Posts Tagged 'Keynes'

Does Macroeconomics Need Financial Foundations?

One of the little instances of collateral damage occasioned by the hue and cry following upon Stephen Williamson’s post arguing that quantitative easing has been deflationary was the dustup between Scott Sumner and financial journalist and blogger Izabella Kaminska. I am not going to comment on the specifics of their exchange except to say that the misunderstanding and hard feelings between them seem to have been resolved more or less amicably. However, in quickly skimming the exchange between them, I was rather struck by the condescending tone of Kaminska’s (perhaps understandable coming from the aggrieved party) comment about the lack of comprehension by Scott and Market Monetarists more generally of the basics of finance.

First I’d just like to say I feel much of the misunderstanding comes from the fact that market monetarists tend to ignore the influence of shadow banking and market plumbing in the monetary world. I also think (especially from my conversation with Lars Christensen) that they ignore technological disruption, and the influence this has on wealth distribution and purchasing decisions amongst the wealthy, banks and corporates. Also, as I outlined in the post, my view is slightly different to Williamson’s, it’s based mostly on the scarcity of safe assets and how this can magnify hoarding instincts and fragment store-of-value markets, in a Gresham’s law kind of way. Expectations obviously factor into it, and I think Williamson is absolutely right on that front. But personally I don’t think it’s anything to do with temporary or permanent money expansion expectations. IMO It’s much more about risk expectations, which can — if momentum builds — shift very very quickly, making something deflationary, inflationary very quickly. Though, that doesn’t mean I am worried about inflation (largely because I suspect we may have reached an important productivity inflection point).

This remark was followed up with several comments blasting Market Monetarists for their ignorance of the basics of finance and commending Kaminska for the depth of her understanding to which Kaminska warmly responded adding a few additional jibes at Sumner and Market Monetarists. Here is one.

Market monetarists are getting testy because now that everybody started scrutinizing QE they will be exposed as ignorant. The mechanisms they originally advocated QE would work through will be seen as hopelessly naive. For them the money is like glass beads squirting out of the Federal Reserve, you start talking about stuff like collateral, liquid assets, balance sheets and shadow banking and they are out of their depth.

For laughs: Sumner once tried to defend the childish textbook model of banks lending out reserves and it ended in a colossal embarrassment in the comments section http://www.themoneyillusion.com/?p=5893

For you to defend your credentials in front of such “experts” is absurd. There is a lot more depth to your understanding than to their sandbox vision of the monetary system. And yes, it *is* crazy that journalists and bloggers can talk about these things with more sense than academics. But this [is] the world we live in.

To which Kaminska graciously replied:

Thanks as well! And I tend to agree with your assessment of the market monetarist view of the world.

So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?

Well, this whole episode started when Stephen Williamson had a blog post arguing that QE was deflationary, and the reason it’s deflationary is that creating more high powered money provides the economy with more safe assets and thereby reduces the liquidity premium associated with safe assets like short-term Treasuries and cash. By reducing the liquidity premium, QE causes the real interest rate to fall, which implies a lower rate of inflation.

Kaminska thinks that this argument, which Market Monetarists find hard to digest, makes sense, though she can’t quite bring herself to endorse it either. But she finds the emphasis on collateral and safety and market plumbing very much to her taste. In my previous post, I raised what I thought were some problems with Williamson’s argument.

First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries? If I compare the rates on short-term Treasuries with the rates on commercial paper issued by non-Financial institutions, I don’t find much difference. If there is a substantial unmet demand for good collateral, and there is only a small difference in yield between commercial paper and short-term Treasuries, one would think that non-financial firms could make a killing by issuing a lot more commercial paper. When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.

Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset. If that is a possibility, why is the size of the liquidity premium not constrained?

I also pointed out in my previous post that a declining liquidity premium would be associated with a shift out of money and into real assets, which would cause an increase in asset prices. An increase in asset prices would tend to be associated with an increase in the value of the underlying service flows embodied in the assets, in other words in an increase in current prices, so that, if Williamson is right, QE should have caused measured inflation to rise even as it caused inflation expectations to fall. Of course Williamson believes that the decrease in liquidity premium is associated with a decline in real interest rates, but it is not clear that a decline in real interest rates has any implications for the current price level. So Williamson’s claim that his model explains the decline in observed inflation since QE was instituted does not seem all that compelling.

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

I don’t say that finance and banking are not important. Current spreads between borrowing and lending rates, may not provide a sufficient margin for banks to provide the intermediation services that they once provided to a wide range of customers. Businesses have a wider range of options in obtaining financing than they used to, so instead of holding bank accounts with banks and foregoing interest on deposits to be able to have a credit line with their banker, they park their money with a money market fund and obtain financing by issuing commercial paper. This works well for firms large enough to have direct access to lenders, but smaller businesses can’t borrow directly from the market and can only borrow from banks at much higher rates or by absorbing higher costs on their bank accounts than they would bear on a money market fund.

At any rate, when market interest rates are low, and when perceived credit risks are high, there is very little margin for banks to earn a profit from intermediation. If so, the money multiplier — a crude measure of how much intermediation banks are engaging in goes down — it is up to the monetary authority to provide the public with the liquidity they demand by increasing the amount of bank reserves available to the banking system. Otherwise, total spending would contract sharply as the public tried to build up their cash balances by reducing their own spending – not a pretty picture.

So finance is certainly important, and I really ought to know more about market plumbing and counterparty risk  and all that than I do, but the most important thing to know about finance is that the financial system tends to break down when the jointly held expectations of borrowers and lenders that the loans that they agreed to would be repaid on schedule by the borrowers are disappointed. There are all kinds of reasons why, in a given case, those jointly held expectations might be disappointed. But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

Hawtrey’s Good and Bad Trade: Part II

Here I am again back at you finally with another installment in my series on Hawtrey’s Good and Bad Trade. In my first installment I provided some background on Hawtrey and a quick overview of the book, including a mention of the interesting fact (brought to my attention by David Laidler) that Hawtrey used the term “effective demand” in pretty much the same way that Keynes, some 20 years later, would use it in the General Theory.

In this post, I want to discuss what I consider the highlights of the first six chapters. The first chapter is a general introduction to the entire volume laying out the basic premise of the book, which is that the business cycle, understood as recurring fluctuations in the level of employment, is the result of monetary disturbances that lead to alternating phases of expansion and contraction. It is relatively easy for workers to find employment in expansions, but more difficult to do so in contractions. From the standpoint of the theory of economic equilibrium, the close correlation between employment and nominal income over the business cycle is somewhat paradoxical, because, according to the equilibrium theory, the allocation of resources is governed by relative, not absolute, prices. In the theory of equilibrium, a proportional increase or decrease in all prices should have no effect on employment. To explain the paradox, Hawtrey relies on the rigidity of some prices, and especially wages, an empirical fact that, Hawtrey believed, was an essential aspect of any economic system, and a necessary condition for the cyclicality of output and employment.

In Hawtrey’s view, economic expansions and contractions are caused by variations in effective demand, which he defines as total money income. (For reasons I discussed about a year and a half ago, I prefer to define “effective demand” as total money expenditure.) What determines effective demand, according to Hawtrey, is the relationship between the amount of money people are holding and the amount that they would, on average over time, like to hold. The way to think about the amount of money that people would like to hold is to imagine that there is some proportion of their annual income that people aim to hold in the form of cash.

The relationship between the amount of cash being held and the amount that people would like to hold depends on the nature of the monetary system. Hawtrey considers two types of monetary system: one type (discussed in chapter 2) is a pure fiat money system in which all money is issued by government; the other (discussed in chapter 3) is a credit system in which money is also created by banks by promising to redeem, on demand, their obligations (either deposits or negotiable banknotes) for fiat money. Credit money is issued by banks in exchange for a variety of assets, usually the untraded IOUs of borrowers.

In a pure fiat money system, effective demand depends chiefly on the amount of fiat money that people want to hold and on the amount of fiat money created by the government, fiat money being the only money available. A pure fiat money system, Hawtrey understood, was just the sort of system in which the propositions of the quantity theory of money would obtain at least in the medium to long run.

[I]f the adjustment [to a reduction in the quantity of money] could be made entirely by a suitable diminution of wages and salaries, accompanied by a corresponding diminution of prices, the commercial community could be placed forthwith in a new position of equilibrium, in which the output would continue unchanged, and distribution would only be modified by the apportionment of a somewhat larger share of the national product to the possessors of interest, rent, and other kinds of fixed incomes. In fact, the change in the circulating medium is merely a change in the machinery of distribution, and a change, moreover, which, once made, does not impair the effectiveness of that machinery. If the habits of the community are adapted without delay to the change, the production of wealth will continue unabated. If customary prices resist the change, the adjustment, which is bound to come sooner or later, will only be forced upon the people by the pressure of distress. (p. 41)

In a fiat money system, if the public have less money than they would like to hold their only recourse is to attempt to reduce their expenditures relative to their receipts, either offering more in exchange, which tends to depress prices or reducing their purchases, making it that much more difficult for anyone to increase sales except by reducing prices. The problem is that in a fiat system the amount of money is what it is, so that if one person manages to increase his holdings of money by increasing sales relative to purchases, his increase in cash balances must have be gained at the expense of someone else. With a fixed amount of fiat money in existence, the public as a whole cannot increase their holdings of cash, so equilibrium can be restored only by reducing the quantity of money demanded. But the reduction in the amount of money that people want to hold cannot occur unless income in money terms goes down. Money income can go down only if total output in real terms, or if the price level, falls. With nominal income down, people, wanting to hold some particular share of their nominal income in the form of money, will be content with a smaller cash balance than they were before, and will stop trying to increase their cash balances by cutting their expenditure. Because some prices — and especially wages — tend to be sticky, Hawtrey felt that it was inevitable that the adjustment to reduction in the amount of fiat money would cause both real income and prices to fall.

