A neo- Wicksellian perspective on the financial crisis and the common core of Keynesian and Hayekian Economics Part 1 -Theory
“Thornton does not only recognize (as Hume had done) that in the short period monetary causes may have real effects; he also recognized that in a credit system the reverse can happen. Real causes have monetary effects”[1]
Abstract
“Thornton does not only recognize (as Hume had done) that in the short period monetary causes may have real effects; he also recognized that in a credit system the reverse can happen. Real causes have monetary effects”[1]
Abstract
This paper makes three points about the current economic cycle (the ‘Cycle’) in the US. First, when the economy was booming from 2002 – 2007, the sum of domestic consumption and investment exceeded the value of domestic output. The difference was reflected in a growing trade deficit. Without the trade deficit there could not have been a sustained housing investment and price boom with full employment, because domestic output constraints would have caused prices and interest rates to rise to offset the pressure for increased spending, which would have countered the increased investment demand and damped asset prices. This point holds independently of financial market structure and leverage. Thus, Fed Chairman Ben Bernanke and former US Treasury Secretary Henry Paulson correctly identified, as a necessary condition for the boom to occur, the glut of savings in Asia that was transmitted to the US economy.
Second, modern macroeconomic theory is unable to account for this type of economic cycle because its basic conceptual framework does not allow for the existence of autonomous, market determined credit expansion and contraction. This bias was consistent with financial market conditions in developed countries for nearly a century, when currency monopoly and tight banking regulations conferred on central banks significant control over aggregate credit. But financial deregulation that has progressed over the past 20 years has enabled significant autonomous credit creation by commercial banks and financial markets, which has reduced the control over credit possessed by central banks.
Third, the cycle can be understood in the context of an earlier tradition of monetary theory, developed by Keynes and Hayek. Doing so requires a shift away from the modern framework descended from Ricardo and towards one descended from Wicksell[2].
Background
Background
The severe US boom and bust cycle in trade, credit and asset prices of the past decade has some unique features relative to other postwar business cycles.
(1) The current account deficit reached unprecedented heights during the boom phase.
(2) Credit expansion, financial sector leverage and financial asset prices increased at comparatively higher rates than in the past during the boom, and then collapsed.
(3) Losses in the banking sector during the recession have caused a severe contraction in credit.
These features were present during the late 1920’s boom and subsequent Great Depression and many of these features, particularly the co-incidence of large trade deficits and financial crisis, have repeated themselves throughout history[3]. Because the severe expansion and subsequent contraction of credit is so prominent a feature of the Cycle, any attempt to understand it requires a framework in which such phenomena can occur and can have an effect on other economic variables.
Modern Macro
Modern Macro
Modern macro-economic theory has proven itself an apparatus incapable of explaining a cycle characterized by an explosion followed by an implosion of privately created credit. The Dynamic Stochastic General Equilibrium (DSGE) framework starts from an assumed general equilibrium in which Say’s Law –the proposition that aggregate demand for goods is equal to the aggregate of goods produced – holds, and examines deviations from this optimum arising from exogenous shocks and rigidities in price movements. There is an interest rate, but no financial intermediation sector in the models.
There are two dominant approaches in modern macro: Real Business Cycle models explain fluctuations in GDP and its components as arising from equilibrium responses to movements in non-financial variables exogenous to the economy, like productivity growth rates and time preferences of individuals. New Keynesian models derive fluctuations from disequilibrium responses to movements in real and financial variables interacting with slow adjusting prices. Leverage is ignored as credit and money is either assumed controlled by the central bank, or eliminated altogether. None of the leading graduate Macro textbooks have so much as a chapter devoted to banking and the economic effects of expansions and contractions in credit.
The ‘toy model’ introduced by Olivier Blanchard (currently IMF Chief Economist) in his 2008 review of ‘The State of Macro’[4], has no financial sector, only interest rate setting by the Central Bank. Indeed, a financial sector has no place in a complete markets model in which there is no issue of inter-temporal coordination failure –because agents can contract in advance for future delivery of goods - and the composition of finance –debt and equity - is irrelevant to the macro-economy because all debts cancel out and there is no possibility of bankruptcy[5].
This was not always so. From the late 18th century, when financial innovation accelerated in the UK, until the 1930’s, economists often looked to the banking sector as the locus of economic fluctuations. According to John Hicks, economists like David Hume and Henry Thornton believed
“ …there is the penalty that the credit system is an unstable system. It rests upon confidence and trust; when trust is absent it can just shrivel up. It is unstable in the other direction too; when there is too much ‘confidence’ or optimism it can explode in bursts of speculation”[6]
The principal protagonists of the academic debate of the 1930’s, Keynes and Hayek, agreed that the depression had its roots in a failure of financial intermediation. They believed the supply of, and demand for, ‘inside’ money –bank credit and mutual funds – created by the banking sector, expanded and contracted due to market determined fluctuations in the supply of credit and the demand for borrowing ; such fluctuations sometimes spilled over, and sometimes were caused by , excess demand for goods. They debated within a paradigm constructed by Knut Wicksell that identified the expansion and contraction of credit as central to explaining price movements, and expanded Wicksell’s model to allow for credit fluctuations to affect aggregate output.[7]
John Hicks’ IS-LM interpretation of Keynes’ General Theory marked a turning point[8]. Hicks’ model, which became the canonical macro model until it was replaced by the DSGE framework in the 1980’s, embedded a neo-Ricardian assumption that monetary aggregates –base money and bank created credit - could be controlled by the central bank, therefore private banking activities per se, had no macro-economic effects. Hicks’ innovation was carried further along by the Monetarist Counter-revolution, led by Milton Friedman and his colleagues, who asserted that economic fluctuations resulted primarily from movements in monetary aggregates under the control of central banks. Friedman famously advocated that central banks operate with fixed monetary policy ‘rules’, as preferable to traditional ‘discretion’ in managing the banking system; as the promotion of price stability is the most effective way to reduce deviations from the natural rate of employment.[9] Friedman claimed the weight of empirical evidence supported his position
“ It is a matter of record that periods of relative stability of in the rate of Monetary growth have also been periods of relative stability in economic activity…Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity”[10]
Friedman’s assertion may be correct, but it does not settle the question of causality, Post Hoc Ergo Propter Hoc?[11] Was the monetary environment a product of monetary policy, or of market forces? It may be that the answer to that question differs by circumstance and depends on the contingencies of financial institutional structure. From the early 20th century, government monopoly on currency issue and mandatory reserve requirements for banks prevented the demand for base money from vanishing, thus conferring Central banks with continued monetary influence, while the Post WWII Bretton Woods system that tied developed country currencies to the dollar and Glass Steagal impediments to financial innovation, restricted the growth of non-bank, privately created credit. Indeed, it is probably no mere co-incidence that the correlation between monetary aggregates under central bank control, like M1 and M2, and GDP have broken down since the advent of financial deregulation in the US and UK beginning in the 1980’s.
