history of thought – J. W. Mason

Taking Money Seriously

(Text of a talk I delivered at the Watson Institute for International and Public Affairs at Brown University on June 17, 2024.)

There is an odd dual quality to the world around us.

Consider a building. It has one, two or many stories; it’s made of wood, brick or steel; heated with oil or gas; with doors, windows and so on. If you could disassemble the building you could make a precise quantitative description of it — so many bricks, so much length of wire and pipe, so many tiles and panes of glass.

A building also has a second set of characteristics, that are not visible to the senses. Every building has an owner, who has more or less exclusive rights to the use of it. It has a price, reflected in some past or prospective sale and recorded on a balance sheet. It generates a stream of money payments. To the owner from tenants to whom the owner delegated som of their rights. From the owner to mortgage lenders and tax authorities, and to the people whose labor keeps them operating — or to the businesses that command that labor. Like the bricks in the building’s walls or the water flowing through its pipes, these can be expressed as numbers. But unlike those physical quantities, all of these can be expressed in the same way, as dollars or other units of currency.

What is the relationship between these two sets of characteristics? Do the prices and payments simply describe the or reflect the physical qualities? Or do they have their own independent existence?

My starting point is that this is a problem — that the answer is not obvious.

The relationship between money-world and the concrete social and material world is long-standing, though not always explicit, question in the history of economic thought. A central strand in that history is the search for an answer that unifies these two worlds into one.

From the beginnings of economics down to today’s textbooks, you can find variations on the argument that money quantities and money payments are just shorthand for the characteristics and use of concrete material objects. They are neutral — mere descriptions, which can’t change the underlying things.

In 1752, we find David Hume writing that “Money is nothing but the representation of labour and commodities… Where coin is in greater plenty; as a greater quantity of it is required to represent the same quantity of goods; it can have no effect, either good or bad.”

And at the turn of the 21st century, we hear the same thing from FOMC member Lawrence Meyer: “Monetary policy cannot influence real variables–such as output and employment.” Money, he says, only affects “inflation in the long run. This immediately makes price stability … the direct, unequivocal, and singular long-term objective of monetary policy.”

We could add endless examples in between.

This view profoundly shapes most of our thinking about the economy.

We’ve all heard that money is neutral — that changes in the supply or availability of money only affect the price level while leaving relative prices and real activity unchanged. We’ve probably encountered the Coase Theorem, which says that the way goods are allocated to meet real human needs should be independent of who holds the associated property rights. We are used to talking about “real” output and “real “ interest rates without worrying too much about what they refer to.

There is, of course, also a long history of arguments on the other side — that money is autonomous, that money and credit are active forces shaping the concrete world of production and exchange, that there is no underlying value to which money-prices refer. But for the most part, these counter-perspectives occupy marginal or subterranean positions in economic theory, though they may have been influential in other domains.

The great exception is, of course, Keynes. Indeed, there is an argument that what was revolutionary about the Keynesian revolution was his break with orthodoxy on precisely this point. In the period leading up to the General Theory, he explained that the difference between the economic orthodoxy and the new theory he was seeking to develop was fundamentally the difference between the dominant vision of the economy in terms of what he called “real exchange,” and an alternative he vision he described as “monetary production.”

The orthodox theory (in our day as well as his) started from an economy in which commodities exchanged for other commodities, and then brought money in at a later stage, if at all, without changing the fundamental material tradeoffs on which exchange was based. His theory, by contrast, would describe an economy in which money is not neutral, and in which the organization of production cannot be understood in nonmonetary terms. Or in his words, it is the theory of “an economy in which money plays a part of its own and affects motives and decisions and is … so that the course of events cannot predicted, either in the long period or in the short, without a knowledge of the behavior of money.”

If you are fortunate enough to have been educated in the Keynesian tradition, then it’s easy enough to reject the idea that money is neutral. But figuring out how money world and concrete social reality do connect — that is not so straightforward.

I’m currently in the final stages of writing a book with Arjun Jayadev, Money and Things, that is about exactly this question — the interface of money world with the social and material world outside of it.

Starting from Keynes monetary-production vision, we explore question of how money matters in four settings.

First, the determination of the interest rate. There is, we argue, a basic incompatibility between a theory of the interest rate as price of saving or of time, and of the monetary interest rate we observe in the real world. And once we take seriously the idea of interest as the price of liquidity, we see why money cannot be neutral — why financial conditions invariably influence the composition as well as the level of expenditure.

Second, price indexes and “real” quantities. The ubiquitous “real” quantities constructed by economists are, we suggest, at best phantom images of monetary quantities. Human productive activity is not in itself describable in terms of aggregate quantities. Obviously particular physical quantities, like the materials in this building, do exist. But there is no way to make a quantitative comparison between these heterogeneous things except on the basis of money prices — prices are not measuring any preexisting value. Prices within an exchange community are objective, from the point of view of those within the community. But there is no logically consistent procedure for comparing “real” output once you leave boundaries of a given exchange community, whether across time or between countries

The third area we look at the interface of money world and social reality is corporate finance and governance. We see the corporation as a central site of tension between the distinct social logics of money and production. Corporations are the central institutions of monetary production, but they are not themselves organized on market principles. In effect, the pursuit of profit pushes wealth owners to accept a temporary suspension of the logic of market – but this can only be carried so far.

The fourth area is debt and capital. These two central aggregates of money-world are generally understood to reflect “real,” nonmonetary facts about the world — a mass of means of production in the case of capital, cumulated spending relative to income in the case of debt. But the actual historical evolution of these aggregates cannot, we show, be understood in this way in either case. The evolution of capital as we observe it, in the form of wealth, is driven by changes in the value of existing claims on production, rather than the accumulation of new capital goods. These valuation changes in turn reflect, first, social factors influencing division of income between workers and owners and, second, financial factors influencing valuations of future income streams. Debt is indeed related to borrowing, in a way that capital is not related to accumulation. But changes in indebtedness over time owe as much to interest, income and price-level changes that affect burden of existing debt stock as they do to new borrowing. And in any case borrowing mainly finances asset ownership, as opposed to the dissaving that the real-excahnge vision imagines it as.

Even with the generous time allotted to me, I can’t discuss all four of those areas. So in this talk I will focus on the interest rate.

Some of what I am going to say here may seem familiar, or obvious.

But I think it’s important to start here because it is so central to debates about money and macroeconomics. Axel Leijonhufvud long ago argued that the theory of the interest rate was at the heart of the confusion in modern macroeconomics. “The inconclusive quarrels … that drag on because the contending parties cannot agree what the issue is, largely stem from this source.” I think this is still largely true.

Orthodoxy thinks of the interest rate as the price of savings, or loanable funds, or alternatively, as the tradeoff between consumption in the future and consumption in the present.

Interest in this sense is a fundamentally non-monetary concept. It is a price of two commodities, based on the same balance of scarcity and human needs that are the basis of other prices. The tradeoff between a shirt today and a shirt next year, expressed in the interest rate, is no different between the tradeoff between a cotton shirt and a linen one, or one with short versus long sleeves. The commodities just happen to be distinguished by time, rather than some other quality.

Monetary loans, in this view, are just like a loan of a tangible object. I have a some sugar, let’s say. My neighbor knocks on the door, and asks to borrow it. If I lend it to them, I give up the use of it today. Tomorrow, the neighbor will return the same amount of sugar to me, plus something extra – perhaps one of the cookies they baked with it. Whatever income you receive from ownership of an asset — whether we call it interest, profit or cookies — is a reward for deferring your use of the concrete services that the asset provides.

This way of thinking about interest is ubiquitous in economics. In the early 19th century Nassau Senior described interest as the reward for abstinence, which gives it a nice air of Protestant morality. In a current textbook, in this case Gregory Mankiw’s, you can find the same idea expressed in more neutral language: “Saving and investment can be interpreted in terms of supply and demand … of loanable funds — households lend their savings to investors or deposit their savings in a bank that then loans the funds out.”

It’s a little ambiguous exactly how we are supposed to imagine these funds, but clearly they are something that already exists before the bank comes into the picture. Just as with the sugar, if their owner is not currently using them, they can lend them to someone else, and get a reward for doing so.

If you’ve studied macroeconomics at the graduate level, you probably spent much of the semester thinking about variations on this story of tradeoffs between stuff today and stuff in the future, in the form of an Euler equation equating marginal costs and benefits across time. It’s not much of an exaggeration to say that mathematically elaborated versions of this story are the contemporary macro curriculum.

Money and finance don’t come into this story. As Mankiw says, investors can borrow from the public directly or indirectly via banks – the economic logic is the same either way.

We might challenge this story from a couple of directions.

One criticism — first made by Piero Sraffa, in a famous debate with Friedrich Hayek about 100 years ago — is that in a non monetary world each commodity will have its own distinct rate of interest. Let’s say a pound of flour trades for 1.1 pounds (or kilograms) of flour a year from now. What will a pound or kilo of sugar today trade for? If, over the intervening year, the price of usage rises relative to the price of flour, then a given quantity of sugar today will trade for a smaller amount of sugar a year from now, than the same quantity of flour will. Unless the relative price of flour and sugar are fixed, their interest rates will be different. Flour today will trade at one rate for flour in the future, sugar at a different rate; the use of a car or a house, a kilowatt of electricity, and so on will each trade with the same thing in the future at their own rates, reflecting actual and expected conditions in the markets for each of these commodities. There’s no way to say that any one of these myriad own-rates is “the” rate of interest.

Careful discussions of the natural rate of interest will acknowledge that it is only defined under the assumption that relative prices never change.

Another problem is that the savings story assumes that the thing to be loaned — whether it is a specific commodity or generic funds — already exists. But in the monetary economy we live in, production is carried out for sale. Things that are not purchased, will not be produced. When you decide not to consume something, you don’t make that thing available for someone else. Rather, you reduce the output of it, and the income of the producers of it, by the same amount as you reduce your own consumption.

Saving, remember, is the difference between income and consumption. For you as an individual, you can take my income as given when deciding how much to consume. So consuming less means saving more. But at the level of the economy as a whole, income is not independent of consumption. A decision to consume less does not raise aggregate saving, it lowers aggregate income. This is the fallacy of consumption emphasized by Keynes: individual decisions about consumption and saving have no effect on aggregate saving.

So the question of how the interest rate is determined, is linked directly to the idea of demand constraints.

Alternatively, rather than criticizing the loanable-funds story, we can start from the other direction, from the monetary world we actually live in. Then we’ll see that credit transactions don’t involve the sort of tradeoff between present and future that orthodoxy focuses on.

Let’s say you are buying a home.

On the day that you settle , you visit the bank to finalize your mortgage. The bank manager puts in two ledger entries: One is a credit to your account, and a liability to the bank, which we call the deposit. The other, equal and offsetting entry is a credit to the bank’s own account, and a liability for you. This is what we call the loan. The first is an IOU from the bank to you, payable at any time. The second is an IOU from you to the bank, with specified payments every month, typically, in the US, for the next 30 years. Like ordinary IOUs, these ledger entries are created simply by recording them — in earlier times it was called “fountain pen” money.

The deposit is then immediately transferred to the seller, in return for the title to the house. For the bank, this simply means changing the name on the deposit — in effect, you communicate to the bank that their debt that was payable to you, is now payable to the seller. On your balance sheet, one asset has been swapped for another — the $250,000 deposit, in this case, for a house worth $250,000. The seller makes the opposite swap, of the title to a house for an equal value IOU from the bank.

As we can see, there is no saving or dissaving here. Everyone has just swapped assets of equal value.

This mortgage is not a loan of preexisting funds or of anything else. No one had to first make a deposit at the bank in order to allow them to make this loan. The deposit — the money — was created in the process of making the loan itself. Banking does not channel saving to borrowing as in the loanable-funds view, but allows a swap of promises.

One thing I always emphasize to my students: You should not talk about putting money in the bank. The bank’s record is the money.

On one level this is common knowledge. I am sure almost everyone in this room could explain how banks create money. But the larger implications are seldom thought through.

What did this transaction consist of? A set of promises. The bank made a promise to the borrowers, and the borrowers made a promise to the bank. And then the bank’s promise was transferred to the sellers, who can transfer it to some third party in turn.

The reason that the bank is needed here is because you cannot directly make a promise to the seller.

You are willing to make a promise of future payments whose present value is worth more than the value the seller puts on their house. Accepting that deal will make both sides better off. But you can’t close that deal, because your promise of payments over the next 30 years is not credible. They don’t know if you are good for it. They don’t have the ability to enforce it. And even they trust you, maybe because you’re related or have some other relationship, other people do not. So the seller can’t turn your promise of payment into an immediate claim on other things they might want.

Orthodox theory starts from assumption that everyone can freely contract over income and commodities at any date in the future. That familiar Euler equation is based on the idea that you can allocate your income from any future period to consumption in the present, or vice versa. That is the framework within which the interest rate looks like a tradeoff between present and future. But you can’t understand interest in a framework that abstracts away from precisely the function that money and credit play in real economies.

The fundamental role of a bank, as Hyman Minsky emphasized, is not intermediation but acceptance. Banks function as third parties who broaden the range of transactions that can take place on the basis of promises. You are willing to commit to a flow of money payments to gain legal rights to the house. But that is not enough to acquire the house. The bank, on the other hand, precisely because its own promises are widely trusted, is in a position to accept a promise from you.

Interest is not paid because consumption today is more desirable than consumption in the future. Interest is paid because credible promises about the future are hard to make.

The cost of the mortgage loan is not that anyone had to postpone their spending. The cost is that the balance sheets of both transactors have become less liquid.

We can think of liquidity in terms of flexibility — an asset or a balance sheet position is liquid insofar as it broadens your range of options. Less liquidity, means fewer options.

For you as a homebuyer, the result of the transaction is that you have committed yourself to a set of fixed money payments over the next 30 years, and acquired the legal rights associated with ownership of a home. These rights are presumably worth more to you than the rental housing you could acquire with a similar flow of money payments. But title to the house cannot easily be turned back into money and thereby to claims on other parts of the social product. Home ownership involves — for better or worse — a long-term commitment to live in a particular place. The tradeoff the homebuyer makes by borrowing is not more consumption today in exchange for less consumption tomorrow. It is a higher level of consumption today and tomorrow, in exchange for reduced flexibility in their budget and where they will live. Both the commitment to make the mortgage payments and the non-fungibility of home ownership leave less leeway to adapt to unexpected future developments.

On the other side, the bank has added a deposit liability, which requires payment at any time, and a mortgage asset which in itself promises payment only on a fixed schedule in the future. This likewise reduces the bank’s freedom of maneuver. They are exposed not only to the risk that the borrower will not make payments, but also to the risk of capital loss if interest rates rise during the period they hold the mortgage, and to the risk that the mortgage will not be saleable in an emergency, or only at an unexpectedly low price. As real world examples like, recently, Silicon Valley Bank show, these latter risks may in practice be much more serious than the default risk. The cost to the bank making the loan is that its balance sheet becomes more fragile.

Or as Keynes put it in a 1937 article, “The interest rate … can be regarded as being determined by the interplay of the terms on which the public desires to become more or less liquid and those on which the banking system is ready to become more or less unliquid.”

Of course in the real world things are more complicated. The bank does not need to wait for the mortgage payments to be made at the scheduled time. It can transfer the mortgage to a third party, trading off some of the income it expected for a more liquid position. The buyer might be some other financial institution looking for a position farther toward the income end of the liquidity-income tradeoff, perhaps with multiple layers of balance sheets in between. Or the buyer might be the professional liquidity-providers at the central bank.

Incidentally, this is an answer to a question that people don’t ask often enough: How is it that the central bank is able to set the interest rate at all? The central bank plays no part in the market for loanable funds. But central banks are very much in the liquidity business.

It is monetary policy, after all, not savings policy.

One thing this points to is that there is no fundamental difference between routine monetary policy and the central bank’s role as a lender of last resort and a regulator. All of these activities are about managing the level of liquidity within the financial system. How easy is it to meet your obligations. Too hard, and the web of obligations breaks. Too easy, and the web of money obligations loses its ability to shape our activity, and no longer serves as an effective coordination device.

As the price of money — the price for flexibility in making payments as opposed to fixed commitments — the interest rate is a central parameter of any monetary economy. The metaphor of “tight” or “loose” conditions for high or low interest rates captures an important truth about the connection between interest and the flexibility or rigidity of the financial system. High interest rates correspond to a situation in which promises of future payment are worth less in terms of command over resources today. When it’s harder to gain control over real resources with promises of future payment, the pattern of today’s payments is more tightly linked to yesterday’s income. Conversely, low interest rates mean that a promise of future payments goes a long way in securing resources today. That means that claims on real resources therefore depend less on incomes in the past, and more on beliefs about the future. And because interest rate changes always come in an environment of preexisting money commitments, interest also acts as a scaling variable, reweighting the claims of creditors against the income of debtors.

In addition to credit transactions, the other setting in which interest appears in the real world is in the price of existing assets.

A promise of money payments in the future becomes an object in its own right, distinct from those payments themselves. I started out by saying that all sorts of tangible objects have a shadowy double in money-world. But a flow of money payments can also acquire a phantom double. A promise of future payment creates a new property right, with its owner and market price.

When we focus on that fact, we see an important role for convention in the determination of interest. To some important extent, bond prices – and therefore interest rates – are what they are, because that is what market participants expect them to be.

A corporate bond promises a set of future payments. It’s easy in a theoretical world of certainty, to talk as if the bond just is those future payments. But it is not.

This is not just because it might default, which is easy to incorporate into the model. It’s not just because any real bond was issued in a certain jurisdiction, and conveys rights and obligations beyond payment of interest — though these other characteristics always exist and can sometimes be important. It’s because the bond can be traded, and has a price which can change independent of the stream of future payments.

If interest rates fall, your bond’s price will rise — and that possibility itself is a factor in the price of the bond.

This helps explain a widely acknowledged anomaly in financial markets. The expectation hypothesis says that the interest rate on a longer bond should be the same as the average of shorter rates over the same period, or at least that they should be related by a stable term premium. This seems like a straightforward arbitrage, but it fails completely, even in its weaker form.

The answer to this puzzle is an important part of Keynes’ argument in The General Theory. Market participants are not just interested in the two payment streams. They are interested in the price of the long bond itself.

Remember, the price of an asset always moves inversely with its yield. When rates on a given type of credit instrument go up, the price of that instrument falls. Now let’s say it’s widely believed that a 10 year bond is unlikely to trade below 2 percent for very long. Then you would be foolish to buy it at a yield much below 2 percent, because you are going to face a capital loss when yields return to their normal level. And if most people believe this, then the yield never will fall below 2 percent, no matter what happens with short rates.

In a real world where the future is uncertain and monetary commitments have their own independent existence, there is an important sense in which interest rates, especially longer ones, are what they are because that’s what people expect them to be.

One important implication of this is that we cannot think of various market interest rates as simply “the” interest rate, plus a risk premium. Different interest rates can move independently for reasons that have nothing to do with credit risk.

On the one hand, we have a body of theory built up on the idea of “the” interest rate as a tradeoff between present and future consumption. On the other, we have actual interest rates, set in the financial system in quite different ways.

People sometimes try to square the circle with the idea of a natural rate. Yes, they say, we know about liquidity and the term premium and the importance of different kinds of financial intermediaries and regulation and so on. But we still want to use the intertemporal model we were taught in graduate school. We reconcile this by treating the model as an analysis of what the interest rate ought to be. Yes, banks set interest rates in all kinds of ways, but there is only one interest rate consistent with stable prices and, more broadly, appropriate use of society’s resources. We call this the natural rate.

This idea was first formulated around the turn of the 20th century by Swedish economist Knut Wicksell. But the most influential modern statement comes from Milton Friedman. He introduces the natural rate of interest, along with its close cousin the natural rate of unemployment, in his 1968 Presidential Address to the American Economics Association, which has been described as the most influential paper in economics since World War II. The natural rates there correspond to the rates that would be “ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information … and so on.”

The appeal of the concept is clear: It provides a bridge between the nonmonetary world of intertemporal exchange of economic theory, and the monetary world of credit contracts in which we actually live. In so doing, it turns the intertemporal story from a descriptive one to a prescriptive one — from an account of how interest rates are determined, to a story about how central banks should conduct monetary policy.

Fed Chair Jerome Powell gave a nice example of how central bankers think of the natural rate in a speech a few years ago. He introduces the natural interest rate R* with the statement that “In conventional models of the economy, major economic quantities … fluctuate around values that are considered ‘normal,’ or ‘natural,’ or ‘desired.’” R* reflects “views on the longer-run normal values for … the federal funds rate” which are based on “ fundamental structural features of the economy.”

Notice the confusion here between the terms normal, natural and desired, three words with quite different meanings. R* is apparently supposed to be the long-term average interest rate, and the interest rate that we would see in a world governed only fundamentals and the interest rate that delvers the best policy outcomes.

This conflation is a ubiquitous and essential feature of discussions of natural rate. Like the controlled slipping between the two disks of a clutch in a car, it allows systems moving in quite different ways to be joined up without either side fracturing from the stress. The ambiguity between these distinct meanings is itself normal, natural and desired.

The ECB gives perhaps an even nicer statement: “At its most basic level, the interest rate is the ‘price of time’ — the remuneration for postponing spending into the future.” R* corresponds to this. It is a rate of interest determined by purely non monetary factors, which should be unaffected by developments in the financial system. Unfortunately, the actual interest rate may depart from this. In that case, the natural rate, says the ECB, “while unobservable … provides a useful guidepost for monetary policy.”

I love the idea of an unobservable guidepost. It perfectly distills the contradiction embodied in the idea of R*.

As a description of what the interest rate is, a loanable-funds model is merely wrong. But when it’s turned into a model of the natural rate, it isn’t even wrong. It has no content at all. There is no way to connect any of the terms in the model with any observable fact in the world.

Go back to Friedman’s formulation, and you’ll see the problem: We don’t possess a model that embeds all the “actual structural characteristics” of the economy. For an economy whose structures evolve in historical time, it doesn’t make sense to even imagine such a thing.

In practice, the short-run natural rate is defined as the one that results in inflation being at target — which is to say, whatever interest rate the central bank prefers.

The long-run natural rate is commonly defined as the real interest rate where “all markets are in equilibrium and there is therefore no pressure for any resources to be redistributed or growth rates for any variables to change.” In this hypothetical steady state, the interest rate depends only on the same structural features that are supposed to determine long-term growth — the rate of technical progress, population growth, and households’ willingness to defer consumption.

But there is no way to get from the short run to the long run. The real world is never in a situation where all markets are in equilibrium. Yes, we can sometimes identify long-run trends. But there is no reason to think that the only variables that matter for those trends are the ones we have chosen to focus on in a particular class of models. All those “actual structural characteristics” continue to exist in the long run.