Although Hawtrey correctly perceived that the simple quantity theory would not, even in theory, hold precisely for a credit system, his analysis of the credit system was incomplete inasmuch as he did not fully take into account the factors governing the public’s choice between holding credit money as opposed to fiat money or the incentives of the banking system to create credit money. That theory was not worked out till James Tobin did so 50 years later (another important anniversary worthy of note), though John Fullarton made an impressive start in his great work on the subject in 1844, a work Hawtrey must have been familiar with, but, to my knowledge, never discussed in detail.

In such a banking system there is no necessary connexion between the total of the deposits and the amount of coin which has been paid to the banks. A banker may at any time grant a customer a loan by simply adding to the balance standing to the customer’s credit in the books of the bank. No cash passes, but the customer acquires the right, during the currency of the loan, to draw cheques on the bank up to the amount lent. When the period of the loan expires, if the customer has a large enough balance to his credit, the loan can be repaid without any cash being employed, the amount of the loan being simply deducted from the balance. So long as the loan is outstanding it represents a clear addition to the available stock of “money,” in the sense of purchasing power. It is “money” in the the sense which will play, in a community possessing banks, the same part as money in the stricter sense of legal tender currency would play in the fictitious bankless community whose commercial conditions we previously have been considering. This is the most distinctive feature of the banking system, that between the stock of legal tender currency and the trading community there is interposed an intermediary, the banker, who can, if he wishes, create money out of nothing. (PP. 56-57)

This formulation is incomplete, inasmuch as it leaves the decision of the banker about how much money to create unconstrained by the usual forces of marginal revenue and marginal cost that supposedly determine the decisions of other profit-seeking businessmen. Hawtrey is not oblivious to the problem, but does not advance the analysis as far as he might have.

We have now to find out how this functionary uses his power and under what limitations he works. Something has already been said of the contingencies for which he must provide. Whenever he grants a loan and thereby creates money, he must expect a certain portion of this money to be applied sooner or later, to purposes for which legal tender currency is necessary. Sums will be drawn out from time to time to be spent either in wages or in small purchases, and the currency so applied will take a little time to find its way back to the banks. Large purchases will be paid for by cheque, involving a mere transfer of credit from one banking account to another, but the recipient of the cheque may wish to apply it ot the payment of wages, etc. Thus the principal limitation upon the banker’s freedom to create money is that he must have a reserve to meet the fresh demands for cash to which the creation of new money may lead. (Id.)

This is a very narrow view, apparently assuming that there is but one banker and that the only drain on the reserves of the banker is the withdrawal of currency by depositors. The possibility that recipients of cheques drawn on one bank may prefer to hold those funds in a different bank so that the bank must pay a competitive rate of interest on its deposits to induce its deposits to be held rather than those of another bank is not considered.

In trade a seller encourages or discourages buyers by lowering or raising his prices. So a banker encourages or discourages borrowers by lowering or raising the rate of interest. (p.58)

Again, Hawtrey only saw half the picture. The banker is setting two rates: the rate that he charges borrowers and the rate that he pays to depositors. It is the spread between those two rates that determines the marginal revenue from creating another dollar of deposits. Given that marginal revenue, the banker must form some estimate of the likely cost associated with creating another dollar of deposits (an estimate that depends to a large degree on expectations that may or may not be turn out to be correct), and it is the comparison between the marginal revenue from creating additional deposits with the expected cost of creating additional deposits that determines whether a bank wants to expand or contract its deposits.

Of course, the incomplete analysis of the decision making of the banker is not just Hawtrey’s, it is characteristic of all Wicksellian natural-rate theories. However, in contrast to other versions of the natural-rate genre, Hawtrey managed to avoid the logical gap in those theories: the failure to see that it is the spread between the lending and the deposit rates, not the difference between the lending rate and the natural rate, that determines whether banks are trying to expand or contract. But that is a point that I will have to come back to in the next installment in this series in which I will try to follow through the main steps of Hawtrey’s argument about how a banking system adjusts to a reduction in the quantity of fiat money (aka legal tender currency or base money) is reduced. That analysis, which hinges on the role of merchants and traders whose holding of inventories of goods is financed by borrowing from the banks, was a critical intellectual innovation of Hawtrey’s and was the key to his avoidance of the Wicksellian explanatory gap.

Hicks on Keynes and the Theory of the Demand for Money

One of my favorite papers is one published by J. R. Hicks in 1935 “A Suggestion for Simplifying the Demand for Theory of Money.” The aim of that paper was to explain how to reconcile the concept of a demand for money into the theory of rational choice. Although Marshall had attempted to do so in his writings, his formulations of the idea were not fully satisfactory, and other Cambridge economists, notably Pigou, Lavington, Robertson, and Keynes, struggled to express the idea in a more satisfactory way than Marshall had done.

In Hicks’s introductory essay to volume II of his Collected Essays on Economic Theory in which his 1935 essay appears, Hicks recounts that Keynes told him after reading his essay that the essay was similar to the theory of liquidity preference, on which Keynes was then working.

To anyone who comes over from the theory of value to the theory of money, there are a number of things which are rather startling. Chief of these is the preoccupation of monetary theorists with a certain equation, which states that the price of goods multiplied by the quantity of goods equals the amount of money which is spent on them. The equation crops up again and again, and it has all sorts of ingenious little arithmetical tricks performed on it. Sometimes it comes out as MV = PT . . .

Now we, of the theory of value, are not unfamiliar with this equation, and there was a time when we used to attach as much importance to it as monetary theorists seem to do still. This was in the middle of the last century, when we used to talk about value being “a ratio between demand and supply.” Even now, we accept the equation, and work it, more or less implicitly, into our systems. But we are rather inclined to take it for granted, since it is rather tautologous, and since we have found that another equation, not alternative to the quantity equation, but complementary with it, is much more significant. This is the equation which states that the relative value of two commodities depends upon their relative marginal utility.

Now to an ingénue, who comes over to monetary theory, it is extremely trying to be deprived of this sheet-anchor. It was marginal utility that really made sense of the theory of value; and to come to a branch of economics which does without marginal utility altogether! No wonder there are such difficulties and such differences! What is wanted is a “marginal revolution!”

That is my suggestion. But I know that it will meet with apparently crushing objections. I shall be told that the suggestion has been tried out before. It was tried by Wicksell, and though it led to interesting results, it did not lead to a marginal utility theory of money. It was tried by Mises, and led to the conclusion that money is a ghost of gold – because, so it appeared, money as such has no marginal utility. The suggestion has a history, and its history is not encouraging.

This would be enough to frighten one off, were it not for two things. Both in the theory of value and in the theory of money there have been developments in the twenty of thirty years since Wicksell and Mises wrote. And these developments have considerably reduced the barriers that blocked their way.

In the theory of value, the work of Pareto, Wicksteed, and their successors, has broadened and deepened our whole conception of marginal utility. We now realize that the marginal utility analysis is nothing else than a general theory of choice, which is applicable whenever the choice is between alternatives that are capable of quantitative expression. Now money is obviously capable of quantitative expression, and therefore the objection that money has no marginal utility must be wrong. People do choose to have money rather than other things, and therefore, in the relevant sense, money must have a marginal utility.

But merely to call their marginal utility X, and then proceed to draw curves, would not be very helpful. Fortunately the developments in monetary theory to which I alluded come to our rescue.

Mr. Keynes’s Treatise, so far as I have been able to discover, contains at least three theories of money. One of them is the Savings and Investment theory, which . . . seems to me only a quantity theory much glorified. One of them is a Wicksellian natural rate theory. But the third is altogether more interesting. It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor – to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the “bearishness” or “bullishness” of the public, upon their relative desire for liquidity or profit.

My suggestion may, therefore, be reformulated. It seems to me that this third theory of Mr. Keynes really contains the most important of his theoretical contribution; that here, at last, we have something which, on the analogy (the approximate analogy) of value theory, does begin to offer a chance of making the whole thing easily intelligible; that it si form this point, not from velocity of circulation, or Saving and Investment, that we ought to start in constructing the theory of money. But in saying this I am being more Keynesian than Keynes [note to Blue Aurora this was written in 1934 and published in 1935].

The point of this extended quotation, in case it is not obvious to the reader, is that Hicks is here crediting Keynes in his Treatise on Money with a crucial conceptual advance in formulating a theory of the demand for money consistent with the marginalist theory of value. Hicks himself recognized that Keynes in the General Theory worked out a more comprehensive version of the theory than that which he presented in his essay, even though they were not entirely the same. So there was no excuse for Friedman to present a theory of the demand for money which he described “as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets,” without crediting Keynes for that theory, just because he rejected the idea of absolute liquidity preference.

Here is how Hicks summed up the relationship in his introductory essay referred to above.

