Archive for the 'Phillips Curve' Category

The Road to Incoherence: Arthur Burns and the Agony of Central Banking

Published September 3, 2023 Arthur Burns , incomes policy , J. K. Galbraith , Milton Friedman , Nathan Tankus , Phillips Curve , political business cycles , R. G. Hawtrey , wage and price controls , wage-price guideposts 14 Comments
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UPDATE: My concluding paragraph was inadverently deleted from my post, so even if you’ve already read the post, you may want to go back and read my concluding paragraph.

Last December, Nathan Tankus wrote an essay for his substack site defending Arthur Burns and his record as Fed Chairman in the 1970s when inflation rose to double digits, setting the stage for Volcker’s shock therapy in 1981-82. Tankus believes that Burns has been blamed unfairly for the supposedly dreadful performance of the economy in the 1970s, a decade that probably ranks second for dreadfulness, after the 1930s, in the economic history of the 20th century. Nathan is not the first commentator or blogger I’ve seen over the past 10 years or so to offer a revisionist, favorable, take on Burns’s tenure at the Fed. Here are links to my earlier posts on Burns revisionism (link, link, link)

Nathan properly criticizes the treatment of the 1970s in journalistic mentions to that fraught decade. The decade endured a lot of unpleasantness along with the chronically high inflation that remains its most memorable feature, but it was also a decade of considerable economic growth, and, despite three recessions and rising unemployment, a huge increase in total US employment.

Nathan believes that Burns has been denigrated unfairly as a weak Fed Chairman who either ignored the inflationary forces, or succumbed, despite his conservative, anti-inflationary, political inclinations, to Nixon’s entreaties and pressure tactics, and deployed monetary policy to assist Nixon’s 1972 re-election campaign. Although the latter charge has at least some validity – it’s no accident that the literature on political business cycles, especially a seminal 1975 paper on that topic by William Nordhaus, a future Nobel laureate, was inspired by the Burns-Nixon episode – it’s not the whole story.

But, what is more important than Burns being cajoled or coerced by Nixon to speed the recovery from the 1969-70 recession, is that Burns was the victim of his own conceptual error in supposing that, if the incomes policy that he favored were adtoped, monetary expansion by the Fed wouldn’t lead to the inflationary consequences that they ultimately did have. Burns’s conceptual failure — whether willful or thoughtless — was to overlook the relationship between aggregate income and inflation. Although his confusion about that critical relationship was then widely, though not universally, held, his failure seems obvious, almost banal. But there were then only a few able to both identify and explain the failure and draw the appropriate policy implications. (In an earlier post about Burns, I’ve discussed Ralph Hawtrey’s final book published in 1966, but likely never noticed by Burns, in which the confusions were clearly dispelled and the appropriate policy implications clearly delineated.)

Nathan attributes the deterioration of Burns’s reputation to the influence of Milton Friedman, who wrote his doctoral dissertation under Burns at Columbia. Friedman, to be sure, was sharply critical of Burns’s performance at the Fed, but the acerbity of Friedman’s criticism also reflects his outrage that Burns had betrayed conservative, or “free-market”, principles by helping to persuade Nixon to adopt wage-and-price controls in 1971. Though I share Friedman’s disapproval of Burns’s role in the adoption of wage-and-price controls, Burns’s monetary-policy can be assessed independently of how one views the merits of the wage-and-price controls sought by Burns.

Here’s how Nathan describes Burns:

The actual Burns was – in his time – a well respected Monetary Policy “Hawk” who believed deeply in restrictive austerity. This was nearly universally acknowledged during his tenure, and then for a few years after. A New York Times article from 1978 about Burns’s successor, George Miller illustrates this well. Entitled “Miller Fights Inflation In Arthur Burns’s Style”, the article argues that Miller tightened monetary policy far more aggressively than the Carter administration expected and spoke in conservative, inflation focused and austere terms. In other words, he was a clone of Arthur Burns.

The reason this has been forgotten is the total victory of one influential dissenter: Milton Friedman. Milton Friedman, in real time, pilloried his former mentor as a money supply expanding inflationist. That view deserves its own piece sometime (spoiler: it’s mostly wrong.)

Given Friedman’s dictum — “inflation is always and everywhere a monetary phenomenon” – it’s no surprise that Friedman blamed the Federal Reserve and Burns for inflation. While confidently asserting on the one hand that changes in the quantity of money cause corresponding changes in prices, Friedman, on the other hand, invoked unexplained long and variable lags between changes in the quantity of money and changes in prices to parry evidence that the supposed correlations were less than clear-cut. So, Friedman’s narrow focus on the quantity of money rather than on total spending – increaes in the quantity of money being as much an effect as a cause of increased nominal spending and income — actually undercut his critique of Fed policy. In what follows I will therefore not discuss the quantity of money, which was, in Friedman’s mind, the key variable that had to be controlled to reduce or stop inflation. Instead, I focus on the behavior of total nominal spending (aka aggregate demand) and total nominal income, which is what monetary policy (perhaps in conjunction with fiscal policy) has some useful capacity to control.

Upon becoming Fed Chairman early in 1970, Burns continued the monetary tightening initiated by his predecessor in 1969 when inflation had risen to 6%. Although the recession caused by that tightening had started only two months before Burns succeeded Martin, inflation hardly declined, notwithstanding a steady rise in unemployment from the 3.4% rate inherited by Nixon in January 1969, at the start of his Presidency, to 4.2% when Burns became Chairman, and to 6.1% at the end of 1970.

The minimal impact of recession on inflation was troubling to Burns, reinforcing his doubts about the efficacy of conventional monetary and fiscal policy tools in an economy that seemed no longer to operate as supposed by textbook theory. It wasn’t long before Burn, in Congressional testimony (5/18/1970) voiced doubts about the efficacy of monetary policy in restraining inflation.

Another deficiency in the formulation of stabilization policies in the United States has been our tendency to rely too heavily on monetary restriction as a device to curb inflation…. severely restrictive monetary policies distort the structure of production. General monetary controls… have highly uneven effects on different sectors of the economy. On the one hand, monetary restraint has relatively slight impact on consumer spending or on the investments of large businesses. On the other hand, the homebuilding industry, State and local construction, real estate firms, and other small businesses are likely to be seriously handicapped in their operations. When restrictive monetary policies are pursued vigorously over a prolonged period, these sectors may be so adversely affected that the consequences become socially and economically intolerable.

We are in the transitional period of cost-push inflation, and we therefore need to adjust our policies to the special character of the inflationary pressures that we are now experiencing. An effort to offset, through monetary and fiscal restraints, all of the upward push that rising costs are now exerting on prices would be most unwise. Such an effort would restrict aggregate demand so severely as to increase greatly the risks of a very serious business recession. . . . There may be a useful… role for an incomes policy to play in shortening the period between suppression of excess demand and restoration of reasonable price stability.

Quoted by R. Hetzel in “Arthur Burns and Inflation” Federal Reserve Bank of Richmond Economic Quarterly, Winter 1998

The cost-push view of inflation that Burns articulated was not a new one for Burns. He had discussed it in a 1967 lecture at a seminar organized by the American Enterprise Institute concerning the wage-price guideposts, which had been invoked during the Eisenhower administration when he was CEA Chairman, and were continued in the Kennedy-Johnson administrations, to discourage labor and business from “excessive” increases in wages and prices.

The seminar consisted of two lectures, one by Burns (presumably offering a “conservative” or Republican view) and another by Paul Samuelson (offering a “liberal” or Democratic view), followed by the responses each to the other, and finally by questions from an audience of economists drawn from Washington-area universities, think-tanks and government agencies, and the responses of Burns and Samuelson. Transcripts of the lectures and the follow-up discusions were included in a volume published by AEI.

Inflation had become a contentious political issue in 1967, Republicans blaming the Johnson Administration for the highest inflation since the early 1950s. Though Burns, while voicing mild criticism of how the guideposts were administered and skepticism about their overall effect on inflation, neither rejected them on principle nor dismissed them as ineffective.

So, Burns did not arrive at the Fed as an ideological opponent of government intervention in the decisions of business and organized labor. Had Milton Friedman participated in the AEI seminar, he would have voiced implacable opposition to the guideposts as ineffective in practice and an arbitrary — extra-legal and therefore especially obnoxious — exercise of government power over the private sector. Burns’s conservatism, unlike Friedman’s, was the conventional Republican pro-business attitude, and, as Nathan himself notes, business wasn’t at all averse to government assistance in resisting union wage demands.

That doesn’t mean that Burns’s views hadn’t changed since 1967 when he voiced tepid support for guideposts as benchmarks for business and labor in setting prices and negotiating labor contracts. But the failure of monetary tightening and a deepening recession to cause more than a minimal slowdown in inflation seems to have shattered Burns’s shaky confidence that monetary policy could control inflation.

Unlike the preceding recessions in which increased (but still low) inflation quickly led to monetary tightening, the 1969-70 recession began only after inflation had risen steadily for five years from less than 2% in 1965 to 6% in 1969. It’s actually not surprising — it, at least, shouldn’t have been — that, after rising steadily for five years and becoming ingrained in public expectations, inflation would become less responsive to monetary tightening and recession than it had been before becoming ingrained in expectations. Nevertheless, the failure of a recession induced by monetary tightening to curtail inflation seems to have been considered by Burns proof that inflation is not a purely monetary phenomenon.

The further lesson drawn by Burns from the minimal decline in inflation after a year of monetary tightening followed by a recession and rising unemployment was that persistent inflation reflects the power of big business and big labor to keep raising prices and wages regardless of market conditions. The latter lesson became the basis of his approach to the inflation problem. Inflation control had to reckon with the new reality that, even if restrictive monetary and fiscal policies were adopted, it was big business and big labor that controlled pricing and inflation.

While the rationale that Burns offered for an incomes policy differed little from the rationale for the wage-price guideposts to which Burns had earlier paid lip-service, in articulating the old rationale, perhaps to provide the appearance of novelty, Burns found it useful to package the rationale in a new terminology — the vague British catchphrase “incomes policy” covering both informal wage-price guideposts and mandatory wage-price controls. The phrase helped him justify shifting monetary policy from restraint to stimulus, even though inflation was still unacceptably high, by asserting that responsibility for controlling inflation was merely being transferred, not abandoned, to another government entity with the legal power and authority to exercise that control.

It’s also noteworthy that both Burns’s diagnosis of inflation and the treatment that he recommended were remarkably similar to the diagnosis and treatment advanced in a 1967 best-selling book, The New Industrial State, by the famed Harvard economist and former adviser to President Kennedy, J. K. Galbraith.

Despite their very different political views and affiliations, Burns and Galbraith, both influenced by the Institutionalist School of economics, were skeptical of the standard neoclassical textbook paradigm. Galbraith argued that big corporations make their plans based on the prices and wages that they can impose on their smaller suppliers and smaller customers (especially, in Galbraith’s view, through the skillful deployment of modern advertising techniques) while negotiating pricing terms with labor unions and other large suppliers and with their large customers. (For more on Galbraith see this post.)

Though more sympathetic to big business and less sympathetic to big labor than Galbraith, Burns, by 1970, seems to have fully internalized, whether deliberately or inadvertently, the Galbrathian view of inflation.

