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Interest on Reserves and Credit Deadlock

UPDATE (2/25/2022): George Selgin informs me that in the final version (his book Floored) of the Cato working paper which I discuss below he modified the argument that I criticize that paying interest on reserves caused banks to raise their lending rates to borrowers and that he now generally agrees with my argument that paying interest on reserves did not cause banks to raise the interest rates they charged borrowers. George also points out that I did misstate his position slightly. He did not argue, as I wrote, that paying interest on reserves caused banks to raise interest rates to borrowers; his argument was that banks would accept a reduced percentage of loan applications at the prevailing rate of interest.

The economic theory of banking has a long and checkered history reflecting an ongoing dialectic between two views of banking. One view, let’s call it the reserve view, is that the circulating bank liabilities, now almost exclusively bank deposits, are created by banks after they receive deposits of currency (either metallic or fiat). Rather than hold the currency in their vaults as “safe deposits,” banks cleverly (or in the view of some, deceitfully or fraudulently) lend out claims to their reserves in exchange for the IOUs of borrowers, from which they derive a stream of interest income.

The alternative view of banking, let’s call it the anti-reserve view (in chapter 7 of my new book Studies in the History of Monetary Theory, I trace the two views David Hume and Adam Smith) bank liabilities are first issued by established money lenders, probably traders or merchants, widely known to be solvent and well-capitalized, whose debts are widely recognized as reliable and safe. Borrowers therefore prefer to exchange their own debt for that of the lenders, which is more acceptable in exchange than their own less reliable debt. Lenders denominate their IOUs in terms of an accepted currency so that borrowers can use the lender’s IOU instead of the currency. To make their IOUs circulate like currency, lenders promise to redeem their IOUs on demand, so they must either hold, or have immediate access to, currency.

These two views of banking lead to conflicting interpretations of the hugely increased reserve holdings of banks since the aftermath of the 2008 financial crisis. Under the reserve view, reserves held by banks are the raw material from which deposits are created. Because of the inflationary potential of newly created deposits, a rapid infusion of reserves into the banking system is regarded as an inflationary surge waiting to happen.

On the anti-reserve view, however, causation flows not from reserves to deposits, but from deposits to reserves. Banks do not create deposits because they hold redundant reserves; they hold reserves because they create deposits, the holding of reserves being a the cost of creating deposits. Being a safe asset enabling banks to satisfy instantly, and without advance notice, demands for deposit redemption, reserves are held only as a precaution.

All businesses choose the forms in which to hold the assets best-suited to their operations. Manufactures own structures, buildings and machines used in producing the products they sell as well as holding inventories of finished or semi-finished outputs and inputs into the production process, as well as liquid capital like bank deposits, and other interest or income-generating assets. Banks also hold a variety of real assets (e.g., buildings, vaults, computers and machines) and a variety of financial assets. An important class of those financial assets are promissory notes of borrowers to whom banks have issued loans by creating deposits. In the ordinary course of business, banks accumulate reserves when new or existing customers make deposits, and when net positive clearings with other banks cause an inflow of reserves. The direction and the magnitude of the flow of reserves into, or out of, a bank are not beyond its power to control. Nor does a bank lack other means than increasing lending to reduce its holdings of unwanted reserves.

While reserves are the safest, most liquid, and most convenient asset that banks can hold, non-interest-bearing reserves provide banks with no pecuniary yield, so holding reserves rather than interest-bearing assets, or assets expected to appreciate involve a sacrifice of income that must be offset by the safety, liquidity and convenience provided by reserves. When the Fed began paying interest on reserves in October 2008, the holding of reserves no longer required foregoing a pecuniary yield offered by alternative assets. The next safest and most liquid class of assets available to banks is short-term Treasury notes, which do provide at least a small nominal interest return. Until October 2008, there was an active overnight market for reserves — the Federal Funds market — in which banks with excess reserves could lend to banks with insufficient reserves, thereby enabling the banking system as a whole to minimize the aggregate holding of excess (i.e., not legally required) reserves.

Legally required reserves being unavailable to banks to satisfy redemption demands without incurring a penalty for non-compliance with the legal reserve requirement, required reserves provide banks with little safety or liquidity. So, to obtain the desired safety and liquidity, banks must hold excess reserves. The cost (foregone interest) of holding excess reserves banks can be minimized by holding interest-bearing Treasuries easily exchanged for reserves and by lending or borrowing as needed in the overnight Fed Funds market. In normal conditions, the banking system can operate efficiently with excess reserves equal to only about one percent of total deposits.

The Fed did not begin paying interest on reserves until October 2008, less than a month after a financial panic and crisis brought the US and the international financial system to the brink of a catastrophic meltdown. The solvency of financial institutions and banks having been impaired by a rapid loss of asset value, distinguishing between solvent and insolvent counterparties became nearly impossible, putting almost any economic activity dependent on credit at risk of being unwound.

In danger of insolvency and desperate for liquidity, banks tried to hoard reserves and increase holdings of Treasury debt. Though yielding minimal interest, Treasury notes serve as preferred collateral in the Fed Funds market, enabling borrowers to offer lenders nearly zero-risk overnight or short-term lending opportunities via repurchase agreements in which Treasury notes are sold spot and repurchased forward at a preset price reflecting an implied interest rate on the loan.

Increased demand for Treasuries raised their prices and reduced their yields, but declining yields and lending rates couldn’t end the crisis once credit markets became paralyzed by pervasive doubts about counterparty solvency. Banks stopped lending to new customers, while hesitating, or even refusing, to renew or maintain credit facilities for existing customers, and were themselves often unable to borrow reserves without posting Treasuries as collateral for repo loans.

After steadfastly refusing to reduce its Fed Fund target rate and ease credit conditions, notwithstanding rapidly worsening economic conditions, during the summer of 2008, an intransigent stance from which it refused to budge even after the financial panic erupted in mid-September. While Treasury yields were falling as the markets sought liquidity and safety, chaotic market conditions caused overnight rates in the Fed Funds market to fluctuate erratically. Finally relenting in October as credit markets verged on collapse, the Fed reduced its Fed Funds target rate by 50 basis points. In the catastrophic conditions of October 2008, the half-percent reduction in the Fed Funds target was hardly adequate.

To prevent a system-wide catastrophe, the Fed began lending to banks on the security of assets of doubtful value or to buy assets — at book, rather than (unknown) market, value – that were not normally eligible to be purchased by the Fed. The resulting rapid expansion of the Fed’s balance sheet and the creation of bank reserves (Fed liabilities) raised fears (shared by the Fed) of potential future inflation. 

Fearing that its direct lending to banks and its asset purchases were increasing bank reserves excessively, thereby driving the Fed Funds rate below its target, the Fed sought, and received, Congressional permission to begin paying interest on bank reserves so that banks would hold the newly acquired reserves, rather use the reserves to acquire assets like borrower IOUs, lest total spending and aggregate demand increase. Avoiding such a potentially inflationary increase in aggregate demand had been the chief policy objective of the Fed throughout 2008 even as the economy slid into deep recession just prior to the start of the financial crisis, and the Fed was sticking to that policy.

Struggling to contain a deepening financial crisis while adhering to a commitment to a 2-percent inflation target, the Fed experimented for almost two months with both its traditional Fed Funds target and its new policy of paying interest on bank reserves. The Fed eventually settled on a target for the Fed Funds rate between zero and .25% while paying .25% interest on reserves, thereby making it unnecessary for banks with accounts at the Fed to borrow, and making them unwilling to lend, reserves in the Fed Funds market. Thanks to the massive infusion of reserves into the banking system, the panic was quelled and the immediate financial crisis receded, but the underlying weakness of an economy was aggravated and continued to deepen; the liquidity and solvency problems that triggered the crisis were solved, but the aggregate-demand deficiency was not.

In his excellent historical and analytical account of how and why the Fed adopted its policy of paying interest on reserves, George Selgin credits the idea that had the Fed not paid interest to banks on their reserves, they would have used those reserves to increase lending, thereby providing stimulus to the economy. (Update: as noted above, the argument I criticize was made in Cato Working Paper not in the published version of George’s book, and he informs me that he modified the argument in the published version and now disavows it.) Although I agree with George that paying interest on bank reserves reduced aggregate demand, I disagree with his argument that the reduction in aggregate demand was caused by increased interest charged to borrowers owing to the payment of interest on reserves.

George believes that, by paying interest on reserves, the Fed increased the attractiveness of holding reserves relative to higher-yielding assets like the IOUs of borrowers. And, sure enough, after the Fed began paying interest on reserves, the share of bank loans in total bank assets declined by about the same percentage as the share of reserves in total bank assets.

The logic underlying this argument is that, at the margin, an optimizing bank equates the anticipated yield from holding every asset in its portfolio. If the expected return at margin from bank loans exceeds the expected return from reserves, an optimizing bank will increase its lending until the marginal return from lending no longer exceeds the marginal return from holding reserves. When the Fed began paying interest on reserves, the expected return at the margin from holding reserves increased and exceeded the expected return at the margin from bank loans, giving banks an incentive to increase their holdings of reserves relative to their holdings of bank loans. Presumably this means that banks would try to increase their holdings of bank reserves and reduce their lending.

At least two problems undercut this logic. First, as explained above, the yield from holding an asset can be pecuniary – a yield of interest, of dividends, or appreciation – or a flow of services. Clearly, the yield from holding reserves is primarily the service flow associated with the safety, liquidity and convenience provided by reserves. Before October 2008, reserves provided no pecuniary yield, either in explicit interest or expected appreciation, the optimal quantity of reserves held was such that, at the margin, the safety, liquidity and convenience generated by reserves was just sufficient to match the pecuniary return from the loan assets expected by an optimizing bank.

After the Fed began paying interest on reserves, the combined pecuniary and service return from holding reserves exceeded the return from banks’ loan assets. So, banks therefore chose to increase their holdings of reserves until the expected pecuniary and service yield from reserves no longer exceeded the expected return from loan assets. But as banks increased their reserve holdings, the marginal service flow provided by reserves diminished until the marginal pecuniary plus service yield was again equalized across the assets held in banks’ asset portfolios. But that does not imply that banks reduced their lending or the value of the loan assets in their portfolios compared to the value of loan assets held before interest was paid on reserves; it just means that optimal bank portfolios after the Fed began paying interest on bank reserves contained more reserves than previously.

Indeed, because reserves provided a higher pecuniary yield and more safety, liquidity and convenience than holding Treasuries, banks were willing to add reserves to their portfolios without limit, because holding reserves became costless. The only limit on the holding of bank reserves was the willingness of the Fed to create more reserves by buying additional assets from the private sector. The proceeds of sales would be deposited in the banking system. The yield on the acquired assets would accrue to the Fed, and that yield would be transferred to the banking system by way of interest paid on those reserves.

