Posts
Regression to the mean
4 months ago
Showing posts with label money. Show all posts
Showing posts with label money. Show all posts
Friday, December 10, 2010
Friday, November 12, 2010
The Equation of Exchange and the Metaphysics of Commerce
"The Balance of trade is the metaphysics of commerce, which few understand and which serves no other purpose than to disturb the imagination" - Thomas Fitzsimmons, 1785
What would you all think if I wrote "By definition Y=C+I+G, so if you increase G you increase Y". You probably wouldn't take me very seriously. Even when I make a case for fiscal policy, it's never that case. Freshmen learn what's wrong with that argument. Would it improve things at all if instead I said "By definition Y=C+I+G, so if you increase G holding everything else constant you increase Y"? This version is at least logically coherent, but would your opinion of me change all that much? Probably not. Let me put it this way - I should hope you would still think I was talking nonsense. It's true that Y=C+I+G; that is trivially true. But when you change government spending, you can't expect other things in the equation to stay the same. So the first, unqualified statement that I made is logically wrong because nothing constrains C and I to stay the same, allowing me to conclude that we can increase G ad infinitum to achieve permanent growth. The second version of my statement was logically sound, but meaningless and demonstrative of a very poor understanding of economics. The lack of understanding is evident not in my manipulation of the equation itself, but in my understanding of the meaning and use of the equation.
Unfortunately, Don Boudreaux recently made precisely the same mistake with another famous economic law, the equation of exchange, MV=PQ. Don writes:
"In today’s Wall Street Journal, U.S Treasury Secretary Timothy Geithner, Singapore Finance Minister Tharman Shanmugaratnam, and Australia Treasurer Wayne Swan worry aloud that, in emerging economies, “rapid growth” increases “the risk of domestic inflation.” Baloney. Inflation is the result of too much money chasing too few goods. So by increasing the flow of goods (and services) produced in an economy, rapid growth decreases the risk of domestic inflation. That the finance ministers of three major world governments do not understand this fundamental fact is appalling." (emphasis is mine)
Don is quite wrong here, and the various finance ministers he cites are correct*. The key to understanding how to think about the quantity theory is that it's simply a balancing of the books. Alone, it tells you nothing about the causal relationship between any of these variables. I want to emphasize that because a lot of people from all sides of the aisle treat it like it's a causal law (Exhibit A being the regular testimony in the banking committee of the politician that every libertarian wants to pretend isn't just another politician).
Don is discussing the role that rapid growth (and increase in Q) plays in inflation. Taking the naive view of the equation of exchange, he reasons that since P = MV/Q, when Q increases P (the general price level) must decrease. He doesn't even say "holding everything else constant", and so his claim is logically wrong. But even if he had said "holding everything else constant", that just begs the question - why would you ever claim to hold everything else constant? Don certainly wouldn't let me get away with "holding everything else constant" in the national income identity. So how does Q grow in Don's example? Well for the answer to that question we have to turn to some method of determining output - Q. For this, of course, economists traditionally turn to supply and demand. Profit maximizers and utility maximizers come together in a market and set their respective marginal benefits and marginal costs equal to each other and come to agreement on a Q and a P**. So that gives us two of the four variables in the quantity theory - not bad. How does Q and P change in a supply and demand model? Well, the supply schedule can shift, the demand schedule can shift, or both can shift simultaneously. These supply and demand curves, unlike the equation of exchange, are actual behavioral claims made by economists. If you have a given set of preferences, and you have certain rational and informational prerequisites, and you face a particular suite of prices you will purchase Q goods for P dollars each in the market. This is claimed to be causal and it does describe behavioral relationships. It is not an accounting identity like MV=PQ or Y=C+I+G. So what happens if demand for goods and services increases? We would expect to see Q and P both increase. What happens if the supply schedule shifts to the right? We would expect to see Q increase and P decrease.
Now, to make another trivially true statement, we can say that if M and V are held fixed, these supply and demand dynamics will be reflected in observed values. On this point alone - even at this "trivially true"/"ceteris paribus" stage in the game, and after adding one supply curve and one demand curve to give some actual behavioral traction to our equation of exchange, Don is clearly wrong. Output growth can occur for at least two reasons - a supply shift (i.e. - increased productivity) or a demand shift, and a shift in demand will cause prices to increase at the same time that quantity increases***.
But presumably we aren't satisfied with a "trivially true" refuation of Don's point. When supply or demand shift, things happen to M and V too. When demand for goods and services increases, more transactions occur and people increase the rate at which they spend a given stock of money. In other words, the velocity of money, V, increases. Another way of saying this is that the desire to hold on to cash decreases if your demand for goods and services increases and your income stays the same. That cash did not circulate before, and now it is put into circulation. This is a standard impact of an increase in demand, and its inverse is why Keynesians associate low demand with an increase in the desire to hold cash or other liquid, idle assets. So if we have demand-lead growth, we would expect V to go up as well (which is another reason why when Q goes up in the equation of exchange you can't simply assume P goes down - that increase in Q may be a part of a process that simultaneously increases V).
