Friday, March 27, 2009

Keynes vs Monetarism vs Libertarianism

Which comes first, monetarism or libertarianism?

Monetarism is the value judgement that comes out of Milton Friedman, after his study of the long history of US money supply figures, that changes in the money supply has an impact on the real economy.

I don't think Friedman was trying to take a different stance from JM Keynes.

Keynes who was saying, under conditions of a liquidity trap whereby people are holding on to cash even if interest rates were cut down to zero because it is a far better way to preserve capital value and the expansion of the money supply will not help to boost the real economy, the government may need to step in to spend in order to create employment - on the assumption that there is a direct relationship between an increase in the output level and in the employment level.

The concept of the multiplier comes in as an afterthought to this basic Keynes proposition and the multiplier was then taken up as the symbol of the new religion by Keynesians when in fact the concept of the multiplier was invented by Richard Kahn. The multiplier helps Keynes to sell his basic proposition of the need for government spending - the selling point is this: You only have to spend a little, and the economy will take care of itself. The multiplier concept is now an integral component of the Keynesian mental apparatus (not Keynes') as taught in university mathematics courses disguised as economics that the first thing that policy makers with primary education in economics think instantly of whenever they think about policy is the multiplier. This is clearly a mental rut.

Friedman was basically a Keynesian but he was no Keynes. He sought to modify the Keynes proposition by saying that indeed you cannot flood the market with the money supply in a down market in the hope of boosting the real economy because you may get instead inflation - but you can that pre-emptive monetary measures to sustain the real economic growth by controlling inflationary expectations and inflationary forces by restraining the growth of the monetary base and hence the money supply. Hence, the x% rule on monetary growth by the Monetarists.

A technical note was made by Don Patinkin in a big thick book who argued that in a recession when prices fall there will be a real balance effect that will, technically if pushed to the extreme, be able to restore the economy back to full employment on its own without Keynesian interference in the system.

Many other economists also came into the fray to generate the glory days of the bloom of a thousand economic flowery ideas but they were only of two species - only different colours. We shall not enter through this door.

Instead, let's talk about the two species.

The Classical economists, as Keynes labelled them, were in fact excellent thinkers and they had done excellent work, in my view. Classical economists were fundamentalist economists. They thought in real value terms, they thought in the long term. This was necessary at the start of a new thought process. In fact, I would call the Classical economists the Zen masters of economics. What they thought was real in the long run - that's the absolute fundamental - and the Classical economic analysis remains true today in the long run.

But the policy translations of Zen masters are the same everywhere: Do nothing. Let things be what they are suppose to be. Observe the rise and fall. Be at peace even in the midst of apparent chaos. It is chaos because you do not understand it. Once you've understood it, it is nothing.

Perfect Market Competition and the Free Market

Perfect market competition is a theoretical concept invented by Neoclassical economists principally Alfred Marshall to describe the mathematics of economics that he was trying to create. Mathematically, the intersection between two lines is a point which is not a dot. How do you describe the intersection of the supply line and the demand line. For things to be absolutely perfect, you need perfect market competition.

Of course, Joan Robinson and others came in to poo-poo Marshall's mathematical schematics. But the Marshallian scissors were perfect tools for teaching young initiates into the abstract world of economic theory. I think it is the Marshallian scissors that started the teaching of economic theory as an industry in the universities.

But perfect market competition is not the same as Free Market Enterprise.

Free market is an ideology created to counter mercantilism. Free market is an ideology along the line of the French Revolution.

Miltion Friedman, in all his later writings, was a free market enterprise ideologue. This dovetails very nicely into his x% monetary rule. So Monetarism was packaged with Libertarianism as a new industry that runs very profitably as the Chicago School of Economics. The success of the Chicago School has become the scourage of the free world. This is where we are today.

Greenspan violated the x% monetary rule by accelerating US monetary growth to cure what was essentially US loss in global competitiveness. To justify this fundamental monetarist violation, he brought in the Free Market ideology. His current defence of his misrule is that the problem was not the policy makers but the failure of the industry to regulate itself.

The violation of the x% monetary rule simply means the creation of inflationary pressures, inflation and inflationary expectations.

Instead of monetary restriction to cure the inflation, current policy thinking calls for more "monetary measures" by which is meant physically to increase the quantity of money in the system. It is no ordinary monetary increase; it is senseless monetary expansion. Flood the market.

The basic point in my policy prescription is this: We know we are going to pump in more water in a flooded situation. Instead of just simply pumping water mindlessly, we should be more vigilant and more mindful how and where we are pumping that extra water in. We should pump in water to dry areas, areas that need water, and not areas that are already flooded unless there are people in boats who need extra water to take them over the bumps they are trapped in. We have to be mindful of the collateral damage.

