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My Milton Friedman Problem

In my previous post , I discussed Keynes’s perplexing and problematic criticism of the Fisher equation in chapter 11 of the General Theory, perplexing because it is difficult to understand what Keynes is trying to say in the passage, and problematic because it is not only inconsistent with Keynes’s reasoning in earlier writings in which he essentially reproduced Fisher’s argument, it is also inconsistent with Keynes’s reasoning in chapter 17 of the General Theory in his exposition of own rates of interest and their equilibrium relationship. Scott Sumner honored me with a whole post on his blog which he entitled “Glasner on Keynes and the Fisher Effect,” quite a nice little ego boost.

After paraphrasing some of what I had written in his own terminology, Scott quoted me in responding to a dismissive comment that Krugman recently made about Milton Friedman, of whom Scott tends to be highly protective. Here’s the passage I am referring to.

PPS. Paul Krugman recently wrote the following:

Just stabilize the money supply, declared Milton Friedman, and we don’t need any of this Keynesian stuff (even though Friedman, when pressured into providing an underlying framework, basically acknowledged that he believed in IS-LM).

Actually Friedman hated IS-LM. I don’t doubt that one could write down a set of equilibria in the money market and goods market, as a function of interest rates and real output, for almost any model. But does this sound like a guy who “believed in” the IS-LM model as a useful way of thinking about macro policy?

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

It turns out that IS-LM curves will look very different if one moves away from the interest rate transmission mechanism of the Keynesians. Again, here’s David:

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Please do. Krugman reads Glasner’s blog, and if David keeps posting on this stuff then Krugman will eventually realize that hearing a few wisecracks from older Keynesians about various non-Keynesian traditions doesn’t make one an expert on the history of monetary thought.

I wrote a comment on Scott’s blog responding to this post in which, after thanking him for mentioning me in the same breath as Keynes and Fisher, I observed that I didn’t find Krugman’s characterization of Friedman as someone who basically believed in IS-LM as being in any way implausible.

Then, about Friedman, I don’t think he believed in IS-LM, but it’s not as if he had an alternative macromodel. He didn’t have a macromodel, so he was stuck with something like an IS-LM model by default, as was made painfully clear by his attempt to spell out his framework for monetary analysis in the early 1970s. Basically he just tinkered with the IS-LM to allow the price level to be determined, rather than leaving it undetermined as in the original Hicksian formulation. Of course in his policy analysis and historical work he was not constained by any formal macromodel, so he followed his instincts which were often reliable, but sometimes not so.

So I am afraid that my take may on Friedman may be a little closer to Krugman’s than to yours. But the real point is that IS-LM is just a framework that can be adjusted to suit the purposes of the modeler. For Friedman the important thing was to deny that that there is a liquidity trap, and introduce an explicit money-supply-money-demand relation to determine the absolute price level. It’s not just Krugman who says that, it’s also Don Patinkin and Harry Johnson. Whether Krugman knows the history of thought, I don’t know, but surely Patinkin and Johnson did.

Scott responded:

I’m afraid I strongly disagree regarding Friedman. The IS-LM “model” is much more than just the IS-LM graph, or even an assumption about the interest elasticity of money demand. For instance, suppose a shift in LM also causes IS to shift. Is that still the IS-LM model? If so, then I’d say it should be called the “IS-LM tautology” as literally anything would be possible.

When I read Friedman’s work it comes across as a sort of sustained assault on IS-LM type thinking.

To which I replied:

I think that if you look at Friedman’s responses to his critics the volume Milton Friedman’s Monetary Framework: A Debate with his Critics, he said explicitly that he didn’t think that the main differences among Keynesians and Monetarists were about theory, but about empirical estimates of the relevant elasticities. So I think that in this argument Friedman’s on my side.

And finally Scott:

This would probably be easier if you provided some examples of monetary ideas that are in conflict with IS-LM. Or indeed any ideas that are in conflict with IS-LM. I worry that people are interpreting IS-LM too broadly.

For instance, do Keynesians “believe” in MV=PY? Obviously yes. Do they think it’s useful? No.

Everyone agrees there are a set of points where the money market is in equilibrium. People don’t agree on whether easy money raises interest rates or lowers interest rates. In my view the term “believing in IS-LM” implies a belief that easy money lowers rates, which boosts investment, which boosts RGDP. (At least when not at the zero bound.) Friedman may agree that easy money boosts RGDP, but may not agree on the transmission mechanism.

People used IS-LM to argue against the Friedman and Schwartz view that tight money caused the Depression. They’d say; “How could tight money have caused the Depression? Interest rates fell sharply in 1930?”

I think that Friedman meant that economists agreed on some of the theoretical building blocks of IS-LM, but not on how the entire picture fit together.

Oddly, your critique of Keynes reminds me a lot of Friedman’s critiques of Keynes.

Actually, this was not the first time that I provoked a negative response by writing critically about Friedman. Almost a year and a half ago, I wrote a post (“Was Milton Friedman a Closet Keynesian?”) which drew some critical comments from such reliably supportive commenters as Marcus Nunes, W. Peden, and Luis Arroyo. I guess Scott must have been otherwise occupied, because I didn’t hear a word from him. Here’s what I said:

Commenting on a supremely silly and embarrassingly uninformed (no, Ms. Shlaes, A Monetary History of the United States was not Friedman’s first great work, Essays in Positive Economics, Studies in the Quantity Theory of Money, A Theory of the Consumption Function, A Program for Monetary Stability, and Capitalism and Freedom were all published before A Monetary History of the US was published) column by Amity Shlaes, accusing Ben Bernanke of betraying the teachings of Milton Friedman, teachings that Bernanke had once promised would guide the Fed for ever more, Paul Krugman turned the tables and accused Friedman of having been a crypto-Keynesian.