What happens with the money stock? Well, of course that depends on how you define money. If you're thinking in terms of a very narrow definition of money, you can safely assume that that stays fixed and the explanation provided above of P, Q, and V gives you what you need. I don't know too much about this end of the theory, but clearly there are definitions of M with varying breadth. Nominal credit creation in response to an increase in demand can also be said to increase the money supply, and would also create inflationary pressure. Would you have nominal credit creation in response to a productivity (i.e. - supply schedule) increase? I don't really see why you would expect that. People need less exchange media to conduct the same amount of commerce, so it's probably less sensitive to supply-lead growth. Then again, if the aggregate demand schedule is highly elastic, maybe you would need more. These are the kinds of issues you have to think through - the equation of exchange doesn't provide you the answer to any of these relationships.
So be careful when you use these. Don't get caught saying "when we print more money it creates inflation" or "when output grows, it lowers prices". These are abuses of the quantity theory.
*George Selgin has some comments in the comment section of this post that are worth reviewing. I think Selgin is basically right and understands precisely what I'm saying here. Unfortunately he was clearly indulging Don's misunderstanding of the issue when he was taking issue with my comments, and trying to paper over a pretty egregious Cafe Hayek post.
**You could of course raise some market process objections to this story, but the basic supply and demand relationship has been experimentally verified (by other George Mason professors, in fact), so whatever non-auctioneer market process is going on is clearly giving us about the same results, which should not be surprising to anyone.
***In the article that Don discusses, the authors mainly point to demand-lead growth in emerging economies as the inflation risk for emerging economies only. They specifically cite demand for exports, growing domestic demand, and rising commodity prices (which have been demand-driven, not supply-driven).
Quantity theory links:
- I started a thread on this issue in Jonathan's forum here.
- This recent post by Brad DeLong doesn't explicitly mention the quantity theory, but he does bring up the problems with a Monetarist approach to the crisis. His critique is based on the interpretation of Monetarism as a misuse of the quantity theory... or at least a misuse given the very special circumstances we're going through now.
- Stephen Williamson replies to Mark Thoma and writes: "This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand [for US currency] goes away." I'm not sure if Williamson is saying that "old-fashioned quantity theorists" misuse the equation of exchange, but this doesn't seem quite right as a critique of the quantity theory itself. If there is an increase in world demand for US currency that you expect to be temporary, then that's the same as saying there is a decrease in V that you expect to be temporary. If you expect it to be temporary, then you'd expect an increase in V in the future. If, following the processes I outlined above, you think that increase in V is going to be paired with an increase in demand and thus P and Q, then Williamson's worry about inflation in the future is perfectly justified and perfectly consistent with the quantity theory. It's simply not on the top of my list of things to worry about right now. When we actually see that inflation, it means we're probably out of the slump.
- Bill Mitchell, of the Modern Monetary Theory school, has a weekly quiz. The second question of a recent quiz is on the quantity theory. Mitchell sets up a straw man of what quantity theorists believe (essentially attributing Don Boudreaux-type views to them), and then credits Keynes with fixing all that. This is a little much - many users of the quantity theory long before Keynes used the quantity theory without making these mistakes, and Keynes certainly embraced the quantity theory - and he used it correctly and to great effect. So Mitchell's analysis here is correct - but his history is a little self-serving.
- Jonathan reposts some thoughts by Richard Ebeling on Hayek and the quantity theory here.
- And of course, a lot of this emerges from our discussion of Hayek's Prices and Production. You'll find my post on the first lecture, in which I deal with some of these questions, here. I think Hayek does much the same thing that Mitchell does with his treatment - he provides a reasonably accurate analysis of the quantity theory, but a fairly self-serving history of the idea. He also has a weird "this isn't important and in fact it's misleading" reaction to it by the end.
- Keynes has a suberb discussion of the use and misuse of the quantity theory in the Tract on Monetary Reform (it actually is the same discussion where he says "in the long run we're all dead"). I'll hopefully get a chance to quote it at length this weekend, but if I don't please look it up yourselves
*****
What would you all think if I wrote "By definition Y=C+I+G, so if you increase G you increase Y". You probably wouldn't take me very seriously. Even when I make a case for fiscal policy, it's never that case. Freshmen learn what's wrong with that argument. Would it improve things at all if instead I said "By definition Y=C+I+G, so if you increase G holding everything else constant you increase Y"? This version is at least logically coherent, but would your opinion of me change all that much? Probably not. Let me put it this way - I should hope you would still think I was talking nonsense. It's true that Y=C+I+G; that is trivially true. But when you change government spending, you can't expect other things in the equation to stay the same. So the first, unqualified statement that I made is logically wrong because nothing constrains C and I to stay the same, allowing me to conclude that we can increase G ad infinitum to achieve permanent growth. The second version of my statement was logically sound, but meaningless and demonstrative of a very poor understanding of economics. The lack of understanding is evident not in my manipulation of the equation itself, but in my understanding of the meaning and use of the equation.
