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I had planned to do a follow-up post to my recent interaction with Fable on market monetarism, then decided that before doing so I first need to discuss why Fable and I approach macroeconomics from different perspectives. I am not a monetarist in the strict sense of favoring money supply targeting, but I do use a broadly monetarist approach to macro. Fable uses a broadly Keynesian approach, perhaps better described as New Keynesian.
Because advanced AIs train on vast range of economic research, you’d expect them to use an approach that is similar to the consensus view of economists. So it is no surprise that Fable is Keynesian, as that basic approach is much more popular than monetarism. I will try to explain why Fable is mostly Keynesian by showing how the economics profession came to adopt the Keynesian approach.
Part 1: The Monetarist and Keynesian approaches
I keep using the term “approach”, which is rather vague, so let me be a bit more specific. Monetarists try to explain movements in nominal aggregates such as the price level and NGDP by looking at changes in the supply and demand for money:
price level = (nominal money supply)/(real money demand) = Ms/md
NGDP = (nominal money supply) x (velocity) = Ms/(1/V) = Ms/k
where “k” is the share of NGDP held as money balances. Thus md and k are two ways of defining money demand. Think of md as the total purchasing power of the public’s money holdings, and k as the share of gross income the public chooses to hold as money.
In plain English, the rate of inflation is the percentage change in the money supply minus the percentage change in real money demand. If they change at exactly the same rate, the price level is stable.
The percentage change in NGDP is the percentage change in the money supply minus the percentage change in the share of NGDP that the public holds as money. If the money supply grows 4% faster than the k ratio changes, then NGDP grows at 4%.
To be clear, neither of these claims are theories; both are identities, true by definition. That’s why I call this the monetarist approach, not the monetarist model.
The Keynesian approach can also be explained with an identity:
GDP = Consumption + Investment + Gov. Output + Net Exports = C + I + G + NX
Note that I say “GDP”, not NGDP, as simpler Keynesian models often don’t discriminate between real and nominal GDP, treating the price level as fixed in the short run. Then the price level gets explained separately with some sort of Phillips Curve model.
To summarize, people using the monetarist approach try to explain movements in NGDP by looking at changes in money supply and demand, whereas people using the Keynesian approach try to explain movements in GDP by looking at factors that influence consumption, investment, government output and net exports.
Again, all of the equations above are identities, true by definition. It is purely a question of convenience—which approach provides a more coherent and useful model of NGDP determination? In section 2, I’ll explain why I find the monetarist approach to be more useful. In section 3, I’ll explain why back in 1936 the Keynesian approach seemed like the more sensible way of looking at things. Perhaps it was.
In section 4, I’ll show how the economics profession became locked into the Keynesian approach, and continued to use this model even after it was no longer appropriate. Instead of reverting to a superior monetarist approach, they kept adding epicycles to the Keynesian model, eventually ending up with what is now called New Keynesianism. Monetarists are partly to blame, as they did a poor job of adapting their model to the policy needs of a modern fiat money economy. They failed to offer an attractive alternative to Keynesianism.
I feel like market monetarism does offer an attractive alternative to Keynesianism, but I worry that it is now too late to change. The Keynesian approach is like the QWERTY keyboard or Microsoft Windows—perhaps non-optimal, but hard to displace with something better.
Part 2: Monetarism and high inflation
In principle, the monetarist approach has no ideological implications, as it treats changes in money supply and demand symmetrically, each being equally important. Real world monetarists, however, treated money supply changes as being more important. It became associated with right wing economics, where undesirable movements in prices and NGDP could be “blamed” on changes in the money supply, i.e., blamed on mistakes made by government policymakers. This was probably a mistake, a turn-off for idealistic young reformers, who lean to the left.
As a practical matter, the focus on the money supply works best in an environment of very high inflation and NGDP growth rates. Interestingly, this view seems to be accepted by both monetarists and Keynesians. Here’s Milton Friedman in 1975:
Double-digit inflation and double-digit interest rates, not the elegance of theoretical reasoning or the overwhelming persuasiveness of serried masses of statistics massaged through modern computers, explain the rediscovery of money.
Most economics textbooks are written by Keynesians, and most use the Keynesian approach (C+I+G+NX) in their core macro chapters. But most of these books also include a brief discussion of the monetarist approach, and almost always in the context of high inflation countries. Some have graphs showing a correlation of money and prices during hyperinflation in Germany. Others contain a graph showing the cross sectional correlation of money and prices for perhaps a dozen high inflation countries.
