Perry G Mehrling One stop shopping for all things "money view" Fri, 29 Sep 2017 18:52:49 +0000 en-US hourly 1 Cryptos Fear Credit Fri, 29 Sep 2017 18:52:49 +0000 Proposals for monetary reform, whether mild or radical, are always and everywhere informed by some underlying theory of money.  A week ago I spent two days talking with a group of technologists and lawyers–perhaps I should say digital coders and legal coders–and pressed them on this point.  Chatham House rules prevent me from associating views with actual people, but the views themselves are the important thing.

So far as I understand, and it is important to emphasize that there was not consensus on the details, the technologists see themselves as creating a form of money more trustworthy than that issued by sovereign states, more trustworthy because the rules of money creation (whether proof-of-work or proof-of-stake or whatever) limit issue to a fixed and finite quantity.  Scarcity of the tokens today, and confidence that scarcity will be maintained in years to come, are supposed to support the value of the tokens today.  Importantly, no such confidence can be attached to state-issued money; quite the contrary states are seen as reliable abusers of money issue for their own purposes.  Cryptocurrency is digital gold while fiat currency is just paper, subject to overissue and hence depreciation.

From this point of view, current holders/users of cryptocurrency are just early adopters.  Once everyone else realizes the superiority of cryptocurrency, they will all want to switch over, and the value of fiat currency will collapse.  The (fluctuating) prospect of that eventual switchover shows up today in the (fluctuating) exchange rate between crypto and fiat (as here).  And the (fluctuating) prospects of different cryptocurrencies shows up today in the (fluctuating) exchange rates between different cryptocurrencies (as here).  According to the theory, one of the cryptocurrencies will be the future global currency, replacing the dollar, but no one knows which one.  People who got into Facebook at the beginning are all multimillionaires; early adopters of the future global cryptocurrency will be too, but which one will it be?  That’s what the lack of consensus about the details is all about.

One of the most fascinating things about the technologist view of the world is their deep suspicion (even fear) of credit of any kind.  They appreciate all too well the extent to which modern society is constructed as a web of interconnected and overlapping promises to pay, and they don’t like it one bit.  (One of my interests these days is “Financialization and its Discontents”, and I dare say that the discontent of the technologists is as deep as that of the most committed Polanyian, but of a completely opposite sort.)  Fiat money is untrustworthy enough, promises to pay fiat money are doubly untrustworthy.  One way around the problem would be to require full collateralization of all such promises, maybe even using so-called “smart contract” technology to ensure that promised payments are made automatically, basically an equity-based rather than debt-based system.  In effect, we have here a version of Henry Simons’ Good Financial Society, but with peer-to-peer cryptocurrency taking the place of his 100% reserve money.  Simons was of course responding to the global credit collapse of the Great Depression; the cryptos are responding instead to the more recent global financial crisis.

I view all of this through the lens of the money view, which places banking at the center of attention, views banking as fundamentally a swap of IOUs, and views money as nothing more than the highest form of credit.  It is view developed not so much around a philosophical ideal but rather as a way of making sense of the operation of the world as it actually exists, outside the window as it were.  In that world, the payment system is essentially a credit system, in which offsetting promises to pay clear with only very minimal use of money.  And prices arise from the activity of profit-seeking dealers who absorb fluctuations in demand and supply by standing ready to take any excess onto their own balance sheet, relying on credit markets to fund the resulting inventory fluctuations.  One can imagine automating a lot of that activity–and blockchain technology may well be useful for that task–but one cannot imagine eliminating the credit element.  Credit is not a bug, but a feature.

This point of view draws special attention to the place where markets are being made to convert one cryptocurrency into another, and especially the place where markets are being made to convert cryptocurrency into so-called fiat.  Someone or something is making those markets, and in so doing expanding and contracting a balance sheet, in search of expected profit (see here for example).  Cryptos fear credit, but I suspect they will soon discover that credit is a feature not a bug, and that will require them to re-examine the implicit monetary theory that underlies their coding.  To date, technologists seem to have felt that they have nothing to learn from the operation of the existing monetary and financial system, as their disruption is intended to replace it with something better.  But from a money view standpoint, it is the institution of credit that is the real disruptor, which is fundamentally why it is feared, by cryptos and also by the rest of us.  The answer, as Bagehot long ago taught us, is not to eliminate credit but rather to manage it, and “Lombard Street has a great deal of money to manage”.












The Making of a Public Economist Thu, 06 Jul 2017 16:38:08 +0000 Walter Lippman (1889-1974) is usually remembered, if at all, as a journalist and political commentator, and certainly not as an economist.  But that is exactly how we should understand him, so argues Craufurd Goodwin, in his last book Walter Lippman, Public Economist.  The reason we don’t see him as an economist is that our understanding of what it means to be an economist has changed so much, indeed narrowed so much, from what it was in the pre-WWII context of Lippman’s mature work.

Seen in context, Lippman appears like an American version of the British John Maynard Keynes, whom Lippman first met at the 1919 Versailles peace conference and with whom he maintained a warm friendship thereafter.  “Despite their later engagement with economics, neither was attracted to the subject at first.  Their initial interests were in philosophy, literature, and the arts.  They took little economics as undergraduates and found the prospect of postgraduate study and a full-time career in academe unappealing.  They both wanted to act on a wider stage and to speak to a larger audience with a longer list of topics than they could envisage at even one of the best universities.” (48)  “The life that appealed most to Lippman was that of his British Fabian friends, a life that combined serious scholarly endeavor with civic engagement, public education, politics at a distance, and to some degree with creative literature and the arts.  The best way to achieve this life in America, he concluded, was as a newspaper columnist.” (75)

From this perspective, Lippman’s column “Today and Tomorrow”, published initially three and then two times a week from 1931-1949, offers a real time record of one man’s effort to make sense of the economic turmoil of those years of Depression and then War.  And his 1934 book The Method of Freedom stands as an American analogue to Keynes 1936 General Theory of Employment, Interest and Money, pointing the way to a new economic model—“free collectivism” or “a compensated free market”—and a regenerated form of political liberalism.   Lippman:  “It is collectivist because it acknowledges the obligation of the state for the standard of life and the operation of the economic order as a whole.  It is free because it preserves within very wide limits the liberty of private transactions.  Its object is not to direct private enterprise and choice according to an official plan but to put them and keep them in a working equilibrium.  Its method is to redress the balance of private actions by compensating public actions.  The system of free collectivism originates not in military necessity but in an effort to correct the abuses and overcome the disorders of capitalism” (138).

But Lippman goes even further than Keynes, according to Goodwin.  As a journalist, he had already developed a sophisticated sense of mass psychology (in effect a theory of Keynes’ “animal spirits”).  Lippman again:  “Imitation, the herd instinct, the contagion of numbers, fashions, moods, rather than a truly enlightened self-interest, have tended to govern the economy.  The submerging of individualism in mass behavior is a consequence of the increasing complexity of the economic order…It follows that if individuals are to continue to decide when they will buy and sell, spend and save, borrow and lend, expand and contract their enterprises, some kind of compensatory mechanism to redress their liability to error must be set up by public authority.” (139)

Roosevelt’s New Deal was very much behind the curve in this respect, at least during the first years which were dominated by the National Recovery Act.  Lippman 1936:  “We cannot subscribe to the view of those New Dealers who claim that their experiments in monopoly, restriction, and centralized political power are in the interests of the abundant life.  We believe that the New Era and the New Deal are two streams from the same source.  The one fostered private monopoly in the name of national prosperity.  The other has fostered state controlled monopolies in the name of national welfare.  We believe that both are an aberration…” (375).   Only in 1938, with the Temporary National Economic Committee, did the New Deal begin seriously to engage the macroeconomic dimension of the problem, and shortly thereafter that initial engagement was overwhelmed by war preparations.

