dollar, or even pressure to reverse the yen depreciation of the last six months. Well, if that’s the case, I would guess that the Japanese would view their ability to engage in monetary expansion as being constrained by the willingness of the US to tolerate yen depreciation, a willingness that in turn would depend on the stance of US monetary policy.

In short, from the Japanese perspective, the easier US monetary policy is, the more space is available to the Japanese to loosen their monetary policy. Now if you think that this may be a bit far-fetched, you obviously haven’t been reading the Wall Street Journal editorial page, which periodically runs screeds about how easy US monetary policy is forcing other countries to adopt easy monetary policies.

That’s why Bernanke’s incoherent policy statement last Wednesday may have led to an expectation of a yen appreciation against the dollar, and why it also led to an expectation of reduced future Japanese cash flows. Reduced expectations of US monetary expansion and US economic growth imply a reduced demand for Japanese exports. In addition, the expectation of US pressure on Japan to reverse yen depreciation would imply a further contraction of Japanese domestic demand, further reducing expected cash flows and, consequently, Japanese asset prices. But how does this account for the drop in Japanese bond prices? Simple. To force an increase in the value of the yen against the dollar, the Bank of Japan would have to tighten money by raising Japanese interest rates.

PS Lars Christensen kindly informs me that he has a further discussion of Japanese monetary policy and the Nikkei sell-off here.


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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