The truth, although nobody on the right will ever admit it, is that Friedman was basically a Keynesian — or, if you like, a Hicksian. His framework was just IS-LM coupled with an assertion that the LM curve was close enough to vertical — and money demand sufficiently stable — that steady growth in the money supply would do the job of economic stabilization. These were empirical propositions, not basic differences in analysis; and if they turn out to be wrong (as they have), monetarism dissolves back into Keynesianism.

Krugman is being unkind, but he is at least partly right. In his famous introduction to Studies in the Quantity Theory of Money, which he called “The Quantity Theory of Money: A Restatement,” Friedman gave the game away when he called the quantity theory of money a theory of the demand for money, an almost shockingly absurd characterization of what anyone had ever thought the quantity theory of money was. At best one might have said that the quantity theory of money was a non-theory of the demand for money, but Friedman somehow got it into his head that he could get away with repackaging the Cambridge theory of the demand for money — the basis on which Keynes built his theory of liquidity preference — and calling that theory the quantity theory of money, while ascribing it not to Cambridge, but to a largely imaginary oral tradition at the University of Chicago. Friedman was eventually called on this bit of scholarly legerdemain by his old friend from graduate school at Chicago Don Patinkin, and, subsequently, in an increasingly vitriolic series of essays and lectures by his then Chicago colleague Harry Johnson. Friedman never repeated his references to the Chicago oral tradition in his later writings about the quantity theory. . . . But the simple fact is that Friedman was never able to set down a monetary or a macroeconomic model that wasn’t grounded in the conventional macroeconomics of his time.

As further evidence of Friedman’s very conventional theoretical conception of monetary theory, I could also cite Friedman’s famous (or, if you prefer, infamous) comment (often mistakenly attributed to Richard Nixon) “we are all Keynesians now” and the not so famous second half of the comment “and none of us are Keynesians anymore.” That was simply Friedman’s way of signaling his basic assent to the neoclassical synthesis which was built on the foundation of Hicksian IS-LM model augmented with a real balance effect and the assumption that prices and wages are sticky in the short run and flexible in the long run. So Friedman meant that we are all Keynesians now in the sense that the IS-LM model derived by Hicks from the General Theory was more or less universally accepted, but that none of us are Keynesians anymore in the sense that this framework was reconciled with the supposed neoclassical principle of the monetary neutrality of a unique full-employment equilibrium that can, in principle, be achieved by market forces, a principle that Keynes claimed to have disproved.

But to be fair, I should also observe that missing from Krugman’s take down of Friedman was any mention that in the original HIcksian IS-LM model, the price level was left undetermined, so that as late as 1970, most Keynesians were still in denial that inflation was a monetary phenomenon, arguing instead that inflation was essentially a cost-push phenomenon determined by the rate of increase in wages. Control of inflation was thus not primarily under the control of the central bank, but required some sort of “incomes policy” (wage-price guidelines, guideposts, controls or what have you) which opened the door for Nixon to cynically outflank his Democratic (Keynesian) opponents by coopting their proposals for price controls when he imposed a wage-price freeze (almost 42 years ago on August 15, 1971) to his everlasting shame and discredit.

Scott asked me to list some monetary ideas that I believe are in conflict with IS-LM. I have done so in my earlier posts (here, here, here and here) on Earl Thompson’s paper “A Reformulation of Macroeconomic Theory” (not that I am totally satisfied with Thompson’s model either, but that’s a topic for another post). Three of the main messages from Thompson’s work are that IS-LM mischaracterizes the monetary sector, because in a modern monetary economy the money supply is endogenous, not exogenous as Keynes and Friedman assumed. Second, the IS curve (or something corresponding to it) is not negatively sloped as Keynesians generally assume, but upward-sloping. I don’t think Friedman ever said a word about an upward-sloping IS curve. Third, the IS-LM model is essentially a one-period model which makes it difficult to carry out a dynamic analysis that incorporates expectations into that framework. Analysis of inflation, expectations, and the distinction between nominal and real interest rates requires a richer model than the HIcksian IS-LM apparatus. But Friedman didn’t scrap IS-LM, he expanded it to accommodate expectations, inflation, and the distinction between real and nominal interest rates.

Scott’s complaint about IS-LM seems to be that it implies that easy money reduces interest rates and that tight money raises rates, but, in reality, it’s the opposite. But I don’t think that you need a macro-model to understand that low inflation implies low interest rates and that high inflation implies high interest rates. There is nothing in IS-LM that contradicts that insight; it just requires augmenting the model with a term for expectations. But there’s nothing in the model that prevents you from seeing the distinction between real and nominal interest rates. Similarly, there is nothing in MV = PY that prevented Friedman from seeing that increasing the quantity of money by 3% a year was not likely to stabilize the economy. If you are committed to a particular result, you can always torture a model in such a way that the desired result can be deduced from it. Friedman did it to MV = PY to get his 3% rule; Keynesians (or some of them) did it to IS-LM to argue that low interest rates always indicate easy money (and it’s not only Keynesians who do that, as Scott knows only too well). So what? Those are examples of the universal tendency to forget that there is an identification problem. I blame the modeler, not the model.

OK, so why am I not a fan of Friedman’s? Here are some reasons. But before I list them, I will state for the record that he was a great economist, and deserved the professional accolades that he received in his long and amazingly productive career. I just don’t think that he was that great a monetary theorist, but his accomplishments far exceeded his contributions to monetary theory. The accomplishments mainly stemmed from his great understanding of price theory, and his skill in applying it to economic problems, and his great skill as a mathematical statistician.

1 His knowledge of the history of monetary theory was very inadequate. He had an inordinately high opinion of Lloyd Mints’s History of Banking Theory which was obsessed with proving that the real bills doctrine was a fallacy, uncritically adopting its pro-currency-school and anti-banking-school bias.

