Michael Woodford on the Interdependence of Monetary and Fiscal Policy

(I started writing this post a couple weeks ago and gave up after it got unreasonably long. I don’t feel like finishing it, but rather than let it go to waste I’m putting it up as is. So be warned, it goes on for a long while and then just stops.)

I sat down and read the Michael Woodford article on monetary and fiscal policy I mentioned in the earlier post. It’s very interesting, both directly for what it says substantively, and indirectly for what it says about the modern consensus in economics.

(For those who don’t know, Michael Woodford is a central figure in mainstream New Keynsian macro. His book Interest and Prices is probably the most widely used New Keynesian macro text in top graduate programs.)

The argument of this article is that the question of what monetary policy rule is the best route to price stabilization, cannot be separated from what fiscal rule is followed by the budget authorities. Similarly, any target for the public debt cannot be reduced to a budget rule, but depends on the policy followed by the monetary authorities — though Woodford is not so interested in this side of the question.

This is not a new idea for readers of this blog. But it’s interesting to hear Woodford’s description of the orthodox view.

It is now widely accepted that the choice of monetary policy to achieve a target path of inflation can …, and ought, to be separated from .. the chice of fiscal policy.

Woodford rejects this view — he insists that fiscal policy matters for price stability, and monetary policy matters for the debt-GDP ratio. Most economists think that monetary policy is irrelevant for the debt-GDP ratio, he says,

because seignorage revenues are such a small fraction of total government revenues. … [This] neglects a more important channel … the effects of monetary policy upon the real value of outstanding government debt, through its effects on the price level and upon the real debt service required, … insofar as monetary policy can affect real as well as nominal rates.

There are two deeper issues in the background here, that help explain why orthodox economics ignores the importance of monetary policy for the debt ratio and fiscal policy for price stability. First is the idea, which we can trace from Wicksell through Hayek to Milton Friedman and on to today’s New Keynesians, that the “natural” interest rate in the sense of the interest rate consistent with price stability, must be the same as the “natural” interest rate in the sense of the Walrasian intertemporal rate that would exist in a frictionless, perfect-information economy that somehow corresponded to the economy that actually exists. Few economists are bold enough or naive enough to state this assumption explicitly, but it is fundamental to the project of reconciling orthodox monetary policy with a vision in which money is neutral in the long run. If you want the same interest rate to be “natural” in both senses, it’s a problem if the price-stability natural rate depends on something like fiscal policy, which is not reducible to tastes, technologies and endowments.

Second is the notion of the “long run” itself. For economists, this refers to a situation in which the endogenous variables have fully adjusted to the exogenous variables. This requires a clean (or anyway order-of-magnitude) separation between “fast” endogenous and “slow” exogenous variables; it also requires a sufficiently long time between disturbances.

Woodford, in the passage above, refers to the effects of changes in inflation and interest rates on the burden of the outstanding government debt. This is an important departure from orthodoxy, since in a true “long run” situation, debt would have fully adjusted to the prevailing interest and inflation rates. Woodford, in tune with the practical concerns of central bankers, rejects the ubiquitous methodological condition of modern macroeconomics, that we should only consider fully adjusted long run positions. His whole discussion of public debt, in this paper and elsewhere, rejects the usual working assumption that the existing levels of inflation and interest rates have prevailed since time immemorial. He explicitly analyzes changes in interest and inflation in the context of a historically given debt stock.

Woodford's attitude toward the “natural” rate is more complicated. He certainly doesn’t take it for granted that the price-stability and Walrasian “natural” rates are the same. But a big part of his project — in Interest and Prices in particular — is precisely to develop a model in which they do turn out to coincide.

Let’s continue with the paper. Most economists believe that:

“Fiscal policy is thought to be unimportant for inflation… [because] inflation is a purely monetary phenomenon,” or else because “insofar as consumers have rational expectations, fiscal policy should have no effect on aggregate demand.”

Woodford rejects both of these claims. Even if people are individually rational, the system as a whole can be “non-Ricardian.” By this he means that changes in government spending will not be offset one for one by changes in private spending. “This happens essentially through the effects of fiscal disturbances upon private sector budget constraints and hence on aggregate demand.” For this reason, “A central bank charged with maintaining price stability cannot be indifferent as to how fiscal policy is set.”

Traditionally, the orthodox view of inflation is that it is the result of the money supply growing at a different rate than real economic activity, the latter being independent of the money supply. This does allow for fiscal effects on the price level, but only insofar as public borrowing is monetized. In the familiar “fiscal dominance” scenario, the primary surplus or deficit is fixed by the budget authorities and if the implied issue of public debt is different from the desired holdings of the private sector, the central bank must finance the difference with seignorage. The resulting change in the money supply produces corresponding inflation.

As Woodford says, this is not a useful way of thinking about these issues in real economies, at least in developed countries like the United States. In reality, even when the central bank is subordinate to the budget authorities, as in wartime, this does not take the form of direct monetization of deficits. Rather, “fiscal dominance manifests itself through pressure on the central bank to use monetary policy to maintain the market value of government debt. A classic example is … U.S. monetary policy between 1942 and 1951. … Supporting the price of long-term [government] bonds seems to have been the central element of Fed policy through the late 1940s.” This policy did not affect the price level directly through the money supply, but rather because the target interest rate was too low during the war (although the resulting inflation did not show up until after 1945, due to price controls during the war itself), and too high during in 1948-1950, when the federal government was running large surpluses. In either case, Woodford emphasizes, the causality runs from interest rates, to the price level, to the money supply; the quantity of money plays no independent role.

The basic story Woodford wants to tell is the fiscal theory of the price level. If the stock of outstanding government bonds is greater than the public wants to hold at the prevailing interest rate, then the price of bonds should fall. Normally, this would mean an increase in rates. But if interest rates are pegged — or in other words, if the price of bonds relative to money is fixed — then the price of the whole complex of government liabilities falls. Which is another way of saying the price level rises. Another way of looking at this is that, if output is initially at potential and the volume of government debt rises  with no fall in its nominal price, this must

make households feel wealthier … and thus leads them to demand goods and services in excess of those the economy can supply. … Equilibrium is restored when prices rise to the point that the real value of nominal assets no longer exceeds the present value of expected future primary surpluses.

Of course, this begs the question of why government debt is voluntarily held at a positive price even when there is no reason to expect future primary surpluses. More broadly, it doesn’t explain why anyone wants to hold non-interest bearing government liabilities at all. Woodford could take a chartalist line, talk about tax obligations, but he doesn’t. But even then he'd haven’t of he wouldn't have explained why people hold large stocks of government debt, which by definition is in excess of tax burden.  The natural answer is that government liabilities are a source of liquidity for the private sector. But if he says that, the rest of his argument is in trouble. First, if demand for government debt is about liquidity, then private actors should consider the terms on which other private actors will accept government liabilities. Second, if liquidity is valuable, then real outcomes will be different in a liquidity-abundant world than in a liquidity-scarce one. This is the fundamental problem with the idea that money is neutral. If money were truly neutral, in the sense that the exact same transactions happen in a world with money that would happen in a hypothetical moneyless world, then there would be no reason for money to be used at all.

