Archive for the 'demand for money' Category

How not to Win Friends and Influence People

Published January 31, 2016 Bank of France , David Beckworth , demand for money , expectations , Federal Reserve , financial crisis , Great Depression , Milton Friedman , Paul Krugman , Ted Cruz 31 Comments
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Last week David Beckworth and Ramesh Ponnuru wrote a very astute op-ed article in the New York Times explaining how the Fed was tightening its monetary policy in 2008 even as the economy was rapidly falling into recession. Although there are a couple of substantive points on which I might take issue with Beckworth and Ponnuru (more about that below), I think that on the whole they do a very good job of covering the important points about the 2008 financial crisis given that their article had less than 1000 words.

That said, Beckworth and Ponnuru made a really horrible – to me incomprehensible — blunder. For some reason, in the second paragraph of their piece, after having recounted the conventional narrative of the 2008 financial crisis as an inevitable result of housing bubble and the associated misconduct of the financial industry in their first paragraph, Beckworth and Ponnuru cite Ted Cruz as the spokesman for the alternative view that they are about to present. They compound that blunder in a disclaimer identifying one of them – presumably Ponnuru — as a friend of Ted Cruz – for some recent pro-Cruz pronouncements from Ponnuru see here, here, and here – thereby transforming what might have been a piece of neutral policy analysis into a pro-Cruz campaign document. Aside from the unseemliness of turning Cruz into the poster-boy for Market Monetarism and NGDP Level Targeting, when, as recently as last October 28, Mr. Cruz was advocating resurrection of the gold standard while bashing the Fed for debasing the currency, a shout-out to Ted Cruz is obviously not a gesture calculated to engage readers (of the New York Times for heaven sakes) and predispose them to be receptive to the message they want to convey.

I suppose that this would be the appropriate spot for me to add a disclaimer of my own. I do not know, and am no friend of, Ted Cruz, but I was a FTC employee during Cruz’s brief tenure at the agency from July 2002 to December 2003. I can also affirm that I have absolutely no recollection of having ever seen or interacted with him while he was at the agency or since, and have spoken to only one current FTC employee who does remember him.

Predictably, Beckworth and Ponnuru provoked a barrage of negative responses to their argument that the Fed was responsible for the 2008 financial crisis by not easing monetary policy for most of 2008 when, even before the financial crisis, the economy was sliding into a deep recession. Much of the criticism focuses on the ambiguous nature of the concepts of causation and responsibility when hardly any political or economic event is the direct result of just one cause. So to say that the Fed caused or was responsible for the 2008 financial crisis cannot possibly mean that the Fed single-handedly brought it about, and that, but for the Fed’s actions, no crisis would have occurred. That clearly was not the case; the Fed was operating in an environment in which not only its past actions but the actions of private parties and public and political institutions increased the vulnerability of the financial system. To say that the Fed’s actions of commission or omission “caused” the financial crisis in no way absolves all the other actors from responsibility for creating the conditions in which the Fed found itself and in which the Fed’s actions became crucial for the path that the economy actually followed.

Consider the Great Depression. I think it is totally reasonable to say that the Great Depression was the result of the combination of a succession of interest rate increases by the Fed in 1928 and 1929 and by the insane policy adopted by the Bank of France in 1928 and continued for several years thereafter to convert its holdings of foreign-exchange reserves into gold. But does saying that the Fed and the Bank of France caused the Great Depression mean that World War I and the abandonment of the gold standard and the doubling of the price level in terms of gold during the war were irrelevant to the Great Depression? Of course not. Does it mean that accumulation of World War I debt and reparations obligations imposed on Germany by the Treaty of Versailles and the accumulation of debt issued by German state and local governments — debt and obligations that found their way onto the balance sheets of banks all over the world, were irrelevant to the Great Depression? Not at all.

Nevertheless, it does make sense to speak of the role of monetary policy as a specific cause of the Great Depression because the decisions made by the central bankers made a difference at critical moments when it would have been possible to avoid the calamity had they adopted policies that would have avoided a rapid accumulation of gold reserves by the Fed and the Bank of France, thereby moderating or counteracting, instead of intensifying, the deflationary pressures threatening the world economy. Interestingly, many of those objecting to the notion that Fed policy caused the 2008 financial crisis are not at all bothered by the idea that humans are causing global warming even though the world has evidently undergone previous cycles of rising and falling temperatures about which no one would suggest that humans played any causal role. Just as the existence of non-human factors that affect climate does not preclude one from arguing that humans are now playing a key role in the current upswing of temperatures, the existence of non-monetary factors contributing to the 2008 financial crisis need not preclude one from attributing a causal role in the crisis to the Fed.

So let’s have a look at some of the specific criticisms directed at Beckworth and Ponnuru. Here’s Paul Krugman’s take in which he refers back to an earlier exchange last December between Mr. Cruz and Janet Yellen when she testified before Congress:

Back when Ted Cruz first floated his claim that the Fed caused the Great Recession — and some neo-monetarists spoke up in support — I noted that this was a repeat of the old Milton Friedman two-step.

First, you declare that the Fed could have prevented a disaster — the Great Depression in Friedman’s case, the Great Recession this time around. This is an arguable position, although Friedman’s claims about the 30s look a lot less convincing now that we have tried again to deal with a liquidity trap. But then this morphs into the claim that the Fed caused the disaster. See, government is the problem, not the solution! And the motivation for this bait-and-switch is, indeed, political.

Now come Beckworth and Ponnuru to make the argument at greater length, and it’s quite direct: because the Fed “caused” the crisis, things like financial deregulation and runaway bankers had nothing to do with it.

As regular readers of this blog – if there are any – already know, I am not a big fan of Milton Friedman’s work on the Great Depression, and I agree with Krugman’s criticism that Friedman allowed his ideological preferences or commitments to exert an undue influence not only on his policy advocacy but on his substantive analysis. Thus, trying to make a case for his dumb k-percent rule as an alternative monetary regime to the classical gold standard regime generally favored by his libertarian, classical liberal and conservative ideological brethren, he went to great and unreasonable lengths to deny the obvious fact that the demand for money is anything but stable, because such an admission would have made the k-percent rule untenable on its face as it proved to be when Paul Volcker misguidedly tried to follow Friedman’s advice and conduct monetary policy by targeting monetary aggregates. Even worse, because he was so wedded to the naïve quantity-theory monetary framework he thought he was reviving – when in fact he was using a modified version of the Cambride/Keynesian demand for money, even making the patently absurd claim that the quantity theory of money was a theory of the demand for money – Friedman insisted on conducting monetary analysis under the assumption – also made by Keynes — that quantity of money is directly under the control of the monetary authority when in fact, under a gold standard – which means during the Great Depression – the quantity of money for any country is endogenously determined. As a result, there was a total mismatch between Friedman’s monetary model and the institutional setting in place at the time of the monetary phenomenon he was purporting to explain.

