I just discovered a very good blogger that shares some of my ideas (and has actually been blogging much longer than I have.) The blogger, Nick Rowe, has a couple of very interesting posts on monetarism here and here. (He also linked to my blog, but I have been so busy that I only now noticed.) Mr. Rowe indicates that he was a student of David Laidler, and before talking about Nick’s ideas, I’d like to say a few things about Mr. Laidler.
Mr. Laidler believes that macroeconomists have a great deal to learn from studying the history of their field. I read several of his excellent books on the history of monetary theory, linked here and here. It seems to me that scholars like David Laidler occupy an increasingly marginal place in modern macroeconomics, mostly on the fringes—such as the history of economic thought. But I’m coming to believe that the field of macroeconomics made a big mistake in adopting a highly technical and abstract style in recent decades.
If this crisis shows anything, it is the importance of having people who can think along a number of different dimensions at once. I am not impressed by young hotshot theoreticians who tell me that the liquidity trap “all boils down to X.” Or “monetary policy is simply this.” No, it doesn’t all boil down to anything, as you may have gathered from my other posts. You cannot understand liquidity traps without understanding the history of the Great Depression, and 1994-2008 Japan. (In my other posts I argue that neither “trap” was what it seemed to be.) You need to understand exactly how the Fed works, what the policy of paying interest on reserves means, and whether that rate could be negative. You need to understand the issue of policy credibility, and what sort of signals markets are likely to find credible. You need to understand the pros and cons of unconventional open market operations involving risky assets. You need to understand the many different channels by which monetary injections can impact AD. You need to understand the international political friction caused by currency devaluation. It even helps to understand how word choice subtly shapes our thinking (i.e., use of the term “expectations trap,” for what is not necessarily a trap at all.) It doesn’t “all boil down to” anything. It’s complicated, not mathematically complicated, but conceptually complicated.
The world economy right now desperately needs a lot more people with the depth of knowledge and wisdom of David Laidler, and fewer people who are adept at doing DSGE models, but are unable to offer practical advice in a crisis.
I only met him once, and I recall that we chatted about the tech bubble. Mr. Laidler argued that this event showed that inflation targeting was flawed, and that central banks needed to pay more attention to asset prices. I replied (no surprise) that I thought if the Fed targeted NGDP it would at least partially address the issues that he was worried about. I do think that my NGDP proposal is looking even better after the events of the past 5 years, but even I would have to concede that these events favor Mr. Laidler’s point of view even more strongly than mine.
Nick Rowe does a much better job that I could of explaining the current trends in monetary theory, especially Woodford’s “Neo-Wicksellian” model, which completely excludes money. BTW, I have always thought that money must appear somewhere in Woodford’s model, as you can’t have a price level without a medium of account. I think that what Woodford means is that you don’t need a medium of exchange (i.e. M1.) I vaguely recall that Bennett McCallum argued that the model did contain a money-like asset, interbank clearing balances. (Someone correct me if I am wrong here.)
Nick Rowe also sees the need to take another look at some of the ideas put forward by the monetarists:
So we need to revert to an older, earlier way of thinking. Monetary policy is about changing the stock of money. The objective of monetary policy, in a recession, is to create an excess supply of money. People accept money in exchange for whatever they sell to the central bank, because money by definition is a medium of exchange. But they don’t want to hold all that money. Or rather, the objective of the central bank is to buy so much stuff that people don’t want to hold the money they temporarily accept in exchange. An excess supply of money is a hot potato, passing from hand to hand. It does not disappear when it is spent. It spills over into other markets, creating an excess demand for goods and assets in those other markets, increasing quantities and prices in those other markets. And it goes on increasing quantities and prices until quantities and prices increase enough that people do want to hold the extra stock of money.
That’s classic Monetarism. That’s what I learned from David Laidler. That’s what I hear when I read Scott Sumner too.
When I first read that paragraph I thought “wait a minute, I’m not a monetarist.” I have a major problem with classic monetarism in two areas, monetary aggregates and policy lags. I think that poor choices regarding these two issues did much to discredit the broader quantity theory approach. The specific errors were to assume that the demand for money, however defined, was stable enough to make it a useful indicator (or instrument) of monetary policy. The second mistake was to reject inflation or NGDP targeting on the grounds that because of policy lags, it would do more harm than good. And as I will argue in a later post, because monetarists paid insufficient attention to the fact that monetary policy affects financial markets immediately, they misidentified many monetary shocks, and overestimated the length of policy lags.
Nevertheless, when I read Milton Friedman’s monetary economics I feel that he is saying important things than most other economists overlook. So I am sure than certain core concepts of monetarism are deeply ingrained in my bones. It wasn’t hard for Nick Rowe to notice that.
My problem with Woodford’s Neo-Wicksellian approach, and indeed any Keynesian interest rate-oriented view of monetary policy, is that it doesn’t seem to explain many real world phenomena in a way that I find transparent. During the Great Inflation of the 1960s-80s, some countries averaged 5% inflation, some 10%, some 20%, some 40%, some 80%. I don’t doubt that Woodford’s model is technically correct, and I’m sure there is some way to explain these differing long run inflation rates with the time path of the policy rate relative to some (unobserved) natural rate of interest, but it is hard for me to visualize the process. Much easier to just think about different money supply growth rates (always being aware of the fact that velocity does change.)
And I don’t think it is just me. The two most famous proponents of the interest rate approach to monetary policy are Wicksell and Keynes. (With Keynes’ main contribution being the ineffectiveness of money at the zero bound.) It is striking that both of these figures reverted to a sort of crude quantity theory in the early 1920s. Why did this happen? Because in the early 1920s the world saw some of the most dramatic movements in price levels ever seen. Germany and some other European countries experience rapid growth in their money supply, and hyperinflation. The U.S. and several other countries with stable exchange rates experienced extraordinary declines in their monetary base (perhaps the largest decline in U.S. history) and extremely rapid deflation. One constant theme in my research into the history of monetary thought is that developments in theory almost always reflect the issues of the day. That’s why one cannot really understand monetary economics, even at a theoretical level, without understanding history. And that’s what people like myself and Nick Rowe learned from David Laidler.
I strongly recommend Nick Rowe’s blog to my readers.
P.S. The work by Keynes that I referred to was the Tract on Monetary Reform (1923.) I’ll try to dig up the Wicksell quotation.
Update: The Wicksell quotation may not be in English. But Lars Jonung discusses it in the European Economic Review, 32, pp 2-3, 1988. I should also mention that my earlier comments were not intended to be anti-math. Abstract models can be useful, and many of the top macroeconomists have both great technical skills and a very suble intuitive understanding of macro issues. My point is that it is increasingly difficult for people like Laidler to get published in good journals, or hired by top departments (unless there have been recent changes that I am not aware of.)