There are many things right with New Keynesian macroeconomics. It is a very good synthesis of many strands in Monetarist, Keynesian, and New Classical macroeconomics. But this post is not about what's right with New Keynesian macroeconomics.
There are also many things wrong with current New Keynesian macroeconomics. New Keynesian macroeconomists are aware of many of those things. But this post is not about all the things that are wrong. It's about some of the things that are wrong. I'm coming at this from a "Market Monetarist" (aka Quasi Monetarist) perspective.
"New Keynesian macroeconomics" can mean a lot of things. What I have in mind here might better be called "Neo-Wicksellian" macroeconomics, because monetary policy is seen as interest rate policy.
1. New Keynesian macroeconomics makes no sense whatsoever in a barter economy. And yet nowhere is the assumption of monetary exchange made explicit. You can't see money in the model, but it must be there somewhere, or the model just wouldn't make any sense.
1a. The producers in New Keynesian models are imperfectly competitive. They choose to set price above marginal cost. If two producers have price above marginal cost, both could gain by a barter deal in which they both produce additional output and exchange it at the ratio given by their posted prices.
1b. Even if we replace imperfect with perfect competition, and assume prices are fixed, it would be impossible to have a recession with excess supply of all goods in a barter economy. Two producers who wanted to sell more but couldn't find customers would simply produce additional output and do a barter deal.
There is something fundamentally wrong with a model that implicitly assumes monetary exchange but does not make this assumption explicit, and does not even have money in the model.
2. New Keynesian models explicitly assume that money is the medium of account. But again, there is no money in the model. Prices are set in terms of a good that does not exist.
3. New Keynesian models explicitly assume that the nominal rate of interest is set by a central bank. Central banks have special power over monetary policy only because they issue irredeemable money. Yet that irredeemable money does not appear in the model.
4. New Keynesian models have only one transmission mechanism for monetary policy — the effect of current and expected future interest rates on desired consumption and investment.
4a. We know that a permanent change in the stock of central bank money will change the long run equilibrium values of all nominal variables but will leave interest rates unchanged.
4b. We know that monetary policy will still affect nominal variables in the long run, and real variables in the short run (assuming sticky prices), even in a world with no interest rates, no borrowing or lending, or where interest rates are set by law. So the interest rate channel cannot be the only possible transmission mechanism for monetary policy.
4c. We can imagine a world in which central banks implement monetary policy in many different ways than by setting a rate of interest. For example, they can set the price of a commodity like gold, and vary that price. Or they can give away money for free, and vary the quantity they give away.
4d. Central banks that issue irredeemable money aren't even banks. A bank both borrows and lends. It has assets and liabilities. An irredeemable liability is not a liability, so central banks don't have liabilities. They don't even need assets, unless they choose to buy back some of their money in exchange for those assets. A central bank, since it is not a bank, does not have to borrow or lend, and need not have anything to do with interest rates.
5. New Keynesian macroeconomics asserts that central banks must lower current or expected future real interest rates in order to get an economy out of a recession. This assertion is, I believe, often false. The IS curve will probably slope upwards in a recession. Recovery from a recession is compatible with an increase in real interest rates.
6. This to me is the killer. New Keynesian models lead good economists, who correctly diagnose the monetary nature of the recession, at the same time to believe that monetary policy is powerless at the zero lower bound. And recommend fiscal policy instead. This is like correctly diagnosing magneto trouble, then recommending we all get out and push the car, rather than fixing the magneto. I just refuse to accept that that's the best we can do. We need to understand that monetary magneto better, and learn how to fix it. And it is my frustration with this lack of correspondence between diagnosis and policy prescription that has lead me on my three year search for something better.
I have been eclectic in my search, taking ideas that seem useful regardless of their source. Some are Monetarist. Some are Old Keynesian. And Clower is as much a Keynesian as a Monetarist. I side with Silvio Gessell against Keynes on the role of money in general gluts.
Like other "Market Monetarists" I think that monetary policy can cure what is at root a monetary problem. But we don't all agree on everything. Lars Christensen provides a good survey (pdf). This post is in part a response to Arash Molavi Vassei. Scott Sumner responds here. Josh Hendrickson here.
All equilibrium theories have a disequilibrium story on the side. If the demand curve for apples shifts right, that creates excess demand for apples at the old equilibrium price, so individual sellers can raise their prices above other sellers' prices and still sell their apples, and this process is what gets the price to the new equilibrium. In monetary economics we call this disequilibrium story the monetary policy transmission mechanism. The interest rate transmission mechanism is the New Keynesian disequilibrium story. It's not the only possible story. It's not even a very good story, as I argue above.
My MX6 developed "magneto" trouble last Summer, 100kms away from home. Replacing the alternator is a 2 hour job, and I didn't want to do it at the side of the road. So I bought a new battery at Canadian Tire, replaced the old battery when it finally died, and that got me home. I replaced the alternator the next morning. There are circumstances when a bodge job is the best you can do. But it's not really satisfactory.
Worthwhile Canadian Initiative 
Is there any real point to all this?
In particular, what is the different policy proposal for an economy at the zero lower bound, and has any economy recovered by using that policy?
