Sunday, July 18, 2010

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 = kd PY

Here kd is the demand to hold money per unit of money income. M and P are causally related, if kd 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 kd 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 kd 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 kd 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.


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

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

London, S. 2003. “Lunch with the FT – Milton Friedman,” Financial Times (7 June).

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.

Galbraith versus Krugman on Deficit Spending

In a recent post, Paul Krugman has criticised James K. Galbraith’s view of deficit spending. The latter is obviously influenced by Modern Monetary Theory. For the relevant documents, see here:

Paul Krugman, “I Would Do Anything For Stimulus, But I Won’t Do That,” July 17, 2010.

James K. Galbraith, Statement to the Commission on Deficit Reduction, June 30, 2010.

Krugman’s complaint is as follows:

there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency. The most prominent advocate of this view is probably Jamie Galbraith, but he’s not alone.

Krugman is undoubtedly referring to Modern Monetary Theory (MMT)/neo-Chartalism. However, he is wrong to accuse neo-Chartalists of thinking that “deficits are never a problem.” In fact, Modern Monetary Theory says that, even though deficits are not “financially” constrained, they face real constraints in available resources, capacity utilization, the unemployment level, the exchange rate, the external balance, and inflation rate.

This is quite different from saying that “deficits are never a problem.” Clearly deficits can be, if they cause excessive inflation and push the current account deficit to an unsustainable level. Investor confidence is also a factor influencing the exchange rate, but, since behaviour in these financial markets is fundamentally irrational and subject to panics, one cannot predict what they will do, and the government should not be held hostage by them.

Krugman has misunderstood Galbraith. If we look at what Galbraith actually says, it is very clear:

[sc there is a] common belief that the government must borrow in order to spend, and thus that the government faces “funding risks” in private markets. Such risks exist … for private individuals, for companies, for state and local governments, and for national governments such as Greece that have ceded monetary sovereignty to a central bank. But the situation of the United States government is quite different. The U.S. government spends (and the Federal Reserve lends) in a very simple way. It does so by writing checks – in fact simply by marking up numbers in a computer. Those numbers then appear in the bank accounts of the payees, who may be government employees, private contractors, or the recipients of federal transfer programs. The effect of government check-writing is to create a deposit in the banking system. This is a “free reserve.” Banks of course prefer to earn interest on their reserves. Thus they demand a US Treasury bond, which pays more interest without incurring any form of credit or default risk … The Treasury can meet that demand, or not, at its option – it can permit, or not permit, the stock of US Treasury bonds in circulation to increase. So long as U.S. banks are required to accept U.S. government checks – which is to say so long as the Republic exists – then the government can and does spend without borrowing, if it chooses to do so. And, if it chooses to issue Treasuries to meet the demand, it can do that as well. There is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail …. Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar.

Galbraith is entirely right, and Krugman omits the words in bold, and from these words it is quite clear that Galbraith understands that there are real constraints on deficit spending, not phantom “financial” ones. Moreover, it is perfectly clear that Galbraith is talking about deficit spending during a period of high unemployment and low capacity utilization, and perhaps even in the face of a double dip recession.

In his response to Galbraith, Krugman adopts the flawed quantity theory of money and attempts to prove mathematically what is perfectly obvious: that hyperinflation can result from continuous budget deficits that are monetized by the central bank. But, since Modern Monetary Theory already acknowledges that inflation is a real constraint on deficit spending, Krugman’s analysis seems rather pointless.

Consequently, James K. Galbraith is correct.


Galbraith has responded to Krugman:

It is clear Krugman has misrepresented Galbraith. Modern Monetary Theory has always said that there are real limits to deficit spending, and inflation is one of them.

Wednesday, July 7, 2010

What Type of Keynesian is Paul Krugman?

In a recent post I reviewed the three varieties of Keynesian economics (see Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review). A question raised by this post is this: what kind of Keynesian is Paul Krugman?

Paul Krugman is an outstanding liberal economist and won the Nobel Memorial Prize in Economics in 2008. I admire Krugman's work very much. Krugman began his career as a New Keynesian, but he is sometimes regarded as an “Old Keynesian” (i.e., more like a post-WWII neoclassical synthesis Keynesian such as James Tobin). However, calling Krugman an “Old Keynesian” is probably misleading. Krugman in early 2009 made this comment on his blog after reading Hyman Minsky:

I really am gravitating toward a Keynes-Fisher-Minsky view of macro, although of the three I’d much rather read Keynes.

