What Would Keynes Say?

December 2009

RS: I would agree with one thing: of course, in the early 1930s being on the Gold Standard was a great constraint on monetary policy, and once America got off the Gold Standard then it became easier and monetary conditions eased. And that was also true of Britain after 1931. But I would say that the crucial thing in a recovery is not the growth of the money supply — that is the growth of bank money, money produced by the central bank — but the growth of

aggregate spending, and the connection between these two is actually not a close one, especially not in abnormal times. In normal times, and this was one of the things Friedman's book did establish, there is a stable relationship between the supply of money and, in the old equation, the speed with which it's spent. And that of course does suggest that a simple increase in the quantity of money will cause output and prices to rise in the same proportion. But when things are as disturbed as they now are, and when both banks and companies are actually hoarding money and sitting on cash balances, then I think you have to establish a much stronger connection between money and velocity than Tim has been able to do.

The important thing is to get aggregate spending up, and the surest way to do this is by the government spending the money itself. And even in that case, some of the money might be saved and one can argue about the size of what's called the multiplier, how much extra government spending induces additional private spending. One can argue about all that, but it's the spending that's the important thing, not the quantity of money in itself.

TC: This all goes back a very long way, with one of the best statements on the problem being by Irving Fisher in 1911. If the government and central bank take action to increase the amount of money, if the banking system then expands its deposit liabilities, the quantity of money grows. Suppose the quantity of money increases by, say, 50 per cent. Is there then a change in people's and companies' desired ratio of money to their income and wealth? The evidence is overwhelming, from all countries, from all periods, that the desired ratio does not change. Alternatively, the velocity of circulation is not affected by changes in the level or rate of growth of money. What that means is that if the quantity of money rises by 10 or 15 per cent, it is very likely that the equilibrium level of the national income will also rise by 10 or 15 per cent.

RS: In the long run.

TC: You're going ask about lags — again this is Friedman's work, which, by the way, I've spent 30 years looking at and trying to comment on the numbers...

RS: It doesn't take that long.

TC: The lag between money and output is very short. In fact we had a very vivid demonstration of this in the middle of 2008. We had gone in this country from roughly a 12 per cent growth of money in late 2006 and early 2007 to nil in the middle of 2008. In fact, in mid-2008 companies' money holdings were actually falling. And what happened to the economy? You went from quasi-boom conditions to an appalling recession, with hardly any lag at all. The facts speak for themselves. The critical thing about what the Bank of England has done with quantitative easing is to have tried to bring back a positive rate of monetary growth. That is what really matters to the economy. To a large extent the fiscal deficit is a distraction and of no importance.

Tags:

Like this article? Share, save or print using the icons below:

Ralph Mugrave

October 23rd, 2010
12:10 PM

In your flax economy you say that printing money destroys “the value of the participants' cash balances”. So how come the monetary base of the U.S. increased by an astronomic and unprecedented amount 18 months ago, yet inflation is currently at record lows? As distinct from the above evidence, and moving on to the INTENTION behind money printing, the intention or objective is to bring sufficient extra demand to bring full employment, but not so much as to cause excess inflation. Also in your flax economy you make the very unrealistic assumption that there is only one final product, namely clothing, and that the market for this is saturated. But let’s run with that assumption. An economy where there are no consumers who want any more goods or services is an economy where there is no unemployment. That is there is no one who wants to work extra hours so as to consume more. No Keynsian with any common sense would advocate money printing (or any other method of increasing demand) in these circumstances.

