That Safe Asset Shortage, Continued

Regular readers of the blog will know that we have been having a contradiction with Brad DeLong and the rest of the monetarist mainstream of modern macroeconomics.

They think that demand constraints imply, by definition, an excess demand for money or “safe assets.” Unemployment implies disequilibrium, for them; if everyone can achieve their desired transactions at the prevailing prices, then society’s productive capacity will always be fully utilized. Whereas I think that the interdependence of income and expenditure means that all markets can clear at a range of different levels of output and employment.

What does this mean in practice? I am pretty sure that no one thinks the desire to accumulate safe assets  directly reduces demand for current goods from households and nonfinancial businesses. If a safe asset shortage is restricting demand for real goods and services, it must be via an unwillingness of banks to hold the liabilities of nonfinancial units. Somebody has to be credit constrained.

So then: What spending is more credit constrained now, than before the crisis?

It’s natural to say, business investment. But in fact, nonresidential investment is recovering nicely. And as I pointed out last week, by any obvious measure credit conditions for business are exceptionally favorable. Risky business debt is trading at historically low yields, while the volume of new issues of high-risk corporate debt is more than twice what it was on the eve of the crisis. There’s some evidence that credit constraints were important for businesses in the immediate post-Lehmann period, if not more recently; but even for the acute crisis period it’s hard to explain the majority of the decline in business investment that way. And today, it certainly looks like the supply of business credit is higher, not lower, than before 2008.

Similarly, if a lack of safe assets has reduced intermediaries’ willingness to hold household liabilities, it’s hard to see it in the data. We know that interest rates are low. We know that most household deleveraging has taken place via default, as opposed to reduced borrowing. We know the applications for mortgages and new credit cards have continued to be accepted at the same rate as before the crisis. And this week’s new Household Credit and Debt Report confirms that people are coming no closer than before the crisis, to exhausting their credit-card credit. Here’s a graph I just made of credit card balances and limits, from the report:

Ratio of total credit card balances to total limits (blue bars) on left scale; indexes of actual and trend consumption (orange lines) on right scale. Source: New York Fed.

The blue bars show total credit card debt outstanding, divided by total credit card limits. As you can see, borrowers did significantly draw down their credit in the immediate crisis period, with balances rising from about 23% to about 28% of total credit available. This is just as one would expect in a situation where more people were pushing up against liquidity constraints. But for the past year and a half, the ratio of credit card balances to limits has been no higher than before the crisis. Yet, as the orange lines show, consumption hasn’t returned to the pre-crisis trend; if anything, it continues to fall further behind. So it looks like a large number of household were pressing against their credit limit during the recession itself (as during the previous one), but not since 2011. One more reason to think that, while the financial crisis may have helped trigger the downturn, household consumption today is not being held back a lack of available credit, or a safe asset shortage.

If it’s credit constraints holding back real expenditure, who or what exactly is constrained?

Tell Me About that “Safe Asset Shortage” Again

From today’s FT:

US Junk Debt Yield Hits Historic Low

The average yield on US junk-rated debt fell below 5 per cent for the first time on Monday, setting yet another milestone in a multiyear rally and illustrating the massive demand for fixed income returns as central banks suppress interest rates. 

Junk bonds and equities often move in tandem, and with the S&P 500 rising above 1,600 points for the first time and sitting on a double digit gain this year, speculative rated corporate bonds are also on a tear. … With corporate default rates below historical averages, investors are willing to overlook the weaker credit quality in exchange for higher returns on the securities, analysts said. … The demand for yield has become the major driver of investor behaviour this year, as they downplay high valuations for junk bonds and dividend paying stocks. 

“Maybe the hurdles of 6 per cent and now 5 per cent on high-yield bonds are less relevant given the insatiable demand for income,” said Jim Sarni, managing principal at Payden & Rygel. “People need income and they are less concerned about valuations.”

In other words, the demand for risky assets is exceptionally high, and this has driven up their price. Or to put it the other way, if you are a high-risk corporate borrower, now is a very good time to be looking for a loan.

Here’s the same thing in a figure. Instead of their absolute yield, this shows the spread of junk bonds over AAA:

Difference between CCC- and AAA bond yields

See how high it is now, over on the far right? Yeah, me neither. But if the premium for safe assets is currently quite low, how can you say that it is a shortage of safe assets that is holding back the recovery? If financial markets are willing to lend money to risky borrowers on exceptionally generous terms, how can you say the problem is a shortage of risk-bearing capacity?

Now, the shortage-of-safe-assets story does fit the acute financial crisis period. There was a period in late 2008 and early 2009 when banks were very wary of holding risky assets, and this may have had real effects. (I say “may” because some large part of the apparent fall in the supply of credit in the crisis was limited to banks’ unwillingness to lend to each other.) But by the end of 2009, the disruptions in the financial markets were over, and by all the obvious measures credit was as available as before the crisis. The difference is that now households and firms wished to borrow less. So, yes, there was excess demand for safe assets in the crisis itself; but since then, it seems to me, we are in a situation where all markets clear, just at a lower level of activity.

This is a perfect illustration of the importance of the difference between the intertemporal optimization vision of modern macro, and the income-expenditure vision of older Keynesian macro. In modern macro, it is necessarily true that a shortfall of demand for currently produced goods and services is equivalent to an excess demand for money or some other asset that the private sector can’t produce. Or as DeLong puts it:

If you relieve the excess demand for financial assets, you also cure the excess supply of goods and services (the shortfall of aggregate demand) and the excess supply of labor (mass unemployment).

Because what else can people spend their (given, lifetime) income on, except currently produced stuff or assets? If they want less of one, that must mean they want more of the other.

In the Keynesian vision, by contrast, there’s no fixed budget — no endowment — to be allocated. People don’t know their lifetime income; indeed, there is no true expected value of future income out there for them to know. So households and businesses adjust current spending based on current income. Which means that all markets can clear at a various different levels of aggregate activity. Or in other words, people can rationally believe they are on their budget constraint at different levels of expenditure, so there is no reason that a decline in desired expenditure in one direction (currently produced stuff) has to be accompanied by an increase in some other direction (safe assets or money).

(This is one reason why fundamental uncertainty is important to the Keynesian system.)

For income-expenditure Keynesians, it may well be true that the financial meltdown triggered the recession. But that doesn’t mean that an ongoing depression implies an ongoing credit crisis. Once underway, a low level of activity is self-reinforcing, even if financial markets return to a pristine state and asset markets all clear perfectly. Modern macro, on the other hand, does need a continued failure in financial markets to explain output continuing to fall short of potential. So they imagine a “safe asset shortage” even when the markets are shouting “safe asset glut.”

EDIT: I made this same case, more convincingly I think, in this post from December about credit card debt. The key points are (1) current low demand is much more a matter of depressed consumption than depressed investment; (2) it’s nonsense to say that households suffer from a shortage of safe assets since they face an infinitely-elastic supply of government-guaranteed bank deposits, the safest, most liquid asset there is; (3) while it’s possible in principle for a safe-asset shortage to show up as an unwillingness of financial intermediaries to hold household debt, the evidence is overwhelming that the fall in household borrowing is driven by demand, not supply. The entire fall in credit card debt is accounted for by defaults and reduced applications; the proportion of credit card applications accepted, and the average balance per card, have not fallen at all.

Credit Cards and the Corridor

I don’t know if most people realize how much credit card debt fell during and after the Great Recession. It fell by a lot! Credit card debt outstanding today is about $180 billion, or 21 percent, lower than it was at the end of 2007. This is a 50 percent larger fall than in mortgage debt in percentage terms — though the fall in mortgages is of course much bigger in absolute dollars.
This fall in credit card debt is entirely explained by the drop in the number of credit card accounts, from about 500 million to 380 million. The average balance on open credit card accounts is about the same today as it was when the recession began.

The obvious question is, is this fall in consumer credit due to supply, or demand? Are banks less willing to lend, or are households less eager to borrow?

Here’s some interesting data that helps shed light on this question, from the Fed’s most recent Quarterly Report on Household Credit and Finance.