Paul Krugman, “Actually existing Minsky,” May 19, 2009,

However, as of October 2009, Krugman still declared himself an economist basically using New Keynesian macroeconomic foundations:

I … quarrel with designating me a “radical Keynesian.” I’m just a Keynesian, willing to follow the logic of my analysis. A perfectly standard New Keynesian model, with intertemporal optimization and all that — the kind of model that is standard in freshwater courses — says that under current conditions fiscal stimulus should be very strong, much stronger than what we’re actually doing.

Paul Krugman, “Samuel Brittan’s recipe for recovery,” October 16, 2009,

Krugman rejects the idea that he is a “radical” Keynesian, and his use of a New Keynesian model supports this.

Nevertheless, Post Keynesian economists have pointed out that Krugman seems to share similarities with their macroeconomics: he apparently emphasises changes in liquidity preference as a cause of unemployment, has refuted the New Keynesian idea that price and wage stickiness is the fundamental cause of involuntary unemployment, and rejects Say’s law. If this is the case, these ideas make him much closer to Post Keynesian macroeconomics than he perhaps realises (see Felipe Rezende, Keynes’s Relevance and Krugman’s Economics, August 18, 2009, New Economic Perspectives Blog).

Post Keynesian Resources

This blog advocates Post Keynesian macroeconomics. There are a number of websites that offer Post Keynesian analysis and commentary. This post gives the interested reader a selection of links for Post Keynesian thought.

Post Keynesian Economics Study Group

Paul Davidson, Professor of Economics, University of Tennessee

Victoria Chick, Emeritus Professor of Economics at University College London

Mark Hayes, Robinson College, Cambridge

Steve Keen, Associate Professor of Economics & Finance at the University of Western Sydney

Dr. Thomas Palley, PhD. in Economics (Yale University)

Marc Lavoie, Professor in the Department of Economics at the University of Ottawa

Dr. J. Barkley Rosser, Jr., Professor of Economics, James Madison University

Philip Arestis

Robert Pollin, Professor of economics at the University of Massachusetts-Amherst

Professor Malcolm Sawyer, Leeds University Business School

Professor Sheila Dow, University of Stirling, Ann Pettifor blog

Michael Hudson

Neochartalism/Modern Monetary Theory

New Economic Perspectives from Kansas City and Beyond

L. Randall Wray, Professor of Economics at the University of Missouri-Kansas City

Bill Mitchell, Research Professor in Economics and Director of the Centre of Full Employment and Equity at the University of Newcastle, NSW Australia

Warren Mosler, The Center of the Universe

Centre of Full Employment and Equity (CofFEE)

Other Resources

Real-World Economics Review Blog

Econospeak Blog

James Galbraith

Robert Skidelsky’s Official Website (Emeritus professor of political economy at the University of Warwick, England)

The Other Canon

Tony Lawson, Staff Page, University of Cambridge

Thoughts On Economics, Robert Vienneau

Post-Keynesian Observations

Levy Economics Institute of Bard College

Unsettling Economics, Michael Perelman

The Progressive Economics Forum

Neoclassical Synthesis Keynesianism, New Keynesianism and Post Keynesianism: A Review

With the use of fiscal policy in many countries around the world during the great recession of 2008–2009, the macroeconomics of Keynesianism is now a lively topic. My blog advocates a Post Keynesian approach to economics, but Post Keynesianism is not the only Keynesian school.

In fact, there are three types of Keynesianism, and supporters and enemies of Keynesian economics should be clear about what type of Keynesianism they are talking about.

In what follows, I give a brief introduction to the three varieties of Keynesianism.

(1) The post-WWII Neoclassical Synthesis Keynesians (= Neo-Keynesians / hydraulic Keynesians / bastard Keynesians / Hicksian Keynesians).
In the aftermath of the Second World War, American economics was reformed by number of economists who were influenced by Keynes. However, partly in the environment of McCarthyism and partly through their own re-interpretation of Keynes (as well as the role of the Canadian economist Robert Bryce in spreading a flawed understanding of Keynes’ theories in the US), Paul Samuelson and Robert M. Solow diluted Keynes’s work by joining it with neoclassical economics (Davidson 2010: 247). Lorie Tarshis, the Canadian student of Keynes, had written a fairly good textbook summary of Keynes’s General Theory for American universities in the 1940s, but the book was attacked by conservatives who regarded it as inspired by communism, and in particular William F. Buckley denounced the book in his God and Man at Yale (1951). Consequently, a version of Keynesianism that used neoclassical microeconomics to justify general Keynesian macroeconomic policies was adopted as the orthodoxy in America, principally through the work of Paul Samuelson and Robert M. Solow, as well as the IS/LM model of the British neoclassical John Hicks (who worked at Oxford university). Hicks, Solow and Samuelson were influenced by neoclassical Walrasian general equilibrium theory.

