Fed Policy Matters Except When It Doesn't: A Puzzle

Can someone explain why measures of the broader money stock increase at a greater rate than the monetary base during recent recessions?

Looking to Hayek on Rethinking Macro

In Prices and Production Hayek writes,

Firstly, that money acts upon prices and production only if the general price level changes, and therefore, that prices and production are always unaffected by money - that they are at their ‘natural’ level, - if the price level remains stable. (7)

Macroeconomic aggregates do not act upon one another. Equations that describe macroeconomic activity provide this illusion. I.e., if the money stock increase by x%, GDP will grow by y%. Trends like these might exist in macroeconomic data, but this by no means suggests a fundamental relationship. An increase in the money stock, for example, acts directly on prices of particular goods. Consider simple, endogenous changes in the money stock that might occur in a boom without a central bank. Say that new credit is created in response to an increase in demand for loanable funds. The new money will be used to by particular goods whose prices will rise due to an increase in investment. This will translate to an increase in the price level over time, but there is no force acting directly on the price level. Most economists understand this, but our models suggest that the macro-aggregates do act upon one another, so this is worth explicitly stating.

Not Always on the PPF – Problems with the Hayekian Triangle

There are three shortcomings of the Hayekian triangle I wish to bring to light.

1) Empirically, prices in all stages of production tend to move together.
2) Related to critique 1, the Hayekian triangle assumes an economy at full employment equilibrium.
3) The Hayekian triangle is an incoherent representation of the macroeconomy.

In his book, Risk and Business Cycles, Tyler Cowen considers points 1) and 2)

Positive comovement [in prices of goods at both the early and latter stages of production] poses a dilemma for theories of the business cycle which start with the assumption of full employment. Comovement requires that all, or nearly all sectors of the economy expand at once, as we usually find in the data. (30)

This poses a problem for Hayek’s analysis where resources are moving from the latter stages to the earlier stages of production. This process is depicted below (Prices and Production, 44, 52).

Notice that the triangle gained two rows. This gain comes at the loss of the length of the already existent rows. That is, investment increases at the expense of consumption in the early stages of the boom. Hayek’s model is a static one where the economy starts at a full-employment equilibrium. In the case of credit expansion it is pushed from this equlibrium. Consumption does not reduce to compensate for the lengthening of production and there is even an increase in consumption as wages rise. Consumers compete with producers for resources in an unsustainable boom that is inevitably followed by a bust. Hayek’s model describes an aspect of reality, but how significant is that aspect? Is artificial expansion of credit necessary for this scenario? 

The model assumes that the economy is at the edge of the PPF, that it is at a full-employment equilibrium. A more likely scenario is that the economy is constantly oscillating between the edge of the PPF and the origin. Of course, an economy with well-functioning markets likely operates in greater proximity to the PPF than the origin. Central bank intervention will distort this natural fluctuation, though it is unclear in what ways and to what extent. The state of the economy is always in flux, so the same intervention will not always lead to the same results. The assumption of full employment equilibrium obscures the interaction between natural fluctuations and central bank intervention, and thus the model overemphasizes a unique case. This might be corrected by expanding the model to include different levels of employment.

As a model of the macroeconomy the triangle is represents a snapshot at a given point in time. In this interpretation, the triangle is an aggregation which describes the macro economy in a misleading manner. We might represent an individual good in Hayekian form, and trace out changes in different stages with only minor distortion, but when used to represent the entire economy the triangle must implicitly assume price levels similar to those for which he critiques his peers. In his critique of Hawtrey’s discussion of the price level Hayek writes,

But the main concern of this type of theory is avowed, with certain suppositions ‘tendencies, which affect all prices equally, or at any rate, impartially, at the same time in the same direction.’ And it is only after the alleged causal relation between changes in the quantity of money and average prices has thus been established that effects on relative prices are considered. (5)

But Hayek refers to the price ratios between the stages of production. In referring to the macro economy, he must be referring to the ratio of price levels between the stages (assuming that stages can be neatly represented at this level of analysis). Hayek did not to apply this critique to his own theory. 

As a representation of the macro economy, the triangle also errs in predicting the nature of new investments. Consider Hawtrey’s critique of Hayek’s stages.

It is quite likely that the additional investment will be predominantly in the earlier stages, but it is not necessarily so. It might happen that the next most remunerative openings for investment are mainly or exclusively among the later stages. There is no necessary connection between the margin of investment and the stages, and the introduction of the stages into the exposition of the extension of investment serves no useful purpose. (243) 

There may be a tendency for increased investment in the later earlier stages, but that tendency ought not preclude a broadening of the triangle’s base. Hawtrey also argues that there is a continual deepening of the capital structure during booms and depressions. Expansion may augment this deepening but it can also broaden the capital structure during the boom period if there are unrealized gains in the later stages that result from the lowering of the interest rate.

Unlike the problem first discussed, I am not sure that these last two can be easily corrected. In terms of macroeconomic analysis, we are left with a triangle whose usefulness is exceeded by its obscurantism.

More on Rethinking Macroeconomics and Micro-Foundations:

Some of the most powerful tools of modern macro lack micro-foundations. Given the sort of micro-foundations that have been attempted to this point in time, I don’t mind that my research employs aggregate demand (AD) as equivalent to the money stock (M) times velocity (V). In other words, the quantity theory as an accounting identity is a useful tool for macroeconomic analysis. For those not familiar, see this simple AD-AS graph.

