And if they start telling you different stories depending which one you are looking at, then the next step is to go into the data and try to find out why. I don't think there are mechanical rules here to apply to policy. I wouldn't want to argue this. That's a long answer to a short question. I wouldn't want to argue with Steve Hanke about this. He's closer to the data than I am, and as far as I can see, what he's saying is consistent with what I've been saying. Russ: And that's just a way of explaining the slowness of the recovery relative to the depth of the shock.
Guest: That's right. I've certainly been surprised at the amount of quantitative easing that the Fed has had to carry out to get the monetary system moving again. And, as I say, I'd like to see it moving even faster; but I'm not sitting in the policy chair wondering how I'm going to unwind all this eventually when the economy comes around. I don't think that's the problem for next year. I think we've got a way to go yet.
Russ: That's a rare moment of honesty, even from an EconTalk guest. I appreciate that. Russ: I want to go to a question that I've asked many times to different guests, and I appreciate my listeners' patience. But I think you actually have a lot of insight into this question relative to some of the people I ask. And that's the following. I was trained, as you were, at the U. You think about the quantity of money. Now, you might debate or be unsure as you alluded to as to which definition, which aggregate measure is the right one.
But we were told to look at quantities. If you want to understand the impact on the nominal economy, if you want to look at the impact of monetary policy on inflation, you look at money. The quantity of money. And yet, over the last 10, 15, 20 years, the Chairs of the Fed, plus many monetary economists, always talk about interest rates. What's going on there? Why are there two different approaches? Help me understand that. Guest: Well, what I think happened was that people like me, in the s and s, overstated the case for the reliability of the rate of growth of the money supply as the anchor for monetary policy.
Things didn't work out as well as expected in a number of places. You also have Milton Friedman's really catastrophically bad call at the end of the Volker disinflation, that double-digit inflation was just around the corner again. And central banks were put off relying on money growth.
And I think they threw the baby out with the bathwater. I think money growth targeting wasn't very effective for a policy framework; but I don't think that was a good reason to stop looking at these variables altogether. But a lot of people did. And parallel to that, of course, you had developments in monetary theory, starting in the s, s. Big names there, people like John Taylor and Michael Woodford, Lars Svensson, who started building models of monetary policy in which they simply cut out the financial system altogether and just concentrated on direct links between policy interest rates and the level of spending in the economy.
And that kind of model works just fine when the monetary system is functioning. When the monetary system is functioning you can ignore it. And I'm afraid we had about 15 years when leading scholars of monetary economics just cut the monetary and financial system out of their analysis. And that's been a shame. I hope that one beneficial side effect of the last few dreadful years is that people will start paying attention to those monetary aggregates again.
Just as a side remark: In Europe, the European Central Bank had a reference value for the rate of growth of M3 as sort of backup to its regular policy-making framework. And for reasons that are quite beyond me, this reference value disappeared altogether in the last 3 or 4 years. Money growth has been incredibly sluggish in the EU European Union ; and look at the stagnation in that economy. I don't think that's an accident. Russ: Is there a parallel in the U. I remember after I interviewed Milton in , I questioned him about one of his claims about the Great Moderation--which we were of course at the tail end of at the time; we didn't realize it.
It was one of the thrills of my life that a plus-year-old economist--I think Milton was 92 at that point--sent me a spreadsheet and he said, Oh, you don't want to look at M1; you want to look at M2. And M2 was very, very steady, as he had essentially claimed. But it hasn't really--has M2 reflected this crisis that we are in? Guest: My recollection is that it did indeed.
That its growth rate really went into a bit of a spin after the collapse of Lehman Brothers. But that in the last little while it's got back again. And then the growth rate has been coming back since. So, what you don't find in the U. There's no big contraction in money growth before the downturn started.
That's one of the mysteries about this particular episode. But once it got going, you got this spiraling downwards. And, as I say, this time around, unlike the s, the Fed's expansionary reaction to that put a stop to the contraction before it gathered too much momentum. Russ: Well, obviously there's a cause and effect issue in monetary policy, especially when it's linked to a financial crisis.
And as you point out-- Guest: Well, that's right. The process is a recursive one. Monetary policy causes the economy to contract; and a contracting economy, if you don't watch it, starts making the money supply contract even further. That's what was going on there. Russ: And I would say especially if it originates in the financial sector. There's some debate--you allude to it in your writing--about what I would call the 'real side' or the microeconomics side.
