Archive for the 'Nick Rowe' Category

Samuelson Rules the Seas

I think Nick Rowe is a great economist; I really do. And on top of that, he recently has shown himself to be a very brave economist, fearlessly claiming to have shown that Paul Samuelson’s classic 1980 takedown (“A Corrected Version of Hume’s Equilibrating Mechanisms for International Trade“) of David Hume’s classic 1752 articulation of the price-specie-flow mechanism (PSFM) (“Of the Balance of Trade“) was all wrong. Although I am a great admirer of Paul Samuelson, I am far from believing that he was error-free. But I would be very cautious about attributing an error in pure economic theory to Samuelson. So if you were placing bets, Nick would certainly be the longshot in this match-up.

Of course, I should admit that I am not an entirely disinterested observer of this engagement, because in the early 1970s, long before I discovered the Samuelson article that Nick is challenging, Earl Thompson had convinced me that Hume’s account of PSFM was all wrong, the international arbitrage of tradable-goods prices implying that gold movements between countries couldn’t cause the relative price levels of those countries in terms of gold to deviate from a common level, beyond the limits imposed by the operation of international commodity arbitrage. And Thompson’s reasoning was largely restated in the ensuing decade by Jacob Frenkel and Harry Johnson (“The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins”) and by Donald McCloskey and Richard Zecher (“How the Gold Standard Really Worked”) both in the 1976 volume on The Monetary Approach to the Balance of Payments edited by Johnson and Frenkel, and by David Laidler in his essay “Adam Smith as a Monetary Economist,” explaining why in The Wealth of Nations Smith ignored his best friend Hume’s classic essay on PSFM. So the main point of Samuelson’s takedown of Hume and the PSFM was not even original. What was original about Samuelson’s classic article was his dismissal of the rationalization that PSFM applies when there are both non-tradable and tradable goods, so that national price levels can deviate from the common international price level in terms of tradables, showing that the inclusion of tradables into the analysis serves only to slow down the adjustment process after a gold-supply shock.

So let’s follow Nick in his daring quest to disprove Samuelson, and see where that leads us.

Assume that durable sailing ships are costly to build, but have low (or zero for simplicity) operating costs. Assume apples are the only tradeable good, and one ship can transport one apple per year across the English Channel between Britain and France (the only countries in the world). Let P be the price of apples in Britain, P* be the price of apples in France, and R be the annual rental of a ship, (all prices measured in gold), then R=ABS(P*-P).

I am sorry to report that Nick has not gotten off to a good start here. There cannot be only tradable good. It takes two tango and two to trade. If apples are being traded, they must be traded for something, and that something is something other than apples. And, just to avoid misunderstanding, let me say that that something is also something other than gold. Otherwise, there couldn’t possibly be a difference between the Thompson-Frenkel-Johnson-McCloskey-Zecher-Laidler-Samuelson critique of PSFM and the PSFM. We need at least three goods – two real goods plus gold – providing a relative price between the two real goods and two absolute prices quoted in terms of gold (the numeraire). So if there are at least two absolute prices, then Nick’s equation for the annual rental of a ship R must be rewritten as follows R=ABS[P(A)*-P(A)+P(SE)*-P(SE)], where P(A) is the price of apples in Britain, P(A)* is the price of apples in France, P(SE) is the price of something else in Britain, and P(SE)* is the price of that same something else in France.

OK, now back to Nick:

In this model, the Law of One Price (P=P*) will only hold if the volume of exports of apples (in either direction) is unconstrained by the existing stock of ships, so rentals on ships are driven to zero. But then no ships would be built to export apples if ship rentals were expected to be always zero, which is a contradiction of the Law of One Price because arbitrage is impossible without ships. But an existing stock of ships represents a sunk cost (sorry) and they keep on sailing even as rentals approach zero. They sail around Samuelson’s Iceberg model (sorry) of transport costs.

This is a peculiar result in two respects. First, it suggests, perhaps inadvertently, that the law of price requires equality between the prices of goods in every location when in fact it only requires that prices in different locations not differ by more than the cost of transportation. The second, more serious, peculiarity is that with only one good being traded the price difference in that single good between the two locations has to be sufficient to cover the cost of building the ship. That suggests that there has to be a very large price difference in that single good to justify building the ship, but in fact there are at least two goods being shipped, so it is the sum of the price differences of the two goods that must be sufficient to cover the cost of building the ship. The more tradable goods there are, the smaller the price differences in any single good necessary to cover the cost of building the ship.

Again, back to Nick:

Start with zero exports, zero ships, and P=P*. Then suppose, like Hume, that some of the gold in Britain magically disappears. (And unlike Hume, just to keep it simple, suppose that gold magically reappears in France.)

Uh-oh. Just to keep it simple? I don’t think so. To me, keeping it simple would mean looking at one change in initial conditions at a time. The one relevant change – the one discussed by Hume – is a reduction in the stock of gold in Britain. But Nick is looking at two changes — a reduced stock of gold in Britain and an increased stock of gold in France — simultaneously. Why does it matter? Because the key point at issue is whether a national price level – i.e, Britain’s — can deviate from the international price level. In Nick’s two-country example, there should be one national price level and one international price level, which means that the only price level subject to change as a result of the change in initial conditions should be, as in Hume’s example, the British price level, while the French price level – representing the international price level – remained constant. In a two-country model, this can only be made plausible by assuming that France is large compared to Britain, so that a loss of gold could potentially affect the British price level without changing the French price level. Once again back to Nick.

The price of apples in Britain drops, the price of apples in France rises, and so the rent on a ship is now positive because you can use it to export apples from Britain to France. If that rent is big enough, and expected to stay big long enough, some ships will be built, and Britain will export apples to France in exchange for gold. Gold will flow from France to Britain, so the stock of gold will slowly rise in Britain and slowly fall in France, and the price of apples will likewise slowly rise in Britain and fall in France, so ship rentals will slowly fall, and the price of ships (the Present Value of those rents) will eventually fall below the cost of production, so no new ships will be built. But the ships already built will keep on sailing until rentals fall to zero or they rot (whichever comes first).

So notice what Nick has done. Instead of confronting the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique of Hume, which asserts that a world price level determines the national price level, Nick has simply begged the question by not assuming that the world price of gold, which determines the world price level, is constant. Instead, he posits a decreased value of gold in France, owing to an increased French stock of gold, and an increased value of gold in Britain, owing to a decreased British stock of gold, and then conflating the resulting adjustment in the value gold with the operation of commodity arbitrage. Why Nick thinks his discussion is relevant to the Thompson-Frenkel-Johnson-McCloseky-Zecher-Laidler-Samuelson critique escapes me.

The flow of exports and hence the flow of specie is limited by the stock of ships. And only a finite number of ships will be built. So we observe David Hume’s price-specie flow mechanism playing out in real time.

This bugs me. Because it’s all sorta obvious really.

Yes, it bugs me, too. And, yes, it is obvious. But why is it relevant to the question under discussion, which is whether there is an international price level in terms of gold that constrains movements in national price levels in countries in which gold is the numeraire. In other words, if there is a shock to the gold stock of a small open economy, how much will the price level in that small open economy change? By the percentage change in the stock of gold in that country – as Hume maintained – or by the minisicule percentage change in the international stock of gold, gold prices in the country that has lost gold being constrained from changing by more than allowed by the cost of arbitrage operations? Nick’s little example is simply orthogonal to the question under discussion.

I skip Nick’s little exegetical discussion of Hume’s essay and proceed to what I think is the final substantive point that Nick makes.

Prices don’t just arbitrage themselves. Even if we take the limit of my model, as the cost of building ships approaches zero, we need to explain what process ensures the Law of One Price holds in equilibrium. Suppose it didn’t…then people would buy low and sell high…..you know the rest.

There are different equilibrium conditions being confused here. The equilibrium arbitrage conditions are not same as the equilibrium conditions for international monetary equilibrium. Arbitrage conditions for individual commodities can hold even if the international distribution of gold is not in equilibrium. So I really don’t know what conclusion Nick is alluding to here.

But let me end on what I hope is a conciliatory and constructive note. As always, Nick is making an insightful argument, even if it is misplaced in the context of Hume and PSFM. And the upshot of Nick’s argument is that transportation costs are a function of the dispersion of prices, because, as the incentive to ship products to capture arbitrage profits increases, the cost of shipping will increase as arbitragers bid up the value of resources specialized to the processes of transporting stuff. So the assumption that the cost of transportation can be treated as a parameter is not really valid, which means that the constraints imposed on national price level movements are not really parametric, they are endongenously determined within an appropriately specified general equilibrium model. If Nick is willing to settle for that proposition, I don’t think that our positions are that far apart.

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Cyclical versus Secular Causes of Stagnation

Nick Rowe and Scott Sumner have recently had an interesting little debate about whether the slowdown in real GDP growth and labor productivity since the 2007-09 downturn is the result of cyclical or secular factors. Nick argues that successful inflation targeting in the two decades before the 2007 downturn had given rise to entrepreneurial expectations of stable aggregate demand, thereby providing a supportive macroeconomic environment for long-term investment that generates rising labor productivity over time. By undermining confidence in macroeconomic stability, the 2007-09 downturn diminished the willingness of businesses to continue make long-term investments and thus compromised one of the institutional pillars supporting long-term investment and productivity growth. Despite a recovery, expectations of future aggregate demand are now held with less confidence – higher perceived variance – than previously, thereby reducing entrepreneurial willingness to commit to the long-term capital expansion that increases productivity.

Scott is skeptical of the argument, because productivity growth had already started to decline after the 2001 downturn. Of course, one could argue that geopolitical uncertainty after the 9/11 attack and the invasions of Afghanistan and Iraq could have had a similar depressing effect on investment well before the 2007 downturn. So the decline in productivity growth that was underway at the time of the 2007 downturn is not necessarily inconsistent with Nick’s basic story. But Scott at least partially defends himself against that response by showing that real long-term investment as a share of GDP rose sharply after the 2001 downturn and was well above the levels of 1950s and 1960s.