Keynes’s Liquidity theory was so near to mine, and was put over in so much more effective a way than I could hope to achieve, that it seemed pointless, at first, to emphasize differences. Sometimes, indeed, he put his in such a way that there was hardly any difference. But, as time went on, what came to be regarded in many quarters, as Keynesian theory was something much more mechanical than he had probably intended. It was certainly more mechanical than I had intended. So in the end I had ot go back to “Simplifying,” and to insist that its message was a Declaration of Independence, not only from the “free market” school from which I was expressly liberating myself, but also from what came to pass as Keynesian economics.

Liquidity Trap or Credit Deadlock

In earlier posts in my series about Hawtrey and Keynes, I’ve mentioned the close connection between Hawtrey’s concept of a “credit deadlock” and the better-known Keynesian concept of a “liquidity trap,” a term actually coined by J. R. Hicks in his classic paper summarizing the Keynesian system by way of the IS-LM model. As I’ve previously noted, the two concepts, though similar, are not identical, a characteristic of much of their work on money and business cycles. Their ideas, often very similar, almost always differ in some important way, often leading to sharply different policy implications. Keynes recognized the similarities in their thinking, acknowledging his intellectual debt to Hawtrey several times, but, on occasion, Keynes could not contain his frustration and exasperation with what he felt was Hawtrey’s obstinate refusal to see what he was driving at.

In this post, commenter GDF asked me about the credit deadlock and the liquidity trap:

Would you mind explaining your thoughts apropos of differences between Hawtrey’s credit deadlock theory and Keynes’ liquidity trap. It seems to me that modern liquidity trapists like Krugman, Woodford etc. have more in common with Hawtrey than Keynes in the sense that they deal with low money demand elasticity w.r.t. the short rate rather than high money demand elasticity w.r.t. the long rate.

To which I answered:

My view is that credit deadlock refers to a situation of extreme entrepreneurial pessimism, which I would associate with negative real rates of interest. Keynes’s liquidity trap occurs at positive real rates of interest (not the zero lower bound) because bear bond speculators will not allow the long-term rate to fall below some lower threshold because of the risk of suffering a capital loss on long-term bonds once the interest rate rises. Hawtrey did not think much of this argument.

Subsequently in this post, commenter Rob Rawlings suggested that I write about the credit deadlock and provided a link to a draft of a paper by Roger Sandilands, “Hawtreyan ‘Credit Deadlock’ or Keynesian ‘Liquidity Trap’? Lessons for Japan from the Great Depression” (eventually published as the final chapter in the volume David Laidler’s Contributions to Economics, edited by Robert Leeson, an outstanding collection of papers celebrating one of the greatest economists of our time). In our recent exchange of emails about Hawtrey, Laidler also drew my attention to Sandilands’s paper.

Sandilands’s paper covers an extremely wide range of topics in both the history of economics (mainly about Hawtrey and especially the largely forgotten Laughlin Currie), the history of the Great Depression, and the chronic Japanese deflation and slowdown since the early 1990s. But for this post, the relevant point from Sandilands’s paper is the lengthy quotation with which he concludes from Laidler’s paper, “Woodford and Wicksell on Interest and Prices: The Place of the Pure Credit Economy in the Theory of Monetary Policy.”

To begin with, a “liquidity trap” is a state of affairs in which the demnd for money becomes perfectly elastic with respect to a long rate of interest at some low positive level of the latter. Until the policy of “quantitative easing” was begun in 2001, the ratio of the Japanese money stock to national income, whether money was measured by the base, M1, or any broader aggregate, rose slowly at best, and it was short, not long, rates of interest that were essentially zero. Given these facts, it is hard to see what the empirical basis for the diagnosis of a liquidity trap could have been. On the other hand, and again before 2001, the empirical evidence gave no reason to reject the hypothesis that a quite separate and distinct phenomenon was at work, namely a Hawtreyan “credit deadlock”. Here the problem is not a high elasticity of the economy’s demand for money with respect to the long rate of interest, but a low elasticity of its demand for bank credit with respect to the short rate, which inhibits the borrowing that is a necessary prerequisite for money creation. The solution to a credit deadlock, as Hawtrey pointed out, is vigorous open market operations to bring about increases in the monetary base, and therefore the supply of chequable deposits, that mere manipulation of short term interest rates is usually sufficient to accomplish in less depressed times.

Now the conditions for a liquidity trap might indeed have existed in Japan in the 1990s. Until the credit deadlock affecting its monetary system was broken by quantitative easing in 2001 . . . it was impossible to know this. As it has happened, however, the subsequent vigorous up-turn of the Japanese economy that began in 2002 and is still proceeding is beginning to suggest that there was no liquidity trap at work in that economy. If further evidence bears out this conclusion, a serious policy error was made in the 1990s, and that error was based on a theory of monetary policy that treats the short interest rate as the central bank’s only tool, and characterizes the transmission mechanism as working solely through the influence of interest rates on aggregate demand.

That theory provided no means for Japanese policy makers to distinguish between a liquidity trap, which is a possible feature of the demand for money function, and a credit deadlock which is a characteristic of the money supply process, or for them to entertain the possibility that variations in the money supply might affect aggregate demand by channels over and above any effect on market rates of interest. It was therefore a dangerously defective guide to the conduct of monetary policy in Japan, as it is in any depressed economy.

Laidler is making two important points in this quotation. First, he is distinguishing, a bit more fully than I did in my reply above to GDF, between a credit deadlock and a liquidity trap. The liquidity trap is a property of the demand for money, premised on an empirical hypothesis of Keynes about the existence of bear speculators (afraid of taking capital losses once the long-term rate rises to its normal level) willing to hold unlimited amounts of money rather than long-term bonds, once long-term rates approach some low, but positive, level. But under Keynes’s analysis, there would be no reason why the banking system would not supply the amount of money demanded by bear speculators. In Hawtrey’s credit deadlock, however, the problem is not that the demand to hold money becomes perfectly elastic when the long-term rate reaches some low level, but that, because entrepreneurial expectations are so pessimistic, banks cannot find borrowers to lend to, even if short-term rates fall to zero. Keynes and Hawtrey were positing different causal mechanisms, Keynes focusing on the demand to hold money, Hawtrey on the supply of bank money. (I would note parenthetically that Laidler is leaving out an important distinction between the zero rate at which the central bank is lending to banks and the positive rate — sufficient to cover intermediation costs – at which banks will lend to their customers. The lack of borrowing at the zero lower bound is at least partly a reflection of a disintermediation process that occurs when there is insufficient loan demand to make intermediation by commercial banks profitable.)

Laidler’s second point is an empirical judgment about the Japanese experience in the 1990s and early 2000s. He argues that the relative success of quantitative easing in Japan in the early 2000s shows that Japan was suffering not from a liquidity trap, but from a credit deadlock. That quantitative easing succeeded in Japan after years of stagnation and slow monetary growth suggests to Laidler that the problem in the 1990s was not a liquidity trap, but a credit deadlock. If there was a liquidity trap, why did the unlimited demand to hold cash on the part of bear speculators not elicit a huge increase in the Japanese money supply? In fact, the Japanese money supply increased only modestly in the 1990s. The Japanese recovery in the early 200s coincided with a rapid increase in the money supply in response to open-market purchases by the Bank of Japan.  Quantitative easing worked not through a reduction of interest rates, but through the portfolio effects of increasing the quantity of cash balances in the economy, causing an increase in spending as a way of reducing unwanted cash balances.

How, then, on Laidler’s account, can we explain the feebleness of the US recovery from the 2007-09 downturn, notwithstanding the massive increase in the US monetary base? One possible answer, of course, is that the stimulative effects of increasing the monetary base have been sterilized by the Fed’s policy of paying interest on reserves. The other answer is that increasing the monetary base in a state of credit deadlock can stimulate a recovery only by changing expectations. However, long-term expectations, as reflected in the long-term real interest rates implicit in TIPS spreads, seem to have become more pessimistic since quantitative easing began in 2009. In this context, a passage, quoted by Sandilands, from the 1950 edition of Hawtrey’s Currency and Credit seems highly relevant.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.

Hawtrey and the “Treasury View”

Mention the name Ralph Hawtrey to most economists, even, I daresay to most monetary economists, and you are unlikely to get much more than a blank stare. Some might recognize the name because of it is associated with Keynes, but few are likely to be able to cite any particular achievement or contribution for which he is remembered or worth remembering. Actually, your best chance of eliciting a response about Hawtrey might be to pose your query to an acolyte of Austrian Business Cycle theory, for whom Hawtrey frequently serves as a foil, because of his belief that central banks ought to implement a policy of price-level (actually wage-level) stabilization to dampen the business cycle, Murray Rothbard having described him as “one of the evil genius of the 1920s” (right up there, no doubt, with the likes of Lenin, Trotsky, Stalin and Mussolini). But if, despite the odds, you found someone who knew something about Hawtrey, there’s a good chance that it would be for his articulation of what has come to be known as the “Treasury View.”

The Treasury View was a position articulated in 1929 by Winston Churchill, then Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, in a speech to the House of Commons opposing proposals by Lloyd George and the Liberals, supported notably by Keynes, to increase government spending on public-works projects as a way of re-employing the unemployed. Churchill invoked the “orthodox Treasury View” that spending on public works would simply divert an equal amount of private spending on other investment projects or consumption. Spending on public-works projects was justified if and only if the rate of return over cost from those projects was judged to be greater than the rate of return over cost from alternative private spending; public works spending could not be justified as a means by which to put the unemployed back to work. The theoretical basis for this position was an article published by Hawtrey in 1925 “Public Expenditure and the Demand for Labour.”