THIS IS SIMPLY NOT DONE.
Sorry. I had to vent somewhere.
vjk: “Granted, the BoC has very little of it in the system, about $150M daily last time I looked, but not zero.”
Most of this year, net reserves have been very near $25M. In the last few weeks it’s gone up to about $400M, which might mean that somebody is having trouble in the interbank market and is using the SLF (the discount window). No matter what, it’s pennies.
“If the BoC has no liabilities, that means there will be no interbank market which means that the whole system will come to a standstill and the overnight rates will go through the roof. ”
Of course, yes, not literally zero. As close to zero as the system can handle without small errors causing big problems.
“Besides, in order to threaten credibly, the CB has to deliver on those threats from time to time through OMOs.”
They are delivering all the time. They might put extra cash in the system if they see that rates are trading high, and then, in the afternoon as everyone scrambles to unload the hot potato and rates are dropping, they’ll come back in and remove the excess before it ever actually occurs. The threat of an overnight balance can be very real if the BoC has already been in the market. So usually they end up doing trades during the day that, by the time of settlement (18:30 or whatever) add up to net zero.
Nick: yup, it’s worthwhile taking the time to think about how things ought to be in a better world!
Bill: “The central bank only purchases private securities, and they have have some credit risk.”
In my thought experiment I was imagining a “mutual bank,” ie. only one type of liability: money. I was also imagining that anyone could redeem money in return their share of the banks portfolio of assets. Monetary policy, then, consists exclusively of “stock splits”. The bank anticipates that prices of consumer goods will fall, eg., by half, so it splits each share in two; a purely nominal change, with zero redistributive effect. You can achieve this in any 100% reserve system if the commercial banks were required to pass on the policy rate into deposit accounts. That is the purest form of monetary operation. To the extent that anything else can effectively accomplish that, it is monetary. Otherwise we can call it fiscal.
“The notion that the government just has to make profits out of the system and how the government profits are impacted is what makes it monetary policy or fiscal policy seems… wrongheaded… confused…”
I don’t want governments to make profit from the system. I want money to be a neutral veil. The point is to avoid social engineering through money.
Scott: “Or more precisely an economy where the net amount of money is zero, and monetary policy is done by adjusting the demand for money rather than the supply of money?”
I think it’s quite different. Money wouldn’t be created by risk averse investors lending to risk seeking ones. It would be created by monetization of capital assets. Investors exchange units of the market portfolio for units of the CB. And my proposal is to meet whatever monetary target by adjusting the quantity of the unit of account by splitting it (paying interest). But that wouldn’t change the market value of the total medium of exchange which is given by the value of the CBs assets. And it doesn’t redistribute wealth since everyone maintains a claim on the same fraction of the central banks assets.
I see much less potential for runaway money creation or destruction in such an economy so I think the need for stabilization would be smaller. That said, there’d still be changes in velocity so an NGDP level or similar target strikes me as eminently practical.
you can’t have a barter society that includes cash. accumulated cash overwhelms accumulated barter… unless you’re bartering raw supplies like oil, gold and diamonds… but then you’re bartering it for cash. cash is the killer app that killed barter… which is now so old skool. i hear it’s two chickens for an angiogram at the bunny ranch…
Mind/body dualism, Nick. Failed metaphysics. An economy is not a car.
It’s very hard to argue with monetarist position on formal grounds. (Believe me, I’ve tried.) Telling a coherent story about a shortfall of demand for currently-produced output that doesn’t involve excess demand for money may be possible, but I have not figured out how to do it.
But arguing with the policy conclusions that monetarists like Nick want to draw, may be easier.
I see at least two problems with the leap from the diagnosis of excess money demand to the prescription of a monetary solution.
First, what is “money”? Here, it seems to be base money, high-powered money — reserves and currency. But clearly, the stuff that actual economic units — firms and households — have excess demand for, is not just reserves (which they can’t hold anyway) and currency. It’s some broader class of assets that are money-like in the sense that (1) they are safe and convenient stores of value and (2) they can be used for settling contractual obligations. (People talk more about 1 but 2 is probably more important.) Of course money also includes anything that can quickly and reliably be turned into money.
So to get from excess “there’s demand for money” to “the solution is monetary policy” you have to jump over the process that connects the “money” that central banks control to the “money” that is actually in excess demand. There’s a lot of complex institutional detail in that process, but Nick just jumps over it. But without understanding that, you really have no idea if a particular form of monetary policy is actually increasing the stock of the money that’s in excess demand. This may be hard to do, especially since the moneyness of different assets are often going be endogenous to policy, and to whatever problem created the need for policy. It’s a lot easier to find the illiquid end of the spectrum — it’s hard to know when reserves are going to be more money than T-bills and when they are not, but they are both surely a lot more money than an hour of labor. So policy has a more secure purchase when it tried to increase demand for the illiquid stuff, rather than the supply of the liquid stuff.