The most we can say is this: As long as there is some reasonably consistent relationship between the policy interest rate set by the central bank and inflation, or whatever its target is, then there will be some level of the policy rate that gets you to the target. But there’s no way to identify that with “the interest rate” of a theoretical model. The current level of aggregate spending in the economy depends on all sorts of contingent, institutional factors, on sentiment, on choices made in the past, on the whole range of government policies. If you ask, what policy interest rate is most likely to move inflation toward 2 percent, all that stuff matters just as much as the supposed fundamentals.

The best you can do is set the policy rate by whatever rule of thumb or process you prefer, and then after the fact say that there must be some model where that would be the optimal choice.

Michael Woodford is the author of Interest and Prices, one of the most influential efforts to incorporate monetary policy into a modern macroeconomic model. He pretty explicitly acknowledges that’s what he was doing — trying to backfill a theory to explain the choices that central banks were already making.

What are the implications of this?

First, with regard to monetary policy, let’s acknowledge that it involves political choices made to achieve a variety of often conflicting social goals. As Ben Braun and others have written about very insightfully.

Second, recognizing that interest is the price of liquidity, set in financial markets, is important for how we think about sovereign debt.

There’s a widespread story about fiscal crises that goes something like this. First, a government’s fiscal balance (surplus or deficit) over time determines its debt-GDP ratio. If a country has a high debt to GDP, that’s the result of overspending relative to tax revenues. Second, the debt ratio determines to market confidence; private investors do not want to buy the debt of a country that has already issued too much. Third, the state of market confidence determines the interest rate the government faces, or whether it can borrow at all. Fourth, there is a clear line where high debt and high interest rates make debt unsustainable; austerity is the unavoidable requirement once that line is passed. And finally, when austerity restores debt sustainability, that will contribute to economic growth.

Alberto Alesina was among the most vigorous promoters of this story, but it’s a very common one.

If you accept the premises, the conclusions follow logically. Even better, they offer the satisfying spectacle of public-sector hubris meeting its nemesis. But when we look at debt as a monetary phenomenon, we see that its dynamics don’t run along such well-oiled tracks.

First of all, as a historical matter, differences in growth, inflation and interest rates are at least as important as the fiscal position in determining the evolution of the debt ratio over time. Where debt is already high, moderately slower growth or higher interest rates can easily raise the debt ratio faster than even very large surpluses can reduce it – as many countries subject to austerity have discovered. Conversely, rapid economic growth and low interest rates can lead to very large reductions in the debt ratio without the government ever running surpluses, as in the US and UK after World War II. More recently, Ireland reduced its debt-GDP ratio by 20 points in just five years in the mid-1990s while continuing to run substantial deficits, thanks to very fast growth of the “Celtic tiger” period.

At the second step, market demand for government debt clearly is not an “objective” assessment of the fiscal position, but reflects broader liquidity conditions and the self-confirming conventional expectations of speculative markets. The claim that interest rates reflect the soundness or otherwise of public budgets runs up against a glaring problem: The financial markets that recoil from a country’s bonds one day were usually buying them eagerly the day before. The same markets that sent interest rates on Spanish, Portuguese and Greek bonds soaring in 2010 were the ones snapping up their public and private debt at rock-bottom rates in the mid-2000s. And they’re the same markets that returned to buying those countries debt at historically low levels today, even as their debt ratios, in many cases, remained very high.

People like Alesina got hopelessly tangled up on this point. They wanted to insist both that post-crisis interest rates reflected an objective assessment of the state of public finances, and that the low rates before the crisis were the result of a speculative bubble. But you can’t have it both ways.

This is not to say that financial markets are never a constraint on government budgets. For most of the world, which doesn’t enjoy the backstop of a Fed or ECB, they very much are. But we should never imagine that financial conditions are an objective reflection of a country’s fiscal position, or of the balance of savings and investment.

The third big takeaway, maybe the biggest one, is that money is never neutral.

If the interest rate is a price, what it is a price of is not “saving” or the willingness to wait. It is not “remuneration for deferring spending,” as the ECB has it. Rather, it is of the capacity to make and accept promises. And where this capacity really matters, is where finance is used not just to rearrange claims on existing assets and resources, but to organize the creation of new ones. The technical advantages of long lived means of production and specialized organizations can only be realized if people are in a position to make long-term commitments. And in a world where production is organized mainly through money payments, that in turn depends on the degree of liquidity.

There are, at any moment, an endless number of ways some part of society’s resources could be reorganized so as to generate greater incomes, and hopefully use values. You could open a restaurant, or build a house, or get a degree, or write a computer program, or put on a play. The physical resources for these activities are not scarce; the present value of the income they can generate exceeds their costs at any reasonable discount rate. What is scarce is trust. You, starting on a project, must exercise a claim on society’s resources now; society must accept your promise of benefits later. The hierarchy of money allows participants in various collective projects to substitute trust in a third party for trust in each other. But trust is still the scarce resource.

Within the economy, some activities are more trust-intensive, or liquidity-constrained, than others.

Liquidity is more of a problem when there is a larger separation between outlays and rewards, and when rewards are more uncertain.

Liquidity is more of the problem when the scale of the outlay required is larger.

Liquidity and trust are more important when decisions are irreversible.

Trust is more important when something new is being done.

Trust is more scarce when we are talking about coordination between people without any prior relationship.

These are the problems that money and credit help solve. Abundant money does not just lead people to pay more for the same goods. It shifts their spending toward things that require bigger upfront payments and longer-term commitments, and that are riskier.

I was listening to an interview with an executive from wind-power company on the Odd Lots podcast the other day. “We like to say that our fuel is free,” he said. “But really, our fuel is the cost of capital.” The interest rate matters more for wind power than for gas or coal, because the costs must be paid almost entirely up front, as opposed to when the power is produced.

When costs and returns are close together, credit is less important.

In settings where ongoing relationships exist, money is less important as a coordinating mechanism. Markets are for arms-length transactions between strangers.

Minsky’s version of the story emphasizes that we have to think about money in terms of two prices, current production and long-lived assets. Long-lived assets must be financed – acquiring one typically requires committing to a series of future payments . So their price is sensitive to the availability of money. An increase in the money supply — contra Hume, contra Meyer — does not raise all prices in unison. It disproportionately raises the price of long-lived assets, encouraging production of them. And it is long-lived assets that are the basis of modern industrial production.

The relative value of capital goods, and the choice between more and less capital-intensive production techniques, depends on the rate of interest. Capital goods – and the corporations and other long-lived entities that make use of them – are by their nature illiquid. The willingness of wealth owners to commit their wealth to these forms depends, therefore, on the availability of liquidity. We cannot analyze conditions of production in non-monetary terms first and then afterward add money and interest to the story. Conditions of production themselves depend fundamentally on the network of money payments and commitments that structure them, and how flexible that network is.

Taking money seriously requires us to reconceptualize the real economy.

The idea of the interest rate as the price of saving assumes, as I mentioned before, that output already exists to be either consumed or saved. Similarly, the idea of interest as an intertemporal price — the price of time, as the ECB has it — implies that future output is already determined, at least probabilistically. We can’t trade off current consumption against future consumption unless future consumption already exists for us to trade.

Wicksell, who did as much as anyone to create the natural-rate framework of today’s central banks, captured this aspect of it perfectly when he compared economic growth to wine barrels aging in the cellar. The wine is already there. The problem is just deciding when to open the barrels — you would like to have some wine now, but you know the wine will get better if you wait.

In policy contexts, this corresponds to the idea of a level of potential output (or full employment) that is given from the supply side. The productive capacity of the economy is already there; the most that money, or demand, can accomplish is managing aggregate spending so that production stays close to that capacity.

This is the perspective from which someone like Lawrence Meyer, or Paul Krugman for that matter, says that monetary policy can only affect prices in the long run. They assume that potential output is already given.

But one of the big lessons we have learned from the past 15 years of macroeconomic instability is that the economy’s productive potential is much more unstable, and much less certain, than economists used to think. We’ve seen that the labor force grows and shrinks in response to labor market conditions. We’ve seen that investment and productivity growth are highly sensitive to demand. If a lack of spending causes output to fall short of potential today, potential will be lower tomorrow. And if the economy runs hot for a while, potential output will rise.

We can see the same thing at the level of individual industries. One of the most striking, and encouraging developments of recent years has been the rapid fall in costs for renewable energy generation. It is clear that this fall in costs is the result, as much as the cause, of the rapid growth in spending on these technologies. And that in turn is largely due to successful policies to direct credit to those areas.

A perspective that sees money as epiphenomenal to the “real economy” of production would have ruled out that possibility.

This sort of learning by doing is ubiquitous in the real world. Economists prefer to assume decreasing returns only because that’s an easy way to get a unique market equilibrium.

This is one area where formal economics and everyday intuition diverge sharply. Ask someone whether they think that buying more or something, or making more of something, will cause the unit price to go up or down. If you reserve a block of hotel rooms, will the rooms be cheaper or more expensive than if you reserve just one? And then think about what this implies about the slope of the supply curve.

There’s a wonderful story by the great German-Mexican writer B. Traven called “Assembly Line.” The story gets its subversive humor from a confrontation between an American businessman, who takes it for granted that costs should decline with output, and a village artisan who insists on actually behaving like the textbook producer in a world of decreasing returns.

In modern economies, if not in the village, the businessman’s intuition is correct. Increasing returns are very much the normal case. This means that multiple equilibria and path dependence are the rule. And — bringing us back to money — that means that what can be produced, and at what cost, is a function of how spending has been directed in the past.

Taking money seriously, as its own autonomous social domain, means recognizing that social and material reality is not like money. We cannot think of it in terms of a set of existing objects to be allocated, between uses or over time. Production is not a quantity of capital and a quantity of labor being combined in a production function. It is organized human activity, coordinated in a variety of ways, aimed at open-ended transformation of the world whose results are not knowable in advance.

On a negative side, this means we should be skeptical about any economic concept described as “natural” or “real”. These are very often an attempt to smuggle in a vision of a non monetary economy fundamentally different from our own, or to disguise a normative claim as a positive one, or both.

For example, we should be cautious about “real” interest rates. This term is ubiquitous, but it implicitly suggests that the underlying transaction is a swap of goods today for goods tomorrow, which just happens to take monetary form. But in fact it’s a swap of IOUs — one set of money payments for another. There’s no reason that the relative price of money versus commodities would come into it.

And in fact, when we look historically, before the era of inflation-targeting central banks there was no particular relationship between inflation and interest rates.

We should also be skeptical of the idea of real GDP, or the price level. That’s another big theme of the book, but it’s beyond the scope of today’s talk.

On the positive side, this perspective is, I think, essential preparation to explore when and in what contexts finance matters for production. Obviously, in reality, most production coordinated in non-market ways, both within firms — which are planned economies internally — and through various forms of economy-wide planning. But there are also cases where the distribution of monetary claims through the financial system is very important. Understanding which specific activities are credit-constrained, and in what circumstances, seems like an important research area to me, especially in the context of climate change.

Let me mention one more direction in which I think this perspective points us.

As I suggested, the idea of the interest rate as the price of time, and the larger real-exchange vision of which it is part, treats money flows and aggregates as stand-ins for an underlying nonmonetary real economy. People who take this view tend not be especially concerned with exactly how the monetary values are constructed. Which rate, out of the complex of interest rates, is “the” interest rate? Which f the various possible inflation rates, and over what period, do we subtract to get the “real” interest rate? What payments exactly are included in GDP, and what do we do if that changes, or if it’s different in different countries?

If we think of the monetary values as just proxies for some underlying “real” value, the answers to these questions don’t really matter.

I was reading a paper recently that used the intensity of nighttime illumination across the Earth’s surface as an alternative measure of real output. It’s an interesting exercise. But obviously, if that’s the spirit you are approaching GDP in, you don’t worry about how the value of financial services is calculated, or on what basis we are imputing the services of owner-occupied housing. The number produced by the BEA is just another proxy for the true value of real output, that you can approximate in all kinds of other ways.

On the other hand, if you think that the money values are what is actually real — if you don’t think they are proxies for any underlying material quantity — then you have to be very concerned with the way they are calculated. If the interest rate really does mean the payments on a loan contract, and not some hypothetical exchange rate between the past and the future, then you have to be clear about which loan contract you have in mind.

Along the same lines, most economists treat the object of inquiry as the underlying causal relationships in the economy, those “fundamental structural characteristics” that are supposed to be stable over time. Recall that the natural rate of interest is explicitly defined with respect to a long run equilibrium where all macroeconomic variables are constant, or growing at a constant rate. If that’s how you think of what you are doing, then specific historical developments are interesting at most as case studies, or as motivations for the real work, which consists of timeless formal models.

But if we take money seriously, then we don’t need to postulate this kind of underlying deep structure. If we don’t think of interest in terms of a tradeoff between the present and the future, then we don’t need to think of future income and output as being in any sense already determined. And if money matters for the activity of production, both as financing for investment and as demand, then there is no reason to think the actual evolution of the economy can be understood in terms of a long-run trend determined by fundamentals.

The only sensible object of inquiry in this case is particular events that have happened, or might happen.

Approaching our subject this way means working in terms of the variables we actually observe and measure. If we study GDP, it is GDP as the national accountants actually define it and measure it, not “output” in the abstract. These variables are generally monetary.

It means focusing on explanations for specific historical developments, rather than modeling the behavior of “the economy” in the abstract.

It means elevating descriptive work over the kinds of causal questions that economists usually ask. Which means broadening our empirical toolkit away from econometrics.

These methodological suggestions might seem far removed from alternative accounts of the interest rate. But as Arjun and I have worked on this book, we’ve become convinced that the two are closely related. Taking money seriously, and rejecting conventional ideas of the real economy, have far-reaching implications for how we do economics.

Recognizing that money is its own domain allows us to see productive activity as an open-ended historical process, rather than a static problem of allocation. By focusing on money, we can get a clearer view of the non-monetary world — and, hopefully, be in a better position to change it.

Keynes and Socialism

(Text of a talk I delivered at the Neubauer Institute in Chicago on April 5, 2024.)

My goal in this talk is to convince you that there is a Keynesian vision that is much more radical and far-reaching then our familiar idea of Keynesian economics.

I say “a” Keynesian vision. Keynes was an outstanding example of his rival Hayek’s dictum that no one can be a great economist who is only an economist. He was a great economist, and he was many other things as well. He was always engaged with the urgent problems of his day; his arguments were intended to address specific problems and persuade specific audiences, and they are not always easy to reconcile. So I can’t claim to speak for the authentic Keynes. But I think I speak for an authentic Keynes. In particular, the argument I want to make here is strongly influenced by the work of Jim Crotty, whose efforts to synthesize the visions of Keynes and of Marx were formative for me, as for many people who have passed through the economics department at the University of Massachusetts.

Where should we begin? Why not at the beginning of the Keynesian revolution? According to Luigi Passinetti, this has a very specific date: October 1932. That is when Keynes returned to King’s College in Cambridge for the Michaelmas term to deliver, not his old lectures on “The Pure Theory of Money,” but a new set of lectures on “The Monetary Theory of Production”. In an article of the same title written around the same time, he explained that the difference between the economic orthodoxy of the “the theory which I desiderate” was fundamentally the difference between a vision of the economy in terms of what he called “real exchange” and of monetary production. The lack of such a theory, he argued, was “the main reason why the problem of crises remains unsolved.”

The obvious distinction between these two visions is whether money can be regarded as neutral; and more particularly whether the interest rate can be thought of — as the textbook of economics of our times as well as his insist — as the price of goods today versus goods tomorrow, or whether we must think of it as, in some sense, the price of money.

But there is a deeper distinction between these two visions that I think Keynes also had in mind. On the ones side, we may think of economic life fundamentally in terms of objects — material things that can be owned and exchanged, which exist prior to their entry into economic life, and which have a value — reflecting the difficulty of acquiring them and their capacity to meet human needs. This value merely happens to be represented in terms of money. On the other side, we may think of economic life fundamentally in terms of collective human activity, an organized, open-ended process of transforming the world, a process in which the pursuit of money plays a central organizing role.

Lionel Robbins, also writing in 1932, gave perhaps the most influential summary of the orthodox view when he wrote that economics is the study of the allocation of scarce means among alternative uses. For Keynes, by contrast, the central problem is not scarcity, but coordination. And what distinguishes the sphere of the economy from other areas of life is that coordination here happens largely through money payments and commitments.

From Robbins’ real-exchange perspective, the “means” available to us at any time are given, it is only a question of what is the best use for them. For Keynes, the starting point is coordinated human activity. In a world where coordination failures are ubiquitous, there is no reason to think — as there would be if the problem were scarcity — that satisfying some human need requires withdrawing resources from meeting some other equally urgent need. (In 1932, obviously, this question was of more than academic interest.) What kinds of productive activity are possible depends, in particular, on the terms on which money is available to finance it and the ease with which its results can be converted back into money. It is for this reason, as Keynes great American successor Hyman Minsky emphasized, that money can never be neutral.

If the monetary production view rejects the idea that what is scarce is material means, it also rejects the idea that economic life is organized around the meeting of human needs. The pursuit of money for its own sake is the organizing principle of private production. On this point, Keynes recognized his affinity with Karl Marx. Marx, he wrote, “pointed out that the nature of production in the actual world is not, as economists seem often to suppose, a case of C-M-C’, i. e., of exchanging commodity (or effort). That may be the standpoint of the private consumer. But it is not the attitude of business, which is the case of M-C-M’, i. e., of parting with money for commodity (or effort) in order to obtain more money.”

Ignoring or downplaying money, as economic theory has historically done, requires imagining the “real” world is money-like. Conversely, recognizing money as a distinct social institution requires a reconception of the social world outside of money. We must ask both how monetary claims and values evolve independently of the real activity of production, and how money builds on, reinforces or undermines other forms of authority and coordination. And we must ask how the institutions of money and credit both enable and constrain our collective decision making. All these questions are unavoidably political.

For Keynes, modern capitalism is best understood through the tension between the distinct logics of money and of production. For the orthodox economics both of Keynes’s day and our own, there is no such tension. The model is one of “real exchange” in which a given endowment of goods and a given set of preferences yielded a vector of relative prices. Money prices represent the value that goods already have, and money itself merely facilitates the process of exchange without altering it in any important way.

Keynes of course was not the first to insist on a deeper role for money. Along with Marx, there is a long counter tradition that approaches economic problems as an open ended process of transformation rather than the allocation of existing goods, and that recognizes the critical role of money in organizing this process. These include the “Army of brave heretics and cranks” Keynes acknowledges as his predecessors.

One of the pioneers in this army was John Law. Law is remembered today mainly for the failure of his fiat currency proposals (and their contribution to the fiscal troubles of French monarchy), an object lesson for over-ambitious monetary reformers. But this is unfair. Unlike most other early monetary reformer, Law had a clearly articulated theory behind his proposals. Schumpeter goes so far as to put him “in the front rank of monetary theorists of all times.”

Law’s great insight was that money is not simply a commodity whose value comes from its non-monetary uses. Facilitating exchange is itself a very important function, which makes whatever is used for that purpose valuable even if it has no other use.

“Money,” he wrote, “is not the Value for which goods are exchanged, but the Value by which goods are exchanged.” The fact that money’s value comes from its use in facilitating exchange, and not merely from the labor and other real resources embodied in it, means that a scarcity of money need not reflect any physical scarcity. In fact, the scarcity of money itself may be what limits the availability of labor: “’tis with little success Laws are made, for Employing the Poor or Idle in Countries where Money is scarce.”

Law here is imagining money as a way of organizing and mobilizing production.

If the capacity to pay for things — and make commitments to future payments — is valuable, then the community could be made better off by providing more of it. Law’s schemes to set up credit-money issuing banks – in Scotland before the more famous efforts in France – were explicitly presented as programs for economic development.

Underlying this project is a recognition that is central to the monetary production view; the organization of production through exchange is not a timeless fact of human existence, but something that requires specific institutional underpinning — which someone has to provide. Like Alexander Hamilton’s similar but more successful interventions a half century later, Law envisioned the provision of abundant liquidity as part of a broader project of promoting commerce and industry.

This vision was taken up a bit later by Thornton and the anti-bullionists during the debates over suspension of gold convertibility during and after the Napoleonic Wars. A subsequent version was put forward by the mid-19th century Banking School and its outstanding figure, Thomas Tooke — who was incidentally the only contemporary bourgeois economist who Karl Marx seems to have admired — and by thinkers like Walter Bagehot, who built their theory on first hand experience of business and finance.

A number of lines divide these proto-Keynesian writers from the real-exchange orthodoxy.

To begin with, there is a basic difference in how they think of money – rather than a commodity or token that exists in a definite quantity, they see it as a form of record-keeping, whose material form is irrelevant. In other words credit, the recording of promises, is fundamental; currency as just one particular form of it.

Second, is the question of whether there is some simple or “natural” rule that governs the behavior of monetary or credit, or whether they require active management. In the early debates, these rules were supposed to be gold convertibility or the real bills doctrine; a similar intellectual function was performed by Milton Friedman’s proposed money-supply growth rule in the 20th century or the Taylor Rule that is supposed to govern monetary policy today. On the other side, for these thinkers, “money cannot manage itself,” in Bagehot’s famous phrase.

Third, there is the basic question of whether money is a passive reflection of an already existing real economy, or whether production itself depends on and is organized by money and credit. In other words, the conception of money is inseparable from how the non-monetary economy is imagined. In the real-exchange vision, there is a definite quantity of commodities already existing or potentially producible, which money at best helps to allocate. In the monetary production view, goods only come into existence as they are financed and paid for, and the productive capacity of the economy comes into being through an open-ended process of active development.

It’s worth quoting Bagehot’s Lombard Street for an example:

The ready availability of credit for English businesses, he writes,

gives us an enormous advantage in competition with less advanced countries — less advanced, that is, in this particular respect of credit. In a new trade English capital is instantly at the disposal of persons capable of understanding the new opportunities… In countries where there is little money to lend, … enterprising traders are long kept back, because they cannot borrow the capital without which skill and knowledge are useless. … The Suez Canal is a curious case of this … That London and Liverpool should be centres of East India commerce is a geographic anomaly … The main use of the Canal has been by the English not because England has rich people … but because she possesses an unequalled fund of floating money.

The capacity for reorganization is what matters, in other words. The economic problem is not a scarcity of material wealth, but of institutions that can rapidly redirect it to new opportunities. For Bagehot as for Keynes, the binding constraint is coordination.