Despite these serious logical problems, Woodford uses the orthodox apparatus to make some interesting points. For example, he argues that the reason the mid-century policy of fixing a nominal interest rate did not lead to price instability, was because of adjustments in the federal budget position. It is, he says, a puzzle how

a regime that … fixed nominal interest rates was consistent with relatively stable prices for so long. … According to the familiar Wicksellian view summarized by Friedman, an attempt to peg nominal interest rates should lead to either an inflationary or a deflationary spiral. … It is striking that people were willing to hold long-term Treasury securities at 2.5% during the temporary high inflation (25% annual rate) of 1946-1947; evidently there was little fear … [of] an explosive Wicksellian ‘cumulative process.’

Woodford is right that the consistency of fixed nominal interest rates with price stability even after the removal of wartime price controls is a problem for the simple Wicksell-monetarist view. Whether his preferred solution — an expectation of continued federal budget surpluses — is right, is a different question.

Turning to the other side, the dependence of the budget position on prevailing interest rates, Woodford gives an excellent critique of the prevailing notion of a government intertemporal budget constraint (ITBC), in which government spending must be adjusted so that the present value of future surpluses just equals today’s debt. It is widely believed, he says, that government must satisfy such a constraint, “just as in the case of households and firms. It would then follow that fiscal policy must necessarily be Ricardian,” that is, have no effect on the spending choices of rational, non-liquidity-constrained private actors. “It is true,” he continues, “that general equilibrium models always assume that households and firms optimize subject to a set of budget constraints that imply an intertemporal budget constraint, though they may be even more stringent (as it may not even be possible to borrow against all … future income.”

Note the careful phrasing: I’ve noticed this in Woodford’s other writing too, that he adopts rational expectations as a method without ever endorsing it as a positive claim about the world. Of course we shouldn’t talk about intertemporal budget constraints at all, it’s a meaningless concept for private as well as public borrowers, for reasons Woodford himself makes clear.

This is a nice part of the paper, Woodford’s treatment of the “transversality condition.” This, or the equivalent “no-Ponzi” condition, says that the debt of a government — or any other economic unit — must go to zero as time goes to infinity. The reason mainstream models require this condition is that they assume that in any given period, it is possible for anyone to borrow without limit at the prevailing interest rate. This invites the question: why not then consume an infinite amount forever with borrowed funds? The transversality condition says: You just can’t. It is still the case that at any moment, there is no limit on borrowing; but somehow or other, over infinite time net borrowing must come out to zero. This amounts to deal with the fact that one’s assumptions imply absurd conclusions by introducing another assumption, that absurd outcomes can’t happen. Woodford sees clearly that this does not offer a meaningful limit on fiscal policy:

What kind of constraint upon fiscal policy does this [theory] require? A mere commitment to “satisfy the transversality condition” is plainly unsuitable; this would place no constraints upon observable behavior over any finite time period, so that it is hard to see how the public should be convinced of the truth of such a commitment, in the absence of a commitment to some more specific constraint that happens to imply satisfaction of the transversality condition.

What Woodford doesn’t see, or at least doesn’t acknowledge, is that the transversality condition is equally meaningless as applied to private actors. Which means that you need some positive theory about what range of balance sheet positions are available in any given period — in other words a theory of liquidity. And, that the intertemporal budget constraint is meaningless, has no place in any positive economics.

But in any case, even if we accept the intertemporal budget constraint for private units, it is not applicable to sovereign governments since, (1) they are large relative to the economy and (2) they are not maximizing consumption. All that is needed is that someone ends up voluntarily holding the government’s debt. Even if the government is optimizing something, it is not doing so with respect to fixed prices — or fixed output, though Woodford never considers the possibility of unemployed real resources, a rather major limitation of all his work I’ve read.

Woodford notes, reasonably enough, that if the government issues more liabilities than the public wants to hold at the prevailing prices, then the price of government liabilities will fall; “but this is a condition for market equilibrium given the government’s policy, and not a precondition for the government to issue” new liabilities. In this respect, he suggests that the government is in the same position as a company that issues stock, or, more precisely, a company that repurchases shares rather than issuing dividends. (The formal argument that dividends and repurchases are interchangeable, for which Woodford cites Cochrane, is relevant for my “disgorge the cash” work.)

The advantage of this analogy [between the government a share-repurchasing corporation] is that it is clear in the stock case that the equation is an equilibrium condition that determines the share price, … and not a constraint on corporate policies. There is no requirement, enforced in financial markets, that the company generate earnings that validate whatever market valuation of its stock may happen to exist.

The government is different from the company only because prices happen to be “quoted in units of its liabilities.”

As a positive argument this is not useful, for two related reasons. First, it is still essentially a monetarist account of inflation, except with total government liabilities replacing “money.” And second, he deliberately leaves out any discussion of real effects of inflation. This means that he doesn’t give any explanation for price stability is important. More broadly, he doesn’t have any account of the inflation process that links up to real-world discussions. The article purports to be about a central bank following a Taylor rule, but the word “unemployment” does not occur in it. Nor does the word “liquidity”, inviting the question of why anyone holds money in the first place. As I mentioned earlier, this is a larger problem with the whole idea that money is neutral. In this case, Woodford suggests that one can fully explain inflation in a framework in which inflation is costless, and then introduce costs (to motivate policy) without the positive analysis being affected. Interest and Prices does not have this problem — it is carefully constructed precisely to ensure that conventional monetary policy is both welfare-optimizing, and produces an outcome identical to a Walrasian world without monetary frictions. But this isn’t general — the book’s central model is custom-designed to produce just that result.

The question raised by the article is: If both price stability and debt sustainability are functions of both the government budget and monetary policy, why do we have such a strong consensus in favor of stabilizing output solely via the interest rate, and adjusting the government budget position solely in view of the government debt? Woodford admits that in principle, price stability can be achieved in a “bond price-support regime” in which the government budget responds to shifts in private expenditure and the central bank is responsible only for interest payments on government debt. Formally, Woodford acknowledges, this type of regime should work just as well as the conventional “independent” central bank setup. The problem is that in practice

the nature of the legislative process in a democracy makes it unlikely that government budgets can subjected to the same degree of discipline as monetary policy actions. A nontrivial degree of random variation in the equilibrium price level would be inevitable under the price-support regime, both as a result of random disturbances to fiscal policy that could not be prevented, and as a result of inability to adjust fiscal policy with sufficient precision to offset the consequences of other real disturbances. 

There it is. The only argument for central bank independence is an argument against democracy. Woodford continues:

Controlling inflation through an interest-rate rule such as the Taylor rule represents a more practical alternative, both because it is more politically realistic to imagine monetary policy being subordinated wholly to this task, and because it is technically more feasible to “fine-tune” monetary policy actions as necessary to maintain consistency with stable prices.

The claim that interest rates can be adjusted more quickly than budgets is worth taking seriously. Though of course, one way of taking it seriously would be to contemplate arrangements under which taxes and spending could be adjusted more quickly. But look at the other point: The selling point of orthodoxy, says the pope of modern macroeconomics, is that policy can “subordinated wholly” to “controlling inflation.” Look at Europe today, and tell me they aren’t reaping what they sowed.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is "free." A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and "risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today's New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: "Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts." ' Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also "to deal in debts of varying degrees of risk," i.e., high grade private securities and perhaps state and local issues.

