Archive for the 'Scott Sumner' Category

Sumner on the Demand for Money, Interest Rates and Barsky and Summers

Scott Sumner had two outstanding posts a couple of weeks ago (here and here) discussing the relationship between interest rates and NGDP, making a number of important points, which I largely agree with, even though I have some (mostly semantic) quibbles about the details. I especially liked how in the second post he applied the analysis of Robert Barsky and Larry Summers in their article about Gibson’s Paradox under the gold standard to recent monetary experience. The two posts are so good and cover such a wide range of topics that the best way for me to address them is by cutting and pasting relevant passages and commenting on them.

Scott begins with the equation of exchange MV = PY. I personally prefer the Cambridge version (M = kPY) where k stands for the fraction of income that people hold as cash, thereby making it clear that the relevant concept is how much money want to hold, not that mysterious metaphysical concept called the velocity of circulation V (= 1/k). With attention focused on the decision about how much money to hold, it is natural to think of the rate of interest as the opportunity cost of holding non-interest-bearing cash balances. When the rate of interest rate rises, the desired holdings of non-interest-bearing cash tend to fall; in other words k falls (and V rises). With unchanged M, the equation is satisfied only if PY increases. So the notion that a reduction in interest rates, in and of itself, is expansionary is based on a misunderstanding. An increase in the amount of money demanded is always contractionary. A reduction in interest rates increases the amount of money demanded (if money is non-interest-bearing). A reduction in interest rates is therefore contractionary (all else equal).

Scott suggests some reasons why this basic relationship seems paradoxical.

Sometimes, not always, reductions in interest rates are caused by an increase in the monetary base. (This was not the case in late 2007 and early 2008, but it is the case on some occasions.) When there is an expansionary monetary policy, specifically an exogenous increase in M, then when interest rates fall, V tends to fall by less than M rises. So the policy as a whole causes NGDP to rise, even as the specific impact of lower interest rates is to cause NGDP to fall.

To this I would add that, as discussed in my recent posts about Keynes and Fisher, Keynes in the General Theory seemed to be advancing a purely monetary theory of the rate of interest. If Keynes meant that the rate of interest is determined exclusively by monetary factors, then a falling rate of interest is a sure sign of an excess supply of money. Of course in the Hicksian world of IS-LM, the rate of interest is simultaneously determined by both equilibrium in the money market and an equilibrium rate of total spending, but Keynes seems to have had trouble with the notion that the rate of interest could be simultaneously determined by not one, but two, equilibrium conditions.

Another problem is the Keynesian model, which hopelessly confuses the transmission mechanism. Any Keynesian model with currency that says low interest rates are expansionary is flat out wrong.

But if Keynes believed that the rate of interest is exclusively determined by money demand and money supply, then the only possible cause of a low or falling interest rate is the state of the money market, the supply side of which is always under the control of the monetary authority. Or stated differently, in the Keynesian model, the money-supply function is perfectly elastic at the target rate of interest, so that the monetary authority supplies whatever amount of money is demanded at that rate of interest. I disagree with the underlying view of what determines the rate of interest, but given that theory of the rate of interest, the model is not incoherent and doesn’t confuse the transmission mechanism.

That’s probably why economists were so confused by 2008. Many people confuse aggregate demand with consumption. Thus they think low rates encourage people to “spend” and that this n somehow boosts AD and NGDP. But it doesn’t, at least not in the way they assume. If by “spend” you mean higher velocity, then yes, spending more boosts NGDP. But we’ve already seen that lower interest rates don’t boost velocity, rather they lower velocity.

But, remember that Keynes believed that the interest rate can be reduced only by increasing the quantity of money, which nullifies the contractionary effect of a reduced interest rate.

Even worse, some assume that “spending” is the same as consumption, hence if low rates encourage people to save less and consume more, then AD will rise. This is reasoning from a price change on steroids! When you don’t spend you save, and saving goes into investment, which is also part of GDP.

But this is reasoning from an accounting identity. The question is what happens if people try to save. The Keynesian argument is that the attempt to save will be self-defeating; instead of increased saving, there is reduced income. Both scenarios are consistent with the accounting identity. The question is which causal mechanism is operating? Does an attempt to increase saving cause investment to increase, or does it cause income to go down? Seemingly aware of the alternative scenario, Scott continues:

Now here’s were amateur Keynesians get hopelessly confused. They recall reading something about the paradox of thrift, about planned vs. actual saving, about the fact that an attempt to save more might depress NGDP, and that in the end people may fail to save more, and instead NGDP will fall. This is possible, but even if true it has no bearing on my claim that low rates are contractionary.

Just so. But there is not necessarily any confusion; the issue may be just a difference in how monetary policy is implemented. You can think of the monetary authority as having a choice in setting its policy in terms of the quantity of the monetary base, or in terms of an interest-rate target. Scott characterizes monetary policy in terms of the base, allowing the interest rate to adjust; Keynesians characterize monetary policy in terms of an interest-rate target, allowing the monetary base to adjust. The underlying analysis should not depend on how policy is characterized. I think that this is borne out by Scott’s next paragraph, which is consistent with a policy choice on the part of the Keynesian monetary authority to raise interest rates as needed to curb aggregate demand when aggregate demand is excessive.

To see the problem with this analysis, consider the Keynesian explanations for increases in AD. One theory is that animal spirits propel businesses to invest more. Another is that consumer optimism propels consumers to spend more. Another is that fiscal policy becomes more expansionary, boosting the budget deficit. What do all three of these shocks have in common? In all three cases the shock leads to higher interest rates. (Use the S&I diagram to show this.) Yes, in all three cases the higher interest rates boost velocity, and hence ceteris paribus (i.e. fixed monetary base) the higher V leads to more NGDP. But that’s not an example of low rates boosting AD, it’s an example of some factor boosting AD, and also raising interest rates.

In the Keynesian terminology, the shocks do lead to higher rates, but only because excessive aggregate demand, caused by animal spirits, consumer optimism, or government budget deficits, has to be curbed by interest-rate increases. The ceteris paribus assumption is ambiguous; it can be interpreted to mean holding the monetary base constant or holding the interest-rate target constant. I don’t often cite Milton Friedman as an authority, but one of his early classic papers was “The Marshallian Demand Curve” in which he pointed out that there is an ambiguity in what is held constant along the demand curve: prices of other goods or real income. You can hold only one of the two constant, not both, and you get a different demand curve depending on which ceteris paribus assumption you make. So the upshot of my commentary here is that, although Scott is right to point out that the standard reasoning about how a change in interest rates affects NGDP implicitly assumes that the quantity of money is changing, that valid point doesn’t refute the standard reasoning. There is an inherent ambiguity in specifying what is actually held constant in any ceteris paribus exercise. It’s good to make these ambiguities explicit, and there might be good reasons to prefer one ceteris paribus assumption over another, but a ceteris paribus assumption isn’t a sufficient basis for rejecting a model.

Now just to be clear, I agree with Scott that, as a matter of positive economics, the interest rate is not fully under the control of the monetary authority. And one reason that it’s not  is that the rate of interest is embedded in the entire price system, not just a particular short-term rate that the central bank may be able to control. So I don’t accept the basic Keynesian premise that monetary authority can always make the rate of interest whatever it wants it to be, though the monetary authority probably does have some control over short-term rates.

Scott also provides an analysis of the effects of interest on reserves, and he is absolutely correct to point out that paying interest on reserves is deflationary.

I will just note that near the end of his post, Scott makes a comment about living “in a Ratex world.” WADR, I don’t think that ratex is at all descriptive of reality, but I will save that discussion for another time.

Scott followed up the post about the contractionary effects of low interest rates with a post about the 1988 Barsky and Summers paper.

Barsky and Summers . . . claim that the “Gibson Paradox” is caused by the fact that low interest rates are deflationary under the gold standard, and that causation runs from falling interest rates to deflation. Note that there was no NGDP data for this period, so they use the price level rather than NGDP as their nominal indicator. But their basic argument is identical to mine.

The Gibson Paradox referred to the tendency of prices and interest rates to be highly correlated under the gold standard. Initially some people thought this was due to the Fisher effect, but it turns out that prices were roughly a random walk under the gold standard, and hence the expected rate of inflation was close to zero. So the actual correlation was between prices and both real and nominal interest rates. Nonetheless, the nominal interest rate is the key causal variable in their model, even though changes in that variable are mostly due to changes in the real interest rate.

Since gold is a durable good with a fixed price, the nominal interest rate is the opportunity cost of holding that good. A lower nominal rate tends to increase the demand for gold, for both monetary and non-monetary purposes.  And an increased demand for gold is deflationary (and also reduces NGDP.)

Very insightful on Scott’s part to see the connection between the Barsky and Summers analysis and the standard theory of the demand for money. I had previously thought about the Barsky and Summers discussion simply as a present-value problem. The present value of any durable asset, generating a given expected flow of future services, must vary inversely with the interest rate at which those future services are discounted. Since the future price level under the gold standard was expected to be roughly stable, any change in nominal interest rates implied a change in real interest rates. The value of gold, like other durable assets, varied inversely with nominal interest rate. But with the nominal value of gold fixed by the gold standard, changes in the value of gold implied a change in the price level, an increased value of gold being deflationary and a decreased value of gold inflationary. Scott rightly observes that the same idea can be expressed in the language of monetary theory by thinking of the nominal interest rate as the cost of holding any asset, so that a reduction in the nominal interest rate has to increase the demand to own assets, because reducing the cost of holding an asset increases the demand to own it, thereby raising its value in exchange, provided that current output of the asset is small relative to the total stock.