And you point out that the Austrian view, the idea that both the collapse and the current mess did see a very rapid run-up on asset prices that suddenly collapsed; and that obviously caused some challenges for the financial sector. Guest: Yeah. I mean, that's right. People keep calling these things 'financial crises'. They are really asset market crises. And they happen on the margin between markets for financial assets and markets for real assets.
Like real estate and factories and physical investment. I don't think the monetarist story of the onset of the Great Depression by the way, or the monetarist story about the onset of this Great Recession, is quite plausible enough. I can't find anything in the data in the s or the data in the run-up to this event, that shows a degree of sort of conventional tightening of money growth that can account for the speed of the subsequent downturn.
That really looks like, in both cases, an economy where something was going badly wrong in real asset markets, and it just needed a little bit of tap from the financial markets to set a downward spiral going. And, you're right--the Austrians were the pioneers of this kind of analysis, in the s even; and of course there are still Austrians around. And if I may sort of put in a plug for Cambridge, England, where John Maynard Keynes was, Keynes's colleague, Sir Dennis Robertson was developing a parallel analysis to this in the s.
And he wrote a little textbook; and its edition has got a couple of paragraphs expressing his fears about what was likely to happen in the United States if that asset market boom kept on going. And this was before the Great Depression and before the stock market crash. In contrast, the representative of monetarism in the United States in the s was probably Irving Fisher; and Irving Fisher didn't see anything coming. He was just concentrating on the behavior of the price level and saying all is well, right down to October And indeed afterwards. So, I think we've got to give the Austrians and Dennis Robertson some credit.
And I'd like to see our profession start taking that analysis a little bit more seriously. I mean the mainstream of our profession; because of course the people who have been propounding it are certainly professionals themselves. But they are in a minority.
Russ: Yeah. I think the biggest challenge--you refer to it in one of your working papers, a very nice paper--you refer to monetarism without money, meaning this focus on interest rates. And I would phrase that a little bit differently, which you alluded to a minute ago, which is: Macroeconomics without the financial sector seems to be not a good idea. But the division of labor is limited by the extent of the market.
And as economists have gotten more successful and there are more of us, we've specialized a lot. It seems to me now that economics needs to integrated that a little more successfully. Guest: Oh, I think that's right. Let me give you a sort of quick take on what I think happened. We talk about a market economy, and we talk about markets determining prices and allocating resources and all the rest of it. And if we go to the world we live in, what we see is, when we look and see how markets actually function, it's: we exchange goods and services against money or in credit transactions, and money passing from hand to hand, credit transactions among agents are absolutely fundamental to the way in which the markets work.
Fair enough. But we can't model the monetary and financial system every time we try to address an economic problem about the effectiveness, shall we say, about tax policy or the desirability of a free trade deal with some other country. So we abstract from it, and we talk about the market functioning. Now, that kind of analysis, that microeconomic analysis, has been enormously successful, and one of the big movements in macroeconomics in the last 30 years has been to use that kind of microeconomics as a basis for macroeconomics.
Well, my take on that has always been, is that abstracting from the monetary and financial system is all very well for many problems, but not for the problems of the macroeconomy. And you've seen a lot of people trying to put monetary and financial factors back into this kind of model of the market economy, not realizing that it's already in those models.
A tacit assumption that the monetary and financial systems are functioning all very well, thank you. So they are trying to put the monetary and financial system into the same model twice, with different assumptions about the way it works. And it comes out as a bit of a mess. And I think that's where we've been.
Russ: Before I move on, do you want to say anything about the decision by the Fed to pay interest on reserves? Why you think they did that and if it has any significance? Guest: Gee. If I remember, Milton was in favor of paying interest on reserves way back in the s with his program for monetary stability. Russ: What was the argument he made for it? Guest: The argument was that if you paid interest on reserves you would give the banking system less incentive to try to evade the reserve requirements, and hence you would give the Fed more control over the behavior of the monetary aggregates.
That was the essence of Milton's argument. The other argument for it that became very popular in the s, up here in Canada at least, is that forcing banks to hold non-interest-bearing reserves was putting a tax on banks; and there was no particular reason for taxing those institutions. So, pay them interest on reserves and relieve them of that tax. The way we went in Canada was the opposite direction: we just phased out reserve requirements and essentially we've got a monetary control mechanism that no longer relies on the reserve base.
I'm sorry--I haven't really given a straight answer to your question. Russ: Well, let me ask it a different way. Guest: I haven't lost any sleep about the Fed paying interest on reserves; I really haven't. But I do notice that it makes the banks more willing to hold the proceeds of quantitative easing without getting out into the market and making loans, and I wonder if the Fed noticed, paid quite as much attention to that side effect as it deserved. But that's a technical detail in the execution of policy, and takes us back to: Has policy been expansionary enough?
