Do “net financial assets” matter?

I’ve just read Steve Waldman’s post on “net financial assets” and am connecting it up with Michael Pettis’ excellent discussion. (See also Cullen Roche’s comment on the issue.)

Steve discusses the decomposition of financial positions on which MMT is based. He points out that the term “net financial assets” is used for the “private sector domestic financial position” which refers exclusively to the aggregate netted financial position of both households and firms and explicitly excludes “real” savings such as any housing stock that is fully paid up. By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises — this is the essential characteristic that distinguishes a claim to a financial asset from a claim to a real asset.

For Steve, there is a tradeoff between holding financial claims and holding real claims, and a principal reason for holding financial claims is to offset the risk of the real claims. Thus, Steve goes on to claim that to the degree that such a positive private sector financial position is due to claims on government, the government is using its credibility to provide a kind of insurance against real economy risk.

This is where I think Steve both gets what happened in 2008 right, and gets the big picture of the relationship between the financial and the real, and between the private sector and the public sector wrong. Steve is completely correct that in 2008 the issue of public sector liabilities played a huge insurance and stabilization role.  But Steve extends his argument to the claim that: “The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state.”

The key point I want to make in this post is this: the financial and the real are so interdependent that they cannot actually be divorced. The same is true of the private and the public sectors. Financial activity and real activity, public sector activity and private sector activity are all just windows into a single, highly-integrated economy. Thus, I would argue that it is equally correct to state that: “The domestic public sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the private sector.”

That financial activity and real activity are two sides of the same coin is most obvious when one considers that the credibility of private sector financial liabilities depends fundamentally on the performance of the real economy. But it is equally true that the credibility of public sector liabilities (when measured in real terms) depends fundamentally on the robustness of the real economy as well. Those countries that have very highly rated debt did not achieve this status ex nihilo, but because of the historical performance of their economies and the robustness of their private sectors.

Thus, it is entirely correct that the public sector can temporarily step in to provide insurance for the private sector when it is struggling, but the view that it is the public sector that is the primary provider of insurance fails to capture the genuine interdependence that lies at the heart of a modern economy.

Indeed, Steve recognizes the danger of framing the financial and the real and the public and the private in this way in his last paragraph, where he acknowledges that this publicly-issued insurance is in fact provided in real terms at the expense of a segment of the private sector — the segment that does not hold the claims on government.

Michael Pettis on Creating Money out of Thin Air

Now let’s turn to Michael Pettis (whom I’ve never met, so I’ll call him by his last name). Pettis has long stood out as an economist with a uniquely strong understanding of the relationship between the financial and the real. He argues that “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

His two cases are a full employment economy (without growth) and an economy with an output gap. He argues that it is only in the latter case that the funding provided by banks (or government) can have an effect on output. In a comment to Pettis’ post I observed that his first case fails to take into account Schumpeter’s theory of growth. An economy is at full employment only for a given technology. Once there is a technical innovation, the full employment level of output will increase. Schumpeter’s theory was that the role of banking in the economy was to fund such innovation. Thus, there is a third case in which bank finance in a full employment economy does not just transfer resources to a different activity, but transfers them to an innovative activity that fundamentally alters the full employment level of output. Thus, it is not only when the economy is performing below potential that bank funding can create the production that makes savings equal to investment. When banks fund fundamental technological innovation, it is “as if” the original economy were functioning below potential (which of course if we hold technology constant at the higher level, was in fact the case — but this deprives the concept of “potential GDP” of its meaning entirely.)

Schumpeter was well aware that the same bank funding mechanisms that finance fundamental technological innovation, also finance technological failures and a vast amount of other business activity. Indeed, he argued that even though the banking system was needed to finance innovation and growth, the consequences of the decision making process by which banks performed this role included both business cycles and — when banking system performed badly — depressions.

In short, there is very good reason to believe that even in a “full-employment” economy when banks create debt, some fraction of that process creates additional demand. The problem is that the fraction in question depends entirely on the institutional structure of the banking system and its ability to direct financing into genuine innovation. It’s far from clear that this fraction will exhibit any stability over time.

How Did We Get Here: The Fault Lies in Our Models

So why do economists fall into the trap of treating the financial and the real as separable phenomena? Why do macroeconomists of all persuasion look for solutions in the so-called public sector?

