Abstract
Milton Friedman concedes that his use of “the quantity theory to derive a theory of nominal income rather than a theory of prices or real income” bypasses “the breakdown of nominal income between real income and prices” (1971, p. 34). This helps to explain why his predictions of real versus price level effects of given monetary policies are little, if any, better than could be obtained by tossing a coin.1
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Endnotes
With the explosion of Ml that accompanied the Fed’s abandonment of its targeted growth rate for money in latter 1982, Friedman predicted precipitous inflation to be forthwith followed by recession. Neither happened. Friedman’s claimed two year lag of prices behind money merely reflects the business cycle. The accuracy of his predictions depends upon when in the cycle the prediction is made and how much the particular cycle deviates from the average, which are matters of chance.
Despite the fact that the advice he gave (1940) in How to Pay for the War (without inflation) was taken by neither his generation nor the generations that conducted the Korean and Vietnam conflicts.
Following is an outline of the three basic elasticities and their corresponding sub-elasticities summarizing Keynes’ short-run model of money and prices (1936, Book V): (1) Elasticity of effective demand (D) relative to M: explained by Keynes’ real income (employment) theory (consumption function, investment function, and liquidity preference function in conjunction with change in the money supply. The elasticity of prices depends on (a) the elasticity of output (eo) and (b) the elasticity of wages (ew (a) elasticity of output (O) relative to effective demand (D): The elasticity of output (eo) is explained by the elasticity of employment (ec), assuming a fixed production function. Dw is the number of wage units expected to be spent for the output of labor and N is employment. The elasticity of output (eo) is also the product of the elasticities of effective demand and employment: (b) elasticity of wage units (W) relative to effective demand (D): Thus, eq = 1-(ec) (eo), where eo = 1-cw Hence, a depression may be characterized when eq = 0 and full employment when eq = 1. (3) Elasticity of prices (P) relative to changes in the quantity of money: e = (eD) (ep)
This is the aspect of Keynes concentrated on by both his opponents and proponents (other than the neo-Keynesians), a curiosity that may be accounted for by the fact that the Keynesian debate crystallized in the atmosphere of the Great Depression and the subsequent fear of another following World War II.
Keynes’ parenthetical observation that validation of the neoclassical quantity theory “in the long run” is as inevitable as death implied his recognition of the methodological shift of neoclassical monetary theorists from analytical to historical time (supra, Chap. 3).
Fisher (1918, p. 71): “Since periods of transition are the rule and those of equilibrium are the exception, the mechanism of exchange is almost always in a dynamic [i.e., disequilibrium] rather than static [i.e., equilibrium] condition.”
Fisher affirmed that the business cycle averaged 10 years in duration (1918, p. 70), and he proposed a positive remedial program in the form of the “compensated dollar” (1913). He was referring to the pre-Keynesian business cycle in contrast to the inventory cycle that now gets the attention of Americans as well as Europeans.
This should surprise only those whose knowledge of Keynes is limited to secondary sources. Aside from the Treatise on Probability and Essays in Biography, virtually everything that Keynes wrote dealt with the subject of money.
This has been no secret since Hayek (1939, p. 77) or, at the latest, Harold G. Moulton (1958, pp. 43–44), the first president of Brookings Institution. Actually, Moulton had revealed this truth to the financial community much earlier (1921, 1938). Agreement on the definition of money is not necessary because the reality of the concept has always preceded the inclination to articulate it. The concept of money implicit in human behavior and efforts to describe it is anything generally acceptable as a medium of exchange in space and time. This translates into a generally acceptable means of payment for commodities, services, and securities, and the elaboration of the medium of exchange concept of money disposes of Albert G. Hart’s semantic objections to it (cf. Mason 1980, n. 22). Any generally accepted means of payment in any community will become a generally used store of value and unit of account in that community. This concept of money is consistent with Keynes’ monetary theory as well as with those of the classics and neoclassics. For the supporting argument and documentation see Mason (1980, pp. 222–223 including n. 19). Such a view of money has the incidental advantage of correcting the Friedman-Schwartz misconception (1970, pp. 136–170, 197–198) that has misled more than monetarists (Mason 1976b, pp. 525–530). Quantification of the concept necessitates only empirical identification of its market counterparts. Contrary to a perplexing contemporary convention, it is the quantity (not the concept) of money that changes with institutional modifications in the financial sector (pp. 525–526).
See also: Clower (1964; 1965; 1967), Clower and Leijonhufvud (1975), Leijonhufvud (1966), Davidson and Weintraub (1973), Weintraub (1961; 1963; 1966; 1976), and Moore (1978a; 1978b).
Domestic deficits, if large enough, will raise domestic interest rates sufficiently to push foreign securities purchases to the point of lifting the external value of money enough to generate a foreign trade deficit commensurate with the contemporary exportation of securities and thus balancing the efflux of securities with an influx of funds. This may bring the foreign current account into compatibility with the combined domestic deficits. In short, foreigners may acquire the wherewithal to purchase the debts of a domestic deficit country by net exports of their own goods and services. Thus, up to a point (to be confronted later), the aggregate domestic deficit may be financed by a foreign current account deficit (Mason 1987, pp. 139–145).