I do mind inflation. Sustained inflation of domestic prices - like sustained depreciation of the external value of the currency - is the quiet robber of the lives of ordinary people who know that their lives are getting harder and harder but do not realise how they are being robbed of the little asset values they spent their whole lives collecting drop by drop.

I do mind zero interest rates because zero interest rates is the most intellectually defunct idea I have ever come across - and countries that practice it are disenfranchising the future of their children. Zero interest rates destroy the role of money in the intertemporal allocation of resources.

But we have totally ignored the most fundamental required action: Building the future.

13 comments:

hishamh said...

Good post, I think I'm beginning to understand you better.

I have to disagree with this point however:

"It is no ordinary monetary increase; it is senseless monetary expansion. Flood the market."

You're ignoring two things here: the role of real (as opposed to nominal) interest rates; and the velocity of money.

Even under the conditions of a liquidity trap, where monetary policy has no traction in terms of the real economy, monetary expansion does have a role in keeping down real interest rates, thus reducing the cost of investment and borrowing.

Second, while I agree with your characterization of Greenspan, the violation of the x% rule came about after it was shown that it didn't work as expected - primarily because of the instability of money velocity. The burden of policy then fell on the interest rate, which then implied greater volatility in the money supply.

The issue of velocity is where Friedman departed substantially from Keynes - an unstable money velocity is implicit in Keynes' analysis, while Friedman took it for granted that it was stable (or stable enough), and thus could be used to control output and inflation.

If the Fisher identity holds, then when both output and money velocity fall sufficiently (which is a pretty good description of the current situation), expansion of the monetary base is necessary to prevent general price deflation, given the lag time required for implementing fiscal policy changes.

I consider general price deflation about the worse economic malaise there is.

I'm making the distinction here between asset prices and wage/goods prices. I believe the former is necessary (and in fact is happening now), but the latter exceptionally dangerous and unnecessary to achieve global rebalancing.

Asset price deflation destroys wealth, but wealth can be rebuilt. Income deflation destroys lives and people, and makes wealth and welfare accumulation impossible.

etheorist said...
This comment has been removed by the author.
etheorist said...

hishamh,

Thank you.

Monetary expansion will keep nominal interest rates down and asset prices up thereby keeping real interest rates down. This has been the case for many many years. To continue to do it is senseless. You can never cut nominal interest rates low enough to chase after falling prices.

Friedman's conclusion of a stable money velocity is the result of averaging through decades and decades. In the short run, it is not true.

If prices must fall for adjustment in the economy to be complete, then we must be brave enough to face the reality. At the end of the day, even morphine will wear off.

The position you are holding has brought the US economy to where it is today - thanks to Mr. Green.

If monetary expansion continues to support asset prices, then stagflation will occur - not the V-shape trajectory that we all prefer.

hishamh said...

I think we have to settle for agreeing to disagree.

The onset of potential depression, as this situation is threatening to be, in my view changes all the rules. My position isn't that of supporting past monetary abuses, or that of using monetary expansion as a growth stabilisation policy. I got that illusion beat out of me in 1995-98.

We're well past the stage where monetary policy use is effective for demand management - but that is not the intention under these circumstances.

I agree with you in that you can't chase after falling prices - but you can alter the psychology of liquidity preference so you don't need to. However, by not pushing to the zero interest rate boundary and not pursuing quantitative easing, the greater will be the impetus to the debt deflation spiral - with potentially no floor. We no longer have the backing of gold to provide a natural cushion for the deflationary process, a factor that helped reduce the severity of depressions in the 19th century.

Under current policy as implemented, I see potential (but not necessarily probable) stagflation ahead - a V shaped recovery by my reading is virtually impossible. Growth will be slow and fragile, but it will be growth, and there will be a redressing of global imbalances.

The American consumer has been dealt a heavy psychological blow and will no longer be willing or able to function as the consumer of last resort. Balance sheet repair will take some time not only in the US, but in the UK, Spain, and much of Europe.

On the other hand, I don't see monetary expansion, even on the scale we're seeing today, as triggering high inflation much less hyperinflation - the specifics of what the FRB, the BOE, and the ECB are doing mitigate against that possibility.

But the alternative of just letting nominal prices fall while doing nothing will be utter stagnation with little possiblity of recovery - Roubini's L "recovery" at best, the abyss at worst.

etheorist said...

hishamh,

Surprisingly - or rather not if I take you to be a reasonable economist - I agree with you completely on the above.