The answer to the first question is almost certainly the heavy reliance of the economics profession on “market-clearing” based models. In models with market-clearing everybody buys and sells at the same time and liquidity frictions are eliminated by assumption. Of course, one of the most important economic roles played by financial assets is to address the problem of liquidity frictions. As a result, economists are generally trained to be blind to the connections between the financial and the real. People like Michael Pettis and proponents of MMT are trying to remove the blindfold. They are, however, attempting to do so without the benefit of formal models of liquidity frictions. This is a mistake, because the economics profession now has models of liquidity frictions. The future lies in the marriage of Schumpeter and Minsky’s intuition with New Monetarist models.

The answer to the second question is that we have a whole generation of macroeconomic policy-makers who think that the principal macroeconomic economic debate lies between Keynesians and Monetarists, when in fact both of these schools assume that the government is the insurer of last resort. The only distinction between these schools is whether the insurance is provided by fiscal or by monetary means. (To understand why our economies are struggling right now one need only understand how the assumption that the government is the fundamental source of liquidity has completely undermined the quality of our financial regulation.)

The concept of liquidity as a fundamentally private sector phenomenon that both drives the process of growth and periodically requires a little support from the government (e.g. giving the private sector time to weather a financial panic without the government actually bearing a penny of the losses) has been entirely lost. Only the future can tell us the price of this intellectual amnesia.

On the “Low for Long” Report

Given that my preferred explanation for low real interest rates are the changes that have been wrought within the developed world’s financial markets — and in particular the growth in collateralized inter-bank lending, I read with interest the newly released report, Low for Long? Causes and Consequences of Persistently Low Interest Rates by Sir Charles Bean, Christian Broda, Takatoshi Ito, and Randall Kroszner.

The authors establish the basic facts:

the world long-term real risk-free rate has been drifting down remorselessly from around 4% in the late 1990s to just below zero today.


The very low level of long-term risk-free real interest rates in the advanced economies is historically most unusual. Real rates have rarely been so low; when they have been, it has almost invariably been during or after a war, when there was a degree of financial repression and/or inflation was elevated. The present configuration of low real rates with low inflation appears to be unprecedented.

In Chapter 2 the authors discuss the various explanations for why real interest rates have declined “remorselessly” from 1998 or 1999 on. While the authors do discuss shifts in preferences in favor of “safe assets,” they do not even mention what I would consider the most important explanation for such a demand shift: the increasing collateralization of financial exposures on the part of our biggest financial institutions. (As was noted in my previous post, data on this is available from the ISDA.) Indeed, the only source of an increase in demand for safe assets that the report cites which is consistent with the timing of the drop in rates is the increase in emerging market demand for foreign exchange buffers subsequent to the Asian financial crisis. All of the other explanations in this subsection refer to sources of increased demand subsequent to the crisis (post-crisis recognizing of the extent of possible bad outcomes, post-crisis regulatory requirements for banks to hold larger buffers of safe assets, and the demand for safe assets created by central bank quantitative easing policies.)

What is missing from the report is this: the latter stage of the Asian financial crisis coincided with the LTCM failure. The LTCM failure led to a significant increase in the collateralization of financial sector exposures. Collateralization ramped up continuously over the early years of the current millennium as laws supporting collateralization regimes were adopted in the US, the UK, and Europe. It is remarkable that this potential explanation of prolonged low rates on “safe assets” which has the same timing as the emerging markets savings glut explanation and therefore meets one of the most important criteria considered by the report has been entirely omitted from it.

This lapse strikes me as evidence that the financial sector is invisible to modern macroeconomists. I, of course, can’t help wondering whether this blindness is generated by the models they work with. In my view, we need to take a long and hard look at modern finance and how it has changed the way the real economy operates.

Economics, the big questions, and scoring opportunities

Barry Ritholtz sends us to Brad DeLong using a sports analogy to criticize the economics profession:

The first principle of success in practically any endeavor is to move not toward where the ball is, but where it is going to be. Economists, as a rule, ignore this principle, indulging in the likely-to-be-vain hope that policies that would have worked yesterday will still work tomorrow

The only sport I have much understanding of is soccer, and this principle is far from correct in soccer. I have long felt that economists are seriously handicapped by their failure to follow basic team sport principles, so here’s my sports analogy for economics.

