Archive for May, 2014

Thomas Piketty and Joseph Schumpeter (and Gerard Debreu)

Everybody else seems to have an opinion about Thomas PIketty, so why not me? As if the last two months of Piketty-mania (reminiscent, to those of a certain age, of an earlier invasion of American shores, exactly 50 years ago, by four European rock-stars) were not enough, there has been a renewed flurry of interest this week about Piketty’s blockbuster book triggered by Chris Giles’s recent criticism in the Financial Times of Piketty’s use of income data, which mainly goes to show that, love him or hate him, people cannot get enough of Professor Piketty. Now I will admit upfront that I have not read Piketty’s book, and from my superficial perusal of the recent criticisms, they seem less problematic than the missteps of Reinhart and Rogoff in claiming that, beyond a critical 90% ratio of national debt to national income, the burden of national debt begins to significantly depress economic growth. But in any event, my comments in this post are directed at Piketty’s conceptual approach, not on his use of the data in his empirical work. In fact, I think that Larry Summers in his superficially laudatory, but substantively critical, review has already made most of the essential points about Piketty’s book. But I think that Summers left out a couple of important issues — issues touched upon usefully by George Cooper in a recent blog post about Piketty — which bear further emphasis, .

Just to set the stage for my comments, here is my understanding of the main conceptual point of Piketty’s book. Piketty believes that the essence of capitalism is that capital generates a return to the owners of capital that, on average over time, is equal to the rate of interest. Capital grows; it accumulates. And the rate of accumulation is equal to the rate of interest. However, the rate of interest is generally somewhat higher than the rate of growth of the economy. So if capital is accumulating at a rate of growth equal to, say, 5%, and the economy is growing at a rate of growth equal to only 3%, the share of income accruing to the owners of capital will grow over time. It is in this simple theoretical framework — the relationship between the rate of economic growth to the rate of interest — that Piketty believes he has found the explanation not only for the increase in inequality over the past few centuries of capitalist development, but for the especially rapid increase in inequality over the past 30 years.

While praising Piketty’s scholarship, empirical research and rhetorical prowess, Summers does not handle Piketty’s main thesis gently. Summers points out that, as accumulation proceeds, the incentive to engage in further accumulation tends to weaken, so the iron law of increasing inequality posited by Piketty is not nearly as inflexible as Piketty suggests. Now one could respond that, once accumulation reaches a certain threshold, the capacity to consume weakens as well, if only, as Gary Becker liked to remind us, because of the constraint that time imposes on consumption.

Perhaps so, but the return to capital is not the only, or even the most important, source of inequality. I would interpret Summers’ point to be the following: pure accumulation is unlikely to generate enough growth in wealth to outstrip the capacity to increase consumption. To generate an increase in wealth so large that consumption can’t keep up, there must be not just a return to the ownership of capital, there must be profit in the Knightian or Schumpeterian sense of a profit over and above the return on capital. Alternatively, there must be some extraordinary rent on a unique, irreproducible factor of production. Accumulation by itself, without the stimulus of entrepreneurial profit, reflecting the the application of new knowledge in the broadest sense of the term, cannot go on for very long. It is entrepreneurial profits and rents to unique factors of production (or awards of government monopolies or other privileges) not plain vanilla accumulation that account for the accumulation of extraordinary amounts of wealth. Moreover, it seems that philanthropy (especially conspicuous philanthropy) provides an excellent outlet for the dissipation of accumulated wealth and can easily be combined with quasi-consumption activities, like art patronage or political activism, as more conventional consumption outlets become exhausted.

Summers backs up his conceptual criticism with a powerful factual argument. Comparing the Forbes list of the 400 richest individuals in 1982 with the Forbes list for 2012 Summers observes:

When Forbes compared its list of the wealthiest Americans in 1982 and 2012, it found that less than one tenth of the 1982 list was still on the list in 2012, despite the fact that a significant majority of members of the 1982 list would have qualified for the 2012 list if they had accumulated wealth at a real rate of even 4 percent a year. They did not, given pressures to spend, donate, or misinvest their wealth. In a similar vein, the data also indicate, contra Piketty, that the share of the Forbes 400 who inherited their wealth is in sharp decline.