(Graph from here.)

Output measured in nominal terms is P*y. The quantity equation states that P*y = MV. (This is an accounting identity that provides macroeconomics with its own macro-foundations.) We can replace AD with MV as a result of the accounting identity known as the quantity equation. This presents an intuitive framework for understanding fluctuations in aggregate demand. If M rises (falls), then AD rises (falls). Likewise for velocity which is the inverse of portfolio demand for money – think of portfolio demand (1/V) as cash reserves as opposed to transactions demand (output, y) which is money spent on goods and services.

We know that, for example, in depressions M and V tend to move together. The broader stock of money contracts and velocity falls (demand for money rises). So the quantity theory guides us to consider the composition of and changes in the money stock. We can ask, why the money stock fell during the Great Depression and find that waves of bank failures in the United States led to a monetary contraction. We find that these failures were due to a combination of a fragile unit-banking system which disallowed large banks from operating branch banks and tight monetary policy from the Federal Reserve. The latter was due to a dedication to maintaining high level of gold reserves, which was part of a general increase in demand for gold by central banks. The quantity theory tells us that these factors surely pushed down gold denominated prices and played a significant role in the international crisis.

Research that employs the quantity theory has been fruitful and I assume that it will continue to be so.

While useful, reliance on economic aggregates also obscure analysis. These aggregates do not act on one another directly, but emerge through individual interactions. Causation is not always obvious and requires careful intepretation. Note that I can rewrite the quantity equation four ways:

M = P*y/V

V = P*y/M

P = M*V/y

y = M*V/P

One may dig deeper into causation and define each variable by a set of parameters. Say we define M as a function of output and the interest rate, M(y, i) and y as a function of capital, labor, and technology, y(K, AL). This entails greater specificity and a nice model that we can test econometrically.  This may provide us with new information, but we are left operating within a framework that conveys a teleological myth that says, “given starting point A, the economy will move to point B.” Good economists work around this problem, but can we have a branch of macroeconomics that embraces the problem itself?

Richard Wagner thinks so. He observes the problem discussed above,

Equilibrium-centered macro theory can, of course, give an account of interdependence among economic activities. Indeed, such an account is perhaps the prime virtue of this theoretical framework. What it cannot do, however, is give an account of turbulence that arises through inconsistencies among plans because no action is presumed to take place until all plans are mutually consistent. All plans are pre-reconciled within the equilibrium framework, just as the actions of the members of a parade are pre-reconciled. The alternative to the equilibrium framework is to treat the ecology of plans as an emergent process where macro-level objects supervene on micro-level interaction. Any relation among macro-level variables is thus intermediated through interaction among entities at the micro level. (“The Macro Economy as an Emergent Ecology of Plans”, 438)

The economy is itself defined by turbulence and this turbulence cannot be consistently observed via macroeconomic aggregates, though it does generate the macroeconomic data. To posit the macroeconomy as a formula with an optimal solution ignores the competition and conflict that occur at the micro level.

How can one model the sort of competition that I underscored in yesterday’s post? How can one represent an economy that does not move directly from equilibrium to equilibrium? Or an economy without equilibrium in the strict sense? Recent attempts have drawn on string theory where there are different layers of interaction (Potts, 2000; Potts and Morrison, 2007). For their “micro meso macro” framework, Potts and Morrisson explain,

In mmm [micro meso macro], an economic system is conceptualized as being made of generic rules that allow carriers to perform operations (Dopfer and Potts, 2004). A rule and its population of carriers is a meso unit, the macroeconomic system is a complex system of connected meso units, and economic evolution is the process of change in meso units, either through novel generic rules being introduced into the economic system or through a change in the population of each meso rule. Evolutionary macroeconomics is the study of how the entire systems of meso are coordinated and how they change. Evolutionary mesoeconomics is concerned with the structure and population of each generic rule, and evolutionary microeconomics is the study of the individual processes of adoption by a carrier (such as an agent) of the rule. This framework is intended to capture the idea of economic evolution as a process of endogenous transformation of the economic order through the origination, adoption and retention of new economic ideas, or generic rules, that may variously manifest as behaviours, organizing rules or technologies. (Potts and Morrison, 309)

Micro meso macro is a convenient representative case of this new macroeconomics. It emphasizes connections between individuals, resources, firms, etc… and rules about those connections. 

The task is far from complete. The challenge is to build and employ models that impart new understanding of market processes and the emergence of institutions. These will be models that include the messy details of individual interaction and of randomness. Within this framework, one can include optimization as one possible outcome without being constrained by its determinism and avoid "throwing the baby out with the bathwater."

Markets Fail, That is Why They Work: Thoughts on Garrison's Time and Money

Roger Garrison’s Time and Money lays out explicitly the Austrian Business Cycle Theory with a  focus on the impact of central bank intervention. His exposition is clear. In fact, so clear that it lays out a fundamental weakness in the theory. In the chapter title, “Sustainable and Unsustainable Growth”, Garrison argues booms funded by an increase in real savings don’t result in resource misallocation.