Seeing no reason why the pace of productivity growth couldn’t have been affected by both cyclical and secular forces, I am happy to agree with both Nick and Scott. But I also have my own theory about the slowdown in productivity growth, which I have discussed previously, so this seems like a good time to weigh in again on the topic. As I pointed out in a 2015 post, one characteristic that distinguishes the 2007-09 downturn from earlier downturns is that it was associated with relatively large sectoral shifts in demand. Thus, the 2007-09 downturn was characterized by a higher percentage of jobs lost in the downturn that were not subsequently restored than was the case in earlier downturns. In earlier downturns, the decline in aggregate demand caused workers to be laid off temporarily from their jobs when demand and output fell, but a large percentage of laid-off workers were later rehired by their former when demand and output recovered. And even many of those laid-off workers that weren’t rehired by their previous employers still eventually found jobs doing work very similar to what they had been doing before losing their old jobs.

The depth and the severity of recessions can be measured not just by the unemployment rate, but also by the long-term unemployment rate. What set the 2007-09 downturn and the recovery apart from earlier downturns — even the 1981-82 downturn, in which the unemployment rate rose to almost 11 percent, higher than the 10 percent rate at depth of the 2007-09 downturn – was a long-term unemployment rate substantially higher, followed by a slower rate of decline, than in any post-World-War II downturn. I quote from a recent article on long-term unemployment

In January 2017, there were 1.85 million long-term unemployed. The number first dropped below two million in May 2015. That means 24.2 percent of the unemployed have been looking for work for six months. That’s better than the record high of 46 percent in the second quarter of 2010.

Sadly, it’s barely better than the darkest days of the 1981 recession. At that point, 26 percent of the unemployed were out of work for more than six months. On the other hand, total unemployment was worse than it is today. There was a 10.8 percent overall unemployment rate. In other words, the Great Recession created a higher percent of long-term unemployment.(Source: “Potential Causes and Implications of the Rise in Long-Term Unemployment,” The Federal Reserve Bank of Richmond, September 2011.)

Here’s how I put it in 2015.

[T]he 2008-09 downturn was associated with major sectoral shifts that caused an unusually large reallocation of labor from industries like construction and finance to other industries so that an unusually large number of workers have had to find new jobs doing work different from what they were doing previously. In many recessions, laid-off workers are either re-employed at their old jobs or find new jobs doing basically the same work that they had been doing at their old jobs. When workers transfer from one job to another similar job, there is little reason to expect a decline in their productivity after they are re-employed, but when workers are re-employed doing something very different from what they did before, a significant drop in their productivity in their new jobs is likely.

In addition, the number of long-term unemployed (27 weeks or more) since the 2000-09 downturn has been unusually high. Workers who remain unemployed for an extended period of time tend to suffer an erosion of skills, causing their productivity to drop when they are re-employed even if they are able to find a new job in their old occupation. It seems likely that the percentage of long-term unemployed workers that switch occupations is larger than the percentage of short-term unemployed workers that switch occupations, so the unusually high rate of long-term unemployment has probably had a doubly negative effect on labor productivity.

Long-term unemployment has adverse effects on health and many other metrics of well-being, effects that aren’t confined to the unemployed, but extend to their families, friends and communities. An increase in long-term unemployment, even if originally caused by an aggregate demand shock, is associated with a long-term negative supply shock. So it’s not surprising that the unusually and persistently high rate of long-term unemployment after the 2007-09 downturn, causing a massive loss of human capital, has depressed the subsequent growth in labor productivity. In my 2015 post, I tried to provide an optimistic interpretation of this phenomenon, but my optimism was misplaced, because the damage inflicted by long-term unemployment is very often irreversible, and rates of long-term unemployment have remained stubbornly high notwithstanding the steady decline in the overall unemployment rate.

Accounting for a disproportionate share of the long-term unemployed, discouraged older workers, chronically unable to find new jobs, have prematurely departed from the labor force. These older workers have presumably been replaced by younger entrants into the labor force, and one would suppose that the productivity of the younger workers is, on average, substantially lower than the productivity of the older and more experienced workers whom they have replaced, though presumably as they gain experience and acquire skills, the productivity of new workers will rise over time. Thus the demographic shift in the labor force is another reason for the low productivity growth since the 2007-09 downturn. But that effect, though largely demographic, has also had a cyclical component, making it difficult to disentangle the cyclical from the secular causes of sluggish productivity growth.

That difficulty is further compounded by another contributory cause of slow productivity growth. In my 2016 post, I discussed the late Walter Oi’s idea that labor is not really a variable factor of production as it is typically treated in simplified models, but a quasi-fixed factor. Here’s how Oi explained the idea:

For analytic purposes fixed employment costs can be separated into two categories called, for convenience, hiring and training costs. Hiring costs are defined as those costs that have no effect on a worker’s productivity and include outlays for recruiting, for processing payroll records, and for supplements such as unemployment compensation. These costs are closely related to the number of new workers and only indirectly related to the flow of labor’s services Training expenses, on the other hand, are investments in the human agent, specifically designed to improve a worker’s productivity.

The training activity typically entails direct money outlays as well as numerous implicit costs such as the allocation of old workers to teaching skills and rejection of unqualified workers during the training period.

So, if the 2007-09 downturn and the recovery was associated with an unusually high flow of workers from old jobs into new jobs, there has been an unusually high level of training expenses incurred by firms as they have brought workers into new jobs. The large investments by firms in training new workers have inevitably caused measured labor productivity to lag below previous trends when the fraction of workers entering the labor force or requiring new training to learn new skills was likely less than it has been since 2009. This idea, at any rate, does provide some reason to hope for at least a modest improvement in productivity and economic growth over time, even if the human cost of almost a decade of extremely high long-term unemployment is now largely irremediable and irretrievable.

Nick Rowe Ignores, But Does Not Refute, the Law of Reflux

In yet another splendid post, Nick Rowe once again explains what makes money – the medium of exchange – so special. Money – the medium of exchange – is the only commodity that is traded in every market. Unlike every other commodity, each of which has a market of its very own, in which it – and only it – is traded (for money!), money has no market of its own, because money — the medium of exchange — is traded in every other market.

This distinction is valid and every important, and Nick is right to emphasize it, even obsess about it. Here’s how Nick described it his post:

1. If you want to increase the stock of land in your portfolio, there’s only one way to do it. You must increase the flow of land into your portfolio, by buying more land.

If you want to increase the stock of bonds in your portfolio, there’s only one way to do it. You must increase the flow of bonds into your portfolio, by buying more bonds.

If you want to increase the stock of equities in your portfolio, there’s only one way to do it. You must increase the flow of equities into your portfolio, by buying more equities.

But if you want to increase the stock of money in your portfolio, there are two ways to do it. You can increase the flow of money into your portfolio, by buying more money (selling more other things for money). Or you can decrease the flow of money out of your portfolio, by selling less money (buying less other things for money).

An individual who wants to increase his stock of money will still have a flow of money out of his portfolio. But he will plan to have a bigger flow in than flow out.

OK, let’s think about this for a second. Again, I totally agree with Nick that money is traded in every market. But is it really the case that there is no market in which only money is traded? If there is no market in which only money is traded, how do we explain the quantity of money in existence at any moment of time as the result of an economic process? Is it – I mean the quantity of money — just like an external fact of nature that is inexplicable in terms of economic theory?

Well, actually, the answer is: maybe it is, and maybe it’s not. Sometimes, we do just take the quantity of money to be an exogenous variable determined by some outside – noneconomic – force, aka the Monetary Authority, which, exercising its discretion, determines – judiciously or arbitrarily, take your pick – The Quantity of Money. But sometimes we acknowledge that the quantity of money is actually determined by economic forces, and is not a purely exogenous variable; we say that money is endogenous. And sometimes we do both; we distinguish between outside (exogenous) money and inside (endogenous) money.

But if we do acknowledge that there is – or that there might be – an economic process that determines what the quantity of money is, how can we not also acknowledge that there is – or might be — some market – a market dedicated to money, and nothing but money – in which the quantity of money is determined? Let’s now pick up where I left off in Nick’s post:

2. There is a market where land is exchanged for money; a market where bonds are exchanged for money; a market where equities are exchanged for money; and markets where all other goods and services are exchanged for money. “The money market” (singular) is an oxymoron. The money markets (plural) are all those markets. A monetary exchange economy is not an economy with one central Walrasian market where anything can be exchanged for anything else. Every market is a money market, in a monetary exchange economy.

An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money might be observed in any market.

Yes, an excess demand for money might be observed in any market, as people tried to shed, or to accumulate, money by altering their spending on other commodities. But is there no other way in which people wishing to hold more or less money than they now hold could obtain, or dispose of, money as desired?

Well, to answer that question, it helps to ask another question: what is the economic process that brings (inside) money – i.e., the money created by a presumably explicable process of economic activity — into existence? And the answer is that ordinary people exchange their liabilities with banks (or similar entities) and in return they receive the special liabilities of the banks. The difference between the liabilities of ordinary individuals and the special liabilities of banks is that the liabilities of ordinary individuals are not acceptable as payment for stuff, but the special liabilities of banks are acceptable as payment for stuff. In other words, special bank liabilities are a medium of exchange; they are (inside) money. So if I am holding less (more) money than I would like to hold, I can adjust the amount I am holding by altering my spending patterns in the ways that Nick lists in his post, or I can enter into a transaction with a bank to increase (decrease) the amount of money that I am holding. This is a perfectly well-defined market in which the public exchanges “money-backing” instruments (their IOUs) with which the banks create the monetary instruments that the banks give the public in return.

Whenever the total amount of (inside) money held by the non-bank public does not equal the total amount of (inside) money in existence, there are market forces operating by which the non-bank public and the banks can enter into transactions whereby the amount of (inside) money is adjusted to eliminate the excess demand for (supply of) (inside) money. This adjustment process does not operate instantaneously, and sometimes it may even operate dysfunctionally, but, whether it operates well or not so well, the process does operate, and we ignore it at our peril.

The rest of Nick’s post dwells on the problems caused by “price stickiness.” I may try to write another post soon about “price stickiness,” so I will just make a brief further comment about one further statement made by Nick:

Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio.

