Archive for the 'James Tobin' Category

Thoughts and Details on the Fiscal Theory of the Price Level

Published July 21, 2024 Adam Smith , bimetalism , Chris Sims , Earl Thompson , Eric Leeper , Fiscal Theory of the Price Level , gold standard , James Tobin , John Cochrane , Keynes , Michael Woodford 6 Comments
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The Fiscal Theory of the Price Level has been percolating among monetary theorists for over three decades: Eric Leeper being the first to offer a formalization of the idea, with Chris Sims and Michael Woodford soon contributed to its further development. But the underlying idea that the taxation power of the state is essential for the acceptability of fiat money was advanced by Adam Smith in the Wealth of Nations to explain how fiat money could be worth more than its minimal cost of production. The Smith connection suggests a somewhat surprising and non-trivial intellectual kinship between the Fiscal Theory and Modern Monetary Theory that proponents of neither theory are pleased to acknowledge.

While the Fiscal Theory has important insights, it seems to promise more than it delivers. Presuming to offer a more robust explanation of price-level or inflation fluctuations than the simple quantity theory (not that high a bar), it shares with its counterpart an incomplete account of the demand for money, paying insufficient attention to the reasons for, and the responses to, fluctuations in that demand.

In this post and perhaps one or two more to follow, I use a 2022 article by John Cochrane showing how the Fiscal Theory accounts for both recent and earlier inflationary and disinflationary episodes more persuasively than do other theories of the price level, whether Monetarist or Keynesian regardless of specific orientation. Those interested in a fuller exposition of the Fiscal Theory will want to read Cochrane’s recent volume on the subject.

Let’s start with Cochrane’s brief description of the Fiscal Theory (p. 126):

The fiscal theory states that inflation adjusts so that the real value of government debt equals the present value of primary surpluses.

Most simply, money is valuable because we need money to pay taxes. If, on average, people have more money than they need to pay taxes, they try to buy things, driving up prices. In the words of Adam Smith (1776 [1930], Book II, chap. II): “A prince, who should enact that a certain proportion of his taxes be paid in a paper money of a certain kind, might thereby give a certain value to this paper money . . .” Taxes are a percentage of income. Thus, as prices and wages rise, your dollar income rises, and the amount of money you must pay in taxes rises. A higher price level soaks up excess money with tax payments. Equivalently, the real value of money, the amount of goods and services a dollar buys, declines as the price level rises. But the real value of taxes does not change (much), so a higher price level lowers the real value of money until it equals the real value of tax payments.

It’s useful to quote Adam Smith about how to account for the value of intrinsically worthless pieces of paper, but Smith was explaining the source of the value of fiat money, not necessarily the actual value of any given fiat money at any particular time or the causes of fluctuations in the value of fiat money over time. Precious metals were originally used as media of exchange only because they had a value independent of their being used as media of exchange. But once they are so used, their value in exchange rises above the value those metals would have had if they had not been used as media of exchange.

For a century or more before the mid-1870s, when both gold and silver were widely used as media of exchange, an ounce of gold had been worth between 15 and 16 times more than an ounce of silver. Many countries, including the US before the Civil War, operated on a bimetallic standard in which the legal or mint value of gold in terms of the local currency was set between 15 to 16 times the mint value of silver in terms of the local currency. As long as the relative market values of gold and silver remained close to the legal ratio, bimetallic systems could operate with both gold and silver coins circulating. But when the market value of one of the metals appreciated relative to the other, legally overvalued coins would disappear from circulation being replaced by the legally undervalued coins. Gresham’s Law (“bad” money drives out “good” money) in action. But, inasmuch as increased monetary demand for the overvalued metal tended to raise the market value of that metal relative to that of the other, bimetallic systems had a modest stabilizing property.

After the North prevailed in 1865 over the South in the Civil War and the unification of Germany in 1871, both the US and Germany opted for a legal gold standard rather than a bimetallic standard. And by 1874, the increased demand for gold had raised the value of gold sufficiently to breach the historical 16 to 1 upper bound on the value of gold relative to silver. The countries remaining on a legal or de facto (bimetallic) silver standard experienced inflation. To avoid importing inflation by way of Gresham’s Law, countries on the silver standard began refusing silver for coinage, thereby accelerating the depreciation of silver relative to gold, and promoting the international transition to the gold standard, which, by 1880, was more or less complete.