So although there were big problems with Friedman’s account of the Great Depression and his characterization of the Fed’s mishandling of the Great Depression, fixing those problems doesn’t reduce the Fed’s culpability. What is certainly true is that the Great Depression, the result of a complex set of circumstances going back at least 15 years to the start of World War I, might well have been avoided largely or entirely, but for the egregious conduct of the Fed and Bank of France. But it is also true that, at the onset of the Great Depression, there was no consensus about how to conduct monetary policy, even though Hawtrey and Cassel and a handful of others well understood how terribly monetary policy had gone off track. But theirs was a minority view, and Hawtrey and Cassel are still largely ignored or forgotten.

Ted Cruz may view the Fed’s mistakes in 2008 as a club with which to beat up on Janet Yellen, but for most of the rest of us who think that Fed mistakes were a critical element of the 2008 financial crisis, the point is not to make an ideological statement, it is to understand what went wrong and to try to keep it from happening again.

Krugman sends us to Mike Konczal for further commentary on Beckworth and Ponnuru.

Is Ted Cruz right about the Great Recession and the Federal Reserve? From a November debate, Cruz argued that “in the third quarter of 2008, the Fed tightened the money and crashed those asset prices, which caused a cascading collapse.”

Fleshing that argument out in the New York Times is David Beckworth and Ramesh Ponnuru, backing and expanding Cruz’s theory that “the Federal Reserve caused the crisis by tightening monetary policy in 2008.”

But wait, didn’t the Federal Reserve lower rates during that time?

Um, no. The Fed cut its interest rate target to 2.25% on March 18, 2008, and to 2% on April 20, which by my calculations would have been in the second quarter of 2008. There it remained until it was reduced to 1.5% on October 8, which by my calculations would have been in the fourth quarter of 2008. So on the face of it, Mr. Cruz was right that the Fed kept its interest rate target constant for over five months while the economy was contracting in real terms in the third quarter at a rate of 1.9% (and growing in nominal terms at a mere 0.8% rate)

Konczal goes on to accuse Cruz of inconsistency for blaming the Fed for tightening policy in 2008 before the crash while bashing the Fed for quantitative easing after the crash. That certainly is a just criticism, and I really hope someone asks Cruz to explain himself, though my expectations that that will happen are not very high. But that’s Cruz’s problem, not Beckworth’s or Ponnuru’s.

Konczal also focuses on the ambiguity in saying that the Fed caused the financial crisis by not cutting interest rates earlier:

I think a lot of people’s frustrations with the article – see Barry Ritholtz at Bloomberg here – is the authors slipping between many possible interpretations. Here’s the three that I could read them making, though these aren’t actual quotes from the piece:

(a) “The Federal Reserve could have stopped the panic in the financial markets with more easing.”

There’s nothing in the Valukas bankruptcy report on Lehman, or any of the numerous other reports that have since come out, that leads me to believe Lehman wouldn’t have failed if the short-term interest rate was lowered. One way to see the crisis was in the interbank lending spreads, often called the TED spread, which is a measure of banking panic. Looking at an image of the spread and its components, you can see a falling short-term t-bill rate didn’t ease that spread throughout 2008.

And, as Matt O’Brien noted, Bear Stearns failed before the passive tightening started.

The problem with this criticism is that it assumes that the only way that the Fed can be effective is by altering the interest rate that it effectively sets on overnight loans. It ignores the relationship between the interest rate that the Fed sets and total spending. That relationship is not entirely obvious, but almost all monetary economists have assumed that there is such a relationship, even if they can’t exactly agree on the mechanism by which the relationship is brought into existence. So it is not enough to look at the effect of the Fed’s interest rate on Lehman or Bear Stearns, you also have to look at the relationship between the interest rate and total spending and how a higher rate of total spending would have affected Lehman and Bear Stearns. If the economy had been performing better in the second and third quarters, the assets that Lehman and Bear Stearns were holding would not have lost as much of their value. And even if Lehman and Bear Stearns had not survived, arranging for their takeover by other firms might have been less difficult.

But beyond that, Beckworth and Ponnuru themselves overlook the fact that tightening by the Fed did not begin in the third quarter – or even the second quarter – of 2008. The tightening may have already begun in as early as the middle of 2006. The chart below shows the rate of expansion of the adjusted monetary base from January 2004 through September 2008. From 2004 through the middle of 2006, the biweekly rate of expansion of the monetary base was consistently at an annual rate exceeding 4% with the exception of a six-month interval at the end of 2005 when the rate fell to the 3-4% range. But from the middle of 2006 through September 2008, the bi-weekly rate of expansion was consistently below 3%, and was well below 2% for most of 2008. Now, I am generally wary of reading too much into changes in the monetary aggregates, because those changes can reflect either changes in supply conditions or demand conditions. However, when the economy is contracting, with the rate of growth in total spending falling substantially below trend, and the rate of growth in the monetary aggregates is decreasing sharply, it isn’t unreasonable to infer that monetary policy was being tightened. So, the monetary policy may well have been tightened as early as 2006, and, insofar as the rate of growth of the monetary base is indicative of the stance of monetary policy, that tightening was hardly passive.

adjusted_monetary_base

(b) “The Federal Reserve could have helped the recovery by acting earlier in 2008. Unemployment would have peaked at, say, 9.5 percent, instead of 10 percent.”

That would have been good! I would have been a fan of that outcome, and I’m willing to believe it. That’s 700,000 people with a job that they wouldn’t have had otherwise. The stimulus should have been bigger too, with a second round once it was clear how deep the hole was and how Treasuries were crashing too.

Again, there are two points. First, tightening may well have begun at least a year or two before the third quarter of 2008. Second, the economy started collapsing in the third quarter of 2008, and the run-up in the value of the dollar starting in July 2008, foolishly interpreted by the Fed as a vote of confidence in its anti-inflation policy, was really a cry for help as the economy was being starved of liquidity just as the demand for liquidity was becoming really intense. That denial of liquidity led to a perverse situation in which the return to holding cash began to exceed the return on real assets, setting the stage for a collapse in asset prices and a financial panic. The Fed could have prevented the panic, by providing more liquidity. Had it done so, the financial crisis would have been avoided, and the collapse in the real economy and the rise in unemployment would have been substantially mitigate.

c – “The Federal Reserve could have stopped the Great Recession from ever happening. Unemployment in 2009 wouldn’t have gone above 5.5 percent.”