Paul Samuelson coined the expression “neoclassical synthesis” to refer to the new theory that blended Keynesianism with neoclassical microeconomics. The “neoclassical synthesis Keynesians” assumed that involuntary unemployment was only due to inflexible wages and prices, and accepted the three neoclassical axioms of (1) neutral money, (2) gross substitution and (3) the ergodicity of the future, contrary to Keynes’s General Theory. Because of its departure from Keynes’s ideas, Joan Robinson labelled the neoclassical synthesis as “bastard Keynesianism” (Lodewijks 2003: 25; for the history of Keynesian policy in the US, see Turgeon 1996). This largely American version of Keynesianism was therefore open to theoretical attacks by monetarists and New Classicals in the 1970s, and today there are not many neoclassical synthesis Keynesians left.

Owing to their flawed neoclassical theory, the neoclassical synthesis Keynesians had difficulties explaining and dealing with stagflation, and were discredited in the 1970s. Many morphed into “New Keynesians,” and those who did not (e.g., James Tobin) came to be called “Old Keynesians.” Some well known neoclassical synthesis Keynesians were John R. Hicks (1904–1989), Frank Hahn, Abba P. Lerner, William J. Baumol, Franco Modigliani, Paul A. Samuelson, Robert Eisner, Walter W. Heller and Robert M. Solow. Notably, John R. Hicks actually renounced the IS-LM model (and the neoclassical synthesis) in the early 1980s and came to associate himself with the Post Keynesian school (Hicks 1980–1981).

(2) New Keynesians.
The New Keynesians emerged in the 1980s and are even further from Keynes’ theory than the neoclassical synthesis Keynesians. New Keynesians are one of the two main schools of mainstream macroeconomics today. The “new macroeconomic consensus” is essentially a mix of New Classical and New Keynesian theory, but the “Keynesianism” of the latter is so watered down that it hardly even deserves that name. In the wake of the monetarist and New Classical assault on neoclassical synthesis Keynesianism, New Keynesianism emerged by providing a more consistent neoclassical microeconomic foundation for Keynesian macroeconomics. New Keynesians are essentially neoclassicals who believe that monetary intervention is the main instrument of economic policy, although there are different strands of opinion within New Keynesian analysis, most notably that of Joseph Stiglitz (King 2002: 239). Some have recognised the usefulness of fiscal policy, but others are actually sceptical about fiscal intervention (Snowdon and Vane 2005: 364). For example, in some modern “New Keynesian” textbooks, one finds a loanable funds theory, Say’s law, opposition to budget deficits (on the grounds that they crowd out private investment and produce higher interest rates), the quantity theory of money, monetarist inflation targeting, and no discussion of aggregate demand – a complete and utter travesty of Keynes’s thinking (Lodewijks 2003: 29).

New Keynesians use rational expectations and assume that the cause of involuntary unemployment is sticky prices and wages, but also assume neutral money in the long run and Say’s law as well (King 2002: 233–239). Prominent New Keynesian include Joseph E. Stiglitz, Olivier Blanchard, John B. Taylor, David H. Romer, Christina D. Romer, Bradford DeLong, and N. Gregory Mankiw. Paul Krugman is a New Keynesian, but the question of how far he has deviated from New Keynesianism is controversial.

(3) Post Keynesians.
Post Keynesians are the true heirs to Keynes and have built upon his work. The forebears of the Post Keynesian school were the Cambridge associates and students of Keynes who rejected the neoclassical synthesis. These were Joan Robinson (1903–1983), Richard F. Kahn (1905–1989), E. Austin G. Robinson (1897-1993), and Nicholas Kaldor (1908–1986). After WWII, Cambridge Keynesianism and Post Keynesianism were influential in the UK, Canada, continental Europe, and Australia (King 2002: 141–159), but went into decline after 1980, as neoclassical economics once again became mainstream economic theory. It should be noted that both the Sraffians (or Neo-Ricardians) and Kaleckians emerged as economic schools strongly associated with Post Keynesianism after 1945. But today Post Keynesianism can be clearly defined in the “narrow tent” sense advocated by Paul Davidson, which excludes the Sraffians and Kaleckians. As Paul Davidson argues,
[sc. it is an error to include] … Sraffians as well as Kaleckians in … [the] Post Keynesian classification. Sraffians reject Keynes’s notion of the importance of uncertainty (i.e., nonergodicity) in determining the effective demand equilibrium solution. Moreover Sraffa and the Sraffians have no room for money in their analytical system. While Keynes argued that interest rates and liquidity preference were at the heart of the involuntary unemployment problem, Kalecki assumed that interest rates had no important effects on the economic system. To grant Sraffians and Kaleckians citizenship in the Post Keynesian school, therefore, assures that some “Post Keynesians” will rely on an analytical model that is logically inconsistent …. [and] Kalecki’s monetary analysis is so different from Keynes’s General Theory that Kalecki cannot be classified as a Post Keynesian (Davidson 2003–2004: 247–248).
Paul Davidson (2003-2004: 251) dates the emergence of Post Keynesianism as a distinct school to the publication of Sidney Weintraub’s book An Approach to the Theory of Income Distribution (1958). Post Keynesians emphasise Keynes’ principle of effective demand and the fundamental role that liquidity preference plays in market economies. Post Keynesians also reject the three axioms of neoclassical economics, which are as follows:

(1) the gross substitution axiom;
(2) the neutrality of money axiom, and
(3) the axiom of an ergodic economic world.

None of these axioms is correct. They are simply not an accurate description of the real world characteristics of modern capitalist economies. In reality, money is never neutral, non-reproducible financial assets are not gross substitutes for commodities, and we face a fundamentally non-ergodic future.

Post Keynesians also emphasise liquidity preference theory and its role in causing involuntary unemployment. The essence of this is that increasing demand for liquid assets (money and financial assets) will not lead to demand for goods and services. Shifts in liquidity preference can cause long-run involuntary unemployment, since, in the face of fundamental uncertainty about the future, investment in commodity production can become unstable (Barkley Rosser 2001: 560).

One of the most interesting, original and exciting developments in Post Keynesianism is neochartalism or modern monetary theory (MMT). This provides a bold and empirically-grounded theory of how our modern fiat monetary systems actually work, and, most notably, destroys the tired old analogy between private debt and government debt that is a favourite of conservatives.

Finally, it should be noted that Post Keynesianism is not mainstream economics and remains a heterodox school. Prominent Post Keynesians (living and dead) include Sidney Weintraub (1914–1983), Paul Davidson, Geoffrey C. Harcourt, Victoria Chick, Jan A. Kregel, Basil J. Moore, Sheila Dow, Thomas I. Palley, Malcolm Sawyer, Philip Arestis, Marc Lavoie, Steve Keen and Mark Hayes. Some well known neochartalists include L. Randall Wray, Bill Mitchell, and Warren Mosler.


Hyman Minsky’s financial instability thesis is clearly an important insight into financial markets, and is certainly directly relevant to the crisis of 2008. Hyman Minsky undoubtedly had an affinity with the Post Keynesian school, and his work is taken very seriously in Post Keynesian economics (most notably by Steve Keen). Nevertheless, Minsky was an idiosyncratic Keynesian and the question whether he should be categorised as a Post Keynesian is debateable. Paul Davidson has argued that
Hyman Minsky is identified [sc. in King 2002: 110] as the second American Post Keynesian … Minsky attended many “Post Keynesian” summer schools in Trieste, Italy as did Kaleckians and many Sraffians who now identify themselves as neo-Ricardians. Accordingly, mere attendance at the Trieste school does not make one a Post Keynesian. Minsky often told me that he never wanted to be identified as a Post Keynesian (hence he fails King’s test of identifying oneself as a Post Keynesian). According to King, Minsky was not an advocate of incomes policies — a hallmark of Post Keynesianism in America. King states that Minsky “had no particular objection to aggregate supply-demand analysis or to a tax based incomes policy — but did not regard them as especially interesting or important” … It is hard to understand why someone who thinks that Keynes’s aggregate supply and demand analysis of the principle of effective demand is neither interesting nor important can be classified as a Post Keynesian … In reality Minsky was, and always wanted to be, a mainstream Keynesian who used the Modigliani variant of the ISLM system and whose major distinction from other mainstream Keynesians was that he possessed knowledge of actual real world financial markets. His “inherently unstable” financial fragility hypothesis … was based on his reading of the activities on financial markets during the period between the onset of the Great Depression and the beginning of the Second World War …. Since Minsky refused to adopt Keynes’s principle of effective demand as the basic analytical system, and instead adopted an analytical structure that relied on some of the restrictive axioms of the special case classical theory, it is difficult for me to understand why King classifies Minsky as a Post Keynesian much less the “second US Post Keynesian” (Davidson 2003–2004: 252–253).
Minsky, then, was closer to the neoclassical synthesis Keynesians than to the Post Keynesians. It can also be said that Abba Lerner was never really a Post Keynesian either (King 2002: 119), although his functional finance theory was very influential in the development of neochartalism (or modern monetary theory).