Russ: But it's a nice segue to the next topic, really, which is some of the criticism of the Fed that have been coming not from the fiscal side but from monetarists. I'm going to read a quote from a working paper of yours, talking about criticisms of the Fed: that it has exceeded the bounds of its responsibilities as lender of last resort by rescuing insolvent investment banks and insurance companies rather than limiting itself to providing liquidity to solvent commercial banks; that by co-operating with the Treasury in many of these activities it has surrendered its policy making independence, and that the massive increase in its cash liabilities that has resulted from these policies and subsequent quantitative easing, carries with it a serious inflationary threat.
So, why don't we take these one at a time. Guest: And be clear: I was trying to paraphrase people I was disagreeing with. Russ: I understand. This is not your view. But I thought it was a fabulous summary of what many people have accused the Fed of. You are going to defend the Fed against most, if not all, of these charges. Let's start with this one of, traditionally--goes back to, I suppose, Bagehot, who said that the Fed should be the lender of last resort, but only solvent banks; it shouldn't be propping up insolvent banks.
And yet the Fed seems to have propped up everybody, once Lehman Brothers failed. Guest: Well, first of all, Bagehot didn't say that.
If you comb Lombard Street on your computer and look for the word 'solvent', you are only going to find it in one place; and he's talking about Britain being solvent in a case of a balance of payments crisis. So Bagehot really didn't say that. He said some things about you probably don't want to bail out really badly run institutions. But he thought that that was a minor problem. I think something that people have forgotten about these principles of the lender of last resort that we inherited from the 19th century--when Bagehot wrote Lombard Street , there was no limited liability in banking.
The banks were partnerships or they were joint stock companies, but there was unlimited liability on their owners. So the notion of an insolvent bank in was a very different thing to a notion of an insolvent bank now. Russ: That's a good point. Guest: It's a family business; the family has to be broke before the institution is insolvent.
Russ: But it doesn't change--and I appreciate what you wrote; you wrote that the world changes and Lombard Street doesn't exist any more, so we need to be thinking about this in a different way. And I certainly accept that, the logic of that. The problem is, the way I understand Bagehot--whether I'm right about it, and I apologize if I'm misrepresenting him about the solvency issue. But basically, the thing that was appealing about that is you don't want to be the lender of last resort to every bank, because if you are, there is a terrible moral hazard problem.
That banks will have an incentive to misbehave; their creditors, more importantly, will have an incentive to lend imprudently. And it seems to me we've gone down a very dangerous road. But you are more sanguine. What's your optimism?
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Guest: Well, it is a dangerous road. But the whole, that's because the financial system is a dangerous place when a crisis is beginning. The first issue is: Can you really tell the difference between a solvent institution and one that's just lacking in liquidity when there is a run on it. Northern Rock, for example, the first example in British history for heaven knows how long, over a century, of an institution that had customers lining up outside the doors to get their cash. Now, as far as I can tell, Northern Rock had a pretty good, solid portfolio of mortgages.
There was nothing the matter with the mortgages it was holding. Its problem was that its supply of lending in the commercial paper market had just dried up, as part of the worldwide commercial paper market collapse. And it was a classic issue of an institution being short of liquidity. But the Bank of England sat on its hands, just for a little while; allowed this run to develop.
And by the time they got everything settled with Northern Rock, the financial crisis had taken its toll; the economy had turned down; and what had started out as a liquidity problem for that institution did indeed turn into a solvency problem. But you can make a cogent argument that the reason it did turn into a solvency problem was that the liquidity problem wasn't handled early enough. A similar thing where an argument can be made about the case of the Bank of the United States in in New York--that the Fed let that one go broke.
And yet they paid a pretty good proportion of their debts when the bankruptcy was finally settled in, I think, or It's not clear that they were insolvent. They might have been illiquid. But the point is, it's difficult to tell the difference, and I would rather err on the side of making sure the financial system doesn't start to seize up.
So, I'm not too keen on a strict interpretation of that solvency, the liquidity-solvency thing. I would rather err on the expansionary side, to keep the system moving. Russ: Well, I take your point. Guest: I mean, a lot of people would disagree with me. I don't think it's the kind of thing that you can lay hard and fast rules down about.