Unfortunately, Don Boudreaux recently made precisely the same mistake with another famous economic law, the equation of exchange, MV=PQ. Don writes:
"In today’s Wall Street Journal, U.S Treasury Secretary Timothy Geithner, Singapore Finance Minister Tharman Shanmugaratnam, and Australia Treasurer Wayne Swan worry aloud that, in emerging economies, “rapid growth” increases “the risk of domestic inflation.” Baloney. Inflation is the result of too much money chasing too few goods. So by increasing the flow of goods (and services) produced in an economy, rapid growth decreases the risk of domestic inflation. That the finance ministers of three major world governments do not understand this fundamental fact is appalling." (emphasis is mine)
Don is quite wrong here, and the various finance ministers he cites are correct*. The key to understanding how to think about the quantity theory is that it's simply a balancing of the books. Alone, it tells you nothing about the causal relationship between any of these variables. I want to emphasize that because a lot of people from all sides of the aisle treat it like it's a causal law (Exhibit A being the regular testimony in the banking committee of the politician that every libertarian wants to pretend isn't just another politician).
Don is discussing the role that rapid growth (and increase in Q) plays in inflation. Taking the naive view of the equation of exchange, he reasons that since P = MV/Q, when Q increases P (the general price level) must decrease. He doesn't even say "holding everything else constant", and so his claim is logically wrong. But even if he had said "holding everything else constant", that just begs the question - why would you ever claim to hold everything else constant? Don certainly wouldn't let me get away with "holding everything else constant" in the national income identity. So how does Q grow in Don's example? Well for the answer to that question we have to turn to some method of determining output - Q. For this, of course, economists traditionally turn to supply and demand. Profit maximizers and utility maximizers come together in a market and set their respective marginal benefits and marginal costs equal to each other and come to agreement on a Q and a P**. So that gives us two of the four variables in the quantity theory - not bad. How does Q and P change in a supply and demand model? Well, the supply schedule can shift, the demand schedule can shift, or both can shift simultaneously. These supply and demand curves, unlike the equation of exchange, are actual behavioral claims made by economists. If you have a given set of preferences, and you have certain rational and informational prerequisites, and you face a particular suite of prices you will purchase Q goods for P dollars each in the market. This is claimed to be causal and it does describe behavioral relationships. It is not an accounting identity like MV=PQ or Y=C+I+G. So what happens if demand for goods and services increases? We would expect to see Q and P both increase. What happens if the supply schedule shifts to the right? We would expect to see Q increase and P decrease.
Now, to make another trivially true statement, we can say that if M and V are held fixed, these supply and demand dynamics will be reflected in observed values. On this point alone - even at this "trivially true"/"ceteris paribus" stage in the game, and after adding one supply curve and one demand curve to give some actual behavioral traction to our equation of exchange, Don is clearly wrong. Output growth can occur for at least two reasons - a supply shift (i.e. - increased productivity) or a demand shift, and a shift in demand will cause prices to increase at the same time that quantity increases***.
But presumably we aren't satisfied with a "trivially true" refuation of Don's point. When supply or demand shift, things happen to M and V too. When demand for goods and services increases, more transactions occur and people increase the rate at which they spend a given stock of money. In other words, the velocity of money, V, increases. Another way of saying this is that the desire to hold on to cash decreases if your demand for goods and services increases and your income stays the same. That cash did not circulate before, and now it is put into circulation. This is a standard impact of an increase in demand, and its inverse is why Keynesians associate low demand with an increase in the desire to hold cash or other liquid, idle assets. So if we have demand-lead growth, we would expect V to go up as well (which is another reason why when Q goes up in the equation of exchange you can't simply assume P goes down - that increase in Q may be a part of a process that simultaneously increases V).
What happens with the money stock? Well, of course that depends on how you define money. If you're thinking in terms of a very narrow definition of money, you can safely assume that that stays fixed and the explanation provided above of P, Q, and V gives you what you need. I don't know too much about this end of the theory, but clearly there are definitions of M with varying breadth. Nominal credit creation in response to an increase in demand can also be said to increase the money supply, and would also create inflationary pressure. Would you have nominal credit creation in response to a productivity (i.e. - supply schedule) increase? I don't really see why you would expect that. People need less exchange media to conduct the same amount of commerce, so it's probably less sensitive to supply-lead growth. Then again, if the aggregate demand schedule is highly elastic, maybe you would need more. These are the kinds of issues you have to think through - the equation of exchange doesn't provide you the answer to any of these relationships.
So be careful when you use these. Don't get caught saying "when we print more money it creates inflation" or "when output grows, it lowers prices". These are abuses of the quantity theory.
*George Selgin has some comments in the comment section of this post that are worth reviewing. I think Selgin is basically right and understands precisely what I'm saying here. Unfortunately he was clearly indulging Don's misunderstanding of the issue when he was taking issue with my comments, and trying to paper over a pretty egregious Cafe Hayek post.
**You could of course raise some market process objections to this story, but the basic supply and demand relationship has been experimentally verified (by other George Mason professors, in fact), so whatever non-auctioneer market process is going on is clearly giving us about the same results, which should not be surprising to anyone.
***In the article that Don discusses, the authors mainly point to demand-lead growth in emerging economies as the inflation risk for emerging economies only. They specifically cite demand for exports, growing domestic demand, and rising commodity prices (which have been demand-driven, not supply-driven).
*****
Quantity theory links:
- I started a thread on this issue in Jonathan's forum here.
- This recent post by Brad DeLong doesn't explicitly mention the quantity theory, but he does bring up the problems with a Monetarist approach to the crisis. His critique is based on the interpretation of Monetarism as a misuse of the quantity theory... or at least a misuse given the very special circumstances we're going through now.
