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

Econ Evolution Diagram

Here's a diagram to go with the post below on selected highlights of recent economic history:

Evolution of Selected Economic Schools

Economic History

Selected highlights of recent economic history:

• up to1930 -- Laissez-faire is the conventional wisdom in capitalist countries, supported by Say's Law, i.e.: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value."
  Shorter version of Say's Law: "supply creates its own demand".
• 1895 -- The chartalist theory was introduced by German statistician and economist G. F. Knapp.  Important contributions were made by Alfred Mitchell-Innes in 1913-1914. Chartalism experienced a revival under Keynes and Abba P. Lerner, and has a number of modern proponents.  Chartalism is a descriptive economic theory that details the procedures and consequences of using government-issued tokens as the unit of money, i.e., fiat money. The name derives from the Latin charta, in the sense of a token or ticket. The modern theoretical body of work on chartalism is known as Modern Monetary Theory (MMT).
• Great Depression -- Keynes emerges as preeminent economist noting need for government to step in when markets fail.  Full employment cannot be maintained via laissez-faire policies, but demand can be boosted via fiscal policy to stimulate the economy.
  Shorter version of Keynesianism:  "demand creates its own supply".
• 1940-1970 -- Keynesian economics reigns supreme in US and Europe. John Kenneth Galbraith is perhaps the leading Keynesian economist.
• 1940-1970 -- neo-Keynesian economics developed to integrate classical (pre-Keynes) economics with Keynesian economics.  Paul Samuelson is perhaps the leading neo-Keynesian economist, developing a neoclassical synthesis which still dominates mainstream economics.  His 1948 textbook became the standard.
• ~ 1945 -- early liberal forms of Keynesianism:
• 1943 -- Abba Lerner develops functional finance, a theory of purposeful financing to meet explicit goals, including full employment, no taxation designed solely to fund expenditure or finance investment, and low inflation.  Functional finance is based upon the effective demand principle and chartalism.
• 1947 --  Lorie Tarshis writes first introductory textbook that brought Keynesian thinking into American university classrooms. The work swiftly lost popularity after it was charged with excessive sympathy to communism by McCarthyist activists. 
• 1970-1980 -- Stagflation and lack of political will lead to loss of faith in fiscal policy.  Monetarist alternative promoted by Milton Friedman gains prominence
• 1980 -- Laissez-faire economics regains prominence in Republican circles under the guise of Supply-side Economics.  This fits well with Milton Friedman's Monetarism.
• 1990 -- New Keynesian economics develops as a successor to the dormant neo-Keynesianism and a response to the resurgent laissez-faire advocates.  This watered-down Keynesianism adds little that is new or interesting (in my opinion), but is popular with powerful centrist Democrats as it offers a practical alternative to the laissez-faire Republicans.
• 1975-present -- (most of this section is from Wikipedia) Post-Keynesian economics emerges as a school of economic thought with its origins in the works of John Maynard Keynes. Keynes's biographer Lord Skidelsky writes that the Post Keynesian school has remained closest to the spirit of Keynes's own work.
           Post-Keynesian economists are united in maintaining that Keynes's theory is seriously misrepresented by the two other principal Keynesian schools:  neo-Keynesian economics which was orthodox in the 1950s and 60s – and by New Keynesian economics, which together with various strands of neoclassical economics has been dominant in mainstream macroeconomics since the 1980s.
           The theoretical foundation of post-Keynesian economics is the principle of effective demand, that demand matters in the long as well as the short run, so that a competitive market economy has no natural or automatic tendency towards full employment.
           The positive contribution of post-Keynesian economics has extended beyond the theory of aggregate employment to theories of income distribution, growth, trade and development in which money demand plays a key role, whereas in neoclassical economics these are determined by the 'real' forces of technology, preferences and endowment. In the field of monetary theory, post-Keynesian economists were among the first to emphasize that the money supply responds to the demand for bank credit, so that the central bank can choose either the quantity of money or the interest rate but not both at the same time.
           This view has largely been incorporated into monetary policy, which now targets the interest rate as an instrument, rather than the quantity of money. In the field of finance, Hyman Minsky put forward a theory of financial crisis based on financial fragility, which has recently received renewed attention.
• 1994-present -- Modern Modern Theory (MMT) is a branch of Post-Keynesian economics and Functional Finance as well as the modern version of Chartalism.  Along with the features of Post-Keynesian economics mentioned above, MMT relies on the work of Wynne Godley who described the accounting-oriented sectoral financial balances which constrain the macro economy.  For example, government deficits generally correspond to private sector surpluses as a simple matter of accounting.
            As one would expect from the name, MMT describes the working of modern fiat currencies in considerable detail.  This provides stark contrasts and significant insights in comparison with conventional economic schools (New Keynesian and laissez-faire/neoclassical/monetarist) which are based upon gold standard monetary systems.
           MMT is somewhat unique among economic schools in that it has both liberal and conservative supporters.  While most in the MMT community are liberal and advocate liberal policies, MMT also has conservative advocates.  The descriptive aspects of modern fiat monetary systems stand alone and can be separated from any policy recommendations of MMT proponents.