Similarly whether you should stick only to banks. Well, there are two arguments about what the lender of last resort should be doing. The first is the traditional monetarist one. The real object of the exercise is to stop the money supply from contracting. So, keep the institutions whose liabilities make up the money supply in business. There's another argument that says what's really important is the market for short term interbank credit, because that's what oils the wheels of commerce and keeps industry going; and you've got to make sure that those markets don't get disrupted.
That's the kind of argument that's associated with Ben Bernanke's work. But if you actually go back to the 19th century literature, you'll find both of these arguments around, even in the 19th century. And the second argument, the Bernanke-style argument in particular, which by the way was also partly Bagehot's, that's an argument that says you don't want to be too strict in drawing the line between what's an institution that's the kind of institution that you are going to rescue and what's the kind of institution you've got no business going near.
Once again, if the collapse of a merchant bank, or the collapse of an insurance company, is going to impinge on the ability of the commercial banks to function, it's the job of a lender of last resort to make sure that doesn't happen. And again, there's a lot of precedence for this. The Baring Crisis of in London evolved because Baring Brothers, who weren't a commercial bank--they were a merchant bank--were marketing Argentinian bonds in London.
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And they got caught with big inventory of Argentinian bonds that they couldn't sell. And the Bank of England essentially organized a bailout of Baring Brothers by getting their creditors to hold off calling in their debts until the episode was over. Russ: Yep, the same thing. Guest: There was an eerie similarity. And that's lender-of-last-resort activity, but it's not the traditional lend-freely only to solvent banks in order only to stop the money supply collapsing.
So, there's a lot of precedence for these things. Russ: So, reminding myself, or warning, our reminder earlier that we're not sitting in the policy chair; we're just having a nice chat on a late summer afternoon: It does seem that that viewpoint, which I totally understand from a policy-maker's perspective--you know, err on the side of caution, make sure that you don't let the banking system collapse. Once we're in that world, which I would argue is the world we've lived in for the last 25 or 30 years, we've created a situation where the large creditors of large financial institutions know that they are part of a complicated, tangled system.
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Now, we could debate whether that is the result of policy mistakes, or policy decisions, or whether it's just some natural progression of technology and globalization. Doesn't matter. That's the world we live in. In that world, the presumption is: Intervene. The presumption is: Lend. The presumption is: Rescue. The presumption is: Bailout.
We're in a world where that sector of the economy is effectively being highly subsidized by this inevitable decision. It seems like a very unhealthy political economy. Guest: Well, I think you've said two things about it. First of all, to the extent that the monetary and financial system are public goods as well as made up of a lot of private-sector institutions there is a sort of traditional case for the provision of public goods with subsidies that comes out of welfare economics. I don't want to make too much of that. But I think one has got to distinguish among who actually gets bailed out in these operations.
And if it turns out there's been fraud involved, being prosecuted and put in prison. What I would like to do is keep the network of credit markets functioning and stop the money supply collapsing. And I would have thought it was possible in a rough and ready sort of way at least to devise a policy that does that. I mean, an awful lot of people lost an awful lot of equity by holding stock in the wrong banks in the United States.
Russ: But they're the wrong people to look at. They are the people who rolled the dice, diversified, a lot of them made a killing along the way; some got out in time, some didn't. It's the creditors , the fixed income folks, who worry about the solvency of the institution, not the equity people. The equity people don't want to be wiped out obviously. But you get the upside. The creditors don't get the upside. An unhealthy system. And you alluded to the fact that in the old days, banks were partnerships and we've moved away from that.
And I argue that's because we've subsidized moving away from it. Guest: Yah, but you surely can devise means of keeping the institutions functioning while having some of their bondholders take some fairly sizeable haircuts, and stop the entire financial system from collapsing.
Look, I'm not arguing that moral hazard isn't a problem. What I'm arguing is that when a financial crisis gets going these things happen so fast, policy makers have to make decisions; I would just as soon they erred on the easy side. But I recognize the moral hazard issue.
And I don't have a straight answer to it. I recall Charles Goodhart in England saying, some time in early , that moral hazard is something we worry about next year; for the moment we have to keep the financial system functioning. And there is a lot to that. Russ: Yeah; it's the road to hell, too, if you are not careful. Guest: I take it--I've heard the argument made and I don't have a straight answer to it. Somebody had to be allowed to collapse and it may as well have been Lehman Brothers. Russ: I think you said the right thing when you said there is a way to design a system that keeps some of the incentives.