But something else is also going on here, a misunderstanding, derived from a fundamental ambiguity, about what capital actually means. Capital can refer either to a durable physical asset or to a sum of money. When economists refer to capital as a factor of production, they are thinking of capital as a physical asset. But in most models, economists try to simplify the analysis by collapsing the diversity of the entire stock of heterogeneous capital assets into single homogeneous substance called “capital” and then measure it not in terms of its physical units (which, given heterogeneity, is strictly impossible) but in terms of its value. This creates all kinds of problems, leading to some mighty arguments among economists ever since the latter part of the nineteenth century when Carl Menger (the first Austrian economist) turned on his prize pupil Eugen von Bohm-Bawerk who wrote three dense volumes discussing the theory of capital and interest, and pronounced Bohm-Bawerk’s theory of capital “the greatest blunder in the history of economics.” I remember wanting to ask F. A. Hayek, who, trying to restate Bohm-Bawerk’s theory in a coherent form, wrote a volume about 75 years ago called The Pure Theory of Capital, which probably has been read from cover to cover by fewer than 100 living souls, and probably understood by fewer than 20 of those, what he made of Menger’s remark, but, to my eternal sorrow, I forgot to ask him that question the last time that I saw him.

At any rate, treating capital as a homogeneous substance that can be measured in terms of its value rather than in terms of physical units involves serious, perhaps intractable, problems. For certain purposes, it may be worthwhile to ignore those problems and work with a simplified model (a single output which can be consumed or used as a factor of production), but the magnitude of the simplification is rarely acknowledged. In his discussion, Piketty seems, as best as I could determine using obvious search terms on Amazon, unaware of the conceptual problems involved in speaking about capital as a homogeneous substance measured in terms of its value.

In the real world, capital is anything but homogeneous. It consists of an array of very specialized, often unique, physical embodiments. Once installed, physical capital is usually sunk, and its value is highly uncertain. In contrast to the imaginary model of a homogenous substance that just seems to grow at fixed natural rate, the real physical capital that is deployed in the process of producing goods and services is complex and ever-changing in its physical and economic characteristics, and the economic valuations associated with its various individual components are in perpetual flux. While the total value of all capital may be growing at a fairly steady rate over time, the values of the individual assets that constitute the total stock of capital fluctuate wildly, and few owners of physical capital have any guarantee that the value of their assets will appreciate at a steady rate over time.

Now one would have thought that an eminent scholar like Professor Piketty would, in the course of a 700-page book about capital, have had occasion to comment on enormous diversity and ever-changing composition of the stock of physical capital. These changes are driven by a competitive process in which entrepreneurs constantly introduce new products and new methods of producing products, a competitive process that enriches some owners of new capital, and, it turns out, impoverishes others — owners of old, suddenly obsolete, capital. It is a process that Joseph Schumpeter in his first great book, The Theory of Economic Development, memorably called “creative destruction.” But the term “creative destruction” or the title of Schumpeter’s book does not appear at all in Piketty’s book, and Schumpeter’s name appears only once, in connection not with the notion of creative destruction, but with his, possibly ironic, prediction in a later book Capitalism, Socialism and Democracy that socialism would eventually replace capitalism.

Thus, Piketty’s version of capitalist accumulation seems much too abstract and too far removed from the way in which great fortunes are amassed to provide real insight into the sources of increasing inequality. Insofar as such fortunes are associated with accumulation of capital, they are likely to be the result of the creation of new forms of capital associated with new products, or new production processes. The creation of new capital simultaneously destroys old forms of capital. New fortunes are amassed, and old ones dissipated. The model of steady accumulation that is at the heart of Piketty’s account of inexorably increasing inequality misses this essential feature of capitalism.

I don’t say that Schumpeter’s account of creative destruction means that increasing inequality is a trend that should be welcomed. There may well be arguments that capitalist development and creative destruction are socially inefficient. I have explained in previous posts (e.g., here, here, and here) why I think that a lot of financial-market activity is likely to be socially wasteful. Similar arguments might be made about other kinds of activities in non-financial markets where the private gain exceeds the social gain. Winner-take-all markets seem to be characterized by this divergence between private and social benefits and costs, apparently accounting for a growing share of economic activity, are an obvious source of inequality. But what I find most disturbing about the growth in inequality over the past 30 years is that great wealth has gained increased social status. That seems to me to be a very unfortunate change in public attitudes. I have no problem with people getting rich, even filthy rich. But don’t expect me to admire them because they are rich.