2 He covered up his lack of knowledge of the history of monetary theory by inventing a non-existent Chicago oral tradition and using it as a disguise for his repackaging the Cambridge theory of the demand for money and aspects of the Keynesian theory of liquidity preference as the quantity theory of money, while deliberately obfuscating the role of the interest rate as the opportunity cost of holding money.

3 His theory of international monetary adjustment was a naïve version of the Humean Price-Specie-Flow mechanism, ignoring the tendency of commodity arbitrage to equalize price levels under the gold standard even without gold shipments, thereby misinterpreting the significance of gold shipments under the gold standard.

4 In trying to find a respectable alternative to Keynesian theory, he completely ignored all pre-Keynesian monetary theories other than what he regarded as the discredited Austrian theory, overlooking or suppressing the fact that Hawtrey and Cassel had 40 years before he published the Monetary History of the United States provided (before the fact) a monetary explanation for the Great Depression, which he claimed to have discovered. And in every important respect, Friedman’s explanation was inferior to and retrogression from Hawtrey and Cassel explanation.

5 For example, his theory provided no explanation for the beginning of the downturn in 1929, treating it as if it were simply routine business-cycle downturn, while ignoring the international dimensions, and especially the critical role played by the insane Bank of France.

6 His 3% rule was predicated on the implicit assumption that the demand for money (or velocity of circulation) is highly stable, a proposition for which there was, at best, weak empirical support. Moreover, it was completely at variance with experience during the nineteenth century when the model for his 3% rule — Peel’s Bank Charter Act of 1844 — had to be suspended three times in the next 22 years as a result of financial crises largely induced, as Walter Bagehot explained, by the restriction on creation of banknotes imposed by the Bank Charter Act. However, despite its obvious shortcomings, the 3% rule did serve as an ideological shield with which Friedman could defend his libertarian credentials against criticism for his opposition to the gold standard (so beloved of libertarians) and to free banking (the theory of which Friedman did not comprehend until late in his career).

7 Despite his professed libertarianism, he was an intellectual bully who abused underlings (students and junior professors) who dared to disagree with him, as documented in Perry Mehrling’s biography of Fischer Black, and confirmed to me by others who attended his lectures. Black was made so uncomfortable by Friedman that Black fled Chicago to seek refuge among the Keynesians at MIT.

Hawtrey on the Keynesian Explanation of Unemployment

Published July 11, 2013 Hawtrey , Keynes , Say's Law , W. H. Hutt 14 Comments
Tags: real-business cycle theory, unemployment

Here is a tidbit I just found the end of R. G. Hawtrey’s long chapter on the General Theory in his volume Capital and Employment, (second edition, 1952) pp. 218-19.

Unemployment in Great Britain seemed at the time [1935 when Keynes finished writing the General Theory] to be chronic: the number of unemployed had never fallen below a million since 1921. Keynes was looking for an explanation of chronic unemployment, but it was hardly plausible to attribute it to the low long-term rate of interest [i.e., to a liquidity trap]. The yield of Government securities had been exceptionally high till the Conversion of 1932.

And in reality there is no school of thought for which the explanation of unemployment presents any difficulty. If wages are too high for full employment, and resist reduction, unemployment is bound to result. Adam Smith held that for a growing population a corresponding growth of capital was essential to maintain wages at or above subsistence level; the penalty for the failure of capital to grow was unemployment as well as starvation. For his successors it was self-evident that the employment afforded by the “wage fund” was inversely proportional to the rate of wages, and, when the theory of the wage fund was superseded by that of the marginal yield of labour, it was no less self-evident that a wage-level held above marginal yield would prevent full employment. Say’s loi des debouches declared that production generated its own demand; but if for any reason production was below capacity and there was unemployment, the demand generated would be no more than sufficient to absorb output at that level.

What I find especially interesting in the passage is Hawtrey’s correct understanding of Say’s Law, so that it constitutes not, as Keynes supposed, an assertion that unemployment is impossible, but an explanation of how aggregate demand is itself just the flip side of aggregate supply. Contractions of supply can be cumulative. It’s not just Keynesians who forget this essential point. RBC theorists and others who model the business cycle as a general-equilibrium phenomenon miss an essential feature of what constitutes the business cycle.

Scott Sumner, Meet Robert Lucas

Published May 21, 2013 credit deadlock , expectations , Hawtrey , monetary policy , Robert Lucas , Scott Sumner 32 Comments
Tags: Lucas Critique, Sumner critique

I just saw Scott Sumner’s latest post. It’s about the zero fiscal multiplier. Scott makes a good and important point, which is that, under almost any conditions, fiscal policy cannot be effective if monetary policy is aiming at a policy objective that is inconsistent with that fiscal policy. Here’s how Scott puts it in his typical understated fashion.

From today’s news:

The marked improvement in the labor market since the U.S. central bank began its third round of quantitative easing, or QE3, has added an edge to calls by some policy hawks to dial down the stimulus. The roughly 50 percent jump in monthly job creation since the program began has even won renewed support from centrists, raising at least some chance the Fed could ratchet back its buying as early as next month.

I hope I don’t have to do any more of these. The fiscal multiplier theory is as dead as John Cleese’s parrot. The growth in jobs didn’t slow with fiscal austerity, it sped up! And the Fed is saying that any job improvement due to fiscal stimulus will be offset with tighter money. They talk like the multiplier is zero, and their actions produce a zero multiplier.