However, the present-value approach does have an advantage over the opportunity-cost approach, because the present-value approach relates the value of gold or money to the entire term structure of interest rates, while the opportunity-cost approach can only handle a single interest rate – presumably the short-term rate – that is relevant to the decision to hold money at any given moment in time. In simple models of the IS-LM ilk, the only interest rate under consideration is the short-term rate, or the term-structure is assumed to have a fixed shape so that all interest rates are equally affected by, or along with, any change in the short-term rate. The latter assumption of course is clearly unrealistic, though Keynes made it without a second thought. However, in his Century of Bank Rate, Hawtrey showed that between 1844 and 1938, when the gold standard was in effect in Britain (except 1914-25 and 1931-38) short-term rates and long-term rates often moved by significantly different magnitudes and even in opposite directions.

Scott makes a further interesting observation:

The puzzle of why the economy does poorly when interest rates fall (such as during 2007-09) is in principle just as interesting as the one Barsky and Summers looked at. Just as gold was the medium of account during the gold standard, base money is currently the medium of account. And just as causation went from falling interest rates to higher demand for gold to deflation under the gold standard, causation went from falling interest rates to higher demand for base money to recession in 2007-08.

There is something to this point, but I think Scott may be making too much of it. Falling interest rates in 2007 may have caused the demand for money to increase, but other factors were also important in causing contraction. The problem in 2008 was that the real rate of interest was falling, while the Fed, fixated on commodity (especially energy) prices, kept interest rates too high given the rapidly deteriorating economy. With expected yields from holding real assets falling, the Fed, by not cutting interest rates any further between April and October of 2008, precipitated a financial crisis once inflationary expectations started collapsing in August 2008, the expected yield from holding money dominating the expected yield from holding real assets, bringing about a pathological Fisher effect in which asset values had to collapse for the yields from holding money and from holding assets to be equalized.

Under the gold standard, the value of gold was actually sensitive to two separate interest-rate effects – one reflected in the short-term rate and one reflected in the long-term rate. The latter effect is the one focused on by Barsky and Summers, though they also performed some tests on the short-term rate. However, it was through the short-term rate that the central bank, in particular the Bank of England, the dominant central bank during in the pre-World War I era, manifested its demand for gold reserves, raising the short-term rate when it was trying to accumulate gold and reducing the short-term rate when it was willing to reduce its reserve holdings. Barsky and Summers found the long-term rate to be more highly correlated with the price level than the short-term rate. I conjecture that the reason for that result is that the long-term rate is what captures the theoretical inverse relationship between the interest rate and the value of a durable asset, while the short-term rate would be negatively correlated with the value of gold when (as is usually the case) it moves together with the long-term rate but may sometimes be positively correlated with the value of gold (when the central bank is trying to accumulate gold) and thereby tightening the world market for gold. I don’t know if Barsky and Summers ran regressions using both long-term and short-term rates, but using both long-term and short-term rates in the same regression might have allowed them to find evidence of both effects in the data.

PS I have been too busy and too distracted of late to keep up with comments on earlier posts. Sorry for not responding promptly. In case anyone is still interested, I hope to respond to comments over the next few days, and to post and respond more regularly than I have been doing for the past few weeks.

The Free Market Economy Is Awesome and Fragile

Scott Sumner’s three most recent posts (here, here, and here)have been really great, and I’ld like to comment on all of them. I will start with a comment on his post discussing whether the free market economy is stable; perhaps I will get around to the other two next week. Scott uses a 2009 paper by Robert Hetzel as the starting point for his discussion. Hetzel distinguishes between those who view the stabilizing properties of price adjustment as being overwhelmed by real instabilities reflecting fluctuations in consumer and entrepreneurial sentiment – waves of optimism and pessimism – and those who regard the economy as either perpetually in equilibrium (RBC theorists) or just usually in equilibrium (Monetarists) unless destabilized by monetary shocks. Scott classifies himself, along with Hetzel and Milton Friedman, in the latter category.

Scott then brings Paul Krugman into the mix:

Friedman, Hetzel, and I all share the view that the private economy is basically stable, unless disturbed by monetary shocks. Paul Krugman has criticized this view, and indeed accused Friedman of intellectual dishonesty, for claiming that the Fed caused the Great Depression. In Krugman’s view, the account in Friedman and Schwartz’s Monetary History suggests that the Depression was caused by an unstable private economy, which the Fed failed to rescue because of insufficiently interventionist monetary policies. He thinks Friedman was subtly distorting the message to make his broader libertarian ideology seem more appealing.

This is a tricky topic for me to handle, because my own view of what happened in the Great Depression is in one sense similar to Friedman’s – monetary policy, not some spontaneous collapse of the private economy, was what precipitated and prolonged the Great Depression – but Friedman had a partial, simplistic and distorted view of how and why monetary policy failed. And although I believe Friedman was correct to argue that the Great Depression did not prove that the free market economy is inherently unstable and requires comprehensive government intervention to keep it from collapsing, I think that his account of the Great Depression was to some extent informed by his belief that his own simple k-percent rule for monetary growth was a golden bullet that would ensure economic stability and high employment.

I’d like to first ask a basic question: Is this a distinction without a meaningful difference? There are actually two issues here. First, does the Fed always have the ability to stabilize the economy, or does the zero bound sometimes render their policies impotent?  In that case the two views clearly do differ. But the more interesting philosophical question occurs when not at the zero bound, which has been the case for all but one postwar recession. In that case, does it make more sense to say the Fed caused a recession, or failed to prevent it?

Here’s an analogy. Someone might claim that LeBron James is a very weak and frail life form, whose legs will cramp up during basketball games without frequent consumption of fluids. Another might suggest that James is a healthy and powerful athlete, who needs to drink plenty of fluids to perform at his best during basketball games. In a sense, both are describing the same underlying reality, albeit with very different framing techniques. Nonetheless, I think the second description is better. It is a more informative description of LeBron James’s physical condition, relative to average people.

By analogy, I believe the private economy in the US is far more likely to be stable with decent monetary policy than is the economy of Venezuela (which can fall into depression even with sufficiently expansionary monetary policy, or indeed overly expansionary policies.)

I like Scott’s LeBron James analogy, but I have two problems with it. First, although LeBron James is a great player, he’s not perfect. Sometimes, even he messes up. When he messes up, it may not be his fault, in the sense that, with better information or better foresight – say, a little more rest in the second quarter – he might have sunk the game-winning three-pointer at the buzzer. Second, it’s one thing to say that a monetary shock caused the Great Depression, but maybe we just don’t know how to avoid monetary shocks. LeBron can miss shots, so can the Fed. Milton Friedman certainly didn’t know how to avoid monetary shocks, because his pet k-percent rule, as F. A. Hayek shrewdly observed, was a simply a monetary shock waiting to happen. And John Taylor certainly doesn’t know how to avoid monetary shocks, because his pet rule would have caused the Fed to raise interest rates in 2011 with possibly devastating consequences. I agree that a nominal GDP level target would have resulted in a monetary policy superior to the policy the Fed has been conducting since 2008, but do I really know that? I am not sure that I do. The false promise held out by Friedman was that it is easy to get monetary policy right all the time. It certainly wasn’t the case for Friedman’s pet rule, and I don’t think that there is any monetary rule out there that we can be sure will keep us safe and secure and fully employed.

But going beyond the LeBron analogy, I would make a further point. We just have no theoretical basis for saying that the free-market economy is stable. We can prove that, under some assumptions – and it is, to say the least, debatable whether the assumptions could properly be described as reasonable – a model economy corresponding to the basic neoclassical paradigm can be solved for an equilibrium solution. The existence of an equilibrium solution means basically that the neoclassical model is logically coherent, not that it tells us much about how any actual economy works. The pieces of the puzzle could all be put together in a way so that everything fits, but that doesn’t mean that in practice there is any mechanism whereby that equilibrium is ever reached or even approximated.

Axel Leijonhufvud, who is certainly an admirer of Hayek, addresses the question of the stability of the free-market economy in terms of what he calls a corridor. If you think of an economy moving along a time path, and if you think of the time path that would be followed by the economy if it were operating at a full-employment equilibrium, Leijonjhufvud’s corridor hypothesis is that the actual time path of the economy tends to revert to the equilibrium time path as long as deviations from the equilibrium are kept within certain limits, those limits defining the corridor. However, if the economy, for whatever reasons (exogenous shocks or some other mishaps) leaves the corridor, the spontaneous equilibrating tendencies causing the actual time path to revert back to the equilibrium time path may break down, and there may be no further tendency for the economy to revert back to its equilibrium time path. And as I pointed out recently in my post on Earl Thompson’s “Reformulation of Macroeconomic Theory,” he was able to construct a purely neoclassical model with two potential equilibria, one of which was unstable so that a shock form the lower equilibrium would lead either to a reversion to the higher-level equilibrium or to downward spiral with no endogenous stopping point.

Having said all that, I still agree with Scott’s bottom line: if the economy is operating below full employment, and inflation and interest rates are low, there is very likely a problem with monetary policy.

Scott Sumner Defends EMH

Last week I wrote about the sudden increase in stock market volatility as an illustration of why the efficient market hypothesis (EMH) is not entirely accurate. I focused on the empirical argument made by Robert Shiller that the observed volatility of stock prices is greater than the volatility implied by the proposition that stock prices reflect rational expectations of future dividends paid out by the listed corporations. I made two further points about EMH: a) empirical evidence cited in favor of EMH like the absence of simple trading rules that would generate excess profits and the lack of serial correlation in the returns earned by asset managers is also consistent with theories of asset pricing other than EMH such as Keynes’s casino (beauty contest) model, and b) the distinction between fundamentals and expectations that underlies the EMH model is not valid because expectations are themselves fundamental owing to the potential for expectations to be self-fulfilling.

