The national debt: Hamilton vs. Jefferson

Alexander Hamilton and Thomas Jefferson were the first prominent American rivals in a debate that continues today. Here's a summary of Hamilton's Report on Public Credit and the debate around it.

For today's discussion, see Debt and its Discontents.

Moore (1979) The endogenous money stock

Does money supply determine inflation or does inflation determine money supply?

In The endogenous money stock, Basil Moore makes the case that the quantity of money is determined more by bank credit responding to cost and price increases than vice versa. He divides the inflation problem into two questions: (1) what is the relation between monetary growth and inflation? and (2) What is the source of change in the money stock? The data shows clear correlation between money supply and inflation, so the bigger focus is on question 2.

Moore first lays out the monetarist argument:

"The essence of monetarism can be expressed in two central propositions: a) Monetary changes are the dominant cause of changes in nominal income, swamping the temporary and minor influence of fiscal changes. b) There is no long-run, stable trade-off between inflation and unemployment; that is, the natural rate of unemployment hypothesis is valid. Changes in the rate of monetary growth cannot cause the rate of unemployment to diverge permanently from its "natural rate," except under conditions of continuously accelerating inflation."

Monetarists recommend monetary restriction to fight inflation. Their recommendation did not change when the evidence in the early 1970s (sluggish downward response of wage rates to high unemployment) proved their prescription to be painful and ineffective. Tobin has written that "Distinctively monetarist policy recommendations stem less from theoretical or even empirical findings than from distinctive value judgments. The preferences revealed consistently in those recommendations are for minimising the public sector and for paying a high cost in unemployment to stabilise prices."

One of the main sources of doubt about the monetarist argument is the question of causality.

"While the monetarists have made a case for the exogeneity of money in terms of the ability of the central bank ultimately to control the money stock, in their empirical work they unfortunately have confused the issues of causality and exogeneity. The money stock is indeed exogenous in the sense that it is ultimately under the control of the central bank. But, in econometrics, exogeneity is used in another sense: to say that a variable is exogenous is to regard it as independent of the influence of the variable whose value it seeks to explain. ... [However] the Federal Reserve and other central banks characteristically have accommodated the needs of business and the Treasury, and have operated to maintain orderly conditions in the bond markets and stabilize market interest rates."

Moore uses the relationship between prices and wage increases to show that 

"if the monetary authorities do not permit the money stock to accommodate to the rate of increase in money wages, monetary demand will not be sufficient to maintain existing employment output. Financial disorder will result if contractual obligations cannot be met, leading to downward pressure on the growth of real income and an accompanying rise in unemployment ... to the extent the authorities follow an accommodating monetary policy in order to prevent financial instability and enable real income to follow its trend path, the nominal rate of growth in the money stock will be determined by the rate of growth of money wages." 

Sort of reiterating that point, with a view of the whole economy:

"In modern economies, production costs are normally incurred and paid prior to the receipt of sales revenue. These costs represent a working-capital investment to the firm. If current production flow costs duplicate the following period, the proceeds from past sales will exactly finance current working capital costs. When wage increases raise production costs, however, even unchanged production schedules will require more working capital in money terms. Accordingly, firms must increase their borrowing from banks to finance these higher production costs for each level of output. In this manner, increases in money wage rates which exceed productivity increments and so raise unit labor costs will lead to an endogenous increase in the demand for credit, even if the aggregate production flow remains unchanged.

"Whenever the central bank accommodates this increased demand for credit, there will be a high statistical correlation between increases in the money stock and increases in prices, with the former preceding the latter."

Of course, the world is uncertain and not in equilibrium:

"The pervasive uncertainty of the real world means that decision makers seek to hold buffer stocks -- that is, inventories -- as a mechanism for absorbing unforeseen shocks ... The buffer stock par excellence is money. This suggests that individuals do not immediately adjust their money balances to a unique desired equilibrium level, but allow their holdings to fluctuate up or down, until some ceiling or floor limit is reached, before making the adjustment. To the extent that the above analysis is correct, supply-side changes (credit) largely determine short-term monetary growth. If money is supply determined in the short run, it follows that the demand for money is in short-run disequilibrium. Evidence for this is the fact that changes in real money balances [the amount of stuff a given amount of money can buy] are largely independent, and real money balances typically rise initially when the nominal money stock expands sharply. Only over the longer term is the price level determined by restoration of the equilibrium demand for money function.

In summary:

"Economists have mistakenly accepted the high-powered base approach to the determinants of monetary growth. Bank lending is the proximate and predominant source of monetary change. With lagged reserve requirements, once the deposits have been created the central bank has no choice but to make the required reserves available."

