How to Approach the Problem of Inflation in Economics


In my previous post I laid out why the Phillips Curve theory of inflation is wrong and why it was misguided to try to rebuild it. The key point I made in that regard was that inflation is a complex, multifaceted historical process and any attempt to reduce it to some abstract timeless law would always end in failure and confusion.

In this post I hope to address how the problem of inflation should be approached. In doing so I will draw on the excellent and under-read 1983 book by Wynne Godley and Francis Cripps Macroeconomics. This book led to the stock-flow consistent models that were put forward in Godley and Lavoie’s book Monetary Economics. I actually think that the 1983 book is a better guide for working economists (which is not to diminish the latter achievement). The models in it — if we can even call them models — are far more open-ended than those put forward in the Godley and Lavoie book.

In the book Godley and Cripps spend a lot of time on inflation and inflation accounting. The beginning of the chapter on inflation gives a good idea of the approach the authors take in the book which is an approach to macroeconomics that I would fully endorse. They write:

Our main concern is with logical accounting relationships which constrain what can happen without fully determining what will happen. (p169, Emphasis Original)

They do make some behavioral assumptions in the chapter but these are always highlighted as being rather arbitrary. The key is to understanding the mechanisms through which inflation is generated and what happens when these mechanisms are activated.

The authors focus mainly on wages, interest charges, profits and taxes and how these feed into inflation. It is important to note that these are rather different issues to those I dealt with in my last post. In my last post I tried to highlight some of the general types of inflation, of which I argued there were four. What Godley and Cripps are doing is highlighting the mechanism through which inflation feeds into the price system.

It is a fantastic approach and must be read in the original to be appreciated. It shows that the inflation process is one that is essentially distributional. When it occurs it manifests as various groups in society — governments, workers, capitalists and rentiers — vying to keep intact or even increase their purchasing power. Godley and Cripps summarise as such:

Each component of prices can be regarded as a claim on real income. We have portrayed inflation as a self-perpetuating process of adjustment which occurs when these real claims are mutually inconsistent. No single component — wages, interest, profits or taxes — can be regarded as causing the inconsistency by itself. (p215)

The authors use a framework that deploys the hypothesis of indexation. That is, the assumption various agents might bid up their share in line with rising prices. The extreme inflationary case then becomes one in which every component is fully indexed in which case inflation becomes infinite (hyperinflation), while the extreme non-inflationary case is the one in which there is no indexation and every component does not respond to a rise in prices at all. The authors write:

We have given no theory at all about what determines the various real claims. Instead we have concentrated on the process by which they are reconciled. If all components of prices were fully protected against this process (fully indexed) inflation would be totally unstable, accelerating rapidly and indefinitely whenever the real claims were inconsistent. The fact is that inflation is not so unstable from year to year despite substantial exogenous shocks from changes in tax rates, government incomes policies, interest rates and — in open economies — prices of imports and exports. The observed element of stability in inflation tells us that indexation is by no means complete and therefore that at least some real incomes are vulnerable to inflation. (p215).

This is a fascinating approach and one that I think should be promoted by every ‘real world’, reality-based economist. It sets up a framework through which we can actually study inflation in the real world. In doing so it sidesteps the need for some sort of silly General Theory of inflation that holds good across time and space. The authors note this explicitly when they write:

We very much doubt whether any purely economic theory can ‘explain’ the rate of inflation or indeed whether it is fruitful to seek any general explanation. (p215).

Heterodox economists arguing with orthodox economists like Tom Palley would do well listening to this pearl of wisdom. Because trying to build a ‘model’ that explains inflation is likely to lead up a dark alley and it will come back to haunt the builder when an inflation that it cannot explain takes place.

Now, if we can just get Godley and Cripps’ book reissued! I note that the paperback version is currently selling on Amazon used for over £68. In the future I might look into approaching some people to suggest a reissue. It would be very timely indeed.


Posted in Economic Policy, Economic Theory | 2 Comments

The Phillips Curve: Timelessly Misleading


Tom Palley has written a blog post politely requesting that Paul Krugman might give a bit of recognition to non-mainstream contributors to economics. It would be nice to see this happen but I doubt that it will (although Palley is getting a bit of blog play out of it which is nice). Anyway, I note that in the post he links to a discussion him and Krugman had regarding the Phillips Curve. Before I get to the arguments put forward here let us examine the Phillips Curve in some detail.

The curve was an empirical relationship that the economist William Phillips found in 1958. Phillips noted that movements in wages and unemployment were negatively correlated in the UK between 1913 and 1948. The neo-Keynesians then picked up on this and argued that there would be a negative relationship between unemployment and inflation. They figured that wages were the key driver of inflation and that, since unemployment was the key driver of wages, then it must be the level of unemployment that must drive inflation.

