Pascal Salin’s “Money and Micro-Economics” is now online. I was hoping to find some insights into market process oriented macro, but instead found a blasé overview with a weak critique of market monetarism. Perhaps nothing stands out more than Salin’s distaste for monetary expansion. This attitude is reflected clearly in Salin’s suggestion that market monetarism should be called “market Kenesianism” as “it is simply a branch of new-Keynesianism." I’m not sure what book in intellectual history that Salin is reading from, but I do know that he lacks foundation for his interpretation of market monetarism. As I have noted before, market monetarists of the heirs of Ralph Hawtrey, not John Maynard Keynes. Macroeconomic outcomes are dependent upon microeconomic outcomes, but certain macroeconomic variables tell us a lot about economic conditions. This information can be employed in a manner that considers market process in analysis and policy implementation, rather than inhibits market robustness.
Salin's prime error appears to be the assumption that the macroeconomy can be defined solely in terms of microeconomic agents. A macroeconomics that does not give special attention to certain macrovariables is of little service. While it is understandable that economists interested in market process emphasize that information is lost in aggregation, a loss of information does not necessitate that useful information does not exist in these macrovariables. This really requires a detour into the pillars of macroeconomic analysis:
1. Say’s Principle
2. The Equation of Exchange
These concepts permeate any discussion of macroeconomics, although their employment is not always recognized explicitly. Consider Say’s principle. Say’s law expresses the principle in its most basic form. Goods must pay for goods. In other words, if you want to demand a good, you must have the means to facilitate exchange with payment. This means is tied at some point to either one’s labor, a good in one’s possession, or a promise, of a good or service outstanding. Say’s principle, as formulated by Leijonhufvud and Clower (1973), identify money as an nth commodity included in Say’s identity. It conveys that if there is an excess demand for money, there must be an excess supply of goods in some other market or markets. The only way for all markets of available goods and services to clear is for either more money to enter the hands of those agents demanding more money or for prices to fall. Prices, especially wages, tend to be sticky downward, so the extent to which prices are unable to adjust there is a shortfall in demand and a falloff in economic activity.
Cue the equation of exchange and the role of expectations. The equation of exchange, MV = Py, tells us that changes in velocity can affect prices and output levels. An increase in demand for money materializes as an increase cash balances. An agent will increase portfolio demand for money as a result of deflationary expectations (money is expected to be worth more in the future), in response to increased uncertainty, or as a result of planned future expenditures not induced by expected deflation. The reader can see that demand for money is dependent on what one expects to use it for in the future and on expectation of future conditions more generally. Modern finance blurs the line between an increase in portfolio demand and an increase in investment, the latter of which tends also to increase the broader money stock. The difficulty comes when secure investments are exhausted and cease to respond to the amount of savings in the economy. When this occurs, short term rates fall toward zero and the yield curve steepens (Moreira and Savov 2013; Sunderam 2012). In the short run, low rates might result from an expansion of the monetary base, but it is unlikely that the market could be fooled for nearly a decade. The cause of our recent low rates lies elsewhere. If nominal rates on short term securities are depressed for an extended period of time, the likely cause is increased uncertainty, deflationary expectations, or both. In any case, the reader can see that expectations are intimately tied to demand for money and quasi-moneys.
A nominal income target can help eliminate both uncertainty about the availability of credit to creditworthy borrowers during a downturn and self-feeding deflationary expectations. And as I will later explain, the mechanisms by which a nominal income rule can be implemented need not lead to insurmountable systemic distortions. The key to understanding this lies in tying together the core principles of classical macroeconomics which I have outlined.
As many of my readers know, the mechanisms governing the gold standard closely parallel those governing a nominal income level target. It should be no surprise that it also illustrates the principle that I am attempting to convey. Under the gold standard, the monetary gold stock consistently grew at a rate of 2 to 3% per year. The years during which the growth rate of the gold stock deviated from this range tend to correlate tightly with changes in the price level (see figure from a recent post). When gold denominated prices fell sharply (the price of gold rose), the rate of growth might be as high as 7 to 10%. Barring a sudden reduction of the world’s gold stock – perhaps the plot of a devious Goldfinger or simply the result of insane banking policies – a rise in the price of gold was concomitant with an increase in demand for gold. As Say’s principle tells us, an increase in demand leading to an excess demand for gold implies a relative increase in present surplus stocks of goods. Luckily, an increase in the price of gold tends to increase the quantity supplied in a given period. Thus, gold flowed from mines and the market for non-monetary gold into the hands of those who valued it more as money. In other words, a shortage of gold identifies itself by a rise in the price of gold and, thus, simultaneously promotes its own remedy. Unfortunately, modern monetary systems lack this sort of mechanism for the monetary base.
