The Keynesian-Monetarist debates and reverse causation (or how Keynesians destroyed monetarism using only logic)

Traditional monetarist theory held that changes in the money stock are the best indicator of monetary influence on the economy, and that these influences have a significant impact on the course of economic activity over the business cycle.

The idea that "money matters" in this sense is not new. In many ways, monetarism's basic premise dates back to the beginning of political economy as a discipline. However, in the 1950s, the idea gained prominence when a number of "money supply theorists", as they were called back then, began producing studies and charts that appeared to lend support to the view that changes in the money supply had a predominant role in causing fluctuations in (nominal) income and output.

Initially, (neo-)Keynesian economists -- who as a result of their reading of events of both the onset of and recovery from the Great Depression viewed income (output) as determined largely by aggregate demand or the spending of firms, government and household spending -- were not phased. At first, Keynesians responded by saying that their preferred theoretical approach, the Hicks-Hansen IS-LM model, already recognized the role of money in affecting economic activity via the LM curve.* However, these Keynesians also argued that, while money does have a role in driving economic activity, it was of secondary importance, behind consumer and investment spending.**

Also, while Keynesians admitted that fluctuations in the money supply can affect economic activity, they also argued that the seemingly causal relationship between money and output portrayed in monetarist studies could partly be explained by changes in the public's demand for money, the propensity to hold financial assets in the form of money.

The debate intensified when Milton Friedman and other monetarists produced studies (seemingly) showing the empirical importance of money over spending and investment in explaining output fluctuations. In order to show that fluctuations in the money supply cause fluctuations in output, monetarists had to demonstrate that the demand for money was stable (to support their view regarding the predominant role of the money supply in affecting economic activity), and that fluctuations in aggregate demand were a weak source of fluctuations in income.

With respect to the stability of the demand for money, Keynesians argued that the demand for money was not stable (i.e., as a stable function of interest rates, expected inflation, wealth and other variables), nor predictable (thus countering the monetarist view that the predictability in the demand for money would enable the monetary authority to expand or contract the money supply to offset any predicted changes in money demand). The neo-Keynesian view was later proven right when the stability in money demand collapsed in the 1970s and 1980s in the US.

As for the monetarist claim that money supply fluctuations outperformed the traditional Keynesian drivers such as investment and other forms of spending in explaining output fluctuations, which figured most prominently in Friedman's "A Monetary History of the United States", neo-Keynesians responded in several ways.

First, Keynesian critics proposed that the apparent causal relationship stemming from money to income (and economic activity overall) might be a fallacious case of post hoc ergo propter hoc (i.e., what comes before must therefore be the cause), or at the very least, a statistical illusion caused by the fact that investment is recorded in national income accounts in periods subsequent to monetary aggregates, which capture the same transaction but at an earlier stage when investors first come to the money market.

Also, Keynesians challenged the methodological approach used by Friedman and other monetarists to support their claim that the money supply is the key variable explaining fluctuations in output. Most importantly, Keynesian critics suggested that Friedman's approach in the "Monetary History" of assuming an exogenous money supply under the full control of the monetary authority and completely independent from the influence of other economic variables, was unrealistic and overstated the influence of money on economic activity.

Over 50 years ago, neo-Keynesian economists John Kareken and Robert Solow, using simple logic, pointed out the fatal flaw in the monetarist assumption of the exogeneity of the money supply:

The unrealiability of this line of argument is suggested by the following reducio ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth.

Karaken and Solow in this example were not suggesting that the money stock was endogenous in the sense that the money supply was negatively correlated with aggregate spending shocks. Rather, they were suggesting that abstracting from the actual behavior of the central bank as Friedman did could result in flawed conclusions about the magnitude of monetary policy's impact on the economy.***

Also, this line of reasoning suggested that the statistically significant relationship (correlation) between money and output highlighted by the monetarists should not be understood as implying that changes in the supply of money cause changes in income. Instead, this objection suggested the possibility that the observed relationship could just as well be the consequence of reverse causality, that is, that spending shocks, by affecting money demand and generating pressure on the interest rate, led to accommodating changes in the supply of reserves provided by the Fed during that period, and ultimately resulted in changes in the money supply.

