Archive for the 'Monetarism' Category

What’s Wrong with Monetarism?

UPDATE: (05/06): In an email Richard Lipsey has chided me for seeming to endorse the notion that 1970s stagflation refuted Keynesian economics. Lipsey rightly points out that by introducing inflation expectations into the Phillips Curve or the Aggregate Supply Curve, a standard Keynesian model is perfectly capable of explaining stagflation, so that it is simply wrong to suggest that 1970s stagflation constituted an empirical refutation of Keynesian theory. So my statement in the penultimate paragraph that the k-percent rule

was empirically demolished in the 1980s in a failure even more embarrassing than the stagflation failure of Keynesian economics.

should be amended to read “the supposed stagflation failure of Keynesian economics.”

Brad DeLong recently did a post (“The Disappearance of Monetarism”) referencing an old (apparently unpublished) paper of his following up his 2000 article (“The Triumph of Monetarism”) in the Journal of Economic Perspectives. Paul Krugman added his own gloss on DeLong on Friedman in a post called “Why Monetarism Failed.” In the JEP paper, DeLong argued that the New Keynesian policy consensus of the 1990s was built on the foundation of what DeLong called “classic monetarism,” the analytical core of the doctrine developed by Friedman in the 1950s and 1960s, a core that survived the demise of what he called “political monetarism,” the set of factual assumptions and policy preferences required to justify Friedman’s k-percent rule as the holy grail of monetary policy.

In his follow-up paper, DeLong balanced his enthusiasm for Friedman with a bow toward Keynes, noting the influence of Keynes on both classic and political monetarism, arguing that, unlike earlier adherents of the quantity theory, Friedman believed that a passive monetary policy was not the appropriate policy stance during the Great Depression; Friedman famously held the Fed responsible for the depth and duration of what he called the Great Contraction, because it had allowed the US money supply to drop by a third between 1929 and 1933. This was in sharp contrast to hard-core laissez-faire opponents of Fed policy, who regarded even the mild and largely ineffectual steps taken by the Fed – increasing the monetary base by 15% – as illegitimate interventionism to obstruct the salutary liquidation of bad investments, thereby postponing the necessary reallocation of real resources to more valuable uses. So, according to DeLong, Friedman, no less than Keynes, was battling against the hard-core laissez-faire opponents of any positive action to speed recovery from the Depression. While Keynes believed that in a deep depression only fiscal policy would be effective, Friedman believed that, even in a deep depression, monetary policy would be effective. But both agreed that there was no structural reason why stimulus would necessarily counterproductive; both rejected the idea that only if the increased output generated during the recovery was of a particular composition would recovery be sustainable.

Indeed, that’s why Friedman has always been regarded with suspicion by laissez-faire dogmatists who correctly judged him to be soft in his criticism of Keynesian doctrines, never having disputed the possibility that “artificially” increasing demand – either by government spending or by money creation — in a deep depression could lead to sustainable economic growth. From the point of view of laissez-faire dogmatists that concession to Keynesianism constituted a total sellout of fundamental free-market principles.

Friedman parried such attacks on the purity of his free-market dogmatism with a counterattack against his free-market dogmatist opponents, arguing that the gold standard to which they were attached so fervently was itself inconsistent with free-market principles, because, in virtually all historical instances of the gold standard, the monetary authorities charged with overseeing or administering the gold standard retained discretionary authority allowing them to set interest rates and exercise control over the quantity of money. Because monetary authorities retained substantial discretionary latitude under the gold standard, Friedman argued that a gold standard was institutionally inadequate and incapable of constraining the behavior of the monetary authorities responsible for its operation.

The point of a gold standard, in Friedman’s view, was that it makes it costly to increase the quantity of money. That might once have been true, but advances in banking technology eventually made it easy for banks to increase the quantity of money without any increase in the quantity of gold, making inflation possible even under a gold standard. True, eventually the inflation would have to be reversed to maintain the gold standard, but that simply made alternative periods of boom and bust inevitable. Thus, the gold standard, i.e., a mere obligation to convert banknotes or deposits into gold, was an inadequate constraint on the quantity of money, and an inadequate systemic assurance of stability.

In other words, if the point of a gold standard is to prevent the quantity of money from growing excessively, then, why not just eliminate the middleman, and simply establish a monetary rule constraining the growth in the quantity of money. That was why Friedman believed that his k-percent rule – please pardon the expression – trumped the gold standard, accomplishing directly what the gold standard could not accomplish, even indirectly: a gradual steady increase in the quantity of money that would prevent monetary-induced booms and busts.

Moreover, the k-percent rule made the monetary authority responsible for one thing, and one thing alone, imposing a rule on the monetary authority prescribing the time path of a targeted instrument – the quantity of money – over which the monetary authority has direct control: the quantity of money. The belief that the monetary authority in a modern banking system has direct control over the quantity of money was, of course, an obvious mistake. That the mistake could have persisted as long as it did was the result of the analytical distraction of the money multiplier: one of the leading fallacies of twentieth-century monetary thought, a fallacy that introductory textbooks unfortunately continue even now to foist upon unsuspecting students.

The money multiplier is not a structural supply-side variable, it is a reduced-form variable incorporating both supply-side and demand-side parameters, but Friedman and other Monetarists insisted on treating it as if it were a structural — and a deep structural variable at that – supply variable, so that it no less vulnerable to the Lucas Critique than, say, the Phillips Curve. Nevertheless, for at least a decade and a half after his refutation of the structural Phillips Curve, demonstrating its dangers as a guide to policy making, Friedman continued treating the money multiplier as if it were a deep structural variable, leading to the Monetarist forecasting debacle of the 1980s when Friedman and his acolytes were confidently predicting – over and over again — the return of double-digit inflation because the quantity of money was increasing for most of the 1980s at double-digit rates.

So once the k-percent rule collapsed under an avalanche of contradictory evidence, the Monetarist alternative to the gold standard that Friedman had persuasively, though fallaciously, argued was, on strictly libertarian grounds, preferable to the gold standard, the gold standard once again became the default position of laissez-faire dogmatists. There was to be sure some consideration given to free banking as an alternative to the gold standard. In his old age, after winning the Nobel Prize, F. A. Hayek introduced a proposal for direct currency competition — the elimination of legal tender laws and the like – which he later developed into a proposal for the denationalization of money. Hayek’s proposals suggested that convertibility into a real commodity was not necessary for a non-legal tender currency to have value – a proposition which I have argued is fallacious. So Hayek can be regarded as the grandfather of crypto currencies like the bitcoin. On the other hand, advocates of free banking, with a few exceptions like Earl Thompson and me, have generally gravitated back to the gold standard.