Another good account of recent economic history is in this paper by David Colander - Functional Finance, New Classical Economics and Great Great Grandsons.

More detail is provided below, mainly from John Kenneth Galbraith...

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Here are some notes I took from John Kenneth Galbraith’s book via a commenter named "from Mexico" at the Naked Capitalism blog:

Say’s Law, not a thing of startling complexity, held that, from the proceeds of every sale of goods, there was paid out to someone somewhere in wages, salaries, interest, rent or profit (or there was taken from the man who absorbed a loss) the wherewithal to buy that item. As with one item, so with all. This being so, there could not be a shortage of purchasing power in the economy….

Until Keynes, Say’s Law had ruled in economics for more than a century. And the rule was no casual thing; to a remarkable degree acceptance of Say was the test by which reputable economists were distinguished from the crackpots. Until late in the ’30s no candidate for a Ph.D. at a major American university who spoke seriously of a shortage of purchasing power as a cause of depression could be passed. He was a man who saw only the surface of things, was unworthy of the company of scholars. Say’s Law stands as the most distinguished example of the stability of economic ideas, including when they are wrong….

This was the doctrine, perhaps more accurately the theology, that Keynes brought to an end…..

To suggest that there might be oversaving now no longer cost a man his degree or, necessarily, his promotion. That the proper remedy for oversaving was public spending financed by borrowing was henceforth a fit topic for discussion — although it continued to provoke bitter rebuke. The way was now open for public action.

[....]

The Keynesian adjustment to an excess of savings is through a reduction in aggregate demand. When demand falls, something must give, and what gives must be either prices or production. If prices can be held up by the market power of the corporation, it is production that must fall. When production falls, so will employment. With corporate market power, unemployment will thus become a highly distinctive feature of the Keynesian adjustment.

[….]

What had always been believed, as against Keynes and the Keynesians, was an inordinately powerful thing. For two hundred years Americans of the truest blood had displayed a penchant for paper money. For seventy years they had agitated for silver. Monetary experiment in the United States was thus in an ancient and politically most acceptable tradition. It also retained a large political constituency. A congressman or senator, returning to Oklahoma or Iowa after urging an issue of green-backs to enhance prices and advance social justice, could be a hero. No such tradition and no such constituency supported the idea of deficit financing, a deliberately, promiscuously unbalanced budget. A man returning to Iowa after advocating this in Washington might be thought dangerously insane.

Wise governments had always sought to balance their budgets. Failure to do so had always been proof of political inadequacy; things need not be any more complicated than that….