Aside from his likely sincere belief that conventional anti-inflationary monetary and fiscal policy were no longer effective in an economy dominated by big business and big labor, Burns had other more political motivations for shifting his policy preferences toward direct controls over wages and prices. A full account of his thinking would require closer attention to the documentary record than I have undertaken, but, Burns was undoubtedly under pressure from Nixon to avoid a recession in the 1972 election year like the one precipitated by the Fed in 1960 when the Fed moved to suppress a minor uptick in inflation following its possibly excessive monetary stimulus after the 1957-58 recession. Burns had warned Nixon in 1960 that a looming recession might hurt his chances in the upcoming election, and Nixon thereafter blamed his 1960 loss on the Fed and on the failure of the Eisenhower adminisration to increase spending to promote recovery. Moreover, the disastrous (for Republicans) losses in the 1958 midterm elections were widely attributed to the 1957-58 recession. Substantial GOP losses in the 1970 midterms, plainly attributable to the 1970 recession, further increased Nixon’s anxiety and his pressure on Burns to hasten a recovery through monetary expansion to ensure Nixon’s reelection.

But it’s worth taking note of a subtle difference between the rationale for wage-price guideposts and the rationale for an incomes policy. While wage-price guideposts were aimed solely at individual decisions about wages and prices, the idea of an incomes policy had a macroeconomic aspect: reconciling the income demands of labor and business in a way that ensured consistency between the flow of aggregate income and low inflation. According to Burns, reconciling those diverse and conflicting income demands with low inflation required an incomes policy to prevent unrestrained individual demands for increased wages and prices from expanding the flow of income so much that inflation would be the necessary result.

What Burns and most other advocates of incomes policies overlooked is that incomes are generated from the spending decisions of households, business firms and the government. Those spending decisions are influenced by the monetary- and fiscal-policy choices of the monetary and fiscal authorities. Any combination of monetary- and fiscal-policy choices entails corresponding flows of total spending and total income. For any inflation target, there is a set of monetary- and fiscal-policy combinations that entails flows of total spending and total income consistent with that target.

Burns’s fallacy (and that of most incomes-policy supporters) was to disregard the relationship between total spending and monetary- and fiscal-policy choices. The limits on wage increases imposed by an incomes policy can be maintained only if a monetary- and fiscal-policy combination consistent with those limits is chosen. Burns’s fallacy is commonly known as the fallacy of composition: the idea that what is true for one individual in a group must be true for the group as a whole. For example, one spectator watching a ball game can get a better view of the game by standing up, but if all spectators stand up together, none of them gets a better view.

Wage increases for one worker or for workers in one firm can be limited to the percentage specified by the incomes policy, but the wage increases for all workers can’t be limited to the percentage specified by the incomes policy unless the chosen monetary- and fiscal-policy combination is consistent with that percentage.

If aggregate nominal spending and income exceed the nominal income consistent with the inflation target, only two outcomes are possible. The first, and more likely, outcome is that the demand for labor associated with the actual increase in aggregate demand will overwhelm the prescribed limit on wage increases. If it’s in the interest of workers to receive wage increases exceeding the permitted increase — and it surely is — and if it’s also in the interest of employers trying to increase output because demand for their output increases by more than expected, making it profitable to hire additional workers at increased wages, it’s hard to imagine that wages wouldn’t increase by more than the incomes policy allows. Indeed, since price increases are typically allowed only if costs increase, there’s an added incentive for firms to agree to wage increases to make price increases allowable.

Second, even if the limits on wage increases were not exceeded, those limits imply an income transfer from workers to employers. The implicit income redistribution might involve some reduction in total spending and in aggregate demand, but, ultimately, as long as the total spending and total income associated with the chosen monetary- and fiscal-policy combination exceeds the total income consistent with the inflation target, excess demands for goods will either cause domestic prices to rise or induce increased imports at increased prices, thereby depreciating the domestic currency and raising the prices of imported final goods and raw materials. Those increased prices and costs will be a further source of inflationary pressure on prices and on wages, thereby increasing inflation above the target or forcing the chosen monetary- and fiscal-policy combination to be tightened to prevent further currency depreciation.

To recapitulate, Burns actually had the glimmering of an insight into the problem of reducing inflation in an economy in which most economic agents make plans and decisions based on their inflationary expectations. When people make plans and commitments in expectation of persistent future inflation, reducing, much less stopping, inflation is hard, because doing so must disappoint their expectations, rendering the plans and commitments based on those expectations costly, or even impossible, to fulfill. The promise of an incomes policy is that, by gradually reducing inflation and facilitating the implementation of the fiscal and monetary policies necessary to reduce inflation, it can reduce expectations of inflation, thereby reducing the cost of reducing inflation by monetary and fiscal restraint.

But instead of understanding that an incomes policy aimed at reducing inflation by limiting the increases in wages and prices to percentages consistent with reduced inflation could succeed only if monetary and fiscal policies were also amed at slowing the growth of total spending and total income to rates consistent with the inflation target, Burns conducted a monetary policy with little attention to its consistency with explicit or implicit inflation targets. The failure to reduce the growth of aggregate spending and income rendered the incomes policy unfeasible, thereby ensuring the incomes policy aiming to reduce inflation would fail. The failure to grasp the impossibility of controlling wage-and-pricing decisions at the micro level without controlling aggregate spending and income at the macro level was the fatal conceptual mistake that guaranteed Burns’s failure as Fed Chairman. Perhaps Burns’s failure was tragic, but failure it was.

Let’s now look at the results of Burns’s monetary policies. The chart below shows the annual rates of change in nominal GDP and real GDP from Q1-1968 to Q1-1980

https://fred.stlouisfed.org/graph/?graph_id=1249697#

To give Burns his due, the freeze and the cost-of-living council that replaced it 90 days afterwards was a splendid political success, igniting an immediate stock-market boom and increasing Nixon’s popularity with both Democrats and Republicans notwithstanding Nixon’s repudiation of his repeated pledges never to impose wage-and-price controls. Burns continued — though erratically — the monetary easing that he began at the end of 1970, providing sufficient stimulus to reduce unemployment, which had barely budged from the peak rate of 6.1% in December 1970 to 6.0% in September 1971. While the decline in the unemployment rate was modest, to 5.6% in October 1972, the last official report before the election, total US employment between June 1970 (when US employment was at its cyclical trough) and October 1972 increased by 5%, reflecting both cyclical recovery and the beginning of an influx of babyboomers and women into the labor force.

The monetary stimulus provided by the Fed between the end of the recession in November 1970 and October 1972 can be inferred from the increase in total spending and income (as measured by nominal GDP) from Q1-1971 and Q3-1972. In that 7-quarter period, total spending and income increased by 18.6% (corresponding to an annual rate of 10.6%). Because the economy in Q4-1970 was still in a recession, nominal spending and income could increase at a faster rate during the recovery while inflation was declining than would have been consistent with the inflation target if maintained permanently.

But as the expansion continued, with employment and output expanding rapidly, the monetary stimulus should have been gradually withdrawn to slow the growth of total spending and income to a rate consistent with a low inflation target. But rather than taper off monetary stimulus, the Fed actually allowed total spending and income growth to accelerate in the next three quarters (Q4-1972 through Q2-1973) to an annual rate of 12.7%.

Inflation, which at first had shown only minimal signs of increasing as output and employment expanded rapidly before the 1972 election, not surprisingly began to accelerate rapidly in the first half of 1973. (The chart below provides three broadly consistent measures of inflation (Consumer Price Index, Personal Consumption Expenditures, and GDP implicit price deflator at quarterly intervals). The chart shows that all three measures show inflation rising rapidly in the first hals of 1973, with inflation in Q2-1973 in a range between 6.3% and 8.6%.

https://fred.stlouisfed.org/graph/?graph_id=1247181&rn=117

Burns rejected criticisms that the Fed was responsible for resurgent inflation, citing a variety of special factors like rising commodity prices as the cause of rising inflation. But, having allowed the growth of total spending and income to accelerate from Q4-1972 and Q2-1973, in violation of the rationale for the incomes policy that he had recommended, Burns had no credible defense of the Fed’s monetary policy.

With inflation approaching double digit levels – the highest in over 20 years – Burns and the Fed had already begun to raise interest rates in the first half of 1973, but not until the third quarter did rates rise enough to slow the growth of total spending and income. A belated tightening was, of course, in order, but, as if to compensate for its tardiness, the Fed, as it has so often been wont to do, tightened too aggressively, causing the growth of total spending to decline from 11% in Q2 1973 to less than 5% in Q3 1973, a slowdown that caused real GDP to fall, and the unemployment rate, having just reached its lowest point (4.6%) since April 1970, a rate not matched again for two decades, to start rising.

Perhaps surprised by the depth of the third-quarter slowdown, the Fed eased policy somewhat in the fourth quarter until war broke out between Egypt, Syria and Israel, soon followed by a cutback in overall oil production by OPEC and a selective boycott by Arab oil producers of countries, like the US, considered supportive of Israel. With oil prices quadrupling over the next few months, the cutback in oil production triggered a classic inflationary supply shock.

It’s now widely, though not universally, understood that the optimal policy response to a negative supply shock is not to tighten monetary policy, but to allow the price level to increase permanently and inflation to increase transitorily, with no attempt to reverse th price-level and inflation effects. But, given the Fed’s failure to prevent inflation from accelerating in the first half of 1973, the knee-jerk reaction of Burns and the Fed was to tighten monetary policy again after the brief relaxation in Q4-1973, as if previous mistakes could be rectified by another in the opposite direction.

The result was, by some measures, the deepest recession since 1937-38 with unemployment rising rapidly to 9% by May 1975. Because of the negative supply shock, most measures of inflation, despite monetary tightening, were above 10% for almost all of 1974. While the reduction in nominal GDP growth during the recession was only to 8%, which, under normal conditions, would have been excessive, the appropriate target for NGDP growth, given the severity of the supply shock that was causing both labor and capital to be idled, would, at least initially, have been closer to the pre-recession rate of 12.7% than to 8%. The monetary response to a supply shock should take into account that, at least during the contraction and even in the early stages of a recovery, monetary expansion, by encouraging the reemployment of resources, thereby moderating the decline in output, can actually be disinflationary.

I pause here to observe that inflation need not increase just because unemployment is falling. That is an inference often mistakenly drawn from the Phillips Curve relationship between unemployment and inflation. It is a naive and vulgar misunderstanding of the Phillips Curve to assume that dcelining unemployment is always and everywhere inflationary. The kernel of truth in that inference is that monetary expansion tends to be inflationary when the economy operates at close to full employment without sufficient slack to allow output to increase in proportion to an increase in aggregate spending. However, when the economy is operating with slack and is far from full employment, the inference is invalid and counter-productive.

Burns eventually did loosen monetary policy to promote recovery in the second half of 1975, output expanding rapidly even as inflation declined to the mid-single digits while unemployment fell from 9% in May 1975 to 7.7% in October 1976. But, just as it did after the 1972 Presidential election, growth of NGDP actually increased after the 1976 Presidential election.

In the seven quarters from Q1-1975 through Q3-1976, nominal GDP grew at an average annual rate of 10.2%, with inflation fallng from a 7.7% to 9.4% range in Q1-1975 to a 5.3% to 6.5% range in Q3-1976; in the four quarters from Q4-1976 through Q3-1977, nominal GDP grew at an average rate of 10.9%, with inflation remaining roughly unchanged (in the 5% to 6.2% range). Burns may have been trying to accommodate the desires of the Carter Administration to promote a rapid reduction in unemployment as Carter had promised as a Presidential candidate. Unemployment in March 1977 stood at 7.4% no less than it was in May 1976. While the unemployment rate was concerning, unemployment rates in the 1970s reflected the influx of baby boomers and women lacking work experience into work force, which tended to increase measured unemployment despite rapid job growth. Between May 1976 and March 1977, for example, an average of over 200,000 new jobs a month were filled despite an unchanged unemployment rate.

