Noah Smith Fumbles Argument, Endorses Post-Keynesian Endogenous Money Theory


Economists say the darnedest things sometimes. They often say things that are factually inaccurate. Noah Smith put his foot in it recently when he claimed in a Bloomberg article:

It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.

Now, this seems odd to me. In the article he notes that Post-Keynesians and Austrians do in fact think that credit fuels economic growth. Given that many of these economists hold academic positions and publish in academic journals are we to assume that they are not among academic economists? We will give Smith the benefit of the doubt here and assume that rather than belittling his colleagues he is simply a fuzzy writer who would do well sharpening his sentences before professional publication.

But when I read that I thought it more than a bit curious. After all, don’t monetarists believe that in the short-run economic growth is dictated by the growth in the money supply? Hey, don’t take my word for it, here is Milton Friedman himself in his article famous ‘A Theoretical Framework for Monetary Analysis‘:

I regard the description of our position as ‘money is all that matters for changes in nominal income and for short-run changes in real income’ as an exaggeration but one gives the right flavor to our conclusions. (p217)

Or, if that isn’t clear enough for you try this quote from his paper co-authored with Anna Schwartz ‘Money and Business Cycles‘:

There seems to us, accordingly, to be an extraordinarily strong case for the propositions that (i) appreciable changes in the rate of growth of the “stock of money are a necessary and sufficient condition for appreciable changes in the rate of growth of money income; and that (2) this is true both for long secular changes and also for changes over periods roughly the length of business cycles. (p53)

Now, we must assume that Smith — being an academic economist — knows the formula for money supply growth. For those readers outside the citadel of academic economics here it is:

Growth in £M3 = Public sector borrowing – non-bank purchase of government debt + bank lending to the private sector + net external private sector inflow – increase in non deposit liabilities of banks.

You see those highlighted terms? Yeah… those would be credit growth. And since the monetarists thought that growth in M3 fueled — and, indeed, caused — real GDP growth in the short-run and nominal GDP growth in the long-run we can only conclude that credit does indeed fuel economic growth in monetaristland. Indeed, it even causes economic growth for the monetarists.

But here is where it gets even weirder: New Keynesians also believe that credit fuels economic growth! One of the defining features of New Keynesian economics is that it believes money is non-neutral in the short-run. You don’t have to be an ivory tower academic economist to figure this out either. You could just check the Wiki page for ‘New Keynesian economics’ which states in no uncertain terms:

New Keynesian economists fully agree with New Classical economists that in the long run, the classical dichotomy holds: changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Furthermore, some New Keynesian models confirm the non-neutrality of money under several conditions.

This is what led leading New Keynesian economist Greg Mankiw to state that New Keynesian economics should more properly be called ‘New Monetarist’ economics. You see, if money is non-neutral in the short-run then money growth does fuel real GDP growth in the short-run. And if the key component of money supply growth is credit growth then it follows that credit growth fuels GDP growth in the short-run for New Keynesians! This is all basic stuff that is given on undergraduate macro exams. How on earth can an academic economist like Smith get it so shockingly wrong!?

Well, actually if we examine his article carefully we see that Smith is just not writing clearly and that is what is leading to his confusion. He writes:

Here’s an alternative idea: Maybe credit is a follower, not a driver, of the boom-bust cycle. Maybe credit grows when the economy is growing, because of the need to finance investment, and shrinks when the economy is shrinking, because of the lack of investment. In retrospect, looking at a chart of credit growth vs. GDP growth, it might look like credit caused the cycle, but in fact it was just a passive tag-along.

Um… what!? Smith said earlier that academic economists “don’t instinctively believe in credit-fueled growth” but what he is talking about here is clearly… credit-fueled growth. That is, the growth is caused by other factors and fueled by credit! A car is fueled by petrol but driven by a driver. I am fueled by carbohydrates absorbed through my digestive system but my actions have something to do with mad electrical stuff going on in my brain. Smith’s writing is deeply and chronically confused. He has completely fumbled his entire argument by confusing the terms ‘to fuel’ and ‘to cause’. ‘To fuel’ is not ‘to cause’.

Interestingly, the argument that credit fuels growth but that growth is determined by other factors  like, as Smith says, “productivity changes, or changes in monetary policy, or changes in people’s sentiment and animal spirits” is the Post-Keynesian endogenous money argument. Here is a crystal clear statement from Post-Keynesian endogenous money theorist Basil Moore’s classic paper ‘Unpacking the Post-Keynesian Black Box‘:

The evidence suggests that the quantity of bank intermediation is determined primarily by the demand for bank credit. (pp538-539)

There you have it: the roots of Post-Keynesian endogenous money theory where credit/money is an endogenous variable. This is in contrast to, say, the ISLM where money/credit is an exogenous variable.

Smith is confused because, like most mainstream economists, he doesn’t know what he believes any more. Many of these people, for example, believed that the QE programs would drive (not fuel!) economic growth. But they were sorely mistaken. Now you see them fumbling around in the dark. Fortunately, they are arriving at the conclusions that heterodox economists arrived at decades ago. Welcome to the club, Noah, and please try not to insinuate that those academics who came to your own conclusions 40 years ago are not to be included under the heading ‘academic economists’. You may just be being fuzzy in your use of the English language but if this discussion has taught us anything it is that such fuzzy use of language can lead to substantial conceptual confusion.


About pilkingtonphil

Philip Pilkington is a macroeconomist and investment professional. Writing about all things macro and investment. Views my own.You can follow him on Twitter at @philippilk.
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5 Responses to Noah Smith Fumbles Argument, Endorses Post-Keynesian Endogenous Money Theory

  1. I think part of the confusion comes from the common supply side argument that credit does drive growth, and which doesn’t get addressed nearly enough imo considering the last decade. While your explanation really clarified the point, we still have to deal with the fact that a large portion of policy makers are making decisions under the assumption that monetary policy is enough, as clearly shown by the anemic fiscal response to the financial crisis. I’ll take any push back against that idea I can get, even when it is a little muddled.

    • Yes, the confusion comes from the fact that Smith is fighting with shadows — in this case, the shadows of monetarism and the ISLM. He then, rather hilariously, names these shadows “Post-Keynesians and Austrians”. The level of scholarship among contemporary mainstream economists would be absolutely hilarious if it were not so disheartening.

  2. Ben Johannson says:

    Also demonstrates the incoherent New Keynesian thinking on inflation, where they almost always assume it is a monetary phenomenon despite their claim to fully understand endogenous money and its implications.

  3. BJ says:

    “It seems like the only people who don’t instinctively believe in credit-fueled growth are academic economists.”

    Without knowing the context, it seems like you’ve made a logical error in your understanding of what he said. He didn’t say they were mutually exclusive sets. He just said that the only set of people not entirely contained within “those who instinctively believe in credit-fueled growth” are academic economists. This does not exclude the possibility of some academic economists having this instinct.

    “…the only people who aren’t misguided about economics are economists.”

    This doesn’t mean that there are no misguided economists.

    • Cute.

      The sentence construction implies that the group “academic’ economists” (X), “don’t instinctively believe in credit-fuelled growth” while every other group (not-X) does. Therefore if you believe in credit-fuelled growth then you are not an academic economist (X), rather you are something else (not-X).

      Of course, without trying to analyse prose in such a rigid manner you could just read the rest of the article and see that this is exactly what Smith is getting at.

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