This is classic Sumner, and he deserves credit for rediscovering an argument that Ralph Hawtrey made in 1925, but was ignored and then forgotten until Sumner figured it out for himself. When I went through Hawtrey’s analysis in my recent series of posts on Hawtrey and Keynes, Scott immediately identified the identity between what Hawtrey was saying and what he was saying. So up to this point, I am with Scott all the way. But then he loses me, by asking the following question

Has there ever been a more decisive refutation of a major economic theory?

What’s wrong with that question? Well, it seems to me to fly in the face of another critique by another famous economist whom, I think, Scott actually knows: Robert Lucas. Almost 40 years ago, Lucas published a paper about the Phillips Curve in which he argued that the existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation. That simple point, dressed up with just enough mathematical notation to obscure its obviousness, helped Lucas win the Noble Prize, and before long became widely known as the Lucas Critique.

The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions. Observed relationships between economic variables are useless for policy makers unless they understand those deep structural relationships and how they are affected by expectations.

But now Scott seems to be turning the Lucas Critique on its head by saying that the expectations that result from a particular policy regime — a policy regime that has been subjected to withering criticism by none other than Scott himself – refutes a structural theory (that government spending can increase aggregate spending and income) of how the economy works. I don’t think so. The fact that the Fed has adopted and tenaciously sticks to a perverse reaction function cannot refute a theory in which the Fed’s reaction function is a matter of choice not necessity.

I agree with Scott that monetary policy is usually the best tool for macroeconomic stabilization. But that doesn’t mean that fiscal policy can never ever promote recovery. Even Ralph Hawtrey, originator of the “Treasury view” that fiscal policy is powerless to affect aggregate spending, acknowledged that, in a credit deadlock, when expectations are so pessimistic that the monetary authority is powerless to increase private spending, deficit spending by the government financed by money creation might be the only way to increase aggregate spending. That, to be sure, is a pathological situation. But, with at least some real interest rates, currently below zero, it is not impossible to suppose that we are, or have been, in something like a Hawtreyan credit deadlock. I don’t say that we are in one, just that it’s possible that we are close enough to being there that we can’t confidently exclude the possibility, if only the Fed would listen to Scott and stop targeting 2% inflation, of a positive fiscal multiplier.

With US NGDP not even increasing at a 4% annual rate, and the US economy far below its pre-2008 trendline of 5% annual NGDP growth, I don’t understand why one wouldn’t welcome the aid of fiscal policy in getting NDGP to increase at a faster rate than it has for the last 5 years. Sure the economy has been expanding despite a sharp turn toward contractionary fiscal policy two years ago. If fiscal stimulus had not been withdrawn so rapidly, can we be sure that the economy would not have grown faster? Under conditions such as these, as Hawtrey himself well understood, the prudent course of action is to err on the side of recklessness.

A Newly Revised Version of My Paper (with Ron Batchelder) on Hawtrey and Cassel Is Now Available on SSRN

Published May 7, 2013 Cassel , Friedman , Great Depression , Hawtrey , Hayek , Keynes 6 Comments
Tags: Cassel, Great Depression, Harry Johnson, Hawtrey

This may not be the most important news of the day, but for those wishing to immerse themselves in the economics of Hawtrey and Cassel, a newly revised version of my paper with Ron Batchelder “Pre-Keynesian Monetary Explanations of the Great Depression: Whatever Happened to Hawtrey and Cassel?” is now available on SSRN.

The paper has also recently been submitted to a journal for review, so we are hoping that it will finally be published before too long. Wish us luck. Here’s the slightly revised abstract.

A strictly monetary theory of the Great Depression is generally thought to have originated with Milton Friedman. Designed to counter the Keynesian notion that the Depression resulted from instabilities inherent in modern capitalist economies, Friedman’s explanation identified the culprit as an ill-conceived monetary policy pursued by an inept Federal Reserve Board. More recent work on the Depression suggests that the causes of the Depression, rooted in the attempt to restore an international gold standard that had been suspended after World War I started, were more international in scope than Friedman believed. We document that current views about the causes of the Depression were anticipated in the 1920s by Ralph Hawtrey and Gustav Cassel who independently warned that restoring the gold standard risked causing a disastrous deflation unless the resulting increase in the international monetary demand for gold could be limited. Although their early warnings of potential disaster were validated, and their policy advice after the Depression started was consistently correct, their contributions were later ignored or forgotten. This paper explores the possible reasons for the remarkable disregard by later economists of the Hawtrey-Cassel monetary explanation of the Great Depression.

Hawtrey Reviews Cassel

Published May 6, 2013 Cassel , Great Depression , Hawtrey , inflation , monetary policy 3 Comments
Tags: Cassel, Hawtrey, inflation

While doing further research on Ralph Hawtrey, I recently came across a brief 1933 review written by Hawtrey in the Economic Journal of a short book by Gustav Cassel, The Crisis in the World Monetary System. Sound familiar? The review provides a wonderfully succinct summary of the views of both Cassel and Hawtrey of the causes of, and the cure for, the Great Depression. The review can still be read with pleasure and profit. It can also be read with wonder. It is amazing that something written 80 years ago about the problem of monetary disorder can have such relevance to the problems of today. Here is the review in full. And pay special attention to the last paragraph.

The delivery of a series of three lectures at Oxford last summer has given Professor Cassel an opportunity of fulfilling his function of instructing public opinion in the intricacies of economic theory, especially of monetary theory in their application to current events. This little book of just under 100 pages is the result. As admirers of Professor Cassel will expect, it is full of wisdom, expressed with an admirable clarity and simplicity.

He points out that so long as the policy of economising gold, recommended at the Genoa Conference, was carried out, it was possible to prevent any considerable rise in the value of gold. “The world reaped the fruits of this policy in an economic development in which most countries had their share and which for some countries meant a great deal of prosperity” (p. 27).

