Quoting "James A. Donald" <[EMAIL PROTECTED]>:
> --
> At 05:25 PM 5/4/2001 -0400, Faustine wrote:
> > I just have a real problem with the kind of mentality that says it's
> okay to let other people pre-digest the issues for you as long as you know
> they have good premises and "their heart is in the right place".
>
> I have a real problem with someone who's sole form of debate is the ad
> hominem attack, based on a straw man caricature of those she so
> plainly hates and fears.
Having trouble setting up that filter file?
(For the record, I wasn't talking about, thinking of, or in any way making
a "hidden nasty reference" to you in my reply to Anonymous either.)
Contrary to what you may believe, being critical of some libertarians doesn't
equal rejecting libertarianism. There's nothing ad-hominem about it: the main
thing I hate and fear is what's going to happen to this country if the people
who care about freedom and individual liberty let themselves get as
intellectually lazy as the majority of the populace. No free passes, damn it.
Anyway, in an attempt to make the title of this thread truly relevant to its
content, here's a controversial article that came out a few days ago that some
people might find interesting...I don't agree with it by a long shot (i.e. he's
shilling, not me) but I'd be glad to take it up in detail with anyone who
cares, here (or by e-mail if it's too off-topic.) It beats bickering over
personality disorders, at any rate!
~Faustine.
***
The Monatarist Counterrevolution, Dr. Bradford DeLong
Last year I published an essay (DeLong, 2000) arguing that modern Keynesians
are really monetarists. Even if they--we--do not really like to admit it, most
of the key elements in how modern "new Keynesian" economists view the world are
derived from or heavily influenced by the work of Milton Friedman.
But that essay left me unsatisfied, for it was only half of the story. Just as
modern Keynesians are (in many respects) monetarists, so modern monetarists are
really Keynesians--even though they like to admit it even less. They are
Keynesians in the sense that they have the same profound and deep distrust in
the laissez-faire market economy's ability to deliver macroeconomic stability.
Moreover, they share the confidence John Maynard Keynes had that limited and
strategic government interventions and policies could produce macroeconomic
stability while still leaving enormous space for the operation of the market.
Thus there are no believers in true laissez-faire left, at least not as far as
academic macroeconomics is concerned. The rhetoric of post-World War II
monetarism held that it was a return to laissez-faire in macroeconomics. All
the government had to do was to get out of the way and leave monetary policy
in "neutral," and macroeconomic stabilization would be successfully achieved.
But on closer inspection the "neutral" monetary policy advocated in works like
Friedman and Schwartz (1963) turns out to be a policy that pre-Keynesian
generations would have called extraordinarily activist on a number of levels.
The laissez-faire rhetoric obscures the extraordinarily broad common ground
that Milton Friedman shares with John Maynard Keynes.
This recognition has important implications for understanding the meaning and
effect of the monetarist counterrevolution of the late 1960s and 1970s. The
majority view of the monetarist counterrevolution was shaped while it was
ongoing by Harry Johnson's Ely Lecture, "The Keynesian Revolution and the
Monetarist Counterrevolution" (Johnson, 1971). Johnson saw the monetarist
counterrevolution as a true intellectual revolution--one that renders the
previous literature obsolete, irrelevant, and uninteresting as the post-
revolutionary generation focuses on new issues and dismisses the old questions
and answers as badly posed or simply incoherent. Johnson also--relatively
cynically--saw the monetarist counterrevolution as the triumph not of new
evidence (or a reevalution of old evidence) but as the triumph of misleading
rhetoric, and was not sure that it reflected an advance in knowledge. And
Johnson saw the counterrevolution as a genuine counterrevolution that would--if
successful return economists' thinking to its previous state.
I want to argue that, underneath its laissez-faire rhetoric about a non-
activist, neutral monetary policy, the monetarism of the monetarist
counterrevolution had been thoroughly infected by the Keynesian virus. It
carried with it a way of thinking about macroeconomic policy that was
as "activist" in its own way as John Maynard Keynes could have ever wished.