As it became evident, towards the end of 1977 that Burns would not be reappointed Chairman, and someone else more amentable to providing further monetary stimulus would replace him, the dollar started falling in foreign-exchange markets, almost 7% between September 1977 and March 1978, a depreciation that provoked a countervailing monetary tightening and an increase in interest rates by the Fed. The depreciation and the tightening were reflected in reduced NGDP growth and increased inflation in Q4 1977 and Q1 1978 just as Burns was being replaced by his successor G. William Miller in March 1978.

So, a retrospective on Burns’s record as Fed Chairman provides no support for a revisionist rehabilitation of that record. Not only did Burns lack a coherent theoretical understanding of the effects of monetary policy on macroeconomic performance, which, to be fair, didn’t set him apart from his predecessors or successors, but he allowed himself to be beguiled by the idea of an incomes policy as an alternative to monetary policy as a way to control inflation. Had he properly understood the rationale of an incomes policy, he would have realized that it could serve a useful function only insofar as it supplemented, not replaced, a monetary policy aiming to reduce the growth of aggregate demand to a rate consistent with reducing inflation. Instead, Burns viewed the incomes policy as a means to eliminate the upward pressure of wage increases on costs, increases that, for the most part, merely compensated workers for real-wage reductions resulting from previous unanticipated inflation. But the cause of the cost-push phenomenon that was so concerning to Burns is aggregate-demand growth, which either raises prices or encourages output increases that make it profitable for businesses to incur those increased costs. Burns’s failure to grasp these causal relationships led him to a series of incoherent policy decisions that gravely damaged the US economy.

Hayek and the Lucas Critique

Published May 23, 2022 Alvin Hansen , Hayek , Herbert Tout , intertemporal equilibrium , Keynes , Lucas Critique , microfoundations , Milton Friedman , natural rate of unemployment , Phillips Curve , Robert Lucas 3 Comments

In March I wrote a blog post, “Robert Lucas and the Pretense of Science,” which was a draft proposal for a paper for a conference on Coordination Issues in Historical Perspectives to be held in September. My proposal having been accepted I’m going to post sections of the paper on the blog in hopes of getting some feedback as a write the paper. What follows is the first of several anticipated draft sections.

Just 31 years old, F. A. Hayek rose rapidly to stardom after giving four lectures at the London School of Economics at the invitation of his almost exact contemporary, and soon to be best friend, Lionel Robbins. Hayek had already published several important works, of which Hayek ([1928], 1984) laying out basic conceptualization of an intertemporal equilibrium almost simultaneously with the similar conceptualizations of two young Swedish economists, Gunnar Myrdal (1927) and Erik Lindahl [1929] 1939), was the most important.

Hayek’s (1931a) LSE lectures aimed to provide a policy-relevant version of a specific theoretical model of the business cycle that drew upon but was a just a particular instantiation of the general conceptualization developed in his 1928 contribution. Delivered less than two years after the start of the Great Depression, Hayek’s lectures gave a historical overview of the monetary theory of business-cycles, an account of how monetary disturbances cause real effects, and a skeptical discussion of how monetary policy might, or more likely might not, counteract or mitigate the downturn then underway. It was Hayek’s skepticism about countercyclical policy that helped make those lectures so compelling but also elicited such a hostile reaction during the unfolding crisis.

The extraordinary success of his lectures established Hayek’s reputation as a preeminent monetary theorist alongside established figures like Irving Fisher, A. C. Pigou, D. H. Robertson, R. G. Hawtrey, and of course J. M. Keynes. Hayek’s (1931b) critical review of Keynes’s just published Treatise on Money (1930), published soon after his LSE lectures, provoking a heated exchange with Keynes, himself, showed him to be a skilled debater and a powerful polemicist.

Hayek’s meteoric rise was, however, followed by a rapid fall from the briefly held pinnacle of his early career. Aside from the imperfections and weaknesses of his own theoretical framework (Glasner and Zimmerman 2021), his diagnosis of the causes of the Great Depression (Glasner and Batchelder [1994] 2021a, 2021b) and his policy advice (Glasner 2021) were theoretically misguided and inappropriate to the deflationary conditions underlying the Great Depression).

Nevertheless, Hayek’s conceptualization of intertemporal equilibrium provided insight into the role not only of prices, but also of price expectations, in accounting for cyclical fluctuations. In Hayek’s 1931 version of his cycle theory, the upturn results from bank-financed investment spending enabled by monetary expansion that fuels an economic boom characterized by increased total spending, output and employment. However, owing to resource constraints, misalignments between demand and supply, and drains of bank reserves, the optimistic expectations engendered by the boom are doomed to eventual disappointment, whereupon a downturn begins.

I need not engage here with the substance of Hayek’s cycle theory which I have criticized elsewhere (see references above). But I would like to consider his 1934 explanation, responding to Hansen and Tout (1933), of why a permanent monetary expansion would be impossible. Hansen and Tout disputed Hayek’s contention that monetary expansion would inevitably lead to a recession, because an unconstrained monetary authority would not be forced by a reserve drain to halt a monetary expansion, allowing a boom to continue indefinitely, permanently maintaining an excess of investment over saving.

Hayek (1934) responded as follows:

[A] constant rate of forced saving (i.e., investment in excess of voluntary saving) a rate of credit expansion which will enable the producers of intermediate products, during each successive unit of time, to compete successfully with the producers of consumers’ goods for constant additional quantities of the original factors of production. But as the competing demand from the producers of consumers’ goods rises (in terms of money) in consequence of, and in proportion to, the preceding increase of expenditure on the factors of production (income), an increase of credit which is to enable the producers of intermediate products to attract additional original factors, will have to be, not only absolutely but even relatively, greater than the last increase which is now reflected in the increased demand for consumers’ goods. Even in order to attract only as great a proportion of the original factors, i.e., in order merely to maintain the already existing capital, every new increase would have to be proportional to the last increase, i.e., credit would have to expand progressively at a constant rate. But in order to bring about constant additions to capital, it would have to do more: it would have to increase at a constantly increasing rate. The rate at which this rate of increase must increase would be dependent upon the time lag between the first expenditure of the additional money on the factors of production and the re-expenditure of the income so created on consumers’ goods. . . .

But I think it can be shown . . . that . . . such a policy would . . . inevitably lead to a rapid and progressive rise in prices which, in addition to its other undesirable effects, would set up movements which would soon counteract, and finally more than offset, the “forced saving.” That it is impossible, either for a simple progressive increase of credit which only helps to maintain, and does not add to, the already existing “forced saving,” or for an increase in credit at an increasing rate, to continue for a considerable time without causing a rise in prices, results from the fact that in neither case have we reason to assume that the increase in the supply of consumers’ goods will keep pace with the increase in the flow of money coming on to the market for consumers’ goods. Insofar as, in the second case, the credit expansion leads to an ultimate increase in the output of consumers’ goods, this increase will lag considerably and increasingly (as the period of production increases) behind the increase in the demand for them. But whether the prices of consumers’ goods will rise faster or slower, all other prices, and particularly the prices of the original factors of production, will rise even faster. It is only a question of time when this general and progressive rise of prices becomes very rapid. My argument is not that such a development is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result—a constant rate of forced saving, or maintenance without the help of voluntary saving of capital accumulated by forced saving—is to be achieved.

Friedman’s (1968) argument why monetary expansion could not permanently reduce unemployment below its “natural rate” closely mirrors (though he almost certainly never read) Hayek’s argument that monetary expansion could not permanently maintain a rate of investment spending above the rate of voluntary saving. Generalizing Friedman’s logic, Lucas (1976) transformed it into a critique of using econometric estimates of relationships like the Phillips Curve, the specific target of Friedman’s argument, as a basis for predicting the effects of policy changes, such estimates being conditional on implicit expectational assumptions which aren’t invariant to the policy changes derived from those estimates.

Restated differently, such econometric estimates are reduced forms that, without identifying restrictions, do not allow the estimated regression coefficients to be used to predict the effects of a policy change.

Only by specifying, and estimating, the deep structural relationships governing the response to a policy change could the effect of a potential policy change be predicted with some confidence that the prediction would not prove erroneous because of changes in the econometrically estimated relationships once agents altered their behavior in response to the policy change.

In his 1974 Nobel Lecture, Hayek offered a similar explanation of why an observed correlation between aggregate demand and employment provides no basis for predicting the effect of policies aimed at increasing aggregate demand and reducing unemployment if the likely changes in structural relationships caused by those policies are not taken into account.

[T]he very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection . . . money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour . . . into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained . . . The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because . . . this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

Hayek’s point that an observed correlation between the rate of inflation (a proxy for aggregate demand) and unemployment cannot be relied on in making economic policy was articulated succinctly and abstractly by Lucas as follows:

In short, one can imagine situations in which empirical Phillips curves exhibit long lags and situations in which there are no lagged effects. In either case, the “long-run” output inflation relationship as calculated or simulated in the conventional way has no bearing on the actual consequences of pursing a policy of inflation.

[T]he ability . . . to forecast consequences of a change in policy rests crucially on the assumption that the parameters describing the new policy . . . are known by agents. Over periods for which this assumption is not approximately valid . . . empirical Phillips curves will appear subject to “parameter drift,” describable over the sample period, but unpredictable for all but the very near future.

The lesson inferred by both Hayek and Lucas was that Keynesian macroeconomic models of aggregate demand, inflation and employment can’t reliably guide economic policy and should be discarded in favor of models more securely grounded in the microeconomic theories of supply and demand that emerged from the Marginal Revolution of the 1870s and eventually becoming the neoclassical economic theory that describes the characteristics of an efficient, decentralized and self-regulating economic system. This was the microeconomic basis on which Hayek and Lucas believed macroeconomic theory ought to be based instead of the Keynesian system that they were criticizing. But that superficial similarity obscures the profound methodological and substantive differences between them.

Those differences will be considered in future posts.

References

Friedman, M. 1968. “The Role of Monetary Policy.” American Economic Review 58(1):1-17.

Glasner, D. 2021. “Hayek, Deflation, Gold and Nihilism.” Ch. 16 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. [1994] 2021. “Debt, Deflation, the Gold Standard and the Great Depression.” Ch. 13 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. 2021. “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” Ch. 14 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Zimmerman, P. 2021.  “The Sraffa-Hayek Debate on the Natural Rate of Interest.” Ch. 15 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Hansen, A. and Tout, H. 1933. “Annual Survey of Business Cycle Theory: Investment and Saving in Business Cycle Theory,” Econometrica 1(2): 119-47.

Hayek, F. A. [1928] 1984. “Intertemporal Price Equilibrium and Movements in the Value of Money.” In R. McCloughry (Ed.), Money, Capital and Fluctuations: Early Essays (pp. 171–215). Routledge.

Hayek, F. A. 1931a. Prices and Produciton. London: Macmillan.

Hayek, F. A. 1931b. “Reflections on the Pure Theory of Money of Mr. Keynes.” Economica 33:270-95.

Hayek, F. A. 1934. “Capital and Industrial Fluctuations.” Econometrica 2(2): 152-67.

Keynes, J. M. 1930. A Treatise on Money. 2 vols. London: Macmillan.

Lindahl. E. [1929] 1939. “The Place of Capital in the Theory of Price.” In E. Lindahl, Studies in the Theory of Money and Capital. George, Allen & Unwin.

Lucas, R. E. [1976] 1985. “Econometric Policy Evaluation: A Critique.” In R. E. Lucas, Studies in Business-Cycle Theory. Cambridge: MIT Press.