That's a quote from The General Theory, with Hansen's gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base - the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System's lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It's on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.


[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as "central bank independence freaks."

Strange Defeat

Following up on the previous post, below the fold is an article Arjun and I wrote last year for the Indian publication Economic and Political Weekly, on how liberal New Keynesian economists planted the seeds of their own defeat in the policy arena. 

I should add that Krugman is very far from the worst in this respect. If I criticize my soon-to-be colleague so much, it's only because of his visibility, and because the clarity of his writing and his genuinely admirable political commitments make it easier to see the constraints imposed by his theoretical commitments. You might say that his distinct virtues bring the common vices into sharper focus.

The Call Is Coming from Inside the House

Paul Krugman wonders why no one listens to academic economists. Almost all the economists in the IGM Survey agree that the 2009 stimulus bill successfully reduced unemployment and that its benefits outweighed its costs. So why are these questions still controversial?

One answer is that economists don’t listen to themselves. More precisely, liberal economists like Krugman who want the state to take a more active role in managing the economy, continue to teach  an economic theory that has no place for activist policy.

Let me give a concrete example.

One of Krugman’s bugaboos is the persistence of claims that expansionary monetary policy must lead to higher inflation. Even after 5-plus years of ultra-loose policy with no rising inflation in sight, we keep hearing that since so “much money has been created…, there should already be considerable inflation.” (That’s from exhibit A in DeLong’s roundup of inflationphobia.) As an empirical matter, of course, Krugman is right. But where could someone have gotten this idea that an increase in the money supply must always lead to higher inflation? Perhaps from an undergraduate economics class? Very possibly -- if that class used Krugman’s textbook.

Here’s what Krugman's International Economics says about money and inflation:

A permanent increase in the money supply causes a proportional increase in the price level’s long-run value. … we should expect the data to show a clear-cut positive association between money supplies and price levels. If real-world data did not provide strong evidence that money supplies and price levels move together in the long run, the usefulness of the theory of money demand we have developed would be in severe doubt. 

… 

Sharp swings in inflation rates [are] accompanied by swings in growth rates of money supplies… On average, years with higher money growth also tend to be years with higher inflation. In addition, the data points cluster around the 45-degree line, along which money supplies and price levels increase in proportion. … the data confirm the strong long-run link between national money supplies and national price levels predicted by economic theory. 

… 

Although the price levels appear to display short-run stickiness in many countries, a change in the money supply creates immediate demand and cost pressures that eventually lead to future increases in the price level. 

… 

A permanent increase in the level of a country’s money supply ultimately results in a proportional rise in its price level but has no effect on the long-run values of the interest rate or real output. 

This last sentence is simply the claim that money is neutral in the long run, which Krugman continues to affirm on his blog. [1] The “long run” is not precisely defined here, but it is clearly not very long, since we are told that “Even year by year, there is a strong positive relation between average Latin American money supply growth and inflation.”

From the neutrality of money, a natural inference about policy is drawn:

Suppose the Fed wishes to stimulate the economy and therefore carries out an increase in the level of the U.S. money supply. … the U.S. price level is the sole variable changing in the long run along with the nominal exchange rate E$/€. … The only long-run effect of the U.S. money supply increase is to raise all dollar prices.

What is “the money supply”? In the US context, Krugman explicitly identifies it as M1, currency and checkable deposits, which (he says) is determined by the central bank. Since 2008, M1 has more than doubled in the US — an annual rate of increase of 11 percent, compared with an average of 2.5 percent over the preceding decade. Krugman’s textbook states, in  unambiguous terms, that such an acceleration of money growth will lead to a proportionate acceleration of inflation. He can hardly blame the inflation hawks for believing what he himself has taught a generation of economics students.

You might think these claims about money and inflation are unfortunate oversights, or asides from the main argument. They are not. The assumption that prices must eventually change in proportion to the central bank-determined money supply is central to the book’s four chapters on macroeconomic policy in an open economy. The entire discussion in these chapters is in terms of a version of the Dornbusch “overshooting” model. In this model, we assume that

1. Real exchange rates are fixed in the long run by purchasing power parity (PPP).
2. Interest rate differentials between countries are possible only if they are offset by expected changes in the nominal exchange rate.

Expansionary monetary policy means reducing interest rates here relative to the rest of the world. In a world of freely mobile capital, investors will hold our lower-return bonds only if they expect our nominal exchange rate to appreciate in the future. With the long-run real exchange rate pinned down by PPP, the expected future nominal exchange rate depends on expected inflation. So to determine what exchange rate today will make investors willing to holder our lower-interest bonds, we have to know how policy has changed their expectations of the future price level. Unless investors believe that changes in the money supply will translate reliably into changes in the price level, there is no way for monetary policy to operate in this model.

So  these are not throwaway lines. The more thoroughly a student understands the discussion in Krugman’s textbook, the stronger should be their belief that sustained expansionary monetary policy must be inflationary. Because if it is not, Krugman gives you no tools whatsoever to think about policy.

Let me anticipate a couple of objections:

Undergraduate textbooks don’t reflect the current state of economic theory. Sure, this is often true, for better or worse. (IS-LM has existed for decades only in the Hades of undergraduate instruction.) But it’s not much of a defense, is it? If Paul Krugman has been teaching his undergraduates economic theory that produces disastrous results when used as a guide for policy, you would think that would provoke some soul-searching on his part. But as far as I can tell, it hasn’t. But in this case I think the textbook does a good job summarizing the relevant scholarship. The textbook closely follows the model in Dornbusch’s Expectations and Exchange Rate Dynamics, which similarly depends on the assumption that the price level changes proportionately with the money supply. The Dornbusch article is among the most cited in open-economy macroeconomics and international finance, and continues to appear on international finance syllabuses in most top PhD programs.

Everything changes at the zero lower bound. Defending the textbook on the ground that it's pre-ZLB effectively concedes that what economists were teaching before 2008 has become useless since then. (No wonder people don’t listen.) If orthodox theory as of 2007 has proved to be all wrong in the post-Lehmann world, shouldn’t that at least raise some doubts about whether it was all right pre-Lehmann? But again, that's irrelevant here, since I am looking at the 9th Edition, published in 2011. And it does talk about the liquidity trap — not, to be sure, in the main chapters on macroeconomic policy, but in a two-page section at the end. The conclusion of that section is that while temporary increases in the money supply will be ineffective at the zero lower bond, a permanent increase will have the same effects as always: “Suppose the central bank can credibly promise to raise the money supply permanently … output will therefore expand, and the currency will depreciate.” (The accompanying diagram shows how the economy returns to full employment.) The only way such a policy might fail is if there is reason to believe that the increase in the money supply will subsequently be reversed. Just to underline the point, the further reading suggested on policy at the zero lower bound is an article by Lars Svennson that calls a permanent expansion in the money supply “the foolproof way” to escape a liquidity trap. There’s no suggestion here that the relationship between monetary policy and inflation is any less reliable at the ZLB; the only difference is that the higher inflation that must inevitably result from monetary expansion is now desirable rather than costly. This might help if Krugman were a market monetarist, and wanted to blame the whole Great Recession and slow recovery on bad policy by the Fed; but (to his credit) he isn’t and doesn’t.