I quote Davidson (2003–2004: 263–264) on the differences between the Sraffians/Kaleckians and “narrow tent” Post Keynesians:
[n]either Sraffians nor Kaleckians explicitly reject the classical axioms of ergodicity and the neutrality of money …. For example, the Sraffians reject the importance of uncertainty and hence the [non-neutral] role of money as well as Marshallian microfoundations … The Kaleckians emphasized that Keynes’s stress on uncertainty was because Keynes adopted an “atomistically competitive” model while Kalecki’s analysis is essentially oligopolistic. According to Kalecki and the Kaleckians it was the imperfections in capital markets and therefore the need to internally finance investment via retained earnings that was a significant cause of unemployment and not liquidity preference under uncertainty.

Barkley Rosser, J. 2001. “Alternative Keynesian and Post Keynesian Perspectives on Uncertainty and Expectations,” Journal of Post Keynesian Economics 23.4: 545–566.

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

Davidson, P. 2003–2004. “Setting the Record Straight on ‘A History of Post Keynesian Economics,’” Journal of Post Keynesian Economics 26.2 245–272.

Davidson, P. 2005. “Responses to Lavoie, King, and Dow on what Post Keynesianism is and who is a Post Keynesian,” Journal of Post Keynesian Economics 27.3: 393–408.

Davidson, P. 2010. “Keynes’s Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, Hampshire, UK.

Hicks, J. R. 1980–1981. “IS-LM: An Explanation”, Journal of Post Keynesian Economics 3.2: 139–154.

King, J. E. 2002. A History of Post-Keynesian Economics since 1936, Edward Elgar, Chelten

Lodewijks, J. 2003. “Bastard Keynesianism,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, Edward Elgar Publishing, Cheltenham, UK. 24–29.

Snowdon, B. and Vane, H. R. 2005. Modern Macroeconomics: Its Origins, Development and Current State, Edward Elgar, Cheltenham.

Turgeon, L. 1996. Bastard Keynesianism: The Evolution of Economic Thinking and Policymaking since World War II, Greenwood Press, Westport, Conn.

Saturday, July 3, 2010

Is GDP Meaningless?

The truly strange idea that GDP is “meaningless” seems quite prevalent. The idea is seen frequently on the Cynicus Economicus blog.

Are we really to believe that GDP literally has no “meaning”? To think so, one would seriously have to argue that GDP
(1) lacks any significance;
(2) is without use or value, and
(3) contains nothing of substance which can be agreed or disagreed with.
Unfortunately for those who believe this, the idea that GDP is “meaningless” is utterly ludicrous.

First, what is GDP? GDP equals private consumption + gross investment + government spending + (exports − imports).

GDP is a measure of the value of a country’s overall economic output or national income in terms of output. It can also be defined as “the market value of all final goods and services made within the borders of a country in a year.”

One objection that people have is that GDP is “fake” because it supposedly measures “consumption on imported products as national income.” But these people are actually clueless about what GDP actually is. In fact, by definition, the value of imported goods in the trade deficit is subtracted from GDP whether they were bought in consumption, investment or by government spending, and the resulting measure of GDP leaves us with the value of all domestic goods and services. Thus GDP is national income minus imports in the trade deficit. The value of the remaining imports is paid for by earnings on exports, so one can hardly complain that this is based on debt.

Now to the idea that GDP is “meaningless.” If this were really the case, then an immediate consequence is the components of GDP are also meaningless.

We can start with exports minus imports. Does the total value of UK exports “lack any significance” or have “no use”? The earnings from exports are a fundamental source of income through foreign exchange for a country. The total value of money spent on imports also shows how much a country is consuming from overseas. And are we to say that establishing whether or not a country has a trade deficit or surplus (i.e., exports – imports) “lacks any significance”? Clearly it does not. It is a fundamental measure of trade balance. People who regard current account deficits as a form of “living beyond one’s means” are clearly directly dependent on a major component of GDP to establish whether a country has a trade deficit or not. Such people cannot claim that a country is “living beyond its means” and then claim that the trade balance component of GPD is a meaningless measure because they are dependent on it themselves. Without it, they would have no justification whatsoever for their view, as they would have no knowledge at all of whether the country is in trade balance or not.

Next, let’s look at gross investment. Although gross investment includes spending on housing, it excludes spending on financial assets or financial instruments. Thus by definition it excludes the second major type of economic activity that causes debt-fuelled bubble growth. Although much housing is funded with debt, it at least provides a real asset that is of use to the community that can be resold as a benefit to other people. That overinvestment in housing through debt was a major factor in distorting economies over the last 20 years is undeniable. But, with orderly deleveraging and a proper correction in prices, the houses themselves are real assets that will make the community wealthier, not poorer. There is no sense in which the housing construction component of GDP “lacks any significance.” It might have been funded by excessive private debt, but this is saying something quite different from the former statement about GDP. Moreover, gross investment also includes replacement purchases, net additions to capital assets and investments in inventories. Thus gross investment includes new spending in capital goods, production facilities and factories. These are fundamental parts of the productive sector of the economy allowing it to engage in production. The belief that a measure of this “lacks any meaning” is utterly absurd. It can tell you a great deal about how much investment there is in real productive capacity in an economy (one criticism of gross investment is that it does not take account of the cost of depreciation. But this limitation is well known, and hardly makes the measure “without significance or value”).