Roosevelt did not disagree; in his first post-convention radio speech he said the country must “stop the deficits,” adding that “Any Government, like any family, can for a year spend a little more than it earns. But you and I know that a continuation of that habit means the poorhouse.” 23

The beliefs so affirmed by the two Presidents were still powerful five years later — still a formidable barrier against the ideas of a distant English don. There was also explicit in Roosevelt’s position what has come to be called the fallacy of composition. This too was a staunch bar to the Keynesian ideas — and it remains influential to this day.

An engagingly plausible mode of thought, the fallacy of composition extends the economics of the family to that of the government. A family cannot indefinitely spend beyond its income. So neither can a government. A parent who borrows to live leaves debts, not a competence, to those who come after. A government that borrows does the same. Both are morally deficient.

The comparison between family and state, on second thought, is implausible…. [I]t should be observed that the wealth and solvency of a nation depend on what its national economy produces. If borrowing and spending enhance production, as the Keynesian ideas held, then such borrowing and spending enhance solvency. Only rarely do borrowing and spending enhance wealth for a family. It was an enduring complaint of Keynesians that their opposition did not understand what they were trying to do. It was equally the case that the Keynesians did not understand the depth of the tradition to which their opposition was subject or the power by which it was governed…..

The Great Depression showed the patent ineffectuality of monetary policy for rescuing the country from a slump — for breaking out of the underemployment equilibrium once this had been fully and firmly established. For this only fiscal policy would serve. Only fiscal policy ensured not just that money was available to be borrowed but that it would be borrowed and would be spent. This was the lesson of John Maynard Keynes...

By the early ’60s it had become the conventional wisdom of the New Economics that, at full employment, the revenues raised by the Federal government were too large in relation to expenditures. The result was “a fiscal drag” upon output, income and employment. To lessen this drag, a horizontal reduction in taxes was deemed necessary. By now, public sophistication allowed of such action; taxes could be reduced and the deficit increased for the deliberate and exclusive purpose of increasing the budget deficit and so improving economic performance. In 1964, such a reduction, amounting to $14 billion in revenues, was enacted. It was “the most overt and dramatic expression of the new approach to economic policy.”

Implicit in this action, however, was the need to reverse it should an excess of demand start pulling up prices. And this, as later history would amply establish, was far more difficult.

[….]

If taxes cannot be increased except under the force majeure of war and public expenditures cannot be decreased much for any reason, it follows that Keynesian policy is unavailable for limiting demand. It can expand purchasing power but it cannot contract it. During the twenty good years no reliable method was devised for dealing with the wage-price spiral — with direct market power as a cause of inflation. And fiscal policy was also becoming unavailable for dealing with inflation. The goals were there; the instruments for reaching them were becoming distressingly inoperative. There was one exception, and that was monetary policy. Nothing in the decline of other instruments was as unfortunate as the increasing faith in this one.

The final flaw was this revival, during these years, of faith in monetary policy. In light of the history of this instrument it was as surprising as it was damaging.

[….]

[M]uch of the revival was owing to the effective evangelism of the most diligent student of monetary policy and history during these years, Professor Milton Friedman. As a devout and principled conservative, Professor Friedman saw monetary policy as the key to the conservative faith. It required no direct intervention by the state in the market. It elided the direct management of expenditures and taxation, not to mention the large budget, which was implicit in the Keynesian system. It was a formula for minimizing the role of government — for returning to the wonderfully simpler world of the past…. It was merely that the task was far simpler than previously assumed; Professor Friedman returned to Irving Fisher and held that attention need be paid only to the quantity of money in Fisher’s equation…. If these aggregates were so controlled as to allow for a steady moderate increase related in magnitude to the increase in economic activity, the task of economic management was accomplished. There is nothing more…. Professor Friedman’s case was not casually advanced; it was supported by massive evidence which, as necessary, was arranged to serve the author’s purpose. (Substantial changes in the velocity of money use had especially to be explained away. There was also the serious and unresolved problem just mentioned of what was to be counted as money.) In the years to come, Professor Friedman’s breathtakingly simple solution…would powerfully support the hope that all problems could be solved by the magic of monetary management. Alas.