Scott responded to my criticism by referencing two of his earlier posts — one criticizing the Keynesian beauty contest model, and another criticizing the Keynesian argument that the market can stay irrational longer than any trader seeking to exploit such irrationality can stay solvent – and by writing a new post describing what he called the self-awareness of markets.

Let me begin with Scott’s criticism of the beauty-contest model. I do so by registering my agreement with Scott that the beauty contest model is not a good description of how stocks are typically priced. As I have said, I don’t view EMH as being radically wrong, and in much applied work (including some of my own) it is an extremely useful assumption to make. But EMH describes a kind of equilibrium condition, and not all economic processes can be characterized or approximated by equilibrium conditions.

Perhaps the chief contribution of recent Austrian economics has been to explain how all entrepreneurial activity aims at exploiting latent disequilibrium relationships in the price system. We have no theoretical or empirical basis for assuming that deviations of prices whether for assets for services and whether prices are determined in auction markets or in imperfectly competitive markets that prices cannot deviate substantially from their equilibrium values.  We have no theoretical or empirical basis for assuming that substantial deviations of prices — whether for assets or for services, and whether prices are determined in auction markets or in imperfectly competitive markets — from their equilibrium values are immediately or even quickly eliminated. (Let me note parenthetically that vulgar Austrians who deny that prices voluntarily agreed upon are ever different from equilibrium values thereby undermine the Austrian theory of entrepreneurship based on the equilibrating activity of entrepreneurs which is the source of the profits they earn. The profits earned are ipso facto evidence of disequilibrium pricing. Austrians can’t have it both ways.)

So my disagreement with Scott about the beauty-contest theory of stock prices as an alternative to EMH is relatively small. My main reason for mentioning the beauty-contest theory was not to advocate it but to point out that the sort of empirical evidence that Scott cites in support of EMH is also consistent with the beauty-contest theory. As Scott emphasizes himself, it’s not easy to predict who judges will choose as the winner of the beauty contest. And Keynes also used a casino metaphor to describe stock pricing in same chapter (12) of the General Theory in which he developed the beauty-contest analogy. However, there do seem to be times when prices are rising or falling for extended periods of time, and enough people, observing the trends and guessing that the trends will continue long enough so that they can rely on continuation of the trend in making investment decisions, keep the trend going despite underlying forces that eventually cause a price collapse.

Let’s turn to Scott’s post about the ability of the market to stay irrational longer than any individual trader can stay solvent.

The markets can stay irrational for longer than you can stay solvent.

Thus people who felt that tech stocks were overvalued in 1996, or American real estate was overvalued in 2003, and who shorted tech stocks or MBSs, might go bankrupt before their accurate predictions were finally vindicated.

There are lots of problems with this argument. First of all, it’s not clear that stocks were overvalued in 1996, or that real estate was overvalued in 2003. Lots of people who made those claims later claimed that subsequent events had proven them correct, but it’s not obvious why they were justified in making this claim. If you claim X is overvalued at time t, is it vindication if X later rises much higher, and then falls back to the levels of time t?

I agree with Scott that the argument is problematic; it is almost impossible to specify when a suspected bubble is really a bubble. However, I don’t think that Scott fully comes to terms with the argument. The argument doesn’t depend on the time lag between the beginning of the run-up and the peak; it depends on the unwillingness of most speculators to buck a trend when there is no clear terminal point to the run-up. Scott continues:

The first thing to note is that the term ‘bubble’ implies asset mis-pricing that is easily observable. A positive bubble is when asset prices are clearly irrationally high, and a negative bubble is when asset price are clearly irrationally low. If these bubbles existed, then investors could earn excess returns in a highly diversified contra-bubble fund. At any given time there are many assets that pundits think are overpriced, and many others that are seen as underpriced. These asset classes include stocks, bonds, foreign exchange, REITs, commodities, etc. And even within stocks there are many different sectors, biotech might be booming while oil is plunging. And then you have dozens of markets around the world that respond to local factors. So if you think QE has led Japanese equity prices to be overvalued, and tight money has led Swiss stocks to be undervalued, the fund could take appropriate short positions in Japanese stocks and long positions in Swiss stocks.

A highly diversified mutual fund that takes advantage of bubble mis-pricing should clearly outperform other investments, such as index funds. Or at least it should if the EMH is not true. I happen to think the EMH is true, or at least roughly true, and hence I don’t actually expect to see the average contra-bubble fund do well. (Of course individual funds may do better or worse than average.)

I think that Scott is conflating a couple of questions here: a) is EMH a valid theory of asset prices? b) are asset prices frequently characterized by bubble-like behavior? Even if the answer to b) is no, the answer to a) need not be yes. Investors may be able, by identifying mis-priced assets, to earn excess returns even if the mis-pricing doesn’t meet a threshold level required for identifying a bubble. But the main point that Scott is making is that if there are a lot of examples of mis-pricing out there, it should be possible for astute investors capable of identifying mis-priced assets to diversify their portfolios sufficiently to avoid the problem of staying solvent longer than the market is irrational.

That is a very good point, worth taking into account. But it’s not dispositive and certainly doesn’t dispose of the objection that investors are unlikely to try to bet against a bubble, at least not in sufficient numbers to keep it from expanding. The reason is that the absence of proof is not proof of absence. That of course is a legal, not a scientific, principle, but it expresses a valid common-sense notion, you can’t make an evidentiary inference that something is not the case simply because you have not found evidence that it is the case. So you can’t infer from the non-implementatio of the plausible investment strategies listed by Scott that such strategies would not have generated excess returns if they were implemented. We simply don’t know whether they would be profitable or not.

In his new post Scott makes the following observation about what I had written in my post on excess volatility.

David Glasner seems to feel that it’s not rational for consumers to change their views on the economy after a stock crash. I will argue the reverse, that rationality requires them to do so. First, here’s David:

This seems an odd interpretation of what I had written because in the passage quoted by Scott I wrote the following:

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs?

So, like Scott, I am saying that it is rational for people to revise their expectations based on new information that there has been a stock crash. I guess what Scott meant to say is that my argument, while valid, is not an argument against EMH, because the scenario I am describing is consistent with EMH. But that is not the case. Scott goes on to provide his own example.

All citizens are told there’s a jar with lots of jellybeans locked away in a room. That’s all they know. The average citizen guesstimates there are 453 jellybeans in this mysterious jar. Now 10,000 citizens are allowed in to look at the jar. They each guess the contents, and their average guess is 761 jellybeans. This information is reported to the other citizens. They revise their estimate accordingly.

But there’s a difference between my example and Scott’s. In my example, the future course of the economy depends on whether people are optimistic or pessimistic. In Scott’s example, the number of jellybeans in the jar is what it is regardless of what people expect it to be. The problem with EMH is that it presumes that there is some criterion of efficiency that is independent of expectations, just as in Scott’s example there is objective knowledge out there of the number of jellybeans in the jar. I claim that there is no criterion of market efficiency that is independent of expectations, even though some expectations may produce better outcomes than those produced by other expectations.

Economic Prejudice and High-Minded Sloganeering

In a post yesterday commenting on Paul Krugman’s takedown of a silly and ignorant piece of writing about monetary policy by William Cohan, Scott Sumner expressed his annoyance at the level of ignorance displayed people writing for supposedly elite publications like the New York Times which published Cohan’s rant about how it’s time for the Fed to show some spine and stop manipulating interest rates. Scott, ever vigilant, noticed that another elite publication the Financial Times published an equally silly rant by Avinah Persaud exhorting the Fed to show steel and raise rates.

Scott focused on one particular example of silliness about the importance of raising interest rates ASAP notwithstanding the fact that the Fed has failed to meet its 2% inflation target for something like 39 consecutive months:

Yet monetary policy cannot confine itself to reacting to the latest inflation data if it is to promote the wider goals of financial stability and sustainable economic growth. An over-reliance on extremely accommodative monetary policy may be one of the reasons why the world has not escaped from the clutches of a financial crisis that began more than eight years ago.

Scott deftly skewers Persaud with the following comment:

I suppose that’s why the eurozone economy took off after 2011, while the US failed to grow.  The ECB avoided our foolish QE policies, and “showed steel” by raising interest rates twice in the spring of 2011.  If only we had done the same.

But Scott allowed the following bit of nonsense on Persaud’s part to escape unscathed (I don’t mean to be critical of Scott, there’s only so much nonsense that any single person be expected to hold up to public derision):

The slowdown in the Chinese economy has its roots in decisions made far from Beijing. In the past five years, central banks in all the big advanced economies have embarked on huge quantitative easing programmes, buying financial assets with newly created cash. Because of the effect they have on exchange rates, these policies have a “beggar-thy-neighbour” quality. Growth has been shuffled from place to place — first the US, then Europe and Japan — with one country’s gains coming at the expense of another. This zero-sum game cannot launch a lasting global recovery. China is the latest loser. Last week’s renminbi devaluation brought into focus that since 2010, China’s export-driven economy has laboured under a 25 per cent appreciation of its real effective exchange rate.

