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Hawtrey’s Good and Bad Trade, Part V: Did Hawtrey Discover PPP?

Published October 8, 2013 Cassel , Hawtrey , monetary theory , purchasing power parity 2 Comments
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The first seven chapters of Hawtrey’s Good and Bad Trade present an admirably succinct exposition of the theory of a fiat monetary system with a banking system that issues a credit money convertible into the fiat money supplied by the government. Hawtrey also explains how cyclical fluctuations in output, employment and prices could arise in such a system, given that the interest rates set by banks in the course of their lending operations inevitably deviate, even if for no more than very short periods of time, from what he calls their natural levels. See the wonderful quotation (from pp. 76-77) in my previous post about the inherent instability of the equilibrium between the market rate set by banks and the natural rate.

In chapter 7, Hawtrey considers an international system of fiat currencies, each one issued by the government of a single country in which only that currency (or credit money convertible into that currency) is acceptable as payment. Hawtrey sets as his objective an explanation of the exchange rates between pairs of such currencies and the corresponding price levels in those countries. In summing up his discussion (pp. 90-93) of what determines the rate of exchange between any two currencies, Hawtrey makes the following observation

Practically, it may be said that the rate of exchange equates the general level of prices of commodities in one country with that in the other. This is of course only approximately true, since the rate of exchange is affected only by those commodities which are or might be transported between the two countries. If one of the two countries is at a disadvantage in the production of commodities which cannot be imported, or indeed in those which can only be imported at a specially heavy cost, the general level of prices, calculated fairly over all commodities, will be higher in that country than in the other. But, subject to this important qualification, the rate of exchange under stable conditions does represent that ratio between the units of currency which makes the price-levels and therefore the purchasing powers of the two units equal. (pp. 92-93)

That, of course, is a terse, but characteristically precise, statement of the purchasing power parity doctrine. What makes it interesting, and possibly noteworthy, is that Hawtrey made it 100 years ago, in 1913, which is five years before Hawtrey’s older contemporary, Gustav Cassel, who is usually credited with having originated the doctrine in 1918 in his paper “Abnormal Deviations in International Exchanges” Economic Journal 28:413-15. Here’s how Cassel put it:

According to the theory of international exchanges which I have tried to develop during the course of the war, the rate of exchange between two countries is primarily determined by the quotient between the internal purchasing power against goods of the money of each country. The general inflation which has taken place during the war has lowered this purchasing power in all countries, though in a very different degree, and the rates of exchanges should accordingly be expected to deviate from their old parity in proportion to the inflation in each country.

At every moment the real parity between two countries is represented by this quotient between the purchasing power of the money in the one country and the other. I propose to call this parity “the purchasing power parity.” As long as anything like free movement of merchandise and a somewhat comprehensive trade between two countries takes place, the actual rate of exchange cannot deviate very much from this purchasing power parity. (p. 413)

Hawtrey proceeds, in the rest of the chapter, to explain how international relationships would be affected by a contraction in the currency of one country. The immediate effects would be the same as those described in the case of a single closed economy. However, in an international system, the effects of a contraction in one country would create opportunities for international transactions, both real and financial, that would involve both countries in the adjustment to the initial monetary disturbance originating in one of them.

Hawtrey sums up the discussion about the adjustment to a contraction of the currency of one country as follows:

From the above description, which is necessarily rather complicated, it will be seen that the mutual influence of two areas with independent currency systems is on the whole not very great Indeed, the only important consequence to either of a contraction of currency in the other, is the tendency for the first to lend money to the second in order to get the benefit of the high rate of interest. This hastens the movement towards ultimate equilibrium in the area of stringency. At the same time it would raise the rate of interest slightly in the other country But as this rise in the rate of interest is due to an enhanced demand for loans, it will not have the effect of diminishing the total stock of bankers’ money. (p. 99)

He concludes the chapter with a refinement of the purchasing power parity doctrine.

It is important to notice that as soon as the assumption of stable conditions is abandoned the rate of exchange ceases to represent the ratio of the purchasing powers of the two units of currency which it relates. A difference between the rates of interest in the two countries concerned displaces the rate of exchange from its normal position of equality with this ratio, in the same direction as if the purchasing power of the currency with the higher rate of interest had been increased. Such a divergence between the rates of interest would only occur in case of some financial disturbance, and though such disturbances, great or small, are bound to be frequent, the ratio of purchasing powers may still be taken (subject to the qualification previously explained) to be the normal significance of the rate of exchange. (p. 101)

Hawtrey’s Good and Bad Trade, Part IV: The Inherent Instability of Credit

Published October 4, 2013 Hawtrey , monetary theory , Uncategorized 6 Comments

I don’t have a particularly good memory for specific facts or of books and articles that I have read, even ones that I really enjoyed or thought were very important. If I am lucky, I can remember on or two highlights or retain some general idea of what the book or article was about. So I often find myself surprised when reading something for the second time when I come across a passage that I had forgotten and experience the shock and awe of discovery while knowing, and perhaps even remembering, that I had read this all before once upon a time. That is just the experience I had when reading chapter 7 (“Origination of Monetary Disturbances in an Isolated Community”) of Good and Bad Trade. I think that I read Good and Bad Trade for the first time in the spring of 2009. On the whole, I would say that I was less impressed with it than I was with some other books of his that I had read (especially The Art of Central Banking and The Gold Standard in Theory and Practice), but reading chapter 7 a second time really enhanced my appreciation for how insightful Hawtrey was and how well he explained the underlying causes for what he called, in one of his great phrases “the inherent instability of credit.” He starts of chapter 7 with the following deceptively modest introductory paragraphs.

In the last two chapters we have postulated a perfectly arbitrary change in the quantity of legal tender currency in circulation. However closely the consequences traced from such an arbitrary change may correspond with the phenomena we have set out to explain, we have accomplished nothing till we have shown that causes which will lead to those consequences actually occur. . . .

At the present stage, however it is already possible to make a preliminary survey of the causes of fluctuations with the advantage of an artificial simplification of the problem. And at the outset it must be recognized that arbitrary changes in the quantity of legal tender currency in circulation cannot be of much practical importance. Such changes rarely occur. . . .

But what we are looking for is the origination of changes not necessarily in the quantity of legal tender currency but in the quantity of purchasing power, which is based on the quantity of credit money. . . . For example, if the banker suddenly came to the conclusion that the proportion of reserves to liabilities previously maintained was too low, and decided to increase, this would necessitate a reduction in deposits exactly similar to the reduction which in the last chapter we supposed them to make in consequence of a reduction in the actual stock of legal tender currency. Or there might casual variations in their reserves. These reserves simply consist of that portion of the existing supply of cash [i.e., currency] which happens for the moment not to be in the pockets, tills, cashboxes, etc., of the public. The amount of money which any individual carries about with him at any time is largely a matter of chance, and consequently there may very well be variations in the cash in circulation and therefore contrary variations in the reserves, which are really in the nature of casual variations . . . (pp. 73-74)

After explaining that the amount of cash (i.e., currency) held by the public tends to fluctuate cyclically because increasing employment and increasing wage payments involve an increasing demand for currency (most workers having been paid with currency not by check, and certainly not by electronic transfer, in the nineteenth and early twentieth centuries), so that banks would generally tend to experience declining reserves over the course of the business cycle, Hawtrey offered another reason why banks would be subject to cyclical disturbances affecting their reserve position.

[W]henever the prevailing rate of profit deviates from the rate of interest charged on loans the discrepancy between them at once tends to be enlarged. If trade is for the moment stable and the market rate of interest is equal to the profit rate, and if we suppose that by any cause the profit rate is slightly increased, there will be an increased demand for loans at the existing market rate. But this increased demand for loans leads to an increase in the aggregate amount of purchasing power, which in turn still further increases the profit rate. This process will continue with ever accelerated force until the bankers intervene to save their reserves by raising the rate of interest up to and above the now enhanced profit rate. A parallel phenomenon occurs when the profit rate, through some chance cause, drops below the market rate; the consequent curtailment of loans and so of purchasing power leads at once to a greater and growing fall in profits, until the bankers intervene by reducing the rate of interest. It appears, therefore, that the equilibrium which the bankers have to maintain in fixing the rate of interest is essentially “unstable,” in the sense that if the rate of interest deviates from its proper value by any amount, however small, the deviation will tend to grow greater and greater until steps are taken to correct it. This of itself shows that the money market must be subject to fluctuations. A flag in a steady breeze could theoretically remain in equilibrium if it were spread out perfectly flat in the exact direction of the breeze. But it can be shown mathematically that that position is “unstable,” that if the flag deviates from it to any extent, however small, it will tend to deviate further. Consequently the flag flaps. (pp. 76-77)

Hawtrey also mentions other economic forces tending to amplify fluctuations, forces implicated in the general phenomenon of credit.

Credit money is composed of the obligations of bankers, and if a banker cannot meet his obligations the credit money dependent upon him is wholly or partly destroyed. Again, against his obligations the banker holds equivalent assets, together with a margin. These assets are composed chiefly of two items, legal tender currency and loans to traders. The solvency of the banker will depend largely on the reality of these assets, and the value of the loans will depend in turn on the solvency of the borrowers. (p. 77)

Hawtrey describes one of the principal assets held by English commercial banks in his day, the mercantile bill, with which a dealer or wholesaler making an order from a manufacturer obligates himself to pay for the ordered merchandise upon delivery at some fixed time, say 120 days, after the order is placed. The IOU of the dealer, the bill, can be immediately presented by the manufacturer to his banker who will then advance the funds to the manufacturer with which to cover the costs of producing the order for the dealer. When the order is filled four months hence, the dealer will pay for the order and the manufacturer will then be able to discharge his obligation to his banker.

