A typology of monetary theories - II

Carrying on from where I stopped last time on the monetary typology

5. Henry Thornton : I sometimes like to think that macroeconomics - or at least modern monetary economics - began with Henry Thornton. During the Bullionist controversy, he wrote his magnum opus at the start of the 19th century. The text, revived in the economic literature through the efforts of Jacob Viner in the 1930s, reads more modern than a majority of contemporary monetary discussions. Thornton's work is possibly the first successful marriage of the currency and the banking principles (see pg 296 onwards here for more reference on the difference between the two). Schumpeter considered it the best theoretical monetary performance of the 1790-1870 era in his HEA (pp 657-658). Thornton anticipated Wicksell's cumulative process of the expansion or contraction of the economy, in what was a bid to explain the observed regularity  between issue of central bank liabilities and the nominal economy, which is simply assumed by the quantity theory of money (QTM).  As Schumpeter notes (HEA, pp 676-677, 702-703), only Ricardo and a few of his closest associates ever believed in the "strict" (we would today call it "naive") form of quantity theory. Thornton, though he was on Ricardo's side in the Bullionist controversy, sought to explain it using processes and phenomena that he saw in the 'real world', rather than posit it as a matter of logic, as Ricardo did. In all, Thornton represents the centre in the theory of monetary policy - comfortable with currency and credit, with quantities and rates, with a belief in the power of central banks, though acting through private financial agents.

6. Schumpeter : I label this cell with Josef Schumpeter's name borrowing from Ashwin, who describes endogenous money creation through banks' extension of credit as an idea that is first/best explained in Ch 3 of his book Theory of Economic Development. I haven't read it, so I will defer to Ashwin's judgement, with the caveat that Schumpeter was an unbelievably wide scholar of the history of economic thought, and it is my prior that someone so widely read is unlikely to hold 'polar' positions. So, Schumpeter himself might have been a 'Schumpeter-ian centrist', somewhere between the Thornton & Schumpeter cells in my typology. However, we are more concerned with what the cell signifies rather than the views of Schumpeter himself - so what makes for a Schumpeterian theory of monetary actors and mechanisms?

In short, this is a view that infuses the financial/banking system with a lot of autonomy, through both prices (interest rates) and quantities and thus renders the central bank a relatively smaller player in the purely monetary scheme of things. The endogeneity of money (supply) is a common heterodox position and a large number of theorists with widely divergent policy prescriptions - Austrians, Real Bills theorists, Post Keynesians, etc. - hold views on it which seem remarkably similar. I submit that what would be specifically *Schumpeterian* is the view that the financial system leads/should lead credit and money creation rather than responding passively to consumer or investor (real economy investors, i.e. businesses) demand. The argument is definitely a claim about how the world works but is perhaps also normative, enshrined in Schumpeter's twin views - as Ashwin describes it - of money creation through elastic credit as the differentia specifica of capitalism, and of the banker as the capitalist par excellence. This is in some contrast to the real bills view (banks/central banks *should* extend money only against safe, short term collateral) as well as the canonical Post Keynesian 'horizontalist' view that even privately created endogenous money is merely 'accommodative' i.e. responding passively to exogenous money demand. However, the monetary views of some notable 20th century empirical theorists - particularly John Gurley and Edmund Shaw - are of a Schumpeterian nature and the approach also resonates with Post Keynesians of a more 'Structuralist' persuasion - witness Thomas Palley or Bob Pallin.

7. Woodford/New View : In 2003, Mike Woodford wrote what continues to be the benchmark monetary theory text in graduate macroeconomics. Woodford visualized a "cashless", or more precisely a currency-less economy where monetary policy is focused on price stability and is conducted using just the short rate, with the rest of the yield curve taking care of itself through financial equilibrium. While this has been seen as a modern take on a Wicksellian 'pure credit' economy, Woodford's attempt should also be seen as the proper development of the 'New View' of monetary economics that began with Jim Tobin's explorations of monetary economics in a world of modern financial internediaries and assets in the early 1960s. As Perry Mehrling notes, Woodford's work should be seen not simply as a New Keynesian reponse to the rational expectations revolution, but also as an initial attempt by modern macroeconomics to rise to the challenge of modern finance.

I identify the critical element of this view as the attempt to infuse the monetary sovereign with full policy control through a monetary instrument, even in a world of entirely interest-bearing money. Money is the numeraire, and the main monetary channel is expectations of future monetary action. In developed economies with elaborate forward-looking financial markets, in a world of treasury ETFs, money market mutual funds, zero-cost sweeps between demand deposits and time deposits etc. - the Woodford-ian schema seems entirely reasonable as the default prior to begin working with.

Rest to follow in parts III and IV.

A typology of monetary theories - I

As a much delayed follow up from my post proposing a top-level framework for thinking about business cycle macro, here's a framework for thinking about monetary theories.

Note that this is primarily about a theory of monetary mechanisms and propagation and thus corresponds better as a theory of monetary policy, rather than pure monetary theory, which would be more concerned with questions like 'why does money have non-zero value in equilibrium'. Yet, because of the centrality of the financial system in macroeconomic ups and downs and because of the growth of central banking with the urge to exert control over the financial system, arguably developments in the history of macroeconomic thought basically parallel developments in the history of central banking.

