Hans Albert on the Quantity Theory of Money

I continue with a topic from Albert et al. (2012): the quantity theory of money.

Albert et al. (2012: 304) notes that the classical quantity theory of money holds that changes in the stock of money cause changes in the price level, and in extreme forms that the changes are proportional.

When this empirically testable version of the theory proved questionable, less stringent forms of the quantity theory were developed:

“Unfortunately, this [sc. Classical] theory has not proven to be successful, consequently it has been necessary to resort to a less demanding form of it. In the course of the development of economic thought, this form, too, has been abandoned in favor of what is known as the quantity or exchange equation, which maintains that the product of the amount of money and speed of money flow is identical to the product of the trade volume and the price level. However, as it is normally interpreted, this equation is analytic; thus the transition from the old quantity theory to the equation of exchange results in a tautology, and consequently a decrease in the informational content to zero, something which has by no means been noticed by all theoreticians.” (Albert et al. 2012: 304–305).

Thus the stipulation of the quantity theory that the velocity of circulation and trade volume need to be held constant is akin to the ceteris paribus assumption of the law of demand.

In fact, matters are far worse than even Albert believes.

As Albert notes, two main versions of quantity theory are used:

(1) The Equation of Exchange: MV = PT,
where
M = quantity of money;
V = velocity of circulation;
P = general price level, and
T = total number of transactions.

(2) the Cambridge Cash Balance equation: M = k_d PY,
where
M = quantity of money;
k_d = the amount of money held as cash or money balances;
P = general price level, and
Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services)

A number of assumptions have to be made for the quantity theory to explain changes in the price level:

(1) prices are flexible and respond to demand changes in either (1) both the short and long run, or (2) at least in the long run. Related to this is a tacit assumption that the economy is near equilibrium in the sense of full use of resources and high employment, where stocks and capacity utilization are not fundamental methods to deal with demand.

(2) money supply is exogenous;

(3) under the equation of exchange, for an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.

Under the Cambridge Cash Balance equation, M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

(4) the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.

(5) in some extreme forms there is the assumption, following from (1), that money stock increases induce direct and proportional changes in the price level.

So how realistic are these assumptions?

The answer is not very realistic at all:

(1) most prices are mark-up prices and relatively inflexible with respect to demand changes in both the short and long run. Most capitalist economies are far from full use of resources, and even in booms businesses make use of stocks and capacity utilisation to manage demand changes, rather than changes in prices.

(2) money supply is largely endogenous;

(3) The velocity of money and demand for money are unstable, subject to shocks and move pro-cyclically (Leo 2005; Levy-Orlik 2012: 170);

(4) the direction of causation. Under an endogenous system the direction of causation is generally from credit demand and price increases to money supply increases (Robinson 1970; Davidson and Weintraub 1973).

Therefore the direction of causation generally runs:

credit/demand deposit money demand → broad money supply increase → base money increase. (Moore 2003: 118).

This is true, as noted above, since the money supply is endogenous: most of the money stock is “broad money” or bank money, and the major driver of the expansion of this type of money is (1) credit expansion in the form of bank loans plus (2) the creation of ordinary demand deposits and saving accounts.

(5) that money stock increases necessarily or generally induce direct and proportional changes in the price level is empirically false (De Grauwe and Polan 2005).

It follows that the quantity theory in most of its theoretical forms can only be made true by simply transforming it into an analytic a priori statement about a hypothetical world of marginal or near zero relevance to the real world.

BIBLIOGRAPHY
Albert, Hans, Arnold, Darrell and Frank Maier-Rigaud. 2012. “Model Platonism: Neoclassical economic thought in critical light,” Journal of Institutional Economics 8.3: 295–323.

Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.

De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,” International Review of Applied Economics 19.1: 119–135.

Levy-Orlik, N. 2012. “Keynes’s Views in Financing Economic Growth: The Role of Capital Markets in the Process of Funding,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Keynes’s General Theory for Today: Contemporary Perspectives. Edward Elgar, Cheltenham. 167–185.

Moore, B. 2003. “Endogenous Money,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.

Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.

Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.

Hans Albert on the Law of Demand

Albert et al. (2012) is a translation of one of Hans Albert’s papers on neoclassical economics (Albert 1963).

In what follows I focus on his statements on the law of demand, though there is much else of interest in the paper, including a discussion of the quantity theory of money (one could also add a fine discussion of the law of demand and its shortcomings in Philip Mirowski’s The Effortless Economy of Science? [2004]).

