Archive for September, 2017

Milton Friedman and the Chicago School of Debating

I had planned to follow up my previous post, about Milton Friedman and the price of money, with a clarification and further explanation of my assertion that Friedman’s failure to understand that there is both a purchase price of money – roughly corresponding to the inverse of the price level – and a rental price of money – roughly corresponding, but not necessarily equal, to the rate of interest. The basic clarification and extension were prompted by a comment/question from Bob Murphy to which I responded with a comment of my own. I thought that it would be worth a separate post to elaborate on that point (and perhaps I’ll get around to writing it), but in the meantime I have been captivated by several intertwined Twitter threads – triggered by the recent scandal over the deplorable, abusive and sexist putdowns that infest so many of the interactions on the now infamous Economics Job Market Rumors website – about the historical role of the economics workshops in fostering a culture of rudeness in academic economic interactions and whether such rudeness has discouraged young women entering the economics profession.

Rather than run through the Twitter threads here I will just focus on an excellent post by Carolyn Sissoko who recognizes the value of the aggressive debating fostered by the Chicago workshops in honing the critical skills that young economists need to be make real contributions to the advancement of knowledge. The truth is that being overly kind and solicitous toward the feelings of a scientific researcher doesn’t do the researcher a favor nor does it promote the advancement of science, or, for that matter, of any intellectual discipline. The only way that knowledge really advances is by rooting out error, not an easy task, and critical skills — the skills to tease out the implications of an argument and to check its consistency with other propositions that we believe or that seem reasonable, or with the empirical facts that we already know or that might be able to discover – are essential to performing the task well.

I think Carolyn was aiming at a similar point in her blogpost. Here’s how she puts it:

Claudia Sahm writes about ” the toll that our profession’s aggressive, status-obsessed culture can take” and references specific dismissive criticism that is particularly content-free and therefore non-constructive. Matthew Kahn follows up with some ideas about improving mutual respect noting that “researchers are very tough on each other in public seminars (the “Chicago seminar” style).” This is followed up by prominent economists’ tweets about economics’ hyper-aggressiveness and rudeness.

I think it’s important to distinguish between the consequences of “status-obsession,” dismissiveness of women’s work and an “aggressive” seminar-style.

First, a properly run “Chicago-style” seminar requires senior economists who set the right tone. The most harshly criticized economists are senior colleagues and the point is that the resultant debate about the nature of economic knowledge is instructive and constructive for all. Yes, everyone is criticized, but students have been shown many techniques for responding to criticism by the time they are presenting. Crucial is the focus on advancing economic knowledge and an emphasis on argument rather than “status-obsession”.

The simple fact is that “Chicago-style” seminars when they are conducted by “status-obsessed” economists are likely to go catastrophically wrong. One cannot mix a kiss up-kick down culture with a “Chicago-style” seminar. They are like oil and water.

Carolyn is totally right to stress the importance of debate and criticism, and she is equally right to point out the need for the right kind of balance in the workshop environment so that criticism and debate are focused on ideas and concepts and evidence, and not on social advancement for oneself by trying to look good at someone else’s expense and even more so not to use an unavoidably adversarial social situation as an opportunity to make someone look bad or foolish. And the responsibility for setting the right tone is necessarily the responsibility of the leader(s) of the workshop.

In a tweet responding to Carolyn’s post, Beatrice Cherrier quoted an excerpt from a 2007 paper by Ross Emmett about the origins of the Chicago workshops which grew out of the somewhat contentious environment at Chicago where the Cowles Commission was housed in the 1940s and early 1950s before moving to Yale. The first formal workshop at Chicago – the money workshop – was introduced by Milton Friedman in the early 1950s when he took over responsibility for teaching the graduate course in monetary theory. However, Emmett, who draws on extensive interviews with former Chicago graduate students, singles out the Industrial Organization workshop presided over by George Stigler, a pricklier character than Friedman, and the Law and Economics workshop in the Law School as “the most notorious, and [having given] Chicago workshops a reputation for chewing up visitors.” But Emmett notes that “most workshop debate was intense without being insulting.”