This I don’t believe. Do they? There’s a lot of “might have kept that decline from happening or at least moderated it” back-and-forth language in the piece.

Is the argument that we’d somehow avoid the zero-lower bound? Ben Bernanke recently showed that interest rates would have had to go to about -4 percent to offset the Great Recession at the time. Hitting the zero-lower bound earlier than later is good policy, but it’s still there.

I think there’s an argument about “expectations,” and “expectations” wouldn’t have been set for a Great Recession. A lot of the “expectations” stuff has a magic and tautological quality to it once it leaves the models and enters the policy discussion, but the idea that a random speech about inflation worries could have shifted the Taylor Rule 4 percent seems really off base. Why doesn’t it go haywire all the time, since people are always giving speeches?

Well, I have shown in this paper that, starting in 2008, there was a strong empirical relationship between stock prices and inflation expectations, so it’s not just tautological. And we’re not talking about random speeches; we are talking about the decisions of the FOMC and the reasons that were given for those decisions. The markets pay a lot of attention to those reason.

And couldn’t it be just as likely that since the Fed was so confident about inflation in mid-2008 it boosted nominal income, by giving people a higher level of inflation expectations than they’d have otherwise? Given the failure of the Evans Rule and QE3 to stabilize inflation (or even prevent it from collapsing) in 2013, I imagine transporting them back to 2008 would haven’t fundamentally changed the game.

The inflation in 2008 was not induced by monetary policy, but by adverse supply shocks, expectations of higher inflation, given the Fed’s inflation targeting were thus tantamount to predictions of further monetary tightening.

If your mental model is that the Federal Reserve delaying something three months is capable of throwing 8.7 million people out of work, you should probably want to have much more shovel-ready construction and automatic stabilizers, the second of which kicked in right away without delay, as part of your agenda. It seems odd to put all the eggs in this basket if you also believe that even the most minor of mistakes are capable of devastating the economy so greatly.

Once again, it’s not a matter of just three months, but even if it were, in the summer of 2008 the economy was at a kind of inflection point, and the failure to ease monetary policy at that critical moment led directly to a financial crisis with cascading effects on the real economy. If the financial crisis could have been avoided by preventing total spending from dropping far below trend in the third quarter, the crisis might have been avoided, and the subsequent loss of output and employment could have been greatly mitigated.

And just to be clear, I have pointed out previously that the free market economy is fragile, because its smooth functioning depends on the coherence and consistency of expectations. That makes monetary policy very important, but I don’t dismiss shovel-ready construction and automatic stabilizers as means of anchoring expectations in a useful way, in contrast to the perverse way that inflation targeting stabilizes expectations.

Sumner on the Demand for Money, Interest Rates and Barsky and Summers

Published January 5, 2016 demand for money , gold standard , Keynes , Larry Summers , Robert Barsky , Scott Sumner 8 Comments
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Scott Sumner had two outstanding posts a couple of weeks ago (here and here) discussing the relationship between interest rates and NGDP, making a number of important points, which I largely agree with, even though I have some (mostly semantic) quibbles about the details. I especially liked how in the second post he applied the analysis of Robert Barsky and Larry Summers in their article about Gibson’s Paradox under the gold standard to recent monetary experience. The two posts are so good and cover such a wide range of topics that the best way for me to address them is by cutting and pasting relevant passages and commenting on them.

Scott begins with the equation of exchange MV = PY. I personally prefer the Cambridge version (M = kPY) where k stands for the fraction of income that people hold as cash, thereby making it clear that the relevant concept is how much money want to hold, not that mysterious metaphysical concept called the velocity of circulation V (= 1/k). With attention focused on the decision about how much money to hold, it is natural to think of the rate of interest as the opportunity cost of holding non-interest-bearing cash balances. When the rate of interest rate rises, the desired holdings of non-interest-bearing cash tend to fall; in other words k falls (and V rises). With unchanged M, the equation is satisfied only if PY increases. So the notion that a reduction in interest rates, in and of itself, is expansionary is based on a misunderstanding. An increase in the amount of money demanded is always contractionary. A reduction in interest rates increases the amount of money demanded (if money is non-interest-bearing). A reduction in interest rates is therefore contractionary (all else equal).

Scott suggests some reasons why this basic relationship seems paradoxical.

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base. (This was not the case in late 2007 and early 2008, but it is the case on some occasions.) When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises. So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

To this I would add that, as discussed in my recent posts about Keynes and Fisher, Keynes in the General Theory seemed to be advancing a purely monetary theory of the rate of interest. If Keynes meant that the rate of interest is determined exclusively by monetary factors, then a falling rate of interest is a sure sign of an excess supply of money. Of course in the Hicksian world of IS-LM, the rate of interest is simultaneously determined by both equilibrium in the money market and an equilibrium rate of total spending, but Keynes seems to have had trouble with the notion that the rate of interest could be simultaneously determined by not one, but two, equilibrium conditions.

Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism. Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.

But if Keynes believed that the rate of interest is exclusively determined by money demand and money supply, then the only possible cause of a low or falling interest rate is the state of the money market, the supply side of which is always under the control of the monetary authority. Or stated differently, in the Keynesian model, the money-supply function is perfectly elastic at the target rate of interest, so that the monetary authority supplies whatever amount of money is demanded at that rate of interest. I disagree with the underlying view of what determines the rate of interest, but given that theory of the rate of interest, the model is not incoherent and doesn’t confuse the transmission mechanism.

That’s probably why economists were so confused by 2008. Many people confuse aggregate demand with consumption. Thus they think low rates encourage people to “spend” and that this n somehow boosts AD and NGDP. But it doesn’t, at least not in the way they assume. If by “spend” you mean higher velocity, then yes, spending more boosts NGDP. But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

But, remember that Keynes believed that the interest rate can be reduced only by increasing the quantity of money, which nullifies the contractionary effect of a reduced interest rate.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise. This is reasoning from a price change on steroids! When you don’t spend you save, and saving goes into investment, which is also part of GDP.