It is worth highlighting that there is something quietly radical in Bagehot’s argument here. The textbooks tell us that international trade is basically a problem of the optimal allocation of labor, land and other material resources, according to countries’ inherent capacities for production. But here it’s being claimed is not any preexisting comparative advantage in production, but rather the development of productive capacities via money; financial power allows a country to reorganize the international division of labor to its own advantage.

Thinkers like Bagehot, Thornton or Hamilton certainly had some success on policy level. For the development of central banking, in particular, these early expressions of of monetary production view played an important role. But it was Keynes who developed these insights into a systematic theory of monetary production.

Let’s talk first about the monetary side of this dyad.

The nature and management of money were central to Keynes’ interventions, as a list of his major works suggests – from Indian Currency Questions to the General Theory of Employment, Interest and Money. The title of the latter expresses not just a list of topics but a logical sequence: employment is determined by the interest rate, which is determined by the availability of money.

One important element Keynes adds to the earlier tradition is the framing of the services provided by money as liquidity. This reflects the ability to make payments and satisfy obligations of all kinds, not just the exchange of goods focused on by Law and his successors. It also foregrounds the need for flexibility in the face of an unknown future.

The flip side of liquidity — less emphasized in his own writings but very much by post Keynesians like Hyman Minsky — is money’s capacity to facilitate trust and promises. Money as a social technology provides offers flexibility and commitment.

The fact that bank deposit — an IOU — will be accepted by anyone is very desirable for wealth owner who wants to keep their options open. But also makes bank very useful to people who want to make lasting commitments to each other, but who don’t have a direct relationship that would allow them to trust each other. Banks’ fundamental role is “acceptance,” as Minsky put it – standing in as a trusted third party to make all kinds of promises possible.

Drawing on his experience as a practitioner, Keynes also developed the idea of self-confirming expectations in financial markets. Someone buying an asset to sell in the near term is not interested in its “fundamental” value – the long-run flow of income it will generate – but in what other market participants will think is its value tomorrow. Where such short-term speculation dominates, asset prices take on an arbitrary, self-referential character. This idea is important for our purposes not just because it underpins Keynes’ critique of the “insane gambling casinos” of modern financial markets, but because it helps explain the autonomy of financial values. Prices set in asset markets — including, importantly, the interest rate — are not guide to any real tradeoffs or long term possibilities.

Both liquidity and self-confirming conventions are tied to a distinctive epistemology , which emphasizes the fundamental unknowability of the future. In Keynes’ famous statement in chapter 12 of the General Theory,

By ‘uncertain’ knowledge … I do not mean merely to distinguish what is known for certain from what is only probable. The sense in which I am using the term is that in which the prospect of a European war is uncertain, … About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know!

Turning to the production side, taking the he monetary-production view means that neither the routine operation of capitalist economies nor the choices facing us in response to challenges like climate change should be seen in terms of scarcity and allocation.

The real-exchange paradigm sees production as non-monetary process of transforming inputs into outputs through a physical process we can represent as a production function. We know if we add this much labor and this much “capital” at one end, we’ll get this many consumption goods at the other end; the job of market price is to tell us if it is worth it. Thinking instead in terms of monetary production does not just mean adding money as another input. It means reconceiving the production process. The fundamental problem is now coordination — capacity for organized cooperation.

I’ve said that before. Let me now spell out a little more what I mean by it.

To say that production is an open ended collective activity of transforming the world, means that its possibilities are not knowable in advance. We don’t know how much labor and machinery and raw materials it will take to produce something new — or something old on an increased scale — until we actually do it. Nor do we know how much labor is potentially available until there’s demand for it.

We see this clearly in a phenomenon that has gotten increasing attention in macroeconomic discussions lately — what economists call hysteresis. In textbook theories, how much the economy is capable of producing — potential output — does not depend on how much we actually do produce There are only so many resources available, whether we are using them or not. But in reality, it’s clear that both the labor force and measured productivity growth are highly sensitive to current demand. Rather than a fixed number of people available to work, so that employing more in one area requires fewer working somewhere else, there is an immense, in practice effectively unlimited fringe of people who can be drawn into the labor force when demand for labor is strong. Technology, similarly, is not given from outside the economy, but develops in response to demand and wage growth and via investment.

All this is of course true when we are asking questions like, how much of our energy needs could in principle be met by renewable sources in 20 years? In that case, it is abundantly clear that the steep fall in the cost of wind and solar power we’ve already seen is the result of increased demand for them. It’s not something that would have happened on its own. But increasing returns and learning by doing are ubiquitous in real economies. In large buildings, for instance, the cost of constructing later floors is typically lower than the cost of constructing earlier ones.

In a world where hysteresis and increasing returns are important, it makes no sense to think in terms of a fixed amount of capacity, where producing more of one thing requires producing correspondingly less of something else. What is scarce, is the capacity to rapidly redirect resources from one use to a different one.

A second important dimension of the Keynesian perspective on production is that it is not simply a matter of combining material inputs, but happens within discrete social organisms. We have to take the firm seriously as ongoing community embodying multiple social logics. Firms combine the structured cooperation needed for production; a nexus of payments and incomes; an internal hierarchy of command and obedience; and a polis or imagined community for those employed by or otherwise associated with it.

While firms do engage in market transactions and exist — in principle at least — in order to generate profits, this is not how they operate internally. Within the firm, the organization of production is consciously planned and hierarchical. Wealth owners, meanwhile, do not normally own capital goods as such, but rather financial claims against these social organisms.

When we combine this understanding of production with Keynesian insights into money and finance , we are likely to conclude, as Keynes himself did, that an economy that depends on long-lived capital goods (and long-lived business enterprises, and scientific knowledge) cannot be effectively organized through the pursuit of private profit.

First, because the profits from these kinds of activities depend on developments well off in the future that cannot cannot be known with any confidence.

Second, because these choices are irreversible — capital goods specialized and embedded in particular production processes and enterprises. (Another aspect of this, not emphasized by Keynes, but one which wealth owners are very conscious of, is that wealth embodied in long-lived means of production can lose its character as wealth. It may effectively belong to the managers of the firm, or even the workers, rather than to its notional owners.) Finally, uncertainty about the future amplifies and exacerbates the problems of coordination.

The reason that many potentially valuable activities are not undertaken is not that they would require real resources that people would prefer to use otherwise. It is that people don’t feel they can risk the irreversible commitment those activities would entail. Many long-lived projects that would easily pay for themselves in both private and social terms are not carried out, because an insufficient capacity for trustworthy promises means that large-scale cooperation appears too risky to those in control of the required resources, who prefer to keep their their options open.

Or as Keynes put it: “That the world after several millennia of steady individual saving, is so poor as it is in accumulated capital-assets, is to be explained neither by the improvident propensities of mankind, nor even by the destruction of war, but by the high liquidity- premiums formerly attaching to the ownership of land and now attaching to money.”

The problem, Keynes is saying, is that wealth owners prefer land and money to claims on concrete productive processes. Monetary production means production organized by money and in pursuit of money. But also identifies conflict between production and money.

We see this clearly in a development context, where — as Joe Studwell has recently emphasized — the essential first step is to break the power of landlords and close off the option of capital flight so that private wealth owners have no option but to hold their wealth as claims on society in the form of productive enterprises.

The whole history of the corporation is filled with conflicts between the enterprise’s commitment to its own ongoing production process, and the desire of shareholders and other financial claimants to hold their wealth in more liquid, monetary form. The expansion or even continued existence of the corporation as an enterprise requires constantly fending off the demands of the rentiers to get “their” money back, now. The “complaining participants” of the Dutch East India Company in the 1620s, sound, in this respect, strikingly similar to shareholder activists of the 1980s.

Where privately-owned capital has worked tolerably well — as Keynes thought it had in the period before WWI, at least in the UK — it was because private owners were not exclusively or even mainly focused on monetary profit.

“Enterprise,” he writes, “only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. Only a little more than an expedition to the South Pole, is it based on an exact calculation of benefits to come. Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die.”

(It’s a curious thing that this iconic Keynesian term is almost always used today to describe financial markets, even though it occurs in a discussion of real investment. This is perhaps symptomatic of the loss of the production term of the monetary production theory from most later interpretations of Keynes.)

The idea that investment in prewar capitalism had depended as much on historically specific social and cultural factors rather than simply opportunities for profit was one that Keynes often returned to. “If the steam locomotive were to be discovered today,” he wrote elsewhere, “I much doubt if unaided private enterprise would build railways in England.”

We can find examples of the same thing in the US. The Boston Associates who pioneered textile factories in New England seem to have been more preserving the dominant social position of their interlinked families as in maximizing monetary returns. Schumpeter suggested that the possibility of establishing such “industrial dynasties” was essential to the growth of capitalism. Historians like Jonathan Levy give us vivid portraits of early American industrialists Carnegie and Ford as outstanding examples of animal spirits — both sought to increase the scale and efficiency of production as a goal in itself, as opposed to profit maximization.

In Keynes’ view, this was the only basis on which sustained private investment could work. A systematic application of financial criteria to private enterprise resulted in level of investment that was dangerously unstable and almost always too low. On the other hand — as emphasized by Kalecki but recognized by Keynes as well — a dependence on wealth owners pursuit of investment for its own sake required a particular social and political climate — one that might be quite inimical to other important social goals, if it could be maintained at all.

The solution therefore was to separate investment decisions from the pursuit of private wealth. The call for the “more or less comprehensive socialization of investment” at the end of The General Theory, is not the throwaway line that it appears as in that book, but reflects a program that Keynes had struggled with and developed since the 1920s. The Keynesian political program was not one of countercyclical fiscal policy, which he was always skeptical of. Rather it envisioned a number of more or less autonomous quasi-public bodies – housing authorities, hospitals, universities and so on – providing for the production of their own specific social goods, in an institutional environment that allowed them to ignore considerations of profitability.

The idea that large scale investment must be taken out of private hands was at the heart of Keynes’ positive program.

At this point, some of you may be thinking that that I have said two contradictory things. First, I said that a central insight of the Keynesian vision is that money and credit are essential tools for the organization of production. And then, I said that there is irreconcilable conflict between the logic of money and the needs of production. If you are thinking that, you are right. I am saying both of these things.

The way to reconcile this contradiction is to see these as two distinct moments in a single historical process.

We can think of money as a social solvent. It breaks up earlier forms of coordination, erases any connection between people.As the Bank of International Settlements economist Claudio Borio puts it: “a well functioning monetary system …is a highly efficient means of ‘erasing’ any relationship between transacting parties.” A lawyers’ term for this feature of money is privity, which “cuts off adverse claims, and abolishes the .. history of the account. If my bank balance is $100 … there is nothing else to know about the balance.”

In his book Debt, David Graeber illustrates this same social-solvent quality of money with the striking story of naturalist Ernest Thompson Seton, who was sent a bill by his father for all the costs of raising him. He paid the bill — and never spoke to his father again. Or as Marx and Engels famously put it, the extension of markets and money into new domains of social life has “pitilessly torn asunder the motley feudal ties that bound man to his “natural superiors”, and has left remaining no other nexus between man and man than naked self-interest, than callous “cash payment”.

But what they neglected to add is that social ties don’t stay torn asunder forever. The older social relations that organized production may be replaced by the cash nexus, but that is not the last step, even under capitalism. In the Keynesian vision, at least, this is a temporary step toward the re-embedding of productive activity in new social relationships. I described money a moment ago as a social solvent. But one could also call it a social catalyst. By breaking up the social ties that formerly organized productive activity, it allows them to be reorganized in new and more complex forms.

Money, in the Keynesian vision, is a tool that allows promises between strangers. But people who work together do not remain strangers. Early corporations were sometimes organized internally as markets, with “inside contractors” negotiating with each other. But reliance on the callous cash payment seldom lasted for long. Large-scale production today depends on coordination through formal authority. Property rights become a kind of badge or regalia of the person who has coordination rights, rather than the organizing principle in its own right.

Money and credit are critical for re-allocating resources and activity, when big changes are needed. But big changes are inherently a transition from one state to another. Money is necessary to establish new production communities but not to maintain them once they exist. Money as a social solvent frees up the raw material — organized human activity — from which larger structures, more extensive divisions of labor, are built. But once larger-scale coordination established, the continued presence of this social solvent eating away at it, becomes destructive.

This brings us to the political vision. Keynes, as Jim Crotty emphasizes, consistently described himself as a socialist. Unlike some of his American followers, he saw the transformation of productive activity via money and private investment as being a distinct historical process with a definite endpoint.

There is, I think, a deep affinity between the Keynes vision of the economy as a system of monetary production, and the idea that this system can be transcended.

If money is merely a veil, as orthodox economics imagines, that implies that social reality must resemble money. It is composed of measurable quantities with well-defined ownership rights, which can be swapped and combined to yield discrete increments of human wellbeing. That’s just the way the world is. But if we see money as a distinct institution, that frees us to imagine the rest of life in terms of concrete human activities, with their own logics and structures. It opens space for a vision of the good life as something quite different from an endless accumulation of commodities – a central strand of Keynes’ thinking since his early study of the philosopher G. E. Moore.

In contemporary debates – over climate change in particular – a “Keynesian” position is often opposed to a degrowth one. But as Victoria Chick observes in a perceptive essay, there are important affinities between Keynes and anti-growth writers like E. F. Schumacher. He looked forward to a world in which accumulation and economic growth had come to an end, daily life was organized around “friendship and the contemplation of beautiful objects,” and the pursuit of wealth would be regarded as “one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.”

This vision of productive activity as devoted to its own particular ends, and of the good life as something distinct from the rewards offered by the purchase and use of commodities, suggests a deeper affinity with Marx and the socialist tradition.

Keynes was quite critical of what he called “doctrinaire State Socialism.” But his objections, he insisted, had nothing to do with its aims, which he shared. Rather, he said, “I criticize it because it misses the significance of what is actually happening.” In his view, “The battle of Socialism against unlimited private profit is being won in detail hour by hour … We must take full advantage of the natural tendencies of the day.”

From Keynes’ point of view, the tension between the logic of money and the needs of production was already being resolved in favor of the latter. In his 1926 essay “The End of Laissez Faire,” he observed that “one of the most interesting and unnoticed developments of recent decades has been the tendency of big enterprise to socialize itself.” As shareholders’ role in the enterprise diminishes, “the general stability and reputation of the institution are more considered by the management than the maximum of pro

A shift from production for profit to production for use — to borrow Marx’s language — did not necessarily require a change in formal ownership. The question is not ownership as such, but the source of authority of those managing the production process, and the ends to which they are oriented. Market competition creates pressure to organize production so as to maximize monetary profits over some, often quite short, time horizon. But this pressure is not constant or absolute, and it is offset by other pressures. Keynes pointed to the example of the Bank of England, still in his day a private corporation owned by its shareholders, but in practice a fully public institution.

Marx himself had imagined something similar:

As he writes in Volume III of Capital,

Stock companies in general — developed with the credit system — have an increasing tendency to separate … management as a function from the ownership of capital… the mere manager who has no title whatever to the capital, … performs all the real functions pertaining to the functioning capitalist as such, … and the capitalist disappears as superfluous from the production process.

The separation of ownership from direction or oversight of production in the corporation is, Marx argues, an important step away from ownership as the organizing principle of production. “The stock company,” he continues, “is a transition toward the conversion of all functions… which still remain linked with capitalist property, into mere functions of associated producers.”

In short, he writes, the joint stock company represents as much as the worker-owned cooperative “the abolition of the capitalist mode of production within the capitalist mode of production itself.”

It might seem strange to imagine the tendency toward self-socialization of the corporation when examples of its subordination to finance are all around us. Sears, Toys R Us, the ice-cream-and-diner chain Friendly’s – there’s a seemingly endless list of functioning businesses purchased by private equity funds and then hollowed out or liquidated while generating big payouts for capital owners. Surely this is as far as one could get from Keynes’ vision of an inexorable victory of corporate socialism over private profit?

But I think this is a one-sided view. I think it’s a mistake — a big mistake — to identify the world around us as one straightforwardly organized by markets, the pursuit of profit and the logic of money.

As David Graeber emphasized, there is no such thing as a capitalist economy, or even a capitalist enterprise. In any real human activity, we find distinct social logics, sometimes reinforcing each other, sometimes in contradiction.

We should never imagine world around us — even in the most thoroughly “capitalist” moments — is simply the working out of a logic pdf property, prices and profit. Contradictory logics at work in every firm — even the most rapacious profit hungry enterprise depends for its operations on norms, rules, relationships of trust between the people who constitute it. The genuine material progress we have enjoyed under capitalism is not just due to the profit motive but perhaps even more so in spite of it.

One benefit of this perspective is it helps us see broader possibilities for opposition to the rule of money. The fundamental political conflict under capitalism is not just between workers and owners, but between logic of production process and of private ownership and markets. Thorstein Veblen provocatively imagined this latter conflict taking the form of a “soviet of engineers” rebelling against “sabotage” by financial claimants. A Soviet of engineers may sound fanciful today, but conflicts between the interests of finance and the needs of productive enterprise — and those who identify with them — are ongoing.

Teaching and nursing, for example, are the two largest occupations that require professional credentials.But teachers and nurses are also certainly workers, who organize as workers — teachers have one of the highest unionization rates of any occupation. In recent years, this organizing can be quite adversarial, even militant. We all recall waves of teacher strikes in recent years — not only in California but in states with deeply anti-union politics like West Virginia, Oklahoma, Arizona and Kentucky. The demands in these strikes have been workers’ demands for better pay and working conditions. But they have also been professionals’ demands for autonomy and respect and the integrity of their particular production process. From what I can tell, these two kinds of demands are intertwined and reinforcing.

This struggle for the right to do one’s job properly is sometimes described as “militant professionalism.” Veblen may have talked about engineers rather than teachers, but this kind of politics is, I think, precisely what he had in mind.

More broadly, we know that public sector unions are only effective when they present themselves as advocates for the public and for the users of the service they provide, and not only for their members as workers. Radical social service workers have fought for the rights of welfare recipients. Powerful health care workers unions, like SEIU 1199 in New York, are successful because they present themselves as advocates for the health care system as a whole.

On the other side, I think most of us would agree that the decline or disappearance of local news outlets is a real loss for society. Of course, the replacement of newspapers with social media and search engines isn’t commodification in the straightforward sense. This is a question of one set of for-profit businesses being displaced by another. But on the other hand, newspapers are not only for-profit businesses. There is a distinct professional ethos of journalism, that developed alongside journalism as a business. Obviously the “professional conscience” (the phrase is Michelet’s) of journalists was compatible with the interests of media businesses. But it was not reducible to them. And often enough, it was in tension with them.

I am very much in favor of new models of employee-owned, public and non-profit journalism. Certainly there is an important role for government ownership, and for models like Wikipedia. But I also think — and this is the distinct contribution of the Keynesian socialist — that we should not be thinking only in terms of payments and ownership. The development of a distinct professional norms for today’s information sector is independently valuable and necessary, regardless of who owns new media companies. It may be that creating space for those norms is the most important contribution that alternative ownership models can make

For a final example of this political possibilities of the monetary-production view, we can look closer by, to higher education, where most of us in this room make our institutional home. We have all heard warnings about how universities are under attack, they’re being politicized or corporatized, they’re coming to be run more like businesses. Probably some of us have given such warnings.

I don’t want to dismiss the real concerns behind them. But what’s striking to me is how much less often one hears about the positive values that are being threatened. Think about how often you hear people talk about how the university is under attack, is in decline, is being undermined. Now think about how often you hear people talk about the positive values of intellectual inquiry for its own sake that the university embodies. How often do you hear people talk about the positive value of academic freedom and self-government, either as specific values of the university or as models for the broader society? If your social media feed is like mine, you may have a hard time finding examples of that second category at all.

Obviously, one can’t defend something from attack without at some point making the positive case that there is something there worth defending. But the point is broader than that. The self-governing university dedicated to education and scholarship and as ends in themselves, is not, despite its patina of medieval ritual, a holdover from the distant past. It’s an institution that has grown up alongside modern capitalism. It’s an institution that, in the US especially, has greatly expanded within our own lifetimes.

If we want to think seriously about the political economy of the university, we can’t just talk about how it is under attack. We must also be able to talk about how it has grown, how it has displaced social organization on the basis of profit. (We should note here the failure of the for-profit model in higher education.) We should of course acknowledge the ways in which higher education serves the needs of capital, how it contributes to the reproduction of labor power. But we also should acknowledge all the ways that is more than this.

When we talk about the value of higher education, we often talk about the products — scholarship, education. But we don’t often talk about the process, the degree to which academics, unlike most other workers, manage our own classrooms according to our own judgements about what should be taught and how to effectively teach it. We don’t talk about how, almost uniquely in modern workplaces, we the faculty employees make decisions about hiring and promotion collectively and more or less democratically. People from all over the world come to study in American universities. It’s remarkable — and remarkably little discussed — how this successful export industry is, in effect, run by worker co-ops.

At this moment in particular, it is vitally important that we make the case for academic freedom as a positive principle.

Let me spell out, since it may not be obvious, how this political vision connects to the monetary production vision of the economy that I was discussing earlier.

The dominant paradigm in economics — which shapes all of our thinking, whether we have ever studied economics in the classroom — is what Keynes called, I distinction to his own approach, the real exchange vision. From the real-exchange perspective, money prices and payments are a superficial express of pre-existing qualities of things — that they are owned by someone, that they take a certain amount of labor to produce and have a definite capacity to satisfy human needs. From this point of view, production is just a special case of exchange.

It’s only once we see money as an institution in itself, a particular way of organizing human life, that we can see production as something distinct and separate from it. That’s what allows us to see the production process itself, and the relationships and norms that constitute it, as a site of social power and a market on a path toward a better world. The use values we socialists oppose to exchange value exist in the sphere of production as well as consumption. The political demands that teachers make as teachers are not legible unless we see the activity they’re engaged in in terms other than equivalents of money paid and received.

I want to end by sketching out a second political application of this vision, in the domain of climate policy.

First, decarbonization will be experienced as an economic boom. Money payments, I’ve emphasized, are an essential tool for rearranging productive activity, and decarbonizing will require a great deal of our activity to be rearranged. There will be major changes in our patterns of production and consumption, which in turn will require substantial changes to our means of production and built environment. These changes are brought about by flows money.

Concretely: creating new means of production, new tools and machinery and knowledge, requires spending money. Abandoning old ones does not. Replacing existing structures and tools and techniques faster than they would be in the normal course of capitalist development, implies an increase in aggregate money expenditure. Similarly, when a new or expanding business wants to bid workers away from other employment, they have to offer a higher wage than an established business needs to in order to retain its current workers. So a rapid reallocation of workers implies a faster rise in money wages.