Liberal Keynesian economists made a deal with the devil decades ago, when they conceded the theoretical high ground. Paul Krugman the textbook author says authoritatively that money is neutral in the long run and that a permanent increase in the money supply can only lead to inflation. Why shouldn't people listen to him, and ignore Paul Krugman the blogger?


[1] That Krugman post also contains the following rather revealing explanation of his approach to textbook writing:

Why do AS-AD? First, you do want a quick introduction to the notion that supply shocks and demand shocks are different ... and AS-AD gets you to that notion in a quick and dirty, back of the envelope way. 

Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind.

This is striking for several reasons. First, Krugman wants students to believe in the "self-correcting economy," even if this requires teaching them models that do not reflect the way professional economists think. Second, they should think that this self-correction happens through "price flexibility." In other words, what he wants his students to look at, say, falling wages in Greece, and think that the problem must be that they have not fallen enough. That's what "a return to full employment via price flexibility" means. Third, and most relevant for this post, this vision of self-correction-by-prices is directly linked to the idea that money is neutral in the long run -- in other words, that a sustained increase in the money supply must eventually result in a proportionate increase in prices. What Krugman is saying here, in other words, is that a "surprising big" part of his thinking on pedagogy is how to inculcate the exact errors that drive him crazy in policy settings. But that's what happens once you accept that your job as an educator is to produce ideological fables.

New Keynesians Don't Believe Their Models

Here's the thing about about saltwater, New Keynesian economists: They don't believe their own theory.

Via John Cochrane, here is a great example. In the NBER Macroeconomics Annual a couple years ago, Gauti Eggertson laid out the canonical New Keynesian case for the effectiveness of fiscal policy when interest rates are at the Zero Lower Bound. In the model Eggertson describes there -- the model that is supposed to provide the intellectual underpinnings for fiscal stimulus -- the multiplier on government spending at the ZLB is indeed much larger than in normal conditions, 2.3 rather than 0.48. But the same model says that at the ZLB, cuts in taxes on labor are contractionary, with a multiplier of -1. Every dollar of "stimulus" from the Making Work Pay tax credit, in other words, actually reduced GDP by a dollar. Or as Eggertson puts it, "Cutting taxes on labor ... is contractionary under the circumstances the United States is experiencing today. "

Now, obviously there are reasons why one might believe this. For instance, maybe lower payroll taxes just allow employers to reduce wages by the same amount, and then in response to their lower costs they reduce prices, which is deflationary. There's nothing wrong with that story in principle. No, the point isn't that the New Keynesian claim that payroll tax cuts reduce demand is wrong -- though I think that it is. The point is that nobody actually believes it.

In the debates over the stimulus bill back at the beginning of 2009, everyone agreed that payroll tax cuts were stimulus just as much as spending increases. The CBO certainly did. There were plenty of "New Keynesian" economists involved in that debate, and while they may have said that tax cuts would boost demand less than direct government spending, I'm pretty sure that not one of them said that payroll tax cuts would actually reduce demand. And when the payroll tax cuts were allowed to expire at the end of 2012, did anyone make the case that this was actually expansionary? Of course not. The conventional wisdom was that the payroll tax cuts had a large, positive effect on demand, with a multiplier around positive 1. Regardless of good New Keynesian theory.

As a matter of fact, even Eggertson doesn't seem to believe that raising taxes on labor will boost demand, whether or not it's what the math says. The "natural result" of his model, he admits, is that any increase in government spending should be financed by higher taxes. But:

There may, however, be important reasons outside the model that suggest that an increase in labor and capital taxes may be unwise and/or impractical. For these reasons I am not ready to suggest, based on this analysis alone, that raising capital and labor taxes is a good idea at zero interest rates. Indeed, my conjecture is that a reasonable case can be made for a temporary budget deficit to finance a stimulus plan... 

Well, yeah. I think most of us can agree that raising payroll taxes in a recession is probably not the best idea. But at this point, what are we even doing here? If you're going to defer to arguments "outside the model" whenever the model says something inconvenient or surprising, why are you even doing it?


EDIT: I put this post up a few days ago, then took it down because it seemed a little thin and I thought I would add another example or two of the same kind of thing. But I'm feeling now that more criticism of mainstream economics is not a good use of my time. If that's what you want, you should check out this great post by Noah Smith. Noah is so effective here for the same reason that he's sometimes so irritatingly wrong -- he's writing from inside the mainstream. The truth is, to properly criticize these models, you have to have a deep knowledge of them, which he has and I do not.

Arjun and I have a piece in an upcoming Economics and Politics Weekly on how liberal, "saltwater" economists share the blame for creating an intellectual environment favorable to austerian arguments, however much they oppose them in particular cases. I feel pretty good about it -- will link here when it comes out -- I think for me, that's enough criticism of modern macro. In general, the problem with radical economists is they spend too much time on negative criticism of the economics profession, and not enough making a positive case for an alternative. This criticism applies to me too. My comparative advantage in econblogging is presenting interesting Keynesian and Marxist work.

One thing one learns working at a place like Working Families, the hard thing is not convincing people that shit is fucked up and bullshit, the hard thing is convincing them there's anything they can do about it.  Same deal here: The real challenge isn't showing the other guys are wrong, it's showing that we have something better.

Aggregate Demand and Modern Macro

Start with a point on language.

People often talk about aggregate demand as if it were a quantity. But this is not exactly right. There's no number or set of numbers in the national accounts labeled "aggregate demand". Rather, aggregate demand is a way of interpreting the numbers in the national accounts. (Admittedly, it's the way of interpreting them that guided their creation in the first place). It's a statement about a relationship between economic quantities. Specifically, it's a statement that we should think about current income and current expenditure as mutually determining each other.

This way of thinking is logically incompatible with the way macroeconomics is taught in (almost) all graduate programs today, which is in terms of optimization under an intertemporal budget constraint. I'll avoid semi-pejorative terms like mainstream and neoclassical, and instead follow Robert Gordon and call this approach modern macro.

In the Keynesian income-expenditure vision -- which today survives only, as Leijonhufvud put it, "in the Hades of undergraduate instruction" -- we think of economic actors as making decisions about current spending in terms of current receipts. If I earn $X, I will spend $Y; if I earn one dollar more, I'll spend so many additional cents. We can add detail by breaking these income and expenditure flows in various ways -- income from dividends vs. incomes from wages, income to someone at the top decile vs someone at the bottom, income to urban households vs income to rural ones; and expenditures on services, durable goods, taxes, etc., which generate income in their turn. This is the way macro forecasting models used by business and government were traditionally constructed, and may still be for all I know.

Again, these are relationships; they tell us that for any given level of aggregate money income, there is a corresponding level of aggregate expenditure. The level of income that is actually realized, is the one for which desired expenditure just equals income. And if someone for whatever reason adjusts their desired level of expenditure at that income, the realized level of income will change in the same direction, by a greater or lesser extent. (This is the multiplier.)

I should stress that while this way of thinking may imply or suggest concrete predictions, these are not themselves empirical claims, but logical relationships.