The market works. But just how the intertemporal markets work requires that we shift our attention to the intertemporal structure of production. The altered shape of the Hayekian triangle shows just how the additional investment funds are used. The rate of interest governs the intertemporal pattern of investment as well as the overall level. The lower interst rate, which is reflected in the more shallow slope of the triangle’s hypotenuse, favors relatively long-term investments. Resources are bid away from late stages of production, where demand is weak because of the currently low consumption, and into early stages, where demand is strong because of the lower rate of interest. That is, if the marginal increment of investment in early stages was just worthwhile, given the costs of borrowing, then additional increments will be seen as worthwhile, given the new, lower costs of borrowing. While many firms are simply reacting to the spread between their output prices and their input prices in the light of the reduced cost of borrowing, the general pattern of intertemporal restructuring is consistent with an anticipation of a strengthened future demand for consumption goods made possible by the increased saving. (64)

Garrison presents us with the beginning state, interest rates drop, and guides us to the end state, claiming that credit markets reallocate resources from the late stages of production to the earlier stages of production. Boom. There you have it. Interest rates coordinate production and markets adjust. But just how does this occur? This is a challenging question for Austrians who do not believe that business cycles can occur endogenously (not to suggest that this is the case for all Austrians).

The process of bidding away resources from the late stages of production does not occur smoothly. Let us imagine that the interest rate has dropped and new profit opportunities arise because there is a discrepancy between the rate of return for the new project and the rate of interest. Entrepreneurs will flock to the new opportunity. The more attractive the opportunity, the greater the number of entrepreneurs who will pursue the project. The entrepreneurs know that they are competing against other entrepreneurs and that not everyone can be successful in this endeavor. Likewise, banks provide credit to entrepreneurs that they believe will be successful. Again, the banks are aware that not every investment in this new opportunity will succeed, but they hope to do better than their competitors by allocating loans wisely and operating efficiently.

With the passage of time, entrepreneurs either reap rewards for their success or losses for their failure. The rise of the interest rate from increased demand for loanable funds and the fall in the rate of return on the new projects from the increase in entrepreneurial activity make this scenario unavoidable. There will be failure and it will occur under conditions where all actors are profit maximizing. If there was significant interest in the sector where the new investment opportunity arose, there may also be significant levels of failure, especially if the sector is highly competitive. We can expect that, alongside bankruptcies, prices in the sector will fall and credit will tighten due to debt-deflation. That is, bankruptcies will decrease the amount of funds available in the sector. Eventually, these assets will be bought by successful firms or new entrepreneurs at lower prices.

Thus, we have the formation of a business cycle without central bank intervention. This is not to suggest that central bank intervention in credit markets cannot encourage bubbles to be larger and more numerous, only that this should be the starting point of a business cycle theory. As Joseph Schumpeter argued in “The Explanation of the Business Cycle”,

…is it not imperative to develop for the purposes of fundamental explanation an analysis independent of the occurrence of impulses from without – an analysis of the way in which new things come to be done in industrial life, and old methods come to be eliminated together with those firms who cannot rise above them? (297)

It is imperative that we have an endogenous theory of the cycle as our starting point. This is a story where low interest rates induced from increased savings encourages a boom and subsequent bust. Garrison’s model does not allow for this. It suggests that markets transition smoothly from one state to the next as long as changes in the interest rate are produced endogenously.

That is, the change in the underlying economic realities imply an altered growth path; the market process translates the technological advance into the new preferred growth path; and there is nothing in the nature of this market process that turns the process against itself. (60)

Nothing to turn the process against itself? Nothing except the entrepreneur. Nothing except competition and failure. Markets fail. That is the beauty of markets.

"We're All [mostly] Monetarists Now", not New Keynesians

New Keynesians are a variant of old monetarism. They are grappling with the same macroeconomic questions. Why does the economy experience extended periods of disequilibria? One New Keynesian answer, for example, is sticky nominal price and real wages. Despite a newly proposed answers, the question itself is not a Keynesian question. This brings me to the problem that Simon Wren-Lewis at Mostly Macro presents.

When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term. [2] Why do I use the term anti-Keynesian rather than, say, New Classical? Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.

He mentions another division, that of mainstream and heterodox, but this division appears to be swallowed by this [Mainstream] Keynesian/Anti-Keynesian divide that Simon posits.

Generalizations are troublesome. This one is especially troublesome because it obscures the origins of the arguments that New Keynesians grapple with. It also suggests that  Wren-Lewis either ignores or misinterprets the history of economic thought. If New Keynesians have abandoned the Old Keynesian position on fiscal policy (it might be more accurate to say that they let the issue fade into the background), then they are, as Leland Yeager points out in “New Keynesians and Old Monetarists”, actually Old Monetarists. Two cases in intellectual history will suffice to make the point.

In a recent post, I presented an argument between Ralph Hawtrey and John Maynard Keynes where Keynes questioned the efficacy of monetary policy in regard to high unemployment. This was an ongoing debate between Hawtrey and Keynes. It did not only appear at the Macmillan Commission. Hawtrey dedicated “Public Expenditures and Trade Depression” (1933) to confronting this issue. In response to Keynes proposition that monetary policy can be impotent, Hawtrey wrote

But to a great extent their [the central bank’s] purchases of securities will result merely in the investment market paying off advances, so that the desired increase in the banks' assets is offset. If the banks persist in buying securities beyond the point at which the indebtedness of the investment market has been reduced to a minimum, the result will be a disproportionate rise in the prices of gilt-edged securities. There will thus be very great pressure upon the banks to find additional borrowers, and, in view of what I have said above as to the intermittent and partial character of the pessimism which seems to dominate markets, I should contend that there is good reason to expect that the borrowers would be forthcoming

Hawtrey accepted that the markets do not immediately adjust to aggregate demand shocks and argued that, given an institutional arrangement where central banks influence the money stock, an expansion via open-market purchases is sufficient to offset negative aggregate demand shocks due to a credit contraction. He also doubted the efficacy of fiscal policy. He was not a New Keynesian.