Exactly how Hawtrey’s position first articulated in a professional economics journal four years earlier became the orthodox Treasury View in March 1929 is far from clear. Alan Gaukroger in his doctoral dissertation on Hawtrey’s career at the Treasury provides much helpful background information. Apparently, Hawtrey’s position was elevated into the “orthodox Treasury View” because Churchill required some authority on which to rely in opposing Liberal agitation for public-works spending which the Conservative government and Churchill’s top Treasury advisers and the Bank of England did not want to adopt for a variety of reason. The “orthodox Treasury View” provided a convenient and respectable doctrinal cover with which to clothe their largely political opposition to public-works spending. This is not to say that Churchill and his advisers were insincere in taking the position that they did, merely that Churchill’s position emerged from on-the-spot political improvisation in the course of which Hawtrey’s paper was dredged up from obscurity rather than from applying any long-standing, well-established, Treasury doctrine. For an illuminating discussion of all this, see chapter 5 (pp. 234-75) of Gaukroger’s dissertation.

I have seen references to the Treasury View for a very long time, probably no later than my first year in graduate school, but until a week or two ago, I had never actually read Hawtrey’s 1925 paper. Brad Delong, who has waged a bit of a campaign against the Treasury View on his blog as part of his larger war against opponents of President Obama’s stimulus program, once left a comment on a post of mine about Hawtrey’s explanation of the Great Depression, asking whether I would defend Hawtrey’s position that public-works spending would not increase employment. I think I responded by pleading ignorance of what Hawtrey had actually said in his 1925 article, but that Hawtrey’s explanation of the Great Depression was theoretically independent of his position about whether public-works spending could increase employment. So in a sense, this post is partly belated reply to Delong’s query.

The first thing to say about Hawtrey’s paper is that it’s hard to understand. Hawtrey is usually a very clear expositor of his ideas, but sometimes I just can’t figure out what he means. His introductory discussion of A. C. Pigou’s position on the wisdom of concentrating spending on public works in years of trade depression was largely incomprehensible to me, but it is worth reading, nevertheless, for the following commentary on a passage from Pigou’s Wealth and Welfare in which Pigou proposed to “pass behind the distorting veil of money.”

Perhaps if Professsor Pigou had carried the argument so far, he would have become convinced that the distorting veil of money cannot be put aside. As well might he play lawn tennis without the distorting veil of the net. All the skill and all the energy emanate from the players and are transmitted through the racket to the balls. The net does nothing; it is a mere limiting condition. So is money.

Employment is given by producers. They produce in response to an effective demand for products. Effective demand means ultimately money, offered by consumers in the market.

A wonderful insight, marvelously phrased, but I can’t really tell, beyond Pigou’s desire to ignore the “distorting veil of money,” how it relates to anything Pigou wrote. At any rate, from here Hawtrey proceeds to his substantive argument, positing “a community in which there is unemployment.” In other words, “at the existing level of prices and wages, the consumers’ outlay [Hawtrey's term for total spending] is sufficient only to employ a part of the productive resources of the country.” Beyond the bare statement that spending is insufficient to employ all resources at current prices, no deeper cause of unemployment is provided. The problem Hawtrey is going to address is what happens if the government borrows money to spend on new public works?

Hawtrey starts by assuming that the government borrows from private individuals (rather than from the central bank), allowing Hawtrey to take the quantity of money to be constant through the entire exercise, a crucial assumption. The funds that the government borrows therefore come either from that portion of consumer income that would have been saved, in which case they are not available to be spent on whatever private investment projects they would otherwise have financed, or they are taken from idle balances held by the public (the “unspent margin” in Hawtrey’s terminology). If the borrowed funds are obtained from cash held by the public, Hawtrey argues that the public will gradually reduce spending in order to restore their cash holdings to their normal level. Thus, either way, increased government spending financed by borrowing must be offset by a corresponding reduction in private spending. Nor does Hawtrey concede that there will necessarily be a temporary increase in spending, because the public may curtail expenditures to build up their cash balances in anticipation of lending to the government. Moreover, there is always an immediate effect on income from any form of spending (Hawtrey understood the idea of a multiplier effect, having relied on it in his explanation of how an increase in the stock of inventories held by traders in response to a cut in interest rates would produce a cumulative increase in total income and spending), so if government spending on public works reduces spending elsewhere, there is no necessary net increase in total spending even in the short run. Here is how Hawtrey sums up the crux of his argument.

To show why this does not happen, we must go back to consider the hypothesis with which we started. We assumed that no additional bank credits are created. It follows that there is no increase in the supply of the means of payment. As soon as the people employed on the new public works begin to receive payment, they will begin to accumulate cash balances and bank balances. Their balances can only be provided at the expense of the people already receiving incomes. These latter will therefore become short of ready cash and will curtail their expenditures with a view to restoring their balances. An individual can increase his balance by curtailing his expenditure, but if the unspent margin (that is to say, the total of all cash balances and bank balances) remains unchanged, he can only increase his balance at the expense of those of his neighbours. If all simultaneously try to increase their balances, they try in vain. The effect can only be that sales of goods are diminished, and the consumers’ income is reduced as much as the consumers’ outlay. In the end the normal proportion between the consumers’ income and the unspent margin is restored, not by an increase in balances, but by a decrease in incomes. It is this limitation of the unspent margin that really prevents the new Government expenditure from creating employment. (pp. 41-42)

Stated in these terms, the argument suggests another possible mechanism by which government expenditure could increase total income and employment: an increase in velocity. And Hawtrey explicitly recognized it.

There is, however, one possibility which would in certain conditions make the Government operations the means of a real increase in the rapidity of circulation. In a period of depression the rapidity of circulation is low, because people cannot find profitable outlets for their surplus funds and they accumulate idle balances. If the Government comes forward with an attractive gild-edged loan, it may raise money, not merely by taking the place of other possible capital issues, but by securing money that would otherwise have remained idle in balances. (pp. 42-43)

In other words, Hawtrey did indeed recognize the problem of a zero lower bound (in later works he called it a “credit deadlock”) in which the return to holding money exceeds the expected return from holding real capital assets, and that, in such circumstances, government spending could cause aggregate spending and income to increase.

Having established that, absent any increase in cash balances, government spending would have stimulative effects only at the zero lower bound, Hawtrey proceeded to analyze the case in which government spending increased along with an increase in cash balances.

In the simple case where the Government finances its operations by the creation of bank credits, there is no diminution in the consumers’ outlay to set against the new expenditure. It is not necessary for the whole of the expenditure to be so financed. All that is required is a sufficient increase in bank credits to supply balances of cash and credit for those engaged in the new enterprise, without diminishing the balances held by the rest of the community. . . . If the new works are financed by the creation of bank credits, they will give additional employment. (p. 43)

After making this concession, however, Hawtrey added a qualification, which has provoked the outrage of many Keynesians.

What has been shown is that expenditure on public works, if accompanied by a creation of credit, will give employment. But then the same reasoning shows that a creation of credit unaccompanied by any expenditure on public works would be equally effective in giving employment.

The public works are merely a piece of ritual, convenient to people who want to be able to say that they are doing something, but otherwise irrelevant. To stimulate an expansion of credit is usually only too easy. To resort for the purpose to the construction of expensive public works is to burn down the house for the sake of the roast pig.

That applies to the case where the works are financed by credit creation. In the practical application of the policy, however, this part of the programme is omitted. The works are started by the Government at the very moment when the central bank is doing all it can to prevent credit from expanding. The Chinaman burns down his house in emulation of his neighbour’s meal of roast pork, but omits the pig.

Keynesians are no doubt offended by the dismissive reference to public-works spending as “a piece of ritual.” But it is worth recalling the context in which Hawtrey published his paper in 1925 (read to the Economics Club on February 10). Britain was then in the final stages of restoring the prewar dollar-sterling parity in anticipation of formally reestablishing gold convertibility and the gold standard. In order to accomplish this goal, the Bank of England raised its bank rate to 5%, even though unemployment was still over 10%. Indeed, Hawtrey did favor going back on the gold standard, but not at any cost. His view was that the central position of London in international trade meant that the Bank of England had leeway to set its bank rate, and other central banks would adjust their rates to the bank rate in London. Hawtrey may or may not have been correct in assessing the extent of the discretionary power of the Bank of England to set its bank rate. But given his expansive view of the power of the Bank of England, it made no sense to Hawtrey that the Bank of England was setting its bank rate at 5% (historically a rate characterizing periods of “dear money” as Hawtrey demonstrated subsequently in his Century of Bank Rate) in order to reduce total spending, thereby inducing an inflow of gold, while the Government simultaneously initiated public-works spending to reduce unemployment. The unemployment was attributable to the restriction of spending caused by the high bank rate, so the obvious, and most effective, remedy for unemployment was a reduced bank rate, thereby inducing an automatic increase in spending. Given his view of the powers of the Bank of England, Hawtrey felt that the gold standard would take care of itself. But even if he was wrong, he did not feel that restoring the gold standard was worth the required contraction of spending and employment.

From the standpoint of pure monetary analysis, notwithstanding all the bad press that the “Treasury View” has received, there is very little on which to fault the paper that gave birth to the “Treasury View.”

Keynes v. Hawtrey on British Monetary Policy after Rejoining the Gold Standard

The close, but not always cozy, relationship between Keynes and Hawtrey was summed up beautifully by Keynes in 1929 when, commenting on a paper by Hawtrey, “Money and Index Numbers,” presented to the Royal Statistical Society, Keynes began as follows.