–JOHN KENNETH GALBRAITH, Money: Whence it Came, Where it Went

Jonathan Schlefer, at The New York Times, provides a brief biography of Wynne Godley, full of praise.

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If the economics profession takes on the challenge of reworking the mainstream models that famously failed to predict the crisis, it might well turn to one of the few economists who saw it coming, Wynne Godley of the Levy Economics Institute. Mr. Godley, unfortunately, died at 83 in 2010, perhaps too soon to bask in the credit many feel he deserves.
But his influence has begun to spread. Martin Wolf, the eminent columnist for The Financial Times, and Jan Hatzius, chief economist of global investment research at Goldman Sachs, borrow from his approach. Several groups of economists in North America and Europe — some supported by the Institute for New Economic Thinking established by the financier and philanthropist George Soros after the crisis — are building on his models...It was far from a first for Mr. Godley. In January 2000, the Council of Economic Advisers for President Bill Clinton hailed a still “youthful-looking and vigorous” expansion. That March, Mr. Godley and L. Randall Wray of the University of Missouri-Kansas City derided it, declaring, “Goldilocks is doomed.” Within days, the Nasdaq stock market peaked, heralding the end of the dot-com bubble.

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Matias Vernengo (nakedkeynesianism) adds some commentary: 

http://nakedkeynesianism.blogspot.com/2013/09/hydraulic-krugman-on-wynne-godley.html

Paul Krugman commented on the NY Times piece on Wynne. There are many little incorrect interpretations, which derive from his lack of understanding of the history of ideas. First, he equates Wynne's model with the old hydraulic Keynesianism (i.e. Neoclassical Synthesis) of Phillips (of Phillips curve fame, but also of the hydraulic model of the British economy). Nothing further from the truth...
Krugman then says these models were abandoned because they failed in the face of the Great Inflation of the 1970s, and because they did not deal with consumption in a coherent way. Here again he is wrong. First of all, Wynne's models had no trouble dealing with the inflation of the 1970s, correctly pointing out the effects of oil prices, devaluation, and wage pressures from the cost side rather than demand pull views, and he was one of the few that correctly foresaw the big recession that the Thatcher policies would cause. ...
PS: Full disclosure, I'm quite biased on this topic, having worked for Wynne at the Levy Economics Institute for two years in 1997-98.
PS': Two additional posts by Unlearning Economics and Philip Pilkington and a link by Lars Syll (h/t for the link to Unlearning)....

Again from Phil Pilkington's blog: Pilkington and Syll find evidence of a 1996 debate between Krugman and Galbraith...

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Lars Syll has brought my attention to a very interesting exchange between Jamie Galbraith and Paul Krugman from 1996 that is archived on the latter’s website (or a website created for him, I cannot tell). Much of the discussion is on long dead arguments from the 1990s that now look as antiquated as early episodes of Friends. But there are two things that are interesting about the debate.

First of all, in retrospect, it looks to me like Krugman is on the wrong side of pretty much every issue. He seems cavalier about the rising income inequality in the US — something he has since renounced (but only due to reality really beating him over the head). He shrugs off a falling labour share in national income — something which has since become so obvious that not even the flashiest debater could cover it up. At one point his support of Pete Peterson’s Social Security privatisation campaign is mentioned (yep, old Pete Pete was selling that hoary “Social Security is imminently broke” line back in ’96 and Krugman at one point fell for it).
There also seems to be a sense with Krugman that the Washington Consensus would lead to general prosperity, although it is hard to pin — one year before the Asian crisis and the subsequent fracturing of said consensus. And then there’s the move toward a budget surplus by the Clinton administration; something now argued by many to have precipitated the rise in private sector debt that ultimately led to the financial crisis of 2008.