The intertemporal optimization approach followed in modern macro is based on a different set of logical relationships. In this framework, agents know their endowments and tastes (and everyone else's, though usually in these models agents are assumed to be identical) and the available production technology in all future periods. So they know all possible mixes of consumption and leisure available to them over the entire future and the utility each provides. Based on this knowledge they pick, for all periods simultaneously ("on the 8th day of creation" -- that's Leijonhufvud again) the optimal path of labor, output and consumption.

I realize that to non-economists this looks very strange. I want to stress, I'm not giving a dismissive or hostile summary. To anyone who's done economics graduate work in the last 15 or 20 years (a few heterodox enclaves excepted) constructing models like this is just what "doing macroeconomics" means.

(For a concrete example, a first-year grad textbook offers as one of its first exercises in thinking like an economist the question of why countries often run current account deficits in wartime. The answer is entirely in terms of why countries would choose to allocate a greater share of consumption to periods when there is war, and how interest rates adjust to make this happen. The possibility that war leads to higher incomes and expenditure, some of which inevitably falls on imported goods -- the natural answer in the income-expenditure framework -- is not even mentioned. Incidentally, as this example suggests, thinking in terms of intertemporal allocation is not always necessarily wrong.)

In these models, there is no special relationship between income and expenditure flows just because they happen to take place at the same time or in any particular order. The choice between jam today and jam tomorrow is no different from the choice between blackberry and lingonberry jam, and the checks you get from your current job and from the job you'll hold ten years from now are no more different than the checks from two different jobs that you hold right now are. Over one year or 50, the problem is simply the best allocation of your total income over your possible consumption baskets -- subject, of course, to various constraints which may make the optimal allocation unachievable.

My point here is not that modern models are unrealistic. I am perfectly happy to stipulate that the realism of assumptions doesn't matter. Models are tools for logical analysis, not toy train sets -- they don't have to look like real economies to be useful.

(Although I do have to point out that modern macroeconomics models are often defended precisely on the grounds of microfoundations -- i.e. more realistic assumptions. But it is simply not true that modern models are more "microfounded" than income-expenditure ones in any normal English sense. Microfoundations does not mean, as you might imagine, that a model has an explicit story about the individual agents in the economy and how they make choices -- the old Keynesian models do at least as well as the modern ones by that standard. Rather, microfoundations means that the agents' choices consist of optimizing some quantity under true -- i.e. model consistent -- expectations.)

But again, I come not to bury or dispraise modern models. My point is just that they are logically incompatible with the concept of aggregate demand. It's not that modern macroeconomists believe that aggregate demand is unimportant, it's that within their framework those words don't mean anything. Carefully written macro papers don't even footnote it as a minor factor that can be ignored. Even something anodyne like "demand might also play a role" would come across like the guy in that comic who asks the engineers if they've "considered logarithms" to help with cooling.

The atomic units of one vision are flows -- that is, money per time period -- between economic units. The atomic units of the other are prices and quantities of different goods. Any particular empirical question can be addressed within either vision. But they generate very different intuitions, and ideas of what questions are most important. 

Still, it is true that the same concrete phenomena can be described in either language. The IS curve is the obvious example. In the Hades of the undergraduate classroom we get the old Keynesian story of changes in interest rate changing desired aggregate expenditure at each given income. While in the sunlit Arcadia of graduate classes, the same relationship between interest rates and current expenditure is derived explicitly from intertemporal optimization.

So what's the problem, you say. If either language can be used to describe the same phenomena, why not use the same language as the vast majority of other economists?

This is a serious question, and those of us who want to do macro without DSGE models need a real answer for it. My answer is that default assumptions matter. Yes, with the right tweaks the two models can be brought to a middle ground, with roughly the same mix of effects from the current state and expected future states of the world. But even if you can get agreement on certain concrete predictions, you won't agree on what parts of them depend on the hard core of your theory and what on more or less ad hoc auxiliary assumptions. So Occam's Razor will cut in opposite directions -- a change that simplifies the story from one perspective, is adding complexity from the other.

For example, from the income-expenditure perspective, saying that future interest rates will have a similar effect on current activity as current interest rates do, is a strong additional assumption. Whereas from the modern perspective, it's saying that they don't have similar effects that is the additional assumption that needs to be explained. Or again, taking an example with concrete applications to teaching, the most natural way to think about interest rates and exchange rates in the income-expenditure vision is in terms of how the the flow of foreign investment responds to interest rates differentials. Whereas in the modern perspective -- which is now infiltrating even the underworld -- the most natural way is in terms of rational agents' optimal asset mix, taking into account the true expected values of future exchange rates and interest rates.

Or, what got me thinking about this in the first place. I've been reading a lot of empirical work on credit constraints and business investment in the Great Recession -- I might do a post on it in the next week or so, though an academic style literature review seems a bit dull even for this blog -- and three things have become clear.

First, the commitment to intertemporal optimization means that New Keynesians really need financial frictions. In a world where current output is an important factor in investment, where investment spending is linked to profit income, and where expectations are an independently adjusting variable, it's no problem to have a slowdown in investment triggered by fall in demand in some other sector, by a fall in the profit share, or by beliefs about the future becoming more pessimistic. But in the modern consensus, the optimal capital stock is determined by the fundamental parameters of the model and known to all agents, so you need a more or less permanent fall in the return on investment, due presumably to some negative technological shock or bad government policy. Liberal economists hate this stuff, but in an important sense it's just a logical application of the models they all teach. If in all your graduate classes you talk about investment and growth in terms of the technologically-determined marginal product of capital, you can hardly blame people when, faced with a slowdown in investment and growth, they figure that's the first place to look. The alternative is some constraint that prevents firms from moving toward their desired capital stock, which really has to be a financial friction of some kind. For the older Keynesian perspective credit constraints are one possible reason among others for a non-supply-side determined fall in investment; for the modern perspective they're the only game in town.

Second, the persistence of slumps is a problem for them in a way that it's not in the income-expenditure approach. Like the previous point, this follows from the fundamental fact that in the modern approach, while there can be constraints that prevent desired expenditure from being achieved, there's never causation from actual expenditure to desired expenditure. Businesses know, based on fundamentals, their optimal capital stock, and choose an investment path that gets them there while minimizing adjustment costs. Similarly, households know their lifetime income and utility-maximizing consumption path. Credit constraints may hold down investment or consumption in one period, but once they're relaxed, desired expenditure will be as high or higher than before. So you need persistent constraints to explain persistently depressed spending. Whereas in the income-expenditure model there is no puzzle. Depressed investment in one period directly reduces investment demand in the next period, both by reducing capacity utilization and by reducing the flow of profit income. If your core vision of the economy is a market, optimizing the allocation of scare resources, then if that optimal allocation isn't being achieved there must be some ongoing obstacle to trade. Whereas if you think of the economy in terms of income and expenditure flows, it seems perfectly natural that an interruption to some flow will will disrupt the pattern, and once the obstacle is removed the pattern will return to its only form only slowly if at all.

