Douglas Irwin, a very fine economist at Dartmouth College, has a very puzzling opinion piece in yesterday’s Financial Times. The root of the puzzle is that Irwin seems to accept what I consider the naïve monetarist view, yet calling it by a new name “market monetarism,” that the effectiveness of monetary policy largely revolves around portfolio adjustment effects that are induced by an increase in real balances. (Isn’t this warmed over Pigou, and 1970s monetarism?)
What seems to be new is the “Divisa monetary indexes” which weight the different components of the monetary aggregates by their monetary services. In principle, this is what Milton Friedman talked about in his course ”Money: The Demand Side” in the early 1970s. He said then that he thought it would be a good idea to weight the various components of the money supply by their “degrees of moneyness.” He did wonder, as I recall, if these weights would be stable over time.
Now, by this new measure, monetary policy has been tight. In fact, the money supply is no higher today than in early 2008. We must not confuse the level of interest rates with the degree of tightness of policy. Interest rates are low but money is tight. The policy conclusion seems to be that QE3 is (or will be) too little.
What view of the monetary mechanism does this imply? Changes in the money supply (credit?) affect the real economy via spending and since employment is low, more spending will boost this and economic growth. Spending on what? Hey, it doesn’t matter. Spending is spending. (We are all Keynesians now?!)
Does it not matter that in an extremely low interest-rate environment that spending is likely to be channeled in directions different from where they would be in a higher interest-rate environment? Movements of money toward higher risk assets, to the stock market, to real-estate markets in other countries and so forth are important. How much of this is sustainable?
The “market monetarist” paradigm, as explained by Professor Irwin, focuses on a weighted monetary aggregate in the same way that many economists focus on the price level. If neither is changing very much then nothing much of interest is happening. But I guess this is what aggregate economics is all about.
What I find especially confusing is that market monetarists agree with Keynes that while relative prices of commodities matter, the price of credit – the interest rate – doesn’t allocate anything to anything. Now the first point our market people better believe, or else the Ghost of Friedman will drive them insane. But the second is a real puzzle for a market (fill-in-the-blank).
I know about liquidity traps and all that. But that is first-year Keynesian macroeconomics.
The only thing new here seems to be the weighted monetary aggregate. But, new or old, I cannot believe how simplistic this is.