Arnold Kling  

Am I a heterodox Keynesian?

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Freddie Mac--victim, villain, ... Voting, Vote-Selling, and Exte...

Probably. Politically, I'm in a different place, obviously, and I'm not heavily invested in macro as a subject. But how else would you label someone who believes the following:

1. Textbook macro is misguided.
2. The most useful insights in macro are not well expressed in terms of equations.
3. A big part of the story is financial market psychology.
4. Another big part of the story is the slow process by which information diffuses in markets. Yes, that means that wages and prices are slow to adjust. But no, that does not mean that equations with fixed W and P are a good way to describe this phenomenon.
5. The money supply is not a very useful concept in today's economy.

Tyler wrote,


More generally, the currency vs. interest-bearing assets decision doesn't have many implications for foreign exchange markets, if any.

Nowadays, I don't think that traditional monetary theory has much relevance. The last time ordinary monetary policy made a difference was in 1980-82, when Paul Volcker broke the 1970's inflation. But even then, I think that the key was the interaction of his policies of raising interest rates with the regulatory environment for banks and savings and loans. The whole S&L industry basically went under, and we had a whale of a recession.

But just as an oil price shock is easier to deal with now that we do not have price controls, I think that without deposit interest ceilings a rise in short-term interest rates would not be nearly as devastating as it was in 1980-82.

I see the conventional money supply as a relatively small fish in a big pond of financial markets. The Fed affects one teeny-tiny interest rate, the Federal Funds rate. Meanwhile, what matters for the economy are all sorts of other financial rates, including mortgage rates, the P/E ratio for stocks, and so on. The Fed does not control those. See Can Greenspan Steer?

I think that risk premiums matter a lot, and they change as the confidence of investors in financial intermediaries ebbs and flows. The recent cycle in subprime mortgage lending is a good illustration, as I explained in The Risk Disclosure Problem.

Some financial market prices can vary widely. Even Fischer Black once said that markets are only efficient up to a factor of 2. Today, no one knows the right long-term price for oil. If speculators woke up tomorrow convinced that in three years that price will be $30, then we would have $30 oil, at least for a while.

No one knows the right long-term value for the exchange rate between the dollar and other currencies. When investors change their outlook, the exchange rate can move dramatically.

A large change in the exchange rate sends an important signal to people who buy and sell tradable goods and services. However, it takes a really long time for this signal to affect prices and quantities. The reaction is quicker in some markets than in others. Because the signal is not processed immediately and fully in all markets, trade patterns are affected. Typically, a depreciation will cause a rise in exports and a fall in imports.

I think of cyclical unemployment as resulting from the slow diffusion of signals in the labor market. Basically, unemployment is a signal that average wages need to fall. But average wages are the outcome of local decisions made by individual firms in particular markets and by individual workers in particular occupations. It could take years for the signal to work its way through the entire economy, by which point conditions will have changed, anyway.

This description of macro may seem vague and imprecise. But I think it's better than textbook macro, which promises greater precision but is precisely incorrect.


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CATEGORIES: Macroeconomics



COMMENTS (15 to date)
Dan in Euroland writes:

Arnold,

Alhough it is not Macro, have you taken a look at Sam Boweles's book "Microeconomics: Behavior, Institutions, and Evolution"? (that title is a link). I think you would find it interesting as evolutionary models (like the replicator dynamic) are introduced to economic applications.

I would be curious as to what you thought of evolutionary game theory and complexity analysis applied to economic applications. Do you think these methods of analysis are superior to the traditional "as if" neoclassical framework? Or at least lend themselves to insights that the traditional optimization framework would miss?

EdH writes:

Arnold

I can not answer your questioning about macro, but exchange rates are somewhat simpler. The US has run up a very high balance of trade deficit. It could do this because the US remained a great place to invest, so the world needed to gain dollars to make those investments. It had two ways, sell items and services to the US for dollars or find a way of borrowing dollars in exchange for their currency. The time the exchange rate began to drop corresponded with the time it became more likely the US would become a less tax friendly country. Not only are the 2003 tax cuts now likely to end, but greater tax rates are being proposed by the party expected to remain Congressional power, and gain the Presidency.

Investing must be a forward looking endeavor. At the margin the US has become a less desirable place to make that investment. While trade is slow to adapt, obtaining money through exchange is quick in response. Thus the fast reaction in the exchange markets. A monetary response can not fix this except in the long run, finally adjusting to the slow down of the US economy due to investment drop off. The only quick fix is to convince the world that the current tax reductions will remain essentially in place, and perhaps new reductions are forth coming. And I see no way that will happen soon.

Mitch writes:

"5. The money supply is not a very useful concept in today's economy."