So, once there is a monetary demand to hold fiat money, the simple fiscal theory of the value of money cannot provide a full account of the value of money any more than a theory of the value of gold based on the non-monetary demand for gold could account for the price level under the gold standard.

The limitations implicit in the Fiscal Theory are implicit in Cochrane’s summary of the Fiscal Theory: inflation adjusts so that the real value of government debt equals the present value of primary surpluses. In other words, the Fiscal Theory treats both bonds and money issued by the government or the monetary authority (i.e., the monetary base or outside money) as government debt. But that’s true only if the monetary base and government bonds are perfect, or at least very close, substitutes. Cochrane argues that the monetary base is, if not perfectly, at least easily, substitutable for bonds, so that the real value of government debt is, at least to a first approximation, independent of the ratio of government bonds held by the public to the monetary base held by the public.

However, if the demand for the monetary base, apart from its use in discharging tax liabilities, is distinct from the demand for government bonds, the monetary base constitutes net wealth not merely a liability. The basic proposition of the Fiscal Theory must then be revised as follows: inflation adjusts so that the real value of government debt does not exceed the present value of primary surpluses. The corollary of the amended proposition is that if the monetary base constitutes net wealth, inflation need not be affected by the real value of government debt.

If the fiscal constraint isn’t binding, so that the primary budget surplus exceeds government debt (exclusive of the monetary base), the monetary authority can control inflation by conducting open market operations (exchanging outside money for government debt or vice versa). By creating outside money to purchase government debt, the monetary authority decreases the real debt liability of the government correspondingly. However, the extent to which outside money constitutes net wealth depends on the real demand of the public to hold outside money rather than government debt or inside money. If the real demand to hold outside money declines, the wealth represented by the stock of outside money is diminished correspondingly. Unless outside money is retired by way of a government surplus or by the sale of government debt by the monetary authority, the price level will rise.

Explaining why outside money and government debt sold to the public are equivalent, Cochrane argues:

In the monetarist story, assets such as checking accounts, created by banks, satisfy money demand, and so are just as inflationary as government-provided cash. Thus, the government must control checking accounts and other “inside” liquid assets. In the basic fiscal theory, only government money, cash and bank reserves, matter for inflation. Your checking account is an asset to you but a liability to the bank, so more checking accounts do not make the private sector as a whole feel wealthier and desire to spend more. The government need not control the quantity of checking accounts and other liquid assets. However, in the basic fiscal theory, government debt, which promises money, is just as inflationary as money itself. Reserves and cash are just overnight government debt.

Cochrane is correct, as James Tobin explained over 60 years ago, that inside money supplied by banks is not inherently inflationary. But what is true of bank liabilities, which are redeemable on demand for government issued outside money, is not necessarily true of government outside money. In a footnote at end of the quoted passage, Cochrane acknowledges that difference.

Reserves are accounts banks hold at the Federal Reserve. Banks may freely convert reserves to cash and back. The Fed issues cash and reserves, and invests in Treasury debt, just like a giant money-market fund. Because the interest the Fed pays on reserves comes from the interest it gets from Treasury securities, and since it remits any profits to the Treasury, we really can unite Fed and Treasury balance sheets and consider cash and reserves as very short-term and liquid forms of government debt, at least to first order.

Since banks began receiving interest on reserves held at the Fed, the distinction between Treasury liabilities held by the public and Treasury liabilities held by the Fed was—to first order—nullified, as was the operational distinction between the Treasury and the Fed. But the conceptual distinction between money and debt is not inherently a nullity, and, insofar as the operational distinction has been nullified, it’s because, in 2008, the Fed began paying competitive interest on bank reserves held at the Fed. So, insofar as the Fiscal Theory relies on the equivalence of government debt and government fiat money, it relies either on a zero nominal interest rate or a policy of paying competitive interest on reserves held at the Fed. I shall return to this point below.

Keynes, in Chapter 17 of the General Theory, despite erroneously explaining interest as merely a reward for foregoing the exercise not of time–but of liquidity–preference, argued correctly that the expected return on alternative assets held over time would be equalized in equilibrium. Expected returns from holding assets, net of holding costs, can accrue as pecuniary payments e.g., interest, as flows of valuable in-kind services, or as appreciation. Keynes’s insight was to identify the liquidity provided by money as an in-kind service flow for which holders forego the interest payments or expected appreciation that they could have gained from holding non-monetary assets.