But this is reasoning from an accounting identity. The question is what happens if people try to save. The Keynesian argument is that the attempt to save will be self-defeating; instead of increased saving, there is reduced income. Both scenarios are consistent with the accounting identity. The question is which causal mechanism is operating? Does an attempt to increase saving cause investment to increase, or does it cause income to go down? Seemingly aware of the alternative scenario, Scott continues:

Now here’s were amateur Keynesians get hopelessly confused. They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall. This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

Just so. But there is not necessarily any confusion; the issue may be just a difference in how monetary policy is implemented. You can think of the monetary authority as having a choice in setting its policy in terms of the quantity of the monetary base, or in terms of an interest-rate target. Scott characterizes monetary policy in terms of the base, allowing the interest rate to adjust; Keynesians characterize monetary policy in terms of an interest-rate target, allowing the monetary base to adjust. The underlying analysis should not depend on how policy is characterized. I think that this is borne out by Scott’s next paragraph, which is consistent with a policy choice on the part of the Keynesian monetary authority to raise interest rates as needed to curb aggregate demand when aggregate demand is excessive.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD. One theory is that animal spirits propel businesses to invest more. Another is that consumer optimism propels consumers to spend more. Another is that fiscal policy becomes more expansionary, boosting the budget deficit. What do all three of these shocks have in common? In all three cases the shock leads to higher interest rates. (Use the S&I diagram to show this.) Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP. But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

In the Keynesian terminology, the shocks do lead to higher rates, but only because excessive aggregate demand, caused by animal spirits, consumer optimism, or government budget deficits, has to be curbed by interest-rate increases. The ceteris paribus assumption is ambiguous; it can be interpreted to mean holding the monetary base constant or holding the interest-rate target constant. I don’t often cite Milton Friedman as an authority, but one of his early classic papers was “The Marshallian Demand Curve” in which he pointed out that there is an ambiguity in what is held constant along the demand curve: prices of other goods or real income. You can hold only one of the two constant, not both, and you get a different demand curve depending on which ceteris paribus assumption you make. So the upshot of my commentary here is that, although Scott is right to point out that the standard reasoning about how a change in interest rates affects NGDP implicitly assumes that the quantity of money is changing, that valid point doesn’t refute the standard reasoning. There is an inherent ambiguity in specifying what is actually held constant in any ceteris paribus exercise. It’s good to make these ambiguities explicit, and there might be good reasons to prefer one ceteris paribus assumption over another, but a ceteris paribus assumption isn’t a sufficient basis for rejecting a model.

Now just to be clear, I agree with Scott that, as a matter of positive economics, the interest rate is not fully under the control of the monetary authority. And one reason that it’s not  is that the rate of interest is embedded in the entire price system, not just a particular short-term rate that the central bank may be able to control. So I don’t accept the basic Keynesian premise that monetary authority can always make the rate of interest whatever it wants it to be, though the monetary authority probably does have some control over short-term rates.

Scott also provides an analysis of the effects of interest on reserves, and he is absolutely correct to point out that paying interest on reserves is deflationary.

I will just note that near the end of his post, Scott makes a comment about living “in a Ratex world.” WADR, I don’t think that ratex is at all descriptive of reality, but I will save that discussion for another time.

Scott followed up the post about the contractionary effects of low interest rates with a post about the 1988 Barsky and Summers paper.

Barsky and Summers . . . claim that the “Gibson Paradox” is caused by the fact that low interest rates are deflationary under the gold standard, and that causation runs from falling interest rates to deflation. Note that there was no NGDP data for this period, so they use the price level rather than NGDP as their nominal indicator. But their basic argument is identical to mine.

The Gibson Paradox referred to the tendency of prices and interest rates to be highly correlated under the gold standard. Initially some people thought this was due to the Fisher effect, but it turns out that prices were roughly a random walk under the gold standard, and hence the expected rate of inflation was close to zero. So the actual correlation was between prices and both real and nominal interest rates. Nonetheless, the nominal interest rate is the key causal variable in their model, even though changes in that variable are mostly due to changes in the real interest rate.

Since gold is a durable good with a fixed price, the nominal interest rate is the opportunity cost of holding that good. A lower nominal rate tends to increase the demand for gold, for both monetary and non-monetary purposes.  And an increased demand for gold is deflationary (and also reduces NGDP.)

Very insightful on Scott’s part to see the connection between the Barsky and Summers analysis and the standard theory of the demand for money. I had previously thought about the Barsky and Summers discussion simply as a present-value problem. The present value of any durable asset, generating a given expected flow of future services, must vary inversely with the interest rate at which those future services are discounted. Since the future price level under the gold standard was expected to be roughly stable, any change in nominal interest rates implied a change in real interest rates. The value of gold, like other durable assets, varied inversely with nominal interest rate. But with the nominal value of gold fixed by the gold standard, changes in the value of gold implied a change in the price level, an increased value of gold being deflationary and a decreased value of gold inflationary. Scott rightly observes that the same idea can be expressed in the language of monetary theory by thinking of the nominal interest rate as the cost of holding any asset, so that a reduction in the nominal interest rate has to increase the demand to own assets, because reducing the cost of holding an asset increases the demand to own it, thereby raising its value in exchange, provided that current output of the asset is small relative to the total stock.

However, the present-value approach does have an advantage over the opportunity-cost approach, because the present-value approach relates the value of gold or money to the entire term structure of interest rates, while the opportunity-cost approach can only handle a single interest rate – presumably the short-term rate – that is relevant to the decision to hold money at any given moment in time. In simple models of the IS-LM ilk, the only interest rate under consideration is the short-term rate, or the term-structure is assumed to have a fixed shape so that all interest rates are equally affected by, or along with, any change in the short-term rate. The latter assumption of course is clearly unrealistic, though Keynes made it without a second thought. However, in his Century of Bank Rate, Hawtrey showed that between 1844 and 1938, when the gold standard was in effect in Britain (except 1914-25 and 1931-38) short-term rates and long-term rates often moved by significantly different magnitudes and even in opposite directions.

Scott makes a further interesting observation:

The puzzle of why the economy does poorly when interest rates fall (such as during 2007-09) is in principle just as interesting as the one Barsky and Summers looked at. Just as gold was the medium of account during the gold standard, base money is currently the medium of account. And just as causation went from falling interest rates to higher demand for gold to deflation under the gold standard, causation went from falling interest rates to higher demand for base money to recession in 2007-08.

There is something to this point, but I think Scott may be making too much of it. Falling interest rates in 2007 may have caused the demand for money to increase, but other factors were also important in causing contraction. The problem in 2008 was that the real rate of interest was falling, while the Fed, fixated on commodity (especially energy) prices, kept interest rates too high given the rapidly deteriorating economy. With expected yields from holding real assets falling, the Fed, by not cutting interest rates any further between April and October of 2008, precipitated a financial crisis once inflationary expectations started collapsing in August 2008, the expected yield from holding money dominating the expected yield from holding real assets, bringing about a pathological Fisher effect in which asset values had to collapse for the yields from holding money and from holding assets to be equalized.