Progress up to 1928 was normally healthy; it was not more rapid than was usual in the pre-war period. It was interrupted in 1929 by the fall of prices, for which in Professor Cassel’s view the responsibility rests on the central banks. “The course of a ship is doubtless the combined result of wind, current and navigation, and each of these factors could be quoted as independent causes of the result that the ship arrives at a certain place.” But it is navigation that is within human control, and consequently the responsibility rests on the captain. So a central bank, which has the monopoly of supplying the community with currency, bears the responsibility for variations in the value of the currency (pp. 46-7).

Under a gold standard the responsibility becomes international, but “if some important central banks follow a policy which must lead, say, to a violent increase in the value of gold, the behaviour of such banks must be regarded as the cause of this movement” (p. 48).

Professor Cassel further apportions a heavy share of the responsibility for the breakdown to war debts and reparations. “The payment of war debts in conjunction with the unwillingness to receive payment in the normal form of goods led to unreasonable demands on the world’s monetary stocks; and the claimants failed to use in a proper way the gold that they had accumulated” (pp. 71-2).

Just as a reminder, if you have made it this far, don’t stop without reading the next and final paragraph.

Finally, for a remedy, “the best thing that the gold standard countries could do for a rapid economic recovery would be immediately to start an inflation of their currencies. If this inflation were the outcome of a deliberate and well-conceived policy it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts” (p. 94).

Let’s read that again:

If inflation were the outcome of a deliberate and well-conceived policy, it could be controlled, and the consequent rise of the general level of commodity prices could be kept within such limits as were deemed desirable for the restoration of a necessary equilibrium between different groups of prices, wages, and commercial debts.

They Come not to Praise Market Monetarism, but to Bury It

Published April 29, 2013 credit deadlock , expectations , fiscal policy , Hawtrey , monetary policy , Paul Krugman , Uncategorized , zero lower bound 28 Comments
Tags: austerity, Mike Konczal, Paul Krugman, Sumner critique

For some reason – maybe he is still annoyed with Scott Sumner – Paul Krugman decided to channel a post by Mike Konczal purporting to show that Market Monetarism has been refuted by the preliminary first quarter GDP numbers showing NGDP increasing at a 3.7% rate and real GDP increasing at a 2.5% rate in Q1. To Konczal and Krugman (hereinafter K&K) this shows that fiscal policy, not monetary policy, is what matters most for macroeconomic performance. Why is that? Because the Fed, since embarking on its latest splurge of bond purchasing last September, has failed to stimulate economic activity in the face of the increasingly contractionary stance of fiscal policy since them (the fiscal 2013 budget deficit recently being projected to be $775 billion, a mere 4.8% of GDP).

So can we get this straight? GDP is now rising at about the same rate it has been rising since the start of the “recovery” from the 2007-09 downturn. Since September monetary policy has become easier and fiscal policy tighter. And that proves what? Sorry, I still don’t get it. But then again, I was always a little slow on the uptake.

Marcus Nunes, the Economist, Scott Sumner, and David Beckworth all weigh in on the not very devastating K&K onslaught. (Also see this post by Evan Soltas written before the fact.) But let me try to cool things down a bit.

If we posit that we are still in something akin to a zero-lower-bound situation, there are perfectly respectable theoretical grounds on which to recommend both fiscal and monetary stimulus. It is true that monetary policy, in principle, could stimulate a recovery even without fiscal stimulus — and even in the face of fiscal contraction — but for monetary policy to be able to be that effective, it would have to operate through the expectations channel, raising price-level expectations sufficiently to induce private spending. However, for good or ill, monetary policy is not aiming at more than a marginal change in inflation expectations. In that kind of policy environment, the potential effect of monetary policy is sharply constrained. Hence, the monetary theoretical case for fiscal stimulus. This is classic Hawtreyan credit deadlock (see here and here).

If monetary policy can’t do all the work by itself, then the question is whether fiscal policy can help. In principle it could if the Fed is willing to monetize the added debt generated by the fiscal stimulus. But there’s the rub. If the Fed has to monetize the added debt created by the fiscal stimulus — which, for argument’s sake, let us assume is more stimulative than equivalent monetary expansion without the fiscal stimulus — what are we supposed to assume will happen to inflation and inflation expectations?

Here is the internal contradiction – the Sumner critique, if you will – implicit in the Keynesian fiscal-policy prescription. Can fiscal policy work without increasing the rate of inflation or inflation expectations? If monetary policy alone cannot work, because it cannot break through the inflation targeting regime that traps us at the 2 percent inflation ceiling, how is fiscal policy supposed to work its way around the 2% inflation ceiling, except by absolving monetary policy of the obligation to keep inflation at or below the ceiling? But if we can allow the ceiling to be pierced by fiscal policy, why can’t we allow it to be pierced by monetary policy?

Perhaps K&K can explain that one to us.

Liquidity Trap or Credit Deadlock

Published April 22, 2013 credit deadlock , David Laidler , Hawtrey , Keynes , liquidity preference 21 Comments
Tags: Hawtrey, Keynes, Laidler, quantitative easing

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

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

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

To which I answered:

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

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

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

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

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

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

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

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

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

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

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

David Laidler on Hawtrey and the Treasury View

Published April 16, 2013 David Laidler , fiscal policy , Hawtrey , monetary policy , Treasury view Leave a Comment
Tags: David Laidler, Hawtrey, Richard Kahn, Treasury View

My recent post on Hawtrey and the Treasury View occasioned an exchange of emails with David Laidler about Hawtrey, the Treasury View. and the gold standard. As usual, David made some important points that I thought would be worth sharing. I will try to come back to some of his points in future posts, but for now I will just refer to his comments about Hawtrey and the Treasury View.

David drew my attention to his own discussion of Hawtrey and the Treasury View in his excellent book Fabricating the Keynesian Revolution (especially pp. 112-28). Here are some excerpts.