The predictions of the Fiscal Theory therefore seem contingent on blurring the distinction between inside and outside money. Outside money is created either by the government or the central bank. Instruments convertible into outside money, such as commercial bank deposits and Treasury debt, are alternatives to outside money, and may therefore affect the demand to hold outside money. So, even if Treasury debt is classified money, it is properly classified as inside, not outside, money. As long as the demand of the public to hold high-powered money is distinct from its demand to hold other assets, the monetary authority has sufficient leverage over the price level to conduct monetary policy.

If there’s no distinct demand for outside money (AKA the monetary base), then differences, during a given time period, between the quantity of outside money demanded by the public and the stock created by the monetary authority have no macroeconomic (price-level) consequences. But if there is a distinct demand, the stock of outside money, contrary to the presumption of the Fiscal Theory, isn’t a net liability of the monetary authority or the government; it’s an asset constituting part of the net wealth of the community.

Nevertheless, Cochrane is right that financial innovation over time has steadily increased the importance of inside money compared to outside money, a process that nineteenth century monetary economists (notably the Currency and Banking Schools) were already trying understand as bank deposits began displacing banknotes as the primary monetary instrument used to mediate exchange and to store liquidity. Continuing financial innovation and the rapid evolution of electronic payments technology, especially in this century have again transformed how commercial and financial transactions are executed and how households make purchases and store liquidity.

The Fiscal Theory described by Cochrane therefore provides insight into our evolving and increasingly electronic monetary system. While Cochrane emphasizes the payment of interest on reserves held by banks at rates equal to, or greater than, the yields on short-term Treasury debt, an alternative arrangement in which the Fed paid little or no interest on bank reserves could also operate efficiently by means of an overnight interbank lending market. The amount of reserves held by banks would fall drastically as the banking system adjusted to operating with minimal reserves sufficient to meet the liquidity needs of the banking system, with the Fed discount window available as a backstop.

Thus, in our modern monetary system, the Fed can either operate with a large balance sheet of Treasury and other highly liquid debt while paying competitive interest on the abundant reserves held by banks, or with a small balance sheet while Treasuries and other highly liquid debt are held by banks holding only minimal reserves. The size of the Fed balance sheet per se is relatively insignificant as a matter of economic control. What matters is that by paying competitive interest on bank reserves held at the Fed, the Fed has rendered itself, as Cochrane correctly argues, incapable of conducting an effective monetary policy. Awash in reserves, banks have become unresponsive to changes in the Fed’s policy rate.

By significantly reducing or eliminating interest on bank reserves, the Fed would not only shrink its balance sheet, it would increase, if only to a limited extent, the effectiveness of monetary policy by making banks more responsive to changes in its policy rate. However, given that most banks can operate effectively with reserves that are a small fraction of their deposit liabilities, Cochrane may be right that the Fed’s monetary policy in the modern system would still be limited, because changes in the Fed’s interest-rate target would induce only small adjustments in banks’ lending practices and policies.

While it’s true that the huge stock of currency now in the hands of the public (likely held mostly abroad not in the US) would continue to provide a buffer against inflationary or deflationary fiscal shocks, the demand for currency is likely not very responsive to changes in interest rates, so that Fed policy changes would have little or no macroeconomic effect on the demand for US currency. Indeed, any effect would likely be in the wrong direction, an increase in interest rates, for example, tending to reduce the amount of currency demanded thereby reducing the dollar exchange rate, and raising, not reducing, inflation.

Almost 40 years ago, in my book Free Banking and Monetary Reform, written in the wake of 1970s inflation and the brutal Volcker disinflation, I argued for a radical monetary reform. After discussing the early manifestations of the financial innovation then just starting to transform the monetary system, I proposed a free-banking regime in which competitive banks would pay interest on demand deposits (which was then prohibited). An important impetus for financial innovation was then to avoid the implicit taxation of bank deposits imposed by legal reserve requirements. The erosion of the tax base by financial innovation caused reductions in, and eventual elimination of, those reserve requirements. As I pointed out (p. 169):

As long as there is a demand for high-powered money, the Fed can conduct monetary policy by controlling [either directly or, by using an interest-rate target as its policy instrument, indirectly] the quantity of high-powered money. Since there is a demand for high-powered money apart from the demand to hold required reserves, reserve requirements are not logically necessary for conducting monetary policy. Nor is control over the overall quantity of money necessary for the Fed to operate a monetary policy. All it needs, as noted, is to control the quantity of high-powered money. And it would have that control even if required reserves were zero.