The effect of quantitative easing on exchange rates is not the result of foreign-exchange-market intervention; it is the result of increasing the total quantity of base money. Expanding the monetary base reduces the value of the domestic currency unit relative to foreign currencies by raising prices in terms of the domestic currency relative to prices in terms of foreign currencies. There is no beggar-thy-neighbor effect from monetary expansion of this sort. And even if exchange-rate depreciation were achieved by direct intervention in the foreign-exchange markets, the beggar-thy-neighbor effect would be transitory as prices in terms of domestic and foreign currencies would adjust to reflect the altered exchange rate. As I have explained in a number of previous posts on currency manipulation (e.g., here, here, and here) relying on Max Corden’s contributions of 30 years ago on the concept of exchange-rate protection, a “beggar-thy-neighbor” effect is achieved only if there is simultaneous intervention in foreign-exchange markets to reduce the exchange rate of the domestic currency combined with offsetting open-market sales to contractnot expand – the monetary base (or, alternatively, increased reserve requirements to increase the domestic demand to hold the monetary base). So the allegation that quantitative easing has any substantial “beggar-thy-nation” effect is totally without foundation in economic theory. It is just the ignorant repetition of absurd economic prejudices dressed up in high-minded sloganeering about “zero-sum games” and “beggar-thy-neighbor” effects.

And while the real exchange rate of the Chinese yuan may have increased by 25% since 2010, the real exchange rate of the dollar over the same period in which the US was allegedly pursuing a beggar thy nation policy increased by about 12%. The appreciation of the dollar reflects the relative increase in the strength of the US economy over the past 5 years, precisely the opposite of a beggar-thy-neighbor strategy.

And at an intuitive level, it is just absurd to think that China would have been better off if the US, out of a tender solicitude for the welfare of Chinese workers, had foregone monetary expansion, and allowed its domestic economy to stagnate totally. To whom would the Chinese have exported in that case?

Excess Volatility Strikes Again

Both David Henderson and Scott Sumner had some fun with this declaration of victory on behalf of Austrian Business Cycle Theory by Robert Murphy after the recent mini-stock-market crash.

As shocking as these developments [drops in stock prices and increased volatility] may be to some analysts, those versed in the writings of economist Ludwig von Mises have been warning for years that the Federal Reserve was setting us up for another crash.

While it’s always tempting to join in the fun of mocking ABCT, I am going to try to be virtuous and resist temptation, and instead comment on a different lesson that I would draw from the recent stock market fluctuations.

To do so, let me quote from Scott’s post:

Austrians aren’t the only ones who think they have something useful to say about future trends in asset prices. Keynesians and others also like to talk about “bubbles”, which I take as an implied prediction that the asset will do poorly over an extended period of time. If not, what exactly does “bubble” mean? I think this is all foolish; assume the Efficient Markets Hypothesis is roughly accurate, and look for what markets are telling us about policy.

I agree with Scott that it is nearly impossible to define “bubble” in an operational ex ante way. And I also agree that there is much truth in the Efficient Market Hypothesis and that it can be a useful tool in making inferences about the effects of policies as I tried to show a few years back in this paper. But I also think that there are some conceptual problems with EMH that Scott and others don’t take as seriously as they should. Scott believes that there is powerful empirical evidence that supports EMH. Responding to Murphy’s charge that EMH is no more falsifiable than ABCT, Scott replied:

The EMH is most certainly “falsifiable.”  It’s been tested in many ways.  Some people even claim that it has been falsified, although I’m not convinced.  In the tests that I think are the most relevant the EMH comes out ahead.  (Stocks respond immediately to news, stocks follow roughly a random walk, indexed funds outperformed managed funds, excess returns are not serially correlated, or not enough to profit from, etc., etc.)

A few comments come to mind.

First, Nobel laureate Robert Shiller was awarded the prize largely for work showing that stock prices exhibit excess volatility. The recent sharp fall in stock prices followed by a sharp rebound raise the possibility that stock prices have been fluctuating for reasons other than the flow of new publicly available information, which, according to EMH, is what determines stock prices. Shiller’s work is not necessarily definitive, so it’s possible to reconcile EMH with observed volatility, but I think that there are good reasons for skepticism.

Second, there are theories other than EMH that predict or are at least consistent with stock prices following a random walk. A good example is Keynes’s discussion of the stock exchange in chapter 12 of the General Theory in which Keynes actually formulated a version of EMH, but rejected it based on his intuition that investors focused on “fundamentals” would not have the capital resources to finance their positions when, for whatever reason, market sentiment turns against them. According to Keynes, picking stocks is like guessing who will win a beauty contest. You can guess either by forming an opinion about the most beautiful contestant or by guessing who the judges will think is the most beautiful. Forming an opinion about who is the most beautiful is like picking stocks based on fundamentals or EMH, guessing who the judges will think is most beautiful is like picking stocks based on predicting market sentiment (Keynesian theory). EMH and the Keynesian theory are totally contrary to each other, but it’s not clear to me that any of the tests mentioned by Scott (random fluctuations in stock prices, index funds outperforming managed funds, excess returns not serially correlated) is inconsistent with the Keynesian theory.

Third, EMH presumes that there is a direct line of causation running from “fundamentals” to “expectations,” and that expectations are rationally inferred from “fundamentals.” That neat conceptual dichotomy between objective fundamentals and rational expectations based on fundamentals presumes that fundamentals are independent of expectations. But that is clearly false. The state of expectations is itself fundamental. Expectations can be and often are self-fulfilling. That is a commonplace observation about social interactions. The nature and character of many social interactions depends on the expectations with which people enter into those interactions.

I may hold a very optimistic view about the state of the economy today. But suppose that I wake up tomorrow and hear that the Shanghai stock market crashes, going down by 30% in one day. Will my expectations be completely independent of my observation of falling asset prices in China? Maybe, but what if I hear that S&P futures are down by 10%? If other people start revising their expectations, will it not become rational for me to change my own expectations at some point? How can it not be rational for me to change my expectations if I see that everyone else is changing theirs? If people are becoming more pessimistic they will reduce their spending, and my income and my wealth, directly or indirectly, depend on how much other people are planning to spend. So my plans have to take into account the expectations of others.

An equilibrium requires consistent expectations among individuals. If you posit an exogenous change in the expectations of some people, unless there is only one set of expectations that is consistent with equilibrium, the exogenous change in the expectations of some may very well imply a movement toward another equilibrium with a set of expectations from the set characterizing the previous equilibrium. There may be cases in which the shock to expectations is ephemeral, expectations reverting to what they were previously. Perhaps that was what happened last week. But it is also possible that expectations are volatile, and will continue to fluctuate. If so, who knows where we will wind up? EMH provides no insight into that question.

I started out by saying that I was going to resist the temptation to mock ABCT, but I’m afraid that I must acknowledge that temptation has got the better of me. Here are two charts: the first shows the movement of gold prices from August 2005 to August 2015, the second shows the movement of the S&P 500 from August 2005 to August 2015. I leave it to readers to decide which chart is displaying the more bubble-like price behavior.

Why Theories of National Income Based on Accounting Identities Are Nonsensical and Error-Ridden, Part II

In this installment of my series on Richard Lipsey’s essay “The Foundations of the Theory of National Income,” I am going to focus on a single issue: what inferences about reality are deducible from a definition about the meaning of the terms used in a scientific theory? In my first installment I listed seven common statements about the basic Keynesian income-expenditure model that are found in most textbooks. The first concerned the confusion between the equality of investment and saving (or between income and expenditure) as an equilibrium condition and a definitional identity. Interpreting the equality of savings and investment as an identity essentially means collapsing the entire model onto the 45-degree line and arbitrarily choosing some point on the 45-degree line as the solution of the model.

That nonsensical interpretation of the simple Keynesian cross is obviously unsatisfactory, so, in an effort to save both the definitional identity of savings and investment and the equality of investment and savings as an equilibrium condition, the textbooks have introduced a distinction between ex ante and ex post in which savings and investment are defined to be identically equal ex post, but planned (ex ante) savings may differ from planned (ex ante) investment, their equality being the condition for equilibrium.

Now, to be fair, it is perfectly legitimate to define an equilibrium in terms of plan consistency, and to say that the inconsistency of the plans occasions a process of readjustment in the plans, and that it is the readjustment in the plans which leads to a new equilibrium. The problem with the textbook treatment is that it draws factual inferences about the adjustment process to a disequilibrium in which planned saving is not equal to planned investment from the definitional identity between ex post savings and ex post investment. In particular, the typical textbook treatment infers that in a disequilibrium with planned savings not equal to planned investment, the adjustment process is characterized by unplanned positive or negative investment (inventory accumulation or decumulation) corresponding to the gap between planned savings and planned investment. Identifying a gap between planned saving and planned investment with unplanned inventory accumulation or decumulation, as textbook treatments of the income expenditure model typically do, is logically unfounded.

Again, I want to be careful, I am not saying that unplanned inventory accumulation or decumulation could not occur in response to a difference gap between planned savings and planned investment, or even that such unplanned inventory accumulation or decumulation is unlikely to occur. What I am saying is that the definitional identity between ex post savings and ex post investment does not imply that such inventory accumulation or decumulation takes place and certainly not that the amount by which inventories change is necessarily equal to the gap between planned savings and planned investment.

Richard Lipsey made the key point in his comment on my previous post:

The main issue in this whole discussion is, I think, can we use a definitional identity to rule out an imaginable state of the universe. The answer is “No”, which is why Keynes was wrong. The definitional identity of S ≡ I tells us nothing about what will happen if agents wish to save a different amount from what agents wish to invest.

Here is how Lipsey put it in his 1972 essay:

The error in this interpretation lies in the belief that the identity EY can tell us what can and cannot happen in the world. If it were possible that a definitional identity could rule out certain imaginable events, then such a definitional identity would be an informative statement having empirical content! If it is a genuine definitional identity (which follows from our use of words and is compatible with all states of the universe) then it is only telling us that we are using E and Y to refer to the same thing, and this statement no more allows us to place restrictions on what happens in the world than does the statement that we are not using E and Y to refer to the same thing.

