The Day Monetarism Died

We are undergoing a paradigm shift in conventional wisdom regarding macro-economics.  For the last 32 years, the conventional wisdom has been that we can manage the economy via central bank tinkering with interest rates.  That view is no longer plausible.  Continual lowering of interest rates plus the "extraordinary" measure of quantitative easing, has only proceeded to still lower inflation rates -- in direct opposition to the conventional wisdom.

18 months ago I moved the bulk of my lifetime savings to longer term U.S. Treasury bonds.  I did this in response to conventional wisdom that inflation and interest rates were certainly on the rise.  6 months ago, the conventional wisdom was unanimous as expressed here -- http://blogs.marketwatch.com/thetell/2014/04/22/100-of-economists-think-yields-will-rise-within-six-months/ - " a survey of 67 economists this month shows every single one of them expects the 10-year Treasury  10_YEAR  yield to rise in the next six months."

Well I was right and the 67 economists were wrong - big time. Interest rates have plunged over the past 6 months -- almost 6 months to the day since this was published.  The conventional wisdom is the utter fantasy that the central bank can control the economy.  The central bank said that the economy was improving and that their policies would generate inflation.  But they have been proven wrong time and again, and this last episode will be the last hurrah of these Oz-like wizards

The Tortured Logic of an Elite Economist

Kenneth Rogoff is a Professor of Economics at Harvard University, who has served as a chief economist at the International Monetary Fund (IMF), and at the Board of Governors of the Federal Reserve System. He is one of the elite mainstream U.S. economists, with degrees from Yale and MIT. With that in mind, it's interesting to look at a recent column he wrote which puts the incoherence of his economic worldview on display.

The column is entitled, The Exaggerated Death of Inflation and is published in The Guardian, He seems to be responding to Paul Krugman and other liberal economists who argue that inflation is not a concern at the present time in the developed nations.  The point is not unreasonable, but the supporting logic is tortured.

Rogoff's main point is that central banks are powerless to control inflation; it is a political choice (presumably related to fiscal policy which is beyond the control of central banks, although Rogoff doesn't acknowledge this).  Here are Rogoff's exact words:

a country's long-term inflation rate is still the outcome of political choices not technocratic decisions ... No matter how much central banks may wish to present the level of inflation as a mere technocratic decision, it is ultimately a social choice.

Thus, his fundamental point is that central banks can't control inflation.  However, he repeatedly talks about the tremendous progress and powerful tools that central banks now possess.  Quotes:

massive institutional improvements concerning central banks have created formidable barriers to high inflation 

back then, monetary authorities were working with old-fashioned Keynesian macroeconomic models, which encouraged the delusion that monetary policy could indefinitely boost the economy with low inflation and low interest rates. Central bankers today are no longer so naive 

Modern central banking has worked wonders to bring down inflation.

Inflation has been subdued in recent decades by technological and political changes accelerating the pace of globalization, and thus lowering wages in developed countries as more stuff is made in competing low wage developing countries. Rogoff acknowledges this with the following contorted logic:

increasing globalisation and technological advances made it much easier for central banks to deliver both solid growth and low inflation 

He seems to live in a world of economists who all agree that central banks are tremendously powerful and enlightened, so he ends up with this tortured and incoherent piece on how central banks don't really have all that much power.

cross posted at Mike Norman Economics

Burning Man Festival

pix from http://www.fubiz.net/en/2013/09/16/gorgeous-sculpture-at-burning-man/

The Sluggish Economy

Kevin Drum, whose blog on Mother Jones is my favorite, has the following 3 posts up today:

• Economy Doing Ever So Slightly Better Than We Thought
  "Nobody should mistake this for anything meaningful... GDP growth for the first half of the year now clocks in at about 2.1 percent instead of 1.9 percent, but that's pretty anemic either way."
• Stock Buybacks Are a Symptom, Not a Disease
• Mitch McConnell Doesn't Get to Decide if Republicans Will Threaten Another Government Shutdown

There's a common theme here which is that the economy is crappy, and our dysfunctional government (Republican obstructionism) isn't going to do anything constructive to improve the situation.