A nominal income target is an nth best policy option which economists in favor of free markets ought to seriously consider. I don’t expect that anyone in the developed world will find himself or herself living in Mises’s evenly rotating economy any time soon. Absent from reality is a robust free-banking system that would develop absent financial regulation and central bank accommodation. Since I do not expect the state to give up its monopoly on money any time soon. A rule that endogenizes the base money stock so as to 1) compensate for changes in portfolio demand for money and 2) stabilize expectations about the growth rate of the money stock, and therefore about inflation/deflation and monetary policy more generally, can help promote the coallescence of the plans of economic agents and avoid distortions that arise from expectation of targeted bail outs. This is especially important in a world where banks have come to expect central bank accommodation during periods of constrained liquidity and crisis. The recent crisis has shown that those managing private banks have come to integrate fiscal and monetary intervention into their expectations (Calomiris 2009). When accommodation becomes expected, the result is increased leverage and irresponsible lending.
By essentially turning the central bank into a computer program, a monetary rule will stabilize expectations about monetary policy. A monetary rule will essentially vanquish deflationary expectations and any expectations of a future bailout. This allows credit to play a coordinating rule whereby lending can, at a price, alleviate a shortage in money. If monetary expansion is 1) expected and 2) distributed broadly across financial markets, distortions from expansion will be minimized and money will tend to enter the hands of those who value it most (Selgin 2012). A policy of nominal income targeting alongside the reforms suggested by George Selgin would go a long way to minimizing distortions that result from interventions in financial markets. Thus, I am not convinced that Salin is considering a novel or uncorrectable problem in his description of Cantillon effects:
Those who are the first ones to borrow obtain a gain in purchasing power in comparison with others, since they can spend the money thus obtained before the increase in prices occurs when there is more money creation. Insofar as money creation implies a decrease in interest rates, some people also receive a benefit from money creation for this reason. Money creation therefore has distributional effects which cannot be justified since they are completely arbitrary. (11)
There is a cost to inaction just as there is a cost to monetary activism. At least a rule promotes stable expectations.
Unfortunately, Salin does not consider the three principles that lie at the heart of macroeconomics. By concentrating on microeconomic relationships and ignoring the macroeconomic principles that I have outlined, Salin has not really presented much that is new or useful to the debate regarding monetary policy. Strangely, he also finds that predictable expansion leads to uncertainty, but does not fully explain why:
In addition, an expansionary monetary policy creates uncertainty since no one can forecast accurately and precisely the rate of inflation and, above all, the distortions in price structures (which depend on the structure of credit and the structure of expenditures made by those who benefit from credits of monetary origin). (12)
To the extent that Salin is correct, this problem holds true for any expansion of the monetary base or of credit. This includes, to a lesser extent, expansion under a decentralized commodity standard, which is Salin’s (and my) standard par excellence.
Those of us interested in market process and macroeconomic problems need to consider the full extent of the problems which we study. If I or anyone else promotes a free market monetary system, we cannot simply rely on the systems theoretical superiority to win the day. We need to consider improvements to the current system that can be made. As long as the government continues to promote a legal tender monopoly, bright minds should consider how to make that standard as little damaging as possible. In addition to those made in this post, I have suggested a number of other reforms including the elimination of capital gains taxes and of regulations that inhibit liquidity. If we are stuck with a legal tender monopoly, a monetary base constrained by a predictable rule is probably the best policy possible. Hayek appears to have come to grips with this once he stopped defending the international gold standard (both the classical gold and gold exchange standards were managed standards; see Hayek 1943 and 1960 about rules and predictability). It is time that market process theorists consider how an nth best policy might do the least harm or even promote development. In doing so, we must also make clear that we are suggesting an nth best solution, not a road to Utopia.
I’ll close by briefly addressing one critique by Salin that appears to have teeth. He argues that “monetary instruments should be used to solve monetary problems and real instruments to solve real problems (19).” Salin critiques nominal income level targeting on the grounds that expansion under a target will lead to inflation even when there is no growth in real income. On these grounds, I might also criticize the gold standard. The gold stock tended to grow even in years of contraction. In essence, the gold standard was a de facto income target, but one that was not only guided by changes in demand for money, but also changes in the supply of gold. In some years, surprise discoveries led to gold production that was far above average. In other years, constrained supply led to a relatively unresponsive money stock. As Barsky and DeLong have shown, inflationary expectations do not appear to have been accurate under such a scenario. Although his phrase may roll smoothly off my tongue – “monetary instruments should be used to solve monetary problems” – it is unclear that the type of system that Salin suggests is actually an historical artifact. No natural money that I know of is governed by this principle.
Markets use imperfect moneys. What is important for a monetary system is that market actors can collectively form accurate expectations about future monetary conditions. This need a nominal income target can fulfill. If this condition is fulfilled, a failure of expectations to converge will not be the fault of monetary policy but will lie elsewhere.