In soccer, the job of every player on the field is to move the ball to the position that maximizes the likelihood of scoring. The job of a coach at the developmental level is to teach the players to “see the field” before the ball is received in order to read where the ball needs to move next . Usually there are only one or two good answers to this maximization problem. Good players create danger by making the right choices of where to pass, and mediocre players don’t. (If you want to see a realization of this maximization process in action, watch Germany’s 2014 World Cup games.)

So “the first principle of success” in soccer is to create scoring opportunities by moving the ball effectively (and not always forward) on the field. (The second principle of success is to move when you don’t have the ball to a position that will make you the optimizing choice for the player receiving the ball. That is, contra DeLong, a good player creates the place where the ball will be next.) The problem with the economics profession is that it plays like Spain in the 2014 World Cup, it’s very good at passing side to side, but much weaker when it comes to creating and finishing scoring opportunities.

Thus, the economics profession must, first, define the scoring opportunities — or the big questions that economics must answer — and, second, the profession needs to play as a team always trying to move the ball into a position so that your teammate can score — except in the unusual case that you are best positioned to take the shot.

This, I think, is one way to understand Paul Romer’s critique of the economics profession. He is concerned that the current process promotes prima donna-like behavior, where the authors of articles set themselves the task of dribbling through four defenders and succeed only at losing possession of the ball entirely. And when there is team play it is wasted, dithering about, not even trying to answer important questions.

In short, the economics profession has an extraordinary wealth of formal analytic tools. Now that those tools have been developed, the challenge is to deploy them effectively to answer the big — mostly macroeconomic — questions. In order for this deployment to be effective, teamwork is necessary. The masters of the formal tools need to stop passing the ball laterally and start working on deploying them to answer the big questions. (The segment of the profession that seems to me to be making the greatest progress in the latter effort is “new monetarism.”) The proponents of big questions need to stop sniping at the formalists, acknowledge the weaknesses in their own economic toolbox, and, I would argue, set to work building models that take money and finance more seriously than New Keynesian models do.

I am optimistic that this challenge can be met. Teamwork was in evidence when the New Keynesian models were developed. And post-crisis, there is widespread acknowledgment of the need for better incorporation of finance into economic models, and many steps along this path have already been taken. But the economics profession needs to remember that the fastest way to progress is to act always with awareness of where the goal is, with a broad view of the entire field of players, and with each individual making careful decisions as to how to move the ball so that someone else can score.

Negative real rates signify a broken financial system

Noah Smith reviews the debate over negative real rates, and Brad DeLong remarks on “how profoundly strange and unexpected” is the current environment. While Noah covers all the most common explanations for real rates, I think that he — and most of econo-blogosphere — are missing a key factor that is probably driving this data.

First, recall that the problem of negative real rates is very much focused on the “safe” side of the market. That is, it is Treasuries (and similar assets like Bunds) that bear negative real rates. The market rates available to non-public borrowers are much higher than the rate on “safe assets.” (The distinction between these two rates is the premise behind Caballero and Farhi’s work.)

In my view the missing element of the discourse on the low yields of safe assets is the remarkable change in the structure of the financial system that started very slowly in the 1990s, accelerated at the end of that decade, and was a full-fledged financial revolution by the end of the next decade. This change is the collateralization of inter-bank lending, that previously was unsecured and funded on the basis of reputation-type mechanism.

ISDA data shows that with the growth of swaps starting in the early 1990s, collateralization of bilateral derivatives contracts become fairly common, though far from ubiquitous. Subsequent to the 1998 LTCM crisis, collateralization of derivatives contracts became much more widespread. The 2000 Commodities Futures Modernization Act pre-empted long-standing common law and state law constraints on derivatives markets, which subsequently grew dramatically — along with the use of collateral. The 2005 bankruptcy reform act dramatically changed markets for collateral, and in particular made it possible for the repos of just about any asset to trade on a par with derivatives collateral.

In addition in the early naughties, the growth of structured financial assets that made possible synthetic assets in which “investors” sold protection on bonds (instead of investing in actual bonds) and held the collateral that was used to guarantee payment on the protection contracts in “safe assets.” Finally, financial market participants have sometimes commented that the Basel rules for banks promoted collateralized interbank lending over unsecured interbank lending (though I’ve never really investigated this point).

In short, the same data the Ben Bernanke explained in terms of a “savings glut” can also be explained by the financial industry’s massive increase in demand for safe assets that serve as high quality collateral over the same time period. The financial industry’s demand is a demand for safety and cannot be met by risky assets, so it is an excellent explanation for the 21st divergence between the behavior of “safe” interest rates and risky interest rates.