So while I agree with DeLong and Krugman (and for that matter with his many laissez-faire dogmatist critics) that Friedman had Keynesian inclinations which, depending on his audience, he sometimes emphasized, and sometimes suppressed, the most important reason that he was unable to retain his hold on right-wing monetary-economics thinking is that his key monetary-policy proposal – the k-percent rule – was empirically demolished in a failure even more embarrassing than the stagflation failure of Keynesian economics. With the k-percent rule no longer available as an alternative, what’s a right-wing ideologue to do?

Anyone for nominal gross domestic product level targeting (or NGDPLT for short)?


Milton Friedman, Monetarism, and the Great and Little Depressions

Brad Delong has a nice little piece bashing Milton Friedman, an activity that, within reasonable limits, I consider altogether commendable and like to engage in myself from time to time (see here, here, here, here, here , here, here, here, here and here). Citing Barry Eichengreen’s recent book Hall of Mirrors, Delong tries to lay the blame for our long-lasting Little Depression (aka Great Recession) on Milton Friedman and his disciples whose purely monetary explanation for the Great Depression caused the rest of us to neglect or ignore the work of Keynes and Minsky and their followers in explaining the Great Depression.

According to Eichengreen, the Great Depression and the Great Recession are related. The inadequate response to our current troubles can be traced to the triumph of the monetarist disciples of Milton Friedman over their Keynesian and Minskyite peers in describing the history of the Great Depression.

In A Monetary History of the United States, published in 1963, Friedman and Anna Jacobson Schwartz famously argued that the Great Depression was due solely and completely to the failure of the US Federal Reserve to expand the country’s monetary base and thereby keep the economy on a path of stable growth. Had there been no decline in the money stock, their argument goes, there would have been no Great Depression.

This interpretation makes a certain kind of sense, but it relies on a critical assumption. Friedman and Schwartz’s prescription would have worked only if interest rates and what economists call the “velocity of money” – the rate at which money changes hands – were largely independent of one another.

What is more likely, however, is that the drop in interest rates resulting from the interventions needed to expand the country’s supply of money would have put a brake on the velocity of money, undermining the proposed cure. In that case, ending the Great Depression would have also required the fiscal expansion called for by John Maynard Keynes and the supportive credit-market policies prescribed by Hyman Minsky.

I’m sorry, but I find this criticism of Friedman and his followers just a bit annoying. Why? Well, there are a number of reasons, but I will focus on one: it perpetuates the myth that a purely monetary explanation of the Great Depression originated with Friedman.

Why is it a myth? Because it wasn’t Friedman who first propounded a purely monetary theory of the Great Depression. Nor did the few precursors, like Clark Warburton, that Friedman ever acknowledged. Ralph Hawtrey and Gustav Cassel did — 10 years before the start of the Great Depression in 1919, when they independently warned that going back on the gold standard at the post-World War I price level (in terms of gold) — about twice the pre-War price level — would cause a disastrous deflation unless the world’s monetary authorities took concerted action to reduce the international monetary demand for gold as countries went back on the gold standard to a level consistent with the elevated post-War price level. The Genoa Monetary Conference of 1922, inspired by the work of Hawtrey and Cassel, resulted in an agreement (unfortunately voluntary and non-binding) that, as countries returned to the gold standard, they would neither reintroduce gold coinage nor keep their monetary reserves in the form of physical gold, but instead would hold reserves in dollar or (once the gold convertibility of sterling was restored) pound-denominated assets. (Ron Batchelder and I have a paper discussing the work of Hawtrey and Casssel on the Great Depression; Doug Irwin has a paper discussing Cassel.)

After the short, but fierce, deflation of 1920-21 (see here and here), when the US (about the only country in the world then on the gold standard) led the world in reducing the price level by about a third, but still about two-thirds higher than the pre-War price level, the Genoa system worked moderately well until 1928 when the Bank of France, totally defying the Genoa Agreement, launched its insane policy of converting its monetary reserves into physical gold. As long as the US was prepared to accommodate the insane French gold-lust by permitting a sufficient efflux of gold from its own immense holdings, the Genoa system continued to function. But in late 1928 and 1929, the Fed, responding to domestic fears about a possible stock-market bubble, kept raising interest rates to levels not seen since the deflationary disaster of 1920-21. And sure enough, a 6.5% discount rate (just shy of the calamitous 7% rate set in 1920) reversed the flow of gold out of the US, and soon the US was accumulating gold almost as rapidly as the insane Bank of France was.

This was exactly the scenario against which Hawtrey and Cassel had been warning since 1919. They saw it happening, and watched in horror while their warnings were disregarded as virtually the whole world plunged blindly into a deflationary abyss. Keynes had some inkling of what was going on – he was an old friend and admirer of Hawtrey and had considerable regard for Cassel – but, for reasons I don’t really understand, Keynes was intent on explaining the downturn in terms of his own evolving theoretical vision of how the economy works, even though just about everything that was happening had already been foreseen by Hawtrey and Cassel.

More than a quarter of a century after the fact, and after the Keynesian Revolution in macroeconomics was well established, along came Friedman, woefully ignorant of pre-Keynesian monetary theory, but determined to show that the Keynesian explanation for the Great Depression was wrong and unnecessary. So Friedman came up with his own explanation of the Great Depression that did not even begin until December 1930 when the Fed allowed the Bank of United States to fail, triggering, in Friedman’s telling, a wave of bank failures that caused the US money supply to decline by a third by 1933. Rather than see the Great Depression as a global phenomenon caused by a massive increase in the world’s monetary demand for gold, Friedman portrayed it as a largely domestic phenomenon, though somehow linked to contemporaneous downturns elsewhere, for which the primary explanation was the Fed’s passivity in the face of contagious bank failures. Friedman, mistaking the epiphenomenon for the phenomenon itself, ignorantly disregarded the monetary theory of the Great Depression that had already been worked out by Hawtrey and Cassel and substituted in its place a simplistic, dumbed-down version of the quantity theory. So Friedman reinvented the wheel, but did a really miserable job of it.

A. C. Pigou, Alfred Marshall’s student and successor at Cambridge, was a brilliant and prolific economic theorist in his own right. In his modesty and reverence for his teacher, Pigou was given to say “It’s all in Marshall.” When it comes to explaining the Great Depression, one might say as well “it’s all in Hawtrey.”

So I agree that Delong is totally justified in criticizing Friedman and his followers for giving such a silly explanation of the Great Depression, as if it were, for all intents and purposes, made in the US, and as if the Great Depression didn’t really start until 1931. But the problem with Friedman is not, as Delong suggests, that he distracted us from the superior insights of Keynes and Minsky into the causes of the Great Depression. The problem is that Friedman botched the monetary theory, even though the monetary theory had already been worked out for him if only he had bothered to read it. But Friedman’s interest in the history of monetary theory did not extend very far, if at all, beyond an overrated book by his teacher Lloyd Mints A History of Banking Theory.