It was quite a heroic leap by the profession to formalise a General Law from a total of 35 observations, but formalise they did. After all, it was a neat theory and economics at this time was trying to emulate the hard sciences. Well, the Phillips Curve didn’t work so well over the next half century. Here is a scatterplot diagram with a fitted curve showing the relationship between unemployment and wages in the USA from 1947-2014 (all data from FRED).


Now, if we saw a negative correlation — that is, if inflation rose as unemployment fell — we would expect to see a strong downward-sloping relationship. Actually the relationship is slightly upward-sloping meaning that inflation more so increased when unemployment increased. We also see a very low R-squared which can also be seen by how far off the line the various datapoints are. In English: there is no firm relationship here and the extremely weak relationship we do find runs in the opposite direction to what the Phillips Curve would predict.

So much for Phillips Curve theory. But what about the relationship between unemployment and wages? After all, this is what Phillips himself tried to show. It was the neo-Keynesians that came after him that tried to generalise based on his observations.


Well, here we at least see a somewhat negative relationship, albeit extremely weak. But we see an even lower R-squared. Basically it seems that the relationship between wages and unemployment in this period is pretty chaotic. In English: again, this is bunk; the sought after relationship does not exist.

Is this all hopeless then? Can we say nothing about inflation at all? No, all is not lost. There is one relationship that does hold firm: namely, that between wages and inflation.


Ah, there we go! There is a nice strong relationship between wages and inflation. When wages rise, inflation tends to rise. This, however, does raise the question of causality. After all, it could be that rising inflation leads to rising wages. Or it could mean the other way around. Frankly, we cannot say.

Indeed, I would be very hesitant to make any generalisations here. Sometimes inflations are wage-led. But sometimes wages rise in response to other sources of inflation. Every inflation must be studied in its particularity. Trying to generalise abstract laws that mimic laws in engineering or hard sciences is just stupid and will just lead up a blind alley.

This brings me back to Palley’s post. He notes that the mainstream have basically tried to solve this problem by incorporating expectations. If workers expect inflation they will bid up wages and so on. This is obvious nonsense and will not lead anywhere at all. If, for example, workers were heavily unionised and radicals got control over the unions we could easily imagine them just bidding up wages no matter what they thought inflation might be. They would just be doing so in order to get more of the economic pie. It is not like this has never happened before in history (*cough*, Allende in Chile, *cough*).

Palley is more realistic in this regard when he writes:

In my view, the real issue is the extent to which inflation expectations are incorporated into wage behavior. Workers may have absolutely correct expectations of inflation but not incorporate them into nominal wage demands because of job fears. (My Emphasis)

Here Palley hints at the fact that there is an aspect of social power to the bargaining process. Hence, if workers fear getting fired they might not try to bid up their wages. But once you open this box it is pretty hard to close. The power dynamics of worker bargaining are enormously complex and require historical and institutional nuance. Palley appears to instead fall back on the idea that bargaining power depends on unemployment — that is, that workers will bid up wages when there is low unemployment. But, as we have seen above, this position does not have empirical support.

In reality power dynamics are complicated and need to be studied in and of themselves. There are also many different types of inflation, as John Harvey has noted elsewhere in an excellent piece. In my forthcoming book I note four key types of inflation. These are as follows:

  1. Demand-pull inflation.
  2. Cost-push inflation.
  3. Speculative inflation.
  4. Exchange-rate inflation.

In laying out a Phillips Curve, or any other contraption, we are likely to only capture one type of inflation. Indeed, in the case of the Phillips Curve we only capture one sub-type of one type of inflation — namely, a sub-type of cost-push inflation (wage inflation). This does not lead to cogent thought. Given that Palley is in a dialogue with Krugman it might be worth pointing out that the latter has extremely crude views on real-world inflation which I have noted before. In subordinating one’s thoughts to a contraption one always runs the risk of blocking out the real-world.

Why is it so controversial to make this point? Why do we have to try to form a single theory of inflation? Why is it that a theory is only valid when it has been laid down in black and white form in a model? After WWII the profession tried to formulate a General Law of inflation. It was a disaster. Why on earth would we want to try to do this again? If economists — especially Keynesians — have not yet grasped that history will melt their attempts at timeless construction, they learned nothing from the lessons of the 1970s.

