Money, Macro & the Crisis

Recently, I've found myself reading a lot on the crisis, monetary policy and macroeconomics. This includes the usual suspects, some newly discovered stuff and a book. But most of all, I've been reading research papers, including some that were published a few decades ago. Some sort of clarity and a framework have begun to emerge and I'm now finally able to get the drift on some of the more technical discussions on the relevant issues. There are two prominent themes in these readings that emerge often and that I find myself agreeing with most strongly.

The first is that there is a pressing need to incorporate finance and into macroeconomics. Earlier, this incorporation had stopped at understanding the role of money in the economy with a cursory glance at the banking system. The basic channel that unifies money, the banking system and the real economy is credit and credit has never really been incorporated into mainstream macro. If there is only one thing that we learn from Minsky, it should be this: incorporate credit as the concept and the financial sector as the context to inform macroeconomic policy.

The second theme is that dynamic monetary disequilibrium is a consistent feature of the modern credit economy. If you take a look at the criticisms of the New Classical school (esp. John Cochrane) coming from De Long and Krugman and many others in the recent online economic wars, there is one constant refrain: the New Classical school has failed to grasp the role that money can play in the modern economy. The New Classical school has an implicit belief in the Say's Law, and thus believes that there can be no general supply glut, that excess supply in one sector is offset by excess demand in another, that savings always equal investment and hence recessions are temporary readjustments in overall social preference from some goods and sectors to other. It thus believes in the 'neutrality of money', i.e the idea that money only functions as a medium of exchange, that investment and consumption decisions are made in real terms and hence the only source of demand for money is the 'transactions demand'. As many have pointed out, this is a model that could perhaps accurately describe a barter economy, or to a monetary economy where the velocity of money is a fixed technological constant subject only to exogenous shocks and thus behaves as if it were a barter economy.

While the barter system has not existed for a long time now, the relatively simpler economy of the past, say until the 19th century, could perhaps be approximated by such a model. In an explicitly monetary economy, however, money also seems to perform the function of a store of value and thus there could be disequilibrium, especially a monetary disequilibrium. A fully fledged 'finance economy' has since become the reality in the 20th century, and such a finance economy seems to have the ability to magnify and reinforce the monetary disequilibriums.

There are, of course, a number of people and streams of thought that have tried to incorporate credit into their understanding of macroeconomics and business cycles. Apart from Minsky, the Austrian Business Cycle theory is one such. Broadly, it says that money is easy in good times due to actions of market participants and artificially low interest rates set by the central bank. This excess money causes businesses to over-invest, thus temporarily causing a bubble. Ultimately this bubble bursts, resulting in a temporary under-investment that brings the economy back to its 'normal' state. Central banks should not try to increase liquidity during such a crisis, for that will just create another such bubble. Murray Rothbard's version of the business cycle also has people over-inesting irrationally only in the presence of the central bank!

Because of the resemblance of the boom-bust hypothesis to the technology bubble to mortgage bubble shift of the past decade, and because of its incorporation of credit, this theory has gained some credence in the past year. It has however, been criticized on various grounds at various times by several economists, including both Keynes and Friedman. The central issue with the theory is that it also seems to believe in the neutrality of money. Moreover, the theory seems to treat irrational over-investment as a moral evil and recessions are seen as having the salutory effect of bringing people back to the preferred state of rationality. This can seem as a Great Depression-apologist stance and Krugman has indeed attributed part of the blame for the broad-based central bank failures during the depression to the Austrians.

Apart from the Austrians and Minsky, there was at least one other economist whose ideas seem strikingly close to the events unfolding of the crisis, but who doesn't seem to have gotten much attention. Henry Simons is considered one of the founders of the Chicago school. Simons recognised and distrusted the high volatility of the liquidity demand of money and believed that the credit cycle and short term debt issued by banks and corporations exposed any financial system built on it to severe fluctuations through asset liability mismatches, which could then spread the fluctuation to the real sector. He was also concerned a lot about maintaining the price level. In one theory, we see the amalgamation of several strands of thought that have come to dominate academic thought in the crisis.

Though Simons's understanding of the inherent fragility and positive feedback of the financial system is similar to Minsky's and Bernanke's, his policy prescriptions differ. He recommends full reserve banking, the gold standard, the complete absence of short term debt, and strict monetary management by the government. If these frameworks are in place, it seems to me that the rest of the economy starts resembling an 'as if' barter system and his favoured policy stance of laissez faire becomes workable.

A full reserve banking solution has also been provided by others wary of the financial system or the government, including Rothbard and intermittently, Friedman. The causes of course, differ. The generation of money through fractional reserve banking has been compared to counterfeiting by more than a few respected economists, including Maurice Allais. The debate is not only interesting (though perhaps lop-sided), it is critical to understanding the tenuous relationship between money and credit in the financial economy.

Credit is endogenous, it comes about from the interaction of the financial and the real sectors. Indeed, it is also the main channel of transmission between the two. Proponents of fractional reserve banking argue that it is just the way to implement the 'monetization' of credit. Proponents of full reserve banking are concerned either about the supposedly illusory money (Rothbard, Allais) or about financial fragility (Simons).

Of course, even within the 'monetization of credit' philosophy, one can ask where does the money itself come from. While the monetarists and many Keynesians believe that money, though inevitable, is still exogenous and comes from the government and the central bank as a way to monetize the credit, the circuit theorists argue that money is an endogenous property of a credit economy itself. Indeed, in their view, credit IS money. Of course, there are the agnostics in between these two views.

We can thus summarize the broad ways of looking at the theory and concept of money, arranged in a roughly free market to interventionist order.

1) Money is neutral and always in equilibrium.

2) Money is neutral but there are temporary, required credit disequilibria.

3) Money is not neutral and sometimes in disequilibrium, but exogneous.

4) Money is not neutral and often in disequilibrium, and may be exogenous or endogenous.

5) Money is not neutral, often in disequilibrium and endogenous.

My own views are closest to 4.

(This post has left out several contextually required links. The next one is going to be a mega link fest)