Post Keynesians on Milton Friedman

There is some discussion of Milton Friedman at the moment by Paul Krugman (here and here).

So in that spirit, I think some heterodox Keynesian views of Friedman are worth mentioning:

Thomas Palley, “Milton Friedman: The Great Conservative Partisan,” November 27th, 2006.

James K. Galbraith, “The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus,” March 31, 2008.

One can also revisit Friedman’s debate with the Post Keynesian economists Paul Davidson and Sidney Weintraub (Davidson and Weintraub 1973), which, I think, makes profitable reading.

All in all, Thomas Palley has a nice summing up of Friedman’s monetarist doctrine:

“Monetarism’s most famous aphorism is that ‘inflation is always and everywhere a monetary phenomenon.’ This saying reflects Friedman’s polemical powers, capturing for monetarists what all sensible economists already knew. Inflation is about rising prices, and prices are intrinsically a monetary phenomenon since they are denominated in money terms.

Sustained inflation requires that the money supply grow in order to finance transacting at higher prices. For Friedman, this made villainous central banks the exclusive cause of inflation because of his belief that they control the money supply. However, the reality is that the private sector can also inflate the money supply through its own credit creation activities. Additionally, central banks (viz. the Bernanke Fed) may be compelled to temporarily accommodate inflationary private sector pressures to avoid triggering costly recessions. The implication is that inflation can have different causes, something Friedman denied. Sometimes inflation is caused by excessively easy monetary policy or large budget deficits financed by central banks. Other times it is due to private sector forces, including speculative booms and conflicts over income distribution.”
Thomas Palley, “Milton Friedman: The Great Conservative Partisan,” November 27th, 2006.

Moreover, attempts by central banks to actually control base money or the broad money stock, as under Margaret Thatcher and Paul Volcker, ended in miserable failure. Central banks soon turned to inflation targeting, and the idea of direct controls on money supply growth died a humiliating death.

This is no doubt what prompted John Kenneth Galbraith (father of James K. Galbraith) to say that “Milton Friedman’s misfortune is that his economic policies have been tried”!

UPDATE
Here are some further links:

Ramanan, “Nicholas Kaldor on Milton Friedman’s Influence,” The Case For Concerted Action, 13 July 2013.

“Milton Friedman’s Distortions, Part II,” Unlearning Economics, July 12, 2013.

“Milton Friedman’s Distortions,” Unlearning Economics, November 27, 2012.

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

Monetarists Fail History, Time and Again

Certain supporters of monetarism are telling me in the comments on my last post that the central bank can indeed directly control the broad money supply.

Well, that was news to Milton Friedman as reported in a 2003 interview:

“... prepare to be amazed: Milton Friedman has changed his mind. ‘The use of quantity of money as a target has not been a success,’ concedes the grand old man of conservative economics. ‘I’m not sure I would as of today push it as hard as I once did.’”
Simon London, “Lunch with the FT – Milton Friedman,” Financial Times, 7 June 2003.

I imagine Friedman had in mind the quasi-monetarist experiments of Paul Volcker and Thatcher. Both attempted to control the growth rate of the money supply – and both failed and resulted in disaster.

In the case of Paul Volcker, he adopted a monetarist policy at the Federal Reserve in October, 1979. He gave up direct targeting of the federal funds rate and instead wanted to control the growth rate of M1 by directly targeting the growth rate of nonborrowed-reserves. According to the quantity theory, the central bank had the power to exogenously set the money supply and thus control inflation. But the result was a catastrophe. The Federal Reserve was utterly unable to achieve its reserve target or M1 target. In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy.

Thatcher’s monetarist experiment involved the Medium Term Financial Strategy (MTFS) from May 1979 to the mid-1980s. The MTFS stressed the monetarist idea that inflation is (supposedly) caused by excessive money supply growth, but the twist in Thatcher’s monetarist thinking (or really that of her advisers) was that the excess money supply growth in Britain was caused by government deficits through borrowing from the banking system.

The first flaw in this ideology was the notion of a straightforward direction of causation from money supply growth to the price level. In fact, money supply growth is, generally speaking, a consequence of real economic variables such as credit growth and the rising prices of factor inputs. Secondly, although there was some British government borrowing from the banking system, bond purchases in the UK tended to be made by the non-bank private sector (Stewart 1993: 49). Michael Stewart notes that the empirical evidence from the last years of the 1970s shows that 98% of government borrowing was from the non-bank private sector and not directly from the banking sector (Stewart 1993: 49–50).