The whole value of the manufacturer’s efforts in producing the goods depends upon there being an effective demand for them when they are completed. It is only because the dealer anticipates that this effective demand for them will be forthcoming that he gives the manufacturer the order. The dealer, in fact, is taking the responsibility of saying how £10,000 worth of the productive capacity of the country shall be employed. The manufacturer, in accepting the order, and the banker in discounting the bill, are both endorsing the opinion of the dealer. The whole transaction is based ultimately on an expectation of a future demand, which must be more or less speculative. But the banker is doubly insured against the risk. Both the dealer and the manufacturer are men of substance. If the dealer cannot dispose of the goods for £10,000, he is prepared to bear the loss himself. He expects some of his ventures to fail, and others to bring him more than he counted on. Take the rough with the smooth he will probably make a profit. . . . And if the dealer becomes insolvent, there is still the manufacturer to save the banker from loss. . . . Where bills are not used a banker may lend on the sole credit of a dealer or manufacturer, relying on the value of the business to which he lends as the ultimate security for the loan.

Now if a contraction of credit money occurs, the consequent slackening of demand, and fall in the prices of commodities, will lead to a widespread disappointment of dealers’ expectations. At such a time the weakest dealers are likely to be impaired. An individual or company in starting a manufacturing business would usually add to the capital they can provide themselves, further sums borrowed in the form of debentures secured on the business and yielding a fixed rate of interest. . . . But when the general level of prices is falling, the value of the entire business will be falling also, while the debenture and other liabilities, being expressed in money, will remain unchanged. . . . [D]uring the period of falling prices, the expenses of production resist the downward tendency, and the profits are temporarily diminished and may be entirely obliterated or turned into an actual loss. A weak business cannot bear the strain, and being unable to pay its debenture interest and having no further assets on which to borrow, it will fail. If it is not reconstructed but ceases operations altogether, that will of course contribute to the general diminution of output. Its inability to meet its engagements will at the same time inflict loss on the banks. But at present we are considering credit, and credit depends on the expectation of future solvency. A business which is believed to be weak will have difficulty in borrowing, because bankers fear that it may fail. At a time of contracting trade the probability of any given business failing will be increased. At the same time the probability of any particular venture for which it may desire to borrow resulting in a loss instead of a profit will likewise be increased. Consequently at such a time credit will be impaired, but this will be the consequence, not the cause of the contracting trade. (pp. 79-80)

Finally, Hawtrey directs our attention to the credit of bankers.

We have already seen that the banker’s estimate of the proper proportion of his reserve to his liabilities is almost entirely empirical, and that an arbitrary change in the proportion which he thinks fit to maintain between them will carry with it an increase or decrease, as the case may be, in the available amount of purchasing power in the community. If a banker really underestimates the proper amount of reserve, and does not correct his estimate, he may find himself at a moment of strain with his reserve rapidly melting away and no prospect of the process coming to an end before the reserve is exhausted. His natural remedy is to borrow from other banks; but this he can only do if they believe his position to be sound. If they will not lend, he must try to curtail his loans. But if has been lending imprudently, he will find that on his refusing to renew loans the borrowers will in some cases become bankrupt and his money will be lost. It is just when a banker has been lending imprudently that his fellow-bankers will refuse to lend to him, and thus the same mistake cuts him off simultaneously from the two possible remedies. (pp. 81-82)

Interestingly, though he explains how it is possible that credit may become unstable, leading to cumulative fluctuations in economic activity, Hawtrey concludes this chapter by arguing that without changes in aggregate purchasing power (which, in Hawtrey’s terminology, means the total quantity of fiat and credit money). The problem with that formulation is that what Hawtrey has just shown is that the quantity of credit money fluctuates with the state of credit, so to say that economic activity will not fluctuate much if aggregate purchasing power is held stable is to beg the question. The quantity of credit money will not remain stable unless credit remains stable, and if credit is unstable, which is what Hawtrey has just shown, the quantity of credit money will not remain stable.

Hawtrey’s Good and Bad Trade, Part III: Banking and Interest Rates

Published October 1, 2013 Hawtrey , monetary theory , natural rate of interest 11 Comments
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In my previous installment in this series, I began discussing Hawtrey’s analysis of a banking system that creates credit money convertible into a pure fiat money. I noted what seem to me to be defects in Hawtrey’s analysis, mainly related to his incomplete recognition of all the incentives governing banks when deciding how much money to create by making loans. Nevertheless, it is worth following Hawtrey, even with the gap, as he works his way through his analysis .

But, before we try to follow Hawtrey, it will be helpful to think about where he is heading. In his analysis of a pure fiat money system, all — actually not quite all, but almost all — of the analytical work was done by considering how a difference between the amount of fiat money people want to hold and the greater or lesser amount that they actually do hold is resolved. If they hold less money than they want, total spending decreases as people try (unsuccessfully in the aggregate) to build up their cash balances, and if they hold more money than they want, spending increases as people try (unsuccessfully in the aggregate) to part with their excess cash hoaldings. Reaching a new equilibrium entails an adjustment of the ratio of total spending to the stock of fiat money that characterized the initial equilibrium. There may be an interest rate in such an economy, but a change in the interest rate plays no part in the adjustment process that restores equilibrium after a monetary shock (i.e., a change in the stock of fiat money). Hawtrey aims to compare (and contrast) this adjustment process with the adjustment process to a change in the quantity of fiat money when not all money is fiat money — when there is also credit money (created by banks and convertible into fiat money) circulating along with fiat money.

In analyzing a monetary disturbance to a credit-money system, Hawtrey takes as his starting point a banking system in equilibrium, with banks and individuals holding just the amount of currency, reserves and deposits that they want to hold. He then posits a reduction in the total stock of currency.

The first effect of the contraction of the currency is that the working balance of cash in the hands of individual members of the community will be diminished. The precise proportion in which this diminution is shared between bankers and other people does not matter, for those who have banking accounts will quickly draw out enough cash to restore their working balances. As soon as this process is completed we have two effects; first, that the greater part, indeed practically the whole, of the currency withdrawn comes out of the banks’ reserves, and secondly, that the total amount of purchasing power in the community (i.e., currency in circulation plus bank balances) is diminished by the amount of currency withdrawn. One consequence of the existence of a banking system is that a given diminution in the stock of currency produces at this stage much less than a proportional diminution in the total of purchasing power. (pp. 58-59)

Hawtrey goes on to explain this point with a numerical example. Suppose total purchasing power (i.e., the sum of currency plus deposits) were £1 billion of which £250 million were currency and £750 million deposits. If the stock of currency were reduced by 10%, the amount of currency would fall to £225 million, with total stock of purchasing power falling to £975 million. (Note by the way, that Hawtrey’s figure for total purchasing power, or the total stock of money, does not correspond to the usual definition of the money stock in which only currency held by the public, not by the banking system, are counted.) At any rate, the key point for Hawtrey is that under a fiat currency with a banking system, the percentage decrease (10%) in the stock of currency is not equal to the percentage decrease in the total stock of money (2.5%), so that a 10% reduction in the stock of currency, unlike the pure fiat currency case, would not force down the price level by 10% (at least, not without introducing other variables into the picture). Having replenished their holdings of currency by converting deposits into currency, the total cash holdings of the public are only slightly (2.5%) less than the amount they would like to hold, so that only a 2.5% reduction in total spending would seem to be necessary to restore the kind of monetary equilibrium on which Hawtrey was focused in discussing the pure fiat money case. A different sort of disequilibrium involving a different adjustment process had to be added to his analytical landscape.

The new disequilibrium introduced by Hawtrey was that between the amount of currency held by the banks as reserves against their liabilities (deposits) and the amount of currency that they are actually holding. Thus, even though banks met the demands of their depositors to replenish the fiat currency that, by assumption, had been taken from their existing cash balances, that response by the banks, while (largely) eliminating one disequilibrium, also created another one: the banks now find that their reserves, given the amount of liabilities (deposits) on their balance sheets, are less than they would like them to be. Hawtrey is thus positing the existence of a demand function by the banks to hold reserves, a function that depends on the amount of liabilities that they create. (Like most banking theorists, Hawtrey assumes that the functional relationship between bank deposits and banks’ desired reserves is proportional, but there are obviously economies of scale in holding reserves, so that the relationship between bank deposits and desired reserves is certainly less than proportional.) The means by which banks can replenish their reserves, according to Hawtrey, again following traditional banking theory, is to raise the interest rate that they charge borrowers. Here, again, Hawtrey was not quite on the mark, overlooking the possibility that banks could offer to pay interest (or to increase the rate that they were already paying on deposits) as a way of reducing the tendency of depositors to withdraw deposits in exchange for currency.

The special insight brought by Hawtrey to this analysis is that a particular group of entrepreneurs (traders and merchants), whose largest expense is the interest paid on advances from banks to finance their holdings of inventories, are highly sensitive to variations in the bank lending rate, and adjust the size of their inventories accordingly. And since it is the manufacturers to whom traders and merchants are placing orders, the output of factories is necessarily sensitive to the size of the inventories that merchants and traders are trying to hold. Thus, if banks, desiring to replenish their depleted reserves held against deposits, raise interest rates on loans, it will immediately reduce the size of inventories that merchants and traders want to hold, causing them to diminish their orders to manufacturers. But as manufacturers reduce output in response to diminished orders from merchants, the incomes of employees and others providing services and materials to the manufacturers will also fall, so that traders and merchants will find that they are accumulating inventories because their sales to dealers and retailers are slackening, offsetting the effect of their diminished orders to manufacturers, and, in turn, causing merchants and traders to reduce further their orders from manufacturers.

As this process works itself out, prices and output will tend to fall (at least relative to trend), so that traders and merchants will gradually succeed in reducing their indebtedness to the banks, implying that the total deposits created by the banking system will decrease. As their deposit liabilities decline, the amount of reserves that the banks would like to hold declines as well, so that gradually this adjustment process will restore an equilibrium between the total quantity of reserves demanded by the banking system and the total quantity of reserves that is made available to the banks (i.e., the total quantity of currency minus the amount of currency that the public chooses to hold as cash). However, the story does not end with the restoration of equilibrium for the banking system. Despite equilibrium in the banking system, total spending, output, and employment will have fallen from their original equilibrium levels. Full equilibrium will not be restored until prices and wages fall enough to make total spending consistent with a stock of currency 10% less than it was in the original equilibrium. Thus, in the end, it turns out that a 10% reduction in the quantity of currency in a monetary system with both fiat money and credit money will cause a 10% reduction in the price level when a new equilibrium is reached. However, the adjustment process by which a new equilibrium is reached, involving changes not only in absolute prices and wages, but in interest rates, is more complicated than the adjustment process in a pure fiat money system.

