26 April 2011

Hyman Minsky and the theory of money

Hyman Minsky stands apart from all other economists in the attention he paid to and the understanding he brought to bear upon both financial crises and the role of financial institutions in causing them.

A quarter century after the publication of Minsky's magnum opus Stabilizing an unstable economy what strikes one on reading it is both the clarity of his conception and the fact that so little of it has penetrated mainstream economics.

Read the whole article

Category: Economics


23 April 2011

Why financial bubbles persist

What is the difference between bread and bonds? Or more generally, what is the difference between a real good or service and a financial asset?

Real goods and services have a variety of use-values. Bread feeds us, houses shelter us, clothes warm us. Like Tolstoy's happy families, on the other hand, financial assets are all alike. Insofar as they are financial assets, they have a single use-value associated with them: the possibility that their prices will rise. People buy real goods and services to satisfy real needs. They buy financial assets (tulips, South Sea stock, bonds, houses) with only one expectation: that their prices will go up.

Real goods and services obey the law of demand and supply. When the price of bread goes up we buy less bread and more rice instead, assuming that the price of rice hasn't also gone up. When the shares of Wonderful Widgets go up, we buy more of them in the expectation that the price will go up further.

Real goods and services are bought once and consumed once, even if it is over an extended period of time. Financial assets can be bought and sold over and over again.

But there is a third difference and it is on this that I shall dwell at length.

Wonderful Widgets has a great idea to make the most wonderful thing after apple pie. It takes a bank loan and sets about beginning to manufacture it, using real goods and services. Assuming that the economy is at full capacity, this reduces the real goods and services available to other firms. Some of them have real customers and real profits today, not hypothetical ones in the future like Wonderful Widgets, and they bid higher prices for the real goods and services that Wonderful Widget is now laying a claim to. So Wonderful Widgets has to mobilise additional financial resources from elsewhere if it has to go ahead with its plans. If it cannot it has to abandon its plans. If it does manage to persuade banks or investors to fork out more money it can go ahead. But since it is calling on real goods and services, those goods and services will not be available to other firms, and they have to cut back on their own investments. So the economy has a tendency to self-correct malinvestments in the manufacture of real goods and services because these malinvestments reduce the resources available to other firms and thus exact an immediate cost.

Not so with financial assets. A share of Wonderful Widgets is just a piece of paper or an electronic entry in a computer. Buying more shares of Wonderful Widgets (and doing this a hundred times over) does not reduce the real goods and services available to other firms in the economy. All it requires is other bits of paper called dollars or other electronic entries in computers. If banks are willing to extend new loans for the purchase of shares the price of Wonderful Widgets can go up for an extended period of time without having any effect on the real economy. The only immediate effect will be an increase in money supply. Some people may spend part of the profits from the sale of shares and this may cause inflation or, more likely in our day, fuel imports. But most of the profits are likely to be reinvested in the mania.

As exuberance spreads more and more people borrow money to buy shares of Wonderful Widgets, and its price goes up further, inducing more people to buy and so on. Since there is not much negative effect on the real economy, the bubble can persist for a long time. As far as the real economy is concerned a financial bubble is costless. The effect is a steady rise in the money supply, up a gentle slope at first and then steeper and steeper. When reality strikes, the price of Wonderful Widgets descends, much faster than it went up. The effect on money supply is starker. Where it went up a slope, it falls off a precipice as no new loans are made and old loans are not paid back.

It is at this point that the financial bubble exacts its toll on the real economy. The banking system can create money out of nothing. But when the bubble bursts banks' assets get wiped out leaving their liabilities intact. So banks have to curtail lending, not only to speculators but also to firms producing real goods and services. And that sets off a recession.

The figure below shows corrected money supply from 2001 to 2011, with every sign that a new asset bubble is in the process of formation right now.


Category: Economics


21 April 2011

Paul Krugman, money and rent control

A couple of days ago I chanced upon a wonderful column by Paul Krugman. It appeared in the New York Times of 7 June 2000 and I must quote from it at some length.

"... consider an article that appeared in yesterday's New York Times, 'In San Francisco, Renters Are Supplicants.' It was an interesting piece, with its tales of would-be renters spending months pounding the pavements, of dozens of desperate applicants arriving at a newly offered apartment, trying to impress the landlord with their credentials. And yet there was something crucial missing -- specifically, two words I knew had to be part of the story.

"Not that I have any special knowledge about San Francisco's housing market -- in fact, as of yesterday morning I didn't know a thing about it. But it was immediately obvious from the story what was going on. To an economist, or for that matter a freshman who has taken Economics 101, everything about that story fairly screamed those two words -- which are, of course, 'rent control.'

"... The analysis of rent control is among the best-understood issues in all of economics, and -- among economists, anyway -- one of the least controversial. In 1992 a poll of the American Economic Association found 93 percent of its members agreeing that 'a ceiling on rents reduces the quality and quantity of housing.' Almost every freshman-level textbook contains a case study on rent control, using its known adverse side effects to illustrate the principles of supply and demand. Sky-high rents on uncontrolled apartments, because desperate renters have nowhere to go -- and the absence of new apartment construction, despite those high rents, because landlords fear that controls will be extended? Predictable. Bitter relations between tenants and landlords, with an arms race between ever-more ingenious strategies to force tenants out -- what yesterday's article oddly described as 'free-market horror stories' -- and constantly proliferating regulations designed to block those strategies? Predictable."