But for some reason--I think we know the reason, political reasons-- Guest: Yeah, yeah-- Russ: it doesn't seem to happen. I'm not so much disagreeing with you as the tendency we have as economists to advocate what we think is the best policy, neglecting the fact that the way we want it implemented and the way it actually gets implemented is not the same thing.
Guest: That's fair enough. That's a fair enough point. I won't pretend to have a straight answer to it, because I don't. I really don't. Russ: Let's go to the second part of your response to the critics of the Fed's behavior, which is to me incredibly interesting, especially given the history of monetary policy. Many monetarists, Allan Meltzer being one who I've interviewed on this program who has said exactly what you were criticizing, have said that this Fed policy of massive quantitative easing, the enormous buildup in high-powered money on the balance sheet of the Fed, is going to cause huge inflation.
It's going to be very disastrous. We know inflation is a terrible virus once it starts to spread. And yet nothing has happened. They've been forced to argue--and I'm one of those people; I'm not an expert, don't pretend to be one, but I still thought it was going to happen--we've been forced to say: Well, it's coming; it's just a matter of time.
Guest: Well, first of all, I really don't understand particularly why Allan has paid so much attention to the behavior of the monetary base and so little to the behavior of the money supply during this episode. If we go back to Friedman and Schwartz and the story of the early s, between and , the monetary base actually expanded. The money supply collapsed by about a third, and the economy collapsed. Now that to me is devastatingly powerful evidence that what matters is the money supply and not the monetary base.
This time around we've had this huge expansion of the monetary base, and believe me, nobody's been looking more closely at the behavior of the money supply more closely than I have to see when that was coming through. And beginning to register an inflationary threat. But here we are, what, 5 years later, and it hasn't happened yet. Well, the people saying it's going to happen eventually: Yeah, maybe it is going to happen eventually.
If I may just deviate for a moment, my first senior colleague in monetary economics, my first job, was Hyman Minsky.
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In he was explaining to me that our financial crisis was just around the corner. And eventually Hyman Minsky was right. But it was 50 years later, almost. Yeah, they'll be right eventually. But I've asked Allan, and I don't think I've really had a very good answer: Why are you paying so much attention to the monetary base and why have you been paying so little attention to the behavior of the money supply this time around? And he tells me that the monetary base is the policy instrument; policy is our measure; it's extremely expansionary, and policies like that have always led to inflation eventually in the past.
Well, maybe he'll be right eventually, but I see no sign of it yet. Russ: Yah. When I asked him--and this was a few years ago and it still hasn't happened yet, but when I asked him at the time, his argument was that when the economy started to recover, those reserves that the banks are holding at the Fed would start to go out into the economy, and there would be terrible pressure on the Fed to let that happen at high levels, because the economy would be recovering. It would be very difficult to tighten at a time when the economy is finally starting to recover.
And it hasn't quite worked that way. The recovery has been so mediocre, there hasn't been this sudden, exhilarating whoosh of money and confidence. Guest: No, there hasn't. These are exactly the worries that the Fed had in , when it doubled reserve requirements. There were lots of free reserves building up in the system, and the Fed was very nervous that it was going to lose control of the money supply.
There was an expansion going on; they doubled reserve requirements and what happened was that the banks that were subject to those reserve requirements immediately built up a stock of reserves again. That contributed to a downturn in the money supply, and that downturn in the money supply contributed to the recession of So, I think there have been precedents for this kind of behavior in the past.
And I'm glad the Fed hasn't followed Allan's advice this time around. For one thing, it obviated any necessity for consistency; he would say what needed to be said one day and if it needed to be changed the next day, then he would simply make it happen. He loved to pose in the role of a Cassandra whose warnings were not listened to. But, in fact, his early success in swinging around public opinion about the peace treaties had given him probably even an exaggerated estimate of his powers.
I shall never forget one occasion—I believe the last time that I met him—when he startled me by an uncommonly frank expression of this. It was early in , shortly after he had returned from the strenuous and exhausting negotiations in Washington on the British loan…. A turn in the conversation made me ask him whether he was not concerned about what some of his disciples were making of his theories.
After a not very complimentary remark about the persons concerned, he proceeded to reassure me by explaining that those ideas had been badly needed at the time he had launched them. But three months later he was dead. Other economists have expressed similar views of Keynes. He once explained that his policy prescriptions were often unrelated to their apparent theoretical underpinnings. They are not meant to be definitive; they are subject to all sorts of special assumptions and are necessarily related to the particular conditions of the time. General Theory, regarded as a more or less all-embracing theory, and the applications of it which can be made in different circumstances according to the different sets of realistic assumptions.