Second, even though a pure coordination problem model probably can’t describe what we see in real recessions, there still can be an important coordination problem aspect to them. Specifically, the monetarist solution (fix the problem from the money-supply side) assumes that additions to the total stock of money will find their way to the particular units with excess money demand more or less automatically. It seems to me that it should be clear from the past few years (if not long before) that this simply isn’t how the financial system works. There are huge transaction costs in many credit transactions that make it very possible for some units to be experiencing excess demand for money while other have excess supply. Again, the effectiveness of monetary policy as it’s normally conceived is probably much more dependent on the specific institutional structure of the financial system than someone like Nick wants to acknowledge.
It’s true that a Walrasian barter economy without money cannot experience recessions. It does not follow that the best framework for thinking about recessions, is Walrasian barter with money added.
Excellent comment by JW Mason @ 01:54am.
What Phil said. I’m going to have to come back to this later.
K:
“which might mean that somebody is having trouble in the interbank market and is using the SLF
”
Not necessarily. Hard to say from the weekly stat table as the overdraft loan terms are between 1 and 4 days so their impact on the CAP total balance may be negligible. Appears to be due to bond acquisition by BoC (monetary policy ) and notes in circulation fluctuations.
CAP -> CPA
JW Mason: So to get from excess “there’s demand for money” to “the solution is monetary policy” you have to jump over the process that connects the “money” that central banks control to the “money” that is actually in excess demand. There’s a lot of complex institutional detail in that process, but Nick just jumps over it. But without understanding that, you really have no idea if a particular form of monetary policy is actually increasing the stock of the money that’s in excess demand.
To my mind the more fundamental problem is that there is only a notional excess demand for money. At depressed levels of income households show no inclination to add to their holdings of money. It’s reasonable to believe that at full employment they would hold more, but that doesn’t, of itself, mean that the central bank can get us from here to there.
At times I get the sense that what Nick and other MMs want is a model which elevates radical monetary policies above fiscal policy. But if they actually have such a model I haven’t seen it. Of course there’s nothing wrong with searching for a model which will justify what your intuition tells you is the right policy. Keynes was advocating public works long before he wrote the GT. But right now the MMs aren’t so much a school of thought as a school of instinct.
Yes, Josh, it’s transaction costs all the way down! Fixing the economy’s “magneto” may take a lot longer than two hours at the side of the road. A lot longer.
Inestimably longer.
K: “But, alas, we dream!”
Bill Woolsey said: “Suppose there is no government debt.”
K, let’s take that a step further. Can you imagine an economy with no currency denominated gov’t debt and no currency denominated private debt?
“This is like correctly diagnosing magneto trouble, then recommending we all get out and push the car, rather than fixing the magneto. I just refuse to accept that that’s the best we can do. We need to understand that monetary magneto better, and learn how to fix it.”
I’m not sure why you’d want to stop at understanding the monetary magneto; why not keeping pushing until you can create a complete set of Arrow-Debreu contingent markets? I think policy is supposed to fall by the wayside at that point.
And I’m not being snarky….I’m trying to point out that there are many pretty-valid approaches to policy formulation and that differences in what they take as “exogenous” can be key. Is it fair to put Nick’s approach on a continuum somewhere between those who just worry about “what can pass the Republicans in the House?” and those who think only in terms of perfect, frictionless and complete markets? Can all three approaches be defended?
This is an important point. But it also cuts against the Keynesian / fiscal “solution”, which suffers from exactly the same sort of problem, often in spades.
And who will arrive at these solutions more competently: the U.S. Congress? the Federal Reserve? or distributed decision makers & learners “crowd sourced” to the markets?
And what if we replaced the Central Plan makers at the Fed with a “crowd sourced” distributed system of independent learners & deciders to “solve” the problem, i.e. via private banking and the denationalization of money? I.e. the solution of Bagehot & Hayek.
Mason writes,
“the monetarist solution (fix the problem from the money-supply side) assumes that additions to the total stock of money will find their way to the particular units with excess money demand more or less automatically. It seems to me that it should be clear from the past few years (if not long before) that this simply isn’t how the financial system works’
Foster & Catchings & Sen. Wagner & many other Americans were advocating public works to eliminate deficiencies of demand before Keynes, in the 1920s … Herbert Hoover was such a fan of Foster & Catchings that he wrote a complementary introduction to one of their books on the topic.
The economics profession proved collectively incapable of refuting the arguments of Foster & Catchings, in a world-famous prize competition to refute their work.
In many ways, Keynes in 1936 didn’t do much more than put a fancy “modern” and “scientific” imprimatur rooted in Marshallian economics on the prior ideas of Foster & Catchings, by tacking on an absurd monetary gloss effectively assumed away both economic scarcity and any genuine guidance role for prices across time, especially in the domain of production goods and inputs to production.
In other words, just as Foster & Catchings instructed the “instincts” of Sen. Wagner & Herbert Hoover in the 1920s, so to it seems did they also set the scientific background atmosphere for in which Keynes'”instincts” eventually grew and advanced.
Kevin wrote,
“Keynes was advocating public works long before he wrote the GT.”
There is a bit of unreality floating around this thread that the Central Bank does not have liabilities. It is a simplistic but true observation that the CB’s balance sheet must balance. Assets = Liabilities + Owner’s Equity. There has to be “Something” in all those categories. Determining what that something is or should be the point of monetary policy, but you can’t go neglecting one side of the balance sheet and focus exclusively on the other because the math will no longer work.