And consider also Herbert J. Davenport, who Yeager quotes in the above-mentioned piece. 

Goods and services exchange for each other through the intermediary of money, for which an excess demand may sometimes develop. ‘The halfway house become a house of stopping.’ The problem is ‘withdrawal of a large part of the money supply at the existing level of prices; it is a change in the entire demand schedule of goods.’ (290) [internal quote from Davidson]

Yeager continues on the same page,

Supplies of bank account money and bank credit typically shrink at the stage of downturn into depression. A scramble for base money both by banks’ customers and by banks trying to fortify their imperiled reserves enters into Davenport’s story.

In this presentation, a negative aggregate demand shock initiated by a credit contraction occurs endogenously! Davenport accepts that economies do not immediately re-equilibrate after a demand shock. According to Yeager, Davenport wrote this in 1913, so he can hardly be considered a New Keynesian. No, this was the status-quo of pre-Keynesian arguments concerning the business cycle. Most theories from the time period implicitly concerned themselves with upward sloping short run aggregate demand supply curves, though they did not point this out explicitly. Note that this was also the case with Hawtrey's earlier work, Good Trade and Bad, which was written in 1913. 

The short-run aggregate supply curve was not purely a discovery by Keynes, so can we stop deluding ourselves and just admit that, except for the New Classicals, “we’re all monetarists now”?

HT David Glasner for his follow-upon the Wren Lewis post and Nick Rowe for his suggestion that "'Monetarist' vs 'anti-Monetarist' would work as well.”

I think that it works better.

More on Cassel and Socialism: Hayek Quotes Cassel on Planning in "Freedom and the Economic System"

Hayek quoted Cassel to support his argument. He wrote that "Professor Gustav Cassel states his apprehension there with a clarity which leaves nothing to be desired. He writes:"

Planned Economy will always tend to develop into Dictatorship . . . [because] experience has shown that representative bodies are unable to fulfill all the multitudinous functions connected with economic leadership without becoming more and more involved in the struggle between competing interests with the consequence of a moral decay ending in party - if not individual - corruption. The parliamentary system can be saved only by wise and deliberate restrictions of the function of parliament. Economic dictatorship is much more dangerous than people believe. Once authoritative control has been established, it will not alwyas be possible to limit it to the economic domain. ("Freedom and the Economic System", Socialism and War, 192)

Hayek quotes from "From Protectionism through Planned Economy to Dictatorship", written in 1934. A keyword search in Individualism and Economic Order reveal only a passing reference about Cassel's work on interest. Elsewhere, Hayek references Cassel in regard to monetary theory and the business cycle, but I find no obvious alliance in the socialist calculation debate. 

One modern Austrian, Jesús Huerta de Soto, derides Cassel for his comments about the viability of socialism, but the socialism that Cassel referred to was a poor representation of the system. In theorizing about a socialist economy, he wrote "Our socialist economy must thus essentially be based on the free exchange of personal services and means of satisfying personal wants." (133) He goes on to say that the economy needs money and that workers do not receive equal wages. Later in the book he refers to the entrepreneur and the lack of appreciation for him by socialists, as I mentioned in the previous post. There is a semantic problem here. Cassel's use of the word "socialism" is a loose one. If, as de Soto suggests, Cassel’s work was foundational for later proponents of planning, they were not reading his work very closely. For now, this snapshot of intellectual history remains murky.

Cassel: Praised Entrepreneurship and Critiqued Socialism but Ignored by Austrians?

A few excerpts from Fundamental Thoughts in Economics will suffice to make this point. Cassel was highly skeptical of political power and believed that economic analysis was necessary to check the efforts to expand government's scope when that expansion was unwarranted and the goals of the expansion were unrealistic.

The observance of this rule [to minimize assumptions in modeling] enables us to determine the degree to which economic conditions are independent of social order. In fact, this is the only way by which science can effectively oppose popular overvaluation of political power. But such a study of social economy is also of great importance for science itself, in as much as it is an aid for penetrating deeper into the true nature of important economic phenomena. It is sometimes useful to form an idea of how certain feature of our actual economic life would present themselves in a hypothetical, purely socialistic society, with the whole production centralized in the hands of a single authority, and what modifications the phenomena would thereby undergo. Such an investigation shows that the dogmatic socialists' belief in the radically transforming effect of their social order on the essential economic phenomena is quite groundless, and in fact represents a superstitious overvaluation of political power." (25-26)

He even consider calculation under a socialist system in The Theory of Social Economy. His definition of socialism is somewhat vague, but he does consider the limits of economic planning,

In our economic system, the work of directing production in conformity with the requirements of consumers falls principally upon the entrepreneurs. This task is by no means so simple as Socialists imagine when they say that all that is necessary is to compile statistics of wants in advance and then officially to regulate production on the basis of these statistics. Regulating consumption in this manner would be equivalent, in a large degree, to suppressing the freedom of choice. of consumption that is characteristic of the exchange economy. But the consumers wish most decidedly to retain this freedom of choice to the last moment.  