More recently, the ‘New Neoclassical Synthesis” (NNS), embodied in Woodford modern classic Interest & Prices ( sometimes referred to as the ‘Bible” of Central Bankers), models an economy without a monetary aggregate. In this framework, the central bank sets the rate at which it lends to private banks and the resulting money supply is endogenously determined. The NNS adopts the concept of a ‘natural rate’ of interest developed by Wicksell.[12] The basic form of the model does not track any monetary aggregate and the ‘market rate’ of interest is set by the central bank in its lending policy to private banks.
The NNS view can be represented by a three equation system: An aggregate supply relation, an aggregate demand relation and a monetary policy equation. In this framework the central bank controls the interest rate rather than a monetary aggregate, so, while the NNS has rejected the quantity-theoretic analysis of Monetarism, it assumes the central bank can achieve the same degree of monetary control through its control over the market rate of interest and there is no room for commercial banks or financial markets in the creation of credit or the influencing of the level of economic activity.
In recent decades, our monetary system has moved away from the Ricardian/Monetarist world of rigidly quantity constrained metallic money and much closer to the pure credit world of Wicksell; A world, unlike that described by the NNS, in which the process of credit creation is not fully under the control of the central bank.
We now turn to an earlier tradition, where, in John Hicks’ phrase “the market makes its money”[13], to establish a framework for understanding the Cycle.
The Wicksellian Framework
“prices constitute…a spiral spring which serves to transmit the power between the natural and the money rates of interest; but the spring must first be sufficiently stretched or compressed. In a pure cash economy, the spring is short and rigid; it becomes longer and more elastic in accordance with the stage of development of the system of credit and banking” (Wicksell 1936)
The problem that concerned Wicksell was this.”Since the days of Ricardo, the non-bank public’s demand for minted gold had gone basically to zero…the entire enormous structure of credit was balanced as an inverted pyramid on the slender gold reserve of the bank of England. Wicksell asked the question: What would happen if both the gold coin to bank note ratio and the bank’s gold reserve ratio went to zero in the limit? The answer was his “pure credit economy” model, in which the supply of bank notes was indeterminate.” [14]
Say’s Law
The ‘toy model’ introduced by Olivier Blanchard (currently IMF Chief Economist) in his 2008 review of ‘The State of Macro’[4], has no financial sector, only interest rate setting by the Central Bank. Indeed, a financial sector has no place in a complete markets model in which there is no issue of inter-temporal coordination failure –because agents can contract in advance for future delivery of goods - and the composition of finance –debt and equity - is irrelevant to the macro-economy because all debts cancel out and there is no possibility of bankruptcy[5].
This was not always so. From the late 18th century, when financial innovation accelerated in the UK, until the 1930’s, economists often looked to the banking sector as the locus of economic fluctuations. According to John Hicks, economists like David Hume and Henry Thornton believed
“ …there is the penalty that the credit system is an unstable system. It rests upon confidence and trust; when trust is absent it can just shrivel up. It is unstable in the other direction too; when there is too much ‘confidence’ or optimism it can explode in bursts of speculation”[6]
The principal protagonists of the academic debate of the 1930’s, Keynes and Hayek, agreed that the depression had its roots in a failure of financial intermediation. They believed the supply of, and demand for, ‘inside’ money –bank credit and mutual funds – created by the banking sector, expanded and contracted due to market determined fluctuations in the supply of credit and the demand for borrowing ; such fluctuations sometimes spilled over, and sometimes were caused by , excess demand for goods. They debated within a paradigm constructed by Knut Wicksell that identified the expansion and contraction of credit as central to explaining price movements, and expanded Wicksell’s model to allow for credit fluctuations to affect aggregate output.[7]
John Hicks’ IS-LM interpretation of Keynes’ General Theory marked a turning point[8]. Hicks’ model, which became the canonical macro model until it was replaced by the DSGE framework in the 1980’s, embedded a neo-Ricardian assumption that monetary aggregates –base money and bank created credit - could be controlled by the central bank, therefore private banking activities per se, had no macro-economic effects. Hicks’ innovation was carried further along by the Monetarist Counter-revolution, led by Milton Friedman and his colleagues, who asserted that economic fluctuations resulted primarily from movements in monetary aggregates under the control of central banks. Friedman famously advocated that central banks operate with fixed monetary policy ‘rules’, as preferable to traditional ‘discretion’ in managing the banking system; as the promotion of price stability is the most effective way to reduce deviations from the natural rate of employment.[9] Friedman claimed the weight of empirical evidence supported his position
“ It is a matter of record that periods of relative stability of in the rate of Monetary growth have also been periods of relative stability in economic activity…Periods of wide swings in the rate of monetary growth have also been periods of wide swings in economic activity”[10]
Friedman’s assertion may be correct, but it does not settle the question of causality, Post Hoc Ergo Propter Hoc?[11] Was the monetary environment a product of monetary policy, or of market forces? It may be that the answer to that question differs by circumstance and depends on the contingencies of financial institutional structure. From the early 20th century, government monopoly on currency issue and mandatory reserve requirements for banks prevented the demand for base money from vanishing, thus conferring Central banks with continued monetary influence, while the Post WWII Bretton Woods system that tied developed country currencies to the dollar and Glass Steagal impediments to financial innovation, restricted the growth of non-bank, privately created credit. Indeed, it is probably no mere co-incidence that the correlation between monetary aggregates under central bank control, like M1 and M2, and GDP have broken down since the advent of financial deregulation in the US and UK beginning in the 1980’s.
