The Trouble with History

Over the past three years I’ve responded to numerous comments from people in either the post-Keynesian/MMT tradition or the Austrian tradition.  Many commenters seem self-taught—which is fine with me as I’m also mostly self-taught.  Many have gained insights from major interwar economists (especially Keynes, von Mises and Hayek.)  That’s also fine, as I’ve learned a lot from interwar economists like Fisher, Hawtrey, Cassel, Einzig, and Warren.

But there’s one problem with relying on interwar analysis—it’s very much a product of its time.  Prior to WWII, pure fiat money regimes were treated as pathological cases, associated with hyperinflation.  Most currencies were either fixed to gold, or expected to be fixed in the near future.  Studies have shown that the expected rate of inflation is roughly zero under a commodity money exchange, which is just another way of saying the expected change in the relative price of gold was roughly zero.  This had many important consequences for monetary policy:

1. There was almost no Fisher effect in interest rates.  This meant that changes in nominal interest rates were probably a better indicator of the stance of monetary policy than today.  (Although still far from ideal.)
2. Liquidity traps were more likely for two reasons; expected inflation was quite low, and the monetary authority could not credibly commit to a higher inflation target.  That made fiscal stimulus relatively attractive.
3. The Phillips curve was more stable.
4. The nominal/real distinction was less important.  The concept of the super-neutrality of money was not well understood.

One of my favorite Milton Friedman sayings was something to the effect that “In the past 200 years macroeconomics has merely gone one derivative beyond Hume.”

When I object to comments by MMTers or Austrians, it’s most often based on the issues listed above.  They seem a prisoner of the interwar period, failing to see how everything changes with a pure fiat money regime.

For instance, both types of commenters put too much weight in interest rates as an indicator of easy or tight money.  In the case of MMTers, there seems an inability to imagine “expansionary monetary policy” as being something like a shift from 10% trend inflation to 20% trend inflation, engineered via faster trend growth in the base.  You certainly won’t find anything like that in Keynes, as far as I know he never once discussed the idea of using central bank policy to permanently  raise the trend rate of inflation.  Of course if this were to occur, you’d get higher interest rates.  MMTers seem to assume the easy money would drive rates to zero, at which point the extra money would be hoarded.

MMTers also seem to make no distinction between real and nominal changes in bank balance sheets.  Consider a monetary policy that has no impact on real bank assets or liabilities. If it created higher inflation, then nominal deposits, nominal loans, and nominal reserves would all rise proportionately.  In that scenario it makes no sense to talk about loans causing deposits or deposits causing loans.  In real terms nothing has caused anything.  Thus the sort of considerations you’d use for analyzing a real change in the banking system is completely different from the sort of analysis you’d apply to a purely nominal change in the banking system.  Microeconomic factors determine the real size of the system (in the long run), whereas monetary policy explains any additional long run nominal changes.

The Austrians often complain that my 5% NGDP target proposal would lead to an unsustainable boom, and then a bust.  Let me be very clear that during the interwar period this criticism would be exactly correct.  A 5% NGDP growth track would have been completely unsustainable, and would have ended in tragedy. But that has no relevance for today, as money is approximately super-neutral in the long run.  You can do 5% NGDP growth from now until the end of time without any unsustainable imbalances developing.  (I don’t think the actual growth track of the 1920s, which was considerably slower, was unsustainable, but reasonable people can disagree on that point.)

Update:  The preceding paragraph assumed a commodity-backed currency, which limits long-term NGDP growth to about 3%/year.

In defense of interwar Austrianism, there was some merit in worrying more about booms than slumps.  After all, the natural rate hypothesis says that you can stabilize the growth track of RGDP by either cutting off the peaks or filling in the valleys—it shouldn’t matter.  But the tools available to policymakers were not symmetrical.  It was easier to restrain a boom via tight money, than to pump up a weak economy through easy money.   That’s because there’s a zero lower bound on gold reserves, but no upper bound.  It’s an asymmetry familiar to students of fixed exchange rate regimes.

But that asymmetry no longer exists in the modern world.  Indeed under a pure fiat regime an Australian NGDP trend growth rate (7%) might be best, as you’d never have to worry about hitting the zero lower bound.  So when Austrian commenters worry that 5% NGDP growth might be unsustainable, they are worried about a constraint that disappeared many decades ago.

I strongly recommend that both MMTers and Austrians take a look at Milton Friedman’s work on money super-neutrality, which is where I first learned the basics of monetary theory.  (Sorry, I don’t recall which articles.)

PS. I think both schools of thought have gained a bit of traction in recent years for roughly the same reason—the current 2% inflation target is a little bit like a gold standard.  So you get some stylized facts that seem to fit each model.  But never lose sight of the fact that central banks can change that target—and when that happens everything changes.

PPS.  I regard New Keynesian economics as the philosophy Keynes would have endorsed once he learned about the super-neutrality of money.

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