But that comes back again and again to that old timey question: why does every aspect of economic theory need to be cast in terms of a model? Sometimes modelling clarifies thought, but sometimes it obfuscates it. Inflation is such a complex, historical phenomenon it is definitely one that is obfuscated by modelling. So, why the need for models? Frankly, I think it is on those that build them to justify this, not on me to engage in conjecture in criticising it.

Posted in Economic History, Economic Theory | 20 Comments

Murray Rothbard, Edmund Burke and Intellectual Myopia


There is nothing so sad as to watch someone mistake a parody of his character for a complement. I suppose there are three ways to respond to people having fun on your behalf. The first, and most endearing, is to accept the joke for what it is and laugh along with it. The second, and rather less endearing, is to get very mad at the person making the joke. The third, and obviously the worst, is to think that the joker is actually praising the less than praiseworthy aspects of your character.

Murray Rothbard — a somewhat silly and all-round angry man — strikes me as someone who would often respond to parody in the vein of a certain méconnaissance, thereby reenforcing and doubling the original parody. Typical of this is Rothbard’s crowning achievement of Burkean scholarship ‘A Note on Burke’s Vindication of the Natural Society‘.

The short essay deals with the Irish conservative philosopher Edmund Burke’s essay ‘A Vindication of the Natural Society‘. In the essay Burke tries to show that the criticisms levied against the Church and against organised religion could easily be turned against any and all social institutions. He tries to show this by engaging in biting satire of the type that was the hallmark of Irish intellectuals of the day — a style that could also be found in Jonathan Swift and George Berkeley.

The object of his satirical irony is Lord Bolingbroke. Bolingbroke was an English statesman and writer. He had an enormous influence at the time but a perusal of his writings shows them to rather shallow and poorly strung together. They used a rhetorical strategy to debunk religion that is still popular today: basically, you chronicle all the evils of the world and then pin them on religion. Burke’s satirical genius was to use this same rhetorical strategy against the institution of government; something that Bolingbroke held quite dear. The idea here is to show up the vacuity of the rhetorical strategy by demonstrating that it could be applied to basically anything.

It is well-known that Burke’s essay was a satire. At the time some mistook it for being serious. But Burke quickly pointed out that it was a joke. Rothbard, however, thinks that Burke was just trying to cover up his true motivations. He writes:

A less conservative work could hardly be imagined; in fact, Burke’s Vindication was perhaps the first modern expression of rationalistic and individualistic anarchism…  Careful reading reveals hardly a trace of irony or satire. In fact , it is a very sober and earnest treatise, written in his characteristic style. (p1)

Of course, it is well-known that Burke’s essay is not “written in his characteristic style” at all. As I have already said, Burke mimics Bolingbroke’s style in the essay. Because Burke published pseudonymously many critics of the day actually thought that the work was by Bolingbroke. This was part of the joke. But this is completely lost on a man so blind to what he does not want to see as Rothbard.

So, why does Rothbard read it as being serious? Simply because he cannot see what more sophisticated readers can: namely, that Burke’s arguments are so obviously ridiculous. You see, Rothbard is a sort of self-parody. He makes extremely poor, emotionally-driven arguments of the sort that Burke parodies. He takes an institution — namely, the state — and then highlights all that is negative about it. He never tries to take a balanced view because such a view would undermine his extreme black and white worldview. Such a worldview is characterised by what psychologists call ‘splitting‘. That is, dividing the world up into purely good and purely evil entities and then spending one’s time attacking the evil entities and upholding the good. When Rothbard was confronted with a parody of this he simply could not deal with it. He is wholly unable to take an ironical view of himself because such psychological processes block out irony altogether.

So why is it that Burke’s parody was obviously ridiculous in his own time but today does not seem so ridiculous to some intellectuals? I think the answer to this is obvious: intellectuals today no longer hold the power in society that they held in the past. Men like Burke and Bolingbroke actually had to hold power. They had to engage in the day-to-day processes of government. Men like Rothbard, on the other hand, do not hold any responsibility at all. They thus display a sort of teenager-like immaturity. They wrap themselves in Utopian fantasies and hide themselves from the world.

While the more extreme variations of this tendency manifest in the anarcho-capitalism of Rothbard, less extreme variations can be found across the humanities today in various forms. Much of contemporary economics displays the same childish naivety, minus the Good-versus-Evil psychological splitting. Only in a few disciplines, such as Law, does academia remain directly tied to the real world. This is very sad and accounts, I think, for the stagnation of political society that we see today. Society cannot move forward because those that are supposed to generate new political ideas are disengaged from the political process. This is giving rise to somewhat worrying tendencies in, for example, Europe today.