Neoclassical economics tends to engage in fundamental analysis by means of highly abstract principles, abstracted from social data (Albert et al. 2012: 296).

In particular, neoclassical laws have a tendency to “immunise” neoclassical theory against refutation by experience and empirical evidence, a methodology Albert dubs “model Platonism” (Albert et al. 2012: 300).

The tendency has reached an apotheosis (of stupidity in my view) in the apriorism of some economic theory, most notably, as Albert points out, associated with the praxeology of Mises and his Austrian and non-Austrian methodological followers (Albert et al. 2012: 300, with n. 15).

The law of demand is in fact used in both neoclassical and Austrian economics, and this abstract law – in its abstract form – posits a universally true demand function, in which quantity demanded of a commodity is a decreasing function of price (Albert et al. 2012: 302).

The problem identified by Albert is a crucial one: at first sight, the law looks like it is an empirically testable proposition with substantive informational content about the real world (Albert et al. 2012: 302). But, as Albert says,

“... upon closer examination, this impression fades. As is well known, the law is usually tagged with a clause that entails numerous interpretation problems: the ceteris paribus clause. In the strict sense this must thus at least be formulated as follows to be acceptable to the majority of theoreticians: ceteris paribus – that is, all things being equal – the demanded quantity of a consumer good is a monotone-decreasing function of its price. The ceteris paribus clause is not a relatively insignificant addition, which might be ignored. Rather, it can be viewed as an integral element of the law of demand itself.” (Albert et al. 2012: 302).

So the ceteris paribus assumption is crucial to the law.

What is the epistemological status of the law of demand?

Albert sees it as a general hypothetical proposition: that is, a conditional statement with the antecedent-consequent/if-then structure (Albert et al. 2012: 302).

The ceteris paribus assumption must be part of the antecedent, so that the law can be written:

If, with all other factors held constant except price, the price of a good is reduced, then the quantity demanded will increase, and

If, with all other factors held constant except price, the price of a good is increased, then the quantity demanded will fall.

Hans Albert hits the nail on the head about the epistemological problem here:

“If the factors that are to be left constant remain undetermined, as not so rarely happens, then the law of demand under question is fully immunized to facts, because every case which initially appears contrary must, in the final analysis, be shown to be compatible with this law. The clause here produces something of an absolute alibi, since, for every apparently deviating behavior, some altered factors can be made responsible. This makes the statement untestable, and its informational content decreases to zero.” (Albert et al. 2012: 303).

Of course, once the ceteris paribus is appropriately interpreted to mean everything conceivable except price must be held constant, then the consequence of this is all too clear: the law of demand is reduced to an analytic a priori proposition, which has been made true by definition and with respect to the real world has become not-informative (Albert et al. 2012: 303).

For how can you refute or test a tautology?

I have said the same thing myself here, on the basis of a summary of Steve Keen devastating critique of the law (Keen 2011: 38–73).

Of course, responses can be made: doesn’t natural science also use abstract laws? E.g.,

Newton’s law of universal gravitation:
any two bodies in the universe attract each other with a force that is directly proportional to the product of their masses and inversely proportional to the square of the distance between them.

Newton’s first law of motion:
an object at rest will stay at rest unless acted on by an outside force, and an object in motion will stay in motion unless acted on by an outside force.

But these laws are testable to a high level, while the law of demand is not.

For neoclassical economics claims to be able to test the “law of demand,” but the “testing” is simply models where attempts are made to separate out the impact of a price change into the “income effect” and “substitution effect,” by means of changing indifference curves, budget constraints and employing Hicksian compensated demand curves. The result is simply that the “law of demand” is proven only for a single, isolated consumer.

Worse still, the Sonnenschein-Mantel-Debreu theorem finds that the law of demand does not necessarily apply to market demand curves, and the attempts to show how the law of demand could govern the behaviour of market demand curves result in the equally absurd result that this can only happen if in effect there is only one commodity and only one consumer in an economy.

The devastating result of all this is simply this: all the “proofs” reduce the law of demand to an analytic a priori statement that is informationally vacuous – exactly as Han Albert notes.

Further Reading
Lars P. Syll, “Hans Albert on Neoclassical Economics — Fully immunized to Facts,” 26 February, 2014.

Philip Pilkington, “Hans Albert Expands Robinson’s Critique of Marginal Utility Theory to the Law of Demand,” Fixing the Economists, February 27, 2014.