      But as we just saw, the stability of the demand for high-powered money is also important. If the demand for required reserves is more stable than the demand for other components of high-powered money, reducing demand for required reserves makes the overall demand for high-powered money less stable. And as I pointed out earlier, the less stable the demand for high-powered money is, the greater the risk of error in the conduct of monetary policy will be.

So, although the Fed could, even with a greatly reduced stock of bank reserves as a basis for conducting monetary policy, still control inflation, the risk of destabilizing policy errors might well increase. One response to such risks would be to reimpose at least a modest reserve requirement, thereby increasing the stock of bank reserves on which to conduct monetary policy. The effectiveness of reimposing legal reserve requirements in the current environment is itself questionable. But in my book, I proposed, adopting Earl Thompson’s idea (inspired by Irving Fisher’s compensated dollar plan) for a labor standard stabilizing a wage index using the price of gold as a vehicle for a system of indirect convertibility. (See chapter 11 of my book for details). An alternative for achieving more or less the same result might to adapt Thompson’s proposal to stabilizing nominal GDP, as Scott Sumner and others have been advocating since the 2008 financial crisis.

So, despite my theoretical reservations about the Fiscal Theory of the Price Level, it seems to me that, in practice, we have a lot in common.

Three Propagation Mechanisms in Lucas and Sargent with a Response from Brad DeLong

Published April 3, 2022 Franco Modigliani , impulse and propagation , James Tobin , New Classical macroeconomics , Ragnar Frisch , Robert Lucas , Thomas Sargent 7 Comments

UPDATE (4/3/2022): Reupping this post with the response to my query sent by Brad DeLong.

I’m writing this post in hopes of eliciting some guidance from readers about the three propagation mechanisms to which Robert Lucas and Thomas Sargent refer in their famous 1978 article, “After Keynesian Macroeconomics.” The three propagation mechanisms were mentioned to parry criticisms of the rational-expectations principle underlying the New Classical macroeconomics that Lucas and Sargent were then developing as an alternative to Keynesian macroeconomics. I am wondering how subsequent research has dealt with these propagation mechanisms and how they are now treated in current macro-theory. Here is the relevant passage from Lucas and Sargent:

A second line of criticism stems from the correct observation that if agents’ expectations are rational and if their information sets include lagged values of the variable being forecast, then agents’ forecast errors must be a serially uncorrelated random process. That is, on average there must be no detectable relationships between a period’s forecast error and any previous period’s. This feature has led several critics to conclude that equilibrium models cannot account for more than an insignificant part of the highly serially correlated movements we observe in real output, employment, unemployment, and other series. Tobin (1977, p. 461) has put the argument succinctly:

One currently popular explanation of variations in employment is temporary confusion of relative and absolute prices. Employers and workers are fooled into too many jobs by unexpected inflation, but only until they learn it affects other prices, not just the prices of what they sell. The reverse happens temporarily when inflation falls short of expectation. This model can scarcely explain more than transient disequilibrium in labor markets.

So how can the faithful explain the slow cycles of unemployment we actually observe? Only by arguing that the natural rate itself fluctuates, that variations in unemployment rates are substantially changes in voluntary, frictional, or structural unemployment rather than in involuntary joblessness due to generally deficient demand.

The critics typically conclude that the theory only attributes a very minor role to aggregate demand fluctuations and necessarily depends on disturbances to aggregate supply to account for most of the fluctuations in real output over the business cycle. “In other words,” as Modigliani (1977) has said, “what happened to the United States in the 1930’s was a severe attack of contagious laziness.” This criticism is fallacious because it fails to distinguish properly between sources of impulses and propagation mechanisms, a distinction stressed by Ragnar Frisch in a classic 1933 paper that provided many of the technical foundations for Keynesian macroeconometric models. Even though the new classical theory implies that the forecast errors which are the aggregate demand impulses are serially uncorrelated, it is certainly logically possible that propagation mechanisms are at work that convert these impulses into serially correlated movements in real variables like output and employment. Indeed, detailed theoretical work has already shown that two concrete propagation mechanisms do precisely that.

One mechanism stems from the presence of costs to firms of adjusting their stocks of capital and labor rapidly. The presence of these costs is known to make it optimal for firms to spread out over time their response to the relative price signals they receive. That is, such a mechanism causes a firm to convert the serially uncorrelated forecast errors in predicting relative prices into serially correlated movements in factor demands and output.