As for whether fiscal expansion called for by Keynes was necessary to end the Great Depression, we do know that the key factor explaining recovery from the Great Depression was leaving the gold standard. And the most important example of the importance of leaving the gold standard is the remarkable explosion of output in the US beginning in April 1933 (surely before expansionary fiscal policy could take effect) following the suspension of the gold standard by FDR and an effective 40% devaluation of the dollar in terms of gold. Between April and July 1933, industrial production in the US increased by 70%, stock prices nearly doubled, employment rose by 25%, while wholesale prices rose by 14%. All that is directly attributable to FDR’s decision to take the US off gold, and devalue the dollar (see here). Unfortunately, in July 1933, FDR snatched defeat from the jaws of victory (or depression from the jaws of recovery) by starting the National Recovery Administration, whose stated goal was (OMG!) to raise prices by cartelizing industries and restricting output, while imposing a 30% increase in nominal wages. That was enough to bring the recovery to a virtual standstill, prolonging the Great Depression for years.

I don’t say that the fiscal expansion under FDR had no stimulative effect in the Great Depression or that the fiscal expansion under Obama in the Little Depression had no stimulative effect, but you can’t prove that monetary policy is useless just by reminding us that Friedman liked to assume (as if it were a fact) that the demand for money is highly insensitive to changes in the rate of interest. The difference between the rapid recovery from the Great Depression when countries left the gold standard and the weak recovery from the Little Depression is that leaving the gold standard had an immediate effect on price-level expectations, while monetary expansion during the Little Depression was undertaken with explicit assurances by the monetary authorities that the 2% inflation target – in the upper direction, at any rate — was, and would forever more remain, sacred and inviolable.

Krugman on the Volcker Disinflation

Earlier in the week, Paul Krugman wrote about the Volcker disinflation of the 1980s. Krugman’s annoyance at Stephen Moore (whom Krugman flatters by calling him an economist) and John Cochrane (whom Krugman disflatters by comparing him to Stephen Moore) is understandable, but he has less excuse for letting himself get carried away in an outburst of Keynesian triumphalism.

Right-wing economists like Stephen Moore and John Cochrane — it’s becoming ever harder to tell the difference — have some curious beliefs about history. One of those beliefs is that the experience of disinflation in the 1980s was a huge shock to Keynesians, refuting everything they believed. What makes this belief curious is that it’s the exact opposite of the truth. Keynesians came into the Volcker disinflation — yes, it was mainly the Fed’s doing, not Reagan’s — with a standard, indeed textbook, model of what should happen. And events matched their expectations almost precisely.

I’ve been cleaning out my library, and just unearthed my copy of Dornbusch and Fischer’s Macroeconomics, first edition, copyright 1978. Quite a lot of that book was concerned with inflation and disinflation, using an adaptive-expectations Phillips curve — that is, an assumed relationship in which the current inflation rate depends on the unemployment rate and on lagged inflation. Using that approach, they laid out at some length various scenarios for a strategy of reducing the rate of money growth, and hence eventually reducing inflation. Here’s one of their charts, with the top half showing inflation and the bottom half showing unemployment:

Not the cleanest dynamics in the world, but the basic point should be clear: cutting inflation would require a temporary surge in unemployment. Eventually, however, unemployment could come back down to more or less its original level; this temporary surge in unemployment would deliver a permanent reduction in the inflation rate, because it would change expectations.

And here’s what the Volcker disinflation actually looked like:

A temporary but huge surge in unemployment, with inflation coming down to a sustained lower level.

So were Keynesian economists feeling amazed and dismayed by the events of the 1980s? On the contrary, they were feeling pretty smug: disinflation had played out exactly the way the models in their textbooks said it should.

Well, this is true, but only up to a point. What Krugman neglects to mention, which is why the Volcker disinflation is not widely viewed as having enhanced the Keynesian forecasting record, is that most Keynesians had opposed the Reagan tax cuts, and one of their main arguments was that the tax cuts would be inflationary. However, in the Reagan-Volcker combination of loose fiscal policy and tight money, it was tight money that dominated. Score one for the Monetarists. The rapid drop in inflation, though accompanied by high unemployment, was viewed as a vindication of the Monetarist view that inflation is always and everywhere a monetary phenomenon, a view which now seems pretty commonplace, but in the 1970s and 1980s was hotly contested, including by Keynesians.

However, the (Friedmanian) Monetarist view was only partially vindicated, because the Volcker disinflation was achieved by way of high interest rates not by tightly controlling the money supply. As I have written before on this blog (here and here) and in chapter 10 of my book on free banking (especially, pp. 214-21), Volcker actually tried very hard to slow down the rate of growth in the money supply, but the attempt to implement a k-percent rule induced perverse dynamics, creating a precautionary demand for money whenever monetary growth overshot the target range, the anticipation of an imminent future tightening causing people, fearful that cash would soon be unavailable, to hoard cash by liquidating assets before the tightening. The scenario played itself out repeatedly in the 1981-82 period, when the most closely watched economic or financial statistic in the world was the Fed’s weekly report of growth in the money supply, with growth rates over the target range being associated with falling stock and commodities prices. Finally, in the summer of 1982, Volcker announced that the Fed would stop trying to achieve its money growth targets, and the great stock market rally of the 1980s took off, and economic recovery quickly followed.

So neither the old-line Keynesian dismissal of monetary policy as irrelevant to the control of inflation, nor the Monetarist obsession with controlling the monetary aggregates fared very well in the aftermath of the Volcker disinflation. The result was the New Keynesian focus on monetary policy as the key tool for macroeconomic stabilization, except that monetary policy no longer meant controlling a targeted monetary aggregate, but controlling a targeted interest rate (as in the Taylor rule).

But Krugman doesn’t mention any of this, focusing instead on the conflicts among  non-Keynesians.

Indeed, it was the other side of the macro divide that was left scrambling for answers. The models Chicago was promoting in the 1970s, based on the work of Robert Lucas and company, said that unemployment should have come down quickly, as soon as people realized that the Fed really was bringing down inflation.

Lucas came to Chicago in 1975, and he was the wave of the future at Chicago, but it’s not as if Friedman disappeared; after all, he did win the Nobel Prize in 1976. And although Friedman did not explicitly attack Lucas, it’s clear that, to his credit, Friedman never bought into the rational-expectations revolution. So although Friedman may have been surprised at the depth of the 1981-82 recession – in part attributable to the perverse effects of the money-supply targeting he had convinced the Fed to adopt – the adaptive-expectations model in the Dornbusch-Fischer macro textbook is as much Friedmanian as Keynesian. And by the way, Dornbush and Fischer were both at Chicago in the mid 1970s when the first edition of their macro text was written.