Finally, you may be wondering what all of this has to do with Gerard Debreu. Well, nothing really, but I couldn’t help noticing that Piketty refers in an endnote (p. 654) to “the work of Adam Smith, Friedrich Hayek, and Kenneth Arrow and  Claude Debreu” apparently forgetting that the name of his famous countryman, winner of the Nobel Memorial Prize for Economics in 1983, is not Claude, but Gerard, Debreu. Perhaps Piketty confused Debreu with another eminent Frenchman Claude Debussy, but I hope that in the next printing of his book, Piketty will correct this unfortunate error.

UPDATE (5/29 at 9:46 EDST): Thanks to Kevin Donoghue for checking with Arthur Goldhammer, who translated Piketty’s book from the original French. Goldhammer took responsibility for getting Debreu’s first name wrong in the English edition. In the French edition, only Debreu’s last name was mentioned.

Never Reason from a Disequilibrium

One of Scott Sumner’s many contributions as a blogger has been to show over and over and over again how easy it is to lapse into fallacious economic reasoning by positing a price change and then trying to draw inferences about the results of the price change. The problem is that a price change doesn’t just happen; it is the result of some other change. There being two basic categories of changes (demand and supply) that can affect price, there are always at least two possible causes for a given price change. So, until you have specified the antecedent change responsible for the price change under consideration, you can’t work out the consequences of the price change.

In this post, I want to extend Scott’s insight in a slightly different direction, and explain how every economic analysis has to begin with a statement about the initial conditions from which the analysis starts. In particular, you need to be clear about the equilibrium position corresponding to the initial conditions from which you are starting. If you posit some change in the system, but your starting point isn’t an equilibrium, you have no way of separating out the adjustment to the change that you are imposing on the system from the change the system would be undergoing simply to reach the equilibrium toward which it is already moving, or, even worse, from the change the system would be undergoing if its movement is not toward equilibrium.

Every theoretical analysis in economics properly imposes a ceteris paribus condition. Unfortunately, the ubiquitous ceteris paribus condition comes dangerously close to rendering economic theory irrefutable, except perhaps in a statistical sense, because empirical refutations of the theory can always be attributed to changes, abstracted from only in the theory, but not in the real world of our experience. An empirical model with a sufficient number of data points may be able to control for the changes in conditions that the theory holds constant, but the underlying theory is a comparison of equilibrium states (comparative statics), and it is quite a stretch to assume that the effects of perpetual disequilibrium can be treated as nothing but white noise. Austrians are right to be skeptical of econometric analysis; so was Keynes, for that matter. But skepticism need not imply nihilism.

Let me try to illustrate this principle by applying it to the Keynesian analysis of involuntary unemployment. In the General Theory Keynes argued that if adequate demand is deficient, the likely result is an equilibrium with involuntary unemployment. The “classical” argument that Keynes disputed was that, in principle at least, involuntary unemployment could not persist, because unemployed workers, if only they would accept reduced money wages, would eventually find employment. Keynes denied that involuntary unemployment could not persist, arguing that if workers did accept reduced money wages, the wage reductions would not get translated into reduced real wages. Instead, falling nominal wages would induce employers to cut prices by roughly the same percentage as the reduction in nominal wages, leaving real wages more or less unchanged, thereby nullifying the effectiveness of nominal-wage cuts, and, instead, fueling a vicious downward spiral of prices and wages.

In making this argument, Keynes didn’t dispute the neoclassical proposition that, with a given capital stock, the marginal product of labor declines as employment increases, implying that real wages have to fall for employment to be increased. His argument was about the nature of the labor-supply curve, labor supply, in Keynes’s view, being a function of both the real and the nominal wage, not, as in the neoclassical theory, only the real wage. Under Keynes’s “neoclassical” analysis, the problem with nominal-wage cuts is that they don’t do the job, because they lead to corresponding price cuts. The only way to reduce unemployment, Keynes insisted, is to raise the price level. With nominal wages constant, an increased price level would achieve the real-wage cut necessary for employment to be increased. And this is precisely how Keynes defined involuntary unemployment: the willingness of workers to increase the amount of labor actually supplied in response to a price level increase that reduces their real wage.