Greg: And Hayek didn’t fully realize that a monetary economy can be strangled by its money market. Not enough money = failure to clear = recession. Money is a noose around the economy’s neck. Tighten it and you strangle it.
Adjusting prices downward or injecting more money comes to the same thing: paying for defaults. Downward price adjustments means borrowers pay, increasing the money supply means lenders pay. We have been going around in circles for seventy years over who should pay. But ultimately somebody will pay.
Determinant:
For an accountant, there must be something in these categories ,anything, just so there is some fictional balance.
The CB balance its sheet with TB. These TB are backed by the Full Faith and Credit of the Gov’t. Ultimately the faith that the economy will run and the Canadian Revenue Agency will collect taxes. The same as with a personnal margin of credit.The bank hope we will have an income and pay back. Nothing of value to sell in a functioning market.
I won’t go in whether the CB has “liabilities”. But it has no assets in the sense a business has assets. There is nothing but hope. And the fact that Oz functions and we don’t want the push the curtain too much.
Jacques, that is true for any bank. It has loans on the asset side and deposit/bond obligations on the liability side. Just because the assets are not tangible does not mean that they are pure hope. They are, in fact contracts, not wishes. The real side of the economy orients itself in such a way as to try to fulfill those contracts, even to the point of doing things that might seem silly if one ignores the financial contracts and looks only at the underlying tangible assets.
The collapse of “shadow money” and liquidity generally is part of Hayek’s explanatory machinery.
So Hayek did realize that the “money” market was part of the “strangulation” process. He did realize that “not enough money” was part of the failure to clear at the turn of the boom / decent into bust — he writes about that, including discussions of the disequilibrium caused by the “secondary deflation / depression”. And it does this very early and very late and consistently throughout his career.
In other words, all of the work of your remark here is done with the weasel word “fully”. Eliminate “fully” and your remark is false.
The ambiguity and cognitive near meaninglessness of your remark is indicated by the fact that there is no economists you could not say the same thing about .. if you leave in the word “fully”.
D said,
“And Hayek didn’t fully realize that a monetary economy can be strangled by its money market. Not enough money = failure to clear = recession.’
rsj: as long as goods and services are not delivered , contracts are wishes. Even a court order and a baillif can’t change that.
But Jacque, that’s a simplistic view. First, debt is always rolled over, and expectations of return are just as, if not more important. Government debt, as its backed by taxes, is pretty damn strong. Even if the government has trouble collecting taxes now, it only needs to send a signal that it will be able to collect taxes at some future point, and the debt is treated as risk-free today.
Similarly, take the point of view of a firm. It is having trouble selling goods today and earning a high margin today. So it lays off a lot of employees, closes some divisions and takes efforts to regain its higher margin. If the investors believe the efforts are credible, then the stock price of the firm goes up, even though it has less tangible capital and less revenue as a result of the liquidation.
So the relationship between tangible stuff and the value of promises can often go in the opposite direction of what you would expect. And typically the tangible stuff follows, rather than leads, the promises.
If economics is supposed to be a science, then one should base one’s macroeconomic theory on actual evidence. There is no evidence that a barter economy has ever existed:
http://www.nakedcapitalism.com/2011/09/david-graeber-on-the-invention-of-money-%E2%80%93-notes-on-sex-adventure-monomaniacal-sociopathy-and-the-true-function-of-economics.html
As such, attacking the New Keynesians for (apparently) not being able to make sense of a barter economy is no better than attacking chemists for not being able to explain phlogiston, or attacking physicists for not being able to explain the workings of a time-travelling DeLorean. It’s fantasy, not science.
J. V. DuBois:
Firstly, no-one reasonably believes this always. We don’t trust the market to allocate resources for many things (police, justice, education, etc). So simply asserting that the market is better is not an argument for the Central Bank handing money over and leaving it to the market – it ignores “market failures” in other words.
Secondly, it’s not simply the “market” we’re talking about, is it. If the Central Bank does QE, then it benefits the already wealthy:
Click to access credit-where-its-due.pdf
(report from UK perspective)
who aren’t exactly in need of desperate help. QE as it stands is not neutral. The Central Banks have already picked winners. The question should be about making sure those winners are the right people.
What’s wrong with Min’s suggestion of doing QE and then mailing out cheques to those who need the money? And after all, they’re the ones most likely to spend it, rather than save it, thus increasing monetary velocity. And for those that save, it would also help them deleverage quicker.
Finally, the focus on monetary policy here misses two points:
1. We’re not really talking about monetary policy as it used to be thought. Nor is what Nick is suggesting not fiscal policy. At best, we’ve established that there is no neat dividing line between fiscal and monetary policy. You can call these proposals “monetary if you want, but I see no reason not to call them “fiscal” either.
2. It misses the point of what problem we’re trying to fix. The problem is not simply “lack of growth”. The main problem is huge amounts of unemployment (and too low wages), causing immense human misery. It is this misery that we need to end first and foremost (similarly, lets end world hunger before we start talking about productivity rises in Ethiopia). And as one man once send, monetary policy has long and variable lags. This is not going to help the average working class individual fast enough. Government can directly provide jobs. Let it do so while we wait for other interventions (monetary, quasi-monetary, fiscal, call them what you want) to have their effect.