There are very few writers on monetary subjects from whom one receives more stimulus and useful suggestion . . . and I think there are few writers on these subjects with whom I personally feel more fundamental sympathy and agreement. The paradox is that in spite of that, I nearly always disagree in detail with what he says! Yet truly and sincerely he is one of the writers who seems to me to be most nearly on the right track!

The tension between these two friendly rivals was dramatically displayed in April 1930, when Hawtrey gave testimony before the Macmillan Committee (The Committee on Finance and Industry) established after the stock-market crash in 1929 to investigate the causes of depressed economic conditions and chronically high unemployment in Britain. The Committee, chaired by Hugh Pattison Macmillan, included an impressive roster of prominent economists, financiers, civil servants, and politicians, but its dominant figure was undoubtedly Keynes, who was a relentless interrogator of witnesses and principal author of the Committee’s final report. Keynes’s position was that, having mistakenly rejoined the gold standard at the prewar parity in 1925, Britain had no alternative but to follow a policy of high interest rates to protect the dollar-sterling exchange rate that had been so imprudently adopted. Under those circumstances, reducing unemployment required a different kind of policy intervention from reducing the bank rate, which is what Hawtrey had been advocating continuously since 1925.

In chapter 5 of his outstanding doctoral dissertation on Hawtrey’s career at the Treasury, which for me has been a gold mine (no pun intended) of information, Alan Gaukroger discusses the work of the Macmillan Committee, focusing particularly on Hawtrey’s testimony in April 1930 and the reaction to that testimony by the Committee. Especially interesting are the excerpts from Hawtrey’s responses to questions asked by the Committee, mostly by Keynes. Hawtrey’s argument was that despite the overvaluation of sterling, the Bank of England could have reduced British unemployment had it dared to cut the bank rate rather than raise it to 5% in 1925 before rejoining the gold standard and keeping it there, with only very brief reductions to 4 or 4.5% subsequently. Although reducing bank rate would likely have caused an outflow of gold, Hawtrey believed that the gold standard was not worth the game if it could only be sustained at the cost of the chronically high unemployment that was the necessary consequence of dear money. But more than that, Hawtrey believed that, because of London’s importance as the principal center for financing international trade, cutting interest rates in London would have led to a fall in interest rates in the rest of the world, thereby moderating the loss of gold and reducing the risk of being forced off the gold standard. It was on that point that Hawtrey faced the toughest questioning.

After Hawtrey’s first day of his testimony, in which he argued to a skeptical committee that the Bank of England, if it were willing to take the lead in reducing interest rates, could induce a world-wide reduction in interest rates, Hawtrey was confronted by the chairman of the Committee, Hugh Macmillan. Summarizing Hawtrey’s position, Macmillan entered into the following exchange with Hawtrey

MACMILLAN. Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY. I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, and might have continued with a 4 percent Bank Rate.

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

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

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

HAWTREY. . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it. I think it is possible that the situation arose in the interval between the return to the gold standard . . . and the early part of 1927 . . . That was the period at which the greater part of the fall in the [international] price level took place. [Gaukroger, p. 298]

Somewhat later, Keynes began his questioning.

KEYNES. When we returned to the gold standard we tried to restore equilibrium by trying to lower prices here, whereas we could have used our influence much more effectively by trying to raise prices elsewhere?

HAWTREY. Yes.

KEYNES . . . I should like to take the argument a little further . . . . the reason the method adopted has not been successful, as I understand you, is partly . . . the intrinsic difficulty of . . . [reducing] wages?

HAWTREY. Yes.

KEYNES. . . . and partly the fact that the effort to reduce [prices] causes a sympathetic movement abroad . . .?

HAWTREY. Yes.

KEYNES. . . . you assume a low Bank Rate [here] would have raised prices elsewhere?

HAWTREY. Yes.

KEYNES. But it would also, presumably, have raised [prices] here?

HAWTREY. . . . what I have been saying . . . is aimed primarily at avoiding the fall in prices both here and abroad. . . .it is possible there might have been an actual rise in prices here . . .

KEYNES. One would have expected our Bank Rate to have more effect on our own price level than on the price level of the rest of the world?

HAWTREY. Yes.

KEYNES. So, in that case . . . wouldn’t dear money have been more efficacious . . . in restoring equilibrium between home and foreign price . . .?

HAWTREY. . . .the export of gold itself would have tended to produce equilibrium. It depends very much at what stage you suppose the process to be applied.

KEYNES. . . . so cheap money here affects the outside world more than it affects us, but dear money here affects us more than it affects the outside world.

HAWTREY. No. My suggestion is that through cheap money here, the export of gold encourages credit expansion elsewhere, but the loss of gold tends to have some restrictive effect on credit here.

KEYNES. But this can only happen if the loss of gold causes a reversal of the cheap money policy?

HAWTREY. No, I think that the export of gold has some effect consistent with cheap money.

In his questioning, Keynes focused on an apparent asymmetry in Hawtrey’s argument. Hawtrey had argued that allowing an efflux of gold would encourage credit expansion in the rest of the world, which would make it easier for British prices to adjust to a rising international price level rather than having to fall all the way to a stable or declining international price level. Keynes countered that, even if the rest of the world adjusted its policy to the easier British policy, it was not plausible to assume that the effect of British policy would be greater on the international price level than on the internal British price level. Thus, for British monetary policy to facilitate the adjustment of the internal British price level to the international price level, cheap money would tend to be self-defeating, inasmuch as cheap money would tend to raise British prices faster than it raised the international price level. Thus, according to Keynes, for monetary policy to close the gap between the elevated internal British price level and the international price level, a dear-money policy was necessary, because dear money would reduce British internal prices faster than it reduced international prices.

Hawtrey’s response was that the export of gold would induce a policy change by other central banks. What Keynes called a dear-money policy was the status quo policy in which the Bank of England was aiming to maintain its current gold reserve. Under Hawtrey’s implicit central-bank reaction function, dear money (i.e., holding Bank of England gold reserves constant) would induce no reaction by other central banks. However, an easy-money policy (i.e., exporting Bank of England gold reserves) would induce a “sympathetic” easing of policy by other central banks. Thus, the asymmetry in Hawtrey’s argument was not really an asymmetry, because, in the context of the exchange between Keynes and Hawtrey, dear money meant keeping Bank of England gold reserves constant, while easy money meant allowing the export of gold. Thus, only easy money would induce a sympathetic response from other central banks. Unfortunately, Hawtrey’s response did not explain that the asymmetry identified by Keynes was a property not of Hawtrey’s central-bank reaction function, but of Keynes’s implicit definitions of cheap and dear money. Instead, Hawtrey offered a cryptic response about “the loss of gold tend[ing] to have some restrictive effect on credit” in Britain.

The larger point is that, regardless of the validity of Hawtrey’s central-bank reaction function as a representation of the role of the Bank of England in the international monetary system under the interwar gold standard, Hawtrey’s model of how the gold standard operated was not called into question by this exchange. It is not clear from the exchange whether Keynes was actually trying to challenge Hawtrey on his model of the international monetary system or was just trying to cast doubt on Hawtrey’s position that monetary policy was, on its own, a powerful enough instrument to have eliminated unemployment in Britain without adopting any other remedial policies, especially Keynes’s preferred policy of public works. As the theoretical source of the Treasury View that public works were incapable of increasing employment without monetary expansion, it is entirely possible that that was Keynes’s ultimate objective. However, with the passage of time, Keynes drifted farther and farther away from the monetary model that, in large measure, he shared with Hawtrey in the 1920s and the early 1930s.

Keynes and Hawtrey: The General Theory

Before pausing for an interlude about the dueling reviews of Hayek and Hawtrey on each other’s works in the February 1932 issue of Economica, I had taken my discussion of the long personal and professional relationship between Hawtrey and Keynes through Hawtrey’s review of Keynes’s Treatise on Money. The review was originally written as a Treasury document for Hawtrey’s superiors at the Treasury (and eventually published in slightly revised form as chapter six of The Art of Central Banking), but Hawtrey sent it almost immediately to Keynes. Although Hawtrey subjected Keynes’s key analytical result in the Treatise — his fundamental equations, relating changes in the price level to the difference between savings and investment — to sharp criticism, Keynes responded to Hawtrey’s criticisms with (possibly uncharacteristic) good grace, writing back to Hawtrey: “it is very seldom indeed that an author can expect to get as a criticism anything so tremendously useful to himself,” adding that he was “working it out all over again.” What Keynes was working out all over again of course eventually evolved into his General Theory.

Probably because Keynes had benefited so much from Hawtrey’s comments on and criticisms of the Treatise, which he received only shortly before delivering the final draft to the publisher, Keynes began sending Hawtrey early drafts of the General Theory instead of waiting, as he had when writing the Treatise, till the book was almost done. There was thus a protracted period of debate and argument between Keynes and Hawtrey over the General Theory, a process that clearly frustrated and annoyed Keynes, though he never actually terminated the discussion with Hawtrey. “Hawtrey,” Keynes wrote to his wife in 1933, “was very sweet to the last but quite mad. One can argue with him a long time on a perfectly sane and interesting basis and then, suddenly, one is in a madhouse.” On the accuracy of that characterization, I cannot comment, but clearly the two Cambridge Apostles were failing to communicate.