So although decarbonization will substantively involve a mix of expansions of activity in some areas and reduction of activity in others, it will increase the aggregate volume of money flows. A boom in this sense is not just a period of faster measured growth, but a period in which demand is persistently high relative to the economy’s productive potential and tight labor markets strengthen the bargaining position of workers relative to employers – what is sometimes called a “high-pressure economy.”

Second. There is no tradeoff between decarbonization and current living standards. Decarbonization is not mainly a matter of diverting productive activity away from other needs, but mobilizing new production, with positive spillovers toward production for other purposes.

Here again, there is a critical difference between the monetary-production and the real-exchange views of the economy. In the real-exchange paradigm, we possess a certain quantity of “means.” If we choose to use some of them to reduce our carbon emissions, there will be less available for everything else. But when we think in terms of social coordination organized in large part through money flows, there is no reason to think this. There is no reason to believe that everyone who is willing and able to work is actually working, or people’s labor is being used in anything like its best possible way for the satisfaction of real human needs. Nor are relative prices today a good guide to long-run social tradeoffs.

Third. If we face a political conflict involving climate and growth, this will come not because decarbonization requires accepting a lower level of growth, but because it will entail faster economic growth than existing institutions can handle. Today’s neoliberal macroeconomic model depends on limiting economic growth as a way of managing distributional conflicts. Rapid growth under decarbonization will be accompanied by disproportionate rise in wages and the power of workers. Most of us in this room will probably see that as a desirable outcome. But it will inevitably create sharp conflicts and resistance from wealth owners, which need to be planned for and managed. Complaints about current “labor shortages” should be a warning call on this front.

Fourth. There is no international coordination problem — the countries that move fastest on climate will reap direct benefits.

An influential view of the international dimension of climate policy is that “free riding … lies at the heart of the failure to deal with climate change.” (That is William Nordhaus, who won the Nobel for his work on the economics of climate change.) Individual countries, in this view, bear the full cost of decarbonization measures but only get a fraction of the global benefits, and countries that do not engage in decarbonization can free-ride on the efforts of those that do.

A glance at the news should be enough to show you how backward this view is. Do Europeans look at US support for the wind, solar and battery industries, or the US at China’s support for them, and say, “oh, what wonderfully public-spirited shouldering of the costs of the climate crisis”? Obviously not. Rather, they are seen as strategic investments which other countries, in their own national interest, must seek to match.

Fifth. Price based measures cannot be the main tools for decarbonization.

There is a widely held view that the central tool for addressing climate should be an increase in the relative price of carbon-intensive commodities, through a carbon tax or equivalent. I was at a meeting a few years ago where a senior member of the Obama economics team was also present. “The only question I have about climate policy,” he said, “is whether a carbon tax is 80 percent of the solution, or 100 percent of the solution.” If you’ve received a proper economics education, this is a very reasonable viewpoint. You’ve been trained to see the economy as essentially an allocation problem where existing resources need to be directed to their highest-value use, and prices are the preferred tool for that.

From a Keynesian perspective the problem looks different. The challenge is coordination — bottlenecks and the need for simultaneous advances in multiple areas. Markets can, in the long run, be very powerful tools for this, but they can’t do it quickly. For rapid, large-scale reorganization of activity, they have to be combined with conscious planning — and that is the problem. The fundamental constraint on decarbonization should not be viewed as the potential output of the economy, but of planning capacity for large-scale non-market coordination.

If there is a fundamental conflict between capitalism and sustainability, I suggest, it is not because the drive for endless accumulation in money terms implies or requires an endless increase in material throughputs. Nor is it the need for production to generate a profit. There’s no reason why a decarbonized production process cannot be profitable. It’s true that renewable energy, with its high proportion of fixed costs, is not viable in a fully competitive market — but that’s a characteristic it shares with many other existing industries.

The fundamental problem, rather, is that capitalism treats the collective processes of social production as the private property of individuals. It is because the fiction of a market economy prevents us from developing the forms of non-market coordination that actually organize production, and that we will need on a much larger scale. Rapid decarbonization will require considerably more centralized coordination than is usual in today’s advanced economies. Treatment of our collective activity to transform the world as if it belonged exclusively to whoever holds the relevant property rights, is a fundamental obstacle to redirecting that activity in a rational way.

Eich on Marx on Money

I’ve been using some of Stefan Eich’s The Currency of Politics in the graduate class I’m teaching this semester. (I read it last year, after seeing a glowing mention of it by Adam Tooze.) This week, we talked about his chapter on Marx, which reminded me that I wrote some notes on it when I first read it. I thought it might be worthwhile turning them into a blogpost, incorporating some points that came out in the discussion in today’s class.

Eich begins with one commonly held idea of Marx’s views of money: that he was “a more or less closeted adherent of metallism who essentially accepted … gold-standard presumptions” — specifically, that the relative value of commodities is prior to whatever we happen to use for units of account and payments, that the value of gold (or whatever is used for money) is determined just like that of any other commodity, and that changes to the monetary system can’t have any effects on real activity (or at least, only disruptive ones). Eich’s argument is that while Marx’s theoretical views on money were more subtle and complex than this, he did share the operational conclusion that monetary reform was a dead end for political action. In Eich’s summary, while at the time of the Manifesto Marx still believed in a public takeover of the banking system as part of a socialist program, by the the 1860s he had come to believe that “any activist monetary policy to alter the level of investment, let alone … shake off exploitation, was futile.”

Marx’s arguments on money of course developed in response to the arguments of Proudhon and similar socialists like Robert Owen. For these socialists (in Eich’s telling; but it seems right to me) scarcity of gold and limits on credit were “obstacles to reciprocal exchange,” preventing people from undertaking all kinds of productive activity on a cooperative basis and creating conditions of material scarcity and dependence on employers. “A People’s Bank,” as Eich writes channeling Proudhon, “was the only way to guarantee the meaningfulness of the right to work.” Ordinary people are capable of doing much more socially useful (and remunerative) work than whatever jobs they were offered. But under the prevailing monopoly of credit, we have no way to convert our capacity to work into access to the means of production we would need to realize it.

Why, we can imagine Proudhon asking, do you need to work for a boss? Because he owns the factory. And why does he own the factory? Is it because only he had the necessary skills, dedication, and ambition to establish it? No, of course not. It’s because only he had the money to pay for it. Democratize money, and you can democratize production.

Marx turned this around. Rather than money being the reason why a small group of employers control the means of production, it is, under capitalism, simply an expression of that fact. And if we are going to attribute this control to a prior monopoly, it should be to land and the productive forces of nature, not money. The capitalist class inherits its coercive power from the landlord side of its family tree, not the banker side.

In Marx’s view, Proudhon had turned the fundamental reality of life under capitalism — that people are free to exchange their labor power for any other commodity — into an ideal. He attributed the negative consequences of organizing society around market exchange to monopolies and other deviations from it. (This is a criticism that might also be leveled against many subsequent reformers, including the ”market socialists” of our own time.)

That labor time is the center of gravity for prices is not a universal fact about commodities. It is a tendency — only a tendency — under capitalism specifically, as a result of several concrete social developments. First, again, production is carried out by wage labor. Second, wage labor is deskilled, homogenized, proletarianized. The equivalence of one hour of anyone’s labor for one hour of anyone else’s is a sociological fact reflecting that fact that workers really are interchangeable. Just as important, production must be carried out for profit, because capitalists compete both in the markets for their product and for the means of production. It is the objective need for them to produce at the lowest possible cost, or else cease being capitalists, that ensures that production is carried out with the socially necessary labor time and no more.

The equivalence of commodities produced by the same amount of labor is the result of proletarianization on the one side and the hard budget constraint on the other. The compulsion of the market, enforced by the “artificial” scarcity of money, is not an illegitimate deviation from the logic of equal exchange but its precondition. The need for money plays an essential coordinating function. This doesn’t mean that no other form of coordination is possible. But if you want to dethrone money-owners from control of the production process, you have to first create another way to organize it.

So one version of Marx’s response to Proudhon might go like this. In a world where production was not organized on capitalist lines, we could still have market exchange of various things. But the prices would be more or less conventional. Productive activity, on the other side, would be embedded in all kinds of other social relationships. We would not have commodities produced for sale by abstract labor, but particular use values produced by particular forms of activity carried out by particular people. Given the integration of production with the rest of life, there would be no way to quantitatively compare the amount of labor time embodied in different objects of exchange; and even if there were, the immobility of embedded labor means there would be no tendency for prices to adjust in line with those quantities. The situation that Proudhon is setting up as the ideal — prices corresponding to labor time, which can be freely exchanged for commodities of equal value — reflects a situation where labor is already proletarianized. Only when workers have lost any social ties to their work, and labor has been separated from the rest of life, does labor time become commensurable.

In the real world, the owners of the means of production have harnessed all our collective efforts into the production of commodities by wage labor for sale in the market, in order to accumulate more means of production – that is to say, capital. In this world, and only in this world, quantitative comparisons in terms of money must reflect the amount of labor required for production. Changes to the money system cannot change these relative values. At the same time, it’s only the requirement to produce for the market that ensures that one hour of labor really is equivalent to any other. Proudhon’s system of labor chits, in which anyone who spent an hour doing something could get a claim on the product of an hour of anyone else’s labor, would destroy the equivalence that the chits are supposed to represent. (A similar criticism might be made of job guarantee proposals today.)

For the mature Marx, money is merely “the form of appearance of the measure of value which is immanent in commodities, namely labor time.” There is a great deal to unpack in a statement like this. But the conclusion that changes in the quantity or form of money can have no effect on relative prices does indeed seem to be shared with the gold-standard orthodoxy of his time (and of ours).

The difference is that for Marx, that quantifiable labor time was not a fact of nature. People’s productive activities become uniform and homogeneous only as work is proletarianized, deskilled, and organized in pursuit of profit. It is not a general fact about exchange. Money might be neutral in the sense of not entering into the determination of relative prices, which are determined by labor time. But the existence of money is essential for there to be relative prices at all. The possibility of transforming authority over particular production processes into claims on the social product in general is a precondition for generalized wage labor to exist.

While Marx does look like commodity money theorist in some important ways, he shared with the credit-money theorists, and greatly developed, the idea — mostly implicit until then — that the productive capacities of a society are not something that exist prior to exchange, but develop only through the generalization of monetary exchange. Much more than earlier writers, or than Keynes and later Keynesians, he foregrounded the qualitative transformation of society that comes with the organization of production around the pursuit of money.

You could get much of this from any number of writers on Marx. What is a bit more distinctive in the Eich chapter is the links he makes between the theory and Marx’s political engagement. When Marx was writing his critique of Proudhon’s monetary-reform proposals in the 1840s, Eich observes, he and Engels still believed that public ownership of the banks was an important plank in the socialist program. Democratically-controlled banks would “make it possible to regulate the credit system in the interest of the people as a whole, and … undermine the dominion of the great money men. Further, by gradually substituting paper money for gold and silver coin, the universal means of exchange … will be cheapened.” At this point they still held out the idea that public credit could both alleviate monetary bottlenecks on production and be a move toward the regulation of production “according to the general interest of society as represented in the state.”

By the 1850s, however, Marx had grown skeptical of the relevance of money and banking for a socialist program. In a letter to Engels, he wrote that the only way forward was to “cut himself loose from all this ‘money shit’”; a few years later, he said, in an address to the First International, that “the currency question has nothing at all to do with the subject before us.” In the Grundrisse he asked rhetorically, “Can the existing relations of production and the relations of distribution which correspond to them be revolutionized by a change in the instrument of circulation…? Can such a transformation be undertaken without touching the existing relations of production and social relations which rest on them?” The answer, obviously, is No.

The reader of Marx’s published work might reasonably come away with something like this understanding of money: Generalized use of money is a precondition of wage labor, and leads to qualitative transformations of human life. But control over money is not the source of capitalists’ power, and the logic of capitalism doesn’t depend on the specific workings of the financial system. To understand the sources of conflict and crises under capitalism, and its transformative power and development over time, one should focus on the organization of production and the hierarchical relationships within the workplace. Capitalism is essentially a system of hierarchical control over labor. Money and finance are at best second order.

Eich doesn’t dispute this, as a description of what Marx actually he wrote.. But he argues that this rejection of finance as a site of political action was based on the specific conditions of the times. Today, though, the power and salience of organized labor has diminished. Meanwhile, central banks are more visible as sites of power, and the allocation of credit is a major political issue. A Marx writing now, he suggests, might take a different view on the value of monetary reform to a socialist program. I’m not sure, though, if this is a judgment that many people inspired by Marx would share.

In Praise of Profiteering

Of the usefulness of the concept, that is.¹

In my comments on inflation, I’ve emphasized supply disruptions more than market power. But as I’ll explain in this post, I think the market power or profiteering frame is also a valid and useful one.

Thanks in large part to Lindsay Owens and her team at the Groundwork Collaborative, the idea that corporate profiteering is an important part of today’s inflation is getting a surprising amount of traction, including from the administration. So it’s no surprise that it’s attracted some hostile pushback. This sneering piece by Catherine Rampell in the Washington Post is typical, so let’s start from there.

For critics like Rampell, the profiteering claim isn’t just wrong, but “conspiracy theory”, vacuous and incoherent:

The theory goes something like this: The reason prices are up so much is that companies have gotten “greedy” and are conspiring to “pad their profits,” “profiteer” and “price-gouge.” No one has managed to define “profiteering” and “price-gouging” more specifically than “raising prices more than I’d like.”

The problem with this narrative is that it’s just a pejorative tautology. Yes, prices are going up because companies are raising prices. Okay. This is the economic equivalent of saying “It’s raining because water is falling from the sky.”

The interesting thing about the profiteering story, to me, is precisely that it’s not a tautology. As a matter of logic, one might just as easily say “prices are going up because consumers are paying more.” It is not an axiomatic truth that businesses are who decide on prices. It is not a feature of textbook economics (where firms are price takers) nor is it an empirically true of all markets. As for profiteering, there is a straightforward definition — price increases that don’t reflect any change in the costs of production. Both economically and in the common-sense morality that terms like “price gouging” appeal to, there’s a distinction between price increases that reflect higher costs and ones that do not. And there’s nothing novel or strange about policies to limit the latter.

These two points are related. If prices were set straightforwardly as a markup over marginal costs, it wouldn’t make sense to say that “companies are raising prices.” And there wouldn’t be any question of price-gouging. The starting point here is, that’s not necessarily how prices are set. And once we agree that prices are a decision variable for firms, rather than an automatic market outcome, it’s not obvious why there shouldn’t be a public interest in how that decision gets made.

Think about water. It’s a commonplace that big increases in the price of bottled water in a disaster zone should not be allowed. The marginal cost of selling a bottle of water already on the shelf is no higher than in normal times. Nor are high prices for bottled water serving a function as signals — the premise is precisely that the quantity available is temporarily fixed. And everyone agrees that in these settings, willingness to pay is not a good measure of need.

What about water in normal times? In most of the United States, piped water is provided by local government. But in some places, it is provided by private water companies. And in those cases, invariably, its price is tightly regulated by a public utility commission, with price increases limited to cases where an increase in costs has been established. According to this recent GAO report, states with private water utilities all “rely on the same standard formula … to set private for-profit water rates. The formula relies on the actual costs of the utility …. including capital invested in its facilities, operations and maintenance costs, taxes, and other adjustments.”

The principle in these types of regulations — which, again, are ubiquitous and uncontroversial — is that in the real world prices may or may not track costs of production. Price increases that reflect higher costs are legitimate, and should be permitted; ones that do not are not, and should not.

Rent control is very controversial, both among economists and the general public. But I have never heard “water rate control” brought up as an example of an illegitimate government interference in the market, or seen a study of how much more water would be provided if utilities could charge what the market would bear. (Maybe some enterprising young economist will take that on.)

The same goes for many other public utilities — electricity, gas, and so on. Here in New York, a utility that wants to raise its electricity rates has to submit a filing to the Public Service Commission documenting the its operating and capital costs; if the proposed increase doesn’t reflect the company’s costs, it is not allowed. Obviously this isn’t so simple in practice, and the system certainly has its critics. But the point is, no one thinks that electricity — an industry that combines very high fixed costs, concentration and very inelastic demand, and which is an essential input to all kinds of other activity — is something where prices can be left to the market.

So the the question is not: Should prices be regulated or controlled? Nor is it whether some price increases are unreasonable. The answers to those questions are obviously, uncontroversially Yes. The question is whether the price regulation of utilities, and the economic analysis behind it, should be extended to other areas, or to prices in general.

People like Rampell are not thinking in terms of our world of production by large organizations using specialized tools and techniques. They are imagining an Econ 101 world where there is a fixed stock of stuff, and the market price is the one where people just want to buy that much. There are, to be sure, cases where this is a reasonable first approximation — used car dealers, say. But it is not a good description of most of the economy. Markets are not allocating a given stock of stuff, but guiding production. This production is carried out by large enterprises with substantial market power. They are not price takers. For most goods and services, price is a decision variable for producers, involving tradeoffs on a number of margins.²

In the models taught in introductory microeconomics, producers are price takers; they choose a quantity of output which they will sell at the going price. Given rising marginal costs — each additional unit of output costs more to produce than the last one — firms will carry out production just to the point where marginal cost equals the market price. This model is in principle consistent with the existence of fixed as well as marginal costs: Free entry and exit ensures that revenue at the market price just covers fixed costs, plus the normal profit (whatever that is).

The usual situation in a modern economy, however, is flat or declining marginal costs. Non-increasing marginal costs, nonzero fixed costs, and competitive pricing cannot coexist: In the absence of increasing marginal costs, a price equal to marginal cost leaves nothing to cover fixed costs. Modern industries, which invariably involve substantial fixed costs and flat or declining marginal costs at normal levels of output, require some degree of monopoly power in order to survive. This is the economic logic behind patents and copyrights — developing a new idea is costly, but disseminating it is cheap. So if we are relying on private businesses for this, they must be granted some degree of monopoly.³

The problem is, once we agree that some degree of market power is necessary in order for industries without declining returns to cover their fixed costs, how do we know how much market power is enough? Too much market power, and firms can make super-normal profits by holding prices above the level required to cover their costs, reducing access to whatever social useful thing they supply. Too little market power, and competing firms will be inefficiently small, drive each other to bankruptcy, or simply decline to enter, depriving society of the useful thing entirely. Returning to the IP example: To the extent that copyrights and patents serve an economic function, it is possible for them to be either too long or too short.

The problem gets worse when we think about what fixed costs men concretely. On the one hand, the decision to pay for a particular long-lived means of production is irreversible and taken in historical time; producers don’t know in advance whether their margins over costs of production will be enough to recoup the outlay. But on the other hand, the form these costs take is financial: A company has, typically, borrowed to pay for its plant, equipment and intellectual property; the concrete ongoing costs it faces are debt service payments. These may change after the fact, by, for example, being discharged in bankruptcy — which does not in general prevent the firm from continuing to operate. So there may be a very wide space between a price high enough to induce new firms to enter and a price low enough to induce existing firms to exit.

In addition, concerns over market share, public opinion, financing constraints, strategic interaction with competitors and other considerations mean that the price chosen within this space will not necessarily be the one that maximizes short-term profits (to the extent that this can even be known.) A lower price might allow a firm to gain market share, but risk retaliation from competitors. A higher price might allow for increased payments to shareholders, but risk a backlash from regulators or bad press. Narrowly economic factors may set some broad limits to pricing, but within them there is a broad range for strategic choices by sellers.

These issues were central to economic debates around the turn of the last century, particularly in the context of railroads. In the second half of the 19th century, railroads were the overwhelmingly dominant industrial businesses. And they clearly did not fit the models of competitive producers pricing according to marginal cost that the economics profession was then developing.

Railroads provided an essential function, for which there were no good alternatives. A single line on a given route had an effective monopoly, while two lines in parallel were almost perfect substitutes. The largest part of costs were fixed. But on the other hand, a firm that failed to meet its fixed costs would see its debt discharged in bankruptcy and then continue operating under new ownership. The result was cycles of price gouging and ruinous competition, in which farmers and small businesses could (much of the time) reasonably complain that they were being crushed by rapacious railroad owners, and railroads could (some of the time) reasonably complain they were being driven to the wall by cutthroat competition. Or as Alfred Chandler puts it,

Railroad competition presented an entirely new business phenomenon. Never before had a very small number of very large enterprises competed for the same business. And never before had competitors been saddled with such high fixed costs. In the 1880s fixed costs…averaged two-thirds of total cost. The relentless pressure of such costs quickly convinced railroad managers that uncontrolled competition of through traffic would be “ruinous”. As long as a road had cars available to carry freight, the temptation to attract traffic by reducing rates was always there. … To both the railroad managers and investors, the logic of such competition would be bankruptcy for all.⁴

As Michael Perelman explains in his excellent books The End of Economics and Railroading Economics (from which the following quotes are drawn), the problem of the railroads was the problem for the first generation of American professional economists. As these economists were developing models in which prices set in competitive markets would guarantee both a rational allocation of society’s resources and a normatively fair distribution of incomes, it was clear that in the era’s dominant industry, market prices did not work at all.

Already in the 1870s, Charles Francis Adams could observe:

The traditions of political economy,…notwithstanding, there are functions of modern life, the number of which is also continually increasing, which necessarily partake in their essence of the character of monopolies…. Now it is found that, whenever this characteristic exists, the effect of competition is not to regulate cost or equalize production, but under a greater or less degree of friction to bring about combination and a closer monopoly. This law is invariable. It knows no exceptions.

Arthur Hadley, an early president of the American Economic Association, made a similar argument. Where railroads competed, prices fell to a level that was too low to recover fixed costs, eventually sending one or both lines into bankruptcy. In the absence of competition, railroads could charge monopoly prices, which might be much higher than fixed costs. Equating prices to marginal costs made sense in an economy of small farmers or artisans. But in industries where most costs took the form of large, irreversible investments in fixed capital, there was no automatic process that would bring prices in line with costs. In Perelman’s summary:

In order to attract new capital into the business, rates must be high enough to pay not merely operating expenses, but fixed charges on both old and new capital. But, when capital is once invested, it can afford to make rates hardly above the level of operating expenses rather than lose a given piece of business. This “fighting rate” may be only one-half or one-third of a rate which would pay fixed charges. Based on his knowledge of the railroads, [Hadley] concluded that “survival of the fittest is only possible when the unfittest can be physically removed—a thing which is impossible in the case of an unfit trunk line.”

Perelman continues:

The root of the problem, for Hadley, was that to build a new line, owners had to expect rates high enough to cover not only the costs of operating it but the costs of constructing it, the financing charges, and a premium for risk; while to continue running an existing line, rates only had to cover operating costs. And these costs were essentially invariant to the volume of traffic on the line.

