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Temporary Equilibrium One More Time

It’s always nice to be noticed, especially by Paul Krugman. So I am not upset, but in his response to my previous post, I don’t think that Krugman quite understood what I was trying to convey. I will try to be clearer this time. It will be easiest if I just quote from his post and insert my comments or explanations.

Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”.

Actually, that’s not what I was trying to say. I wasn’t making any explicit connection between Hicks’s temporary-equilibrium concept from Value and Capital and the IS-LM model that he introduced two years earlier in his paper on Keynes and the Classics. Of course that doesn’t mean that the temporary equilibrium method isn’t connected to the IS-LM model; one would need to do a more in-depth study than I have done of Hicks’s intellectual development to determine how much IS-LM was influenced by Hicks’s interest in intertemporal equilibrium and in the method of temporary equilibrium as a way of analyzing intertemporal issues.

This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago.

Now I do think that it’s fair to say that the IS-LM model was very much in the spirit of Value and Capital, in which Hicks deployed an explicit general-equilibrium model to analyze an economy at a Keynesian level of aggregation: goods, bonds, and money. But the temporary-equilibrium aspect of Value and Capital went beyond the Keynesian analysis, because the temporary equilibrium analysis was explicitly intertemporal, all agents formulating plans based on explicit future price expectations, and the inconsistency between expected prices and actual prices was explicitly noted, while in the General Theory, and in IS-LM, price expectations were kept in the background, making an appearance only in the discussion of the marginal efficiency of capital.

So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful.

That is precisely where I think Krugman’s grasp on the concept of temporary equilibrium is slipping. Temporary equilibrium is indeed about periods, and it is explicitly dynamic. In my previous post I referred to Hicks’s discussion in Capital and Growth, about 25 years after writing Value and Capital, in which he wrote

The Temporary Equilibrium model of Value and Capital, also, is “quasi-static” [like the Keynes theory] – in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

As I read this passage now — and it really bothered me when I read it as I was writing my previous post — I realize that what Hicks was saying was that his desire to conform to the Keynesian paradigm led him to compromise the integrity of the temporary equilibrium model, by forcing it to be “quasi-static” when it really was essentially dynamic. The challenge has been to convert a “quasi-static” IS-LM model into something closer to the temporary-equilibrium method that Hicks introduced, but did not fully execute in Value and Capital.

What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equiibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket.

Yes, I agree! Rational expectations, full-equilibrium models have turned out to be a regression, not an advance. But the way I would make the point is that the temporary-equilibrium method provides a sort of a middle way to do intertemporal dynamics without presuming that consumption plans and investment plans are always optimal.

What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes.

Again, I agree. We can’t work without some sort of equilibrium conditions, but temporary equilibrium provides a way to keep the discipline of equilibrium without assuming (nearly) full optimality.

Still, Glasner says that temporary equilibrium must involve disappointed expectations, and fails to take account of the dynamics that must result as expectations are revised.

Perhaps I was unclear, but I thought I was saying just the opposite. It’s the “quasi-static” IS-LM model, not temporary equilibrium, that fails to take account of the dynamics produced by revised expectations.

I guess I’d say two things. First, I’m not sure that this is always true. Hicks did indeed assume static expectations — the future will be like the present; but in Keynes’s vision of an economy stuck in sustained depression, such static expectations will be more or less right.

Again, I agree. There may be self-fulfilling expectations of a low-income, low-employment equilibrium. But I don’t think that that is the only explanation for such a situation, and certainly not for the downturn that can lead to such an equilibrium.

Second, those of us who use temporary equilibrium often do think in terms of dynamics as expectations adjust. In fact, you could say that the textbook story of how the short-run aggregate supply curve adjusts over time, eventually restoring full employment, is just that kind of thing. It’s not a great story, but it is the kind of dynamics Glasner wants — and it’s Econ 101 stuff.

Again, I agree. It’s not a great story, but, like it or not, the story is not a Keynesian story.

So where does this leave us? I’m not sure, but my impression is that Krugman, in his admiration for the IS-LM model, is trying too hard to identify IS-LM with the temporary-equilibrium approach, which I think represented a major conceptual advance over both the Keynesian model and the IS-LM representation of the Keynesian model. Temporary equilibrium and IS-LM are not necessarily inconsistent, but I mainly wanted to point out that the two aren’t the same, and shouldn’t be conflated.