Under the gold standard, the value of gold was actually sensitive to two separate interest-rate effects – one reflected in the short-term rate and one reflected in the long-term rate. The latter effect is the one focused on by Barsky and Summers, though they also performed some tests on the short-term rate. However, it was through the short-term rate that the central bank, in particular the Bank of England, the dominant central bank during in the pre-World War I era, manifested its demand for gold reserves, raising the short-term rate when it was trying to accumulate gold and reducing the short-term rate when it was willing to reduce its reserve holdings. Barsky and Summers found the long-term rate to be more highly correlated with the price level than the short-term rate. I conjecture that the reason for that result is that the long-term rate is what captures the theoretical inverse relationship between the interest rate and the value of a durable asset, while the short-term rate would be negatively correlated with the value of gold when (as is usually the case) it moves together with the long-term rate but may sometimes be positively correlated with the value of gold (when the central bank is trying to accumulate gold) and thereby tightening the world market for gold. I don’t know if Barsky and Summers ran regressions using both long-term and short-term rates, but using both long-term and short-term rates in the same regression might have allowed them to find evidence of both effects in the data.

PS I have been too busy and too distracted of late to keep up with comments on earlier posts. Sorry for not responding promptly. In case anyone is still interested, I hope to respond to comments over the next few days, and to post and respond more regularly than I have been doing for the past few weeks.

Why Are Corporations Hoarding all that Cash?

Published October 31, 2014 Austrian Business-Cycle Theory , corporate income tax , demand for money 26 Comments
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One of the ongoing puzzles of this joyless recovery (to give it the benefit of the doubt) has been the huge accumulation of cash by corporations. The puzzle is that the huge cash hoards that companies are sitting on are being generated by high earnings, high earning reflected in – or, perhaps more accurately, anticipated by — rising stock prices since the stock market bottomed out in March 2009. So one would think that the high earnings would have encouraged these highly profitable companies to expand output, building new capacity and hiring new workers, rather than accumulate all that cash. But the growth in cash holdings by companies has dwarfed the growth in new capital spending and employment. So what gives?

Corporations, obviously, are not all the same, so that any simple broad generalizations about what they are doing and why are very questionable. A disproportionate share of the newly accumulated cash is in the hands of large companies, especially in the telecommunications sector, the most notorious case being Apple, whose hoard is reportedly close to 200 billion dollars. Let me also observe that the increase in cash holding by corporations has been increasing for a long time, especially since the mid-1990s, tapering off in the mid-2000s before dipping during the financial crisis. But the upward trend resumed and accelerated after the crisis.

Here are some of the reasons that I have seen mentioned or have thought of myself for all this corporate cash hoarding.

A basic proposition of the theory of the demand for money is that an increase in uncertainty increases the demand for money. It is certain that the financial crisis was associated with increased uncertainty, raising the demand for money during and, owing to residual effects of the crisis, after the crisis. One might wonder why, if the demand for money increased during the crisis, corporate cash holdings decreased. The answer is that cash flows during the crisis were drastically reduced, requiring companies to expend cash even though they would have preferred to squirrel it away. The crisis was a period of extreme disequilibrium, and corporations (like many other economic agents) were forced way off their demand curves. So some part of the increase in corporate cash holdings can probably be attributed to a general increase in overall macroeconomic uncertainty. However, macroeconomic conditions has been fairly stable now for the last two or three years, at least in the US. So, although one could argue that the general macroeconomic environment is more uncertain than it was before the crisis, it would be hard to argue that uncertainty has not been gradually diminishing over the past few years, even as corporate cash hoards have continued to grow rapidly.

Some people – I don’t have to name them, you know who they are – like to say that the increase in uncertainty is all, or perhaps only mostly, due to the policies of the Obama administration and the Federal Reserve, especially, but not only, Obamacare and quantitative easing. But Obamacare was enacted in 2010, and it has been implemented gradually since then, coming more or less fully into effect this year. So the uncertainty associated with Obamacare should have been decreasing over time. Quantitative easing has been in effect in one form or another for most of the past four years, so people have gotten used to it. There is now uncertainty about when and how it will come to an end, but there is no sign that concerns about its gradual termination are causing any major market disturbances. So one can’t easily attribute the continuing increase in corporate cash-holding to uncertainty caused by Obamacare or quantitative-easing.

There are also microeconomic sources of uncertainty that are specific to particular sectors or industries, accounting for faster rates of increase in cash-holding by particular types of corporations, but the increase in cash-holding has not been confined to any single group of corporations, though large multi-national corporations, especially technology, media, and telecommunications companies have shown the largest increases in cash holdings. A study by economists at the St. Louis Fed suggested that R&D intensive corporations, being subject to high uncertainty owing to the unpredictable outcomes of their R&D activities, have been increasing their cash holdings more rapidly than less R&D intensive corporations. As R&D expenditures increase as a share of total investment, total cash holding by corporations would be expected to increase. But, again, this explanation can account for a long-term trend towards increased corporate cash holding, but not for the surge in corporate cash holding since 2009.

Let’s think again about why a profitable company is holding a lot of cash. So what can a profitable company do with all that cash gushing into its coffers? Well, 1) it can just hold on to the cash, 2) it could invest in new plant and equipment, (we’ll come back to this in a moment), 3) it could go out and buy other companies, 4) it could pay bonuses to some or all of the employees (guess which ones) of the company, or 5) it could return the cash to the owners of the company by paying dividends or by repurchasing stock.

As promised, let’s now think a bit more about option 2). There are broadly speaking three categories of capital investment. First, there is capital investment that replaces old and depreciating equipment with new and possibly improved equipment, but does not alter the firm’s structure or methods of production. It simply allows the company to keep doing what it has been doing, but perhaps a little bit more efficiently. Second, there is capital investment that aims to alter the structure of production, by adopting a new method or technique of production. Third, there is capital investment intended to increase the total productive capacity of the firm, enabling the firm to expand its output and increase its sales.

Notice that the first category is necessary for any firm unless it is about to go out of business. A firm may postpone such investment if it is not currently profitable, but it can’t postpone it for long without compromising the viability of the firm. Capital replacement is important, but to a large extent it is automatic, not being sensitive to relatively small changes in economic incentives.

The second category does depend importantly on the relative profitability of different techniques, and these decisions require pretty careful and detailed assessments by corporate management to decide which ones will be profitable and should be undertaken and which ones are unlikely to be profitable or involve too much risk to be undertaken. I note parenthetically that it is only a subset (probably a small subset) of this category that is sensitive to the interest-rate mechanism that looms so large in Austrian business-cycle theory. To presume that this probably small sub-category of interest-sensitive investment is what drives the business cycle involves a huge, and empirically unsupported, assumption.

The third – and undoubtedly the largest — category depends primarily not on calculations about the relative cost and profitability of different techniques, but on expectations about future demand for the firm’s output. If firms believe that they can increase sales at current prices, they will expand capacity to produce more output. If they don’t invest in increased capacity, they will probably lose market share to their competitors.