The red line shows the number of credit card accounts closed over the preceding 12 months, while the blue line shows the number opened. So the gap between the blue and red lines equals the change in the number of accounts. The spike in the red line is mostly write-offs, or defaults. I’ll return to those in a subsequent post; for now let’s look at the blue and green lines. The green line shows the number of inquiries, that is, applications for new cards by consumers. The blue line, again, shows the number issued. As we can see, the number of new accounts tracks the number of inquiries almost exactly. [1] What do we conclude from this? That the fall in the rate at which new credit cards are issued is entirely a matter of reduced demand, not supply. And given that balances on outstanding credit cards have not fallen, it’s hard to avoid the conclusion that banks’ reduced willingness to lend played little or no role in the fall in consumer credit.

Of course one figure isn’t dispositive, and mortgage debt is much more important quantitatively than credit card debt. But Dean Baker has been making a similar argument about mortgages for several years now:

the ratio of applications to [home] sales has not risen notably in this slump, indicating that the inability of potential homebuyers to get mortgages has not been a big factor in the housing downturn.

As a matter of fact, after reading that post (or one of Dean’s many others making the same point), I tried to construct a similar ratio for credit cards, but I wasn’t able to find the data. I didn’t realize then that the Fed publishes it regularly in the household credit report.

Needless to say, the ratio of applications to contracts is hardly the last word on this question, and needless to say there are plenty of more sophisticated attempts out there to disentangle the roles of supply and demand in the fall in borrowing. Rather than get into the data issues in more detail right now, I want to talk about what is at stake. Does it matter whether a fall in borrowing is more driven by the supply of credit or the demand for it? I think it does, both for theory and for policy.

One important question, of course, is the historical one: Did the financial crisis straightforwardly cause the recession by cutting off the supply of credit for nonfinancial borrowers, or were other factors more important? I admit to being agnostic on this question — I do think that credit constraints were dragging down fixed investment in the year or so before the recession officially began, but I’m not sure how important this was quantitatively. But setting aside the historical question, we also need to ask, is the availability of credit the binding constraint on real activity today?

For monetarists and New Keynesians, the answer has to be Yes almost by definition. Here’s DeLong:

There is indeed a “fundamental” configuration of asset prices–one that produces full employment, the optimal level of investment given the time preference of economic agents and the expected future growth of the economy, and the optimal division of investment between safe, moderately risky, and blue-sky projects. 

However, right now the private market cannot deliver this “fundamental” configuration of asset prices. The aftermath of the financial crisis has left us without sufficient trusted financial intermediaries … no private-sector agent can create the safe securities that patient and prudent investors wish to hold. The overleverage left in the aftermath of the financial crisis has left a good many investors and financial intermediaries petrified of losing all their money and being forced to exit the game–hence the risk tolerance of the private sector is depressed far below levels that are appropriate given the fundamentals… Until this overleverage is worked off, the private marketplace left to its own will deliver a price of safe assets far above fundamentals  … and a level of investment and thus of employment far below the economy’s sustainable and optimal equilibrium.

In such a situation, by issuing safe assets–and thus raising their supply–the government pushes the price of safe assets down and thus closer to its proper fundamental equilibrium value.

In other words, there is a unique, stable, optimal equilibrium for the macroeconomy. All agents know their expected lifetime income and preferred expenditures in that equilibrium. The only reason we are not there, is if some market fails to clear. If there is a shortfall of demand for currently produced output, then there must be excess demand for some asset the private sector cannot produce. In the monetarist version of the story, that asset is money. [2] In DeLong’s version, it’s “safe assets” more generally. But the logic is the same.

This is why DeLong is so confident that continued zero interest rates and QE must work — that it is literally impossible for output to remain below potential if the Fed follows its stated policy for the next three years. If the only reason for the economy to be off its unique, optimal growth path is excess demand for safe assets, then a sufficient increase in the supply of safe assets has to be able to get us back onto it.

But is this right?

Note that in the passage above, DeLong refers to a depressed “level of investment and thus of employment.” That’s how we’re accustomed to think about demand shortfalls, and most of the time it’s a reasonable shorthand — investment (business and residential) generally does drive fluctuations in demand. But it’s not so clear that this is true of the current situation. Here, check this out:

We’re looking at output relative to potential for GDP and its components; I’ve defined potential as 2.5 percent real annual growth from the 2007Q4 peak. [3] What we see here is investment and consumption both fell during the recession proper, but since 2010, investment has recovered strongly and is almost back to trend. The continued output gap is mainly accounted for by the failure of consumption to show any signs of returning to trend — if anything, consumption growth has decelerated further in the recovery.

You can’t explain low household consumption demand in terms of a shortage of safe assets. The safest, most liquid asset available to households is bank deposits, and the supply of these is perfectly elastic. I should note that it is possible (though not necessarily correct) to explain falling consumption this way for the early 1930s, when people were trying to withdraw their savings from banks and convert them into cash. The private sector cannot print bills or mint coins. But classical bank runs are no longer a thing; people are not trying to literally hoard cash; it is impossible that a lack of safe savings vehicles for households is what’s holding down consumption today.

So if we are going to explain the continued consumption shortfall in DeLong’s preferred terms, households must be credit-constrained. It is not plausible that households are restricting consumption in order to bid up the price of some money-like asset in fixed supply. But it is plausible that the lack of trusted financial intermediaries makes investors less willing to hold households’ debt, and that this is limiting some households’ ability to borrow and thus their consumption. In that case, it could be that increasing the supply of safe assets will provide enough of a cushion that investors are again willing to hold risky assets like household debt, and this will allow households to return to their optimal consumption path. That’s the only way DeLong’s story works.

It’s plausible, yes; but is it true? The credit card data is evidence that, no, it is not. If you believe the evidence of that first figure, the fall in consumer borrowing is driven by demand, not supply; continued weakness in consumption is not the result of unwillingness of investors to hold household debt due to excess demand for safe assets. If you believe the figure, investors are no less willing to hold consumer debt than they were before the recession; it’s households that are less willing to borrow.

Again, one figure isn’t dispositive. But what I really want to establish is the logical point: The shortage-of-safe-assets explanation of the continued output gap, and the corollary belief in the efficacy of monetary policy, only makes sense if the weakness in nonfinancial units’ expenditure is due to continued tightness of credit constraints. So every additional piece of evidence that low consumption (and investment, though again investment is not especially low) is not due to credit constraints, is another nail in the coffin of the shortage-of-safe-assets story.

So what’s the alternative? Well, that’s beyond the scope of this post. But basically, it’s this. Rather than assume there is a unique, stable, optimal equilibrium, we say that the macroeconomy has multiple equilibria and/or divergent adjustment dynamics. More specifically, we emphasize the positive feedback between current income and expenditure. For small deviations in income, people and businesses don’t adjust their expenditure, but use credit and and/or liquid assets to maintain it at its normal level. But for large deviations, this buffering no longer takes place, both because of financing constraints and because true lifetime income is uncertain, so people’s beliefs about it change in response to changes in current income.

In other word’s Axel Leijonhufvud’s “corridor of stability”. Within certain bounds (the corridor), the economy experiences stabilizing feedback, based on relative prices; beyond them, it experiences destabilizing feedback based on the income-expenditure link. Within these bounds, the multiplier is weak; outside them, it is “strong enough for effects of shocks to be endogenously amplified. Within the corridor, the prescription is in favor of ‘monetarist,’ outside in favor of ‘fiscalist’, policy prescriptions.”
I’m going to break that thought off here. The important point for now is that if you think that the continued depressed level of real economic activity is due to excess demand for safe assets, you really need evidence that the expenditure of households and businesses is limited by the unwillingness of investors to hold their liabilities, i.e. that they face credit constraints. And this credit card data is one more piece of evidence that they don’t. Which, among other things, makes it less likely that central bank interventions to remove risk from the balance sheets of the financial system will meaningfully boost  output and employment.