Krugman on Minsky, IS-LM and Temporary Equilibrium

Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS-LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory – precisely the stuff that could not easily be distilled into a simple analytic model.

Here’s Krugman:

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I.

There are really two questions here. The less important is whether something like IS-LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ.

It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that

Only a theory that was explicitly cyclical and overtly financial was capable of being useful

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says.

This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium.

But I would take issue with the following assertion by Krugman.

The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this.

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing.

When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary-equilibrium method.

Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self-fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment.

Now to be fair, I have to admit that Hicks, himself, who introduced the temporary-equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary-equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is.

Nick Rowe Teaches Us a Lot about Apples and Bananas

Last week I wrote a post responding to a post by Nick Rowe about money and coordination failures. Over the weekend, Nick posted a response to my post (and to one by Brad Delong). Nick’s latest post was all about apples and bananas. It was an interesting post, though for some reason – no doubt unrelated to its form or substance – I found the post difficult to read and think about. But having now read, and I think, understood (more or less), what Nick wrote, I confess to being somewhat underwhelmed. Let me try to explain why I don’t think that Nick has adequately addressed the point that I was raising.

That point being that while coordination failures can indeed be, and frequently are, the result of a monetary disturbance, one that creates an excess demand for money, thereby leading to a contraction of spending, and thus to a reduction of output and employment, it is also possible that a coordination failure can occur independently of a monetary disturbance, at least a disturbance that could be characterized as an excess demand for money that triggers a reduction in spending, income, output, and employment.

Without evaluating his reasoning, I will just restate key elements of Nick’s model – actually two parallel models. There are apple trees and banana trees, and people like to consume both apples and bananas. Some people own apple trees, and some people own banana trees. Owners of apple trees and owners of banana trees trade apples for bananas, so that they can consume a well-balanced diet of both apples and bananas. Oh, and there’s also some gold around. People like gold, but it’s not clear why. In one version of the model, people use it as a medium of exchange, selling bananas for gold and using gold to buy apples or selling apples for gold and using gold to buy bananas. In the other version of the model, people just barter apples for bananas. Nick then proceeds to show that if trade is conducted by barter, an increase in the demand for gold, does not affect the allocation of resources, because agents continue to trade apples for bananas to achieve the desired allocation, even if the value of gold is held fixed. However, if trade is mediated by gold, the increased demand for gold, with prices held fixed, implies corresponding excess supplies of both apples and bananas, preventing the optimal reallocation of apples and bananas through trade, which Nick characterizes as a recession. However, if there is a shift in demand from bananas to apples or vice versa, with prices fixed in either model, there will be an excess demand for bananas and an excess supply of apples (or vice versa). The outcome is suboptimal because Pareto-improving trade is prevented, but there is no recession in Nick’s view because the excess supply of one real good is exactly offset by an excess demand for the other real good. Finally, Nick considers a case in which there is trade in apple trees and banana trees. An increase in the demand for fruit trees, owing to a reduced rate of time preference, causes no problems in the barter model, because there is no impediment to trading apples for bananas. However, in the money model, the reduced rate of time preference causes an increase in the amount of gold people want to hold, the foregone interest from holding more having been reduced, which prevents optimal trade with prices held fixed.

Here are the conclusions that Nick draws from his two models.

Bottom line. My conclusions.

For the second shock (a change in preferences away from apples towards bananas), we get the same reduction in the volume of trade whether we are in a barter or a monetary economy. Monetary coordination failures play no role in this sort of “recession”. But would we call that a “recession”? Well, it doesn’t look like a normal recession, because there is an excess demand for bananas.

For both the first and third shocks, we get a reduction in the volume of trade in a monetary economy, and none in the barter economy. Monetary coordination failures play a decisive role in these sorts of recessions, even though the third shock that caused the recession was not a monetary shock. It was simply an increased demand for fruit trees, because agents became more patient. And these sorts of recessions do look like recessions, because there is an excess supply of both apples and bananas.