The difficulty of the problem lies precisely in the fact that the constantly varying demands of consumers, which cannot be determined in advance with any degree of certainty, must be satisfied, despite incessant changes in the methods and conditions of production. This work is actually done - naturally not perfectly - by a number of independent entrepreneurs, each of whom, on the whole, looks merely to his own interest.  

This solution of the problem is possible because, whenever a want that can be paid for is left unsatisfied, or is not completely satisfied, or satisfied only at an abnormally high price - every time, that is, the problem of the 'economic direction of social production' is not satisfactorily solved - an entrepreneur is encouraged by the prospect of earning a special profit to make a better provision for the want in question, and the productive process is thus steadily improved. The entrepreneur intervenes, not only where something is to be done for the immediate satisfaction of consumers' wants, but everywhere where the productive process, somewhere among the thousands of its component processes, exhibits a gap which leaves room for his enterprise. In this way, all these partial processes are united into a single productive process, embracing the entire satisfaction of wants in the exchange economy. (171)

Notice that, even though Cassel was a general equilibrium theorist who loved the specificity provided by math, he was very clear that economics is about humans acting. He even emphasizes the entrepreneur, yet does not receive a citation, as far as I have looked, in Israel Kirzner’s Market Theory and the Price System. A search through the index of Human Action reveals that Cassel is mentioned once: only indirectly via a citation. The more I the study economists that practiced prior to the Keynesian era, the more I believe that the Austrian school has harmed itself by not fully employing the ideas of these potential intellectual allies. If anyone knows of a story as pertaining to this apparent separation, I would love to learn more.

Keynes vs. Hawtrey (Final Round): Gold Demand and Gold Prices

When Keynes wrote his General Theory, he emphasized solutions to the problem of depression and did not worry himself with the reason for the Great Depression. This is understandable as a change in policies contemporary to Keynes might have helped fend off further deepening of the Depression. As the gold standard was intimately tied to problems, Keynes perception of its operation might provide insight into why he disagreed with Ralph Hawtrey’s review of monetary policy in the late 1920s.

Keynes understood that conflicting policies from independent central banks hampered the functioning of the gold standard.

Thus, to overcome the obstacles to an international agreement – the conservatism of France and the independence of the United States – might cause serious and perhaps intolerable delays… (A Treatise on Money, ii., 336-7; 1965)

To-day the reasons seem stronger – in spite of the disastrous inefficiency which the international gold standard has worked since its restoration five years ago (fulfilling the worst fears and the gloomiest prognostications of its opponents), and the economic losses… to reverse the order of procedure… and to hope for progress from that starting-point towards a scientific management of the central controls… of our economic life. (338)

While his recognition of the problem is appropriate, his analysis of the monetary problem is less adequate. He relied primarily on the interest rate in conducting his analysis. He argued that in the case where there is a discrepancies between interest rates in gold standard countries,

…the restoration of equilibrium may require not only a change in interest-rate, but also a lasting change in income-levels (and probably price-levels). That is to say, a country’s price-level and income level are affected not only by changes in the price-level abroad, but also by changes in interest-rate, due to a change in the demand for investment abroad relatively to the demand at home. (i., 326-27)

While not incorrect, Keynes omitted a more fundamental element: the international price of gold (or in other words the international price level).

Gold might move between countries as a result of discrepancies between domestic interest rates and foreign interest rates. Likewise with discrepancies between domestic prices and international prices. But what about when the international price level plummets? Ralph Hawtrey, in his review of the Treatise critiqued Keynes for giving “insufficient prominence to the international aspects of the credit cycle (The Art of Central Banking, 400; 1934).” He elaborates,

He defines the cycle in terms of the price level, for by ‘the alterations of excess and defect in the rate of investment over that of saving’ he means alternations of excess and defect of the price level over costs. But with a gold standard the price level is determined internationally. The internal price level of any particular country varies relatively to its external price level in response to the credit measures taken to correct any variation in its balance of payments. But the external price levels of all countries with a common monetary standard move together. I regard the credit cycle as essentially a periodical fluctuations in the world value of gold. (400-1)

The cause of the Great Depression, Hawtrey believed, was that central banks increased demand for gold and forced upward the price of gold. He though that this could have been prevented had the Bank of England and the Federal Reserve led the world in lowering reserve ratios.

Keynes and Hawtrey and conflicted on this issue previously at the Macmillan Commission.  Keynes questioned Hawtrey about the relationship between employment and the gold standard. (I should note that Alan Gaukroger has done a tremendous favor to those interested in the history of thought by including this conversation in his doctoral thesis)

KEYNES.  . . . you regard the history of events from 1924 to 1930, and their effect on unemployment, as the tragedy of a series of avoidable errors in monetary policy?

               

HAWTREY. Well, yes.

KEYNES. And that is based on two assumptions. . . . the Bank of England could . . . have followed an easy money policy without losing too much gold . . . and . . . if it had . . . that would have cured unemployment?

HAWTREY. Yes

KEYNES. As regards the first, of course, you can only get a conclusive answer by trying?