Further proof of the incompetence of the strange form of British monetarism pursued under Thatcher was its focus on the broad money stock M3. The Medium Term Financial Strategy (MTFS) prescribed targets for the growth rates of M3, but, during the first three years of Thatcher’s rule, M3 grew by around 50% per annum, which was twice as much as the government’s targets (Stewart 1993: 50). A further perverse effect of the rise in UK interest rates was to cause the selling-off of long term financial assets and the shift of the money into interest-bearing bank deposits – which of course caused the growth rate of M3 to soar! (Stewart 1993: 50).

But, of course, it would be too much to expect fans of monetarism to learn some history, wouldn’t it.

BIBLIOGRAPHY
Stewart, Michael. 1993. Keynes in the 1990s: A Return to Economic Sanity. Penguin, Harmondsworth.

“In the Long Run we are all Dead”: What Did Keynes Mean by That?

So Niall Ferguson made a fool of himself in recent remarks about Keynes. Ferguson’s comments are not a new charge: the egregious and laughable Austrian Hans-Hermann Hoppe put his foot in his mouth and said virtually the same thing as well some years ago.

Apart from the fact that Keynes appears to have been bisexual, not exclusively homosexual, and apparently lived as a normal married man who was romantically and sexually attracted to his wife Lydia Lopokova after his marriage, the various other ideas dragged up by Ferguson are wrong on so many levels.

The most important issue is, quite simply, Keynes was not indifferent to the long run at all. Ferguson, Hoppe, and a long line of other idiots hostile to Keynes do not know what they are talking about.

All the controversy comes from Keynes’s assertion that “in the long run we are all dead.” This is a statement lifted from Keynes’s A Tract on Monetary Reform (1923) that is often taken out of context and misunderstood, as Matias Vernengo argues here.

When Keynes wrote A Tract on Monetary Reform, he was still a believer in the truth of the quantity theory of money, and stated that its “correspondence with fact is not open to question” (Keynes 1923: 74). Keynes even thought that

“… money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy” (Keynes 1923: 75).

Keynes then proceeded to defend the quantity theory and the direct relation “between the quantity of cash … and the level of prices” (Keynes 1923: 78). So Keynes was not even a “Keynesian” when he wrote these words.

In his discussion of the quantity theory in A Tract on Monetary Reform, Keynes uses the following equation:

n = p(k + rk′),

where
n = quantity of money, or currency notes or other forms of cash in public circulation;
p = the index number of the cost of living;
k = consumption units of cash on hand;
k′ = money people want to be available in banks in the form of their demand deposits or checking accounts;
r = cash reserves of the banks.

In this version, Keynes thinks that as long as k, k′ and r remain unchanged, if n rises, then p will rise too (Keynes 1923: 77).

Both k and k′ appear to be roughly the equivalent of k_d in the Cambridge Cash Balance equation (see Appendix below).

Shortly after this discussion comes the famous passage:

“The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows. Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k′, — that is to say, in mathematical parlance that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k′, must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.

Now ‘in the long run’ this is probably true. If, after the American Civil War, the American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k′ would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes 1923: 79–80).

In other words, the famous “in the long run we are all dead” statement was about the long run and short run effects as predicted by the quantity theory, not about deficit spending or Keynesian stimulus.

In essence, Keynes’s passage boils down to the instability of the demand to hold money.

Keynes concluded that the quantity of money and the cash reserves of the banks are “under the direct control (or ought to be) of the central banking authorities” (Keynes 1923: 84).

In contrast, the money that people desire to hold either as (1) cash on hand or (2) in the form of demand deposits or checking accounts changes, and is not under the control of the central bank. The latter “depends on the mood of the public and the business world” (Keynes 1923: 84).

So Keynes concludes:

“The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over k and k′, and, in so far as this fails or is impracticable, in deliberately varying n and r so as to counterbalance the movement of k and k′.

The usual method of exercising a stabilising influence over k and k′, especially over k′, is that of bank-rate. A tendency of k′ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to counterbalance an increase of k′, because, by encouraging borrowing from the banks, it prevents r from increasing or causes r to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary n and r on occasion.

Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have n and r thoroughly under control. For example, so long as inflationary taxation is in question n will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard n is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system r will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks.

At the present time in Great Britain r is very completely controlled, and n also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other. The second duty of the authorities is therefore worth discussing, namely, the use of their control over n and r to counterbalance changes in k and k′. Even if k and k′ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless p could be kept reasonably steady by suitable modifications of the values of n and r.

Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping n and r steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of n and r, when k and k′ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in n or r, but by changes in k and k′. It follows that they can only be cured if we are ready deliberately to increase and decrease n and r, when symptoms of movement are showing in the values of k and k′.” (Keynes 1923: 85–86).

So what we have here is Keynes the quasi-monetarist advocating short-term monetarist solutions to changes in the demand to hold money. To avoid destabilising price level shocks, Keynes argued that the bank rate must be changed.

The neoclassical theory held that in the long run markets would adjust and return to full employment equilibrium in response to shocks, and Keynes seems to have agreed, but – like other Marshallian neoclassicals – argued that short term pain from the destabilising forces of deflation during recessions was unnecessary and monetary interventions should be used to stabilise economies.

Nor was Keynes ignoring the “long run” in his discussion: the whole point, as Matias Vernengo argues, is that “action in the short run facilitates the road towards the fully adjusted equilibrium in the long run.”

Appendix
Keynes’s formulation of the quantity theory is different from the Cambridge Cash Balance equation:

M = k_d PY

where M = quantity of money;
k_d = the demand to hold money per unit of money income;
P = the price level
Y = the volume of all transactions that enter into the value of national income (goods and services).

M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

BIBLIOGRAPHY
Amadeo, Edward J. 1989. Keynes’s Principle of Effective Demand. Edward Elgar, UK and Brookfield, VT.

Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

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

An Overview of the Major Schools of Economics

The major approaches to economics can be divided into

(1) neoclassical theories and
(2) non-neoclassical or heterodox schools.

The neoclassical schools include Supply-side economics, Monetarism, New Classical economics, and New Keynesian economics.

The mainstream and orthodox approach to economics is the New Consensus Macroeconomics, which is a synthesis of the main neoclassical approaches. But the mainstream neoclassicals do not agree on all issues: at the higher level they can be found in different groups like the monetarists, New Classicals, and New Keynesians.

There are three major heterodox, or non-neoclassical traditions: Austrian economics, Post Keynesian economics, and Marxism (and Marxism has more in common with Classical economics/Classical political economy, an older economic theory).

These divisions can be seen in the chart below (please open it in a new tab or window to see a larger version).

On the development of the Keynesian schools, I have already written a post called “Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review,” July 7, 2010.

After 1945, there were two Keynesian traditions:

(1) the neoclassical synthesis and
(2) the Cambridge Keynesians, who were the founders and progenitors of the Post Keynesian school.

Post Keynesian economics has no need for, and rejects, the IS-LM model of Hicks, the Phillips curve, and the empirically unsupported notion of the liquidity trap (Davidson 2002: 95). It is a more radical development of Keynesian theory, true to Keynes’ fundamental ideas (if not to all his more conservatively-minded policy recommendations), and has always rejected the foundational neoclassical axioms (namely, the gross substitution axiom, neutrality of money axiom, and the ergodic axiom).

The New Keynesians emerged after the collapse of neoclassical synthesis Keynesianism in the 1970s, but even modern New Keynesianism can be divided into conservative and liberal/progressive wings. Both Paul Krugman and Joseph Stiglitz are outstanding liberal New Keynesians. By contrast, George W. Bush took advice from the rather more neoliberal or economically conservative Republican New Keynesian N. Gregory Mankiw, who was chairman of Bush’s Council of Economic Advisors from 2003 to 2005. Despite the name “Keynesian”, there is a good deal of false and questionable neoclassical theory in New Keynesian economics, and in many ways it is inferior to the Post Keynesian tradition. Indeed, some of the worst writings of the conservative New Keynesians can actually be regarded as a travesty of Keynes’ thought. In its best, progressive forms, New Keynesian theory parallels Post Keynesian thinking.

The various types of libertarians are discussed in “The Types of Pro-Free Market Libertarians,” January 30, 2011.

Compared to the Austrians, the monetarists and New Classicals in fact support numerous state interventions, and their economics is derived from a revived neo-Walrasian general equilibrium theory. In fact, many Austrians are hostile to the mainstream monetarists and New Classicals, and there are very significant differences between their economic ideas.

As we can see, not all economists who support extreme or strong free markets are libertarians. I have not included monetarists as libertarians, but of course there is some overlap between the two sets. Although it is true that some supply-siders, monetarists, New Classicals, and Republicans think of themselves as “libertarians” in some way as well, many in fact do not. Modern conservatism or conservative economics comes in many forms, and by no means can it all be simply labelled as “libertarianism”.