A second propagation mechanism is already present in the most classical of economic growth models. Households’ optimal accumulation plans for claims on physical capital and other assets convert serially uncorrelated impulses into serially correlated demands for the accumulation of real assets. This happens because agents typically want to divide any unexpected changes in income partly between consuming and accumulating assets. Thus, the demand for assets next period depends on initial stocks and on unexpected changes in the prices or income facing agents. This dependence makes serially uncorrelated surprises lead to serially correlated movements in demands for physical assets. Lucas (1975) showed how this propagation mechanism readily accepts errors in forecasting aggregate demand as an impulse source.

A third likely propagation mechanism has been identified by recent work in search theory. (See, for example, McCall 1965, Mortensen 1970, and Lucas and Prescott 1974.) Search theory tries to explain why workers who for some reason are without jobs find it rational not necessarily to take the first job offer that comes along but instead to remain unemployed for awhile until a better offer materializes. Similarly, the theory explains why a firm may find it optimal to wait until a more suitable job applicant appears so that vacancies persist for some time. Mainly for technical reasons, consistent theoretical models that permit this propagation mechanism to accept errors in forecasting aggregate demand as an impulse have not yet been worked out, but the mechanism seems likely eventually to play an important role in a successful model of the time series behavior of the unemployment rate. In models where agents have imperfect information, either of the first two mechanisms and probably the third can make serially correlated movements in real variables stem from the introduction of a serially uncorrelated sequence of forecasting errors. Thus theoretical and econometric models have been constructed in which in principle the serially uncorrelated process of forecasting errors can account for any proportion between zero and one of the steady state variance of real output or employment. The argument that such models must necessarily attribute most of the variance in real output and employment to variations in aggregate supply is simply wrong logically.

My problem with the Lucas-Sargent argument is that even if the deviations from a long-run equilibrium path are serially correlated, shouldn’t those deviations be diminishing over time after the initial disturbance. Can these propagation mechanisms account for amplification of the initial disturbance before the adjustment toward the equilibrium path begins? I would gratefully welcome any responses.

David Glasner has a question about the “rational expectations” business-cycle theories developed in the 1970s:

David Glasner: Three Propagation Mechanisms in Lucas & Sargent: ‘I’m… hop[ing for]… some guidance… about… propagation mechanisms… [in] Robert Lucas and Thomas Sargent[‘s]… “After Keynesian Macroeconomics.”… 

The critics typically conclude that the theory only attributes a very minor role to aggregate demand fluctuations and necessarily depends on disturbances to aggregate supply…. [But] even though the new classical theory implies that the forecast errors which are the aggregate demand impulses are serially uncorrelated, it is certainly logically possible that propagation mechanisms are at work that convert these impulses into serially correlated movements in real variables like output and employment… the presence of costs to firms of adjusting their stocks of capital and labor rapidly…. accumulation plans for claims on physical capital and other assets convert serially uncorrelated impulses into serially correlated demands for the accumulation of real assets… workers who for some reason are without jobs find it rational not necessarily to take the first job offer that comes along but instead to remain unemployed for awhile until a better offer materializes…. In principle the serially uncorrelated process of forecasting errors can account for any proportion between zero and one of the [serially correlated] steady state variance of real output or employment. The argument that such models must necessarily attribute most of the variance in real output and employment to variations in aggregate supply is simply wrong logically…

My problem with the Lucas-Sargent argument is that even if the deviations from a long-run equilibrium path are serially correlated, shouldn’t those deviations be diminishing over time after the initial disturbance? Can these propagation mechanisms account for amplification of the initial disturbance before the adjustment toward the equilibrium path begins? I would gratefully welcome any responses…

In some ways this is of only history-of-thought interest. For Lucas and Prescott, at least, had within five years of the writing of “After Keynesian Macroeconomics” decided that the critics were right: that their models of how mistaken decisions driven by serially-uncorrelated forecast errors could not account for the bulk of the serially correlated business-cycle variance of real output and employment, and they needed to shift to studying real business cycle theory instead of price-misperceptions theory. The first problem was that time-series methods generated shocks that came at the wrong times to explain recessions. The second problem was that the propagation mechanisms did not amplify but rather damped the shock: at best they produced some kind of partial-adjustment process that extended the impact of a shock on real variables to N periods and diminished its impact in any single period to 1/N. There was no… what is the word?…. multiplier in the system.