Or as John Bates Clark put it in 1901: “There is often a considerable range within which trusts can control prices without calling potential competition into positive activity.”

These were some of the leading figures in the economics profession around the turn of the century, so it’s striking how unambiguously they rejected the Marshallian orthodoxy of equilibrium prices. When the American Economics Association met for the first time, its proposed statement of principles included the line: “While we recognize the necessity of individual initiative in industrial life, we hold that the doctrine of laissez-faire is unsafe in politics and unsound in morals.” Politically, they were not socialists or radicals. They rejected competitive markets, but not private ownership. That however left the question, how should prices be regulated?

For a conservative economist like Hadley, the answer was social norms:

This power [of the trusts] is so great that it can only be controlled by public opinion—not by statute…. There are means enough. Don’t let him come to your house. Disqualify him socially. You may say that it is not an operative remedy. This is a mistake. Whenever it is understood that certain practices are so clearly against public need and public necessity that the man who perpetrates them is not allowed to associate on even terms with his fellow men, you have in your hands an all-powerful remedy.

Unfortunately, in practice, the withholding of dinner party invitations is not always an operative remedy.

In principle, there are many other ways to solve the problem. Intellectually, one can assume it away by simply insisting on declining returns to scale; or one can allow constant returns but have firms rent the services of undifferentiated capital, so there are no fixed costs. If the problem is not assumed away — a more practical option for theorists than for policymakers — it could in principle be solved by somehow ensuring that producers enjoy just the right degree of monopoly. This is what patents and copyrights are presumably supposed to do. Another possible answer is to say that where competition is not possible, that is an activity that should be carried out by the public. That was, of course, where urban rail systems ended up. For someone like Oskar Lange, it was a decisive argument for socializing production more broadly.⁵

Alternatively, one can accept cartels or monopolies (perhaps under the tutelage of dominant banks) in the hopes that social pressure or norms will limit prices, or on the grounds that a useful service provided at monopoly prices is still better than it not being provided at all. This was, broadly, the view of figures like Hadley, Ely and Clark, and arguably a big part of how things worked out.

But the main resolution to the problem, at least in the case of railroads, came from the increasing public pressure to regulate prices. The Interstate Commerce Commission was established to regulate railroad rates in 1887; its authority was initially limited, and it faced challenges from hostile Gilded-Age courts. But it was strengthened over the ensuing decades. The guiding principle was that rates should be high enough to cover a railroad’s full costs and a reasonable return, but no higher. This required railroads, among other things, to adopt more systematic and consistent accounting for capital costs.

Indeed, there’s a sense in which the logic of Langean socialism describes much of the evolution of private markets over the 20th century. The spread of cost-based price regulation forced firms to systematically measure and account for marginal costs in a way they might not have done otherwise. Mark Wilson, in his fascinating Destructive Creation, describes how the use of cost-plus contracts during World War II rationalized accounting in a broad range of industries. Systems of railroad-like rate regulation were applied to a number of more or less utility-like businesses both before and after the war, imposing from above the rational relationship between costs and prices that the market could not. Many of these regulations have been rolled back since the 1970s, but as noted earlier, many others remain in place.

Late 19th-century debates over railroad regulation might not be the most obvious place to look for guidance to today’s inflation debates. But as Axel Leijonhufvud points out in a beautiful essay on “The Uses of the Past,” economics is not progressive in the way that physical sciences are — we can’t assume that the useful contributions of the past are all incorporated into today’s thought. Economists’ thinking often changes for reasons of politics or fashion, while the questions posed by reality are changing as well as well, often in quite different ways. Older ideas may be more relevant to new problems than the current state of the art. History of economic thought becomes useful, Leijonhufvud writes,

when the road that took you to the ‘frontier of the field’ ends in a swamp or blind alley. A lot of them do. … Back there, in the past, there were forks in the road and it is possible, even plausible, that some roads were more passable than the one that looked most promising at the time.

The road I want to take from those earlier debates is that in a setting of high fixed costs and pervasive market power, how businesses set prices is a legitimate question, both as an object of inquiry and target for policy. One of the central insights of the railroad economists is that in modern capital-intensive industries, there is a wide range over which prices are, in an economic sense, indeterminate. Depending on competitive conditions and the strategic choices of firms, prices can be persistently too high or too low relative to costs. This indeterminacy means that pricing decisions are, at least potentially, a political question.

It’s worth emphasizing here that in empirical studies of how firms actually set prices — which admittedly are rather rare in the economics literature — an important factor in these decisions often seems to be norms around price-setting. In a classic paper on sticky prices, Alan Blinder surveyed business decision-makers on why they don’t change prices more frequently. The most common answer was, “it would antagonize customers.” In a recent ECB survey, one of the top two answers to the same question from businesses selling to the public was, similarly, that “customers expect prices to remain roughly the same.” (The other one was fear that competitors would not follow suit.)

This kind of survey data supports the idea, relied on by the Groundwork team, that businesses with substantial market power might be reluctant to use it in normal times. Those inhibitions would be lifted in an environment like that of the pandemic recovery, where individual price hikes are less likely to be seen as norm violations, or to be noticed at all. (And are more likely to be matched by competitors.)

Even more: It suggests that the moralizing language that critics like Rampell object to can, itself, be a form of inflation control. If fear of antagonizing customers is normally an important restraint on price increases then maybe we need to stoke up that antagonism! The language of “greedflation,” which I admit I didn’t originally care for, can be seen as an updated version of Arthur Hadley’s proposal to “disqualify socially” any business owner who raised prices too much. It is also, of course, useful in the fight for more direct price regulation, which is unlikely to get far on the basis of dispassionate analysis alone.

And this, I think, is a big source of the hostility toward Groundwork and toward others making the greedflation argument, like Isabella Weber.⁶ They are taking something that has been understood as a neutral, objective market outcome and reframing it as a moral and political question. This is, in Keynes’ terms, a question about the line between the Agenda and the Non-Agenda of political debates; and these are often more acrimonious than disputes where the legitimacy of the question itself is accepted by everyone, however much they may disagree on the answer.

By the same token, I think this line-shifting is a central contribution of the profiteering work. The 2022-23 inflation seems on its way to coming to an end on its own as supply disruptions gradually revolve themselves, just as (albeit more slowly than) Team Transitory always predicted. But even if the aggregate price level is behaving itself, rising prices can remain burdensome and economically costly in all kinds of areas (as can ruinous competition and underinvestment in others). Prices will remain an important political question, even if inflation is not.

My neighbor Stephanie Luce, who spent many years working in the Living Wage movement, often points out that the direct impact of those measures was in general quite small. But that does not mean that all the hard work and organizing that went into them was wasted. A more important contribution, she argues, is that they establish a moral vision and language around wages. Beyond their direct effects, living wage campaigns help shift discussions of wage-setting from economic criteria to questions of fairness and justice. In the same way, establishing price setting as a legitimate part of the political agenda is a step forward that will have lasting value even after the current bout of inflation is long over.

Keynes on Newton and the Methods of Science

I’ve just been reading Keynes’ short sketches of Isaac Newton in Essays in Biography. (Is there any topic he wasn’t interesting on?) His thesis is that Newton was not so much the first modern scientist as “the last of the magicians” — “a magician who believed that by intense concentration of mind on traditional hermetics and revealed books he could discover the secrets of nature and the course of future events, just as by the pure play of mind on a few facts of observation he had unveiled the secrets of the heavens.”

The two pieces are fascinating in their own right, but they also crystallized something I’ve been thinking about for a while about the relationship between the methods and the subject matter of the physical sciences.

It’s no secret that Newton had an interest in the occult, astrology and alchemy and so on. Keynes’ argument is that this was not a sideline to his “scientific” work, but was his project, of which his investigations into mathematics and the physical world formed just a part. In Keynes’ words,

He looked on the whole universe and all that is in it as a riddle, as a secret which could be read by applying pure thought to … mystic clues which God had laid about the world to allow a sort of philosopher’s treasure hunt to the esoteric brotherhood. He believed that these clues were to be found partly in the evidence of the heavens and in the constitution of elements… but also partly in certain papers and traditions … back to the original cryptic revelation in Babylonia. …

In Keynes’ view — supported by the vast collection of unpublished papers Newton left after his death, which Keynes made it his mission to recover for Cambridge — Newton looked for a mathematical pattern in the movements of the planets in exactly the same way as one would look for the pattern in a coded message or a secret meaning in a ancient text. Indeed, Keynes says, Newton did look in the same way for secret messages in ancient texts, with the same approach and during the same period in which he was developing calculus and his laws of motion.

There was extreme method in his madness. All his unpublished works on esoteric and theological matters are marked by careful learning, accurate method and extreme sobriety of statement. They are just as sane as the Principia, if their whole matter and purpose were not magical. They were nearly all composed during the same twenty-five years of his mathematical studies.

Even in his alchemical research, which superficially resembled modern chemistry, he was looking for secret messages. He was, says Keynes, “almost entirely concerned, not in serious experiment, but in trying to read the riddle of tradition, to find meaning in cryptic verses, to imitate the alleged but largely imaginary experiments of the initiates of past centuries.”

There’s an interesting parallel here to Foucault’s discussion in The Order of Things of 16th century comparative anatomy. When someone like Pierre Belon carefully compares the structures of a bird’s skeleton to a human one, it superficially resembles modern biology, but really “belongs to the same analogical cosmography as the comparison between apoplexy and tempests,” reflecting the idea that man “stands in proportion to the heavens just as he does to animals and plants.”

Newton’s “scientific” work was, similarly, an integral part of his search for ancient secrets and, perhaps, for him, not the most important part. Keynes approvingly quotes the words that George Bernard Shaw (drawing on some of the same material) puts in Newton’s mouth:

There are so many more important things to be worked at: the transmutations of matter, the elixir of life, the magic of light and color, above all the secret meaning of the Scriptures. And when I should be concentrating my mind on these I find myself wandering off into idle games of speculation about numbers in infinite series, and dividing curves into indivisibly short triangle bases. How silly!

None of this, Keynes insists, is to diminish Newton’s greatness as a thinker or the value of his achievements. His scientific accomplishments flowed from this same conviction that the world was a puzzle that would reveal some simple, logical, in retrospect obvious solution if one stared at it long enough. His greatest strength was his power of concentration, his ability to

hold a problem in his mind for hours and days and weeks until it surrendered to him its secret. Then being a supreme mathematical technician he could dress it up… for purposes of exposition, but it was his intuition which was pre-eminent … The proofs … were not the instrument of discovery.

There is the story of how he informed Halley of one of his most fundamental discoveries of planetary motion. ‘Yes,’ replied Halley, ‘but how do you know that? Have you proved it?’ Newton was taken aback—’Why, I’ve known it for years,’ he replied. ‘ If you’ll give me a few days, I’ll certainly find you a proof of it’—as in due course he did.

This is a style of thinking that we are probably all familiar with — the conviction that a difficult problem must have an answer, and that once we see it in a flash of insight we’ll know that it’s right. (In movies and tv shows, intellectual work is almost never presented in any other way.) Some problems really do have answers like this. Many, of course, do not. But you can’t necessarily know in advance which is which.

Which brings me to the larger point I want to draw out of these essays. Newton was not wrong to think that if the motion of the planets could be explained by a simple, universal law expressible in precise mathematical terms, other, more directly consequential questions might be explained the same way. As Keynes puts it,

He did read the riddle of the heavens. And he believed that by the same powers of his introspective imagination he would read the riddle of the Godhead, the riddle of past and future events divinely fore-ordained, the riddle of the elements…, the riddle of health and of immortality.

It’s a cliché that economists suffer from physics envy. There is definitely some truth to this (though how much the object of envy resembles actual physics I couldn’t say.) The positive content of this envy might be summarized as follows: The techniques of physical sciences have yielded good results where they have been applied, in physics, chemistry, etc. So we should expect similar good results if we apply the same techniques to human society. If we don’t have a hard science of human society, it’s simply because no one has yet done the work to develop one. (Economists, it’s worth noting, are not alone in believing this.)

In Robert Solow’s critical but hardly uniformed judgement,

the best and the brightest in the profession proceed as if economics is the physics of society. There is a single universal model of the world. It only needs to be applied. You could drop a modern economist from a time machine … at any time in any place, along with his or her personal computer; he or she could set up in business without even bothering to ask what time and which place. In a little while, the up-to-date economist will have maximized a familiar-looking present-value integral, made a few familiar log-linear approximations, and run the obligatory familiar regression.

It’s not hard to find examples of this sort of time-machine economics. David Romer’s widely-used macroeconomics textbook, for example, offers pre-contact population density in Australia and Tasmania (helpfully illustrated with a figure going back to one million BC) as an illustration of endogenous growth theory. Whether you’re asking about GDP growth next year, the industrial revolution or the human population in the Pleistocene, it’s all the same equilibrium condition.

Romer’s own reflections on economics methodology (in an interview with Snowdon and Vane) are a perfect example of what I am talking about.

As a formal or mathematical science, economics is still very young. You might say it is still in early adolescence. Remember, at the same time that Einstein was working out the theory of general relativity in physics, economists were still talking to each other using ambiguous words and crude diagrams.

In other words, people who studied physical reality embraced precise mathematical formalism early, and had success. The people who studied society stuck with “ambiguous words and crude diagrams” and did not. Of course, Romer says, that is now being corrected. But it’s not surprising that with its late start, economics hasn’t yet produced as definite and useful knowledge as the physical science have.

This is where Newton comes in. His occult interests are a perfect illustration of why the Romer view gets it backward. The same techniques of mathematical formalization, the same effort to build up from an axiomatic foundation, the same search for precisely expressible universal laws, have been applied to the whole range of domains right from the beginning — often, as in Newton’s case, by the same people. We have not, it seems to me, gained useful knowledge of orbits and atoms because that’s where the techniques of physical science happen to have been applied. Those techniques have been consistently applied there precisely because that’s where they turned out to yield useful knowledge.

In the interview quoted above, Romer defends the aggregate production function (that “drove Robinson to distraction”) and Real Business Cycle theory as the sort of radical abstraction science requires. You have “to strip things down to their bare essentials” and thoroughly grasp those before building back up to a more realistic picture.

There’s something reminiscent of Newton the mystic-scientist in this conviction that things like business cycles or production in a capitalist economy have an essential nature which can be grasped and precisely formalized without all the messy details of observable reality. It’s tempting to think that there must be one true signal hiding in all that noise. But I think it’s safe to say that there isn’t. As applied to certain physical phenomena, the idea that apparently disparate phenomena are united by a single beautiful mathematical or geometric structure has been enormously productive. As applied to business cycles or industrial production, or human health and longevity, or Bible exegesis, it yields nonsense and crankery.

In his second sketch, Keynes quotes a late statement of Newton’s reflecting on his own work:

I do not know what I may appear to the world; but to myself I seem to have been only like a boy, playing on the sea-shore, and diverting myself in now and then finding a smoother pebble or a prettier shell than ordinary, whilst the great ocean of truth lay all undiscovered before me.

I’m sure this quote is familiar to anyone who’s read anything about Newton, but it was new and striking to me. One way of reading it as support for the view that Newton’s scientific work was, in his mind, a sideshow to the really important inquiries which he had set aside. But another way is as a statement of what I think is arguably the essence of a scientific mindset – the willingness to a accept ignorance and uncertainty. My friend Peter Dorman once made an observation about science that has always stuck with me – that what distinguishes scientific thought is the disproportionate priority put on avoiding Type I errors (accepting a false claim) over avoiding Type II errors (rejecting a true claim). Until an extraordinary degree of confidence can be reached, one simply says “I don’t know”.

It seems to me that if social scientists are going to borrow something from the practices of Newton and his successors, it shouldn’t be an aversion to “ambiguous words,” the use calculus or geometric proofs, or the formulation of universal mathematical laws. It should be his recognition of the vast ocean of our ignorance. We need to accept that on most important questions we don’t know the answers and probably cannot know them. Then maybe we can recognize the small pebbles of knowledge that are accessible to us.

At Jacobin: Review of Beth Popp Berman’s Thinking Like an Economist

(This review appeared in the Summer 2022 edition of Jacobin.)

After the passage of Medicare and Medicaid, universal health insurance seemed to be on its way. In 1971, the New York Times observed that “Americans from all strata of society … are swinging over to the idea that good health care, like good education, ought to be a fundamental right of citizenship.” That same year, Ted Kennedy introduced a bill providing universal coverage with no payments at the point of service, on the grounds that “health care for all our people must now be recognized as a right.” The bill didn’t pass, but it laid down a marker for future health care reform.

But when Democratic presidents and congresses took up health care in later years they chose a different path. Rather than pitching health care as a right of citizenship, the goal was better-functioning markets for health care as a commodity. From the “consumer choice health plan” proposed by Alain Enthoven in the Carter administration, though the 1993 Clinton plan down to Obama’s ACA, the goal of reform was no longer the universal provision of health care, but addressing certain specific failures in the market for health insurance.

The intellectual roots of this shift are the subject of Beth Popp Berman’s new book Thinking Like an Economist: How Efficiency Replaced Equity in U.S. Public Policy. A distinct style of thinking, she argues, reshaped ideas how about how government should work and what it could achieve. This “economic style” of thinking, originating among Democrats rather than on the Right, “centered efficiency and cost-effectiveness, choice and incentives, and competition and the market mechanism… Its implicit theory of politics imagined that disinterested technocrats could make reasonably neutral, apolitical policy decisions.” Rather than see particular domains of public life, like health care or the environment, as embodying their own distinct goals and logics, they were imagined in terms of an idealized market, where the question was what specific market failure, if any, the government should correct.

The book traces this evolution in various policy domains, focusing on the microeconomic questions of regulation, social provision and market governance rather than the higher-profile debates among macroeconomists. Covering mainly the period of the Kennedy through Reagan administrations, with brief discussions of more recent developments, the book documents how the economic style of reasoning displaced alternative ways of thinking about policy questions. The first generation of environmental regulation, for example, favored high, inflexible standards such as simply forbidding emission of certain substances. Workplace and consumer safety laws similarly favored categorical prohibitions and requirements.

But to regulators trained in economics, this made no sense. To an economist, “the optimal level of air pollution, worker illness, or car accidents might be lower than its current level, but it was probably not zero.” As economist Marc Roberts wrote with frustration of the Clean Water Act, “There is no be no case-by-case balancing of costs and benefits, no attempt at ‘fine-tuning’ the process of resource allocation.’”

The book has aroused hostility from economists, who insist that this is an unfairly one-sided portrayal of their profession. I think Berman has the better of the argument here. As anyone who has taken an economics course in college can confirm, there really is such a thing as “thinking like an economist,” even if not every economist thinks that way. Framing every question as a problem of optimization under constraints is a very particular style of reasoning. And, as Berman observes, the most important site of this thinking is not the work of professional economists with their “frontier research,” but undergraduate classes and in schools of public policy where those in government, non-profits, and the press acquire this perspective.

Berman also is right to link this distinctive economic style of reasoning to a narrowing of American political horizons. At the same time, she is appropriately cautious about attributing too much independent influence to it — ideas matter, she suggests, but as tools of power rather than sources of it.

The problem with the book is not that she is unfair to economists; it’s that she concedes too much ground to them. Thinking Like an Economist is attentive to the shifting backgrounds of leaders and staff in federal agencies — if you’re wondering who was the first economics PhD to head the Justice Department’s Antitrust Division, this is the book for you. But this institutional history, while important, sometimes crowds out critical engagement with the ideas being discussed.

Take the term efficiency, which seems to occur on almost every page of the book, starting with the cover. The essence of the economic style, says Berman, is that government should make decisions “to promote efficiency.” But what does that mean?

We know what “efficient” means as applied to, say, a refrigerator. It means comparing a measurable input (electricity, in this case) to a well-defined outcome (a given volume maintained at a given temperature). There is nothing distinct to economics in preferring a more energy-efficient to a less energy-efficient appliance. Unions planning organizing campaigns, socialists running in elections, or public housing administrators all similarly face the problem of getting the most out of their scarce resources.

But what if the question is whether you should have a refrigerator in the first place, or if refrigerators ought to be privately owned? What could “efficient” mean here?

To an economist, the answer is the one that maximizes “utility” or “welfare.” These things, of course, are unobservable. So the measurement of inputs and output that defines efficiency in the every day sense is impossible.

Instead, what we do is start with an abstract model in which all choices involve using or trading property claims, and people know and care about only their own private interests. Then we show that in this model, exchange at market prices will satisfy a particular definition of efficiency — either Pareto, where no one can get a better outcome without someone else getting a worse one, or Kaldor-Hicks, where improvements to one person’s situation at the expense of another’s are allowed as long as the winners could, in principle, make the losers whole. Finally, in a sort of argument by homonym, this specialized and near-tautological meaning of “efficiency” is imported back into real-world settings, where it is used interchangeably with the everyday doing-more-with-less one.

When someone steeped in the economic style of thinking says “efficiency,” they mean something quite different from what normal people would. Rather than a favorable ratio of measurable out- puts to inputs, they mean a desirable outcome in terms of unmeasurable welfare or utility, which is simply assumed to be reached via markets. A great part of the power of economics in policy debates comes through the conflation of these two meanings. A common-sensical wish to get better outcomes with less resources gets turned into a universal rule that economic life should be organized around private property and private exchange.

Berman is well aware of the ambiguities of her key term, and the book contains some good discussions of these different meanings. But that understanding seldom makes it into the primary narrative of the book, where economists are allowed to pose as advocates of an undifferentiated “efficiency,” as opposed to non-economic social and political values. This forces Berman into the position of arguing that making government programs work well is in conflict with making them fair, when in reality an ideological preference for markets is often in conflict with both.

To be sure, there are cases where Berman’s frame works. Health care as a right is fundamentally different from a good that should be delivered efficiently, by whatever meaning. But in other cases, it leads her seriously astray. There are many things to criticize in the United States’ thread- bare welfare state. But is one of them really that it focuses too much on raising recipients’ in- comes, as opposed to relieving their “feelings of anomie and alienation”? Or again, there are many reasons to prefer 1960s and ‘70s style environmental regulation, with simple categorical rules, to the more recent focus on incentives and flexibility. But I am not sure that “the sacredness of Mother Earth” is the most convincing one.