The reason for the crappy economy is fairly simple and is described well in the following paper by Thomas Palley: The theory of global imbalances: mainstream economics vs. structural Keynesianism.  Basically, the wave of globalization since 1980 has resulted in chronic and massive U.S. trade deficits.  The move of manufacturing jobs to China and other developing economies has undermined wages in the U.S., resulting in stagnant incomes and purchasing power.  (This was offset for a time by increasing consumer credit, but that disappeared with the housing bubble in 2008.)

As the U.S. consumer market is the driving force for growth in China and other developing economies, stagnant U.S. consumption is rebounding into slower growth in developing economies and intensified competition, including currency devaluation.  Corporate profits have been up in spite of the stagnating consumption, but this cannot go on.  Profits are now being used to buy back stocks (at high prices), since increased physical investment is not needed.  Also, higher profits, as compared to wages, lead to stagnation as profits tend to be reinvested rather than spent.

So the global economy is deflating, with profits and stock prices set to crater, and the Republicans are completely off the reservation.

The Downside of Monetary Policy

Many times in recent years I've seen liberal commentators (<cough>Kevin Drum</cough>) say things like, "we need looser monetary policy ... it can't hurt". Unfortunately, that's not true.

Monetary policy is really a very blunt tool.  The central bank can raise or lower interest rates, but the effects are unpredictable.  If we rely on monetary policy to repeatedly boost the economy over a secular period where the economy needs repeated boosts due to globalization, we're likely to see interest rates fall to 0 and stay there, while overinvestment in interest rate sensitive sectors such as housing results in repeated booms and busts in these sectors.  Indeed, that is exactly what we have witnessed over the last 30-some years.

I ran across an article with data and commentary along this line discussing the housing market in the U.S. over the last several years:  http://www.alhambrapartners.com/2014/03/18/departing-science/.  Excerpt:

New York Fed president William Dudley said in an interview with the Wall Street Journal this month that “persistent headwinds” to growth explained why the economy would be unable to bear much higher interest rates in the years ahead...  Headwinds are nothing more than the economy doing something other than modeled...   

Monetary policy’s most fervent channel lies through mortgage finance... Unfortunately, mortgage issuance is off nearly 60% in less than a year since the word taper entered the mainstream... there is something very wrong when a relatively small increase in mortgage rates leads to such a dramatic decline

Real estate construction has a macro component to it that has already seen some reversal in the GDP figures (a tailwind turning headwind, as it were). It looks like that is deepening still further, but more importantly, there is the looming possibility of a second, albeit smaller, housing bust forming in such close proximity to the first.

Headwinds are not some exogenous factor, they are monetarism put into practice.

Here's another post from Alhambra Partners demonstrating the recent ineffectiveness of monetary policy... 

Money Supply -- Bank Lending and Government Spending

The post below is inspired, and to some extent taken literally from my comments at http://www.winterspeak.com/2014/03/bank-of-england-goes-mmt.html.

Here's a simpler proof that government spending accounts for more money creation than does private credit creation:

1. All government spending transfers money to private sector (by definition).

2. Private credit creation may or may not create new money in any particular time period (as repayments are greater than new loans in some time periods).

3. Empirical data exists for 1 and 2 above and shows that government spending generally results in almost twice as much money creation in a typical year compared to net private credit creation.

4. Government bond issuance withdraws money from the economy in exchange for the interest bearing bonds.There is no evidence that this withdraws any purchasing power, since the T-bonds are guaranteed by U.S. government and are the most liquid investments in the world. The inconceivability of default is one of the few things that Dems and Reps agree upon. Even if bonds were worthless (a ridiculous assumption) and subtracted from the impact of government spending, the amount of money created by government spending would be larger than the amount created by net private credit.

5. Taxes come out of the total money supply without regard to how the money was created.

What are the implications?

1. People like Cullen Roche who say that private credit creation accounts for 90% on total money creation are wrong.

2. Conclusions based upon #1 above are without foundation.

3. Fiscal policy is the main factor in money creation, outweighing all private banking activity.

4. Adding in the fact that interest rates are only one of many factor in private credit creation, monetary policy has a trivial impact on the macro-economy.

......................

Here's another way of looking at it...

Those who compare government spending and private bank money creation imply that we can keep track of money inflows and outflows from one time period to another, and in this manner determine the relative impact of various sources of money in the economy.