- Stephen Williamson replies to Mark Thoma and writes: "This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand [for US currency] goes away." I'm not sure if Williamson is saying that "old-fashioned quantity theorists" misuse the equation of exchange, but this doesn't seem quite right as a critique of the quantity theory itself. If there is an increase in world demand for US currency that you expect to be temporary, then that's the same as saying there is a decrease in V that you expect to be temporary. If you expect it to be temporary, then you'd expect an increase in V in the future. If, following the processes I outlined above, you think that increase in V is going to be paired with an increase in demand and thus P and Q, then Williamson's worry about inflation in the future is perfectly justified and perfectly consistent with the quantity theory. It's simply not on the top of my list of things to worry about right now. When we actually see that inflation, it means we're probably out of the slump.
- Bill Mitchell, of the Modern Monetary Theory school, has a weekly quiz. The second question of a recent quiz is on the quantity theory. Mitchell sets up a straw man of what quantity theorists believe (essentially attributing Don Boudreaux-type views to them), and then credits Keynes with fixing all that. This is a little much - many users of the quantity theory long before Keynes used the quantity theory without making these mistakes, and Keynes certainly embraced the quantity theory - and he used it correctly and to great effect. So Mitchell's analysis here is correct - but his history is a little self-serving.
- Jonathan reposts some thoughts by Richard Ebeling on Hayek and the quantity theory here.
- And of course, a lot of this emerges from our discussion of Hayek's Prices and Production. You'll find my post on the first lecture, in which I deal with some of these questions, here. I think Hayek does much the same thing that Mitchell does with his treatment - he provides a reasonably accurate analysis of the quantity theory, but a fairly self-serving history of the idea. He also has a weird "this isn't important and in fact it's misleading" reaction to it by the end.
- Keynes has a suberb discussion of the use and misuse of the quantity theory in the Tract on Monetary Reform (it actually is the same discussion where he says "in the long run we're all dead"). I'll hopefully get a chance to quote it at length this weekend, but if I don't please look it up yourselves
Saturday, July 24, 2010
More on the owls...
In this post critiquing Davidson, Galbraith, and Skidelsky's passivity with respect to the long-term debt, I got several interesting responses from post-Keynesian commenters. A lot of it was resources on the "deficit owl" perspective. I spent a little time looking through each, and doing a cursory review of what they call "Modern Monetary Theory" and has also been called Chartalism (really not a strategically developed name, which I'm guessing has more than a little to do with the newer MMT designation!).Most of the emphases of this school of thought are right on target. They specifically highlight the implications of sovereignty for the federal debt. A sovereign debt crisis in the U.S. is not a risk the way it is in Greece because we have the freedom to monetize our debt. Of course these guys also talk about functional finance, stabilization policy, and liquidity preference. This is all very good - it can be hard to get a New Keynesian to talk about liquidity preference sometimes! So the real sticking point seems to be the debt. We agree debt monetization removes the risk of a sovereign debt crisis - this is quite standard analysis and not anything that really distinguishes Galbraith, Davidson, and Skidelsky from Reich, Stiglitz, and Krugman. I think the Krugman point (recently, in a disagreement with Galbraith) is the important point to make - debt monetization provides budgetary flexibility (on top of the already substantial flexibility provided by our credit rating and the nature of sovereign governments), but it ultimately just kicks the can down the road. Problems emerge later in terms of inflation and interest rates, but more importantly real growth rates. Janos Kornai's famous observation that governments face "soft budget constraints" doesn't mean that they face no budget constraints. I read and buy into Keynes, Minsky, and Lerner - but I also read and buy into Reinhart and Rogoff (and, well, Keynes!) on the risks involved.
One intriguing option raised by Joe Firestone in the comment section of the last post is to stop issuing debt instruments and just start crediting bank accounts. He provides this link to that option, and L. Randall Wray discusses it further here. They essentially want to cut out the middle man of the Federal Reserve. I don't know enough about the implications of this, and I'd love to hear more discussion in the comment section, but two thoughts immediately come to mind. First, this would bring an end to independence in monetary policy, which is not a pleasant prospect for most economists. Second, as James Macdonald argues, public debt has historically been an essential element in restraining government. Hoarded treasure (aside from being macroeconomically inefficient) ensures that sovereigns are unaccountable to their citizens. Citizen creditors ensure that their government stays accountable. Cutting out this debt instrument gives a sovereign all the revenue-raising power of government bonds, without any of the risk of nervous creditors restraining policy. Perhaps a robust republic can be maintained in such an environment, but if the Macdonald point is right, the chance of abuses are very real.
OK, enough talk. Time for some links. Thanks to Joe Firestone for sharing most of these:
- New Economic Perspectives is a post-Keynesian blog I've followed for a little while now.
- Warren Mosler's blog
- This is Bill Mitchell's blog. Mitchell is at the University of Newcastle's Centre for Full Employment and Equity.
- Here is an interview of Randall Wray and Bill Mitchell, talking about MMT. This is the first one, there are several more that follow.
- Firedoglake and Corrente post regularly on Modern Monetary Theory. I've pulled the MMT tagged posts here (FDL) and here (Corrente) for your convenience.