Greg:
I’m not interested in a Hayek v Keynes showdown debate, so I’ll just mention one weakness with your argument:
Your argument is that “crowd-sourcing” as you term it, is the more trustworthy solution. That is, it isn’t an argument that government could never solve the problem, only that it’s much less likely than the market to do so. The problem with this argument is that it is vulnerable to a reductio ad absurdum. After all, if we can’t trust the government to choose the correct solution to the crisis, then why should we trust the government to read Hayek or his heirs, and implement Hayek’s ideas correctly?
That is, if the government is so bad at decision making, then why would it opt for Hayek? My argument has this form:
P1: Governments can’t be trusted to do central planning correctly in the slightest, not even monetary policy.
P2: The best form of monetary policy is to not do it, from Hayek.
C: From P1, government will fail to not do monetary policy. It will instead do monetary policy, which is bad according to P2.
So if the government won’t listen to Hayek (who in your opinion was right), then who will it listen to instead? By continuing to advocate Hayek rather than some more moderate position, you (by P1) fail to get yourself heard by the government, thus defeating the point of your advocacy of Hayek.
In other words, if Hayek was right, then there’s no way to get government to listen to what you want it to do (or top doing). Advocating Hayek is self-defeating.
[Also, on your bit about the market being better because its “distributed decision makers & learners”, this is totally flawed. Not everyone has equal standing in the market – some have more money/purchasing power than others, and so their actions in the market carry more weight. A better form of crowd-sourcing and “distributed decision makers & learners” would be either direct democracy (i.e. everyone’s voice counts equally, no arbitrary-ness in who gets how much say), or deliberative democracy (that is we decide what to allocate resources on based on discussion, with everyone getting the same free speech rights, but we reach a consensus rather than a simple vote). Even these have weaknesses – compare the American populations general support of creationism or intelligent design with scientists support of evolution for instance. Very often the wisdom of crowds is replaced by the madness of crowds. In short, what system is best for finding out truth? Every system is flawed. Let’s not get ideological about this. And “what is the best way to allocate resources?” is not a question of the same type as “did mankind evolve?”. The latter is about truth, the former about morality. There is no right answer. So the solution must be a political one. Choosing the market above all else is inherently a political choice. You’ve decided on the means before we’ve even decided on the ends we’re aiming for. There are other consequentialist arguments against government, but this Hayekian one is not a good one IMO.]
You seem to think that the natural rate hypothesis, that is accepted in New Keynesian models, is fine. No problem with the fact that there seems little evidence for it?
Too Much Fed: “K, let’s take that a step further. Can you imagine an economy with no currency denominated gov’t debt and no currency denominated private debt?”
I think so. As Nick once pointed out, nominal debt is a lot like glass (and equity like rubber? I forget). It breaks, and causes huge dead weight losses when it does so (the lawyers take half). The principal benefit of debt is tax treatment. So companies and individuals lever up until the marginal increased expected cost of default approaches the marginal tax benefit. And the financial sector encourages favourable tax treatment of debt (like the US mortgage deduction) because it increases borrowing and the money supply. But without those tax reasons (there are other minor effects), Modigliani-Miller says there is no benefit to corporate leverage, since investors can choose their own level of leverage. I think that’s true. And margin borrowing against liquid stocks should be more efficient than borrowing against illiquid corporate assets. So change the tax code and we would have way less debt and far less dead weight losses from bankruptcy. I don’t see why we couldn’t have just equity.
Could governments equity finance? Maybe they could issue “stock” that entitles the owner to a proportion of future revenues. Could work, and seems more transparent, i.e.: “This year, in order to finance current services and tax cuts, we sold to private interests 1% of what could have been future government services. Once we’ve sold 100% of future revenues, you’ll be all out of services. Forever.”
The MMT crowd would have the government not finance at all. I.e. all their debt would be monetized. I think this is a bad idea because the market mechanism for government debt pricing is really important. It is our consensus estimate of the ability of the government to shift current expenditures onto future tax payers. Higher yielding bonds prevent governments from taking on liabilities that the market estimates that future tax payers are going to want to pay for. The owners of the government debt can then monetize it at the CB at its fair market price if they have a desire for increased liquidity. But allowing any issuer (including government) to circumvent market demand and directly monetize their debt results in a moral hazard that is likely to be hyper-inflationary. That’s why we need independent central banks.
Your question is important because, as Nick discussed in a post a month or two ago, If you back the CB’s balance sheet with nominal liabilities and the CB has no equity, then the value of the liabilities (money) of the CB can be undefined if they are not equal in quantity to the amount of nominal assets. So CB’s need to issue equity, or they need to own a substantial amount of non-nominal assets (equity). But I don’t think governments need to “equity” finance for my central bank proposal to work. The CB just needs to hold a lot of private sector equity securities relative to the amount of nominal assets.