So why are high inflation countries the ones where monetarism looks best? It turns out that changes in money demand are usually relatively small, typically in single digits. Thus when the change in the money supply is extremely large, it dominates shifts in money demand. Look at the long run correlation between money supply growth (the base) and both inflation and NGDP growth, taken from an old textbook by Robert Barro, which used annual averages (mostly from the 1960-1990 period):
Notice a fairly strong positive correlation for the high inflation countries. But the correlation for the lower inflation countries is much weaker (albeit still positive):
Here I’ll use the example of a stock split to provide the intuition. If Boeing does a two for one stock split, doubling the number of shares, you might expect that change to have little or no impact on Boeing’s market cap, particularly if the split had been previously announced. If so, you might expect the value of individual shares to fall from say $100 to $50 dollars on the day of the split. But it is also possible that other factors influenced the demand for Boeing’s shares on the same day that the number of shares doubled. Perhaps they received a big new order for jets, which boosted their market cap by 2%. In that case, the price of a single share might not fall exactly from $100 to $50, rather the price might fall to $51/share.
Similarly, if you double the money supply overnight, you might expect the purchasing power of each dollar bill to fall in half. That would occur through a doubling of the price level for goods and services. But if at the same time the real demand for money rose by 2%, then instead of the price level doubling, it might rise by slightly less than two-fold.
Unfortunately, monetarists made the mistake of putting too much emphasis on the importance of money supply changes, and too little emphasis on the importance of changes in money demand, especially for low inflation economies. As a result, their approach lost favor when important changes in prices and NGDP seemed to be driven by “non-monetary” factors.
I put “non-monetary” in scare quotes because these cases still involved monetary factors—specifically changes in the demand for money. But by focusing so much on changes in the supply of money, monetarists gave the impression that their model had nothing to offer when the demand for money was unstable. And that is when Keynesianism appeared on the scene, ready to fill the gap created by flaws in monetarism.
[Here I’m cheating a bit, as monetarism is a post-WWII term for ideas created after Keynes wrote his General Theory. But monetarism builds on the work of early quantity theorists like Irving Fisher. Keynes was reacting against that sort of classical Quantity Theory model.]
Part 3. Keynesianism is a gold standard model (whereas monetarism is the gold standard of models)
In several previous papers, I argued that Keynesianism can be thought of in a number of ways:
A gold standard model
A monetary ineffectiveness model
A zero expected inflation model
These are not three separate views, rather they are three aspects of the same basic idea. Monetary policy is severely constrained under a gold standard regime, especially in the long run. The global price level tends to be determined by the marginal cost of producing gold, leaving very little room for central banks to engage in policies such as inflation targeting. Indeed, under the international gold standard, the long run average rate of inflation was roughly zero. For that reason, monetary policy can seem “ineffective” during a slump, although it is better described as being constrained by the gold price peg.
Under the gold standard, there were frequent increases and decreases in the price level, but these were largely unanticipated. With almost no expected inflation, there was little or no “Fisher effect” for nominal interest rates. Indeed, adding a Fisher effect to the New Keynesian model was one of the “epicycles” that I referred to above, but even today the Keynesian approach does a poor job of explaining interest rates, with an excessive focus on their use as a central bank policy tool. Too much reasoning from a price change.
Think about how different the world of 1936 was from the inflationary decades shown in the two tables above. Between 1929 and 1933, the US price level had fallen by more than 25% and NGDP fell nearly in half. And yet both the global stock of gold and the US monetary base had actually increased over that 4-year period. To be sure, postwar monetarists emphasized the decline in broader monetary aggregates such as M1 and M2. But this data wasn’t fully understood at the time, and even if it had been it is not clear whether central banks like the Fed had the ability to control those broader aggregates at a time when the public was pulling money out of banks and hoarding cash. Put simply, monetarist explanations focusing on the money supply did not appear to be very useful.
To be clear, I do believe the basic monetarist approach is highly useful for studying the Great Depression. Indeed my book entitled The Midas Paradox explains the deflation of 1929-33 in terms of changes in the global supply and demand for gold. I showed that the basic problem was that while the supply of gold rose modestly during that period, gold demand grew much more rapidly due to a combination of private and central bank gold hoarding. Gold was the medium of account, the thing in which all other prices were measured. So gold played the same role as money does in a fiat money model.
Thus, even in the case of the Great Depression, there is nothing wrong with using a model that looks at shifts in gold supply and demand, or the money supply and money demand. The actual problem is that monetarists were associated with the view that velocity is fairly stable and changes in the money supply are the key driver of nominal aggregates, a view that did not seem to be applicable to a world where prices and NGDP fell sharply despite a large increase in the monetary base.
It’s not enough to be correct, your model must also seem correct. During the 1920s, Hayek had argued that central banks should stabilize NGDP. But when NGDP plunged sharply after 1929, Hayek refused to support monetary stimulus. His underlying model was correct, but his policy advice was so misguided that people stopped listening to him.