It was stunning to watch in real time in the early 1980s. As Paul Volcker hit the economy on the head with the monetary-stringency brick, repeatedly, quarter after quarter; as his serially correlated and hence easily anticipated policy moves had large and highly serially correlated effects on output; Robert Lucas and company simply… pretended it was not happening: that monetary policy was not having major effects on output and employment in the first half of the 1980s, and that it was not the case thjat the monetary policies that were having such profound real impacts had no plausible interpretation as “surprises” leading to “misperceptions”. Meanwhile, over in the other corner, Robert Barro was claiming that he saw no break in the standard pattern of federal deficits from the Reagan administration’s combination of tax cuts plus defense buildup.

Those of us who were graduate students at the time watched this, and drew conclusions about the likelihood that Lucas, Prescott, and company had good enough judgment and close enough contact with reality that their proposed “real business cycle” research program would be a productive one—conclusions that, I think, time has proved fully correct.

Behind all this, of course, was this issue: the “microfoundations” of the Lucas “island economy” model were totally stupid: people are supposed to “misperceive” relative prices because they know the nominal prices at which they sell but do not know the nominal prices at which they buy, hence people confuse a monetary shock-generated rise in the nominal price level with an increase in the real price of what they produce, and hence work harder and longer and produce more? (I forget who it was who said at the time that the model seemed to require a family in which the husband worked and the wife went to the grocery store and the husband never listened to anything the wife said.) These so-called “microfoundations” could only be rationally understood as some kind of metaphor. But what kind of metaphor? And why should it have any special status, and claim on our attention?

Paul Krugman’s judgment on the consequences of this intellectual turn is even harsher than mine:

What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed. And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view—the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith…

I would merely say that it has left us, over what is now two generations, with a turn to DSGE models—Dynamic Stochastic General Equilibrium—that must satisfy a set of formal rhetorical requirements that really do not help us fit the data, and that it gave many, many people an excuse not to read and hence a license to remain ignorant of James Tobin.

Brad

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Can There Really Be an Excess Supply of Commercial Bank Money?

Published March 31, 2014 endogenous money , James Tobin , Law of Reflux , monetary theory , money multiplier , Nick Rowe 84 Comments

Nick Rowe has answered the question in the affirmative. Nick mistakenly believes that I have argued that there cannot be an excess supply of commercial bank money. In fact, I agree with him that there can be an excess supply of commercial bank money, and, for that matter, that there can be an excess demand for commercial bank money. Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone? That’s the issue. I claim that there is a market mechanism that tends to equilibrate the quantity of bank money created with the amount demanded, so that if too much bank money is created, the excess will tend to be withdrawn from circulation without generating an increase in total expenditure. Nick denies that there is any such mechanism.

Nick and I have been discussing this point for about two and a half years, and every time I think we inch a bit closer to agreement, it seems that the divide separating us seems unbridgeable. But I’m not ready to give up yet. On the other hand, James Tobin explained it all over 50 years ago (when the idea seemed so radical it was called the New View) in his wonderful, classic (I don’t have enough adjectives superlatives to do it justice) paper “Commercial Banks and Creators of Money.” And how can I hope to improve on Tobin’s performance? (Actually there was a flaw in Tobin’s argument, which was not to recognize a key distinction between the inside (beta) money created by banks and the outside (alpha) money created by the monetary authority, but that has nothing to do with the logic of Tobin’s argument about commercial banks.)

Message to Nick: You need to write an article (a simple blog post won’t do, but it would be a start) explaining what you think is wrong with Tobin’s argument. I think that’s a hopeless task, but I’m sorry that’s the challenge you’ve chosen for yourself. Good luck, you’ll need it.

With that introduction out of the way, let me comment directly on Nick’s post. Nick has a subsequent post defending both the Keynesian multiplier and the money multiplier. I reserve the right (but don’t promise) to respond to that post at a later date; I have my hands full with this post. Here’s Nick:

Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.

The primary duty of a central bank is not to make a profit. It is possible to analyze and understand its motivations and its actions in terms of policy objectives that do not reflect the economic interests of its immediate owners. On the other hand, commercial banks are primarily in business to make a profit, and it should be possible to explain their actions in terms of their profit-enhancing effects. As I follow Nick’s argument, I will try to point where I think Nick fails to keep this distinction in mind. Back to Nick:

Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.

