What is a ‘Long-Run Trend’?

Everyone complains about his memory, and no one complains about his judgment.

— François de La Rochefoucauld

In the comments to my post yesterday on monetarism the notion of the ‘long-run trend’ came up. A regular commenter ivansml insisted that monetarist theory ‘worked’ if you averaged the periods over five years. It does not — or, at least, it sometimes works and it sometimes does not; which means, to my mind, that it doesn’t work because either the monetarist ‘law’ holds or it doesn’t; science does not allow for a vague middle ground. But I want to focus more so on what is and what is not a ‘long-run trend’.

Mainstreamers like ivansml seem to think that you obtain a long-run trend by reducing the number of observations through some sort of averaging. So, if you have a monthly time series running over thirty years which yields 360 observations you reduce this to five year averages and thus obtain 6 observations instead. This is a bizarre concept of a long-run trend. It is widespread in the mainstream and, to my mind, just represents poor methodological understanding of what statistics say and do not say. When we average some data set and reduce the number of observations we do not obtain any new trend. Rather we just… reduce the number of observations.

The effects that this has on our conclusions will depend (a) on the particular structure of the data we are using, (b) on the averaging period that we choose — i.e. five years, two years, ten years etc. — and (c) on the year in which we start averaging — i.e. if I choose 1990 as my first observation for a three year average my data points will look different to if I choose 1991. Obviously all these effects are in some sense arbitrary — most especially the latter two.

Since (c) is perhaps the least intuitively obvious let us take a closer look at it. In the table below we have an arbitrary dataset. We have averaged over the course of three years. But in one column we have used 1990 as the starting point of the average and in the other column we have used 1991. Look at how different the results we get are!

This is why we typically try to get as many observations as possible when we do statistical work. We rarely, if ever, want to reduce the number of observations as this can lead us far astray. When we try to reduce the number of observations we can engage in manipulation even if this is not our intention. If we are not very careful we may find ourselves averaging the data in such a way as to produce the results that we a priori want to produce. I am of the opinion that this happens all the time in so-called empirical work in economics. Keynes seemed acutely aware of something similar in his famous critical work on Tinbergen when he wrote:

Although there may be many factors with different trends, there is only one trend line, and I have not understood the process by which this single trend is evolved. The use of rectilinear trend (in post-war years) means, apparently, that a straight line is drawn between the first year of the series and the last. The result is, of course, that it makes a huge difference at what date you stop. In the case of the United States (p. 56) the series runs from 1919 to 1933, which, as a result of the abnormal circumstances of the first and last years, involves the paradox that the United States was in a severe downward trend throughout the whole period, including the period ending in 1929, amounting in all to 20 per cent.; whereas if Prof. Tinbergen had stopped in 1929, he would have used a sharply rising trend line instead of a sharply falling one for the same years. This looks to be a disastrous procedure. Prof. Tinbergen is quite aware of the point. In a footnote to p. 47 he mentions that “the trend chosen for the American figures (post-war period) may be somewhat biased by the fact that the period starts with a boom year and ends with a slump year.” But he is not disturbed, since he has persuaded himself, if I follow him correctly, that it does not really make any difference what trend line you take. (pp565-566 — My Emphasis)

So, if we might be misled by simply averaging periods in order to arrive at ‘long-run trends’ what meaning can we ascribe this term? After all, it does seem intuitively plausible that ‘long-run trends’ exist. I think that they certainly do. But they are far vaguer than the marginalists seem to have in mind. Here is a long-run trend.

 

This trend states precisely this: “Over the 1,000 years from 1000AD to 2000AD, the population, measured in terms of men, women and children, rises at the same time as production measured in 1985 dollars rises”. That’s a trend. It’s long-run. It requires basically no statistical tomfoolery. It’s a long-run trend! It’s quite a humble trend and gives us no conjectural knowledge of any sorts of ‘laws’. It just is what it is: an historical long-run trend that may or may not continue into the future.

This is what we should mean by ‘long-term trend’. A long-term trend is a trend that appears to hold good over a number of years. It is not captured by some arbitrary process of averaging. That is likely just statistical tomfoolery that the researcher is tricking themselves with and magically obtaining results with after a long process of trial and error.

It should be mentioned that the old monetarists never, to my knowledge, tried this particular trick. What they instead did was they tried to say that there might be lags in how long it took for the money supply to affect prices. This allowed them to produce testable causal relationships. For example, they might say that a x% increase in the money supply would lead to a y% increase in inflation after a period of, say, 36 months.