Arrow on Rawls

I'm curious about the contradictions between the utilitarian Pareto-optimal principle used by most economists and the difference principle / maximin / "veil of ignorance" principle ignored by most economists.

Vilfredo Pareto argued that a policy could only be efficient if it makes no one worse off. Cynically one could say that was a convenient theory for an Italian of noble blood to propose. John Rawls, on the other hand, argued that we should focus more on maximizing the well-being of the worst-off member of society. He called it the difference principle, economists call it maximin. To make this theory salient, Rawls proposed a "veil of ignorance": if you are about to enter the world but do not know who you will be, what kind of society do you want to enter?

Kenneth Arrow's critical review of Rawls' A Theory of Justice helped to convince me that Rawls' veil of ignorance is a useful social justice principle and that economists should bring it into decision-making. That is not the point Arrow was trying to make.

I'm no moral or political philosopher so maybe Arrow's arguments are more valid than I give them credit for, but I found them to be (1) a bit irrelevant since he immediately took things to their logical extreme instead of seriously considering the veil of ignorance as a useful decision making mechanism, and (2) a bit contradictory.

1. Logical extremes

One example of an argument employed by Arrow is that, as Pareto and Irving Fisher have argued, "there is no quantitative meaning for utility for an individual" -- it's an ordinalist position. "If the utility of an individual is not measurable, then a fortiori the comparison of utilities of different individuals is not meaningful ... Consider an individual who is incapable of deriving much pleasure from anything, whether because of psychological or physical limitations. He may well be the worst-off individual and, therefore, be the touchstone of distribution policy, even though he derives little satisfaction from the additional income." ... oversimplifying, I interpret this as: why house the homeless if one guy remains depressed? IMO Arrow is missing the point here.

2. Contradictions

Where Arrow is slightly contradictory he is at his most interesting. He was of course brilliant so there is a lot of good info even when I doubt the validity of his argument.

To take a step back, Rawls' argument that society should maximize the utility of the worst-off has two parts. First, in the original position where the quality of your entire life is at stake, it's reasonable to have high degree of risk aversion, and being concerned with worst possible outcome is an extreme form of risk aversion. Second, probabilities are in fact ill defined and should not be employed in such a calculation. Here Arrow points out:

"The second point is a version of a recurrent and unresolved controversy in the theory of behavior under uncertainty: are all uncertainties expressible by probabilities? The view that they are has a long history and has been given axiomatic justification by Ramsey and by L. J. Savage. The contrary view has been upheld by F. H. Knight and by many writers who have held to an objective view of probability; the maximin theory of rational decision-making under uncertainty was set forth by A. Wald specifically in the latter context. Among economists, G. L. S. Shackle has been a noted advocate of a more general theory which includes maximin as a special case. L. Hurwicz and I have given a set of axioms which imply that choice will be based on some function of the maximum and the minimum utility."

 And a few pages later, in defense of a utilitarian approach:

"As Ramsey and von Neumann and Morgenstern have shown, if one considers choice among risky alternatives, there is a sense in which a quantitative utility can be given meaning. Specifically, if choice among probability distributions satisfies certain apparently natural rationality conditions, then it can be shown that there is a utility function (unique up to a positive linear transformation) on the outcomes such that probability distributions of outcomes are ordered in accordance with the mathematical expectation of the utility of the outcome."

Near the end, explaining why there might not be a meaningful universal concept of justice:

"One problem is that any actual individual must necessarily have limited information about the world, and different individuals have different information."

Arrow casts doubt on Rawls' theory by saying that we can express decision making under uncertainty as a set of probabilities of futures outcomes. A few pages later he says we of course have limited information about the world, in other words it is impossible to express the future as a set of probabilities.

Maybe I'm misreading the argument, but it seems contradictory. In any event I need to read Rawls' book before I write more on this. Arrow's review is worth reading for his summary of decision making under uncertainty and his views on utilitarianism.

Inflation and Wicksell, by Leijonhufvud

The Federal Reserve does not have a working theory of inflation. That is a big deal because price stability is half its mandate.

The Phillips curve relationship -- a negative correlation between unemployment and inflation, identified by A.W. Phillips in data for the UK between 1861 and 1957 -- has been weak. Possible reasons include (i) people expect lower inflation and it's a self-fulfilling prophesy, (ii) labor unions are weaker so wage gains are weaker so corporate costs increase more slowly, (iii) the rise of e-commerce has created more competition between retailers, and (iv) shifting factories to lower-cost producers like China has kept costs down. Any/all of these factors might be keeping inflation down.