Having then demolished the Friedman assumption of an exogenous money supply, neo-Keynesians in the 1960s thus allowed for the possibility that the relationship between money and economic activity could be the result of actions from the public, as they respond to current economic conditions, and that these actions from the public could have such a significant influence on observed movements in the money stock that one could not tell the direction of causality between money and economic activity simply by looking at measurements of monetary aggregates and income.

For a few years later, a lively debate on reverse causation followed between monetarists and the economic staff of the St. Louis Federal Reserve Bank on one side and neo-Keynesians and staff economists of the Federal Reserve Board on the other. Empirically, a breakthrough in favor of the reverse causation argument occurred in 1973 when two staff economists of the Federal Reserve Board, Raymond Lombra and Raymond Torto, demonstrated in a paper entitled "Federal Reserve Defensive Behavior and the Reverse Causation Argument" that during the 1953-1968 period the supply and demand for money was interdependent and that this interdependence provided an avenue for the reverse influence of the business cycle on money.

In doing so, Lombra and Torto confirmed the endogeneity of the monetary base and money supply resulting from the Fed's offsetting and accommodating actions whenever it sought to stabilize conditions in the money market by pegging the level of short-term interest rates over the short-run:

If the demand for money is, in part, a function of the level of economic activity and the supply of money has been at least partially demand determined, then the money stock is endogenous whether or not the Fed has the power to control it

However, the conclusions by Lombra and Torto were eclipsed by the conclusions of a paper published one year earlier by Christopher Sims utilizing newly developed statistical techniques which contended that the hypothesis of unidirectional causality running from money to income could not be rejected. Of course, monetarists, in their attempt to support their case, cited this work with approval since it appeared to support the monetarist assumption of an exogenous money supply.

In 1982, Sims published another paper recognizing that his earlier work and work based on it was open to serious question. This paper along with Lombra and Torto's paper should have demolished the monetarist case from the start. Unfortunately, such an attack was not enough to stop the monetarist ascendancy that was gathering support within and outside the economics profession (such as the St.Louis Federal Reserve Bank) in the 1970 and 80s.

Today, we know that this monetarist view influenced later New Keynesians (not older New Keynesians like Stiglitz, Akerlof and Blinder). Some Post Keynesians adhere to reverse causation in their monetary economics.

* The LM curve had been relegated to the background (as a supporting role) during the war years and early post-war years when interest rates were pegged as a result of the Treasury-Fed accord

** The main changes through which the real money supply affects the economy are: the real balance effect, the portfolio effect, and money as a medium of exchange effect.

*** More specifically, by assigning total control over the money supply to the central bank in their model, Friedman and other monetarists were effectively dismissing the potential influence of both the banking system and the real economy in influencing the money supply.

Stiglitz on credit creation by banks

For those who think that Joseph Stiglitz doesn't know that banks actually create credit:

"We are not in a corn economy where banks serve as an intermediary between farmers who have excess seed and farmers who want more seed. We are in an economy where banks actually create credit. And that makes a very big difference."

h/t: wonkmonk

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:

If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]

The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 

However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]

Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]

Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 

The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]

While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)

One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.

James Tobin on why deflation isn't a cure for unemployment

There's been a lot written lately on why the Pigou effect (i.e., increase in output and employment caused by an increase in consumption due to a rise in the real balances of wealth) isn't a foolproof way around the problem of the zero lower bound. It reminded me of these lines by James Tobin:

Suppose all dollar prices and wages are lower by x per cent. Will aggregate demand for products and for labour be greater? Maybe, because with the same quantity of currency and bank reserves, interest rates could be lower and encourage businesses and households to spend. But in depressions, interest rates may be already as low as they can be; after all, the interest rate on currency cannot be less than zero. Anyway, as Keynes observed, lowering the overall price level cannot reduce interest rates more than the central bank could on its own, with much less social trauma. 