Hawtrey summed up his analysis in terms of three interest rates. First, the natural rate “which represented the actual labour-saving value of capital at the level of capitalisation reached by industry. This ratio of labour saved per annum to labour expended on first cost is a physical property of the capital actually in use, and under perfectly stable monetary conditions is equal to the market rate of interest.” Second the market rate which “diverges from the natural rate according to the tendency of prices. When prices are rising them market rate is higher, and when falling lower, than the natural rate, and this divergence is due to the fat that the actual profits of business show under those conditions corresponding movements.” Third, there is the profit rate, “which represents the true profits of business prevailing for the time being,” and does not necessarily coincide with the market rate.

The market rate is in fact the bankers’ rate, and is greater or less than the profit rate, according as the bankers wish to discourage or encourage borrowing. . . .

Consequently, for the banker’s purposes, a “high” rate of interest is one which is above the profit rate, and it is only when the rate of interest is equal to the profit rate that there is no tendency towards either an increase or decrease in temporary borrowing. In any of the three cases the rate of interest may be either above or below the natural rate. If the natural rate is 4% and the profit rate in consequence is only 2%, a market rate of 3% is “high,” and will result in a curtailment of borrowing. If prices are rising and the profit rate is 6%, a market rate of 5% is “low,” and will be compatible with an increased borrowing.

In the case we are now considering we assumed the disturbance to be a departure from perfectly stable conditions, in which the market rate of interest would be identical with the “natural” rate. On the contraction of the currency occurring the bankers raised the market rate above the natural rate. But at the same time the fall of prices began, and there must consequently be a fall of the profit rate below the natural rate. As we now see, the market rate may actually fall below the natural rate, and so long as it remains above the profit rate it will still be a “high” rate of interest.

When the restoration of the bank reserves is completed the market rate will drop down to equality with the profit rate, and they will remain equal to one another and below the natural rate until the fall of prices has gone far enough to re-establish equilibrium. (pp. 66-67)

Although it seems to me that Hawtrey, in focusing exclusively on the short-term lending rate of banks to explain the adjustment of the banking system to a disturbance, missed an important aspect of the overall picture (i.e., the deposit rate), Hawtrey did explain the efficacy of a traditional tool of monetary policy, the short-term lending rate of the banking system (the idea of a central bank having not yet been introduced at this stage of Hawtrey’s exposition). And he did so while avoiding the logical gap in the standard version of the natural-rate-market-rate theory as developed by both Thornton and Wicksell (see section 3 of my paper on Ricardo and Thornton here) explaining why changes in the bank rate could affect aggregate demand without assuming, as do conventional descriptions of the adjustment process, that the system was adjusting to an excess demand for or an excess supply of bank deposits.

Hawtrey’s Good and Bad Trade: Part II

Published September 24, 2013 Hawtrey , James Tobin , John Fullarton , Knut Wicksell , monetary theory , natural rate of interest 21 Comments
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Here I am again back at you finally with another installment in my series on Hawtrey’s Good and Bad Trade. In my first installment I provided some background on Hawtrey and a quick overview of the book, including a mention of the interesting fact (brought to my attention by David Laidler) that Hawtrey used the term “effective demand” in pretty much the same way that Keynes, some 20 years later, would use it in the General Theory.

In this post, I want to discuss what I consider the highlights of the first six chapters. The first chapter is a general introduction to the entire volume laying out the basic premise of the book, which is that the business cycle, understood as recurring fluctuations in the level of employment, is the result of monetary disturbances that lead to alternating phases of expansion and contraction. It is relatively easy for workers to find employment in expansions, but more difficult to do so in contractions. From the standpoint of the theory of economic equilibrium, the close correlation between employment and nominal income over the business cycle is somewhat paradoxical, because, according to the equilibrium theory, the allocation of resources is governed by relative, not absolute, prices. In the theory of equilibrium, a proportional increase or decrease in all prices should have no effect on employment. To explain the paradox, Hawtrey relies on the rigidity of some prices, and especially wages, an empirical fact that, Hawtrey believed, was an essential aspect of any economic system, and a necessary condition for the cyclicality of output and employment.

In Hawtrey’s view, economic expansions and contractions are caused by variations in effective demand, which he defines as total money income. (For reasons I discussed about a year and a half ago, I prefer to define “effective demand” as total money expenditure.) What determines effective demand, according to Hawtrey, is the relationship between the amount of money people are holding and the amount that they would, on average over time, like to hold. The way to think about the amount of money that people would like to hold is to imagine that there is some proportion of their annual income that people aim to hold in the form of cash.

The relationship between the amount of cash being held and the amount that people would like to hold depends on the nature of the monetary system. Hawtrey considers two types of monetary system: one type (discussed in chapter 2) is a pure fiat money system in which all money is issued by government; the other (discussed in chapter 3) is a credit system in which money is also created by banks by promising to redeem, on demand, their obligations (either deposits or negotiable banknotes) for fiat money. Credit money is issued by banks in exchange for a variety of assets, usually the untraded IOUs of borrowers.

In a pure fiat money system, effective demand depends chiefly on the amount of fiat money that people want to hold and on the amount of fiat money created by the government, fiat money being the only money available. A pure fiat money system, Hawtrey understood, was just the sort of system in which the propositions of the quantity theory of money would obtain at least in the medium to long run.

[I]f the adjustment [to a reduction in the quantity of money] could be made entirely by a suitable diminution of wages and salaries, accompanied by a corresponding diminution of prices, the commercial community could be placed forthwith in a new position of equilibrium, in which the output would continue unchanged, and distribution would only be modified by the apportionment of a somewhat larger share of the national product to the possessors of interest, rent, and other kinds of fixed incomes. In fact, the change in the circulating medium is merely a change in the machinery of distribution, and a change, moreover, which, once made, does not impair the effectiveness of that machinery. If the habits of the community are adapted without delay to the change, the production of wealth will continue unabated. If customary prices resist the change, the adjustment, which is bound to come sooner or later, will only be forced upon the people by the pressure of distress. (p. 41)

In a fiat money system, if the public have less money than they would like to hold their only recourse is to attempt to reduce their expenditures relative to their receipts, either offering more in exchange, which tends to depress prices or reducing their purchases, making it that much more difficult for anyone to increase sales except by reducing prices. The problem is that in a fiat system the amount of money is what it is, so that if one person manages to increase his holdings of money by increasing sales relative to purchases, his increase in cash balances must have be gained at the expense of someone else. With a fixed amount of fiat money in existence, the public as a whole cannot increase their holdings of cash, so equilibrium can be restored only by reducing the quantity of money demanded. But the reduction in the amount of money that people want to hold cannot occur unless income in money terms goes down. Money income can go down only if total output in real terms, or if the price level, falls. With nominal income down, people, wanting to hold some particular share of their nominal income in the form of money, will be content with a smaller cash balance than they were before, and will stop trying to increase their cash balances by cutting their expenditure. Because some prices — and especially wages — tend to be sticky, Hawtrey felt that it was inevitable that the adjustment to reduction in the amount of fiat money would cause both real income and prices to fall.

Although Hawtrey correctly perceived that the simple quantity theory would not, even in theory, hold precisely for a credit system, his analysis of the credit system was incomplete inasmuch as he did not fully take into account the factors governing the public’s choice between holding credit money as opposed to fiat money or the incentives of the banking system to create credit money. That theory was not worked out till James Tobin did so 50 years later (another important anniversary worthy of note), though John Fullarton made an impressive start in his great work on the subject in 1844, a work Hawtrey must have been familiar with, but, to my knowledge, never discussed in detail.

In such a banking system there is no necessary connexion between the total of the deposits and the amount of coin which has been paid to the banks. A banker may at any time grant a customer a loan by simply adding to the balance standing to the customer’s credit in the books of the bank. No cash passes, but the customer acquires the right, during the currency of the loan, to draw cheques on the bank up to the amount lent. When the period of the loan expires, if the customer has a large enough balance to his credit, the loan can be repaid without any cash being employed, the amount of the loan being simply deducted from the balance. So long as the loan is outstanding it represents a clear addition to the available stock of “money,” in the sense of purchasing power. It is “money” in the the sense which will play, in a community possessing banks, the same part as money in the stricter sense of legal tender currency would play in the fictitious bankless community whose commercial conditions we previously have been considering. This is the most distinctive feature of the banking system, that between the stock of legal tender currency and the trading community there is interposed an intermediary, the banker, who can, if he wishes, create money out of nothing. (PP. 56-57)

This formulation is incomplete, inasmuch as it leaves the decision of the banker about how much money to create unconstrained by the usual forces of marginal revenue and marginal cost that supposedly determine the decisions of other profit-seeking businessmen. Hawtrey is not oblivious to the problem, but does not advance the analysis as far as he might have.

We have now to find out how this functionary uses his power and under what limitations he works. Something has already been said of the contingencies for which he must provide. Whenever he grants a loan and thereby creates money, he must expect a certain portion of this money to be applied sooner or later, to purposes for which legal tender currency is necessary. Sums will be drawn out from time to time to be spent either in wages or in small purchases, and the currency so applied will take a little time to find its way back to the banks. Large purchases will be paid for by cheque, involving a mere transfer of credit from one banking account to another, but the recipient of the cheque may wish to apply it ot the payment of wages, etc. Thus the principal limitation upon the banker’s freedom to create money is that he must have a reserve to meet the fresh demands for cash to which the creation of new money may lead. (Id.)