Or, to say the same thing another way: if we want to understand a decrease in output and employment caused by structural unemployment, monetary coordination failures don’t matter, and we can ignore money. Everything else is a monetary coordination failure. Even if the original shock was not a monetary shock, that non-monetary shock can cause a recession because it causes a monetary coordination failure.

Why am I underwhelmed by Nick’s conclusions? Well, it just seems that, WADR, he is making a really trivial point. I mean in a two-good world with essentially two representative agents, there is not really that much that can go wrong. To put this model through its limited endowment of possible disturbances, and to show that only an excess demand for money implies a “recession,” doesn’t seem to me to prove a great deal. And I was tempted to say that the main thing that it proves is how minimal is the contribution to macroeconomic understanding that can be derived from a two-good, two-agent model.

But, in fact, even within a two-good, two-agent model, it turns out there is room for a coordination problem, not considered by Nick, to occur. In his very astute comment on Nick’s post, Kevin Donoghue correctly pointed out that even trade between an apple grower and a banana grower depends on the expectations of each that the other will actually have what to sell in the next period. How much each one plants depends on his expectations of how much the other will plant. If neither expects the other to plant, the output of both will fall.

Commenting on an excellent paper by Backhouse and Laidler about the promising developments in macroeconomics that were cut short because of the IS-LM revolution, I made reference to a passage quoted by Backhouse and Laidler from Bjorn Hansson about the Stockholm School. It was the Stockholm School along with Hayek who really began to think deeply about the relationship between expectations and coordination failures. Keynes also thought about that, but didn’t grasp the point as deeply as did the Swedes and the Austrians. Sorry to quote myself, but it’s already late and I’m getting tired. I think the quote explains what I think is so lacking in a lot of modern macroeconomics, and, I am sorry to say, in Nick’s discussion of apples and bananas.

Backhouse and Laidler go on to cite the Stockholm School (of which Ohlin was a leading figure) as an example of explicitly dynamic analysis.

As Bjorn Hansson (1982) has shown, this group developed an explicit method, using the idea of a succession of “unit periods,” in which each period began with agents having plans based on newly formed expectations about the outcome of executing them, and ended with the economy in some new situation that was the outcome of executing them, and ended with the economy in some new situation that was the outcome of market processes set in motion by the incompatibility of those plans, and in which expectations had been reformulated, too, in the light of experience. They applied this method to the construction of a wide variety of what they called “model sequences,” many of which involved downward spirals in economic activity at whose very heart lay rising unemployment. This is not the place to discuss the vexed question of the extent to which some of this work anticipated the Keynesian multiplier process, but it should be noted that, in IS-LM, it is the limit to which such processes move, rather than the time path they follow to get there, that is emphasized.

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.

But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes. No wonder Ohlin sounds annoyed in his comment, quoted by Backhouse and Laidler, about Keynes. Tractability trumped insight.

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

Responding to Scott Sumner

Scott Sumner cites this passage from my previous post about coordination failures.

I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is so great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Evidently, Scott doesn’t quite find my argument that coordination failures are possible, even without an excess demand for money, persuasive. So he puts the following question to me.

Why is it different from alleviating an excess demand for money?

I suppose that my response is this is: I am not sure what the question means. Does Scott mean to say that he does not accept that in my examples there really is no excess demand for money? Or does he mean that the effects of the coordination failure are no different from what they would be if there were an excess demand for money, any deflationary problem being treatable by increasing the quantity of money, thereby creating an excess supply of money. If Scott’s question is the latter, then he might be saying that the two cases are observationally equivalent, so that my distinction between a coordination failure with an excess demand for money and a coordination failure without an excess demand for money is really not a difference worth making a fuss about. The first question raises an analytical issue; the second a pragmatic issue.

Scott continues:

As far as I know the demand for money is usually defined as either M/P or the Cambridge K.  In either case, a debt crisis might raise the demand for money, and cause a recession if the supply of money is fixed.  Or the Fed could adjust the supply of money to offset the change in the demand for money, and this would prevent any change in AD, P, and NGDP.