Furthermore, since the 2008 crisis the financial industry’s demand for collateral has only increased. In 2008 the unsecured interbank markets, including both the Federal Funds market and the Libor market, collapsed. They have not recovered. Interbank lending has shifted almost entirely to a collateralized basis. While it is true that the demand for collateral that was created by structured finance products has largely disappeared, this is most likely offset by regulatory changes that increase the demand for collateral.

In short, the best explanation for why private markets are forcing interest rates to zero is that the banking system is broken. The system which functioned for centuries on the basis of unsecured, reputation-based, inter bank lending no longer exists. ZIRP is just evidence that the financial industry is turning to government as a source of the liquidity that the financial industry is no longer capable of creating on its own.

Models, Depressions, and “Natural” Economics

My recent work has led me to study classical banking theory, which informed both Wicksell’s and Schumpeter’s understanding of the economy. Classical banking theory views bank liabilities as the primary form of money and argues that, given a well-structured financial system, the quantity of money is endogenously determined by the demands of the business community for the finance of accounts receivable and similar short-term loans.

This theory of money views the role of banks and supply of money as passively responding the needs of the real economy. And this view was, probably correctly, targeted as one of the reasons U.S. officials failed to act aggressively during the Great Depression in he 1930s. Certainly both the Monetarists and the Keynesians who would develop what is now known as macroeconomics saw classical banking theory as a school of thought that was best exterminated. And these days extraordinarily sophisticated works that took a banking theory approach in the mid-20th century are now relegated to the moth-balled “depository” shelves of university book stacks (e.g. the work of R.S. Sayers).

In short, in the 1930s there was a predominant model of the money and banking system. This model when it was applied to circumstances far beyond the realm of its usual operation failed. When it failed, proponents could not recognize that failure and instead used the model to justify the view that real economic performance was a “natural” phenomenon about which there was nothing they could do. They were firmly convinced there was no need to act.

Reading David Beckwith and Paul Krugman today, I couldn’t help wondering whether history is beginning to rhyme. After describing the views of those who doubt the continued efficacy of policy rates that are held at zero, Beckwith writes:

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.

Krugman, discussing Beckwith’s post, gives a very clear description of how this view is the output of the current predominant model of the macroeconomy:

He’s completely right about the economics. . . . we have a very clear model that tells us what interest rates would be in the absence of distortions and rigidities, the Wicksellian natural rate — the rate of interest consistent with an economy subject neither to inflationary overheating nor deflationary excess supply. And with inflation consistently below the generally accepted 2 percent target, this model says that the actual interest rate, at zero, is above the natural rate, not below.

And all I can hear reading this is the rhyme of history. We have a model and we rely on it to be right. That model tells us that low rates are “natural.” There is nothing more to be done. We must keep rates at zero until the economy improves. But just as in the 1930s the model is being applied far beyond the region of the data in which we have knowledge that it works.

And my guess is that just as in the 1930s we will find that we need to develop a completely different model, built on completely different premises in order to develop policy recommendations for our current problems. My own view is that this a good time to revive classical banking theory and relearn what it has to say about central bank policy and what makes the economy tick.

David Andalfatto has given a very simple explanation of why such new models are needed: the data can be explained by debt-constraints just as well as it can be explained by a negative real interest rate. This accords very closely with Schumpeter’s view that every economic “catastrophe” can be attributed to dysfunction in the banking sector. Perhaps it will be only after we have relearned how to model the monetary role of the banking system that we will be able to escape the tragedy of ZIRP.

Corporate liability and the “crimes were committed” approach to law enforcement

Pursuant to Attorney General Loretta Lynch’s welcome change in DoJ policy, it occurred to me that an old draft post of mine might actually merit being posted, so here goes:

After listening to a presentation on the impressive growth in enforcement actions resulting in corporate criminal liability a few months ago, it occurred to me that people without legal training might not actually understand the reasoning behind the critique that individual prosecutions should almost always accompany corporate criminal liability. (The presenter at one point framed such critiques as claiming that prosecutors were colluding with management against the shareholders.)

The problem with corporate criminal liability is this: every crime has a mens rea or element of intent that must be proved as part of the prosecutor’s case. Negligence is one of the lower levels of mens rea, but many instances of negligence are not crimes. Often a “knowing” or “should have known” standard is applied in criminal law.