It is well known that Hawtrey was a firm advocate of using the central bank’s discount rate – bank rate, as it is called in British terminology – as the principal instrument of monetary policy, and this might at first sight seem to place him in the tradition of Walter Bagehot. However, Hawtrey’s conception of the appropriate target for policy was very different from Bagehot’s, and he was well aware of the this difference. Bagehot had regarded the maintenance of gold convertibility as the sine qua non of monetary policy, and as Hawtrey told reader of his Art of Central Banking, “a central bank working the gold standard must rectify an outflow of gold by a restriction of credit and an inflow of gold by a relaxation of credit. Under Hawtrey’s preferred scheme, on the other hand,

substantially the plan embodied in the currency resolution adopted at the Genoa Conference of 1922, . . . the contral banks of the world [would[ regulated credit with a view to preventing undue fluctuations in the purchasing power of gold.

More generally he saw the task of central banking as being to mitigate that inherent instability of credit which was the driving force of economic fluctuations, by ensuring, as far as possible, that cumulative expansions and contractions of bank deposits were eliminated, or, failing that, when faced by depression, to bring about whatever degree of monetary expansion might be required to restore economic activity to a satisfactory level. (pp. 122-23)

Laidler links Hawtrey’s position about the efficacy of central bank policy in moderating economic fluctuations to Hawtrey’s 1925 paper on public-works spending and employment, the classic statement of the Treasury View.

Unlike the majority of his English . . . contemporaries, Hawtrey thus had few doubts about the ultimate powers of conventional monetary policy to stimulate the economy, even in the most depressed circumstances. In parallel with that belief . . . he was skeptical about the powers of government-expenditure programs to have any aggregate effects on income and employment, except to the extent that they were financed by money creation. Hawtrey was, in fact, the originator of the particular version of “the Treasury view” of those matters that Hicks . . . characterized in terms of a vertical-LM-curve version of the IS-LM framework.

Hawtrey had presented at least the bare bones of that doctrine in Good and Bad Trade (1913), but his definitive exposition is to be found in his 1925 Economica paper. . . . [T]hat exposition was cast in terms of a system in which, given the levels of money wages and prices, the levels of output and employment were determined by the aggregate rate of low of expenditure on public works can be shown to imply an increase in the overall level of effective demand, the consequences must be an equal reduction in the expenditure of some other sector. . . .

That argument by Hawtrey deserves more respect than it is usually given. His conclusions do indeed follow from the money-growth-driven income-expenditure system with which he analysed the cycle. They follow from an IS-LM model when the economy is operating where the interest sensitivity of the demand for money in negligible, so that what Hicks would later call “the classical theory” is relevant. If, with the benefit of hindsight, Hawtrey might be convicted of over-generalizing from a special case, his analysis nevertheless made a significant contribution in demonstrating the dangers inherent in Pigou’s practice of going “behind the distorting veil of money” in order to deal with such matters. Hawtrey’s view, that the influence of public-works expenditures on the economy’s overall rate of flow of money expenditures was crucial to their effects on employment was surely valid. (pp.125-26)

Laidler then observes that no one else writing at the time had identified the interest-sensitivity of the demand for money as the relevant factor in judging whether public-works expenditure could increase employment.

It is true that the idea of a systematic interest sensitivity of the demand for money had been worked out by Lavington in the early 1920s, but it is also true that none of Hawtrey’s critics . . . saw its critical relevance to this matter during that decade and into the next. Indeed, Hawtrey himself came as close as any of them did before 1936 to developing a more general, not to say correct, argument about thte influence of the monetary system on the efficacy of public-works expenditure. . . . And he argued that once an expansion got under way, increased velocity would indeed accompany it. However, and crucially, he also insisted that “if no expansion of credit at all is allowed, the conditions which produce increased rapidity of circulation cannot begin to develop.”

Hindsight, illuminated by an IS-LM diagram with an upward-sloping LM curve, shows that the last step of his argument was erroneous, but Hawtrey was not alone in holding such a position. The fact is that in the 1920s and early 1930s, many advocates of public-works expenditures were careful to note that their success would be contingent upon their being accommodated by appropriate monetary measures. For example, when Richard Kahn addressed that issue in his classic article on the employment multiplier, he argued as follows:

It is, however, important to realize that the intelligent co-operation of the banking system is being taken for granted. . . . If the increased circulation of notes and the increased demand for working capital that may result from increased employment are made the occasion for a restriction of credit, then any attempt to increase employment . . . may be rendered nugatory. (pp. 126-27)

Thus, Laidler shows that Hawtrey’s position on the conditions in which public-works spending could increase employment was practically indistinguishable from Richard Kahn’s position on the same question in 1931. And I would emphasize once again that, inasmuch as Hawtrey’s 1925 position was taken when the Bank of England policy was setting its lending rate at the historically high level of 5% to encourage an inflow of gold and allow England to restore the gold standard at the prewar parity, Hawtrey was correct, notwithstanding any tendency of public-works spending to increase velocity, to dismiss public-works spending as a remedy for unemployment as long as bank rate was not reduced.

Hawtrey and the “Treasury View”

Published April 10, 2013 Hawtrey , Keynes , monetary history , monetary policy , monetary theory , zero lower bound 25 Comments
Tags: Brad Delong, Hawtrey, Keynes, Treasury View, Winston Chuchill

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hawtrey v. Keynes on the Rate of Interest that Matters

Published March 31, 2013 expectations , fiscal policy , Hawtrey , J. R. Hicks , Keynes , monetary policy , monetary theory 7 Comments
Tags: Austrian Business-Cycle Theory, business cycles, rational expectations

In my previous post, I quoted Keynes’s remark about the “stimulus and useful suggestion” he had received from Hawtrey and the “fundamental sympathy and agreement” that he felt with Hawtrey even though he nearly always disagreed with Hawtrey in detail. One important instance of such simultaneous agreement about principle and disagreement about detail involves their conflicting views about whether it is the short-run rate of interest (bank rate) or the long-run rate of interest (bond rate) that is mainly responsible for the fluctuations in investment that characterize business cycles, the fluctuations that monetary policy should therefore attempt to control.