[1] For some reason, inquiries are given over the past six months while the other two series are given over the past year. This implies that about half of all inquiries result in a new account being opened. The important point for our purposes is that this fraction did not change at all during the financial crisis and recession.

[2] To be fair, you can also find this story in the General Theory — “unemployment develops because people want the moon,” etc. But it’s not the only story you can find there. And, I would argue, Keynes really intends this as a story of how downturns begin, and not why they persist.

[3] Yes, it would be more “correct” to use the BEA’s measure of potential output. But the results would be qualitatively very similar, and I don’t think there’s nearly enough precision in measures of potential output to make the few tenths of a point difference meaningful.

LATE UPDATE: Here is a similar graph for the previous recession & recovery.

IMF: Abolish the Debt!

Not exactly; you have to read between the lines a little.

People are talking about this new thing from the IMF, reviving the 1930s-era “Chicago plan” for 100% reserve banking. Red meat for the end-the-Fed crowd. The paper shares a coauthor, Michael Kumhof, with that other notable recent piece of IMF rabble-rousing, on how inequality is responsible for financial crises. Anyway, the Chicago plan. It was the brainchild of Herbert Simon Henry Simons and Irving Fisher:

The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.  

Fisher (1936) claimed four major advantages for this plan. First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations. Second, 100% reserve backing would completely eliminate bank runs. Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt. Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

Kumhof and his coauthor Jaromir Benes run through how such a thing would be implemented today, and then estimate its effects on output and prices in a DSGE model. (I don’t care about that second part.) My opinion: I don’t think this makes sense practically as a practical policy proposal or strategically as a political focal point. But it’s not crazy. I think it’s a useful thought experiment to clarify what we do and don’t need banks for, and I’m glad that some people around Occupy seem to be noticing and talking about it.


Though Kumhof and Benes don’t quite say so, this proposal should really be understood as addressing two distinct and separate problems:

1. Stabilization via monetary policy is constrained by the fact that its traditional tools have less purchase on private credit creation than they are imagined to or they used to, and not just at the ZLB. (As discussed repeatedly on this blog, e.g. these posts and this one.) So if the state wants to continue relying on monetary policy as its main countercyclical tool, we need to think about institutional changes that would strengthen the transmission mechanism.

2. If government liabilities are more liquid than the liabilities of even the biggest banks, as they certainly seem to be, then the banking system plays no function with respect to federal borrowing. The banks that hold federal debt are providing “anti-intermediation” — they are replacing more liquid assets with less liquid ones. In this sense, whatever income banks get from holding federal debt and providing means of payment are pure rents – it would be more efficient for federal liabilities to serve as means of payment directly.

The Chicago plan is the stone that is supposed to kill both these birds. I think it misses both, but in an intellectually productive way. In other words, it’s fun to think about.

The goal of the plan is to, in effect, collapse the categories of inside money, outside money and government debt by eliminating the first and turning the third into the second. Equivalently, it’s an attempt to legislate the economy into functioning the way monetarists (and some MMTers) say it already does, with a fixed money supply set by policy. You could think of it as another intervention in the centuries-old Currency School vs. Banking School debate — except that unlike most Currency School advocates over the past two centuries, Kumhof and Benes acknowledge that the Banking School is right about how existing financial systems operate, and that 100% reserves is not a return to some “natural” arrangement but a radical and far-reaching reform.

Why wouldn’t it work?

On the first goal, improving the reliability of stabilization policy, it’s important to recognize that deposits are not where the action is, and haven’t been for a long time. So 100% reserve backing of deposits is really the smallest piece of this thing. In effect, it’s a proposal to tighten the Fed’s handle on the narrow money supply — M1, in the jargon. but most means of payment in the economy aren’t captured by M1 — they don’t take the form of deposits, and haven’t for a long time. (In this respect things have really changed since 1936.) So it wouldn’t be enough to tighten the rules on deposit creation; you’d have to abolish (or impose the same reserve requirements on) all the other assets that serve as means of payment (and are more or less captured in M2 and formerly in M3), and prevent the financial system from developing new ones.

The proposal does do this, but it’s pretty draconian — under Kumhof and Benes’ plan “there is no lending at all between private agents.” As soon as you relax that restriction, the plan’s advantages in terms of stabilization go away. An absolute legal prohibition on IOUs might please Ezra Pound, but it’s hard to see it playing well among any of the IMF’s other constituencies. And the reality is if anything worse than that, because, as the Islamic world has been finding for 1,400 years now, it is very hard to legally distinguish debt contracts from other kinds of private contracts. So in practice you’d need an almost Soviet level of control over economic activity to realize something like this.

Perhaps I’m exaggerating the practical difficulties faced by the plan, but even if you could overcome them, it would only solve half the problem. The proposal only strengthens contractionary policy, not expansionary policy. It might have prevented the acceleration in credit creation in the 1980s and 1990s, but wouldn’t have done anything to boost credit creation and real activity in the past few years. It’s true that it would prevent the specific dynamic that Fisher (and later Friedman) blamed for the Depression, a positive feedback in a downturn between bank failures and a falling money supply. But that dynamic no longer exists, given deposit insurance and active countercyclical monetary policy, altho I suppose one could imagine it reappearing again in the future…

Part of the issue is whether you think lack of effective demand = lack of nominal effective demand = excess demand for money, by definition. This is the standard New Keynesian view, borrowed from monetarism. In this view a recession necessarily involves an insufficient money supply. But I don’t accept this. And once you accept that recessions involve multiple equilibria or coordination failures, there is no reason to think that increasing the supply of money must logically be a reliable way to get out of one, and lots of empirical evidence that it isn’t.

But even if the “Chicago plan” is not a workable solution to the breakdown of the monetary policy transmission mechanism, it’s a useful exercise. At the least, it calls attention to the fact that there is a breakdown — in a monetarist world, reforming the financial system to allow the central bank to control the money supply would be like legislating the law of gravity. Kumhof and Benes are clear that this proposal is only meaningful because under current arrangements, money is fully endogenous:

The critical feature of our theoretical model is that it exhibits the key function of banks in modern economies, which is not their largely incidental function as financial intermediaries between depositors and borrowers, but rather their central function as creators and destroyers of money. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending. This fact can be verified in the description of the money creation system in many central bank statements, and it is obvious to anybody who has ever lent money and created the resulting book entries.

(As a footnote tartly notes, that includes Kumhof, a former banker.)

So while the proposal doesn’t describe something you could actually do, it does help illuminate the current system of credit creation, via a sharply contrasting ideal alternative.

How about the second goal, eliminating the value-subtracting activity of banks “financing” government debt? Here I think they are onto something important. Interest is a payment for liquidity, as we’ve known since Keynes. So there is no economic reason for the government to pay interest to financial intermediaries when its own liabilities are the most liquid there are.

The problem here is, it’s not clear why, once you recognize this, you would stop at splitting of the payment system from credit creation. Why doesn’t the state provide means of payment directly? Whatever arguments there were for a state monopoly on money issue presumably don’t go away when money becomes electronic, so why isn’t there a public debit card just like there is federal currency? (This becomes really obvious when you look at the outright scams that happen when private businesses manage EBT cards, etc.) Of course there are people who want private currencies, but they are crazy libertarians. And yet without anyone accepting their arguments, we’ve implicitly gone along with them as the economy has moved toward electronic means of payment — every time you pay with a debit or credit card, some financial parasite takes their cut. The obvious solution is to end the private monopoly on means of payment. (What do want? Postal savings and a public payment system! When do we want them? Now!) Benes and Kumhof don’t go all the way there, but their plan is at least a step in that direction.

There’s a broader point here. Axel Leijonhufvud (among others) suggests that the fundamental reason there is a term premium (and at least part of the reason there is a liquidity premium) is that there is a chronic excess of long-term, illiquid assets in the form of physical capital, because of the technical superiority of roundabout production processes. That is, the time to maturity of the representative asset is longer than the horizon of the typical asset-holder. Thus the “constitutional weakness” (Hicks) at the long end of the credit market.