Interestingly, in trying to explain why nominal-wage cuts would fail to increase employment, Keynes suggested that the redistribution of income from workers to entrepreneurs associated with reduced nominal wages would tend to reduce consumption, thereby reducing, not increasing, employment. But if that is so, how is it that a reduced real wage, achieved via inflation, would increase employment? Why would the distributional effect of a reduced nominal, but unchanged real, wage be more adverse to employment han a reduced real wage, achieved, with a fixed nominal wage, by way of a price-level increase?

Keynes’s explanation for all this is confused. In chapter 19, where he makes the argument that money-wage cuts can’t eliminate involuntary unemployment, he presents a variety of reasons why nominal-wage cuts are ineffective, and it is usually not clear at what level of theoretical abstraction he is operating, and whether he is arguing that nominal-wage cuts would not work even in principle, or that, although nominal-wage cuts might succeed in theory, they would inevitably fail in practice. Even more puzzling, It is not clear whether he thinks that real wages have to fall to achieve full employment or that full employment could be restored by an increase in aggregate demand with no reduction in real wages. In particular, because Keynes doesn’t start his analysis from a full-employment equilibrium, and doesn’t specify the shock that moves the economy off its equilibrium position, we can only guess whether Keynes is talking about a shock that had reduced labor productivity or (more likely) a shock to entrepreneurial expectations (animal spirits) that has no direct effect on labor productivity.

There was a rhetorical payoff for Keynes in maintaining that ambiguity, because he wanted to present a “general theory” in which full employment is a special case. Keynes therefore emphasized that the labor market is not self-equilibrating by way of nominal-wage adjustments. That was a perfectly fine and useful insight: when the entire system is out of kilter; there is no guarantee that just letting the free market set prices will bring everything back into place. The theory of price adjustment is fundamentally a partial-equilibrium theory that isolates the disequiibrium of a single market, with all other markets in (approximate) equilibrium. There is no necessary connection between the adjustment process in a partial-equilibrium setting and the adjustment process in a full-equilibrium setting. The stability of a single market in disequilibrium does not imply the stability of the entire system of markets in disequilibrium. Keynes might have presented his “general theory” as a theory of disequilibrium, but he preferred (perhaps because he had no other tools to work with) to spell out his theory in terms of familiar equilibrium concepts: savings equaling investment and income equaling expenditure, leaving it ambiguous whether the failure to reach a full-employment equilibrium is caused by a real wage that is too high or an interest rate that is too high. Axel Leijonhufvud highlights the distinction between a disequilibrium in the real wage and a disequilibrium in the interest rate in an important essay “The Wicksell Connection” included in his book Information and Coordination.

Because Keynes did not commit himself on whether a reduction in the real wage is necessary for equilibrium to be restored, it is hard to assess his argument about whether, by accepting reduced money wages, workers could in fact reduce their real wages sufficiently to bring about full employment. Keynes’s argument that money-wage cuts accepted by workers would be undone by corresponding price cuts reflecting reduced production costs is hardly compelling. If the current level of money wages is too high for firms to produce profitably, it is not obvious why the reduced money wages paid by entrepreneurs would be entirely dissipated by price reductions, with none of the cost decline being reflected in increased profit margins. If wage cuts do increase profit margins, that would encourage entrepreneurs to increase output, potentially triggering an expansionary multiplier process. In other words, if the source of disequilibrium is that the real wage is too high, the real wage depending on both the nominal wage and price level, what is the basis for concluding that a reduction in the nominal wage would cause a change in the price level sufficient to keep the real wage at a disequilibrium level? Is it not more likely that the price level would fall no more than required to bring the real wage back to the equilibrium level consistent with full employment? The question is not meant as an expression of policy preference; it is a question about the logic of Keynes’s analysis.

Interestingly, present-day opponents of monetary stimulus (for whom “Keynesian” is a term of extreme derision) like to make a sort of Keynesian argument. Monetary stimulus, by raising the price level, reduces the real wage. That means that monetary stimulus is bad, as it is harmful to workers, whose interests, we all know, is the highest priority – except perhaps the interests of rentiers living off the interest generated by their bond portfolios — of many opponents of monetary stimulus. Once again, the logic is less than compelling. Keynes believed that an increase in the price level could reduce the real wage, a reduction that, at least potentially, might be necessary for the restoration of full employment.