Already in 1913 in his first work on monetary theory, Good and Bad Trade, Hawtrey had identified the short-term interest rate as the key causal variable in the business cycle, inasmuch as the holdings of inventories that traders want to hold are highly sensitive to the short-term interest rates at which traders borrow to finance those holdings. Increases in the desired inventories induce output increases by manufacturers, thereby generating increased incomes for workers and increased spending by consumers, further increasing the desired holding of stocks by traders. Reduced short-term interest rates, according to Hawtrey, initiated a cumulative process leading to a permanently higher level of nominal income and output. But Keynes disputed whether adjustments in the desired stocks held by traders were of sufficient size to account for the observed fluctuations in income and employment. Instead, Keynes argued, it was fluctuations in fixed-capital investment that accounted for the fluctuations in income and employment characteristic of business cycles. In his retrospective (1969) on the differences between Hawtrey and Keynes, J. R. Hicks observed that “there are large parts of the Treatise [on Money] which are a reply to Currency and Credit Hawtrey’s 1919 book on monetary theory and business cycles. But despite their differences, Hicks emphasized that Hawtrey and Keynes

started from common ground, not only on the need for policy, but in agreement that the instrument of policy was the rate of interest, or “terms of credit,” to be determined, directly or indirectly, by a Central Bank. But what rate of interest? It was Hawtrey’s doctrine that the terms of bank lending had a direct eSect on the activity of trade and industry; traders, having more to pay for credit, would seek to reduce their stocks, being therefore less willing to buy and more willing to sell. Keynes, from the start (or at least from the time of the Treatise 1930) rejected this in his opinion too simple view. He substituted for it (or began by substituting for it) an alternative mechanism through the long rate of interest. A change in the terms of bank lending affected the long rate of interest, the terms on which business could raise long-term capital; only in this roundabout way would a change in the terms of bank lending affect the activity of industry.

I think we can now see, after all that has happened, and has been said, since 1930, that the trouble with both of these views (as they were presented, or at least as they were got over) was that the forces they purported to identify were not strong enough to bear the weight that was put upon them. This is what Keynes said about Hawtrey (I quote from the Treatise):

The whole emphasis is placed on one particular kind of investment, namely, investment by dealers and middlemen in liquid goods-to which a degree of sensitivity to changes in Bank Rate is attributed which certainly does not exist in fact…. [Hawtrey] relies exclusively on the increased costs of business resulting from dearer money. [He] admits that these additional costs will be too small materially to affect the manufacturer, but assumes without investigation that they do materially affect the trader…. Yet probably the question whether he is paying S or 6 per cent for the accommodation he receives from his banker influences the mind of the dealer very little more than it influences the mind of the manufacturer as compared with the current and prospective rate of take-off for the goods he deals in and his expectations as to their prospective price-movements. [Treatise on Money, v. I, pp. 193-95.]

Although Hicks did not do so, it is worth quoting the rest of Keynes’s criticism of Hawtrey

The classical refutation of Hawtrey was given by Tooke in his examination of an argument very similar to Hawtrey’s, put forward nearly a hundred years ago by Joseph Hume. Before the crisis of 1836-37 the partisans of the “currency theory” . . . considered the influence of the Bank of England on the price level only operated through the amount of its circulation; but in 1839 the new-fangled notion was invented that Bank-rate also had an independent influence through its effect on “speculation.”

Keynes then quoted the following passage from Tooke:

There are, doubtless, persons, who, upon imperfect information, and upon insufficient grounds, or with too sanguine a view of contingencies in their favour, speculate improvidently; but their motive or inducement so to speculate is the opinion which, whether well or ill-founded, or whether upon their own view or upon the authority or example of other persons, they entertain the probability of an advance of price. It is not the mere facility of borrowing, or the difference between borrowing at 3 or at 6 percent that supplies the motive for purchasing, or even for selling. Few persons of the description here mentioned ever speculate but upon the confident expectation of an advance of price of at least 10 percent.

In his review of the Treatise, published in The Art of Central Banking, Hawtrey took note of this passage and Keynes’s invocation of Tooke’s comment on Joseph Hume.

This quotation from Tooke is entirely beside the point. My argument relates not to speculators . . . but to regular dealers or merchants. And as to these there is no evidence, in the following passage, that Tooke’s view of the effects of a rise in the rate of interest did not differ very widely from that which I have advocated. In volume v. of his History of Prices (p. 584) he wrote:

Inasmuch as a higher than ordinary rate of interest supposes a contraction of credit, such goods as are held by means of a large proportion of borrowed capital may be forced for sale by a difficulty in obtaining banking accommodation, the measure of which difficulty is in the rate of discount and perhaps in the insufficiency of security. In this view, and in this view only, a rate of interest higher than ordinary may be said to have an influence in depressing prices.

Tooke here concentrates on the effect of a high rate of interest in hastening sales. I should lay more emphasis on delaying purchases. But at any rate he clearly recognizes the susceptibility to credit conditions of the regular dealers in commodities.

And Hicks, after quoting Keynes’s criticism of Hawtrey’s focus on the short-term interest, followed up with following observation about Keynes:

Granted, but could not very much the same be said of Keynes’s own alternative mechanism? One has a feeling that in the years when he was designing the General Theory he was still clinging to it, for it is deeply embedded in the structure of his theory; yet one suspects that before the book left his hands it was already beginning to pass out. It has left a deep mark on the teaching of Keynesian economics, but a much less deep mark upon its practical influence. In the fight that ensued after the publication of the General Theory, it was quite clearly a casualty.