So, if I don’t think that paying interest on bank reserves caused banks to raise interest rates on loans, why do I think that paying interest on bank reserves reduced aggregate demand and slowed the recovery from the Little Depression (aka Great Recession)?

The conventional story, derived from the reserve view, is that if banks have more reserves than they wish to hold, they try to dispose of their excess reserves by increasing their lending to borrowers. But banks wouldn’t increase lending to borrowers unless the expected profitability of such lending increased; no increase in the quantity of non-interest-bearing reserves of the banks would have increased the profitability of bank lending unless consumer confidence or business optimism increased, neither of which depends in a straightforward way on the quantity of reserves held by banks.

In several published papers on classical monetary theory which were revised and republished in my new book Studies in the History of Monetary Theory (chapters 2-5 and 7 see front matter for original publication information), I described a mechanism of bank lending and money creation. Competitive banks create money by lending, but how much money they create is constrained by the willingness of the public to hold the liabilities (deposits) emitted in the process of lending.

The money-lending, deposit-creation process can be imperfectly described within a partial-equilibrium, marginal-revenue, marginal-cost framework. The marginal revenue from creating money corresponds to the spread between a bank’s borrowing rate (the interest rate paid on deposits) and its lending rate (the interest rate charged borrowers). At the margin, this spread equals the bank’s cost of intermediation, which includes the cost of holding reserves. The cost of intermediation increases as the difference between the yields on Treasuries and reserves increase, and as the quantity of reserves held increases.

So, in the basic model I work with, paying interest on reserves reduces the cost of creating deposits, thereby tending to increase the amount of lending by banks, contrary to Selgin’s argument that paying interest on reserves reduces bank lending by inducing banks to raise interest rates on loans.

But, in a recession — and even more so in a financial crisis or panic — the cost of intermediation increases, causing banks to reduce their lending, primarily by limiting or denying the extension of credit to new and existing customers. Of course, in a recession, businesses and households demand fewer loans to finance spending plans, and instead seek credit with which to meet current obligations coming due. As banks’ costs of intermediation rise, they inevitably curtail lending, increasing the share of reserves in banks’ total assets.

While Selgin attributes the increasing share of reserves in banks’ assets to the payment of interest on reserves, a more plausible explanation of the increase is that it results from the increased intermediation costs associated with recession and a financial crisis, which more than offset the cost reduction from paying interest on reserves.

Although paying interest on reserves was a major innovation, in a sense it was just a continuation of the policy approach adopted by the Fed in 2004 when started gradually raising its Fed Funds target rate to 5.25% in June 2006, where it stood until July 2007. Combined with the bursting of the housing bubble in 2006, the 5.25% Fed Funds target produced a gradual slowdown that led the Fed to reduce its target, but always too little and too late, as the economy slid into recession at the end of 2007. So, the payment of interest on reserves, intended to ensure that the reserves would not trigger a surge in spending, was entirely consistent with the restrictive policy orientation of the Fed before the financial panic and crisis of 2008, which continued during and after the crisis. That policy was largely responsible for the unusually weak economic recovery and expansion in the decade after the crisis, when banks willingly absorbed all the reserves created by the Fed.

The specific point on which I disagree with Selgin is his belief that paying interest on bank reserves discouraged banks from increasing their lending despite the increase in their reserves. I maintain that paying interest on reserves did not discourage banks from lending, but instead altered their incentive to hold reserves versus holding Treasuries. That decision was independent of the banks’ lending decisions. The demand for loans to finance spending plans by businesses and households was declining because of macroeconomic conditions in a recessionary economy during a financial crisis and recession and the subsequent slow recovery.

Had the Fed not paid interest on reserves while purchasing assets to provide liquidity to the banking system, I am doubtful that banks would have provided credit for increased private spending. If no interest were paid on reserves, it seems more likely that banks would have used the additional reserves created by the Fed to purchase Treasuries than to increase lending, driving up their prices and reducing their yields. Instead of receiving interest of .25% on their reserves, banks would have received slightly less interest on short-term Treasuries. So, without interest on reserves, banks would have received less interest income, and incurred slightly more risk, than they actually did. The Fed, on the other hand, would have had a net increase in revenue by not paying more interest to banks than it received from the Treasuries sold by the banks to the Fed.

The only plausible difference between paying interest on reserves and not doing so that I can see is that the Fed, by paying interest on reserves, lent credibility to its commitment to keep inflation at, or below, its 2-percent target. The Fed’s own justification for seeking permission to pay interest on reserves, as Selgin (Floored, p. 18) documented with a passage from Bernanke’s memoir , was that not doing so might result in an inflationary increase in lending by banks trying to shed their excess reserves. Because I believe that expectations of inflation have a tendency to be self-fulfilling, I don’t dismiss the idea that paying interest on reserves helped the Fed anchor inflation expectations at or near its 2-percent inflation target.

Economic conditions after the financial crisis of 2008-09 were characterized by an extreme entrepreneurial pessimism that Ralph Hawtrey called a credit deadlock, conditions akin to, but distinct from, the more familiar Keynesian phenomenon of a liquidity trap. The difference is that a credit deadlock results from pessimism so intense that entrepreneurs (and presumably households as well) are unwilling, regardless of the interest rate on loans, to undertake long-term spending plans (capital investment by businesses or consumer-durables purchases by households) requiring credit financing. In a liquidity trap, such spending plans might be undertaken at a sufficiently low interest rate, but the interest rate cannot fall, bear speculators cashing in their long-term bond holdings as soon as long-term bond prices rise to a level that speculators regard as unsustainable. To me, at least, the Hawtreyan credit deadlock seems a more plausible description of conditions in 2008-09 than the Keynesian liquidity trap.

In a Hawtreyan credit deadlock, the capacity of monetary policy to increase spending and aggregate demand is largely eliminated. Here’s Hawtrey’s description from the 1950 edition of his classic work Currency and Credit.

If the banks fail to stimulate short-term borrowing, they can create credit by themselves buying securities in the investment market. The market will seek to use the resources thus placed in it, and it will become more favourable to new flotations and sales of securities. But even so and expansion of the flow of money is not ensured. If the money created is to move and to swell the consumers’ income, the favourable market must evoke additional capital outlay. That is likely to take time and conceivably capital outlay may fail to respond. A deficiency of demand for consumable goods reacts on capital outlay, for when the existing capacity of industries is underemployed, there is little demand for capital outlay to extend capacity. . .

The deadlock then is complete, and, unless it is to continue unbroken till some fortuitous circumstance restarts activity, recourse must be had to directly inflationary expedients, such as government expenditures far in excess of revenue, or a deliberate depreciation of the foreign exchange value of the money unit.

In this passage, Hawtrey, originator of the widely reviled “Treasury View” (also see chapters 10-11 of my Studies in the History of Monetary Theory) that denied the efficacy of fiscal policy as a countercyclical tool, acknowledged the efficacy of fiscal policy in a credit deadlock, while monetary policy could be effective only through currency devaluation or depreciation, though I would add that in monetary policy could also be effective by inducing or creating expectations of inflation.

The long, but painfully slow, recovery from the 2008-09 financial crisis lent credence to Hawtrey’s description of credit deadlock, and my own empirical findings of the unusual positive correlation between changes in inflation expectations and changes in the S&P 500 supports the idea that increasing inflation expectations are a means whereby monetary policy can enable an escape from credit deadlock.

What’s Right and not so Right with Modern Monetary Theory

UPDATE (2/5/21: A little while ago I posted this tweet on Twitter

So I thought I would re-up this post from July 2020 about MMT in response to a tweet asking me what might be a better criticism of MMT.

I am finishing up a first draft of a paper on fiat money, bitcoins and cryptocurrencies that will be included in a forthcoming volume on bitcoins and cryptocurrencies. The paper is loosely based on a number of posts that have appeared on this blog since I started blogging almost nine years ago. My first post appeared on July 5, 2011. Here are some of my posts on and fiat money, bitcoins and cryptocurrencies (this, this, this, and this). In writing the paper, it occurred to me that it might be worthwhile to include a comment on Modern Monetary Theory inasmuch as the proposition that the value of fiat money is derived from the acceptability of fiat money for discharging the tax liabilities imposed by the governments issuing those fiat moneys, which is a proposition that Modern Monetary Theorists have adopted from the chartalist school of thought associated with the work of G. F. Knapp. But there were clearly other economists before and since Knapp that have offered roughly the same explanation for the positive value of fiat money that offers no real non-monetary services to those holding such moneys. Here is the section from my draft about Modern Monetary Theory.

Although there’s a long line of prominent economic theorists who have recognized that acceptability of a fiat money for discharging tax liabilities, the proposition is now generally associated with the chartalist views of G. F. Knapp, whose views have been explicitly cited in recent works by economists associated with what is known as Modern Monetary Theory (MMT). While the capacity of fiat money to discharge tax liabilities is surely an important aspect of MMT, not all propositions associated with MMT automatically follow from that premise. Recognizing the role of the capacity of fiat money to discharge tax liabilities, Knapp juxtaposed his “state theory of money” from the metallist theory. The latter holds that the institution of money evolved from barter trade, because certain valuable commodities, especially precious metals became widely used as media of exchange, because, for whatever reason, they were readily accepted in exchange, thereby triggering the self-reinforcing network effects discussed above.[1]

However, the often bitter debates between chartalists and metallists notwithstanding, there is no necessary, or logical, inconsistency between the theories. Both theories about the origin of money could be simultaneously true, each under different historical conditions. Each theory posits an explanation for why a monetary instrument providing no direct service is readily accepted in exchange. That one explanation could be true does not entail the falsity of the other.

Taking chartalism as its theoretical foundation, MMT focuses on a set of accounting identities that are presumed to embody deep structural relationships. Because money is regarded as the creature of the state, the quantity of money is said to reflect the cumulative difference between government tax revenues and expenditures which are financed by issuing fiat money. The role of government bonds is to provide a buffer with which short-term fluctuations in the inflow of taxes (recurrently peaking at particular times of the year when tax payments become due) and government expenditures.

But the problem with MMT, shared with many other sorts of monetary theory, is that it focuses on a particular causal relationship, working through the implications of that relationship conditioned on a ceteris-paribus assumption that all other relationships are held constant and are unaffected by the changes on which the theory is focusing, regardless of whether the assumption can be maintained.