The picture Goodwin paints of the Keynesian revolution in economic policy thus downplays the role of academia—the usual story that Galbraith, for example, tells of Keynes coming to America through Harvard—and instead emphasizes the role of Lippman, as public intellectual and indeed public economist, but most importantly as best selling author whose columns reached an audience of eight million.  The Keynesian revolution in America was first a revolution in public consciousness, with academia and policy circles following after.  “There were those who criticized Roosevelt for creating a Brain Trust and encouraging creative thinking in government.  Lippmann was not among them.  His complaint was that members of this Brain Trust did not have enough brains.” (312)

Inadequate economic education was part of the problem.  One of the most fascinating chapters in the book recounts Lippman’s efforts, as chair of the economics visiting committee, to reform teaching of economics at Harvard, his alma mater (56-73).  The other part of the problem was ensuring that government service was open to the best and brightest.  Lippman:  “The cult of mediocrity, which is a form of inverted snobbery, is not democracy.” (313)   What we need, according to Lippman, is a kind of Council of Economic Advisors—here arguably is the origin of the Council we actually got as part of the postwar 1946 Employment Act.

But what kind of economics do we need?  “He worried that the methods of the engineer, seemingly creeping into economics, were dangerous in constructing public policy…A continuing problem was the large number of well-meaning and enterprising bureaucrats, such as Roosevelt’s Brain Trust, who kept on generating ill-thought-out schemes supposedly to improve the economy and who used the excuse of the depression to put them in place.  Since these schemes were the bureaucrats’ babies, they found for them tenaciously.” (229-230)  “He regretted especially the isolation of economics from political science, history, psychology, and philosophy; the result had been that those trained in economics paid so little attention to values and to the determinants of human motivation that they were ill equipped to deal with the real world.” (253)

Writing at a time when the Great Depression led many to embrace totalitarian alternatives to the market system, Lippman imagined an alternative future and urged it on his readers.  Today, our own Great Recession challenges us similarly, not only as economists but also as citizens.  Today, as then, “moderate, sensible, public-spirited behavior seem[s] absent everywhere.” (224)  For us, Lippman provides a model of what nevertheless can be done, doggedly writing his columns in an effort to shift public opinion in the direction of the rule of reason, even in the darkest days.

Beyond the Taylor Rule Fri, 09 Sep 2016 11:39:13 +0000 The following is in blog form the substance of a talk I gave Sept 7 at a Mercatus conference, “Monetary Policy Rules for a Post-Crisis World.

“Rules versus discretion” is a hardy perennial of monetary policy debate, dating from earliest debates between Bullionists and anti-Bullionists, to the 19th century Currency School versus Banking School, up to the 20th century monetarists versus Keynesians.   The reason this debate is perennial, according to me, is that it is fundamentally about whether the current state of affairs requires more discipline or more elasticity.  The monetary system changes over time so that sometimes one side is right and sometimes the other.  Also, the multiple parts of the system are rarely in sync so that what is needed in one part (or area) is not the same as what is needed elsewhere.

From this point of view, Henry Simons, in his famous 1936 “Rules Versus Authorities“, did us all a disservice by overlaying this perennial monetary debate onto the most pressing debate of his own time:  Economics versus Politics, Liberalism versus Socialism, Rule of Law versus Arbitrary Authority, Freedom versus Tyranny.  After Simons’ overlay, it was no longer possible to consider the possible virtues of the opposing position, if only for a different time or a different place.  One side was right, and the other was wrong, on moral and principled grounds, no room for debate, are you with us or against us?

Here possibly we find the reason for so much heat in the long-ago debate between Friedman’s 3% money growth rule, and the Keynesian advocacy for countercyclical fiscal policy.  And here also possibly we find the reason for so little light from that debate, at least at the time.  With the benefit of historical distance, perhaps we can step away from the ideological overlay and examine the analytical substance underneath.

In a sense, the central question was about what is the right framework for thinking about macroeconomic fluctuation, the tried and true tradition of the quantity theory of money–MV=PY in a nutshell–or the dangerously new foreign Keynesian import–C+I+G=Y in a nutshell.  If the former was correct, then a money growth rule made a lot of sense, as a kind of anchor for the swings of credit, restraining boom on the way up and preventing collapse on the way down.  But if the latter was correct, then a money growth rule was dangerous nonsense, since what was needed on the way up and the way down both was a direct fiscal counter to the swing of aggregate demand.  (There was of course also a third choice, Copeland’s Money Flows approach, but that one more or less got lost in the din, unfortunately according to me.)

In the context of that heated debate, the enormous attraction of the Taylor Rule was that it managed to frame the Keynesian case in rule-bound terms, thus occupying Simons’ ideological high ground but with apparently Keynesian content.  Taylor began, it is worth recalling, simply by noting that empirically, notwithstanding all the talk about discretion, monetary policy already seemed to be following some kind of a rule, just not a constant money growth rule.  Irving Fisher had suggested that, left to their own devices, markets compensate for expected inflation by raising the nominal interest rate, one for one.  Taylor suggested that policy authorities, left to their own devices, overcompensate for expected inflation by raising rates even more, and that they also take into account the level of aggregate activity by lowering rates when the economy is operating below capacity.  And so the debate shifted, no longer “rules versus discretion” but now money growth rule versus Taylor Rule, or some other rule.

As we know, the Taylor Rule won that debate, but the crucial argument was not analytical but empirical, the empirical breakdown in the money demand relation on which the money growth rule depended.  Central banks had not been following a money growth rule, but in retrospect that seemed like a good thing.  They had instead been following a different rule, and that also seemed like a good thing, since in practice it seemed to be delivering good economic outcomes.  Out with the money supply/demand frame, and in with the Taylor Rule, eventually embedded in the New Keynesian DSGE orthodoxy.

From a money view perspective, this historical shift can be understood as a response to institutional developments in the supply of liquidity.  The immediate postwar period was a system of monetary liquidity, when everyone, including banks, was flush with government paper pegged in price; deficit agents settled with surplus agents simply by transferring their holdings of monetary liquidity.  In that environment, money growth rules made a certain amount of sense.  Over time, however, as wartime stores got spent, we shifted to a system of funding liquidity; now deficit agents settled with surplus agents (on the margin) by borrowing, most commonly indirectly through a financial intermediary.  In that environment, interest rate rules made more sense.

What about today?

From a money view perspective, the fundamental source of leverage for monetary policy comes from the central role of the central bank in the payments system.  In a monetary liquidity system, that centrality shows up as control over issuance of the ultimate means of payment.  In a funding liquidity system, that same centrality shows up as control over the price of overnight borrowing, i.e. the price of delaying the “day of reckoning”.  But today, arguably, we are living in a market liquidity system; deficit agents settle with surplus agents by selling an asset, most commonly by using it as collateral for borrowing.  In that environment, interest rate rules may no longer be the right kind of rule.

Rightly you may ask, “Are you sure we are living in a market liquidity system?”  Maybe that was so before the financial crisis, but maybe not so today.   Interbank markets, in both unsecured and secured credit, are basically shut down, and the Liquidity Coverage Ratio seems intended to return us to the immediate postwar system of monetary liquidity.  Having put our toes briefly into the market liquidity water, we found it too hot and have ever since been retreating to cooler pools, walking back all the way to the immediate postwar monetary liquidity system.

I answer, “Maybe so, but also maybe not.”  Maybe instead the current problem is that we do not have the right monetary rule to ensure stable operation of the new liquidity system.  Remember the turmoil of the 1970s, the interregnum between monetarist money growth rules and Keynesian interest rate rules?  Possibly we are living in just such an interregnum right now.  Instead of nostalgia for a simpler past, we need to be engaged with the project of designing resilient monetary policy frameworks for the complex future.