Of course, Keynesian economics fit in nicely with liberal political views about the need for government to be more deeply involved in the economy, which were dominant among the intelligentsia of the s and s. In short, Keynesian economics was a brilliant synthesis of both the theoretical and the practical.
It was primarily a theory for the times that also made some important contributions to economic science. His theories, however, made them seem scientific rather than merely opportunistic. Honest conservatives have always understood this. He had two basic motivations. One was to destroy the labor unions and the other was to maintain the free market.
Keynes despised the American Keynesians. His whole idea was to have an impotent government that would do nothing but, through tax and spending policies, maintain the equilibrium of the free market. Keynes was the real father of neoconservatism, far more than Hayek! John Kenneth Galbraith, whose politics were well to the left of Keynes, not to mention Drucker, agreed with this assessment.
He valued institutions which had historic roots in the country; he was a great upholder of the virtues of the middle-class which, in his view, had been responsible for all the good things that we now enjoy; he believed in the supreme value of intellectual leadership, in the wisdom of the chosen few; he was interested in showing how narrow was the circle of kinship from which the great British leaders in statesmanship and thinking had been drawn; and he was an intense lover of his country….
He was not a Socialist. His regard for the middle- class, for artists, scientists and brain workers of all kinds made him dislike the class-conscious elements of Socialism. He had no egalitarian sentiment; if he wanted to improve the lot of the poor…that was not for the sake of equality, but in order to make their lives happier and better…. He considered the doctrine of State Socialism to be quite obsolete. Keynes often expressed disdain for Soviet Communism. On the economic side I cannot perceive that Russian Communism has made any contribution to our economic problems of intellectual interest or scientific value.
I do not think that it contains, or is likely to contain, any piece of useful economic technique which we could not apply, if we chose, with equal or greater success in a society which retained all the marks, I will not say of nineteenth-century individualistic capitalism, but of British bourgeois ideals. On the other hand, we have everything to lose by the methods of violent change.
In Western industrial conditions the tactics of Red revolution would throw the whole population into a pit of poverty and death. Keynes understood completely the central role of profit in the capitalist system. This is one reason why he was so strongly opposed to deflation and why, at the end of the day, his cure for unemployment was to restore profits to employers. This made Keynes a strong opponent of national economic planning, which was much in vogue after the Second World War. Indeed, the whole point of his General Theory, Keynes felt, was about preserving what was good and necessary in capitalism as well as protecting it against authoritarian attacks by separating microeconomics, the economics of prices and the firm, from macroeconomics, the economics of the economy as a whole.
In order to preserve economic freedom in the former, which Keynes thought was essential for efficiency, increased government intervention in the latter was unavoidable. While pure free marketers might lament this development, the alternative, as Keynes saw it, was the complete destruction of capitalism and its replacement by some form of socialism. As he explained:. It is certain that the world will not much longer tolerate the unemployment which…is associated—and, in my opinion, inevitably associated—with present-day capitalistic individualism.
But it may be possible by a right analysis of the problem to cure the disease whilst preserving efficiency and freedom. Just as in the war the regulation of aggregate spending is the only way to avoid the destruction of choice and initiative…through the complex tyranny of all-round rationing, so in peace it is only the application of this principle which will provide the environment in which the choice and initiative of the individual can be safely left free. This is the one kind of compulsion of which the effect is to enlarge liberty. Those who, entangled in old unserviceable maxims, fail to see this further-reaching objective have not grasped, to speak American, the big idea.
If high unemployment was allowed to continue for too long, Keynes thought the inevitable result would be socialism—total government control—and the destruction of political freedom. This highly undesirable result had to be resisted and could only be held at bay if rigid adherence to laissez-faire gave way, but not too much. Keynes died at the age of 63 on April 21, , shortly after returning from an arduous visit to the United States where he had participated in negotiations relating to postwar economic institutions such as the International Monetary Fund.
He did not live to see the final triumph of his ideas, which really reached their pinnacle in the s. I was completing this book just as the economic crisis hit with severity in the fall of and was very grateful for having finished the research because it greatly clarified in my mind what needed to be done for the economy.
However, velocity—the speed at which money turns over as people spend it—fell so much in and that it had economic effects identical to a sharp decline in the money supply. The decline in spending—and hence velocity—resulted from the collapse in wealth that in turn resulted from a sharp fall in housing and stock prices. But rather than lead to a doubling of the money supply, banks simply sat on the money because there was no demand for loans.