-----
Pre-Keynesian Business Cycle Theory
The quantity theory of money goes back to David Hume. But the transformation of
the quantity theory of money into a tool for making quantitative analyses and
predictions of the price level, inflation, and interest rates was the creation
of Irving Fisher (1911).
However, the quantity theory of money as developed by Fisher (1911) and his
peers was not a useful tool for business cycle analysis. It amounted to an
assertion that other things being equal--ceteris paribus--the price level would
be proportional to the money stock coupled with a laundry list of what those
other things might be. But it did not investigate the relationship of monetary
policy and monetary shocks to the "ceteris" that were to be "paribus." And it
did not engage in any significant analysis of the money supply determination
process at all.
These theoretical shortcomings led other economists to become exasperated with
monetarist analyses of events made by their colleagues in the monetary and
financial chaos that was the immediate aftermath of World War I. This
exasperation led John Maynard Keynes to write what is perhaps the most
frequently quoted of his many lines, the declaration in his Tract on Monetary
Reform (1923) that standard quantity-theoretic analyses were useless:
"Now 'in the long run' this [way of summarizing the quantity theory: that a
doubling of the money stock doubles the price level] is probably true.... But
this long run is a misleading guide to current affairs. In the long run we are
all dead. Economists set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us that when the storm is long past the
ocean is flat again..."
Most economists today would agree with Keynes. Milton Friedman certainly does.
In his 1956 "The Quantity Theory of Money--A Restatement," Friedman sets out
that one of his principal goals is to rescue monetarism from the "atrophied and
rigid caricature" of an economic theory that it had become in the interwar
period. According to Friedman, it was the inadequacies of this framework that
opened the way for the original Keynesian Revolution. The atrophied and rigid
caricature of the quantity theory painted a "dismal picture." By
contrast, "Keynes's interpretation of the depression and of the right policy to
cure it must have come like a flash of light on a dark night" (Friedman
(1974)). Keynes's General Theory may not have had a correct theory of business-
cycle fluctuations in employment and output, but it least it had a theory.
The second strand of pre-Keynesian business cycle theory, was, to caricature it
only slightly, the over-investment theory claim that nothing could be done to
avoid, moderate, or shorten depressions. One of the most striking declarations
of this "liquidationist" point of view came from Herbert Hoover's Secretary of
the Treasury, Andrew Mellon, who saw the Great Depression as a healthy process
of macroeconomic purgation. In his memoirs Herbert Hoover (1952) wrote wrote
bitterly of Mellon and the others who had advised inaction during the downslide.
This point of view was not one that originated with bankers and politicians. It
was held by some of the most eminent economists of the day. I take Joseph
Schumpeter's (1934) expression of it to be representative--certainly
Schumpeter's is the most rhetorically powerful and analytically coherent.
Schumpeter begins from the observation that the course of economic development
is never smooth. Investments and enterprises are gambles on the future, made by
innovative entrepreneurs who see new things to be done or new ways to produce
old commodities.
Sometimes these gambles will fail. The actual future that comes to pass is one
in which ex post certain investments should not have been made, or in which ex
post certain enterprises should not have been undertaken because they are not
producing the requisite profits. The economy is left with "too much" capital
given what the state of technology factor supplies, and demand turned out to
be, or is perhaps left with the "wrong kinds" of capital.
The best that can be done in such a situation is to shut down those production
processes and enterprises that were based on guesses about the way the future
would look that did not come to pass. The liquidation of investments and
businesses releases factors from unprofitable uses; they can then be redeployed
to other sectors, used to produce socially useful current services (in the "too
much" capital case) or alternative investment goods (in the "wrong kinds"
case), and used by further waves of entrepreneurs in new gambles on a still-
uncertain future. But without the initial liquidation, the redeployment and the
subsequent wave of innovation and entrepreneuship cannot take place.
It follows, says Schumpeter, that depressions are this process of liquidation
and preparation for the redeployment of resources. From Schumpeter's
perspective, "depressions are not simply evils, which we might attempt to
suppress, but...forms of something which has to be done, namely, adjustment
to...change." This socially productive function of depressions creates "the
chief difficulty" faced by economic policy makers. For "most of what would be
effective in remedying a depression would be equally effective in preventing
this adjustment" (Schumpeter, 1934; p. 16). The process of dynamic economic
growth requires that underutilized factors register their availability on
markets. Policies that stimulate demand in recessions keep factors engaged in
activities that do not produce value in excess of social cost. Such policies
keep factor markets from registering the potential availability of productive
resources for redeployment.