I may have been a bit dramatic - but my point is that you can do all your monetary relaxation - but fears linger.

Hence, I call for more speific, concrete, clearer policy on government programmes - programmes that will build a new future - rather than spraying bullets blindly in the dark - although I will not restraint the authorities from doing that - only to warn them that it is not sufficient to solve the problem.

So what do we do?

It is good to spar with people of the same level.

hishamh said...

Dramatic is right - I'm about having heart attacks here!

But I concede your point. Populist measures such as shopping vouchers and cash handouts won't address the underlying structural problems we are facing, and just postpone the moment of pain.

I am much encouraged by the tack Malaysia's planners have taken on that score - just enough measures to ease the present downturn, but with more of the focus squarely on medium-long term investment. The US stimulus is more populist, but that is understandable under the legislative constraints they operate under.

I think the problem policy makers are having is that the future structure of the global economy is unclear - there is little historical guidance for adjustments of the magnitude we have to make. Neither is there any consensus yet on what it should be, beyond the fact that there will be no return to the status quo ante.

Under the circumstances, the best that can be hoped for is a lot of experimentation and stumbling about.

de minimis said...

Just a note to thank you and hishamh for the post and ensuing dialogue. This is an excellent example of civilised meeting of minds and gentlemanly discussion that is so regrettably absent in this day and age. Kudos to you both.

etheorist said...

Just two monkeys throwing bananas at each other from afar!

hishamh said...

Yes, bananas - without the skins!

Nehemiah said...

Interesting discussion. I tend to agree that monetary expansion is a policy with either a non existent or dangerous exit strategy. Yet, is there a paradox about quantitative easing which you guys have overlooked?

Under QE, the US government is buying government bonds in the secondary market to control the yield curve, i.e. maintain an artificial rate of interest that does not reflect the future risk of inflation/deflation.

Meanwhile, the Fed is printing money at unprecedented rates of increase. So here is the paradox that may explode in the face of policy makers and economists who still think within stable state models:

1) an artificial yield curve induced by the government to tell everyone that all is well.

(2) An excessive rise in paper money supply that will soon be chasing after too few goods and is beyond the non-speculative demand for money. (Some speculators will take advantage of easy money to create another leveraged bubble but that is also a zero sum game.)

So what kind of monetary policy is that?

In addition, the velocity of money, which is not measurable, is clearly falling because of balance sheet recession: companies are not borrowing. Going forward, the further decline in money velocity may be triggered by the collapse of GE and the loss of 3 m jobs.

Nehemiah said...

Interesting discussion. Yet, I think there is a paradox about quantitative easing which you guys may have overlooked.

Under QE, the US government is buying government bonds in the secondary market to control the yield curve, i.e. maintain an artificial rate of interest that does not reflect the future risk of inflation/deflation.

Meanwhile, the Fed is printing money at unprecedented rates of increase. So here is the paradox that may explode in the face of policy makers and economists who still think within stable state models:

1) an artificial yield curve induced by the government to tell everyone that all is well.

(2) An excessive rise in paper money supply that will soon be chasing after too few goods and is beyond the non-speculative demand for money. (Some speculators will take advantage of easy money to create another leveraged bubble but that is also a zero sum game.)

So what kind of monetary policy is that?

In addition, the velocity of money, which is not measurable, is clearly falling because of balance sheet recession: companies are not borrowing. Going forward, the further decline in money velocity may be triggered by the collapse of GE and the loss of 3 m jobs.

hishamh said...

Thanks for your points Nehemiah - especially about the yield curve. I don't think however that anybody is missing the distortion in the price signals from massive government borrowing - at least for now.

My thinking is that monetary policy right now is in crisis mode. As you rightly point out, velocity is collapsing - but given the concurrent collapse in output and zero nominal interest rates, QE is necessary to ward off the beginnings of a debt-deflation spiral that would be extremely damaging vice the alternatives.

There is of course the price to be paid later. Whether we'll get persistently higher inflation in my view is still uncertain. I don't think we will see the systemic overleveraging we saw in the last few years - a lot of it came from the explosion in CDS, rather than loose money per se.

Second question is will US households revert to the kind of borrowing/dissaving behaviour they've indulged in since 1980; I don't think that's a given either.

etheorist said...

Nehemiah,

That is the kind of monetary policy that abuses the reserve money.

The problem is very much like the problem of drug addiction - is the withdrawal necessary? Should we fear job losses?

I share with hishamh that we should prevent job lossess if we can. But if we have to sacrifice jobs in the short term for jobs in the long term, it may be a necessary trade-off.

Stagflation is the path trodden by those who do not wish to take the bull by the horns.