More recently, the ‘New Neoclassical Synthesis” (NNS), embodied in Woodford modern classic Interest & Prices ( sometimes referred to as the ‘Bible” of Central Bankers), models an economy without a monetary aggregate. In this framework, the central bank sets the rate at which it lends to private banks and the resulting money supply is endogenously determined. The NNS adopts the concept of a ‘natural rate’ of interest developed by Wicksell.[12] The basic form of the model does not track any monetary aggregate and the ‘market rate’ of interest is set by the central bank in its lending policy to private banks.
The NNS view can be represented by a three equation system: An aggregate supply relation, an aggregate demand relation and a monetary policy equation. In this framework the central bank controls the interest rate rather than a monetary aggregate, so, while the NNS has rejected the quantity-theoretic analysis of Monetarism, it assumes the central bank can achieve the same degree of monetary control through its control over the market rate of interest and there is no room for commercial banks or financial markets in the creation of credit or the influencing of the level of economic activity.
In recent decades, our monetary system has moved away from the Ricardian/Monetarist world of rigidly quantity constrained metallic money and much closer to the pure credit world of Wicksell; A world, unlike that described by the NNS, in which the process of credit creation is not fully under the control of the central bank.
We now turn to an earlier tradition, where, in John Hicks’ phrase “the market makes its money”[13], to establish a framework for understanding the Cycle.
The Wicksellian Framework
“prices constitute…a spiral spring which serves to transmit the power between the natural and the money rates of interest; but the spring must first be sufficiently stretched or compressed. In a pure cash economy, the spring is short and rigid; it becomes longer and more elastic in accordance with the stage of development of the system of credit and banking” (Wicksell 1936)
The problem that concerned Wicksell was this.”Since the days of Ricardo, the non-bank public’s demand for minted gold had gone basically to zero…the entire enormous structure of credit was balanced as an inverted pyramid on the slender gold reserve of the bank of England. Wicksell asked the question: What would happen if both the gold coin to bank note ratio and the bank’s gold reserve ratio went to zero in the limit? The answer was his “pure credit economy” model, in which the supply of bank notes was indeterminate.” [14]
Say’s Law
Say’s Law says that real aggregate demand (Yd) is derived from real aggregate supply (Ys), thus Yd = Ys at all times. Let us assume a closed economy where money (M) is comprised of ‘base money’ like bullion issued by a central bank is the only financial asset. Let P represent an index of prices. Then, by Walras’ Law that supply equals demand across all markets in equilibrium, we have
(1) (Yd - Ys) + (Md - Ms)/P = 0
(1) (Yd - Ys) + (Md - Ms)/P = 0
By Say’s Law, the left side falls to zero and there can never be any excess demand or supply of money. Money is a ‘veil’ behind which the ‘real’ economy operates, the classical Quantity Theory of Money. We can look at this in terms of Investment and Savings. By definition Yd = C+I+G, Where C is consumption, I is investment and G is government spending, and Ys = C+S+T, where S is savings and T is taxation. Assuming , for the sake of convenience only, a balanced government budget (G=T), we can transform equation (1) into
(2) (I - S) + (Md - Ms)/P = 0
Now, by Say’s Law, I = S, so Md = Ms. Say’s Law is in essence a dichotomy, as it separates the real and monetary sides completely –i.e. disequilibrium in the money markets cannot spill over into disequilibrium in goods markets. Money can have no effect on economic activity.
Credit Money: Ex Ante and Ex Post
Wicksell described a process by which money could affect goods markets, by introducing into the neoclassical model a banking sector. His innovation was to make desired investment independent of desired savings, so ex ante aggregate demand is free to rise above or drop below a given aggregate supply. He accomplished this by formalizing the concept of credit money created by banks. Banks create credit by gathering deposits, which function as money, and lending out a portion of the deposits, which is an extension of credit. Banks can increase or decrease the effective money supply by moving loan interest rates in such a manner as to cause a disequilibrium in the goods market, as a credit expansion will be associated with an increase in desired investment independently of desired savings. The distinction between desired magnitudes –ex ante- and actual magnitudes –ex post- is crucial. A disequilibrium occurs when ex ante. Savings and investment may be forced into equality ex post – by definition – but an ex ante discrepancy will set in motion a process of adjustment in prices and quantities until (if the system is stable) the ex ante and ex post magnitudes are identical.
In this way, ex ante disequilibrium in the money supply –or, more generally in credit – can spill over to disequilibrium in the goods market, by inducing agents to rebalance all elements of their budget; expenditure and wealth portfolio. This global rebalancing will cause prices and real variables to move. Money is no longer a ‘veil’ over the goods market. Money and banking can affect real activity.
The ‘Natural Rate’
(2) (I - S) + (Md - Ms)/P = 0
Now, by Say’s Law, I = S, so Md = Ms. Say’s Law is in essence a dichotomy, as it separates the real and monetary sides completely –i.e. disequilibrium in the money markets cannot spill over into disequilibrium in goods markets. Money can have no effect on economic activity.