Lipsey illustrated the problem using the simple Keynesian cross diagram. To make the discussion a bit easier to follow, I am going to refer to my own slightly altered version (using a specific numerical example) of the familiar diagram. Setting investment (I) equal to 100 and assuming the following consumption function

C = 25 + .5Y

We can easily solve for an equilibrium income of 250 corresponding to the intersection of the expenditure function with the 45-degree line.

What happens if we posit that the system is at a disequilibrium point, say Y = 400. The usual interpretation is that at Y = 400, planned (ex ante) investment is less than savings and planned (ex ante) expenditure is less than income. Because, actual (ex post) investment is identically equal to savings and because actual (ex post) expenditure is identically equal to income, unplanned investment must occur to guarantee that the investment-savings identity is satisfied. The amount of unplanned investment is shown on the graph as the vertical distance between the expenditure function (E(Y)) at Y = 400 and the 45-degree line at Y = 400. This distance is shown in my diagram as the vertical distance between the points a and b on the diagram, and it is easy to check that the distance corresponds to a value of 75.

So the basic textbook interpretation of the Keynesian cross is using the savings-investment identity to derive a proposition about the behavior of the economy in disequilibrium. It is saying that an economy in disequilibrium with planned investment less than planned savings adjusts to the disequilibrium through unplanned inventory accumulation (unplanned investment) that exactly matches the difference between planned saving and planned investment. But it is logically impossible for a verbal identity (between savings and investment) — an identity that can never be violated in any actual state of the world — to give us any information about what actually happens in the world, because whatever happens in the world, the identity will always be satisfied.

Recall erroneous propositions 2, 3 and 4, listed in part I of this series:

2 Although people may try to save different amounts from what people try to invest, savings can’t be different from investment; realized (ex post) savings necessarily always equals realized (ex post) investment.

3 Out of equilibrium, planned savings do not equal planned investment, so it follows from (2) that someone’s plans are being disappointed, and there must be either unplanned savings or dissavings, or unplanned investment or disinvestment

4 The simultaneous fulfilment of the plans of savers and investors occurs only when income is at its equilibrium level just as the plans of buyers and sellers can be simultaneously fulfilled only at the equilibrium price.

If realized (ex post) savings necessarily always equals realized (ex post) investment, that equality is the result of how we have chosen to define those terms, not because of people actually are behaving, e.g., by unwillingly accumulating inventories or failing to save as much as they had intended to. However people behave, the identity between savings and investment will be satisfied. And whether savers and investors are able to fulfill their plans or are unable to do so cannot possibly be inferred from a definition that says that savings and investment mean the same thing.

In several of his comments on my recent posts, Scott Sumner has cited the professional consensus that savings and investment are defined to be equal. I am not so sure that there is really a consensus on that point, because I don’t think that most economists have thought carefully about what the identity actually means. But even if there is a consensus that savings is identical to investment, no empirical implication follows from that definition. But typical textbook expositions, and I think even Scott himself when he is not being careful, do use the savings-investment identity to make inferences about what actually happens in the real world.

In the next installment, I will go through a numerical example that shows, based on a simple lagged adjustment between consumption and income (household consumption in this period being a function of income in the previous period), that planned savings and planned investment can be realized and unequal in the transition from one equilibrium to another.

PS I apologize for having been unable to respond to a number of comments to previous posts. I will try to respond in the next day or two.

Savings and Investment Aren’t the Same Thing and There’s No Good Reason to Define them as Such

Scott Sumner responded to my previous post criticizing his use of the investment-savings identity in a post on the advantages NGDI over NGDP, and to my posts from three years ago criticizing him for relying on the savings-investment identity. Scott remains unpersuaded by my criticism. I want to understand why my criticism appears so ineffective, so I’m going to try to understand Scott’s recent response, which begins by referring to economics textbooks. Since it is well documented that economics textbooks consistently misuse the savings-investment identity, it would not be surprising to find out that the textbooks disagree with my position (though Scott doesn’t actually cite chapter and verse).

Economics textbooks define savings as being equal to investment:

S = I

To say that something is equal to investment doesn’t seem to me to be much of a definition of whatever that something is. So Scott elaborates on the definition.

This means savings is defined as the funds used for investment.

OK, savings are the funds used for investment. Does that mean that savings and investment are identical? Savings are funds accruing (unconsumed income measured in dollars per unit time); investments are real physical assets produced per unit time, so they obviously are not identical physical entities. So it is not self-evident – at least not to me — how the funds for investment can be said to be identical to investment itself. The two don’t seem to be self-evidently identical to Scott either, because he invokes another identity.

It’s derived from another identity, which says that in a closed economy with no government, gross domestic product equals gross domestic income:

GDI = C + S = C + I = GDP

Bill Woolsey in a post commenting on my post and Scott’s earlier post to which I responded attempts to explain why these two flows are identical:

In a closed private economy, saving must equal investment. This is a matter of definition. Saving is defined as income less consumption. All output is defined as either being consumer goods or capital goods. Consumption is spending on consumer goods and investment is spending on capital goods. All expenditure is either on consumer goods or capital goods. Since income equals expenditure, and consumption is itself, then income less consumption must equal expenditure less consumption. By the definition of saving and investment, saving and investment are always equal.

I guess someone might think that is all insightful, but it comes down to saying that purchases equals sales.

Bill is very careful in saying that savings is defined as income less consumption, and all output is defined as either being consumer goods or capital goods, and all consumption is (presumably also by definition) spending (aka expenditure) on consumer goods and investment is spending (aka expenditure) on capital goods. So all expenditures are made either on consumer goods or on capital goods. Then Bill concludes that by the definition of savings and investment, savings and investment are always equal (identical), because consumption is itself and income equals expenditure. But Bill does not say why income equals expenditure. Is it because income and expenditure are identical? But, as I just pointed out, it is not self-evident that income (defined as the earnings accruing to households per unit time) and expenditure (defined as the revenues accruing to business firms in payment for final output produced per unit time) are identical.

Now perhaps Bill (no doubt with Scott’s concurrence) is willing to define expenditure as being equal to income, but why is it necessary to define income and expenditure, which don’t obviously refer to the same thing, as being equal by definition? I mean we know that the Morningstar is Venus, but that identity was not established by definition, but by empirical observation. What observation establishes that income (the earnings of factors of production per unit time) and expenditure (revenues accruing to business firms for output sold per unit time) are identical? As Scott has himself noted on numerous occasions, measured NGDI can differ and has frequently differed substantially from measured NGDP.

It is certainly true that we are talking about a circular flow: expenditure turns into income and income into expenditure. Expenditures by households and by business firms for the final output produced by business firms generate the incomes paid by business firms to households and the income paid to households provides the wherewithal for households to pay for final output. But that doesn’t mean that income is identical to expenditure. Chickens generate eggs and eggs generate chickens. That doesn’t mean that a chicken is identical to an egg.

Then Scott addresses my criticism:

David Glasner doesn’t like these definitions, but for some reason that I haven’t been able to figure out he doesn’t say that he doesn’t like the definitions, but rather he claims they are wrong. But the economics profession is entitled to define terms as they wish; there is no fact of the matter. In contrast, Glasner suggests that my claim is only true as some sort of equilibrium condition:

It’s not a question of liking or not liking, but one ought to be parsimonious in choosing definitions. Is there any compelling reason to insist on defining expenditure to be the same as income? On the contrary, as far as I can tell, there is a decent prima facie case to be made that expenditure and income refer to distinct entities, and are not just different names for the same entity. Perhaps there is some theoretical advantage to defining expenditure and income to be the same thing. If so, I have yet to hear what it is. On the contrary, there is a huge theoretical disadvantage to defining income and expenditure to be identical: doing so makes the Keynesian income-expenditure model unintelligible. Come to think of it, perhaps Scott, a self-described hater of the Keynesian cross, likes that definition. But even if you hate a model, you should try to make it as good and as coherent as possible, before rejecting it. This post is already getting too long, so I will save for a separate post a discussion of why defining income and expenditure to be identical makes the Keynesian income-expenditure model, and the loanable funds doctrine, too, for that matter. For now, let me just say that if you insist that the savings-investment equality (or alternatively the income-expenditure equality) is an identity rather than an equilibrium condition, you have drained all the explanatory content out of your model.

Scott objects to this statement from my previous post:

Scott begins by discussing the simplest version of the income-expenditure model (aka the Keynesian cross or 45-degree model), while treating it, as did Keynes, as if it were interchangeable with the national-accounting identities:

In the standard national income accounting, gross domestic income equals gross domestic output. In the simplest model of all (with no government or trade) you have the following identity:

NGDI = C + S = C + I = NGDP (it also applies to RGDI and RGDP)

Because these two variables are identical, any model that explains one will, ipso facto, explain the other.

Here is Scott’s response:

David’s characterization of my views is simply incorrect. And it’s easy to explain why. I hate the Keynesian cross, and think it’s a lousy model, and yet I have no problem with the national income identities, and believe they occasionally help to clarify thinking. The quote he provides does not in any way “discuss” the Keynesian cross model, just as mentioning MV=PY would not be “discussing” the Quantity Theory of Money.

OK, I believe Scott when he says that he’s not a fan of the Keynesian cross, but it was Scott who brought up consumption smoothing in response to a decline in aggregate demand caused by central bank policy. Consumption smoothing is a neo-classical revision of the Keynesian consumption function, so I was just trying to put Scott’s ideas into the context of a familiar model that utilizes the equality of savings and investment to determine equilibrium income. My point was that Scott was positing a decrease in saving and asserting, by way of the savings-investment identity, that investment would necessarily drop by the same amount that saving had dropped. My response was that the savings-investment identity does not allow you to infer by how much investment falls in response to an assumed decrease in savings, because savings and investment are mutually determined within a macroeconomic model. It doesn’t have to be the Keynesian cross, but you need more than an accounting identity and an assumption that savings falls by x to determine what happens to investment.