For example, MMT posits that increases in taxes are deflationary and reductions in taxes are inflationary, because an increase in taxes implies a net drain of purchasing power from the private sector to the government sector and a reduction in taxes implies an injection of purchasing power.[2] According to the MMT, the price level reflects the relationship between total spending and total available productive resources, At given current prices, some level of total spending would just suffice to ensure that all available resources are fully employed. If total spending exceeds that amount, the excess spending must cause prices to rise to absorb the extra spending.

This naïve theory of inflation captures a basic intuition about the effect of increasing the rate of spending, but it is not a complete theory of inflation, because the level of spending depends not only on how much the government spends and how much tax revenue it collects; it also depends on, among other things, whether the public is trying to add to, or to reduce, the quantity of cash balances being held. Now it’s true that an efficiently operating banking system tends to adjust the quantity of cash to the demands of the public, but the banking system also has demands for the reserves that the government, via the central bank, makes available to be held, and its demands to hold reserves may match, or fall short of, the amount that banks at any moment wish to hold.

There is an interbank system of reserves, but if the amount of reserves that the government central bank creates is systematically above the amount of reserves that banks wish to hold, the deficiency will have repercussions on total spending. MMT theorists insist that the government central bank is obligated to provide whatever quantity of reserves is demanded, but that’s because the demand of banks to hold reserves is a function of the foregone interest incurred by banks holding reserves. Given the cost of holding reserves implied by the interest-rate target established by the government central bank, the banking system will demand a corresponding quantity of reserves, and, at that interest rate, government central banks will supply all the reserves demanded. But that doesn’t mean that, in setting its target rate, the government central bank isn’t implicitly determining the quantity of reserves for the entire system, thereby exercising an independent influence on the price level or the rate of inflation that must be reconciled with the fiscal stance of the government.

A tendency toward oversimplification is hardly unique to MMT. It’s also characteristic of older schools of thought, like the metallist theory of money, the polar opposite from the MMT and the chartalist theory. The metallist theory asserts that the value of a metallic money must equal the value of the amount of the metal represented by any particular monetary unit defined in terms of that metal. Under a gold standard, for example, all monetary units represent some particular quantity of gold, and the relative values of those units correspond to the ratios of the gold represented by those units. The value of gold standard currency therefore doesn’t deviate more than trivially from the value of the amount of gold represented by the currency.

But, here again, we confront a simplification; the value of gold, or of any commodity serving as a monetary standard, isn’t independent of its monetary-standard function. The value of any commodity depends on the total demand for any and all purposes for which it is, or may be, used. If gold serves as money, either as coins actually exchanged or a reserves sitting in bank vaults, that amount of gold is withdrawn from potential non-monetary uses, so that the value of gold relative to other commodities must rise to reflect the diversion of that portion of the total stock from non-monetary uses. If the demand to hold money rises, and the additional money that must be created to meet that demand requires additional gold to be converted into monetary form, either as coins or as reserves held by banks, the additional derived demand for gold tends to increase the value of gold, and, as a result, the value of money.

Moreover, insofar as governments accumulate reserves of gold that are otherwise held idle, the decision about how much gold reserves to continue holding in relation to the monetary claims on those reserves also affects the value of gold. It’s therefore not necessarily correct to say that, under a gold standard, the value of gold determines the value of money. The strictly correct proposition is that, under a gold standard, the value of gold and the value of money must be equal. But the value of money causally affects the value of gold no less than the value of gold causally affects the value of money.

In the context of a fiat money, whose value necessarily reflects expectations of its future purchasing power, it is not only the current policies of the government and the monetary authority, but expectations about future economic conditions and about the future responses of policy-makers to those conditions that determine the value of a fiat money. A useful theory of the value of money and of the effect of monetary policy on the value of money cannot be formulated without taking the expectations of individuals into account. Rational-expectations may be a useful first step to in formulating models that explicitly take expectations into account, but their underlying suppositions of most rational-expectations models are too far-fetched – especially the assumption that all expectations converge on the “correct” probability distributions of all future prices – to provide practical insight, much less useful policy guidance (Glasner 2020).

So, in the end, all simple theories of causation, like MMT, that suggest one particular variable determines the value of another are untenable in any complex system of mutually interrelated phenomena (Hayek 1967). There are few systems in nature as complex as a modern economy; only if it were possible to write out a complete system of equations describing all those interrelationships, could we trace out the effects of increasing the income tax rate or the level of government spending on the overall price level, as MMT claims to do. But for a complex interrelated system, no direct causal relationship between any two variables to the exclusion of all the others is likely to serve as a reliable guide to policy except in special situations when it can plausibly be assumed that a ceteris-paribus assumption is likely to be even approximately true.

[1] The classic exposition of this theory of money was provided by Carl Menger (1892).

[2] In an alternate version of the tax theory of inflation, an increase in taxes increases the value of money by increasing the demand of money at the moment when tax liabilities come due. The value of money is determined by its value at those peak periods, and it is the expected value of money at those peak periods that maintains its value during non-peak periods. The problem with this version is that it presumes that the value of money is solely a function of its value in discharging tax liabilities, but money is also demanded to serve as a medium of exchange which implies an increase in value above the value it would have solely from the demand occasioned by its acceptability to discharge tax liabilities.

The Rises and Falls of Keynesianism and Monetarism

The following is extracted from a paper on the history of macroeconomics that I’m now writing. I don’t know yet where or when it will be published and there may or may not be further installments, but I would be interested in any comments or suggestions that readers might have. Regular readers, if there are any, will probably recognize some familiar themes that I’ve been writing about in a number of my posts over the past several months. So despite the diminished frequency of my posting, I haven’t been entirely idle.

Recognizing the cognitive dissonance between the vision of the optimal equilibrium of a competitive market economy described by Marshallian economic theory and the massive unemployment of the Great Depression, Keynes offered an alternative, and, in his view, more general, theory, the optimal neoclassical equilibrium being a special case.[1] The explanatory barrier that Keynes struggled, not quite successfully, to overcome in the dire circumstances of the 1930s, was why market-price adjustments do not have the equilibrating tendencies attributed to them by Marshallian theory. The power of Keynes’s analysis, enhanced by his rhetorical gifts, enabled him to persuade much of the economics profession, especially many of the most gifted younger economists at the time, that he was right. But his argument, failing to expose the key weakness in the neoclassical orthodoxy, was incomplete.

The full title of Keynes’s book, The General Theory of Employment, Interest and Money identifies the key elements of his revision of neoclassical theory. First, contrary to a simplistic application of Marshallian theory, the mass unemployment of the Great Depression would not be substantially reduced by cutting wages to “clear” the labor market. The reason, according to Keynes, is that the levels of output and unemployment depend not on money wages, but on planned total spending (aggregate demand). Mass unemployment is the result of too little spending not excessive wages. Reducing wages would simply cause a corresponding decline in total spending, without increasing output or employment.

If wage cuts do not increase output and employment, the ensuing high unemployment, Keynes argued, is involuntary, not the outcome of optimizing choices made by workers and employers. Ever since, the notion that unemployment can be involuntary has remained a contested issue between Keynesians and neoclassicists, a contest requiring resolution in favor of one or the other theory or some reconciliation of the two.

Besides rejecting the neoclassical theory of employment, Keynes also famously disputed the neoclassical theory of interest by arguing that the rate of interest is not, as in the neoclassical theory, a reward for saving, but a reward for sacrificing liquidity. In Keynes’s view, rather than equilibrate savings and investment, interest equilibrates the demand to hold the money issued by the monetary authority with the amount issued by the monetary authority. Under the neoclassical theory, it is the price level that adjusts to equilibrate the demand for money with the quantity issued.

Had Keynes been more attuned to the Walrasian paradigm, he might have recast his argument that cutting wages would not eliminate unemployment by noting the inapplicability of a Marshallian supply-demand analysis of the labor market (accounting for over 50 percent of national income), because wage cuts would shift demand and supply curves in almost every other input and output market, grossly violating the ceteris-paribus assumption underlying Marshallian supply-demand paradigm. When every change in the wage shifts supply and demand curves in all markets for good and services, which in turn causes the labor-demand and labor-supply curves to shift, a supply-demand analysis of aggregate unemployment becomes a futile exercise.

Keynes’s work had two immediate effects on economics and economists. First, it immediately opened up a new field of research – macroeconomics – based on his theory that total output and employment are determined by aggregate demand. Representing only one element of Keynes’s argument, the simplified Keynesian model, on which macroeconomic theory was founded, seemed disconnected from either the Marshallian or Walrasian versions of neoclassical theory.

Second, the apparent disconnect between the simple Keynesian macro-model and neoclassical theory provoked an ongoing debate about the extent to which Keynesian theory could be deduced, or even reconciled, with the premises of neoclassical theory. Initial steps toward a reconciliation were provided when a model incorporating the quantity of money and the interest rate into the Keynesian analysis was introduced, soon becoming the canonical macroeconomic model of undergraduate and graduate textbooks.

Critics of Keynesian theory, usually those opposed to its support for deficit spending as a tool of aggregate demand management, its supposed inflationary bias, and its encouragement or toleration of government intervention in the free-market economy, tried to debunk Keynesianism by pointing out its inconsistencies with the neoclassical doctrine of a self-regulating market economy. But proponents of Keynesian precepts were also trying to reconcile Keynesian analysis with neoclassical theory. Future Nobel Prize winners like J. R. Hicks, J. E. Meade, Paul Samuelson, Franco Modigliani, James Tobin, and Lawrence Klein all derived various Keynesian propositions from neoclassical assumptions, usually by resorting to the un-Keynesian assumption of rigid or sticky prices and wages.

What both Keynesian and neoclassical economists failed to see is that, notwithstanding the optimality of an economy with equilibrium market prices, in either the Walrasian or the Marshallian versions, cannot explain either how that set of equilibrium prices is, or can be, found, or how it results automatically from the routine operation of free markets.

The assumption made implicitly by both Keynesians and neoclassicals was that, in an ideal perfectly competitive free-market economy, prices would adjust, if not instantaneously, at least eventually, to their equilibrium, market-clearing, levels so that the economy would achieve an equilibrium state. Not all Keynesians, of course, agreed that a perfectly competitive economy would reach that outcome, even in the long-run. But, according to neoclassical theory, equilibrium is the state toward which a competitive economy is drawn.

Keynesian policy could therefore be rationalized as an instrument for reversing departures from equilibrium and ensuring that such departures are relatively small and transitory. Notwithstanding Keynes’s explicit argument that wage cuts cannot eliminate involuntary unemployment, the sticky-prices-and-wages story was too convenient not to be adopted as a rationalization of Keynesian policy while also reconciling that policy with the neoclassical orthodoxy associated with the postwar ascendancy of the Walrasian paradigm.