It was as if an individual took savings out of an interest-earning account and deposited them all in a checking account earning no interest. In short, money was immobilized and simply piled up in ultrasafe Treasury bills instead of financing consumption and investment. Indeed, at one point yields on T-bills actually fell to zero. This view put me very much in the minority among conservatives, virtually all of whom felt that fiscal stimulus was useless and that the Fed had gone overboard in trying to stimulate money growth.
But they had made the same arguments in the early s. Now, as then, I think Keynes was right and the conservatives were wrong. Graham Jr. Benjamin and Levis A. See J. Ekirch Jr. See also Peter F. New York: Threshold Editions, Bernstein, ed. Rothbard, eds. On the negative reaction to publication of The General Theory by those on the political left, see Skidelsky, Economist as Savior, Keynes was always very hostile to socialism despite its popularity among the British intellectual class in the s; see Skidelsky, Economist as Savior, ; Keynes, Writings, , Hall and Michael R.
In essence, he wanted inflation to compensate for deflation, but contrary to conservative dogma, Keynes was not a crude inflationist—he wanted stable money and opposed both inflation and deflation. A key problem, then and now, was that interest rates were so low that the economy was caught in a liquidity trap. Under such circumstances, monetary policy was impotent and needed an expansionary fiscal policy to mobilize sterile cash, raise velocity and thereby to raise prices. This is a problem today as well because a fall in velocity has exactly the same macroeconomic effect as a fall in the money supply.
I believe that the economy still needs aggressive fiscal expansion to raise velocity for all the same reasons Keynes advocated such a policy in the s. His theories provide the best guide to the problems we face today that economics has to offer. As he wrote in [Russian Revolution leader Vladimir] Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. As Lenin said in Hundreds of thousands of ruble notes are being issued daily by our Treasury. As Keynes explained in Our problem is to reduce money wages and, through them, the cost of living, with the idea that, when the circle is complete, real wages will be as high, or nearly as high, as before….
The Great Depression When the Great Depression began, Keynes opposed the traditional cure for economic downturns—price and wage cuts that would restore equilibrium. As Keynes explained to an American audience in a lecture: Will not the social resistance to a drastic downward readjustment of salaries and wages be an ugly and dangerous thing? As Keynes explained: Nor should the argument seem strange that taxation may be so high as to defeat its object, and that, given sufficient time to gather the fruits, a reduction of taxation will run a better chance than an increase of balancing the budget.
The General Theory. As he put it early in the book: Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labor whenever there is a rise in the price of wage- goods. Reaction to the General Theory The initial reaction to The General Theory among professional economists was quite modest.
Beard explains: In its range the shock of the economic collapse was startling to President Roosevelt and his advisers. Flynn made this observation: Well, it looks as if the United States was going to have its war scare and of course its battle implements to match the degree of our fright. It forced the federal government to run deficits on an unprecedented scale, while the Federal Reserve fixed interest rates and provided as much liquidity to the banking system as necessary to keep them from rising.
Contemporary Relevance I was completing this book just as the economic crisis hit with severity in the fall of and was very grateful for having finished the research because it greatly clarified in my mind what needed to be done for the economy. The parallel to the Great Depression seemed clear to me. Spread the wealth. What's been said: Discussions found on the web:. Read this next. See appendix. A resolution of the value-utility argument over money requires some reassessment of money.
Much of the confusion and error in characterizing money has resulted from concentrating on the nominal quantity rather than on the real quantity. In the absence of expectations, the real quantity is largely independent of the nominal quantity. A nominal unit of money loses utility during an inflation in proportion to the rise in prices. But a real unit of money— the nominal unit adjusted for changes in the value of the money unit—loses no utility until it no longer performs in its usual way as a disburser of income between payment periods.
However, the quantity of nominal money units is as irrelevant to the real value of the money stock as is the calibration of apples in bushels or pounds to the real value of apples. Utility and value are not on the same plane. Utility precedes value and is parallel to scarcity. Money has subjective utility and objective value , regardless of whether a price index inverted measures its value accurately or not. This correction does not deny the principle that consumption guides production.
Nonetheless, the scarcity of resources used in getting the supply of anything to market is essential for setting the terms on which the demand is satisfied. Both Fisher and von Mises emphasized the impossibility of measuring subjective utilities. Both saw utility as a force operating in markets, and also as a force whose magnitude marginally declines. He did not mean to throw out the gold standard.