This seems reasonable enough to me, so let's look at this sort of model.    In the beginning (first time period), money is injected into the economy via government spending and private loans.  This gives us our initial partition of the total money supply into government generated (say G$) and bank generated (say B$).  

In each successive time period, money is injected into G$ via government spending, and removed from G$ via taxes.  Note that all government spending goes into G$, but not all taxes are collected from G$ as the money in B$ is also subject to taxes.  

In each time period, money is injected into B$ via private bank lending, and removed from B$ via repayment of private loans and via payment of taxes.

In each period, the size of B$ changes by bank lending - repayment of loans - tax payments.  The size of G$ changes by government spending - tax payments.  Assuming tax payments are the same proportion in the two sectors, the relevant measures are net bank lending versus total government spending.

................................

The common mistake is to compare the effect of private sector lending before taxes with the effect of government spending after (incorrectly computed) taxes.

Take the following example of a new monetary system.  In the first period there is no government deficit and net $1 T private credit creation.  The government spends $1 T collects $1 T in taxes using a 50% marginal tax rate.  So at the end of the first period private bank lending has resulted in $500 billion new dollars after taxes.  Government spending has also generated $500 B after taxes.  

.................................

Here's another way of looking at it:

When discussing the impact of various sectors, you may think at a superficial level that one sector's impact is zero because it has various components that cancel each other out.  However, that is shown to be incorrect when you look in more detail and see that the apparent cancelling out is caused by reducing the impact of another sector, and not just cancelling out the same sector.

Modern Monetary Theory and Unitarian Universalism

The evolution of economic conventional wisdom is following a path similar to that of religious conventional wisdom.

Printing presses and improved global communications enabled enlightenment thinkers to question the religious dogma of the Middle Ages.  Over hundreds of years, many reformed Christian movements, including Unitarianism and Universalism, emerged as more reality-based and compassionate alternatives to the authoritarian and superstitious religions of yore.  In the current era, many people have discarded organized religion altogether as the reformed Christian churches are increasingly seen to rely upon dubious historical and ethical foundations. Unitarian Universalism is one denomination that has made a clean break with Christian dogma, while at the same recognizing the value of organized religion in addressing a variety of human needs and aspirations.

In the realm of economics, the conventional wisdom is a hodgepodge of supposed economic laws that bear little relation to reality and serve mainly to uphold the economic status quo.  Beneath the fiction, however, the conventional wisdom is based upon the "common sense" of the prevailing ethos and thus captures real moral and practical conventions.

Just as religion has evolved by way of various reform and reactionary movements, economics has seen its share of revolutions and counterrevolutions.  One of the most significant was the Keynesian revolution during and after the Great Depression.  For the last thirty-some years, however, the conventional wisdom has moved back in the fundamentalist direction where the invisible hand of the marketplace and other supposed laws of nature are believed to limit our economic opportunities.  Neoliberal economists play a role similar to the reformed Christian churches in reaction to the more radical reformers, such as the Modern Monetary Theorists.  The MMTers believe that economic laws and institutions need not be cast in concrete and subject to arbitrary mathematical constraints, and that the "economy" is a human creation which can be improved upon.

Modern Monetary Theory is indeed a left leaning economic school, just as Unitarian Universalism is a left leaning religious denomination.  UUs claim that our religious foundation is based upon principles that transcend politics, such as freedom of conscience, justice, and compassion.  But in practice we tend to be political liberals.  MMTers claim that our economic school is based upon observation as to how the economy actually works, which should transcend politics.  But in practice we tend to be political liberals.

There are no doubt many other religions and economic schools that have followed similar trajectories, but these are the two that I know and love the best...

Economic Discourse: Focus on the Problem, Not the Model

This post is inspired by two observations:

• Phil Pilkington is onto something important in recent posts regarding the utility of macro-economic modeling.  Specifically, he observes that macro-economics is an open system in which precise experiments and firm conclusions are impossible.  
• Personally, I have observed good economic discussions devolve into overly wordy, time-wasting theoretical slogs.  In my experience, this happens when either:
  --Tangential economic models are introduced, and the frame of reference for the discussion is changed inappropriately.
  OR
  --The discussion is based upon unrealistic assumptions. 