HAWTREY. Yes

KEYNES.  . . . as regards the other, do you consider that the level of money wages in this country was such that, in order to obtain full employment, the rise of prices in the outside world would have had to be quite substantial?

HAWTREY. No . . . Wages in America are 120 per cent above the pre-war level and prices are about 40 per cent above . . . no doubt [due] to technical improvements in production. . . . The Americans do not have a monopoly on technical improvements. I think it reasonable to assume that the enormous disparity . . . between prices and wages would have had its counterpart here. Wages here are [only] 70 per cent . . . above the pre-war level. (293-94)

Here, Alan Gaukroger notes that Hawtrey was responding to “the implication in Keynes’s question that British wages were unduly high in relation to world rates." The conversation continued on,

KEYNES. It is an expression of opinion on your part. The argument to me is rather this. One wants a man to weight 12 stone to be healthy. He, in fact, weighs 10 stone’ you say if he ate another biscuit every day he would weigh 12 stone. But all you have proved is that the tendency of the biscuit would be to increase his weight?

HAWTREY. I think you have statistical data which take you further than that. The American price level in 1925 was 161 . . . now it is 140. That disparity is . . . fully equivalent to the percentage of unemployment here.               

KEYNES.  . . .  to assert that if the Bank of England had been brave it could have had sufficiently cheap money to prevent a fall of prices is, it seems to me, unwarranted?

HAWTREY. I have given you ground for supposing the . . . price change involved was sufficient . . . that ought to wipe out all exceptional unemployment we are suffering from. (294-95)

Hawtrey suggested that England could encourage prices to rise internationally if only the Bank of England eased its monetary stance. Other countries would likely adjust their policies to maintain their exchange rate with the pound, which would mitigate to some extent gold outflows from England. It is difficult to know for sure if Hawtrey was correct. Had this been the policy of the Bank of England from the beginning of the gold exchange standard, it might have accomplished this maintenance of higher prices abroad. If not, that is if England’s lowering of the reserve ratio did not sufficiently lower demand for gold internationally, it would have been forced to leave the gold standard much earlier than it did in 1931, rather than extend its period of high unemployment rates.

According to Hawtrey, increased demand for gold was the impetus for the fall in prices and was the primary factor preventing recovery. Keynes downplayed this factor. He believed that markets lacked a timely mechanism for adjustment of monetary disequilibrium. This was true whether or not the gold standard operated efficiently. J. Stuart Wood, in his superb summary of business cycle theories notes that “Keynes argued that there was no market mechanism which could bring the supply of savings into equality with the demand for borrowed funds for investment, and Keynes assumed that capital goods are homogeneous, neglecting the heterogeneity of capital goods which Mises and Hayek saw as the essential cause of the recession (An Encyclopedia of Keynesian Economics, 79; 1997).” Although Keynes understood the problems associated with the gold standard, he saw the Depression as an endogenous phenomenon that did not necessarily need the gold standard to occur. He appears have believed that Hawtrey’s theory of gold demand and depression was insufficient because it assumed that, otherwise, savings and investment would be matched automatically.

Of course, Keynes won the battle for the minds of his contemporaries. It is less clear that his diagnosis was more apt than that of Hawtrey.

Away from an Equilibrium Approach to Business Cycle Theory: A Search for Intellectual Roots

One might find it peculiar that economists, professionals whose primary focus is on models of equilibrium, expend a tremendous amount of intellectual effort in attempt to explain the occurrence of non-equilibrium phenomena known as business cycles. Jason Potts observes that “it is widely held that bubbles are inconsistent with the theory of stable general equilibria in markets, and conventionally argued that bubble formation disrupts the natural efficiencies of market capitalism.”[1] Nor was he the first to make this observation. John Maynard Keynes, Gustav Cassel, Joseph Schumpeter, and Friederich Hayek, to name only a few, were all aware of the contradiction between equilibrium models and the persistence of business cycles. I suggest that our understanding might be improved by revisiting their arguments and connecting their ideas to a modern research program.

               

We start with the gloomiest of views which come from John Maynard Keynes. In his General Theory Keynes argues that high unemployment levels are inherent in the free market system. In the words of David Glasner and Ronald Batchelder, “Instead of attributing high unemployment to monetary mismanagement, as he and Hawtrey had previously, Keynes saw high unemployment as deeply rooted in the structure of modern economic systems regardless of monetary policy or the exchange rate.”[2] Keynes’s theory of business cycles was that, not only were they inherent in markets, but that they lacked mechanism for a timely self-correction.[3] In his analysis, Keynes ignored the cause of the Great Depression and instead posited solutions to it. The only problem with this was that the cause of the Great Depression, destructive central bank policies, were ongoing even as he promoted expansionary fiscal policy as a solution for unemployment.[4]

               