When a prosecutor chooses to seek corporate criminal liability, without bringing any cases of individual criminal liability, the problem is whether it makes logical sense to argue that the corporation had the mens rea for the crime, but no individual in the corporation had the mens rea (or the one with the mens rea managed not to take relevant action in promotion of the crime). Now one can dream up special circumstances where this position would actually be logical, but it seems to a lot of people that this situation should be rare.

Critics of corporate liability (I’m thinking of Judge Rakoff and Bill Black here, for example) would probably argue that pursuing corporate criminal liability, without pursuing individual liability is tantamount to stating that a crime was committed, but we don’t know by whom. (Note that the reverse where there is individual criminal liability without corporate criminal liability is likely to be much more common. Rogue employees and a genuine effort on the part of the corporation to avoid the criminal activity would both be good reasons – though not necessarily successful reasons – for not extending criminal liability from an individual to the corporation.)

Overall an important criticism of the growth of deferred prosecution agreements and non prosecution agreements is that finding this growth acceptable in the absence of individual prosecutions is essentially lowering the standards for what a prosecutor is supposed to do. “A crime was committed, but I don’t know by whom” should not be the normal stopping point for a prosecutor’s case.

The argument is, of course, not that there should never be corporate criminal liability without an accompanying case for individual liability, but simply that this outcome should be relatively rare. In general, we want our prosecutors to think of their jobs as going all the way to finding out “who done it,” and not stopping with “a crime was committed” and a fine was paid.

In short, the argument against treating a finding of corporate criminal liability as an end point is not about “collusion,” but instead goes to the heart of what it means to enforce the law.

An egregious error on the history of central bank actions in crises

Brad DeLong, who is a brilliant economic historian and whose work I greatly respect, has really mistaken his facts with respect to the history of the Bank of England. And in no small part because DeLong is so respected and so deserving of respect, this post is pure siwoti.

DeLong writes: “central banks are government-chartered corporations rather than government agencies precisely to give them additional freedom of action. Corporations can and do do things that are ultra vires. Governments then either sanction them, or decide not to. During British financial crises of the nineteenth century, the Bank of England repeatedly violated the terms of its 1844 charter restricting its powers to print bank notes. The Chancellor the Exchequer would then not take any steps in response to sanction it.”

DeLong gets the facts precisely backwards. In 19th century crises prior to any breach of the 1844 Act, the Act was suspended by the British government, which promised to indemnify the Bank for legal liability for any breach of the restrictions in the 1844 Act. The text of the 1847 letter was published in the Annual Register and was the model for subsequent letters. It read:

”Her Majesty’s Government have come to the conclusion that the time has arrived when they ought to attempt, by some extraordinary and temporary measure, to restore confidence to the mercantile and manufacturing community; for this purpose they recommend to the Directors of the Bank of England, in the present emergency, to enlarge the amount of their discounts and advances upon approved security, but that in order to retain this operation within reasonable limits, a high rate of interest should be charged. In present circumstances they would suggest, that the rate of interest should not be less than 8 per cent. If this course should lead to any infringement of the existing law, her Majesty’s Government will be prepared to propose to Parliament, on its meeting, a bill of indemnity. ”

In the kabuki show that took place during each of these events, the Bank typically denied that action on the part of the government was necessary. In 1847 it was the mercantile community that depended for existence on the support of the Bank, which sent a delegation to Downing Street to ask that the 1844 Act be suspended (Clapham, II, 208-09). Thus, the Bank most certainly did not act ultra vires. Instead, the terms of its charter were explicitly relaxed by the government each and every time the Bank breached the terms of the 1844 Act.

The relevant part of the 1857 Bill of Indemnity reads:

“the said Governor and Company, and all Persons who have been concerned in such Issues or in doing or advising any such Acts as aforesaid, are hereby indemnified and discharged in respect thereof, and all Indictments and Informations, Actions, Suits, Prosecutions, and Proceedings whatsoever commenced or to be commenced against the said Governor and Company or any Person or Persons in relation to the Acts or Matter aforesaid, or any of them, are hereby discharged and made void.” (See R.H. Inglis Palgrave, Bank Rate and the Money Market, 1903 p. 92)

In short, far from delegating to the central bank the authority to make the decision to take ultra vires actions, the Chancellor of the Exchequer and the Prime Minister were important participants in every single crisis — and they signed off on extraordinary actions by the Bank, before the Bank’s actions were taken.