And my comment is simply that Nick is begging the question here. He is assuming that there is no market mechanism by which individuals can increase the flow of money into their portfolios. But that is clearly not true, because most of the money in the hands of the public now was created by a process in which individuals increased the flow of money into their portfolios by exchanging their own “money-backing” IOUs with banks in return for the “monetary” IOUs created by banks.

The endogenous process by which the quantity of monetary IOUs created by the banking system corresponds to the amount of monetary IOUs that the public wants to hold at any moment of time is what is known as the Law of Reflux. Nick may believe — and may even be right — that the Law of Reflux is invalid, but if that is what Nick believes, he needs to make an argument, not assume a conclusion.

Helicopter Money and the Reflux Problem

Although I try not to seem overly self-confident or self-satisfied, I do give myself a bit of credit for being willing to admit my mistakes, of which I’ve made my share. So I am going to come straight out and admit it up front: I have not been reading Nick Rowe’s blog lately. Realizing my mistake, I recently looked up his posts for the past few months. Reading one of Nick’s posts is always an educational experience, teaching us how to think about an economic problem in the way that a good – I mean a really good — economist ought to think about the problem. I don’t always agree with Nick, but in trying to figure out whether I agree — and if not, why not — I always find that I have gained some fresh understanding of, or a deeper insight into, the problem than I had before. So in this post, I want to discuss a post that Nick wrote for his blog a couple of months ago on “helicopter money” and the law of reflux. Nick and I have argued about the law of reflux several times (see, e.g., here, here and here, and for those who just can’t get enough here is J. P. Koning’s take on Rowe v. Glasner) and I suspect that we still don’t see eye to eye on whether or under what circumstances the law of reflux has any validity. The key point that I have emphasized is that there is a difference in the way that commercial banks create money and the way that a central bank or a monetary authority creates money. In other words, I think that I hold a position somewhere in between Nick’s skepticism about the law of reflux and Mike Sproul’s unqualified affirmation of the law of reflux. So the truth is that I don’t totally disagree with what Nick writes about helicopter money. But I think it will help me and possibly people who read this post if I can explain where and why I take issue with what Nick has to say on the subject of helicopter money.

Nick begins his discussion with an extreme example in which people have a fixed and unchanging demand for money – one always needs to bear in mind that when economists speak about a demand for money they mean a demand to hold money in their wallets or their bank accounts. People will accept money in excess of their demand to hold money, but if the amount of money that they have in their wallets or in their bank accounts is more than desired, they don’t necessarily take immediate steps to get rid of their excess cash, though they will be more tolerant of excess cash in their bank accounts than in their wallets. So if central bank helicopters start bombarding the population with piles of new cash, those targeted will pick up the cash and put the cash in their wallets or deposit it into their bank accounts, but they won’t just keep the new cash in their wallets or their banks accounts permanently, because they will generally have better options for the superfluous cash than just leaving it in their wallets or their bank accounts. But what else can they do with their excess cash?

Well the usual story is that they spend the cash. But what do they spend it on? And the usual answer is that they buy stuff with the excess cash, causing a little consumption boom that either drives up prices of goods and services, or possibly, if wages and prices are “sticky,” causes total output to increase (at least temporarily unless the story starts from an initial condition of unemployed resources). And that’s what Nick seems to be suggesting in this passage.

If the central bank prints more currency, and drops it out of a helicopter, will the people refuse to pick it up, and leave the newly-printed notes lying on the sidewalk?

No. That’s silly. They will pick it up, and spend it. Each individual knows he can get rid of any excess money, even though it is impossible for individuals in the aggregate to get rid of excess money. What is true for each individual is false for the whole. It’s a fallacy of composition to assume otherwise.

But this version of the story is problematic for the same reason that early estimates of the multiplier in Keynesian models were vastly overstated. A one-time helicopter drop of money will be treated by most people as a windfall, not as a permanent increase in their income, so that it will not cause people to increase their spending on stuff except insofar as they expect their permanent income to have increased. So the main response of most people to the helicopter drop will be to make some adjustments in the composition of their balance sheets. People may use the cash to buy other income generating assets (including consumer durables), but they will hardly change their direct expenditures on present consumption.

So what else could people do with excess cash besides buying consumer durables? Well, they could buy real or financial assets (e.g., houses and paintings or bonds) driving up the value of those assets, but it is not clear why the value of those assets, which fundamentally reflect the expected future flows of real services or cash associated with those assets and the rates at which people discount future consumption relative to present consumption, is should be affected by an increase in the amount of cash that people happen to be holding at any particular moment in time. People could also use their cash to pay off debts, but that would just mean that the cash held by debtors would be transferred into the hands of their creditors. So the question what happens to the excess cash, and, if nothing happens to it, how the excess cash comes to be willingly held is not an easy question to answer.

Being the smart economist that he is, Nick understands the problem and he addresses it a few paragraphs below in a broader context in which people can put cash into savings accounts as well as spend it on stuff.

Now let me assume that the central bank also offers savings accounts, as well as issuing currency. Savings accounts may pay interest (at a rate set by the central bank), but cannot be used as a medium of exchange.

Start in equilibrium where the stock of currency is exactly $100 per person. What happens if the central bank prints more currency and drops it out of a helicopter, holding constant the nominal rate of interest it pays on savings accounts?

I know what you are thinking. I know how most economists would be thinking. (At least, I think I do.) “Aha! This time it’s different! Because now people can get rid of the excess currency, by depositing it in their savings accounts at the central bank, so Helicopter Money won’t work.” You are implicitly invoking the Law of Reflux to say that an excess supply of money must return to the bank that issued that money.

And you are thinking wrong. You are making exactly the same fallacy of composition as you would have been making if you said that people would leave the excess currency lying on the sidewalk.People in aggregate can only get rid of the excess currency by depositing it in their savings accounts (or throwing it away) therefore each individual will get rid of his excess currency by depositing it in his savings account (since it’s better than throwing it away).

There are 1,001 different ways an individual can get rid of excess currency, and depositing it in his savings account is only one of those 1,001 ways. Why should an individual care if depositing it in his savings account is the only way that works for the aggregate? (If people always thought like that, littering would never be a problem.) And if individuals do spend any portion of their excess currency, so that NGDP rises, and is expected to keep in rising, then the (assumed fixed) nominal interest rate offered on savings accounts at the central bank will start to look less attractive, and people will actually withdraw money from their savings accounts. Not because they want to hold extra currency, but because they plan to spend it.

There are indeed 1,001 ways that people could dispose of their excess cash balances, but how many of those 1,001 ways would be optimal under the assumptions of Nick’s little thought experiment? Not that many, because optimal spending decisions would be dictated by preferences for consumption over time, and there is no reason to assume that optimal spending plans would be significantly changed by the apparent, and not terribly large, wealth windfall associated with the helicopter drops. There could be some increase in purchases of assets like consumer durables, but one would expect that most of the windfall would be used to retire debt or to acquire interest-earning assets like central-bank deposits or their equivalent.

So, to be clear, I am not saying that Nick has it all wrong; I don’t deny that there could be some increase in expenditures on stuff; all I am saying is that in the standard optimizing models that we use, the implied effect on spending from an increase in cash holding seems to be pretty small.

Nick then goes on to bring commercial banks into his story.

The central bank issues currency, and also offers accounts at which central banks can keep “reserves”. People use both central bank currency and commercial bank chequing accounts as their media of exchange; commercial banks use their reserve accounts at the central bank as the medium of exchange they use for transactions between themselves. And the central bank allows commercial banks to swap currency for reserves in either direction, and reserves pay a nominal rate of interest set by the central bank.

My story now (as best as I can tell) matches the (implicit) model in “Helicopter Money: the Illusion of a Free Lunch” by Claudio Borio, Piti Disyatat, and Anna Zabai. (HT Giles Wilkes.) They argue that Helicopter Money will be unwanted and must Reflux to the central bank to be held as central bank reserves, where those reserves pay interest and so are just like (very short-term) government bonds, or savings accounts at the central bank. Their argument rests on a fallacy of composition. Individuals in aggregate can only get rid of unwanted currency that way, but this does not mean that individuals will choose to get rid of unwanted currency that way.

It seems to me that the effect that Nick is relying on is rather weak. If non-interest-bearing helicopter money can be costlessly converted into interest-bearing reserves at the central bank, then commercial banks will compete with each other to induce people with unwanted helicopter money in their pockets to convert the cash into interest-bearing deposits, so that the banks can pocket the interest on reserves. Competition will force the banks to share their interest income with depositors. Again, there may be some increase in spending on stuff associated with the helicopter drops, but it seems unlikely that it would be very large relative to the size of the drop.

It seems to me that the only way to answer the question how an excess supply of cash following a helicopter drop gets eliminated is to use the idea proposed by Earl Thompson over 40 years ago in his seminal, but unpublished, paper “A Reformulation of Macroeconomic Theory” which I have discussed in five posts (here, here, here, here and here) over the past four years. Even as I write this sentence, I feel a certain thrill of discovery in understanding more clearly than I ever have before the profound significance of Earl’s insight. The idea is simply this: in any intertemporal macroeconomic model, the expected rate of inflation, or the expected future price level, has to function, not as a parameter, but as an equilibrating variable. In any intertemporal macromodel, there will be a unique expected rate of inflation, or expected future price level, that is consistent with equilibrium. If actual expected inflation equals the equilibrium expected rate the economy may achieve its equilibrium, if the actual expected rate does not equal the equilibrium expected rate, the economy cannot reach equilibrium.

So if the monetary authority bombards its population with helicopter money, the economy will not reach equilibrium unless the expected rate of inflation of the public equals the rate of inflation (or the future price level) that is consistent with the amount of helicopter money being dropped by the monetary authority. But the fact that the expected rate of inflation is an equilibrating variable tells us nothing – absolutely nothing – about whether there is any economic mechanism whereby the equilibrium expectation of inflation is actually realized. The reason that the equilibrium value of expected inflation tells us nothing about the mechanism by which the equilibrium expected rate of inflation is achieved is that the mechanism does not exist. If it pleases you to say that rational expectations is such a mechanism, you are free to do so, but it should be obvious that the assertion that rational expectations ensures that the the actual expected rate of inflation is the equilibrium expected rate of inflation is nothing more than an exercise in question begging.