Greg:
Here is how Hayek got in wrong on money and recessions: http://www.skidelskyr.com/site/article/interpreting-the-great-depression-hayek-versus-keynes/
“These Hayekian and Keynesian forecasts turned into explanations of the slump once it had happened. In a lecture in Cambridge in 1931 Hayek, newly brought to the LSE by Lionel Robbins, expounded the theory of his book, Prices and Production. The slump was due to a crisis of over-investment –overinvestment in relation to the amount of consumption people wanted to forego –financed by credit-creation by the banking system. The slump was merely the process of eliminating the unsustainable investments, those not financed by genuine savings. Government pumping more money into the economy would merely prolong the agony. The quickest cure would be for people to save more, to bring about a recovery in private investment. Richard Kahn records that this lecture was received in total silence by Hayek’s Cambridge audience. To break the ice, Kahn asked: ‘Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemployment?’. ‘Yes’, Hayek replied, turning to a blackboard full of triangles, ‘but it would take a very long mathematical argument to explain why.'”
Wrong, Mr. Hayek. A Depression is a state-space transition from a supply-constrained economy to a money-constrained economy. Once that transition is made, the economy will permanently settle into a lower state of consumption and investment. You can try to collapse the economy’s capacity, contracting its Production Possibilities Frontier, but that both eliminates capacity, creates involuntary unemployment and extracts a terrible human cost.
Further in a money-constrained economy the clearing rate of interest cannot be attained by the market (it lies beyond the area of attainable rates for a given money supply). In this case investment will not work to grow the economy because economic growth to make savings turn into investment requires a clearing rate of interest. This isn’t possible in a Depression state-space.
No, don’t try to invest your way out of it first. First inject more money, get rid of involuntary unemployment, transition to a full capacity economy and then, only then, invest your way to growth. But the first step is to create more money. Inflationistas be d**ned.
I meant “Higher yielding bonds prevent governments from taking on liabilities that the market estimates that future tax payers aren’t going to want to pay for”
Scott: I don’t think Woodford is at all clear on whether his “cashless” economy is also a “moneyless” economy.
Jim: well, economies that went off gold (raised the price of gold) in the 1930’s seemed to recover, even though interest rates were near zero. We need the modern equivalent.
Patrick. Agreed. But I’m not American, so try mostly to stay out of US politics. But I thought Scott Sumner’s response was right. You could argue that in this case, if US monetary policy is screwed up, it affects a lot more than just the US.
K @11.23. Neat thought experiment. The Quantity Theory thought-experiment is very much like a stock split. Some of the “backing” theorists have used that analogy before. But you are turning it into a (possible) policy recommendation. Filed at the back of my mind for possible future use.
no exit: ? I know cash kills barter (mostly).
Sandwichman: metaphors are like motorbikes; they don’t run on 4 wheels.
JW: “But arguing with the policy conclusions that monetarists like Nick want to draw, may be easier.”
Agreed. That monetary policy can always cure a monetary problem does not follow as a matter of pure logic. (But, dammit, it ought to!)
What is “money”? I see the medium of exchange function as essential; the medium of account function as secondary, but still important. Yes, money is also some sort of store of wealth, but so are hundreds of other goods too.
“Of course money also includes anything that can quickly and reliably be turned into money.”
I don’t agree with that. Near monies may be near monies at the individual level, but not at the aggregate level. Plus, a difference in degree can become a difference in kind. There is a spectrum of goods with different degrees of liquidity, but the good at the most liquid end of that spectrum becomes used in a totally different way. It becomes the medium of exchange.
“There are huge transaction costs in many credit transactions that make it very possible for some units to be experiencing excess demand for money while other have excess supply.”
Agreed. A representative agent model is a bit of a failure here. For example, it is (especially) the unemployed who have an excess demand for money. So to suggest that there can’t be an excess demand for money, because anyone with an excess demand for money could just sell bonds, is missing the point.
“It’s true that a Walrasian barter economy without money cannot experience recessions. It does not follow that the best framework for thinking about recessions, is Walrasian barter with money added.”
OK, but if you really do “add money” (in some essential way) to a Walrasian model, it is such a different model that it isn’t really Walrasian any more. This was the critique of Patinkin, that he added money to a Walrasian model without adding it in any essential way (people didn’t need to use money to buy and sell goods). Patinkin’s model is formally identical to my “bling” model. Take a barter economy, then add M/P to the utility function. Let M be the stock of bling. An excess demand for bling cannot cause a recession.
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/imagine-theres-no-money.html
Kevin: “To my mind the more fundamental problem is that there is only a notional excess demand for money. At depressed levels of income households show no inclination to add to their holdings of money. It’s reasonable to believe that at full employment they would hold more, but that doesn’t, of itself, mean that the central bank can get us from here to there.”
That’s what happens in a standard ISLM model, with a downward-sloping IS and Md/P=L(Y,i). But, with uncertainty removed, other assets would become safer and more profitable, so the stock demand for money might fall. Also, remember that the unemployed have an excess flow demand for money in the labour market, and presumably an excess stock demand too. If an unempolyed individual succeeded in selling his labour, he would spend most of his extra flow of money income.
Sandwichman: Asset prices would respond to a change in monetary policy in much less than 2 hours. But yes, it is better to build a magneto that doesn’t break than to keep fixing it when it does break. Then we don’t have to waste 2 hours at the side of the road, or keep buying new batteries.