Knowledge thus becomes a sort of simulation of knowledge. It unmoors itself from reality and floats off into the ether. The last time we saw something this extreme was probably in the Middle Ages when the Scholastics ran the academies. Then too the process gave rise to a sort of static society where nothing moved and nothing changed. Out of this comes pure power-grabs by those who can manage it. This, again, is what we see today; and this accounts for much of the income inequality and so forth. Faced with this radicals can read Rothbardian fantasies, while non-radicals can do problem sets on expected utility or some other such nonsense. Meanwhile the political situation in Europe deteriorates rapidly and everyone braces themselves for the political turmoil that will be unleashed when the financial system melts down once more.

Update: Someone has said that I should give an example of Burke’s essay that clearly shows his humorous intentions. Here is one of my favourites (again, note that Rothbard actually read this thinking it to be “sober and earnest”):

How far mere Nature would have carried us, we may judge by the Examples of those Animals, who still follow her Laws, and even of those to whom she has given Dispositions more fierce, and Arms more terrible than ever she intended we should use. It is an incontestable Truth, that there is more Havock made in one Year by Men, of Men, than has been made by all the Lions, Tygers, Panthers, Ounces, Leopards, Hyenas, Rhinoceroses, Elephants, Bears, and Wolves, upon their several Species, since the Beginning of the World; though these agree ill enough with each other, and have a much greater Proportion of Rage and Fury in their Composition than we have. But with respect to you, ye Legislators, ye Civilizers of Mankind! ye Orpheuses, Moseses, Minoses, Solons, Theseuses, Lycurguses, Numas! with Respect to you be it spoken, your Regulations have done more Mischief in cold Blood, than all the Rage of the fiercest Animals in their greatest Terrors, or Furies, have ever done, or ever could do!

Posted in Philosophy, Politics | 4 Comments

Meanwhile, in the Meeja


I have written a piece for Al Jazeera on Janet Yellen’s recent comments on specific asset markets. This is a big turning point for the Fed but it leads to major contradictions in their policy goals.

Fed’s targeting of asset bubbles leads to contradictions

I would also encourage readers to take a look at the following article in which David Levy — head of Levy Forecasting which is the only firm in the world that uses the Levy-Kalecki profit equation for forecasting purposes — predicts a recession in the US next year. The Levy crowd are some of the best forecasters in the world and they are definitely worth paying attention to. I am going to try to get in contact with David to find out more about this forecast as it could be a very big deal — both from a policy perspective and an investing perspective.

Doom and gloom: 2015 global recession warning from financial seers of the century

Posted in Market Analysis, Media/Journalism | Leave a comment

Financial Markets in Keynesian Macroeconomic Theory 101

class insession

Yesterday when I published my post on Krugman and the vulgar Keynesians not understanding the meaning to the term ‘liquidity trap’ I came to realise that many readers — both sympathetic and hostile — do not really understand the Keynesian theory of financial markets. I then realised that this was actually quite understandable given that it is not much discussed today (with some notable exceptions such as Jan Kregel and Minskyians like Randall Wray).

Some years ago the financial markets were very much so discussed and understood. Key references in this regard are the works of Keynes himself (particularly the Treatise on Money), GLS Shackle, Roy Harrod’s book Money and Joan Robinson’s essay ‘The Rate of Interest’. There are also some more minor works but I will not here provide a bibliography. (From a purely theoretical point-of-view I have found Shackle’s work the best while from an institutional point-of-view I have found Harrod’s work best).

Okay, let’s first start by what we mean by ‘cash’ and ‘bonds’ in Keynesian financial theory. Most people are being led down a wayward path by the likes of vulgar monetary economists like Krugman in this regard (or was he a trade economist? someone remind me…). They seem to think that ‘cash’ is money — deposits, notes, coins, that sort of thing — and ‘bonds’ are government securities. Actually, in financial marketspeak cash includes short-term government securities. It also includes money market funds and other highly liquid investments. There is a nice guide to this at the money manager Charles Schwab’s website here. In this guide the author writes:

What is cash?

Many people think of cash as physical currency—actual bills and coins in circulation. For practical purposes, however, the term “cash” also includes traditional bank deposits, such as checking and savings accounts, where you generally have access to your funds on demand and without risk of losing any principal (up to FDIC limits).

In an investment context, however, the definition of cash expands to other types of cash investments, including short-term, relatively safe investment vehicles such as money market funds, US Treasury bills (T-bills), corporate commercial paper and other short-term securities.