And it seem to me that, in explaining why helicopter drops are not nullified by reflux, Nick is implicitly relying on a change in inflation expectations as a reason why putting money into savings accounts will not eliminate the excess supply of cash. But it also seems to me that Nick is just saying that for equilibrium to be restored after a helicopter drop, inflation expectations have to change. Nothing I have said above should be understood to deny the possibility that inflation expectations could change as a result of a helicopter drop. In fact I think there is a strong likelihood that helicopter drops change inflation expectations. The point I am making is that we should be clear about whether we are making a contingent – potentially false — assertion about a causal relationship or making a logically necessary inference from given premises.

Thus, moving away from strictly logical reasoning, Nick makes an appeal to experience to argue that helicopter drops are effective.

We know, empirically, that helicopter money (in moderation of course) does not lead to bizarre consequences. Helicopter money is perfectly normal; central banks do it (almost) all the time. They print currency, the stock of currency grows over time, and since that currency pays no interest this is a profitable business for central banks and the governments that own them.

Ah yes, in the good old days before central banks started paying interest on reserves. After it became costless to hold money, helicopter drops aren’t what they used to be.

The demand for central bank currency seems to rise roughly in proportion to NGDP (the US is maybe an exception, since much is held abroad), so countries with rising NGDP are normally doing helicopter money. And doing helicopter money, just once, does not empirically lead to central banks being forced to set nominal interest rates at zero forever. And it would be utterly bizarre if it did; what else are governments supposed to do with the profits central banks earn from printing paper currency?

Why, of course! Give them to the banks by paying interest on reserves. Nick concludes with this thought.

The lesson we learn from all this is that the Law of Reflux will prevent Helicopter Money from working only if the central bank refuses to let NGDP rise at the same time. Which is like saying that pressing down on the gas pedal won’t work if you press the brake pedal down hard enough so the car can’t accelerate.

I would put it slightly differently. If the central bank engages in helicopter drops while simultaneously proclaiming that its inflation target is below the rate of inflation consistent with its helicopter drops, reflux may prevent helicopter drops from having any effect.

There Is No Intertemporal Budget Constraint

Last week Nick Rowe posted a link to a just published article in a special issue of the Review of Keynesian Economics commemorating the 80th anniversary of the General Theory. Nick’s article discusses the confusion in the General Theory between saving and hoarding, and Nick invited readers to weigh in with comments about his article. The ROKE issue also features an article by Simon Wren-Lewis explaining the eclipse of Keynesian theory as a result of the New Classical Counter-Revolution, correctly identified by Wren-Lewis as a revolution inspired not by empirical success but by a methodological obsession with reductive micro-foundationalism. While deploring the New Classical methodological authoritarianism, Wren-Lewis takes solace from the ability of New Keynesians to survive under the New Classical methodological regime, salvaging a role for activist counter-cyclical policy by, in effect, negotiating a safe haven for the sticky-price assumption despite its shaky methodological credentials. The methodological fiction that sticky prices qualify as micro-founded allowed New Keynesianism to survive despite the ascendancy of micro-foundationalist methodology, thereby enabling the core Keynesian policy message to survive.

I mention the Wren-Lewis article in this context because of an exchange between two of the commenters on Nick’s article: the presumably pseudonymous Avon Barksdale and blogger Jason Smith about microfoundations and Keynesian economics. Avon began by chastising Nick for wasting time discussing Keynes’s 80-year old ideas, something Avon thinks would never happen in a discussion about a true science like physics, the 100-year-old ideas of Einstein being of no interest except insofar as they have been incorporated into the theoretical corpus of modern physics. Of course, this is simply vulgar scientism, as if the only legitimate way to do economics is to mimic how physicists do physics. This methodological scolding is typically charming New Classical arrogance. Sort of reminds one of how Friedrich Engels described Marxian theory as scientific socialism. I mean who, other than a religious fanatic, would be stupid enough to argue with the assertions of science?

Avon continues with a quotation from David Levine, a fine economist who has done a lot of good work, but who is also enthralled by the New Classical methodology. Avon’s scientism provoked the following comment from Jason Smith, a Ph. D. in physics with a deep interest in and understanding of economics.

You quote from Levine: “Keynesianism as argued by people such as Paul Krugman and Brad DeLong is a theory without people either rational or irrational”

This is false. The L in ISLM means liquidity preference and e.g. here …

http://krugman.blogs.nytimes.com/2013/11/18/the-new-keynesian-case-for-fiscal-policy-wonkish/

… Krugman mentions an Euler equation. The Euler equation essentially says that an agent must be indifferent between consuming one more unit today on the one hand and saving that unit and consuming in the future on the other if utility is maximized.

So there are agents in both formulations preferring one state of the world relative to others.

Avon replied:

Jason,

“This is false. The L in ISLM means liquidity preference and e.g. here”

I know what ISLM is. It’s not recursive so it really doesn’t have people in it. The dynamics are not set by any micro-foundation. If you’d like to see models with people in them, try Ljungqvist and Sargent, Recursive Macroeconomic Theory.

To which Jason retorted:

Avon,

So the definition of “people” is restricted to agents making multi-period optimizations over time, solving a dynamic programming problem?

Well then any such theory is obviously wrong because people don’t behave that way. For example, humans don’t optimize the dictator game. How can you add up optimizing agents and get a result that is true for non-optimizing agents … coincident with the details of the optimizing agents mattering.

Your microfoundation requirement is like saying the ideal gas law doesn’t have any atoms in it. And it doesn’t! It is an aggregate property of individual “agents” that don’t have properties like temperature or pressure (or even volume in a meaningful sense). Atoms optimize entropy, but not out of any preferences.

So how do you know for a fact that macro properties like inflation or interest rates are directly related to agent optimizations? Maybe inflation is like temperature — it doesn’t exist for individuals and is only a property of economics in aggregate.

These questions are not answered definitively, and they’d have to be to enforce a requirement for microfoundations … or a particular way of solving the problem.

Are quarks important to nuclear physics? Not really — it’s all pions and nucleons. Emergent degrees of freedom. Sure, you can calculate pion scattering from QCD lattice calculations (quark and gluon DoF), but it doesn’t give an empirically better result than chiral perturbation theory (pion DoF) that ignores the microfoundations (QCD).

Assuming quarks are required to solve nuclear physics problems would have been a giant step backwards.

To which Avon rejoined:

Jason

The microfoundation of nuclear physics and quarks is quantum mechanics and quantum field theory. How the degrees of freedom reorganize under the renormalization group flow, what effective field theory results is an empirical question. Keynesian economics is worse tha[n] useless. It’s wrong empirically, it has no theoretical foundation, it has no laws. It has no microfoundation. No serious grad school has taught Keynesian economics in nearly 40 years.

To which Jason answered:

Avon,

RG flow is irrelevant to chiral perturbation theory which is based on the approximate chiral symmetry of QCD. And chiral perturbation theory could exist without QCD as the “microfoundation”.

Quantum field theory is not a ‘microfoundation’, but rather a framework for building theories that may or may not have microfoundations. As Weinberg (1979) said:

” … quantum field theory itself has no content beyond analyticity, unitarity,
cluster decomposition, and symmetry.”

If I put together an NJL model, there is no requirement that the scalar field condensate be composed of quark-antiquark pairs. In fact, the basic idea was used for Cooper pairs as a model of superconductivity. Same macro theory; different microfoundations. And that is a general problem with microfoundations — different microfoundations can lead to the same macro theory, so which one is right?

And the IS-LM model is actually pretty empirically accurate (for economics):

http://informationtransfereconomics.blogspot.com/2014/03/the-islm-model-again.html

To which Avon responded:

First, ISLM analysis does not hold empirically. It just doesn’t work. That’s why we ended up with the macro revolution of the 70s and 80s. Keynesian economics ignores intertemporal budget constraints, it violates Ricardian equivalence. It’s just not the way the world works. People might not solve dynamic programs to set their consumption path, but at least these models include a future which people plan over. These models work far better than Keynesian ISLM reasoning.

As for chiral perturbation theory and the approximate chiral symmetries of QCD, I am not making the case that NJL models requires QCD. NJL is an effective field theory so it comes from something else. That something else happens to be QCD. It could have been something else, that’s an empirical question. The microfoundation I’m talking about with theories like NJL is QFT and the symmetries of the vacuum, not the short distance physics that might be responsible for it. The microfoundation here is about the basic laws, the principles.

ISLM and Keynesian economics has none of this. There is no principle. The microfoundation of modern macro is not about increasing the degrees of freedom to model every person in the economy on some short distance scale, it is about building the basic principles from consistent economic laws that we find in microeconomics.

Well, I totally agree that IS-LM is a flawed macroeconomic model, and, in its original form, it was borderline-incoherent, being a single-period model with an interest rate, a concept without meaning except as an intertemporal price relationship. These deficiencies of IS-LM became obvious in the 1970s, so the model was extended to include a future period, with an expected future price level, making it possible to speak meaningfully about real and nominal interest rates, inflation and an equilibrium rate of spending. So the failure of IS-LM to explain stagflation, cited by Avon as the justification for rejecting IS-LM in favor of New Classical macro, was not that hard to fix, at least enough to make it serviceable. And comparisons of the empirical success of augmented IS-LM and the New Classical models have shown that IS-LM models consistently outperform New Classical models.

What Avon fails to see is that the microfoundations that he considers essential for macroeconomics are themselves derived from the assumption that the economy is operating in macroeconomic equilibrium. Thus, insisting on microfoundations – at least in the formalist sense that Avon and New Classical macroeconomists understand the term – does not provide a foundation for macroeconomics; it is just question begging aka circular reasoning or petitio principia.

The circularity is obvious from even a cursory reading of Samuelson’s Foundations of Economic Analysis, Robert Lucas’s model for doing economics. What Samuelson called meaningful theorems – thereby betraying his misguided acceptance of the now discredited logical positivist dogma that only potentially empirically verifiable statements have meaning – are derived using the comparative-statics method, which involves finding the sign of the derivative of an endogenous economic variable with respect to a change in some parameter. But the comparative-statics method is premised on the assumption that before and after the parameter change the system is in full equilibrium or at an optimum, and that the equilibrium, if not unique, is at least locally stable and the parameter change is sufficiently small not to displace the system so far that it does not revert back to a new equilibrium close to the original one. So the microeconomic laws invoked by Avon are valid only in the neighborhood of a stable equilibrium, and the macroeconomics that Avon’s New Classical mentors have imposed on the economics profession is a macroeconomics that, by methodological fiat, is operative only in the neighborhood of a locally stable equilibrium.