Is it possible to iron out the cycles, leaving an economy growing steadily on
some equilibrium path rather than irregularly with rapid booms and slumps?
Schumpeter (1939) thinks not, for business cycles are not "...like tonsils,
separable things that might be treated by themselves." Instead, business cycles
are "...like the beat of the heart, of the essence of the organism that
displays them." In order for one wave of entrepreneurship to be followed by
another, prospective entrepreneurs must know where and in what quantities
resources available for recombination and redeployment are available. Until
they can learn this, they face "the imposibility of calculating costs and
receipts in a satisfactory way...[T]he difficulty of planning new things and
the risk of failure are greatly increased....[I]t is necessary to wait until
things settle down...before embarking on [new] innovation."
Schumpeter thus argues that monetary policy does not allow policy makers to
choose between depression and no depression, but only between depression now
and a worse depression later.
"Inflation...pushed far enough [would] undoubtedly turn depression into the
sham prosperity so familiar from European postwar experience," claims
Schumpeter (1934), but it "would, in the end, lead to a collapse worse than the
one it was called in to remedy." Hence his "...analysis leads us to believe
that recovery is sound only if it does come of itself. For any revival which is
merely due to artificial stimulus leaves part of the work of depressions undone
and adds, to an undigested remnant of maladjustment, new maladjustment of its
own which has to be liquidated in turn, thus threatening business with another
[worse] crisis ahead."
Stimulative monetary policies, therefore, "are particulary apt to keep up, and
add to, maladjustment, and to produce additional trouble for the future."
Moreover, words like "stimulative" carry a special meaning in this context: if
private sector actions would lead to a fall in, say, the nominal money stock,
then a public sector attempt to counteract the consequences of such private-
sector actions by injecting sufficient reserves to hold the nominal money stock
constant would be "stimulative."
The doctrine that in the long run the Great Depression would turn out to have
been "good medicine" for the economy, and that proponents of stimulative
policies were shortsighted enemies of the public welfare drew many anguished
cries of dissent. British economist Ralph Hawtrey scorned those who warned
against stimulative policies at the nadir of the Great Depression. To call for
more liquidation and deflation was, Hawtrey said, "to cry, 'Fire! Fire!' in
Noah's flood." Keynes (1931) tried to discredit the "liquidationist view" with
ridicule. He called it an "imbecility" to argue that the "wonderful outburst of
productive energy" during the boom of 1924-29 had made the Great Depression
inevitable. He spoke of Schumpeter and his fellow travelers as:
"...austere and puritanical souls [who] regard [the Great Depression] ...as an
inevitable and a desirable nemesis on... "overexpansion" as they call it....It
would, they feel, be a victory for the mammon of unrighteousness if so much
prosperity was not subsequently balanced by universal bankruptcy. We need, they
say, what they politely call a 'prolonged liquidation' to put us right. The
liquidation, they tell us, is not yet complete. But in time it will be. And
when sufficient time has elapsed for the completion of the liquidation, all
will be well with us again..."
-----
Keynesian Monetarism
It is on this point that we find complete and total agreement between John
Maynard Keynes and Milton Friedman. The critique of monetary policy during the
Great Depression found in Friedman and Schwartz (1963) is precisely that the
Federal Reserve did not do enough to stimulate the economy during the Great
Depression. It injected reserves into the banking system, yes, but it did not
inject enough reserves to counteract the decline in the money multiplier that
took place between 1929 and 1933 that reduced the money stock and starved the
economy of liquidity. As Friedman (1974) observed, the Old Chicago Monetarism
of Jacob Viner, Henry Simons, and Frank Knight had stressed the variability of
velocity, its potential correlation with the rate of inflation, and the
instability of the money multiplier. Thus they condemned the Hoover
administration government for monetary and fiscal policies that had "permitt
[ed] banks to fail and the quantity of deposits to decline" that they saw at
the root of America's macroeconomic policies in the Great Depression. To cure
the depression they called for massive stimulative monetary expansion and large
government deficits.