Dear Arnold,

I understand with that that only interest rates count as an indicator, but not monetary aggregates.

Or maybe you also mean that the interest rates of the money market are irrelevant. If it is so, why are financial markets obsessed with the Fed? Why is the Fed in charge of the goal of "full employment"? In fact, the Fed dominates what happens in the financial sector through its open market purchases.

Keep in mind that central bankers do not "manage" interest rates out of the blue. Open market operations -mainly "liquidity injections"-, grounded in the legal tender laws and the power to create 'liquidity' (i.e. money and credit -the money supply) without any limits, are the main reason why interest rates stay where they are. Quantities and prices are inextricably linked. I am sure you know this very well.

I agree that it is very difficult to measure the money supply (as it is very difficult to distinguish debt from money in terms of liquidity), but it is even more difficult to measure the value of productivity (as it is distorted by monetary factors), the value of capital, or entirely arbitrary concepts such as the "output gap", used everywhere by policymakers. The fact that something is hard to measure does not mean that it is not important. Credit aggregates tell lots of useful things, particularly if you correlate them with consumption and investment spending, the CPI or commodity prices or the current account (as has been done since the 1920s).

I suggest that the present-day exclusive focus on interest rates (i.e. monetary prices) disregarding monetary quantities is a symptom of a worrying situation in mainstream economic analysis -particularly monetary policy analysis. In this sense, your view is perfectly aligned with the dominant keynesian trend.

Mitch writes:

As for your larger point that financial markets are largely independent of the Fed, it is true that there are autonomous factors in creating liquidity in the financial system (the 'money multiplier'). However, they are not at all independent of the availability of credit.

If those factors are really independent, they would be vulnerable to runs and completely independent of interest rates in the money market (as those are manipulated by the Fed). Instead, what has happened in markets since August seems a lagged consequence of Fed super-stimulus since 2001 (and particularly 2003-05) and a slightly less expansionary monetary policy in 2006.

If you care about the psychology of the financial market, I'd just count how many financial market participants ask for an interest rate cut by the Fed. The Fed uber-influence is either a self-fulfilled prophecy (quite a flimsy theory) or it is grounded in real facts: Its influence, direct or indirect, in all financial markets through its open market operations.

Lauren writes:

Hi, Arnold.

You wrote:

5. The money supply is not a very useful concept in today's economy.

Are you saying it's not useful for individuals, say because inflation has been under control? Or are you saying it's not useful for the Fed?

The Federal Reserve has focussed on the money supply as one of its primary variables since the late 1970s. That inflation is reasonably under control in the U.S. is surely due to that or the Fed wouldn't bother. Are you saying the Fed doesn't bother with the money supply in the modern economy? Or that the Fed shouldn't bother with the money supply in the modern economy? Or are you saying that individuals don't have to heed the money supply in the modern economy, say because we can trust the Fed to handle that for us?

To say that money supply is not a very useful concept for individuals may possibly mean that the small variations in it that we see now don't mean much in understanding or predicting the future of the economy. But surely you can't mean that the money supply doesn't matter for the economy? What if the Fed stopped paying attention to it, say if political pressures led the Fed to stop focusing on money supply and revert to previous behavior that focused solely on interest rates?

It's been clear to the Fed and to macroeconomists since the inflation fiascos of the 1970s that the money supply matters for inflation. It was predicted theoretically and it was the very inflation fiascos of the 1970s that made it empirically clear that the money supply matters. How exactly to measure the money supply is a technical detail, but that the money supply matters for inflation is not controversial. Are you saying that as a modern-day latent Keynesian you even doubt this? Or are you saying that you are confident that inflation is under control, so the ordinary citizen can stop worrying about small variations in the money supply?

Lauren

Badger writes:

Funny how fast you seem have forgotten about all those nasty hyperinflationary episodes in history. Arnold, maybe your should take a look once more at the empirical evidence regarding the connection between money & inflation. Or just follow Bryan's advice and leave macro to the pros.

Wojtek Grabski writes:

Just because a dynamical system has a large degree of chaos on short time scales, doesn't negate the possibility that the steady-state solution fits with some guiding equation.

At the very least one can't make the jump to a completely random set of independent, piece-wise, solutions to explain the chaos way -- Keynesian economics purports to do exactly that.

Wojtek Grabski writes:

Just because a dynamical system has a large degree of chaos on short time scales, doesn't negate the possibility that the steady-state solution fits with some guiding equation.

At the very least one can't make the jump to a completely random set of independent, piece-wise, solutions to explain the chaos way -- Keynesian economics purports to do exactly that.