For the purposes of financial macroeconomics I think that we would be best to exclude corporate commercial paper. This is very short-term debt issued by corporations. Although highly liquid, it nevertheless displays many dynamics associated with what should properly be called ‘bonds’. I would also say that, following the Modern Monetary Theorists (MMTers), we should probably be clear that government securities should only be treated as cash proper if they are denominated in the currency of issuance. (For practical purposes we can modify this when needed).

What about stocks? Stocks are unusual in that they do not yield a rate of interest. Yes, they throw off dividends but this is not the same thing. The rate of interest on bonds is inversely related to the price of the same bonds. When the price rises, the rate of interest falls. When the price falls, the rate of interest rises. On stocks, however, this relationship is by no means clear. Dividends are a completely different beast. Nevertheless, we can count stocks as ‘bonds’ to a large extent if we remember that they do not have the same interest rate dynamics. Stocks are generally expected to rally when the price of actual bonds is high and their interest rates low.

Now this might seem rather odd because we all know how central banks control the interest rate, right? When the central banks want to lower the interest rate they buy up government securities, while when they want to raise the rate of interest they sell government securities and drain reserves. But if government securities are counted as ‘cash’ this really makes no difference. What the central bank is trying to do is to use cash and cash substitutes (government securities) to affect the interest rates in other markets.

The primary goal of, say, lowering the interest rate is to allow companies to borrow more cheaply. Here is a nice graph showing some interest rates to get a feel for what is going on in the financial markets. We will examine this in more granular detail later.


As we can see, the three-month Treasury bill rate tracks the overnight rate set by the Fed. This is because these are basically cash substitutes. The Corporate Baa Bond Yield, on the other hand — and this is only one of many interest rates I could have chosen — does track the other two to some extent but not completely. Although it generally gravitates toward the overnight rate it does display some independent dynamics of its own.

The gap between the yield on bonds and the ‘cash’ interest rate — to deploy our terminology — is a measure of what Keynes called ‘liquidity preference’. It reflects the market’s taste for low yield ‘cash’ over higher yield ‘bonds’. Let us be clear: in a functioning market there will always be a spread here to reflect relative risk. But, as we shall see, this spread is not fully under the control of the monetary authorities at all times and the amount by which it fluctuates day-to-day and month-to-month is reflective of liquidity preference. Schwab provides us with a nice table telling their customers how to hold this ‘cash’ liquidity.


Very broadly speaking we can say, in Keynesian terms, that checking, saving (and deposit) accounts are used for what Keynes called the ‘transactions motive’. While all the others are used for what he called the ‘precautionary motive’ and the ‘speculative motive’.

Let us zoom here on a recent period to get a better idea of what is going on.


Here I have marked two recent periods where we see financial markets clearly responding to increased perceived risk. Looking at the time series we see that the Baa Corporate Bond Yield follows the overnight rate quite smoothly. But just prior to the 2001 recession while there was turmoil in the stock markets we see a clear, small spike that is not in keeping with the general smooth movement. This spike accounts for a jump in interest rates on Baa bonds of nearly 0.5%. This may not seem all that significant but in the land of the financial markets it is a very significant event and is indicative of heightened liquidity preference.

The second period I have marked is much more extreme. Here the Fed was rapidly lowering interest rates. Markets were anticipating this lowering too. Yet the Baa bond yield spiked by two full percentage points. This is a liquidity trap proper. The market were roiled by the turmoil that was taking place after 2008 and they all rushed for cash even though the interest rate on this cash was falling. By 2010 the liquidity trap had subsided. This was mainly in response to the markets coming to believe that the bailouts were convincingly going to fix the financial system. TARP did more to ease the liquidity trap, I would argue, than QE did.

Well, that’s all for today class. Use this knowledge to go out and attack the vulgar Keynesians that are clogging up the general discourse with poorly defined terms and nonsense. Today we do not face a liquidity trap. Rather we face a situation in which investment is not responding to low interest rates. That is what vulgar ISLMist Keynesians call an ‘investment trap’ and it takes place when the IS-curve on the ISLM diagram is vertical. While I do not buy into this notion it is far closer to where we are today than being in a liquidity trap. If one must worship at the temple of ISLM at least get it right, for God’s sake!

Posted in Economic Theory, Market Analysis | 20 Comments

Paul Krugman Does Not Understand the Liquidity Trap


I came across a very amusing piece from Krugman in 2010. The piece is entitled ‘Nobody Understands the Liquidity Trap‘. Actually, Krugman might have a point — if we include him in the ‘everybody’ that does not understand the liquidity trap and thus conclude that he, and all those that listen to him, do not understand the liquidity trap.