Perhaps a better division of extreme or strong pro-free market ideologues would be as follows:

(1) Libertarians, including Austrians (Anarcho-capitalists, Misesians, Hayekians, moderate subjectivists, radical subjectivists) and non-Austrian libertarians (Randians, Robert Nozick’s libertarianism, David D. Friedman’s anarcho-capitalism, and non-Austrian neoclassical libertarians), and

(2) Mainstream neoclassical theorists, including Supply-siders, Monetarists, New Classicals, and conservative New Keynesians.

This can be shown in another chart below.

There is a blue line that divides the New Keynesians into conservatives on the left and liberals/progressives on the right. It is unfair to characterise the liberal/progressive New Keynesians as strong pro-free market ideologues, so they should be excluded from the other groups. The libertarians outside the black box (i.e., the Austrians and Randians) are non-neoclassicals but pro-free market. Those libertarians inside the black box are neoclassicals or influenced by neoclassical theory.

Now over the past 65 years (since about 1945) we have had two different economic systems based on two different macroeconomic theories:

(1) neoclassical synthesis Keynesianism and Cambridge Keynesianism/Post Keynesianism from 1945 to about 1979;
(2) revived neoclassical macrotheory from the late 1970s.

The revival of neo-Walrasian neoclassical theory was done mainly by (1) Milton Friedman and (2) the New Classicals at the University of Chicago in the 1970s, including John F. Muth, Robert Lucas, Thomas J. Sargent, Robert J. Barro, Neil Wallace, Robert M. Townsend, Robert E. Hall, Edward C. Prescott and Finn E. Kydland. In many ways, the New Classicals are the worst of all the revived neoclassical theories, because they have been one of the most powerful schools, with considerable influence.

While Neoclassical synthesis Keynesianism had its theoretical problems, derived from the mistaken attempt to wed it to fundamental neoclassical ideas, it provided a far better system than the one that we have seen since about 1979.

The new neoclassical orthodoxy that emerged in the 1980s can be called “neoliberalism,” the “Washington consensus,” or “globalization.”

Reaganomics and Thatcherism were blends of the various new neoclassical ideas. In particular, Reaganomics was a strange blend of monetarism and supply-side economics, with a type of military Keynesianism brought in via Reagan’s huge budget deficits. Thatcherism was a more doctrinaire neoliberal ideology influenced by Milton Friedman, with a tinge of Austrian rhetoric, via Friedrich von Hayek.

While forms of monetarism and supply-side economics rather quickly fell from favour amongst policy-makers (indeed I think that forms of monetarism or quasi-monetarism in fact failed rather spectacularly), the New Classical economics emerged as the dominant neoclassical theory, and, through its arguments with the New Keynesians, the resulting synthesis lead to the New Consensus Macroeconomics by the early 1990s. It is this modern consensus that has come under severe attack in the wake of the 2007–2009 global financial crisis and great recession.

It is clear that the New Consensus Macroeconomics has failed. The question is whether some of the more intelligent New Keynesians can escape from the death-grip of neoclassical economics and develop a better macroeconomic theory, purging it of its unnecessary, mad and bad neoclassical ideas. If that happens, my money is on Post Keynesian economics to be the new economic paradigm.

BIBLIOGRAPHY

Davidson, P. 2002. Financial Markets, Money, and the Real World, Edward Elgar, Cheltenham.

The Quantity Theory of Money: A Critique

The quantity theory of money is widely used to predict that increases in the money supply lead to a direct, mechanistic increase in the price level. Keynes had strong criticisms of the quantity of money equation, and Post Keynesians have made even stronger attacks on the theory.

The quantity theory of money assumes that there is a direct, proportional relationship between the money supply and the inflation rate or price level.

Recent empirical work on whether this is actually true has not been kind to the quantity theory:

“The quantity theory of money is based on two propositions. First, in the long run, there is proportionality between money growth and inflation, i.e., when money growth increases by x% inflation also rises by x% .... We subjected these statements to empirical tests using a sample which covers most countries in the world during the last 30 years. Our findings can be summarised as follows. First, when analysing the full sample of countries, we find a strong positive relation between the long-run growth rate of money and inflation. However, this relation is not proportional. Our second finding is that this strong link between inflation and money growth is almost wholly due to the presence of high-inflation or hyperinflation countries in the sample. The relation between inflation and money growth for low-inflation countries (on average less than 10% per year over 30 years) is weak, if not absent” (De Grauwe and Polan 2005: 256).