The statement merely describes the fundamental monetary implications of the meaning of “foreign exchange” (claims on foreign money) and the mechanics of the foreign exchange market. The customary neglect of these elementary monetary implications remains puzzling.
For consideration of some of the relevant issues and literature, see Schirm (1983). Within limits, the international current and capital accounts may work out in this apparently benign manner, permitting markets to recycle the excess saving of some nations (e.g., Japan) to countries with deficient saving rates (e.g., the United States). Obviously, foreign financing of domestic profligacy cannot continue indefinitely. If the domestic banking system fails to supply enough money (checking deposits) to meet the payments commitments of the private and public sectors, domestic interest rates will rise, attracting money from abroad. Efforts of the central bank to offset the monetary effects of loose fiscal policy, by tight monetary policy, will be frustrated by the resulting elevation of interest rates that will motivate augmentation of the foreign fund inflow until domestic interest rates either cease to lure foreign financing or rise sufficiently to shut off real domestic investment. Collapse will then be the “order” of the day, and it will not be contained within the country of origin. The irrelevance of extant models of the monetary “system” to the pathology of cyclical turning points precludes prediction and prevention of downturns. The limits to foreign financing of self-indulgence have short-run and long-run dimensions. The short-run limit is primarily psychological and, therefore, probably beyond rational comprehension and control. Any long-run solution must speak to the underlying problem, namely, cultural differences that cannot be immediately bridged by manipulation of exchange rates, tariffs, or quotas (Mason 1987, pp. 150–151). For the implications of these fundamentals relative to the role of international finance in the quite dissimilar problem of the survival of Eastern Europe following the collapse of the Soviet Empire, see Mason (1992, esp. n. 30)
These formerly perceived verities were lost in the terminological clutter of the 1950s and 1960s when contemporary balance of payments jargon appeared to be designed to postpone recognition of the necessity for adjustment of the presumably pegged exchange rates.
Keynes had imperiously characterized Hayek’s trade cycle theory as an example of “how, starting from a mistake, a remorseless logician can end up in Bedlam” (Keynes 1931, p. 394). This referred to Hayek’s use of his Prices and Production (1931c) to refute Keynes’ Treatise on Money.
Keynes1 antagonism toward Hayek’s cycle theory was no doubt blunted by Keynes’ own subsequent dissatisfaction with his Treatise on Money (Hayek 1966, p. 78), which had turned out to be more static (less dynamic) than he had intended (Keynes, 1936, p. vii). Hayek had interpreted Keynes’ caustic reaction to Prices and Production as the counterattack for Hayek’s negative review of Keynes’ Treatise (Hayek 1966, p. 78). Hayek did not formally respond to Keynes’ General Theory (Boehm 1989b, n. 1) because he did not wish to waste time again reacting to a position Keynes might forthwith abandon (Hayek 1966, pp. 78–79). Hayek lived to witness that Keynes did not regard investment as a constant (cf. Hayek 1966, p. 79). In any event, their mutual respect improved with the mutual disarmament that occurred over the time of their interaction.
Hayek and Keynes probably differed less in their views of “the market” than did Hayek and the neo-Austrians who claim to be his disciples (Boehm 1989b [especially the section on “Tacit Knowledge”]).
In private correspondence Stephan Boehm affirmed my resolution of the Hayek-Keynes theoretical paradox, adding that a broader paradox remains in that “starting from broadly similar methodological positions they derive polar policy conclusions” (May 18, 1989). I am equally fascinated by this puzzle but must leave it for others to solve as it goes beyond the limits of the present treatise.
The political as well as economic views of Keynes and Hayek were more compatible than either realized. Although Hayek differed with Keynes’ apparent complacency towards the growing rigidity of wages, he conceded that adjustment of money expenditures to the “given rate of wages” was justified by the British attempt to raise the value of the pound in the twenties, and he concluded that such official accommodation of the microeconomic market inflexibilities undermined market viability (1978, p. 92). It is doubtful that Keynes would have disagreed. Experience demonstrates the difficulties of freeing the free market!
Modern arguments for “free banking” and “concurrent competitive currencies” are based on experience before bank deposits were recognized as “money.” The proposal is undermined by explicit acknowledgment that the public is entitled to government protection against fraud. Since liabilities of banks constitute the bulk of the modern money supply, effects of banking fraud may be pervasive enough to justify special legislation and regulation. Moreover, monetary libertarians compound the confusion of “money” and “currency,” the meanings of which have switched since the classical school restricted the term “money” to that which had currency as a medium of exchange and constituted the standard of value, i.e., specie. Since then, “currency” has come to be limited to paper money and token coins, in contrast to bank deposits that circulate via checks, which generally effect single payments without continuing to circulate as currency does. “Currency” and “money” have reversed their positions as genus and species without the apparent awareness of modern authorities.