While this is not nearly as bad data manipulation as reducing observations through arbitrary averages, it is not without its own problems. Again, such lagging can allow the researcher to alter the lags over and over until they find what it is they want. Keynes accused Tinbergen of precisely this in his famous criticism. He wrote:

The treatment of time-lags and trends deserves much fuller discussion if the reader is to understand clearly what it involves. To the best of my understanding, Prof. Tinbergen is not presented with his time-lags, as he is with his qualitative analysis, by his economist friends, but invents them for himself. This he seems to do by some sort of trial-and-error method. That is to say, he fidgets about until he finds a time-lag which does not fit in too badly with the theory he is testing and with the general presuppositions of his method. No example is given of the process of determining time-lags which appear, when they come, ready-made (cf. p. 48). But there is another passage (p. 39) where Prof. Tinbergen seems to agree that time-lags must be given a priori. (p565)

Historical statistics are a delicate beast and must be handled with care. Otherwise the researcher risks finding precisely what they wish to find in those columns of numbers. As the Bible says (Matthew 7:7): “Ask and it will be given to you; seek and you will find; knock and the door will be opened to you.” When in doubt — and we should always be in doubt handling historical statistics — clarity of thought and simplicity of assumptions are the only prophylactic against error. The idea of arbitrarily averaging a dataset to reduce the number of observations is murky in the extreme, hides more than it illuminates and is not at all clear in its assumptions. Lagging at least has the advantage of clarity. But it is clearly a practice that is very much so open to abuse.

Inflation is NOT Always and Everywhere a Monetary Phenomenon

Monetarism is a hoary old myth that does its damage in two distinct ways. The first is that, piggybacking on Milton Friedman’s personality, basically an entire generation of economists are actually monetarist in their practical thinking. Greg Mankiw once remarked that New Keynesianism should more accurately be called New Monetarism and a glance at the actual pronouncements of even the more self-critical the New Keynesians shows this beyond a shadow of a doubt.

The second way in which monetarism does its damage is what might be called ‘man-in-the-street-monetarism’. Man-in-the-street-monetarism is the knee-jerk reaction you get from people who have no training in economics (and some people who actually do but obviously weren’t paying close attention!) but who nevertheless read about economic matters and so forth. When they hear ‘money printing’ they instantly think ‘inflation’. This can interfere with conversations at dinner parties but it also infects the journalistic media. In its more extreme forms it leads people into economic cults like the neo-Austrian school that has become so popular on the internet after the financial crisis. These poor suckers are then sold gold and other dodgy investment vehicles by industry frontmen.

The essence of monetarism is in the transformation of an identity put forward in Irving Fisher’s classic 1911 work The Purchasing Power of Money into a supposed causal relationship. In that work Fisher laid out the following identity:

That equation reads: “The amount of money, M, multiplied by its velocity, V, is equal by identity to the sum of the quantity of goods and services purchased, Q, times the sum of their prices, p.” Note the clause “equal by identity”. The equals sign with an extra bar indicates that this is a tautological statement. It simply must be true. In the book Fisher discusses a number of ways in which this identity might hold. I think that while Fisher’s discussion was far more nuanced than the monetarists that grew out of the 1960s and 1970s it is nevertheless quite misleading. I lay out this argument in the chapter on money in my forthcoming book.

The monetarists proper converted this identity into a behavioral equation. This equation ran as follows and should be read running from left to right:

Note two things. First, the fact that we have converted the “equal by identity” sign into a standard equals sign. This implies causality running from left to right. So, the left-hand side of the equation causes the right-hand side. Secondly, we have placed ‘hats’ on the velocity and quantity variables. This implies that they are to be thought of as fixed. Thus the equation reads: “The sum of prices is equal to the quantity of money”. We understand the sum of prices here to be the Consumer Price Index (CPI).

Even when Friedman first came out with these statements they were showed to be empirically vacuous in the classic empiricist, anti-monetarist text The Scourge of Monetarism by Nicholas Kaldor. But today we have easy access to these statistics and can quickly run the relevant regressions. So, let’s see how monetarism fairs when confronted with the facts today.

First it should be noted that one peculiar feature of monetarism is its vagueness. When monetarist policies were implemented in the late-1970s and early-1980s and did not have the intended effects, monetarist economists began to cast doubt on the measures being used to calculate the money supply. Any time the policy didn’t work the economists would say that the central banks were not measuring the money supply properly. This is a classic use of theoretical argument to immunise marginalist economic theories against empirical criticism and was a tendency much discussed by the neo-positivist philosopher Hans Albert. For this reason we will include three key measures of the money supply — M1, M2 and M3 — and plot them against the CPI to give the theory the best possible chance to come to empirically verifiable conclusions. All the data that follows comes from FRED and the years chosen are based on availability.

Let us first lay these out in a standard graph form to see if we can intuitively spot any correlation. All graphs measure percentage changes year-on-year of both variables mapped. The reader can click on the image to enlarge it.