That characterization brought to mind the encounter at the money workshop at Chicago in the early 1970s between Milton Friedman and a young assistant professor recently arrived at Chicago by the name of Fischer Black. The incident is recounted in chapter six (“The Money Wars) of Perry Mehrling’s wonderful biography of Black (Fischer Black and the Revolutionary Idea of Finance). Here is how Mehrling describes the encounter.

Friedman’s Workshop in Money and Banking was the most famous workshop at Chicago, and special rules applied. You had to have Friedman’s permission to attend, and one of the requirements for attendance was to offer work of your own for discussion by the other members of the workshop. Furthermore, in Friedman’s workshop presentation was limited to just a few minutes at the beginning. Everyone was expected to have read the paper already, and to have come prepared to discuss it. Friedman himself always led off the discussion, framing the issues that he thought most needed attention.

Into the lion’s den went Fischer, with the very paper that Friedman had dismissed as fallacious (Fisher arguing that inflationary overissue of money by banks is impossible because of the law of reflux). Jim Lorie recalls, “It was like an infidel going to St. Peter’s and announcing that all this stuff about Jesus was wrong.” Friedman led off the discussion: “Fisher Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.” And so it began. But after two hours of defending the indefensible, Fischer emerged bloodied but unbowed. As one participant remembers, the final score was Fisher Black 10, Monetary Workshop 0.

And the next week, Fischer was back again, now forcing others to defend themselves against his own criticisms. If it was a theoretical paper, he would point out the profit opportunity implied for anyone who understood the model. If it was an empirical paper, he would point out how the correlations were consistent with his own theory as well as the quantity theory. “But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with  nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that  an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the issue. (pp. 159-60)

So here was a case in which Friedman, the senior economist responsible for the seminar engaged in some blatant intimidation tactics against a junior colleague with whom he happened to disagree on a fundamental theoretical point. Against most junior colleagues, and almost all graduate students, such tactics would likely have succeeded in cowing the insubordinate upstart. But Fischer Black, who relished the maverick role, was not one to be intimidated. The question is what lesson did graduate students take away from the Friedman/Black encounter. That you could survive a battle with Friedman, or that, if you dissented from orthodoxy, Friedman would try to crush you?


Milton Friedman Says that the Rate of Interest Is NOT the Price of Money: Don’t Listen to Him!

In the comments to Scott Sumner’s post asking for a definition of currency manipulation, one of Scott’s regular commenters, Patrick Sullivan, wrote the following in reply to an earlier comment by Bob Murphy:

‘For example, if Fed officials take some actions during the day and we see interest rates go up, surely that’s all we need to know if we’re going to classify it as “tight” or “loose” money, right?’

As I was saying just a day or so ago, until the economics profession grasps that interest rates are NOT the price[s] of money, there’s no hope that journalists or the general public will.

Bob Murphy, you might want to reread ‘Monetary Policy v. Fiscal Policy.’ The transcript of the famous NYU debate in 1968 between Walter Heller and Milton Friedman. You’ve just made the same freshman error Heller made back then. Look for Friedman’s correction of that error in his rebuttal.

Friedman’s repeated claims that the rate of interest is not the price of money have been echoed by his many acolytes so often that it is evidently now taken as clear evidence of economic illiteracy (or “a freshman error,” as Patrick Sullivan describes it) to suggest that the rate of interest is the price of money. It was good of Sullivan to provide an exact reference to this statement of Friedman, not that similar references are hard to find, Friedman never having been one who was loathe to repeat himself. He did so often, and not without eloquence. Even though I usually quote Friedman to criticize him, I would never dream of questioning his brilliance or his skill as an economic analyst, but he was a much better price theorist than a monetary theorist, and he was a tad too self-confident, which made him disinclined to be self-critical or to admit error, or even entertain such a remote possibility.

So I took Sullivan’s advice and found the debate transcript and looked up passage in which Friedman chided Heller for saying that the rate of interest is the price of money. Here is what Friedman said in responding to Heller:

Let me turn to some of the specific issues that Walter raised in his first discussion and see if I can clarify a few points that came up.