And third: Only conservative economists acknowledge this theoretical divide. You can find John Cochrane writing very clearly about alternative perspectives in macro. But saltwater economists -- and the best ones are often the worst in this respect -- are scrupulously atheoretical. I suspect this is because they know that if they wanted to describe their material in a more general way, they'd have to use the language of intertemporal optimization, and they are smart enough to know what a tar baby that is. So they become pure empiricists.

In Leon Fink's wonderful history of the New York health care workers' union 1199, Upheaval in the Quiet Zone, he talks about how the union's early leaders and activists were disproportionately drawn from Communist Party members and sympathizers, and other leftists. Like other communist-led unions, 1199 was kicked out of the CIO in the 1940s, but unlike most of the others, it didn't fade into obscurity. Originally a drugstore-employees union, it led the new wave of organizing of health care and public employees in the 1960s. Fink attributes a large part of its unusual commitment to organizing non-white and female workers, in an explicitly civil-rights framework, and its unusual lack of corruption and venality, to the continued solidarity of the generation of the 1930s. Their shared political commitments were a powerful source of coordination and discipline. But, says Fink, it was impossible for them to pass these commitments on to the next generation. Yes, in 1199, unlike most other unions, individual leftists were not purged; but there was still no organized left, either within the union or in connection to a broader movement. So there was no way for the first generation to reproduce themselves, and as they retired 1199 became exposed to the same pressures that produced conservative, self-serving leadership in so many other unions.

I feel there's something similar going on in economics. There are plenty of people at mainstream departments with a basically Keynesian vision of the economy. But they write and, especially, teach in a language that is basically alien to that vision. They're not reproducing the capacity for their own thought. They're running a kind of intellectual extractive industry, mining older traditions for insights but doing nothing to maintain them.

I had this conversation with a friend at a top department the other day:

me: http://noahpinionblog.blogspot.com/2013/03/the-swamp-of-dsge-despair.html

  what do you think? is this kind of critique valid/useful?

11:17 AM him: its totally true

11:18 AM and you wouldn't know what was getting baked into the cake unless you were trained in the literature

  I only started understanding the New Keynsian models a little while ago

  and just had the lazy "they are too complicated" criticism

11:19 AM now I understand that they are stupidly too complicated (as Noah's post points out)

11:20 AM me: so what is one supposed to do?

  if this is the state of macro

 him: i dunno. I think participating in this literature is a fucking horror show

 me: but you don't like heterodox people either, so....?

11:21 AM him: maybe become a historian

  or figure out some simple variant of the DSGEmodels that you can make your point and publish empirical stuff

This is where so many smart people I know end up. You have to use mainstream models -- you can't move the profession or help shape policy (or get a good job) otherwise. But on many questions, using those models means, at best, contorting your argument into a forced and unnatural framework, with arbitrary-seeming assumptions doing a lot of the work; at worst it means wading head-deep into an intellectual swamp. So you do some mix of what my friend suggests here: find a version of the modern framework that is loose enough to cram your ideas into without too much buckling; or give up on telling a coherent story about the world and become a pure empiricist. (Or give up on economics.) But either way, your insights about the world have to come from somewhere else. And that's the problem, because insight isn't cheap. The line I hear so often -- let's master mainstream methods so we can better promote our ideas -- assumes you've already got all your ideas, so the only work left is publicity.

If we want to take questions of aggregate demand and everything that goes with it -- booms, crises, slumps -- seriously, then we need a theoretical framework in which those questions arise naturally.


[*] Keynes' original term was "effective demand." The two are interchangeable today. But it's interesting to read the original passages in the GT. While they are confusingly written, there's no question that Keynes' meant "effective" in the sense of "being in effect." That is, of many possible levels of demand possible in an economy, which do we actually see? This is different from the way the term is usually understood, as "having effect," that is, backed with money. Demand backed with money is, of course, simply demand.  


UPDATE: The Cochrane post linked above is really good, very worth reading. It gives more of the specific flavor of these models than I do. He writes: In Old Keynesian models,

consumption depends on today's income through the "marginal propensity to consume" mpc. 

Modern new-Keynesian models are utterly different from this traditional view. Lots of people, especially in policy, commentary, and blogging circles, like to wave their hands over the equations of new Keynesian models and claim they provide formal cover for traditional old-Keynesian intuition, with all the optimization, budget constraints, and market clearing conditions that the old-Keynesian analysis never really got right taken care of. A quick look at our equations and the underlying logic shows that this is absolutely not the case.  

Consider how lowering interest rates is supposed to help. In the old Keynesian model, investment I = I(r) responds to lower interest rates, output and income Y = C + I + G, so rising investment raises income, which raises consumption in (4), which raises income some more, and so on. By contrast, the simple new-Keynesian model needs no investment, and interest rates simply rearrange consumption demand over time. 

Similarly, consider how raising government spending is supposed to help. In the old Keynesian model,  raising G in Y = C + I + G raises Y, which raises consumption C by (4), which raises Y some more, and so on. In the new-Keynesian model, the big multiplier comes because raising government spending raises inflation, which lowers interest rates, and once again brings consumption forward in time.

Note, for example, that in a standard New Keynesian model, expected future interest rates enter into current consumption exactly as the present interest rate does. This will obviously shape people's intuitions about things like the effectiveness of forward guidance by the Fed.


UPDATE 2: As usual, this blog is just an updated, but otherwise much inferior, version of What Leijonhufvud Said. From his 2006 essay The Uses of the Past:

We should expect to find an ahistorical attitude among a group of scientists busily soling puzzles within an agreed-upon paradigm... Preoccupation with the past is then a diversion or a luxury. When things are going well it is full steam ahead! .... As long as "normal" progress continues to be made in the established directions, there is no need to reexamine the past... 

Things begin to look different if and when the workable vein runs out or, to change the metaphor, when the road that took you to the "frontier of the field" ends in a swamp or in a blind alley. A lot of them do. Our fads run out and we get stuck. Reactions to finding yourself in a cul-de-sac differ. Tenured professors might be content to accommodate themselves to it, spend their time tidying up the place, putting in modern conveniences... Braver souls will want out and see a tremendous leap of the creative imagination as the only way out -- a prescription, however, that will leave ordinary mortals just climbing the walls. Another way to go is to backtrack. Back there, in the past, there were forks in the road and it is possible, even probable, that some roads were more promising than the one that looked most promising at the time...

This is exactly the spirit in which I'm trying to rehabilitate postwar income-expenditure Keynesianism. The whole essay is very worth reading, if you're interest at all in the history of economic thought.

Prices and the European Crisis, Continued

In comments to yesterday's post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,

pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.

I don't know. I suppose we all agree that exchange rate changes won't help in the short run (in fact, I'm not sure Krugman does agree), but I'm not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was

We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.

We "know," it "must": not much wiggle room there.

So this is the question, and I think it's an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It's worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because

he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country's currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: "A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country's merchandise balance." Keynes was convinced that for Britain exchange depreciation would be disastrous...

Keynes' "elasticity pessimism" is distinctly unfashionable today. It's an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade. 

Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries' long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let's look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece's merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it's hard to see a relationship between the exchange rate and trade flows. It's especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s -- quite a large movement as these things go -- had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It's very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It's hard to judge this just by looking at a figure. (That's why God gave us econometrics -- though to be honest I'm a bit skeptical about the possibility of getting a definite answer here.) But here's a suggestive point. Greece's real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It's hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it's hard to see fixed exchange rates, in themselves, as an important cause of the crisis.


[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I've quoted this here before, but it's worth repeating:

I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth... Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. ... Thus we are driven to supply-side explanations...

The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.


UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country's growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance -- this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven't had time to read the paper properly yet, but I wouldn't be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, "But devaluation has to work. It just has to." And she knows this stuff far better than I do, so, maybe.

Graeber Cycles and the Wicksellian Judgment Day

So it's halfway through the semester, and I'm looking over the midterms. Good news: Learning has taken place.

One of the things you hope students learn in a course like this is that money consists of three things: demand deposits (checking accounts and the like), currency and bank reserves. The first is a liability of private banks, the latter two are liabilities of the central bank. That money is always someone's liability -- a debt -- is often a hard thing for students to get their heads around, so one can end up teaching it a bit catechistically. Balance sheets, with their absolute (except for the exceptions) and seemingly arbitrary rules, can feel a bit like religious formula. On this test, the question about the definition of money was one of the few that didn't require students to think.

But when you do think about it, it's a very strange thing. What we teach as just a fact about the world, is really the product of -- or rather, a moment in -- a very specific historical evolution. We are lumping together two very different kinds of "money." Currency looks like classical money, like gold; but demand deposits do not. The most obvious difference, at least in the context of macroeconomics, is that one is exogenous (or set by policy) and the other endogenous. We paper this over by talking about reserve requirements, which allow the central bank to set "the" money supply to determine "the" interest rate. But everyone knows that reserve requirements are a dead letter and have been for decades, probably. While monetarists like Nick Rowe insist that there's something special about currency -- they have to, given the logic of their theories -- in the real world the link between the "money" issued by central banks and the "money" that matters for the economy has attenuated to imperceptible gossamer, if it hasn't been severed entirely. The best explanation for how conventional monetary policy works today is pure convention: With the supply of money entirely in the hands of private banks, policy is effective only because market participants expect it to be effective.

In other words, central banks today are like the Chinese emperor Wang Wei-Shao in the mid-1960s film Genghis Khan:

One of the film's early scenes shows the exquisitely attired emperor, calligraphy brush in hand, elegantly composing a poem. With an ethereal self-assurace born of unquestioning confidence in the divinely ordained course of worldly affairs, he explains that the poem's purpose is to express his displeasure at the Mongol barbarians who have lately been creating a disturbance on the empire's western frontier, and, by so doing, cause them to desist.  

Today expressions of intentions by leaders of the world's major central banks typically have immediate repercussions in financial markets... Central bankers' public utterances ... regularly move prices and yields in the financial markets, and these financial variables in turn affect non-financial economic activity... Indeed, a widely shared opinion today is that central bank need not actually do anything. ... 

In truth the ability of central banks to affect the evolution of prices and output ... [is] something of a mystery. ... Each [explanation of their influence] ... turns out to depend on one or another of a series of by now familiar fictions: households and firms need currency to purchase goods and services; banks can issue only reserve-bearing liabilities; no non-bank financial institutions create credit; and so on. 

... at a practical level, there is today [1999] little doubt that a country's monetary policy not only can but does largely determine the evolution of its price level..., and almost as little doubt that monetary policy exerts significant influence over ... employment and output... Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. ... There may well have been a time when the might of the Chinese empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders withdraw.

What looked potential a dozen years ago is now actual, if it wasn't already then. It's impossible to tell any sensible macroeconomic story that hinges on the quantity of outside money. The shift in our language from  money, which can be measured -- that one could formulate a "quantity theory" of  -- to discussions of liquidity, still a noun but now not a tangible thing but a property that adheres in different assets to different degrees, is a key diagnostic. And liquidity is a result of the operations of the financial system, not a feature of the natural world or a dial that can be set by the central bank. In 1820 or 1960 or arguably even in 1990 you could tell a kind of monetarist story that had some purchase on reality. Not today. But, and this is my point! it's not a simple before and after story. Because, not in 1890 either.

David Graeber, in his magisterial Debt: The First 5,000 Years [1], describes a very long alternation between world economies based on commodity money and world economies based on credit money. (Graeber's idiolect is money and debt; let's use here the standard terms.) The former is anonymous, universal and disembedded, corresponds to centralized states and extensive warfare, and develops alongside those other great institutions for separating people from their social contexts, slavery and bureaucracy. [2] Credit, by contrast, is personal, particular, and unavoidably connected with specific relationships and obligations; it corresponds to decentralized, heterogeneous forms of authority. The alternations between commodity-money systems,with their transcendental, monotheistic religious-philosophical superstructures; and credit systems, with their eclectic, immanent, pantheistic superstructures, is, in my opinion, the heart of Debt. (The contrast between medieval Christianity, with its endless mediations by saints and relics and the letters of Christ's name, and modern Christianity, with just you and the unknowable Divine, is paradigmatic.) Alternations not cycles, since there is no theory of the transition; probably just as well.

For Graeber, the whole half-millenium from the 16th through the 20th centuries is a period of the dominion of money, a dominion only now -- maybe -- coming to an end. But closer to ground level, there are shorter cycles. This comes through clearly in Axel Leijonhufvud's brilliant short essay on Wicksell's monetary theory, which is really the reason this post exists. (h/t David Glasner, I think Ashwin at Macroeconomic Resilience.) Among a whole series of sharp observations, Leijonhufvud makes the point that the past two centuries have seen several swings between commodity (or quasi-commodity) money and credit money. In the early modern period, the age of Adam Smith, there really was a (commodity) money economy, you could talk about a quantity of money. But even by the time of Ricardo, who first properly formalized the corresponding theory, this was ceasing to be true (as Wicksell also recognized), and by the later 19th century it wasn't true at all. The high gold standard era (1870-1914, roughly) really used gold only for settling international balances between central banks; for private transactions, it was an age not of gold but of bank-issued paper money. [3]

If I somehow found myself teaching this course in the 18th century, I'd explain that money means gold, or gold and silver. But by the mid 19th century, if you asked people about the money in their pocket, they would have pulled out paper bills, not so unlike bills of today -- except they very likely would have been bills issued by private banks.

The new world of bank-created money worried classical economists like Wicksell, who, like later monetarists, were strongly committed to the idea that the overall price level depends on the amount of money in circulation. The problem is that in a world of pure credit money, it's impossible to base a theory of the price level on the relationship between the quantity of money and the level of output, since the former is determined by the latter. Today we've resolved this problem by just giving up on a theory of the price level, and focusing on inflation instead. But this didn't look like an acceptable solution before World War II. For economists then -- for any reasonable person -- a trajectory of the price level toward infinity was an obvious absurdity that would inevitably come to a halt, disastrously if followed too far. Whereas today, that trajectory is the precise definition of price stability, that is, stable inflation. [4] Wicksell was part of an economics profession that saw explaining the price level as a, maybe the, key task; but he had no doubt that the trend was toward an ever-diminishing role for gold, at least domestically, leaving the money supply in the hands of the banks and the price level frighteningly unmoored.