So far as I can see, one piece of a possible new framework is already in place, the emergency lending framework.  We learned, in the crisis, that in the brave new world of market liquidity central banks are called upon to serve as dealers of last resort, not just lenders of last resort.  We have learned a lot about how actually to do it:  support markets not institutions, outside spread not inside spread, liquidity not solvency, core not periphery.   And we have also begun to construct the institutional framework to do it globally, not just locally–I speak of the system of central bank liquidity swaps, priced at 50 bp away from covered interest parity.

We know about emergency lending, but what we are missing is the macroeconomic framework to guide a new rule for stabilization policy.  After MV=PY we got C+I+G=Y.  Today we are feeling our way beyond C+I+G=Y, and so also beyond the Taylor Rule.  Maybe time to look back at Copeland, reconstructing his money flow approach for the modern world?  That’s where I’m placing my bet.

From a money flow perspective, there are logically only three sources of funds for agents who find themselves in deficit on the goods and services account.  They can dishoard (spend money balances), borrow, or sell some asset.  In the argument sketched above, I have suggested that post-war institutional developments have followed a course emphasizing first dishoarding, then borrowing, and then selling, i.e. monetary liquidity, then funding liquidity, then market liquidity.  All three are now in play, but the new one is market liquidity.  That’s the one that broke in the global financial crisis, and that’s the one we need to fix in order to get the system working again.





Family Reunion at Jackson Hole Tue, 30 Aug 2016 18:56:10 +0000 You can title your conference whatever you want, but the actual content will depend on the speaker list.  The convenors of the Jackson Hole Economic Symposium apparently hoped to generate discussion about “Designing Resilient Monetary Policy Frameworks for the Future“.  Having read all the papers, I can report that only one of them really engages the conference title.  Everyone else just talked about what was on their mind under the more general heading of “Economic Policy.”

Like any family reunion, the gathering at Jackson Hole served mainly as an opportunity to update individual member status, and to reassert filial bonds.   Better than any family reunion, the convenors were able to ensure a generally harmonious event by controlling the invitation list.  Crazy uncles were blessedly absent, so there was nothing to disturb the choreography.

The festivities opened and closed with remarks by genuine central bankers, the United States (Yellen) to start, with Mexico, Europe, and Japan to close, and those are the remarks that made the news.  In between, the substantive papers were all generally authored by academics, discussed by policy makers, and ignored by the press.

The order of play seems to have been designed to alternate monetary economists (Goodfriend, Sims, Reis) with financial economists (Duffie, Bindseil, Stein).  The only non-academic paper, perhaps tellingly, is also the only paper that actually engaged the conference title, “Evaluating Monetary Policy Operational Frameworks” by Ulrich Bindseil.  (I’ll say more about this exception below.)

Also telling, the papers by the monetary economists are all essentially about models of the economy, with the occasional current factoid sprinkled in for flavor, whereas the papers by the financial economists are much more empirical, engaging with empirical and institutional reality.  What is notable about the former is the specific model choice, no DSGE or monetarism among them; what is notable about the latter is the particular focus on money markets, the primary place where central banks engage the larger financial system.

Just so, from Goodfriend we get a version of standard Fisher-Wicksell intertemporal asset pricing, tweaked to include the possibility of negative policy rates; from Sims we get a tweaked revival of the fiscal theory of the price level which emphasizes the intertemporal government budget constraint as the determinant of inflation; and from Reis we get a tweaked revival of old partial equilibrium stories about how supply and demand for reserves determine short term interest rates.

Just so, from Duffie (with co-author Krishnamurthy) we get discussion of the widening dispersion of money market rates across different markets, and some thoughts on what is causing it; from Bindseil we get discussion of the operational framework that links private money markets with central bank policy instruments, most importantly the short term money rate of interest; and from Stein (with co-authors Greenwood and Hanson) we get suggestions about how the Fed might manage its current balance sheet, still swollen from crisis intervention and multiple rounds of QE.

As I say, it is Bindseil who comes closest to addressing the advertised topic, though his focus is narrowly on the operational framework, not the monetary policy framework more generally.  “Design” and “Resilience” are central themes of his paper, but its great strength is to locate those themes in a larger discussion of historical and institutional evolution.  It is experience, not abstract models, that informs his ideas about design.

Bindseil explicitly recognizes that central banks engage not only with private money markets but also with sovereign governments, and not only with national but also with international counterparties.  He locates the crisis of 2007-2009 in a much longer process of evolution of central bank operational frameworks, a process of learning and exploration that continues today alongside similar evolution of the environment in which they operate.  And throughout that evolution, up to today, there has always been fundamental disagreement–he calls it “philosophical” disagreement–on a number of very central issues.

For Bindseil, the issue of “resilience” is centrally about restoration of deep and liquid private money markets and capital markets.   Currently, as a consequence of crisis and subsequent QE, central banks are doing a lot of what these private markets used to do; interbank money markets are more or less dormant.  The challenge for Bindseil is how to shift the balance toward more private liquidity provision and financial intermediation.  (Myself, I always liken this challenge to the one the world faced after WWII, in shifting from war finance to peace finance.)  The goal is to build a system that can absorb all but the largest shocks itself, without having to resort to the central bank balance sheet.  The central bank should backstop the market, not replace it.

At the center of the question of “design” Bindseil places the question:

how ambitious, activist and complexity friendly (or, alternatively, skeptical, humble and simplicity‐oriented) a central bank should be in its operational framework design

As I read him, Bindseil leans toward the skeptical, humble, and simplicity-oriented side of that spectrum.   And that explains why he focuses so much attention on operational frameworks, and none at all on the larger monetary policy framework.   It is here, in the evolving operational framework, that we find the foundation and pre-requisite for any future monetary policy framework.  We start there not only because it is foundational, but also because of the limits of our knowledge about other matters.  Ideally we want a rule-based system, but that “requires having achieved a high level of understanding of the economic relationships at stake” (p. 12).  Long experience of operational frameworks gives us that necessary high level of understanding, which is not so present in other areas.

From this point of view, the most notable feature of Yellen’s opening remarks is how little reference she makes to any academic model.  For better or worse, the essential basis of everything she said was the Fed’s own econometric model, so-called FRB/US (pronounced “ferbus”), and the simulations of that model conducted by David Reifschneider and published just before Jackson Hole.  The model suggests that the Fed can still, even in its current overextended state, absorb a large macroeconomic shock if it really has to, and that it can do so without negative policy rates.   Maybe, maybe not.  It’s a model, representing our current level of understanding how the macroeconomy works.  How high is that level of understanding?  Only a crazy uncle would dare ask such a question, and by construction there were none in attendance.

In sum, only one person dared talk about designing resilience, and his discussion was confined to the most narrow operational framework.   One way of understanding the silence is that people talked about what they knew about.  Invoking Wittgenstein, perhaps it is a case of “whereof one is not able to speak thereof one must be silent”.  After the crisis, we are reconstructing knowledge as well as markets.  Both are slow business.

Financialization and its Discontents Mon, 01 Aug 2016 20:18:25 +0000 Financialization is not new, nor is discontent with it.

“Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist economy center around the impact of finance upon system behavior.”  Minsky (1967)

Fifty years ago, Minsky zeroed in on instability as the central flaw of the financial system of his time, and located the source of that instability in excessive business borrowing and bank lending.  But his was an economist’s discontent.  Non-economists go farther, in at least three dimensions.

Polanyi (1944) famously zeroed in on the way that the logic of markets gets extended to “fictitious commodities”–land, labor, and money–and the way that society reacts defensively to that illegitimate extension.  Today, arguably, it is the logic of finance that has been so extended, turning everything it touches into an asset with a speculative price.