Avon dismisses Keynesian economics because it ignores intertemporal budget constraints. But the intertemporal budget constraint doesn’t exist in any objective sense. Certainly macroeconomics has to take into account intertemporal choice, but the idea of an intertemporal budget constraint analogous to the microeconomic budget constraint underlying the basic theory of consumer choice is totally misguided. In the static theory of consumer choice, the consumer has a given resource endowment and known prices at which consumers can transact at will, so the utility-maximizing vector of purchases and sales can be determined as the solution of a constrained-maximization problem.

In the intertemporal context, consumers have a given resource endowment, but prices are not known. So consumers have to make current transactions based on their expectations about future prices and a variety of other circumstances about which consumers can only guess. Their budget constraints are thus not real but totally conjectural based on their expectations of future prices. The optimizing Euler equations are therefore entirely conjectural as well, and subject to continual revision in response to changing expectations. The idea that the microeconomic theory of consumer choice is straightforwardly applicable to the intertemporal choice problem in a setting in which consumers don’t know what future prices will be and agents’ expectations of future prices are a) likely to be very different from each other and thus b) likely to be different from their ultimate realizations is a huge stretch. The intertemporal budget constraint has a completely different role in macroeconomics from the role it has in microeconomics.

If I expect that the demand for my services will be such that my disposable income next year would be $500k, my consumption choices would be very different from what they would have been if I were expecting a disposable income of $100k next year. If I expect a disposable income of $500k next year, and it turns out that next year’s income is only $100k, I may find myself in considerable difficulty, because my planned expenditure and the future payments I have obligated myself to make may exceed my disposable income or my capacity to borrow. So if there are a lot of people who overestimate their future incomes, the repercussions of their over-optimism may reverberate throughout the economy, leading to bankruptcies and unemployment and other bad stuff.

A large enough initial shock of mistaken expectations can become self-amplifying, at least for a time, possibly resembling the way a large initial displacement of water can generate a tsunami. A financial crisis, which is hard to model as an equilibrium phenomenon, may rather be an emergent phenomenon with microeconomic sources, but whose propagation can’t be described in microeconomic terms. New Classical macroeconomics simply excludes such possibilities on methodological grounds by imposing a rational-expectations general-equilibrium structure on all macroeconomic models.

This is not to say that the rational expectations assumption does not have a useful analytical role in macroeconomics. But the most interesting and most important problems in macroeconomics arise when the rational expectations assumption does not hold, because it is when individual expectations are very different and very unstable – say, like now, for instance — that macroeconomies become vulnerable to really scary instability.

Simon Wren-Lewis makes a similar point in his paper in the Review of Keynesian Economics.

Much discussion of current divisions within macroeconomics focuses on the ‘saltwater/freshwater’ divide. This understates the importance of the New Classical Counter Revolution (hereafter NCCR). It may be more helpful to think about the NCCR as involving two strands. The one most commonly talked about involves Keynesian monetary and fiscal policy. That is of course very important, and plays a role in the policy reaction to the recent Great Recession. However I want to suggest that in some ways the second strand, which was methodological, is more important. The NCCR helped completely change the way academic macroeconomics is done.

Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. As Hoover (2001, p. 72) writes, ‘[t]he conviction that macroeconomics must possess microfoundations has changed the face of the discipline in the last quarter century’. In terms of this second strand, the NCCR was triumphant and remains largely unchallenged within mainstream academic macroeconomics.

Perhaps I will have some more to say about Wren-Lewis’s article in a future post. And perhaps also about Nick Rowe’s article.

HT: Tom Brown

Update (02/11/16):

On his blog Jason Smith provides some further commentary on his exchange with Avon on Nick Rowe’s blog, explaining at greater length how irrelevant microfoundations are to doing real empirically relevant physics. He also expands on and puts into a broader meta-theoretical context my point about the extremely narrow range of applicability of the rational-expectations equilibrium assumptions of New Classical macroeconomics.

David Glasner found a back-and-forth between me and a commenter (with the pseudonym “Avon Barksdale” after [a] character on The Wire who [didn’t end] up taking an economics class [per Tom below]) on Nick Rowe’s blog who expressed the (widely held) view that the only scientific way to proceed in economics is with rigorous microfoundations. “Avon” held physics up as a purported shining example of this approach.
I couldn’t let it go: even physics isn’t that reductionist. I gave several examples of cases where the microfoundations were actually known, but not used to figure things out: thermodynamics, nuclear physics. Even modern physics is supposedly built on string theory. However physicists do not require every pion scattering amplitude be calculated from QCD. Some people do do so-called lattice calculations. But many resort to the “effective” chiral perturbation theory. In a sense, that was what my thesis was about — an effective theory that bridges the gap between lattice QCD and chiral perturbation theory. That effective theory even gave up on one of the basic principles of QCD — confinement. It would be like an economist giving up opportunity cost (a basic principle of the micro theory). But no physicist ever said to me “your model is flawed because it doesn’t have true microfoundations”. That’s because the kind of hard core reductionism that surrounds the microfoundations paradigm doesn’t exist in physics — the most hard core reductionist natural science!
In his post, Glasner repeated something that he had before and — probably because it was in the context of a bunch of quotes about physics — I thought of another analogy.

Glasner says:

But the comparative-statics method is premised on the assumption that before and after the parameter change the system is in full equilibrium or at an optimum, and that the equilibrium, if not unique, is at least locally stable and the parameter change is sufficiently small not to displace the system so far that it does not revert back to a new equilibrium close to the original one. So the microeconomic laws invoked by Avon are valid only in the neighborhood of a stable equilibrium, and the macroeconomics that Avon’s New Classical mentors have imposed on the economics profession is a macroeconomics that, by methodological fiat, is operative only in the neighborhood of a locally stable equilibrium.

 

This hits on a basic principle of physics: any theory radically simplifies near an equilibrium.

Go to Jason’s blog to read the rest of his important and insightful post.

Neo-Fisherism and All That

A few weeks ago Michael Woodford and his Columbia colleague Mariana Garcia-Schmidt made an initial response to the Neo-Fisherian argument advanced by, among others, John Cochrane and Stephen Williamson that a central bank can achieve its inflation target by pegging its interest-rate instrument at a rate such that if the expected inflation rate is the inflation rate targeted by the central bank, the Fisher equation would be satisfied. In other words, if the central bank wants 2% inflation, it should set the interest rate instrument under its control at the Fisherian real rate of interest (aka the natural rate) plus 2% expected inflation. So if the Fisherian real rate is 2%, the central bank should set its interest-rate instrument (Fed Funds rate) at 4%, because, in equilibrium – and, under rational expectations, that is the only policy-relevant solution of the model – inflation expectations must satisfy the Fisher equation.

The Neo-Fisherians believe that, by way of this insight, they have overturned at least two centuries of standard monetary theory, dating back at least to Henry Thornton, instructing the monetary authorities to raise interest rates to combat inflation and to reduce interest rates to counter deflation. According to the Neo-Fisherian Revolution, this was all wrong: the way to reduce inflation is for the monetary authority to reduce the setting on its interest-rate instrument and the way to counter deflation is to raise the setting on the instrument. That is supposedly why the Fed, by reducing its Fed Funds target practically to zero, has locked us into a low-inflation environment.

Unwilling to junk more than 200 years of received doctrine on the basis, not of a behavioral relationship, but a reduced-form equilibrium condition containing no information about the direction of causality, few monetary economists and no policy makers have become devotees of the Neo-Fisherian Revolution. Nevertheless, the Neo-Fisherian argument has drawn enough attention to elicit a response from Michael Woodford, who is the go-to monetary theorist for monetary-policy makers. The Woodford-Garcia-Schmidt (hereinafter WGS) response (for now just a slide presentation) has already been discussed by Noah Smith, Nick Rowe, Scott Sumner, Brad DeLong, Roger Farmer and John Cochrane. Nick Rowe’s discussion, not surprisingly, is especially penetrating in distilling the WGS presentation into its intuitive essence.

Using Nick’s discussion as a starting point, I am going to offer some comments of my own on Neo-Fisherism and the WGS critique. Right off the bat, WGS concede that it is possible that by increasing the setting of its interest-rate instrument, a central bank could, move the economy from one rational-expectations equilibrium to another, the only difference between the two being that inflation in the second would differ from inflation in the first by an amount exactly equal to the difference in the corresponding settings of the interest-rate instrument. John Cochrane apparently feels pretty good about having extracted this concession from WGS, remarking

My first reaction is relief — if Woodford says it is a prediction of the standard perfect foresight / rational expectations version, that means I didn’t screw up somewhere. And if one has to resort to learning and non-rational expectations to get rid of a result, the battle is half won.

And my first reaction to Cochrane’s first reaction is: why only half? What else is there to worry about besides a comparison of rational-expectations equilibria? Well, let Cochrane read Nick Rowe’s blogpost. If he did, he might realize that if you do no more than compare alternative steady-state equilibria, ignoring the path leading from one equilibrium to the other, you miss just about everything that makes macroeconomics worth studying (by the way I do realize the question-begging nature of that remark). Of course that won’t necessarily bother Cochrane, because, like other practitioners of modern macroeconomics, he has convinced himself that it is precisely by excluding everything but rational-expectations equilibria from consideration that modern macroeconomics has made what its practitioners like to think of as progress, and what its critics regard as the opposite .

