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.
READER COMMENTS
Brian Donohue
Jul 8 2020 at 2:41pm
Excellent post.
Market Fiscalist
Jul 8 2020 at 3:53pm
On the MMT paragraph: I have been doing some reading in this area recently and slightly disagree with a couple of your points. While MMTers undoubtedly think that that interest rates can be set to any desired level without causing problems and most leading MMTers support a zero rate policy I do not think that this point is key to the theory and in fact some MMTers oppose it. And I think it more accurate to sat that an MMT response to inflation would be to cut the deficit – not necessarily by raising taxes.
Scott Sumner
Jul 8 2020 at 6:58pm
That’s fine. I knew that whatever I wrote someone would disagree. I could have had an MMTer write the paragraph and someone would have disagreed, as I learned back when I tried to debate them. They’d say X. I’d say “So your saying X”. They’d reply, “No, we believe Y.
Whack a mole.
Market Fiscalist
Jul 8 2020 at 11:09pm
I think I’m just making some basic points about MMT that most MMTers (and others who have checked-up on the theory) would agree with it – not saying anything contentious.
BTW: I’m really not a fan of MMT and I really liked John Cochrane’s recent review of Stephanie Kelton’s book on MMT:
https://johnhcochrane.blogspot.com/2020/07/magical-monetary-theory-full-review.h
which in my view encapsulates things very well.
Postkey
Jul 8 2020 at 4:53pm
“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.”
Try: ‘New Paradigm in Macroeconomics’, by R.A.Werner, or
‘Princes of the Yen: Central Bank Truth Documentary’
https://www.youtube.com/watch?v=p5Ac7ap_MAY
Scott Sumner
Jul 8 2020 at 6:59pm
Youtube? I think I’ll pass.
Michael Sandifer
Jul 8 2020 at 11:45pm
He’s a real macroeconomist who I encountered in econ Twitter. He claims that QE wasn’t effective, because much of the money flowed to the non-GDP economy. He prefers the government borrowing directly from the private banks to stimulate the economy.
Postkey
Jul 9 2020 at 5:59am
You pass on economic texts also?
Scott Sumner
Jul 9 2020 at 12:44pm
I’ll start with an article, before spending time on a textbook.
Postkey
Jul 9 2020 at 1:28pm
Here: https://professorwerner.org/pubtype/journal-paper-academic-journal/ ate several!
Postkey
Jul 9 2020 at 11:00am
”Richard Andreas Werner (born January 5, 1967) is a German banking and development economist who is a university professor at De Montfort University.
. . . In 1995, he proposed a new monetary policy to swiftly deal with banking crises, which he called ‘Quantitative Easing‘, published in the Nikkei. [2] He also first used the expression “QE2” in public, referring to the need to implement ‘true quantitative easing’ as an expansion in credit creation.[3] His 2001 book ‘Princes of the Yen’ was a number one general bestseller in Japan. In 2014 he published the first empirical evidence that each bank creates credit when it issues a new loan. [4]”
https://en.wikipedia.org/wiki/Richard_Werner
Thomas Hutcheson
Jul 8 2020 at 6:20pm
Clearly MM is the least heretical, merely expanding the standard theory to recommend using other instruments (the Fed being unwilling to reduce ST interest rates to negative levels called for by Taylor type rule)) to achieve the Fed’s supposed objectives.
Scott Sumner
Jul 9 2020 at 12:46pm
Thomas, You said:
“Clearly MM is the least heretical”
I’m not sure. Our claim that tight money caused the Great Recession is arguably more heretical than anything the other two schools of thought say.
Laron
Jul 8 2020 at 9:50pm
Although pre-2008, where would you put the Austrians in this MMT/Fisherian/MM framework?
Matthias Görgens
Jul 8 2020 at 10:33pm
Would probably depend on which Austrians?
Eg George Selgin is sort-of something like an Austrian, but of the three schools he seems to have the most sympathies for the market monetarists. But not sure sticking Austrians in this classification makes sense. It’s like trying to look at European political parties and trying to decide whether they are Republicans or Democrats.
(And, of course, Internet-Austrians make up their own special breeds..)
Laron
Jul 8 2020 at 11:05pm
Yeah I wasn’t sure if it would really fit but was curious if they could be worked in (for whichever definition of “Austrian” you prefer).
Scott Sumner
Jul 9 2020 at 12:47pm
On the imaginary quotation I provide, I’d say the Austrians are mainstream. Of course they are heretical on some other issues.
Michael Rulle
Jul 10 2020 at 8:19am
My sense is MM acceptance is gradually happening—-or at least moving in that direction. For example, Bernanke admits he was “tight” after the fact.
My standard thought process about most new ideas is that very few things are new. And while economics is a science which is really in large part a study of the human species——hence extraordinarily complex——-I find it amazing that there is still such great disagreement among thousands of smart people about Monetary Policy.
I am making a Kuhn like comment——-he always assumed “better” models replaced lesser models—-as they predict better. What is “correct” about “mainstream monetary models”, even if less correct?
Was it always incorrect? Or is Monetary Policy intrinsically intertwined with how investors (meaning people who create businesses as well as those who by securities) react——which itself is always changing?
Monetery Policy, according to MM, requires targeting NGDP——-but the required actions are always in flux——why?
Tuharsky
Jul 14 2020 at 2:59pm
It seems to me like all MMT, Market Monetarism, and Neo-Fisherianism all reject traditional monetarism, or at least the traditional MV = PY quantity theory in which V and Y are generally assumed to be exogenously fixed. They all, however, accept the monetarist’s claim that recessions and depressions have monetary causes, and therefore all think that it is necessary to reform the monetary system to prevent economic crisis.
To me, the three schools of thought differ mostly in terms of the instrument they recommend to use to control the monetary conditions and the price level. Market monetarists still generally prefer manipulating the quantity of money, although they no longer try to measure the quantity of money or assess monetary conditions directly, instead leaving it to the market via some mechanism like an NGDP futures market. MMTers want to use tax and spending, traditional fiscal policy. Neo-Fisherians prefer that the fed continue to manipulate short term interest rates.
Of those 3, the most interesting to me is the Neo-Fisherians. They start with an accounting identity everyone agrees must be true, and proceed to reinterpret its meaning without providing any real causal mechanism. What makes it nice, though, is that Neo-Fisherianism seems to be falsifiable in a way that MMT and market monetarism isn’t. Couldn’t we easily, once and for all, decide if Neo-Fisherianism works by just raising interest rates to “normal” levels and then waiting 6 months and seeing if inflation expectations adjust, as evidenced by TIPS spreads? Falsifying MMT, by contrast, would require massive political change thats likely not reversible, and I bet most supporters would continue on supporting it even if inflation were to take off, instead claiming that taxes were not raised sufficiently to prevent it. Market Monetarism I find more plausible than MMT, but its even more difficult to falsify since it is manipulating a variable – the money supply – that it openly admits cannot be measured. Would it really wreck the economy that bad to try raising rates to 3% or 4% to give the Neo-Fisherians a chance to put their theory to the test?
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