Myrdal, G. 1927. Prisbildningsproblemet och Foranderligheten (Price Formation and the Change Factor). Almqvist & Wicksell.

Mankiw’s Phillips-Curve Agonistes

Published September 3, 2019 Gregory Mankiw , Phillips Curve 10 Comments
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The steady expansion of employment and reduction in unemployment since the recovery from the financial crisis of 2008 and the subsequent Little Depression, even as inflation remained almost continuously between 1.5 and 2% (with only a slight uptick to 3% in 2011), has led many observers to conclude that the negative correlation between inflation and unemployment posited by the Phillips Curve is no longer valid. So, almost a month ago, Greg Mankiw wrote New York Times Sunday Business Section defending the Phillips Curve as an analytical tool that ought to inform monetary policy-making by the Federal Reserve and other monetary authorities.

Mankiw starts with a brief potted history of the Phillips Curve.

The economist George Akerlof, a Nobel laureate and the husband of the former Federal Reserve chair Janet Yellen, once called the Phillips curve “probably the single most important macroeconomic relationship.” So it is worth recalling what the Phillips curve is, why it plays a central role in mainstream economics and why it has so many critics.

The story begins in 1958, when the economist A. W. Phillips published an article reporting an inverse relationship between unemployment and inflation in Britain. He reasoned that when unemployment is high, workers are easy to find, so employers hardly raise wages, if they do so at all.

But when unemployment is low, employers have trouble attracting workers, so they raise wages faster. Inflation in wages soon turns into inflation in the prices of goods and services.

Let’s pause for a moment and think about that explanation. If we translate it into a supply-demand framework in which the equilibrium corresponds to the intersection of a downward-sloping demand for labor curve with an upward-sloping supply of labor curve. The equilibrium is associated with some amount of unemployment inasmuch as there are always some workers transitioning from one job to another. The fewer and the more rapid the transitions, the less unemployment. The farther to the right the intersection of the demand curve and the supply curve, the more workers are employed and the fewer are transitioning between jobs in any time period.

I must note parenthetically that, as I have written recently, a supply-demand framework (aka partial equilibrium analysis) is not really the appropriate way to think about unemployment, because the equilibrium level of wages and the rates of unemployment must be analyzed, as, using different terminology, Keynes argued, in a general equilibrium, not a partial equilibrium, framework. But for ease of exposition, I use the partial equilibrium supply-demand paradigm.

Mankiw’s assertion that when unemployment is low, employers have trouble attracting workers, and therefore have to raise wages to hire, or retain, as many workers as they would like to employ, could be true. And that is the way that Mankiw wants us to focus on the relationship between wages and unemployment. Mankiw is focusing on the demand side as an explanation for low unemployment. But low unemployment could also reflect the eagerness of workers to be employed, even at low wages, so that workers quickly accept job offers rather than searching or holding out for better offers.

This is a classic issue in empirical estimates of demand. If high prices are associated with high output, does that mean that the data show that demand curves are upward-sloping, so that when suppliers raise price, customers increase want to buy more of their products? Obviously not. Suppliers raise their price because at low prices their customers are want to buy more than producers want to sell. So to estimate a demand curve, there must be some way of identifying factors that cause the entire demand curve to shift.

The identification problem in estimating demand curves has been understood since the early years of the 20th century. It is incredible that economists, especially one as steeped in the history of the discipline as Mankiw, talk about the Phillips Curve as if they had never heard of the identification problem.

When you estimate a demand curve without being able to identify shifts in demand, you are not estimating a demand curve, you are estimating a reduced form that combines — and fails to identify or distinguish between — both demand and supply. The Phillips Curve is a reduced form that captures both factors that affect the demand for labor and the supply of labor, though as I mentioned above, talking about the demand for labor and the supply of labor in the normal partial equilibrium sense of those terms is itself misleading and inappropriate.

What is unambiguously true, however, is that whatever else the Phillips Curve may be, it is a reduced form and not a deep structural relationship in an economy. It therefore is of little if any use in helping policy makers figure out whether to tighten or ease monetary policy.

For centuries, economists have understood that inflation is ultimately a monetary phenomenon. They noticed that when the world’s economies operated under a gold standard, gold discoveries resulted in higher prices for goods and services. And when central banks in economies with fiat money created large quantities — Germany in the interwar period, Zimbabwe in 2008, or Venezuela recently — the result was hyperinflation.

But economists also noticed that monetary conditions affect economic activity. Gold discoveries often lead to booming economies, and central banks easing monetary policy usually stimulate production and employment, at least for a while.

The Phillips curve helps explain how inflation and economic activity are related. At every moment, central bankers face a trade-off. They can stimulate production and employment at the cost of higher inflation. Or they can fight inflation at the cost of slower economic growth.

The Phillips curve, a reduced form, a mere correlation revealing no deep or necessary structural relationship between inflation and unemployment, explains nothing. It merely reflects the fact that, under a certain set of conditions, monetary expansion is associated with increased output and employment, and, accordingly, with reduced unemployment. And, under a certain set of conditions, monetary contraction is associated with reduced output and unemployment, and, accordingly, increased unemployment. We know now – and have long known — all about those relationships, without the Phillips Curve.

But under other conditions, high inflation may be associated with non-monetary factors (negative supply shocks) causing falling output and employment. And under still other conditions, low inflation may be associated with rising output and employment. There is no deep structural reason causing low unemployment to be incompatible with low inflation or causing high unemployment to be incompatible with high inflation. To suggest that the Phillips Curve is somehow a necessary relationship rather than a coincidental correlation between inflation and unemployment is a shockingly superficial reading of the evidence betraying an embarrassing misunderstanding of elementary theory.

Mankiw seems to be vaguely aware of his own confusion when he writes the following.

Today, most economists believe there is a trade-off between inflation and unemployment in the sense that actions taken by a central bank push these variables in opposite directions.

Mankiw’s qualification that the trade-off between inflation and unemployment reflects the tendency of rapid monetary expansion to cause output and employment to expand (at least temporarily) and prices to rise is a tacit admission that there is no necessary trade-off between inflation and unemployment. What we refer to as a Phillips Curve is simply the tendency for changes in monetary policy to affect inflation and unemployment in opposite directions, not a necessary structural relationship between inflation and unemployment. This is not rocket science. I can’t understand why Mankiw has trouble understanding that the fact that monetary policy may cause unemployment to rise when it causes inflation to fall and vice versa seems is not the same thing as a necessary inverse relationship between inflation and unemployment.

As a corollary, they also believe there must be a minimum level of unemployment that the economy can sustain without inflation rising too high. But for various reasons, that level fluctuates and is difficult to determine.

The level of unemployment that can be sustained without inflation is both unobservable and subject to change. Monetary policy can stimulate a rapid reduction in unemployment when unemployment is clearly higher than normal, as unemployment falls ongoing monetary expansion carries a risk of increasing inflation. But that doesn’t mean that unemployment cannot continue to fall without triggering an increase in inflation.

Mankiw concludes with the following bit of advice.

The Fed’s job is to balance the competing risks of rising unemployment and rising inflation. Striking just the right balance is never easy. The first step, however, is to recognize that the Phillips curve is always out there lurking.

That is just silly. The risk of increasing inflation is there with or without recognizing that the Phillips curve is out there lurking. To avoid the risk of inflation in a responsible way means using monetary policy to keep the rate of increase in nominal GDP within a reasonably narrow band providing enough room for the normal rate of growth in output with a rate of inflation sufficient to keep nominal interest rates moderately low, but substantially above zero. You don’t need a Phillips curve to figure that out.

The Phillips Curve and the Lucas Critique

Published March 30, 2018 David Andolfatto , Lucas Critique , Paul Krugman , Phillips Curve 21 Comments
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With unemployment at the lowest levels since the start of the millennium (initial unemployment claims in February were the lowest since 1973!), lots of people are starting to wonder if we might be headed for a pick-up in the rate of inflation, which has been averaging well under 2% a year since the financial crisis of September 2008 ushered in the Little Depression of 2008-09 and beyond. The Fed has already signaled its intention to continue raising interest rates even though inflation remains well anchored at rates below the Fed’s 2% target. And among Fed watchers and Fed cognoscenti, the only question being asked is not whether the Fed will raise its Fed Funds rate target, but how frequent those (presumably) quarter-point increments will be.

The prevailing view seems to be that the thought process of the Federal Open Market Committee (FOMC) in raising interest rates — even before there is any real evidence of an increase in an inflation rate that is still below the Fed’s 2% target — is that a preemptive strike is required to prevent inflation from accelerating and rising above what has become an inflation ceiling — not an inflation target — of 2%.

Why does the Fed believe that inflation is going to rise? That’s what the econoblogosphere has, of late, been trying to figure out. And the consensus seems to be that the FOMC is basing its assessment that the risk that inflation will break the 2% ceiling that it has implicitly adopted has become unacceptably high. That risk assessment is based on some sort of analysis in which it is inferred from the Phillips Curve that, with unemployment nearing historically low levels, rising inflation has become dangerously likely. And so the next question is: why is the FOMC fretting about the Phillips Curve?

In a blog post earlier this week, David Andolfatto of the St. Louis Federal Reserve Bank, tried to spell out in some detail the kind of reasoning that lay behind the FOMC decision to actively tighten the stance of monetary policy to avoid any increase in inflation. At the same time, Andolfatto expressed his own view, that the rate of inflation is not determined by the rate of unemployment, but by the stance of monetary policy.

Andolfatto’s avowal of monetarist faith in the purely monetary forces that govern the rate of inflation elicited a rejoinder from Paul Krugman expressing considerable annoyance at Andolfatto’s monetarism.

Here are three questions about inflation, unemployment, and Fed policy. Some people may imagine that they’re the same question, but they definitely aren’t:

  1. Does the Fed know how low the unemployment rate can go?
  2. Should the Fed be tightening now, even though inflation is still low?
  3. Is there any relationship between unemployment and inflation?

It seems obvious to me that the answer to (1) is no. We’re currently well above historical estimates of full employment, and inflation remains subdued. Could unemployment fall to 3.5% without accelerating inflation? Honestly, we don’t know.

Agreed.

I would also argue that the Fed is making a mistake by tightening now, for several reasons. One is that we really don’t know how low U can go, and won’t find out if we don’t give it a chance. Another is that the costs of getting it wrong are asymmetric: waiting too long to tighten might be awkward, but tightening too soon increases the risks of falling back into a liquidity trap. Finally, there are very good reasons to believe that the Fed’s 2 percent inflation target is too low; certainly the belief that it was high enough to make the zero lower bound irrelevant has been massively falsified by experience.

Agreed, but the better approach would be to target the price level, or even better nominal GDP, so that short-term undershooting of the inflation target would provide increased leeway to allow inflation to overshoot the inflation target without undermining the credibility of the commitment to price stability.

But should we drop the whole notion that unemployment has anything to do with inflation? Via FTAlphaville, I see that David Andolfatto is at it again, asserting that there’s something weird about asserting an unemployment-inflation link, and that inflation is driven by an imbalance between money supply and money demand.

But one can fully accept that inflation is driven by an excess supply of money without denying that there is a link between inflation and unemployment. In the normal course of events an excess supply of money may lead to increased spending as people attempt to exchange their excess cash balances for real goods and services. The increased spending can induce additional output and additional employment along with rising prices. The reverse happens when there is an excess demand for cash balances and people attempt to build up their cash holdings by cutting back their spending, reducing output. So the inflation unemployment relationship results from the effects induced by a particular causal circumstance. Nor does that mean that an imbalance in the supply of money is the only cause of inflation or price level changes.