Another possibility, stressed by Professor Pigou, is that owners of assets denominated in dollars feel richer after the purchasing power of the dollar has increased; therefore, they buy more goods. The trouble is that debtors with dollar obligations are correspondingly poorer. There is a small excess of privately owned credits over private debts, the monetary issues and near-money obligations of the central government. But this net credit may not be sufficient to offset the likelihood that increased private debt burdens deter spending more than the corresponding gains in the purchasing power of creditors encourage it. So argued Irving Fisher, my revered predecessor at Yale. Even if Pigou, rather than Fisher, is right, the direct effect of the price level on demand is not an equilibrating mechanism of any practical importance. Certainly, the big deflation during the Great Depression did no good. 

A serious drawback to deflation (or disinflation) as an adjustment mechanism is its perverse effect on aggregate demand. Even if lower prices stimulate demand once prices have fallen, the process of falling prices is destabilizing. If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods. For this reason, Keynes and Fisher rejected concerted deflation as a remedy for depression and unemployment. 

Reference

Tobin, J., "Business cycles and economic growth: Current controversies about theory and policy", Bulletin, the American Academy of Arts and Science, Vol. XLVII, No.3, December 1993.

Is there a moral aspect to economic policy?

From Ed Luce of the Financial Times (a good article):

Mr Bernanke’s grounding has given him the authority to dismiss those who view the meltdown through a moral lens and want to purge society for its excesses. Had he embraced this popular intuition, the US would now be following the UK into triple-dip recession. As Mr Bernanke noted in Texas shortly after Rick Perry, its governor, had all but threatened him with a lynch mob: “I am not a believer in the Old Testament theory of the business cycle.”

As a general rule, any argument pushing for less government intervention on moral grounds in a weak economy should be viewed with suspicion. "Less is more" can be an acceptable rule for making decisions of a personal nature but in the realm of economic policy, it's often just bad advice. This is largely because of the two-sided nature of any monetary transaction: your spending is my income, public sector spending is private sector income.

A few years ago, economist Ben Friedman examined how morality intersects with economics and public policy. His view is that government intervention, in terms of its impact on the lives of citizens through its role in fostering economic growth, 'less' is definitely 'less':

A commonly held view is that government policy should try, insofar as it can, to avoid interfering with private economic initiative: the expectation of greater profits is ample incentive for a firm to expand production, or build a new factory, while the prospect of higher wages is likewise sufficient to encourage workers to seek out training or invest in their own education...The best that government can do (so the story goes) is minimize taxes, or safety regulations...The "right" pace of economic growth is whatever the market - that is, the aggregate of all private decisions - would deliver on its own.

But this familiar view too is seriously incomplete. To the extent that economic growth brings not only higher private incomes but also greater openness, tolerance, and democracy -- benefits we value but that the market does not price -- and to the extent that these unpriced benefits outweigh any unpriced harm that might ensue, market forces alone will systematically provide too little growth. Calling for government to stand aside while the market determines our economic growth ignores the vital role of public policy: the right rate of economic growth is greater than the purely market-determined rate, and the role of government policy is to foster it. (2005:14)

The point here is that public policy positively influences a society's moral character when it helps to raise living standards, which in turn affect the attitude of people toward themselves and encourages greater openness and tolerance.

Also, on a separate yet related point, it's really hard to believe there's any good to be found in the popular view that government action should be avoided because it (allegedly) stifles private sector initiative. On this point, I think Bill White of the Bank for International Settlements makes a good point:

...faced with serious deflationary tendencies, all of the weapons in the macroeconomic arsenal should be used to their full effect to ensure that aggregate demand is maintained. The concept of "creative destruction" has a certain intuitive appeal, but it should be remembered that the phrase was coined well before the onset of the Great Depression.

Reference

Friedman, B., The moral consequences of economic growth, 2005, New York, Knopf