By a few years into the 80s it was obvious that those models were unsustainable in the face of the data. But rather than admit that their dismissal of Keynes was premature, most of those guys went into real business cycle theory — basically, denying that the Fed had anything to do with recessions. And from there they just kept digging ever deeper into the rabbit hole.

But anyway, what you need to know is that the 80s were actually a decade of Keynesian analysis triumphant.

I am just as appalled as Krugman by the real-business-cycle episode, but it was as much a rejection of Friedman, and of all other non-Keynesian monetary theory, as of Keynes. So the inspiring morality tale spun by Krugman in which the hardy band of true-blue Keynesians prevail against those nasty new classical barbarians is a bit overdone and vastly oversimplified.

The Nearly Forgotten Dearly Beloved 1920-21 Depression Yet Again; Or, Never Reason from a Quantity Change

The industrious James Grant recently published a book about the 1920-21 Depression. It has received enthusiastic reviews in the Wall Street Journal and Barron’s, was the subject of an admiring column by Washington Post columnist Robert J. Samuelson, and was celebrated at a Cato Institute panel discussion, luncheon, and book-signing event. The Cato extravaganza elicited a dismissive blog post by Barkley Rosser which was linked to by Paul Krugman on his blog. The Rosser/Krugman tandem provoked an unhappy reply on the Free Banking blog from George Selgin who chaired the Cato panel discussion. And the 1920-21 Depression is now the latest hot topic in the econblogosphere.

I am afraid that there are multiple layers of errors and confusion that are being mixed up and compounded in this discussion, errors and confusion derived from basic misunderstandings about how the gold standard operated that have been plaguing the economics profession and the financial world for about two and a half centuries. If you want to understand how the gold standard worked, what you have to read is the book by Ralph Hawtrey entitled – drum roll, please – The Gold Standard.

Here are the basic things you need to know about the gold standard.

1 The gold standard operates by creating an equivalence between a currency unit and a fixed amount of gold.

2 The gold standard does not require gold to circulate as money in the form of coins. That was historically the case, but a gold standard can function with no gold coins or even gold certificates.

3 The value of a currency unit and the value of a corresponding weight of gold are necessarily equalized by arbitrage.

4 Equality between a currency unit and a corresponding weight of gold does not necessarily show the direction of causality; the currency unit may determine the value of gold, not the other way around. In other words, making gold the standard of value for currency affects the demand for gold which affects the value of gold. Decisions made by monetary authorities under the gold standard necessarily affect the value of gold, so a gold standard does not somehow make the value of money independent of monetary policy.

5 When more than one country is on a gold standard, the countries share a common price level, because the value of gold is determined in an international market.

Keeping those basics in mind, let’s quickly try to understand what was going on in 1920 when the Fed decided to raise its discount rate to the then unprecedented level of 7 percent. But the situation in 1920 was the outcome of the previous six years of World War I that effectively destroyed the gold standard as a functioning institution, even though its existence was in some sense still legally recognized.

Under the gold standard, gold was the ultimate way of discharging international debts. In World War I, belligerents had to pay for imports with gold, thus governments amassed all available gold with which to pay for the imports required to support the war effort. Gold coins were melted down and converted to bullion so the gold could be exported. For a private citizen in a belligerent country to demand that the national currency unit be converted to gold would be considered an unpatriotic if not a treasonous act. So the gold standard ceased to function in belligerent countries. In non-belligerent countries, which were busy exporting to the belligerents, the result was a massive inflow of gold, causing a spectacular increase in the amount of gold held by the US Treasury between 1914 and 1917. Other non-belligerents like Sweden and Switzerland experienced similar inflows.

Quantity theorists and Monetarists like Milton Friedman habitually misinterpret the wartime inflation, and attributing the inflation to an inflow of gold that increased the money supply, thereby perpetrating the price-specie-flow-mechanism fallacy. What actually happened was that the huge demonetization of gold coins by the belligerents and their export of large quantities of gold to non-belligerent countries in which a free market in gold continued to operate drove down the value of gold. A falling value of gold under a gold standard logically implies rising prices for all other goods and services. Rising prices increased the nominal demand for money, which more or less automatically caused a corresponding adjustment in the quantity of money. A rising price level caused the quantity of money to increase, not the other way around.

In 1917, just before the US entered the war, the US, still effectively on a gold standard as gold flowed into the Treasury, had experienced a drastic inflation, like all other gold standard countries, because gold was rapidly losing value, as it was being demonetized and exported by the belligerent countries. But when the US entered the war in 1917, the US, like other belligerents, suspended operation of the gold standard, thereby accelerating the depreciation of gold, forcing the few remaining countries on the gold standard to suspend the gold standard to avoid runaway inflation. Inflationary pressure in the US did increase after entry into the war, but the war-induced fiat inflation, to some extent suppressed or disguised by price controls, was actually slower than inflation in terms of gold.

When the war ended, the US went back on the gold standard by again making the dollar convertible into gold at the legal parity. Doing so meant that the US price level in terms of dollars was below the notional (no currency any longer being convertible into gold) world price level in terms of gold. In other belligerent countries, notably Britain, France and Germany, inflation in terms of their national currencies exceeded gold inflation, requiring them to deflate even to restore the legal parity in terms of gold.  Thus, the US was the only country in the world that was both willing and able to return to the gold standard at the prewar parity. Sweden and Switzerland could have done so, but preferred to avoid the inflationary consequences of a return to the gold standard.

Once the dollar convertibility into gold was restored, arbitrage forced the US price level to rise to so that it would equal the gold price level. The excess of the gold price level over the US price level level explains the anomalous post-war inflation – everyone knows that prices are supposed to fall, not rise, when a war ends — in the US. The rest of the world, then, had to choose between accepting US inflation, by keeping their currencies pegged to the dollar, or allowing their currencies to appreciate against the dollar. The anomalous post-war inflation was caused by the reequilibration of the US price level to the gold price levels, not, as commonly supposed, by Fed inexperience or incompetence.

To stop the post-war inflation, the Fed could have simply abandoned the gold standard, or it could have revalued the dollar in terms of gold, by reducing the official dollar price of gold. (I ignore the minor detail that the official dollar price of gold was then determined by statute.) Instead, the Fed — whether knowingly or not I can’t say – chose to increase the value of gold. The method by which it did so was to raise its discount rate, thereby making it easier to obtain dollars by selling gold to the Treasury than to borrow from the Fed. The flood of gold into the Treasury in 1920-21 succeeded in taking a huge amount of gold out of private and public hands, thus driving up the real value of gold, and forcing down the gold price level. That’s when the brutal deflation of 1920-21 started. At some point, the Fed and the Treasury decided that they had had enough, having amassed about 40% of the world’s gold reserves, and began reducing the discount rate, thereby slowing the inflow of gold into the US, and stopping its appreciation. And that’s when and how the dearly beloved, but quite dreadful, depression of 1920-21 came to an end.