Oh dear, oh dear. Typically we should be able to pick up any correlation intuitively but in the above graphs — which represent all the data that FRED provides on the various money supply measures — we really do not see much to be hopeful for. Nevertheless, let us run some simple regressions to see if there is a correlation hiding in plain view that our all-too-human faculties have missed.

Oh no! This is very bad news for our monetarist friends. First of all, we must note that if the monetarist theory is true we should see a positive correlation between the money supply and prices. That is, when the money supply rises so too should prices and vice versa. This would be indicated in the regressions by an upward-sloping trendline. But in all three regressions we see a negative correlation indicated by a downward-sloping trendline. Embarrassing!

Secondly, we should note that the correlation coefficient, annotated the R-squared, is very, very weak in all three regressions. This is reflective of the intuitive fact that the graphs we laid out previously showed no significant relationship between the variables. Thirdly, we should note that the generally favoured measure of the money supply by monetarists is the M3 and in our regressions the M3 had the lowest correlation coefficient and the most substantially negative relationship. If these regressions are anything to go by we should more so expect prices to fall when the M3 grows!

But before we take our leave from monetarist fantasyland let us zoom in on the best ‘natural experiment’ of the thesis that we find in the data: namely, the extreme events surrounding 2008. Here is the data for the M1 and the M2 plotted against the CPI for that era (data for M3 is not available as it was discontinued in 2005):

Again, the data seems to run entirely contrary to the monetarist theory. Recall that above we read the monetarist equation to say that an increase in the money supply causes a rise in prices. But here we see both money supply measures rising toward the end of the 2008 as prices fell. This runs exactly contrary to what the monetarists would have you believe. Indeed, the negative relationship between the M1 monetary base and the price level is extremely statistically significant. Here is a regression plotting that important 12 month period:

All we can conclude from this is that monetarist theory — whether in academic form or in its man-in-the-street variant — is deeply, deeply misleading. The real world facts seem to run exactly contrary to the theory. Indeed, I do not think you could hope for a stronger refutation of any theory by engaging in data analysis. And yet the theory will continue to live on, zombie-like in the minds of academic economists, the media and the general public. Why? Why did this doctrine impose itself on the minds of men, especially in the 1970s and 1980s?

This, I think, is when ideology comes to play a role. I have documented some reasons for the rise of monetarist doctrine in this era on this blog before and readers can consult that particular post. But that post mainly focused on the case of the UK. With regards to the US James Galbraith and William Darity Jr. put forward the following argument as to monetarism’s supposed adoption by the Federal Reserve in the late-1970s and early-1980s in their excellent textbook Macroeconomics:

The Federal Reserve was no more monetarist in the early 1980s than it had ever been; it merely found for a time that monetarist arguments could be used to justify a severe credit crunch, and resulting recession, when these were felt necessary to bring a rapid end to inflation. (p244)

Amen to that!

The ‘Information Asymmetry’ Paradigm is Vacuous

Sympathetic Post-Keynesian types often ask me what I think of the whole ‘asymmetric information’ paradigm. They’re often struck when I say that I think that its vacuous. After all doesn’t this paradigm undermine the dreaded General Equilibrium theory? Well yes it does but that doesn’t mean that it is in any way substantive. You can’t just lend a paradigm credence because it produces results that overlap with your own.

In his book Minding the Markets — about which I will be writing more posts on in the coming days — David Tuckett provides a very nice summary of George Akerflof’s famous ‘market for lemons’ paper. I actually did this in my masters degree — marginalist microeconomists love this paper because of its Sudoku-puzzle qualities — but I never wanted to write about it because I didn’t want to bother summarising it. Tuckett has done me a great service in this regard. He writes:

Akerlof supposed that in the secondhand car market well- informed sellers face ignorant buyers and that there were two kinds of car – reliable cars and lemons. The seller knows which he thinks he has but it is difficult for the buyer to tell. His formal analysis showed how the price of used cars will be discounted to reflect the incidence of lemons in the population. It will be an average of the values of good cars and lemons. But that average is a good price for the owner of a lemon, but a disappointing price for the seller of a reliable car. So owners of lemons will want to sell and owners of reliable cars will not. As buyers discover this, that knowledge will pull down the price of secondhand cars. And things will get worse. The lower the average price, the more reluctant the owners of more reliable cars will be to sell and the more suspicious buyers will get, driving things down further. The end result will be that secondhand cars will be of poor quality and many secondhand cars will be bad buys even at low prices. (p5)

That’s basically it. That is pretty much what all the fuss is about. The student is then taught to work this out carefully in some sort of tedious problem set form. The exercise shows that within the given assumptions the market breaks down pretty much completely. Akerlof provisionally reaches pretty absurd conclusions when he writes:

The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.

Really? People being dishonest in a market drive honest people out of this market? Really? Does the author genuinely think that this is a description of the real world? Well, in the real world there are many car dealers that sell junk and yet, for some bizarre reason, the market continues to exist.