For a large part of the past 40 years, policymakers operated from a Quantity Theory of money view, summarized by Milton Friedman's "inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." This sounds legitimate but was always a bit dubious. It became openly indefensible after the huge increase in the money supply after 2008 did not result in inflation. Since the mid 1990s inflation has almost always been lower than the increase in M2. But knowing that the Quantity Theory is not right does not answer the question of what actually causes inflation.

Axel Leijonhufvud (1997) points out that Knut Wicksell made some good points on this in 1898 (as well as on "the hypothesis of intertemporal disequilibrium as the key to the understanding of business cycles"), which many economists have ignored to the detriment of macroeconomics and monetary theory as we understand it today.

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.404.5867&rep=rep1&type=pdf.

Here are three questions Leijonhfvud's article helps to answer 

1. Why is the Quantity Theory suspect?

David Ricardo's quantity theory of the price level is "completely sound and correct" for a pure "cash economy". We live however in a mostly credit economy.

"Bank money was credit money and, unlike metallic money, could not be in excess supply, Tooke maintained. An overissue by the banks would simply produce a "reflux" of notes in repayment of loans. If expansions and contractions of the banks drove the price level, rising prices should be associated with low interest rates and vice versa. But the evidence ... was just the opposite."  

2. Why not just adopt the alternative theory?

Thomas Tooke's anti-quantity theoretical conclusion is that the price level determines the stock of money. This may be true, "but it left one with no tenable theory of the price level at all."

Wicksell concluded that "the Quantity Theory cannot just be thrown overboard ... The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand." This omission becomes major when bank credit reduces the role of metallic money in the economy. 

"Wicksell presented a pure credit system model as "a precise antithesis to the equally imaginary case of a pure cash system, in which credit plays no part whatever ... The strategy for developing applied monetary theory, he suggested, was to regard actual monetary systems

"as combinations of these two extreme types. If we can obtain a clear picture of the causes responsible for the value of money in both of these imaginary cases, we shall, I think, have found the right key to a solution of the complications which monetary phenomena exhibit in practice."

3. What's the right combination?

There's the rub.

Wicksell's suggestion "is a stroke of genius ... But it is by the same token deeply problematic, for Wicksell has very little to tell us about how to go about fashioning a viable synthesis from his two antithetical models."

"This lack of an outline of the suggested synthesis has been unfortunate in that the Ricardian thesis and Tookean antithesis have been carried down to the present day as mutually exclusive theories with Monetarists denying the relevance of credit and Credit theorists still lacking a theory of the price level. Thus Milton Friedman turned the evolutionary argument against Credit theories: monetary theory should focus on the banking system's liabilities and not on their assets which evolution had reduced to a minor component of total credit. More recently, monetary general equilibrium theorists have generally been content simply to brush credit under the Modigliani-Miller rug. On the other side, the Tookean tradition has its most persuasive advocate today in Basil Moore."

The instability that Wicksell foresaw was postponed when in the early 20th century governments monopolized note issue and imposed reserve requirements on banks, which "gave the Quantity Theory a new lease of life." In recent decades, however, the expanded use of "smart cards" (credit cards) and the elimination of reserve requirements (which happened officially on March 15, 2020, but effectively years ago) have probably all but ended any stable relationship between aggregate demand and the "vanishingly small" monetary base.

"The newest generation of jet fighter planes ... are inherently unstable in the air and depend on extremely fast feedback-based electronic control (In fact, they cannot be flown by human pilots).

"Price level stabilization by Wicksellian bank rate policy may become similarly challenging before very long. Perhaps it is fortunate that we will be able to entrust it to a Nintendo-trained generation."

The world keeps changing and monetary policymakers need to keep adapting. 

Final note: this article is worth (re) reading, it's short and there's much in that I don't cover here.

Did the Fed save stocks?

Yes. The Federal Reserve's balance sheet expanded by $3 trillion in April and May while S&P 500 market capitalization increased by $4 trillion.

Keen on credit and aggregate demand

I had a two hour debate with a colleague today. We got to the heart of some of the disagreement when I asked "do you agree with the statement that money and credit is unimportant when thinking about economic policy." He said yes. I, on the other hand, think money and credit is important when thinking about the economy.

I watched a Steve Keen video on the debt problem and coincidentally he mentions many of the same points we discussed. But the reason I'm posting any of this is because of a point Steve makes in the video, quoted below. Really makes clear why credit is important in economic analysis. Keen explains that this is what he added to the analysis of endogenous money stock, introduced by Basil Moore in 1979.

"Nobody borrows for the sheer pleasure of being in debt. You borrow to spend. so when you borrow, that change in money becomes a change in demand, and credit therefore is an essential part of aggregate demand."

Simple and brilliant.