Inappropriate Use of Math and Statistics

Pilkington's posts:

• Abstraction, Language and Modelling in Economics
• Econometrics and Numerical Prediction
• A Quick Note on Michael Emmett Brady’s Paper on Keynes and Probability
• Disturbing Distributions in Economic Statistics
• On DSGE and the art of using absolutely ridiculous modeling assumptions

and a few quotes (color changes are used to distinguish separate quotes from various posts):

This is where economics has erred since at least the turn of the 19th century. The early marginalists occupied two groups. One were the Walrasians who, following Leon Walras, were perfectly content to confine themselves to barren speculation of unrealistic nonsense provided it was done in a nice, formal mathematical manner. The other group were the Marshallians who tried to bring such abstract speculation down to earth...

A good example of a closed system is a controlled scientific experiment. By setting the experiment up so that it is continuous through time (ergodic) and is not interfered with by outside forces, the experimenter ‘closes’ the system upon itself. For realists, any data then generated by this experiment can reliably be used to make inferences about the future. 

An open system, on the other hand, is open to change, fluctuation and new trends emerging. It is also not closed to outside forces interfering. The realists think that open systems are what we generally deal with in the social sciences, including economics. We cannot reliably use data generated in such open systems to make predictions about the future because, for example, although inflation and wages may be strongly correlated over a certain time period they may not be in the next time period...

Unfortunately, reality is staring me in the face, and it’s telling me that we don’t need more complicated models. 

If I go to the trouble of fixing up a model, say by adding counterparty risk considerations, then I’m implicitly assuming the problem with the existing models is that they’re being used honestly but aren’t mathematically up to the task. 

If we replace okay models with more complicated models, as many people are suggesting we do, without first addressing the lying problem, it will only allow people to lie even more. This is because the complexity of a model itself is an obstacle to understanding its results, and more complex models allow more manipulation …

Timewasting Discussions

There are two specific topics which drive me crazy:

1. Any discussion about the IS/LM model.  Krugman is a big proponent of this, but he generally labels his columns discussing IS/LM as "nerdy".  I have concluded that this is because the IS/LM model only makes things much more complicated than they need to be.
2. Any discussion with Market Monetarists.  These inevitably start with the unrealistic assumption that the "Fed" can do whatever it wants in terms of controlling the economy.  Managing expectations by making pronouncements is generally the means by which they can exercise this power.  Any conversation discussing such a mythical economy goes in circles.

Here are some examples:

No: Saving Does Not Increase Savings

Here, Asymptosis attempts to clarify the various senses in which the terms saving and savings are used in macroeconomics.  All goes relatively well until he throws in this:

The IS/LM model seems to be inescapably based on the misconception detailed above — that more saving results in more savings hence, because of supply and demand for loanable funds, lower interest rates.  But: if Krugman’s constantly repeated assertions are correct, that model seems to perform very well.  Why is this true? What am I not understanding? 

At this point, the focus of the discussion shifts from What do the terms saving and savings represent in macroeconomics? to How does the IS/LM model work?  The latter question is perhaps worthy of a separate post, but only detracts from the main topic of the current post.

Terminal Demographics 

Here, Interfluidity attempts to discuss the causes of inflation in the 1970s.  He engages with several Market Monetarists, and the results are an extremely long discussion that will make your head spin.  The problem is that the Market Monetarism uses 100 sentences where 1 will do.   Here is an exchange I had with a Market Monetarist in the comments of the referenced post:

Me: To say that the macro-economy can or should be managed through this one tool (interest rates) is not reasonable. We could just as well say that the inflation of the 1970s could have been prevented by raising taxes, or decreasing public expenditures, or wage and price controls, or breaking OPEC, etc…