But if a larger proportion of the private economy’s outside assets are made up of government debt rather than physical capital, (and if a larger proportion of saving is done by institutions rather than households, tho that’s iffier) then this constitutional weakness goes away, and there’s no reason to have anyone collecting a fee for maturity transformation. Ashwin at Macroeconomic Resilience has written some very smart stuff about this.

Banks came into existence, in other words, in a world where most savers had a very high demand for liquidity, and most liabilities were risky and illiquid. So you needed someone to stand between, to intermediate. But today most saving is via institutional investors with long horizons — pensions etc. — or internal to the firm, while a very large proportion of borrowing is by sovereign governments, and so less risky/more liquid than anything banks can issue. In this world there’s no need for intermediaries in the old sense; they’re just rent-collecting parasites. This is not the way the “Chicago plan” is motivated but it seems like a not-bad way of making the point.


Third piece, the transition. How do you go to a 100%-reserve world without a huge contraction of credit and activity? Here their solution is kind of clever. If you look at US nonfinancial debt, they observe, total business and home mortgage debt together come to about $20 trillion, and total government and non-mortgage household debt also come to about $20 trillion. Only the former, which finances investment, is socially productive, they figure. Under the Chicago Plan, banks would need $20 trillion in new reserves to avoid reducing the investment-financing part of their lending. Where do those new reserves come from? By the central bank buying up and extinguishing the other, non-productive half of the debt. It’s the best-credentialed jubilee proposal you’re likely to see.

Of course banks are worse off because half their interest-earning assets are replaced with sterile reserves. But in the logic of the proposal, there’s no social cost to that, since the lost interest income was for value-substracting “anti-intermediation” (my phrase, not theirs) activity; it was the banks’ fee for substituting less liquid for more liquid assets. Strictly speaking,though, this only applies to government debt. It’s not clear what’s supposed to happen with the stuff the non-mortgage household debt was paying for. Some of it, like credit card debt, was incurred just incidentally to making payments, and would no longer be needed in a world with separate payment and credit systems. As for the rest, they don’t say. It would be logical to see it as mostly for essentials that are better provide publicly, financed by continued reserve issuance. But that would be, as somebody said, not just reading between the lines, but off the edge of the page.

Overall, I like it. A lot. Not because I think it’s a good policy proposal or even (probably) a useful focal point for political mobilization. In general, I think that one should avoid, even for rhetorical purposes, the presumption that economic policy is set by a benevolent philosopher-king (an assumption baked into standard macro models). Agreeing on how the banking system “should” function under some more or less implicit set of constraints will not get us a bit closer to a society fit for human beings. But politically, having paper from the IMF suggesting, even in this rather artificial way, that the simplest solution to excessive debt is just to abolish it, has got to be useful in the coming rising of the debtors. Intellectually, meanwhile, what I like about this is that it puts in sharp relief how little the existing financial system can be explained, as it usually is, as the solution to the economic problems of intermediation and liquidity provision. If the functions banks are supposedly performing could be performed much more efficiently and easily without them, then banks must really be for something else.

EDIT: Oh and also, I’ve got to quote this bit:

Any debate on the origins of money is not of merely academic interest, because it leads directly to a debate on the nature of money, which in turn has a critical bearing on arguments as to who should control the issuance of money. … Since the thirteenth century [the] precious-metals-based system has, in Europe, been accompanied, and increasingly supplanted, by the private issuance of bank money, more properly called credit. On the other hand, the historically and anthropologically correct state/institutional story for the origins of money is one of the arguments supporting the government issuance and control of money under the rule of law. In practice this has mainly taken the form of interest-free issuance of notes or coins, although it could equally take the form of electronic deposits. 

There is another issue that tends to get confused with the much more fundamental debate concerning the control over the issuance of money, namely the debate over “real” precious-metals-backed money versus fiat money. … this debate is mostly a diversion, because even during historical regimes based on precious metals the main reason for the high relative value of precious metals was … government fiat and not the intrinsic qualities of the metals.These matters are especially confused in Smith (1776), who takes a primitive commodity view of money… 

The historical debate concerning the nature and control of money is the subject of Zarlenga (2002), a masterful work that traces this debate back to ancient Mesopotamia, Greece and Rome. Like Graeber (2011), he shows that private issuance of money has repeatedly led to major societal problems throughout recorded history, due to usury associated with private debts. Zarlenga does not adopt the common but simplistic definition of usury as the charging of “excessive interest”, but rather as “taking something for nothing” through the calculated misuse of a nation’s money system for private gain.

This is a really smart passage for a bunch of reasons. But what I really like about it is that it vindicates my position in the great Graeber debate on about three different levels. Take that, Mike Beggs!

Graeber Cycles and the Wicksellian Judgment Day

So it’s halfway through the semester, and I’m looking over the midterms. Good news: Learning has taken place.

One of the things you hope students learn in a course like this is that money consists of three things: demand deposits (checking accounts and the like), currency and bank reserves. The first is a liability of private banks, the latter two are liabilities of the central bank. That money is always someone’s liability — a debt — is often a hard thing for students to get their heads around, so one can end up teaching it a bit catechistically. Balance sheets, with their absolute (except for the exceptions) and seemingly arbitrary rules, can feel a bit like religious formula. On this test, the question about the definition of money was one of the few that didn’t require students to think.

But when you do think about it, it’s a very strange thing. What we teach as just a fact about the world, is really the product of — or rather, a moment in — a very specific historical evolution. We are lumping together two very different kinds of “money.” Currency looks like classical money, like gold; but demand deposits do not. The most obvious difference, at least in the context of macroeconomics, is that one is exogenous (or set by policy) and the other endogenous. We paper this over by talking about reserve requirements, which allow the central bank to set “the” money supply to determine “the” interest rate. But everyone knows that reserve requirements are a dead letter and have been for decades, probably. While monetarists like Nick Rowe insist that there’s something special about currency — they have to, given the logic of their theories — in the real world the link between the “money” issued by central banks and the “money” that matters for the economy has attenuated to imperceptible gossamer, if it hasn’t been severed entirely. The best explanation for how conventional monetary policy works today is pure convention: With the supply of money entirely in the hands of private banks, policy is effective only because market participants expect it to be effective.

In other words, central banks today are like the Chinese emperor Wang Wei-Shao in the mid-1960s film Genghis Khan:

One of the film’s early scenes shows the exquisitely attired emperor, calligraphy brush in hand, elegantly composing a poem. With an ethereal self-assurace born of unquestioning confidence in the divinely ordained course of worldly affairs, he explains that the poem’s purpose is to express his displeasure at the Mongol barbarians who have lately been creating a disturbance on the empire’s western frontier, and, by so doing, cause them to desist.  

Today expressions of intentions by leaders of the world’s major central banks typically have immediate repercussions in financial markets… Central bankers’ public utterances … regularly move prices and yields in the financial markets, and these financial variables in turn affect non-financial economic activity… Indeed, a widely shared opinion today is that central bank need not actually do anything. … 

In truth the ability of central banks to affect the evolution of prices and output … [is] something of a mystery. … Each [explanation of their influence] … turns out to depend on one or another of a series of by now familiar fictions: households and firms need currency to purchase goods and services; banks can issue only reserve-bearing liabilities; no non-bank financial institutions create credit; and so on. 

… at a practical level, there is today [1999] little doubt that a country’s monetary policy not only can but does largely determine the evolution of its price level…, and almost as little doubt that monetary policy exerts significant influence over … employment and output… Circumstances change over time, however, and when they do the fictions that once described matters adequately may no longer do so. … There may well have been a time when the might of the Chinese empire was such that the mere suggestion of willingness to use it was sufficient to make potential invaders withdraw.

What looked potential a dozen years ago is now actual, if it wasn’t already then. It’s impossible to tell any sensible macroeconomic story that hinges on the quantity of outside money. The shift in our language from  money, which can be measured — that one could formulate a “quantity theory” of  — to discussions of liquidity, still a noun but now not a tangible thing but a property that adheres in different assets to different degrees, is a key diagnostic. And liquidity is a result of the operations of the financial system, not a feature of the natural world or a dial that can be set by the central bank. In 1820 or 1960 or arguably even in 1990 you could tell a kind of monetarist story that had some purchase on reality. Not today. But, and this is my point! it’s not a simple before and after story. Because, not in 1890 either.