So, if corporations have been accumulating cash rather than investing in new plant and equipment to expand output – the sort of investment that would involve major expenditures and a significant drawdown of cash hoards — the most obvious explanation seems to be that firms don’t expect future demand at current prices to increase enough to justify such investments. A surge in corporate cash holding is an indication that corporate expectations about future demand are not very optimistic. Mildly pessimistic expectations about future demand are not inconsistent with high current profitability and rising stock prices.

I will not comment about why companies are not using their cash to buy other companies or to pay more and bigger bonuses to employees, but I do want to say something about why companies aren’t paying higher dividends to stockholders or buying back stock. One reason that they are not increasing dividend payments is that dividends are not tax-deductible. The non-deductibility of dividends is a terrible flaw in our corporate tax code. (See this post about Hyman Minsky’s opinion of the corporate income tax.) It penalizes giving the owners of companies the ability to decide how to allocate their capital, locking up capital in existing corporations because capital gains are taxed at a lower rate than dividends.

Now it would still be possible for corporations with excess cash to repurchase stock, allowing stockholders to be taxed at the lower rate on capital gains instead of the higher rate on dividends. But for multinational corporations, there is another obstacle to returning cash to stockholders either by paying dividends or by stock repurchase: cash now held overseas would be subject to the 35% corporate tax rate on either dividends or stock repurchases, imposing a huge penalty on returning idle cash to stockholders. So, instead of the cash being made available to millions of stockholders to spend or invest as they wish, creating new demand for output or providing capital to firms seeking new financing, the money is now effectively embargoed in corporate treasuries. What a waste.

Just How Infamous Was that Infamous Open Letter to Bernanke?

Published October 28, 2014 Ben Bernanke , credit deadlock , deflation , demand for money , gold standard , Great Depression , Hawtrey , inflation , Keynes , liquidity trap , Little Depression , monetary policy , QE , zero lower bound 21 Comments
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There’s been a lot of comment recently about the infamous 2010 open letter to Ben Bernanke penned by an assorted group of economists, journalists, and financiers warning that the Fed’s quantitative easing policy would cause inflation and currency debasement.

Critics of that letter (e.g., Paul Krugman and Brad Delong) have been having fun with the signatories, ridiculing them for what now seems like a chicken-little forecast of disaster. Those signatories who have responded to inquiries about how they now feel about that letter, notably Cliff Asness and Nial Ferguson, have made two arguments: 1) the letter was just a warning that QE was creating a risk of inflation, and 2) despite the historically low levels of inflation since the letter was written, the risk that inflation could increase as a result of QE still exists.

For the most part, critics of the open letter have focused on the absence of inflation since the Fed adopted QE, the critics characterizing the absence of inflation despite QE as an easily predictable outcome, a straightforward implication of basic macroeconomics, which it was ignorant or foolish of the signatories to have ignored. In particular, the signatories should have known that, once interest rates fall to the zero lower bound, the demand for money becoming highly elastic so that the public willingly holds any amount of money that is created, monetary policy is rendered ineffective. Just as a semantic point, I would observe that the term “liquidity trap” used to describe such a situation is actually a slight misnomer inasmuch as the term was coined to describe a situation posited by Keynes in which the demand for money becomes elastic above the zero lower bound. So the assertion that monetary policy is ineffective at the zero lower bound is actually a weaker claim than the one Keynes made about the liquidity trap. As I have suggested previously, the current zero-lower-bound argument is better described as a Hawtreyan credit deadlock than a Keynesian liquidity trap.

Sorry, but I couldn’t resist the parenthetical history-of-thought digression; let’s get back to that infamous open letter.

Those now heaping scorn on signatories to the open letter are claiming that it was obvious that quantitative easing would not increase inflation. I must confess that I did not think that that was the case; I believed that quantitative easing by the Fed could indeed produce inflation. And that’s why I was in favor of quantitative easing. I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR’s suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling. Unfortunately, FDR spoiled it all by getting Congress to pass the monumentally stupid National Industrial Recovery Act, thereby strangling the recovery with mandatory wage increases, cost increases, and regulatory ceilings on output as a way to raise prices. Talk about snatching defeat from the jaws of victory!

Inflation having worked splendidly as a recovery strategy during the Great Depression, I have believed all along that we could quickly recover from the Little Depression if only we would give inflation a chance. In the Great Depression, too, there were those that argued either that monetary policy is ineffective – “you can’t push on a string” — or that it would be calamitous — causing inflation and currency debasement – or, even both. But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don’t forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So my problem with the open letter to Bernanke is not that the letter failed to recognize the existence of a Keynesian liquidity trap or a Hawtreyan credit deadlock, but that the open letter viewed inflation as the problem when, in my estimation at any rate, inflation is the solution.

Now, it is certainly possible that, as critics of the open letter maintain, monetary policy at the zero lower bound is ineffective. However, there is evidence that QE announcements, at least initially, did raise inflation expectations as reflected in TIPS spreads. And we also know (see my paper) that for a considerable period of time (from 2008 through at least 2012) stock prices were positively correlated with inflation expectations, a correlation that one would not expect to observe under normal circumstances.

So why did the huge increase in the monetary base during the Little Depression not cause significant inflation even though monetary policy during the Great Depression clearly did raise the price level in the US and in the other countries that left the gold standard? Well, perhaps the success of monetary policy in ending the Great Depression could not be repeated under modern conditions when all currencies are already fiat currencies. It may be that, starting from an interwar gold standard inherently biased toward deflation, abandoning the gold standard created, more or less automatically, inflationary expectations that allowed prices to rise rapidly toward levels consistent with a restoration of macroeconomic equilibrium. However, in the current fiat money system in which inflation expectations have become anchored to an inflation target of 2 percent or less, no amount of money creation can budge inflation off its expected path, especially at the zero lower bound, and especially when the Fed is paying higher interest on reserves than yielded by short-term Treasuries.

Under our current inflation-targeting monetary regime, the expectation of low inflation seems to have become self-fulfilling. Without an explicit increase in the inflation target or the price-level target (or the NGDP target), the Fed cannot deliver the inflation that could provide a significant economic stimulus. So the problem, it seems to me, is not that we are stuck in a liquidity trap; the problem is that we are stuck in an inflation-targeting monetary regime.

 

Never Mistake a Change in Quantity Demanded for a Change in Demand

Published December 26, 2013 demand for money , macroeconomics , Scott Sumner 6 Comments
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We are all in Scott Sumner’s debt for teaching (or reminding) us never, ever to reason from a price change. The reason is simple. You can’t just posit a price change and then start making inferences from the price change, because price changes don’t just happen spontaneously. If there’s a price change, it’s because something else has caused price to change. Maybe demand has increased; maybe supply has decreased; maybe neither supply nor demand has changed, but the market was in disequilibrium before and is in equilibrium now at the new price; maybe neither supply nor demand has changed, but the market was in equilibrium before and is in disequilibrium now. There could be other scenarios as well, but unless you specify at least one of them, you can’t reason sensibly about the implications of the price change.