In other words, although Keynes in the Treatise believed that variation in the long-term interest rate could moderate business-cycle fluctuations by increasing or decreasing the amount of capital expenditure by business firms, Keynes in the General Theory was already advocating the direct control of spending through fiscal policy and minimizing the likely effectiveness of trying to control spending via the effect of monetary policy on the long-term interest rate. Hicks then goes on to observe that the most effective response to Keynes’s view that monetary policy operates by way of its effect on the long-term rate of interest came from none other than Hawtrey.

It had taken him some time to mount his attack on Keynes’s “modus operandi of Bank Rate” but when it came it was formidable. The empirical data which Keynes had used to support his thesis were derived from a short period only-the 1920’s; and Hawtrey was able to show that it was only in the first half of that decade (when, in the immediate aftermath of the War, the long rate in England was for that time unusually volatile) that an effect of monetary policy on the long rate, sufficient to give substantial support yo Keynes’s case, was at all readily detectable. Hawtrey took a much longer period. In A Century of Bank Rate which, in spite of the narrowness of its subject, seems to me to be one of his best books, he ploughed through the whole of the British experience from 1844 to the date of writing; and of any effect of Bank Rate (or of any short rate) upon the long rate of interest, sufficient to carry the weight of Keynes’s argument, he found little trace.

On the whole I think that we may infer that Bank Rate and measures of credit restriction taken together rarely, if ever, affected the price of Consols by more than two or three points; whereas a variation of }4 percent in the long-term rate of interest would correspond to about four points in the price of a 3 percent stock.

Now a variation of even less than 1/8 per cent in the long-term rate of interest ought, theoretically and in the long run, to have a definite effect for what it is worth on the volume of capital outlay…. But there is in reality no close adjustment of prospective yield to the rate of interest. Most of the industrial projects offered for exploitation at any time promise yields ever so far above the rate of interest…. [They will not be adopted until] promoters are satisfied that the projects they take up will yield a commensurate profit, and the rate of interest calculated on money raised will probably be no more than a very moderate deduction from this profit. [A Century of Bank Rate pp. 170-71]

Hicks concludes that, as regards the effect of the rate of interest on investment and aggregate spending, Keynes and Hawtrey cancelled each other out, thereby clearing the path for fiscal policy to take over as the key policy instrument for macroeconomic stabilization, a conclusion that Hawtrey never accepted. But Hicks adds an interesting and very modern-sounding (even 40 years on) twist to his argument.

When I reviewed the General Theory, the explicit introduction of expectations was one of the things which I praised; but I have since come to feel that what Keynes gave with one hand, he took away with the other. Expectations do appear in the General Theory, but (in the main) they appear as data; as autonomous influences that come in from outside, not as elements that are moulded in the course of the process that is being analysed. . . .

I would maintain that in this respect Hawtrey is distinctly superior. In his analysis of the “psychological effect” of Bank Rate — it is not just a vague indication, it is analysis — he identifies an element which ought to come into any monetary theory, whether the mechanism with which it is concerned is Hawtrey’s, or any other. . . .

What is essential, on Hawtrey’s analysis, is that it should be possible (and should look as if it were possible) for the Central Bank to take decisive action. There is a world of difference . . . between action which is determinedly directed to imposing restraint, so that it gives the impression that if not effective in itself, it will be followed by further doses of the same medicine; and identically the same action which does not engender the same expectations. Identically the same action may be indecisive, if it appears to be no more than an adjustment to existing market conditions; or if the impression is given that it is the most that is politically possible. If conditions are such that gentle pressure can be exerted in a decisive manner, no more than gentle pressure will, as a rule, be required. But as soon as there is doubt about decisiveness, gentle pressure is useless; even what would otherwise be regarded as violent action may then be ineffective. [p. 313]

There is a term which was invented, and then spoiled, by Pigou . . . on which I am itching to get my hand; it is the term announcement effect. . . . I want to use the announcement effect of an act of policy to mean the change which takes place in people’s minds, the change in the prospect which they think to be before them, before there is any change which expresses itself in transactions of any kind. It is the same as what Hawtrey calls “psychological effect”; but that is a bad term, for it suggests something irrational, and this is entirely rational. Expectations of the future (entirely rational expectations) [note Hicks’s use of the term “rational expectations before Lucas or Sargent] are based upon the data that are available in the present. An act of policy (if it is what I have called a decisive action) is a significant addition to the data that are available; it should result, and should almost immediately result, in a shift in expectations. This is what I mean by an announcement effect.

What I learn from Hawtrey’s analysis is that the “classical” Bank Rate system was strong, or could be strong, in its announcement effects. Fiscal policy, at least as so far practised, gets from this point of view much worse marks. It is not simply that it is slow, being subject to all sorts of parliamentary and administrative delays; made indecisive, merely because the gap between announcement and effective operation is liable to be so long. This is by no means its only defect. Its announcement effect is poor, for the very reason which is often claimed to be one of its merits its selectivity; for selectivity implies complexity and an instrument which is to have a strong announcement effect should, above all, be simple. [p. 315]

Just to conclude this rather long and perhaps rambling selection of quotes with a tangentially related observation, I will note that Hawtrey’s criticism of Keynes’s identification of the long-term interest rate as the key causal and policy variable for the analysis of business cycles applies with equal force to Austrian business-cycle theory, which, as far as I can tell, rarely, if ever, distinguishes between the effects of changes in short-term and long-term rates caused by monetary policy.

HT: Alan Gaukroger

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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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