That last phrase is Berman’s, from the introduction. It’s noteworthy that in her long and informative chapter on environmental regulation, we never hear the case for strong, inflexible standards being made in such terms. Rather, the first generation of regulators “built ambitious and relatively rigid rules … because they saw inflexibility as a tool for preventing capture” by industry, and because they believed that “setting high, even seemingly unrealistic standards … could drive rapid improvements” in technology. Meanwhile, their economics-influenced opponents like Charles Schultze (a leading economist in the Johnson and Carter administrations, and a central figure in the book) and Carter EPA appointee Bill Drayton, seem to have been motivated less by measurable policy outcomes than by objections on principle to “command and control” regulation. As one colleague described Drayton’s belief that companies should be allowed to offset emissions at one plant with reductions elsewhere, “What was driving Bill was pure intellectual conviction that this was a truly elegant approach — The Right Approach, with a capital ’T’ and ‘R’.” This does not look like a conflict between the values of equity and efficiency. It looks like a conflict between the goal of making regulation effective on one side, versus a preference for markets as such on the other.

On anti-trust regulation, the subject of another chapter in the book, the efficiency-versus-equity frame also obscures more than it reveals. The fundamental shift here was, as Berman says, away from a concern with size or market share, toward a narrower focus on horizontal agreements between competitors. And it is true that this shift was sometimes justified in terms of the supposed greater efficiency of dominant firms. But we shouldn’t take this justification at face value. As critical anti-trust scholars like Sanjukta Paul have shown, courts were not really interested in evidence for (or against) such efficiency. Rather, the guiding principle was a preference for top-down coordination by owners over other forms of economic coordination. This is why centralized price-setting by Amazon is acceptable, but an effort to bargain jointly with it by publishers was unacceptable; or why manufacturers’ prohibitions on resale of their products were accept- able but the American Medical Association’s limits on advertising by physicians was unacceptable. The issue here is not efficiency versus equity, or even centralized versus decentralized economic decision making. It’s about what kind of authority can be exercised in the economic sphere.

Berman ends the book with the suggestion that rebuilding the public sector calls for rethinking the language in which policies are understood and evaluated. On this, I fully agree. Readers who were politically active in the 2000s may recall the enormous mobilizations against George W. Bush’s proposals for Social Security privatization — and the failure, after those were abandoned, to translate this defensive program into a positive case for expanding social insurance. More recently, we’ve seen heroic labor actions by public teachers across the country. But while these have sometimes succeeded in their immediate goals, they haven’t translated into a broader argument for the value of public services and civil service protections.

As Berman says, it’s not enough to make the case for particular public programs; what we need is better language to make the positive case for the public sector in general.

No Maestros: Further Thoughts

One of the things we see in the questions of monetary policy transmission discussed in my Barron’s piece is the real cost of an orthodox economics education. If your vision of the economy is shaped by mainstream theory, it is impossible to think about what central banks actually do.

The models taught in graduate economics classes feature an “interest rate” that is the price of goods today in terms of identical goods in the future. Agents in these models are assumed to be able to freely trade off consumption today against consumption at any point in the future, and to distribute income from any time in the future over their lifetime as they see fit, subject only to the “no Ponzi” condition that over infinite time their spending must equal their income. This is a world, in other words, of infinite liquidity. There are no credit markets as such, only real goods at different dates.⁷

Monetary policy in this framework is then thought of in terms of changing the terms at which goods today trade for goods tomorrow, with the goal of keeping it at some “natural” level. It’s not at all clear how the central bank is supposed to set the terms of all these different transactions, or what frictions cause the time premium to deviate from the natural level, or whether the existence of those frictions might have broader consequences. ⁸ But there’s no reason to get distracted by this imaginary world, because it has nothing at all to do with what real central banks do.

In the real world, there are not, in general, markets where goods today trade for identical goods at some future date. But there are credit markets, which is where the price we call “the interest rate” is found. The typical transaction in a credit market is a loan — for example, a mortgage. A mortgage does not involve any trading-off of future against present income. Rather, it is income-positive for both parties in every period.

The borrower is getting a flow of housing services and making a flow of mortgage payments, both of which are the same in every period. Presumably they are getting more/better housing services for their mortgage payment than they would for an equivalent rental payment in every period (otherwise, they wouldn’t be buying the house.) Far from getting present consumption at the expense of future consumption, the borrower probably expects to benefit more from owning the house in the future, when rents will be higher but the mortgage payment is the same.

The bank, meanwhile, is getting more income in every period from the mortgage loan than it is paying to the holder of the newly-created deposit. No one associated with the bank is giving up any present consumption — the loan just involves creating two offsetting entries on the bank’s books. Both parties to the transaction are getting higher income over the whole life of the mortgage.

So no one, in the mortgage transaction, is trading off the present against the future. The transaction will raise the income of both sides in every period. So why not make more mortgages to infinity? Because what both parties are giving up in exchange for the higher income is liquidity. For the homeowner, the mortgage payments yield more housing services than equivalent rent payments, but they are also harder to adjust if circumstances change. Renting gives you less housing for your buck, but it’s easier to move if it turns out you’d rather live somewhere else. For the bank, the mortgage loan (its asset) carries a higher interest rate than the deposit (its liability), but involves the risk that the borrower will not repay, and also the risk that, in a crisis, ownership of the mortgage cannot be turned into immediate cashflows while the deposit is payable on demand.

In short, the fundamental tradeoff in credit markets – what the interest rate is the price of – is not less now versus more later, but income versus liquidity and safety.⁹

Money and credit are hierarchical. Bank deposits are an asset for us – they are money – but are a liability for banks. They must settle their own transactions with a different asset, which is a liability for the higher level of the system. The Fed sits at the top of this hierarchy. That is what makes its actions effective. It’s not that it can magically change the terms of every transaction that involves things happening at different dates. It’s that, because its liabilities are what banks use to settle their obligations to each other, it can influence how easy or difficult they find it to settle those liabilities and hence, how willing they are to take on the risk of expanding their balance sheets.

So when we think about the transmission of monetary policy, we have to think about two fundamental questions. First, how much do central bank actions change liquidity conditions within the financial system? And second, how much does real activity depends on the terms on which credit is available?

We might gloss this as supply and demand for credit. The mortgage, however, is typical of credit transactions in another way: It involves a change in ownership of an existing asset rather than the current production of goods and services. This is by far the most common case. So some large part of monetary policy transmission is presumably via changes in prices of assets rather than directly via credit-financed current production. ¹⁰ There are only small parts of the economy where production is directly sensitive to credit conditions.

One area where current production does seem to be sensitive to interest rates is housing construction. This is, I suppose, because on the one hand developers are not large corporations that can finance investment spending internally, and on the other hand land and buildings are better collateral than other capital goods. My impression – tho I’m getting well outside my area of expertise here – is that some significant part of construction finance is shorter maturity loans, where rates will be more closely linked to the policy rate. And then of course the sale price of the buildings will be influenced by prevailing interest rates as well. As a first approximation you could argue that this is the channel by which Fed actions influence the real economy. Or as this older but still compelling article puts it, “Housing IS the business cycle.”

Of course there are other possible channels. For instance, it’s sometimes argued that during the middle third of the 20th century, when reserve requirements really bound, changes in the quantity of reserves had a direct quantitative effect on the overall volume of lending, without the interest rate playing a central role one way or the other. I’m not sure how true this is — it’s something I’d like to understand better — but in any case it’s not relevant to monetary policy today. Robert Triffin argued that inventories of raw materials and imported commodities were likely to be financed with short term debt, so higher interest rates would put downward pressure on their prices specifically. This also is probably only of historical interest.

The point is, deciding how much, how quickly and how reliably changes in the central bank’s policy rate will affect real activity (and then, perhaps, inflation) would seem to require a fairly fine-grained institutional knowledge about the financial system and the financing needs of real activity. The models taught in graduate macroeconomics are entirely useless for this purpose. Even for people not immersed in academic macro, the fixation on “the” interest rate as opposed to credit conditions broadly is a real problem.

These are not new debates, of course. I’ve linked before to Juan Acosta’s fascinating article about the 1950s debates between Paul Samuelson and various economists associated with the Fed.¹¹ The lines of debate then were a bit different from now, with the academic economists more skeptical of monetary policy’s ability to influence real economic outcomes. What Fed economist Robert Roosa seems to have eventually convinced Samuelson of, is that monetary policy works not so much through the interest rate — which then as now didn’t seem to have big effect on investment decision. It works rather by changing the willingness of banks to lend — what was then known as “the availability doctrine.” This is reflected in later editions of his textbook, which added an explanation of monetary policy in terms of credit rationing.

Even if a lender should make little or no change in the rate of interest that he advertises to his customers, there may probably still be the following important effect of “easy money.” … the lender will now be rationing out credit much more liberally than would be the case if the money market were very tight and interest rates were tending to rise. … Whenever in what follows I speak of a lowering of interest rates, I shall also have in mind the equally important relaxation of the rationing of credit and general increase in the availability of equity and loan capital to business.

The idea that “the interest rate” is a metaphor or synecdoche for a broader easing of credit conditions is important step toward realism. But as so often happens, the nuance has gotten lost and the metaphor gets taken literally.

Alternative Visions of Inflation

Like many people, I’ve been thinking a bit about inflation lately. One source of confusion, it seems to me, is that underlying concept has shifted in a rather fundamental way, but the full implications of this shift haven’t been taken on board.

I was talking with my Roosevelt colleague Lauren Melodia about inflation and alternative policies to manage it, which is a topic I hope Roosevelt will be engaging in more in the later part of this year. In the course of our conversation, it occurred to me that there’s a basic source of confusion about inflation.

Many of our ideas about inflation originated in the context of a fixed quantity money. The original meaning of the term “inflation” was an increase in the stock of money, not a general increase in the price level. Over there you’ve got a quantity of stuff; over here you’ve got a quantity of money. When the stock of money grows rapidly and outpaces the growth of stuff, that’s inflation.

In recent decades, even mainstream economists have largely abandoned the idea of the money stock as a meaningful economic quantity, and especially the idea that there is a straightforward relationship between money and inflation.

Here is what a typical mainstream macroeconomics textbook — Olivier Blanchard’s, in this case; but most are similar — says about inflation today. (You can just read the lines in italics.)

There are three stories about inflation here: one based on expected inflation, one based on markup pricing, and one based on unemployment. We can think of these as corresponding to three kinds of inflation in the real world — inertial, supply-drive, and demand-driven. What there is not, is any mention of money. Money comes into the story only in the way that it did for Keynes: as an influence on the interest rate.

To be fair, the book does eventually bring up the idea of a direct link between the money supply and inflation, but only to explain why it is obsolete and irrelevant for the modern world:

Until the 1980s, the strategy was to choose a target rate of money growth and to allow for deviations from that target rate as a function of activity. The rationale was simple. A low target rate of money growth implied a low average rate of inflation. …

That strategy did not work well.

First, the relation between money growth and inflation turned out to be far from tight, even in the medium run. … Second, the relation between the money supply and the interest rate in the short run also turned out also to be unreliable. …

Throughout the 1970s and 1980s, frequent and large shifts in money demand created serious problems for central banks. … Starting in the early 1990s, a dramatic rethinking of monetary policy took place based on targeting inflation rather than money growth, and the use of an interest rate rule.

Obviously, I don’t endorse everything in the textbook.¹² (The idea of a tight link between unemployment and inflation is not looking much better than the idea of a tight link between inflation and the money supply.) I bring it up here just to establish that the absence of a link between money growth and inflation is not radical or heterodox, but literally the textbook view.

One way of thinking about the first Blanchard passage above is that the three stories about inflation correspond to three stories about price setting. Prices may be set based on expectations of where prices will be, or prices may be set based on market power (the markup), or prices may be set based on costs of production.

This seems to me to be the beginning of wisdom with respect to inflation: Inflation is just an increase in prices, so for every theory of price setting there’s a corresponding theory of inflation. There is wide variation in how prices get set across periods, countries and markets, so there must be a corresponding variety of inflations.

Besides the three mentioned by Blanchard, there’s one other story that inflation is perhaps even more widespread. We could call this too much spending chasing too little production.

The too-much-spending view of inflation corresponds to a ceiling on output, rather than a floor on unemployment, as the inflationary barrier. As the NAIRU has given way to potential output as the operational form of supply constraints on macroeconomic policy, this understanding of inflation has arguably become the dominant one, even if without formalization in textbooks. It overlaps with the unemployment story in making current demand conditions a key driver of inflation, even if the transmission mechanism is different.

Superfically “too much spending relative to production” sounds a lot like “too money relative to goods.” (As to a lesser extent does “too much wage growth relative to productivity growth.”) But while these formulations sound similar, they have quite different implications. Intuitions formed by the old quantity-of-money view don’t work for the new stories.

The older understanding of inflation, which runs more or less unchanged from David Hume through Irving Fisher to Milton Friedman and contemporary monetarists, goes like this. There’s a stock of goods, which people can exchange for their mutual benefit. For whatever reasons, goods don’t exchange directly for other goods, but only for money. Money in turn is only used for purchasing goods. When someone receives money in exchange for a good, they turn around and spend it on some good themselves — not instantly, but after some delay determined by the practical requirements of exchange. (Imagine you’ve collected your earnings from your market stall today, and can take them to spend at a different market tomorrow.) The total amount of money, meanwhile, is fixed exogenously — the quantity of gold in circulation, or equivalently the amount of fiat tokens created by the government via its central bank.

Under these assumptions, we can write the familiar equation

MV = PY

If Y, the level of output, is determined by resources, technology and other “real” factors, and V is a function of the technical process of exchange — how long must pass between the receipt of money and it spending — then we’re left with a direct relationship between the change in M and the change in P. “Inflation is always and everywhere a monetary phenomenon.”¹³

I think something like this underlies most folk wisdom about inflation. And as is often the case, the folk wisdom has outlived whatever basis in reality it may once have had.¹⁴

Below, I want to sketch out some ways in which the implications of the excessive-spending-relative-to-production vision of inflation are importantly different from those of the excessive-money-relative-to-goods vision. But first, a couple of caveats.

First, the idea of a given or exogenous quantity of money isn’t wrong a priori, as a matter of logic; it’s an approximation that happens not to fit the economy in which we live. Exactly what range of historical settings it does fit is a tricky question, which I would love to see someone try to answer. But I think it’s safe to say that many important historical inflations, both under metallic and fiat regimes, fit comfortably enough in a monetarist framework.

Second, the fact that the monetarist understanding of inflation is wrong (at least for contemporary advanced economies) doesn’t mean that the modern mainstream view is right. There is no reason to think there is one general theory of inflation, any more than there is one general etiology of a fever. Lots of conditions can produce the same symptom. In general, inflation is a persistent, widespread rise in prices, so for any theory of price-setting there’s a corresponding theory of inflation. And the expectations-based propagation mechanism of inertial inflation — where prices are raised in the expectation that prices will rise — is compatible with many different initial inflationary impulses.

That said — here are some important cleavages between the two visions.

1. Money vs spending. More money is just more money, but more spending is always more spending on something in particular. This is probably the most fundamental difference. When we think of inflation in terms of money chasing a given quantity of goods, there is no connection between a change in the quantity of money and a change in individual spending decisions. But when we think of it in terms of spending, that’s no longer true — a decision to spend more is a decision to spend more on some specific thing. People try to carry over intuitions from the former case to the latter, but it doesn’t work. In the modern version, you can’t tell a story about inflation rising that doesn’t say who is trying to buy more of what; and you can’t tell a story about controlling inflation without saying whose spending will be reduced. Spending, unlike money, is not a simple scalar.

The same goes for the wages-markup story of the textbook. In the model, there is a single wage and a single production process. But in reality, a fall in unemployment or any other process that “raises the wage” is raising the wages of somebody in particular.

2. Money vs prices. There is one stock of money, but there are many prices, and many price indices. Which means there are many ways to measure inflation. As I mentioned above, inflation was originally conceived of as definitionally an increase in the quantity of money. Closely related to this is the idea of a decrease in the purchasing power of money, a definition which is still sometimes used. But a decrease in the value of money is not the same as an increase in the prices of goods and services, since money is used for things other than purchasing goods and services. (Merijn Knibbe is very good on this.¹⁵) Even more problematically, there are many different goods and services, whose prices don’t move in unison.

This wasn’t such a big deal for the old concept of inflation, since one could say that all else equal, a one percent increase in the stock of money would imply an additional point of inflation, without worrying too much about which specific prices that showed up in. But in the new concept, there’s no stock of money, only the price changes themselves. So picking the right index is very important. The problem is, there are many possible price indexes, and they don’t all move in unison. It’s no secret that inflation as measured by the CPI averages about half a point higher than that measured by the PCE. But why stop there? Those are just two of the infinitely many possible baskets of goods one could construct price indexes for. Every individual household, every business, every unit of government has their own price index and corresponding inflation rate. If you’ve bought a used car recently, your personal inflation rate is substantially higher than that of people who haven’t. We can average these individual rates together in various ways, but that doesn’t change the fact that there is no true inflation rate out there, only the many different price changes of different commodities.

3. Inflation and relative prices. In the old conception, money is like water in a pool. Regardless of where you pour it in, you get the same rise in the overall level of the pool.

Inflation conceived of in terms of spending doesn’t have that property. First, for the reason above — more spending is always more spending on something. If, let’s say for sake of argument, over-generous stimulus payments are to blame for rising inflation, then the inflation must show up in the particular goods and services that those payments are being used to purchase — which will not be a cross-section of output in general. Second, in the new concept, we are comparing desired spending not to a fixed stock of commodities, but to the productive capacity of the economy. So it matters how elastic output is — how easily production of different goods can be increased in response to stronger demand. Prices of goods in inelastic supply — rental housing, let’s say — will rise more in response to stronger demand, while prices of goods supplied elastically — online services, say — will rise less. It follows that inflation, as a concrete phenomenon, will involve not an across-the-board increase in prices, but a characteristic shift in relative prices.

This is a different point than the familiar one that motivates the use of “core” inflation — that some prices (traditionally, food and energy) are more volatile or noisy, and thus less informative about sustained trends. It’s that when spending increases, some goods systematically rise in price faster than others.

This recent paper by Stock and Watson, for example, suggests that housing, consumer durables and food have historically seen prices vary strongly with the degree of macroeconomic slack, while prices for gasoline, health care, financial services, clothing and motor vehicles do not, or even move the opposite way. They suggest that the lack of a cyclical component in health care and finance reflect the distinct ways that prices are set (or imputed) in those sectors, while the lack of a cyclical component in gas, clothing and autos reflects the fact that these are heavily traded goods whose prices are set internationally. This interpretation seems plausible enough, but if you believe these numbers they have a broader implication: We should not think of cyclical inflation as an across the board increase in prices, but rather as an increase in the price of a fairly small set of market-priced, inelastically supplied goods relative to others.

4. Inflation and wages. As I discussed earlier in the post, the main story about inflation in today’s textbooks is the Phillips curve relationship where low unemployment leads to accelerating inflation. Here it’s particularly clear that today’s orthodoxy has abandoned the quantity-of-money view without giving up the policy conclusions that followed from it.

In the old monetarist view, there was no particular reason that lower unemployment or faster wage growth should be associated with higher inflation. Wages were just one relative price among others. A scarcity of labor would lead to higher real wages, while an exogenous increase in wages would lead to lower employment. But absent a change in the money supply, neither should have any effect on the overall price level.

It’s worth noting here that altho Milton Friedman’s “natural rate of unemployment” is often conflated with the modern NAIRU, the causal logic is completely different. In Friedman’s story, high inflation caused low unemployment, not the reverse. In the modern story, causality runs from lower unemployment to faster wage growth to higher inflation. In the modern story, prices are set as a markup over marginal costs. If the markup is constant, and all wages are part of marginal cost, and all marginal costs are wages, then a change in wages will just be passed through one to one to inflation.

We can ignore the stable markup assumption for now — not because it is necessarily reasonable, but because it’s not obvious in which direction it’s wrong. But if we relax the other assumptions, and allow for non-wage costs of production and fixed wage costs, that unambiguously implies that wage changes are passed through less than one for one to prices. If production inputs include anything other than current labor, then low unemployment should lead to a mix of faster inflation and faster real wage growth. And why on earth should we expect anything else? Why shouldn’t the 101 logic of “reduced supply of X leads to a higher relative price of X” be uniquely inapplicable to labor?¹⁶

There’s an obvious political-ideological reason why textbooks should teach that low unemployment can’t actually make workers better off. But I think it gets a critical boost in plausibility — a papering-over of the extreme assumptions it rests on — from intuitions held over from the old monetarist view. If inflation really was just about faster money growth, then the claim that it leaves real incomes unchanged could work as a reasonable first approximation. Whereas in the markup-pricing story it really doesn’t.

5. Inflation and the central bank. In the quantity-of-money vision, it’s obvious why inflation is the special responsibility of the central bank. In the textbooks, managing the supply of money is often given as the first defining feature of a central bank. Clearly, if inflation is a function of the quantity of money, then primary responsibility for controlling it needs to be in the hands of whoever is in charge of the money supply, whether directly, or indirectly via bank lending.

But here again, it seems, to me, the policy conclusion is being asked to bear weight even after the logical scaffolding supporting it has been removed.

Even if we concede for the sake of argument that the central bank has a special relationship with the quantity of money, it’s still just one of many influences on the level of spending. Indeed, when we think about all the spending decisions made across the economy, “at one interest rate will I borrow the funds for it” is going to be a central consideration in only a few of them. Whether our vision of inflation is too much spending relative to the productive capacity of the economy, or wages increasing faster than productivity, many factors are going to play a role beyond interest rates or central bank actions more broadly.

One might believe that compared with other macro variables, the policy interest rate has a uniquely strong and reliable link to the level of spending and/or wage growth; but almost no one, I think, does believe this. The distinct responsibility of the central bank for inflation gets justified not on economic grounds but political-institutional ones: the central bank can act more quickly than the legislature, it is free of undue political influence, and so on. These claims may or may not be true, but they have nothing in particular to do with inflation. One could justify authority over almost any area of macroeconomic policy on similar grounds.

Conversely, once we fully take on board the idea that the central bank’s control over inflation runs through to the volume of credit creation to the level of spending (and then perhaps via unemployment to wage growth), there is no basis for the distinction between monetary policy proper and other central bank actions. All kinds of regulation and lender-of-last-resort operations equally change the volume and direction of credit creation, and so influenced aggregate spending just as monetary policy in the narrow sense does.

6. The costs of inflation. If inflation is a specifically monetary phenomenon, the costs of inflation presumably involve the use of money. The convenience of quoting relative prices in money becomes a problem when the value of money is changing.