There’s another important piece of advice for anyone trying to do economics: never mistake a change in quantity demanded for a change in demand. A change in demand means that the willingness of people to pay for something has changed, so that, everything else held constant, the price has to change. If for some reason, the price of something goes up, the willingness of people to pay for not having changed, then the quantity of the thing that they demand will go down. But here’s the important point: their demand for that something – their willingness to pay for it – has not gone down; the change in the amount demanded is simply a response to the increased price of that something. In other words, a change in the price of something cannot be the cause of a change in the demand for that something; it can only cause a change in the quantity demanded. A change in demand can be caused only by change in something other than price – maybe a change in wealth, or in fashion, or in taste, or in the season, or in the weather.

Why am I engaging in this bit of pedantry? Well, in a recent post, Scott responded to the following question from Dustin in the comment section to one of his posts.

An elementary question on the topic of interest rates that I’ve been unable to resolve via google:

Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

To which Scott responded as follows:

It’s not at all clear that lower interest rates boost investment (never reason from a price change.)  And even if they did boost investment it is not at all clear that they would boost GDP.

Scott is correct to question the relationship between interest rates and investment. The relationship in the Keynesian model is based on the idea that a reduced interest rate, by reducing the rate at which expected future cash flows are discounted, increases the value of durable assets, so that the optimal size of the capital stock increases, implying a speed up in the rate of capital accumulation (investment). There are a couple of steps missing in the chain of reasoning that goes from a reduced rate of discount to a speed up in the rate of accumulation, but, in the olden days at any rate, economists have usually been willing to rely on their intuition that an increase in the size of the optimal capital stock would translate into an increased rate of capital accumulation.

Alternatively, in the Hawtreyan scheme of things, a reduced rate of interest would increase the optimal size of inventories held by traders and middlemen, causing an increase in orders to manufacturers, and a cycle of rising output and income generated by the attempt to increase inventories. Notice that in the Hawtreyan view, the reduced short-term interest is, in part, a positive supply shock (reducing the costs borne by middlemen and traders of holding inventories financed by short-term borrowing) as long as there are unused resources that can be employed if desired inventories increase in size.

That said, I’m not sure what Scott, in questioning whether a reduction in interesting rates raises investment, meant by his parenthetical remark about reasoning from a price change. Scott was asked about the effect of a Fed policy to reduce interest rates. Why is that reasoning from a price change? And furthermore, if we do posit that investment rises, why is it unclear whether GDP would rise?

Scott continues:

However it’s surprisingly hard to explain why OMPs boost NGDP using the mechanism of interest rates. Dustin is right that lower interest rates increase the demand for money.  They also reduce velocity. Higher money demand and lower velocity will, ceteris paribus, reduce NGDP.  So why does everyone think that a cut in interest rates increases NGDP?  Is it possible that Steve Williamson is right after all?

Sorry, Scott. Lower interest rates don’t increase the demand for money; lower interest rates increase the amount of money demanded. What’s the difference? If an interest-rate reduction increased the demand for money, it would mean that the demand curve had shifted, and the size of that shift would be theoretically unspecified. If that were the case, we would be comparing an unknown increase in investment on the one hand to an unknown increase in money demand on the other hand, the net effect being indeterminate. That’s the argument that Scott seems to be making.

But that’s not, repeat not, what’s going on here. What we have is an interest-rate reduction that triggers an increase investment and also in the amount of money demanded. But there is no shift in the demand curve for money, just a movement along an unchanging demand curve. That imposes a limit on the range of possibilities. What is the limit? It’s the extreme case of a demand curve for money that is perfectly elastic at the current rate of interest — in other words a liquidity trap — so that the slightest reduction in interest rates causes an unlimited increase in the amount of money demanded. But that means that the rate of interest can’t fall, so that investment can’t rise. If the demand for money is less than perfectly elastic, then the rate of interest can in fact be reduced, implying that investment, and therefore NGDP, will increase. The quantity of money demanded increases as well — velocity goes down — but not enough to prevent investment and NGDP from increasing.

So, there’s no ambiguity about the correct answer to Dustin’s question. If Steve Williamson is right, it’s because he has introduced some new analytical element not contained in the old-fashioned macroeconomic analysis. (Note that I use the term “old-fashioned” only as an identifier, not as an expression of preference in either direction.) A policy-induced reduction in the rate of interest must, under standard assumption in the old-fashioned macroeconomics, increase nominal GDP, though the size of the increase depends on specific assumptions about empirical magnitudes. I don’t disagree with Scott’s analysis in terms of the monetary base, I just don’t see a substantive difference between that analysis and the one that I just went through in terms of the interest-rate policy instrument.

Just to offer a non-controversial example, it is possible to reason through the effect of a restriction on imports in terms of a per unit tariff on imports or in terms of a numerical quota on imports. For any per unit tariff, there is a corresponding quota on imports that gives you the same solution. MMT guys often fail to see the symmetry between setting the quantity and the price of bank reserves; in this instance Scott seems to have overlooked the symmetry between the quantity and price of base money.

Sumner Sticks with Friedman

Published August 11, 2013 demand for money , Don Patinkin , J. R. Hicks , Keynes , Mark Blaug , Milton Friedman , Scott Sumner 8 Comments

Scott Sumner won’t let go. Scott had another post today trying to show that the Cambridge Theory of the demand for money was already in place before Keynes arrived on the scene. He quotes from Hicks’s classic article “Mr. Keynes and the Classics” to dispute the quotation from another classic article by Hicks, “A Suggestions for Simplifying the Theory of Money,” which I presented in a post last week, demonstrating that Hicks credited Keynes with an important contribution to the demand for money that went beyond what Pigou, and even Lavington, had provided in their discussions of the demand for money.

In this battle of dueling quotations, I will now call upon Mark Blaug, perhaps the greatest historian of economics since Schumpeter, who in his book Economic Theory in Retrospect devotes an entire chapter (15) to the neoclassical theory of money, interest and prices. I quote from pp. 636-37 (4th edition).

Marshall and his followers went some way to move the theory of the demand for money in the direction of ordinary demand analysis, first, by relating money to net output or national income rather than the broader category of total transactions, and, second, by shifting from money’s rate of turnover to the proportion of annual income that the public wishes to hold in the form of money. In purely formal terms, there I nothing to choose between the Fisherian transaction approach and the Cambridge cash-balance approach, but the Cambridge formulation held out the potential of a genuine portfolio theory of the demand for money, which potential, however, was never fully exploited. . . .