The Uselessness of the Money Multiplier as Brilliantly Elucidated by Nick Rowe

Not long after I started blogging over two and a half years ago, Nick Rowe and I started a friendly argument about the money multiplier. He likes it; I don’t. In his latest post (“Alpha banks, beta banks, fixed exchange rates, market shares, and the money multiplier”), Nick attempts (well, sort of) to defend the money multiplier. Nick has indeed figured out an ingenious way of making sense out of the concept, but in doing so, he has finally and definitively demonstrated its total uselessness.

How did Nick accomplish this remarkable feat? By explaining that there is no significant difference between a commercial bank that denominates its deposits in terms of a central bank currency, thereby committing itself to make its deposits redeemable on demand into a corresponding amount of central bank currency, and a central bank that commits to maintain a fixed exchange rate between its currency and the currency of another central bank — the commitment to a fixed exchange rate being unilateral and one-sided, so that only one of the central banks (the beta bank) is constrained by its unilateral commitment to a fixed exchange rate, while the other central bank (the alpha bank) is free from commitment to an exchange-rate peg.

Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.

For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed’s promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It’s asymmetric redeemability that gives the Bank of Canada its power over the Fed.

Absolutely right! Under these assumptions, the amount of money created by the Fed would be governed, among other things, by its commitment to maintain the exchange-rate peg between the US dollar and the Canadian dollar. However, the numerical relationship between the quantity of US dollars and quantity of Canadian dollars would depend on the demand of US (and possibly Canadian) citizens and residents to hold US dollars. The more US dollars people want to hold, the more dollars the Fed can create.

Nick then goes on to make the following astonishing (for him) assertion.

Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.

In other words, given the price level, the quantity of money adjusts to whatever is the demand for it, the price level being determined unilaterally by the unconstrained (aka “alpha”) central bank.

To see how astonishing (for Nick) this assertion is, consider the following passage from Perry Mehrling’s superb biography of Fischer Black. Mehrling devotes an entire chapter (“The Money Wars”) to the relationship between Black and Milton Friedman. Black came to Chicago as a professor in the Business School, and tried to get Friedman interested in his idea the quantity of money supplied by the banking system adjusted passively to the amount demanded. Friedman dismissed the idea as preposterous, a repetition of the discredited “real bills doctrine,” considered by Friedman to be fallacy long since refuted (definitively) by his teacher Lloyd Mints in his book A History of Banking Theory. Friedman dismissed Black and told him to read Mints, and when Black, newly arrived at Chicago in 1971, presented a paper at the Money Workshop at Chicago, Friedman introduced Black as follows:

Fischer Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.

Mehrling describes the nub of the disagreement between Friedman and Black this way:

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond.The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money casues prices to rise, as Friedman insisted, but it could also mean that an increase in prices casues the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (p. 160)

Well, we now see that Nick Rowe has come down squarely on the side of, gasp, Fischer Black against Milton Friedman. “Wonder of wonders, miracle of miracles!”

But despite making that break with his Monetarist roots, Nick isn’t yet quite ready to let go, lapsing once again into money-multiplier talk.

The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define “money”. Let’s say it’s 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada’s share in the total Canadian+US money supply. 1/1%=100.

Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn’t. But it doesn’t matter.

Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn’t matter.

The only thing that does matter is the Bank of Canada’s market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

The point of the money multiplier is to provide a rationale for saying: “sure, we know that banks create a lot of money, and we don’t really understand what governs the amount of money banks create, but whatever amount of money banks create, that amount is ultimately under the control of the monetary authority, the amount being some multiple of the monetary base. So it’s still as if the central bank decides what M is, so that it really is OK to say that the central bank can control the price level even though M in the quantity equation is not really produced by the central bank. M is exogenously determined, because there is a money multiplier that relates M to B. If that is unclear, I’m sorry, but that’s what the Monetarists have been saying all these years.

Who cares, anyway? Well, all the people that fell for Friedman’s notion (traceable to the General Theory by the way) that monetary policy works by controlling the quantity of money produced by the banking system. Somehow Monetarists like Friedman who was pushing his dumb k% rule for monetary growth thought that it was important to be able to show that the quantity of money could be controlled by the monetary authority. Otherwise, the whole rationale for the k% rule would be manifestly based based on a faulty — actually vacuous — premise. The post-Keynesian exogenous endogenous-money movement was an equally misguided reaction to Friedman’s Monetarist nonsense, taking for granted that if they could show that the money multiplier and the idea that the central bank could control the quantity of money were unfounded, it would follow that inflation is not a monetary phenomenon and is beyond the power of a central bank to control. The two propositions are completely independent of one another, and all the sturm und drang of the last 40 years about endogenous money has been a complete waste of time, an argument about a non-issue. Whether the central bank can control the price level has nothing to do with whether there is or isn’t a multiplier. Get over it.

Nick recognizes this:

The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks’ monies, otherwise it will be forced to redeem its money for other banks’ monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks’ responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.

It’s all about the public’s demand for money, and their relative preferences for holding one money or another. The alpha central bank may or may not be able to achieve some targeted value for its money, but whether it can or can not has nothing to do with its ability to control the quantity of money created by the beta banks that are committed to an exchange rate peg against  the money of the alpha bank. In other words, the money multiplier is a completely useless concept, as useless as a multiplier between, say, the quantity of white Corvettes the total quantity of Corvettes. From now on, I’m going to call this Rowe’s Theorem. Nick, you’re the man!

Second Thoughts on Friedman

After blowing off some steam about Milton Friedman in my previous post, thereby antagonizing a sizable segment of my readership, and after realizing that I had been guilty of a couple of memory lapses in citing sources that I was relying on, I thought that I should go back and consult some of the relevant primary sources. So I looked up Friedman’s 1966 article “Interest Rates and the Demand for Money” published in the Journal of Law and Economics in which he denied that he had ever asserted that the demand for money did not depend on the rate of interest and that the empirical magnitude of the elasticity of money demand with respect to the interest rate was not important unless it approached the very high elasticity associated with the Keynesian liquidity trap. I also took a look at Friedman’s reply to Don Patinkin essay “Friedman on the Quantity Theory and Keynesian Economics” in Milton Friedman’s Monetary Framework: A Debate with his Critics.