The Walrasian ascendancy in neoclassical theory was the culmination of a silent revolution beginning in the late 1920s when the work of Walras and his successors was taken up by a younger generation of mathematically trained economists. The revolution proceeded along many fronts, of which the most important was proving the existence of a solution of the system of equations describing a general equilibrium for a competitive economy — a proof that Walras himself had not provided. The sophisticated mathematics used to describe the relevant general-equilibrium models and derive mathematically rigorous proofs encouraged the process of rapid development, adoption and application of mathematical techniques by subsequent generations of economists.

Despite the early success of the Walrasian paradigm, Kenneth Arrow, perhaps the most important Walrasian theorist of the second half of the twentieth century, drew attention to the explanatory gap within the paradigm: how the adjustment of disequilibrium prices is possible in a model of perfect competition in which every transactor takes market price as given. The Walrasian theory shows that a competitive equilibrium ensuring the consistency of agents’ plans to buy and sell results from an equilibrium set of prices for all goods and services. But the theory is silent about how those equilibrium prices are found and communicated to the agents of the model, the Walrasian tâtonnement process being an empirically empty heuristic artifact.

In fact, the explanatory gap identified by Arrow was even wider than he had suggested or realized, for another aspect of the Walrasian revolution of the late 1920s and 1930s was the extension of the equilibrium concept from a single-period equilibrium to an intertemporal equilibrium. Although earlier works by Irving Fisher and Frank Knight laid a foundation for this extension, the explicit articulation of intertemporal-equilibrium analysis was the nearly simultaneous contribution of three young economists, two Swedes (Myrdal and Lindahl) and an Austrian (Hayek) whose significance, despite being partially incorporated into the canonical Arrow-Debreu-McKenzie version of the Walrasian model, remains insufficiently recognized.

These three economists transformed the concept of equilibrium from an unchanging static economic system at rest to a dynamic system changing from period to period. While Walras and Marshall had conceived of a single-period equilibrium with no tendency to change barring an exogenous change in underlying conditions, Myrdal, Lindahl and Hayek conceived of an equilibrium unfolding through time, defined by the mutual consistency of the optimal plans of disparate agents to buy and sell in the present and in the future.

In formulating optimal plans that extend through time, agents consider both the current prices at which they can buy and sell, and the prices at which they will (or expect to) be able to buy and sell in the future. Although it may sometimes be possible to buy or sell forward at a currently quoted price for future delivery, agents planning to buy and sell goods or services rely, for the most part, on their expectations of future prices. Those expectations, of course, need not always turn out to have been accurate.

The dynamic equilibrium described by Myrdal, Lindahl and Hayek is a contingent event in which all agents have correctly anticipated the future prices on which they have based their plans. In the event that some, if not all, agents have incorrectly anticipated future prices, those agents whose plans were based on incorrect expectations may have to revise their plans or be unable to execute them. But unless all agents share the same expectations of future prices, their expectations cannot all be correct, and some of those plans may not be realized.

The impossibility of an intertemporal equilibrium of optimal plans if agents do not share the same expectations of future prices implies that the adjustment of perfectly flexible market prices is not sufficient an optimal equilibrium to be achieved. I shall have more to say about this point below, but for now I want to note that the growing interest in the quiet Walrasian revolution in neoclassical theory that occurred almost simultaneously with the Keynesian revolution made it inevitable that Keynesian models would be recast in explicitly Walrasian terms.

What emerged from the Walrasian reformulation of Keynesian analysis was the neoclassical synthesis that became the textbook version of macroeconomics in the 1960s and 1970s. But the seemingly anomalous conjunction of both inflation and unemployment during the 1970s led to a reconsideration and widespread rejection of the Keynesian proposition that output and employment are directly related to aggregate demand.

Indeed, supporters of the Monetarist views of Milton Friedman argued that the high inflation and unemployment of the 1970s amounted to an empirical refutation of the Keynesian system. But Friedman’s political conservatism, free-market ideology, and his acerbic criticism of Keynesian policies obscured the extent to which his largely atheoretical monetary thinking was influenced by Keynesian and Marshallian concepts that rendered his version of Monetarism an unattractive alternative for younger monetary theorists, schooled in the Walrasian version of neoclassicism, who were seeking a clear theoretical contrast with the Keynesian macro model.

The brief Monetarist ascendancy following 1970s inflation conveniently collapsed in the early 1980s, after Friedman’s Monetarist policy advice for controlling the quantity of money proved unworkable, when central banks, foolishly trying to implement the advice, prolonged a needlessly deep recession while central banks consistently overshot their monetary targets, thereby provoking a long series of embarrassing warnings from Friedman about the imminent return of double-digit inflation.


[1] Hayek, both a friend and a foe of Keynes, would chide Keynes decades after Keynes’s death for calling his theory a general theory when, in Hayek’s view, it was a special theory relevant only in periods of substantially less than full employment when increasing aggregate demand could increase total output. But in making this criticism, Hayek, himself, implicitly assumed that which he had himself admitted in his theory of intertemporal equilibrium that there is no automatic equilibration mechanism that ensures that general equilibrium obtains.

Sic Transit Inflatio Mundi

Larry Summers continues to lead the charge for a quick, decisive tightening of monetary policy by the Federal Reserve to head off an inflationary surge that, he believes, is about to overtake us. Undoubtedly one of the most capable economists of his generation, Summers also had a long career as a policy maker at the highest levels, so his advice cannot be casually dismissed. Even aside from Summers’s warning, the current economic environment fully justifies heightened concern caused by the recent uptick in inflation.

I am, nevertheless, not inclined to share Summers’s confidence in his oft-repeated predictions of resurgent inflation unless monetary policy is substantially tightened soon to prevent current inflation from being entrenched into the expectations of households and businesses. Summers’s’ latest warning came in a Washington Post op-ed following the statement by the FOMC and by Chairman Jay Powell that Fed policy would shift to give priority to maintaining price stability.

After welcoming the FOMC statement, Summers immediately segued into a critique of the Fed position on every substantive point.

There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.

The not-very-encouraging history of disinflation efforts suggests that the Fed will need to be both skillful and lucky as it seeks to apply sufficient restraint to cause inflation to come down to its 2 percent target without pushing the economy into recession. Unfortunately, several aspects of the Open Market Committee statement and Powell’s news conference suggest that the Fed may not yet fully grasp either the current economic situation or the implications of current monetary policy.

Summers cites the recessions between the Korean War and the 1979-82 Volcker Monetarist experiment to support his anti-inflationary diagnosis and remedy. But none of the three recessions in the 1950s during the Eisenhower Presidency was needed to cope with any significant inflationary threat. There was no substantial inflation in the US during the 1950s, never reaching 3% in any year between 1953 and 1960, and rarely exceeding 2%.

Inflation during the late 1960 and 1970s was caused by a combination of factors, including both excess demand fueled by Vietnam War spending and politically motivated monetary expansion, plus two oil shocks in 1973-74 and 1979-80, an economic environment with only modest similarity to the current economic situation.

But the important lesson from the disastrous Volcker-Friedman recession is that most of the reduction in inflation following Volcker’s decisive move to tighten monetary policy in early 1981 did not come until a year and a half later, when with the US unemployment rate above 10%, Volcker finally abandoned the futile and counterproductive Monetarist policy of making the monetary aggregates policy instruments. Had it not been for the Monetarist obsession with controlling the monetary aggregates, a recovery could have started six months to a year earlier than it did, with inflation continuing on the downward trajectory as output and employment expanded.

The key point is that falling output, in and of itself, tends to cause rising, not falling, prices, so that postponing the start of a recovery actually delays, rather than hastens, the reduction of inflation. As I explained in another post, rather than focusing onthe monetary aggregates, monetary policy ought to have aimed to reduce the rate of growth of total nominal spending from well over 12% in 1980-81 to a rate of about 7%, which would have been consistent with the informal 4% inflation target that Volcker and Reagan had set for themselves.

The appropriate lesson to take away from the Volcker-Friedman recession of 1981-82 is therefore that a central bank can meet its inflation target by reducing the rate of increase in total nominal spending and income to the rate, given anticipated real expansion of capacity and productivity, consistent with its inflation target. The rate of growth in nominal spending and income cannot be controlled with a degree of accuracy, but rates of increase in spending above or below the target rate of increase provide the central bank with real time indications of whether policy needs to be tightened or loosened to meet the inflation target. That approach would avoid the inordinate cost of reducing inflation associated with the Volcker-Friedman episode.

A further aggravating factor in the 1981-82 recession was that interest rates had risen to double-digit levels even before Volcker embarked on his Monetarist anti-inflation strategy, showing how deeply embedded inflation expectations had become in the plans of households and businesses. By contrast, interest rates have actually been falling for months, suggesting that Summers’s warnings about inflation expectations becoming entrenched are overstated.

The Fed forecast calls for inflation to significantly subside even as the economy sustains 3.5 percent unemployment — a development without precedent in U.S. economic history. The Fed believes this even though it regards the sustainable level of unemployment as 4 percent. This only makes sense if the Fed is clinging to the idea that current inflation is transitory and expects it to subside of its own accord.

Summers’s factual assertion that the US unemployment rate has never fallen, without inflationary stimulus, to 3.5%, an argument predicated on the assumption that the natural (or non-accelerating- inflation rate of unemployment) is firmly fixed at 4% is not well supported by the data. In 2019 and early 2020, the unemployment rate dropped to 3.5% without evident inflationary pressure. In the late 1990s unemployment also dropped below 4% without inflationary pressure. So, the expectation that a 3.5% unemployment rate could be restored without inflationary pressure may be optimistic, but it’s hardly unprecedented.

Summers suggests that the Fed is confused because it expects the unemployment rate to fall back to the 3.5% rate of 2019 even while supposedly regarding a 4%, not a 3.5%, rate of unemployment as sustainable. According to Summers, reaching a 3.5% rate of unemployment would be possible only if the current increase in the inflation rate is temporary. But the bond market seems to share that view with the Fed given the recent decreases in the yields on Treasury bonds of 5 to 30 years duration. But Summers takes a different view.

In fact, there is solid reason to think inflation may accelerate. The consumer price index’s shelter component, which represents one-third of the index, has gone up by less than 4 percent, even as private calculations without exception suggest increases of 10 to 20 percent in rent and home prices. Catch-up is likely. More fundamentally, job vacancies are at record levels and the labor market is still heating up, according to the Fed forecast. This portends acceleration rather than deceleration in labor costs — by far the largest cost for the business sector.

Projecting how increases in rent and home prices that have already occurred will affect reported inflation in the future is a tricky exercise. It is certain that those effects will show up in the future, but those effects are already baked into those future inflation reports, so they provide an uneasy basis on which to conduct monetary policy. Insofar as inflation is a problem, it is a problem not because of short-term fluctuations in prices in specific goods, even home prices and rents, or whole sectors of the economy, but because of generalized and potentially continuing long-term trends affecting the whole structure of prices.