Based on the above I thought I would set Mr Krugman a brief examination paper. I suppose you could call it Money 101:

1. Keeping rents low reduces the quantity of housing made available by landlords.
2. Interest is the rent on money.
3. Keeping interest rates low is a good way to encourage banks (moneylords) to lend (rent) money.
4. Explain briefly, using the logic of rent control, why John Maynard Keynes was wrong in thinking 3.
5. Point out at least one other instance where Keynes committed an error by considering only the demand side of an economic situation.
6. Do you think inflationary expectations affect banks' decisions to lend money?
7. Write a brief critique of QE1 and QE2 from the standpoint of rent control.

Though the examination paper is specifically intended for Krugman I cannot think of any economists (especially economists of the Federal Reserve) who would not benefit by answering it. No need to send in the answers.

Category: Economics


20 April 2011

Joseph Schumpeter on Money

I said a few days ago that all economists — the Keynesians, the monetarists and the Austrians — look upon money as cash balances and the demand for money as the demand for cash balances.

I am happy to find that there is at least one exception: Joseph Schumpeter. This is what he says in Business Cycles (1939):

"If people get their 'incomes' each Saturday and spend them on consumers' goods each succeeding Monday — transactions between firms being excluded — then the money will lie about in the vaults of firms from Monday to Saturday, not because there is any demand for cash holdings, but because the institutional arrangement so wills it."

Ah, common sense! So wonderful, so uncommon!

Category: Economics


17 April 2011

Paul Krugman and the liquidity trap

I thought Paul Krugman was the only senior economist afflicted by the scourge of the liquidity trap. But apparently the disease is catching. The New Yorker quotes Larry Summers as saying this month that while searching for insights about what to do in a debt crisis, "I was heavily influenced by the basic I.S.L.M. framework augmented to take account of liquidity traps." In what follows I offer an effective vaccine against the liquidity trap. But of course if people decline to be vaccinated ... [shrug shoulder here].

The liquidity trap thesis originates with what Keynes called the speculative motive for liquidity preference". In Keynes the argument is put somewhat like this. When interest rates are very low, everybody expects them to go up shortly. If this were to happen any bonds they hold would depreciate and they would sustain a loss. Therefore there is a general tendency to opt out of bonds and instead hold cash.

Read the whole article

Category: Economics


13 April 2011

The unbearable stupidity of economists

In uncovering a century of muddled thinking about money by economists one is not sure whom to begin with - the Keynesians, the monetarists or the Austrians -- such is the embarrassment of riches one is confronted with, if riches is the right word to use for the wealth of illogic in all three schools.

We begin with Murray Rothbard. For those not in the know, Rothbard is the third person in the holy trinity of Austrian economics, the first two being Carl Menger and Ludwig von Mises.

In his book, America's Great Depression Rothbard writes:

Read the whole article

Category: Economics


11 April 2011

Milton Friedman on Alan Greenspan

On 31 January 2006 Milton Friedman wrote an article in the Wall Street Journal titled "He has set a standard". The article was on Alan Greenspan and the date was the former Fed chairman's last day at work.

"Over the course of a long friendship, Alan Greenspan and I," Friedman wrote, "have generally found ourselves in accord on monetary theory and policy, with one major exception. I have long favored the use of strict rules to control the amount of money created. Alan says I am wrong and that discretion is preferable, indeed essential. Now that his 18-year stint as chairman of the Fed is finished, I must confess that his performance has persuaded me that he is right -- in his own case. His performance has indeed been remarkable."

On the list of big-time blunders by economists, this must rank right up there along with Irving Fisher's "Stock prices have reached what looks like a permanently high plateau" a few days before the October 1929 crash. Of course Friedman did not live to see the remarkable disaster that Greenspan had wrought.

But that is not the subject of this blog. It is rather to ask: When Friedman spoke of "strict rules to control the amount of money created" what strict rules did he mean in practice? Indeed one can ask: What did he mean by money?

In 1987 the Fed had abandoned growth rate targets for M1. In 2000 the Fed stopped setting growth target ranges for M2. The fact is that both aggregates had ceased to have any meaningful value from the beginning of the eighties, and indeed there were problems with the aggregates going as far back as 1976 when economists began to talk about the "missing money".

In the absence of a meaningful aggregate there was of course no question of "strict rules". And of course Friedman knew that. Otherwise, he would have been able to warn Greenspan that the growth rate of money in the previous three years had been very high.

The article has a triumphal tone to it, the tone of a man who has had his life's work on money more or less brought to fruition in the person of Greenspan. A more appropriate tone would have been one of humility, of a man who had seen a lifetime of work on money come to naught, because no one any longer knew what money was.

Ben Bernanke's speech on monetary aggregates in 2006 has more details.

Category: Economics


09 April 2011

The consensus among economists - I

Without comment:

Federal Reserve Bank of Dallas President Richard Fisher said the central bank faces a "significant" risk of providing record stimulus for too long and should weigh curtailing its $600 billion bond-purchase plan.

Federal Reserve Bank of Atlanta President Dennis Lockhart said the central bank should take its time in withdrawing economic stimulus amid moderate growth and a quickening of inflation that will probably prove temporary.

Category: Economics


07 April 2011

The riddle of money, finally solved

For nearly a century the progress of macroeconomics has been stalled by a single error, an error so silly that generations to come will scarcely believe that it could have persisted for as long as it has done. It is an error that has been committed by John Maynard Keynes and Milton Friedman, John Hicks and James Tobin, Franco Modigliani and Ludwig von Mises, Murray Rothbard and Paul Krugman, and continues to be taught to every economics undergraduate today.

The error has blinded economists so that, like the seven men of Hindostan, they have mistaken the partial reality that has come within their groping grasp for the whole of reality. And this in turn has divided them into warring sects, looking very little like practitioners of a science and a lot like religious fundamentalists. Keynesian has poked fun at monetarist. Monetarist has ridiculed Keynesian. And both have mocked Austrian and been mocked in return.

Read the whole article

Category: Economics


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