The General Theory was published in February 1936, and hardly a month had passed before Hawtrey shared his thoughts about the General Theory with his Treasury colleagues. (Hawtrey subsequently published the review in his collection of essays Capital and Employment.) Hawtrey began by expressing his doubts about Keynes’s attempt to formulate an alternative theory of interest based on liquidity preference in place of the classical theory based on time preference and productivity.

According to [Keynes], the rate of interest is to be regarded not as the reward of abstaining from consumption or of “waiting”, but as the reward of forgoing liquidity. By tying up their savings in investments people forgo liquidity, and the extent to which they are willing to do so will depend on the rate of interest. Anyone’s “liquidity preference” is a function relating the amount of his resources which he will wish ot retain in the form of money to different sets of circumstances, and among those circumstances will be the rate of interest. . . . The supply of money determines the rate of interest, and the rate of interest so determined governs the volume of capital outlay.

As in his criticism of the fundamental equations of the Treatise, Hawtrey was again sharply critical of Keynes’s tendency to argue from definitions rather than from causal relationships.

[A]n essential step in [Keynes's] train of reasoning is the proposition that investment an saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary. [quoted by Alan Gaukroger "The Director of Financial Enquiries A Study of the Treasury Career of R. G. Hawtrey, 1919-1939." pp. 507-08]

But despite the verbal difference between them, Keynes and Hawtrey held a common view that the rate of interest might be too high to allow full employment. Keynes argued that liquidity preference could prevent monetary policy from reducing the rate of interest to a level at which there would be enough private investment spending to generate full employment. Hawtrey held a similar view, except that, according to Hawtrey, the barrier to a sufficient reduction in the rate of interest to allow full employment was not liquidity preference, but a malfunctioning international monetary system under a gold-standard, or fixed-exchange rate, regime. For any country operating under a fixed-exchange-rate or balance-of-payments constraint, the interest rate has to be held at a level consistent with maintaining the gold-standard parity. But that interest rate depends on the interest rates that other countries are setting. Thus, a country may find itself in a situation in which the interest rate consistent with full employment is inconsistent with maintaining its gold-standard parity. Indeed all countries on a gold standard or a fixed exchange rate regime may have interest rates too high for full employment, but each one may feel that it can’t reduce its own interest rate without endangering its exchange-rate parity.

Under the gold standard in the 1920s and 1930s, Hawtrey argued, interest rates were chronically too high to allow full employment, and no country was willing to risk unilaterally reducing its own interest rates, lest it provoke a balance-of-payments crisis. After the 1929 crash, even though interest rates came down, they came down too slowly to stimulate a recovery, because no country would cut interest rates as much and as fast as necessary out of fear doing so would trigger a currency crisis. From 1925, when Britain rejoined the gold standard, to 1931 when Britain left the gold standard, Hawtrey never stopped arguing for lower interest rates, because he was convinced that credit expansion was the only way to increase output and employment. The Bank of England would lose gold, but Hawtrey argued that the point of a gold reserve was to use it when it was necessary. By emitting gold, the Bank of England would encourage other countries to ease their monetary policies and follow England in reducing their interest rates. That, at any rate, is what Hawtrey hoped would happen. Perhaps he was wrong in that hope; we will never know. But even if he was, the outcome would certainly not have been any worse than what resulted from the policy that Hawtrey opposed.

To the contemporary observer, the sense of déjà vu is palpable.

Hayek v. Hawtrey on the Trade Cycle

While searching for material on the close and multi-faceted relationship between Keynes and Hawtrey which I am now studying and writing about, I came across a remarkable juxtaposition of two reviews in the British economics journal Economica, published by the London School of Economics. Economica was, after the Economic Journal published at Cambridge (and edited for many years by Keynes), probably the most important economics journal published in Britain in the early 1930s. Having just arrived in Britain in 1931 to a spectacularly successful debut with his four lectures at LSE, which were soon published as Prices and Production, and having accepted the offer of a professorship at LSE, Hayek began an intense period of teaching and publishing, almost immediately becoming the chief rival of Keynes. The rivalry had been more or less officially inaugurated when Hayek published the first of his two-part review-essay of Keynes’s recently published Treatise on Money in the August 1931 issue of Economica, followed by Keynes’s ill-tempered reply and Hayek’s rejoinder in the November 1931 issue, with the second part of Hayek’s review appearing in the February 1932 issue.

But interestingly in the same February issue containing the second installment of Hayek’s lengthy review essay, Hayek also published a short (2 pages, 3 paragraphs) review of Hawtrey’s Trade Depression and the Way Out immediately following Hawtrey’s review of Hayek’s Prices and Production in the same issue. So not only was Hayek engaging in controversy with Keynes, he was arguing with Hawtrey as well. The points at issue were similar in the two exchanges, but there may well be more to learn from the lower-key, less polemical, exchange between Hayek and Hawtrey than from the overheated exchange between Hayek and Keynes.

So here is my summary (in reverse order) of the two reviews:

Hayek on Trade Depression and the Way Out.

Hayek, in his usual polite fashion, begins by praising Hawtrey’s theoretical eminence and skill as a clear expositor of his position. (“the rare clarity and painstaking precision of his theoretical exposition and his very exceptional knowledge of facts making anything that comes from his pen well worth reading.”) However, noting that Hawtrey’s book was aimed at a popular rather than a professional audience, Hayek accuses Hawtrey of oversimplification in attributing the depression to a lack of monetary stimulus.

Hayek proceeds in his second paragraph to explain what he means by oversimplification. Hayek agrees that the origin of the depression was monetary, but he disputes Hawtrey’s belief that the deflationary shocks were crucial.

[Hawtrey's] insistence upon the relation between “consumers’ income” and “consumers’ outlay” as the only relevant factor prevents him from seeing the highly important effects of monetary causes upon the capitalistic structure of production and leads him along the paths of the “purchasing power theorists” who see the source of all evil in the insufficiency of demand for consumers goods. . . . Against all empirical evidence, he insists that “the first symptom of contracting demand is a decline in sales to the consumer or final purchaser.” In fact, of course, depression has always begun with a decline in demand, not for consumers’ goods but for capital goods, and the one marked phenomenon of the present depression was that the demand for consumers’ goods was very well maintained for a long while after the crisis occurred.

Hayek’s comment seems to me to misinterpret Hawtrey slightly. Hawtrey wrote “a decline in sales to the consumer or final purchaser,” which could refer to a decline in the sales of capital equipment as well as the sales of consumption goods, so Hawtrey’s assertion was not necessarily inconsistent with Hayek’s representation about the stability of consumption expenditure immediately following a cyclical downturn. It would also not be hard to modify Hawtrey’s statement slightly; in an accelerator model, with which Hawtrey was certainly familiar, investment depends on the growth of consumption expenditures, so that a leveling off of consumption, rather than an actual downturn in consumption, would suffice to trigger the downturn in investment which, according to Hayek, was a generally accepted stylized fact characterizing the cyclical downturn.

Hayek continues:

[W]hat Mr. Hawtrey, in common with many other English economists [I wonder whom Hayek could be thinking of], lacks is an adequate basic theory of the factors which affect [the] capitalistic structure of production.

Because of Hawtrey’s preoccupation with the movements of the overall price level, Hayek accuses Hawtrey of attributing the depression solely “to a process of deflation” for which the remedy is credit expansion by the central banks. [Sound familiar?]

[Hawtrey] seems to extend [blame for the depression] on the policy of the Bank of England even to the period before 1929, though according to his own criterion – the rise in the prices of the original factors of production [i.e., wages] – it is clear that, in that period, the trouble was too much credit expansion. “In 1929,” Mr. Hawtrey writes, “when productive activity was at its highest in the United States, wages were 120 percent higher than in 1913, while commodity prices were only 50 percent higher.” Even if we take into account the fact that the greater part of this rise in wages took place before 1921, it is clear that we had much more credit expansion before 1929 than would have been necessary to maintain the world-wage-level. It is not difficult to imagine what would have been the consequences if, during that period, the Bank of England had followed Mr. Hawtrey’s advice and had shown still less reluctance to let go. But perhaps, this would have exposed the dangers of such frankly inflationist advice quicker than will now be the case.

A remarkable passage indeed! To accuse Hawtrey of toleration of inflation, he insinuates that the 50% rise in wages from 1913 to 1929, was at least in part attributable to the inflationary policies Hawtrey was advocating. In fact, I believe that it is clear, though I don’t have easy access to the best data source C. H. Feinstein’s “Changes in Nominal Wages, the Cost of Living, and Real Wages in the United Kingdom over Two Centuries, 1780-1990,” in Labour’s Reward edited by P. Schoillers and V. Zamagni (1995). From 1922 to 1929 the overall trend of nominal wages in Britain was actually negative. Hayek’s reference to “frankly inflationist advice” was not just wrong, but wrong-headed.

Hawtrey on Prices and Production

Hawtrey spends the first two or three pages or so of his review giving a summary of Hayek’s theory, explaining the underlying connection between Hayek and the Bohm-Bawerkian theory of production as a process in time, with the length of time from beginning to end of the production process being a function of the rate of interest. Thus, reducing the rate of interest leads to a lengthening of the production process (average period of production). Credit expansion financed by bank lending is the key cyclical variable, lengthening the period of production, but only temporarily.