So, why then doesn’t the market break down? Well, anyone who has ever dealt in second-hand cars — I used to buy and sell them when I was a teenager — knows that this is all a question of trust. You must convince the customers that the car is not a lemon. You must provide papers documenting the car’s service history and so forth. Maybe they will even hire a mechanic to test the car. Basically, the seller who has limited information tries to gain more information. (Actually, in my experience the seller often doesn’t have full information about the car either if they are a dealer/arbitrager, but I digress…).

Alternatively, the dealer could just try to talk the customer into buying a piece of crap. This happens too, so it can’t be ruled out. But it sure as hell doesn’t lead to the market imploding. Anyway, leaving this aside, Akerlof basically notes this. Tuckett points this out when he writes:

Since we have markets, the conclusion highlights how building trust must be a crucial element in the way financial markets work and demonstrates how parsimonious abstract modelling can very efficiently and rigorously get to the heart of a matter. Buyers can only be persuaded to trust sellers and so come into the market if the underlying situation of information asymmetry is somehow modified. One way is for sellers to try to frame the information context in which decisions are made to make the buyer more confident in the seller – for example, by advertising ‘one owner’ or ‘lady driver’, by offering to show service records or a report from an independent agency, or by taking explicit measures to share the risk of things going wrong in future, such as a guarantee from a reputable source. Some of these devices are discussed in Akerlof’s original paper. (pp5-6)

Okay great. So why do I say that this is vacuous? Well, think about how this argument is fobbed off on the student. First, the student is told to assume perfect information. They are told to think about a very abstract model in which everyone knows everything and prices reflect this perfectly. When the critical student says that they do not believe how this is real markets work they are told to shut up and do their problem set. When they bring up anecdotal evidence that markets work completely differently and have much to do with power-relations, emotions and trust they are again told to shut up.

So, the student either shuts up or they migrate to a more realistic discipline. If they shut up for long enough they eventually move on to intermediate microeconomics. Now they are told to take on board a few instances in which issues such as trust arise. They are then showed how this undermines the perfect information model that they spent a number of years working their asses off to master. Now they are told that these more psychological or sociological aspects of markets need to be studied.

Well then what the hell was the point of studying the perfect markets stuff in the first place!? Any reasonably bright 18 year old can see that markets are predominantly determined by issues of power, emotion and trust. So, why didn’t we just run with it in the first place?

All Akerlof’s model shows is that if you don’t assume perfect information but you do assume some vague notion of rationality the market will break down. Then he provides a few hand-waves as to what actually stabilises markets — which are the very factors that students are told not to think about when they start studying markets! Students are basically led around on a wild goose chase and come out the other side with a bunch of tools that are altogether useless for studying real world markets.

The end result is that the students will try to model these issues of power/emotion/trust using the very same tools that were only really appropriate for the perfect information, perfect rationality assumptions. There’s a term for this in the philosophy of science: its called a ‘degenerating research program’. A research program is degenerative when ad hoc additions are made not to produce novel facts but to defend core assumptions. In this case the core assumptions are those of rationality and market-clearing prices and so forth, while the ad hoc assumptions are handwaves toward issues of trust and so forth that cannot really be studied using the tools that practitioners spend years of their lives acquiring.

A progressive research program would start from the assumption that issues like trust, emotions and power play a fundamental role and would then build on this. So, for example, a progressive researcher might look into existing literature on the psychology and sociology of trust and then try to integrate this with basic economic insights about markets in the study of any particular markets which they would approach not deductively but empirically. This is, in fact, what Tuckett is doing in the book but I will leave this for another day. For now it should just be made clear that at best the asymmetric information paradigm is a degenerating research program, at worst it is a vacuous waste of time and money which is turning out useless economic students that spend their whole time chasing their own tails and have no capacity to actually study interesting multidisciplinary approaches to microeconomics.

Finally, a note on intent. Akerlof warmly received Tuckett’s book and gave it the highest of praise. But Tuckett is completely shunning the core assumptions of marginalist microeconomics. Are we then to assume that Akerlof’s intent in his famous paper was wholly destructive? Should we infer that the idea was to tear down the General Equilibrium edifice so that people could take more realistic approaches? I am certainly willing to entertain the possibility. But this is not what happens. Rather students continue to chase wild geese and learn mathematical tools that are completely inappropriate for dealing with the problems they are studying. They then try to apply these tools to the material and they end up with theories that are just as arcane and irrelevant to the real world as are the old perfect information General Equilibrium models. If you want to tear up the old paradigm you have to do so at the roots. Attacking the branches does nothing at all. In fact, it strengthens it.

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.

 

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.

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!

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

Financial Markets in Keynesian Macroeconomic Theory 101

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!

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.

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.