Credit Money: Ex Ante and Ex Post
Wicksell described a process by which money could affect goods markets, by introducing into the neoclassical model a banking sector. His innovation was to make desired investment independent of desired savings, so ex ante aggregate demand is free to rise above or drop below a given aggregate supply. He accomplished this by formalizing the concept of credit money created by banks. Banks create credit by gathering deposits, which function as money, and lending out a portion of the deposits, which is an extension of credit. Banks can increase or decrease the effective money supply by moving loan interest rates in such a manner as to cause a disequilibrium in the goods market, as a credit expansion will be associated with an increase in desired investment independently of desired savings. The distinction between desired magnitudes –ex ante- and actual magnitudes –ex post- is crucial. A disequilibrium occurs when ex ante. Savings and investment may be forced into equality ex post – by definition – but an ex ante discrepancy will set in motion a process of adjustment in prices and quantities until (if the system is stable) the ex ante and ex post magnitudes are identical.
In this way, ex ante disequilibrium in the money supply –or, more generally in credit – can spill over to disequilibrium in the goods market, by inducing agents to rebalance all elements of their budget; expenditure and wealth portfolio. This global rebalancing will cause prices and real variables to move. Money is no longer a ‘veil’ over the goods market. Money and banking can affect real activity.
The ‘Natural Rate’
The Market Rate, i, is the interest rate charged by banks to borrowers and is determined in the market for the supply of, and demand for, loanable funds. Wicksell introduced the concept of a theoretical ‘Natural Rate’ of interest, r, which is the rate at which ‘desired’ –ex ante – savings equals desired investment. The Natural Rate is equal to the marginal productivity of capital. The macro economy is in equilibrium when the market rate, i, is equal to the Natural Rate, r. In this state, economic actors have no desire to change their supply, demand or prices charged and all ex ante plans are realized as ex post magnitudes. Disequilibrium occurs when the Natural Rate and the Market Rate diverge . In this state ex ante plans of economic agents are inconsistent and therefore ex post realizations differ from plans. In this state a process of change is set in motion.
When r > i, desired investment will exceed desired savings and there will be upward pressure on the prices[15].
When r < i, desired investment is below desired savings and the deficiency in demand will place downward pressure on prices.
The Cumulative Process[16]
We describe Wicksell’s Cumulative Process more formally. Assume with Wicksell that all saving is deposited with banks, that all investment is bank-financed, that banks lend solely to finance investment, and that full employment prevails such that shifts in aggregate demand affect prices but not real output. Then his model reduces to the following equations linking the variables investment I, saving S (both planned, or ex ante, magnitudes), loan rate i, natural rate r, loan demand LD, loan supply LS, excess aggregate demand E, change in the stock of checkable deposits dD/dt, price level change dP/dt, and market-rate change di/dt.
Equation (3) says that planned investment exceeds saving when the loan rate of interest falls below its natural equilibrium level (the level that equilibrates saving and investment):
(3) I - S = a(r - i)
Where the coefficient a relates the investment-saving gap to the interest differential that creates it.
Equation (4) states that the excess of investment over saving equals the additional checkable deposits newly created to finance it,
(4) dD/dt = I -S
In other words, since banks create new checkable deposits by way of loan, deposit expansion occurs when banks lend to investors more than they (banks) receive from savers. Thus equation (4) admits of the following derivation. Denote the investment demand for loans as LD =I(i), where I(i) is the schedule relating desired investment spending to the loan rate of interest. Similarly, denote loan supply as the sum of saving plus new deposits created by banks in accommodating loan demands. In short, LS=S(i)+dD/dt. Equating loan demand and supply and solving for the resulting gap between investment and saving yields equation (4).
Equation (5) says that the new deposits, being spent immediately, spill over into the commodity market to underwrite the excess aggregate demand for goods E implied by the gap between investment and saving:
(5) dD/dt = E
Equation (6) says that this excess aggregate demand bids up prices, which rise in proportion to the excess demand:
(6) dP/dt = bE
where the coefficient b is the factor of proportionality between price level changes and excess demand. Substituting equations (3), (4), and (5), into (6), and (3) into (4), one obtains
(7) dP/dt = ab(r - i)
and
(8) dD/dt = a(r - i)
which together state that price inflation and the deposit growth that underlies it stem from the discrepancy between the natural and market rates of interest.
Finally, since bankers must at some point raise their loan rates to protect their reserves from inflation-induced cash drains into hand-to-hand circulation, one last equation,
(9) di/dt = gdP/dt
closes the model. This equation says that bankers, having worked off excess reserves, now raise their rates in proportion to the rate of price change (g being the factor of proportionality). The equation ensures that the loan rate eventually converges to its natural equilibrium level, as can be seen by substituting equation (7) into the above formula to obtain
(10) di/dt = gab(r - i)
Solving this equation for the time path of the loan rate i yields
(11) i(t) = (i0 -r)exp(-gabt) + r
where t is time, e is the base of natural logarithm system, i0 is the initial disequilibrium level of the loan rate, and r is the given natural rate. With the passage of time, the first term on the right-hand side vanishes and the loan rate converges to the natural rate. At this point, monetary equilibrium is restored. Saving equals investment, excess demand disappears, deposit expansion ceases, and prices stabilize at their new, higher level.
Extensions of the Cumulative Process Model
Keynes’ Extension of Wicksell
We can add an aggregate output response to excess demand to the Wicksellian model to incorporate an effect of excess investment demand on output, in addition to the price level.
(6’) dy/dt = (1-b)E
Where the adjustment parameter is a function of the output gap ( Ymax – Y), where Y is actual output and Ymax is potential output (full employment).
(12) b = f[Ymax - Y], and db/d[Ymax-Y’] >0
In this manner the Wicksellian Cumulative Process can be extended to include adjustments in real variables.
If the Natural Rate of interest were to decline, and the Market Rate of interest could not decline, there would be an excess supply of savings over investment at full employment, and output would need to contract and/or prices decline until the marginal product of capital rose (and with it the Natural Rate of interest) to restore financial market equilibrium. But in this case monetary equilibrium would be inconsistent with full employment (goods market equilibrium) and Say’s Law would fail. That is where Keynes took Wicksell’s Cumulative Process.