Simon: “I’m not sure why you’d want to stop at understanding the monetary magneto; why not keeping pushing until you can create a complete set of Arrow-Debreu contingent markets? I think policy is supposed to fall by the wayside at that point.”
Money (even bad money) is a lot cheaper and more effective than a complete set of A-D markets. That’s why we use it. Even Zimbabwean money survived, and beat barter, until the very end.
Greg: I’m not against private monies. But, as far as I can see, truly independent (i.e. not redeemable at par in government money) seem to fail the test of the market. With a few exceptions, people just don’t use LETS and similar monies.
Determinant: “There is a bit of unreality floating around this thread that the Central Bank does not have liabilities.”
I see it the other way around. You can always force a balance sheet perspective onto a central bank if you push hard enough. Just call an irredeemable currency a “liability”, even when it isn’t. It’s pushing it a bit when we make a regular firm’s balance sheet balance by saying that equity is a liability, but at least shares are a promise to pay a share of the profits. BoC currency isn’t a promise to pay anything.
Jacques: yes. The stuff on the “asset” side of the CB’s balance sheet is even weirder. Most of it (bonds) are promises to pay those “liabilities” that appear on the other side of the balance sheet.
Makes me think that Scott Sumner is really right on this. A central bank is not a bank in any way. The whole balance sheet is some sort of self-referential joke, just to keep the accountants happy.
A: you really missed my point on that bit. Since we live in a monetary economy, it’s perfectly OK if Keynesian models only work in a monetary economy. But it’s not OK if they don’t explain why they only work in a monetary economy. It’s not OK if the model cannot explain why it won’t apply equally well in a barter economy. It’s not OK if a model that only works in a monetary economy doesn’t say anything about money.
It’s like having a physics model which ignores friction and yet only works if there is friction. Something is wrong.
Matias: I’m generally more or less OK with the natural rate hypothesis. I see that as a separate question, not related to the problems with the New Keynesian model from a monetarist perspective.
JW Mason: “it’s hard to know when reserves are going to be more money than T-bills and when they are not, but they are both surely a lot more money than an hour of labor”
This reminds me of the old Keynesian critique of Quantity Theory that velocity actually fluctuates. The easiest response is – you are no better, multiplier is not much more stable. Do you really understand the intricacies of the government projects and how effectively fiscal stimulus flows to units with excess demand for money? If government would choose a fiscal stimulus in form of “iPad for everybody” the result could be huge profits for Apple, maybe a few more people hired in retail – and of course a lot more cash reserves on Apple bank accounts.
So we are back in the realm of reversibility. If you try fiscal stimulus and fail, you may end up with a lot of wasted production. There is no way back, resources were already spent and wasted. You failed to eat that free lunch. On the other hand if you conduct monetary or “fiscal/monetary” policy of buying private assets such as corporate bonds, or stocks – you may always sell them back and try to pour money somewhere else where it has better chance to reach those units craving for money.
Actually I may go further. As Nick mentions in a lot of posts, monetary policy is mostly about expectations and credibility. If government says that they plan to do 10 000 unspecified projects as part of a fiscal stimulus, no one can imagine what effect this will have. Investors may just wait to see what people that recieve that government money want to buy. On the other hand, if central bank says that the policy changed to NGDP level targeting and that for starters they will aim stocks and corporate bonds of most labor intensive industries until it reach certain value, it is quite likely that private investors will pour their money there without need for CB to spend a cent on those stocks/bonds. Remember recent example of Schweizerichse Nationalsbank and you get the idea of what power words of credible institution have. If, as I think we all agree, this recession is one huge coordination failure, and if words, not spending, can solve it – hy not give it a try?
Nick: “So to suggest that there can’t be an excess demand for money, because anyone with an excess demand for money could just sell bonds, is missing the point.”
Right. But which point is it missing? I think it’s missing the point that if borrowing costs are not the same for everyone, there is no unique, independent of wealth distribution, economic equilibrium. This has been known since (moneyless!) CAPM, and probably before. Krugman and Eggertson merely repeated that point in a modern (moneyless!) NK framework.
Nick, thanks for the reply but you lost me. With Y below potential and L(Y,i)=M/P, we’ve got notional (but not effective) excess demand for money. But I don’t see what you mean by “uncertainty removed” unless it’s just whatever uncertainty caused money demand to jump in the first place. That’s not reassuring since it just means the economy might pull itself out of the slump. Similarly it doesn’t help to know that the unemployed would spend income if they had it, when in fact firms don’t see any profit in employing them. But of course you know that, so you must be saying something more which I’m missing.
…if you really do “add money” (in some essential way) to a Walrasian model, it is such a different model that it isn’t really Walrasian any more.
Likewise if you introduce rationing of any sort into a Walrasian model then it isn’t Walrasian any more. So what’s the case for saying that money, rather than quantity constraints, is essential? Now, if by “adding money” you simply mean ruling out barter I’ve no problem with that. But then labels like Market (or Neo or Quasi) Monetarism are misleading. What you’re really promulgating is No-Barter Macro. I’d be happy to sail under that flag. (Though it sounds a bit like No-Bullshit Marxism, a movement of which I know nowt, in that it defines itself by what it seeks to remove from the doctrine to be reformed, rather than by what it seeks to add.)