First, for countries with inflation rates less than 10% (which is most of the developed world), the empirical evidence for the quantity theory of money is either very weak or just non-existent. This is a serious blow to the quantity theory.

Secondly, although countries with high-inflation or hyperinflation show a correlation between the growth rate of money supply and inflation, contrary to the quantity theory, that relation is not proportional. A further blow to the quantity theory is that, in very high inflation countries, inflation rates exceed the growth rates of the money supply, because the velocity of circulation of money increases with high inflation rates (De Grauwe and Polan 2005: 257). This instability in the velocity of circulation is contrary to the quantity theory, which posits a stable velocity of circulation, as we will see below. Finally, De Grauwe and Polan reach the conclusion:

“Our results have some implications for the question regarding the use of the money stock as an intermediate target in monetary policy …. The ECB bases this strategy on the view that ‘‘inflation is always and everywhere a monetary phenomenon.’’ This may be true for high-inflation countries. Our results, however, indicate that there is no evidence for this statement in relatively low-inflation environments … In these environments, money growth is not a useful signal of inflationary conditions, because it is dominated by ‘‘noise’’ originating from velocity shocks. It also follows that the use of the money stock as a guide for steering policies towards price stability is not likely to be useful for countries with a history of low inflation” (De Grauwe and Polan 2005: 258).

We can now move on to the theory itself. There are actually three versions of the quantity theory (the following account is based on Thirlwall 1999). First, Irving Fischer’s equation of exchange provides a widely-cited version of the theory, as follows:

Equation 1: MV = PT

M = quantity of money;
V = velocity of circulation of money;
T = volume of all transactions (both involving intermediate goods and financial assets);
P = average price of the transactions.

For an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.

The second version is the income quantity theory of money, as follows:

Equation 2: MV = PY

V = income velocity of circulation of money, not the total velocity;
Y = the volume of all transactions that enter into the value of national income (goods and services).

It can be seen that Y replaces T in the second equation, and P is therefore the average price of goods and services. V and Y must be constant for the money supply to induce equal or proportional changes in the price level.

Yet a third version of the quantity theory of money is the Cambridge Cash Balance equation:

Equation 3: M = k_d PY

Here k_d is the demand to hold money per unit of money income. M and P are causally related, if k_d and Y are constant (Thirlwall 1999). This version of the quantity theory was used by Milton Friedman.

It can be seen that V (whether it is regarded as the velocity of circulation of money as in equation 1, or the income velocity of circulation of money as in equation 2) or k_d must be constant for the quantity theory of money to work, as must T (in equation 1) or Y (in equations 2 and 3).

Keynes correctly argued that neither k_d nor Y is constant. Pre-Keynesians assumed that Y was constant because of their foolish belief that a free market economy was nearly always in, or moving towards, equilibrium (i.e., full employment and full use of resources). By contrast, Keynes, in his criticism of equation 3, argued that in the absence of full employment, Y will not be constant. Thus the theory breaks down, especially in a recession, depression or even in periods during expansions in the business cycle where full employment is not reached. The neoclassicals also assumed that V was constant because they only accepted the transactions demand for money. Keynes, however, showed that there are three motives for holding money: (1) the transactions motive, (2) the speculative motive, and the (3) precautionary motive.

Keynes thus rejected the idea that there is a direct and proportional relationship between the money supply and the price level. Instead, Keynes argued that the money supply influences the price level indirectly through its effects on the interest rate, income, output, employment and investment. Moreover, prices are also influenced by the costs of production. It is only when there is full employment and full use of resources that money supply increases could then increase the price level in the way the quantity theory predicts.

We can carry Keynes’s critique even further by adding Post Keynesian criticism of the quantity theory.

In reality, the quantity theory also makes an assumption that is fundamentally false. The quantity theory assumes this:

(1) an exogenous money supply;
(2) a stable V or k_d in equation (3) above;
(3) a stable Y in equations (2) and (3) above, and
(4) equilibrium or near equilibrium (high capacity utilization/high employment).

First, we have already seen that (2) and (3) are false. The velocity of money is unstable, subject to shocks and moves pro-cyclically (Leo 2005). If the economy is not at full employment (and has less than full capacity utilization), then Y will actually rise as income rises, and the price level could remain stable in the face of this rising money supply/income.