But Nick Rowe actually takes the trouble to show what might happen if you try to specify the path by which you could get from rational-expectations equilibrium A with the interest-rate instrument of the central bank set at i to rational-expectations equilibrium B with the interest-rate instrument of the central bank set at i ­+ ε. If you try to specify a process of trial-and-error (tatonnement) that leads from A to B, you will almost certainly fail, your only chance being to get it right on your first try. And, as Nick further points out, the very notion of a tatonnement process leading from one equilibrium to another is a huge stretch, because, in the real world there are “no backs” as there are in tatonnement. If you enter into an exchange, you can’t nullify it, as is the case under tatonnement, just because the price you agreed on turns out not to have been an equilibrium price. For there to be a tatonnement path from the first equilibrium that converges on the second requires that monetary authority set its interest-rate instrument in the conventional, not the Neo-Fisherian, manner, using variations in the real interest rate as a lever by which to nudge the economy onto a path leading to a new equilibrium rather than away from it.

The very notion that you don’t have to worry about the path by which you get from one equilibrium to another is so bizarre that it would be merely laughable if it were not so dangerous. Kenneth Boulding used to tell a story about a physicist, a chemist and an economist stranded on a desert island with nothing to eat except a can of food, but nothing to open the can with. The physicist and the chemist tried to figure out a way to open the can, but the economist just said: “assume a can opener.” But I wonder if even Boulding could have imagined the disconnect from reality embodied in the Neo-Fisherian argument.

Having registered my disapproval of Neo-Fisherism, let me now reverse field and make some critical comments about the current state of non-Neo-Fisherian monetary theory, and what makes it vulnerable to off-the-wall ideas like Neo-Fisherism. The important fact to consider about the past two centuries of monetary theory that I referred to above is that for at least three-quarters of that time there was a basic default assumption that the value of money was ultimately governed by the value of some real commodity, usually either silver or gold (or even both). There could be temporary deviations between the value of money and the value of the monetary standard, but because there was a standard, the value of gold or silver provided a benchmark against which the value of money could always be reckoned. I am not saying that this was either a good way of thinking about the value of money or a bad way; I am just pointing out that this was metatheoretical background governing how people thought about money.

Even after the final collapse of the gold standard in the mid-1930s, there was a residue of metalism that remained, people still calculating values in terms of gold equivalents and the value of currency in terms of its gold price. Once the gold standard collapsed, it was inevitable that these inherited habits of thinking about money would eventually give way to new ways of thinking, and it took another 40 years or so, until the official way of thinking about the value of money finally eliminated any vestige of the gold mentality. In our age of enlightenment, no sane person any longer thinks about the value of money in terms of gold or silver equivalents.

But the problem for monetary theory is that, without a real-value equivalent to assign to money, the value of money in our macroeconomic models became theoretically indeterminate. If the value of money is theoretically indeterminate, so, too, is the rate of inflation. The value of money and the rate of inflation are simply, as Fischer Black understood, whatever people in the aggregate expect them to be. Nevertheless, our basic mental processes for understanding how central banks can use an interest-rate instrument to control the value of money are carryovers from an earlier epoch when the value of money was determined, most of the time and in most places, by convertibility, either actual or expected, into gold or silver. The interest-rate instrument of central banks was not primarily designed as a method for controlling the value of money; it was the mechanism by which the central bank could control the amount of reserves on its balance sheet and the amount of gold or silver in its vaults. There was only an indirect connection – at least until the 1920s — between a central bank setting its interest-rate instrument to control its balance sheet and the effect on prices and inflation. The rules of monetary policy developed under a gold standard are not necessarily applicable to an economic system in which the value of money is fundamentally indeterminate.

Viewed from this perspective, the Neo-Fisherian Revolution appears as a kind of reductio ad absurdum of the present confused state of monetary theory in which the price level and the rate of inflation are entirely subjective and determined totally by expectations.

Did David Hume Discover the Vertical Phillips Curve?

In my previous post about Nick Rowe and Milton Friedman, I pointed out to Nick Rowe that Friedman (and Phelps) did not discover the argument that the long-run Phillips Curve, defined so that every rate of inflation is correctly expected, is vertical. The argument I suggested can be traced back at least to Hume. My claim on Hume’s behalf was based on my vague recollection that Hume distinguished between the effect of a high price level and a rising price level, a high price level having no effect on output and employment, while a rising price level increases output and employment.

Scott Sumner offered the following comment, leaving it as an exercise for the reader to figure out what he meant by “didn’t quite get there.”:

As you know Friedman is one of the few areas where we disagree. Here I’ll just address one point, the expectations augmented Phillips Curve. Although I love Hume, he didn’t quite get there, although he did discuss the simple Phillips Curve.

I wrote the following response to Scott referring to the quote that I was thinking of without quoting it verbatim (because I couldn’t remember where to find it):

There is a wonderful quote by Hume about how low prices or high prices are irrelevant to total output, profits and employment, but that unexpected increases in prices are a stimulus to profits, output, and employment. I’ll look for it, and post it.

Nick Rowe then obligingly provided the quotation I was thinking of (but not all of it):

Here, to my mind, is the “money quote” (pun not originally intended) from David Hume’s “Of Money”:

“From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches.”

The first sentence is fine. But the second sentence is very clearly a problem.

Was it Friedman who said “we have only advanced one derivative since Hume”?

OK, so let’s see the whole relevant quotation from Hume’s essay “Of Money.”

Accordingly we find, that, in every kingdom, into which money begins to flow in greater abundance than formerly, everything takes a new face: labour and industry gain life; the merchant becomes more enterprising, the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for, if we consider only the influence which a greater abundance of coin has in the kingdom itself, by heightening the price of Commodities, and obliging everyone to pay a greater number of these little yellow or white pieces for everything he purchases. And as to foreign trade, it appears, that great plenty of money is rather disadvantageous, by raising the price of every kind of labour.

To account, then, for this phenomenon, we must consider, that though the high price of commodities be a necessary consequence of the encrease of gold and silver, yet it follows not immediately upon that encrease; but some time is required before the money circulates through the whole state, and makes its effect be felt on all ranks of people. At first, no alteration is perceived; by degrees the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom. In my opinion, it is only in this interval or intermediate situation, between the acquisition of money and rise of prices, that the encreasing quantity of gold and silver is favourable to industry. When any quantity of money is imported into a nation, it is not at first dispersed into many hands; but is confined to the coffers of a few persons, who immediately seek to employ it to advantage. Here are a set of manufacturers or merchants, we shall suppose, who have received returns of gold and silver for goods which they sent to CADIZ. They are thereby enabled to employ more workmen than formerly, who never dream of demanding higher wages, but are glad of employment from such good paymasters. If workmen become scarce, the manufacturer gives higher wages, but at first requires an encrease of labour; and this is willingly submitted to by the artisan, who can now eat and drink better, to compensate his additional toil and fatigue.

He carries his money to market, where he, finds everything at the same price as formerly, but returns with greater quantity and of better kinds, for the use of his family. The farmer and gardener, finding, that all their commodities are taken off, apply themselves with alacrity to the raising more; and at the same time can afford to take better and more cloths from their tradesmen, whose price is the same as formerly, and their industry only whetted by so much new gain. It is easy to trace the money in its progress through the whole commonwealth; where we shall find, that it must first quicken the diligence of every individual, before it encrease the price of labour. And that the specie may encrease to a considerable pitch, before it have this latter effect, appears, amongst other instances, from the frequent operations of the FRENCH king on the money; where it was always found, that the augmenting of the numerary value did not produce a proportional rise of the prices, at least for some time. In the last year of LOUIS XIV, money was raised three-sevenths, but prices augmented only one. Corn in FRANCE is now sold at the same price, or for the same number of livres, it was in 1683; though silver was then at 30 livres the mark, and is now at 50. Not to mention the great addition of gold and silver, which may have come into that kingdom since the former period.

From the whole of this reasoning we may conclude, that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in a greater or less quantity. The good policy of the magistrate consists only in keeping it, if possible, still encreasing; because, by that means, he keeps alive a spirit of industry in the nation, and encreases the stock of labour, in which consists all real power and riches. A nation, whose money decreases, is actually, at that time, weaker and more miserable than another nation, which possesses no more money, but is on the encreasing hand. This will be easily accounted for, if we consider, that the alterations in the quantity of money, either on one side or the other, are not immediately attended with proportionable alterations in the price of commodities. There is always an interval before matters be adjusted to their new situation; and this interval is as pernicious to industry, when gold and silver are diminishing, as it is advantageous when these metals are encreasing. The workman has not the same employment from the manufacturer and merchant; though he pays the same price for everything in the market. The farmer cannot dispose of his corn and cattle; though he must pay the same rent to his landlord. The poverty, and beggary, and sloth, which must ensue, are easily foreseen.

So Hume understands that once-and-for-all increases in the stock of money and in the price level are neutral, and also that in the transition from one price level to another, there will be a transitory effect on output and employment. However, when he says that the good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of industry in the nation, he seems to be suggesting that the long-run Phillips Curve is actually positively sloped, thus confirming Milton Friedman (and Nick Rowe and Scott Sumner) in saying that Hume was off by one derivative.

While I think that is a fair reading of Hume, it is not the only one, because Hume really was thinking in terms of price levels, not rates of inflation. The idea that a good magistrate would keep the stock of money increasing could not have meant that the rate of inflation would indefinitely continue at a particular rate, only that the temporary increase in the price level would be extended a while longer. So I don’t think that Hume would ever have imagined that there could be a steady predicted rate of inflation lasting for an indefinite period of time. If he could have imagined a steady rate of inflation, I think he would have understood the simple argument that, once expected, the steady rate of inflation would not permanently increase output and employment.

At any rate, even if Hume did not explicitly anticipate Friedman’s argument for a vertical long-run Phillips Curve, certainly there many economists before Friedman who did. I will quote just one example from a source (Hayek’s Constitution of Liberty) that predates Friedman by about eight years. There is every reason to think that Friedman was familiar with the source, Hayek having been Friedman’s colleague at the University of Chicago between 1950 and 1962. The following excerpt is from p. 331 of the 1960 edition.

Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favorable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many per cent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.

The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation price rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the expectational stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.

This was certainly not the first time that Hayek made the same argument. See his Studies in Philosophy Politics and Economics, p. 295-96 for a 1958 version of the argument. Is there any part of Friedman’s argument in his 1968 essay (“The Role of Monetary Policy“) not contained in the quote from Hayek? Nor is there anything to indicate that Hayek thought he was making an argument that was not already familiar. The logic is so obvious that it is actually pointless to look for someone who “discovered” it. If Friedman somehow gets credit for making the discovery, it is simply because he was the one who made the argument at just the moment when the rest of the profession happened to be paying attention.