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. (Graeber’s idiolect is money and debt; let’s use here the standard terms.) The former is anonymous, universal and disembedded, corresponds to centralized states and extensive warfare, and develops alongside those other great institutions for separating people from their social contexts, slavery and bureaucracy. [2] Credit, by contrast, is personal, particular, and unavoidably connected with specific relationships and obligations; it corresponds to decentralized, heterogeneous forms of authority. The alternations between commodity-money systems,with their transcendental, monotheistic religious-philosophical superstructures; and credit systems, with their eclectic, immanent, pantheistic superstructures, is, in my opinion, the heart of Debt. (The contrast between medieval Christianity, with its endless mediations by saints and relics and the letters of Christ’s name, and modern Christianity, with just you and the unknowable Divine, is paradigmatic.) Alternations not cycles, since there is no theory of the transition; probably just as well.

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. (h/t David Glasner, I think Ashwin at Macroeconomic Resilience.) 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. But this didn’t look like an acceptable solution before World War II. For economists then — for any reasonable person — a trajectory of the price level toward infinity was an obvious absurdity that would inevitably come to a halt, disastrously if followed too far. Whereas today, that trajectory is the precise definition of price stability, that is, stable inflation. [4] Wicksell was part of an economics profession that saw explaining the price level as a, maybe the, key task; but he had no doubt that the trend was toward an ever-diminishing role for gold, at least domestically, leaving the money supply in the hands of the banks and the price level frighteningly unmoored.

Wicksell was right. Or at least, he was right when he wrote, a bit before 1900. But a funny thing happened on the way to the world of pure credit money. Thanks to new government controls on the banking system, the trend stopped and even reversed. Leijonhufvud:

Wicksell’s “Day of Judgment” when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death [in 1926]. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system’s total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.

But although Judgment Day was postponed it was not cancelled. … The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, “smart cards” are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting. “Reserve requirements already are becoming a dead issue.”

The second bolded sentence makes a nice point. Milton Friedman and his followers are regarded as opponents of regulation, supporters of laissez-faire, etc. But to the extent that the theory behind monetarism ever had any validity (or still has any validity in its present guises) it is precisely because of strict government control over credit creation. It’s an irony that textbooks gloss over when they treat binding reserve requirements and the money multiplier as if they were facts of nature.

(That’s more traditional textbooks. Newer textbooks replace the obsolete story that the central bank controls interest rates by setting the money supply with a new story that the central bank sets the interest rate by … look, it just does, ok? Formally this is represented by replacing the old upward sloping LM curve with a horizontal MP (for monetary policy) line at the interest rate chosen by the central bank. The old story was artificial and, with respect to recent decades, basically wrong, but it did have the virtue of recognizing that the interest rate is determined in financial markets, and that monetary policy has to operate by changing the supply of liquidity. In the up-to-date modern version, policy might just as well operate by calligraphy.)

So, in the two centuries since Heinrich van Storch lectured the young Grand Dukes of Russia on the economic importance of “precious metals and fine jewels,” capitalism has gone through two full Graeber cycles, from commodity money to credit money, back to (pseudo-)commodity money and now to credit money again. It’s a process that proceeds unevenly; both the reality and the theory of money are uncomfortable hybrids of the two. But reality has advanced further toward the pure credit pole than theory has.

This time, will it make it all the way? Is Leijonhufvud right to suggest that Wicksell’s Day of Judgment was deferred but not canceled, and now is at hand?

Certainly the impotence of conventional monetary policy even before the crisis is a serious omen. And it’s hard to imagine a breakdown of the credit system that would force a return to commodity money, as in, say, medieval China. But on the other hand, it is not hard to imagine a reassertion of the public monopoly on means of payment. Indeed, when you think about it, it’s hard to understand why this monopoly was ever abandoned. The practical advantages of smart cards over paper tokens are undeniable, but there’s no reason that the cards shouldn’t have been public goods just like the tokens were. (For Graeber’s spiritual forefather Karl Polanyi, money, along with land and labor, was one of the core social institutions that could not be treated as commodities without destroying the social fabric.) The evolution of electronic money from credit cards looks contingent, not foreordained. Credit cards are only one of several widely-used electronic means of payment, and there’s no obvious reason why they and not one of the ones issued by public entities should have been adopted universally. This is, after all, an area with extremely strong network externalities, where lock-in is likely. Indeed, in the Benjamin Friedman article quoted above, he explicitly suggests that subway cards issued by the MTA could just as easily have developed into the universal means of payment. After all, the “pay community” of subway riders in New York is even more extensive than the pay community of taxpayers, and there was probably a period in the 1990s when more people had subway cards in their wallets than had credit or debit cards. What’s more, the MTA actually experimented with distributing subway card-reading machines to retailers to allow the cards to be used like, well, money. The experiment was eventually abandoned, but there doesn’t seem to be any reason why it couldn’t have succeeded; even today, with debit/credit cards much more widespread than two decades ago, many campuses find it advantageous to use college-issued smart cards as a kind of local currency.

These issues were touched on in the debate around interchange fees that rocked the econosphere a while back. (Why do checks settle at par — what I pay is exactly what you get — but debit and credit card transactions do not? Should we care?) But that discussion, while useful, could hardly resolve the deeper question: Why have we allowed means of payment to move from being a public good to a private oligopoly? In the not too distant past, if I wanted to give you some money and you wanted to give me a good or service, we didn’t have to pay any third party for permission to make the trade. Now, most of the time, we do. And the payments are not small; monetarists used to (still do?) go on about the “shoe leather costs” of holding more cash as a serious reason to worry about inflation, but no sane person could imagine those costs could come close to five percent of retail spending. And that’s not counting the inefficiencies. This is a private sales tax that we allow to be levied on almost every transaction,  just as distortionary and just as regressive as other sales taxes but without the benefit of, you know, funding public services. The more one thinks about it, the stranger it seems. Why, of all the expansions of public goods and collective provision won over the past 100 or 200 years, is this the one big one that has been rolled back? Why has this act of enclosure apparently not even been noticed, let alone debated? Why has the modern equivalent of minting coinage — the prerogative of sovereigns for as long as there’ve been any — been allowed to pass into the hands of Visa and MasterCard, with neoliberal regimes not just allowing but actively encouraging it?

The view of the mainstream — which in this case stretches well to the left of Krugman and DeLong, and on the right to everyone this side of Ron Paul — is that, whatever the causes of the crisis and however the authorities should or do respond, eventually we will return to the status quo ante. Conventional monetary policy may not be effective now, but there’s no reason to doubt that it will one day get back to so being. I’m not so sure. I think people underestimate the extent to which modern central banking depended on a public monopoly on means of payment, a monopoly that arose — was established — historically, and has now been allowed to lapse. Christina Romer’s Berkeley speech on the glorious counterrevolution in macroeconomic policy may not have been anti-perfectly timed just because it was given months before the beginning of the worst recession in 70 years, but because it marked the end of the period in which the body of theory and policy that she was extolling applied.

[1] Information wants to be free. If there’s a free downloadable version of a book out there, that’s what I’m going to link to. But assuming some bank has demand deposits payable to you on the liability side of its balance sheet (i.e. you’ve got the money), this is a book you ought to buy.

[2] In pre-modern societies a slave is simply someone all of whose kinship ties have been extinguished, and is therefore attached only to the household of his/her master. They were not necessarily low in status or living standards, and they weren’t distinguished by being personally subordinated to somebody, since everyone was. And slavery certainly cannot be defined as a person being property, since, as Graeber shows, private property as we know it is simply a generalization of the law of slavery.

[3] A point also emphasized by Robert Triffin in his essential paper Myths and Realities of the So-Called Gold Standard.