- Recently these guys had a "fiscal sustainability teach-in" at my alma-mater, The George Washington University. The website for that event is here. I know a guy that was involved in this (Alex Lawson - big activist/advocate if any readers know of him), so I heard updates from it. It did a lot of important work I think - trying to educate people on why Social Security isn't the big risk a lot of people think it is. Of course, as my comments above suggest, I also think they down played more genuine risks.
- Joe Firestone shares this New Deal 2.0 post with me to "address some of the concerns" about the long-term debt. Of course nothing Wray writes in here is new to me or controversial to me, nor does it address the concerns I have. I'm not worried about our ability to pay back our debt. I understand why public debt is different from private debt. And regular readers can attest to the fact that I'm not shy about running up deficits. The bigger concern for me is the impact on real growth rates. And that, of course, is precisely the point that this blog post ignores. Anyway, I have two other reasons for highlighting this: (1.) New Deal 2.0 is another good site worth following, and (2.) an interesting historical point they make. The only time we've ever retired the debt was in 1835. In 1837 we had a severe depression. Does anyone know if these two events are related? I imagine at the time the federal budget was too small to make this sort of macroeconomic difference, but it's possible. Nothing says "liquidity preference" quite like a sinking fund. Anyway - just a query. Joe also provides, this, this, this, this, and this to "address my concerns".
- I'll also share once again the Levy Institute's website. This group does a lot of work with Minsky's theories, and also has strong post-Keynesian influences. This is their program on Monetary Policy, and this is an interesting recent working paper from them outlining what "fiscal responsibility" should mean. I thought this was an especially good passage. It highlights the MMT argument, and it provides an interesting philosophical justification and explanation of the role of government:
"If the government acts not as a self-interested individual, but in order to allow citizens to achieve their intended expenditure decisions, it must engage in policies that support private sector decisions in such a way that they lead to public good. It should act to coordinate and offset the incompatible combination of firms’ and households’ intentions. If households follow the rule of virtue and seek to save too much, then the government should run a fiscal deficit that is just equal to the shortfall between households’ desires to save and firms’ expectations of profits. By doing so it can allow each individual to achieve his desired objective. But, it also avoids the loss in income that would result from the mismatch. Here the government can intervene to make private vices into public virtue by encouraging prodigality when the private sector desires to be frugal. Government prodigality is the equivalent of supporting public virtue! This is the fiscal policy of a responsible government, responsible to insure that private sector decisions can be achieved rather thwarted by the law of unintended consequences."
Friday, May 21, 2010
Macro musings
Scott Sumner has an interesting Great Recession/Great Depression comparision:
"It’s worth thinking about where we are in the Great Recession, relative to the same time period in the Great Depression:
1.a October 1929, stocks crash on sharply falling expectations of NGDP [nominal GDP] growth.
1.b October 2008, stocks crash on sharply falling expectations of NGDP growth.
2.a Early 1931, stocks rise on signs of recovery
2.b Early 2010, stocks rise on signs of recovery
3.a May 1931, stocks fall as European banking/sovereign debt crisis begins
3.b May 2010, stocks fall, as European banking/sovereign debt crisis begins
Let’s hope the European debt crisis doesn’t get as bad as in 1931, or if it does, let’s hope the Fed
offsets the effects of the crisis as they should have done in 1931, but didn’t."
He of course has a monetary policy response in mind. I remain somewhat skeptical on unconventional monetary policies like quantitative easing. It makes me worry about asset bubbles. It makes me worry about picking winners (which if it must be done, should be done in a deliberative legislature rather than an opaque board room). It also makes me worry about the liquidity trap. Almost all of my macroeconomics comes from my own reading and thinking - I didn't take that much macro in school - but from this very casual standpoint, it seems to me that the last thing you need in a liquidity trap is more liquidity. Sumner often argues around this simply by asserting that we're not in a liquidity trap - create inflation and there's no zero lower bound problem. That's a fine and reasonable way to deal with Krugman's somewhat problematic definition of a liquidity trap as a zero-lower bound on interest rates, but that's not really what I'm worried about. I'm worried about a Hicksian liquidity trap, where money demand is relatively flat. Sumner's posts are usually extremely long and often above my head, but I still don't quite understand how expansionary monetary policy solves the Hicksian problem.
I see this is as another example of the mistake of acting like all economic downturns are created equally - a mistake I mentioned earlier with respect to wages. Sumner actually provided some good counter-arguments to David Henderson on wages, highlighting the fact that aggregate demand-driven downturns behave differently than other downturns. But he seems to think that from a monetary perspective, all downturns are still created equal.
Anyway, I cite Sumner's chronology here, but anyone that follows the economics blogosphere knows that there are a host of other reasons why I have pulled myself away from calculation and property rights issues and am musing about the macroeconomy today aside from Europe's sovereign debt problems. Deflation worries are on the rise again, and the labor market still isn't looking that chipper. Stocks have taken a dive, and while Steve Horwitz suggests it might have something to do with the financial regulation that just passed the Senate, I have my doubts. (My impression has been that debate over this bill has not been as acrimonious as the health reform bill, and the costs of the bill are considerably less substantial. Moreover, the Senate bill still needs to be reconciled with the House bill. The idea that the market has spoken on a bill that is considerably less controversial and that isn't even through the legislative process seems silly to me. I think Horwitz is reaching. Every business survey you pick up cites consumer demand as a much bigger concern than policy regime uncertainty. Add to that the troubles in Europe, and I think you've got your explanation for stock market behavior).