First of all, the question is, Why do we look only at the money stock? Why don’t we also look at interest rates? Don’t you have to look at both quantity and price? The answer is yes, but the interest rate is not the price of money in the sense of the money stock. The interest rate is the price of credit. The price of money is how much goods and services you have to give up to get a dollar. You can have big changes in the quantity of money without any changes in credit. Consider for a moment the 1848-58 period in the United States. We had a big increase in the quantity of money because of the discovery of gold. This increase didn’t, in the first instance, impinge on the credit markets at all. You must sharply distinguish between money in the sense of the money or credit market, and money in the sense of the quantity of money. And the price of money in that second sense is the inverse of the price level—not the interest rate. The interest rate is the price of credit. As I mentioned earlier, the tax increase we had would tend to reduce the price of credit because it reduces the demand for credit, even though it didn’t affect the money supply at all.

So I do think you have to look at both price and quantity. But the price you have to look at from this point of view is the price level, not the interest rate.

What is wrong with Friedman’s argument? Simply this: any asset has two prices, a purchase price and a rental price. The purchase price is the price one pays (or receives) to buy (or to sell) the asset; the rental price is the price one pays to derive services from the asset for a fixed period of time. The purchase price of a unit of currency is what one has to give up in order to gain ownership of that unit. The purchasing price of money, as Friedman observed, can be expressed as the inverse of the price level, but because money is the medium of exchange, there will actually be a vector of distinct purchase prices of a unit of currency depending on what good or service is being exchanged for money.

But there is also a rental price for money, and that rental price represents what you have to give up in order to hold a unit of currency in your pocket or in your bank account. What you sacrifice is the interest you pay to the one who lends you the unit of currency, or if you already own the unit of currency, it is the interest you forego by not lending that unit of currency to someone else who would be willing to pay to have that additional unit of currency in his pocket or in his bank account instead of in yours. So although the interest rate is in some sense the price of credit, it is, indeed, also the price that one has to pay (or of which to bear the opportunity cost) in order to derive the liquidity services provided by that unit of currency.

It therefore makes perfect sense to speak about the rate of interest as the price of money. It is this price – the rate of interest – that is the cost of holding money and governs how much money people are willing to keep in their pockets and in their bank accounts. The rate of interest is also the revenue per unit of currency per unit of time derived by suppliers of money for as long as the unit of money is held by the public. Money issued by the government generates a return to the government equal to the interest that the government would have had to pay had it borrowed the additional money instead of printing the money itself. That flow of revenue is called seignorage or, alternatively, the inflation tax (which is actually a misnomer, because if nominal interest rates are positive, the government derives revenue from printing money even if inflation is zero or negative).

Similarly banks, by supplying deposits, collect revenue per unit of time equal to the interest collected per unit of time from borrowers. But all depositors, not just borrowers, bear that interest cost, because anyone holding deposits is either by paying interest — in this theoretical exposition I ignore the reprehensible fees and charges that banks routinely exact from their customers — to the bank or is foregoing interest that could have been earned by exchanging the money for an interest-bearing instrument.

Now if banking is a competitive industry banks compete to gain market share by paying depositors interest on deposits held in their institutions, thereby driving down the cost of holding money in the form of deposits rather than in the form of currency. In an ideal competitive banking system, banks would pay depositors interest nearly equal to the interest charged to borrowers, making it almost costless to hold money so that liquidity premium (the difference between the lending rate and the deposit rate) would be driven close to zero.

Friedman’s failure to understand why the rate of interest is indeed a price of money was an unfortunate blind spot in his thinking which led him into a variety of theoretical and policy errors over the course of his long, remarkable, but far from faultless career.

Defining Currency Manipulation for Scott Sumner

A little over a week ago, Scott Sumner wrote a post complaining that I had not yet given him a definition of currency manipulation. That complaint was a little bit surprising to me, because I have been writing about currency manipulation off and on for almost five years already on this blog (here’s my first, my second, and a more recent one). Now, in all modesty, I think some of those posts were pretty good and explained the concept of currency manipulation fairly clearly, so I’m not sure why Scott keeps insisting on the need for a definition. I am more than happy to accommodate him, but before doing so, I want to respond to some comments that he made in his post.