Kevin Donoghue: “To my mind the more fundamental problem is that there is only a notional excess demand for money. At depressed levels of income households show no inclination to add to their holdings of money”
No comprende, sennor. Don’t households with depressed levels of income have a demand for money so that they can spend it? I may have a demand for ice cream, but that does not necessarily mean that it goes right into my freezer. 😉
Kevin: my “uncertainty removed” was just (poor) shorthand for “if AD recovers, risk of default falls, and fear of future unemployment falls, and risk of real assets falling in price falls, etc.”. In other words, we can imagine a lot of reasons why the demand for money might be higher in a recession, even though Y is smaller than Ys.
“Monetarism” (with any qualifiers) is not a very precise label, agreed. But No-barter Macro, with sticky prices and quantity constraints, with a quantity of the medium of exchange actually appearing in the model, and people using it and holding it for some explicit reason, would be a good start.
Kevin, Min: money is weird. It’s not like other assets. Suppliers of fridges can only increase the stock of fridges in public hands if the quantity people want to hold exceeds the current stock. Suppliers of money can increase the stock in public hands even if the current stock of money equals the desired stock. Just buy something. To be willing to accept money does not imply a willingness to hold more money. The stock of money is supply-determined in a way the stock of fridges isn’t.
Kevin Donoghue: “Similarly it doesn’t help to know that the unemployed would spend income if they had it, when in fact firms don’t see any profit in employing them.”
Gee, it seems to me that the fact that the unemployed would spend money if they got their hands on it is widely ignored by policy makers today, and that is one reason for our continued slump. If firms do not hire them, then there are other ways to get money into their hands. And since they would spend it, to get money into circulation. And they would be better customers for employers. Remember, it is customers and potential customers that create jobs.
K’s post said: “Too Much Fed: “K, let’s take that a step further. Can you imagine an economy with no currency denominated gov’t debt and no currency denominated private debt?”
I think so. As Nick once pointed out, nominal debt is a lot like glass (and equity like rubber? I forget). It breaks, and causes huge dead weight losses when it does so (the lawyers take half).”
By “break”, do you mean it can be defaulted on or paid off?
And, “Could governments equity finance?”
“Your question is important because, as Nick discussed in a post a month or two ago, If you back the CB’s balance sheet with nominal liabilities and the CB has no equity, then the value of the liabilities (money) of the CB can be undefined if they are not equal in quantity to the amount of nominal assets. So CB’s need to issue equity, or they need to own a substantial amount of non-nominal assets (equity). But I don’t think governments need to “equity” finance for my central bank proposal to work. The CB just needs to hold a lot of private sector equity securities relative to the amount of nominal assets.”
I like to look at it these ways:
savings of the rich plus savings of the lower and middle class = balanced budget(s) of the various levels of gov’t(s) plus the dissaving of the currency printing entity (CPE) with “currency” and no bond/loan attached
The CPE has a price inflation target. The CPE balance sheet looks like this:
assets = the amount of goods/services in the economy
liabilities = the medium of exchange supply (all “currency” and no gov’t debt and no private debt in this case)
owner’s equity = zero
Would an all “currency” economy be considered an equity financed one?
Min said: “If firms do not hire them, then there are other ways to get money into their hands.”
It is called retirement and funding it correctly.
What is “money”?
Currency plus demand deposits because that is what circulates in the real economy. It does not include central bank reserves because they are a type of “medium of exchange” that only circulates in the banking system covered by the fed.
Min said: “If firms do not hire [the unemployed], then there are other ways to get money into their hands.”
Too Much Fed: “It is called retirement and funding it correctly.”
20 is a little young to retire. 😉
Min, that is true, but there should be some people in their 50’s or 60’s who have worked long enough (30 years or so) they should be able to retire. If those people retire, then either someone moves up a job (promotion) and someone at the bottom gets hired, or someone gets hired.
Too Much Fed: “Min, that is true, but there should be some people in their 50’s or 60’s who have worked long enough (30 years or so) they should be able to retire”
Ready or not, many of them are being forced to retire. And instead of talking about reducing the age for getting Social Security, politicians are talking about raising it!
Your argument is contradicted by facts.
Note well. Lawrence White and others have testified in the past few week before Congress on the topic of free banking.
“By continuing to advocate Hayek rather than some more moderate position, you (by P1) fail to get yourself heard by the government.”
I’m not a scholar of the history of private banking, but my impression is that this is more misleading than factual:
Nick writes,
“Greg: I’m not against private monies. But, as far as I can see, truly independent (i.e. not redeemable at par in government money) seem to fail the test of the market. With a few exceptions, people just don’t use LETS and similar monies.”
Where it has been allowed — and has not been crippled by pathological regulations — private banking & private money did very well.
Determinant, the whole issue is made a cartoon by your discussion, and that of Skidelsky, who is notorious for not knowing his Hayek.
There is a lot to this — and much of the heart of Hayek and the complex relation of his explanatory mechanism to the great complexities of history are completely missing from you simplistic account.
Your sense of certainty on the matter is completely unearned.