The lengthening of the period of production can only take place as long as inflation is increasing, but inflation cannot increase indefinitely. When inflation stops increasing, the period of production starts to contract. Hawtrey explains:

Some intermediate products (“non-specific”) can readily be transferred from one process to another, but others (“specific”) cannot. These latter will no longer be needed. Those who have been using them, and still more those who have producing them, will be thrown out of employment. And here is the “explanation of how it comes about at certain times that some of the existing resources cannot be used.” . . .

The originating cause of the disturbance would therefore be the artificially enhanced demand for producers’ goods arising when the creation of credit in favour of producers supplements the normal flow savings out of income. It is only because the latter cannot last for ever that the reaction which results in under-employment occurs.

But Hawtrey observes that only a small part of the annual capital outlay is applied to lengthening the period of production, capital outlay being devoted mostly to increasing output within the existing period of production, or to enhancing productivity through the addition of new plant and equipment embodying technical progress and new inventions. Thus, most capital spending, even when financed by credit creation, is not associated with any alteration in the period of production. Hawtrey would later introduce the terms capital widening and capital deepening to describe investments that do not affect the period of production and those that do affect it. Nor, in general, are capital-deepening investments the most likely to be adopted in response to a change in the rate of interest.

Similarly, If the rate of interest were to rise, making the most roundabout processes unprofitable, it does not follow that such processes will have to be scrapped.

A piece of equipment may have been installed, of which the yield, in terms of labour saved, is 4 percent on its cost. If the market rate of interest rises to 5 percent, it would no longer be profitable to install a similar piece. But that does not mean that, once installed, it will be left idle. The yield of 4 percent is better than nothing. . . .

When the scrapping of plant is hastened on account of the discovery of some technically improved process, there is a loss not only of interest but of the residue of depreciation allowance that would otherwise have accumulated during its life of usefulness. It is only when the new process promises a very suitable gain in efficiency that premature scrapping is worthwhile. A mere rise in the rate of interest could never have that effect.

But though a rise in the rate of interest is not likely to cause the scrapping of plant, it may prevent the installation of new plant of the kind affected. Those who produce such plant would be thrown out of employment, and it is this effect which is, I think, the main part of Dr. Hayek’s explanation of trade depressions.

But what is the possible magnitude of the effect? The transition from activity to depression is accompanied by a rise in the rate of interest. But the rise in the long-term rate is very slight, and moreover, once depression has set in, the long-term rate is usually lower than ever.

Changes are in any case perpetually occurring in the character of the plant and instrumental goods produced for use in industry. Such changes are apt to throw out of employment any highly specialized capital and labour engaged in the production of plant which becomes obsolete. But among the causes of obsolescence a rise in the rate of interest is certainly one of the least important and over short periods it may safely be said to be quite negligible.

Hawtrey goes on to question Hayek’s implicit assumption that the effects of the depression were an inevitable result of stopping the expansion of credit, an assumption that Hayek disavowed much later, but it was not unreasonable for Hawtrey to challenge Hayek on this point.

It is remarkable that Dr. Hayek does not entertain the possibility of a contraction of credit; he is content to deal with the cessation of further expansion. He maintains that at a time of depression a credit expansion cannot provide a remedy, because if the proportion between the demand for consumers’ goods and the demand for producers’ goods “is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed.” But if credit being contracted, the proportion is being distorted by an artificial restriction of demand.

The expansion of credit is assumed to start by chance, or at any rate no cause is suggested. It is maintained because the rise of prices offers temporary extra profits to entrepreneurs. A contraction of credit might equally well be assumed to start, and then to be maintained because the fall of prices inflicts temporary losses on entrepreneurs, and deters them from borrowing. Is not this to be corrected by credit expansion?

Dr. Hayek recognizes no cause of under-employment of the factors of production except a change in the structure of production, a “shortening of the period.” He does not consider the possibility that if, through a credit contraction or for any other reason, less money altogether is spent on intermediate products (capital goods), the factors of production engaged in producing these products will be under-employed.

Hawtrey then discusses the tension between Hayek’s recognition that the sense in which the quantity of money should be kept constant is the maintenance of a constant stream of money expenditure, so that in fact an ideal monetary policy would adjust the quantity of money to compensate for changes in velocity. Nevertheless, Hayek did not feel that it was within the capacity of monetary policy to adjust the quantity of money in such a way as to keep total monetary expenditure constant over the course of the business cycle.

Here are the concluding two paragraphs of Hawtrey’s review:

In conclusion, I feel bound to say that Dr. Hayek has spoiled an original piece of work which might have been an important contribution to monetary theory, by entangling his argument with the intolerably cumbersome theory of capital derived from Jevons and Bohm-Bawerk. This theory, when it was enunciated, was a noteworthy new departure in the metaphysics of political economy. But it is singularly ill-adapted for use in monetary theory, or indeed in any practical treatment of the capital market.

The result has been to make Dr. Hayek’s work so difficult and obscure that it is impossible to understand his little book of 112 pages except at the cost of many hours of hard work. And at the end we are left with the impression, not only that this is not a necessary consequence of the difficulty of the subject, but that he himself has been led by so ill-chosen a method of analysis to conclusions which he would hardly have accepted if given a more straightforward form of expression.

Keynes and Hawtrey: The Treatise on Money and Discovering the Multiplier

In my previous post on Keynes and Hawtrey, I tried to show the close resemblance between their upbringing and education and early careers. It becomes apparent that Keynes’s brilliance, and perhaps also his more distinguished family connections, had already enabled Keynes to begin overshadowing Hawtrey, four years his senior, as Keynes was approaching his thirties, and by 1919, when Hawtrey was turning 40, Keynes, having achieved something close to superstardom with the publication of The Econoomic Consequences of the Peace, had clearly eclipsed Hawtrey as a public figure, though as a pure monetary theoretician Hawtrey still had a claim to be the more influential of the two. For most of the 1920s, their relative standing did not change greatly, Hawtrey writing prolifically for economics journals as well as several volumes on monetary theory and a general treatise on economics, but without making much of an impression on broader public opinion, while Keynes, who continued to write primarily for a non-professional, though elite, audience, had the much higher public profile.

In the mid-1920s Keynes began writing his first systematic work on monetary theory and policy, the Treatise on Money. The extent to which Keynes communicated with Hawtrey about the Treatise in the five or six years during which he was working on it is unknown to me, but Keynes did send Hawtrey the proofs of the Treatise (totaling over 700 pages) in installments between April and July 1930. Hawtrey sent Keynes detailed comments, which Keynes later called “tremendously useful,” but, except for some minor points, Keynes could not incorporate most of the lengthy comments, criticisms or suggestions he received from Hawtrey before sending the final version of the Treatise to the publisher on September 14. Keynes did not mention Hawtrey in the preface to the Treatise, in which D. H. Robertson, R. F. Kahn, and H. D. Henderson were acknowledged for their assistance. Hawtrey would be mentioned along with Kahn, Joan Robinson, and Roy Harrod in the preface to the General Theory, but Hawtrey’s role in the preparation of the General Theory will be the subject of my next installment in this series. Hawtrey published his comments on the Treatise in his 1932 volume The Art of Central Banking.

Not long after the Treatise was published, and almost immediately subjected to critical reviews by Robertson and Hayek, among others, Keynes made it known that he was dissatisfied with the argument of the Treatise, and began work on what would eventually evolve into the General Theory. Hawtrey’s discussion was especially notable for two criticisms.  First Hawtrey explained that Keynes’s argument that an excess of investment over saving caused prices to rise was in fact a tautology entailed by Keynes’s definition of savings and investment.

[T]he fundamental equations disclose . . . that the price level is composed of two terms, one of which is cost per unit and the other is the difference between price and cost per unit.

Thus the difference between saving and investment is simply another name for the windfall gains or losses or for the difference between prices and costs of output. Throughout the Treatise Mr. Keynes adduces a divergence between saving and investment as the criterion of a departure from monetary equilibrium. But this criterion is nothing more or less than a divergence between prices and costs. Though the criterion ostensibly depends on two economic activities, “investment” and “saving,” it depends in reality not on them but on movements of the price level relative to costs.

That does not mean that the price level may not be influenced by changes in investment or in saving in some sense. But Mr. Keynes’s formula does not record such changes till their effect upon the price level is an accomplished fact. (p. 336)

Hawtrey’s other important criticism was his observation that Keynes assumed that a monetary disequilibrium would manifest itself exclusively in price changes and not at all in changes in output and employment. In fact this criticism followed naturally from Hawtrey’s criticism of Keynes’s definitions of savings and investment, from which the fundamental equations were derived, as not being grounded in the decisions of consumers and entrepreneurs.

With regard to savings, the individual consumers decide what they shall spend (or refrain from spending) on consumption. The balance of their earnings is “savings.” But the balance of their incomes (earnings plus windfall gains) is “investment.” Their decisions determine the amount of investment just as truly and in just the same way as they determine the amount of savings.

For all except entrepreneurs, earnings and income are the same. For entrepreneurs they differ if, and only if, there is a windfall gain or loss. But if there is a windfall gains, the recipients must decide what to do with it exactly as with any other receipt. If there is a windfall loss, the victims are deemed, according to Mr. Keynes’s definition of saving, to “save” the money they do not receive. But this is the result of the definition, not of any “decision.” (p. 345)

Preferring the more natural definition of savings as unconsumed income and of investment as capital outlay, Hawtrey proceeded to suggest an alternative analysis of an increase in saving by consumers. In the alternative analysis both output and prices could vary. It was Hawtrey therefore who provided the impetus for a switch to output and employment, not just prices, as equilibrating variable to a monetary disequilibrium.