Although Hayek long ago recognized that modern money circulated primarily by checks on bank deposits (1939, p. 77; 1978, p. 20), he has since made the confusion of “money” and “currency” explicit (1978, pp. 50–54), and continued to refer to the “monopoly of the issue of money” when he clearly meant the monopoly of the issue of bank notes (i.e., “currency,” in modern usage) (1978, p. 88). The paradox may be resolved by Hayek’s inattention to the distinction between modern and classical usage (p. 24) combined with his confusion of the classical “government monopoly of money” (i.e., specie, in classical terminology) with the modern centralbank monopoly of bank notes and the government monopoly of token coins (pp. 24, 27–28,101–102). These monopolies, either singly or in combination, have little contemporary relevance because “currency” is customarily issued through the central bank and the commercial banking system to the public on demand. Given this fundamental confusion, a semantic solution to the petty cash problem confronting retailers at national borders (Hayek 1978, pp. 23, 51) seemed to suggest the novelty of “competitive currencies,” instead of, simply, the classical explanation of variations in the demand for (instead of the supply of) money, i.e., specie (J. S. Mill 1871, pp. 511–541). Unfortunately, the pressure of other publication deadlines forced Hayek to leave the completion of the first draft of his tract to his editor (Hayek 1978, pp. 14–15). Since the second edition merely patched additions onto the first edition, the issue of “competitive currencies” was not resolved. Prevention of inflation and deflation was Hayek’s goal (1978, pp. 92–95). Consequently, his real concern was the absence of a monetary standard (Mason 1963, pp. 109, 118), not the government or central bank currency monopoly. Relevance of the competitive currency issue to that of the monetary standard has been acknowledged (Girton and Roper 1979, pp. 233–234, 243). Hayek’s argument implies the desirability of a commodityreserve monetary standard (1978, pp. 111, 123–124). Therefore, whether or not government monopolization of note issue has any contemporary relevance, it is doubtful that the claimed advantages of “concurrent currencies” could be achieved without implementation by a commodity-reserve standard (Benjamin Graham 1937; Frank D. Graham 1942, pp. 94–119; 1946, pp. 40–66). With such a monetary standard, the institutional disturbance of concurrent currencies would appear to be unnecessary. For some possible complications of the latter, see Butos (1986, pp. 865–867).
This must have been the explanation of Keynes’ answer to Jacob Viner’s review of The General Theory suggesting the subject could have been handled in more familiar terms via velocity analysis (Viner 1936, pp. 152, 158,166). Keynes’ response was, simply, that people so inclined were on the wrong track (1937, pp. 210, 222–223). He probably thought his unwillingness to follow a methodologically dichotomized route to a general theory was too obvious to need elaboration. By now it should be obvious that in monetary theory, nothing is obvious (or, if obvious, probably erroneous).
The classical school did not really buy the “money is a mere veil” doctrine that their overzealous disciples sought to impose. This is attested to by the vigor with which the leading classical scholars argued their side of the bullion controversy and both sides of the currency debate (Mason 1956, pp. 500–501 [including, particularly, n. 45, pp. 501–502]).
Operating in accordance with the gold standard restored after the Napoleonic Wars, upon their recommendation.
The neoclassical quantity theory was not supposed by its proponents to be relevant to the historical short-run, i.e., to depression (see supra, nn. 6 and 7 of this chap.).
Supra, n. 6 of this chap.
Cf. Dewald (1988, pp. 6–7).
Formalizing the model of new “new economics” will obviously necessitate new mathematics that may challenge mathematicians as well as mathematical economists. For Oskar Morgenstern’s suggested mathematical innovations looking towards appropriate dynamization, see Mason (1990, pp. 184 [including nn. 27–29] and 194).
Mason (1963, pp. 42–43). The classical school never used the term paper standard (Mason 1956, pp. 494–496). Ricardo, for example, regarded inconvertibility of the pound sterling as a temporary aberration during which gold remained the de facto standard of value (Mason 1956, p. 503 [n. 52]). See also Mason (1963, pp. 19, 28, 39,44, 68–69,127 [n. 52], 135 [nn. 49–51]).
This might be the answer that eluded the Fed economist who sought, but did not find, a “new indicator” (target?) of monetary policy and concluded: “It must be recognized that although these credit flows [through banks] might provide useful information for policy purposes, it is unlikely that policymakers would be able to control them with any precision.… The ability of the Federal Reserve to alter the stock of bank loans by changing the supply of bank reserves is probably quite limited” (Federal Reserve Bank of San Fransisco 1989, p. 3). Probably, indeed! For some suggestions, see Mason (1963, pp. 115–120).
A corollary of the democratic premise of an informed electorate is the assumption that the democratic process will select policymakers possessing discretion. This is no more unrealistic than assuming that market agents are blessed with more knowledge and judgment than doctors of philosophy.
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Mason, W.E. (1996). A Neo-Keynesian Open Economy Alternative to Obsolete Nationalistic Monetarism. In: Butos, W.N. (eds) Classical versus Neoclassical Monetary Theories. Springer, Boston, MA. https://doi.org/10.1007/978-1-4615-6261-0_10
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