Scott then makes the following point.

[I]t seems to me that David should not be focusing on me, but the broader profession. If economics textbooks define S=I as an identity, then it’s clear that I’m right. Whether they should define it as an identity is an entirely different question. I happen to think it makes sense, but I could certainly imagine David or anyone else having a different view.

If I am focusing on Scott rather than the broader profession, that simply shows how much more closely I pay attention to Scott than to the broader profession. In this particular case, I think Scott is manifesting a problem that sadly is very widely shared within the broader profession. Second, that Scott shares a problem with the rest of the profession does not establish that Scott is right in the sense that there is any good reason for the profession to have latched on to the savings-investment identity.

In response to my reference to posts from three years ago criticizing him for relying on the savings-investment identity, Scott writes:

I have never in my entire life made any sort of causal claim that relied solely on an identity. In other words, I never did what David claims I did. Like all economists, I may use identities as part of my argument. For instance, if I were to argue that rapid growth in the money supply would increase inflation, and that this would increase nominal interest rates, and that this would increase velocity, I might then go on to discuss the impact on NGDP. In that case I’d be using the MV=PY identity as part of my discussion, but I’d also be making causal arguments based on economic theory. I never rely solely on identities to make a causal claim.

We have a bit of a semantic issue here about what it means to rely on an identity. As I understand him, Scott is asserting that because savings is identical to investment he can make a causal statement about what happens to savings and then rely on the savings-investment identity to infer directly, by substituting the word “investment” for the word “saving” into a causal statement about investment. I don’t accept that the savings-investment identity allows a causal statement about savings to be transformed into a causal statement about investment without further explanation. My claim is that savings and investment are necessarily equal only in equilibrium. A causal statement about savings can’t automatically be transformed into a causal statement about investment without an explanation of how savings and investment were brought into equality in a new equilibrium.

Scott had trouble with my expression of puzzlement at his statement that Keynesians don’t deny that (ex post) less savings leads to less investment. I found that statement so confusing that apparently I wasn’t able to articulate clearly why I thought it was confusing. Let me try a different approach. First, if savings and investment are identical, then less savings can’t lead to less investment, less savings is less investment. A pound is defined as 2.2 kilograms. Does it make sense to reducing my weight in pounds leads to a reduction in my weight in kilograms? Second, if less savings is less investment, what exactly is the qualification “ex post” supposed to signify? Does it make sense to say that ex post if I lost weight in pounds I would lose weight in kilograms, as if I might plan to lose weight in pounds, but not lose weight in kilograms?

In the same post that I cited above, Bill Woolsey makes the following observation:

To say that at the natural interest rate saving equals investment is like saying at the equilibrium price quantity supplied equals quantity demanded. To say that savings always equals investment is like saying that purchases always equals sales by definition.

To compare the relationship between savings and investment to the relationship between purchases and sales is clearly not valid. The definition of the activity called “purchasing” is that a commodity or a service is transferred from a seller to a buyer. Similarly the definition of the activity called “selling” is that a commodity is transferred to a buyer from a seller. The reciprocity between purchasing and selling is inherent in the definition of either activity. But the definition of “saving” does not immediately tell us anything about the activity called “investing.” As Bill concedes in the passage I quoted earlier, the identity between saving and investment must be derived from the supposed identity between income and expenditure. But the definition of “income” does not immediately tell us anything about “expenditure.” Income and expenditure are not two reciprocal sides of the same transaction. When I buy a container of milk, there is a reciprocal relationship between me and the store that has no direct and immediate effect on the relationship between the store and the factors of production used by the store to be able to sell me that container of milk. I don’t deny that there is a relationship, just as there is a relationship between chickens and eggs, but the relationship is not at all like the reciprocal relationship between a buyer and a seller.

UPDATE: (2/18/2015): In a comment to this post, Bill Woolsey points that I did not accurately characterize his post when I said “Bill does not say why income equals expenditure,” by which I meant that he did not say why income is identical to expenditure. If I had been a more careful reader I would have realized that Bill did indeed explain why income is identical to output and output is identical to expenditure, which (by the transitive law) implies that income is identical to expenditure. However, Bill himself actually concedes that the identity between output and expenditure is arrived at only by imputing the value of unsold inventory to the profit of the firm. But this profit is generated not by an actual expenditure of money, it is generated by an accounting convention — a perfectly legitimate accounting convention, but a convention nonetheless. So I continue to maintain that income, defined as the flow of payments to factors of production per unit time, is not identical to either expenditure or to output. Bill also notes that, as Nick Rowe has argued, in a pure service economy in which there were no capital goods or inventories, output would identically equal expenditure. I agree, but only if no services were provided on credit. There would then be a lag between output and the expenditure corresponding to the output. It is precisely the existence of lags between output, expenditure and income that allows for the possibility of non-instantaneous adjustments to changes, thereby creating disequilibrium transitions between one equilibrium and another.

CAUTION Accounting Identity Handle with Care

About three years ago, early in my blogging career, I wrote a series of blog posts (most or all aimed at Scott Sumner) criticizing him for an argument in a blog post about the inefficacy of fiscal stimulus that relied on the definitional equality of savings and investment. Here’s the statement I found objectionable.

Wren-Lewis seems to be . . . making a simple logical error (which is common among Keynesians.)  He equates “spending” with “consumption.”  But the part of income not “spent” is saved, which means it’s spent on investment projects.  Remember that S=I, indeed saving is defined as the resources put into investment projects.  So the tax on consumers will reduce their ability to save and invest.

I’m not going to quote any further from that discussion. If you’re interested here are links to the posts that I wrote (here, here, here, here, here, and this one in which I made an argument so obviously false that, in my embarrassment, I felt like giving up blogging, and this one in which I managed to undo, at least partially, the damage of the self-inflicted wound). But, probably out of exhaustion, that discussion came to an inconclusive end, and Scott and I went on with our lives with no hard feelings.

Well, in a recent post, Scott has again invoked the savings-equals-investment identity, so I am going to have to lodge another protest, even though I thought that, aside from his unfortunate reference to the savings-investment identity, his post made a lot of sense. So I am going to raise the issue one more time – we have had three years to get over our last discussion – hoping that I can now convince Scott to stop using accounting identities to make causal statements.

Scott begins by discussing the simplest version of the income-expenditure model (aka the Keynesian cross or 45-degree model), while treating it, as did Keynes, as if it were interchangeable with the national-accounting identities:

In the standard national income accounting, gross domestic income equals gross domestic output.  In the simplest model of all (with no government or trade) you have the following identity:

NGDI = C + S = C + I = NGDP  (it also applies to RGDI and RGDP)

Because these two variables are identical, any model that explains one will, ipso facto, explain the other.

There is a lot of ground to cover in these few lines. First of all, there are actually three relevant variables — income, output, and expenditure – not just two. Second aggregate income is not really the same thing as consumption and savings. Aggregate income is constituted by the aggregate earnings of all factors of production. However, an accounting identity assures us that all factor incomes accruing to factors of production, which are all ultimately owned by the households providing services to business firms, must be disposed of either by being spent on consumption or by being saved. Aggregate expenditure is different from aggregate income; expenditure is constituted not by the earnings of households, but by their spending on consumption and by the spending of businesses on investment, the purchase of durable equipment not physically embodied in output sold to households or other businesses. Aggregate expenditure is very close to but not identical with aggregate output. They can differ, because not all output is sold, some of it being retained within the firm as work in progress or as inventory. However, in an equilibrium situation in which variables were unchanging, aggregate income, expenditure and output would all be equal.

The equality of these three variables can be thought of as a condition of macroeconomic equilibrium. When a macroeconomic system is not in equilibrium, aggregate factor incomes are not equal to aggregate expenditure or to aggregate output. The inequality between factor incomes and expenditure induces further adjustments in spending and earnings ultimately leading to an equilibrium in which equality between those variables is restored.

So what Scott should have said is that because NGDI and NGDP are equal in equilibrium, any model that explains one will, ipso facto, explain the other, because the equality between the two is the condition for finding a solution to the model. It therefore follows that savings and investment are absolutely not the same thing. Savings is the portion of household earnings from providing factor services that is not spent on consumption. Investment is what business firms spend on plant and equipment. The two magnitudes are obviously not the same, and they do not have to be equal. However, equality between savings and investment is, like the equality between income and expenditure, a condition for macroeconomic equilibrium. In an economy not in equilibrium, savings does not equal investment. But the inequality between savings and investment induces adjustments that, in a stable macroeconomic system, move the economy toward equilibrium. Back to Scott:

Nonetheless, I think if we focus on NGDI we are more likely to be able to think clearly about macro issues.  Consider the recent comment left by Doug:

Regarding Investment, changes in private investment are the single biggest dynamic in the business cycle. While I may be 1/4 the size of C in terms of the contribution to spending, it is 6x more volatile. The economy doesn’t slip into recession because of a fluctuation in Consumption. Changes in Investment drive AD.

This is probably how most people look at things, but in my view it’s highly misleading. Monetary policy drives AD, and AD drives investment. This is easier to explain if we think in terms of NGDI, not NGDP.  Tight money reduces NGDI.  That means the sum of nominal consumption and nominal saving must fall, by the amount that NGDI declines.  What about real income?  If wages are sticky, then as NGDI declines, hours worked will fall, and real income will decline.