Brandeis (1914) objected differently to the way that accumulations of financial wealth–“other people’s money”–tend to undermine democratic political forms (among other problems).  Today, arguably, it is the institutionalized character of those accumulations (TBTF) that threatens political forms.

Bryan (1896) famously drew attention to the “cross of gold”, the deflationary effect of the international gold standard on domestic farm prices in the emerging market economy of the United States.  Today, arguably, the analogous issue is the hegemony of the US dollar imposing discipline on emerging market economies, most importantly the BRICS–Brazil, Russia, India, China, South Africa.

All three of these non-economist discontents are concerned with the boundary between the market system and something else–non-market goods, the political system, national developmental priorities–boundaries on which they see the market system encroaching.  To the extent that capitalism is essentially a financial system, they fear extension of its logic and wish to keep it safely confined.  All three see markets and finance as something separate from society, at least in principle.  The money view, by contrast, sees markets and finance as essential infrastructure for modern society.

Economists, for their part, focus on problems with how the logic of money and finance actually operates, even supposing that logic could be confined within a separate sphere of the “economic”.   Probably no one thinks the present system is working well.  But reaction to evident dysfunction has produced a vast array of proposed fixes, ranging from 100% money to bitcoin, from helicopter money to debt jubilee.

From a money view perspective, it is notable that almost all of the proposed fixes begin analytically from a conception of what money “really is” (or should be), and conceive of credit as a kind of superstructure built on top.  Almost no one starts with credit as the elemental relationship, and hardly anyone recognizes the interlocking web of commitments that constitutes the fabric of the modern economy.

From a money view perspective, the origin of discontent seems to lie in the fact that each of us, in our interface with the essentially financial system that is modern capitalism, operates essentially as a bank, meaning a cash inflow, cash outflow entity.  We like the elasticity of credit, that allows us to spend today and put off payment to the future.  But we don’t like the discipline of money, which is to say ultimate payment.

And most of all, we don’t like the asymmetry of both credit and money.  Creditors may or may not accept our debt, and even when they do they may or may not accept ultimate payment in the coin we prefer.  The system is inherently hierarchical, hence our discontent, a discontent that is only made worse when creditors are people (or institutions) unlike “us”, and especially so when they insist on repayment in a currency not our own.

There is thus good reason for discontent, but there are also lots of bad reasons based on fundamental misunderstanding of the nature of the system.  Focusing on what money really is–whether gold or state fiat–shifts attention away from what credit really is, which is to say away from the center of discontent.  As debtors, we owe society; as creditors, society owes us.  Whether we want to or not, we are each of us banks, managing our daily cash inflow and cash outflow relative to the larger system which is society.


Brandeis, Louis.  1914.  Other People’s Money, and how the bankers use it.

Bryan, William Jennings.  1896.  Cross of Gold Speech.

Minsky, Hyman.  1967.  “Financial Intermediation in the Money and Capital Markets.”

Polanyi, Karl.  1944.  The Great Transformation

Channeling Kindleberger on Brexit Tue, 05 Jul 2016 17:17:15 +0000 What would Charlie have made of Brexit?

Charles P. Kindleberger’s very last book-length effort was the slim volume titled Centralization versus Pluralism, a historical examination of political-economic struggles and swings within some leading nations (1996).  In his frame, the historical struggles and swings he recounts–in the Dutch Republic, Germany, France, Britain, Canada, The United States, Japan and China–were all driven by a fundamental contradiction between the logic of economics and the logic of politics.

From a simple-minded [economic] viewpoint, the world is the optimum economic area, with its constituent countries committed to free trade, a single international currency, and harmonised standards, whereas the optimum social area is much smaller, and based on the criterion that a social unit should be small enough for an individual to know that he or she counted.

The record of history, at least within individual nations, seems to be about swings between each of these separate logics, now one way and now the other, with no sense that one is a more fundamental force than the other.

Under normal circumstances, however defined, but with economic and social change occurring slowly, there is a strong preference for pluralism….When a society is confronted with crisis, it is usually desirable, and in some cases necessary, to shift power to the center, especially if it has been widely dispersed.  Such shifting, however, is not readily accomplished, and may not be possible at all because of institutional inertia.

Kindleberger’s book is about the historical experience within individual nation states, but it is clear that his underlying motivation is to provide some “food for thought” (p. 9) about the future of the European Union, a feat of social engineering that was always close to his heart (as see Ch. 24 in his 1984 Financial History of Western Europe).  His closing sentence urges the reader to develop the argument farther:  “Achieving the necessary identity in Europe among countries as different, say, as Greece and the United Kingdom [sic!], calls for a heroic effort of political imagination, already achieved perhaps by Germany and France, but still elusive on a wider scale”(p. 89).

From a Kindlebergian point of view, the central paradox of Brexit is that it amounts to a push for pluralism or decentralization in a time of evident crisis.  Martin Schulz’ call for a “genuine European government”, in response to the crisis of Brexit, is more like what we might expect, though perhaps “not readily accomplished”, as Kindleberger warns.

But perhaps “take my country back”, as the Leave slogan put it, was not so much about local control as it was about national control, not so much about pluralism as it was about centralization?  After all, power taken away from Brussels most immediately winds up in London.  Kindleberger emphasizes the historically rather extreme centralization of Britain, and the consequent devolution movement in Scotland as response.

In today’s world the monarchy barely exists, but its place is taken in Britain by the prime minister and his (her) cabinet (the executive), the civil service and Parliament.  In combination the three are said to ride roughshod over the rights of localities.

But herein lies another paradox, since of course the heartland of the Leave vote was the east coast of England, while the heartland of the Remain vote was London itself, including all three of the political centers of power that Kindleberger mentions.

Once upon a time, London was not only the center of Britain, but also of the entire British Empire, and as such the unchallenged world financial center in the 19th century, only replaced by New York after WWII.  And even today London remains a critical node in the financially globalized world that now challenges merely national structures of governance.  The global money market, the eurodollar market, grew up in London because New York (or more accurately, Washington DC) didn’t want it, and that seems likely to continue.

Before Brexit, arguably London was to Europe as Singapore was to Asia, a financial window on the larger world.  Europe could thrive despite incomplete banking union, and unrealized capital market union, because of London.  Post-Brexit, the pressure to complete these unions will be much stronger, and that is a pressure for centralization.  But Europe will likely still need its Singapore.

What would Charlie say about Brexit?  He would, I think, see it as just one episode in the larger and on-going drama of centralization versus pluralism.  Indeed it involves at the same time both increasing centralization and increasing pluralism, at different levels of the system.  We are living in a very dynamic period, but it is not chaos.  Kindleberger gives us a frame to understand the logic driving the world-historic events outside our window.

BIS looks through the financial cycle Tue, 28 Jun 2016 20:29:57 +0000 “I wouldn’t start from here,” the BIS never says explicitly in its recent Annual Report, but nevertheless it goes on to paint a rather comprehensive and compelling picture of a possible future toward which they think we should be trying to head, and of the present dysfunctional economic policies that are daily making it harder to achieve that possible future.

As always, the BIS is relentlessly empirical, and worth reading just for that.  But, for me, the biggest value added is, perhaps surprisingly, the analytical architecture on which all this rich empirical work is hung.  Here is how they put it (on page 11):

It is tempting to look at the global economy over time as a set of unrelated frames – or, in economists’ parlance, as a series of unexpected shocks that buffet it about. But a more revealing approach may be to look at it as a movie, with clearly related scenes.

The temptation to which they refer is of course the temptation to which the currently dominant strain of macroeconomic thinking, at least within academia, has yielded with gusto, i.e. the Dynamic Stochastic General Equilibrium model in its various variants.  The BIS is signalling that it is doing something different.