This is a very narrow view, apparently assuming that there is but one banker and that the only drain on the reserves of the banker is the withdrawal of currency by depositors. The possibility that recipients of cheques drawn on one bank may prefer to hold those funds in a different bank so that the bank must pay a competitive rate of interest on its deposits to induce its deposits to be held rather than those of another bank is not considered.

In trade a seller encourages or discourages buyers by lowering or raising his prices. So a banker encourages or discourages borrowers by lowering or raising the rate of interest. (p.58)

Again, Hawtrey only saw half the picture. The banker is setting two rates: the rate that he charges borrowers and the rate that he pays to depositors. It is the spread between those two rates that determines the marginal revenue from creating another dollar of deposits. Given that marginal revenue, the banker must form some estimate of the likely cost associated with creating another dollar of deposits (an estimate that depends to a large degree on expectations that may or may not be turn out to be correct), and it is the comparison between the marginal revenue from creating additional deposits with the expected cost of creating additional deposits that determines whether a bank wants to expand or contract its deposits.

Of course, the incomplete analysis of the decision making of the banker is not just Hawtrey’s, it is characteristic of all Wicksellian natural-rate theories. However, in contrast to other versions of the natural-rate genre, Hawtrey managed to avoid the logical gap in those theories: the failure to see that it is the spread between the lending and the deposit rates, not the difference between the lending rate and the natural rate, that determines whether banks are trying to expand or contract. But that is a point that I will have to come back to in the next installment in this series in which I will try to follow through the main steps of Hawtrey’s argument about how a banking system adjusts to a reduction in the quantity of fiat money (aka legal tender currency or base money) is reduced. That analysis, which hinges on the role of merchants and traders whose holding of inventories of goods is financed by borrowing from the banks, was a critical intellectual innovation of Hawtrey’s and was the key to his avoidance of the Wicksellian explanatory gap.

Uneasy Money Marks the Centenary of Hawtrey’s Good and Bad Trade

Published September 10, 2013 David Laidler , Hawtrey , Keynes 9 Comments
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As promised, I am beginning a series of posts about R. G. Hawtrey’s book Good and Bad Trade, published 100 years ago in 1913. Good and Bad Trade was not only Hawtrey’s first book on economics, it was his first publication of any kind on economics, and only his second publication of any kind, the first having been an article on naval strategy written even before his arrival at Cambridge as an undergraduate. Perhaps on the strength of that youthful publication, Hawtrey’s first position, after having been accepted into the British Civil Service, was in the Admiralty, but he soon was transferred to the Treasury where he remained for over forty years till 1947.

Though he was a Cambridge man, Hawtrey had studied mathematics and philosophy at Cambridge. He was deeply influenced by the Cambridge philosopher G. E. Moore, an influence most clearly evident in one of Hawtrey’s few works of economics not primarily concerned with monetary theory, history or policy, The Economic Problem. Hawtrey’s mathematical interests led him to a correspondence with another Cambridge man, Bertrand Russell, which Russell refers to in his Principia Mathematica. However, Hawtrey seems to have had no contact with Alfred Marshall or any other Cambridge economist. Indeed, the only economist mentioned by Hawtrey in Good and Bad Trade was none other than Irving Fisher, whose distinction between the real and nominal rates of interest Hawtrey invokes in chapter 5. So Hawtrey was clearly an autodidact in economics. It is likely that Hawtrey’s self-education in economics started after his graduation from Cambridge when he was studying for the Civil Service entrance examination, but it seems likely that Hawtrey continued an intensive study of economics even afterwards, for although Hawtrey was not in the habit of engaging in lengthy discussions of earlier economists, his sophisticated familiarity with the history of economics and of economic history is quite unmistakable. Nevertheless, it is a puzzle that Hawtrey uses the term “natural rate of interest” to signify more or less the same idea that Wicksell had when he used the term, but without mentioning Wicksell.

In his introductory chapter, Hawtrey lays out the following objective:

My present purposed is to examine certain elements in the modern economic organization of the world, which appear to be intimately connected with [cyclical] fluctuations. I shall not attempt to work back from a precise statistical analysis of the fluctuations which the world has experienced to the causes of all the phenomena disclosed by such analysis. But I shall endeavor to show what the effects of certain assumed economic causes would be, and it will, I think, be found that these calculated effects correspond very closely with the observed features of the fluctuations.

The general result up to which I hope to work is that the fluctuations are due to disturbances in the available stock of “money” – the term “money” being take to cover every species of purchasing power available for immediate use, both legal tender money and credit money, whether in the form of coin, notes, or deposits at banks. (p. 3)

In the remainder of this post, I will present a quick overview of the entire book, and, then, as a kind of postscript to my earlier series of posts on Hawtrey and Keynes, I will comment on the fact that it seems quite clear that it was Hawtrey who invented the term “effective demand,” defining it in a way that does not appear significantly different from the meaning that Keynes attached to it.

Hawtrey posits that the chief problem associated with the business cycle is that workers are unable to earn an income with which to sustain themselves during business-cycle contractions. The source of this problem in Hawtrey’s view is some sort of malfunction in the monetary system, even though money, when considered from the point of view of an equilibrium, seems unimportant, inasmuch as any set of absolute prices would work just as well as another, provided that relative prices were consistent with equilibrium.

In chapter 2, Hawtrey explains the idea of a demand for money and how this demand for money, together with any fixed amount of inconvertible paper money will determine the absolute level of prices and the relationship between the total amount of money in nominal terms and the total amount of income.

In chapter 3, Hawtrey introduces the idea of credit money and banks, and the role of a central bank.

In chapter 4, Hawtrey discusses the organization of production, the accumulation of capital, and the employment of labor, explaining the matching circular flows: expenditure on goods and services, the output of goods and services, and the incomes accruing from that output.

Having laid the groundwork for his analysis, Hawtrey in chapter 5 provides an initial simplified analysis of the effects of a monetary disturbance in an isolated economy with no banking system.

Hawtrey continues the analysis in chapter 6 with a discussion of a monetary disturbance in an isolated economy with a banking system.

In chapter 7, Hawtrey discusses how a monetary disturbance might actually come about in an isolated community.

In chapter 8, Hawtrey extends the discussion of the previous three chapters to an open economy connected to an international system.

In chapter 9, Hawtrey drops the assumption of an inconvertible paper money and introduces an international metallic system (corresponding to the international gold standard then in operation).

Having completed his basic model of the business cycle, Hawtrey, in chapter 10, introduces other sources of change, e.g., population growth and technological progress, and changes in the supply of gold.

In chapter 11, Hawtrey drops the assumption of the previous chapters that there are no forces leading to change in relative prices among commodities.

In chapter 12, Hawtrey enters into a more detailed analysis of money, credit and banking, and, in chapter 13, he describes international differences in money and banking institutions.

In chapters 14 and 15, Hawtrey traces out the sources and effects of international cyclical disturbances.

In chapter 16, Hawtey considers financial crises and their relationship to cyclical phenomena.

In chapter 17, Hawtrey discusses banking and currency legislation and their effects on the business cycle.

Chapters 18 and 19 are devoted to taxation and public finance.

Finally in chapter 20, Hawtrey poses the question whether cyclical fluctuations can be prevented.

After my series on Hawtrey and Keynes, I condensed those posts into a paper which, after further revision, I hope will eventually appear in the forthcoming Elgar Companion to Keynes. After I sent it to David Laidler for comments, he pointed out to me that I had failed to note that it was actually Hawtrey who, in Good and Bad Trade, introduced the term “effective demand.”

The term makes its first appearance in chapter 1 (p. 4).

The producers of commodities depend, for their profits and for the means of paying wages and other expenses, upon the money which they receive for the finished commodities. They supply in response to a demand, but only to an effective demand. A want becomes an effective demand when the person who experiences the want possesses (and can spare) the purchasing power necessary ot meet the price of the thing which will satisfy it. A man may want a hat, but if he has no money [i.e., income or wealth] he cannot buy it, and his want does not contribute to the effective demand for hats.

Then at the outset of chapter 2 (p. 6), Hawtrey continues:

The total effective demand for all finished commodities in any community is simply the aggregate of all money incomes. The same aggregate represents also the total cost of production of all finished commodities.

Once again, Hawtrey, in chapter 4 (pp. 32-33), returns to the concept of effective demand

It was laid down that the total effective demand for all commodities si simply the aggregate of all incomes, and that the same aggregate represents the total cost of production of all commodities.

Hawtrey attributed fluctuations in employment to fluctuations in effective demand inasmuch as wages and prices would not adjust immediately to a change in total spending.

Here is how Keynes defines aggregate demand in the General Theory (p. 55)

[T]he effective demand is simply the aggregate income or (proceeds) which the entrepreneurs expect to receive, inclusive of the income which they will hand on to the other factors of production, from the amount of current employment which they decide to give. The aggregate demand function relates various hypothetical quantities of employment to the proceeds which their outputs are expected to yield; and the effective demand is the point on the aggregate demand function which becomes effective because, taken in conjunction with the conditions of supply, it corresponds to the level of employment which maximizes the entrepreneur’s expectation of profit.

So Keynes in the General Theory obviously presented an analytically more sophisticated version of the concept of effective demand than Hawtrey did over two decades earlier, having expressed the idea in terms of entrepreneurial expectations of income and expenditure and specifying a general functional relationship (aggregate demand) between employment and expected income. Nevertheless, the basic idea is still very close to Hawtrey’s. Interestingly, Hawtrey never asserted a claim of priority on the concept, whether it was because of his natural reticence or because he was unhappy with how Keynes made use of the idea, or perhaps some other reason, I would not venture to say. But perhaps others would like to weigh in with some speculations of their own.