Hayek’s Extension of Wicksell
In the Cumulative Process, an excess demand for investment over savings, leads to price increases (equation 6). The model does not distinguish capital assets from other commodities, but it is interesting to note that the prices of durable assets should be more sensitive to changes in the interest rate than other goods, since interest is the price of inter-temporal substitution. When the rate at which future consumption is discounted falls, for example, the value of durable assets will rise independently of the pressure of excess demand. In this way reduction of the Market Rate of interest will cause durable asset prices to rise and the subsequent increase in the Market Rate of interest –as the cumulative process brings about adjustment- will cause durable asset prices to decline. In this way, the Cumulative Process embodies an asset price boom and bust cycle.
It is also interesting to note that Wicksell could have made a distinction between a capital goods sector, into which the increased credit is channeled, and the consumption goods sector. The Cumulative Process would then proceed by first exerting upward pressure on capital goods prices which later spread throughout the economy.
If we add the possibility of output expansion in response to excess demand to the above two observations, we can describe a Cumulative Process in which the initial reduction in the Market Rate of interest triggers a large upswing in capital goods prices and output of capital goods, which then spreads throughout the rest of the economy. But when the adjustment completes itself, there might be capital goods production processes initiated in the boom as a result of the lower Market Rate of interest, which take time to build and generate revenue in the future, that become uneconomic when the higher Natural Rate of interest re-asserts itself. Those projects will be abandoned. That is where Hayek took Wicksell’s Cumulative Process.
The Debate of the 1930’s
In his reflection on the great economic debate of the 1930’s over the cause of the economic depression, John Hicks wrote “it is hardly remembered that there was a time when the new theories of Hayek were the principal rivals of the new theories of Keynes. Which was right, Hayek or Keynes?”[17] Hicks, who deserves much credit for forging the ‘neoclassical synthesis’ that dominated macro-economics for a half century after the 1930’s, “took quite a time to make up [his mind]”.
Hicks recognized that Hayek and Keynes shared a common methodological framework, descended from the theory of Swedish economist Knut Wicksell, in which economy-wide disturbances emanated from a malfunctioning of the financial sector when interest rates fail to seek a level at which ex ante desired saving and investment are made equal at full employment; the Wicksellian ‘natural rate’. [18] They both understood that Say’s Law, the proposition that there is demand to consume everything that is produced, may not hold as result of failures in inter-temporal coordination between investments made today –which initiates a time consuming process of production – and the future demand for the goods produced by investment. This can occur when production of goods for future delivery turn out not to be desired when completed, or when the cost of producing the good for future delivery is judged too expensive after the process of production has commenced, or when a loss of confidence in the future demand for the goods produced by the capital stock cause a withdrawal of investment. The collapse in investment spending idles plants, reduces employment and, as a result of the decline in household income, reduces consumer spending. Such circumstances could render the appearance of a general glut of productive capacity and goods amidst unemployment – the fundamental paradox of economic depressions. But, Hicks notes, “Wicksell plus Keynes said one thing, Wicksell plus Hayek said quite another”.
Both Keynes and Hayek added to the Wicksellian Cumulative Process, quantity adjustments to savings and investment. Excess (deficient) ex-ante aggregate demand for goods, E, could trigger an increase (decrease) in output.
The central point of Hayek’s theory is that an unsustainable boom is triggered by a credit expansion causing the market rate to fall below the natural rate , which leads to an increase in I and the initiation of capital investment projects that are not sustainable at r. Thus, when prices ultimately adjust and the market rate is brought in line with the natural rate, projects are abandoned, which causes output to contract.
The central point of Keynes’ theory is that r is based on convention, due to our ignorance of the future, and is prone to fluctuate with changes in collective feelings about the future. A contraction is triggered when the natural rate falls below the minimum feasible market rate in this case, E is negative and desired saving is stuck above desired investment I < S and the disequilibrium in the goods market leads to a contraction in output until savings have declined to a level equal to investment.
Keynes
In his reflection on the great economic debate of the 1930’s over the cause of the economic depression, John Hicks wrote “it is hardly remembered that there was a time when the new theories of Hayek were the principal rivals of the new theories of Keynes. Which was right, Hayek or Keynes?”[17] Hicks, who deserves much credit for forging the ‘neoclassical synthesis’ that dominated macro-economics for a half century after the 1930’s, “took quite a time to make up [his mind]”.
Hicks recognized that Hayek and Keynes shared a common methodological framework, descended from the theory of Swedish economist Knut Wicksell, in which economy-wide disturbances emanated from a malfunctioning of the financial sector when interest rates fail to seek a level at which ex ante desired saving and investment are made equal at full employment; the Wicksellian ‘natural rate’. [18] They both understood that Say’s Law, the proposition that there is demand to consume everything that is produced, may not hold as result of failures in inter-temporal coordination between investments made today –which initiates a time consuming process of production – and the future demand for the goods produced by investment. This can occur when production of goods for future delivery turn out not to be desired when completed, or when the cost of producing the good for future delivery is judged too expensive after the process of production has commenced, or when a loss of confidence in the future demand for the goods produced by the capital stock cause a withdrawal of investment. The collapse in investment spending idles plants, reduces employment and, as a result of the decline in household income, reduces consumer spending. Such circumstances could render the appearance of a general glut of productive capacity and goods amidst unemployment – the fundamental paradox of economic depressions. But, Hicks notes, “Wicksell plus Keynes said one thing, Wicksell plus Hayek said quite another”.
Both Keynes and Hayek added to the Wicksellian Cumulative Process, quantity adjustments to savings and investment. Excess (deficient) ex-ante aggregate demand for goods, E, could trigger an increase (decrease) in output.
The central point of Hayek’s theory is that an unsustainable boom is triggered by a credit expansion causing the market rate to fall below the natural rate , which leads to an increase in I and the initiation of capital investment projects that are not sustainable at r. Thus, when prices ultimately adjust and the market rate is brought in line with the natural rate, projects are abandoned, which causes output to contract.