Scott began by quoting at length from my most recent post in which I responded to his criticism of my contention that China has in the past — but probably not the more recent past — engaged in currency manipulation. My basic argument – buttressed by an extended quotation from the world’s greatest living international-trade theorist, Max Corden — was that although nominal exchange rates are determined by monetary-policy choices, such as exchange-rate pegs or targets or nominal quantities of money, while real exchange rates are determined by real forces of resource endowments, technology, and consumer preferences, it is possible for monetary policy — either deliberately or inadvertently — to affect real exchange rates. This did not seem like a controversial argument to make, but Scott isn’t buying it.

Scott examines the following passage from my quotation of Corden:

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables.

And he finds it wanting.

I can’t figure out what that means. Taken literally it seems to imply that a nominal depreciation that is associated with a real depreciation is a form of protectionism. But that’s obviously nonsense. So what is he claiming? We know the nominal exchange rate doesn’t matter; only the real rate matters. But currency manipulation can’t be just a depreciation in the real exchange rate, as real exchange rates move around for all sorts of reasons. If a revolution broke out in Indonesia tomorrow, I don’t doubt that the real value [of] their currency would plummet. But no one would accuse Indonesia of currency manipulation.

There is I think some confusion in the way Scott interprets what Corden said. Corden says that if monetary policy is used to depreciate the real exchange rate, then it may be that the monetary policy had a protectionist intent. Scott’s response is that there are many reasons why a real exchange rate could depreciate, and most of them have nothing to do with any protectionist intent. If there is a revolution in Indonesia, the Indonesian real exchange rate will depreciate. Scott asks whether Indonesian revolutionaries are currency manipulators. My answer is: not unless there is a plausible argument that the revolution was intended to cause the real exchange rate to depreciate, and that the a revolution is a moderately efficient way of benefitting those Indonesians who would gain from a depreciated exchange rate. I think it would be hard to make even a remotely plausible argument that starting a revolution would be a good way for Indonesian industrialists to capture the rents from their revolutionary protectionist strategy. But if Scott wants to make such an argument, I am willing to hear him out.

Scott considers another example.

How about a decline in the real exchange rate caused by government policy? Maybe, but I don’t recall anyone accusing the Norwegians of currency manipulation when they set up a sovereign wealth fund for their oil riches. That’s a government policy that encourages national saving and hence boosts the current account. Nor was Australia accused of currency manipulation when they did tax reform in the late 1990s.

OK, fair enough. There are government policies that can affect the real exchange rate. Is every government policy that reduces the real exchange rate protectionist? No. The reduction of the real exchange rate may be a by-product, an incidental consequence, of a policy adopted for reasons that have nothing to do with protectionism. The world is a complicated place to live in.

Then referring to a passage of mine in which I made a similar point, Scott comments.

The term ‘motive’ seems to play a role in the passage above:

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading to more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

Scott doesn’t like talking about “motives.”

As an economist, references to “motives” make me very uncomfortable. Let’s take the example of China. Did China’s government try to reduce the real value of the yuan because they saw what happened during the 1997 SE Asia crisis, and wanted a big war chest in case they faced a balance of payments crisis? Or did they do the weak yuan policy to shift resources from domestic industries to tradable goods industries? I have absolutely no idea, nor do I see why it matters. Surely if a concept of currency manipulation has any coherent meaning, it cannot depend on the motive of the policymakers in a particular country? We aren’t mind readers. This is especially true if we are to believe that currency manipulation hurts other countries, as its proponent seem to suggest. How will it be identified?