First and foremost, the BIS “movie” is fundamentally financial.  The central phenomenon that interests them is the “financial cycle”, the expansion of credit in a financial boom and the subsequent contraction of credit in a financial contraction, possibly involving also financial crisis.

Second, but also centrally important, the BIS “movie” is fundamentally global.  Financial markets are global (Ch. II) and so is the real economy (Ch. III).  Spillovers and spillbacks between the advanced economies and the emerging market economies are of the essence, not second order.

Third, the BIS “movie” is fundamentally dollar-centric.  The USD is the dominant funding currency more or less everywhere (p. 57), and the fact that non-dollar economies are funding in dollars is of the essence for understanding the dynamics of the present financial cycle which, they warn, seems to have reached an inflection point.

We know how the movie ended for the last financial cycle, with the global financial crisis of 2007-2009.  And we know how that movie started also, with an asset bubble fueled by the Great Moderation.  The great tragedy is that, in our subsequent attempt to respond to the crisis–with quantitative easing and now negative policy rates–we have in large part been fueling another asset bubble.  We should know by now how that movie ends.

But apparently we don’t, and the reason we don’t is that some of us, the academics among us, have been watching a different movie.  That movie has led us to think that the problem is secular stagnation, and that the solution is aggregate demand stimulus.  That’s why the very expansionary monetary policy by the issuer of USD, which has spilled over to the rest of the world, which has responded with its own very expansionary monetary policy.  And away we go with a massive expansion of private credit globally, much of it in the emerging market economies and much of it dollar-denominated.

From the BIS point of view, this policy response has made the underlying problem worse, not better.  For the real economy, financial booms are a problem because they tend to cause misallocation of resources (capital and labor both) excessively into the boom sectors, which misallocation shows up later as slow productivity growth.  And for the financial economy, booms are a problem because they bust.  The bust is thus coming, although we can’t say exactly when, and this time we face it with very much reduced policy space, especially monetary policy space.  “I wouldn’t start from here,” the BIS never says explicitly, but of course here is exactly where we must start.

In such conditions, it is vital to fix firmly a vision of where we are trying to go.  That’s why the BIS puts so much emphasis on the “macro-financial stability framework.”  For them, the central goal must be to get the global financial cycle under control.  Ending the “doom loop” that links public debt and private banks is one piece of that (Ch. V), but the main cause of the cycle is private debt and so that is what must be tackled.  Indeed, that is the centrally important function of central banking–financial stability, not just price stability.

How exactly are actually existing central banks supposed to deliver financial stability?  The idea seems to be that they should “lean against the wind” of the financial cycle, by tightening more during booms.  The pre-crisis orthodoxy of inflation targeting suggested the existence of an inflation-neutral “natural rate” of interest, and the Taylor Rule for optimally shifting policy rates in response to external shocks.   The lesson of the crisis, according to the BIS, is that we need to replace that orthodoxy with a “finance-neutral natural rate” instead, in order to lean against the wind of the financial cycle.

At present, according to BIS calculation, the finance-neutral natural rate is positive, even as the realized real rate of interest is negative (p. 79).  Monetary policy is thus presently leaning with the wind, not against it, so amplifying instability.  That’s the bad news.

The good news is that banks (at least some of them) are safer, having recapitalized as part of the Basel III reform process:

The best structural safeguard against fair-weather liquidity and its damaging power is to avoid the illusion of permanent market liquidity and to improve the resilience of financial institutions. Stronger capital and liquidity standards are not part of the problem but an essential part of the solution. Stronger market-makers mean more robust market liquidity.

So maybe we will be able to ride out the coming volatility.

But that hope is somewhat at odds with the evidence presented elsewhere on cross-currency basis swap prices and dollar interest rate swap spreads (p. 40).  Sure, maybe the driver of these anomalous prices is “record demand for dollar fund-raising via swaps” (p. 41), and maybe some of that demand is driven by global interest rate misalignment.   And maybe the prices are not so anomalous anyway, just the way that markets are finding to price liquidity now that central banks are no longer giving it away for free.  But it does seem that “limits to arbitrage” must be part of the story at least.

It is clear that the BIS expects the next downturn to be led by an EME private credit crunch, as dollar appreciation undermines credit-worthiness of private corporations which have borrowed in dollars but swapped into local currencies (a kind of arbitrage that picks up the cross-currency basis, BTW).  For EME countries, this “risk-taking channel” of exchange rate transmission looms much larger than the traditional “trade channel”, and it serves as an amplifier of global instability.

Maybe that’s the movie we are in, but I would observe that it is a different movie from the last one, which was driven more by developments in the advanced economies.  So we really can’t know in any detail how this movie ends.  The only way to know is to keep watching, until “the future becomes today.”  One thing is for sure, “after so many years of exceptional accommodation and growing financial market dependence on central banks, the road ahead is bound to be bumpy.”






In memoriam, Jack Treynor Mon, 20 Jun 2016 13:40:34 +0000 [Remarks at Jack Treynor Memorial, MIT Chapel, June 19, 2016]

“Jack has never been easy,” wrote Charles D. Ellis in 1981 as Jack stepped down from his position as editor of the Financial Analysts Journal which he had held since 1969.   In Jack’s own departing words in the same issue of the FAJ, he described a “guerilla war” between black hats and white hats, whose “outcome is still in doubt”.

In retrospect, the years of Jack’s editorship more or less coincided with a most remarkable period in American history when what I have called the revolutionary idea of finance took hold and transformed financial institutions and financial practices utterly.   Jack was in the middle of it all, pushing against the resistance of the Old Guard in his attempt to professionalize the job of financial analyst, but also pushing against the New Guard whose almost religious belief in market efficiency led them to disregard the importance of that very same job.

Here he is, in 1979, retrospectively characterizing the middle ground he was trying to occupy:

I believe in a third view of market efficiency, which holds that the securities market will not always be either quick or accurate in processing new information so that, contrary to the academic view of market efficiency, opportunities to trade profitably against the market consensus exist.  According to this view, however, it is not easy to transform research advantage into superior portfolio performance.  Unless the investor understands what really goes on in securities transactions, he can easily convert even superior research information into the kind of performance that will drive his clients to the poorhouse.   (“Trading Cost and Active Investing”, eventually published in FAJ 1981 as “What Does it Take to Win the Trading Game?”)

To help him keep his balance on that shifting middle ground, he brought onto the board of FAJ his friend Fischer Black, who himself would spend more or less the same crucial formative years hanging out in academia, first at the University of Chicago and then MIT.  The result was a remarkably productive collaboration in which Treynor, taking advantage of his greater closeness to the world of practical experience, produced a series of “ideas in the rough” that Fischer then picked up, reworked, and smoothed out.

Three examples.  In 1971, Treynor thinks about the economics of the dealer function in his “The Only Game in Town” and Black responds with his visionary “Toward a Fully Automated Stock Exchange”.  And then in 1972 Treynor thinks about different options for pension fund reform, and Black responds with his “The Investment Policy Spectrum”.  Also in 1972, Treynor criticizes certain long-standing accounting practices in “The Trouble with Earnings,” and Black responds with “Yes, Virginia, There is Hope:  Tests of the Value Line Ranking System” and “The Magic in Earnings.”

All of this mutual influence was visible to everyone on the pages of FAJ, but I think there was an even deeper influence that was largely invisible.  From the very beginning, it was Treynor’s version of the Capital Asset Pricing Model that got Fischer interested in finance, and it was Fischer’s application of that model successively to monetary theory, business cycles, and then options and warrants that got him into academia (not to mention a posthumous Nobel mention for the options pricing work) without ever earning any formal degree in either economics or finance.