Inflation can also result from nothing more than the anticipation of inflation. Expected inflation can also affect output and employment, so inflation and unemployment are related not only by both being affected by excess supply of (demand for) money, but by both being affect by expected inflation.

Even if you think that inflation is fundamentally a monetary phenomenon (which you shouldn’t, as I’ll explain in a minute), wage- and price-setters don’t care about money demand; they care about their own ability or lack thereof to charge more, which has to – has to – involve the amount of slack in the economy. As Karl Smith pointed out a decade ago, the doctrine of immaculate inflation, in which money translates directly into inflation – a doctrine that was invoked to predict inflationary consequences from Fed easing despite a depressed economy – makes no sense.

There’s no reason for anyone to care about overall money demand in this scenario. Price setters respond to the perceived change in the rate of spending induced by an excess supply of money. (I note parenthetically, that I am referring now to an excess supply of base money, not to an excess supply of bank-created money, which, unlike base money, is not a hot potato that cannot be withdrawn from circulation in response to market incentives.) Now some price setters may actually use macroeconomic information to forecast price movements, but recognizing that channel would take us into the realm of an expectations-theory of inflation, not the strict monetary theory of inflation that Krugman is criticizing.

And the claim that there’s weak or no evidence of a link between unemployment and inflation is sustainable only if you insist on restricting yourself to recent U.S. data. Take a longer and broader view, and the evidence is obvious.

Consider, for example, the case of Spain. Inflation in Spain is definitely not driven by monetary factors, since Spain hasn’t even had its own money since it joined the euro. Nonetheless, there have been big moves in both Spanish inflation and Spanish unemployment:

That period of low unemployment, by Spanish standards, was the result of huge inflows of capital, fueling a real estate bubble. Then came the sudden stop after the Greek crisis, which sent unemployment soaring.

Meanwhile, the pre-crisis era was marked by relatively high inflation, well above the euro-area average; the post-crisis era by near-zero inflation, below the rest of the euro area, allowing Spain to achieve (at immense cost) an “internal devaluation” that has driven an export-led recovery.

So, do you really want to claim that the swings in inflation had nothing to do with the swings in unemployment? Really, really?

No one claims – at least no one who believes in a monetary theory of inflation — should claim that swings in inflation and unemployment are unrelated, but to acknowledge the relationship between inflation and unemployment does not entail acceptance of the proposition that unemployment is a causal determinant of inflation.

But if you concede that unemployment had a lot to do with Spanish inflation and disinflation, you’ve already conceded the basic logic of the Phillips curve. You may say, with considerable justification, that U.S. data are too noisy to have any confidence in particular estimates of that curve. But denying that it makes sense to talk about unemployment driving inflation is foolish.

No it’s not foolish, because the relationship between inflation and unemployment is not a causal relationship; it’s a coincidental relationship. The level of employment depends on many things and some of the things that employment depends on also affect inflation. That doesn’t mean that employment causally affects inflation.

When I read Krugman’s post and the Andalfatto post that provoked Krugman, it occurred to me that the way to summarize all of this is to say that unemployment and inflation are determined by a variety of deep structural (causal) relationships. The Phillips Curve, although it was once fashionable to refer to it as the missing equation in the Keynesian model, is not a structural relationship; it is a reduced form. The negative relationship between unemployment and inflation that is found by empirical studies does not tell us that high unemployment reduces inflation, any more than a positive empirical relationship between the price of a commodity and the quantity sold would tell you that the demand curve for that product is positively sloped.

It may be interesting to know that there is a negative empirical relationship between inflation and unemployment, but we can’t rely on that relationship in making macroeconomic policy. I am not a big admirer of the Lucas Critique for reasons that I have discussed in other posts (e.g., here and here). But, the Lucas Critique, a rather trivial result that was widely understood even before Lucas took ownership of the idea, does at least warn us not to confuse a reduced form with a causal relationship.

Milton Friedman and the Phillips Curve

Published January 12, 2018 Hayek , Milton Friedman , Phillips Curve , Taylor rule , Uncategorized 8 Comments

In December 1967, Milton Friedman delivered his Presidential Address to the American Economic Association in Washington DC. In those days the AEA met in the week between Christmas and New Years, in contrast to the more recent practice of holding the convention in the week after New Years. That’s why the anniversary of Friedman’s 1967 address was celebrated at the 2018 AEA convention. A special session was dedicated to commemoration of that famous address, published in the March 1968 American Economic Review, and fittingly one of the papers at the session as presented by the outgoing AEA president Olivier Blanchard, who also wrote one of the papers discussed at the session. Other papers were written by Thomas Sargent and Robert Hall, and by Greg Mankiw and Ricardo Reis. The papers were discussed by Lawrence Summers, Eric Nakamura, and Stanley Fischer. An all-star cast.

Maybe in a future post, I will comment on the papers presented in the Friedman session, but in this post I want to discuss a point that has been generally overlooked, not only in the three “golden” anniversary papers on Friedman and the Phillips Curve, but, as best as I can recall, in all the commentaries I’ve seen about Friedman and the Phillips Curve. The key point to understand about Friedman’s address is that his argument was basically an extension of the idea of monetary neutrality, which says that the real equilibrium of an economy corresponds to a set of relative prices that allows all agents simultaneously to execute their optimal desired purchases and sales conditioned on those relative prices. So it is only relative prices, not absolute prices, that matter. Taking an economy in equilibrium, if you were suddenly to double all prices, relative prices remaining unchanged, the equilibrium would be preserved and the economy would proceed exactly – and optimally – as before as if nothing had changed. (There are some complications about what is happening to the quantity of money in this thought experiment that I am skipping over.) On the other hand, if you change just a single price, not only would the market in which that price is determined be disequilibrated, at least one, and potentially more than one, other market would be disequilibrated. The point here is that the real economy rules, and equilibrium in the real economy depends on relative, not absolute, prices.

What Friedman did was to argue that if money is neutral with respect to changes in the price level, it should also be neutral with respect to changes in the rate of inflation. The idea that you can wring some extra output and employment out of the economy just by choosing to increase the rate of inflation goes against the grain of two basic principles: (1) monetary neutrality (i.e., the real equilibrium of the economy is determined solely by real factors) and (2) Friedman’s famous non-existence (of a free lunch) theorem. In other words, you can’t make the economy as a whole better off just by printing money.

Or can you?

Actually you can, and Friedman himself understood that you can, but he argued that the possibility of making the economy as a whole better of (in the sense of increasing total output and employment) depends crucially on whether inflation is expected or unexpected. Only if inflation is not expected does it serve to increase output and employment. If inflation is correctly expected, the neutrality principle reasserts itself so that output and employment are no different from what they would have been had prices not changed.

What that means is that policy makers (monetary authorities) can cause output and employment to increase by inflating the currency, as implied by the downward-sloping Phillips Curve, but that simply reflects that actual inflation exceeds expected inflation. And, sure, the monetary authorities can always surprise the public by raising the rate of inflation above the rate expected by the public , but that doesn’t mean that the public can be perpetually fooled by a monetary authority determined to keep inflation higher than expected. If that is the strategy of the monetary authorities, it will lead, sooner or later, to a very unpleasant outcome.

So, in any time period – the length of the time period corresponding to the time during which expectations are given – the short-run Phillips Curve for that time period is downward-sloping. But given the futility of perpetually delivering higher than expected inflation, the long-run Phillips Curve from the point of view of the monetary authorities trying to devise a sustainable policy must be essentially vertical.

Two quick parenthetical remarks. Friedman’s argument was far from original. Many critics of Keynesian policies had made similar arguments; the names Hayek, Haberler, Mises and Viner come immediately to mind, but the list could easily be lengthened. But the earliest version of the argument of which I am aware is Hayek’s 1934 reply in Econometrica to a discussion of Prices and Production by Alvin Hansen and Herbert Tout in their 1933 article reviewing recent business-cycle literature in Econometrica in which they criticized Hayek’s assertion that a monetary expansion that financed investment spending in excess of voluntary savings would be unsustainable. They pointed out that there was nothing to prevent the monetary authority from continuing to create money, thereby continually financing investment in excess of voluntary savings. Hayek’s reply was that a permanent constant rate of monetary expansion would not suffice to permanently finance investment in excess of savings, because once that monetary expansion was expected, prices would adjust so that in real terms the constant flow of monetary expansion would correspond to the same amount of investment that had been undertaken prior to the first and unexpected round of monetary expansion. To maintain a rate of investment permanently in excess of voluntary savings would require progressively increasing rates of monetary expansion over and above the expected rate of monetary expansion, which would sooner or later prove unsustainable. The gist of the argument, more than three decades before Friedman’s 1967 Presidential address, was exactly the same as Friedman’s.

A further aside. But what Hayek failed to see in making this argument was that, in so doing, he was refuting his own argument in Prices and Production that only a constant rate of total expenditure and total income is consistent with maintenance of a real equilibrium in which voluntary saving and planned investment are equal. Obviously, any rate of monetary expansion, if correctly foreseen, would be consistent with a real equilibrium with saving equal to investment.

My second remark is to note the ambiguous meaning of the short-run Phillips Curve relationship. The underlying causal relationship reflected in the negative correlation between inflation and unemployment can be understood either as increases in inflation causing unemployment to go down, or as increases in unemployment causing inflation to go down. Undoubtedly the causality runs in both directions, but subtle differences in the understanding of the causal mechanism can lead to very different policy implications. Usually the Keynesian understanding of the causality is that it runs from unemployment to inflation, while a more monetarist understanding treats inflation as a policy instrument that determines (with expected inflation treated as a parameter) at least directionally the short-run change in the rate of unemployment.

Now here is the main point that I want to make in this post. The standard interpretation of the Friedman argument is that since attempts to increase output and employment by monetary expansion are futile, the best policy for a monetary authority to pursue is a stable and predictable one that keeps the economy at or near the optimal long-run growth path that is determined by real – not monetary – factors. Thus, the best policy is to find a clear and predictable rule for how the monetary authority will behave, so that monetary mismanagement doesn’t inadvertently become a destabilizing force causing the economy to deviate from its optimal growth path. In the 50 years since Friedman’s address, this message has been taken to heart by monetary economists and monetary authorities, leading to a broad consensus in favor of inflation targeting with the target now almost always set at 2% annual inflation. (I leave aside for now the tricky question of what a clear and predictable monetary rule would look like.)

But this interpretation, clearly the one that Friedman himself drew from his argument, doesn’t actually follow from the argument that monetary expansion can’t affect the long-run equilibrium growth path of an economy. The monetary neutrality argument, being a pure comparative-statics exercise, assumes that an economy, starting from a position of equilibrium, is subjected to a parametric change (either in the quantity of money or in the price level) and then asks what will the new equilibrium of the economy look like? The answer is: it will look exactly like the prior equilibrium, except that the price level will be twice as high with twice as much money as previously, but with relative prices unchanged. The same sort of reasoning, with appropriate adjustments, can show that changing the expected rate of inflation will have no effect on the real equilibrium of the economy, with only the rate of inflation and the rate of monetary expansion affected.

This comparative-statics exercise teaches us something, but not as much as Friedman and his followers thought. True, you can’t get more out of the economy – at least not for very long – than its real equilibrium will generate. But what if the economy is not operating at its real equilibrium? Even Friedman didn’t believe that the economy always operates at its real equilibrium. Just read his Monetary History of the United States. Real-business cycle theorists do believe that the economy always operates at its real equilibrium, but they, unlike Friedman, think monetary policy is useless, so we can forget about them — at least for purposes of this discussion. So if we have reason to think that the economy is falling short of its real equilibrium, as almost all of us believe that it sometimes does, why should we assume that monetary policy might not nudge the economy in the direction of its real equilibrium?