[4] Which is a cautionary tale for anyone who thinks the fact that an economic process that involves some ratio diverging to infinity is by defintion unsustainable. Physiocrats thought a trajectory of the farming share of the population toward zeo was an absolute absurdity and that in practice it could certaily not fall below half. They were wrong; and more generally, capitalism is not an equilibrium process. There may be seven unsustainable processes out there, or even more, but you cannot show it simply by noting that the trend of some ratio will take it outside its historic range.

UPDATE: Nick Rowe has a kind of response which, while I don’t agree with it, lays out the case against regarding money as a liability very clearly. I have a long comment there, of which the tl;dr is that we should be thinking — both logically and chronologically — of central bank money evolving from private debt contracts, not from gold currency. I don’t know if Nick read the Leijonhufvud piece I quote here, but the point that it makes is that writing 100-odd years ago, Wicksell started from exactly the position Nick takes now, and then observed how it breaks down with modern (even 1900-era modern) financial systems.

Also, the comments below are exceptionally good; anyone who read this post should definitely read the comments as well.

Are Wages Too High?

Here’s a good one for the right-for-the-wrong-reasons file.

David Glasner is one of an increasing number of Fed critics who would like to see a higher inflation target. Today, he takes aim at a Wall Street Journal editorial that claims that the real victims of cheaper money wouldn’t be, you know, people who own money — creditors — as one might think, but working people. Higher inflation just means lower real wages, says the Journal. Crocodile tears, says Glasner — since when does the Journal care about wage workers? So far, so good, says me.

“What makes this argument so disreputable,”he goes on,

is not just the obviously insincere pretense of concern for the welfare of the working class, but the dishonest implication that employment in a recession or depression can be increased without an, at least temporary, reduction in real wages. Rising unemployment during a contraction implies that real wages are, in some sense, too high, so that a falling real wage tends to be a characteristic of any recovery, at least in its early stages. The only question is whether the falling real wage is brought about through prices rising faster than wages or by wages falling faster than prices. If the Wall Street Journal and other opponents of rising prices don’t want prices to erode real wages, they are ipso facto in favor of falling money wages.

And here we have taken a serious wrong turn.

Glasner is certainly not alone in thinking that rising prices are associated with falling real wages, and vice versa. And he’s also got plenty of company in his belief that since the wage is equal to the marginal product of labor, and marginal products should decline, in the short run higher employment implies a lower real wage. But is he right? Is it true that if employment is to rise, “the only question” is whether wages fall directly or via inflation? Is it true that unemployment necessarily means that wages are too high?

Empirically, it seems questionable. Let’s look at unemployment and wages in the past few decades in the United States. The graph below shows the real hourly wage on the x-axis and the unemployment rate on the y-axis. The red dots show the two years after the peak of unemployment in each of the past five recessions. If reducing unemployment always required lower real wages, the red dots should consistently make upward sloping lines. The real picture, though, is more complicated.

As we can see, the early 2000s recovery and, arguably, the early 1980s recovery were associated with falling real wages. but in the early 1990s, employment recovered with constant real wages — that’s what the vertical line over on the left means. And in the two recessions of the 1970s, the recoveries combined falling unemployment with strongly rising real wages. If we look at other advanced countries, it’s this last pattern we see most often. (I show some examples after the fold.) So while rising employment is sometimes accompanied by a falling real wage, it is clearly not true that, as Glasner claims, it necessarily must be.

This is an important question to get straight. There seems to be a certain convergence happening between progressive-liberal economists and neo-monetarists like Glasner on the desirability of higher inflation in general and nominal GDP targeting in particular. There’s something to be said for this; inflation is the course of least resistance to cancel the debts. But we in the party of movement can’t support this idea or make it part of a broader popular economic program if it’s really a stalking horse for lower wages.

Fortunately, the macroeconomic benefits of a rising price level don’t depend on a falling real wage.
More broadly, the idea that reducing unemployment necessarily means reducing wages doesn’t hold up. It’s wrong empirically, and it involves a basic misunderstanding of what’s going on in recessions.

Yes, labor is idle in a recession, but does that mean its price, the wage, is too high? There is also more excess capacity in the capital stock in a recession; by the same logic, that would mean profits are too high. Real estate vacancy rates are high in a recession, so rents must also be too high. In fact, every factor of production is underutilized in recessions, but it’s logically impossible for the relative price of all factors to be too high. A shortfall in demand for output as a whole (or excess demand for the means of payment, if you’re a monetarist) doesn’t tell us anything about whether relative prices are out of line, or in which direction. If we were seeing technological unemployment — people thrown out of work by the adoption of more capital-intensive forms of production — then there might be something to the statement that “unemployment … implies that real wages are, in some sense, too high.” But that’s not what we see in recessions at all.

Glasner is hardly the only one who thinks that unemployment must somehow involve excessive wages. If he were, he’d hardly be worth arguing with. It’s a common view today, and it was even more common before World War II. Glasner quotes Mises (yikes!), but Schumpeter said the same thing. More interestingly, so did Keynes. In Chapter Two of the General Theory, he announces that he is not challenging what he calls the first postulate of the classical theory of employment, that the wage is equal to the marginal product of labor. And he draws the same conclusion from this that Glasner does:

with a given organisation, equipment and technique, real wages and the volume of output (and hence of employment) are uniquely correlated, so that, in general, an increase in employment can only occur to the accompaniment of a decline in the rate of real wages. Thus I am not disputing this vital fact which the classical economists have (rightly) asserted… [that] the real wage earned by a unit of labour has a unique (inverse) correlation with the volume of employment. Thus if employment increases, then, in the short period, the reward per unit of labour in terms of wage-goods must, in general, decline… This is simply the obverse of the familiar proposition that industry is normally working subject to decreasing returns… So long, indeed, as this proposition holds, any means of increasing employment must lead at the same time to a diminution of the marginal product and hence of the rate of wages measured in terms of this product.

So, wait, if Keynes says it then it can’t be a basic misunderstanding of the principle of aggregate demand, can it? Well, here’s where things get interesting.

Keynes didn’t participate much in the academic discussions following the The General Theory; the last decade of his life was taken up with practical policy work. (As Hyman Minsky observed, this may be one reason why many of his more profound ideas never made into postwar Keynesianism.) But he take part in a discussion in the pages of the Quarterly Journal of Economics, in which the “most important” contribution, per Keynes, was from Jacob Viner, who zeroed in on exactly this question. Viner:

Keynes’ reasoning points obviously to the superiority of inflationary remedies for unemployment over money-wage reductions. … there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead…  [But] Keynes follows the classical doctrine too closely when he concedes that “an increase in employment can only occur to the accompaniment of a decline in the rate of real wages.” This conclusion results from too unqualified an application of law-of-diminishing-returns analysis, and needs to be modified for cyclical unemployment… If a plant geared to work at say 80 per cent of rated capacity is being operated at say only 30 per cent, both the per capita and the marginal output of labor may well be lower at the low rate of operations than at the higher rate, the law of diminishing returns notwithstanding. There is the further empirical consideration that if employers operate in their wage policy in accordance with marginal cost analysis, it is done only imperfectly and unconsciously…

Viner makes two key points here: First, it is not necessarily the case that the marginal product of labor declines with output, especially in a recession or depression when businesses are producing well below capacity. And second, the assumption that wages are equal to marginal product is not a safe one. A third criticism came from Kalecki, that under imperfect competition firms would not set price equal to marginal cost but at some markup above it, a markup that will vary over the course of the business cycle. Keynes fully agreed that all three criticisms — along with some others, which seem less central to me — were correct, and that the first classical postulate was no better grounded than the second. In what I believe was his last substantive economic publication, a 1939 article in the Economic Journal, he returned to the question, showing that it was not true empirically that real wage fall when employment rises and exploring why he and other economists had gotten this wrong. The claim that higher employment must be accommpanied by a lower real wage, he wrote, “is the portion of my book which most needs to be revised.” Indeed, it was the only substantive modification of the argument of the General Theory that he made in his lifetime.