Secondly, what about (1)? Neoclassical Keynesians accepted the idea of an exogenous money supply determined by the central bank (as did Keynes himself), and notably Keynes never broke with the quantity theory of money fully, despite his criticisms. But today Post Keynesian economists have shown that we have an essentially endogenous money supply, so that assumption (1) is wrong. In a modern economy, money is endogenous in the sense that most money is credit money created by banks in response to demand for it from the private sector. As Steve Keen has argued,

“the point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it …. Calling our current financial system a “fiat money” or “fractional reserve banking system” is akin to the blind man who classified an elephant as a snake, because he felt its trunk. We live in a credit money system with a fiat money subsystem that has some independence, but certainly doesn’t rule the monetary roost—far from it.”
Steve Keen, “The Roving Cavaliers of Credit,” Debt Watch, January 31st, 2009

Thirdly, in a recession capacity utilization is low and unemployment is high. The quantity theory also ignores imports in open economies, which can keep inflation low.

It follows that the quantity theory is thus fundamentally false. It can be noted that even Austrian economists reject it as a simplistic theory (see my post The Austrian Theory of Inflation: Myths and Reality).

The Austrians argue that changes in the level of prices depend very much on both real and monetary factors. This is essentially correct. In reality, whether inflation happens or not in an economy could be determined by real factors. Real factors that can overwhelm inflationary pressures from increasing demand when the money supply rises include:

1. the falling prices of specific goods through increasing productivity or output;
2. low capacity utilization rates;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money, and
6. level of employment (= level of demand for goods and services).

An appreciating exchange rate can also reduce inflationary pressures. Whether you get inflation or not in the face of rising money supply depends on the particular state of the economy at that time.

The quantity theory of money was the foundation of monetarism, the macroeconomic theory of Milton Friedman. Monetarism was tried in the US and the UK in the late 1970s and early 1980s, and failed miserably. In the case of the US, Paul Volcker adopted a monetarist policy at the Federal Reserve in October, 1979. He gave up direct targeting of the federal funds rate and wanted to control the growth rate of M1 by directly targeting the growth rate of nonborrowed-reserves. According to the quantity theory, the central bank had the power to exogenously set the money supply and thus control inflation. But the result was a catastrophe. The Federal Reserve was utterly unable to achieve its reserve target or M1 target. This provides strong empirical evidence that broad money supply is endogenous. In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy. Inflation was brought under control because the monetarist disaster caused the federal funds rate to surge to 20%, which caused a crippling recession and demand contraction (as well as a heavy blow to US manufacturing and the Third World debt crisis). The fiction that the Federal Reserve controls the growth rates of monetary aggregates officially ended in 1993, but in practice had ended in 1982. In a 2003 interview with the Financial Times, even Friedman himself admitted that monetary targeting as a central bank policy was a failure:

prepare to be amazed: Milton Friedman has changed his mind. “The use of quantity of money as a target has not been a success,” concedes the grand old man of conservative economics. “I’m not sure I would as of today push it as hard as I once did.
Simon London, “Lunch with the FT – Milton Friedman,” Financial Times (7 June 2003)

Are there cases when the quantity theory of money can actually be a reasonable predictor of inflation? To do so, the economy in question must have these characteristics:

(1) an exogenous money supply;
(2) full or near full employment;
(3) high capacity utilization;
(4) relatively closed to trade;
(5) stable velocity of circulation.

In an astonishing paradox of history, it turns out that, along with price controls, some Marxist and Communist states used a version of the quantity theory of money to predict and control inflation (although how successfully is another question). One can also note that the centrally-planned Communist states were closer to fulfilling the conditions listed above than Western mixed, open economies. Most Communist states fulfilled (2), (3), (4) and arguably (1). Thus Communist states used a crude, short-run version of the quantity theory in planning (Portes 1978: 78; Burton 1980: 4).

Factors (1) to (5) above, however, do not generally apply to a modern developed open economy, so the quantity theory remains a poor method of predicting or explaining inflation.


BIBLIOGRAPHY

Burton, J. 1980. “On Monetarism and Libertarianism,” Journal of the Libertarian Alliance 1.4 (Winter): 1–5.

Davidson, P. 2009. The Keynes Solution: The Path to Global Economic Prosperity, Palgrave Macmillan, New York.