Keynes on the Fisher Equation and Real Interest Rates

Published September 2, 2013 Fisher equation , Irving Fisher , Keynes , monetary policy , monetary theory , natural rate of interest , real interest rates , Uncategorized , zero lower bound 27 Comments
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Almost two months ago, I wrote a post (“Who Sets the Real Rate of Interest?”) about the Fisher equation, questioning the idea that the Fed can, at will, reduce the real rate of interest by printing money, an idea espoused by a lot of people who also deny that the Fed has the power to reduce the rate of unemployment by printing money. A few weeks later, I wrote another post (“On a Difficult Passage in the General Theory“) in which I pointed out the inconsistency between Keynes’s attack on the Fisher equation in chapter 11 of the General Theory and his analysis in chapter 17 of the liquidity premium and the conditions for asset-market equilibrium, an analysis that led Keynes to write down what is actually a generalized version of the Fisher equation. In both of those posts I promised a future post about how to understand the dynamic implications of the Fisher equation and the relationship between Fisher equation and the Keynesian analysis. This post is an attempt to make good on those promises.

As I observed in my earlier post, the Fisher equation is best understood as a property of equilibrium. If the Fisher equation does not hold, then it is reasonable to attribute the failure to some sort of disequilibrium. The most obvious, but not the only, source of disequilibrium is incorrectly expected inflation. Other sources of disequilibrium could be a general economic disorder, the entire economic system being (seriously) out of equilibrium, implying that the real rate of interest is somehow different from the “equilibrium” rate, or, as Milton Friedman might put it, that the real rate is different from the rate that would be ground out by the system of Walrasian (or Casselian or Paretian or Fisherian) equations.

Still a third possibility is that there is more than one equilibrium (i.e., more than one solution to whichever system of equations we are trying to solve). If so, as an economy moves from one equilibrium path to another through time, the nominal (and hence the real) rate of that economy could be changing independently of changes in expected inflation, thereby nullifying the empirical relationship implied (under the assumption of a unique equilibrium) by the Fisher equation.

Now in the canonical Fisherian theory of interest, there is, at any moment of time, a unique equilibrium rate of interest (actually a unique structure of equilibrium rates for all possible combinations of time periods), increasing thrift tending to reduce rates and increasing productivity of capital tending to raise them. While uniqueness of the interest rate cannot easily be derived outside a one-commodity model, the assumption did not seem all that implausible in the context of the canonical Fisherian model with a given technology and given endowments of present and future resources. In the real world, however, the future is unknown, so the future exists now only in our imagination, which means that, fundamentally, the determination of real interest rates cannot be independent of our expectations of the future. There is no unique set of expectations that is consistent with “fundamentals.” Fundamentals and expectations interact to create the future; expectations can be self-fulfilling. One of the reasons why expectations can be self-fulfilling is that often it is the case that individual expectations can only be realized if they are congruent with the expectations of others; expectations are subject to network effects. That was the valid insight in Keynes’s “beauty contest” theory of the stock market in chapter 12 of the GT.

There simply is no reason why there would be only one possible equilibrium time path. Actually, the idea that there is just one possible equilibrium time path seems incredible to me. It seems infinitely more likely that there are many potential equilibrium time paths, each path conditional on a corresponding set of individual expectations. To be sure, not all expectations can be realized. Expectations that can’t be realized produce bubbles. But just because expectations are not realized doesn’t mean that the observed price paths were bubbles; as long as it was possible, under conditions that could possibly have obtained, that the expectations could have been realized, the observed price paths were not bubbles.

Keynes was not the first economist to attribute economic fluctuations to shifts in expectations; J. S. Mill, Stanley Jevons, and A. C. Pigou, among others, emphasized recurrent waves of optimism and pessimism as the key source of cyclical fluctuations. The concept of the marginal efficiency of capital was used by Keynes to show the dependence of the desired capital stock, and hence the amount of investment, on the state of entrepreneurial expectations, but Keynes, just before criticizing the Fisher equation, explicitly identified the MEC with the Fisherian concept of “the rate of return over cost.” At a formal level, at any rate, Keynes was not attacking the Fisherian theory of interest.

So what I want to suggest is that, in attacking the Fisher equation, Keynes was really questioning the idea that a change in inflation expectations operates strictly on the nominal rate of interest without affecting the real rate. In a world in which there is a unique equilibrium real rate, and in which the world is moving along a time-path in the neighborhood of that equilibrium, a change in inflation expectations may operate strictly on the nominal rate and leave the real rate unchanged. In chapter 11, Keynes tried to argue the opposite: that the entire adjustment to a change in expected inflation is concentrated on real rate with the nominal rate unchanged. This idea seems completely unfounded. However, if the equilibrium real rate is not unique, why assume, as the standard renditions of the Fisher equation usually do, that a change in expected inflation affects only the nominal rate? Indeed, even if there is a unique real rate – remember that “unique real rate” in this context refers to a unique yield curve – the assumption that the real rate is invariant with respect to expected inflation may not be true in an appropriate comparative-statics exercise, such as the 1950s-1960s literature on inflation and growth, which recognized the possibility that inflation could induce a shift from holding cash to holding real assets, thereby increasing the rate of capital accumulation and growth, and, consequently, reducing the equilibrium real rate. That literature was flawed, or at least incomplete, in its analysis of inflation, but it was motivated by a valid insight.

In chapter 17, after deriving his generalized version of the Fisher equation, Keynes came back to this point when explaining why he had now abandoned the Wicksellian natural-rate analysis of the Treatise on Money. The natural-rate analysis, Keynes pointed out, presumes the existence of a unique natural rate of interest, but having come to believe that there could be an equilibrium associated with any level of employment, Keynes now concluded that there is actually a natural rate of interest corresponding to each level of employment. What Keynes failed to do in this discussion was to specify the relationship between natural rates of interest and levels of employment, leaving a major gap in his theoretical structure. Had he specified the relationship, we would have an explicit Keynesian IS curve, which might well differ from the downward-sloping Hicksian IS curve. As Earl Thompson, and perhaps others, pointed out about 40 years ago, the Hicksian IS curve is inconsistent with the standard neoclassical theory of production, which Keynes seems (provisionally at least) to have accepted when arguing that, with a given technology and capital stock, increased employment is possible only at a reduced real wage.

But if the Keynesian IS curve is upward-sloping, then Keynes’s criticism of the Fisher equation in chapter 11 is even harder to make sense of than it seems at first sight, because an increase in expected inflation would tend to raise, not (as Keynes implicitly assumed) reduce, the real rate of interest. In other words, for an economy operating at less than full employment, with all expectations except the rate of expected inflation held constant, an increase in the expected rate of inflation, by raising the marginal efficiency of capital, and thereby increasing the expected return on investment, ought to be associated with increased nominal and real rates of interest. If we further assume that entrepreneurial expectations are positively related to the state of the economy, then the positive correlation between inflation expectations and real interest rates would be enhanced. On this interpretation, Keynes’s criticism of the Fisher equation in chapter 11 seems indefensible.

That is one way of looking at the relationship between inflation expectations and the real rate of interest. But there is also another way.

The Fisher equation tells us that, in equilibrium, the nominal rate equals the sum of the prospective real rate and the expected rate of inflation. Usually that’s not a problem, because the prospective real rate tends to be positive, and inflation (at least since about 1938) is almost always positive. That’s the normal case. But there’s also an abnormal (even pathological) case, where the sum of expected inflation and the prospective real rate of interest is less than zero. We know right away that such a situation is abnormal, because it is incompatible with equilibrium. Who would lend money at a negative rate when it’s possible to hold the money and get a zero return? The nominal rate of interest can’t be negative. So if the sum of the prospective real rate (the expected yield on real capital) and the expected inflation rate (the negative of the expected yield on money with a zero nominal interest rate) is negative, then the return to holding money exceeds the yield on real capital, and the Fisher equation breaks down.

In other words, if r + dP/dt < 0, where r is the real rate of interest and dP/dt is the expected rate of inflation, then r < –dP/dt. But since i, the nominal rate of interest, cannot be less than zero, the Fisher equation does not hold, and must be replaced by the Fisher inequality

i > r + dP/dt.

If the Fisher equation can’t be satisfied, all hell breaks loose. Asset prices start crashing as asset owners try to unload their real assets for cash. (Note that I have not specified the time period over which the sum of expected inflation and the prospective yield on real capital are negative. Presumably the duration of that period is not indefinitely long. If it were, the system might implode.)

That’s what was happening in the autumn of 2008, when short-term inflation expectations turned negative in a contracting economy in which the short-term prospects for investment were really lousy and getting worse. The prices of real assets had to fall enough to raise the prospective yield on real assets above the expected yield from holding cash. However, falling asset prices don’t necessary restore equilibrium, because, once a panic starts it can become contagious, with falling asset prices reinforcing the expectation that asset prices will fall, depressing the prospective yield on real capital, so that, rather than bottoming out, the downward spiral feeds on itself.

Thus, for an economy at the zero lower bound, with the expected yield from holding money greater than the prospective yield on real capital, a crash in asset prices may not stabilize itself. If so, something else has to happen to stop the crash: the expected yield from holding money must be forced below the prospective yield on real capital. With the prospective yield on real capital already negative, forcing down the expected yield on money below the prospective yield on capital requires raising expected inflation above the absolute value of the prospective yield on real capital. Thus, if the prospective yield on real capital is -5%, then, to stop the crash, expected inflation would have to be raised to over 5%.

But there is a further practical problem. At the zero lower bound, not only is the prospective real rate not observable, it can’t even be inferred from the Fisher equation, the Fisher equation having become an inequality. All that can be said is that r < –dP/dt.

So, at the zero lower bound, achieving a recovery requires raising expected inflation. But how does raising expected inflation affect the nominal rate of interest? If r + dP/dt < 0, then increasing expected inflation will not increase the nominal rate of interest unless dP/dt increases enough to make r + dP/dt greater than zero. That’s what Keynes seemed to be saying in chapter 11, raising expected inflation won’t affect the nominal rate of interest, just the real rate. So Keynes’s criticism of the Fisher equation seems valid only in the pathological case when the Fisher equation is replaced by the Fisher inequality.