Wicksell was right. Or at least, he was right when he wrote, a bit before 1900. But a funny thing happened on the way to the world of pure credit money. Thanks to new government controls on the banking system, the trend stopped and even reversed. Leijonhufvud:

Wicksell's "Day of Judgment" when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death [in 1926]. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system's total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.

But although Judgment Day was postponed it was not cancelled. ... The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, "smart cards" are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting. "Reserve requirements already are becoming a dead issue."

The second bolded sentence makes a nice point. Milton Friedman and his followers are regarded as opponents of regulation, supporters of laissez-faire, etc. But to the extent that the theory behind monetarism ever had any validity (or still has any validity in its present guises) it is precisely because of strict government control over credit creation. It's an irony that textbooks gloss over when they treat binding reserve requirements and the money multiplier as if they were facts of nature.

(That's more traditional textbooks. Newer textbooks replace the obsolete story that the central bank controls interest rates by setting the money supply with a new story that the central bank sets the interest rate by ... look, it just does, ok? Formally this is represented by replacing the old upward sloping LM curve with a horizontal MP (for monetary policy) line at the interest rate chosen by the central bank. The old story was artificial and, with respect to recent decades, basically wrong, but it did have the virtue of recognizing that the interest rate is determined in financial markets, and that monetary policy has to operate by changing the supply of liquidity. In the up-to-date modern version, policy might just as well operate by calligraphy.)

So, in the two centuries since Heinrich van Storch lectured the young Grand Dukes of Russia on the economic importance of "precious metals and fine jewels," capitalism has gone through two full Graeber cycles, from commodity money to credit money, back to (pseudo-)commodity money and now to credit money again. It's a process that proceeds unevenly; both the reality and the theory of money are uncomfortable hybrids of the two. But reality has advanced further toward the pure credit pole than theory has.

This time, will it make it all the way? Is Leijonhufvud right to suggest that Wicksell's Day of Judgment was deferred but not canceled, and now is at hand?

Certainly the impotence of conventional monetary policy even before the crisis is a serious omen. And it's hard to imagine a breakdown of the credit system that would force a return to commodity money, as in, say, medieval China. But on the other hand, it is not hard to imagine a reassertion of the public monopoly on means of payment. Indeed, when you think about it, it's hard to understand why this monopoly was ever abandoned. The practical advantages of smart cards over paper tokens are undeniable, but there's no reason that the cards shouldn't have been public goods just like the tokens were. (For Graeber's spiritual forefather Karl Polanyi, money, along with land and labor, was one of the core social institutions that could not be treated as commodities without destroying the social fabric.) The evolution of electronic money from credit cards looks contingent, not foreordained. Credit cards are only one of several widely-used electronic means of payment, and there's no obvious reason why they and not one of the ones issued by public entities should have been adopted universally. This is, after all, an area with extremely strong network externalities, where lock-in is likely. Indeed, in the Benjamin Friedman article quoted above, he explicitly suggests that subway cards issued by the MTA could just as easily have developed into the universal means of payment. After all, the "pay community" of subway riders in New York is even more extensive than the pay community of taxpayers, and there was probably a period in the 1990s when more people had subway cards in their wallets than had credit or debit cards. What's more, the MTA actually experimented with distributing subway card-reading machines to retailers to allow the cards to be used like, well, money. The experiment was eventually abandoned, but there doesn't seem to be any reason why it couldn't have succeeded; even today, with debit/credit cards much more widespread than two decades ago, many campuses find it advantageous to use college-issued smart cards as a kind of local currency.

These issues were touched on in the debate around interchange fees that rocked the econosphere a while back. (Why do checks settle at par -- what I pay is exactly what you get -- but debit and credit card transactions do not? Should we care?) But that discussion, while useful, could hardly resolve the deeper question: Why have we allowed means of payment to move from being a public good to a private oligopoly? In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn't have to pay any third party for permission to make the trade. Now, most of the time, we do. And the payments are not small; monetarists used to (still do?) go on about the "shoe leather costs" of holding more cash as a serious reason to worry about inflation, but no sane person could imagine those costs could come close to five percent of retail spending. And that's not counting the inefficiencies. This is a private sales tax that we allow to be levied on almost every transaction,  just as distortionary and just as regressive as other sales taxes but without the benefit of, you know, funding public services. The more one thinks about it, the stranger it seems. Why, of all the expansions of public goods and collective provision won over the past 100 or 200 years, is this the one big one that has been rolled back? Why has this act of enclosure apparently not even been noticed, let alone debated? Why has the modern equivalent of minting coinage -- the prerogative of sovereigns for as long as there've been any -- been allowed to pass into the hands of Visa and MasterCard, with neoliberal regimes not just allowing but actively encouraging it?

The view of the mainstream -- which in this case stretches well to the left of Krugman and DeLong, and on the right to everyone this side of Ron Paul -- is that, whatever the causes of the crisis and however the authorities should or do respond, eventually we will return to the status quo ante. Conventional monetary policy may not be effective now, but there's no reason to doubt that it will one day get back to so being. I'm not so sure. I think people underestimate the extent to which modern central banking depended on a public monopoly on means of payment, a monopoly that arose -- was established -- historically, and has now been allowed to lapse. Christina Romer's Berkeley speech on the glorious counterrevolution in macroeconomic policy may not have been anti-perfectly timed just because it was given months before the beginning of the worst recession in 70 years, but because it marked the end of the period in which the body of theory and policy that she was extolling applied.




[1] Information wants to be free. If there's a free downloadable version of a book out there, that's what I'm going to link to. But assuming some bank has demand deposits payable to you on the liability side of its balance sheet (i.e. you've got the money), this is a book you ought to buy.

[2] In pre-modern societies a slave is simply someone all of whose kinship ties have been extinguished, and is therefore attached only to the household of his/her master. They were not necessarily low in status or living standards, and they weren't distinguished by being personally subordinated to somebody, since everyone was. And slavery certainly cannot be defined as a person being property, since, as Graeber shows, private property as we know it is simply a generalization of the law of slavery.

[3] A point also emphasized by Robert Triffin in his essential paper Myths and Realities of the So-Called Gold Standard.

[4] Which is a cautionary tale for anyone who thinks the fact that an economic process that involves some ratio diverging to infinity is by defintion unsustainable. Physiocrats thought a trajectory of the farming share of the population toward zeo was an absolute absurdity and that in practice it could certaily not fall below half. They were wrong; and more generally, capitalism is not an equilibrium process. There may be seven unsustainable processes out there, or even more, but you cannot show it simply by noting that the trend of some ratio will take it outside its historic range.


UPDATE: Nick Rowe has a kind of response which, while I don't agree with it, lays out the case against regarding money as a liability very clearly. I have a long comment there, of which the tl;dr is that we should be thinking -- both logically and chronologically -- of central bank money evolving from private debt contracts, not from gold currency. I don't know if Nick read the Leijonhufvud piece I quote here, but the point that it makes is that writing 100-odd years ago, Wicksell started from exactly the position Nick takes now, and then observed how it breaks down with modern (even 1900-era modern) financial systems.

Also, the comments below are exceptionally good; anyone who read this post should definitely read the comments as well.