The current number of job vacancies reflects both the demand for, and the supply of, labor. The labor-force participation rate is still well below the pre-pandemic level, reflecting the effect of withdrawal from the labor force by workers afraid of contracting the COVID virus, or unable to find day care for children, or deterred from seeking by other pandemic-related concerns from seeking or accepting employment. Under such circumstances, the re-allocations associated with high job-vacancy rates are likely to enhance the efficiency and productivity of the workers that are re-employed, and need not exacerbate inflationary pressures.

Presumably, the Fed has judged that current aggregate-demand increases have less to do with observed inflation than labor-supply constraints or other supply-side bottlenecks whose effects on prices are likely self-limiting. This judgment is neither obviously right nor obviously wrong. But, for now at least, it is not unreasonable for the Fed to remain cautious before making a drastic policy change, neither committing itself to an immediate tightening, as Summers is proposing, nor doubling down on a commitment to its current accommodative stance.

Meanwhile, the pandemic-related bottlenecks central to the transitory argument are exaggerated. Prices for more than 80 percent of goods in the CPI have increased more than 3 percent in the past year.With the economy’s capacity growing 2 percent a year and the Fed’s own forecast calling for 4 percent growth in 2022, price pressures seem more likely to grow than to abate.

This argument makes no sense. We have, to be sure, gone through a period of actual broad-based inflation, so pointing out that 80% of goods in the CPI have increased in price by more than 3% in the past year is unsurprising. The bottleneck point is that supply constraints have prevented the real economy from growing as fast as nominal spending has grown. As I’ve pointed out recently, there’s an overhang of cash and liquid assets, accumulated rather than spent during the pandemic, which has amplified aggregate-demand growth since the economy began to recover from the pandemic, opening up previously closed opportunities for spending. The mismatch between the growth of demand and the growth of supply has been manifested in rising inflation. If the bottleneck theory of inflation is true, then the short-term growth potential of the economy is greater than the 2% rate posited by Summers. As bottlenecks are removed and workers that withdrew from the labor force during the pandemic are re-employed, the economy could easily grow faster than Summers is willing to acknowledge. Summers simply assumes, but doesn’t demonstrate, his conclusion.

This all suggests that policy will need to restrain demand to restore price stability.

No, it does not suggest that at all. It only suggests the possibility that demand may have to be restrained to keep prices stable. Recent inflation may have been a delayed response to an expansive monetary policy designed to prevent a contraction of demand during the pandemic. A temporary increase in inflation does not necessarily call for an immediate contractionary response. It’s too early to tell with confidence whether preventing future inflation requires, as Summers asserts, monetary policy to be tightened immediately. That option shouldn’t be taken off the table, but the Fed clearly hasn’t done so.

How much tightening is required? No one knows, and the Fed is right to insist that it will monitor the economy and adjust. We do know, however, that monetary policy is far looser today — in a high-inflation, low-unemployment economy — than it was about a year ago when inflation was below the Fed’s target and unemployment was around 8 percent. With relatively constant nominal interest rates, higher inflation and the expectation of future inflation have led to dramatic reductions in real interest rates over the past year. This is why bubbles are increasingly pervasive in asset markets ranging from crypto to beachfront properties and meme stocks to tech start-ups.

Summers, again, is just assuming, not demonstrating, his own preferred conclusion. A year ago, high unemployment was caused by the unique confluence of essentially simultaneous negative demand and supply shocks. The unprecedented coincidence of two simultaneous shocks posed a unique policy challenge to which the Fed has so far responded with remarkable skill. But the unfamiliar and challenging economic environment remains murky, and premature responses to unclear conditions may not yield the anticipated results. Undaunted by any doubt in his own reading of an opaque situation, Summers self-assurance is characteristic and impressive, but his argument is less than compelling.

The implication is that restoring monetary policy to a normal posture, let alone to applying restraint to the economy, will require far more than the three quarter-point rate increases the Fed has predicted for next year. This point takes on particular force once it is recognized that, contrary to Powell’s assertion, almost all economists believe there is a lag of about a year between the application of a rate change and its effect. Failure to restore policy neutrality next year means allowing two more years of highly inflationary monetary policy.

All of this suggests that even with its actions this week, the Fed remains well behind the curve in its commitment to fighting inflation. If its statements reflect its convictions, this is a matter of serious concern.

The idea that there is a one-year lag between applying a policy and its effect is hardly credible. The problem is not the length of the lag, but the uncertain effects of policy in a given set of circumstances. The effects of a change in the money stock or a change in the policy rate may not be apparent if they are offset by other changes. The ceteris-paribus proviso that qualifies every analysis of the effects of monetary policy is rarely satisfied in the real world; almost every policy action by the central bank is an uncertain bet. Under current circumstances, the Fed response to the recent increase in inflation seems eminently sensible: signal that the Fed is anticipating the likelihood that monetary policy will have to be tightened if the current rate of increase in nominal spending remains substantially above the rate consistent with the Fed’s average inflation target of 2%, but wait for further evidence before deciding about the magnitude of any changes in the Fed’s policy instruments.

My Paper “Between Walras and Marshall: Menger’s Third Way” Is Now Posted on SSRN

As regular readers of this blog will realize, several of my recent posts (here, here, here, here, and here) have been incorporated in my new paper, which I have been writing for the upcoming Carl Menger 2021 Conference next week in Nice, France. The paper is now available on SSRN.

Here is the abstract to the paper:

Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium analyses. Given the failure of neoclassical theory to explain the Great Depression, Keynes proposed an explanation of involuntary unemployment. Keynes’s contribution was later subsumed under the neoclassical synthesis of the Keynesian and Walrasian theories. Lacking microfoundations consistent with Walrasian theory, the neoclassical synthesis collapsed. But Walrasian GE theory provides no plausible account of how GE is achieved. Whatever plausibility is attributed to the assumption that price flexibility leads to equilibrium derives from Marshallian PE analysis, with prices equilibrating supply and demand. But Marshallian PE analysis presumes that all markets, but the small one being analyzed, are at equilibrium, so that price adjustments in the analyzed market neither affect nor are affected by other markets. The demand and cost (curves) of PE analysis are drawn on the assumption that all other prices reflect Walrasian GE values. While based on Walrasian assumptions, modern macroeconomics relies on the Marshallian intuition that agents know or anticipate the prices consistent with GE. Menger’s third way offers an alternative to this conceptual impasse by recognizing that nearly all economic activity is subjective and guided by expectations of the future. Current prices are set based on expectations of future prices, so equilibrium is possible only if agents share the same expectations of future prices. If current prices are set based on differing expectations, arbitrage opportunities are created, causing prices and expectations to change, leading to further arbitrage, expectational change, and so on, but not necessarily to equilibrium.

Here is a link to the paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3964127

The current draft if preliminary, and any comments, suggestions or criticisms from readers would be greatly appreciated.

High-Inflation Anxiety

UPDATE (9:25am 11/16/2021): Thanks to philipji for catching some problematic passages in my initially posted version. I have also revised the opening paragraph, which was less than clear. Apologies for my sloppy late-night editing before posting.

When I started blogging ten-plus years ago, most of my posts were about monetary policy, because I then felt that the Fed was not doing as much as it could, and should, have been doing to promote a recovery from the Little Depression (aka Great Recession) for which Fed’s policy mistakes bore heavy responsibility. The 2008 financial crisis and the ensuing deep downturn were largely the product of an overly tight monetary policy starting in 2006, and, despite interest-rate cuts in 2007 and 2008, the Fed’s policy consistently erred on the side of tightness because of concerns about rising oil and commodities prices, for almost two months after the start of the crisis. The stance of monetary policy cannot be assessed just by looking at the level of the central bank policy rate; the stance depends on the relationship between the policy rate and the economic conditions at any particular moment. The 2-percent Fed Funds target in the summer of 2008, given economic conditions at the time, meant that monetary policy was tight, not easy.

Although, after the crisis, the Fed never did as much as it could — and should — have to promote recovery, it at least took small measures to avoid a lapse into a ruinous deflation, even as many of the sound-money types, egged on by deranged right-wing scare mongers, warned of runaway inflation.

Slowly but surely, a pathetically slow recovery by the end of Obama’s second term, brought us back to near full employment. By then, my interest in the conduct of monetary policy had given way to a variety of other concerns as we dove into the anni horribiles of the maladministration of Obama’s successor.

Riding a recovery that started seven and a half years before he took office, and buoyed by a right-wing propaganda juggernaut and a pathetically obscene personality cult that broadcast and amplified his brazenly megalomaniacal self-congratulations for the inherited recovery over which he presided, Obama’s successor watched incompetently as the Covid 19 virus spread through the United States, causing the sharpest drop in output and employment in US history.

Ten months after Obama’s successor departed from the White House, the US economy has recovered much, but not all, of the ground lost during the pandemic, employment still below its peak at the start of 2020, and real output still lagging the roughly 2% real growth path along which the economy had been moving for most of the preceding decade.

However, the very rapid increase in output in Q2 2021 and the less rapid, but still substantial, increase in output in Q3 2021, combined with inflation that has risen to the highest rates in 30 years, has provoked ominous warning of resurgent inflation similar to the inflation from the late 1960s till the early 1980s, ending only with the deep 1981-82 recession caused by the resolute anti-inflation policy administered by Fed Chairman Paul Volcker with the backing of the newly elected Ronald Reagan.

It’s worth briefly revisiting that history (which I have discussed previously on this blog here, here, and especially in the following series (1), (2) and (3) from 2020) to understand the nature of the theoretical misunderstanding and the resulting policy errors in the 1970s and 1980s. While I agree that the recent increase in inflation is worrisome, it’s far from clear that inflation is likely, as many now predict, to get worse, although the inflation risk can’t be dismissed.

What I find equally if not more worrisome is that the anti-inflation commentary that we are hearing now from very serious people like Larry Summers in today’s Washington Post is how much it sounds like the inflation talk of 2008, which frightened the Fed, then presided over by a truly eminent economist, Ben Bernanke, into thinking that the chief risk facing the economy was rising headline inflation that would cause inflation expectations to become “unanchored.”

So, rather than provide an economy rapidly sliding into recession, the FOMC, focused on rapid increases in oil and commodity prices, refused to loosen monetary policy in the summer of 2008, even though the pace of growth in nominal gross domestic product (NGDP) had steadily decelerated measured year on year. The accompanying table shows the steady decline in the quarterly year-on-year growth of NGDP in each successive quarter between Q1 2004 and Q4 2008. Between 2004 and 2006, the decline was gradual, but accelerated in 2007 leading to the start of a recession in December 2007.