Scott is mixing up a lot of different issues here, so let me try to sort them out. There are indeed two plausible explanations for China’s vast accumulation of foreign-exchange reserves in the 1990s and in the 20 aughts. One is a precautionary build-up of foreign-exchange reserves to be available in the event of a financial crisis; the other is exchange-rate protection, aka currency manipulation. It’s true; we can’t read the minds of the policy makers, but we can make reasonable assessments of the relative plausibility of either hypothesis, based on the size of the accumulation, the policy steps that were taken to implement and facilitate the accumulation, the public pronouncements of relevant officials, and, if we had access to them, the internal documents upon which policy-makers relied in reaching their decisions. Now obviously, the Chinese government is not about to share their internal documents with me or any outside investigator, but that is a choice made by the Chinese, not some inherent deficiency in the evidence upon which a diligent researcher could potentially rely in making a determination about the motivation for Chinese policy decisions. As an economic historian of considerable accomplishment, Scott is well aware of the kind of evidence that is relevant to evaluating the motives of policy makers, so I can’t help but suspect that Scott is playfully engaging in a bit of rhetorical obfuscation here.

In the spirit of Bastiat, consider the following analogy. Suppose that for years we had been buying bananas from Colombia for 10 cents a pound. American consumers got to eat lots of cheap tasty fruit, which don’t grow well in non-tropical countries. Then in 2018, Trump sends a team of investigators down to Colombia, and finds out that we’ve been scammed. It’s actually not a warm country, indeed quite cool due to its high elevation. The Colombian government had spent millions building giant greenhouses to grow bananas. We’ve been tricked into buying all these cheap bananas from Colombia, which artificially created a “competitive advantage” in the banana industry through subsidies.

Here’s my question: Why does it matter why the Colombian bananas were cheap? If we benefited from buying the bananas at 10 cents a pound, why would we care if the price reflected true competitive advantage or government subsidy? Does the US benefit from buying 10-cent bananas, or not?

Once again, there’s some tactical diversion taking place. The question at hand is whether a protectionist policy could, in principle, be implemented through monetary policy. The answer is clearly yes. But Scott is now inviting us to consider a different question: Do protectionist policies adopted by one country adversely affect people in other countries. The answer is: it depends. Since there are no bananas grown in the US, export subsidies by the Colombian government to their banana growers would not harm any Americans. However, if there were US banana growers who had invested in banana trees and other banana-growing assets, there would be Americans harmed by the Colombian subsidies. It is possible that the gains to American banana consumers might outweigh the losses to American banana growers, but then there would have to be some comparison of the relative gains and losses.

Now Scott comes back to his demand for a definition.

But that’s not all. Even if you convinced me that we should worry about interventionist policies in our trading partners, I’d still want a definition of currency manipulation. There are a billion ways that a foreign government could influence a real exchange rate. Which ones are “manipulation”? It’s meaningless to talk about China depreciating its currency, without explaining HOW. A currency is just a price, and reasoning from a currency change (real or nominal) is simply reasoning from a price change. Which specific actions constitute currency manipulation? I don’t want motives, I need verifiable actions. And [why] does this concept have to involve a current account surplus? Australia’s been running CA deficits for as long as I can remember. Suppose the Aussie government did enough “currency manipulation” to reduce their trend CA deficit from 4% of GDP to 2% of GDP. But it was still a deficit. Would that be “manipulation”. Why or why not?

OK, here it is: currency manipulation occurs when a government/monetary authority sets a particular nominal exchange-rate target which, it believes, will, at current domestic prices, give its export- and import-competing industries a competitive advantage over their foreign competitors, thereby generating a current account surplus. In addition, to prevent the influx of foreign cash associated with current account surplus from raising domestic non-tradable prices and undermining the competitive advantage of the protected tradable-goods sector, the government/monetary authority either restricts the amount of base money created or, more likely, increases reserve requirements imposed on the banking system to create a persistent excess demand for money, thereby ensuring a continuing current account surplus and accumulation of foreign exchange reserves and preserving the protected position of the tradable-goods sector.

Scott continues:

Should we care why a country has a big CA surplus? Suppose Switzerland has a big CA surplus due to high private saving rates, Singapore has a big CA surplus due to high public saving in common stocks, and China has a CA surplus due to high public saving in foreign exchange. What difference does it make? (And I haven’t even addressed Ricardian equivalence, which further clouds these distinctions.)