I don’t know what Scott means when he says that the demand for money is usually defined as M/P. M/P is a number of units of currency. The demand for money is some functional relationship between desired holdings of money and a list of variables that influence those desired holdings. To say that the demand for money is defined as M/P is to assert an identity between the amount of money demanded and the amount in existence which rules out an excess demand for money by definition, so now I am really confused. The Cambridge k expresses the demand for money in terms of a desired relationship between the amount of money held and nominal income. But again, I can’t tell whether Scott is thinking of k as a functional relationship that depends on a list of variables or as a definition in which case the existence of an excess demand for money is ruled out by definition. So I am still confused.

I agree that a debt crisis could raise the demand for money, but in my example, it is entirely plausible that, on balance, the demand for money to hold went down because debtors would have to use all their resources to pay the interest owed on their debts.

I don’t disagree that the Fed could engage in a monetary policy that would alleviate the debt burden, but the problem they would be addressing would not be an excess demand for money; the problem being addressed would be the debt burden. but under a gold clause inflation wouldn’t help because creditors would be protected from inflation by the requirement that they be repaid in terms of a constant gold value.

Scott concludes:

Perhaps David sees the debt crisis working through supply-side channels—causing a recession despite no change in NGDP.  That’s possible, but it’s not at all clear to me that this is what David has in mind.

The case I had in mind may or may not be associated with a change in NGDP, but any change in NGDP was not induced by an excess demand for money; it was induced by an increase in the value of gold when debts were denominated, as they were under the gold clause, in terms of gold.

I hope that this helps.

PS I see that Nick Rowe has a new post responding to my previous post. I have not yet read it. But it is near the top of my required reading list, so I hope to have a response for him in the next day or two.

Nick Rowe on Money and Coordination Failures

Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.

His post is quite a long one – over 3000 words, all his own – so I won’t try to summarize it, but the main message is that what characterizes money economies – economies in which there is a single asset that serves as the medium of exchange – is that money is involved in almost every transaction. And when a coordination failure occurs in such an economy, there being lots of unsold good and unemployed workers, the proper way to think about what is happening is that it is hard to buy money. Another way of saying that it is hard to buy money is that there is an excess demand for money.

Nick tries to frame his discussion in terms of Walras’s Law. Walras’s Law is a property of a general-equilibrium system in which there are n goods (and services). Some of these goods are produced and sold in the current period; others exist either as gifts of nature (e.g., land and other privately owned natural resources), as legacies of past production). Walras’s Law tells us that in a competitive system in which all transactors can trade at competitive prices, it must be the case that planned sales and purchases (including asset accumulation) for each individual and for all individuals collectively must cancel out. The value of my planned purchases must equal the value of my planned sales. This is a direct implication of the assumption that prices for each good are uniform for all individuals, and the assumption that goods and services may be transferred between individuals only via market transactions (no theft or robbery). Walras’s Law holds even if there is no equilibrium, but only in the notional sense that value of planned purchases and planned sales would exactly cancel each other out. In general-equilibrium models, no trading is allowed except at the equilibrium price vector.

Walras’ Law says that if you have a $1 billion excess supply of newly-produced goods, you must have a $1 billion excess demand for something else. And that something else could be anything. It could be money, or it could be bonds, or it could be land, or it could be safe assets, or it could be….anything other than newly-produced goods. The excess demand that offsets that excess supply for newly-produced goods could pop up anywhere. Daniel Kuehn called this the “Whack-a-mole theory of business cycles”.

If Walras’ Law were right, recessions could be caused by an excess demand for unobtanium, which has zero supply, but a big demand, and the government stupidly passed a law setting a finite maximum price per kilogram for something that doesn’t even exist, thereby causing a recession and mass unemployment.

People might want to buy $1 billion of unobtanium per year, but that does not cause an excess supply of newly-produced goods. It does not cause an excess supply of anything. Because they cannot buy $1 billion of unobtanium. That excess demand for unobtanium does not affect anything anywhere in the economy. Yes, if 1 billion kgs of unobtanium were discovered, and offered for sale at $1 per kg, that would affect things. But it is the supply of unobtanium that would affect things, not the elimination of the excess demand. If instead you eliminated the excess demand by convincing people that unobtanium wasn’t worth buying, absolutely nothing would change.