The central point of Keynes’ theory is that r is based on convention, due to our ignorance of the future, and is prone to fluctuate with changes in collective feelings about the future. A contraction is triggered when the natural rate falls below the minimum feasible market rate in this case, E is negative and desired saving is stuck above desired investment I < S and the disequilibrium in the goods market leads to a contraction in output until savings have declined to a level equal to investment.
Keynes
Keynes located his ‘cause’ of depression in autonomous changes in sentiment over the future returns on investment, which engendered fluctuations in investment spending. Either a situation of general panic, or a secular decline in investment prospects –Keynes wrote about both – would cause investment to decline and put downward pressure on interest rates. But there is a lower bound to interest; it cannot fall below zero and will not fall below a level at which a sufficient number of well capitalized speculators judge it must ultimately rise above, nor can it fall below a level at which fearful savers would risk the illiquidity and contingencies of an investment. More generally, when desired saving exceeds desired investment (ex ante) and the interest sensitivity of the demand for money is high- a condition Keynes called ‘liquidity preference’- then increases in money cannot reduce interest rates sufficiently to re-start investment, which triggers a downward adjustment in income and employment to the point where a reduced level of savings equals investment (ex post)[19].
The market dynamics work as follows: The initial decline in investment causes a reduction in employment, which leads to a drop in consumer expenditures (hence sales), leading to further rounds of employment and spending declines. As income declines, given a fixed marginal propensity to consume out of income, the total amount of saving falls, and the process continues until savings (and, hence, income) has declined to a level at which it equals desired investment.[20] Thus does consumption (and employment) spiral downward via the multiplier. For Keynes, liquidity preference prevents interest rates from clearing the market for savings and investment and is therefore the key to co-ordination failures that can generate unemployment. And there from arises the Keynesian prescription of fiscal stimulus to inject government spending to make up for the deficiency in private spending.[21]
Hayek
Hayek
Where Keynes emphasized the influence of a disequilibrium between savings and investment on the current level of real aggregate demand, Hayek stressed the consequences of such co-ordination failures for the time path of the capital stock and the evolution of the economy’s supply side[22]. Hayek located his ‘cause’ of depression in monetary over-expansion[23]. As Hicks explains “The initial expansion of credit – in ‘pure’ terms, the reduction of the market rate below the natural rate of interest – is that the money value of investment rises, implying a rise in the money prices of producers goods”. The low interest rates encourage increased borrowing from the banking system to undertake investment plans that would not have been initiated at the higher ‘natural’ interest rates. Thus does credit expansion fuel an asset price bubble and investment in projects whose rate of return is below the ‘natural rate’. This is a volatile disequilibrium situation in which the monetary stimulus eventually moves from inflating the prices of investment goods to inflating the prices of all goods, as wages are paid and spent. The spreading inflation ‘reveals’ the distortion in the inter-temporal structure of relative prices as the relative price of capital assets decline and interest rates adjust upward due to an income and inflation induced increase in the demand for nominal money balances, the uneconomic projects –those which were undertaken when interest rates were artificially low and the relative prices of capital assets were artificially high –are abandoned, the prices of capital goods collapse and unemployed resources, including labor, increase markedly.
Policymakers face a choice of further stoking the bubble with ever expanding monetary stimulus, which ultimately can lead nowhere but hyper-inflation and economic collapse, or to hold off and allow market clearing prices to re-establish themselves. This was the position for which Hayek and other ‘Austrian’ economists in the 1930’s were vilified. The unacceptability of official quiescence amidst mass suffering and fears of communist revolution were what probably tipped the balance of popular and professional opinion in favor of Keynes.
Hayek and Keynes centered their explanations of depressions on financial market failures due to deviations of interest from the Wicksellian ‘natural rate’. For Hayek, depression was the aftermath of an artificial boom created by rates forced too low by monetary expansion; for Keynes, depression was triggered by rates stuck too high after a damping of ‘animal spirits’ or secular decline in investment prospects. Both agreed that monetary stimulus provided little help to an economy in depression. [24]
But Hicks uncovered a fatal flaw in Hayek’s model: One that was not clearly understood at the time of the debate, but which became clear (to Hicks, at least) years later. In order for an economy beginning at full employment to generate an investment boom, there must be a corresponding reduction in consumption, at least for a time, since, in a closed economy, the National Income Identity
(13) Y = C + I + G
where Y is output, C is consumption and G is government spending, implies that, at full employment ( Y =Ymax), the sum of consumption and government spending must decline in order for investment to increase. Finite resources must be re-allocated. The Austrians recognized this and called it ‘forced saving’. It is the centerpiece of their analysis of the trade cycle. But where does it come from? What induces consumers to spend less? Moreover, the data (not available in the 1930’s) show that consumer spending increases during booms; the opposite of what Hayek’s theory requires.
Hayek and Keynes centered their explanations of depressions on financial market failures due to deviations of interest from the Wicksellian ‘natural rate’. For Hayek, depression was the aftermath of an artificial boom created by rates forced too low by monetary expansion; for Keynes, depression was triggered by rates stuck too high after a damping of ‘animal spirits’ or secular decline in investment prospects. Both agreed that monetary stimulus provided little help to an economy in depression. [24]
But Hicks uncovered a fatal flaw in Hayek’s model: One that was not clearly understood at the time of the debate, but which became clear (to Hicks, at least) years later. In order for an economy beginning at full employment to generate an investment boom, there must be a corresponding reduction in consumption, at least for a time, since, in a closed economy, the National Income Identity
(13) Y = C + I + G
where Y is output, C is consumption and G is government spending, implies that, at full employment ( Y =Ymax), the sum of consumption and government spending must decline in order for investment to increase. Finite resources must be re-allocated. The Austrians recognized this and called it ‘forced saving’. It is the centerpiece of their analysis of the trade cycle. But where does it come from? What induces consumers to spend less? Moreover, the data (not available in the 1930’s) show that consumer spending increases during booms; the opposite of what Hayek’s theory requires.