They (a) did not believe that the velocity of money was stable, and (b) did not
believe that control of the money supply was straightforward and easy. It did
not believe that the velocity of money was stable because inflation lowered and
deflation raised the opportunity cost of holding real balances. The phase of
the business cycle and the concomitant general price level movements powerfully
affected incentives: economic actors had strong incentives to economize on
money holdings during times of boom and inflation, and to hoard money balances
during times of recession and deflation. These swings in velocity amplified the
effects of monetary shocks on total nominal spending.
It did not believe that controlling the money supply was easy because
fractional-reserve banking in the absence of deposit insurance created the
instability-generating possibility of bank runs. The fear by banks that they
might be caught illiquid could cause substantial swings in the deposit-reserves
ratio. The fear by deposit holders that their bank might be caught illiquid
could cause substantial swings in the deposit-currency ratio. And together
these two ratios determined the money multiplier. Thus the overall level of the
money supply was determined as much by these two unstable ratios as by the
stock of high-powered money itself. And the stock of high-powered money was the
only thing that the central bank could quickly and reliably control.
The worry that control of the monetary base was insufficient to control the
money stock was to be dealt with, in Friedman's (1960) Program for Monetary
Stability, by reforming the banking system to eliminate every possibility of
fluctuations in the money multiplier. Shifts in the deposit-reserve and deposit-
currency ratios would be eliminated by requiring 100% reserve banking. Shifts
in the deposit-reserve ratio then become illegal. Banks can never be caught
illiquid. And in the absence of any possibility that banks will be caught
illiquid, there is no reason for there to be any shifts in the deposit-currency
ratio either.
Shifts in the velocity of money in response to cyclical bursts of inflation and
deflation that amplified fluctuations in the rate of growth of the money stock
would be eliminated by the constant-nominal-money-growth rule. Without cyclical
fluctuations in the money stock and in inflation, there would be no cause of
cyclical fluctuations in the velocity of money. Thus banking system reform and
Federal Reserve reform would eliminate the monetary causes of the business
cycle, and would make both the money supply and the velocity of money stable.
It is important to recognize that in its proper context--that of the pre-World
War II version of the quantity theory and the pre-World War II over-investment
theory--this is a very Keynesian vision of macroeconomic policy.. As Robert
Skidelsky puts it in his three-volume biography of John Maynard Keynes,
Keynes's key contribution was not to find a middle way between "laissez-faire
and central planning... conservatism and socialism" but a genuine Third Way
that achieved the benefits each traditional pole of politics had claimed but
had never been able to deliver. Keynes saw the market economy as having two
great flaws: first, that demand for investment was extraordinarily and
pointlessly volatile as business leaders and investors attempted the hopeless
task of trying to pierce the veil of time and ignorance, and, second, that the
fluctuations in the wage level that classical economic theory relied on to
bring the economy back into balance after such an investment fluctuation either
did not work at all or worked too slowly to be relevant for economic policy.
(No, I am not going to be drawn into the debate about "unemployment
disequilibrium.") But if these problems could be fixed, Keynes believed, then
the standard market-oriented toolkit of economists was worthwhile and relevant
once more.
And this is exactly Friedman's position. The tools used are a little different--
rather than Keynes's focus on investment plus government spending, Friedman
focuses on the banking system and the money stock. But in each case the vision
is one of powerful and strategic but focused and limited government
intervention and control of a narrow section of the economy, in the hope that
the merits of laissez-faire can flourish in the rest of the economy.
My conclusion is simple. Much of the history of macroeconomic thought is often
taught as the rise and fall of alternative schools. Monetarists tend to write
of the rise and fall of Keynesian economics--its rise during the Great
Depression, and its fall in the 1970s under the pressure of stagflation and the
theoretical critiques of Friedman, Phelps, Lucas, Sargent, and Barro. They tend
to see this as the rise "interventionism" and then its decline and replacement
by a more hands-off view that holds that monetary policy should be "neutral."