Source: https://fred.stlouisfed.org/series/DFEDTAR

The decline in the rate of NGDP growth was associated with a gradual increase in the Fed funds target rate from a very low level 1% until Q2 2004, but by Q2 2006, when the rate reached 5%, the slowdown in the growth of total spending quickened. As the rate of spending declined, the Fed eased interest rates in the second half of 2007, but that easing was insufficient to prevent an economy, already suffering financial distress after the the housing bubble burst in 2006, from lapsing into recession.

Although the Fed cut its interest-rate target substantially in March 2008, during the summer of 2008, when the recession was rapidly deteriorating, the FOMC, fearing that inflation expectations would become “unanchored”, given rising headline inflation associated with very large increases in crude-oil prices (which climbed to a record $130 a barrel) and in commodity prices even as the recession was visibly worsening, refused to reduce rates further.

The Fed, to be sure, was confronted with a difficult policy dilemma, but it was a disastrous error to prioritize a speculative concern about the “unanchoring” of long-term inflation expectations over the reality of a fragile and clearly weakening financial system in a contracting economy already clearly in a recession. The Fed made the wrong choice, and the crisis came.

That was then, and now is now. The choices are different, but once again, on one side there is pressure to prioritize the speculative concern about the “unanchoring” of long-term inflation expectations over promoting recovery and increased employment after a a recession and a punishing pandemic. And, once again, the concerns about inflation are driven by a likely transitory increase in the price of crude oil and gasoline prices.

The case for prioritizing fighting inflation was just made by none other than Larry Summers in an op-ed in the Washington Post. Let’s have a look at Summer’s case for fighting inflation now.

Fed Chair Jerome H. Powell’s Jackson Hole speech in late August provided a clear, comprehensive and authoritative statement, enumerated in five pillars, of the widespread team “transitory” view of inflation that prevailed at that time and shaped policy thinking at the central bank and in the administration. Today, all five pillars are wobbly at best.

First, there was a claim that price increases were confined to a few sectors. No longer. In October, prices for commodity goods outside of food and energy rose at more than a 12 percent annual rate. Various Federal Reserve system indexes that exclude sectors with extreme price movements are now at record highs.

https://www.washingtonpost.com/opinions/2021/11/15/inflation-its-past-time-team-transitory-stand-down/

Summers has a point. Price increases are spreading throughout the economy. However, that doesn’t mean that increasing oil prices are not causing the prices of many other products to increase as well, inasmuch as oil and other substitute forms of energy are so widely used throughout the economy. If the increase in oil prices, and likely, in food prices, has peaked, or will do so soon, it does not necessarily make sense to fight a war against an enemy that has retreated or is about to do so.

Second, Powell suggested that high inflation in key sectors, such as used cars and durable goods more broadly, was coming under control and would start falling again. In October, used-car prices accelerated to more than a 30 percent annual inflation rate, new cars to a 17 percent rate and household furnishings by an annualized rate of just above 10 percent.

Id.

Again, citing large increases in the price of cars when it’s clear that there are special circumstances causing new car prices to rise rapidly, bringing used-car prices tagging along, is not very persuasive, especially when those special circumstances appear likely to be short-lived. To be sure other durables prices are also rising, but in the absence of a deeper source of inflation, the atmospherics cited by Summers are not that compelling.

Third, the speech pointed out that there was “little evidence of wage increases that might threaten excessive inflation.” This claim is untenable today with vacancy and quit rates at record highs, workers who switch jobs in sectors ranging from fast food to investment banking getting double-digit pay increases, and ominous Employment Cost Index increases.

Id.

Wage increases are usually an indicator of inflation, though, again the withdrawal, permanent or temporary, of many workers from employment in the past two years is a likely cause of increased wages that is independent of an underlying and ongoing inflationary trend.

Fourth, the speech argued that inflation expectations remained anchored. When Powell spoke, market inflation expectations for the term of the next Federal Reserve chair were around 2.5 percent. Now they are about 3.1 percent, up half a percentage point in the past month alone. And consumer sentiment is at a 10-year low due to inflation fears.

Id.

Clearly inflation expectations have increased over the short term for a variety of reasons that we have just been considering. But the curve of inflation expectations still seems to be reverting toward a lower level in the medium term and the long-term.

Fifth, Powell emphasized global deflationary trends. In the same week the United States learned of the fastest annual inflation rate in 30 years, Japan, China and Germany all reported their highest inflation in more than a decade. And the price of oil, the most important global determinant of inflation, is very high and not expected by forward markets to decline rapidly.

Id.

Again, Summers is simply recycling the same argument. We know that there has been a short-term increase in inflation. The question we need to grapple with is whether this short-term inflationary blip is likely to be self-limiting, or will feed on itself, causing inflation expectations to become “unanchored”. Forward prices of oil may not be showing that the price of oil will decline rapidly, but they aren’t showing expectations of further increases. Without further increases in oil prices, it is fair to ask what the source of further, ongoing inflation, that will cause “unanchoring”?

As it has in the past, the threat of “unanchoring”, is doing an awful lot of work. And it is not clear how the work is being done except by way of begging the question that really needs to be answered not begged.

After his windup, Summers offers fairly mild suggestions for his anti-inflation program, and only one of his comments seems mistaken.

Because of inflation, real interest rates are lower, as money is easier than a year ago. The Fed should signal that this is unacceptable and will be reversed.

Id.

The real interest rate about which the Fed should be concerned is the ex ante real interest rate reflecting both the expected yield from real capital and the expected rate of inflation (which may and often does have feedback effects on the expected yield from real capital). Past inflation does not automatically get transformed into an increase in expected inflation, and it is not necessarily the case that past inflation has left the expected yield from real capital unaffected, so Summers’ inference that the recent blip in inflation necessarily implies that monetary policy has been eased could well be mistaken. Yet again, these are judgments (or even guesses) that policymakers have to make about the subjective judgments of market participants. Those are policy judgments that can’t be made simply by reading off a computer screen.

While I’m not overly concerned by Summers’s list of inflation danger signs, there’s no doubt that inflation risk has risen. Yet, at least for now, that risk seems to be manageable. The risk may require the Fed to take pre-emptive measures against inflation down the road, but I don’t think that we have reached that point yet.

The main reason why I think that inflation risk has been overblown is that inflation is a common occurrence in postwar economies, as occurred in the US after both World Wars, and after the Korean War and the Vietnam War. It is widely recognized that war itself is inflationary owing, among other reasons, to the usual practice of governments to finance wartime expenditures by printing money, but inflationary pressures tend to persist even after the wars end.

Why does inflation persist after wars come to an end? The main reason is that, during wartime, resources, labor and capital, are shifted from producing goods for civilian purposes to waging war and producing and transporting supplies to support the war effort. Because total spending, financed by printing money, increases during the war, money income goes up even though the production of goods and services for civilian purposes goes down.

The output of goods and services for civilian purposes having been reduced, the increased money income accruing to the civilian population implies rising prices of the civilian goods and services that are produced. The tendency for prices to rise during wartime is mitigated by the reduced availability of outlets for private spending, people normally postponing much of their non-essential spending while the war is ongoing. Consequently, the public accumulates cash and liquid assets during wartime with the intention of spending the accumulated cash and liquid assets when life returns to normal after the war.

The lack of outlets for private spending is reinforced when, as happened in World War I, World War II, the Korean War and the late stages of the Vietnam War, price controls prevent the prices of civilian goods still being produced from rising, so that consumers can’t buy goods – either at all or as much as they would like – that they would willingly have paid for. The result is suppressed inflation until wartime price controls are lifted, and deferred price increases are allowed to occur. As prices rise, the excess cash that had been accumulated while the goods people demanded were unavailable is absorbed by purchases made at the postponed increases in price.

In his last book, Incomes and Money, Ralph Hawtrey described with characteristic clarity the process by which postwar inflation absorbed redundant cash balances accumulated during the World War II when price controls were lifted.

America, like Britain, had imposed price controls during the war, and had accumulated a great amount of redundant money. So long as the price controls continued, the American manufacturers were precluded from checking demand by raising their prices. But the price controls were abandoned in the latter half of 1946, and there resulted a rise of prices reaching 30 per cent on manufactured goods in the latter part of 1947. That meant that American industry was able to defend itself against the excess demand. By the end of 1947 the rise of prices had nearly eliminated the redundant money; that it to say, the quantity of money (currency and bank deposits) was little more than in a normal proportion to the national income. There was no longer over-employment in American industry, and there was no reluctance to take export orders.

Hawtrey, Incomes and Money, p. 7

Responding to Paul Krugman’s similar claim that there was high inflation following World War II, Summers posted the following twitter thread.

@paulkrugman continues his efforts to minimize the inflation threat to the American economy and progressive politics by pointing to the fact that inflation surged and then there was a year of deflation after World War 2.

If this is the best argument for not being alarmed that someone as smart, rhetorically effective and committed as Paul can make, my anxiety about inflation is increased.

Pervasive price controls were removed after the war. Economists know that measured prices with controls are artificial, so subsequent inflation proves little.

Millions of soldiers were returning home and a massive demobilization was in effect. Nothing like the current pervasive labor shortage was present.

https://twitter.com/LHSummers/status/1459992638170583041

Summers is surely correct that the situation today is not perfectly analogous to the post-WWII situation, but post-WWII inflation, as Hawtrey explained, was only partially attributable to the lifting of price controls. He ignores the effect of excess cash balances, which ultimately had to be spent or somehow withdrawn from circulation through a deliberate policy of deflation, which neither Summers nor most economists would think advisable or even acceptable. While the inflationary effect of absorbing excess cash balances is therefore almost inevitable, the duration of the inflation is limited and need not cause inflation expectations to become “unanchored.”

With the advent of highly effective Covid vaccines, we are now gradually emerging from the worst horrors of the Covid pandemic, when a substantial fraction of the labor force was either laid off or chose to withdraw from employment. As formerly idle workers return to work, we are in a prolonged quasi-postwar situation.

Just as the demand for civilian products declines during wartime, the demand for a broad range of private goods declined during the pandemic as people stopped going to restaurants, going on vacations, attending public gathering, and limited their driving and travel. Thus, the fraction of earnings that was saved increased as outlets for private spending became unavailable, inappropriate or undesirable.

As the pandemic has receded, restoring outlets for private spending, pent-up suppressed private demands have re-emerged, financed by households drawing down accumulated cash balances or drawing on credit lines augmented by paying down indebtedness. For many goods, like cars, the release of pent-up private demand has outpaced the increase in supply, leading to substantial price increases that are unlikely to be sustained once short-term supply bottlenecks are eliminated. But such imbalances between rapid increases in demand and sluggish increases in supply does not seem like a reliable basis on which to make policy choices.