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

Galbraith, J. K. 2008. “The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus,” The Levy Economics Institute of Bard College Policy Note, 2008

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Portes, R. 1978. “Inflation under Central Planning,” in F. Hirsch and J. H. Goldthorpe (eds), The Political Economy of Inflation, Martin Robertson, London.

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

The Austrian Theory of Inflation: Myths and Reality

Many libertarians, advocates of free market economics or supporters of Austrian economics complain repeatedly about fiat money and increases in the money supply.

Typically, they complain that any increase in the money supply must always lead to a rise in the price level or the inflation rate.

Here is a video of Ron Paul complaining about the Federal Reserve’s creation of money because it will lead to inflation.

It is a view that you find frequently in pro-free market, libertarian, and populist Austrian blogs or commentary.

A very general statement of the Austrian theory of inflation can be found on Wikipedia:

“The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.” http://en.wikipedia.org/wiki/Inflation#Austrian_theory.

So firstly the word “inflation” is defined specifically as an increase in the money supply, and contrary to the popular definition of “an average increase in the price level.” In the Austrian theory, “inflation” is not a general increase in prices, but an increase in the money supply.

The purpose of this post is to show that many people today who are sympathetic to Austrian economics or who are self-proclaimed followers of the Austrian school actually do not understand the Austrian theory of inflation and the price level.

Many people cannot distinguish Milton Friedman’s monetarist theory of the price level (based on the quantity theory of money) from the Austrian view, which is actually quite different from Friedman’s and, moreover, has changed over time.

First, it is necessary to say a word about the quantity theory of money. Contrary to what many believe, Austrians have always had an ambivalent and even critical attitude to the quantity theory of money. The quantity theory of money is the basis of Milton Friedman’s monetarism, a macroeconomic theory that became popular in the late 1970s and early 1980s. The quantity theory is also used frequently by pro-free market writers to decry expansion of the money supply under a fiat monetary system.

However, many Austrians actually have a rather sceptical view of the quantity theory.

Ludwig von Mises, for instance,

“agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).

In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.

The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level. This is ridiculous.

Friedrich August von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002). In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3). Modern Austrians are divided on the issue of the quantity theory of Friedman. Some continue to be critical, like Jesús Huerta de Soto:

“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).

The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort the productive structure of an economy – a cause, they believe, of recessions.

These Austrian views of the quantity theory are frequently ignored or simply unknown to many who hold a crude, vague or confused Austrian view of economics.

Austrians, in essence, have two objections to inflation. The visible effect (if output does not rise) is rising prices. This could be rising prices in goods and services (not necessarily uniformly), but also in the prices of financial and real assets. Austrians quite reasonably include asset price inflation in the overall price level (note that the prices of stocks, bonds, other financial assets, real estate, and commercial property are not normally included in consumer prices indices). But their further complaint is that there is also an invisible effect: the increasing money supply stops the money stock from remaining stable and hence it prevents deflation, which would increase the purchasing power of money. A rising money stock, therefore, does not allow money’s purchasing power to increase through price deflation.

With respect to asset price inflation, the Austrian view ignores the fact that effective financial regulation can prevent bubbles, especially in real assets like housing and real estate. The US, for instance, had stable housing prices from about 1950 until the mid-1970s, and the same was true in many other countries, because of regulation.

The Austrian claim that money supply increases cause the invisible effect of preventing deflation ignores the fact that, although price deflation increases money’s purchasing power, deflation can have devastating effects on economic activity. Debts, for instance, are fixed in nominal terms and, when deflation causes wage and price falls, debtors face a greater burden in repaying debt. The Austrians argue that the gold standard should be restored, but this would leave the level of the money supply subject to external factors like discoveries of gold and the current account balance. In fact, the gold standard was no guarantee of zero inflation: the UK was on the gold standard and had persistent inflation between 1897 and 1912, partly because of the influx of gold from new discoveries.

Furthermore, when we examine articles on the Austrian theory of inflation at the Ludwig von Mises Institute by more academic Austrian scholars, we even find a more balanced argument:

“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”

Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.

Shostak also believes that increasing the money supply leads to a misallocation of resources. This is indeed possible, especially in an unregulated financial system, but it is by no means necessary or inevitable. Credit has to be given to the Austrians for their business cycle theory, because at the time when they first produced it (in the 1920s and 1930s) it was an improvement over the neoclassical view that business cycles caused by a failure of aggregate demand could not occur in capitalism because of Say’s law, and also because the Austrians (like the post Keynesians) correctly saw that money is not “neutral”. However, Austrian business cycle theory still has major flaws and it cannot be accepted, though that is a topic for another essay.