Nick Rowe Goes Bonkers over Milton Friedman

Nick Rowe, usually a very cool guy, recently wrote a gushing post about the awesomeness of Milton Friedman. How uncool of him. As followers of this blog may know, even though I like free markets, am skeptical of big government programs, believe that the business cycle is largely a monetary phenomenon, I am not a fan of Milton Friedman. So I am going to offer some comments about Nick’s panegyric to Friedman.

I can’t think of any economist living today who has had as much influence on economics and economic policy as Milton Friedman had, and still has. Neither on the right, nor on the left.

Bob Lucas and Ned Prescott have not had as much influence on modern macroeconomics as Milton Friedman? I am less of a fan of  Lucas and Prescott than I am of Friedman, but surely Nick can’t be serious.

If you had a time machine, went back to (say) 1985, picked up Milton Friedman, brought him forward to 2015, and showed him the current debate over macroeconomic policy, he could immediately join right in. Is there anything important that would be really new to him?

We are all Friedman’s children and grandchildren. The way that New Keynesians approach macroeconomics owes more to Friedman than to Keynes: the permanent income hypothesis; the expectations-augmented Phillips Curve; the idea that the central bank is responsible for inflation and should follow a transparent rule. The first two Friedman invented; the third pre-dates Friedman, but he persuaded us it was right. Using the nominal interest rate as the monetary policy instrument is non-Friedmanite, but the new-fangled “Quantitative Easing” is just a silly new name for Friedmanite base-control.

Certainly Friedman looms large, and New Keynesianism is indeed a way of rationalizing the price and wage stickiness that Friedman, like so many others, relied on to account for the correlation between downward cyclical movements in nominal GDP, or in its rate of growth, and real GDP. To be sure the permanent-income hypothesis was a great achievement, for it wasn’t just Friedman’s, but the expectations-augmented Phillips Curve was anticipated by far too many people (including David Hume) for Friedman to be given very much credit. He certainly gave an influential statement of the reasoning behind the expectations-augmented Phillips Curve, but that hardly counts as a breakthrough. So of the three key elements of New Keynesianism for which Nick credits Friedman only one was (co-)invented by Friedman; the other two were promoted by Friedman, and he certainly influenced the profession, but they were ideas already out there, when he picked them up. And just what does Nick mean by “Friedmanite base-control?” That Friedman invented open-market operations? Good grief!

Then Nick waxes nostalgic:

We easily forget how daft the 1970’s really were, and some ideas were much worse than pet rocks. (Marxism was by far the worst, of course, and had a lot of support amongst university intellectuals, though not much in economics departments.) When inflation was too high, and we wanted to bring inflation down, many (most?) macroeconomists advocated direct controls on prices and wages.

And governments in Canada, the US, the UK (there must have been more) actually implemented direct controls on prices and wages to bring inflation down. Milton Friedman actually had to argue against price and wage controls and against the prevailing wisdom that inflation was caused by monopoly power, monopoly unions, a grab-bag of sociological factors, and had nothing to do with monetary policy.

Many economists unfortunately either supported, or did not forthrightly oppose, wage and price controls when they were imposed successively in the US, UK and Canada in the early 1970s. And Friedman was certainly right to oppose them, and deserves credit for speaking out eloquently against them. But their failure became palpable to most economists, and it is not as if Friedman required any special insight to see the underlying fallacy that Nick nicely articulates. He was just straightforwardly applying Econ 101.

Imagine if I argued today: “Inflation is dangerously low. In order to increase inflation, governments should pass a law saying that all firms must raise all prices and wages by a minimum of 2% a year, unless they apply for and get special permission from the Prices and Incomes Board to raise them by less.” What are the chances my policy proposal would be accepted?

I hope zero, but are we indebted to Friedman for any argument against wage and price controls that was not understood by economists long before Friedman appeared on the scene?

Friedman had a mountain to move, and he moved it. And because he already moved it, we simply cannot have a Friedman today.

Great men like Friedman require a great job to do, or else they can’t become great men. They also require an aristocracy, oligarchy, or monarchy, where only a few voices can get heard, or else they can’t become one of the few voices. The internet actually makes it harder to create great public intellectuals, which is probably a good thing, simply because it’s harder to stand out as great, when there’s lots of competition.

The right won the economics debate; left and right are just haggling over details. The big debate is no longer about economics (sadly for me); and it won’t be held on the pages of the New York Times or in the economics journals.

Actually I agree with Nick that Friedman was a great man and a great economist. He did make a difference, but the difference was not mainly the result of any important theoretical discoveries or contributions, his theory of the consumption function being his main theoretical contribution. Otherwise, he was a great applied and empirical economist, specializing in US monetary history, but his knowledge of the history of monetary theory was sketchy, causing him to make huge blunders in describing the quantity theory of money as a theory of the demand for money, and in suggesting that his 1956 restatement of the quantity theory was inspired by an imagined Chicago oral tradition, when, in fact, his restatement was a reworking of the Cambridge theory of the demand for money that Keynes had turned into his theory of liquidity preference. He hardly cited the work of earlier monetary theorists, aside from Keynes and Irving Fisher, completely ignoring the monetary theory of Hawtrey and Hawtrey’s monetary explanation of the Great Depression, which preceded Friedman’s by some 30 years. Friedman also wrote a famous paper repackaging a slightly dumbed down version of Karl Popper’s philosophy of science as the methodology of positive economics, without acknowledging Popper, an omission that he seems never to have been called on. But his industriousness and diligence were epic, he had a fine intellect and a true mastery of microeconomic theory, coupled with great empirical and statistical insight when applying theory. His ability to express himself cogently and forcefully in writing and in speech was remarkable, and he had a gift for strategic simplification, which unfortunately often led him to convenient oversimplification. Nor do I doubt that he was sincerely motivated by an idealistic dedication to his conception of free-market principles, which he expounded and defended tirelessly.

Nick seems to believe that because hardly any younger economists recognize then name J. K. Galbraith, and because no one any longer advocates imposing wage and price controls to control or speed up inflation, it is obvious that the right won the economics debate. I don’t entirely disagree with that, but I do think it is more complicated than that, the terms right and left being far too limited to portray a complex reality. Galbraith believed that the book he published in 1967 The New Industrial State was going to demonstrate the market economics was a snare and a delusion, because both the Soviet Union and the US were moving toward an economic system dominated by huge enterprises that engaged in long-term planning and were able to impose their plans on unwilling consumers and workers. The most devastating review of Galbraith’s book was published in the June 1968 edition of The Economic Journal by James Meade, an eminent British economist who had been a close disciple of Keynes at Cambridge, and was a kind of market socialist, or a self-described LibLaberal. The entire essay is worth reading, but I just want to highlight a few excerpts from it.

This argument for a national indicative plan is strangely overlooked by Professor Galbraith. Indeed, there is a great hiatus in his analysis of the economic system as a whole or, perhaps more accurately, in his implied analysis of what the economic system as a whole would be like when virtually the whole of it was controlled by large modern corporations. Professor Galbraith asserts that each modern corporation plans ahead the quantities of the various products which it will produce and the prices at which it will sell them; he assumes we will discuss this assumption later that as a general rule each corporation through its advertising and other sales activi-ties can so mould consumers’ demands that these planned quantities are actually sold at these planned prices. But he never explains why and by what mechanism these individual plans can be expected to build up into a coherent whole. . . .

In short, if all individual plans are to be simultaneously fulfilled they must in the first instance be consistent. But Professor Galbraith never considers this problem. It is a strange oversight in a modern professional economist-to overlook the problem of general, as contrasted with particular, equilibrium. (pp. 377-78)

Professor Galbraith writes always as if planning meant deciding in advance what should be produced and sold, in what quantities, at what cost and at what prices, and then taking effective steps to ensure that quantities and prices of inputs and outputs developed in precisely this way, and as if the market mechanism meant taking no thought for the morrow, taking no initiative in planning ahead the introduction of new products and processes, but just waiting for consumers to come to the firm and order a new car of such-and-such a bespoke design. It is by silly contrasts of this kind that Professor Galbraith pokes fun at his professional colleagues. (p. 382)

In the modern complex economy there are two major forces at work. One of these is that which Professor Galbraith rightly emphasises, namely the increased need for careful forward planning in a system which involves the commitment of large resources to inflexible uses over long periods of time.

But there is a second and equally important trend, which he entirely neglects: namely, the increased need in the modern industrial economy for a price mechanism, that is to say for reliance on a system of prices as a signaling device to indicate to producers and consumers what is and what is not scarce. This increased need for a price mechanism arises because in the modern industrial system input-output relationships have become so complex and the differentiation between products (many of which are the technically sophisticated inputs of other productive processes) has become so manifold that simple quantitative planning without a price or market mechanism becomes increasingly clumsy and inefficient. Moreover, this increased need for a signaling system through prices is occurring at a time when advances in mathematical economics and in the electronic and other technologies for measuring and metering have made a great extension of the price mechanism possible. Public authorities begin to make serious quantitative cost-benefit studies where previously pure hunches would have had to serve; and we nowadays seriously consider as, for example, in electronic metering devices for charging for the use of road space by motor vehicles-extensions of the use of pricing which would previously have been considered technologically impossible.

The particular brand of conventional wisdom which Professor Galbraith promotes in his recent book overlooks all these increased needs and opportunities for the use of the price mechanism. But many of the planned socialist societies are not falling into this error. Experiments which they are making in such devices as setting the maximisation of profit as the success criterion for the managers of socialised plants, in the direct use of the free market as in Yugoslavia, and generally in an increased reliance on price-mechanism indicators for many decentralised decisions constitute an undoubtedly significant development. The use of the price mechanism is, of course, not the same thing as the use of a market mechanism. A completely planned socialist economy could theoretically be run without any markets at all but with a complete system of “shadow prices” to measure relative scarcities and to be used as the decisive indicators for the adjustments to be made in the economy’s quantitative planned inputs and outputs. But in many, though not of course in all, cases an actual market mechanism will be found to be institutionally the best way of operating a price mechanism. There are many degrees and forms of such extensions of the market; for example, in some cases the prices at which transactions take place might be centrally controlled and adjusted, while in others they might be freely determined by supply and demand in the market. But in one form or an-other increased reliance on a price mechanism does imply increased reliance at least on something closely analogous to a market mechanism.