So my mind is more on macroeconomics lately, and I imagine that will only increase as I pick up Garrison's Time and Money.
After Garrison, I'll have more than enough to read. In fact, I don't think I'm going to be reading much history (the other subject I enjoy) for a while. Like many businesses, the Urban Institute is going through some hard times (my job is fine - we do government research, so it's not like there's any existential threat) and we're shutting down our library. That means that employees have been allowed to go through the library's stacks and take what they want before the rest gets tossed. I rescued many of the economics "Handbooks" so that we still have those resources in our research center. In addition to that, though, I've grabbed a lot of classics that I'm eager to get into:
The Microeconomic Foundations of Employment and Inflation Theory, ed. Ed Phelps
Inflation Policy and Unemployment, by Ed Phelps
Money, Interest, and Prices, by Patinkin
The Optimum Theory of Money, and Other Essays, by Friedman
A Monetary History of the United States, by Friedman
The Theory of Wages, by Hicks
A Program for Monetary Stability, by Friedman
Maintaining and Restoring Balance in International Payments, by Fellner, Machlup, and Triffin (does anyone know if this is the where he first raises the Triffin dilemma? I'm sure he mentions it in here, even if it's not where the concern is raised)
A Revision of Demand Theory, by Hicks
Economic Heresies, by Joan Robinson
A Study in the Theory of Investment, by Haavelmo
Essays in the Theory of Economic Growth, by Joan Robinson
Cost and Choice, by Buchanan
I'm most excited to get into Phelps and Patinkin, which I'll probably read after Garrison. I've read the section of Friedman's monetary history dealing with the Depression, but I should probably read that in its entirety too.
Finally, I want to call attention to a post that Evan showed me from An und für sich, a theology blog that he follows. The analysis of monetary policy in the post is kind of standard Yglesias monetary posting: "central bankers don't care about unemployment, just inflation". Insofar as this is a critique of the European Central Bank, I concur. The collective memory of the Weimar hyperinflation is understandable, but its starting to strain credulity. With respect to the Fed, see my concerns above about pursuing more expansionary monetary policy right now. I don't think it's fair to accuse the Fed of not caring about its dual mandate. There are a few things they could be doing (lowering the interest rate they pay on reserves), but not that much more that I would be comfortable with (again, see above). The value added of this post (for me at least), is its citation of Philip Goodchild's Theology of Money, which I had never heard of before. The thesis of the books seems pretty speculative, and I'm not sure what to make of it, but it looks interesting. This is the Amazon blurb:
"Goodchild examines the theory of money in a comparable manner to Adam Smith, Karl Marx and Georg Simmel. However by contrast to the conclusions of these thinkers, he proposes that money is essentially created in excess of reserves, making it a simultaneous credit and debt. Since money is a debt that must be repaid with interest in the form of money, then the creation of money imposes a social demand for an increase in profit and an increase in the creation of money in order to repay debt. This vicious circle drives the expansion of the global economy. In summary, Goodchild argues that money is a promise, a supreme value, a transcendent value and an obligation or a law. He argues that money has taken the place of God. It is the dominant global religion in practice, even if no one believes in it in principle."
I'm not sure about the purpose of looking at Marx. Simmel is an interesting figure to raise. I'm aware of him as one of the first symbolic-interactionist sociologists. I wonder if his Philosophy of Money is an interesting read (Goodchild seems to think it is). Simmel seems to raise concerns about commodification, which I've been interested in as they relate to some of Herbert Marcuse's work. Concerns about what commodificiation does to the value of a thing is an important thing for economists to think about, since our value theory and our understanding of welfare is completely contingent on the assumption of commodification. Markets and exchange optimizes welfare contingent on a good or service's identity as a commodity. But economics offers no guarantee that the commodification of that good or service optimizes welfare relative to its uncommodified state. To state it differently, we have no fundamental welfare theorems guaranteeing us that efficiency will be maximized by the commodification of things - we only know that given the commodification of things, competitive equilibrium guarantees Pareto efficiency.
"It’s worth thinking about where we are in the Great Recession, relative to the same time period in the Great Depression:
1.a October 1929, stocks crash on sharply falling expectations of NGDP [nominal GDP] growth.
1.b October 2008, stocks crash on sharply falling expectations of NGDP growth.
2.a Early 1931, stocks rise on signs of recovery
2.b Early 2010, stocks rise on signs of recovery
3.a May 1931, stocks fall as European banking/sovereign debt crisis begins
3.b May 2010, stocks fall, as European banking/sovereign debt crisis begins
Let’s hope the European debt crisis doesn’t get as bad as in 1931, or if it does, let’s hope the Fed
offsets the effects of the crisis as they should have done in 1931, but didn’t."