But here is my question: why would an increase in the price level reduce the real wage rather than raise money wages along with the price level. To answer that question, you need to have some idea of whether the current level of real wages is above or below the equilibrium level. If unemployment is high, there is at least some reason to think that the equilibrium real wage is less than the current level, which is why an increase in the price level would be expected to cause the real wage to fall, i.e., to move the actual real wage in the direction of equilibrium. But if the current real wage is about equal to, or even below, the equilibrium level, then why would one think that an increase in the price level would not also cause money wages to rise correspondingly? It seems more plausible that, in the absence of a good reason to think otherwise, that inflation would cause real wages to fall only if real wages are above their equilibrium level.

Monetary Theory on the Neo-Fisherite Edge

The week before last, Noah Smith wrote a post “The Neo-Fisherite Rebellion” discussing, rather sympathetically I thought, the contrarian school of monetary thought emerging from the Great American Heartland, according to which, notwithstanding everything monetary economists since Henry Thornton have taught, high interest rates are inflationary and low interest rates deflationary. This view of the relationship between interest rates and inflation was advanced (but later retracted) by Narayana Kocherlakota, President of the Minneapolis Fed in a 2010 lecture, and was embraced and expounded with increased steadfastness by Stephen Williamson of Washington University in St. Louis and the St. Louis Fed in at least one working paper and in a series of posts over the past five or six months (e.g. here, here and here). And John Cochrane of the University of Chicago has picked up on the idea as well in two recent blog posts (here and here). Others seem to be joining the upstart school as well.

The new argument seems simple: given the Fisher equation, in which the nominal interest rate equals the real interest rate plus the (expected) rate of inflation, a central bank can meet its inflation target by setting a fixed nominal interest rate target consistent with its inflation target and keeping it there. Once the central bank sets its target, the long-run neutrality of money, implying that the real interest rate is independent of the nominal targets set by the central bank, ensures that inflation expectations must converge on rates consistent with the nominal interest rate target and the independently determined real interest rate (i.e., the real yield curve), so that the actual and expected rates of inflation adjust to ensure that the Fisher equation is satisfied. If the promise of the central bank to maintain a particular nominal rate over time is believed, the promise will induce a rate of inflation consistent with the nominal interest-rate target and the exogenous real rate.

The novelty of this way of thinking about monetary policy is that monetary theorists have generally assumed that the actual adjustment of the price level or inflation rate depends on whether the target interest rate is greater or less than the real rate plus the expected rate. When the target rate is greater than the real rate plus expected inflation, inflation goes down, and when it is less than the real rate plus expected inflation, inflation goes up. In the conventional treatment, the expected rate of inflation is momentarily fixed, and the (expected) real rate variable. In the Neo-Fisherite school, the (expected) real rate is fixed, and the expected inflation rate is variable. (Just as an aside, I would observe that the idea that expectations about the real rate of interest and the inflation rate cannot occur simultaneously in the short run is not derived from the limited cognitive capacity of economic agents; it can only be derived from the limited intellectual capacity of economic theorists.)

The heretical views expressed by Williamson and Cochrane and earlier by Kocherlakota have understandably elicited scorn and derision from conventional monetary theorists, whether Keynesian, New Keynesian, Monetarist or Market Monetarist. (Williamson having appropriated for himself the New Monetarist label, I regrettably could not preserve an appropriate symmetry in my list of labels for monetary theorists.) As a matter of fact, I wrote a post last December challenging Williamson’s reasoning in arguing that QE had caused a decline in inflation, though in his initial foray into uncharted territory, Williamson was actually making a narrower argument than the more general thesis that he has more recently expounded.

Although deep down, I have no great sympathy for Williamson’s argument, the counterarguments I have seen leave me feeling a bit, shall we say, underwhelmed. That’s not to say that I am becoming a convert to New Monetarism, but I am feeling that we have reached a point at which certain underlying gaps in monetary theory can’t be concealed any longer. To explain what I mean by that remark, let me start by reviewing the historical context in which the ruling doctrine governing central-bank operations via adjustments in the central-bank lending rate evolved. The primary (though historically not the first) source of the doctrine is Henry Thornton in his classic volume The Nature and Effects of the Paper Credit of Great Britain.