So what are we to do now? As always, Ralph Hawtrey offers the best advice. The control of inflation, he taught, ultimately depends on controlling the relationship between the rate of growth in total nominal spending (and income) and the rate of growth of total real output. If total nominal spending (and income) is increasing faster than the increase in total real output, the difference will be reflected in the prices at which goods and services are provided.

In the five years from 2015 to 2019, the average growth rate in nominal spending (and income) was about 3.9%. During that period the average rate of growth in real output was 2.2% annually and the average rate of inflation was 1.7%. It has been reasonably suggested that extrapolating the 3.9% annual growth in nominal spending in the previous five years provides a reasonable baseline against which to compare actual spending in 2020 and 2021.

Actual nominal spending in Q3 2021 was slightly below what nominal GDP would have been in Q3 if it had continued growing at the extrapolated 3.9% growth path in nominal GDP. But for nominal GDP in Q4 not exceed that extrapolated growth path in Q4, Q4 could increase by an annual rate of no more than 4.3%. Inasmuch as spending in Q3 2021 was growing at 7.8%, the growth rate of nominal spending would have to slow substantially in Q4 from its Q3 growth rate.

But it is not clear that a 3.9% growth rate in nominal spending is the appropriate baseline to use. From 2015 to 2019, the average growth rate in real output was only 2.2% annually and the average inflation rate was only 1.7%. The Fed has long announced that its inflation target was 2% and in the 2015 to 2019 period, it consistently failed to meet that target. If the target inflation was 2% rather than 1.7%, presumably the Fed believed that annual growth would not have been less with 2% inflation than with 1.7%, so there is no reason to believe that the Fed should not have been aiming for more than 3.9% growth in total spending. If so a baseline for extrapolating the growth path for nominal spending should certainly not be less than 4.2%, Even a 4.5% baseline seems reasonable, and a baseline as high as 5% does not seem unreasonable.

With a 5% baseline, total nominal spending in Q4 could increase by as much as 5.4% without raising total nominal spending above its target path. But I think the more important point is not whether total spending does or does not rise above its growth path. The important goal is for the growth in nominal spending to decline steadily toward a reasonable growth path of about 4.5 to 5% and for this goal to be communicated to the public in a convincing manner. The 13.4% increase in total spending in Q2, when it appeared that the pandemic might soon be over, was likely a one-off outlier reflecting the release of pent-up demand. The 7.8% increase in Q3 was excessive, but substantially less than the Q2 rate of increase. If the Q4 increase does not continue downward trend in the rate of increase in nominal spending, it will be time to re-evaluate policy to ensure that the growth of spending is brought down to a non-inflationary range.

More on Arrow’s Explanatory Gap and the Milgrom-Stokey Argument

In my post yesterday, I discussed what I call Kenneth Arrow’s explanatory gap: the absence of any account in neoclassical economic theory of how the equilibrium price vector is actually arrived at and how changes in that equilibrium price vector result when changes in underlying conditions imply changes in equilibrium prices. I post below some revisions to several paragraphs in yesterday’s post supplemented by a more detailed discussion of the Milgrom-Stokey “no-trade theorem” and its significance. The following is drawn from a work in progress to be presented later this month at a conference celebrating the 150th anniversary of the publication of the Carl Menger’s Grundsätze der Volkswirtschaftslehre.

Thus, just twenty years after Arrow called attention to the explanatory gap in neoclassical theory by observing that neoclassical theory provides no explanation of how competitive prices can change, Paul Milgrom and Nancy Stokey (1982) turned Arrow’s argument on its head by arguing that, under rational expectations, no trading would ever occur at disequilibrium prices, because every potential trader would realize that an offer to trade at disequilibrium prices would not be made unless the offer was based on private knowledge and would therefore lead to a wealth transfer to the trader relying on private knowledge. Because no traders with rational expectations would agree to a trade at a disequilibrium price, there would be no incentive to seek or exploit private information, and all trades would occur at equilibrium prices.

This would have been a profound and important argument had it been made as a reductio ad absurdum to show the untenability of the rational-expectations as a theory of expectation formation, inasmuch as it leads to the obviously false factual implication that private information is never valuable and that no profitable trades are made by those possessed of private information. In concluding their paper, Milgrom and Stokey (1982) acknowledge the troubling implication of their argument:

Our results concerning rational expectations market equilibria raise anew the disturbing questions expressed by Beja (1977), Grossman and Stiglitz (1980), and Tirole (1980): Why do traders bother to gather information if they cannot profit from it? How does information come to be reflected in prices if informed traders do not trade or if they ignore their private information in making inferences? These questions can be answered satisfactorily only in the context of models of the price formation process; and our central result, the no-trade theorem, applies to all such models when rational expectations are assumed. (p. 17)

What Milgrom and Stokey seem not to have grasped is that the rational-expectations assumption dispenses with the need for a theory of price formation, inasmuch as every agent is assumed to be able to calculate what the equilibrium price is. They attempt to mitigate the extreme nature of this assumption by arguing that by observing price changes, traders can infer what changes in common knowledge would have implied the observed changes. That argument seems insufficient because any given change in price could be caused by more than one potential cause. As Scott Sumner has often argued, one can’t reason from a price change. If one doesn’t have independent knowledge of the cause of the price change, one can’t use the price change as a basis for further inference.

The Explanatory Gap and Mengerian Subjectivism

My last several posts have been focused on Marshall and Walras and the relationships and differences between the partial equilibrium approach of Marshall and the general-equilibrium approach of Walras and how that current state of neoclassical economics is divided between the more practical applied approach of Marshallian partial-equilibrium analysis and the more theoretical general-equilibrium approach of Walras. The divide is particularly important for the history of macroeconomics, because many of the macroeconomic controversies in the decades since Keynes have also involved differences between Marshallians and Walrasians. I’m not happy with either the Marshallian or Walrasian approach, and I have been trying to articulate my unhappiness with both branches of current neoclassical thinking by going back to the work of the forgotten marginal revolutionary, Carl Menger. I’ve been writing a paper for a conference later this month celebrating the 150th anniversary of Menger’s great work which draws on some of my recent musings, because I think it offers at least some hints at how to go about developing an improved neoclassical theory. Here’s a further sampling of my thinking which is drawn from one of the sections of my work in progress.

Both the Marshallian and the Walrasian versions of equilibrium analysis have failed to bridge an explanatory gap between the equilibrium state, whose existence is crucial for such empirical content as can be claimed on behalf of those versions of neoclassical theory, and such an equilibrium state could ever be attained. The gap was identified by one of the chief architects of modern neoclassical theory, Kenneth Arrow, in his 1958 paper “Toward a Theory of Price Adjustment.”

The equilibrium is defined in terms of a set of prices. In the Marshallian version, the equilibrium prices are assumed to have already been determined in all but a single market (or perhaps a subset of closely related markets), so that the Marshallian equilibrium simply represents how, in a single small or isolated market, an equilibrium price in that market is determined, under suitable ceteris-paribus conditions thereby leaving the equilibrium prices determined in other markets unaffected.

In the Walrasian version, all prices in all markets are determined simultaneously, but the method for determining those prices simultaneously was not spelled out by Walras other than by reference to the admittedly fictitious and purely heuristic tâtonnement process.

Both the Marshallian and Walrasian versions can show that equilibrium has optimal properties, but neither version can explain how the equilibrium is reached or how it can be discovered in practice. This is true even in the single-period context in which the Walrasian and Marshallian equilibrium analyses were originally carried out.

The single-period equilibrium has been extended, at least in a formal way, in the standard Arrow-Debreu-McKenzie (ADM) version of the Walrasian equilibrium, but this version is in important respects just an enhanced version of a single-period model inasmuch as all trades take place at time zero in a complete array of future state-contingent markets. So it is something of a stretch to consider the ADM model a truly intertemporal model in which the future can unfold in potentially surprising ways as opposed to just playing out a script already written in which agents go through the motions of executing a set of consistent plans to produce, purchase and sell in a sequence of predetermined actions.

Under less extreme assumptions than those of the ADM model, an intertemporal equilibrium involves both equilibrium current prices and equilibrium expected prices, and just as the equilibrium current prices are the same for all agents, equilibrium expected future prices must be equal for all agents. In his 1937 exposition of the concept of intertemporal equilibrium, Hayek explained the difference between what agents are assumed to know in a state of intertemporal equilibrium and what they are assumed to know in a single-period equilibrium.

If all agents share common knowledge, it may be plausible to assume that they will rationally arrive at similar expectations of the future prices. But if their stock of knowledge consists of both common knowledge and private knowledge, then it seems implausible to assume that the price expectations of different agents will always be in accord. Nevertheless, it is not necessarily inconceivable, though perhaps improbable, that agents will all arrive at the same expectations of future prices.

In the single-period equilibrium, all agents share common knowledge of equilibrium prices of all commodities. But in intertemporal equilibrium, agents lack knowledge of the future, but can only form expectations of future prices derived from their own, more or less accurate, stock of private knowledge. However, an equilibrium may still come about if, based on their private knowledge, they arrive at sufficiently similar expectations of future prices for their plans for their current and future purchases and sales to be mutually compatible.

Thus, just twenty years after Arrow called attention to the explanatory gap in neoclassical theory by observing that there is no neoclassical theory of how competitive prices can change, Milgrom and Stokey turned Arrow’s argument on its head by arguing that, under rational expectations, no trading would ever occur at prices other than equilibrium prices, so that it would be impossible for a trader with private information to take advantage of that information. This argument seems to suffer from a widely shared misunderstanding of what rational expectations signify.

Thus, in the Mengerian view articulated by Hayek, intertemporal equilibrium, given the diversity of private knowledge and expectations, is an unlikely, but not inconceivable, state of affairs, a view that stands in sharp contrast to the argument of Paul Milgrom and Nancy Stokey (1982), in which they argue that under a rational-expectations equilibrium there is no private knowledge, only common knowledge, and that it would be impossible for any trader to trade on private knowledge, because no other trader with rational expectations would be willing to trade with anyone at a price other than the equilibrium price.

Rational expectations is not a property of individual agents making rational and efficient use of the information from whatever source it is acquired. As I have previously explained here (and a revised version here) rational expectations is a property of intertemporal equilibrium; it is not an intrinsic property that agents have by virtue of being rational, just as the fact that the three angles in a triangle sum to 180 degrees is not a property of the angles qua angles, but a property of the triangle. When the expectations that agents hold about future prices are identical, their expectations are equilibrium expectations and they are rational. That the agents hold rational expectations in equilibrium, does not mean that the agents are possessed of the power to calculate equilibrium prices or even to know if their expectations of future prices are equilibrium expectations. Equilibrium is the cause of rational expectations; rational expectations do not exist if the conditions for equilibrium aren’t satisfied. See Blume, Curry and Easley (2006).