An excess demand for unobtanium has absolutely zero effect on the economy. And that is true regardless of the properties of unobtanium. In particular, it makes absolutely no difference whether unobtanium is or is not a close substitute for money.

What is true for unobtanium is also true for any good for which there is excess demand. Except money. If you want to buy 10 bonds, or 10 acres of land, or 10 safe assets, but can only buy 6, because only 6 are offered for sale, those extra 4 bonds might as well be unobtanium. You want to buy 4 extra bonds, but you can’t, so you don’t. Just like you want to buy unobtanium, but you can’t, so you don’t. You can’t do anything so you don’t do anything.

Walras’ Law is wrong. Walras’ Law only works in an economy with one centralised market where all goods can be traded against each other at once. If the Walrasian auctioneer announced a finite price for unobtanium, there would be an excess demand for unobtanium and an excess supply of other goods. People would offer to sell $1 billion of some other goods to finance their offers to buy $1 billion of unobtanium. The only way the auctioneer could clear the market would be by refusing to accept offers to buy unobtanium. But in a monetary exchange economy the market for unobtanium would be a market where unobtanium trades for money. There would be an excess demand for unobtanium, matched by an equal excess supply of money, in that particular market. No other market would be affected, if people knew they could not in fact buy any unobtanium for money, even if they want to.

Now this is a really embarrassing admission to make – and right after making another embarrassing admission in my previous post – I need to stop this – but I have no idea what Nick is saying here. There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about. However, even though I can’t follow Nick’s reasoning, I totally agree with him that Walras’s Law is wrong. But the reason that it’s wrong is not that it implies that recessions could be caused by an excess demand for a non-existent good; the reason is that, in the only context in which a general-equilibrium model could be relevant for macroeconomics, i.e., an incomplete-markets model (aka the Radner model) in which individual agents are forming plans based on their expectations of future prices, prices that will only be observed in future periods, Walras’s Law cannot be true unless all agents have identical and correct expectations of all future prices.

Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world. When they don’t, Walras’s Law does not hold. When Walras’s Law doesn’t hold, things get messy; people default on their obligations, businesses go bankrupt, workers lose their jobs.

Nick thinks it’s all about money. Money is certainly one way in which things can get messed up. The government can cause inflation, and then stop it, as happened in 1920-21 and in 1981-82. People who expected inflation to continue, and made plans based on those expectations,were very likely unable to execute their plans when inflation stopped. But there are other reasons than incorrect inflation expectations that can cause people to have incorrect expectations of future prices.

Actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is go great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Nick invokes Hayek’s paper (“The Use of Knowledge in Society“) to explain how markets work to coordinate the decentralized plans of individual agents. Nick assumes that Hayek failed to mention money in that paper because money is so pervasive a feature of a real-world economy, that Hayek simply took its existence for granted. That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.

Explaining Post-Traumatic-Inflation Stress Disorder

Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

Hey, Look at Me; I Turned Brad Delong into an Apologist for Milton Friedman

It’s always nice to be noticed, so I can hardly complain if Brad Delong wants to defend Milton Friedman on his blog against my criticism of his paper “Real and Pseudo Gold Standards.” I just find it a little bit rich to see Friedman being defended against my criticism by the arch-Keynesian Brad Delong.

But in the spirit of friendly disagreement in which Brad criticizes my criticism, I shall return the compliment and offer some criticisms of my own of Brad’s valiant effort to defend the indefensible.

So let me try to parse what Brad is saying and see if Brad can help me find sense where before I could find none.

I think that Friedman’s paper has somewhat more coherence than David does. From Milton Friedman’s standpoint (and from John Maynard Keynes’s) you need microeconomic [I think Brad meant to say macroeconomic] stability in order for private laissez-faire to be for the best in the best of possible worlds. Macroeconomic stability is:

  1. stable and predictable paths for total spending, the price level, and interest rates; hence
  2. a stable and predictable path for the velocity of money; hence
  3. (1) then achieved by a stable and predictable path for the money stock; and
  4. if (3) is secured by institutions, then expectations of (3) will generate the possibility of (1) and (2) so that if (3) is actually carried out then eppur si muove