You see Krugman confuses the zero-lower bound for the liquidity trap. But in doing so he completely scrambles the meaning of the term ‘liquidity trap’. Let us first get a feel for meaning of the term ‘liquidity trap’. Here is Keynes in the original. In the General Theory he writes:

There is the possibility… that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest.

So, a liquidity trap is a situation when the central bank pumps in money and the rate of interest doesn’t respond. People say: “Meh, I don’t like the look of those bonds, I’ll just hold this cash”, and so bond prices remain low.

Krugman, on the other hand, has completely confused two concepts — that of a zero-lower bound scenario and a liquidity trap. You can see this clearly in his 1998 paper where he writes:

A liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. (p141)

Um, no. A liquidity trap is when people say “nah, I don’t want bonds, I want money”. It is a situation in which the rate of interest on bonds do not respond to an increase in base money. Let us be clear: in a liquidity trap people do not want to hold bonds. In a liquidity trap cautious investors spit bonds back onto the market, their prices fall and their yields rise.

It is thus obvious that a liquidity trap occurs when the rate of interest gets ‘stuck’ and does not respond to an increase in base money. As I have argued before, we saw this in 2009-2010 when interest rates on risky assets failed to respond to Fed intervention. But we do not see this today. The central bank have not today, as Keynes puts it, “lost control over the rate of interest”. After 2009 interest rates came down across the board in response to actions by the central bank. Today it is well-known to even the most myopic mainstream economist that we live in a low yield environment.

What we do see is a zero interest rate. But that is just a zero interest rate. It is not a liquidity trap. We know this because bonds are still very much so in demand. Whereas in a liquidity trap people want to hold money instead of bonds. That is not the case today. Today people are desperate to get their hands on bonds because holding money is eroding their portfolios due to the substantial negative yield being incurred. But in a liquidity trap, as Keynes says, “almost everyone prefers cash to holding a debt”.

Let’s just get that straight: the key symptom that indicates that there is a liquidity trap is that people want to hold cash instead of bonds. Let me state that one more time in a different way: a liquidity trap is when there is a panic across financial markets, people rush to cash and no matter how much cash the central bank issues the demand for financial assets remains depressed.

Last week Janet Yellen said that she was concerned that people were too eager to hold junk bonds. And here are Krugman and the New Keynesian brigade telling us we’re in a liquidity trap. It is completely absurd. What has occurred is that monetary policy has failed to revive the economy. That’s a sad day for mainstream economists who have believed for over three decades that monetary policy is a panacea. But it is still not a ‘liquidity trap’. That term has a specific meaning. It is useful. Equating it with the central bank setting the interest rate near zero is equivalent to destroying the term and sucking it of its meaning.

It gets worse when you think this through in more detail. Recall that for Keynes a liquidity trap is when “the monetary authority would have lost effective control over the rate of interest”. But have the monetary authorities lost control over the rate of interest at the zero bound level? Nope. Anyone who has actually read Keynes’ great work knows that in it he discusses Silvio Gesell’s ‘stamped money’ which would be an obvious way for the monetary authorities to impose negative interest rates of their choosing. Keynes writes:

According to this proposal currency notes (though it would clearly need to apply as well to some forms at least of bank-money) would only retain their value by being stamped each month, like an insurance card, with stamps purchased at a post office. The cost of the stamps could, of course, be fixed at any appropriate figure.

(There are quite a few variations on this idea some of which I’ve noted before — although I’m not very enamored with the idea).

So even by the simple criteria of whether the monetary authorities have lost control over the interest rate it is obvious to any reader of the General Theory that they have not. No liquidity trap here folks!

Now, I know the response to this. “Ugh! You read too many books Phil! Reading books is for humanities students! I’m an economist, I do maths and stuff and I’m a really super serious sort of person that only cares about economic theorising, I don’t care what Keynes said or what other books say, I only care about Science,” says our typical mainstream economist.

Well, this is the thing: the actual concept of a liquidity trap is a very useful tool when applied to understanding financial markets; especially when they go into meltdown. Minsky, for example, uses it at critical points in his work. Meanwhile the Krugmanians deploy it as a fancy sounding word for what is a simple and banal concept: zero interest rates. They use it to give authority to the fact that their economic theory today ultimately says “the Fed can’t lower interest rates past zero therefore we cannot rely on them to revive the economy” which is so flagrantly obvious a monkey could have come up with it — indeed, those who have read Chapter 23 of the General Theory  on stamped money know that this statement is not even true and that our simian pal would be wrong.