Even though Thornton focused on the policy of the Bank of England during the Napoleonic Wars, when Bank of England notes, not gold, were legal tender, his discussion was still in the context of a monetary system in which paper money was generally convertible into either gold or silver. Inconvertible banknotes – aka fiat money — were the exception not the rule. Gold and silver were what Nick Rowe would call alpha money. All other moneys were evaluated in terms of gold and silver, not in terms of a general price level (not yet a widely accepted concept). Even though Bank of England notes became an alternative alpha money during the restriction period of inconvertibility, that situation was generally viewed as temporary, the restoration of convertibility being expected after the war. The value of the paper pound was tracked by the sterling price of gold on the Hamburg exchange. Thus, Ricardo’s first published work was entitled The High Price of Bullion, in which he blamed the high sterling price of bullion at Hamburg on an overissue of banknotes by the Bank of England.

But to get back to Thornton, who was far more concerned with the mechanics of monetary policy than Ricardo, his great contribution was to show that the Bank of England could control the amount of lending (and money creation) by adjusting the interest rate charged to borrowers. If banknotes were depreciating relative to gold, the Bank of England could increase the value of their notes by raising the rate of interest charged on loans.

The point is that if you are a central banker and are trying to target the exchange rate of your currency with respect to an alpha currency, you can do so by adjusting the interest rate that you charge borrowers. Raising the interest rate will cause the exchange value of your currency to rise and reducing the interest rate will cause the exchange value to fall. And if you are operating under strict convertibility, so that you are committed to keep the exchange rate between your currency and an alpha currency at a specified par value, raising that interest rate will cause you to accumulate reserves payable in terms of the alpha currency, and reducing that interest rate will cause you to emit reserves payable in terms of the alpha currency.

So the idea that an increase in the central-bank interest rate tends to increase the exchange value of its currency, or, under a fixed-exchange rate regime, an increase in the foreign exchange reserves of the bank, has a history at least two centuries old, though the doctrine has not exactly been free of misunderstanding or confusion in the course of those two centuries. One of those misunderstandings was about the effect of a change in the central-bank interest rate, under a fixed-exchange rate regime. In fact, as long as the central bank is maintaining a fixed exchange rate between its currency and an alpha currency, changes in the central-bank interest rate don’t affect (at least as a first approximation) either the domestic money supply or the domestic price level; all that changes in the central-bank interest rate can accomplish is to change the bank’s holdings of alpha-currency reserves.

It seems to me that this long well-documented historical association between changes in the central-bank interest rates and the exchange value of currencies and the level of private spending is the basis for the widespread theoretical presumption that raising the central-bank interest rate target is deflationary and reducing it is inflationary. However, the old central-bank doctrine of the Bank Rate was conceived in a world in which gold and silver were the alpha moneys, and central banks – even central banks operating with inconvertible currencies – were beta banks, because the value of a central-bank currency was still reckoned, like the value of inconvertible Bank of England notes in the Napoleonic Wars, in terms of gold and silver.

In the Neo-Fisherite world, central banks rarely peg exchange rates against each other, and there is no longer any outside standard of value to which central banks even nominally commit themselves. In a world without the metallic standard of value in which the conventional theory of central banking developed, do the propositions about the effects of central-bank interest-rate setting still obtain? I am not so sure that they do, not with the analytical tools that we normally deploy when thinking about the effects of central-bank policies. Why not? Because, in a Neo-Fisherite world in which all central banks are alpha banks, I am not so sure that we really know what determines the value of this thing called fiat money. And if we don’t really know what determines the value of a fiat money, how can we really be sure that interest-rate policy works the same way in a Neo-Fisherite world that it used to work when the value of money was determined in relation to a metallic standard? (Just to avoid misunderstanding, I am not – repeat NOT — arguing for restoring the gold standard.)

Why do I say that we don’t know what determines the value of fiat money in a Neo-Fisherite world? Well, consider this. Almost three weeks ago I wrote a post in which I suggested that Bitcoins could be a massive bubble. My explanation for why Bitcoins could be a bubble is that they provide no real (i.e., non-monetary) service, so that their value is totally contingent on, and derived from (or so it seems to me, though I admit that my understanding of Bitcoins is partial and imperfect), the expectation of a positive future resale value. However, it seems certain that the resale value of Bitcoins must eventually fall to zero, so that backward induction implies that Bitcoins, inasmuch as they provide no real service, cannot retain a positive value in the present. On this reasoning, any observed value of a Bitcoin seems inexplicable except as an irrational bubble phenomenon.