I bring all this up because — well, partly just because I think it’s interesting. But it’s worth being reminded, how much of our current economic debate is  recapitulating what people were figuring out in the 1930s. And it’s interesting to see how just how seductive is the idea that high unemployment means that “real wages are, in some sense, too high.” Even Keynes had to be talked out of it, even though it runs counter to the logic of his whole system, and even though there’s no good theoretical or empirical reason to believe it’s true.

Right, back to empirics. Here are a few more graphs, showing, like the US one above, unemployment on the vertical axis and real hourly wages on the horizontal. Data is from the OECD.

The first picture shows five Western European countries in the decade before the crisis. The important part is the left side; what you see there is that in all five countries unemployment fell sharply in the late 90s/early 2000s, even while real wages increased. In Belgium, for example, unemployment fell from 10 percent to a bit over six percent between 1996 and 2002, at the same time as real wages rose by close to 10 percent. The other four (and almost every country in the EU) show similar patterns.

The second one shows Korea. The 1997 Asian crisis is clearly visible here as the huge spike in unemployment in the middle of the graph. But what’s relevant here is the way it seems to slope backward. That’s because real wages fell along with employment in the crisis, and rose with employment in the recovery. Over the same period that unemployment comes back down from 8 to 4 percent, the real wage index rises from 70 to 80. This is the opposite of what we would expect in the Glasner story.

The third one shows Australia and New Zealand. Australia shows two periods of sharply falling unemployment — one in the 1980s accompanied by flat wages (a vertical line) and one in the 1990s accompanied by rising wages. Of all these countries, only New Zealand’s recoveries show a pattern of falling unemployment accompanied by falling real wages — clearly after 1992, and for a quarter or two in 2000.

You may object that these are mostly small open economies. So while the real wage is deflated by the domestic price level, the real question is whether labor costs are rising or falling relative to trade partners. If employment and wages are rising together, that probably just means the currency is depreciating. I don’t think this is true either. Countries often improve their trade balance even when real wages as measured in a common currency are rising, and conversely. That’s “Kaldor’s paradox” — countries with persistently strengthening trade balances tend to be precisely those with rising relative labor costs. But that will have to wait for a future post.

UPDATE: In comments, Will Boisvert calls the graphs above the worst he’s ever seen. OK!

So, here is the same data presented in a hopefully more legible way. The red line is unemployment, the blue line is the real hourly wage. The key question is, when the red line is falling from a peak, is the blue line falling too, or at least decelerating? And the answer, as above, is: Sometimes, but not usually. There is nothing dishonest in the claim that, in a recession, unemployment can be reduced without a decline in the real wage.

What’s the Matter with (Quasi-)Monetarism?

Let’s start from the top.

What is monetarism? As I see it, it’s a set of three claims. (1) There is a stable relationship between base money and the economically-relevant stock of money. [1] That is, there’s a stable relationship between outside money and inside money. (2) There is a stable velocity of money, so we can interpret the equation of exchange MV = PY (or MV = PT) as a behavioral relationship and not just an accounting identity. Since the first claim says that M is set exogenously by the monetary authority, causality in the equation runs from left to right. And (3), the LM aggregate supply curve is shaped like a backward L, so that changes in PY show up entire in Y when the economy is below capacity, and entirely in changes in P when it is at capacity.

In other words, (1) the central bank can control the supply of money; (2) the supply of money determines the level of nominal output; and (3) there is a single strictly optimal level of nominal output, without any tradeoffs. The implication is that monetary policy should be guided by a simple rule, that the money supply should grow at a fixed rate equal to (what we think is) the growth rate of potential output. Which is indeed, exactly what Friedman and other monetarists said.

You can relax (3) if you want — most monetarists would probably agree that in practice, disinflation is going to involve a period of depressed output. (Altho on the other hand, I’m pretty sure that when monetarism was officially adopted as the doctrine of the bank of England under Thatcher, it was claimed that slowing the growth of the money supply would control inflation without affecting growth at all. And the hedge-monetarism you run into today, that insists the huge growth in base money over the past few years could show up as hyperinflation without warning, seems to be implicitly assuming a backward-L shaped LM AS curve as well.) But basically, that’s the monetarist package.

So what’s wrong with this story? Here’s what:

The red line is base money, the blue line is broad money (M2), and the green line is nominal GDP. The monetarist story is that red moves blue, and blue moves green. Between 1990 and 2008, this story isn’t glaringly incompatible with the evidence. But since then? It’s clear that the money multiplier, as we normally talk about it, no longer has any economic reality. There might still be tools out there to control the money supply. But changing the stock of base money — the instrument of central banks, at least in theory, since the early 20th century — is no longer one of them. Monetary policy as we knew it is dead. The divergence between the blue and green lines is less dramatic in this graph, but if anything it’s even more damning. While output and prices lurched downward in the great Recession, the money supply just kept chugging along. Milton Friedman’s idea that stable growth of the money supply is a sufficient condition for stable growth of nominal GDP looks pretty definitively refuted.

So that’s monetarism, and what’s the matter with it. How about quasi-monetarism? What’s the difference from the unprefixed kind?

Some people would say, There is no difference. Quasi-monetarist is just what we call a New Keynesian who’s taken off his Keynes mask and admitted he was a Friedmanite all along. And let’s be honest, that’s sort of true. But it’s like one of those episodes in religious history where at some point the disciples have to acknowledge that, ok, the prophecies don’t seem to have exactly worked out. Which means we have to figure out what they really meant.

In this case, the core commitment is the idea that if PY is too low (we’re experiencing a recession and/or deflation) that means M is too low; if PY is too high (we’re experiencing inflation) that means M is too high. In other words, when we talk about insufficient aggregate demand, what we’re really talking about is just excess demand for money. And therefore, when we talk about policies to boost demand, we’re really just talking about policies to boost the money stock. (Nick Rowe, as usual, is admirably straightforward on this point.) But how to reconcile this with the graph above? You just have to replace some material entities with spiritual ones: The true M, or V, or both, is not visible to mortal eyes. Let’s say that velocity is exogenous but not stable. Then there is still a unique path of M that would guarantee both full employment and stable prices, but it can’t be characterized as a simple growth rate as Friedman hoped. Alternatively, maybe the problem is that the monetary authority can only control M clumsily, and can’t directly observe how far off it is. (This is the DeLong version of quasi-monetarism. The assets that count as M are always changing.) Then, there may still be the One True Growth Rate of M just as Friedman promised, but the monetary authority can’t reliably implement it. Or sublunary M and V could both depart from their platonic ideals. In any case, the answer is clear: Since it’s hard to get MV right, your rule should be to target a steady growth rate of PY (nominal GDP). Which is, indeed, exactly what the quasi-monetarists say. [2]

So what’s the alternative? I’ve been arguing that one alternative is to think of recessions as coordination failures, which could happen even in an economy without money. I’m honestly not sure if that’s going to turn out to be a productive direction to go in, or not. But in terms of the monetarist framework, the alternative is clear. Say that V is not only unstable, but endogenous. Specifically, say that it varies inversely with M. In this case, it remains true — as it must; it’s an accounting identity — that MV = PY. But nonetheless there is nothing you can do to M, that will affect P or Y. (This situation, by the way, is what Keynes meant by a liquidity trap. It wasn’t about the zero lower bound.)

This, I think, is what we actually observe, not just right now, but in general. “The” interest rate is the price of liquidity, that is, the price of money. [3] And what kinds of activity are sensitive to interest rates? Well, uh … none of them. None, anyway, except for housing. When an economic unit is deciding on the division of its income between currently-produced goods and services vs. money, the price at which they exchange just doesn’t seem to be much of a consideration. (Again, except — and it’s an important exception — when the decision takes the form of purchasing housing services from either an existing home, or a new one.) Which means that changes in M don’t have any good channel to produce changes in P or Y. In general, increases or decreases in M will just result in pro rata decreases or increases in V. Yes, it may be formally true that insufficient demand for goods equals excess demand for money; but it doesn’t matter if there’s no well-defined money demand function. A traditional Keynesian expenditure function (Z = A + cY) cannot be usefully simplified, as the quasi-monetarists would like, by thinking of it as a problem of maximizing the flow of consumption subject to some real balance constraint.