The assumption, now routinely regarded as axiomatic, that rational expectations is sufficient to ensure that equilibrium is automatic achieved, and that agents’ price expectations necessarily correspond to equilibrium price expectations is a form of question begging disguised as a methodological imperative that requires all macroeconomic models to be properly microfounded. The newly published volume edited by Arnon, Young and van der Beek Expectations: Theory and Applications from Historical Perspectives contains a wonderful essay by Duncan Foley that elucidates these issues.

In his centenary retrospective on Menger’s contribution, Hayek (1970), commenting on the inexactness of Menger’s account of economic theory, focused on Menger’s reluctance to embrace mathematics as an expository medium with which to articulate economic-theoretical concepts. While this may have been an aspect of Menger’s skepticism about mathematical reasoning, his recognition that expectations of the future are inherently inexact and conjectural and more akin to a range of potential outcomes of different probability may have been an even more significant factor in how Menger chose to articulate his theoretical vision.

But it is noteworthy that Hayek (1937) explicitly recognized that there is no theoretical explanation that accounts for any tendency toward intertemporal equilibrium, and instead merely (and in 1937!) relied an empirical tendency of economies to move in the direction of equilibrium as a justification for considering economic theory to have any practical relevance.

My Conversation with Hendrickson and Albrecht on the Economic Forces Podcast

Josh Hendrickson and Brian Albrecht have just posted our conversation about UCLA economics and economists, price theory vs. microfoundations, and my new book on their new Economic Forces Podcast. It was a really interesting conversation. Below are links to the podcast and to my book, which is now available online, and can be pre-ordered. The print version should be available in December.

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https://link.springer.com/book/10.1007/978-3-030-83426-5

The Walras-Marshall Divide in Neoclassical Theory, Part II

In my previous post, which itself followed up an earlier post “General Equilibrium, Partial Equilibrium and Costs,” I laid out the serious difficulties with neoclassical theory in either its Walrasian or Marshallian versions: its exclusive focus on equilibrium states with no plausible explanation of any economic process that leads from disequilibrium to equilibrium.

The Walrasian approach treats general equilibrium as the primary equilibrium concept, because no equilibrium solution in a single market can be isolated from the equilibrium solutions for all other markets. Marshall understood that no single market could be in isolated equilibrium independent of all other markets, but the practical difficulty of framing an analysis of the simultaneous equilibration of all markets made focusing on general equilibrium unappealing to Marshall, who wanted economic analysis to be relevant to the concerns of the public, i.e., policy makers and men of affairs whom he regarded as his primary audience.

Nevertheless, in doing partial-equilibrium analysis, Marshall conceded that it had to be embedded within a general-equilibrium context, so he was careful to specify the ceteris-paribus conditions under which partial-equilibrium analysis could be undertaken. In particular, any market under analysis had to be sufficiently small, or the disturbance to which that market was subject had to be sufficiently small, for the repercussions of the disturbance in that market to have only minimal effect on other markets, or, if substantial, those effects had to concentrated on a specific market (e.g., the market for a substitute, or complementary, good).

By focusing on equilibrium in a single market, Marshall believed he was making the analysis of equilibrium more tractable than the Walrasian alternative of focusing on the analysis of simultaneous equilibrium in all markets. Walras chose to make his approach to general equilibrium, if not tractable, at least intuitive by appealing to the fiction of tatonnement conducted by an imaginary auctioneer adjusting prices in all markets in response to any inconsistencies in the plans of transactors preventing them from executing their plans at the announced prices.

But it eventually became clear, to Walras and to others, that tatonnement could not be considered a realistic representation of actual market behavior, because the tatonnement fiction disallows trading at disequilibrium prices by pausing all transactions while a complete set of equilibrium prices for all desired transactions is sought by a process of trial and error. Not only is all economic activity and the passage of time suspended during the tatonnement process, there is not even a price-adjustment algorithm that can be relied on to find a complete set of equilibrium prices in a finite number of iterations.

Despite its seeming realism, the Marshallian approach, piecemeal market-by-market equilibration of each distinct market, is no more tenable theoretically than tatonnement, the partial-equilibrium method being premised on a ceteris-paribus assumption in which all prices and all other endogenous variables determined in markets other than the one under analysis are held constant. That assumption can be maintained only on the condition that all markets are in equilibrium. So the implicit assumption of partial-equilibrium analysis is no less theoretically extreme than Walras’s tatonnement fiction.

In my previous post, I quoted Michel De Vroey’s dismissal of Keynes’s rationale for the existence of involuntary unemployment, a violation in De Vroey’s estimation, of Marshallian partial-equilibrium premises. Let me quote De Vroey again.

When the strict Marshallian viewpoint is adopted, everything is simple: it is assumed that the aggregate supply price function incorporates wages at their market-clearing magnitude. Instead, when taking Keynes’s line, it must be assumed that the wage rate that firms consider when constructing their supply price function is a “false” (i.e., non-market-clearing) wage. Now, if we want to keep firms’ perfect foresight assumption (and, let me repeat, we need to lest we fall into a theoretical wilderness), it must be concluded that firms’ incorporation of a false wage into their supply function follows from their correct expectation that this is indeed what will happen in the labor market. That is, firms’ managers are aware that in this market something impairs market clearing. No other explanation than the wage floor assumption is available as long as one remains in the canonical Marshallian framework. Therefore, all Keynes’s claims to the contrary notwithstanding, it is difficult to escape the conclusion that his effective demand reasoning is based on the fixed-wage hypothesis. The reason for unemployment lies in the labor market, and no fuss should be made about effective demand being [the reason rather] than the other way around.

A History of Macroeconomics from Keynes to Lucas and Beyond, pp. 22-23

My interpretation of De Vroey’s argument is that the strict Marshallian viewpoint requires that firms correctly anticipate the wages that they will have to pay in making their hiring and production decisions, while presumably also correctly anticipating the future demand for their products. I am unable to make sense of this argument unless it means that firms — and why should firm owners or managers be the only agents endowed with perfect or correct foresight? – correctly foresee the prices of the products that they sell and of the inputs that they purchase or hire. In other words, the strict Marshallian viewpoint invoked by De Vroey assumes that each transactor foresees, without the intervention of a timeless tatonnement process guided by a fictional auctioneer, the equilibrium price vector. In other words, when the strict Marshallian viewpoint is adopted, everything is simple; every transactor is a Walrasian auctioneer.

My interpretation of Keynes – and perhaps I’m just reading my own criticism of partial-equilibrium analysis into Keynes – is that he understood that the aggregate labor market can’t be analyzed in a partial-equilibrium setting, because Marshall’s ceteris-paribus proviso can’t be maintained for a market that accounts for roughly half the earnings of the economy. When conditions change in the labor market, everything else also changes. So the equilibrium conditions of the labor market must be governed by aggregate equilibrium conditions that can’t be captured in, or accounted for by, a Marshallian partial-equilibrium framework. Because something other than supply and demand in the labor market determines the equilibrium, what happens in the labor market can’t, by itself, restore an equilibrium.

That, I think, was Keynes’s intuition. But while identifying a serious defect in the Marshallian viewpoint, that intuition did not provide an adequate theory of adjustment. But the inadequacy of Keynes’s critique doesn’t rehabilitate the Marshallian viewpoint, certainly not in the form in which De Vroey represents it.

But there’s a deeper problem with the Marshallian viewpoint than just the interdependence of all markets. Although Marshall accepted marginal-utility theory in principle and used it to explain consumer demand, he tried to limit its application to demand while retaining the classical theory of the cost of production as a coordinate factor explaining the relative prices of goods and services. Marginal utility determines demand while cost determines supply, so that the interaction of supply and demand (cost and utility) jointly determine price just as the two blades of a scissor jointly cut a piece of cloth or paper.

This view of the role of cost could be maintained only in the context of the typical Marshallian partial-equilibrium exercise in which all prices — including input prices — except the price of a single output are held fixed at their general-equilibrium values. But the equilibrium prices of inputs are not determined independently of the values of the outputs they produce, so their equilibrium market values are derived exclusively from the value of whatever outputs they produce.

This was a point that Marshall, desiring to minimize the extent to which the Marginal Revolution overturned the classical theory of value, either failed to grasp, or obscured: that both prices and costs are simultaneously determined. By focusing on partial-equilibrium analysis, in which input prices are treated as exogenous variables rather than, as in general-equilibrium analysis, endogenously determined variables, Marshall was able to argue as if the classical theory that the cost incurred to produce something determines its value or its market price, had not been overturned.

The absolute dependence of input prices on the value of the outputs that they are being used to produce was grasped more clearly by Carl Menger than by Walras and certainly more clearly than by Marshall. What’s more, unlike either Walras or Marshall, Menger explicitly recognized the time lapse between the purchasing and hiring of inputs by a firm and the sale of the final output, inputs having been purchased or hired in expectation of the future sale of the output. But expected future sales are at prices anticipated, but not known, in advance, making the valuation of inputs equally conjectural and forcing producers to make commitments without knowing either their costs or their revenues before undertaking those commitments.

It is precisely this contingent relationship between the expectation of future sales at unknown, but anticipated, prices and the valuations that firms attach to the inputs they purchase or hire that provides an alternative to the problematic Marshallian and Walrasian accounts of how equilibrium market prices are actually reached.

The critical role of expected future prices in determining equilibrium prices was missing from both the Marshallian and the Walrasian theories of price determination. In the Walrasian theory, price determination was attributed to a fictional tatonnement process that Walras originally thought might serve as a kind of oversimplified and idealized version of actual market behavior. But Walras seems eventually to have recognized and acknowledged how far removed from reality his tatonnement invention actually was.

The seemingly more realistic Marshallian account of price determination avoided the unrealism of the Walrasian auctioneer, but only by attributing equally, if not more, unrealistic powers of foreknowledge to the transactors than Walras had attributed to his auctioneer. Only Menger, who realistically avoided attributing extraordinary knowledge either to transactors or to an imaginary auctioneer, instead attributing to transactors only an imperfect and fallible ability to anticipate future prices, provided a realistic account, or at least a conceptual approach toward a realistic account, of how prices are actually formed.

In a future post, I will try spell out in greater detail my version of a Mengerian account of price formation and how this account might tell us about the process by which a set of equilibrium prices might be realized.


About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

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