Indeed, to the degree that the Bank issued notes beyond the constraints of the 1844 Act, the government was paid the profits from the issue of those notes. Effectively this was the quid pro quo for the government’s indemnity of the Bank. (See e.g., George Udny, Letter to the Secretary of State for India dated January 1861 pp. 25-26).

Note: updated 8-3-15 3:25 pm PST.

Growth and financial instability: Schumpeter’s hypothesis

I have taken my own advice and read (most of) Schumpeter’s Business Cycles with some care. He has completely blown my mind — and I am left bewildered by how it is possible that this body of work has been all but forgotten.

All the elements of what is now known as the Kindleberger-Minsky model of financial crises were present in Chapter IV of Schumpeter’s Business Cycles, and indeed Minsky cites his advisor as an important source for the financial instability hypothesis.

There is a crucial aspect of Schumpeter’s analysis that is, however, typically omitted from discussions of “Minsky moments.” Schumpeter separated out the “displacement” and “boom” phases of crises as fundamentally productive phenomena: displacement is naturally caused when a transformative innovation is funded by credit creation through the financial system and a boom is the inevitable result. Thus, Schumpeter is careful to construct his argument so that there is no doubt that we need the financial system to create credit. Credit creation ensures that growth due to innovation is accompanied by growth in the money supply, and thus that innovation does not result in deflation.

In short, for Schumpeter displacements and booms are an essential part of the process by which innovation drives economic growth.

Unfortunately the same financial system that creates credit to fund innovation, also creates credit to fund many other activities, including the finance of inventories, expansion of existing businesses, and consumption, all of which appear initially to be justified by the dynamics of the boom, but which in the end cause the economy to overheat. Kindleberger calls this phenomenon “overtrading.” The counterpart to an overheated economy is bad debt. As this economy works through the bad debt, “abnormal” liquidation takes place and “destroys many things which could and would have survived without it. In particular, it often liquidates and weeds out firms which do not command adequate financial support, however sound their business may be.” 155. When the economic circumstances are particularly adverse, debt deflation can set in and cause a depression. This is the stage that Kindleberger named “revulsion.”

Overall, Schumpeter didn’t just describe the dynamics of bubble, he also argued that there was a close connection between these dynamics and the capacity of an economy to take advantage of innovation and to grow. In the process, he concluded that almost every economic “catastrophe” can be attributed to dysfunction in the banking sector – and in particular to a failure on the part of bank lenders and business borrowers to exert appropriate control on the use of credit.

Schumpeter’s error presumably was to acknowledge that it was beyond the scope of economic theory to determine how to discipline the banking and business communities in their use of credit. 156. Thus, the intellectual debates of the middle of the 20th were dominated by economic theorists who could offer simpler answers (spend money, increase the money supply) to extraordinarily complex problems.

Schumpeter’s Monetary Theory of the Macroeconomy

Brad DeLong needs to give Schumpeter’s 1939 work “Business Cycles” a read. DeLong writes that Schumpeter “genuinely seems to have no clue at all that the business cycle is a feature of a monetary economy,” that he did not understand Wicksell, and that he was a sound money ideologue. I have never studied the history of Schumpeter’s thought, so it is possible that there is an “early” Schumpeter of whom these accusations may be accurate, but by 1939 Schumpeter had not only grappled with Wicksell’s approach but written a very cogent critique of it, had worked out a monetary theory of the business cycle, and had aggressively criticized sound money advocates.

The problem is not that Schumpeter was not a monetary economist, but that he offered a fundamental critique of the way money is introduced into the Walrasian model upon which both modern Keynesianism and much of modern neo-monetarism are built. With Tobin and Friedman allied against his ideas, all that has been passed down into the modern canon of Schumpeterian macro is Minsky.

DeLong apparently has missed something very important about Schumpeter: His “entrepreneurs-disrupt-the-circular-flow-and-cause-structural-change-and-growth-theory of enterprise” is fundamentally a monetary theory. Schumpeter’s analysis is built on a whole theory of the monetary system that makes it possible for entrepreneurs to obtain the funds for their yet-to-be-realized projects without diverting too much in the form of real resources from the already established — and reasonably well functioning — economy. In Schumpeter’s theory at the core of a capitalist economy lies not just innovation, but more importantly the monetary finance of innovation.