“Hey, I want to hide the fact that I’m saying something banal so I’m going to use this fancy-sounding word that is in Keynes and is related to the ISLM,” say the Krugmanians. I’m saying rather that we should define the concept of liquidity trap properly because it is a useful and interesting analytical tool, especially when trying to understand what happens in a crisis scenario when the demand for cash really rockets and the monetary authorities really do find that they have lost control over the price of financial assets (and, hence, interest rates).

Which usage is closer to a ‘scientific’ usage. Well, only you, dear reader, can decide that. But that decision will likely be informed by how good an understanding you have of actual financial markets and how they affect the macroeconomy. Let’s just say that economists like Minsky are a better guide than people hocking the ISLM, easily the crudest tool ever invented by a Keynesian monetary economist (Hicks himself, who became quite a good monetary economist after that particular car crash, later basically said this lest we need be reminded).

If you want to understand nothing about financial markets read Krugman and play with the ISLM, if you actually want to understand how financial markets work read Keynes, read Minsky, read Harrod, read Robinson — hell, read Hicks’ more advanced work on money and financial markets. Oh, but then you might have to open a book and actually read it rather than twisting clearly defined concepts to cover up the fact that you’re basically saying nothing beyond the fact that central banks have near zero interest rates. Terrifying prospect.

Posted in Economic Theory | 40 Comments

Can Lachmann’s Arbitrage Save the Austrian Theory of the Interest Rate?


This is the second part of my criticism of Glasner and Zimmerman’s paper. The first part can be found here and should be read and understood before proceeding with the second part. Glasner and Zimmerman note that Ludwig Lachmann tried to rescue Hayek’s theory by introducing market arbitrage. They quote Lachmann as such:

If there is a multiple of commodity rates, it is evidently possible for the money rate of interest to be lower than some but higher than others. What, then, becomes of monetary equilibrium? . . . It is not difficult, however, to close this particular breach in the Austrian rampart. In a barter economy with free competition commodity arbitrage would tend to establish an overall equilibrium rate of interest. Otherwise, if the wheat rate were the highest and the barley rate the lowest of interest rates, it would become profitable to borrow in barely and lend in wheat. Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say, steel, it is no more profitable to lend in wheat than in barley. (p15)

This seems to not be a criticism of Sraffa at all. The own rates of interest still differ it is just that the differences are perfectly reflective of the knowledge that prices will fall in the future as the market equilibrates. Lachmann says this explicitly when he writes:

This does not mean that actual own-rates must all be equal, but that the disparities are exactly offset by disparities between forward prices. The case is exactly parallel to the way in which international arbitrage produces equilibrium in the international money market, where differences in local interest rates are offset by disparities in forward rates. In overall equilibrium, it must be impossible to make gains by “switching” commodities as in currencies. (p15 — My Emphasis)

It is interesting to note that Lachmann is invoking the empirically untrue theory of Purchasing Power Parity (a critique can be found here), but let us ignore this for the moment. Anyway, the above quote is not a critique of Sraffa. This is exactly what Sraffa was arguing. What is so surprising is that Glasner and Zimmerman actually quoted Sraffa saying this four pages beforehand. Here is that quote again:

Suppose there is a change in the distribution of demand between various commodities; immediately some will rise in price, and others will fall; the market will expect that, after a certain time, the supply of the former will increase, and the supply of the latter fall, and accordingly the forward price, for the date on which equilibrium is expected to be restored, will be below the spot price in the case of the former and above it in the case of the latter; in other words, the rate of interest on the former will be higher than on the latter. (p11 — My Emphasis)

Remember that this is a quote from Sraffa that the authors themselves provide! Yet Glasner and Zimmerman nevertheless write:

In contrast, Sraffa’s critique of the (unique) natural rate can apply only under intertemporal disequilibrium, but not under an intertemporal equilibrium in which future prices are correctly foreseen. (p16)

I do not know what to make of this at all. Even if the future prices are correctly foreseen — that is, in the case of a so-called ‘intertemporal equilibrium’ — the interest rates on various commodities will change in relation to one another when changes in the distribution of demand (or changes in supply) cause price changes that will, in the future, call forth changes in the structure of production. Thus Lachmann’s defence appears to have arisen from a simple misreading of Sraffa! Sraffa had already put forward Lachmann’s defence as a criticism!

All that Sraffa is saying is that as The Market directs resources through time the interest rates on various commodities will change in order to shift resources in various directions (if corn is undersupplied the interest rate on corn will rise etc.). In such a case there is no unique ‘natural rate of interest’.