He of course has a monetary policy response in mind. I remain somewhat skeptical on unconventional monetary policies like quantitative easing. It makes me worry about asset bubbles. It makes me worry about picking winners (which if it must be done, should be done in a deliberative legislature rather than an opaque board room). It also makes me worry about the liquidity trap. Almost all of my macroeconomics comes from my own reading and thinking - I didn't take that much macro in school - but from this very casual standpoint, it seems to me that the last thing you need in a liquidity trap is more liquidity. Sumner often argues around this simply by asserting that we're not in a liquidity trap - create inflation and there's no zero lower bound problem. That's a fine and reasonable way to deal with Krugman's somewhat problematic definition of a liquidity trap as a zero-lower bound on interest rates, but that's not really what I'm worried about. I'm worried about a Hicksian liquidity trap, where money demand is relatively flat. Sumner's posts are usually extremely long and often above my head, but I still don't quite understand how expansionary monetary policy solves the Hicksian problem.
I see this is as another example of the mistake of acting like all economic downturns are created equally - a mistake I mentioned earlier with respect to wages. Sumner actually provided some good counter-arguments to David Henderson on wages, highlighting the fact that aggregate demand-driven downturns behave differently than other downturns. But he seems to think that from a monetary perspective, all downturns are still created equal.
Anyway, I cite Sumner's chronology here, but anyone that follows the economics blogosphere knows that there are a host of other reasons why I have pulled myself away from calculation and property rights issues and am musing about the macroeconomy today aside from Europe's sovereign debt problems. Deflation worries are on the rise again, and the labor market still isn't looking that chipper. Stocks have taken a dive, and while Steve Horwitz suggests it might have something to do with the financial regulation that just passed the Senate, I have my doubts. (My impression has been that debate over this bill has not been as acrimonious as the health reform bill, and the costs of the bill are considerably less substantial. Moreover, the Senate bill still needs to be reconciled with the House bill. The idea that the market has spoken on a bill that is considerably less controversial and that isn't even through the legislative process seems silly to me. I think Horwitz is reaching. Every business survey you pick up cites consumer demand as a much bigger concern than policy regime uncertainty. Add to that the troubles in Europe, and I think you've got your explanation for stock market behavior).
So my mind is more on macroeconomics lately, and I imagine that will only increase as I pick up Garrison's Time and Money.
After Garrison, I'll have more than enough to read. In fact, I don't think I'm going to be reading much history (the other subject I enjoy) for a while. Like many businesses, the Urban Institute is going through some hard times (my job is fine - we do government research, so it's not like there's any existential threat) and we're shutting down our library. That means that employees have been allowed to go through the library's stacks and take what they want before the rest gets tossed. I rescued many of the economics "Handbooks" so that we still have those resources in our research center. In addition to that, though, I've grabbed a lot of classics that I'm eager to get into:
The Microeconomic Foundations of Employment and Inflation Theory, ed. Ed Phelps
Inflation Policy and Unemployment, by Ed Phelps
Money, Interest, and Prices, by Patinkin
The Optimum Theory of Money, and Other Essays, by Friedman
A Monetary History of the United States, by Friedman
The Theory of Wages, by Hicks
A Program for Monetary Stability, by Friedman
Maintaining and Restoring Balance in International Payments, by Fellner, Machlup, and Triffin (does anyone know if this is the where he first raises the Triffin dilemma? I'm sure he mentions it in here, even if it's not where the concern is raised)
A Revision of Demand Theory, by Hicks
Economic Heresies, by Joan Robinson
A Study in the Theory of Investment, by Haavelmo
Essays in the Theory of Economic Growth, by Joan Robinson
Cost and Choice, by Buchanan
I'm most excited to get into Phelps and Patinkin, which I'll probably read after Garrison. I've read the section of Friedman's monetary history dealing with the Depression, but I should probably read that in its entirety too.
***
Finally, I want to call attention to a post that Evan showed me from An und für sich, a theology blog that he follows. The analysis of monetary policy in the post is kind of standard Yglesias monetary posting: "central bankers don't care about unemployment, just inflation". Insofar as this is a critique of the European Central Bank, I concur. The collective memory of the Weimar hyperinflation is understandable, but its starting to strain credulity. With respect to the Fed, see my concerns above about pursuing more expansionary monetary policy right now. I don't think it's fair to accuse the Fed of not caring about its dual mandate. There are a few things they could be doing (lowering the interest rate they pay on reserves), but not that much more that I would be comfortable with (again, see above). The value added of this post (for me at least), is its citation of Philip Goodchild's Theology of Money, which I had never heard of before. The thesis of the books seems pretty speculative, and I'm not sure what to make of it, but it looks interesting. This is the Amazon blurb:
"Goodchild examines the theory of money in a comparable manner to Adam Smith, Karl Marx and Georg Simmel. However by contrast to the conclusions of these thinkers, he proposes that money is essentially created in excess of reserves, making it a simultaneous credit and debt. Since money is a debt that must be repaid with interest in the form of money, then the creation of money imposes a social demand for an increase in profit and an increase in the creation of money in order to repay debt. This vicious circle drives the expansion of the global economy. In summary, Goodchild argues that money is a promise, a supreme value, a transcendent value and an obligation or a law. He argues that money has taken the place of God. It is the dominant global religion in practice, even if no one believes in it in principle."