Market Monetarist: True, fiscal policy was expansionary in fiscal years 1964 through 1968. The cyclically adjusted Federal budget balance was reduced from (-0.5%) of potential GDP in fiscal year 1963 to (-4.4%) in fiscal year 1968, and the deficit was increased annually during that time:http://www.cbo.gov/sites/default/files/cbofiles/attachments/43977_AutomaticStablilizers3-2013.pdfBut a 10% income surtax was enacted in 1968 and remained effective through 1970. The cyclically adjusted budget balance rose to (-1.1%) by fiscal year 1970 and remained in the relatively narrow range of (-2.7%) to (-1.3%) from fiscal year 1971 through 1982. In fact despite the image of a deficit prone decade the 1970s were one of the most fiscally responsible decades on record with gross Federal debt setting a post WW II record low of 32.5% of GDP in fiscal year 1981 (President Carter’s last budget).
“…or wage and price controls,…”
Wage and price controls were in effect from 1971Q3 through 1974Q1, and core inflation did fall from an average of 5.0% in the year before they were implemented to 3.1% during Phases 1 and 2. But as they were relaxed it bounced back up. During Phase 3 and 4 it reached 4.2% and 6.1% respectively. And in the year after they were ended core inflation averaged 10.1%. Wage and price controls interfere with relative price adjustments ensuring they will be abandoned and that aggregate inflation will return with some catch up inflation to boot.
“…or breaking OPEC, etc.”
Total energy expenditures as a percent of GDP rose from 8.0% in 1970 to 13.7% in 1980, a change of 5.7 points.
http://www.eia.gov/totalenergy/data/annual/pdf/sec1_13.pdfThe EIA doesn’t have total energy expenditure data from before 1970 but the price of crude petroleum in 2005 dollars was $4.46 per barrel according to the World Bank dataset and this was less than in any year in 1960-69 and was down from 26.6% from its price of $6.08 a barrel in 1965:
http://econ.worldbank.org/WBSITE/EXTERNAL/EXTDEC/EXTDECPROSPECTS/0,,contentMDK:21574907~menuPK:7859231~pagePK:64165401~piPK:64165026~theSitePK:476883,00.html
So chances are very good that total energy expenditures in 1970 as a percent of GDP had fallen from the level they had been in 1965 and yet core inflation had had already risen from 1.3% in 1965 to 4.7% in 1970, and continued to accelerate reaching 9.2% in 1980:
http://research.stlouisfed.org/fred2/graph/?graph_id=109579&category_id=0In contrast total energy prices as a percent of GDP rose from 5.9% in 1999 to 9.9% in 2008, an increase of 4.0 points, and yet core inflation only rose from 1.3% to 2.3%.
So in the Great Inflation a change in total energy expenditures of 5.7 points resulted in an increase in core inflation of 7.9 points and in the 2000s a change in total energy expenditures of 4.0 points resulted in an increase in core inflation of 1.0 points.
This shouldn’t be surprising because research shows that commodity price increases are not an important causal factor in long-term inflation:
http://www.bostonfed.org/economic/ppb/2011/ppb111.pdfDo Commodity Price Spikes Cause Long-Term Inflation?
Geoffrey M. B. Tootell
May 2011
Abstract:
“This public policy brief examines the relationship between trend inflation and commodity price increases and finds that evidence from recent decades supports the notion that commodity price changes do not affect the long-run inflation rate. Evidence from earlier decades suggests that effects on inflation expectations and wages played a key role in whether commodity price movements altered trend inflation. This brief is based on a memo to the president of the Federal Reserve Bank of Boston as background to a meeting of the Federal Open Market Committee.”…

This is not a productive discussion. It's more like a filibuster, and fits a dysfunctional pattern I've observed.

cross posted at Mike Norman Economics

Historical Notes for Future Reference

For future reference (all of the following from Wikipedia):

Alexander del Mar, also Alex Delmar (1836–1926), was an American political economist, historian, numismatist and author.[Note 1] He was the first director of the Bureau of Statistics at the U.S. Treasury Department from 1866–69.[1] [Note 2]
Del Mar was a rigorous historian who made important contributions to the history of money. During the mid-1890s, he was distinctly hostile to a central monetary role for gold as a commodity money, championing the cause of silver and its re-monetization as a prerogative of the state.
He believed strongly in the legal function of money. Del Mar dedicated much of his free time to original research in the great libraries and coin collections of Europe on the history of monetary systems and finance.