This is what Schumpeter has to say about Wicksell (pp. 128 ff.):

The necessity of reconciling a nonmonetary theory with obvious facts of the sphere of money and credit is, in particular, responsible for the idea that there are two kinds if interest rates, a “natural” or “real” one which would also exist in a barter economy and which represents the essence of the phenomenon, a permanent net return from physical means of production, and a monetary one, which fundamentally is but the former’s reflex in the monetary sphere. The two may, nevertheless, differ of course or be made to differ by monetary policy or by an expansion or contraction of bank credit, but this constitutes a disturbance from which a definite string of consequences, among them the business cycle itself, has been deduced. The roots of this idea reach very far into the past and are clearly discernible in the English monetary discussions of the fourth and fifth decades of the nineteenth century. Its role in the thought of our own time is due to the teaching of Knut Wicksell and to the work of a brilliant group of Swedish and Austrian economists. For us, however, there is no such thing as a real rate of interest, except in the same sense in which we speak of real wages : translating both the interest and the capital items of any loan transaction into real terms by means of the expected variation in an index of prices, we may derive an expected and, by performing the same operation ex post, an actual rate of interest in terms of “command over commodities.” But nominal and real rates in this sense are only different measurements of the same thing or, if we prefer to speak of different things even in this case, it is the monetary rate which represents the fundamental phenomenon, and the real rate which represents the derived phenomenon. Hence, the money market with all that happens in it acquires for us a much deeper significance than can be attributed to it from the standpoint just glanced at [i.e. Wicksell]. It becomes the heart, although it never becomes the brain, of the capitalist organism.41

Note 41: Moreover, profits in our sense display no tendency toward equalization. This and the essentially temporary character of profits in our sense should be sufficient to make it quite clear that both our distinction between profit and interest and the relation between them is not identical with an old distinction between normal business profits and contractual interest. However much the writer welcomes anything that will link his teaching to older doctrine, he must point out, first, that normal profits and interest are, according to this view, still the same thing— exactly as contractual and directly earned rent of natural agents is— which he thinks erroneous, and, second, that the analytic problem which he undertook to solve by his theory of interest was precisely to show how it is possible that a theoretically permanent income flows from essentially transient sources and that it should not disappear as a net return through a process of imputation.

One of the points that Schumpeter is making is that if you are going to bring up Walras’s Law then it is clear that you are talking about a barter and not a monetary economy, because the model in which Walras’s Law can be derived is fundamentally a barter economy. (See Jakab and Kumhof for a modern treatment of this issue.) Schumpeter doesn’t tack money onto a model of barter and call it “monetary economics.” Instead he studies the banking system to understand what it does, and then develops a model where the business cycle is driven by phenomena in the money market.

Schumpeter goes on to explain that he has a completely different notion of “capital” than that used by Wicksell. Roughly speaking Schumpeter views capital as financing rather than as a stock of productive goods. He writes (pp. 130 ff.):

Capital in this sense is not goods but balances, not a factor of production but a distinct agent which stands between the entrepreneur and the factors. It can be created by banks because balances can. Its increase and decrease are not the same as increase and decrease of commodities or any particular class of commodities. Its market is simply the money market, and there is no other capital market. No realistic meaning attaches to the statement that, in the latter, “capital” (= some kind or other of producers’ goods) is being ‘lent in the form of money.” But again as in the case of interest the introduction into our analysis of this concept of capital does not do away with the problems of what is traditionally referred to as real capital—on the contrary, they reappear though in a new garb—and results arrived at by means of a monetary theory of capital not always invalidate, but in many cases only reformulate, the proposition of “real” theories of capital. If our understanding of the processes of capitalist society hinges on realizing the fact that monetary capital is a distinct agent, it also hinges on realizing how it is related to the world of commodities.

In addition, Schumpeter explained very clearly that “catastrophes” in capitalist economies are usually due to defective regulation of the banking system. If I remember correctly, DeLong has acknowledged that one of his errors prior to the crisis was to underestimate dysfunction in the banking system. Perhaps if he were more familiar with Schumpeter, he would have been less likely to make that error. Schumpeter writes (p. 117):

Moreover, bankers may, at some times and in some countries, fail to be up to the mark corporatively : that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops. This in itself is sufficient to turn the history of capitalist evolution into a history of catastrophes. One of the results of our historical sketch will, in fact, be that the failure of the banking community to function in the way required by the structure of the capitalist machine accounts for most of the events which the majority of observers would call “catastrophes.” [my emphasis]

Thus, Schumpeter’s error is not to fail to write monetary economics, but to have such a profound understanding of the relationship between money and finance that his work was not understood by the founders of modern macroeconomics.