Keynesians write of the rise and fall of monetarism--its rise during the
monetarist counterrevolution, its fall as the instability of velocity and the
money multiplier became clear, and its replacement by the modern "new
Keynesian" paradigm.
Neither story appears to me to give an accurate or even a particularly useful
vision of how it really happened. The fall of monetarism as a political
doctrine was coupled with the victory of "monetarist" ideas and ways of
thinking in the mainstream: that was the point of DeLong (2000). And what
Friedman and Schwartz (1963) would call a "neutral" hands-off monetary policy
during the Great Depression--one that kept the nominal money stock fixed--would
have been condemned by pre-World War II over-investment theorists as
extraordinarily interventionist.
Indeed, it would have been. Between 1929 and 1933 the Federal Reserve raised
the monetary base by 15% while the nominal money stock shrunk by a third. The
position of Friedman and Schwartz (1963) is that the Federal Reserve should
have injected reserves into the banking system much, much faster. Sometimes to
be "in neutral" requires that you push the pedal through the floor.
-----
References
Philip Cagan (1956), "The Monetary Dynamics of Hyperinflation," in Milton
Friedman, ed. (1956), Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press).
J. Bradford DeLong (2000), "The Triumph [?] of Monetarism," Journal of Economic
Perspectives.
Irving Fisher (1911), The Purchasing Power of Money (New York: Macmillan).
Milton Friedman (1953a), "The Effects of a Full-Employment Policy on Economic
Stability: A Formal Analysis," in Essays on Positive Economics (Chicago:
University of Chicago Press: 1953), pp. 117-132.
Milton Friedman (1953b), Essays on Positive Economics (Chicago: University of
Chicago Press).
Milton Friedman (1956), "The Quantity Theory of Money-A Restatement," in
Studies in the Quantity Theory of Money (Chicago: University of Chicago Press:
0226264068), pp. 3-21.
Milton Friedman (1968), "The Role of Monetary Policy," American Economic Review
58:1 (March), pp. 1-17.
Milton Friedman (1960), A Program for Monetary Stability (New York: Fordham
University Press: 0823203719).
Milton Friedman (1970), "A Theoretical Framework for Monetary Analysis,"
Journal of Political Economy 78:2 (April), pp. 193-238.
Milton Friedman (1971a), "A Monetary Theory of Nominal Income," Journal of
Political Economy 79:2 (April), pp. 323-37.
Milton Friedman (1974), "Comments on the Critics," in Robert J. Gordon, ed.
(1974), Milton Friedman's Monetary Framework: A Debate with His Critics
(Chicago: University of Chicago Press: 0226264076).
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Velocity and the Investment Multiplier in the United States, 1897-1958," in
Stabilization Policies (Englewood Cliffs: Prentice-Hall).
Milton Friedman and Anna J. Schwartz (1963), A Monetary History of the United
States (Princeton: Princeton University Press).
Charles Goodhart (1970), "The Importance of Money," Quarterly Bulletin of the
Bank of England (June), pp. 159-98.
Robert J. Gordon, ed. (1974), Milton Friedman's Monetary Framework: A Debate
with His Critics (Chicago: University of Chicago Press: 0226264076).
Seymour Harris (1934), "Higher Prices," in Douglass Brown et al., Economics of
the
Recovery Program (New York: McGraw-Hill, 1934).
Herbert Hoover (1952), Memoirs (New York: Macmillan).
Harry Johnson (1971), "The Keynesian Revolution and the Monetarist
Counterrevolution," American Economic Review 61 (May), pp. 1-14.
John Maynard Keynes (1923), A Tract on Monetary Reform (London: Macmillan).
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Money (London: Macmillan).
Don Patinkin (1972), "Friedman on the Quantity Theory and Keynesian Economics,"
Journal of Political Economy.
Lionel Robbins (1934), The Great Depression (London: Macmillan).
David Romer (2000), Advanced Macroeconomics 2nd ed. (New York: McGraw-Hill).
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the Recovery Program (New York: McGraw-Hill, 1934).
Joseph Schumpeter (1939), Business Cycles (New York: Macmillan)