Just as significant, according to me, it was Treynor’s thinking about “The Economics of the Dealer Function” (1987) that undergirded Fischer when he shifted from MIT to Goldman Sachs, and I believe stimulated his famous Presidential Address to the American Finance Association “Noise”, including the most famous passage:

We might define an efficient market as one in which price is within a factor of 2 of value; i.e. the price is more than half of value and less than twice value.

Such deviation of price from value of course offers exactly the “opportunity to trade profitably against market consensus” that Treynor was always looking for.


The revolutionary idea of finance transformed the practice of finance, and in time it also transformed academic understanding of finance.   Indeed, both transformations continue to this day; I tell all my students that financial globalization, and the resultant integration of money markets and capital markets, is the defining fact of our age.  But I think there is another, even slower, transformation under way as well, a cultural transformation in how we think about risk and time in our own lives, both as individuals and as collectivities.

Treynor’s thoughts on how to trade profitably against the market consensus amount also to a kind of life philosophy, a way to confront what Keynes called “the dark forces of time and ignorance”.  In the long run, more important than the transformation of financial institutions, or of academic theory, is the way that a changed understanding of risk and time allows people to live different kinds of lives, by freeing them from the superstition that guides action wherever science has yet to penetrate.  And even more important is the way that a changed understanding of risk and time allows people to live different collective lives, by understanding better the larger society of which they are a part, and their place in it.

That cultural revolution is of course still very much unfinished business.  Jack Treynor, by placing himself in the middle of the central transformational event of his generation, was a pioneer not only in the art of investment but also in the art of living.

Global Money, a Work in Progress Sun, 12 Jun 2016 12:31:05 +0000 Today global money is largely private credit money, the issue of a profit-seeking bank that promises ultimate payment in public money which is the issue of some state, quite possibly a different state from the one where the bank is chartered and does its business.  Global money is also largely dollar-denominated, even when the ultimate users of that money lie completely outside the United States.  The issue of dollar-denominated US Treasury bonds is just part of the huge stock of dollar assets and liabilities; the stuff of dollar hegemony is the private credit money dollar, not the issue of the state.

Although global money is substantially private credit money, the fact that it is denominated in dollars means that the Fed is de facto, if not de jure, the ultimate lender of last resort for global money.  Therein lies the rub.  De facto the Fed’s responsibility is global but de jure its authority is only local.  The Fed is essentially hybrid, both government bank and banker’s bank, and also both US central bank and global central bank. The great challenge of the present time is the politics of managing the hybrid reality of the global dollar system.

In the normal course of business, banks meet their gross settlement obligations substantially through offset, and then meet any net deficit by borrowing from other banks in global money markets.  Normally this settlement process functions noiselessly and without intervention by any public authority.  But breakdown or dysfunction in interbank money markets, as occurred between 2007 and 2009, send net deficit banks to their own individual national central banks as backstop.  In 2008, these national central banks revived a network of borrowing arrangements, so-called liquidity swaps, to acquire needed means of ultimate global payment for their client banks.  It is the network of central bank liquidity swaps, centered on the Fed but functioning as a network, that today serves as global lender of last resort.

And it is the network of private foreign exchange swap markets that serves as global dealer of first resort, for a profit.  In a recent speech at the World Bank, Hyun Song Shin of the BIS drew attention to two remarkable facts about that private system (summarized in his Graph 2).  First, prices in the foreign exchange swap system fail to obey Covered Interest Parity.  Second, the degree of deviation from the theoretical CIP ideal seems to be positively correlated with the exchange value of the dollar.   Shin floats an idea about what might be causing these new facts, having to do with institutional investors hedging the dollar exposure in their asset portfolios in order to reduce mismatch with non-dollar pension and insurance liabilities.  But a simpler, and more general, explanation seems to me also worth considering.

From a money view standpoint, deviation from CIP is simply the expected profit for private dealers that is required to entice them to take onto their own balance sheets the opposite side of market imbalances.  The fact that global money is dollar private credit money means that the two facts Shin documents are actually symptoms of the same imbalance.  Possibly hedging demand is an important source of today’s market imbalance, but other sources can also be imagined.  The important point is that in today’s market the cross-currency basis swap operates as a sensitive barometer of market conditions, and central bank liquidity swaps operate to create the outside spread that puts bounds on how far price can deviate from CIP.

The origins of modern central banking can be traced back to the early days of the international gold standard in the 1870s and Bagehot’s famous Lombard Street (1873).  Following Bagehot, in time the Bank of England came self-consciously to embrace de jure responsibility as lender of last resort for its own national banking system.  Bagehot never addressed the problem of lender of last resort for global money, perhaps because the international gold standard centered on London was at that time yet in its infancy.  But it turns out he did know a thing or two about global money, and about the global money markets in which private dealers operated as global dealer of first resort.  We can learn from him for our own time.

In 1869, Walter Bagehot published A Universal Money, a collection of his ruminations on the desirability and possibility of a truly global money.  The occasion was the invitation, at the International Monetary Conference of 1867, for Britain to join the France-led Latin Monetary Union, formed in 1865 with Belgium, Switzerland, and Italy.   The original idea of the Union was to create a common 5-franc silver coin to facilitate trade.  The new idea for an expanded Union was to create a common 25-franc gold coin to expand the reach of the Union, not only to Britain but also the United States and Germany, among others.

Bagehot took this invitation quite seriously, in part because he expected Germany to join.  “Before long all Europe, save England, will have one money, and England be left outstanding with another money.”  But more generally Bagehot thinks a universal money would be a genuinely good thing, if only it were possible.  He argues that the French proposal is not in fact workable–too top-down, disregarding facts on the ground–but proposes his own alternative road to universal money.

In 1869, Bagehot’s alternative proposal was for an Anglo-Saxon Monetary Union between Britain and the US, which he thought Germany might find more attractive than the Latin Union.  His idea was to link the US $5 gold piece with the British pound, while at the same time decimalizing the British currency by treating the farthing (1/4 penny) as 1000th of a new pound.  The future he envisaged was a world of two Unions, the Teutonic and the Latin, between which other countries would be free to choose whether to join, and which to join.

In that case, there would be one Teutonic money and one Latin money; the latter mostly confined to the West of Europe, and the former circulating through the world. Such a monetary state would be an immense improvement on the present. Yearly one nation after another would drop into the union which best suited it; and looking to the commercial activity of the Teutonic races, and the comparative torpor of the Latin races, no doubt the Teutonic money would be most frequently preferred. In this case, as in most, the stronger would daily come to be stronger, and the weaker daily be in comparison if not absolutely weaker. Probably in the end the less coinage would merge in the greater, but at any rate it would be a great step to have but two moneys, and we could well make shift to do with that if we were sure, as we should be, that there never were to be any more.

It didn’t happen that way of course, at least not right away.  The dollar was then off gold, as a consequence of Civil War finance.  And by the time it got back to gold, Britain was well under way on a different project, constructing the international gold standard around the undecimilized pound, using its imperial reach as the core.  (Decimalization would finally take place only in 1971, a full century after Bagehot was writing!)  Thus the Bank of England became de facto central bank of the world even if de jure only central bank of England.

For a while the pound was universal money, but only for a while.  World War I, then world depression, then World War II would finally result in replacing the pound with the dollar as the center of the system, and seventy years later the result is what we see today.  Today the dollar, not the pound, is global money.  And its principal rival is not the French-based Latin Union as Bagehot anticipated, but rather the German-based Eurozone.

But leave all that history aside for the moment.  For our purposes, the most interesting passage of Bagehot’s book is the one where he talks about the determination of foreign exchange rates.  Note in the passage below that there is no hint of the abstract logic of covered interest parity; instead the story is about the price of bills of exchange as determined in dealer markets.