I'm not sure about the purpose of looking at Marx. Simmel is an interesting figure to raise. I'm aware of him as one of the first symbolic-interactionist sociologists. I wonder if his Philosophy of Money is an interesting read (Goodchild seems to think it is). Simmel seems to raise concerns about commodification, which I've been interested in as they relate to some of Herbert Marcuse's work. Concerns about what commodificiation does to the value of a thing is an important thing for economists to think about, since our value theory and our understanding of welfare is completely contingent on the assumption of commodification. Markets and exchange optimizes welfare contingent on a good or service's identity as a commodity. But economics offers no guarantee that the commodification of that good or service optimizes welfare relative to its uncommodified state. To state it differently, we have no fundamental welfare theorems guaranteeing us that efficiency will be maximized by the commodification of things - we only know that given the commodification of things, competitive equilibrium guarantees Pareto efficiency.
Friday, December 11, 2009
The Limits of Monetary Policy (or, "Why DeLong, Krugman, Yglesias, and Sumner are Wrong")
For those of you not connected into the economics blogosphere, the Federal Reserve has been facing a tidal wave of criticism lately. There's the Ron Paul "end the Fed" crowd, of course, but there is also a rising tide of critics arguing that the Fed isn't doing nearly enough to solve the unemployment problem.The criticism is logical enough: the Fed itself predicts extremely low inflation, with almost no inflationary pressure to speak of, combined with extremely high unemployment for several years to come. We're talking about a decade to get back to 5% unemployment, as I understand it. The Federal Reserve argues, however, that it's largely tapped out. It has lowered interest rates as far as it can and it doesn't have many tools left. Several commentators (from both sides of the aisle, but mostly from the left) are astounded:
To be fair, their incredulity is understandable. Bernanke himself is famous for promoting the idea of unconventional monetary policy and praising the "quantitative easing" that the Bank of Japan engaged in in the 1990s. Joe Gagnon, at the Peterson Institute for International Economics, has made waves by proposing exactly what Bernanke promoted back then - several trillion dollars worth of asset purchases to make monetary policy even more accomodating. Right now, with interest rates at 0%, there is no "traditional" way for the Fed to be more expansionary. Purchasing a ton of assets would pump more money into the economy by putting money into the hands of the current asset holders.
So I've thrown the critics several bones. I've said their criticism is "logical enough", and that their "incredulity is understandable". But ultimately, I think the relentless demand for Bernanke to engage in vigorous quantitative easing is highly misplaced. When the Fed lowers interest rates, lowers reserve requirements (requiring firms to hold less reserves allows them to expand credit more easily, which expands the money supply), or expands it's own balance sheet through normal open market operations, monetary policy keeps market distortions to a minimum. Everyone faces the same interest rate and everyone faces the same reserve requirements. Competition picks the winners, the Fed simply sets the macro-trajectory for the economy.
"Quantitative easing" is different; it involves an aggressive expansion of the Fed balance sheet by purchasing all sorts of assets (including government bonds). The problem with this is that the Fed ends up "picking winners". Specific market players get an artificial leg-up. These activities pose a serious risk of distorting market activity and market signals. As a rule of thumb, that's a very bad thing. In exceptional circumstances - such as a liquidity trap - it may be worth the risk. But even if we determine that it is worth the risk in a liquidity trap, who should take that risk in a free society? I would argue that an elected, representative body should engage in those activities - not an appointed board of a central bank. If we're going to engaging in potentially distortionary measures, it needs to be done in the open, and people need to be accountable for these decisions. This is fundamentally what fiscal stimulus (i.e. - deficit spending from the government) does. It's an attempt to "soak up" the extra savings that are causing the economy to stall out, but it's an attempt that bears a real risk of "picking winners". What winners are Congress and the Obama administration picking? Infrastructure. Green jobs. Home-owners. Car buyers. Education. Some of these choices may be good, some may be bad. The point is "we the people" are making these choices, not a central bank.
I have a great deal of respect for the Fed, and I think they have a hugely important role to play in this crisis. I don't even begrudge Ben Bernanke the quantitative easing he's engaged in thus far as an extreme emergency measure. But to insist that this become the order of the day - that this is how we should wage an extended fight against depression - seems very dangerous to me. I do think the Fed is largely tapped out as far as what it can do - not because they can't do more, but because they shoudln't do more. It's time for Congress to step up.
Two additional thoughts:
(1.) Willem Buiter seems to agree with me. I ran across this after I formulated my thoughts (mostly in response to Yglesias's series of posts), but I'm happy to see he agrees with me, and
(2.) I have lots of lingering reservations about quantitative easing that I may comment on in the future. As a teaser, I'll just say it strikes me that quantitative easing risks prolonging a liquidity trap. The Fed is increasing the supply of loanable funds available to institutions that want to borrow, which should drive down the real interest rate - when what we want to do is drive it up (so that the interest rate floor is no longer binding). The only redeeming quality of quantitative easing, it seems to me, is that it may create inflation which would also make the nominal interest rate floor non-binding. I'm still noodling over this - but those are my initial thoughts. This seems to me to be a classic example of what Keynes meant when he said that Roosevelt's policies were like "a slim man trying to get fatter by buying a bigger belt".
Subscribe to:
Posts (Atom)