Keynes produced an explanation for depressions that was consistent with most people’s common-sense intuition about the economy and was also able to account for movements in NGDP that the quantity theorists struggled to explain. Keynes suggested that “aggregate demand” was determined by factors such as deficit spending, business confidence, and the consumer propensity to save. Here is AI Overview listing 5 factors that shift the IS curve to the left in. an IS-LM model:
Decreased Government Spending (G): A reduction in public works, defense, or government services directly lowers aggregate demand.
Increased Taxes (T): Higher taxes lower consumers’ disposable income, which dampens both consumer spending and overall demand
Decreased Investment (I): A drop in business confidence or tighter credit conditions reduces business investment regardless of the interest rate.
Decreased Consumer Spending (C): If households decide to save more of their income and consume less, the IS curve shifts left.
Decreased Net Exports (NX): A drop in foreign demand for domestic goods (or an increase in domestic demand for foreign imports) reduces the net export component of aggregate demand.
These are factors that the Keynesian model views as contractionary—fiscal austerity, lower confidence among businessmen, the paradox of thrift, trade deficits, etc. And when I read the output from Fable, it is quite clear that this is the framework it uses to evaluate macroeconomic debates. But this approach only makes sense in a world where monetary policy is somehow constrained, that is, where central banks are unable to control inflation and/or NGDP. In an unconstrained fiat money world, a central bank could and should offset any of these expenditure shocks in such a way as to prevent them from causing macroeconomic instability.
Here is the famous Keynesian IS-LM diagram, showing the effect of a negative shock such as increased business pessimism (less I), a higher propensity to save (less C), and/or fiscal austerity (less G):
Let me be clear: I hate IS-LM more than almost anything in the world, with the possible exception of MMT. But if I’m going to explain how Fable became Keynesian, I need to give the model the benefit of the doubt, at least for the moment. In addition, I need to make a few simplifying assumptions that are not strictly true but are reasonable approximations of the model’s implications.
The first approximation is to view the LM curve as representing monetary policy. Thus, an increase in the money supply (in the Keynesian model) causes the LM curve to shift right, leading to lower interest rates and higher output. Does it work this way in the real world? Probably not, and least not usually. But this is a widely held way of thinking about macro so let’s accept it for the moment.
If the LM curve is in some sense ”monetary policy”, then a world where monetary policy is constrained by the gold standard can be viewed as a world where the LM curve is stable and the business cycle is caused by left and right shifts in the IS curve. And that’s basically the world described by Keynes in the General Theory. Recessions occurred when businessmen lacked “animal spirits”, when consumers tried to save too much, when foreigners stole our jobs through trade deficits. And the solution was to shift the IS curve back to the right with expansionary fiscal policy (more G and/or lower taxes.)
Can this Keynesian view be reconciled with the monetarist approach? Since both are based on identities, there must be some way to reconcile the two views. Consider the case where the money supply is fixed—why would negative expenditure shocks affect NGDP? If Ms is fixed, a fall in NGDP would be caused by an increase in the demand for money (as a share of GDP). Or lower velocity, if you prefer that framing. And all of the bearish factors cited by Keynes do indeed tend to raise money demand and lower velocity, but not in the way that you might assume.
For instance, the “paradox of thrift” is actually the paradox of money hoarding. More saving by itself would not be contractionary, as saving equals investment. The actual problem is that an attempt to save more depresses interest rates, which increases the demand for money. Recall that interest rates are the opportunity cost of holding (non-interest bearing) cash. That increased demand for money is what causes NGDP to fall.
The logical solution to this problem would be to increase the money supply to match the rise in money demand, in which case an increased propensity to save would not have any contractionary effect. By the time I studied economics in the (inflationary) 1970s, people had mostly stopped worrying about the paradox of thrift, for exactly this reason.
From a monetarist perspective, you might say that Keynesians believe that recessions are caused by low interest rates. A contractionary shock impacts saving and investment in such a way as to reduce interest rates, which then increases real money demand. As people hoard more money, NGDP declines if the money supply doesn’t rise to match the increase in money demand.
Keynesians, however, would be horrified by the claim that their model implies that low interest rates cause recessions, because they don’t look at things using the monetarist (money supply/money demand) framework. They see these contractionary shocks in a very mechanical way, as directly impacting aggregate spending. In contrast, when Keynesians think about the causal impact of changes in interest rates, they think in terms of monetary policy. A Keynesian sees a fall in interest rates as an expansionary monetary policy, that is, a rightward shift in the LM curve, where you move down and to the right along a given IS curve.
And yet, the IS-LM model clearly suggests that we need to avoid this sort of “reasoning from a price change”. A fall in interest rates could be caused either by an expansionary monetary policy (LM shifts to the right) or a contractionary expenditure shock (IS shifts to the left.). And if we hold the money supply constant, then it is more likely that low interest rates would reflect a leftward shift in the IS curve, which would be contractionary. (Technically, it could also reflect money dishoarding.) I wish that Keynesians paid more attention to this possibility.