The answer to that question is not so obvious, but one answer might be that if you use monetary policy to move the economy toward its real equilibrium, you might make mistakes sometimes and overshoot the real equilibrium and then bad stuff would happen and inflation would run out of control, and confidence in the currency would be shattered, and you would find yourself in a re-run of the horrible 1970s. I get that argument, and it is not totally without merit, but I wouldn’t characterize it as overly compelling. On a list of compelling arguments, I would put it just above, or possibly just below, the domino theory on the basis of which the US fought the Vietnam War.

But even if the argument is not overly compelling, it should not be dismissed entirely, so here is a way of taking it into account. Just for fun, I will call it a Taylor Rule for the Inflation Target (IT). Let us assume that the long-run inflation target is 2% and let us say that (Y – Y*) is the output gap between current real GDP and potential GDP (i.e., the GDP corresponding to the real equilibrium of the economy). We could then define the following Taylor Rule for the inflation target:

IT = α(2%) + β((Y – Y*)/ Y*).

This equation says that the inflation target in any period would be a linear combination of the default Inflation Target of 2% times an adjustment coefficient α designed to keep successively chosen Inflation targets from deviating from the long-term price-level-path corresponding to 2% annual inflation and some fraction β of the output gap expressed as a percentage of potential GDP. Thus, for example, if the output gap was -0.5% and β was 0.5, the short-term Inflation Target would be raised to 4.5% if α were 1.

However, if on average output gaps are expected to be negative, then α would have to be chosen to be less than 1 in order for the actual time path of the price level to revert back to a target price-level corresponding to a 2% annual rate.

Such a procedure would fit well with the current dual inflation and employment mandate of the Federal Reserve. The long-term price level path would correspond to the price-stability mandate, while the adjustable short-term choice of the IT would correspond to and promote the goal of maximum employment by raising the inflation target when unemployment was high as a countercyclical policy for promoting recovery. But short-term changes in the IT would not be allowed to cause a long-term deviation of the price level from its target path. The dual mandate would ensure that relatively higher inflation in periods of high unemployment would be compensated for by periods of relatively low inflation in periods of low unemployment.

Alternatively, you could just target nominal GDP at a rate consistent with a long-run average 2% inflation target for the price level, with the target for nominal GDP adjusted over time as needed to ensure that the 2% average inflation target for the price level was also maintained.

Rules vs. Discretion Historically Contemplated

Published April 27, 2017 comparative statics , gold standard , Henry Simons , Milton Friedman , natural rate of interest , Phillips Curve 4 Comments

Here is a new concluding section which I have just written for my paper “Rules versus Discretion in Monetary Policy: Historically Contemplated” which I spoke about last September at the Mercatus Confernce on Monetary Rules in a Post-Crisis World. I have been working a lot on the paper over the past month or so and I hope to post a draft soon on SSRN and it is now under review for publication. I apologize for having written very little in past month and for having failed to respond to any comments on my previous posts. I simply have been too busy with work and life to have any energy left for blogging. I look forward to being more involved in the blog over the next few months and expect to be posting some sections of a couple of papers I am going to be writing. But I’m offering no guarantees. It is gratifying to know that people are still visiting the blog and reading some of my old posts.

Although recognition of a need for some rule to govern the conduct of the monetary authority originated in the perceived incentive of the authority to opportunistically abuse its privileged position, the expectations of the public (including that small, but modestly influential, segment consisting of amateur and professional economists) about what monetary rules might actually accomplish have evolved and expanded over the course of the past two centuries. As Laidler (“Economic Ideas, the Monetary Order, and the Uneasy Case for Monetary Rules”) shows, that evolution has been driven by both the evolution of economic and monetary institutions and the evolution of economic and monetary doctrines about how those institutions work.

I distinguish between two types of rules: price rules and quantity rules. The simplest price rule involved setting the price of a commodity – usually gold or silver – in terms of a monetary unit whose supply was controlled by the monetary authority or defining a monetary unit as a specific quantity of a particular commodity. Under the classical gold standard, for example, the monetary authority stood ready to buy or sell gold on demand at legally determined price of gold in terms of the monetary unit. Thus, the fixed price of gold under the gold standard was originally thought to serve as both the policy target of the rule and the operational instrument for implementing the rule.

However, as monetary institutions and theories evolved, it became apparent that there were policy objectives other than simply maintaining the convertibility of the monetary unit into the standard commodity that required the attention of the monetary authority. The first attempt to impose an additional policy goal on a monetary authority was the Bank Charter Act of 1844 which specified a quantity target – the aggregate of banknotes in circulation in Britain – which the monetary authority — the Bank of England – was required to reach by following a simple mechanical rule. By imposing a 100-percent marginal gold-reserve requirement on the notes issued by the Bank of England, the Bank Charter Act made the quantity of banknotes issued by the Bank of England both the target of the quantity rule and the instrument by which the rule was implemented.

Owing to deficiencies in the monetary theory on the basis of which the Act was designed and to the evolution of British monetary practices and institution, the conceptual elegance of the Bank Charter Act was not matched by its efficacy in practice. But despite, or, more likely, because of, the ultimate failure of Bank Charter Act, the gold standard, surviving recurring financial crises in Great Britain in the middle third of the nineteenth century, was eventually adopted by many other countries in the 1870s, becoming the de facto international monetary system from the late 1870s until the start of World War I. Operation of the gold standard was defined by, and depended on, the observance of a single price rule in which the value of a currency was defined by its legal gold content, so that corresponding to each gold-standard currency, there was an official gold price at which the monetary authority was obligated to buy or sell gold on demand.

The value – the purchasing power — of gold was relatively stable in the 35 or so years of the gold standard era, but that stability could not survive the upheavals associated with World War I, and so the problem of reconstructing the postwar monetary system was what kind of monetary rule to adopt to govern the post-war economy. Was it enough merely to restore the old currency parities – perhaps adjusted for differences in the extent of wartime and postwar currency depreciation — that governed the classical gold standard, or was it necessary to take into account other factors, e.g., the purchasing power of gold, in restoring the gold standard? This basic conundrum was never satisfactorily answered, and the failure to do so undoubtedly was a contributing, and perhaps dominant, factor in the economic collapse that began at the end of 1929, ultimately leading to the abandonment of the gold standard.

Searching for a new monetary regime to replace the failed gold standard, but to some extent inspired by the Bank Charter Act of the previous century, Henry Simons and ten fellow University of Chicago economists devised a totally new monetary system based on 100-percent reserve banking. The original Chicago proposal for 100-percent reserve banking proposed a monetary rule for stabilizing the purchasing power of fiat money. The 100-percent banking proposal would give the monetary authority complete control over the quantity of money, thereby enhancing the power of the monetary authority to achieve its price-level target. The Chicago proposal was thus inspired by a desire to increase the likelihood that the monetary authority could successfully implement the desired price rule. The price level was the target, and the quantity of money was the instrument. But as long as private fractional-reserve banks remained in operation, the monetary authority would lack effective control over the instrument. That was the rationale for replacing fractional reserve banks with 100-percent reserve banks.

But Simons eventually decided in his paper (“Rules versus Authorities in Monetary Policy”) that a price-level target was undesirable in principle, because allowing the monetary authority to choose which price level to stabilize, thereby favoring some groups at the expense of others, would grant too much discretion to the monetary authority. Rejecting price-level stabilization as monetary rule, Simons concluded that the exercise of discretion could be avoided only if the quantity of money was the target as well as the instrument of a monetary rule. Simons’s ideal monetary rule was therefore to keep the quantity of money in the economy constant — forever. But having found the ideal rule, Simons immediately rejected it, because he realized that the reforms in the financial and monetary systems necessary to make such a rule viable over the long run would never be adopted. And so he reluctantly and unhappily reverted back to the price-level stabilization rule that he and his Chicago colleagues had proposed in 1933.

Simons’s student Milton Friedman continued to espouse his teacher’s opposition to discretion, and as late as 1959 (A Program for Monetary Stability) he continued to advocate 100-percent reserve banking. But in the early 1960s, he adopted his k-percent rule and gave up his support for 100-percent banking. But despite giving up on 100-percent banking, Friedman continued to argue that the k-percent rule was less discretionary than the gold standard or a price-level rule, because neither the gold standard nor a price-level rule eliminated the exercise of discretion by the monetary authority in its implementation of policy, failing to acknowledge that, under any of the definitions that he used (usually M1 and sometimes M2), the quantity of money was a target, not an instrument. Of course, Friedman did eventually abandon his k-percent rule, but that acknowledgment came at least a decade after almost everyone else had recognized its unsuitability as a guide for conducting monetary policy, let alone as a legally binding rule, and long after Friedman’s repeated predictions that rapid growth of the monetary aggregates in the 1980s presaged the return of near-double-digit inflation.

However, the work of Kydland and Prescott (“Rules Rather than Discretion: The Inconsistency of Optimal Plans”) on time inconsistency has provided an alternative basis on which argue against discretion: that the lack of commitment to a long-run policy would lead to self-defeating short-term attempts to deviate from the optimal long-term policy.[1]

It is now I think generally understood that a monetary authority has available to it four primary instruments in conducting monetary policy, the quantity of base money, the lending rate it charges to banks, the deposit rate it pays banks on reserves, and an exchange rate against some other currency or some asset. A variety of goals remain available as well, nominal goals like inflation, the price level, or nominal income, or even an index of stock prices, as well as real goals like real GDP and employment.

Ever since Friedman and Phelps independently argued that the long-run Phillips Curve is vertical, a consensus has developed that countercyclical monetary policy is basically ineffectual, because the effects of countercyclical policy will be anticipated so that the only long-run effect of countercyclical policy is to raise the average rate of inflation without affecting output and employment in the long run. Because the reasoning that generates this result is essentially that money is neutral in the long run, the reasoning is not as compelling as the professional consensus in its favor would suggest. The monetary neutrality result only applies under the very special assumptions of a comparative static exercise comparing an initial equilibrium with a final equilibrium. But the whole point of countercyclical policy is to speed the adjustment from a disequilbrium with high unemployment back to a low-unemployment equilibrium. A comparative-statics exercise provides no theoretical, much less empirical, support for the proposition that anticipated monetary policy cannot have real effects.

So the range of possible targets and the range of possible instruments now provide considerable latitude to supporters of monetary rules to recommend alternative monetary rules incorporating many different combinations of alternative instruments and alternative targets. As of now, we have arrived at few solid theoretical conclusions about the relative effectiveness of alternative rules and even less empirical evidence about their effectiveness. But at least we know that, to be viable, a monetary rule will almost certainly have to be expressed in terms of one or more targets while allowing the monetary authority at least some discretion to adjust its control over its chosen instruments in order to effectively achieve its target (McCallum 1987, 1988). That does not seem like a great deal of progress to have made in the two centuries since economists began puzzling over how to construct an appropriate rule to govern the behavior of the monetary authority, but it is progress nonetheless. And, if we are so inclined, we can at least take some comfort in knowing that earlier generations have left us a lot of room for improvement.

Footnote:

[1] Friedman in fact recognized the point in his writings, but he emphasized the dangers of allowing discretion in the choice of instruments rather than the time-inconsistency policy, because it was only former argument that provided a basis for preferring his quantity rule over price rules.