So, monetarism made some strong predictions. Quasi-monetarism admits that those predictions don’t hold up, but argues that the monetarist model is still the right one, we just can’t observe the variables in it as directly as early monetarists hoped. On some level, they may be right! But at some point, when the model gets too loosely coupled with reality, you’ll want to stop using it. Even if, in some sense, it isn’t wrong.

Which is all to say that, even if I can’t find a way to disprove it analytically, I just can’t accept the idea that the question of aggregate demand can be usefully reduced to the question of the supply of money.

[1] The simplest form of the first claim would be that the money multiplier is equal to one: Outside money is all the money there is. Something like this was supposed to be true under the gold standard, tho as the great Robert Triffin points out, it wasn’t really. Over at Windyanabasis, rsj claims that Krugman, a closet quasi-monetarist, implicitly makes this assumption.

[2] In practice, despite the tone of this post, I’m not entirely sure they’re wrong. More generally, Nick Rowe’s clear and thorough posts on this set of questions are essential reading.

[3] I’ve learned from  Bob Pollin never to write that phrase without the quotes. There are lots of interest rates, and it matters.

Are Recessions All About Money: Quasi-Monetarists and Babysitting Co-ops

Today Paul Krugman takes up the question of the post below, are recessions all about (excess demand for) money? The post is in response to an interesting criticism by Henry Kaspar of what Kaspar calls “quasi-monetarists,” a useful term. Let me rephrase Kaspar’s summary of the quasi-monetarist position [1]:

1. Logically, insufficient demand for goods implies excess demand for money, and vice versa.
2. Causally, excess demand for money (i.e. an increase in liquidity preference or a fall in the money supply) is what leads to insufficient demand for goods.
3. The solution is for the monetary authority to increase the supply of money.

Quasi-monetarists say that 2 is true and 3 follows from it. Kaspar says that 2 doesn’t imply 3, and anyway both are false. And Krugman says that 3 is false because of the zero lower bound, and it doesn’t matter if 2 is true, since asking for “the” cause of the crisis is a fool’s errand. But everyone agrees on 1.

Me, though, I have doubts.


An overall shortfall of demand, in which people just don’t want to buy enough goods to maintain full employment, can only happen in a monetary economy; it’s correct to say that what’s happening in such a situation is that people are trying to hoard money instead (which is the moral of the story of the baby-sitting coop). And this problem can ordinarily be solved by simply providing more money.

For those who don’t know it, Krugman’s baby-sitting co-op story is about a group that let members “sell” baby-sitting services to each other in return for tokens, which they could redeem later when they needed baby-sitting themselves. The problem was, too many people wanted to save up tokens, meaning nobody would use them to buy baby-sitting and the system was falling apart. Then someone realizes the answer is to increase the number of tokens, and the whole system runs smoothly again. It’s a great story, one of the rare cases where Keynesian conclusions can be drawn by analogizing the macroeconomy to everyday experience. But I’m not convinced that the fact that demand constraints can arise from money-hoarding, means that they always necessarily do.

Let’s think of the baby-sitting co-op again, but now as a barter economy. Every baby-sitting contract involves two households [2] committing to baby-sit for each other (on different nights, obviously). Unlike in Krugman’s case, there’s no scrip; the only way to consume baby-sitting services is to simultaneously agree to produce them at a given date. Can there be a problem of aggregate demand in this barter economy. Krugman says no; there are plenty of passages where Keynes seems to say no too. But I say, sure, why not?

Let’s assume that participants in the co-op decide each period whether or not to submit an offer, consisting of the nights they’d like to go out and the nights they’re available to baby-sit. Whether or not a transaction takes place depends, of course, on whether some other participant has submitted an offer with corresponding nights to baby-sit and go out. Let’s call the expected probability of an offer succeeding p. However, there’s a cost to submitting an offer: because it takes time, because it’s inconvenient, or just because, as Janet Malcolm says, it isn’t pleasant for a grown man or woman to ask for something when there’s a possibility of being refused. Call the cost c. And, the net benefit from fulfilling a contract — that is, the enjoyment of going out baby-free less the annoyance of a night babysitting — we’ll call U.

So someone will make an offer only when U > c/p. (If say, there is a fifty-fifty chance that an offer will result in a deal, then the benefit from a contract must be at least twice the cost of an offer, since on average you will make two offers for eve contract.) But the problem is, p depends on the behavior of other participants. The more people who are making offers, the greater the chance that any given offer will encounter a matching one and a deal will take place.

It’s easy to show that this system can have multiple, demand-determined equilibria, even though it is a pure barter economy. Let’s call p* the true probability of an offer succeeding; p* isn’t known to the participants, who instead form p by some kind of backward-looking expectations looking at the proportion of their own offers that have succeeded or failed recently. Let’s assume for simplicity that p* is simply equal to the proportion of participants who make offers in any given week. Let’s set c = 2. And let’s say that every week, participants are interested in a sitter one night. In half those weeks, they really want it (U = 6) and in the other half, they’d kind of like it (U = 3). If everybody makes offers only when they really need a sitter, then p = 0.5, meaning half the contracts are fulfilled, giving an expected utility per offer of 2. Since the expected utility from making an offer on a night you only kind of want a sitter is – 1, nobody tries to make offers for those nights, and the equilibrium is stable. On the other hand, if people make offers on both the must-go-out and could-go-out nights, then p = 1, so all the offers have positive expected utility. That equilibrium is stable too. In the first equilibrium, total output is 1 util per participant per week, in the second it’s 2.5.

Now suppose you are stuck in the low equilibrium. How can you get to the high one? Not by increasing the supply of money — there’s no money in the system. And not by changing prices — the price of a night of baby-sitting, in units of nights of baby-sitting, can’t be anything but one. But suppose half the population decided they really wanted to go out every week. Now p* rises to 3/4, and over time, as people observe more of their offers succeeding, p rises toward 3/4 as well. And once p crosses 2/3, offers on the kind-of-want-to-go-out nights have positive expected utility, so people start making offers for those nights as well, so p* rises further, toward one. At that point, even if the underlying demand functions go back to their original form, with a must-go-out night only every other week, the new high-output equilibrium will be stable.

As with any model, of course, the formal properties are less interesting in themselves than for what they illuminate in the real world. Is the Krugman token-shortage model or my pure coordination failure model a better heuristic for understanding recessions in the real world? That’s a hard question!

Hopefully I’ll offer some arguments on that question soon. But I do want to make one logical point first, the same as in the last post but perhaps clearer now. The statement “if there is insufficient demand for currently produced goods, there must excess be demand for money” may look quite similar to the statement “if current output is limited by demand, there must be excess demand for money.” But they’re really quite different; and while the first must be true in some sense, the second, as my hypothetical babysitting co-op shows, is not true at all. As Bruce Wilder suggests in comments, the first version is relevant to acute crises, while the second may be more relevant to prolonged periods of depressed output. But I don’t think either Krugman, Kaspar or the quasi-monetarists make the distinction clearly.

EDIT: Thanks to anonymous commenter for a couple typo corrections, one of them important. Crowd-sourced editing is the best.

Also, you could think of my babysitting example as similar to a Keynesian Cross, which we normally think of as the accounting identity that expenditure equals output, Z = Y, plus the behavioral equation for expenditure, Z = A + cY, except here with A = 0 and c = 1. In that case any level of output is an equilibrium. This is quasi-monetarist Nick Rowe’s idea, but he seems to be OK with my interpretation of it.

FURTHER EDIT: Nick Rowe has a very thoughtful response here. And my new favorite econ blogger, the mysterious rsj, has a very good discussion of these same questions here. Hopefully there’ll be some responses here to both, soonish.

[1] Something about typing this sentence reminds me unavoidably of Lucky Jim. This what neglected topic? This strangely what topic? Summary of the quasi-what?

[2] Can’t help being bugged a little by the way Krugman always refers to the participants as “couples,” even if they mostly were. There are all kinds of families!