The dark side of disequilibrium that Keynes presented was not accepted by many of his experienced peers, whom also acknowledged that bubbles cannot be fully analyzed by equilibrium models. Gustav Cassel, far from condemning the business cycle, wrote, “Anyone who complains of trade cycles, and condemns a social order that facilitates or tolerates their existence, is really complaining of the advance of our material civilization.”[5] For Cassel, the business cycle was the price of progress, a “progress [which] cannot be absolutely uniform.”[6] This cycle was too significant to ignore, but too complex to analyze with simple equilibrium models. Cassel and his contemporaries understood that the business cycle emerged from social interaction that steered the economy away from equilibrium, and “such divergencies can, of course, only be established by a study of actual facts.”[7] Ralph Hawtrey echoed this sentiment, noting that “The trade cycle was an empirical discovery” and that theories of it had “been invented to fit the statistical evidence.”[8] The best that economists can do is to tell a story about the recurring cycle of economic growth and disturbance that fit the data at their disposal. Their stories indicted the cyclical nature of the interest rate as a lagging economic indicator. Its rise only occurred after profits dwindle, thus leading to a contraction precisely when business tend to lack liquidity. This increases demand for money, thus lowering the price level and can spark a credit crisis.[9]

               

To refer to theories about the trade cycle as “stories” is no exaggeration. If a feature of the macroeconomy is for it to deviate away from equilibrium to great extents, economists must identify an actor whose job it is to push the economy away from equilibrium. Enter Joseph Schumpeter’s entrepreneur. Having realized that the business cycle does “not lend itself to description in terms of a theory of equilibrium”, Schumpeter suggested that economists include the entrepreneur in their analysis.[10] Entrepreneurs “destroy any equilibrium that may have established itself or been in process of being established” and in doing so create “cyclical ‘waves’ which are essentially the form ‘progress’ takes in competitive capitalism.”[11] They discover and implement new technologies and reorganized commercial society. They cannot be described in the terms of the physics mimicking worldview of equilibrium models because the results of their actions are of “discontinuous character.”[12] In other words, not only is the entrepreneur disincluded from neoclassical equilibrium analysis, the very nature of the entrepreneur is antithetical to it.[13]

Of course Austrian economists like Frederich von Hayek knew that macroeconomics in general, and the business cycle in particular, cannot be analyzed by the tool set of equilibrium

analysis:

Any theory which limits itself to the explanation of empirically observed interconnections by the methods of elementary theory necessarily contains a self-contradiction. For Trade Cycle theory cannot aim at the adaptation of the adjusting mechanism of static theory to a special case; this scheme of explanation must itself be extended so as to explain how such discrepancies between supply and demand can ever arise.[14]

Much like Schumpeter, Hayek told a story to explain the recurrence of business cycles, only instead of praising entrepreneurs for their disruptive efforts, he condemns central banks. These privileged financial organs expand the money stock “under the pressure of an inflationist ideology.”[15] Due to the nature of the gold standard, this first causes prices to rise, though unevenly, and then fall as an inevitable monetary contraction follows due to gold outflows. This process distorted relative prices – the ratio of prices between goods and services – causing miscalculations by entrepreneurs.

Each of these stories of the business cycle clearly break away from the physics-mimicking framework that thoroughly saturates modern economics. It is for this reason that these early theories ought to be reconsidered. Each theory essentially acknowledges that disequilibrium is a feature of the market system (though Hayek’s theory less so) and that equilibrium theory is ill-suited for analysis of business cycle. If we construct a representative story that includes time and micro level interaction – as opposed to aggregation of micro-level agents, which is nothing more than positing a single macro-level agent – we will have a starting point for a model that includes these details.

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[1] Jason Potts, “Liberty Bubbles” Policy 20 no. 3 (Spring 2004): 2.

[2] Glasner and Bathchelder, “Pre-Keynesian Monetary Theories of the Great Depression: What Ever Happened to Hawtrey and Cassel?” SSRN (April 2013): 42.

[3] John Maynard Keynes, General Theory (Orlando, Florida: Harcourt, Brace, & World Inc., 1965): 314, 320.

[4] John Maynard Keynes, Treatise on Money vol. 2, 376.

[5] Gustav Cassel, The Theory of Social Economy (New York: Augustus M. Kelley, 1967): 645.

[6] Ibid., 646.

[7] Ibid., 533.

[8] Ralph Hawtrey, “The Monetary Theory of the Trade Cycle and Its Statistical Test,” The Quearterly Journal of Economics 41, no. 3 (May 1927): 471,72.

[9] Cassel, The Theory of Social Economy, 649.

[10] Joseph Schumpeter, “The Instability of Capitalism,” The Economic Journal 38, no., 151 (September 1928): 378

[11] Ibid., 383.

[12] Ibid., 378.

[13] This did not stop Israel Kirzner from trying. See Market Theory and the Price System.

[14] F. A. Hayek, Monetary Theory and the Trade Cycle (New York: Sentry Press): 43.

[15] Ibid., 150.

Keynes vs. Hawtrey (Round 2): Fiscal vs Monetary Policy

In 1933, Ralph Hawtrey wrote “Public Expenditure and the Trade Depression” in which he presented a thorough analysis of the effects of fiscal policy. The reader should note that, in it, he refers to government expenditures as “capital outlays”. Hawtrey did not meet Keynes proposal of fiscal expansion with cheer. He notes that the complications inherent in fiscal policy make it a vehicle ill-suited to alleviate economic stress.

A capital programme of the kind advocated cannot be started till after a considerable preparatory interval. Secondly there is the question of magnitude. There is no certainty that, even when it is started, the programme will achieve its object. For it will have to meet precisely the same obstacles as any alternative method of credit expansion. A programme of 100,000,000 a year sounds impressive, but it is only about 3 per cent. of the national  income. A sudden increase of 3 per cent. might quite possibly effect the vital transition, and restore the normal flow of credit. A gradual increase of that amount spread over many months would be very unlikely to do so. The programme might be very much greater. But then there arises a very real difficulty in finding works ripe for execution which are really beneficial. There is a danger of vast sums of money being wasted. (452)

According to Hawtrey, the desired results might be accomplished in a simpler fashion.