Private consumption is the total value of private household final consumption expenditure, including durable goods, non-durable goods, and services. But it also excludes home purchases. It is here that critics complain that GDP is meaningless, because over the past two decades an increasing part of it has been financed by private debt. On the contrary, a measure of the value of private consumption allows us to calculate the extent to which consumption is being increased by private debt. Far from being meaningless or without significance, this is a crucial indicator of the health of the economy. Excessive private debt is a serious problem, but you can only know how serious by calculating GDP and looking at the annual increase in private debt. One can complain that consumption is excessive because of too much private debt, but this does not make the total value of private consumption “meaningless.” It obviously has a great deal of significance.

Lastly, we come to government spending. This is the component of GDP that anti-government advocates of free markets object to. Their objections are usually justified with the a priori belief that government spending is never productive or beneficial. However, if you reject their a priori premise that government is bad, then there is no reason why government spending should not be included in GDP. Government provides fundamental things like basic R&D for science, education, health care, and public infrastructure – all things of use to the community. For example, our public infrastructure and transportation systems are the foundation of economic life.

The second argument against counting government spending in GDP is that sometimes it is based on public debt. This commits the fallacy of equating public debt with private debt. But public debt is wholly different from private sector debt, for these reasons:
(1) the government is the monopoly issuer of its own currency; no private individual can print money;

(2) if necessary, the government can monetise its deficit;

(3) the government has the power to rollover much of its debt, unlike private individuals;

(4) the government’s central bank has the power to buy back bonds with new money and to control interest rates and bond yields if necessary, and

(5) the government has access to tax receipts which grow over time and with economic growth.
Clearly, the belief that government debt is like household debt is utterly false. It may be a “common sense” and “intuitive” idea for many people, but this is no convincing argument in its favour. For many people over the centuries, the idea that the sun revolves around the earth was a “common sense” and “intuitive” belief. But that “belief” couldn’t be more wrong. The same thing applies to the belief that governments are like private households.

Consequently, the government spending component of GDP is meaningful.

On the other hand, there are legitimate criticisms of GDP that can be made. For example, that GDP takes no account of inequality of wealth and does not measure unpaid work. In developing countries where monetary exchanges are much less significant (e.g., where barter still has a place), GDP underestimates economic activity. In cases where economic activity involves repairing damage or rebuilding after some destructive event like a natural disaster or war, GDP is boosted in a way that can be misleading. Yet another problem is that GDP neglects negative externalities, or the harmful effects of economic transactions that are not reflected in the price.

All these criticisms of GDP, however, tend to recognise that it does convey useful information, although there may be limits to how much can be learned from the measure. This is a far cry from the absurd claim that GDP has no meaning.

Appendix 1: Other Confusions about GDP

Reviewing some of the comments on the Cynicus Economicus blog, one finds other confusions about GDP. I list these comments below with responses.
as Cynicus has previously stated GDP is no longer a measure of productivity, but it is a measure of consumption, most of which is via debt spending in shops and by companies.
GDP does not measure productivity. GDP measures the value of output, or national income in terms of output, as some prefer to say. You measure productivity by productivity indices.
Moreover, GDP includes a measure of gross investment (e.g., fixed capital investment), takes account of earnings from exports, and a good deal of government spending in R&D and education can be considered as investment as well. It is not possible to say that GDP is just “a measure of consumption.” Although consumption is clearly part of it, much of this consumption is also national income, spent on domestically-produced goods and services.
and you fail to acknowledge that consumer debt spending on imported goods is also measured in GDP of national income when clearly it is not.
This is false. As I have noted above, GDP is national income in terms of domestic goods and services, and by definition all imported goods in the trade deficit are subtracted from GDP whether they were bought in consumption, investment or by government spending.

Appendix 2: Total US Domestic Spending and Investment Minus Total Imports

As noted above, GDP subtracts the value of the trade deficit. The means to pay for imports not part of the trade deficit come from earnings from exports.

But one can also calculate the value of total US domestic public and private spending and investment minus total imports (= TDSI). To do this we would remove the value of exports from the calculation of GDP as below:

private consumption + gross investment + government spending – imports = TDSI.