I agree with Brad that macroeconomic stability can be described as a persistent circumstance in which the paths for total spending, the price level, and (perhaps) interest rates are stable and predictable. I also agree that a stable and predictable path for the velocity of money is conducive to macroeconomic stability. But note the difference between saying that the time paths for total spending, the price level and (perhaps) interest rates are stable and predictable and that the time path for the velocity of money is stable and predictable. It is, at least possibly the case, that it is within the power of an enlightened monetary authority to provide, or that it would be possible to construct a monetary regime that could provide, stable and predictable paths for total spending and the price level. Whether it is also possible for a monetary authority or a monetary regime to provide a stable and predictable path for interest rates would depend on the inherent variability in the real rate of interest. It may be that variations in the real rate are triggered by avoidable variations in nominal rates, so that if nominal rates are stabilized, real rates will be stabilized, too. But it may be that real rates are inherently variable and unpredictable. But it is at least plausible to argue that the appropriate monetary policy or monetary regime would result in a stable and predictable path of real and nominal interest rates. However, I find it highly implausible to think that it is within the power of any monetary authority or monetary regime to provide a stable and predictable path for the velocity of money. On the contrary, it seems much more likely that in order to provide stability and predictability in the paths for total spending, the price level, and interest rates, the monetary authority or the monetary regime would have to tolerate substantial variations in the velocity of money associated with changes in the public’s demand to hold money. So the notion that a stable and predictable path for the money stock is a characteristic of macroeconomic stability, much less a condition for monetary stability, strikes me as a complete misconception, a misconception propagated, more than anyone else, by Milton Friedman, himself.

Thus, contrary to Brad’s assertion, a stable and predictable path for the money stock is more likely than not to be a condition not for macroeconomic stability, but of macroeconomic instability. And to support my contention that a stable and predictable path for the money stock is macroeconomically destabilizing, let me quote none other than F. A. Hayek. I quote Hayek not because I think he is more authoritative than Friedman – Hayek having made more than his share of bad macroeconomic policy calls (e.g. his 1932 defense of the insane Bank of France) – but because in his own polite way he simply demolished the fallacy underlying Friedman’s fetish with a fixed rate of growth in the money stock (Full Empoyment at Any Price).

I wish I could share the confidence of my friend Milton Friedman who thinks that one could deprive the monetary authorities, in order to prevent the abuse of their powers for political purposes, of all discretionary powers by prescribing the amount of money they may and should add to circulation in any one year. It seems to me that he regards this as practicable because he has become used for statistical purposes to draw a sharp distinction between what is to be regarded as money and what is not. This distinction does not exist in the real world. I believe that, to ensure the convertibility of all kinds of near-money into real money, which is necessary if we are to avoid severe liquidity crises or panics, the monetary authorities must be given some discretion. But I agree with Friedman that we will have to try and get back to a more or less automatic system for regulating the quantity of money in ordinary times. The necessity of “suspending” Sir Robert Peel’s Bank Act of 1844 three times within 25 years after it was passed ought to have taught us this once and for all.

He was briefer and more pointed in a later comment (Denationalization of Money).

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if it ever became known that the amount of cash in circulation was approaching the upper limit and that therefore a need for increased liquidity could not be met.

And for good measure, Hayek added this footnote quoting Bagehot:

To such a situation the classic account of Walter Bagehot . . . would apply: “In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin and would run like magic.

In other words if 3 is secured by institutions, all hell breaks loose.

But let us follow Brad a bit further in his quixotic quest to make Friedman seem sensible.

Now there are two different institutional setups that can produce (3):

  1. a monetarist central bank committed to targeting a k% growth rate of the money stock via open-market operations; or
  2. a gold standard in which a Humean price-specie flow mechanism leads inflating countries to lose and deflating countries to gain gold, tightly coupled to a banking system in which there is a reliable and stable money multiplier, and thus in which the money stock grows at the rate at which the world’s gold stock grows (plus the velocity trend).

Well, I have just – and not for the first time — disposed of 1, and in my previous post, I have disposed of 2. But having started to repeat myself, why not continue.