So here it is - a typology of monetary theorists and theories.

 Here, I've attempted to categorize monetary theories along two axes. The first axis deals with who is the primary monetary actor - central bank vs pvt banks & financiers. The second axis deals with what is the primary monetary mechanism - interest rates (real or nominal) vs the quantity of some monetary aggregates. Short notes on some of the cells follow :

1. Ricardo : As Schumpeter notes in his monumental History of Economic Analysis (Book III, Chapter 7, pp 657-719) the contemporary history of monetary theory goes back to the Bullionist Controversy in the early 19th century, and David Ricardo was the leading flag bearer for the currency school. Broadly speaking, a Ricardian monetary intuition involves a commitment to the quantity theory of money in some form or the other, a belief that 'outside' or central bank money is special, and that what is truly special about CB money is currency. As of today, Scott Sumner best represents Ricardianism in monetary thought. 

2. Old Monetarists : Old monetarists would broadly be people who focus on monetary aggregates, albeit both on base money (currency + reserves) and broad money (bank deposits etc.) aggregates. A classic tendency would be to focus purely on the liabilities of the banking system - as exemplified by Milton Friedman's contention that banks "also" have assets and that that's not quite important - and to infuse the central bank with a lot of control over the banking system. Nick Rowe would probably be a good example of a current theorist who is an old-style monetarist.

3. Real Bills Doctrine : This was the opposite side to Ricardo/Thornton in the Bullionist controversy, and this position has been revived a few times since. The basic contention is that 'money' - liquid media of exchange - is basically to be issued by pvt banks against high quality, short-term collateral. In old-school jargon, this went by the name of discounting against self-liquidating 'real' bills. Though this seems more like practical advice than monetary theory, the implied theory is easy to spot. Central banks are only supposed to respond to accommodate endogenous demand against specific, limited collateral, so that the primary monetary actors are private banks and financiers. Also, the restrictions on the quality and maturity of collateral to be admitted restricts interest rates to a rather narrow band - it is clear that quantities of collateral and exchange media issued are the main mechanisms here. As Perry Mehrling notes in his book on Fischer Black, Milton Friedman blamed this view for demanding that the central bank act in a pro-cyclical fashion and thus exacerbating business cycles.

4. Fisher : Irving Fisher created the first neoclassical macro model, and brought monetarist thought to the United States. He revived the quantity theory, but also brought to notice the monetarist paradox in interest rates - the observation that inflationary policies were associated with higher interest rates rather than lower. He conducted deep research into the construction of price indices and proposed that a monetary regime attempt to maintain price stability. It is clear that Fisher thought it was firmly within the remit and capability of central banks to maintain macroeconomic stability, through quantity mechanisms or rates mechanisms.

Descriptions of the other cells and some 'quadrant'-level aggregations will follow in the next post.

On Reinhart and Rogoff

If you follow macroeconomics or global economic policy, by now you'd be familiar with the recent blow-up over the so-called Reinhart-Rogoff (R-R) results. Carmen Reinhart and Kenneth Rogoff (R&R) have compiled and conducted some extensive research into the experience of countries following financial crises, which led to their book This Time Is Different. The central thesis of book was that financial crises have certain common, hence perhaps predictable, patterns, and among the biggest challenges in mitigating their occurrence or ensuing damage has been the tendency to believe that "this time is different". The book received plaudits when it was released - many have gone on to say that it's been their "bible" in the current global financial crisis.

A subset of the themes that R&R covered in their book was the dynamics between growing public debt and growth. This evolved into an independent line of published research, from which the 'headline' take-away was that countries with public debt/GDP ratios of over 90% experience strikingly slow growth, and thus the 90% level might be an intuitive tipping point beyond which may lie treacherous territory for sovereign borrowing. This argument, though made with suitable academic precaution, has been used or at least invoked by several influential policy-makers in developed economies with debt/GDP ratios exceeding the 90% level, as reason to impose a cutback in fiscal spending immediately. It is obviously at the centre of some of the most important global policy debates of our debates.

Now two days ago, Rortybomb (Mike Konczal) posted research from three University of Massachusetts economists (Herndon, Ash, Pollin) that tried to replicate the Rogoff-Reinhart results but could not. They found that the R-R results resulted from a rather messy combination of an excel code error, choosing to exclude certain data points, and devising a schema of weighting that seemed to skew the results and did not seem intuitively defensible. Unsurprisingly, the microcosm of the online world that cares about these things more or less exploded, first with schadenfreude, then with appeals to subtle readings, and very quickly, as is the wont of online discourse, to more systemic and 'meta' things like the central lessons to be learned from the debacle, the incentives facing economists, etc.

For a quick update on what has been happening, Felix Salmon has a good round-up and Tyler Cowen continues to act as a conscientious and indispensable clearing-house.