Georg Friedrich Knapp (German: [knap]; March 7, 1842 – February 20, 1926) was a German economist who in 1895 published The State Theory of Money, which founded the chartalist school of monetary theory, which takes the statist stance that money must have no intrinsic value and strictly be used as governmentally-issued token, i.e., fiat money...  Staatliche Theorie des Geldes (“The State Theory of Money”), München u. Leipzig, Duncker & Humblot, 1895. 3rd edition 1921. English edition of 1924 in PDF format

Alfred Mitchell-Innes (30 June 1864 – 13 February 1950) was a British diplomat, economist and author... While in Washington, he wrote two articles on money and credit for The Banking Law Journal. The first, 'What is Money?', received an approving review from John Maynard Keynes,[1] which led to the publication of the second, 'Credit Theory of Money'.[2] Long forgotten and rediscovered decades later, the articles have been praised as "the best pair of articles on the nature of money written in the twentieth century".[3]

Frederick Soddy (2 September 1877 – 22 September 1956) was an English radiochemist who explained, with Ernest Rutherford, that radioactivity is due to the transmutation of elements, now known to involve nuclear reactions... In four books written from 1921 to 1934, Soddy carried on a "campaign for a radical restructuring of global monetary relationships",[3] offering a perspective on economics rooted in physics—the laws of thermodynamics, in particular—and was "roundly dismissed as a crank".[4] While most of his proposals - "to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort" - are now conventional practice, his critique of fractional-reserve banking still "remains outside the bounds of conventional wisdom".[5] Soddy wrote that financial debts grew exponentially at compound interest but the real economy was based on exhaustible stocks of fossil fuels. Energy obtained from the fossil fuels could not be used again. This criticism of economic growth is echoed by his intellectual heirs in the now emergent field of ecological economics.[6]

Marriner Stoddard Eccles (September 9, 1890 – December 18, 1977) was a U.S. banker, economist, and member and chairman of the Federal Reserve Board.
Marriner Stoddard Eccles was known during his lifetime chiefly as having been the Chairman of the Federal Reserve under President Franklin Delano Roosevelt. He has been remembered for having even anticipated and certainly then having supported the theories of John Maynard Keynes relative to "inadequate aggregate spending" in the economy which appeared during his tenure.[2] As Eccles wrote in his memoir Beckoning Frontiers (1966):
"As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth ... to provide men with buying power. ... Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. ... The other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."[3] He became known as a defender of Keynesian ideas, though his ideas predated Keynes' The General Theory of Employment, Interest, and Money (1936). In that respect, he is considered by some to have seen monetary policy having secondary importance and that as a result he allowed the Federal Reserve to be sublimated to the interests of the Treasury.

David Rolfe Graeber (/ˈɡreɪbər/; born 12 February 1961) is an American anthropologist, author, anarchist and activist who is currently Professor of Anthropology at the London School of Economics.[1]...  Debt: The First 5000 Years is a book by anthropologist David Graeber published in 2011. Graeber analyzes the function of debt in human history. He traces the history of debt from ancient civilizations to our modern-day economic crises, arguing that debt has often driven revolutions and social and political changes. ... In addition to his anthropological narrative, Graeber also provides direct criticism of modern-day capitalism, questioning many conventionally accepted economic notions, especially: the free market, the historical myth of the concept of barter as the origin of trade, and the concept of money as an independent object of worth, rather than a social relation.[2]

Herman Edward Daly (born 1938) is an American ecological economist and professor at the School of Public Policy of University of Maryland, College Park in the United States. Daly was Senior Economist in the Environment Department of the World Bank, where he helped to develop policy guidelines related to sustainable development. While there, he was engaged in environmental operations work in Latin America. He is closely associated with theories of a Steady state economy. Before joining the World Bank, Daly was a Research Associate at Yale University,^[1] and Alumni Professor of Economics at Louisiana State University. He was a co-founder and associate editor of the journal, Ecological Economics...  In 1989 Daly and John B. Cobb developed the Index of Sustainable Economic Welfare (ISEW), which they proposed as a more valid measure of socio-economic progress than gross domestic product.

UPDATES 2/5/2014:  

Pilkington observes: 

This is where economics has erred since at least the turn of the 19th century. The early marginalists occupied two groups. One were the Walrasians who, following Leon Walras, were perfectly content to confine themselves to barren speculation of unrealistic nonsense provided it was done in a nice, formal mathematical manner. The other group were the Marshallians (Alfred Marshall) who tried to bring such abstract speculation down to earth...

Clearly Marshall was becoming ever more concerned about the use of formal modelling in economics. He could see that it was apt to get out of hand. Marshall’s followers in this sense were, of course, Keynes and the early Post-Keynesians. But they lost the battle. By the 1950s Walrasianism was in the ascent. Even Neo-Keynesians like Solow and Samuelson displayed a penchant for abstractionism that was apt to get carried away with itself and only produce irrelevant dross. 