Gary Rogers writes:

You write:

But just as an oil price shock is easier to deal with now that we do not have price controls

I would add to this that we are dealing better with the oil price shock today than we did only a few years ago because the global warming evangelists have made the populist attacks against high oil prices politically incorrect. This allows market forces to work. For once, these people may have done us a favor.

Bob Dobalina writes:

If speculators woke up tomorrow convinced that in three years that price will be $30, then we would have $30 oil, at least for a while.

Not for bloody long, as all sorts of high-cash-cost supply would disappear more quickly than you might be imagining.

Arnold Kling writes:

Bob,
What if I conducted the oil price exercise the opposite way--speculators wake up tomorrow and say that the long-term price of oil is $150? What mechanisms would stop that from becoming the price of oil for a while?

Lauren,
I think the Fed has stopped focusing on the money supply. Even Volcker did not really focus on the money supply--he used monetary targeting as an excuse to raise interest rates. The Fed is doing inflation targeting.

Badger,
The government can debase the currency, although hyperinflation usually represents a breakdown in fiscal policy more than anything else.

All: if you take freshman macro, you read that the Fed controls "the" interest rate, as if it can increase the money supply and thereby reduce the cost of capital for long term borrowers. I don't believe that story works very well. Long term interest rates tend to follow a random walk. The effect of monetary policy on long-term rates is not nearly as reliable or strong as the textbook model suggests.

Barkley Rosser writes:

Arnold,

Welcome to the club, :-).

Lauren writes:

Hi, Arnold.

Lauren, I think the Fed has stopped focusing on the money supply. Even Volcker did not really focus on the money supply--he used monetary targeting as an excuse to raise interest rates. The Fed is doing inflation targeting.

I agree with that historical overview, but I'm not sure how you get from that to the astonishing broad statement you made:

The money supply is not a very useful concept in today's economy.

The money supply absolutely is a useful concept in today's economy for every citizen to understand.

If oil suppliers said they have stopped focusing on oil supplies and are targeting interest rates and not oil prices, would you say that the concept of oil supply is not useful in today's economy? I think not.

Just because the Fed says it doesn't focus on the money it itself supplies doesn't mean understanding the concept of money supply is not useful for ordinary citizens. A trivial reasonable question would be "useful for what?" If the Fed has political constraints to operate under and can't focus on the effects of increasing or decreasing the money supply, does that mean I as a daily user of money ought reasonably to ignore all understanding the concept of money supply itself?

It would be like your saying to me that taxes aren't a useful concept in today's economy. Or subsidies aren't a useful concept in today's economy. Or food isn't a useful concept in today's economy. As a citizen and as a learner of economics, I can't get much deeper understanding if all I listen to is the government's own statements about what it does about taxes, subsidies, food, etc.! What the government says it's doing or even acts on in its daily functioning doesn't tell me much about whether or not economic concepts are useful for me to know.

When I want to understand a concept, I don't want to know what the Fed or government or the supplier says about what it is doing. I want to know what the economics of the concept is about.

Supply and demand matter. They matter and are useful concepts for any good in economics. They matter whether or not the suppliers and demanders acknowledge or are aware of or want to admit the myriad implications or the future plans or faulty or politically-influenced motives they may have.

Money differs from ordinary goods and services--say, food, oil, etc.--in that its supply is controlled by Central Banks like the Fed, yet it is demanded by every single person in the economy.

The fact that the Fed has never completely bought into what economists have agreed on--that the money supply is the main determinant of inflation--doesn't mean that the money supply is not a useful concept in today's economy. It only means that the Fed's stated claims about what their actions are intended to accomplish--like lowering interest rates--are probably not useful to predict important economic matters like interest rates or inflation. It doesn't mean that the supply of the good itself--money--isn't a useful concept for private individuals to understand.

In fact, the concept may be even more useful and important to understand.

EdH writes:

Arnold

You aimed this at Lauren, but I will respond.

"Lauren,
I think the Fed has stopped focusing on the money supply. Even Volcker did not really focus on the money supply--he used monetary targeting as an excuse to raise interest rates. The Fed is doing inflation targeting."

During early Volcker years, he did manage to commit the Fed to a range as high as 4% in FFR interest rates. This was a big change from the single target rate the Fed again has settled into. Yes, he knew it would result in increased rates, but the mechanism was by limiting the amount of new money put into reserves. I repeat, the mechanism was restricted money, which coming out of high inflation years caused high interest rates, not setting high interest rates which restricted money growth. Read again the minutes from the early Board of Governors meetings and how Volcker maneuvered to exert his influence. It was masterful management.

Greg Ransom writes:

Your view sounds more like Hayek than Keynes.

Where's the Keynes?

It's easy to see where the Hayek is -- all this stuff about signals and knowledge diffusion is pure Hayek.

So again, where's the Keynes?

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