Whether we should care or not care about exchange-rate protection is a question no different from whether we should care about protection by tariffs or quotas. There is an argument for unilateral free trade, but most of the post-World-War II trend toward (somewhat) freer trade has been predicated on the idea of reciprocal reductions in trade barriers. If we believe in the reciprocal reduction of trade barriers, then it is not unreasonable to be concerned about trade barriers that are erected through currency manipulation as a substitute for the tarrifs, import quotas, and export subsidies prohibited under reciprocal trade agreements. If Scott is not interested in reciprocal trade agreements, that’s fine, but it is not unreasonable for those who are interested in reciprocal trade agreements to be concerned about covertly protectionist policies that are imposed as substitutes for tariffs, import quotas, and export subsidies.

We know that the only way that governments can affect the real exchange rate is by enacting policies that impact national saving or national investment. But almost all policies impact either national saving or national investment. So which of those count as manipulation? Is it merely policies that lead to the accumulation of foreign exchange? If so, then won’t you simply encourage countries to use some other technique for boosting national saving? An alternative policy that avoids having them be labeled currency manipulators?

In principle, there could be other policies aimed at increasing national savings that are protectionist in intent. One would have to look at each possible instance and evaluate it. At least that’s what would have to be done if one believes in reciprocal trade agreements.

There were some other points that Scott mentioned in his post that I will not address now, because the hour is late and I’m getting tired. Perhaps I’ll follow up with a short follow-up post in a day or so. Not promising though.

In the General Theory Keynes First Trashed and then Restated the Fisher Equation

I am sorry to have gone on a rather extended hiatus from posting, but I have been struggling to come up with a new draft of a working paper (“The Fisher Effect under Deflationary Expectations“) I wrote with the encouragement of Scott Sumner in 2010 and posted on SSRN in 2011 not too long before I started blogging. Aside from a generous mention of the paper by Scott on his blog, Paul Krugman picked up on it and wrote about it on his blog as well. Because the empirical work was too cursory, I have been trying to update the results and upgrade the techniques. In working on a new draft of my paper, I also hit upon a simple proof of a point that I believe I discovered several years ago: that in the General Theory Keynes criticized Fisher’s distinction between the real and nominal rates of interest even though he used exactly analogous reasoning in his famous theorem on covered interest parity in the forward exchange market and in his discussion of liquidity preference in chapter 17 of the General Theory. So I included a section making that point in the new draft of my paper, which I am reproducing here. Eventually, I hope to write a paper exploring more deeply Keynes’s apparently contradictory thinking on the Fisher equation. Herewith is an excerpt from my paper.

One of the puzzles of Keynes’s General Theory is his criticism of the Fisher equation.

This is the truth which lies behind Professor Irving Fisher’ss theory of what he originally called “Appreciation and Interest” – the  distinction between the money rate of interest and the real rate of interest where the latter is equal to the former after correction for changes in the value of money. It is difficult to make sense of this theory as stated, because it is not clear whether the change in the value of money is or is not assumed to be foreseen. There is no escape from the dilemma that, if it is not foreseen, there will be no effect on current affairs; whilst, if it is foreseen, the prices of existing goods will be forthwith so adjusted that the advantages of holding money and of holding goods are again equalized, and it will be too late for holders of money to gain or to suffer a change in the rate of interest which will offset the prospective change during the period of the loan in the value of money lent. . . .

The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital. The prices of existing assets will always adjust themselves to changes in expectation concerning the prospective value of money. The significance of such changes in expectation lies in their effect on the readiness to produce new assets through their reaction on the marginal efficiency of capital. The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest (that would be a paradoxical way of stimulating output – in so far as the rate of interest rises, the stimulating effect is to that extent offset), but to its raising the marginal efficiency of a given stock of capital. (pp. 142-43)

As if the problem of understanding that criticism were not enough, the problem is further compounded by the fact that one of Keynes’s most important pre-General Theory contributions, his theorem about covered interest parity in his Tract on Monetary Reform seems like a straightforward application of the Fisher equation. According to his covered-interest-parity theorem, in equilibrium, the difference between interest rates quoted in terms of two different currencies will be just enough to equalize borrowing costs in either currency given the anticipated change in the exchange rate between the two currencies over reflected in the market for forward exchange as far into the future as the duration of the loan.