Richard Lipsey and the Phillips Curve Redux

Published March 2, 2017 Lucas Critique , natural rate of unemployment , Phillips Curve , R. G. Lipsey , Roger Farmer 1 Comment
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Almost three and a half years ago, I published a post about Richard Lipsey’s paper “The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium.” The paper originally presented at the 2013 meeting of the History of Econmics Society has just been published in the Journal of the History of Economic Thought, with a slightly revised title “The Phillips Curve and an Assumed Unique Macroeconomic Equilibrium in Historical Context.” The abstract of the revised published version of the paper is different from the earlier abstract included in my 2013 post. Here is the new abstract.

An early post-WWII debate concerned the most desirable demand and inflationary pressures at which to run the economy. Context was provided by Keynesian theory devoid of a full employment equilibrium and containing its mainly forgotten, but still relevant, microeconomic underpinnings. A major input came with the estimates provided by the original Phillips curve. The debate seemed to be rendered obsolete by the curve’s expectations-augmented version with its natural rate of unemployment, and associated unique equilibrium GDP, as the only values consistent with stable inflation. The current behavior of economies with the successful inflation targeting is inconsistent with this natural-rate view, but is consistent with evolutionary theory in which economies have a wide range of GDP-compatible stable inflation. Now the early post-WWII debates are seen not to be as misguided as they appeared to be when economists came to accept the assumptions implicit in the expectations-augmented Phillips curve.

Publication of Lipsey’s article nicely coincides with Roger Farmer’s new book Prosperity for All which I discussed in my previous post. A key point that Roger makes is that the assumption of a unique equilibrium which underlies modern macroeconomics and the vertical long-run Phillips Curve is neither theoretically compelling nor consistent with the empirical evidence. Lipsey’s article powerfully reinforces those arguments. Access to Lipsey’s article is gated on the JHET website, so in addition to the abstract, I will quote the introduction and a couple of paragraphs from the conclusion.

One important early post-WWII debate, which took place particularly in the UK, concerned the demand and inflationary pressures at which it was best to run the economy. The context for this debate was provided by early Keynesian theory with its absence of a unique full-employment equilibrium and its mainly forgotten, but still relevant, microeconomic underpinnings. The original Phillips Curve was highly relevant to this debate. All this changed, however, with the introduction of the expectations-augmented version of the curve with its natural rate of unemployment, and associated unique equilibrium GDP, as the only values consistent with a stable inflation rate. This new view of the economy found easy acceptance partly because most economists seem to feel deeply in their guts — and their training predisposes them to do so — that the economy must have a unique equilibrium to which market forces inevitably propel it, even if the approach is sometimes, as some believe, painfully slow.

The current behavior of economies with successful inflation targeting is inconsistent with the existence of a unique non-accelerating-inflation rate of unemployment (NAIRU) but is consistent with evolutionary theory in which the economy is constantly evolving in the face of path-dependent, endogenously generated, technological change, and has a wide range of unemployment and GDP over which the inflation rate is stable. This view explains what otherwise seems mysterious in the recent experience of many economies and makes the early post-WWII debates not seem as silly as they appeared to be when economists came to accept the assumption of a perfectly inelastic, long-run Phillips curve located at the unique equilibrium level of unemployment. One thing that stands in the way of accepting this view, however, the tyranny of the generally accepted assumption of a unique, self-sustaining macroeconomic equilibrium.

This paper covers some of the key events in the theory concerning, and the experience of, the economy’s behavior with respect to inflation and unemployment over the post-WWII period. The stage is set by the pressure-of-demand debate in the 1950s and the place that the simple Phillips curve came to play in it. The action begins with the introduction of the expectations-augmented Phillips curve and the acceptance by most Keynesians of its implication of a unique, self-sustaining macro equilibrium. This view seemed not inconsistent with the facts of inflation and unemployment until the mid-1990s, when the successful adoption of inflation targeting made it inconsistent with the facts. An alternative view is proposed, on that is capable of explaining current macro behavior and reinstates the relevance of the early pressure-of-demand debate. (pp. 415-16).

In reviewing the evidence that stable inflation is consistent with a range of unemployment rates, Lipsey generalizes the concept of a unique NAIRU to a non-accelerating-inflation band of unemployment (NAIBU) within which multiple rates of unemployment are consistent with a basically stable expected rate of inflation. In an interesting footnote, Lipsey addresses a possible argument against the relevance of the empirical evidence for policy makers based on the Lucas critique.

Some might raise the Lucas critique here, arguing that one finds the NAIBU in the data because policymakers are credibly concerned only with inflation. As soon as policymakers made use of the NAIBU, the whole unemployment-inflation relation that has been seen since the mid-1990s might change or break. For example, unions, particularly in the European Union, where they are typically more powerful than in North America, might alter their behavior once they became aware that the central bank was actually targeting employment levels directly and appeared to have the power to do so. If so, the Bank would have to establish that its priorities were lexicographically ordered with control of inflation paramount so that any level-of-activity target would be quickly dropped whenever inflation threatened to go outside of the target bands. (pp. 426-27)

I would just mention in this context that in this 2013 post about the Lucas critique, I pointed out that in the paper in which Lucas articulated his critique, he assumed that the only possible source of disequilibrium was a mistake in expected inflation. If everything else is working well, causing inflation expectations to be incorrect will make things worse. But if there are other sources of disequilibrium, it is not clear that incorrect inflation expectations will make things worse; they could make things better. That is a point that Lipsey and Kelvin Lancaster taught the profession in a classic article “The General Theory of Second Best,” 20 years before Lucas published his critique of econometric policy evaluation.

I conclude by quoting Lipsey’s penultimate paragraph (the final paragraph being a quote from Lipsey’s paper on the Phillips Curve from the Blaug and Lloyd volume Famous Figures and Diagrams in Economics which I quoted in full in my 2013 post.

So we seem to have gone full circle from the early Keynesian view in which there was no unique level of GDP to which the economy was inevitably drawn, through a simple Phillips curve with its implied trade-0ff, to an expectations-augmented Phillips curve (or any of its more modern equivalents) with its associated unique level of GDP, and finally back to the early Keynesian view in which policymakers had an option as to the average pressure of aggregate demand at which economic activity could be sustained. However, the modern debated about whether to aim for [the high or low range of stable unemployment rates] is not a debate about inflation versus growth, as it was in the 1950s, but between those who would risk an occasional rise of inflation above the target band as the price of getting unemployment as low as possible and those who would risk letting unemployment fall below that indicated by the lower boundary of the NAIBU  as the price of never risking an acceleration of inflation above the target rate. (p. 427)

What’s Wrong with Monetarism?

Published April 26, 2016 Brad Delong , free banking , gold standard , Great Depression , Hayek , Keynes , Lucas Critique , Milton Friedman , Monetarism , money multiplier , Paul Krugman , Phillips Curve 37 Comments
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UPDATE: (05/06): In an email Richard Lipsey has chided me for seeming to endorse the notion that 1970s stagflation refuted Keynesian economics. Lipsey rightly points out that by introducing inflation expectations into the Phillips Curve or the Aggregate Supply Curve, a standard Keynesian model is perfectly capable of explaining stagflation, so that it is simply wrong to suggest that 1970s stagflation constituted an empirical refutation of Keynesian theory. So my statement in the penultimate paragraph that the k-percent rule

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

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

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

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

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

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

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

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

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

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

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

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

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

Making Sense of the Phillips Curve

Published February 4, 2015 Milton Friedman , natural rate of unemployment , New Keynesians , Old Keynesians , Phillips Curve , R. G. Lipsey , Walrasian equilibrium 12 Comments
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In a comment on my previous post about supposedly vertical long run Phillips Curve, Richard Lipsey mentioned a paper he presented a couple of years ago at the History of Economics Society Meeting: “The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium.” In a subsequent comment, Richard also posted the abstract to his paper. The paper provides a succinct yet fascinating overview of the evolution macroeconomists’ interpretations of the Phillips curve since Phillips published his paper almost 60 years ago.

The two key points that I take away from Richard’s discussion are the following. 1) A key microeconomic assumption underlying the Keynesian model is that over a broad range of outputs, most firms are operating under conditions of constant short-run marginal cost, because in the short run firms keep the capital labor ratio fixed, varying their usage of capital along with the amount of labor utilized. With a fixed capital-labor ration, marginal cost is flat. In the usual textbook version, the short-run marginal cost is rising because of a declining capital-labor ratio, requiring an increasing number of workers to wring out successive equal increments of output from a fixed amount of capital. Given flat marginal cost, firms respond to changes in demand by varying output but not price until they hit a capacity bottleneck.

The second point, a straightforward implication of the first, is that there are multiple equilibria for such an economy, each equilibrium corresponding to a different level of total demand, with a price level more or less determined by costs, at any rate until total output approaches the limits of its capacity.

Thus, early on, the Phillips Curve was thought to be relatively flat, with little effect on inflation unless unemployment was forced down below some very low level. The key question was how far unemployment could be pushed down before significant inflationary pressure would begin to emerge. Doctrinaire Keynesians advocated driving unemployment down as low as possible, while skeptics argued that significant inflationary pressure would begin to emerge even at higher rates of unemployment, so that a prudent policy would be to operate at a level of unemployment sufficiently high to keep inflationary pressures in check.

Lipsey allows that, in the 1960s, the view that the Phillips Curve presented a menu of alternative combinations of unemployment and inflation from which policymakers could choose did take hold, acknowledging that he himself expressed such a view in a 1965 paper (“Structural and Deficient Demand Unemployment Reconsidered” in Employment Policy and the Labor Market edited by Arthur Ross), “inflationary points on the Phillips Curve represent[ing] disequilibrium points that had to be maintained by monetary policy that perpetuated the disequilibrium by suitable increases in the rate of monetary expansion.” It was this version of the Phillips Curve that was effectively attacked by Friedman and Phelps, who replaced it with a version in which the equilibrium rate of unemployment is uniquely determined by real factors, the natural rate of unemployment, any deviation from the natural rate resulting in a series of adjustments in inflation and expected inflation that would restore the natural rate of unemployment.

Sometime in the 1960s the Phillips curve came to be thought of as providing a stable trade-off between inflation and unemployment. When Lipsey did adopt this trade-off version, as for example Lipsey (1965), inflationary points on the Phillips curve represented disequilibrium points that had to be maintained by monetary policy that perpetuated the disequilibrium by suitable increases in the rate of monetary expansion. In the new Classical interpretation that began with Edmund Phelps (1967), Milton Friedman (1968) and Lucas and Rapping (1969), each point was an equilibrium point because demands and supplies of agents were shifted from their full-information locations when they misinterpreted the price signals. There was, however, only one full-information equilibrium of income, Y*, and unemployment, U*.

The Friedman-Phelps argument was made as inflation rose significantly in the late 1960s, and the mild 1969-70 recession reduce inflation by only a smidgen, setting the stage for Nixon’s imposition of his disastrous wage and price controls in 1971 combined with a loosening of monetary policy by a compliant Arthur Burns as part of Nixon’s 1972 reelection strategy. When the hangover to the 1972 monetary binge was combined with a quadrupling of oil prices by OPEC in late 1973, the result was a simultaneous increase in inflation and unemployment – stagflation — a combination widely perceived as a decisive refutation of Keynesian theory. To cope with that theoretical conundrum, the Keynesian model was expanded to incorporate the determination of the price level by deriving an aggregate supply and aggregate demand curve in price-level/output space.