So far we have no reason to assume that C or S will fall at a different rate than NGDI. But if real income falls for temporary reasons (the business cycle), then the public will typically smooth consumption.  Thus if NGDP falls by 4%, consumption might fall by 2% while saving might fall by something like 10%.  This is a prediction of the permanent income hypothesis.  And of course if saving falls much more sharply than gross income, investment will also decline sharply, because savings is exactly equal to investment.

First, I observe that consumption smoothing and the permanent-income hypothesis are irrelevant to the discussion, because Scott does not explain where any of his hypothetical numbers come from or how they are related. Based on commenter Doug’s suggestion that savings is ¼ the size of consumption, one could surmise that a 4% reduction in NGDP and a 2% reduction in consumption imply a marginal propensity to consumer of 0.4. Suppose that consumption did not change at all (consumption smoothing to the max), then savings, bearing the entire burden of adjustment, would fall through the floor. What would that imply for the new equilibrium of NGDI? In the standard Keynesian model, a zero marginal propensity to consume would imply a smaller effect on NGDP from a given shock than you get with an MPC of 0.4.

It seems to me that Scott is simply positing numbers and performing calculations independently of any model, and then tells us that the numbers have to to be what he says they are because of an accounting identity. That does not seem like an assertion not an argument, or, maybe like reasoning from a price change. Scott is trying to make an inference about how the world operates from an accounting identity between two magnitudes. The problem is that the two magnitudes are variables in an economic model, and their values are determined by the interaction of all the variables in the model. Just because you can solve the model mathematically by using the equality of two variables as an equilibrium condition does not entitle you to posit a change in one and then conclude that the other must change by the same amount. You have to show how the numbers you have posited are derived from the model.

If two variables are really identical, rather than just being equal in equilibrium, then they are literally the same thing, and you can’t draw any inference about the real world from the fact that they are equal, there being no possible state of the world in which they are not equal. It is only because savings and investment are not the same thing, and because in some states of the world they are not equal, that we can make any empirical statement about what the world is like when savings and investment are equal. Back to Scott:

This is where Keynesian economics has caused endless confusion.  Keynesians don’t deny that (ex post) less saving leads to less investment, but they think this claim is misleading, because (they claim) an attempt by the public to save less will boost NGDP, and this will lead to more investment (and more realized saving.)  In their model when the public attempts to save less (ex ante), it may well end up saving more (ex post.)

I agree that Keynesian economics has caused a lot of confusion about savings and investment, largely because Keynes, who, as a philosopher and a mathematician, should have known better, tied himself into knots by insisting that savings and investment are identical, while at the same time saying that their equality was brought about, not by variations in the rate of interest, but by variations in income. Hawtrey, Robertson, and Haberler, among others, pointed out the confusion, but Keynes never seemed to grasp the point. Textbook treatments of national-income accounting and the simple Keynesian cross still don’t seem to have figured this out. But despite his disdain for Keynesian economics, Scott still has to figure it out, too. The best place to start is Richard Lipsey’s classic article “The Foundations of the Theory of National Income: An Analysis of Some Fundamental Errors” (a gated link is available here).

Scott begins by sayings that Keynesians don’t deny that (ex post) less saving leads to less investment. I don’t understand that assertion at all; Keynesians believe that a desired increase in savings, if desired savings exceeded investment, leads to a decrease in income that reduces saving. But the abortive attempt to increase savings has no effect on investment unless you posit an investment function (AKA an accelerator) that includes income as an independent variable. The accelerator was later added to the basic Keynesian model Hicks and others in order to generate cyclical fluctuations in income and employment, but non-Keynesians like Ralph Hawtrey had discussed the accelerator model long before Keynes wrote the General Theory. Scott then contradicts himself in the next sentence by saying that Keynesians believe that by attempting to save less, the public may wind up saving more. Again this result relies on the assumption of an accelerator-type investment function, which is a non-Keynesian assumption. In the basic Keynesian model investment is determined by entrepreneurial expectations. An increase (decrease) in thrift will be self-defeating, because in the new equilibrium income will have fallen (risen) sufficiently to reduce (increase) savings back to the fixed amount of investment entrepreneurs planned to undertake, entrepreneurial expectations being held fixed over the relevant time period.

I more or less agree with the rest of Scott’s post, but Scott seems to have the same knee-jerk negative reaction to Keynes and Keynesians that I have to Friedman and Friedmanians. Maybe it’s time for both of us to lighten up a bit. Anyway in honor of Scott’s recent appoint to the Ralph Hawtrey Chair of Monetary Policy at the Mercatus Center at George Mason University, I will just close with this quotation from Ralph Hawtrey’s review of the General Theory (chapter 7 of Hawtrey’s Capital and Employment) about Keynes’s treatment of savings and investment as identically equal.

[A]n essential step in [Keynes’s] train of reasoning is the proposition that investment and saving are necessarily equal. That proposition Mr. Keynes never really establishes; he evades the necessity doing so by defining investment and saving as different names for the same thing. He so defines income to be the same thing as output, and therefore, if investment is the excess of output over consumption, and saving is the excess of income over consumption, the two are identical. Identity so established cannot prove anything. The idea that a tendency for investment and saving to become different has to be counteracted by an expansion or contraction of the total of incomes is an absurdity; such a tendency cannot strain the economic system, it can only strain Mr. Keynes’s vocabulary.

Credibility and the Central Bank Balance Sheet

Scott Sumner has been making the argument lately that a central bank with credibility can limit the growth of its balance sheet more effectively than a central bank that is not credible. The context for Scott’s claim is the chronic complaint by QE opponents that the Fed, by doing QE, has dangerously increased the size of its balance sheet, thereby creating an unacceptable risk of future inflation. Scott contends that if the Fed had been more credibly committed to its inflation target of 2%, the Fed would not have needed to create so many dollars in a futile effort to meet its inflation target. In other words, more credibility would mean a smaller balance sheet. That was a clever jujitsu move on Scott’s part, but does his argument really have a basis in economic logic?

The key point here is that the size of a bank’s balance sheet depends on the public’s demand to hold the liabilities of the bank. So for Scott to be right, credibility has to reduce the amount of base money issued by the central bank that the public wants to hold. So, if by credibility we mean the confidence with which the public expects the Fed to meet its announced inflation target, then, when the Fed is undershooting its inflation target so that enhanced credibility would be associated with a rise in expected inflation, enhancing credibility would indeed imply a reduction in the Fed’s balance sheet. However, if the Fed were overshooting its inflation target, enhancing credibility would imply an increase in the Fed’s balance sheet.

The credibility issue has become especially acute after the Swiss National Bank abandoned its peg to the euro last Thursday. To support the peg the Swiss National Bank was committed to buy euros without limit at a price of 1.2 swiss francs per euro, causing the balance sheet of the SNB to expand greatly. The main liability component of a central bank’s balance sheet is the monetary base; the Swiss monetary base has grown from 80bn francs when the peg was adopted in September 2011 to about 400bn francs at present. However, the Swiss monetary base has been in the neighborhood of 400bn francs for over a year, so even assuming that a new wave of demand for swiss francs, based on expectations of a falling euro and capital flight from Russia, had — or was about to — come crashing down on Switzerland, there is no reason to think that the peg had suddenly became unsustainable. Moreover, insofar as the bank was motivated by fears of euro depreciation, the bank could have seamlessly switched from a euro to a dollar peg, which might still be a face-saving way for the bank to reverse course.

So here’s the question: given that there was an international increase in the demand for Swiss francs, if the SNB wanted to limit the increase in the size of its balance sheet, associated with an increase in the international demand for francs, did dropping the euro peg imply a smaller balance sheet than the balance sheet it would have had with the peg maintained? Well, the answer is: it depends. By fooling the markets, and allowing the franc to appreciate by 20% over night, the bank avoided the increased demand for francs that would have occurred had the markets expected the peg to be dropped. So the SNB was able to achieve an unexpected increase in the value of the Swiss franc without encouraging an increase in the demand for francs based on expectations of future appreciation, and to that extent, the SNB was able to reduce the size of its balance sheet.

But another question immediately arises. Now that the franc has appreciated by about 20% after the euro peg was dropped, what will happen to the demand for Swiss francs? The speculative demand for francs based on expected future appreciation has probably been reduced by the sudden appreciation of the franc. However, Switzerland is now facing internal deflation, even if there is no further franc appreciation in foreign exchange markets, as the domestic Swiss price level adjusts to the new higher value of the franc. Oncoming Swiss deflation will increase the expected return to Swiss residents from holding francs while simultaneously reducing the expected return on physical capital in Switzerland, so a substantial shift out of real Swiss assets into cash is likely. Such a shift started immediately last week in the first two days after the peg was dropped, the Swiss stock market falling by about 10 percent, though Swiss equities did make up some of their losses in Monday’s trading. Given an increased Swiss demand to hold francs, the SNB will either have to increase the amount of base money, thereby increasing the size of its balance sheet, or it will have to allow the increased demand for francs to add to deflationary pressure, thereby causing further franc appreciation in the forex markets, attracting further inflows of foreign cash to acquire francs. If the SNB was uncomfortable with the euro peg, the SNB is likely to find out very soon that life without the euro peg or a substitute dollar peg is going to be even more unpleasant.

If your lot in life is to supply the internationally desirable currency of a small open economy – in other words if you are the Swiss National Bank – it is the height of folly to believe that you can place some arbitrary limit on the size of your balance sheet. The size of your balance sheet will ultimately be determined one way or another by the international demand to hold your currency. If you are unwilling to let your balance sheet expand in nominal terms by supplying the amount of cash foreigners demand as they try to exchange their currency for yours, you will only force up the value of your currency, which will make holding your currency even more attractive, at least until the currency appreciation and deflation that you have inflicted on your own economy cause your economy to go down in flames.

