Monetary economics: The three heresies
By Scott Sumner
In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.
In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model. This leads to a period of crisis, and new models are developed to address the empirical anomalies. I believe that this has happened in monetary economics.
Consider the following claim (my words), which reflects the views of most mainstream economists, circa 2007:
“A policy of reducing interest rates to very low levels is highly expansionary. When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”
Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above. And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.
At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:
1. MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow. They recommend that central banks in those countries set interest rates at zero. Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.
2. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.
3. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.” Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.
So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other. How did we end up with such a mess?
The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed. But why three? The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.
Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy. In one sense, MMT can be seen as the most anti-quantity theory model ever developed. Its tenets are almost the polar opposite of monetarism on a wide range of issues.
A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics. In these models, the Fisher effect is far more important than the liquidity effect. Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates. This eventually led to the NeoFisherian model.
A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects. This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes. It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.
Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here. (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics. It has caused all sorts of confusion, and gave birth to three very heterodox models.
This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters. Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.