Some basic figures (in 2009 US dollars):

US GDP: $14.26 trillion (2009 est.)
US Exports: $1.571 trillion (2009 est.)
US Imports – $1.946 trillion (2009 est.)
US trade deficit = 0. 3749 trillion (2009 est.).

The formula we need to work from is here:
GDP = private consumption + gross investment + government spending + (exports − imports).
So in 2009 US private consumption + gross investment + government spending = $14.6349 trillion (which is GDP + the trade deficit).

US imports were $1.946 trillion (2009 est.).

Therefore total US domestic public and private spending and investment minus total imports is as follows:

14.6349 – 1.946 = $12.6889.

Therefore the total value of all US domestic spending and investment minus total imports was $12.6889 trillion.

This means that 88.98% of US GDP was actually private or public spending or investment on US domestic goods and services. That means that the vast majority of GDP was not due to imports at all.

If you seriously believe that GDP is a “worthless” measure because it includes consumption of foreign imports, then it is not difficult to calculate that the actual size of the US economy once imports are subtracted is $12.6889 trillion.

Friday, July 2, 2010

Nationalization: Its Legality under International Law

Nationalization is the expropriation of the assets of a business or corporation (with or without the legal breaking of a previous contract) by a government. Issues arise when the business is based in a different nation from the national government that engages in the nationalization.

I have recently heard the peculiar view that nationalizations are so immoral that a national government should have the right to use force, invasion, occupation or political subversion to protect the assets of one of its domestic corporations from nationalization by a foreign government.

An argument to this effect in support of the idea was offered: “if an individual who owns a house in his home country suddenly finds that his house has been occupied illegally by a group of people, then he can call on the government or police to use force or violence to remove the people occupying his house. Thus nationalization of the assets of a corporation by foreign governments should be dealt with by the use of force by the national government of the corporation.”

An argument like this, however, is utterly unconvincing, because (1) the property rights, contracts or concessions that a corporation has in a foreign country cannot at all be equated with the property rights held by the owner of a house in his own country, and (2) nationalization involves conflict between foreign governments (with sovereign rights over their country’s people and resources) and private businesses, so international law is the relevant legal framework.

With respect to point (1), modern corporations that engage in direct foreign investment to exploit commodities generally have entered contractual production sharing agreements (PDAs) and risk service agreements (RSAs) in which the host government retains absolute sovereignty over its natural resources. The foreign business has no ownership rights in the way that a person owns his house in his own country. These are different property or contractual rights. In modern RSAs, a corporation provides services to the government in the form of construction of capital goods and extraction of a resource. Compensation is paid in cash, not through property rights over resources. If a contract expires and the government chooses to not to renew it, then there is nothing illegal or immoral.

Before WWII when much of the third world was controlled by European empires, colonial governments often granted concessions: contracts in which the corporation had an exclusive license to find and exploit natural commodities like oil, and to have a contractual right to ownership of the commodity it found. But such agreements often occurred after violent invasion and occupation, and after WWII newly independent nations freed from colonial rule asserted their right to ownership of their natural resources unfairly taken from them by European governments. One interesting case is Iran where the British businessman William Knox D’Arcy obtained a sixty-year oil concession virtually over all of Iran by bribing Iranian officials in 1901. In 1914, the Anglo-Persian Oil Company (APOC) was bought out by the British government when it acquired a 52.5% stake in its shares. But the British government increasingly interfered in Iran’s sovereignty and effectively controlled it through semi-colonial rule (even to the extent of maintaining its own army in Iran). Iranian attempts to re-negotiate a contract obtained by bribery were rejected. In 1951, the Anglo-Iranian Oil Company was nationalized by the Iranian government, which provoked a British and American plot to overthrow the Iranian democracy. Aside from the obvious nonsense that Iran’s contract of 1901 due to bribery was free and fair and the absurd idea that Iran’s independence was not violated by Britain, I am surprised that anyone who supports free market economics would defend the UK’s actions on private property grounds, since the Anglo-Iranian Oil Company was itself a British nationalized industry.

In regard to point (2) above, modern international law is perfectly clear: a government has the legal right to exercise control over, or to expropriate, a private foreign investment deemed in its national interest (Schrijver 1997: 289). In particular,

[c]ontemporary international law recognizes the right of every State to nationalize foreign-owned property, even if a predecessor State or a previous government engaged itself, by treaty or by a contract, not to do so. This is a corollary of the principle of permanent sovereignty of a State over all its wealth, natural resources and economic activities and proclaimed in successive General Assembly resolutions and particularly in Article 2, paragraph 1 of Chapter II of the Charter of Economic Rights and Duties of States (Ar├ęchaga 1978: 179).