Lowering Interest Rates is Deflationary by Definition

When Ford Motor lowers the price of a car, that is a deflationary act by definition.  The possibility that the lower price may lead to the sale of more cars does not alter that fact.  The fact that consumers may have some extra money in their pocket after purchasing their car, and use that to buy something else, does not alter the basic fact that lower prices are the realization of deflation.

When the Federal Reserve lowers the price of borrowing, that is a deflationary act by definition.  The fact that the lower price may lead to more loans does not alter that fact.  The fact that borrowers may have some extra money in their pocket after making payments on loans does not alter the fact that the lowered price for borrowing represents deflation in and of itself.

Compounding this obvious first order deflation, the lowered interest rates lower the fiscal balance and thus result in a smaller injection of money from the government into the economy.

There are undoubtedly other effects of lowering interest rates, but these are not so cut and dried as commonly assumed.  Any private loan has two private parties.  Lowering the price for the borrower lowers revenue for the lender, with no net change in income.

An in-depth analysis of the various effects of interest rate changes on the economy will reveal a number of additional considerations.   The argument that is generally made by proponents of monetary policy is that lower rates will lead to increased investment, since the lower price of bank loans will make them more attractive.  But, as we see via Phil Pilkington,

[Keynes'] account of a boom is to say that a high rate of investment causes a fall in expected profits as the supply of productive capacity increases… one thing he would have never have said is that a permanently lower level of the rate of interest would create a permanently higher rate of investment.

This ties into Kalecki’s argument 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. He presents the following graph which shows precisely this dynamic...

Randall Wray provides additional detailed analysis:

Some years ago I co-authored a paper with my colleague Linwood Tauheed, titled SYSTEM DYNAMICS OF INTEREST RATE EFFECTS ON AGGREGATE DEMAND, that investigated the likely impacts of interest rate changes on aggregate demand. We used conventional estimates of interest rate elasticities for investment spending, as well as for parameters like the marginal propensity to consume...  In particular, pay attention to the discussion of conventional estimates of interest rate elasticities—which are surprisingly small

If the price of lumber goes down by a small amount, this doesn't automatically mean that the demand for houses will surge.  Similarly, if the price of borrowing money goes down by a small amount, this doesn't automatically mean that the demand to build new factories will surge.  The cost of borrowing is just one factor among many.  Deflation in borrowing costs is deflationary in and of itself.  The second and higher order effects are subject to debate, but the empirical data from recent U.S. history shows lower interest rates highly correlated with decreasing inflation (and vice versa).  As evidence in support of this assertion, here's my favorite graph:

A Bank Run for the 21st Century

Could we have the equivalent of a 1930s style bank run in this day and age?  I think we already have, and that more and bigger are coming.

In this post, I will attempt to be non-judgmental -- to step back and look at the underlying forces at work which are based upon human nature in our earthly environment.  In the short term, we rant and rave about the evil and stupid people, but occasionally it is good to move beyond that, remove such negative emotion, and try to assess the science driving the action.

Twice in the last 13 years we in the U.S. have experienced declines in the broad stock market indexes of more than 50%.  What do we make of such massive declines in the wealth of the nation?  The conventional wisdom is that these blips are nothing to worry about.  The stock market is inherently volatile, but generally tracks the real economy.  Massive declines in the past have been quickly recouped.  So, while there may be more such scary episodes, one needs only to keep one's cool and in the long run we will continue to grow wealthier.

My take is that recent stock market crashes presage more of the same.  If the conventional wisdom is correct and we can expect more of these, then it's logical to conclude that there will be panic selling from time to time.  Is it reasonable to assume that all such panics will be temporary and quickly corrected as have been the last two (in 2001 and 2008)?

In 2001, the U.S. government reacted swiftly and decisively to the market crash.  Under the leadership of President George W. Bush, tax rates were slashed across the board on income including capital gains and estates.  In 2003, taxes on income, capital gains, and estates were cut yet again.  In the meantime, the Federal Reserve slashed interest rates from 6% to 1%.