There are two points to make about the Humean price-specie-flow mechanism. First, it makes no sense, as Samuelson showed in his classic 1980 paper, inasmuch as it violates arbitrage conditions which do not allow the prices of tradable commodities to differ by more than the costs of transport. The Humean price-specie-flow mechanism presumes that the local domestic price levels are determined by local money supplies (either gold or convertible into gold), but that is simply not possible if arbitrage conditions obtain. There is no price-specie-flow mechanism under the gold standard, there is simply a movement of money sufficient to eliminate excess demands or supplies of money at the constant internationally determined price level. Domestic money supplies are endogenous and prices are (from the point of view of the monetary system) exogenously determined by the value of gold and the exchange rates of the local currencies in terms of gold. There is therefore no stable money multiplier at the level of a national currency (gold or convertible into gold). Friedman’s conception a pure [aka real] gold standard was predicated on a fallacy, namely the price-specie-flow mechanism. No gold standard in history ever operated as Friedman supposed that it operated. There were a few attempts to impose by statutory requirement a 100% (or sometime lower) marginal reserve requirement on banknotes, but that was statutory intervention, not a gold standard, which, at any operational level, is characterized by a fixed exchange rate between gold and the local currency with no restriction on the ability of economic agents to purchase gold at the going market price. the market price, under the gold standard, always equaling (or very closely approximating) the legal exchange rate between gold and the local currency.

Friedman calls (2) a “pure gold standard”. Anything else that claims to be a gold standard is and must be a “pseudo gold standard”. It might be a pseudo gold standard either because something disrupts the Humean price-specie flow mechanism–the “rules of the game” are not obeyed–so that deficit countries do not reliably lose and surplus countries do not reliably gain gold. It might be a pseudo gold standard because the money multiplier is not reliable and stable–because the banking system does not transparently and rapidly transmute a k% shift in the stock of gold into a k% shift in the money stock.

Friedman’s calling (2) “a pure [real] gold standard,” because it actualizes the Humean price-specie-flow-mechanism simply shows that Friedman understood neither the gold standard nor the price-specie-flow mechanism. The supposed rules of the game were designed to make the gold standard function in a particular way. In fact, the evidence shows that the classical gold standard in operation from roughly 1880 to 1914 operated with consistent departures from the “rules of the game.” What allows us to call the monetary regime in operation from 1880 to 1914 a gold standard is not that the rules of the game were observed but that the value of local currencies corresponded to the value of the gold with which they could be freely exchanged at the legal parities. No more and no less. And even Friedman was unwilling to call the gold standard in operation from 1880 to 1914 a pseudo gold standard, because if that was a pseudo-gold standard, there never was a real gold standard. So he was simply talking nonsense when he asserted that during the 1920s there a pseudo gold standard in operation even though gold was freely exchangeable for local currencies at the legal exchange rates.

Or, in short, to Friedman a gold standard is only a real gold standard if it produces a path for the money stock that is a k% rule. Anything else is a pseudo gold standard.

Yes! And that is what Friedman said, and it is absurd. And I am sure that Harry Johnson must have told him so.

The purpose of the paper, in short, is a Talmudic splitting-of-hairs. The point is to allow von Mises and Rueff and their not-so-deep-thinking latter-day followers (paging Paul Ryan! Paging Benn Steil! Paging Charles Koch! Paging Rand Paul!) to remain in their cloud-cuckoo-land of pledging allegiance to the gold standard as a golden calf while at the same time walling them off from and keeping them calm and supportive as the monetarist central bank does its job of keeping our fiat-money system stable by making Say’s Law true enough in practice.

As such, it succeeds admirably.

Or, at least, I think it does…

Have I just given an unconvincing Straussian reading of Friedman–that he knows what he is doing, and that what he is doing is leaving the theoretical husk to the fanatics von Mises and Rueff while keeping the rational kernel for himself, and making the point that a gold standard is a good monetary policy only if it turns out to mimic a good monetarist fiat-money standard policy? That his apparent confusion is simply a way of accomplishing those two tasks without splitting Mont Pelerin of the 1960s into yet more mutually-feuding camps?

I really sympathize with Brad’s effort to recruit Friedman into the worthy cause of combating nonsense. But you can’t combat nonsense with nonsense.

 


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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