BIBLIOGRAPHY
Albert, Hans. 1963. “Modell-Platonismus: Der neoklassische Stil des ökonomischen Denkens in kritischer Beleuchtung,” in F. Karrenberg and H. Albert (eds.), Sozialwissenschaft und Gesellschaftsgestaltung. Festschrift für Gerhard Weisser. Duncker und Humblot, Berlin. 45–76.

Albert, Hans, Arnold, Darrell and Frank Maier-Rigaud. 2012. “Model Platonism: Neoclassical economic thought in critical light,” Journal of Institutional Economics 8.3: 295–323.

Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn). Zed Books, London and New York.

Mirowski, Philip. 2004. The Effortless Economy of Science?. Duke University Press, Durham.

Mises and Logic

Hans Albert points out a serious flaw in Mises’s understanding of logic:

“Mises gives a Kantian answer to the question of how the a priori character of praxeological knowledge and its apodictic certainty is to be explained. This knowledge apparently can be reduced to the logical structure of the human mind which is supposed to be the basis for thought and action. ... On the one hand he seems to suggest that he is introducing with his principle of action a synthetic a priori proposition, as he ascribes informational content to the principle. On the other hand, he declares the question of whether the respective propositions are synthetic or analytic to be purely verbal and therefore uninteresting. This seems to show that he was not aware of the connection between analyticity and informational vacuity. He permanently compares his allegedly a priori knowledge with logical and mathematical knowledge and gives such a description of the respective propositions and their mode of derivation that one comes to suspect them to be analytic. He confounds the analytical character of propositions with the logical character of the relationships between propositions in a deduction. But the fact that particular propositions are deducible from particular sets of premises does not render them analytic. For instance, in physics propositions from geometry get an empirical interpretation, and, interpreted in this way, they are synthetic. But propositions which are the result of the ‘logical unfolding’ of certain concepts contain no information. They are analytic not because they are derived, but because they follow from definitions which do not carry information themselves. When Mises tells us that the concept of money already implies all theorems of the theory of money, the alleged certainty of the basis of this derivation does not help him to establish a nonvacuous economic theory. The theory of money as he envisages it here would be without informational content and could not be used to explain anything.” (Albert 1999: 131–132).

That is a rather serious error. Another criticism of Human Action was pointed out a long time ago by G. J. Schuller:

“Acceptance of Mises’ stated axioms does not necessarily imply acceptance of the ‘principles’ or ‘applications to reality’ which he has drawn from them, even though his logic may be impeccable. When a logical chain grows beyond the limits set by stated assumptions, it uses unstated assumptions. The number of unstated assumptions (axioms, postulates, or other) in Human Action is enormous. If Mises denies this, let him try to rewrite his book as a set of numbered axioms, postulates, and syllogistic inferences using, say, Russell’s Principia or, closer home, Von Neumann’s Theory of Games as a model” (Schuller 1951: 188).

As it happens, Mises seems to have conceded this:

“Every theorem of praxeology is deduced by logical reasoning from the category of action. It partakes of the apodictic certainty provided by logical reasoning that starts from an a priori category. Into the chain of praxeological reasoning the praxeologist introduces certain assumptions concerning the conditions of the environment in which an action takes place. Then he tries to find out how these special conditions affect the result to which his reasoning must lead. The question whether or not the real conditions of the external world correspond to these assumptions is to be answered by experience. But if the answer is in the affirmative, all the conclusions drawn by logically correct praxeological reasoning strictly describe what is going on in reality” (Mises 1978: 44).

This concession makes a nonsense of Mises’s assertion that “Every theorem of praxeology is deduced by logical reasoning from the category of action. It partakes of the apodictic certainty provided by logical reasoning that starts from an a priori category.” If there is even some small doubt about the truth of the synthetic stated and hidden assumptions or premises in praxeological arguments, then the apodictic certainty of the inferences vanishes like a puff of smoke.

BIBLIOGRAPHY

Albert, H. 1999. Between Social Science, Religion and Politics: Essays in Critical Rationalism, Rodopi, Amsterdam.

Mises, L. 1978 [1962]. The Ultimate Foundation of Economic Science: An Essay on Method (2nd edn), Sheed Andrews & McMeel, Kansas City.

Schuller, G. J. 1951. “Mises’ ‘Human Action’: Rejoinder,” American Economic Review 41.1: 185–190.