As Hicks describes Hayek’s model “Labor is a producer’s good: wages are flexible; so the money wage must go up. But what happens about the spending of those wages?...here, at least, there must be an instantaneous or nearly instantaneous, reaction. The higher wage must be followed, nearly at once…by a rise in the demand for consumption goods…But Hayek will not allow that. In spite of the rise in wages the demand for consumption goods does not rise; so the prices for consumption goods do not, at this stage, rise. This is how he is able to maintain that there is a rise in the prices of producers’ goods, relatively to consumers’ goods, lasting right through the boom: the rise on which so much of his argument depends. There has to be a lag of consumption behind wages”. And, for a closed economy, Hicks is completely justified in concluding “Obviously, this lag is not acceptable”.[25]
The Possibility of Offshore ‘Forced Savings’
Now we consider an amendment to Hayek’s model. Suppose there is an offshore economy that supplies the home economy with its excess savings. Is it not possible that a sustained surplus in offshore financial inflows, driven by a persistent trade deficit with an offshore economy – promoted, perhaps, by a mercantilist policy pursued by the offshore economy in which it accumulates foreign reserves by running persistent trade surpluses with the home economy through pegging an undervalued exchange rate and averting price inflation by sterilizing the monetary inflows – might generate an ‘overinvestment boom’ in the home economy? In this case, home economy consumers would increase their spending on imports while offshore savers recycle their export earnings into investment in the home economy. The sum of consumption by home economy consumers and investment in home economy capital stock would exceed the value of home economy output. Hicks’ fatal flaw disappears in the case of an open economy: When the home economy runs a large trade deficit, both consumption and investment can increase. There is no requirement of ‘forced saving’, as home economy consumers do not need to reduce consumption in order to free up resources for investment (of course, this requires that there be ‘forced saving’ in the offshore economy). They can import goods from offshore. The net transfer of resources from the offshore economy to the home economy is matched by a corresponding debt owed by the home economy to the offshore economy.
More formally, the national income identity is expanded to include net exports
(14) Y = C + I + G + [X – M]
where X represent exports and M represents imports. A country running a trade deficit has [X – M] < 0, so domestic investment and consumption will exceed the value of domestic output.
This describes the interaction between the ‘home’ US economy and the ‘offshore’ Chinese economy over the past decade. The trade deficit, a 'real' cause, triggered the credit expansion that fuelled the US housing boom; as Henry Thorton observed nearly two centuries ago,"Real casues have monetary effects".
The Possibility of Offshore ‘Forced Savings’
Now we consider an amendment to Hayek’s model. Suppose there is an offshore economy that supplies the home economy with its excess savings. Is it not possible that a sustained surplus in offshore financial inflows, driven by a persistent trade deficit with an offshore economy – promoted, perhaps, by a mercantilist policy pursued by the offshore economy in which it accumulates foreign reserves by running persistent trade surpluses with the home economy through pegging an undervalued exchange rate and averting price inflation by sterilizing the monetary inflows – might generate an ‘overinvestment boom’ in the home economy? In this case, home economy consumers would increase their spending on imports while offshore savers recycle their export earnings into investment in the home economy. The sum of consumption by home economy consumers and investment in home economy capital stock would exceed the value of home economy output. Hicks’ fatal flaw disappears in the case of an open economy: When the home economy runs a large trade deficit, both consumption and investment can increase. There is no requirement of ‘forced saving’, as home economy consumers do not need to reduce consumption in order to free up resources for investment (of course, this requires that there be ‘forced saving’ in the offshore economy). They can import goods from offshore. The net transfer of resources from the offshore economy to the home economy is matched by a corresponding debt owed by the home economy to the offshore economy.
More formally, the national income identity is expanded to include net exports
(14) Y = C + I + G + [X – M]
where X represent exports and M represents imports. A country running a trade deficit has [X – M] < 0, so domestic investment and consumption will exceed the value of domestic output.
This describes the interaction between the ‘home’ US economy and the ‘offshore’ Chinese economy over the past decade. The trade deficit, a 'real' cause, triggered the credit expansion that fuelled the US housing boom; as Henry Thorton observed nearly two centuries ago,"Real casues have monetary effects".
Stay tuned for Part II
[1] Hicks, John R, 1967, Thornton's Paper Credit in 'Critical Essays in Monetary Theory, Oxford at the Clarendon Press
[2] And Hume and Thornton. See Hicks Ibid
[3] Rogoff, Kenneth and Carmen Reinhart (2009) This Time is Different: Four Centuries of Financial Crises, Princeton University Press.
[4] Blanchard, O.J. , 2008, The State of Macro, MIT WP # 08-17.
[5] Because future sales and future income can be contracted for in advance in all possible future states of the world.
[6] Hicks, John R, Ibid
[3] Rogoff, Kenneth and Carmen Reinhart (2009) This Time is Different: Four Centuries of Financial Crises, Princeton University Press.
[4] Blanchard, O.J. , 2008, The State of Macro, MIT WP # 08-17.
[5] Because future sales and future income can be contracted for in advance in all possible future states of the world.
[6] Hicks, John R, Ibid
[7] Wicksell, Knut (1901) 'Interest and Prices', repreinted 1936 by Macmillan . Wicksell’s most prominent predecessor was Henry Thornton.
[8] Hicks, JR (1937) 'Mr. Keynes and the Classics', Econometrica Vol V, no 2.
[8] Hicks, JR (1937) 'Mr. Keynes and the Classics', Econometrica Vol V, no 2.
[9] “There were at least two strands in classical economics. There was one (represented, roughly speaking, by Ricardo and his followers) which maintained that all would be well if by some device credit money could be made to behave like metallic money…When Milton Friedman tells us that we should have a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money, he is being Ricardian." John Hicks, 'Thornton's Paper credit' .
[10] Friedman (1968) 'The Role of Monetary Policy', Presidential Address to the American Economcis Association, American Economic Review.
[11] Tobin, James ( 1970 ), 'Money and Income, Post Hoc Ergo Propter Hoc?',Quarterly Journal of Economices
.[12] See following section for a description of Wicksell’s framework.