An obvious example is the fixed denominations of currency — monetarists used to talk with about “shoe leather costs” — the costs of needing to go more frequently to the bank (as one then did) to restock on cash. A more consequential example is public incomes or payments fixed in money terms. As recently as the 1990s, one could find FOMC members talking about bracket creep and eroded Social Security payments as possible costs of higher inflation — albeit with some embarrassment, since the schedules of both were already indexed by then. More broadly, in an economy organized around money payments, changes in what a given flow of money can buy will create problems. Here’s one way to think about these problems:

Social coordination requires a mix of certainty and flexibility. It requires economic units to make all kinds of decisions in anticipation of the choices of other units — we are working together; my plans won’t work out if you can change yours too freely. But at the same time, you need to have enough space to adapt to new developments — as with train cars, there needs to be some slack in the coupling between economic unit for things to run smoothly. One dimension of this slack is the treatment of some extended period as if it were a single instant.

This is such a basic, practical requirements of contracting and management that we hardly think about it. For example, budgets — most organizations budget for periods no shorter than a quarter, which means that as far as internal controls and reporting are concerned, anything that happens within that quarter happens at the same time.¹⁷Similarly, invoices normally require payment in 30 or 60 days, thus treating shorter durations as instantaneous. Contracts of all kinds are signed for extended periods on fixed money terms. All these arrangements assume that the changes in prices over a few months or a year are small enough that they can be safely ignored.can be modified when inflation is high enough to make the fiction untenable that 30, 60 or 90 days is an instant. Social coordination strongly benefits from the convention that shorter durations can be ignored for most periods, which means people behave in practice as if they expect inflation over such shorter periods to be zero.

Axel Leijonhufvud’s mid-70s piece on inflation is one of the most compelling accounts of this kinds of cost of inflation — the breakdown of social coordination — that I have seen. For him, the stability of money prices is the sine qua non of decentralized coordination through markets.

In largely nonmonetary economies, important economic rights and obligations will be inseparable from particularized relationships of social status and political allegiance and will be in some measure permanent, inalienable and irrevocable. … In monetary exchange systems, in contrast, the value to the owner of an asset derives from rights, privileges, powers and immunities against society generally rather than from the obligation of some particular person. …

Neoclassical theories rest on a set of abstractions that separate “economic” transactions from the totality of social and political interactions in the system. For a very large set of problems, this separation “works”… But it assumes that the events that we make the subject of … the neoclassical model of the “economic system” do not affect the “social-political system” so as … to invalidate the institutional ceteris paribus clauses of that model. …

Double-digit inflation may label a class of events for which this assumption is a bad one. … It may be that … before the “near-neutral” adjustments can all be smoothly achieved, society unlearns to use money confidently and reacts by restrictions on “the circles people shall serve, the prices they shall charge, and the goods they can buy.”

One important point here is that inflation has a much greater impact than in conventional theory because of the price-stability assumption incorporated into any contract that is denominated in money terms and not settled instantly — which is to say, pretty much any contract. So whatever expectations of inflation people actually hold, the whole legal-economic system is constructed in a way that makes it behave as if inflation expectations were biased toward zero:

The price stability fiction — a dollar is a dollar is a dollar — is as ingrained in our laws as if it were a constitutional principle. Indeed, it may be that no real constitutional principle permeates the Law as completely as does this manifest fiction.

The market-prices-or-feudalism tone of this seems more than a little overheated from today’s perspective, and when Arjun and I asked him about this piece a few years ago, he seemed a bit embarrassed by it. But I still think there is something to it. Market coordination, market rationality, the organization of productive activity through money payments and commitments, really does require the fiction of a fixed relationship between quantities of money and real things. There is some level of inflation at which this is no longer tenable.

So I have no problem with the conventional view that really high inflations — triple digits and above — can cause far-reaching breakdowns in social coordination. But this is not relevant to the question of inflation of 1 or 2 or 5 or probably even 10 percent.

In this sense, I think the mainstream paradoxically both understates and overstates the real costs of inflation. They exaggerate the importances of small differences in inflation. But at the same time, because they completely naturalize the organization of life through markets, they are unable to talk about the possibility that it could break down.

But again, this kind of breakdown of market coordination is not relevant for the sorts of inflation seen in the United States or other rich countries in modern times.

It’s easier to talk about the costs (and benefits) of inflation when we see it as a change in relative prices, and redistribution of income and wealth. If inflation is typically a change in relative prices, then the costs are experienced by those whose incomes rise more slowly than their payments. Keynes emphasized this point in an early article on “Social Consequences of a Change in the Value of Money.”¹⁸

A change in the value of money, that is to say in the level of prices, is important to Society only in so far as its incidence is unequal. Such changes have produced in the past, and are producing now, the vastest social consequences, because, as we all know, when the value of money changes, it does not change equally for all persons or for all purposes. …

Keynes sees the losers from inflation as passive wealth owners, while the winners are active businesses and farmers; workers may gain or lose depending on the degree to which they are organized. For this reason, he sees moderate inflation as being preferable to moderate deflation, though both as evils to be avoided — until well after World War II, the goal of price stability meant what it said.

Let’s return for a minute to the question of wages. As far as I can tell, the experience in modern inflations is that wage changes typically lag behind prices. If you plot nominal wage growth against inflation, you’ll see a clear positive relationship, but with a slope well below 1. This might seem to contradict what I said under point 4. But my point there was that insofar as inflation is driven by increased worker bargaining power, it should be associated with faster real wage growth. In fact, the textbook is wrong not just on logic but on facts. In principle, a wage-driven inflation would see a rise in real wage. But most real inflations are not wage-driven.

In practice, the political costs of inflation are probably mostly due to a relatively small number of highly salient prices.

7. Inflation and production. The old monetarist view had a fixed quantity of money confronting a fixed quantity of goods, with the price level ending up at whatever equated them. As I mentioned above, the fixed-quantity-of-money part of this has been largely abandoned by modern mainstream as well as heterodox economists. But what about the other side? Why doesn’t more spending call forth more production?

The contemporary mainstream has, it seems to me, a couple ways of answering the question. One is the approach of a textbook like Blanchard’s. There, higher spending does lead to to higher employment and output and lower unemployment. But unless unemployment is at a single unique level — the NAIRU — inflation will rise or fall without limit. It’s exceedingly hard to find anything that looks like a NAIRU in the data, as critics have been pointing out for a long time. Even Blanchard himself rejects it when he’s writing for central bankers rather than undergraduates.

There’s a deeper conceptual problem as well. In this story, there is a tradeoff between unemployment and inflation. Unemployment below the NAIRU does mean higher real output and income. The cost of this higher output is an inflation rate that rises steadily from year to year. But even if we believed this, we might ask, how much inflation acceleration is too much? Can we rule out that a permanently higher level of output might be worth a slowly accelerating inflation rate?

Think about it: In the old days, the idea that the price level could increase without limit was considered crazy. After World War II, the British government imposed immense costs on the country not just to stabilize inflation, but to bring the price level back to its prewar level. In the modern view, this was crazy — the level of prices is completely irrelevant. The first derivative of prices — the inflation rate — is also inconsequential, as long as it is stable and predictable. But the second derivative — the change in the rate of inflation — is apparently so consequential that it must be kept at exactly zero at all costs. It’s hard to find a good answer, or indeed any answer, for why this should be so.

The more practical mainstream answer is to say, rather than that there is a tradeoff between unemployment and inflation with one unambiguously best choice, but that there is no tradeoff. In this story, there is a unique level of potential output (not a feature of the textbook model) at which the relationship between demand, unemployment and inflation changes. Below potential, more spending calls forth more production and employment; above potential, more spending only calls forth higher inflation. This looks better as a description of real economies, particular given that the recent experience of long periods of elevated unemployment that have not, contrary to the NAIRU prediction, resulted in ever-accelerating deflation. But it begs the question of why should be such a sharp line.

The alternative view would be that investment, technological change, and other determinants of “potential output” also respond to demand. Supply constraints, in this view, are better thought of in terms of the speed with which supply can respond to demand, rather than an absolute ceiling on output.

Well, this post has gotten too long, and has been sitting in the virtual drawer for quite a while as I keep adding to it. So I am going to break off here. But it seems to me that this is where the most interesting conversations around inflation are going right now — the idea that supply constraints are not absolute but respond to demand with varying lags — that inflation should be seen as often a temporary cost of adjustment to a new higher level of capacity. And the corollary, that anti-inflation policy should aim at identifying supply constraints as much as, or more than, restraining demand.

“Monetary Policy in a Changing World”

While looking for something else, I came across this 1956 article on monetary policy by Erwin Miller. It’s a fascinating read, especially in light of current discussions about, well, monetary policy in a changing world. Reading the article was yet another reminder that, in many ways, debates about central banking were more sophisticated and far-reaching in the 1950s than they are today.

The recent discussions have been focused mainly on what the goals or targets of monetary policy should be. While the rethinking there is welcome — higher wages are not a reliable sign of rising inflation; there are good reasons to accept above-target inflation, if it developed — the tool the Fed is supposed to be using to hit these targets is the overnight interest rate faced by banks, just as it’s been for decades. The mechanism by which this tool works is basically taken for granted — economy-wide interest rates move with the rate set by the Fed, and economic activity reliably responds to changes in these interest rates. If this tool has been ineffective recently, that’s just about the special conditions of the zero lower bound. Still largely off limits are the ideas that, when effective, monetary policy affects income distribution and the composition of output and not just its level, and that, to be effective, monetary policy must actively direct the flow of credit within the economy and not just control the overall level of liquidity.

Miller is asking a more fundamental question: What are the institutional requirements for monetary policy to be effective at all? His answer is that conventional monetary policy makes sense in a world of competitive small businesses and small government, but that different tools are called for in a world of large corporations and where the public sector accounts for a substantial part of economic activity. It’s striking that the assumptions he already thought were outmoded in the 1950s still guide most discussions of macroeconomic policy today.¹⁹

From his point of view, relying on the interest rate as the main tool of macroeconomic management is just an unthinking holdover from the past — the “normal” world of the 1920s — without regard for the changed environment that would favor other approaches. It’s just the same today — with the one difference that you’ll no longer find these arguments in the Quarterly Journal of Economics.²⁰

Rather than resort unimaginatively to traditional devices whose heyday was one with a far different institutional environment, authorities should seek newer solutions better in harmony with the current economic ‘facts of life.’ These newer solutions include, among others, real estate credit control, consumer credit control, and security reserve requirements…, all of which … restrain the volume of credit available in the private sector of the economy.

Miller has several criticisms of conventional monetary policy, or as he calls it, “flexible interest rate policies” — the implicit alternative being the wartime policy of holding key rates fixed. One straightforward criticism is that changing interest rates is itself a form of macroeconomic instability. Indeed, insofar as both interest rates and inflation describe the terms on which present goods trade for future goods, it’s not obvious why stable inflation should be a higher priority than stable interest rates.

A second, more practical problem is that to the extent that a large part of outstanding debt is owed by the public sector, the income effects of interest rate changes will become more important than the price effects. In a world of large public debts, conventional monetary policy will affect mainly the flow of interest payments on existing debt rather than new borrowing. Or as Miller puts it,

If government is compelled to borrow on a large scale for such reasons of social policy — i.e., if the expenditure programs are regarded as of such compelling social importance that they cannot be postponed merely for monetary considerations — then it would appear illogical to raise interest rates against government, the preponderant borrower, in order to restrict credit in the private sphere.

Arguably, this consideration applied more strongly in the 1950s, when government accounted for the majority of all debt outstanding; but even today governments (federal plus state and local) accounts for over a third of total US debt. And the same argument goes for many forms of private debt as well.

As a corollary to this argument — and my MMT friends will like this — Miller notes that a large fraction of federal debt is held by commercial banks, whose liabilities in turn serve as money. This two-step process is, in some sense, equivalent to simply having the government issue the money — except that the private banks get paid interest along the way. Why would inflation call for an increase in this subsidy?

Miller:

The continued existence of a large amount of that bank-held debt may be viewed as a sop to convention, a sophisticated device to issue needed money without appearing to do so. However, it is a device which requires that a subsidy (i.e., interest) be paid the banks to issue this money. It may therefore be argued that the government should redeem these bonds by an issue of paper money (or by an issue of debt to the central bank in exchange for deposit credit). … The upshot would be the removal of the governmental subsidy to banks for performing a function (i.e., creation of money) which constitutionally is the responsibility of the federal government.

Finance franchise, anyone?

This argument, I’m sorry to say, does not really work today — only a small fraction of federal debt is now owned by commercial banks, and there’s no longer a link, if there ever was, between their holdings of federal debt and the amount of money they create by lending. There are still good arguments for a public payments system, but they have to be made on other grounds.

The biggest argument against using a single interest rate as the main tool of macroeconomic management is that it doesn’t work very well. The interesting thing about this article is that Miller doesn’t spend much time on this point. He assumes his readers will already be skeptical:

There remains the question of the effectiveness of interest rates as a deterrent to potential private borrowing. The major arguments for each side of this issue are thoroughly familiar and surely demonstrate most serious doubt concerning that effectiveness.

Among other reasons, interest is a small part of overall cost for most business activity. And in any situation where macroeconomic stabilization is needed, it’s likely that expected returns will be moving for other reasons much faster than a change in interest rates can compensate for. Keynes says the same thing in the General Theory, though Miller doesn’t mention it.²¹ (Maybe in 1956 there wasn’t any need to.)

Because the direct link between interest rates and activity is so weak, Miller notes, more sophisticated defenders of the central bank’s stabilization role argue that it’s not so much a direct link between interest rates and activity as the effect of changes in the policy rate on banks’ lending decisions. These arguments “skillfully shift the points of emphasis … to show how even modest changes in interest rates can bring about significant credit control effects.”

Here Miller is responding to arguments made by a line of Fed-associated economists from his contemporary Robert Roosa through Ben Bernanke. The essence of these arguments is that the main effect of interest rate changes is not on the demand for credit but on the supply. Banks famously lend long and borrow short, so a bank’s lending decisions today must take into account financing conditions in the future. ²² A key piece of this argument — which makes it an improvement on orthodoxy, even if Miller is ultimately right to reject it — is that the effect of monetary policy can’t be reduced to a regular mathematical relationship, like the interest-output semi-elasticity of around 1 found in contemporary forecasting models. Rather, the effect of policy changes today depend on their effects on beliefs about policy tomorrow.

There’s a family resemblance here to modern ideas about forward guidance — though people like Roosa understood that managing market expectations was a trickier thing than just announcing a future policy. But even if one granted the effectiveness of this approach, an instrument that depends on changing beliefs about the long-term future is obviously unsuitable for managing transitory booms and busts.

A related point is that insofar as rising rates make it harder for banks to finance their existing positions, there is a chance this will create enough distress that the Fed will have to intervene — which will, of course, have the effect of making credit more available again. Once the focus shifts from the interest rate to credit conditions, there is no sharp line between the Fed’s monetary policy and lender of last resort roles.

A further criticism of conventional monetary policy is that it disproportionately impacts more interest-sensitive or liquidity-constrained sectors and units. Defenders of conventional monetary policy claim (or more often tacitly assume) that it affects all economic activity equally. The supposedly uniform effect of monetary policy is both supposed to make it an effective tool for macroeconomic management, and helps resolve the ideological tension between the need for such management and the belief in a self-regulating market economy. But of course the effect is not uniform. This is both because debtors and creditors are different, and because interest makes up a different share of the cost of different goods and services.

In particular, investment, especially investment in housing and other structures, is mo sensitive to interest and liquidity conditions than current production. Or as Miller puts it, “Interest rate flexibility uses instability of one variety to fight instability of a presumably more serious variety: the instability of the loanable funds price-level and of capital values is employed in an attempt to check commodity price-level and employment instability.” (emphasis added)

The point that interest rate changes, and monetary conditions generally, change the relative price of capital goods and consumption goods is important. Like much of Miller’s argument, it’s an unacknowledged borrowing from Keynes; more strikingly, it’s an anticipation of Minsky’s famous “two price” model, where the relative price of capital goods and current output is given a central role in explaining macroeconomic dynamics.

If we take a step back, of course, it’s obvious that some goods are more illiquid than others, and that liquidity conditions, or the availability of financing, will matter more for production of these goods than for the more immediately saleable ones. Which is one reason that it makes no sense to think that money is ever “neutral.”²³

Miller continues:

In inflation, e.g., employment of interest rate flexibility would have as a consequence the spreading of windfall capital losses on security transactions, the impairment of capital values generally, the raising of interest costs of governmental units at all levels, the reduction in the liquidity of individuals and institutions in random fashion without regard for their underlying characteristics, the jeopardizing of the orderly completion of financing plans of nonfederal governmental units, and the spreading of fear and uncertainty generally.

Some businesses have large debts; when interest rates rise, their earnings fall relative to businesses that happen to have less debt. Some businesses depend on external finance for investment; when interest rates rise, their costs rise relative to businesses that are able to finance investment internally. In some industries, like residential construction, interest is a big part of overall costs; when interest rates rise, these industries will shrink relative to ones that don’t finance their current operations.

In all these ways, monetary policy is a form of central planning, redirecting activity from some units and sectors to other units and sectors. It’s just a concealed, and in large part for that reason crude and clumsy, form of planning.

Or as Miller puts it, conventional monetary policy

discriminates between those who have equity funds for purchases and those who must borrow to make similar purchases. … In so far as general restrictive action successfully reduces the volume of credit in use, some of those businesses and individuals dependent on bank credit are excluded from purchase marts, while no direct restraint is placed on those capable of financing themselves.

In an earlier era, Miller suggests, most borrowing was for business investment; most investment was externally financed; and business cycles were driven by fluctuations in investment. So there was a certain logic to focusing on interest rates as a tool of stabilization. Honestly, I’m not sure if that was ever true.But I certainly agree that by the 1950s — let alone today — it was not.

In a footnote, Miller offers a more compelling version of this story, attributing to the British economist R. S. Sayers the idea of

sensitive points in an economy. [Sayers] suggests that in the English economy mercantile credit in the middle decades of the nineteenth century and foreign lending in the later decades of that century were very sensitive spots and that the bank rate technique was particularly effective owing to its impact upon them. He then suggests that perhaps these sensitive points have given way to newer ones, namely, stock exchange speculation and consumer credit. Hence he concludes that central bank instruments should be employed which are designed to control these newer sensitive areas.

This, to me, is a remarkably sophisticated view of how we should think about monetary policy and credit conditions. It’s not an economywide increase or decrease in activity, which can be imagined as a representative household shifting their consumption over time; it’s a response of whatever specific sectors or activities are most dependent on credit markets, which will be different in different times and places. Which suggests that a useful education on monetary policy requires less calculus and more history and sociology.

Finally, we get to Miller’s own proposals. In part, these are for selective credit controls — direct limits on the volume of specific kinds of lending are likely to be more effective at reining in inflationary pressures, with less collateral damage. Yes, these kinds of direct controls pick winners and losers — no more than conventional policy does, just more visibly. As Miller notes, credit controls imposed for macroeconomic stabilization wouldn’t be qualitatively different from the various regulations on credit that are already imposed for other purposes — tho admittedly that argument probably went further in a time when private credit was tightly regulated than in the permanent financial Purge we live in today.

His other proposal is for comprehensive security reserve requirements — in effect generalizing the limits on bank lending to financial positions of all kinds. The logic of this idea is clear, but I’m not convinced — certainly I wouldn’t propose it today. I think when you have the kind of massive, complex financial system we have today, rules that have to be applied in detail, at the transaction level, are very hard to make effective. It’s better to focus regulation on the strategic high ground — but please don’t ask me where that is!

More fundamentally, I think the best route to limiting the power of finance is for the public sector itself to take over functions private finance currently provides, as with a public payments system, a public investment banks, etc. This also has the important advantage of supporting broader steps toward an economy built around human needs rather than private profit. And it’s the direction that, grudgingly but steadily, the response to various crises is already pushing us, with the Fed and other authorities reluctantly stepping in to perform various functions that the private financial system fails to. But this is a topic for another time.

Miller himself is rather tentative in his positive proposals. And he forthrightly admits that they are “like all credit control instruments, likely to be far more effective in controlling inflationary situations than in stimulating revival from a depressed condition.” This should be obvious — even Ronald Reagan knew you can’t push on a string. This basic asymmetry is one of the many everyday insights that was lost somewhere in the development of modern macro.

The conversation around monetary policy and macroeconomics is certainly broader and more realistic today than it was 15 or 20 years ago, when I started studying this stuff. And Jerome Powell — and even more the activists and advocates who’ve been shouting at him — deserves credit for the Fed;s tentative moves away from the reflexive fear of full employment that has governed monetary policy for so long. But when you take a longer look and compare today’s debates to earlier decades, it’s hard not to feel that we’re still living in the Dark Ages of macroeconomics

In Jacobin: A Demystifying Decade for Economics

(The new issue of Jacobin has a piece by me on the state of economics ten years after the crisis. The published version is here. I’ve posted a slightly expanded version below. Even though Jacobin was generous with the word count and Seth Ackerman’s edits were as always superb, they still cut some material that, as king of the infinite space of this blog, I would rather include.)

For Economics, a Demystifying Decade

Has economics changed since the crisis? As usual, the answer is: It depends. If we look at the macroeconomic theory of PhD programs and top journals, the answer is clearly, no. Macroeconomic theory remains the same self-contained, abstract art form that it has been for the past twenty-five years. But despite its hegemony over the peak institutions of academic economics, this mainstream is not the only mainstream. The economics of the mainstream policy world (central bankers, Treasury staffers, Financial Times editorialists), only intermittently attentive to the journals in the best times, has gone its own way; the pieties of a decade ago have much less of a hold today. And within the elite academic world, there’s plenty of empirical work that responds to the developments of the past ten years, even if it doesn’t — yet — add up to any alternative vision.

For a socialist, it’s probably a mistake to see economists primarily as either carriers of valuable technical expertise or systematic expositors of capitalist ideology. They are participants in public debates just like anyone else. The profession as the whole is more often found trailing after political developments than advancing them.

***

The first thing to understand about macroeconomic theory is that it is weirder than you think. The heart of it is the idea that the economy can be thought of as a single infinite-lived individual trading off leisure and consumption over all future time. For an orthodox macroeconomist – anyone who hoped to be hired at a research university in the past 30 years – this approach isn’t just one tool among others. It is macroeconomics. Every question has to be expressed as finding the utility-maximizing path of consumption and production over all eternity, under a precisely defined set of constraints. Otherwise it doesn’t scan.

This approach is formalized in something called the Euler equation, which is a device for summing up an infinite series of discounted future values. Some version of this equation is the basis of most articles on macroeconomic theory published in a mainstream journal in the past 30 years.It might seem like an odd default, given the obvious fact that real economies contain households, businesses, governments and other distinct entities, none of whom can turn income in the far distant future into spending today. But it has the advantage of fitting macroeconomic problems — which at face value involve uncertainty, conflicting interests, coordination failures and so on — into the scarce-means-and-competing-ends Robinson Crusoe vision that has long been economics’ home ground.