In his paper Sraffa makes this point directly when he points out that there will be no unique ‘natural’ rate on producers goods and consumers goods. They will each have their own ‘natural’ rate:

But in times of expansion of production, due to additions to savings, there is no such thing as an equilibrium (or unique natural) rate of interest, so that the money rate can neither be equal to, nor lower than it: the “natural” rate of interest on producers’ goods, the demand for which has relatively increased, is higher than the ” natural ” rate on consumers’ goods, the demand for which has relatively fallen. (p51)

This is what does the damage to Hayek’s theory. Thus, Sraffa says, we are on far safer grounds with Wicksell. Wicksell used a price index to understand what he meant by the natural rate. Sraffa notes this clearly and contrasts it with Hayek’s approach:

This, however, though it meets, I think, Dr. Hayek’s criticism, is not in itself a criticism of Wicksell. For there is a ” natural ” rate of interest which, if adopted as bank-rate, will stabilise a price-level (i.e. the price of a composite commodity): it is an average of the “natural ” rates of the commodities entering into the price-level, weighted in the same way as they are in the price-level itself. (p51)

This is what Lachmann also wanted to do. Which gives a further sense that he had not read the debate properly. Recall that he wrote:

Inter-market arbitrage will tend to establish an overall equilibrium in the loan market such that, in terms of a third commodity serving as numéraire, say, steel, it is no more profitable to lend in wheat than in barley.

But this approach, while obviously more coherent, is not without its own problems. As Sraffa points out there will still be no unique rate because there will be a different structure of interest rates for each numeraire chosen as the basis of our price index (note that Sraffa refers to the numeraire as the ‘composite commodity’).

What can be objected to Wicksell is that such a price-level is not unique, and for any composite commodity arbitrarily selected there is a corresponding rate that will equalise the purchasing power, in terms of that composite commodity, of the money saved and of the additional money borrowed for investment. Each of these monetary policies will give the same results in regard to saving and borrowing as a particular non-monetary economy-that is to say, an economy in which the selected composite commodity is used as the standard of deferred payments. (p51)

Sraffa then points out that, since the selection of the numeraire is arbitrary, we may as well have just introduced a monetary standard. He writes:

It appears, therefore, that these non-monetary economies retain the essential feature of money, the singleness of the standard; and we are not much the wiser when we have been shown that a monetary policy is “neutral” in the sense of being equivalent to a non-monetary economy which differs from it almost only by name. (p51)

And so we are back to a monetary economy. The problem then becomes: what is the interest rate on money? Introducing money at different interest rates will have different effects on the interest rates on various commodities. If I open a bank in a barter economy and set the rate of interest equal to 2% the structure of interest rates that pertain across the economy will be very different to the structure of interest rates that pertain across the economy if I set the rate of interest equal to 5% or 0%. In Wicksellian terms: we are now talking not about the ‘natural’ rate of interest but rather the money rate of interest.

Well, now we are at the point where we must ask what sets the interest rate on money. Keynes, who is arguing against Hayek, says that the rate of interest on money is determined by ‘liquidity preference'; that is, the desire on the part of people to hold liquidity as opposed to interest-bearing investments. Some economists complained that Keynes was therefore allowing the interest rate to ‘hang by its own bootstraps’. But after the above discussion we see clearly that it could not have been otherwise. The money rate of interest must necessarily be autonomous of the various commodity rates of interest and so it will be set arbitrarily vis-a-vis the market system. In the real world it might be set by the markets in line with their confidence-levels, by central banks in line with either their confidence-levels or in line with an internally incoherent ‘policy rule’ that they use to absolve themselves from the responsibility of making a judgement or possibly in line with some rather arbitrary law like the usury laws of the Middle Ages.

Before signing off on this issue I should note a point of historical interest: Karl Marx actually realised this point when he investigated the money markets in Das Kapital: Volume III. In Chapter 23, aptly title ‘Division of Profit. Rate of Interest. Natural Rate of Interest.‘, Marx wrote:

The average rate of interest prevailing in a certain country — as distinct from the continually fluctuating market rates — cannot be determined by any law. In this sphere there is no such thing as a natural rate of interest in the sense in which economists speak of a natural rate of profit and a natural rate of wages.

I’m not the biggest fan of Marx but he was way ahead of the curve here. Echoing Keynes’ theory of liquidity preference he quotes Joseph Massie who wrote:

The only thing which any man can be in doubt about on this occasion, is, what proportion of these profits do of right belong to the borrower, and what to the lender; and this there is no other method of determining than by the opinions of borrowers and lenders in general; for right and wrong, in this respect, are only what common consent makes so.

The rate of interest hangs by its own bootstraps or it does not hang at all. There is no alternative.



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