Perhaps on another occasion, I will offer some comments on Friedman and the interest elasticity of the demand for money, but, for now, I will focus on Friedman’s reply to Patinkin, which is most relevant to my previous post. Patinkin’s essay, entitled, “Friedman on the Quantity Theory and Keynesian Economics,” charged that Friedman had repackaged the Keynesian theory as a quantity theory and tried to sell it with a Chicago oral tradition label stuck on the package. That’s an overstatement of a far more sophisticated argument than my one sentence summary can do justice to, but it captures the polemical gist of Patinkin’s argument, an argument that he had made previously in a paper, “The Chicago Tradition, the Quantity Theory, and Friedman” published in the Journal of Money, Credit and Banking which Harry Johnson relied on in his 1970 Richard T. Ely lecture, “The Keynesian Revolution and the Monetarist Counterrevolution.” Friedman took personal offense at what he regarded as attacks on his scholarly integrity in those papers, and his irritation (to put it mildly) with Patinkin is plainly in evidence in his reply to Patinkin. Much, but not all, of my criticism of Friedman stems from my memory of the two papers by Patinkin and Johnson.

Now to give Friedman his due – and to reiterate what I have already said a number of times, Friedman was a great economist and you can learn a lot by reading his arguments carefully because he was a very skillful applied theorist — he makes a number of effective responses to Patinkin’s accusation that he was merely peddling a disguised version of Keynesianism under the banners of the quantity theory and the Chicago oral tradition. These are basically the same arguments that Scott Sumner used in the post that he wrote defending Friedman against my recycling of the Patinkin/Johnson criticism.

First, like earlier quantity theorists, and unlike Keynes in the General Theory, Friedman assumed that the price level is determined (not, as in the GT, somehow fixed exogenously) by the demand for money and the supply (effectively under the complete discretionary control of the monetary authority) of money.

Second, because differences between the demand for money and the supply of money (in nominal terms) are equilibrated primarily by changes in the price level (not, as in the GT, by changes in the rate of interest), the link between monetary policy and the economy that Friedman focused on was the price level not the rate of interest.

Third, Friedman did not deny that the demand for money was affected by the rate of interest, but he maintained that monetary policy would become ineffective only under conditions of a liquidity trap, which was therefore, in Friedman’s view, the chief theoretical innovation of the General Theory, but one which, on empirical grounds, Friedman flatly rejected.

So if I were to restate Patinkin’s objection in somewhat different terms, I would say that Friedman, in 1956 and in later expositions, described the quantity theory as a theory of the demand for money, which as a historical matter is a travesty, because the quantity theory was around for centuries before the concept of a demand for money was even articulated, but the theory of the demand for money that Friedman described was, in fact, very much influenced by the Keynesian theory of liquidity preference, an influence not mentioned by Friedman in 1956 but acknowledged in later expositions. Friedman explained away this failure by saying that Keynes was merely adding to a theory of the demand for money that had been evolving at Cambridge since Marshall’s day, and that the novel element in the General Theory, absolute liquidity preference, was empirically unsupported. That characterization of Keynes’s theory of liquidity preference strikes me as being ungenerous, but both Friedman and Patinkin neglected to point out that Keynes erroneously thought that his theory of liquidity preference was actually a complete theory of the rate of interest that displaced the real theory of interest.

So, my take on the dispute between Friedman and Patinkin is that Patinkin was right that Friedman did not sufficiently acknowledge the extent to which he was indebted to Keynes for the theory of the demand for money that he erroneously identified with the quantity theory of money. On the other hand, because Friedman explicitly allowed for the price level to be determined within his model, he avoided the Keynesian liquidity-preference relationship between the quantity of money and the rate of interest, allowing the real rate of interest to be determined by real factors not liquidity preference. In some sense, Friedman may have exaggerated the conceptual differences between himself and the Keynesians, but, by making a strategic assumption that the price level responds to changes in the quantity of money, Friedman minimized the effect of changes in the quantity of money on interest rates, except via changes in price level expectations.

But, having granted Friedman partial exoneration of the charge that he was a crypto-Keynesian, I want to explore a bit more carefully Friedman’s remarkable defense against the accusation by Patinkin and Johnson that he invented a non-existent Chicago oral tradition under whose name he could present his quasi-Keynesian theory of the demand for money. Friedman began his response to Patinkin with the following expression of outrage.

Patinkin . . . and Johnson criticize me for linking my work to a “Chicago tradition” rather than recognizing that, as they see it, my work is Keynesian. In the course of their criticism, they give a highly misleading impression of the Chicago tradition. . . .

Whether I conveyed the flavor of that tradition or not, there was such a tradition; it was significantly different from the quantity theory tradition that prevailed at other institutions of learning, notably the London School of Economics; that Chicago tradition had a great deal to do with the differential impact of Keynes’s General Theory on economists at Chicago and elsewhere; and it was responsible for the maintenance of interest in the quantity theory at Chicago. (Friedman’s Monetary Framework p. 158 )

Note the reference to the London School of Economics, as if LSE in the 1930s was in any way notable for its quantity theory tradition. There were to be sure monetary theorists of some distinction working at the LSE in the 1930s, but their relationship to the quantity theory was, at best, remote.

Friedman elaborates on this tidbit a few pages later, recalling that in the late 1940s or early 1950s he once debated Abba Lerner at a seminar at the University of Chicago. Despite agreeing with each other about many issues, Friedman recalled that they were in sharp disagreement about the Keynesian Revolution, Lerner being an avid Keynesian, and Friedman being opposed. The reason for their very different reaction to the Keynesian Revolution, Friedman conjectured, was that Lerner had been trained at the London School of Economics “where the dominant view was that the depression was an inevitable result of the prior boom, that it was deepened by the attempts ot prevent prices and wages from falling and firms from going bankrupt, that the monetary authorities had brought on the depression by inflationary policies before the crash and had prolonged it by ‘easy money’ policies thereafter; that the only sound policy was to let the depression run its course, bring down money costs, and eliminate the weak and unsound firms.” For someone trained in such a view, Friedman suggested, the Keynesian program would seem very attractive. Friedman continued:

It was the London School (really Austrian) view that I referred to in my “Restatement” when I spoke of “the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach – and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists.”

The intellectual climate at Chicago had been wholly different. My teachers regarded the depression as largely the product of misguided government policy – or at least greatly intensified by such policies. They blamed the monetary and fiscal authorities for permitting banks to fail and the quantity of deposits to decline. Far from preaching the need to let deflation and bankruptcy run their course, they issued repeated pronouncements calling for governmental action to stem the deflation. . . .

It was this view the the quantity theory that I referred to in my “Restatement” as “a more subtle and relevant version, one in which the quantity theory was connected and integrated with general price theory and became a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions.” (pp. 162-63)

After quoting at length from a talk Jacob Viner gave in 1933 calling for monetary expansion, Friedman winds up with this gem.