In my paper “The Fisher Effect Under Deflationary Expectations,” I found that a strongly positive correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year Treasuries) and asset prices (approximated by S&P 500) over the time period from spring 2008 through the end of 2010, while finding no such correlation over the period from 2003 to 2008. (Extending the data set through 2012 showed the relationship persisted through 2012 but may have broken down in 2013.) This empirical finding seems consistent with the notion that there has been something pathological about the period since 2008. Perhaps one way to think about the nature of the pathology is that the Fisher equation has been replaced by the Fisher inequality, a world in which changes in inflation expectations are reflected in changes in real interest rates instead of changes in nominal rates, the most peculiar kind of world described by Keynes in chapter 11 of the General Theory.

Why Hawtrey and Cassel Trump Friedman and Schwartz

Published August 21, 2013 Cassel , endogenous money , gold standard , Great Depression , Hawtrey , Milton Friedman , monetary policy , monetary theory 36 Comments
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This year is almost two-thirds over, and I still have yet to start writing about one of the two great anniversaries monetary economists are (or should be) celebrating this year. The one that they are already celebrating is the fiftieth anniversary of the publication of The Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz; the one that they should also be celebrating is the 100th anniversary of Good and Bad Trade by Ralph Hawtrey. I am supposed to present a paper to mark the latter anniversary at the Southern Economic Association meetings in November, and I really have to start working on that paper, which I am planning to do by writing a series of posts about the book over the next several weeks.

Good and Bad Trade was Hawtrey’s first publication about economics. He was 34 years old, and had already been working at the Treasury for nearly a decade. Though a Cambridge graduate (in mathematics), Hawtrey was an autodidact in economics, so it is really a mistake to view him as a Cambridge economist. In Good and Bad Trade, he developed a credit theory of money (money as a standard of value in terms of which to discharge debts) in the course of presenting his purely monetary theory of the business cycle, one of the first and most original instances of such a theory. The originality lay in his description of the transmission mechanism by which money — actually the interest rate at which money is lent by banks — influences economic activity, through the planned accumulation or reduction of inventory holdings by traders and middlemen in response to changes in the interest rate at which they can borrow funds. Accumulation of inventories leads to cumulative increases of output and income; reductions in inventories lead to cumulative decreases in output and income. The business cycle (under a gold standard) therefore was driven by changes in bank lending rates in response to changes in lending rate of the central bank. That rate, or Bank Rate, as Hawtrey called it, was governed by the demand of the central bank for gold reserves. A desire to increase gold reserves would call for an increase in Bank Rate, and a willingness to reduce reserves would lead to a reduction in Bank Rate. The basic model presented in Good and Bad Trade was, with minor adjustments and refinements, pretty much the same model that Hawtrey used for the next 60 years, 1971 being the year of his final publication.

But in juxtaposing Hawtrey with Friedman and Schwartz, I really don’t mean to highlight Hawtrey’s theory of the business cycle, important though it may be in its own right, but his explanation of the Great Depression. And the important thing to remember about Hawtrey’s explanation for the Great Depression (the same explanation provided at about the same time by Gustav Cassel who deserves equal credit for diagnosing and explaining the problem both prospectively and retrospectively as explained in my paper with Ron Batchelder and by Doug Irwin in this paper) is that he did not regard the Great Depression as a business-cycle episode, i.e., a recurring phenomenon of economic life under a functioning gold standard with a central bank trying to manage its holdings of gold reserves through manipulation of Bank Rate. The typical business-cycle downturn described by Hawtrey was caused by a central bank responding to a drain on its gold reserves (usually because expanding output and income increased the internal monetary demand for gold to be used as hand-to-hand currency) by raising Bank Rate. What happened in the Great Depression was not a typical business-cycle downturn; it was characteristic of a systemic breakdown in the gold standard. In his 1919 article on the gold standard, Hawtrey described the danger facing the world as it faced the task of reconstructing the international gold standard that had been effectively destroyed by World War I.

We have already observed that the displacement of vast quantities of gold from circulation in Europe has greatly depressed the world value of gold in relation to commodities. Suppose that in a few years’ time the gold standard is restored to practically universal use. If the former currency systems are revived, and with them the old demands for gold, both for circulation in coin and for reserves against note issues, the value of gold in terms of commodities will go up. In proportion as it goes up, the difficulty of regaining or maintaining the gold standard will be accentuated. In other words, if the countries which are striving to recover the gold standard compete with one another for the existing supply of gold, they will drive up the world value of gold, and will find themselves burdened with a much more severe task of deflation than they ever anticipated.

And at the present time the situation is complicated by the portentous burden of the national debts. Except for America and this country, none of the principal participants in the war can see clearly the way to solvency. Even we, with taxation at war level, can only just make ends meet. France, Italy, Germany and Belgium have hardly made a beginning with the solution of their financial problems. The higher the value of the monetary unit in which one of these vast debts is calculated, the greater will be the burden on the taxpayers responsible for it. The effect of inflation in swelling the nominal national income is clearly demonstrated by the British income-tax returns, and by the well-sustained consumption of dutiable commodities notwithstanding enormous increases in the rates of duty. Deflation decreases the money yield of the revenue, while leaving the money burden of the debt undiminished. Deflation also, it is true, diminishes the ex-penses of Government, and when the debt charges are small in proportion to the rest, it does not greatly increase the national burdens. But now that the debt charge itself is our main pre-occupation, we may find the continuance of some degree of inflation a necessary condition of solvency.

So 10 years before the downward spiral into the Great Depression began, Hawtrey (and Cassel) had already identified the nature and cause of the monetary dysfunction associated with a mishandled restoration of the international gold standard which led to the disaster. Nevertheless, in their account of the Great Depression, Friedman and Schwartz paid almost no attention to the perverse dynamics associated with the restoration of the gold standard, completely overlooking the role of the insane Bank of France, while denying that the Great Depression was caused by factors outside the US on the grounds that, in the 1929 and 1930, the US was accumulating gold.

We saw in Chapter 5 that there is good reason to regard the 1920-21 contraction as having been initiated primarily in the United States. The initial step – the sharp rise in discount rates in January 1920 – was indeed a consequence of the prior gold outflow, but that in turn reflected the United States inflation in 1919. The rise in discount rates produced a reversal of the gold movements in May. The second step – the rise in discount rates in June 1920 go the highest level in history – before or since [written in 1963] – was a deliberate act of policy involving a reaction stronger than was needed, since a gold inflow had already begun. It was succeeded by a heavy gold inflow, proof positive that the other countries were being forced to adapt to United States action in order to check their loss of gold, rather than the reverse.

The situation in 1929 was not dissimilar. Again, the initial climactic event – the stock market crash – occurred in the United States. The series of developments which started the stock of money on its accelerated downward course in late 1930 was again predominantly domestic in origin. It would be difficult indeed to attribute the sequence of bank failures to any major current influence from abroad. And again, the clinching evidence that the Unites States was in the van of the movement and not a follower is the flow of gold. If declines elsewhere were being transmitted to the United States, the transmission mechanism would be a balance of payments deficit in the United States as a result of a decline in prices and incomes elsewhere relative to prices and incomes in the United States. That decline would lead to a gold outflow from the United States which, in turn, would tend – if the United States followed gold-standard rules – to lower the stock of money and thereby income and prices in the United States. However, the U.S. gold stock rose during the first two years of the contraction and did not decline, demonstrating as in 1920 that other countries were being forced adapt to our monetary policies rather than the reverse. (p. 360)

Amazingly, Friedman and Schwartz made no mention of the accumulation of gold by the insane Bank of France, which accumulated almost twice as much gold in 1929 and 1930 as did the US. In December 1930, the total monetary gold reserves held by central banks and treasuries had increased to $10.94 billion from $10.06 billion in December 1928 (a net increase of $.88 billion), France’s gold holdings increased by $.85 billion while the holdings of the US increased by $.48 billion, Friedman and Schwartz acknowledge that the increase in the Fed’s discount rate to 6.5% in early 1929 may have played a role in triggering the downturn, but, lacking an international perspective on the deflationary implications of a rapidly tightening international gold market, they treated the increase as a minor misstep, leaving the impression that the downturn was largely unrelated to Fed policy decisions, let alone those of the IBOF. Friedman and Schwartz mention the Bank of France only once in the entire Monetary History. When discussing the possibility that France in 1931 would withdraw funds invested in the US money market, they write: “France was strongly committed to staying on gold, and the French financial community, the Bank of France included, expressed the greatest concern about the United States’ ability and intention to stay on the gold standard.” (p. 397)

So the critical point in Friedman’s narrative of the Great Depression turns out to be the Fed’s decision to allow the Bank of United States to fail in December 1930, more than a year after the stock-market crash, almost a year-and-a-half after the beginning of the downturn in the summer of 1929, almost two years after the Fed raised its discount rate to 6.5%, and over two years after the Bank of France began its insane policy of demanding redemption in gold of much of its sizeable holdings of foreign exchange. Why was a single bank failure so important? Because, for Friedman, it was all about the quantity of money. As a result Friedman and Schwartz minimize the severity of the early stages of the Depression, inasmuch as the quantity of money did not begin dropping significantly until 1931. It is because the quantity of money did not drop in 1928-29, and fell only slightly in 1930 that Friedman and Schwartz did not attribute the 1929 downturn to strictly monetary causes, but rather to “normal” cyclical factors (whatever those might be), perhaps somewhat exacerbated by an ill-timed increase in the Fed discount rate in early 1929. Let’s come back once again to the debate about monetary theory between Friedman and Fischer Black, which I have mentioned in previous posts, after Black arrived at Chicago in 1971.

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond. The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money causes prices to rise, as Friedman insisted, but it could also mean that an increase in prices causes the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (Mehrling, Fischer Black and the Revolutionary Idea of Finance, p. 160)

So Black obviously understood the possibility that, at least under some conditions, it was possible for prices to change exogenously and for the quantity of money to adjust endogenously to the exogenous change in prices. But Friedman was so ideologically committed to the quantity-theoretic direction of causality from the quantity of money to prices that he would not even consider an alternative, and more plausible, assumption about the direction of causality when the value of money is determined by convertibility into a constant amount of gold.