In 2008, the U.S. central bank agreed to buy out trillions of dollars of failing mortgaged backed securities.  This was followed by additional bailouts (e.g. Troubled Asset Relief Program or TARP) and a nearly $1 trillion dollar stimulus program passed by Barack Obama and the Democratic legislature.

So the 2001 and 2008 market panics were reversed with the assistance of massive U.S. federal government bailouts and stimulus programs.  Is it safe to assume that such relief will always be available?  Do we have the equivalent of a Federal Deposit Insurance Program for the stock market?  Of course, the answer is no.  We have no systematic program to rescue the stock market.  Rather we have had a series of ad hoc government rescues.  There is no guarantee that the next time the U.S. government will react swiftly and decisively.  In fact, the political situation in the U.S. is such that precisely the opposite can be expected.

The current situation with regard to the stock market is analogous to the previous state of the banking system where periodic bank runs crippled the economy.  In recent decades, the middle class have come to rely upon the stock market for basic savings   Reaganomics in the 1980s was typified by the rise of 401k pension programs which encouraged middle class employees to fund their retirements by investing in the stock market.  This is just one of many "ownership society" programs which have tied the financial well-being of middle class Americans to the financial success of U.S. corporation.

Aligning the interests of the middle class with the interests of corporate America seemed to be a win-win proposition.  No longer would the benefits of profit-driven capitalism accrue only to the rich capitalists.  Now, the middle class would profit from the accumulation of real wealth, and the corporations responsible for generating this wealth would have a broader base of support.  But some side effects of the ownership society have come to pose serious impediments to the continuing success of this model.

With a greater stake in the stock market, the middle class increasingly favored policies designed to boost corporate profitability.  A whole slew of laws were passed to that end, including lowering of taxes on capital gains and dividends, decreased corporate regulation, and increased legal rights for corporations at the expense of workers.  But far and away the biggest boost to corporate profits has been the acceleration of globalization which has encouraged transfer of jobs to lower wage areas at the expense of places with high labor costs and aging infrastructure.  Corporate profits have claimed an increasing share of national income in the U.S., while the share going to labor has decreased markedly.

In recent years, real growth in the global economy, and in the U.S. in particular, has stagnated somewhat.  As the ownership society received successive bailouts (as noted above in 2001,2003, 2008, 2009), financial prosperity overtook the real economy.  This makes sense because it is stock market value that is now funding much of middle class retirement.  There is political pressure to keep equity prices high.  To this end, extensive sacrifices have been made in labor remuneration and security, environmental protection, and market regulation.  There is political pressure to keep stock prices high.

We've come to rely upon the federal government to keep stock prices high, but this has been accomplished in an ad hoc, contentious, and unfair manner.  The noble idea of distributing national wealth more broadly has resulted in an increasingly risky base for middle class prosperity, and an increasingly impoverished lower class.  There is no FDIC to guarantee one's savings in the stock market.

The ownership society is running out of ways to plausibly and politically maintain stock prices which have taken on a life of their own.  Inevitably, the conventional wisdom that corporate America should not be bailed out and that stock prices should not be government supported will play out in a stock market crash which will have results similar to the bank runs of the 1930s.  Loans that are backed by stock market wealth will totter, and consumption based upon plummeting paper wealth will fall.  Middle class security will evaporate before our eyes.  The Tea Party will blame Obama (assuming this happens before his 2nd term expires), and the Democrats will be left holding the bag.  The stage will be set for a change in the economic zeitgeist.

Of course it's possible that we'll have yet another round of ad hoc bailouts and continue on our present course.  But it seems implausible that we can do this for ever.  Eventually, we will succumb to political pressure to provide greater security for the politically powerful middle class.  We will implement some national wealth (stock market) counterpart to the FDIC guarantees which are taken for granted these days in our banking system.  We will look back upon the current era as a reckless and unstable gilded age.  For those of us currently in the middle class, the important point is that such security will be guaranteed only after another big collapse...