A short summary of just what has happened may be useful. First of all, though the schadenfreude is directed mostly at the Excel error, that error itself does not drive the biggest magnitude change in the result at hand. It pushes the growth experienced by countries with debt in excess of 90% of GDP from -0.1% to merely 0.2%. But removing the asymmetric weights and including all episodes changes it further to 2.2%, and that's really where the meat and juice of the debate lies. Rortybomb has further posted analysis by U-Mass economist Arin Dube that shows that the debt-slow growth correlation actually shows reverse causality, i.e. it's the slow growth that causes high debt ratios, rather than vice versa.

The economists themselves responded remarkably fast, and were forthcoming about accepting the code error. However, they insisted that firstly, they had only claimed association, not causation and secondly, at ~2%, growth for countries with public debt more than 90% of GDP was still a full 1% lower than that of countries with public debt less than 90%. The first is the plausible deniability of every sophist's argument - after all who gets global fame for simply showing that a high ratio is "associated with" a low denominator. It was always the potential causation hinted at which mattered and the op-eds that Rogoff and Reinhart wrote for popular audiences seemed to unambiguously hint at implied causation. The second may still be relevant, but ~2% vs ~3% simply lacks the jaw-drop value of less than 0% vs ~3%, and is actually not even statistically significant.

But the R&R defence wholly skipped over the deeper issues around including and excluding data points and arbitrary weighing schemata. On this, others have risen, not to their defence per se, but to shift focus and draw attention to the larger issues at hand. I have now seen a bunch of these arguments, and none of them are very convincing.

First up, let's get the 'any data analysis exercise will have to make these choices' bit out of the way. This is true, and for precisely this reason data analysis exercises offer, or should offer, at the very least, footnotes or explanatory pieces detailing these choices and a short note on why they were preferred to other choices. Investment banking analysts are routinely laughed at for having plucked out of the air assumptions about projections of growth, industry growth, market share etc. and yet any half decent analyst would not dare offer his or her work without detailing qualitative reasons for the quantitative assumptions being made and a list of sensitivities. Arguably, the former is more important and should be dealt with at depth by an academic - especially if the choices being made are not prime-facie intuitive (like, say, removing a 10 sigma outlier). It is worth pointing out that the main reason R&R come up with the 90% figure is because their intervals are of 30% i.e. they split the data into buckets of 0-30%, 30-60% and so on. This is purely a modelling choice artifact, and the actual tipping point, assuming any exists, may be 80% or 110% or 93.7%.

Here, a good way of going about it might be to to set up a graph and see if there are any natural 'inflection points' and if the simple graph between the two variables won't do, consider natural transformations like time-derivatives or logarithms until you get a graph with an inflection point. Ultimately, your data range choices have to make intuitive sense to numerate people. If you have to torture the data too much, it's quite possible you're looking at a very banal reality.

Another set of defences underscores the point that the episode mostly shows the pitfalls of macro analysis owing to the small data sets available. While true, this is inapplicable to the issue at hand. This is a problem with all data sets that show structural transformation, even if they go back a long time, and so with all data sets that concern themselves with the socio-commercial reality of our society. R & R stand questioned not because they made a prediction using analysis that came unhinged because the original analysis suffered from a small data set. Given the small data set, they chose to transform it in such a manner that very different conclusions were reached than if those transformations were eschewed. These transformations are reminiscent of the sham that passes off for the concept of risk-weighted assets when calculating capital ratios for banks - I contend that the fineness achieved was outweighed by the robustness lost due to it, and that this would have been true even ex-ante.

Finally, some have made the point that R&R are simply reacting to the incentive system in academic economics and popular commentary. Economics, it turns out, is a discipline that does not prize replication of results the way hard sciences do, and prizes novel insight more so that the errors of the type of R&R are rife through the profession. R&R might actually be ahead of the curve by engaging with the criticism so openly. Further, popular commentary obviously rewards strong claims more than agnostic and possibly sterile data inference exercises. Ergo, the choices that R&R made follow. Even if these arguments are true, one is forced to ask - should we then resist the urge to trash R&R or simply add the urge to trash the entire economics profession to the mix? Moreover,  is it alright to apply the leeway in standards that we may be able to afford an up and coming popular essayist or a graduate student seeking a job and tenure to Kenneth Rogoff and Carmen Reinhart. Rogoff has been the chief economist of the IMF, is a member of the super-elite Group of 30 and was a student of Rudiger Dornbusch (who advised several LatAm governments in the '80s) and Stanley Fischer (possibly the macroeconomist with the most star studded policy experience ever) during the phase at MIT which has produced some of the most prominent international macroeconomists of our era (Bernanke, Obstfeld, Krugman, Frankel). He is a plausible contender for the topmost policy jobs in a Republican administration. Reinhart is somewhat less entrenched, but is also a tenured professor at Harvard, a top-10 authority on sovereign debt and default especially in emerging nations, and brought the term 'financial repression' into the modern macro lexicon. By any stretch, they are as about as elite as the academic macropolicy elite gets, and remember that these are days when macroeconomists are disproportionately at the centre of the global policy elite.

No, this defence from diminished expectations won't cut it. To check how diminished our expectations may have become, see this otherwise brilliant Neil Irwin piece where he seems thankful to R&R for simply compiling and collating the data that backed their broader research.

Reinhart and Rogoff did a shoddy job and deserve most of the ridicule coming their way.