This obliviousness to the possibility that prices, under convertibility, could change independently of the quantity of money is probably the reason that Friedman and Schwartz also completely overlooked the short, but sweet, recovery of 1933 following FDR’s suspension of the gold standard in March 1933, when, over the next four months, the dollar depreciated by about 20% in terms of gold, and the producer price index rose by almost 15% as industrial production rose by 70% and stock prices doubled, before the recovery was aborted by the enactment of the NIRA, imposing, among other absurdities, a 20% increase in nominal wages. All of this was understood and explained by Hawtrey in his voluminous writings on the Great Depression, but went unmentioned in the Monetary History.

Not only did Friedman get both the theory and the history wrong, he made a bad move from his own ideological perspective, inasmuch as, according to his own narrative, the Great Depression was not triggered by a monetary disturbance; it was just that bad monetary-policy decisions exacerbated a serious, but not unusual, business-cycle downturn that had already started largely on its own. According to the Hawtrey-Cassel explanation, the source of the crisis was a deflation caused by the joint decisions of the various central banks — most importantly the Federal Reserve and the insane Bank of France — that were managing the restoration of the gold standard after World War I. The instability of the private sector played no part in this explanation. This is not to say that stability of the private sector is entailed by the Hawtrey-Cassel explanation, just that the explanation accounts for both the downturn and the subsequent prolonged deflation and high unemployment, with no need for an assumption, one way or the other, about the stability of the private sector.

Of course, whether the private sector is stable is itself a question too complicated to be answered with a simple yes or no. It is one thing for a car to be stable if it is being steered on a paved highway; it is quite another for the car to be stable if driven into a ditch.

Friedman’s Dictum

Published August 16, 2013 Friedman , Great Depression , Keynes , monetary history , monetary theory , Scott Sumner , Uncategorized 15 Comments
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In his gallant, but in my opinion futile, attempts to defend Milton Friedman against the scandalous charge that Friedman was, gasp, a Keynesian, if not in his policy prescriptions, at least in his theoretical orientation, Scott Sumner has several times referred to the contrast between the implication of the IS-LM model that expansionary monetary policy implies a reduced interest rate, and Friedman’s oft-repeated dictum that high interest rates are a sign of easy money, and low interest rates a sign of tight money. This was a very clever strategic and rhetorical move by Scott, because it did highlight a key difference between Keynesian and Monetarist ideas while distracting attention from the overlap between Friedman and Keynesians on the basic analytics of nominal-income determination.

Alghough I agree with Scott that Friedman’s dictum that high interest rates distinguishes him from Keynes and Keynesian economists, I think that Scott leaves out an important detail: Friedman’s dictum also distinguishes him from just about all pre-Keynesian monetary economists. Keynes did not invent the terms “dear money” and “cheap money.” Those terms were around for over a century before Keynes came on the scene, so Keynes and the Keynesians were merely reflecting the common understanding of all (or nearly all) economists that high interest rates were a sign of “dear” or “tight” money, and low interest rates a sign of “cheap” or “easy” money. For example, in his magisterial A Century of Bank Rate, Hawtrey actually provided numerical bounds on what constituted cheap or dear money in the period he examined, from 1844 to 1938. Cheap money corresponded to a bank rate less than 3.5% and dear money to a bank rate over 4.5%, 3.5 to 4.5% being the intermediate range.

Take the period just leading up to the Great Depression, when Britain returned to the gold standard in 1925. The Bank of England kept its bank rate over 5% almost continuously until well into 1930. Meanwhile the discount rate of the Federal Reserve System from 1925 to late 1928 was between 3.5 and 5%, the increase in the discount rate in 1928 to 5% representing a decisive shift toward tight money that helped drive the world economy into the Great Depression. We all know – and certainly no one better than Scott – that, in the late 1920s, the bank rate was an absolutely reliable indicator of the stance of monetary policy. So what are we to make of Friedman’s dictum?

I think that the key point is that traditional notions of central banking – the idea of “cheap” or “dear” money – were arrived at during the nineteenth century when almost all central banks were operating either in terms of a convertible (gold or silver or bimetallic) standard or with reference to such a standard, so that the effect of monetary policy on prices could be monitored by observing the discount of the currency relative to gold or silver. In other words, there was an international price level in terms of gold (or silver), and the price level of every country could be observed by looking at the relationship of its currency to gold (or silver). As long as convertibility was maintained between a currency and gold (or silver), the price level in terms of that currency was fixed.

If a central bank changed its bank rate, as long as convertibility was maintained (and obviously most changes in bank rate occurred with no change in convertibility), the effect of the change in bank rate was not reflected in the country’s price level (which was determined by convertibility). So what was the point of a change in bank rate under those circumstances? Simply for the central bank to increase or decrease its holding of reserves (usually gold or silver). By increasing bank rate, the central bank would accumulate additional reserves, and, by decreasing bank rate, it would reduce its reserves. A “dear money” policy was the means by which a central bank could add to its reserve and an “easy money” policy was the means by which it could disgorge reserves.

So the idea that a central bank operating under a convertible standard could control its price level was based on a misapprehension — a widely held misapprehension to be sure — but still a mistaken application of the naive quantity theory of money to a convertible monetary standard. Nevertheless, although the irrelevance of bank rate to the domestic price level was not always properly understood in the nineteenth century – economists associated with the Currency School were especially confused on this point — the practical association between interest rates and the stance of monetary policy was well understood, which is why all monetary theorists in the nineteenth and early twentieth centuries agreed that high interest rates were a sign of dear money and low interest rates a sign of cheap money. Keynes and the Keynesians were simply reflecting the conventional wisdom.

Now after World War II, when convertibility was no longer a real constraint on the price level (despite the sham convertibility of the Bretton Woods system), it was a true innovation of Friedman to point out that the old association between dear (cheap) money and high (low) interest rates was no longer a reliable indicator of the stance of monetary policy. However, as a knee-jerk follower of the Currency School – the 3% rule being Friedman’s attempt to adapt the Bank Charter Act of 1844 to a fiat currency, and with equally (and predictably) lousy results – Friedman never understood that under the gold standard, it is the price level which is fixed and the money supply that is endogenously determined, which is why much of the Monetary History, especially the part about the Great Depression (not, as Friedman called it, “Contraction,” erroneously implying that the change in the quantity of money was the cause, rather than the effect, of the deflation that characterized the Great Depression) is fundamentally misguided owing to its comprehensive misunderstanding of the monetary adjustment mechanism under a convertible standard.

PS This is written in haste, so there may be some errors insofar as I relying on my memory without checking my sources. I am sure that readers will correct my lapses of memory

PPS I also apologize for not responding to recent comments, I will try to rectify that transgression over the next few days.

Leijonhufvud on Friedman

Published August 13, 2013 Axel Leijonfuvud , Keynes , Milton Friedman 13 Comments
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Before it was hijacked by Paul Krugman, Scott Sumner and I were having a friendly little argument about whether Milton Friedman repackaged the Keynesian theory of the demand for money as the quantity theory of money transmitted to him via a fictitious Chicago oral tradition, as I, relying on Don Patinkin and Harry Johnson, claim, or whether Friedman was a resolute anti-Keynesian, as Scott claims. We have been trading extended quotations from the literature to try to support our positions.

I now offer some additional quotations, all but one from Axel Leijonhufvud’s wonderful essay “The Wicksell Connection: Variations on a Theme,” published in Leijonfuvud’s volume Information and Coordination (Oxford University Press, 1981). By some coincidence, the quotations tend to support my position, but, more importantly, they shed important light on problems of interpreting what Keynes was really talking about, and suggest a way of thinking about Keynes that takes us beyond the sterile ideological debates into which we tend lapse at the mere mention of the name John Maynard Keynes, or for that matter, Milton Friedman. Of course, the main lesson that readers should take away is: read the whole essay.

Herewith are a few extracts in which Leijonhufvud comments on Friedman and his doctrinal relationship with Keynes.

Milton Friedman has emphatically denied that the elasticity of LM is at issue [in the Monetarist v. Keynesian controversies]. At the same time his use of what is basically an IS-LM structure in presenting his own theory, and his oft-repeated insistence that no theoretical issues but only questions of empirical magnitudes within this shared theoretical frame separate him from his opponents, have apparently fortified others in their belief that (whatever he says) this elasticity must be crucial. Furthermore, Friedman has himself played around with elasticities, for example in advancing the notion of a horizontal IS curve. (p. 144, fn. 22)

The troubles with keeping track of the Wicksellian theme in its Keynesian guises and disguises go far back in time. The original “Savings-equals-Investment” debate did not reach a clear-cut collective verdict. As Lipsey [“The Foundations of the Theory of National Income: An Analysis of Some Fundamental Errors”] has recently shown, confusion persists to the present day. The IS-LM framework did not lend itself too well to a sharp characterization of the question whether the excess demand for bonds or the excess demand for money governs the interest rate. It was concluded that the distinction between the Loanable Funds and Liquidity Preference hypotheses was probably either pointless or misleading and that, in either case, the issue could safely be left unresolved. Correspondingly, Hansen found, Keynes’ insistence that saving and investment determine income while money stock and liquidity preference determine the rate of interest (rather than the other way around) makes no sense once you realize that, in IS-LM, everything simultaneously determines everything.

In Hansen’s reading Keynes’ interest theory was “indeterminate” – money supply and demand could not determine the interest rate, as Keynes would have it, but only give you the LM curve, etc. This way of looking at it missed the issue of which excess demand governs the interest rate.