Thus foreign investors must accept the fact that, when they do business in another nation, they must accept its laws and the possible risk of nationalization of their assets. In fact, modern corporations can take out insurance against the possible losses they might suffer from nationalization, and in no sense can a foreign direct investment in another nation be legally in the same category as the ownership of a house in one’s own country.

The permanent sovereignty that nations have over their natural resources and their right to nationalization, if this can be justified on the grounds of “public utility, security or the national interest,” is fully affirmed in international law and was set out in UN General Assembly Resolution 1803 (XVII) on Permanent Sovereignty over Natural Resources (1962). The relevant part of this resolution is as follows:

The General Assembly,
Declares that:

1. The right of peoples and nations to permanent sovereignty over their natural wealth and resources must be exercised in the interest of their national development and of the well-being of the people of the State concerned.

2. The exploration, development and disposition of such resources, as well as the import of the foreign capital required for these purposes, should be in conformity with the rules and conditions which the peoples and nations freely consider to be necessary or desirable with regard to the authorization, restriction or prohibition of such activities.

3. In cases where authorization is granted, the capital imported and the earnings on that capital shall be governed by the terms thereof, by the national legislation in force, and by international law. The profits derived must be shared in the proportions freely agreed upon, in each case, between the investors and the recipient State, due care being taken to ensure that there is no impairment, for any reason, of that State's sovereignty over its natural wealth and resources.

4. Nationalization, expropriation or requisitioning shall be based on grounds or reasons of public utility, security or the national interest which are recognized as overriding purely individual or private interests, both domestic and foreign. In such cases the owner shall be paid appropriate compensation, in accordance with the rules in force in the State taking such measures in the exercise of its sovereignty and in accordance with international law. In any case where the question of compensation gives rise to a controversy, the national jurisdiction of the State taking such measures shall be exhausted. However, upon agreement by sovereign States and other parties concerned, settlement of the dispute should be made through arbitration or international adjudication.

5. The free and beneficial exercise of the sovereignty of peoples and nations over their natural resources must be furthered by the mutual respect of States based on their sovereign equality.

Permanent Sovereignty over Natural Resources, G.A. res. 1803.

Thus corporations have the right to receive “appropriate compensation.” If the corporation and the national state cannot agree to an appropriate compensation, then this conflict can be settled by international adjudication. The home government of the corporation has no right whatsoever to engage in war, invasion or illegal warfare like political subversion or external sedition (I use “sedition” here in the sense of trying to overthrow the government) against the nationalizing government. To do so is itself a crime under international law.


In the Charter of Economic Rights and Duties of States passed in a UN General Assembly resolution in December 1974 the principle of national sovereignty over natural resources and the right of nationalization is also affirmed. In this charter, compensation is to be offered to the foreign business suffering loss of its investments:

Article 2

1. Every State has and shall freely exercise full permanent sovereignty, including possession, use and disposal, over all its wealth, natural resources and economic activities.

2. Each State has the right:

(a) To regulate and exercise authority over foreign investment within its national jurisdiction in accordance with its laws and regulations and in conformity with its national objectives and priorities. No State shall be compelled to grant preferential treatment to foreign investment;

(b) To regulate and supervise the activities of transnational corporations within its national jurisdiction and take measures to ensure that such activities comply with its laws, rules and regulations and conform with its economic and social policies. Transnational corporations shall not intervene in the internal affairs of a host State. Every State should, with full regard for its sovereign rights, cooperate with other States in the exercise of the right set forth in this subparagraph;

(c) To nationalize, expropriate or transfer ownership of foreign property, in which case appropriate compensation should be paid by the State adopting such measures, taking into account its relevant laws and regulations and all circumstances that the State considers pertinent. In any case where the question of compensation gives rise to a controversy, it shall be settled under the domestic law of the nationalizing State and by its tribunals, unless it is freely and mutually agreed by all States concerned that other peaceful means be sought on the basis of the sovereign equality of States and in accordance with the principle of free choice of means.


Ar├ęchaga, J. E. de. 1978. “State Responsibility for the Nationalization of Foreign-owned Property,” N.Y.U. Journal of International Law and Politics 11: 179–195.

Hyde, J. N. 1956. “Permanent Sovereignty over Natural Wealth and Resources,” American Journal of International Law 50.4: 854–867.

Schachter, O. 1991. International Law in Theory and Practice, Martinus Nijhoff Publishers, Dordrecht, The Netherlands.

Schrijver, N. 1997. Sovereignty over Natural Resources: Balancing Rights and Duties, Cambridge University Press, Cambridge and New York.