Professor Galbraith expressly denies that recent developments in the socialist countries have any significant connections with the use of the market as a controlling device. This denial would, by the uncouth, be called drivel-if I may be permitted to use Professor Galbraith’s own expression. But he has to hold this view simply because the socialist countries continue to plan while he, drawing no distinction between the price mechanism and a market mechanism, believes that one can have either planning or a market-price mechanism but not both. In fact, “planning and the price mechanism” not “planning or the price mechanism” should be a central theme of every modern economist’s work. (pp. 391-92)

In his 1977 Nobel Lecture, as Marcus Nunes informed us a few days ago, Meade explicitly advocated targeting nominal GDP writing as follows:

I have told this particular story simply to make the point that the choice between fiscal action and monetary action must often depend upon basic policy issues which should certainly be the responsibility of the government rather than of any independent monetary authority. Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target path, after taking into account whatever fiscal policies the government may adopt.

So let me ask Nick the following: Was Meade right or left? And was he on the winning side or the losing side?

Nick Rowe Teaches Us a Lot about Apples and Bananas

Last week I wrote a post responding to a post by Nick Rowe about money and coordination failures. Over the weekend, Nick posted a response to my post (and to one by Brad Delong). Nick’s latest post was all about apples and bananas. It was an interesting post, though for some reason – no doubt unrelated to its form or substance – I found the post difficult to read and think about. But having now read, and I think, understood (more or less), what Nick wrote, I confess to being somewhat underwhelmed. Let me try to explain why I don’t think that Nick has adequately addressed the point that I was raising.

That point being that while coordination failures can indeed be, and frequently are, the result of a monetary disturbance, one that creates an excess demand for money, thereby leading to a contraction of spending, and thus to a reduction of output and employment, it is also possible that a coordination failure can occur independently of a monetary disturbance, at least a disturbance that could be characterized as an excess demand for money that triggers a reduction in spending, income, output, and employment.

Without evaluating his reasoning, I will just restate key elements of Nick’s model – actually two parallel models. There are apple trees and banana trees, and people like to consume both apples and bananas. Some people own apple trees, and some people own banana trees. Owners of apple trees and owners of banana trees trade apples for bananas, so that they can consume a well-balanced diet of both apples and bananas. Oh, and there’s also some gold around. People like gold, but it’s not clear why. In one version of the model, people use it as a medium of exchange, selling bananas for gold and using gold to buy apples or selling apples for gold and using gold to buy bananas. In the other version of the model, people just barter apples for bananas. Nick then proceeds to show that if trade is conducted by barter, an increase in the demand for gold, does not affect the allocation of resources, because agents continue to trade apples for bananas to achieve the desired allocation, even if the value of gold is held fixed. However, if trade is mediated by gold, the increased demand for gold, with prices held fixed, implies corresponding excess supplies of both apples and bananas, preventing the optimal reallocation of apples and bananas through trade, which Nick characterizes as a recession. However, if there is a shift in demand from bananas to apples or vice versa, with prices fixed in either model, there will be an excess demand for bananas and an excess supply of apples (or vice versa). The outcome is suboptimal because Pareto-improving trade is prevented, but there is no recession in Nick’s view because the excess supply of one real good is exactly offset by an excess demand for the other real good. Finally, Nick considers a case in which there is trade in apple trees and banana trees. An increase in the demand for fruit trees, owing to a reduced rate of time preference, causes no problems in the barter model, because there is no impediment to trading apples for bananas. However, in the money model, the reduced rate of time preference causes an increase in the amount of gold people want to hold, the foregone interest from holding more having been reduced, which prevents optimal trade with prices held fixed.

Here are the conclusions that Nick draws from his two models.

Bottom line. My conclusions.

For the second shock (a change in preferences away from apples towards bananas), we get the same reduction in the volume of trade whether we are in a barter or a monetary economy. Monetary coordination failures play no role in this sort of “recession”. But would we call that a “recession”? Well, it doesn’t look like a normal recession, because there is an excess demand for bananas.

For both the first and third shocks, we get a reduction in the volume of trade in a monetary economy, and none in the barter economy. Monetary coordination failures play a decisive role in these sorts of recessions, even though the third shock that caused the recession was not a monetary shock. It was simply an increased demand for fruit trees, because agents became more patient. And these sorts of recessions do look like recessions, because there is an excess supply of both apples and bananas.

Or, to say the same thing another way: if we want to understand a decrease in output and employment caused by structural unemployment, monetary coordination failures don’t matter, and we can ignore money. Everything else is a monetary coordination failure. Even if the original shock was not a monetary shock, that non-monetary shock can cause a recession because it causes a monetary coordination failure.

Why am I underwhelmed by Nick’s conclusions? Well, it just seems that, WADR, he is making a really trivial point. I mean in a two-good world with essentially two representative agents, there is not really that much that can go wrong. To put this model through its limited endowment of possible disturbances, and to show that only an excess demand for money implies a “recession,” doesn’t seem to me to prove a great deal. And I was tempted to say that the main thing that it proves is how minimal is the contribution to macroeconomic understanding that can be derived from a two-good, two-agent model.

But, in fact, even within a two-good, two-agent model, it turns out there is room for a coordination problem, not considered by Nick, to occur. In his very astute comment on Nick’s post, Kevin Donoghue correctly pointed out that even trade between an apple grower and a banana grower depends on the expectations of each that the other will actually have what to sell in the next period. How much each one plants depends on his expectations of how much the other will plant. If neither expects the other to plant, the output of both will fall.

Commenting on an excellent paper by Backhouse and Laidler about the promising developments in macroeconomics that were cut short because of the IS-LM revolution, I made reference to a passage quoted by Backhouse and Laidler from Bjorn Hansson about the Stockholm School. It was the Stockholm School along with Hayek who really began to think deeply about the relationship between expectations and coordination failures. Keynes also thought about that, but didn’t grasp the point as deeply as did the Swedes and the Austrians. Sorry to quote myself, but it’s already late and I’m getting tired. I think the quote explains what I think is so lacking in a lot of modern macroeconomics, and, I am sorry to say, in Nick’s discussion of apples and bananas.

Backhouse and Laidler go on to cite the Stockholm School (of which Ohlin was a leading figure) as an example of explicitly dynamic analysis.

As Bjorn Hansson (1982) has shown, this group developed an explicit method, using the idea of a succession of “unit periods,” in which each period began with agents having plans based on newly formed expectations about the outcome of executing them, and ended with the economy in some new situation that was the outcome of executing them, and ended with the economy in some new situation that was the outcome of market processes set in motion by the incompatibility of those plans, and in which expectations had been reformulated, too, in the light of experience. They applied this method to the construction of a wide variety of what they called “model sequences,” many of which involved downward spirals in economic activity at whose very heart lay rising unemployment. This is not the place to discuss the vexed question of the extent to which some of this work anticipated the Keynesian multiplier process, but it should be noted that, in IS-LM, it is the limit to which such processes move, rather than the time path they follow to get there, that is emphasized.

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.

But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes. No wonder Ohlin sounds annoyed in his comment, quoted by Backhouse and Laidler, about Keynes. Tractability trumped insight.

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

Responding to Scott Sumner

Scott Sumner cites this passage from my previous post about coordination failures.

I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is so great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Evidently, Scott doesn’t quite find my argument that coordination failures are possible, even without an excess demand for money, persuasive. So he puts the following question to me.

Why is it different from alleviating an excess demand for money?

I suppose that my response is this is: I am not sure what the question means. Does Scott mean to say that he does not accept that in my examples there really is no excess demand for money? Or does he mean that the effects of the coordination failure are no different from what they would be if there were an excess demand for money, any deflationary problem being treatable by increasing the quantity of money, thereby creating an excess supply of money. If Scott’s question is the latter, then he might be saying that the two cases are observationally equivalent, so that my distinction between a coordination failure with an excess demand for money and a coordination failure without an excess demand for money is really not a difference worth making a fuss about. The first question raises an analytical issue; the second a pragmatic issue.

Scott continues:

As far as I know the demand for money is usually defined as either M/P or the Cambridge K.  In either case, a debt crisis might raise the demand for money, and cause a recession if the supply of money is fixed.  Or the Fed could adjust the supply of money to offset the change in the demand for money, and this would prevent any change in AD, P, and NGDP.

I don’t know what Scott means when he says that the demand for money is usually defined as M/P. M/P is a number of units of currency. The demand for money is some functional relationship between desired holdings of money and a list of variables that influence those desired holdings. To say that the demand for money is defined as M/P is to assert an identity between the amount of money demanded and the amount in existence which rules out an excess demand for money by definition, so now I am really confused. The Cambridge k expresses the demand for money in terms of a desired relationship between the amount of money held and nominal income. But again, I can’t tell whether Scott is thinking of k as a functional relationship that depends on a list of variables or as a definition in which case the existence of an excess demand for money is ruled out by definition. So I am still confused.

I agree that a debt crisis could raise the demand for money, but in my example, it is entirely plausible that, on balance, the demand for money to hold went down because debtors would have to use all their resources to pay the interest owed on their debts.

I don’t disagree that the Fed could engage in a monetary policy that would alleviate the debt burden, but the problem they would be addressing would not be an excess demand for money; the problem being addressed would be the debt burden. but under a gold clause inflation wouldn’t help because creditors would be protected from inflation by the requirement that they be repaid in terms of a constant gold value.

Scott concludes:

Perhaps David sees the debt crisis working through supply-side channels—causing a recession despite no change in NGDP.  That’s possible, but it’s not at all clear to me that this is what David has in mind.

The case I had in mind may or may not be associated with a change in NGDP, but any change in NGDP was not induced by an excess demand for money; it was induced by an increase in the value of gold when debts were denominated, as they were under the gold clause, in terms of gold.

I hope that this helps.

PS I see that Nick Rowe has a new post responding to my previous post. I have not yet read it. But it is near the top of my required reading list, so I hope to have a response for him in the next day or two.


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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