Furthermore, when it comes to “sound money” Schumpeter writes of the 1830s experience with “reckless banking” in the U.S. (pp. 236 ff):

Whatever our opinion might be if we placed ourselves on other possible standpoints, however strongly we may feel it our duty to condemn both the misconduct involved and the public opinion that not only condoned but fostered it, the fact still remains that we have before us the clearest historical instance by which to illustrate the function of credit creation. It was the financing of innovation by credit creation— the only method available, as we have seen in the course of our theoretical argument, in the absence of sufficient results of previous evolution—which is at the bottom of that “reckless banking.” This undoubtedly sheds a different light upon it. Those banks filled their function sometimes dishonestly and even criminally, but they filled a function which can be distinguished from their dishonesty or criminality. Sound money men of all times, hence, threw and still throw away the baby with the bath by condemning the principles of that practice, however understandable their clamor for policing and controlling the practice itself may have been. The people felt this. So did some of the advocates of inflation, though they were unable to formulate their case correctly.

Thus, Prof. DeLong is making very unfair accusations against Schumpeter when he claims that Schumpeter “denies that anything other than budget surpluses and ‘sound money’ can ever be appropriate economic policies.” Schumpeter indicates that the problem with people like DeLong is that they are unable to formulate their case correctly, because they don’t have a good understanding of the relationship between money and finance.

I think that Schumpeter would agree with my view that those who claim that monetary policy can solve the problem of “a shortage of safe assets” are confused. We have a shortage of safe assets, because we have a dysfunctional banking system that is currently incapable of creating safe assets. If this is correct, then holding interest rates at zero will not solve the problem and get the capitalist engine running again. That is like pouring gas into a broken engine and expecting it to run, when of course what is needed is that you make the effort to learn how to fix the engine.

“Behavioral” finance approaches are mainstream in macro

Noah Smith, a finance professor, has written a piece arguing that the finance approach to “behavioral” economics/finance has been very successful, whereas it has been largely rejected by the macroeconomics profession. The piece is confusing, however: even though Smith explains that the term “behaviorial economics” refers to a much narrower field of study than the term “behavioral finance,” he does not explore fully the implications of these two different definitions.

Smith explains the different terms:

To most economists, behavioral economics means using findings from psychology to modify models of individual behavior. But behavioral finance has come to have a much more expansive meaning, basically encompassing anything that doesn’t conform to the Efficient Markets Hypothesis (which says that you can only earn market-beating returns by taking on extra risk).

What is left out of Smith’s piece is that many of the approaches that are categorized as “behavioral” in finance, are categorized as mainstream in macroeconomics. There’s no division between saltwater and freshwater macroeconomists on whether macro needs to study frictions using the whole of the microeconomic toolbox including contract theory, mechanism design, etc. The study of the many ways in which Arrow-Debreu (and more generally the efficient markets hypothesis) fails has been fundamental to the macroeconomic research agenda for at least three decades.

By contrast, when the finance profession categorizes mainstream economic theory as “behavioral,” this has the effect of defining as mainstream finance that which is consistent with the efficient markets hypothesis. As a result finance is probably the only economics-related field that has not yet integrated the mid-20th century critiques of the competitive model into its “mainstream” body of theory. For this reason, the fact that “behavioral finance” is alive and well is hardly surprising: if this were not the case, the field of finance theory would be decades behind the theory that is used throughout the economics profession.

The real question then is why the finance profession has not dropped the “behavioral” moniker from behavioral finance, and renamed non-behavioral finance “frictionless finance.”


Note: It is clear that Paul Romer finds that macroeconomists have a lot of work to do when it comes to incorporating decades-old critiques of the competitive model into the their work. As I understand his argument, he objects to the way the critiques have been incorporated in macro, because this constitutes a pluralistic “views about the shape of the earth differ” approach, rather than an effort to  fully acknowledge and integrate the logical implications of these critiques into what constitutes mainstream theory.  I suspect that Romer would agree, however, that macro theory is several steps ahead of efficient-markets-based finance theory — if only because mainstream macro at least includes theory that is not price-taking and frictionless.


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