The most fundamental cause is to be found in the interest rates obtainable on “short” money – that is to say, on money lent or deposited for short periods of time in the money markets of the two centres under comparison. If by lending dollars in New York for one month the lender could earn interest at the rate of 5-1/2 per cent per annum, whereas by lending sterling in London for one month he could only earn interest at the rate of 4 per cent, then the preference observed above for holding funds in New York rather than in London is wholly explained. That is to say, forward quotations for the purchase of the currency of the dearer money market tend to be cheaper than the spot quotations by a percentage per month equal to the excess of the interest which can be earned in a month in the dearer market over what can be earned in the cheaper. (p. 125)

And as if that self-contradiction not enough, Keynes’s own exposition of the idea of liquidity preference in chapter 17 of the General Theory extends the basic idea of the Fisher equation that expected rates of return from holding different assets must be accounted for in a way that equalizes the expected return from holding any asset. At least formally, it can be shown that the own-interest-rate analysis in chapter 17 of the General Theory explaining how the liquidity premium affects the relative yields of money and alternative assets can be translated into a form that is equivalent to the Fisher equation.

In explaining the factors affecting the expected yields from alternative assets now being held into the future, Keynes lists three classes of return from holding assets: (1) the expected physical real yield (q) (i.e., the ex ante real rate of interest or Fisher’s real rate) from holding an asset, including either or both a flow of physical services or real output or real appreciation; (2) the expected service flow from holding an easily marketable assets generates liquidity services or a liquidity premium (l); and (3) wastage in the asset or a carrying cost (c). Keynes specifies the following equilibrium condition for asset holding: if assets are held into the future, the expected overall return from holding every asset including all service flows, carrying costs, and expected appreciation or depreciation, must be equalized.

[T]he total return expected from the ownership of an asset over a period is equal to its yield minus its carrying cost plus its liquidity premium, i.e., to q c + l. That is to say, q c + l is the own rate of interest of any commodity, where q, c, and l are measured in terms of itself as the standard. (Keynes 1936, p. 226)

Thus, every asset that is held, including money, must generate a return including the liquidity premium l, after subtracting of the carrying cost c. Thus, a standard real asset with zero carrying cost will be expected to generate a return equal to q (= r). For money to be held, at the margin, it must also generate a return equal to q net of its carrying cost, c. In other words, q = lc.

But in equilibrium, the nominal rate of interest must equal the liquidity premium, because if the liquidity premium (at the margin) generated by money exceeds the nominal interest rate, holders of debt instruments returning the nominal rate will convert those instruments into cash, thereby deriving liquidity services in excess of the foregone interest from the debt instruments. Similarly, the carrying cost of holding money is the expected depreciation in the value of money incurred by holding money, which corresponds to expected inflation. Thus, substituting the nominal interest rate for the liquidity premium, and expected inflation for the carrying cost of money, we can rewrite the Keynes equilibrium condition for money to be held in equilibrium as q = r = ipe. But this equation is identical to the Fisher equation: i = r + pe.

Keynes’s version of the Fisher equation makes it obvious that the disequilibrium dynamics that are associated with changes in expected inflation can be triggered not only by decreased inflation expectations but by an increase in the liquidity premium generated by money, and especially if expected inflation falls and the liquidity premium rises simultaneously, as was likely the case during the 2008 financial crisis.

I will not offer a detailed explanation here of the basis on which Keynes criticized the Fisher equation in the General Theory despite having applied the same idea in the Tract on Monetary Reform and restating the same underlying idea some 80 pages later in the General Theory itself. But the basic point is simply this: the seeming contradiction can be rationalized by distinguishing between the Fisher equation as a proposition about a static equilibrium relationship and the Fisher equation as a proposition about the actual adjustment process occasioned by a parametric expectational change. While Keynes clearly did accept the Fisher equation in an equilibrium setting, he did not believe the real interest rate to be uniquely determined by real forces and so he didn’t accept its the invariance of the real interest rate with respect to changes in expected inflation in the Fisher equation. Nevertheless it is stunning that Keynes could have committed such a blatant, if only superficial, self-contradiction without remarking upon it.

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.

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