One is reminded of Hansen’s indeterminacy charge by Friedman’s more recent argument that Keynes’ theory suffered from a “missing equation” – and should be completed by adding an exogenously determined price level. Keynes’ theory . . . was of the dynamic-historical variety. In describing the state of the system at some point in the sequential process, such theories make use of information about the system’s initial (historical) state. Static models do not use historical information, of course, but have to have equations for all endogenous variables. Reading a dynamic-historical theory on the presumption that it is static, therefore, is apt to lead to the mistaken impression that it lacks equations and is indeterminate. (pp. 180-81 and fn. 84)

Friedman, like so many others, filters Keynes and Keynesian theory through the IS-LM model and, consequently, ends up where everyone else ends up: bogged down in the Neoclassical Synthesis, which is to say, with the conclusion that exogenous fixity of money wages was Keynes’ explanation of unemployment. His discussion is notable for a sophisticated treatment of Keynes’ demand for money function and for its sweeping endorsement of the Pigou-effect. . . . (p. 189)

I break off from the final quotation, which is just a small part of an extended discussion of Friedman, because the argument is too dense to summarize adequately, and the entire lengthy passage (pp. 187-94) has to be read to grasp its full import. But I close with one final quotation from Leijonhufvud’s essay “Schools, ‘Revolutions,’ and Research Programmes in Economic Theory,” also contained in Information and Coordination (pp. 291-345).

The most widely known “monetarist,” Professor Milton Friedman, has for a long time consistently voiced the position that “monetarists” and “(neo)-Keynesians” share essentially the same theory and that their differences all derive from contrasting hypotheses concerning certain crucial empirical magnitudes. (He has also, however, persistently denied that the issues can be defined as a “simple” matter of the magnitude of the interest-elasticity of the excess demand for money – an otherwise oft-repeated contention in the debate.) In his recent attempts to provide an explicit representation for his theory, accordingly, Friedman chose ot use the “Keynesian” so-called “IS-LM” framework as his language of formal discourse.

In my opinion, there are “hard core” differences between the two theories and ones, moreover, that the “IS-LM” framework will not help us define. Not only are these differences at the “cosmological” level not accurately represented by the models used, but they will also lead to divergent interpretations of empirical results. (pp. 298-99, fn. 10)

The last paragraph, I suspect, probably sums up not just the inconclusiveness of the debate between Monetarists and Keynesians, but also the inconclusiveness of the debate about whether Friedman was or wasn’t a Keynesian. So be it.

Sumner Sticks with Friedman

Published August 11, 2013 demand for money , Don Patinkin , J. R. Hicks , Keynes , Mark Blaug , Milton Friedman , Scott Sumner 8 Comments

Scott Sumner won’t let go. Scott had another post today trying to show that the Cambridge Theory of the demand for money was already in place before Keynes arrived on the scene. He quotes from Hicks’s classic article “Mr. Keynes and the Classics” to dispute the quotation from another classic article by Hicks, “A Suggestions for Simplifying the Theory of Money,” which I presented in a post last week, demonstrating that Hicks credited Keynes with an important contribution to the demand for money that went beyond what Pigou, and even Lavington, had provided in their discussions of the demand for money.

In this battle of dueling quotations, I will now call upon Mark Blaug, perhaps the greatest historian of economics since Schumpeter, who in his book Economic Theory in Retrospect devotes an entire chapter (15) to the neoclassical theory of money, interest and prices. I quote from pp. 636-37 (4th edition).

Marshall and his followers went some way to move the theory of the demand for money in the direction of ordinary demand analysis, first, by relating money to net output or national income rather than the broader category of total transactions, and, second, by shifting from money’s rate of turnover to the proportion of annual income that the public wishes to hold in the form of money. In purely formal terms, there I nothing to choose between the Fisherian transaction approach and the Cambridge cash-balance approach, but the Cambridge formulation held out the potential of a genuine portfolio theory of the demand for money, which potential, however, was never fully exploited. . . .

The Cambridge formulation implies a demand for money equation, D_m = kPY, which contains no variable to represent the opportunity costs of holding cash, namely the rate of interest or the yield of alternative non-money assets, analogous to the relative price arguments of ordinary demand functions.
Yet a straight-forward application of utility-maximizing principles would have suggested that a rise in interest rates is likely to induce a fall in k as people strive to substitute interest-earning assets for passive money balances in their asset portfolios. Similarly, a fall in interest rates, by lowering the opportunity cost of holding money, is likely to cause a rise in k. Strangely enough, however, the Cambridge monetary theory never explicitly recognized the functional dependence of k on either the rate of interest or the rate on all non-monetary assets. After constructing a framework highly suggestive of a study of all the factors influencing cash-holding decisions, the Cambridge writers tended to lapse back to a list of the determinants of k that differed in no important respects from the list of institutional factors that Fisher had cited in his discussion of V. One can find references in Marshall, Pigou and particularly Lavington to a representative individual striking a balance between the costs of cash holdings in terms of interest foregone (minus the brokerage costs that would have been incurred by the movement into stocks and bonds) and their returns in terms of convenience and security against default but such passages were never systematically integrated with the cash-balance equation. As late as 1923, we find the young Keynes in A Tract on Monetary Reform interpreting k as a stable constant, representing an invariant link in the transmission mechanism connecting money to prices. If only Keynes at that date had read Wicksell instead of Marshall, he might have arrived at a money demand function that incorporates variations in the interest rate years before The General Theory (1936).

Moving to pp. 645-46, we find the following under the heading “The Demand for Money after Keynes.”

In giving explicit consideration to the yields on assets that compete with money, Keynes became one of the founders of the portfolio balance approach to monetary analysis. However, it is Hicks rather than Keynes who ought to be regarded as the founder of the view that the demand for money is simply an aspect of the problem of choosing an optimum portfolio of assets. In a remarkable paper published a year before the appearance of the General Theory, modestly entitled “A Suggestion for Simplifying the Theory of Money,” Hicks argued that money held at least partly as a store of value must be considered a type of capital asset. Hence the demand for money equation must include total wealth and expected rates of return on non-monetary assets as explanatory variables. Because individuals can choose to hold their entire wealth portfolios in the form of cash, the wealth variable represents the budget constraint on money holdings. The yield variables, on the other hand, represent both the opportunity costs of holding money and the substitutions effects of changes in relative rates of return. Individuals optimize their portfolio balances by comparing these yields with the imputed yield in terms of convenience and security of holding money. By these means, Hicks in effect treated the demand for money as a problem of balance sheet equilibrium analyzed along the same lines as those employed in ordinary demand theory.

It was Milton Friedman who carried this Hicksian analysis of money as a capital asset to its logical conclusion. In a 1956 essay, he set out a precise and complete specification of the relevant constraints and opportunity cost variable entering a household’s money demand function. His independent variable included wealth or permanent income – the present value of expected future receipts from all sources, whether personal earning or the income from real property and financial assets – the ratio of human to non-human wealth, expected rates of return on stocks, bonds and real assets, the nominal interest rate, the actual price level, and, finally, the expected percentage change in the price level. Like Hicks, Friedman specified wealth as the appropriate budget constraint but his concept of wealth was much broader than that adopted by Hicks. Whereas Keynes had viewed bonds as the only asset competing with cash, Friedman regarded all types of wealth as potential substitutes for cash holdings in an individual’s balance sheet; thus, instead of a single interest variable in the Keynesian liquidity preference equation, we get a whole list of relative yield variables in Friedman. An additional novel feature, entirely original with Friedman, is the inclusion of the expected rate of change in P as a measure of the anticipated rate of depreciation in the purchasing power of cash balances.

This formulation of the money demand function was offered in a paper entitled “The Quantity Theory of Money: A Restatement.” Friedman claimed not only that the quantity theory of money had always been a theory about the demand for money but also that his reformulation corresponded closely to what some of the great Chicago monetary economists, such as H.C. Simons and L. W. Mints, had always meant by the quantity theory. It is clear, however, from our earlier discussion that the quantity theory of money, while embodying an implicit conception of the demand for money, had always stood first and foremost for a theory of the determination of prices and nominal income; it contained much more than a particular theory of the demand for money.

Finally, Blaug remarks in his “notes for further reading” at the end of chapter 15,

In an influential essay, “The Quantity Theory of Money – A Restatement,” . . . M. Friedman claimed that his restatement was nothing more than the University of Chicago “oral” tradition. That claim was effectively destroyed by D. Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman, JMCB, 1969 .

Well, just a couple of quick comments on Blaug. I don’t entirely agree with everything he says about Cambridge monetary theory, and about the relative importance of Hicks and Keynes in advancing the theory of the demand for money. Cambridge economists may have been a bit more aware that the demand for money was a function of the rate of interest than he admits, and I think Keynes in chapter 17, definitely formulated a theory of the demand for money in a portfolio balance context, so I think that Friedman was indebted to both Hicks and Keynes for his theory of the demand for money.

As for Scott Sumner’s quotation from Hicks’s Mr. Keynes and the Classics, I think the point of that paper was not so much the theory of the demand for money, which had already been addressed in the 1935 paper from which I quoted, as to sketch out a way of generalizing the argument of the General Theory to encompass both the liquidity trap and the non-liquidity trap cases within a single graph. From the standpoint of the IS-LM diagram, the distinctive Keynesian contribution was the case of absolute liquidity preference, that doesn’t mean that Hicks meant that nothing had been added to the theory of the demand for money since Lavington. If that were the case, Hicks would have been denying that his 1935 paper had made any contribution. I don’t think that’s what he meant to suggest.

To sum up: 1) there was no Chicago oral tradition of the demand for money; 2) Friedman’s restatement of the quantity theory owed more to Keynes (and Hicks) than he admitted; 3) Friedman adapted the Cambridge/Keynes/Hicks theory of the demand for money in novel ways that allowed him to develop an analysis of price level changes that was more straightforward than was possible in the IS-LM model, thereby de-emphasizing the link between money and interest rates, which had been a such a prominent feature of the Keynesian models. That of course is a point that Scott Sumner likes to stress. In an upcoming post, I will comment on the fact that it was not just Keynesian models which stressed the link between money and interest rates. Pre-Keynesian monetary models also stressed the connection between easy money and low interest rates and dear money and high interest rates. Friedman’s argument was thus an innovation not only relative to Keynesian models but to orthodox monetary models. What accounts for this innovation?

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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