The important point, however, is that Shostak is careful to qualify his statement quoted above. He says that increasing the money supply will always cause an increase in the level of prices, but then concedes that prices are also “determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.”

This is a very important qualification. He is right that the inflation rate (the rate of increase in a price index like the CPI) and changes in the level of prices also depend very much on real factors, as well as monetary ones. For example, the following factors could tend to decrease the level of prices:

1. the falling prices of specific goods through increasing productivity or output;
2. an appreciating exchange rate;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money;
6. higher unemployment (= less demand for goods and services), and
7. a fall in extension of bank credit.

In reality, all or some of these factors listed above could operate to cause either a zero inflation rate (which Japan actually had in 1996 and 2004) or a fall in average prices (deflation), even when the money supply is still actually increasing.

We can take a real world example. In the late 19th century, the UK experienced sustained price deflation from 1873–1896. However, the actual broad money stock was rising in these years: between 1873–1896 the money stock grew by about 1.3% a year, or over the entire period by about 33%. Yet between 1873–1896 wholesale prices fell by 39%. What happened was that in this period the money supply was rising, but not as fast as demand for money, and also steep falls in the prices of agricultural commodities contributed to the fall in overall prices (Capie and Wood 1997: 287–289).

Now Shostak’s slightly more balanced Austrian view that an increasing money supply does not always necessarily lead to a rise in the price level is hardly ever considered by popular proponents of Austrian school economics.

Instead, we hear endless rants about how increasing the money supply always and automatically devalues or reduces money’s purchasing power.

This simply ignores the fact that the mechanism that reduces the purchasing power of money is an average increase in the price level.

Once it is conceded that (1) the relationship between a rising money stock and rising price level is not automatic, necessary or inevitable and (2) the Austrian business cycle theory is wrong, most of the popular and crude objections to an increasing money supply collapse.

But there is more to be said. If we go right back to the work of Ludwig von Mises in The Theory of Money and Credit (1912), we actually find another definition of inflation:

“In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur. Again, Deflation (or Restriction, or Contraction) signifies: a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange-value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange-value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange-value of money, or even by the fact that we are not able to discern them at all except when they are large” (Mises 1953).

This definition of inflation is hardly ever used by popular followers of Austrian school economics.

The fundamental fact is that Mises did not define an increase in the money supply accompanied by a corresponding demand for money as inflation.

As interpreted by a modern Austrian scholar:

“Mises …. suggests inflation [is] … ‘an increase in the quantity of money above the market demand of money.’ Note that, under Mises’ suggested definition, not every increase in the quantity of money is inflation, only increases that exceed market demand …. [Mises] saves the term inflation for cases where the quantity of money is increasing above the market demand for money” (Cachanosky 2009: 5).

That means that the money supply can continuously rise in proportion to the demand for money, and that this is presumably not objectionable in Mises’ theory.

This is a far cry from some modern advocates of a crude Austrian or quantity theory of money, who complain that any increase in the money supply is bad and will cause a rise in prices.

In addition, if you reject Austrian business cycle theory, this passage quite obviously raises the question of why a rise in fiat money in response to the demand for it in an economy with effective financial regulation that channels credit to productive investments (rather than asset bubbles or speculation) would be a bad thing.


BIBLIOGRAPHY

Arena, R., 2002, “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds), F. A. Hayek as a Political Economist: Economic Analysis and Values, Routledge, London.

Cachanosky, N., 2009, “The Definition of Inflation According to Mises: Implications for the Debate on Free Banking,” Libertarian Papers Vol. 1, Art. No. 43.

Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York, 287–289.

Garrison, R., 2007, “Hayek and Friedman: Head to Head”
http://www.auburn.edu/~garriro/hayek%20and%20friedman.pdf.

Huerta de Soto, J., 2009, “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,” Economicthought.net
http://www.economicthought.net/2009/07/a-critique-of-the-mechanistic-monetarist-version-of-the-quantity-theory-of-money/.

Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.

Quiggin, J., 2009, “Austrian Business Cycle Theory,” May 3rd
http://johnquiggin.com/index.php/archives/2009/05/03/austrian-business-cycle-theory/.

Rothbard, M. N., 2009, The Essential von Mises, von Mises Institute, Auburn, Alabama.

Shostak, F., 2002, “Defining Inflation,” Mises Daily, March 6
http://mises.org/daily/908.