As an extended historical postscript, let me just mention the piece that Markus Brunnermeier and Harold James wrote for Project Syndicate, in which they astutely diagnose the political pressures that may have forced the SNB to abandon the euro peg.

The SNB was not forced to act by a speculative run. No financial crisis forced its hand, and, in theory, the SNB’s directorate could have held the exchange rate and bought foreign assets indefinitely. But domestic criticism of the SNB’s large buildup of exchange-rate reserves (euro assets) was mounting.

In particular, Swiss conservatives disliked the risk to which the SNB was exposed. Fearing that eurozone government bonds were unsafe, they agitated to require the SNB to acquire gold reserves instead, even forcing a referendum on the matter. Though the initiative to require a fixed share of gold reserves failed, the prospect of large-scale quantitative easing by the European Central Bank, together with the euro’s recent slide against the dollar, intensified the political pressure to abandon the peg.

Whereas economists have modeled financial attacks well, there has been little study of just when political pressure becomes unbearable and a central bank gives in. The SNB, for example, had proclaimed loyalty to the peg just days before ending it. As a result, markets will now hesitate to believe central banks’ statements about future policy, and forward guidance (a major post-crisis instrument) will be much more difficult.

There is historical precedent for the victory of political pressure, and for the recent Swiss action. In the late 1960s, the Bundesbank had to buy dollar assets in order to stop the Deutsche mark from rising, and to preserve the integrity of its fixed exchange rate. The discussion in Germany focused on the risks to the Bundesbank’s balance sheet, as well as on the inflationary pressures that came from the currency peg. Some German conservatives at the time would have liked to buy gold, but the Bundesbank had promised the Fed that it would not put the dollar under downward pressure by selling its reserves for gold.

In 1969, Germany unilaterally revalued the Deutsche mark. But that was not enough to stop inflows of foreign currency, and the Bundesbank was obliged to continue to intervene. It continued to reduce its interest rate, but the inflows persisted. In May 1971, the German government – against the wishes of the Bundesbank – abandoned the dollar peg altogether and floated the currency.

This seems basically right to me, but I would point out a key difference between the 1971 episode and last week’s debacle. In 1971, the US was mired in the Vietnam War and an unstable domestic situation; to many observers, the US seemed to be in danger of a political crisis. US inflation was running at 4% a year, and its economy, just emerging from a recession, seemed in danger of stagnating. Germany, accumulating huge reserves of dollars, correctly viewed its own inflation rate of 4% as being imported from America. Totally dependent on the US for defense against the Soviet threat, Germany was in no position to demand that the US redeem its dollar obligations in gold. Given the deep German aversion to inflation, it was indeed politically impossible for the German government not to use its only available means of reducing inflation: allowing the deutschmark to appreciate against the dollar. It is much harder to identify any economic disadvantage that Switzerland has been suffering since it adopted the euro peg in 2011 that is in any way comparable to the pain of the 4% inflation that Germany had to tolerate in 1971 as a result of its dollar peg.

Can We All Export Our Way out of Depression?

Tyler Cowen has a post chastising Keynesians for scolding Germany for advising their Euro counterparts to adopt the virtuous German example of increasing their international competitiveness so that they can increase their exports, thereby increasing GDP and employment. The Keynesian response is that increasing exports is a zero-sum game, so that, far from being a recipe for recovery, the German advice is actually a recipe for continued stagnation.

Tyler doesn’t think much of the Keynesian response.

But that Keynesian counter is a mistake, perhaps brought on by the IS-LM model and its impoverished treatment of banking and credit.

Let’s say all nations could indeed increase their gross exports, although of course the sum of net exports could not go up.  The first effect is that small- and medium-sized enterprises would be more profitable in the currently troubled economies.  They would receive more credit and the broader monetary aggregates would go up in those countries, reflating their economies.  (Price level integration is not so tight in these cases, furthermore much of the reflation could operate through q’s rather than p’s.)  It sometimes feels like the IS-LM users have a mercantilist gold standard model, where the commodity base money can only be shuffled around in zero-sum fashion and not much more can happen in a positive direction.

The problem with Tyler’s rejoinder to the Keynesian response, which, I agree, provides an incomplete picture of what is going on, is that he assumes that which he wants to prove, thereby making his job just a bit too easy. That is, Tyler just assumes that “all nations could indeed increase their gross exports.” Obviously, if all nations increase their gross exports, they will very likely all increase their total output and employment. (It is, I suppose, theoretically possible that all the additional exports could be generated by shifting output from non-tradables to tradables, but that seems an extremely unlikely scenario.) The reaction of credit markets and monetary aggregates would be very much a second-order reaction. It’s the initial assumption–  that all nations could increase gross exports simultaneously — that is doing all the heavy lifting.

Concerning Tyler’s characterization of the IS-LM model as a mercantilist gold-standard model, I agree that IS-LM has serious deficiencies, but that characterization strikes me as unfair. The simple IS-LM model is a closed economy model, with an exogenously determined price level. Such a model certainly has certain similarities to a mercantilist gold standard model, but that doesn’t mean that the two models are essentially the same. There are many ways of augmenting the IS-LM model to turn it into an open-economy model, in which case it would not necessarily resemble the a mercantilist gold-standard model.

Now I am guessing that Tyler would respond to my criticism by asking: “well, why wouldn’t all countries increase their gross exports is they all followed the German advice?”

My response to that question would be that the conclusion that everybody’s exports would increase if everybody became more efficient logically follows only in a comparative-statics framework. But, for purposes of this exercise, we are not starting from an equilibrium, and we have no assurance that, in a disequilibrium environment, the interaction of the overall macro disequilibrium with the posited increase of efficiency would produce, as the comparative-statics exercise would lead us to believe, a straightforward increase in everyone’s exports. Indeed, even the comparative-statics exercise is making an unsubstantiated assumption that the initial equilibrium is locally unique and stable.

Of course, this response might be dismissed as a mere theoretical possibility, though the likelihood that widespread adoption of export-increasing policies in the midst of an international depression, unaccompanied by monetary expansion, would lead to increased output does not seem all that high to me. So let’s think about what might happen if all countries simultaneously adopted export-increasing policies. The first point to consider is that not all countries are the same, and not all are in a position to increase their exports by as much or as quickly as others. Inevitably, some countries would increase their exports faster than others. As a result, it is also inevitable that some countries would lose export markets as other countries penetrated export markets before they did. In addition, some countries would experience declines in domestic output as domestic-import competing industries were forced by import competition to curtail output. In the absence of demand-increasing monetary policies, output and employment in some countries would very likely fall. This is the kernel of truth in the conventional IS-LM analysis that Tyler tries to dismiss. The IS-LM framework abstracts from the output-increasing tendency of export-led growth, but the comparative-statics approach abstracts from aggregate-demand effects that could easily overwhelm the comparative-statics effect.

Now, to be fair, I must acknowledge that Tyler reaches a pretty balanced conclusion:

This interpretation of the meaning of zero-sum net exports is one of the most common economic mistakes you will hear from serious economists in the blogosphere, and yet it is often presented dogmatically or dismissively in a single sentence, without much consideration of more complex or more realistic scenarios.

That is a reasonable conclusion, but I think it would be just as dogmatic, if not more so, to rely on the comparative-statics analysis that Tyler goes through in the first part of his post without consideration of more complex or more realistic scenarios.

Let me also offer a comment on Scott Sumner’s take on Tyler’s post. Scott tries to translate Tyler’s analysis into macroeconomic terms to support Tyler’s comparative-statics analysis. Scott considers three methods by which exports might be increased: 1) supply-side reforms, 2) monetary stimulus aimed at currency depreciation, and 3) increased government saving (fiscal austerity). The first two, Scott believes, lead to increased output and employment, and that the third is a wash. I agree with Scott about monetary stimulus aimed at currency depreciation, but I disagree (at least in part) about the other two.

Supply-side reforms [to increase exports] boost output under either an inflation target, or a dual mandate.  If you want to use the Keynesian model, these reforms boost the Wicksellian equilibrium interest rate, which makes NGDP grow faster, even at the zero bound.

Scott makes a fair point, but I don’t think it is necessarily true for all inflation targets. Here is how I would put it. Because supply-side reforms to increase exports could cause aggregate demand in some countries to fall, and we have very little ability to predict by how much aggregate demand could go down in some countries adversely affected by increased competition from exports by other countries, it is at least possible that worldwide aggregate demand would fall if such policies were generally adopted. You can’t tell how the Wicksellian natural rate would be affected until you’ve accounted for all the indirect feedback effects on aggregate demand. If the Wicksellian natural rate fell, an inflation target, even if met, might not prevent a slowdown in NGDP growth, and a net reduction in output and employment. To prevent a slowdown in NGDP growth would require increasing the inflation target. Of course, under a real dual mandate (as opposed to the sham dual mandate now in place at the Fed) or an NGDP target, monetary policy would have to be loosened sufficiently to prevent output and employment from falling.

As far as government saving (fiscal austerity), I’d say it’s a net wash, for monetary offset reasons.

I am not sure what Scott means about monetary offset in this context. As I have argued in several earlier posts (here, here, here and here), attempting to increase employment via currency depreciation and increased saving involves tightening monetary policy, not loosening it. So I don’t see how fiscal policy can be used to depreciate a currency at the same time that monetary policy is being loosened. At any rate, if monetary policy is being used to depreciate the currency, then I see no difference between options 2) and 3).

But my general comment is that, like Tyler, Scott seems to be exaggerating the difference between his bottom line and the one that comes out of the IS-LM model, though I am certainly not saying that IS-LM is  last word on the subject.

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