J.W. Mason observes:

The Slack Wire: Graeber Cycles and the Wicksellian Judgment Day

David Graeber, in his magisterial Debt: The First 5,000 Years [1], describes a very long alternation between world economies based on commodity money and world economies based on credit money...  For Graeber, the whole half-millenium from the 16th through the 20th centuries is a period of the dominion of money, a dominion only now -- maybe -- coming to an end. But closer to ground level, there are shorter cycles. This comes through clearly in Axel Leijonhufvud's brilliant short essay on Wicksell's monetary theory, which is really the reason this post exists. Among a whole series of sharp observations, Leijonhufvud makes the point that the past two centuries have seen several swings between commodity (or quasi-commodity) money and credit money. In the early modern period, the age of Adam Smith, there really was a (commodity) money economy, you could talk about a quantity of money. But even by the time of Ricardo, who first properly formalized the corresponding theory, this was ceasing to be true (as Wicksell also recognized), and by the later 19th century it wasn't true at all. The high gold standard era (1870-1914, roughly) really used gold only for settling international balances between central banks; for private transactions, it was an age not of gold but of bank-issued paper money. [3]

If I somehow found myself teaching this course in the 18th century, I'd explain that money means gold, or gold and silver. But by the mid 19th century, if you asked people about the money in their pocket, they would have pulled out paper bills, not so unlike bills of today -- except they very likely would have been bills issued by private banks.

The new world of bank-created money worried classical economists like Wicksell, who, like later monetarists, were strongly committed to the idea that the overall price level depends on the amount of money in circulation. The problem is that in a world of pure credit money, it's impossible to base a theory of the price level on the relationship between the quantity of money and the level of output, since the former is determined by the latter. Today we've resolved this problem by just giving up on a theory of the price level, and focusing on inflation instead... I think we have to be able to theorize a world of pure credit money. No central bank, no gold standard. (That's Wicksell.)

Lowering Interest Rates is a Panacea

In a post entitled Why Have Investors Given Up on the Real World?, Kevin Drum says the following,

How should we respond to sustained economic weakness? ...

In a nutshell, the argument for higher inflation is simple. Right now, with interest rates at slightly above zero and inflation running a little less than 2 percent, real interest rates are about -1 percent. But that's too high. Given the weakness of the economy, the market-clearing real interest rate is probably around -3 percent. If inflation were running at 4-5 percent, that's what we'd have, and the economy would recover more quickly. 

There are two arguments opposed to this. The first is that central banks have demonstrated that 2 percent inflation is sustainable. But what about 5 percent? Maybe not. If central banks are willing to let inflation get that high, markets might conclude that they'll respond with even higher inflation if political considerations demand it. Inflationary expectations will go up, the central bank will respond, and soon we'll be in an inflationary spiral, just like the 1970s.

I find it remarkable that Drum is so easily drawn into the rabbit hole of monetarism, a world where the Fed Chair reigns as the Wizard of Oz and economic weakness is solved by a willingness to let inflation get high.  What conceivable logic lies behind such fantasy?

All countries have structural economic problems.  In the United States, our labor force is not competitive because labor is cheaper elsewhere and the technology and political structure exists to move jobs to these other locations.  That is the "economic weakness" of which Drum speaks.  In spite of extremely low interest rates, the American consumer isn't earning enough money to consume more and make additional private investment profitable.

How could the solution to this be just to reduce interest rates?  How would that address the structural problem in any way?  We've been trying this in the U.S. for over 30 years now (see this graph).  Phil Pilkington and others discuss how well this has worked:

Kalecki’s argument was that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone.
[Fixing the Economists]

In sum, a group of bizarro monetarist economists and their naive followers have captured the high, serious ground  They believe that structural problems, such as offshoring and outsourcing of jobs, can be fixed by lowering interest rates.  This has been tried for 30 years whenever the economy falters, and the problem is worse than ever, and rates can't go any lower.  Lower interest rates have yielded lower inflation, to the extent that there is any discernable effect of monetary policy on inflation.  But they believe the problem would be solved if we just somehow get interest rates into negative territory.

 
 
cross posted at Mike Norman Economics