In fact, if what is wanted is a momentary impulse to restart economic activity, it would be more hopeful to look for it in a reduction of taxation than in a programme of expenditure. (452)

In any case, the proposal of spending increases ignored the broader problem of concern.

Then secondly there is the effect of a capital programme on the balance of payments to be taken into account. A country on the gold standard, faced with the prospect of an appreciation of gold and unable to promote the international cooperation requisite to stop it, may be grateful for anything which will relieve the depression without causing an adverse balance of payments. But under those conditions the capital programme can be no more than a palliative; it does not promise to be a turning point in the depression to be followed by a progressive revival, for revival depends on international conditions. (457)

The policies of the United States, to a lesser extent, and France, to a far greater extent, depressed prices, thus leading to a fall in aggregate demand. Even if fiscal policy temporarily compensated for this problem, which it is unclear whether or not it would, this still did not serve as a solution to the international problem. Even if it did, the primary impetus appears to be monetary policy!

Hawtrey observed that the looming international problem complicated the effects of domestic monetary policy. In reflecting upon the effects of expansion from the Federal Reserve, he argues that, though it was somewhat effective, it was not substantial nor long enough.

I do not think the degree of success attained by the open market policy of the Federal Reserve Banks in the summer of 1932 has been sufficiently appreciated. The policy was applied under serious disadvantages. The Bank of France was liquidating its dollar holdings and withdrawing them in gold and the United States lost over $500 millions of gold between February and June. Hoarding also was a complication. … The improvement, it is true, was not sustained. But nor was the policy. The open market purchases ceased in August 1932, and in January 1933 there were even some sales. (451)

Of course an analysis of monetary expansion must also take into account the banking crises that occured at the time, but I must defer that task. Its positive effects on growth also were at least offset in part by France’s insane policy. To jump to the conclusion that monetary policy was ineffective was unwarranted in the eyes of Hawtrey, especially since there was correlation between the program and resumption of growth. Policy suggestions that ignored the problems created by the fouled operation of the international gold standard were a poor second best solution, if they were solutions at all.

I am in the process of finding and interpreting Keynes's response, which I will hopefully get to later this week.

Keynes vs. Hawtrey: Did Keynes Abandon Economic Explanations of Depression?

Hawtrey and Cassel correctly explained, and even predicted, the cause of the Great Depression, but their explanation was missed overshadowed as Keynes won over his peers during the Great Depression. (If you need to get clued in on Hawtrey and Cassel, see my paper and Doug Irwin’s work). David Glasner and Ronald Batchelder explain,

However, the success of the General Theory was such that it eclipsed not only the Austrian theory, whose meteoric rise was followed, even before the General Theory appeared in print, by an almost equally rapid decline, but all other monetary theories. (41) 

The account given by Hawtrey and Cassel, which had first been overshadowed by the short-lived Austrian ascendancy, was pushed still further into the background by the Keynesian Revolution. (42)

It is surprising that theories that emphasized central bank demand for gold fell in the back ground, especially since

In the early 1930 Keynes was still general sympathetic to Hawtrey’s belief that the Depression, the onset of which Keynes dated in 1925 with the restoration of prewar parity in England, had been caused by a deflationary monetary policy. (41) 

Instead of attributing high unemployment to monetary mismanagement, as he and Hawtrey had previously, Keynes saw high unemployment as deeply rooted in the structure of modern economic systems regardless of monetary policy or the exchange rate. (42)

In the General Theory (I'll be referencing the 1964 edition), Keynes had moved to promoting a belief that markets were inherently unstable, especially as they approached the top of the boom-bust cycle and moved into depression. He wrote,

There is, however, another characteristic of what we call the Trade Cycle which our explanation must cover if it is to be adequate; namely, the phenomenon of crisis – the fact that the substitution of a downward for an upward tendency often takes place suddenly and violently, whereas there is, as a rule, no such sharp turning-point when an upward is substituted for a downward tendency. (314)

Keynes believed that due to psychological factors led to sudden changes in expectations and the desire of individuals to change their volume of cash holdings. In other words, the most significant cause of the reversal is a decreased propensity of consumers to consume and of savers to save in banks. He concludes that unregulated markets are inherently unstable.

In conditions to laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands. (320)

No longer was mismanagement of the gold standard a problem for Keynes. It was simply that gold was too constraining to allow the policies that Keynes thought necessary. If the occurrence of depressions and their unnecessary deepening are a fundamental aspect of the market system, then one need not look for a cause. Markets are themselves the cause of depression; policies must seek to stabilize aggregate demand. David Glasner mentions this in his paper.

The model of the General Theory was the model of a world in depression, and makes the Depression seem almost normal. (40)

Glasner points to a needed avenue of research. It was not simply that Keynes won over the profession. Keynes pushed a search for particular causes of depression to the background as his theory became the foundation of a new research program. I'm curious to learn how this attitude toward particular causes of depression is reflected in the work of his contemporaries after they adopted his theory.