It has been pointed out above that a difference between savings and investment [as defined by Keynes] cannot be regarded as the cause of a windfall loss or gain, for it is the windfall loss or gain. To find a causal sequence, we must turn to the decisions relating to consumption and capital outlay. When we do so, we find the windfall loss or gain to be one only among several consequences, and neither the earliest, nor necessarily the most important.

Throughout the Treatise Mr. Keynes refers to these decisions, and bases his argument upon them. And I think it is true to say that almost everywhere what he says may be interpreted as applying to the modified analysis which we have arrived at just as well as to that embodied in his fundamental equations. (p. 349)

To a large extent, Hawtrey’s criticisms of Keynes were criticisms of Keynes’s choice of definitions and the formal structure of his model rather than of the underlying theoretical intuition motivating Keynes’s theoretical apparatus. Hawtrey made this point in correcting Keynes’s misinterpretation of Hawtrey’s own position.

Mr. Keynes attributes to me (rather tentatively, it is true) acceptance of the view of “Bank rate as acting directly on the quantity of bank credit and so on prices in accordance with the Quantity Equation” (vol. 1., p. 188). But the passage which he quotes from my Currency and Credit contains no reference, explicit or implicit, to the quantity equation. Possibly I have misled him by using the expression “contraction of credit” for what I have sometimes called more accurately a “retardation of the creation of credit.”

The doctrine that I have consistently adhered to, that an acceleration or retardation of the creation of credit acts through changes in consumers’ income and outlay on the price level and on productive activity, and not through changes in the unspent margin [Hawtrey's term of holdings of cash], is, I think, very close to Mr. Keynees’s theory. (p. 363)

In drawing attention to his belief “that an acceleration or retardation of the creation of credit acts through changes in consumers’ income and outlay . . . not through changes in the unspent margin,” Hawtrey emphasized that his monetary theory was not strictly speaking a quantity-theoretic monetary theory, as Keynes had erroneously suggested. Rather, he shared with Keynes the belief that there is a tendency for changes in expenditure and income to be cumulative. It was Hawtrey’s belief that the most reliable method by which such changes in income and expenditure could be realized was by way of changes in the short-term interest rate, which normally cause businesses and traders to alter their desired stocks of unfinished goods, working capital and inventories. Those changes, in turn, lead to increases in output and income and consumer outlay, which trigger further increases, and so on. In short, as early as 1913, Hawtrey had already sketched out in Good and Bad Trade the essential concept of a multiplier process initiated by changes in short-term interest rates, by way of their effect on desired stocks of working capital and inventories.

Thus, it is a complete misunderstanding of Hawtrey to suggest that, in the words of Peter Clarke (The Keynesian Revolution in the Making  pp. 242-43) that he was “the man who, having stumbled upon [the multiplier], painstakingly suppressed news of its discovery in his subsequent publications.” The multiplier analysis was not stumbled upon, nor was it suppressed. Rather, Hawtrey simply held that, under normal conditions, unless supported by credit expansion (i.e., a lower bank rate), increased government spending would be offset by reduced spending elsewhere producing no net increase in spending and therefore no multiplier effect. In fact, Hawtrey in 1931 in his Trade Depression and the Way Out (or perhaps only in the second 1933 edition of that book) conceded that under conditions of what he called a “credit deadlock” in which businesses could not be induced to borrow to increase spending, monetary policy would not be effective unless it was used to directly finance government spending. In Keynesian terminology, the situation was described as a liquidity trap, and we no refer to it as the zero lower bound. But the formal analysis of the multiplier was a staple of Hawtrey’s cycle theory from the very beginning. It was just kept in the background, not highlighted as in the Keynesian analysis. But it was perfectly natural for Hawtrey to have explained how Keynes could use it in his commentary on the Treatise.

UPDATE (03/12/13): In reading the excellent doctoral thesis of Alan Gaukroger about Hawtrey’s career at the British Treasury (to view and download the thesis click here) to which I refer in my reply to Luis Arroyo’s comment, I realized that Hawtrey did not introduce the terms “consumers’ income” and “consumers’ outlay” in Good and Bad Trade as I asserted in the post.  Those terms were only introduced six years later in Currency and Credit. I will have to reread the relevant passages more carefully to determine to what extent the introduction of the new terms in Currency and Credit represented an actual change in Hawtrey’s conceptual framework as opposed to the introduction of a new term for an a concept that he had previously worked out.

That Oh So Elusive Natural Rate of Interest

Last week, I did a short post linking to the new draft of my paper with Paul Zimmerman about the Sraffa-Hayek exchange on the natural rate of interest. In the paper, we attempt to assess Sraffa’s criticism in his 1932 review of Prices and Production of Hayek’s use of the idea of a natural rate of interest as well as Hayek’s response, or, perhaps, his lack of response, to Sraffa’s criticism. The issues raised by Sraffa are devilishly tricky, especially because he introduced the unfamiliar terminology of own-rates of interest, later adopted Keynes in chapter 17 of the General Theory in order to express his criticism. The consensus about this debate is that Sraffa got the best of Hayek in this exchange – the natural rate of interest was just one of the issues Sraffa raised, and, in the process, he took Hayek down a peg or two after the startling success that Hayek enjoyed upon his arrival in England, and publication of Prices and Production. In a comment to my post, Greg Ransom questions this conventional version of the exchange, but that’s my story and I’m sticking to it.

What Paul and I do in the paper is to try to understand Sraffa’s criticism of Hayek. It seems to us that the stridency of Sraffa’s attack on Hayek suggests that Sraffa was arguing that Hayek’s conception of a natural rate of interest was somehow incoherent in a barter economy in which there is growth and investment and, thus, changes in relative prices over time, implying that commodity own rates of interest would have differ. If, in a barter economy with growth and savings and investment, there are many own-rates, Sraffa seemed to be saying, it is impossible to identify any one of them as the natural rate of interest. In a later account of the exchange between Sraffa and Hayek, Ludwig Lachmann, a pupil of Hayek, pointed out that, even if there are many own rates in a barter economy, the own rates must, in an intertemporal equilibrium, stand in a unique relationship to each other: the expected net return from holding any asset cannot differ from the expected net return on holding any other asset. That is a condition of equilibrium. If so, it is possible, at least conceptually, to infer a unique real interest rate. That unique real interest rate could be identified with Hayek’s natural rate of interest.

In fact, as we point out in our paper, Irving Fisher in his classic Appreciation and Interest (1896) had demonstrated precisely this point, theoretically extracting the real rate from the different nominal rates of interest corresponding to loans contracted in terms of different assets with different expected rates of price appreciation. Thus, Sraffa did not demonstrate that there was no natural rate of interest. There is a unique real rate of interest in intertemporal equilibrium which corresponds to the Hayekian natural rate. However, what Sraffa could have demonstrated — though had he done so, he would still have been 35 years behind Irving Fisher – is that the unique real rate is consistent with an infinite number of nominal rates provided that those nominal rates reflected corresponding anticipated rate of price appreciation. But, instead, Sraffa argued that there is no unique real rate in intertemporal equilibrium. That was a mistake.

Another interesting (at least to us) point in our paper is that Keynes who, as editor of the Economic Journal, asked Sraffa to review Prices and Production, borrowed Sraffa’s own-rate terminology in chapter 17 of the General Theory, but, instead of following Sraffa’s analysis and arguing that there is no natural rate of interest, Keynes proceeded to derive, using (without acknowledgment) a generalized version of Fisher’s argument of 1896, a unique relationship between commodity own rates, adjusted for expected price changes, and net service yields, such that the expected net returns on all assets would be equalized. From this, Keynes did not conclude, as had Sraffa, that there is no natural rate of interest. Rather, he made a very different argument: that the natural rate of interest is a useless concept, because there are many natural rates each corresponding to a different the level of income and employment, a consideration that Hayek, and presumably Fisher, had avoided by assuming full intertemporal equilibrium. But Keynes never disputed that for any given level of income and employment, there would be a unique real rate to which all commodity own rates had to correspond. Thus, Keynes turned Sraffa’s analysis on its head. And the final point of interest is that even though Keynes, in chapter 17, presented essentially the same analysis of own rates, though in more general terms, that Fisher had presented 40 years earlier, Keynes in chapter 13 explicitly rejected Fisher’s distinction between the real and nominal rates of interest. Go figure.

Bob Murphy wrote a nice paper on the Sraffa-Hayek debate, which I have referred to before on this blog. However, I disagree with him that Sraffa’s criticism of Hayek was correct. In a post earlier this week, he infers, from our statement that, as long as price expectations are correct, any nominal rate is consistent with the unique real natural rate, that we must agree with him that Sraffa was right and Hayek was wrong about the natural rate. I think that Bob is in error on the pure theory here. There is a unique real natural rate in intertemporal equilibrium, and, in principle, the monetary authority could set a money rate equal to that real rate, provided that that nominal rate was consistent with the price expectations held by the public. However, intertemporal equilibrium could be achieved by any nominal interest rate selected by the monetary authority, again provided that the nominal rate chosen was consistent with the price expectations held by the public. In practice, either formulation is very damaging to Hayek’s policy criterion of setting the nominal interest rate equal to the real natural rate. But contrary to Sraffa’s charge, the policy criterion is not incoherent. It is just unworkable, as Hayek formulated it, and, on Hayek’s own theory, the criterion is unnecessary to avoid distorting malinvestments.


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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