Most of the comments I received about that post challenged the relevance of the backward-induction argument. The challenges were mainly of two types: a) the end state, when everyone will certainly stop accepting a Bitcoin in exchange, is very, very far into the future and its date is unknown, and b) the backward-induction argument applies equally to every fiat currency, so my own reasoning, according to my critics, implies that the value of every fiat currency is just as much a bubble phenomenon as the value of a Bitcoin.

My response to the first objection is that even if the strict logic of the backward-induction argument is inconclusive, because of the long and uncertain duration of the time elapse between now and the end state, the argument nevertheless suggests that the value of a Bitcoin is potentially very unsteady and vulnerable to sudden collapse. Those are not generally thought to be desirable attributes in a medium of exchange.

My response to the second objection is that fiat currencies are actually quite different from Bitcoins, because fiat currencies are accepted by governments in discharging the tax liabilities due to them. The discharge of a tax liability is a real (i.e. non-monetary) service, creating a distinct non-monetary demand for fiat currencies, thereby ensuring that fiat currencies retain value, even apart from being accepted as a medium of exchange.

That, at any rate, is my view, which I first heard from Earl Thompson (see his unpublished paper, “A Reformulation of Macroeconomic Theory” pp. 23-25 for a derivation of the value of fiat money when tax liability is a fixed proportion of income). Some other pretty good economists have also held that view, like Abba Lerner, P. H. Wicksteed, and Adam Smith. Georg Friedrich Knapp also held that view, and, in his day, he was certainly well known, but I am unable to pass judgment on whether he was or wasn’t a good economist. But I do know that his views about money were famously misrepresented and caricatured by Ludwig von Mises. However, there are other good economists (Hal Varian for one), apparently unaware of, or untroubled by, the backward induction argument, who don’t think that acceptability in discharging tax liability is required to explain the value of fiat money.

Nor do I think that Thompson’s tax-acceptability theory of the value of money can stand entirely on its own, because it implies a kind of saw-tooth time profile of the price level, so that a fiat currency, earning no liquidity premium, would actually be appreciating between peak tax collection dates, and depreciating immediately following those dates, a pattern not obviously consistent with observed price data, though I do recall that Thompson used to claim that there is a lot of evidence that prices fall just before peak tax-collection dates. I don’t think that anyone has ever tried to combine the tax-acceptability theory with the empirical premise that currency (or base money) does in fact provide significant liquidity services. That, it seems to me, would be a worthwhile endeavor for any eager young researcher to undertake.

What does all of this have to do with the Neo-Fisherite Rebellion? Well, if we don’t have a satisfactory theory of the value of fiat money at hand, which is what another very smart economist Fischer Black – who, to my knowledge never mentioned the tax-liability theory — thought, then the only explanation of the value of fiat money is that, like the value of a Bitcoin, it is whatever people expect it to be. And the rate of inflation is equally inexplicable, being just whatever it is expected to be. So in a Neo-Fisherite world, if the central bank announces that it is reducing its interest-rate target, the effect of the announcement depends entirely on what “the market” reads into the announcement. And that is exactly what Fischer Black believed. See his paper “Active and Passive Monetary Policy in a Neoclassical Model.”

I don’t say that Williamson and his Neo-Fisherite colleagues are correct. Nor have they, to my knowledge, related their arguments to Fischer Black’s work. What I do say (indeed this is a problem I raised almost three years ago in one of my first posts on this blog) is that existing monetary theories of the price level are unable to rule out his result, because the behavior of the price level and inflation seems to depend, more than anything else, on expectations. And it is far from clear to me that there are any fundamentals in which these expectations can be grounded. If you impose the rational expectations assumption, which is almost certainly wrong empirically, maybe you can argue that the central bank provides a focal point for expectations to converge on. The problem, of course, is that in the real world, expectations are all over the place, there being no fundamentals to force the convergence of expectations to a stable equilibrium value.

In other words, it’s just a mess, a bloody mess, and I do not like it, not one little bit.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 1,391 other followers

Follow Uneasy Money on WordPress.com