Monetary Theory, Once Again
By Arnold Kling
Josh Hendrickson and a reader raise interesting questions.First, the reader, who asks how my views relate to post-Keynesian economics.
I have been reading your recalculation theory of the crisis with great interest. If I understand it correctly, your theory essentially says that money is endogenous (and hence irrelevant) and taken to its logical conclusion will perhaps entail a belief in the fiscal theory of the price level. Such endogenous-money-real-disequilibria theories have also been proposed by Minsky-style Post-Keynesians, for example Steve Keen (of Debunking Economics and Debt Deflation Watch). The differences as I understand are
1) Both theories agree that risk premia are currently being re-evaluated but while you see this as a structural shift from some industries to others, the post-Keynesians see this as simply the after-effects of an irrationally exuberant debt overload.
2) In your system money arises from the real economy itself (and is hence irrelevant) and recessions are simply structural re-allocations, some of which may involve re-allocations from private debt to risk-less securities. In the post-Keynesian view, money results from debt (and is relevant, but only because debt is relevant) and recessions are the result of over-leveraging and financial instability.
3) You believe recalculations are not to be meddled with because the meddling (monetary or fiscal) can only make it worse without really changing the natural course of events. They believe running fiscal deficits can help ‘tide over’ recessions and tighter financial regulation can even prevent them.
I would be happy to call my views Austro-Keynesian. I do like the Keynesian (or post-Keynesian) notion that attitudes toward risk follow a cycle: risk averse, then more risk tolerant, then very risk tolerant, then a crash leading to risk aversion. The post-Keynesian financial instability story has merit, in my view. I also am happy to think of markets as having many adjustment problems and other flaws that cause deviations from instantaneous market-clearing. That can be a post-Keynesian view, but it also can be an Austrian view.
Where I part company with the post-Keynesians is when they want to speak of broad aggregates, like consumption and investment. I wonder if trying to think in aggregative terms is not a methodological error.
Instead, I like to think of the economy as if it had an imperfect central planner attempting to solve an incredibly difficult resource allocation problem. In reality, there is no central planner–market prices try to play that role, but they do so much less well than in the neoclassical model. If yesterday’s resource allocation was relatively efficient, our central planner (the price system) can do a reasonable job with today’s allocation just by making small tweaks to what it did yesterday. However, if yesterday’s allocation was way off, or today’s conditions are very different, small tweaks of yesterday’s plan will not get us to full employment. There may be no way to get to full employment quickly.
Keynesians and post-Keynesians see a recession as an imbalance between aggregate saving and aggregate investment, and government can step in to spend the savings that the private sector will not spend. I doubt that this aggregative approach is the right way to think about the Recalculation problem. I don’t think in terms of homogeneous labor and homogeneous capital waiting for someone to come along to deploy arbitrarily. I think in terms of heterogeneous labor and heterogeneous capital, and a lot of the planner’s problem is to convert labor and capital to better uses. If the government wants to help with the planning problem, it cannot just blindly run a deficit. It needs to outguess the market about where resources should wind up and how to get them there.
I would argue that it is possible to minimize the role of money and monetary policy without eliminating it from analysis. This, however, puts Arnold’s theory in a bit of a bind. If money is included, I fail to see how his theory can be distinguished from the natural rate hypothesis. Couldn’t the process of recalculation simply cause the natural rate of unemployment to rise for a period thereby limiting the ability of monetary policy to alleviate unemployment without causing inflation
He may be right that I am taking my anti-monetarism to extremes. I note that in my last post, I dropped a reference to the Nixon re-election monetary expansion, which suggests that I must think that something happened then other than an offsetting decrease in velocity.
However, I am trying to draw a contrast that gets people out of their old habits.
One habit I want to break is the habit of speaking about the natural rate of unemployment. At some level, yes, one can equate the statement “the economy is going through a protracted, complex recalculation” and the statement “the natural rate of unemployment has temporarily risen.” Both statements imply that that the supply side has changed. However, in the Recalculation story, the sudden shift in the pattern of demand due primarily to the housing market crash is the supply shock. In the Keynesian tradition (and even moreso in the monetarist tradition), the fall in nominal GDP is a demand shock, and the supply shock is something you may have to tack on later if you need to explain why raising aggregate demand doesn’t get you to full employment. In fact, I think there are a lot of Keynesians out there (I have in mind the folks who are arguing that we have not yet had enough stimulus) who don’t seem to consider that we’ve had an increase in the natural rate of unemployment.
Another habit I want to try to break is the habit of thinking that nominal income is proportional to money. At any given moment, one can take the ratio of PY/M and say “there’s your proportion for you,” but you can do that if you define M as mackerel as easily as if you define M as the monetary base.
I think of real output as determined by how well the central planner (the market) is doing at allocating resources. I think of the average rate of inflation as determined by people’s habits under what I call the monetary “regime,” meaning the long pattern of government issuance of interest-bearing and non-interest-bearing debt. Most economists want to draw a bright line between those two types of debt, with only the non-interest-bearing debt affecting the price level. I wonder if that distinction is as meaningful in practice as it is in theory. Ironically, the economists that Hendrickson cites as having articulated a “fiscal” theory of inflation are economists of the rational expectations tradition, which I very much reject. I don’t think that people base their day-to-day economic decisions on their assessment of intertemporal government budget constraints.
Instead, I would prefer to think in terms of interest-bearing government debt and non-interest-bearing government debt as sufficiently close substitutes that the total matters more than the composition. Swapping like for like is not a significant event.
The 1981-1984 period is embarrassing for my view. Reagan runs a big deficit, and Volcker does not finance much of it with money. We get a recession and disinflation–exactly what would be predicted by those who take the view that money matters. I would back off and say that when inflation gets to be as high as it was in the late 1970’s, then interest-bearing debt and non-interest-bearing debt are not close substitutes. The higher the inflation rate, the more the economy will conform to monetarist predictions. Even so, it took over a decade to wring inflationary expectations out of the system.
The Recalculation story suggests that unemployment will remain high.* The fiscal theory of inflation says that inflation could be re-ignited by more issuance of government debt.** Those of you who are too young to remember the “misery index” might prepare to become acquainted with that concept.
*If you have an instinctive belief in a trade-off between inflation and unemployment, then remember that in your world I am positing a large rise in the natural rate of unemployment.
**If you have an instinctive belief in the proportionality of PY to MV, then in your world I am suggesting that an increase in government debt will greatly lower the demand for money, increasing V.