The Cambridge formulation implies a demand for money equation, D_m = kPY, which contains no variable to represent the opportunity costs of holding cash, namely the rate of interest or the yield of alternative non-money assets, analogous to the relative price arguments of ordinary demand functions.
Yet a straight-forward application of utility-maximizing principles would have suggested that a rise in interest rates is likely to induce a fall in k as people strive to substitute interest-earning assets for passive money balances in their asset portfolios. Similarly, a fall in interest rates, by lowering the opportunity cost of holding money, is likely to cause a rise in k. Strangely enough, however, the Cambridge monetary theory never explicitly recognized the functional dependence of k on either the rate of interest or the rate on all non-monetary assets. After constructing a framework highly suggestive of a study of all the factors influencing cash-holding decisions, the Cambridge writers tended to lapse back to a list of the determinants of k that differed in no important respects from the list of institutional factors that Fisher had cited in his discussion of V. One can find references in Marshall, Pigou and particularly Lavington to a representative individual striking a balance between the costs of cash holdings in terms of interest foregone (minus the brokerage costs that would have been incurred by the movement into stocks and bonds) and their returns in terms of convenience and security against default but such passages were never systematically integrated with the cash-balance equation. As late as 1923, we find the young Keynes in A Tract on Monetary Reform interpreting k as a stable constant, representing an invariant link in the transmission mechanism connecting money to prices. If only Keynes at that date had read Wicksell instead of Marshall, he might have arrived at a money demand function that incorporates variations in the interest rate years before The General Theory (1936).

Moving to pp. 645-46, we find the following under the heading “The Demand for Money after Keynes.”

In giving explicit consideration to the yields on assets that compete with money, Keynes became one of the founders of the portfolio balance approach to monetary analysis. However, it is Hicks rather than Keynes who ought to be regarded as the founder of the view that the demand for money is simply an aspect of the problem of choosing an optimum portfolio of assets. In a remarkable paper published a year before the appearance of the General Theory, modestly entitled “A Suggestion for Simplifying the Theory of Money,” Hicks argued that money held at least partly as a store of value must be considered a type of capital asset. Hence the demand for money equation must include total wealth and expected rates of return on non-monetary assets as explanatory variables. Because individuals can choose to hold their entire wealth portfolios in the form of cash, the wealth variable represents the budget constraint on money holdings. The yield variables, on the other hand, represent both the opportunity costs of holding money and the substitutions effects of changes in relative rates of return. Individuals optimize their portfolio balances by comparing these yields with the imputed yield in terms of convenience and security of holding money. By these means, Hicks in effect treated the demand for money as a problem of balance sheet equilibrium analyzed along the same lines as those employed in ordinary demand theory.

It was Milton Friedman who carried this Hicksian analysis of money as a capital asset to its logical conclusion. In a 1956 essay, he set out a precise and complete specification of the relevant constraints and opportunity cost variable entering a household’s money demand function. His independent variable included wealth or permanent income – the present value of expected future receipts from all sources, whether personal earning or the income from real property and financial assets – the ratio of human to non-human wealth, expected rates of return on stocks, bonds and real assets, the nominal interest rate, the actual price level, and, finally, the expected percentage change in the price level. Like Hicks, Friedman specified wealth as the appropriate budget constraint but his concept of wealth was much broader than that adopted by Hicks. Whereas Keynes had viewed bonds as the only asset competing with cash, Friedman regarded all types of wealth as potential substitutes for cash holdings in an individual’s balance sheet; thus, instead of a single interest variable in the Keynesian liquidity preference equation, we get a whole list of relative yield variables in Friedman. An additional novel feature, entirely original with Friedman, is the inclusion of the expected rate of change in P as a measure of the anticipated rate of depreciation in the purchasing power of cash balances.

This formulation of the money demand function was offered in a paper entitled “The Quantity Theory of Money: A Restatement.” Friedman claimed not only that the quantity theory of money had always been a theory about the demand for money but also that his reformulation corresponded closely to what some of the great Chicago monetary economists, such as H.C. Simons and L. W. Mints, had always meant by the quantity theory. It is clear, however, from our earlier discussion that the quantity theory of money, while embodying an implicit conception of the demand for money, had always stood first and foremost for a theory of the determination of prices and nominal income; it contained much more than a particular theory of the demand for money.

Finally, Blaug remarks in his “notes for further reading” at the end of chapter 15,

In an influential essay, “The Quantity Theory of Money – A Restatement,” . . . M. Friedman claimed that his restatement was nothing more than the University of Chicago “oral” tradition. That claim was effectively destroyed by D. Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman, JMCB, 1969 .

Well, just a couple of quick comments on Blaug. I don’t entirely agree with everything he says about Cambridge monetary theory, and about the relative importance of Hicks and Keynes in advancing the theory of the demand for money. Cambridge economists may have been a bit more aware that the demand for money was a function of the rate of interest than he admits, and I think Keynes in chapter 17, definitely formulated a theory of the demand for money in a portfolio balance context, so I think that Friedman was indebted to both Hicks and Keynes for his theory of the demand for money.

As for Scott Sumner’s quotation from Hicks’s Mr. Keynes and the Classics, I think the point of that paper was not so much the theory of the demand for money, which had already been addressed in the 1935 paper from which I quoted, as to sketch out a way of generalizing the argument of the General Theory to encompass both the liquidity trap and the non-liquidity trap cases within a single graph. From the standpoint of the IS-LM diagram, the distinctive Keynesian contribution was the case of absolute liquidity preference, that doesn’t mean that Hicks meant that nothing had been added to the theory of the demand for money since Lavington. If that were the case, Hicks would have been denying that his 1935 paper had made any contribution. I don’t think that’s what he meant to suggest.

To sum up: 1) there was no Chicago oral tradition of the demand for money; 2) Friedman’s restatement of the quantity theory owed more to Keynes (and Hicks) than he admitted; 3) Friedman adapted the Cambridge/Keynes/Hicks theory of the demand for money in novel ways that allowed him to develop an analysis of price level changes that was more straightforward than was possible in the IS-LM model, thereby de-emphasizing the link between money and interest rates, which had been a such a prominent feature of the Keynesian models. That of course is a point that Scott Sumner likes to stress. In an upcoming post, I will comment on the fact that it was not just Keynesian models which stressed the link between money and interest rates. Pre-Keynesian monetary models also stressed the connection between easy money and low interest rates and dear money and high interest rates. Friedman’s argument was thus an innovation not only relative to Keynesian models but to orthodox monetary models. What accounts for this innovation?

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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