Archive for the 'Nick Rowe' Category

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.

Nick Rowe on Money and Coordination Failures

Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.

His post is quite a long one – over 3000 words, all his own – so I won’t try to summarize it, but the main message is that what characterizes money economies – economies in which there is a single asset that serves as the medium of exchange – is that money is involved in almost every transaction. And when a coordination failure occurs in such an economy, there being lots of unsold good and unemployed workers, the proper way to think about what is happening is that it is hard to buy money. Another way of saying that it is hard to buy money is that there is an excess demand for money.

Nick tries to frame his discussion in terms of Walras’s Law. Walras’s Law is a property of a general-equilibrium system in which there are n goods (and services). Some of these goods are produced and sold in the current period; others exist either as gifts of nature (e.g., land and other privately owned natural resources), as legacies of past production). Walras’s Law tells us that in a competitive system in which all transactors can trade at competitive prices, it must be the case that planned sales and purchases (including asset accumulation) for each individual and for all individuals collectively must cancel out. The value of my planned purchases must equal the value of my planned sales. This is a direct implication of the assumption that prices for each good are uniform for all individuals, and the assumption that goods and services may be transferred between individuals only via market transactions (no theft or robbery). Walras’s Law holds even if there is no equilibrium, but only in the notional sense that value of planned purchases and planned sales would exactly cancel each other out. In general-equilibrium models, no trading is allowed except at the equilibrium price vector.

Walras’ Law says that if you have a $1 billion excess supply of newly-produced goods, you must have a $1 billion excess demand for something else. And that something else could be anything. It could be money, or it could be bonds, or it could be land, or it could be safe assets, or it could be….anything other than newly-produced goods. The excess demand that offsets that excess supply for newly-produced goods could pop up anywhere. Daniel Kuehn called this the “Whack-a-mole theory of business cycles”.

If Walras’ Law were right, recessions could be caused by an excess demand for unobtanium, which has zero supply, but a big demand, and the government stupidly passed a law setting a finite maximum price per kilogram for something that doesn’t even exist, thereby causing a recession and mass unemployment.

People might want to buy $1 billion of unobtanium per year, but that does not cause an excess supply of newly-produced goods. It does not cause an excess supply of anything. Because they cannot buy $1 billion of unobtanium. That excess demand for unobtanium does not affect anything anywhere in the economy. Yes, if 1 billion kgs of unobtanium were discovered, and offered for sale at $1 per kg, that would affect things. But it is the supply of unobtanium that would affect things, not the elimination of the excess demand. If instead you eliminated the excess demand by convincing people that unobtanium wasn’t worth buying, absolutely nothing would change.

An excess demand for unobtanium has absolutely zero effect on the economy. And that is true regardless of the properties of unobtanium. In particular, it makes absolutely no difference whether unobtanium is or is not a close substitute for money.

What is true for unobtanium is also true for any good for which there is excess demand. Except money. If you want to buy 10 bonds, or 10 acres of land, or 10 safe assets, but can only buy 6, because only 6 are offered for sale, those extra 4 bonds might as well be unobtanium. You want to buy 4 extra bonds, but you can’t, so you don’t. Just like you want to buy unobtanium, but you can’t, so you don’t. You can’t do anything so you don’t do anything.

Walras’ Law is wrong. Walras’ Law only works in an economy with one centralised market where all goods can be traded against each other at once. If the Walrasian auctioneer announced a finite price for unobtanium, there would be an excess demand for unobtanium and an excess supply of other goods. People would offer to sell $1 billion of some other goods to finance their offers to buy $1 billion of unobtanium. The only way the auctioneer could clear the market would be by refusing to accept offers to buy unobtanium. But in a monetary exchange economy the market for unobtanium would be a market where unobtanium trades for money. There would be an excess demand for unobtanium, matched by an equal excess supply of money, in that particular market. No other market would be affected, if people knew they could not in fact buy any unobtanium for money, even if they want to.

Now this is a really embarrassing admission to make – and right after making another embarrassing admission in my previous post – I need to stop this – but I have no idea what Nick is saying here. There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about. However, even though I can’t follow Nick’s reasoning, I totally agree with him that Walras’s Law is wrong. But the reason that it’s wrong is not that it implies that recessions could be caused by an excess demand for a non-existent good; the reason is that, in the only context in which a general-equilibrium model could be relevant for macroeconomics, i.e., an incomplete-markets model (aka the Radner model) in which individual agents are forming plans based on their expectations of future prices, prices that will only be observed in future periods, Walras’s Law cannot be true unless all agents have identical and correct expectations of all future prices.

Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world. When they don’t, Walras’s Law does not hold. When Walras’s Law doesn’t hold, things get messy; people default on their obligations, businesses go bankrupt, workers lose their jobs.

Nick thinks it’s all about money. Money is certainly one way in which things can get messed up. The government can cause inflation, and then stop it, as happened in 1920-21 and in 1981-82. People who expected inflation to continue, and made plans based on those expectations,were very likely unable to execute their plans when inflation stopped. But there are other reasons than incorrect inflation expectations that can cause people to have incorrect expectations of future prices.

Actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. 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 go 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?

Nick invokes Hayek’s paper (“The Use of Knowledge in Society“) to explain how markets work to coordinate the decentralized plans of individual agents. Nick assumes that Hayek failed to mention money in that paper because money is so pervasive a feature of a real-world economy, that Hayek simply took its existence for granted. That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. 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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