An exchange calculation is really the cost of remitting money from one country to another. That cost is substantially the same, whether the country from which the money is exported and the country to which it is imported have the same currencies or different currencies. Australia and England have the same currencies; the sovereign is the main coin in both; but, nevertheless, there is an expense in remitting money to Australia. The remitting banks make a charge for selling their drafts, and this is the common exchange calculation in a new shape. If France and America had the same currencies as England, it would still happen as now, that bills on Paris or New York would be at a discount or a premium. The amount of money wishing to go eastward across the Atlantic, and the amount wishing to go westward, would then as now settle how much was to be paid in London for bills on New York, and how much was to be paid in New York for bills on London. The original element in exchange transactions—the remittance of money—would remain as now, and the two principal accessory difficulties would be just as great. In practical exchange business the rate of interest is to be considered, and the state of credit also. If you buy a bill at three months’ date you lose a certain sum in interest, depending on the rate for the day, and you rely on the credit, more or less good, of the parties to the bill. These main peculiarities of exchange business are fixed by its nature, and no change of currency can alter them.

Bagehot is of course talking about bills that finance trade of actual goods, and the physical cost of remitting money.  In our world, by contrast, trade of financial assets completely swamps trade of real goods, and in world of electronic transfer the substantial cost is not physical but rather the risk exposure from open positions.  Today the most important money market instrument is not the real bill but rather the repo.  Indeed, Pozsar’s recent Credit Suisse paper asserts that the overnight GCF repo market “is the only functioning money market left standing today”, and suggests that the Fed’s new reverse repo facility is one side of the current outside spread that bounds repo rates from below.

Taken together, Shin and Pozsar sketch a map of the emerging system of global money.  It is a system of dealer markets making key prices–FX swap basis and GCF repo–and a network of central bank backstops for those prices–liquidity swaps and reverse repo facilities.

I give the last word to Bagehot who, in his own way, seems to have foreseen something like this moment:

The real objection is that after all this plan does not combine; it leaves us with two moneys; but if all the nations of the world gradually joined either the Latin coinage league or the Teutonic coinage league, trade would be very easy; and the amalgamation of these two might be left to a future and more educated age.

That’s us he is talking about.  Our amalgamation is first about the C6, the top six central banks now joined in the central bank swap network.  It took a global financial crisis to get us to this point.  The next step is bringing in the periphery, starting maybe with the BRICS.  Hopefully we are educated enough to do that without requiring another global financial crisis!

From Keynes to Lucas, and Beyond Mon, 06 Jun 2016 19:00:30 +0000 A History of Macroeconomics, by Michel De Vroey.  Cambridge University Press, 2016.

De Vroey’s book reads like a travelogue recounting his life journey as a macroeconomist, and his considered response to key texts he encountered along the way.  Always thoughtful and penetrating, he stimulates this reader to reflect anew on how we got to where we are today, and what might lie ahead.  In 1981, I commenced my own life journey as a macroeconomist, beginning in my final undergraduate spring semester by reading Keynes’ General Theory, and then continuing on in the fall as a Masters student by reading Malinvaud’s Theory of Unemployment Reconsidered as well as Lucas and Sargent’s newly published reader Rational Expectations and Econometric Practice.  Thirty five years later, De Vroey offers me the chance to revisit the texts on which I spent my youthful energies, and to reconsider the decisions I made about where to position myself in the intellectual turmoil then raging.

The book is an unapologetically internal history of macroeconomics, focused mainly on understanding the internal logic of the books and papers that made a difference.  But it is not Whig history—no triumphal account of the inexorable progress of knowledge.  Quite the contrary, a central theme of the book concerns the demise of a specifically Marshallian approach to economic thinking that DeVroey clearly favors, and that he detects not only in Keynes but also in Friedman, Clower, Leijonhufvud, and Phelps, the last of whom he characterizes as “the only one who really delivered” (p. 148) on the goal of explaining unemployment.

“Delivering”, for De Vroey, means providing an internally coherent theoretical account.  From this point of view, the fundamental problem of macroeconomics is that the urtext that started it all off, Keynes’ General Theory, didn’t actually deliver, and it didn’t deliver because the Marshallian framework that Keynes used to develop his ideas has no real place in it for involuntary unemployment.  Similarly, those who followed after Keynes made progress only to the extent that they deviated from the trade technology assumed by Marshall.  De Vroey’s quotation of Clower and Leijonhufvud’s list of the “main constitutive features” of their own effort to reconstruct macroeconomics reads like De Vroey’s own wish list:

“[The new trade technology] (1) lacks a central information-processing and bill-collecting agency; (2) has, instead, middlemen trying to coordinate production and consumption activities in each output market separately; (3) makes the management of stocks of inventories essential to the coordination of these activities; and (4) has the system potentially subject to the commercial crises associated with expansions and contractions of the volume of bank and non-bank credit” (p. 116).

But that’s not the road we have travelled, at least not yet.

Instead we got the dynamic stochastic general equilibrium (DSGE) program, which had its theoretical origins in Lucas’ “Expectations and the Neutrality of Money” (1972) and its empirical origins in the Real Business Cycle (RBC) work of Kydland and Prescott.  For a while the Keynesians tried to fight it off, defending the traditional IS-LM formulation of Keynes’ message, but it didn’t work.  Today, what De Vroey calls Second-Generation New Keynesian modelling is more or less a direct continuation of the Lucas program.  “New Keynesian modeling is no more directly explanatory of reality than RBC modelling.  This is the price to pay for having given the priority to internal consistency” (p. 334).

De Vroey clearly regrets the direction that macroeconomics has taken, but he also clearly admires the edifice that has been constructed.  By construction, it is definitely an internally coherent theoretical account of something.  The problem is that the internal coherence has been purchased at the price of external incoherence—the models have little connection to external reality.   Indeed, they operate, so De Vroey insists repeatedly, mostly as a kind of political philosophy.  “In an age when expertise is so valued, macroeconomists should refuse to play the part of experts and admit that their social usefulness is of the same subdued variety as that of political philosophers” (p. 380).   From a methodological standpoint, it is simply illegitimate to use these models to pronounce on policy.  Lucas comes in for praise for appreciating this inherent limitation, while those who followed after Lucas come in for criticism for ignoring it.

In a past age, the so-called “neoclassical synthesis” operated to create intellectual space for macroeconomics, which consisted of pragmatic theories of deviation from equilibrium, separate from the theory of long run equilibrium (e.g. Solow growth theory).  There never really was a synthesis, in the sense of an internally coherent theory linking the short run with the long run, just a division of labor.  But with Lucas, that separate space for macroeconomics came under attack and by now it has essentially vanished.  Formerly macroeconomics was about explaining unemployment; today it is entirely about the properties of equilibrium models.  Pragmatic policy-oriented macroeconomics, of the style exemplified by Okun’s posthumous Prices and Quantities (1981), survives only in policy schools and the voices of public intellectuals.  “Against Lucas’s newly defined standards, it was definitely sub-standard” (p. 217).  “With macroeconomics as it stands after the Lucasian revolution, making a theoretical case favoring Keynesian conclusions amounts to fighting with one hand tied behind one’s back:  the task is not impossible but it is difficult” (p. 376).

How did it all come to this?