If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.

Sorry, I don’t understand this at all. First of all, to be sure, there can be n different excess demands for money; some will be positive, some negative. But it is entirely possible that the sum of those n different excess demands is zero. Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services. The process is equilibrated by adjustments in the spreads between interests on loans and deposits governing the profitability of the banks loans and deposits. This is what I meant in the first paragraph when I said that I agree that it is possible for there to an excess demand for or supply of beta money. But the existence of that excess demand or excess supply can be equilibrated via the equilibration of market for beta money and the market for assets (IOUs) providing money-backing services. If there is a market process equilibrating the quantity of beta money, the adjustment can take place independently of the n markets for real goods and services that Nick is concerned with. On the other hand, if there is an excess demand for or supply of alpha money, it is not so clear that there are any market forces that cause that excess demand or supply to be equilibrated without impinging on the n real markets for goods and services.

Nick goes on to pose the following question:

Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?

That’s a great question. Just the question that I would ask. Here’s how Nick looks at it:

If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn’t care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.

The assumption of perfect substitutability doesn’t seem right, as Nick himself indicates, inasmuch as people don’t seem to be indifferent between holding currency (alpha money) and holding deposits (beta money). And Nick focuses mainly on the imperfect-substitutes case. But, aside from that point, I have another problem with Nick’s discussion of perfect substitutes, which is that he seems to be conflate the assumption that alpha and beta moneys are perfect substitutes with the assumption that they are indistinguishable. I may be indifferent between holding currency and deposits, but if I have more deposits than I would like to hold, and I can tell the difference between a unit of currency and a deposit and there is a direct mechanism whereby I can reduce my holdings of deposits – by exchanging the deposit at the bank for another asset – it would seem that there is a mechanism whereby the excess supply of deposits can be eliminated without any change in overall spending. Now let’s look at Nick’s discussion of the more relevant case in which currency and deposits are imperfect substitutes.

Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.

What does it mean for “beta banks to want to prevent the Law of Reflux from reducing the stock of beta money?” Why would beta banks want to do such a foolish thing? Banks want to make profits for their owners. Does Nick think that by “prevent[ing] the Law of Reflux from reducing the stock of beta money” beta banks are increasing their profitability? The method by which he suggests that they could do this is to increase the interest they pay on deposits? That does not seem to me an obvious way of increasing the profits of beta banks. So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.

What does this mean? Is Nick saying something other than that if banks collectively decide on a course of action that is not profit-maximizing either individually or collectively that the outcome will be different from the outcome that would have resulted had they acted with a view to maximize profits? Why should anyone be interested in that observation? At any rate, Nick concludes that because the public would switch from holding currency to deposits, the result would be an increase in total spending, as people tried to reduce their holdings of currency. It is not clear to me that people would be trying to increase their spending by reducing their holdings of deposits, but I can see that there is a certain ambiguity in trying to determine whether there is an excess supply of deposits or not in this case. But the case seems very contrived to say the least.

A more plausible way to look at the case Nick has in mind might be the following. Suppose banks perceive that their (marginal) costs of intermediation have fallen. Intermediation costs are very hard to measure, and banks aren’t necessarily very good at estimating those costs either. That may be one reason for the inherent instability of credit, but that’s a whole other discussion. At any rate, under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending. With bank deposits now yielding higher interest than before, the public would switch some of their holdings of currency to deposits. The shift form holding currency to holding deposits would initially involve an excess demand for deposits and an excess supply of currency. If the alpha bank was determined not to allow the quantity of currency to fall, then the excess supply of currency could be eliminated only through an increase in spending that would raise prices sufficiently to increase the demand to hold currency. But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.

So, my conclusion remains what it was before. The Law of Reflux works to eliminate excess supplies of bank money, without impinging on spending for real goods and services. To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.

Hawtrey’s Good and Bad Trade: Part II

Published September 24, 2013 Hawtrey , James Tobin , John Fullarton , Knut Wicksell , monetary theory , natural rate of interest 21 Comments
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Here I am again back at you finally with another installment in my series on Hawtrey’s Good and Bad Trade. In my first installment I provided some background on Hawtrey and a quick overview of the book, including a mention of the interesting fact (brought to my attention by David Laidler) that Hawtrey used the term “effective demand” in pretty much the same way that Keynes, some 20 years later, would use it in the General Theory.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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