What, in the field of interpretation and policy, did Keynes have to offer those of us who learned their economics at a Chicago filled with these views? Can anyone who knows my work read Viner’s comments and not see the direct links between them and Anna Schwartz’s and my Monetary History or between them and the empirical Studies in the Quantity Theory of Money? Indeed, as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account. Can you find any similar link between [Lionel] Robbins’s [of LSE] comments [in his book The Great Depression] and our work? (p. 167)

So what is the evidence that Friedman provides to counter the scandalous accusation by Patinkin and Johnson that Friedman invented a Chicago oral tradition of the quantity theory? (And don’t forget: the quantity theory is a theory of the demand for money) Well, it’s that, at the London School of Economics, there were a bunch of guys who had crazy views about just allowing the Great Depression to run its course, and those guys were quantity theorists, which is why Keynes had to start a revolution to get rid of them all, but at Chicago, they didn’t allow any of those guys to spout their crazy ideas in the first place, so we didn’t need any damn Keynesian revolution.

Good grief! Is there a single word that makes sense? To begin with those detestable guys at LSE were Austrians, as Friedman acknowledges. What he didn’t say, or didn’t know, is that Austrians, either by self-description or by any reasonable definition of the term, are not quantity theorists. So the idea that there was anything special about the Chicago quantity theory as opposed to any other species of the quantity theory is total humbug.

But hold on, it only gets worse. Friedman holds up Jacob Viner as an exemplar of the Chicago quantity theory oral tradition. Jacob Viner was a superb economist, a magnificent scholar, and a legendary teacher for whom I have the utmost admiration, and I am sure that Friedman learned a lot from him at Chicago, But isn’t it strange that Friedman writes: “as I have read Viner’s talk for purposes of this paper, I have myself been amazed to discover how precisely it foreshadows the main thesis of our Monetary History for the depression period, and have been embarrassed that we made no reference to it in our account.” OMG! This is the oral tradition that exerted such a powerful influence on Friedman and his fellow students? Viner explains how to get out of the depression in 1933, and in 1971 Friedman is “amazed to discover” how precisely Viner’s talk foreshadowed the main thesis of his explanation of the Great Depression? That sounds more like a subliminal tradition than an oral tradition.

Responding to Patinkin’s charge that his theory of the demand for money – remember the quantity theory, according to Friedman is a theory of the demand for money — is largely derived from Keynes, Friedman plays a word game.

Is everything in the General Theory Keynesian? Obviously yes, in the trivial sense that the words were set down on paper by John Maynard Keynes. Obviously no, in the more important sense that the term Keynesian has come to refer to a theory of short-term economic change – or a way of analyzing such change – presented in the General Theory and distinctively different from the theory that preceded it. To take a noncontroversial example: in his chapter 20 on “The Employment Function” and elsewhere, Keynes uses the law of diminishing returns to conclude that an increase of employment requires a decline in real-wage rates. Clearly that does not make the “law of diminishing returns” Keynesian or justify describing the “analytical framework” of someone who embodies the law of diminishing returns in his theoretical structure as Keynesian.

In just the same sense, I maintain that Keynes’s discussion of the demand curve for money in the General Theory is for the most part a continuation of earlier quantity theory approaches, improved and refined but not basically modified. As evidence, I shall cite Keynes’s own writings in the Tract on Monetary Reform – long before he became a Keynesian in the present sense. (p. 168)

There are two problems with this line of defense. First, the analogy to the law of diminishing returns would have been appropriate only if Keynes had played a major role in the discovery of the law of diminishing returns just as, on Friedman’s own admission, he played a major role in discovering the theory of liquidity preference. Second, it is, to say the least, debatable to what extent “Keynes’s discussion of the demand curve for money was merely a continuation of earlier quantity theory approaches, improved and refined but not basically modified.” But there is no basis at all for the suggestion that a Chicago oral tradition was the least bit implicated in those earlier quantity theory approaches. So Friedman’s invocation of a Chicago oral tradition was completely fanciful.

This post has gone on too long already. I have more to say about Friedman’s discussion of the relationship between money, price levels, and interest rates. But that will have to wait till next time.

The Wisdom of David Laidler

Michael Woodford’s paper for the Jackson Hole Symposium on Monetary Policy wasn’t the only important paper on monetary economics to be posted on the internet last month. David Laidler, perhaps the world’s greatest expert on the history of monetary theory and macroeconomics since the time of Adam Smith, has written an important paper with the somewhat cryptic title, “Two Crises, Two Ideas, and One Question.” Most people will figure out pretty quickly which two crises Laidler is referring to, but you will have to read the paper in order to figure out which two ideas and which question, Laidler has on his mind. Actually, you won’t have to read the paper if you keep reading this post, because I am about to tell you. The two ideas are what Laidler calls the “Fisher relation” between real and nominal interest rates, and the idea of a lender of last resort. The question is whether a market economy is inherently stable or unstable.

How does one weave these threads into a coherent narrative? Well, to really understand that you really will just have to read Laidler’s paper, but this snippet from the introduction will give you some sense of what he is up to.

These two particular ideas are especially interesting, because in the 1960s and ’70s, between our two crises, they feature prominently in the Monetarist reassessment of the Great Depression, which helped to establish the dominance in macroeconomic thought of the view that, far from being a manifestation of deep flaws in the very structure of the market economy, as it had at first been taken to be, this crisis was the consequence of serious policy errors visited upon an otherwise robustly self-stabilizing system. The crisis that began in 2007 has re-opened this question.

The Monetarist counterargument to the Keynesian view that the market economy is inherently subject to wide fluctuations and has no strong tendency toward full employment was that the Great Depression was caused primarily by a policy shock, the failure of the Fed to fulfill its duty to act as a lender of last resort during the US financial crisis of 1930-31. Originally, the Fisher relation did not figure prominently in this argument, but it eventually came to dominate Monetarism and the post-Monetarist/New Keynesian orthodoxy in which the job of monetary policy was viewed as setting a nominal interest rate (via a Taylor rule) that would be consistent with expectations of an almost negligible rate of inflation of about 2%.

This comfortable state of affairs – Monetarism without money is how Laidler describes it — in which an inherently stable economy would glide along its long-run growth path with low inflation, only rarely interrupted by short, shallow recessions, was unpleasantly overturned by the housing bubble and the subsequent financial crisis, producing the steepest downturn since 1937-38. That downturn has posed a challenge to Monetarist orthodoxy inasmuch as the sudden collapse, more or less out of nowhere in 2008, seemed to suggest that the market economy is indeed subject to a profound instability, as the Keynesians of old used to maintain. In the Great Depression, Monetarists could argue, it was all, or almost all, the fault of the Federal Reserve for not taking prompt action to save failing banks and for not expanding the money supply sufficiently to avoid deflation. But in 2008, the Fed provided massive support to banks, and even to non-banks like AIG, to prevent a financial meltdown, and then embarked on an aggressive program of open-market purchases that prevented an incipient deflation from taking hold.