Lipsey acknowledges a crucial misstep in constructing the Aggregate Demand/Aggregate Supply framework: assuming a unique macroeconomic equilibrium, an assumption that implied the existence of a unique natural rate of unemployment. Keynesians won the battle, providing a perfectly respectable theoretical explanation for stagflation, but, in doing so, they lost the war to Friedman, paving the way for the malign ascendancy of New Classical economics, with which New Keynesian economics became an effective collaborator. Whether the collaboration was willing or unwilling is unclear and unimportant; by assuming a unique equilibrium, New Keynesians gave up the game.

I was so intent in showing that this AD-AS construction provided a simple Keynesian explanation of stagflation, contrary to the accusation of the New Classical economists that stagflation provided a conclusive refutation of Keynesian economics that I paid too little attention to the enormous importance of the new assumption introduced into Keynesian models. The addition of an expectations-augmented Philips curve, negatively sloped in the short run but vertical in the long run, produced a unique macro equilibrium that would be reached whatever macroeconomic policy was adopted.

Lipsey does not want to go back to the old Keynesian paradigm; he prefers a third approach that can be traced back to, among others, Joseph Schumpeter in which the economy is viewed “as constantly evolving under the impact of endogenously generated technological change.” Such technological change can be vaguely foreseen, but also gives rise to genuine surprises. The course of economic development is not predetermined, but path-dependent. History matters.

I suggest that the explanation of the current behaviour of inflation, output and unemployment in modern industrial economies is provided not by any EWD [equilibrium with deviations] theory but by evolutionary theories. These build on the obvious observation that technological change is continual in modern economies (decade by decade at least since 1760), but uneven (tending to come in spurts), and path dependent (because, among other reasons, knowledge is cumulative with one advance enabling another). These changes are generated endogenously by private-sector, profit-seeking agents competing in terms of new products, new processes and new forms of organisation, and by public sector activities in such places as universities and government research laboratories. They continually alter the structure of the economy, causing waves of serially correlated investment expenditure that are a major cause of cycles, as well as driving the long-term growth that continually transforms our economic, social and political structures. In their important book As Time Goes By, Freeman and Louça (2001) trace these processes as they have operated since the beginnings of the First Industrial Revolution.

A critical distinction in all such theories is between risk, which is easily handled in neoclassical economics, and uncertainty, which is largely ignored in it except to pay it lip service. In risky situations, agents with the same objective function and identical knowledge will chose the same alternative: the one that maximizes the expected value of their profits or utility. This gives rise to unique predictable behaviour of agents acting under specified conditions. In contrast in uncertain situations, two identically situated and motivated agents can, and observably do, choose different alternatives — as for example when different firms all looking for the same technological breakthrough chose different lines of R&D — and there is no way to tell in advance of knowing the results which is the better choice. Importantly, agents typically make R&D decisions under conditions of genuine uncertainty. No one knows if a direction of technological investigation will go up a blind alley or open onto a rich field of applications until funds are spend investigating the route. Sometimes trivial expenses produce results of great value while major expenses produce nothing of value. Since there is no way to decide in advance which of two alternative actions with respect to invention or innovation is the best one until the results are known, there is no unique line of behaviour that maximises agents’ expected profits. Thus agents are better understood as groping into an uncertain future in a purposeful, profit- or utility-seeking manner, rather than as maximizing their profits or utility.

This is certainly the right way to think about how economies evolve over time, but I would just add that even if one stays within the more restricted framework of Walrasian general equilibrium, there is simply no persuasive theoretical reason to assume that there is a unique equilibrium or that an economy will necessarily arrive at that equilibrium no matter how long we wait. I have discussed this point several times before most recently here. The assumption that there is a natural rate of unemployment “ground out,” as Milton Friedman put it so awkwardly, “by the Walrasian system of general equilibrium equations” simply lacks any theoretical foundation. Even in a static model in which knowledge and technology were not evolving, the natural rate of unemployment is a will o the wisp.

Because there is no unique static equilibrium in the evolutionary world in which history matters, no adjustment mechanism is required to maintain it. Instead, the constantly changing economy can exist over a wide range of income, employment and unemployment values, without behaving as it would if its inflation rate were determined by an expectations-augmented Phillips curve or any similar construct centred on unique general equilibrium values of Y and U. Thus there is no stable long-run vertical Phillips curve or aggregate supply curve.

Instead of the Phillips curve there is a band as shown in Figure 4 [See below]. Its midpoint is at the expected rate of inflation. If the central bank has a credible inflation target that it sticks to, the expected rate will be that target rate, shown as πe in the figure. The actual rate will vary around the expected rate depending on a number of influences such as changes in productivity, the price of oil and food, but not significantly on variations in U or Y. At either end of this band, there may be something closer to a conventional Phillips curve with prices and wages falling in the face of a major depression and rising in the face of a major boom financed by monetary expansion. Also, the whole band will be shifted by anything that changes the expected rate of inflation.

phillips_lipsey

Lipsey concludes as follows:

So we seem to have gone full circle from early Keynesian view in which there was no unique level of income to which the economy was inevitably drawn, through a simple Phillips curve with its implied trade off, to an expectations-augmented Phillips curve (or any of its more modern equivalents) with its associated unique level of national income, and finally back to the early non-unique Keynesian view in which policy makers had an option as to the average pressure of aggregate demand at which the economy could be operated.

“Perhaps [then] Keynesians were too hasty in following the New Classical economists in accepting the view that follows from static [and all EWD] models that stable rates of wage and price inflation are poised on the razor’s edge of a unique NAIRU and its accompanying Y*. The alternative does not require a long term Phillips curve trade off, nor does it deny the possibility of accelerating inflations of the kind that have bedevilled many third world countries. It is merely states that industrialised economies with low expected inflation rates may be less precisely responsive than current theory assumes because they are subject to many lags and inertias, and are operating in an ever-changing and uncertain world of endogenous technological change, which has no unique long term static equilibrium. If so, the economy may not be similar to the smoothly functioning mechanical world of Newtonian mechanics but rather to the imperfectly evolving world of evolutionary biology. The Phillips relation then changes from being a precise curve to being a band within which various combinations of inflation and unemployment are possible but outside of which inflation tends to accelerate or decelerate. Perhaps then the great [pre-Phillips curve] debates of the 1940s and early 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflation[ary pressure], were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, one-dimensional, long run Phillips curve located at a unique equilibrium Y* and NAIRU.” (Lipsey, “The Phillips Curve,” In Famous Figures and Diagrams in Economics, edited by Mark Blaug and Peter Lloyd, p. 389)

The Near Irrelevance of the Vertical Long-Run Phillips Curve

Published January 27, 2015 comparative statics , expectations , Milton Friedman , Phillips Curve 26 Comments
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From a discussion about how much credit Milton Friedman deserves for changing the way that economists thought about inflation, I want to nudge the conversation in a slightly different direction, to restate a point that I made some time ago in one of my favorite posts (The Lucas Critique Revisited). But if Friedman taught us anything it is that incessant repetition of the same already obvious point can do wonders for your reputation. That’s one lesson from Milton that I am willing to take to heart, though my tolerance for hearing myself say the same darn thing over and over again is probably not as great as Friedman’s was, which to be sure is not the only way in which I fall short of him by comparison. (I am almost a foot taller than he was by the way). Speaking of being a foot taller than Friedman, I don’t usually post pictures on this blog, but here is one that I have always found rather touching. And if you don’t know who the other guy is in the picture, you have no right to call yourself an economist.

friedman_&_StiglerAt any rate, the expectations augmented, long-run Phillips Curve, as we all know, was shown by Friedman to be vertical. But what exactly does it mean for the expectations-augmented, long-run Phillips Curve to be vertical? Discussions about whether the evidence supports the proposition that the expectations-augmented, long-run Phillips Curve is vertical (including some of the comments on my recent posts) suggest that people are not clear on what “long-run” means in the context of the expectations-augmented Phillips Curve and have not really thought carefully about what empirical content is contained by the proposition that the expectations-augmented, long-run Phillips Curve is vertical.

Just to frame the discussion of the Phillips Curve, let’s talk about what the term “long-run” means in economics. What it certainly does not mean is an amount of calendar time, though I won’t deny that there are frequent attempts to correlate long-run with varying durations of calendar time. But all such attempts either completely misunderstand what the long-run actually represents, or they merely aim to provide the untutored with some illusion of concreteness in what is otherwise a completely abstract discussion. In fact, what “long run” connotes is simply a full transition from one equilibrium state to another in the context of a comparative-statics exercise.

If a change in some exogenous parameter is imposed on a pre-existing equilibrium, then the long-run represents the full transition to a new equilibrium in which all endogenous variables have fully adjusted to the parameter change. The short-run, then, refers to some intermediate adjustment to the parameter change in which some endogenous variables have been arbitrarily held fixed (presumably because of some possibly reasonable assumption that some variables are able to adjust more speedily than other variables to the posited parameter change).

Now the Phillips Curve that was discovered by A. W. Phillips in his original paper was a strictly empirical relation between observed (wage) inflation and observed unemployment. But the expectations-augmented long-run Phillips Curve is a theoretical construct. And what it represents is certainly not an observable relationship between inflation and unemployment; it rather is a locus of points of equilibrium, each point representing full adjustment of the labor market to a particular rate of inflation, where full adjustment means that the rate of inflation is fully anticipated by all economic agents in the model. So what the expectations-augmented, long-run Phillips Curve is telling us is that if we perform a series of comparative-statics exercises in which, starting from full equilibrium with the given rate of inflation fully expected, we impose on the system a parameter change in which the exogenously imposed rate of inflation is changed and deduce a new equilibrium in which the fully and universally expected rate of inflation equals the alternative exogenously imposed inflation parameter, the equilibrium rate of unemployment corresponding to the new inflation parameter will not differ from the equilibrium rate of unemployment corresponding to the original inflation parameter.

Notice, as well, that the expectations-augmented, long-run Phillips Curve is not saying that imposing a new rate of inflation on an actual economic system would lead to a new equilibrium in which there was no change in unemployment; it is merely comparing alternative equilibria of the same system with different exogenously imposed rates of inflation. To make a statement about the effect of a change in the rate of inflation on unemployment, one has to be able to specify an adjustment path in moving from one equilibrium to another. The comparative-statics method says nothing about the adjustment path; it simply compares two alternative equilibrium states and specifies the change in endogenous variable induced by the change in an exogenous parameter.

So the vertical shape of the expectations-augmented, long-run Phillips Curve tells us very little about how, in any given situation, a change in the rate of inflation would actually affect the rate of unemployment. Not only does the expectations-augmented long-run Phillips Curve fail to tell us how a real system starting from equilibrium would be affected by a change in the rate of inflation, the underlying comparative-statics exercise being unable to specify the adjustment path taken by a system once it departs from its original equilibrium state, the expectations augmented, long-run Phillips Curve is even less equipped to tell us about the adjustment to a change in the rate of inflation when a system is not even in equilibrium to begin with.

The entire discourse of the expectations-augmented, long-run Phillips Curve is completely divorced from the kinds of questions that policy makers in the real world usually have to struggle with – questions like will increasing the rate of inflation of an economy in which there is abnormally high unemployment facilitate or obstruct the adjustment process that takes the economy back to a more normal unemployment rate. The expectations-augmented, long-run Phillips Curve may not be completely irrelevant to the making of economic policy – it is good to know, for example, that if we are trying to figure out which time path of NGDP to aim for, there is no particular reason to think that a time path with a 10% rate of growth of NGDP would probably not generate a significantly lower rate of unemployment than a time path with a 5% rate of growth – but its relationship to reality is sufficiently tenuous that it is irrelevant to any discussion of policy alternatives for economies unless those economies are already close to being in equilibrium.

About Me

David Glasner
Washington, DC

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

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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