[13] Hicks, John ( 1989) 'A Market Theory of Money', Oxford at the Clarendon Press.
[10] Friedman (1968) 'The Role of Monetary Policy', Presidential Address to the American Economcis Association, American Economic Review.
[11] Tobin, James ( 1970 ), 'Money and Income, Post Hoc Ergo Propter Hoc?',Quarterly Journal of Economices
.[12] See following section for a description of Wicksell’s framework.
[13] Hicks, John ( 1989) 'A Market Theory of Money', Oxford at the Clarendon Press.
[14] Leijonhufvud (2009), 'The Wicksell Connection, Variations on a Theme' in 'Information and Coordination', Oxford University Press.
[15] And quantities, if the economy is operating at below full employment. Wicksell assumed full employment in his model, but Keynes and Hayek would later relax that constraint.
[16] This is the model described in Humphrey.
[17] Hicks, John (1967) ‘The Hayek Story’ in 'Critical Essays in Monetary Theory'.
[18]The common Wicksellian heritage of Austrian monetary theory, and Keynes’ theory is expounded in detail by Leijonhufvud. See Leijonhufvud, Axel ‘The Wicksell Connection: Variations on a theme’ in Information and Coordination.
[19] A. C. Pigou pointed out that monetary expansion would ultimately stimulate spending. via a ‘real balances’ channel. He reasoned that unemployment would lead to falling wages and prices and, thus, increased ‘real’ money balances and the resulting increased wealth would induce people to spend more, which would reverse the decline and lead the economy back toward full employment. Milton Friedman pointed out that the ‘real balance effect’ could be engineered by a ‘helicopter drop’ of money, and avoid the dislocations caused by deflation. US Fed Chairman Ben Bernanke has, in the past, endorsed Friedman’s prescription and it has formed the centerpiece of his strategy of injecting massive increases in base money to combat the forces of deflation unleashed by the financial meltdown.
[20] This is Keynes’ ‘Paradox of thrift’. An excess of savings leads, via market adjustments, to a state in which savings (and income and employment) are reduced. An increase in spendthrift behavior leads in the opposite direction, to a state of increased savings.
[21] And corresponding government deficits to provide a riskless alternative to hoarding ‘barren’ money.
[22] This passage, and many of the ideas of this paper , were inspired by a recent paper by David Laidler. See his 'Financial Stability, Monetarism and the Wicksell Connection' (the 2007 John Kuszczak Memorial Lecture).
[23] The text refers to the model in Hayek’s Prices and Production, published in 1931, which represented the ‘state of the art’ Austrian model of an interest rate driven ‘monetary’ trade cycle. Later on, after publication of Keynes’ General Theory, Hayek responded with a new ‘real business cycle’ model in Profits, Interest & Investment, published in 1939, which incorporated a Keynesian inspired role for limited fiscal stabilization policy and served as a precursor to the non-monetary ‘structuralist’ trade-cycle model developed by Edmund Phelps in the 1990’s.
[24] The ‘monetarist counter-revolution’; the idea that money is the most significant determinant of aggregate income, underpinned by Milton Friedman’s findings of the imperviousness of consumption expenditures to short term movements in income (permanent income hypothesis), and the higher correlation between money and income than investment and income, lay a generation off from the Keynes –Hayek debate.
[25] The quotes from Hicks in this section are from The Hayek Story cited above.
[15] And quantities, if the economy is operating at below full employment. Wicksell assumed full employment in his model, but Keynes and Hayek would later relax that constraint.
[16] This is the model described in Humphrey.
[17] Hicks, John (1967) ‘The Hayek Story’ in 'Critical Essays in Monetary Theory'.
[18]The common Wicksellian heritage of Austrian monetary theory, and Keynes’ theory is expounded in detail by Leijonhufvud. See Leijonhufvud, Axel ‘The Wicksell Connection: Variations on a theme’ in Information and Coordination.
[19] A. C. Pigou pointed out that monetary expansion would ultimately stimulate spending. via a ‘real balances’ channel. He reasoned that unemployment would lead to falling wages and prices and, thus, increased ‘real’ money balances and the resulting increased wealth would induce people to spend more, which would reverse the decline and lead the economy back toward full employment. Milton Friedman pointed out that the ‘real balance effect’ could be engineered by a ‘helicopter drop’ of money, and avoid the dislocations caused by deflation. US Fed Chairman Ben Bernanke has, in the past, endorsed Friedman’s prescription and it has formed the centerpiece of his strategy of injecting massive increases in base money to combat the forces of deflation unleashed by the financial meltdown.
[20] This is Keynes’ ‘Paradox of thrift’. An excess of savings leads, via market adjustments, to a state in which savings (and income and employment) are reduced. An increase in spendthrift behavior leads in the opposite direction, to a state of increased savings.
[21] And corresponding government deficits to provide a riskless alternative to hoarding ‘barren’ money.
[22] This passage, and many of the ideas of this paper , were inspired by a recent paper by David Laidler. See his 'Financial Stability, Monetarism and the Wicksell Connection' (the 2007 John Kuszczak Memorial Lecture).
[23] The text refers to the model in Hayek’s Prices and Production, published in 1931, which represented the ‘state of the art’ Austrian model of an interest rate driven ‘monetary’ trade cycle. Later on, after publication of Keynes’ General Theory, Hayek responded with a new ‘real business cycle’ model in Profits, Interest & Investment, published in 1939, which incorporated a Keynesian inspired role for limited fiscal stabilization policy and served as a precursor to the non-monetary ‘structuralist’ trade-cycle model developed by Edmund Phelps in the 1990’s.
[24] The ‘monetarist counter-revolution’; the idea that money is the most significant determinant of aggregate income, underpinned by Milton Friedman’s findings of the imperviousness of consumption expenditures to short term movements in income (permanent income hypothesis), and the higher correlation between money and income than investment and income, lay a generation off from the Keynes –Hayek debate.
[25] The quotes from Hicks in this section are from The Hayek Story cited above.
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