Richard Allan

March 30th, 2010
12:03 AM

I'm an economics graduate from the LSE, and I don't understand why this article concentrates on those parts of "macroeconomics" which we only teach to first-year students, and abandon in embarassment by the end of even a three-year Bachelor's degree. The ideas being discussed in this article have absolutely no currency with the economists that I've known. The idea that printing money, or increasing consumption, can somehow increase wealth is ludicrous. Anyone constructing a theoretical economy in his head should be able to see this for himself. Printing money will discourage people from holding cash balances; this will INCREASE instability in the economy by leaving people more vulnerable to liquidity demands. Increasing consumption can only destroy accumulated wealth all the faster. Let's say we have an economy where one worker grows food, another flax, and a third weaves flax into linen. They each "hoard" cash in expectation of future spending requirements. Now suddenly the demand for linen and therefore flax drops off; perhaps the market for clothing has become saturated. What's the commonsense response? Telling the two textile workers to find new jobs. But this would cause "excess capacity" in the economy (the land would have to be ploughed under before it could grow anything else, and the sewing machines are worthless) and "unemployment", which Keynesians can't allow. So what's their solution? Print money, destroying the value of the participants' cash balances, and use it to "stimulate the demand" for textiles, presumably by buying the stuff up and burning it (as we all know occurred during the New Deal). This allows the textile workers to keep their jobs! But what happens to savers? Well, either they have to shrug their shoulders and eliminate their "real savings", leaving them vulnerable to "liquidity shocks" (like a sudden bout of illness rendering them unable to work), or they switch their cash savings for, well, REAL savings; ie. stored food. But assuming the economy is producing the maximum amount of food possible (at least until the flax land is repurposed, which we've decided to prevent for the sake of the textile industry), increasing the amount of "hoarded" food is surely worse for food consumption than any amount of "hoarded" cash. At least someone was eating the damn stuff beforehand! So if the farmer decides to stop saving, and is then laid low by illness, there will be a very sudden "panic" in the economy as textile workers scramble for food production. But if workers replace their cash savings with food savings, inflation won't work any more! You can't print food with which to buy clothes; and since the farmer doesn't want to trade food for clothes (he has enough already), and doesn't want to hold cash (loses its value too quickly), we'll end up with the textile industry collapsing either way! The only difference is that in the meantime, we forced people to make an undesired switch from cash savings to either "no savings" (more volatility in the economy as a result of unpredictable expenditures) or "real savings" (reducing the supply of real goods for consumption). The "fiscal" alternative is a similar Devil's bargain. Either take the farmer's food in taxes now, or borrow food from him, promising to tax him later to pay back his own debt (Ricardian Equivalence shows that these two are exactly similar in terms of effects). If the taxes cause him to scale back his production of food, then you've reduced real wealth in the economy. But if they don't, then surely the taxable proceeds would be better invested somewhere else than in a failing line of business? The same can be said if inflation somehow doesn't cause anyone to alter his cash balances; the concept of opportunity cost means that wasting money (and goods!) by putting them to bad use is just as bad as destroying them. The only way that printing money can increase wealth is if there is genuinely idle capital in the economy which could be devoted to the production of real value (ie. happiness), but for whatever reason, is not. However, the only plausible mechanism by which this capital could be put to work by printing money is if wages are "sticky downwards", so the workers are effectively refusing to work for a utility-maximising wage. But firstly, printing money to force down their real wages was a stupid idea in Keynes's time (where index-linked wage contracts were already becoming commonplace) and is an even more stupid idea nowadays. It will just not have the desired effect. And secondly, if workers refuse to work for a utility-maximising wage, this must be regarded as a voluntary decision on their part; and as a believer in the Harm Principle, I don't believe it's the government's role to reverse voluntary decisions (or "indecisions"). And thirdly, I find it far more likely that diverting any funds to government will be used to reward unproductive special interests than to match genuine demand with genuine excess capacity. In conclusion, I find that this entire article is based on a vision of economics that is (i) out of favour with the economics establishment, (ii) easily disprovable by thought-experiment to anyone capable of consecutive thought, and (iii) a mere attempt to justify government intervention in the economy for its own sake, and for the sake of increasing the "mystique" surrounding economics in order to justify an increase in economists' salaries. The fact that it has attracted no comments thus far is evidence that it has been treated by the readers with the confusion and indifference that it deserves; I simply couldn't allow it to go unchallenged myself.

Post your comment