De Vroey suggests that the rot began all the way back at the very beginning, when some early enthusiasts for Keynes shunted the Keynesian train onto the Walrasian track.  Some of the most fascinating pages of De Vroey’s travelogue trace the steps by which this was done—by Hicks, Modigliani, Klein, and Patinkin (Ch. 2-3).  Every one of them thought, of course, that he was “delivering”.  But the Walrasian framework has no more place in it for involuntary unemployment than does the Marshallian framework, not the original version put forth by Walras himself, not the modern general equilibrium version of Arrow and Debreu, and not even the so-called non-Walrasian equilibrium versions of Dreze, Benassy, and Malinvaud.   In the end, the internal logic of the Walrasian general equilibrium framework inevitably prevails, and that’s why we got new classical macroeconomics, real business cycles, and DSGE.  “Models have a life of their own that may evolve independently from the motivation and vision of those who created them” (p. 203).  De Vroey’s focus on internal history thus leads him to emphasize a kind of inexorable internal dynamic driving that history.

One question begged by De Vroey’s account is why those who wanted to build on Keynes chose to do so in a Walrasian frame.  For the early Keynesians, as DeVroey points out (pp. 299-300), Walras was mainly connected with social engineering and the socialist calculation debate.  As such, the Walrasian model represented a kind of normative goal, and the burning question was whether socialist planning, or free markets, or some hybrid with aggregative management (such as Keynes) could best achieve that normative goal.  De Vroey suggests that Lange was an important source of Walrasianism for Modigliani, Patinkin, and Klein.  In my own work, I have drawn attention instead to the role of Marschak (Mehrling 2002, 2010, 2014).  Whatever the origin, the important point is that Walras was brought in for a reason.  Even more, that reason is arguably the origin of the idea of the neoclassical synthesis, even though Samuelson’s coinage of the actual phrase did not come until 1955 (p. 46).

As a sometime historian of macroeconomics myself, I have some sympathy with this general line of argument, though I would put the emphasis somewhat differently.  For me, the central problem with the Walrasian framework is the lack of any place in it for money, sometimes called the Hahn Problem after Hahn’s 1965 essay which was directed toward Patinkin but applies more generally.   As De Vroey observes (p. 3), Keynes was a money guy, and before the General Theory he wrote the Treatise on Money (1930), which notably was organized around the quantity equation, not the Marshallian frame that De Vroey emphasizes.  The tepid reception of that earlier book is what led Keynes to try again with the General Theory.   As I read Keynes, his policy ideas always come from his practical experience, as investor and statesman, and his books are attempts to translate those ideas into scientific language that will convince his economist colleagues.  The problem is that the decision of his early followers to translate his ideas into a Walrasian frame wound up importing the Hahn Problem into the very center of macroeconomics, though at the time none of them realized it.  What I have called “monetary Walrasianism” (Mehrling 1997) became the postwar orthodoxy not only of the Keynesians but also of monetarists such as Friedman, and it was only with the turn toward microfoundations that the Hahn Problem really began to bite.  As DeVroey points out, even Lucas (1972) had a Friedman-like quantity theoretic frame that included money, and it was not until Kydland and Prescott that money was finally eliminated.   It took a while for the internal logic of the model to play out.

I thus have a certain sympathy with internal history driven by the internal logic of mental frameworks.  But more generally I think that a full understanding of the history of macroeconomics requires more than that.  I conclude by drawing attention to two bits of outside influence that seem to me quite important for the story.

The first is the influence of the American institutionalist tradition, a tradition that was generally antagonistic to Marshall, on the early American Keynesians (Mehrling 1997, especially 130-136 on Alvin Hansen).  De Vroey refers frequently to the “pragmatism” of the early Keynesians, but to my mind he does not adequately appreciate the way that, in the American scene, pragmatism operated as a scientific methodology.  What American institutionalist Richard T. Ely called the “look and see method” is in fact characteristic of most of pre-Keynesian American economics, stemming from the writings of Charles Sanders Peirce and John Dewey, among others.  What looks like eclecticism to a European sensibility is in fact, at least at its best, a disciplined attempt to find the appropriate theoretical framework for a particular problem.  From this point of view, the significant methodological breach represented by Lucas was not so much a shift away from Marshall, as De Vroey argues (Ch. 10), but rather a shift away from pragmatism.

The second is the influence of the new field of finance on macroeconomics.   The idea that prices move to keep markets in equilibrium at every point in time, short run as well as long run, was foundational for modern finance before it became foundational for modern macroeconomics.  In fact, as I have suggested elsewhere, it showed the way (Mehrling 2010).   Way back at the beginning, the idea to understand “Liquidity Preference as Behavior toward Risk” (Tobin 1958) linked the IS-LM model conceptually with developments in asset pricing.   Today the Euler equation characterizing intertemporal optimization lies at the heart of both modern finance and modern macroeconomics:

U′(Cit) = Et[δU′(Cit+1)Rjt+1].

For finance, this equation is about how asset prices Rjt+1 depend on time and risk preferences, the equation is called the “consumption CAPM,” and the asset in question is typically equity or long-term bonds. But the same equation can be used to talk about the intertemporal fluctuation of income, and as such is at the core of both real business cycle theory and its New Keynesian variants. In this application, the asset is typically capital, or a rate of interest.   From this point of view, the significant methodological breach represented by Lucas was not so much a shift toward Walras as it was a shift toward finance.

At the end of the book, De Vroey reaches beyond his internalist historical frame and reflects a bit on the likely effects of the “2008 Recession” on the future of macroeconomics.   Certainly the DSGE models had little to say about the cause of the recession or possible policy response to it.  “As a matter of construction, DSGE models … exclude the possibility of integrating important pathologies into the workings of the market system, and certainly any collapse in the trading system of the extent that we have experienced” (p. 387).  One consequence has been an increased interest in returning to Keynes, but De Vroey thinks there is no going back.  Developments in macroeconomics will continue to respect the methodological strictures that Lucas and his followers have established.  Indeed, currently economists are hard at work trying to integrate a financial sector into the DSGE framework.  “At this juncture, it is however still difficult to gauge whether a mere integration of the financial sector within the existing framework will suffice, or whether a more radical reorientation of macroeconomics will see the light of day” (p. 388).

If I read him right, the radical reorientation that De Vroey has in mind would involve something like what Phelps did.  Specifically, Chapter 14 “Reacting to Lucas:  Alternative Research Lines” has a kind of wistful road-not-travelled feel, drawing our attention to search-theoretic work that De Vroey himself thinks showed promise for a possible alternative direction.  But no one picked it up, and in particular that no one developed an empirical program that would allow researchers to apply the theory to practical problems.  Maybe, but I’m not convinced.

For me the problem with all these search-theoretic models is that they emphasize market failure in the labor market, which they view as a kind of special case.  But the global financial crisis that led to the 2008 Recession was not a breakdown in labor matching.  It was a breakdown in wholesale money markets worldwide, the fundamental infrastructure that supports trading in all markets.   The more general Clower-Leijonhufvud wish list seems to me very much in line with what I have been calling the “Money View”, which I consider to be the natural implicit theory for people whose lives bring them into contact with money markets.   Making that implicit theory explicit would provide foundations for a possible macroeconomics.



Hahn, Frank.  1965.  “On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy,” in Hahn and Brechling, editors, Theory of Interest Rates.

Mehrling, Perry.  1997.  The Money Interest and the Public Interest:  American Monetary Thought, 1920-1970.  Harvard Economic Studies #162.  Cambridge:  Harvard University Press.

Mehrling, Perry.  2002.  “Don Patinkin and the Origins of Postwar Monetary Orthodoxy.” European Journal of the  History of Economic Thought 9 No. 2 (Summer):  161-85.

Mehrling, Perry.  2010.  “A Tale of Two Cities.”  History of Political Economy 42 No. 2:  201-219.

Mehrling, Perry.  2014.  “MIT and Money.”  In MIT and the Transformation of American Economics, edited by E. Roy Weintraub.  History of Political Economy (supplement).  Duke University Press.

Tobin, James.  1958.  “Liquidity Preference as Behavior Towards Risk.”  Review of Economic Studies 25 (February):  65-86.