As a result, self-identifying Monetarists have split into two camps. I will call one camp the Market Monetarists, with whom I identify even though I am much less of a fan of Milton Friedman, the father of Monetarism, than most Market Monetarists, and, borrowing terminology adopted in the last twenty years or so by political conservatives in the US to distinguish between old-fashioned conservatives and neoconservatives, I will call the old-style Monetarists, paleo-Monetarists. The paelo-Monetarists are those like Alan Meltzer, the late Anna Schwartz, Thomas Humphrey, and John Taylor (a late-comer to Monetarism who has learned quite well how to talk to the Monetarist talk). For the paleo-Monetarists, in the absence of deflation, the extension of Fed support to non-banking institutions and the massive expansion of the Fed’s balance sheet cannot be justified. But this poses a dilemma for them. If there is no deflation, why is an inherently stable economy not recovering? It seems to me that it is this conundrum which has led paleo-Monetarists into taking the dubious position that the extreme weakness of the economic recovery is a consequence of fiscal and monetary-policy uncertainty, the passage of interventionist legislation like the Affordable Health Care Act and the Dodd-Frank Bill, and the imposition of various other forms of interventionist regulations by the Obama administration.

Market Monetarists, on the other hand, have all along looked to monetary policy as the ultimate cause of both the downturn in 2008 and the lack of a recovery subsequently. So, on this interpretation, what separates paleo-Monetarists from Market Monetarists is whether you need outright deflation in order to precipitate a serious malfunction in a market economy, or whether something less drastic can suffice. Paleo-Monetarists agree that Japan in the 1990s and even early in the 2000s was suffering from a deflationary monetary policy, a policy requiring extraordinary measures to counteract. But the annual rate of deflation in Japan was never more than about 1% a year, a far cry from the 10% annual rate of deflation in the US between late 1929 and early 1933. Paleo-Monetarists must therefore explain why there is a radical difference between 1% inflation and 1% deflation. Market Monetarists also have a problem in explaining why a positive rate of inflation, albeit less than the 2% rate that is generally preferred, is not adequate to sustain a real recovery from starting more than four years after the original downturn. Or, if you prefer, the question could be restated as why a 3 to 4% rate of increase in NGDP is not adequate to sustain a real recovery, especially given the assumption, shared by paleo-Monetarists and Market Monetarists, that a market economy is generally stable and tends to move toward a full-employment equilibrium.

Here is where I think Laidler’s focus on the Fisher relation is critically important, though Laidler doesn’t explicitly address the argument that I am about to make. This argument, which I originally made in my paper “The Fisher Effect under Deflationary Expectations,” and have repeated in several subsequent blog posts (e.g., here) is that there is no specific rate of deflation that necessarily results in a contracting economy. There is plenty of historical experience, as George Selgin and others have demonstrated, that deflation is consistent with strong economic growth and full employment. In a certain sense, deflation can be a healthy manifestation of growth, allowing that growth, i.e., increasing productivity of some or all factors of production, to be translated into falling output prices. However, deflation is only healthy in an economy that is growing because of productivity gains. If productivity is flagging, there is no space for healthy (productivity-driven) deflation.

The Fisher relation between the nominal interest rate, the real interest rate and the expected rate of deflation basically tells us how much room there is for healthy deflation. If we take the real interest rate as given, that rate constitutes the upper bound on healthy deflation. Why, because deflation greater than real rate of interest implies a nominal rate of interest less than zero. But the nominal rate of interest has a lower bound at zero. So what happens if the expected rate of deflation is greater than the real rate of interest? Fisher doesn’t tell us, because in equilibrium it isn’t possible for the rate of deflation to exceed the real rate of interest. But that doesn’t mean that there can’t be a disequilibrium in which the expected rate of deflation is greater than the real rate of interest. We (or I) can’t exactly model that disequilibrium process, but whatever it is, it’s ugly. Really ugly. Most investment stops, the rate of return on cash (i.e., expected rate of deflation) being greater than the rate of return on real capital. Because the expected yield on holding cash exceeds the expected yield on holding real capital, holders of real capital try to sell their assets for cash. The only problem is that no one wants to buy real capital with cash. The result is a collapse of asset values. At some point, asset values having fallen, and the stock of real capital having worn out without being replaced, a new equilibrium may be reached at which the real rate will again exceed the expected rate of deflation. But that is an optimistic scenario, because the adjustment process of falling asset values and a declining stock of real capital may itself feed pessimistic expectations about the future value of real capital so that there literally might not be a floor to the downward spiral, at least not unless there is some exogenous force that can reverse the downward spiral, e.g., by changing price-level expectations.  Given the riskiness of allowing the rate of deflation to come too close to the real interest rate, it seems prudent to keep deflation below the real rate of interest by a couple of points, so that the nominal interest rate doesn’t fall below 2%.

But notice that this cumulative downward process doesn’t really require actual deflation. The same process could take place even if the expected rate of inflation were positive in an economy with a negative real interest rate. Real interest rates have been steadily falling for over a year, and are now negative even at maturities up to 10 years. What that suggests is that ceiling on tolerable deflation is negative. Negative deflation is the same as inflation, which means that there is a lower bound to tolerable inflation.  When the economy is operating in an environment of very low or negative real rates of interest, the economy can’t recover unless the rate of inflation is above the lower bound of tolerable inflation. We are not in the critical situation that we were in four years ago, when the expected yield on cash was greater than the expected yield on real capital, but it is a close call. Why are businesses, despite high earnings, holding so much cash rather than using it to purchase real capital assets? My interpretation is that with real interest rates negative, businesses do not see a sufficient number of profitable investment projects to invest in. Raising the expected price level would increase the number of investment projects that appear profitable, thereby inducing additional investment spending, finally inducing businesses to draw down, rather than add to, their cash holdings.

So it seems to me that paleo-Monetarists have been misled by a false criterion, one not implied by the Fisher relation that has become central to Monetarist and Post-Monetarist policy orthodoxy. The mere fact that we have not had deflation since 2009 does not mean that monetary policy has not been contractionary, or, at any rate, insufficiently expansionary. So someone committed to the proposition that a market economy is inherently stable is not obliged, as the paleo-Monetarists seem to think, to take the position that monetary policy could not have been responsible for the failure of the feeble recovery since 2009 to bring us back to full employment. Whether it even makes sense to think about an economy as being inherently stable or unstable is a whole other question that I will leave for another day.

HT:  Lars Christensen

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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