He simply recommended periodic modifications to the fixed official price of gold because the production of gold was so great at the time that he feared a gold inflation! Fisher, , His prescription in practice called for only an occasional change in the mint price of gold to adjust for severe changes in its real price that were associated with a chronically rising or falling level of money prices. Fluctuations which can be foreseen and allowed for are not evils. Without such a construction, the common general confusion between relative prices and the price level could never be resolved, so changes in money prices were not likely to be distinguished from changes in real prices.
He recognized that the price level when inverted is the only conceptual means for expressing the price of money, and that a price index is the only practical means for estimating the price level. Money prices he saw as indispensable means for valuing economic goods and services, but, paradoxically, the value of money itself was unquantifiable von Mises, , When the stock of money—even if money is gold—changes, the circumstances of the change where and how the money comes into the system, and who first gets it inevitably result in relative price changes.
In addition, the distribution of wealth and income also change von Mises, , Statistical doctrine cannot provide an accurate means for weight changes. Since monetary changes alter relative prices, von Mises argued, a policy to stabilize the price level would have to fix all relative prices and would result in severe distortions to the economic allocation of resources. The difference between the two schools over this issue is both conceptual and practical.
Both recognized that the purchasing power of money is a reflection of money prices inverted. Fisher developed much the same argument Fisher, , However, Fisher also believed that the price index, with all of its imperfections, was statistically valid and operationally useful. The conceptual validity of a price index seems logical. Imagine an economy in which the purchase and sale of one commodity dominates all exchanges. The market price of that commodity in terms of the money unit when inverted would also be the market price of the money unit in terms of that commodity.
If the number of commodities exchanged for money were to increase, the conceptual means of evaluating the money unit would not change. It would still be the value of the money unit in terms of some aggregate of goods. Indeed, the value of the money unit cannot be measured in any other way. The validity of the concept cannot be denied because of the imperfection of the method used to measure it. The propriety of using index numbers to measure prices, and hence the value of the money unit, is another story. It depends ultimately on the statistical reliability of the method for deriving the index, and is essentially an empirical issue.
For example, given two periods, one of reasonably stable prices and one of pronounced inflation, do relative prices change significantly more in the inflationary period than they do in the stable period? The Austrian view of the value of money, as set out by von Mises, argued correctly that money must be analyzed in a general theory of value. The value of money is determined in all markets where money is exchanged, he wrote.
Very properly, he applied an implicit real balance effect to show how an adjustment of prices resulted from a change in the quantity of money:.
The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. They are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of the [circumstances] that the prices of the goods concerned will rise. Thus the increase of prices continues, having a diminishing effect until all commodities. No quantity theorist or monetarist could describe the adjustment to an excess supply of money more effectively.
The quantity theory assumes an exogenous quantity of money and employs a velocity of circulation and a total output of goods and services—variables outside the decision-making volition of human beings. In his view, therefore, it could not reflect subjective valuations of individuals, von Mises, , This charge is understandable and has long been a criticism of the quantity theory. Another criticism of some moment is that the quantity theory sublimates the real balance effect implicit in its workings, and hides the utility of money.
He had the habit of acknowledging that economic concepts have magnitudes, and he would use these devices analytically; but then he would argue that assigning any precise values to these variables by statistical measurement was improper. All index-number systems are based upon the idea of measuring the utility of a certain quantity of money 5.
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Their purpose is the determination of the subjective significance of the quantity of money in question. For this, recourse must be had to the quite nebulous and illegitimate fiction of an eternal human with invariable valuations von Mises, , Robertson made a similar distinction. Both imply an awareness of the utility of money as money. Both develop demands for money that are methodologically consistent with demand constructions for all other goods and services. Both emphasize the necessity and importance of markets for specifying prices as guides to economic decision making.
Both see the value of money in its classical garb as an inversion of money prices. Both make use of the real balance effect. Wherein then lie their differences? Most of the disagreements are either methodological misunderstandings or questions of empirical fact. One lingering difference between the two, in contrast to their many common principles, is in the validity each assigns to the statistical measurement of prices.
Austrians incongruously deny validity of indexes yet continuously make use of the concept. In this day and age of statistical refinement—never mind the many misuses of statistics—this intellectual position is untenable. Just because a device is not perfect does not mean that it is useless. It should be used, however, with caution and with an understanding of its frailties. The Austrian criticism is a well-considered caveat if it limits itself to this point. Fisher seems to have leaned too far in the other direction by assigning too deterministic a role to index numbers and by emphasizing too literally the influence of money on prices.
Another methodological issue is the Austrian contentiousness for insisting that utility can only be measured ordinally and not cardinally.