There’s a funny history to this technique. It was invented by Frank Ramsey, a young philosopher and mathematician in Keynes’ Cambridge circle in the 1920s, to answer the question: If you were organizing an economy from the top down and had to choose between producing for present needs versus investing to allow more production later, how would you decide the ideal mix? The Euler equation offers a convenient tool for expressing the tradeoff between production in the future versus production today.

This makes sense as a way of describing what a planner should do. But through one of those transmogrifications intellectual history is full of, the same formalism was picked up and popularized after World War II by Solow and Samuelson as a description of how growth actually happens in capitalist economies. The problem of macroeconomics has continued to be framed as how an ideal planner should direct consumption and production to produce the best outcomes for anyone, often with the “ideal planner” language intact. Pick up any modern economics textbook and you’ll find that substantive questions can’t be asked except in terms of how a far sighted agent would choose this path of consumption as the best possible one allowed by the model.

There’s nothing wrong with adopting a simplified formal representation of a fuzzier and more complicated reality. As Marx said, abstraction is the social scientist’s substitute for the microscope or telescope. But these models are not simple by any normal human definition. The models may abstract away from features of the world that non-economists might think are rather fundamental to “the economy” — like the existence of businesses, money, and government — but the part of the world they do represent — the optimal tradeoff between consumption today and consumption tomorrow — is described in the greatest possible detail. This combination of extreme specificity on one dimension and extreme abstraction on the others might seem weird and arbitrary. But in today’s profession, if you don’t at least start from there, you’re not doing economics.

At the same time, many producers of this kind of models do have a quite realistic understanding of the behavior of real economies, often informed by first-hand experience in government. The combination of tight genre constraints and real insight leads to a strange style of theorizing, where the goal is to produce a model that satisfies the the conventions of the discipline while arriving at a conclusion that you’ve already reached by other means. Michael Woodford, perhaps the leading theorist of “New Keynesian” macroeconomics, more or less admits that the purpose of his models is to justify the countercyclical interest rate policy already pursued by central banks in a language acceptable to academic economists. Of course the central bankers themselves don’t learn anything from such an exercise — and you will scan the minutes of Fed meetings in vain for discussion of first-order ARIMA technology shocks — but they presumably find it reassuring to hear that what they already thought is consistent with the most modern economic theory. It’s the economic equivalent of the college president in Randall Jarrell’s Pictures from an Institution:

About anything, anything at all, Dwight Robbins believed what Reason and Virtue and Tolerance and a Comprehensive Organic Synthesis of Values would have him believe. And about anything, anything at all, he believed what it was expedient for the president of Benton College to believe. You looked at the two beliefs, and lo! the two were one. Do you remember, as a child without much time, turning to the back of the arithmetic book, getting the answer to a problem, and then writing down the summary hypothetical operations by which the answer had been, so to speak, arrived at? It is the only method of problem-solving that always gives correct answers…

The development of theory since the crisis has followed this mold. One prominent example: After the crash of 2008, Paul Krugman immediately began talking about the liquidity trap and the “perverse” Keynesian claims that become true when interest rates were stuck at zero. Fiscal policy was now effective, there was no danger in inflation from increases in the money supply, a trade deficit could cost jobs, and so on. He explicated these ideas with the help of the “IS-LM” models found in undergraduate textbooks — genuinely simple abstractions that haven’t played a role in academic work in decades.

Some years later, he and Gautti Eggertson unveiled a model in the approved New Keynesian style, which showed that, indeed, if interest rates were fixed at zero then fiscal policy, normally powerless, now became highly effective. This exercise may have been a display of technical skill (I suppose; I’m not a connoisseur) but what do we learn from it? After all, generating that conclusion was the announced goal from the beginning. The formal model was retrofitted to generate the argument that Krugman and others had been making for years, and lo! the two were one.

It’s a perfect example of Joan Robinson’s line that economic theory is the art of taking a rabbit out of a hat, when you’ve just put it into the hat in full view of the audience. I suppose what someone like Krugman might say in his defense is that he wanted to find out if the rabbit would fit in the hat. But if you do the math right, it always does.

(What’s funnier in this case is that the rabbit actually didn’t fit, but they insisted on pulling it out anyway. As the conservative economist John Cochrane gleefully pointed out, the same model also says that raising taxes on wages should also boost employment in a liquidity trap. But no one believed that before writing down the equations, so they didn’t believe it afterward either. As Krugman’s coauthor Eggerston judiciously put it, “there may be reasons outside the model” to reject the idea that increasing payroll taxes is a good idea in a recession.)

Left critics often imagine economics as an effort to understand reality that’s gotten hopelessly confused, or as a systematic effort to uphold capitalist ideology. But I think both of these claims are, in a way, too kind; they assume that economic theory is “about” the real world in the first place. Better to think of it as a self-constrained art form, whose apparent connections to economic phenomena are results of a confusing overlap in vocabulary. Think about chess and medieval history: The statement that “queens are most effective when supported by strong bishops” might be reasonable in both domains, but its application in the one case will tell you nothing about its application in the other.

Over the past decade, people (such as, famously, Queen Elizabeth) have often asked why economists failed to predict the crisis. As a criticism of economics, this is simultaneously setting the bar too high and too low. Too high, because crises are intrinsically hard to predict. Too low, because modern macroeconomics doesn’t predict anything at all. As Suresh Naidu puts it, the best way to think about what most economic theorists do is as a kind of constrained-maximization poetry. It makes no more sense to ask “is it true” than of a haiku.

***

While theory buzzes around in its fly-bottle, empirical macroeconomics, more attuned to concrete developments, has made a number of genuinely interesting departures. Several areas have been particularly fertile: the importance of financial conditions and credit constraints; government budgets as a tool to stabilize demand and employment; the links between macroeconomic outcomes and the distribution of income; and the importance of aggregate demand even in the long run.

Not surprisingly, the financial crisis spawned a new body of work trying to assess the importance of credit, and financial conditions more broadly, for macroeconomic outcomes. (Similar bodies of work were produced in the wake of previous financial disruptions; these however don’t get much cited in the current iteration.) A large number of empirical papers tried to assess how important access to credit was for household spending and business investment, and how much of the swing from boom to bust could be explained by the tighter limits on credit. Perhaps the outstanding figures here are Atif Mian and Amir Sufi, who assembled a large body of evidence that the boom in lending in the 2000s reflected mainly an increased willingness to lend on the part of banks, rather than an increased desire to borrow on the part of families; and that the subsequent debt overhang explained a large part of depressed income and employment in the years after 2008.

While Mian and Sufi occupy solidly mainstream positions (at Princeton and Chicago, respectively), their work has been embraced by a number of radical economists who see vindication for long-standing left-Keynesian ideas about the financial roots of economic instability. Markus Brunnermeier (also at Princeton) and his coauthors have also done interesting work trying to untangle the mechanisms of the 2008 financial crisis and to generalize them, with particular attention to the old Keynesian concept of liquidity. That finance is important to the economy is not, in itself, news to anyone other than economists; but this new empirical work is valuable in translating this general awareness into concrete usable form.

A second area of renewed empirical interest is fiscal policy — the use of the government budget to manage aggregate demand. Even more than with finance, economics here has followed rather than led the policy debate. Policymakers were turning to large-scale fiscal stimulus well before academics began producing studies of its effectiveness. Still, it’s striking how many new and sophisticated efforts there have been to estimate the fiscal multiplier — the increase in GDP generated by an additional dollar of government spending.

In the US, there’s been particular interest in using variation in government spending and unemployment across states to estimate the effect of the former on the latter. The outstanding work here is probably that of Gabriel Chodorow-Reich. Like most entries in this literature, Chodorow-Reich’s suggests fiscal multipliers that are higher than almost any mainstream economist would have accepted a decade ago, with each dollar of government spending adding perhaps two dollars to GDP. Similar work has been published by the IMF, which acknowledged that past studies had “significantly underestimated” the positive effects of fiscal policy. This mea culpa was particularly striking coming from the global enforcer of economic orthodoxy.

The IMF has also revisited its previously ironclad opposition to capital controls — restrictions on financial flows across national borders. More broadly, it has begun to offer, at least intermittently, a platform for work challenging the “Washington Consensus” it helped establish in the 1980s, though this shift predates the crisis of 2008. The changed tone coming out of the IMF’s research department has so far been only occasionally matched by a change in its lending policies.

Income distribution is another area where there has been a flowering of more diverse empirical work in the past decade. Here of course the outstanding figure is Thomas Piketty. With his collaborators (Gabriel Zucman, Emmanuel Saez and others) he has practically defined a new field. Income distribution has always been a concern of economists, of course, but it has typically been assumed to reflect differences in “skill.” The large differences in pay that appeared to be unexplained by education, experience, and so on, were often attributed to “unmeasured skill.” (As John Eatwell used to joke: Hegemony means you get to name the residual.)

Piketty made distribution — between labor and capital, not just across individuals — into something that evolves independently, and that belongs to the macro level of the economy as a whole rather than the micro level of individuals. When his book Capital in the 21st Century was published, a great deal of attention was focused on the formula “r > g,” supposedly reflecting a deep-seated tendency for capital accumulation to outpace economic growth. But in recent years there’s been an interesting evolution in the empirical work Piketty and his coauthors have published, focusing on countries like Russia/USSR and China, etc., which didn’t feature in the original survey. Political and institutional factors like labor rights and the legal forms taken by businesses have moved to center stage, while the formal reasoning of “r > g” has receded — sometimes literally to a footnote. While no longer embedded in the grand narrative of Capital in the 21st Century, this body of empirical work is extremely valuable, especially since Piketty and company are so generous in making their data publicly available. It has also created space for younger scholars to make similar long-run studies of the distribution of income and wealth in countries that the Piketty team hasn’t yet reached, like Rishabh Kumar’s superb work on India. It has also been extended by other empirical economists, like Lukas Karabarbounis and coauthors, who have looked at changes in income distribution through the lens of market power and the distribution of surplus within the corporation — not something a University of Chicago economist would have ben likely to study a decade ago.

A final area where mainstream empirical work has wandered well beyond its pre-2008 limits is the question of whether aggregate demand — and money and finance more broadly — can affect long-run economic outcomes. The conventional view, still dominant in textbooks, draws a hard line between the short run and the long run, more or less meaning a period longer than one business cycle. In the short run, demand and money matter. But in the long run, the path of the economy depends strictly on “real” factors — population growth, technology, and so on.

Here again, the challenge to conventional wisdom has been prompted by real-world developments. On the one hand, weak demand — reflected in historically low interest rates — has seemed to be an ongoing rather than a cyclical problem. Lawrence Summers dubbed this phenomenon “secular stagnation,” reviving a phrase used in the 1940s by the early American Keynesian Alvin Hansen.

On the other hand, it has become increasingly clear that the productive capacity of the economy is not something separate from current demand and production levels, but dependent on them in various ways. Unemployed workers stop looking for work; businesses operating below capacity don’t invest in new plant and equipment or develop new technology. This has manifested itself most clearly in the fall in labor force participation over the past decade, which has been considerably greater than can be explained on the basis of the aging population or other demographic factors. The bottom line is that an economy that spends several years producing less than it is capable of, will be capable of producing less in the future. This phenomenon, usually called “hysteresis,” has been explored by economists like Laurence Ball, Summers (again) and Brad DeLong, among others. The existence of hysteresis, among other implications, suggests that the costs of high unemployment may be greater than previously believed, and conversely that public spending in a recession can pay for itself by boosting incomes and taxes in future years.

These empirical lines are hard to fit into the box of orthodox theory — not that people don’t try. But so far they don’t add up to more than an eclectic set of provocative results. The creativity in mainstream empirical work has not yet been matched by any effort to find an alternative framework for thinking of the economy as a whole. For people coming from non-mainstream paradigms — Marxist or Keynesian — there is now plenty of useful material in mainstream empirical macroeconomics to draw on – much more than in the previous decade. But these new lines of empirical work have been forced on the mainstream by developments in the outside world that were too pressing to ignore. For the moment, at least, they don’t imply any systematic rethinking of economic theory.

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Perhaps the central feature of the policy mainstream a decade ago was a smug and, in retrospect, remarkable complacency that the macroeconomic problem had been solved by independent central banks like the Federal Reserve. For a sense of the pre-crisis consensus, consider this speech by a prominent economist in September 2007, just as the US was heading into its worst recession since the 1930s:

One of the most striking facts about macropolicy is that we have progressed amazingly. … In my opinion, better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years. … The story of stabilization policy of the last quarter century is one of amazing success.

You might expect the speaker to be a right-wing Chicago type like Robert Lucas, whose claim that “the problem of depression prevention has been solved” was widely mocked after the crisis broke out. But in fact it was Christina Romer, soon headed to Washington as the Obama administration’s top economist. In accounts of the internal debates over fiscal policy that dominated the early days of the administration, Romer often comes across as one of the heroes, arguing for a big program of public spending against more conservative figures like Summers. So it’s especially striking that in the 2007 speech she spoke of a “glorious counterrevolution” against Keynesian ideas. Indeed, she saw the persistence of the idea of using deficit spending to fight unemployment as the one dark spot in an otherwise cloudless sky. There’s more than a little irony in the fact that opponents of the massive stimulus Romer ended up favoring drew their intellectual support from exactly the arguments she had been making just a year earlier. But it’s also a vivid illustration of a consistent pattern: ideas have evolved more rapidly in the world of practical policy than among academic economists.

For further evidence, consider a 2016 paper by Jason Furman, Obama’s final chief economist, on “The New View of Fiscal Policy.” As chair of the White House Council of Economic Advisers, Furman embodied the policy-economics consensus ex officio. Though he didn’t mention his predecessor by name, his paper was almost a point-by-point rebuttal of Romer’s “glorious counterrevolution” speech of a decade earlier. It starts with four propositions shared until recently by almost all respectable economists: that central banks can and should stabilize demand all by themselves, with no role for fiscal policy; that public deficits raise interest rates and crowd out private investment; that budget deficits, even if occasionally called for, need to be strictly controlled with an eye on the public debt; and that any use of fiscal policy must be strictly short-term.

None of this is true, suggests Furman. Central banks cannot reliably stabilize modern economies on their own, increased public spending should be a standard response to a downturn, worries about public debt are overblown, and stimulus may have to be maintained indefinitely. While these arguments obviously remain within a conventional framework in which the role of the public sector is simply to maintain the flow of private spending at a level consistent with full employment, they nonetheless envision much more active management of the economy by the state. It’s a remarkable departure from textbook orthodoxy for someone occupying such a central place in the policy world.

Another example of orthodoxy giving ground under the pressure of practical policymaking is Narayana Kocherlakota. When he was appointed as President of the Federal Reserve Bank of Minneapolis, he was on the right of debates within the Fed, confident that if the central bank simply followed its existing rules the economy would quickly return to full employment, and rejecting the idea of active fiscal policy. But after a few years on the Fed’s governing Federal Open Market Committee (FOMC), he had moved to the far left, “dovish” end of opinion, arguing strongly for a more aggressive approach to bringing unemployment down by any means available, including deficit spending and more aggressive unconventional tools at the Fed. This meant rejecting much of his own earlier work, perhaps the clearest example of a high-profile economist repudiating his views after the crisis; in the process, he got rid of many of the conservative “freshwater” economists in the Minneapolis Fed’s research department.

The reassessment of central banks themselves has run on parallel lines but gone even farther.

For twenty or thirty years before 2008, the orthodox view of central banks offered a two-fold defense against the dangerous idea — inherited from the 1930s — that managing the instability of capitalist economies was a political problem. First, any mismatch between the economy’s productive capabilities (aggregate supply) and the desired purchases of households and businesses (aggregate demand) could be fully resolved by the central bank; the technicians at the Fed and its peers around the world could prevent any recurrence of mass unemployment or runaway inflation. Second, they could do this by following a simple, objective rule, without any need to balance competing goals.

During those decades, Alan Greenspan personified the figure of the omniscient central banker. Venerated by presidents of both parties, Greenspan was literally sanctified in the press — a 1990 cover of The International Economy had him in papal regalia, under the headline, “Alan Greenspan and His College of Cardinals.” A decade later, he would appear on the cover of Time as the central figure in “The Committee to Save the World,” flanked by Robert Rubin and the ubiquitous Summers. And a decade after that he showed up as Bob Woodward’s eponymous Maestro.

In the past decade, this vision of central banks and central bankers has eroded from several sides. The manifest failure to prevent huge falls in output and employment after 2008 is the most obvious problem. The deep recessions in the US, Europe and elsewhere make a mockery of the “virtual disappearance of the business cycle” that people like Romer had held out as the strongest argument for leaving macropolicy to central banks. And while Janet Yellen or Mario Draghi may be widely admired, they command nothing like the authority of a Greenspan.

The pre-2008 consensus is even more profoundly undermined by what central banks did do than what they failed to do. During the crisis itself, the Fed and other central banks decided which financial institutions to rescue and which to allow to fail, which creditors would get paid in full and which would face losses. Both during the crisis and in the period of stagnation that followed, central banks also intervened in a much wider range of markets, on a much larger scale. In the US, perhaps the most dramatic moment came in late summer 2008, when the commercial paper market — the market for short-term loans used by the largest corporations — froze up, and the Fed stepped in with a promise to lend on its own account to anyone who had previously borrowed there. This watershed moment took the Fed from its usual role of regulating and supporting the private financial system, to simply replacing it.

That intervention lasted only a few months, but in other markets the Fed has largely replaced private creditors for a number of years now. Even today, it is the ultimate lender for about 20 percent of new mortgages in the United States. Policies of quantitative easing, in the US and elsewhere, greatly enlarged central banks’ weight in the economy — in the US, the Fed’s assets jumped from 6 percent of GDP to 25 percent, an expansion that is only now beginning to be unwound. These policies also committed central banks to targeting longer-term interest rates, and in some cases other asset prices as well, rather than merely the overnight interest rate that had been the sole official tool of policy in the decades before 2008.

While critics (mostly on the Right) have objected that these interventions “distort” financial markets, this makes no sense from the perspective of a practical central banker. As central bankers like the Fed’s Ben Bernanke or the Bank of England’s Adam Posen have often said in response to such criticism, there is no such thing as an “undistorted” financial market. Central banks are always trying to change financial conditions to whatever it thinks favors full employment and stable prices. But as long as the interventions were limited to a single overnight interest rate, it was possible to paper over the contradiction between active monetary policy and the idea of a self-regulating economy, and pretend that policymakers were just trying to follow the “natural” interest rate, whatever that is. The much broader interventions of the past decade have brought the contradiction out into the open.

The broad array of interventions central banks have had to carry out over the past decade have also provoked some second thoughts about the functioning of financial markets even in normal times. If financial markets can get things wrong so catastrophically during crises, shouldn’t that affect our confidence in their ability to allocate credit the rest of the time? And if we are not confident, that opens the door for a much broader range of interventions — not only to stabilize markets and maintain demand, but to affirmatively direct society’s resources in better ways than private finance would do on its own.

In the past decade, this subversive thought has shown up in some surprisingly prominent places. Wearing his policy rather than his theory hat, Paul Krugman sees

… a broader rationale for policy activism than most macroeconomists—even self-proclaimed Keynesians—have generally offered in recent decades. Most of them… have seen the role for policy as pretty much limited to stabilizing aggregate demand. … Once we admit that there can be big asset mispricing, however, the case for intervention becomes much stronger… There is more potential for and power in [government] intervention than was dreamed of in efficient-market models.

From another direction, the notion that macroeconomic policy does not involve conflicting interests has become harder to sustain as inflation, employment, output and asset prices have followed diverging paths. A central plank of the pre-2008 consensus was the aptly named “divine coincidence,” in which the same level of demand would fortuitously and simultaneously lead to full employment, low and stable inflation, and production at the economy’s potential. Operationally, this was embodied in the “NAIRU” — the level of unemployment below which, supposedly, inflation would begin to rise without limit.

Over the past decade, as estimates of the NAIRU have fluctuated almost as much as the unemployment rate itself, it’s become clear that the NAIRU is too unstable and hard to measure to serve as a guide for policy, if it exists at all. It is striking to see someone as prominent as IMF chief economist Olivier Blanchard write (in 2016) that “the US economy is far from satisfying the ‘divine coincidence’,” meaning that stabilizing inflation and minimizing unemployment are two distinct goals. But if there’s no clear link between unemployment and inflation, it’s not clear why central banks should worry about low unemployment at all, or how they should trade off the risks of prices rising undesirably fast against the risk of too-high unemployment. With surprising frankness, high officials at the Fed and other central banks have acknowledged that they simply don’t know what the link between unemployment and inflation looks like today.

To make matters worse, a number of prominent figures — most vocally at the Bank for International Settlements — have argued that we should not be concerned only with conventional price inflation, but also with the behavior of asset prices, such as stocks or real estate. This “financial stability” mandate, if it is accepted, gives central banks yet another mission. The more outcomes central banks are responsible for, and the less confident we are that they all go together, the harder it is to treat central banks as somehow apolitical, as not subject to the same interplay of interests as the rest of the state.

Given the strategic role occupied by central banks in both modern capitalist economies and economic theory, this rethinking has the potential to lead in some radical directions. How far it will actually do so, of course, remains to be seen. Accounts of the Fed’s most recent conclave in Jackson Hole, Wyoming suggest a sense of “mission accomplished” and a desire to get back to the comfortable pieties of the past. Meanwhile, in Europe, the collapse of the intellectual rationale for central banks has been accompanied by the development of the most powerful central bank-ocracy the world has yet seen. So far the European Central Bank has not let its lack of democratic mandate stop it from making coercive intrusions into the domestic policies of its member states, or from serving as the enforcement arm of Europe’s creditors against recalcitrant debtors like Greece.

One thing we can say for sure: Any future crisis will bring the contradictions of central banks’ role as capitalism’s central planners into even sharper relief.

***

Many critics were disappointed the crisis of a 2008 did not lead to an intellectual revolution on the scale of the 1930s. It’s true that it didn’t. But the image of stasis you’d get from looking at the top journals and textbooks isn’t the whole picture — the most interesting conversations are happening somewhere else. For a generation, leftists in economics have struggled to change the profession, some by launching attacks (often well aimed, but ignored) from the outside, others by trying to make radical ideas parsable in the orthodox language. One lesson of the past decade is that both groups got it backward.

Keynes famously wrote that “Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” It’s a good line. But in recent years the relationship seems to have been more the other way round. If we want to change the economics profession, we need to start changing the world. Economics will follow.

Thanks to Arjun Jayadev, Ethan Kaplan, Mike Konczal and Suresh Naidu for helpful suggestions and comments.