Part 4: Keynesianism is the QWERTY of macroeconomics
[Apparently, the inefficiency of QWERTY keyboards is a myth. But as they say, "When the legend becomes fact, print the legend,"]
After WWII, the US gradually evolved from a quasi-gold standard, where the price of gold was pegged at $35/ounce, to a 100% fiat money system (achieved in January 1968.) Under this new policy regime, the monetarist approach was far superior to the Keynesian approach. At that time, the Keynesian C+I+G+NX framework for aggregate expenditure should have been discarded and replaced with a monetarist approach where NGDP is determined by the monetary authority. The optimal policy was to adjust the money supply to accommodate any change in money demand, keeping M*V = NGDP growing at a steady rate of roughly 4 percent.
In this ideal world, there would be no worries about “animal spirits”, consumer pessimism and trade deficits. No call to run fiscal deficits to “create jobs”. Just keep NGDP growing at 4 percent by adjusting the money supply to accommodate shifts in money demand. After all, the Keynesian model was built to address a world where monetary policy was constrained by the gold standard, and that world no longer exists.
So why didn’t that happen? Why did the Keynesian model continue to dominate the profession, even at the highest level?
If you are a rational reader, your most sensible conclusion would probably be that “Sumner is wrong”. I have enough self-awareness to understand that. Indeed, that’s my “outside view”. But today, I’ll give you my inside view.
Like fish that don’t know they are wet, I believe the economists of the 1930s had no understanding of how much of their worldview implicitly reflected a commodity price peg for the monetary system. Many people know that Keynes opposed the gold standard. Far fewer know that he opposed a fiat money system even more strongly. Keynes favored what today might be called a quasi-gold standard, something like the Bretton Woods system (where the dollar was pegged to gold at $35/ounce and other currencies were pegged to the dollar.)
Keynes (on the right) participated at the 1944 conference that created the Bretton Woods System, although the final version was closer to the American proposal of Harry Dexter White (on the left). This picture was taken in 1946, and Keynes died a few weeks later.
If Keynes had favored fiat money, then presumably he would have advocated something like a 2% inflation target, or more likely an NGDP target. (In the General Theory, Keynes suggests that NGDP is more meaningful than inflation.). But Keynes was horrified by the thought of fiat money, and never envisioned an unconstrained fiat regime as a practical solution. This is why Keynes denied the existence of the Fisher effect, which is only important under a fiat money regime. And this is why he didn’t anticipate stagflation, which is much more likely to occur under a fiat money regime.
A second important factor explaining the durability of Keynesianism is the way that it matches the common sense of most people. To the average person (and even to Fable), it seems like common sense that if consumers try to save more and spend less, it would “hurt the economy”. This false intuition about the economy comes from inappropriately applying a true microeconomic concept to a macroeconomic environment where it is no longer true. If consumers wish to spend less on cars, it really does cost jobs in the auto industry. But if consumers wish to spend less on all goods, it does not cost jobs in the overall economy. Rather (assuming appropriate monetary offset) any loss of jobs in consumer goods industries is fully offset by gains in investment goods industries.
A third problem is that postwar monetarists started advocating money supply targeting, which only works during periods when money demand is stable. When money demand became unstable, the entire monetarist approach was (wrongly) seen as being discredited.
And finally, when countries like Japan (and later the US) hit the zero lower bound for interest rates, many economists wrongly assumed that central banks were “out of ammunition”, which made the Keynesian approach look more attractive. In Alternative Approaches to Monetary Policy I explain why this pessimistic view is incorrect. No fiat money central bank is ever out of ammunition, unless they run out of paper and green ink.
So instead of discarding the Keynesian model and replacing it with a better monetarist model, the profession stuck with the basic Keynesian framework, but kept adding epicycles to address the flaws that people like Milton Friedman kept discovering. The Phillips Curve shifts? Fine, we’ll add inflation expectations. Fisher effect? Fine, we’ll account for that. Rational expectations? Fine, we’ll add that to New Keynesian models.
All these fixes were appropriate, and New Keynesianism was clearly an advance over the older “vulgar” Keynesianism. But these fixes were attached to a decaying carcass. No matter how many epicycles were attached, the Keynesian approach was rotten at its core. This is why the mainstream did such a poor job during 2008, when a few market monetarists saw the underlying problem before the rest of the profession. Money may not have looked “tight” in 2008, but if NGDP is falling then it is tight.
If I knew nothing about a particular field of science, it would be rational for me to put more weight on the consensus view of experts, rather than the views of a tiny minority of heterodox thinkers. Thus, it is completely rational for Fable (and other AIs?) to prefer the Keynesian approach over the monetarist approach. In some ways I’d be frightened if they adopted market monetarism, as that would suggest they were open to be influenced by fringe theorists, which might be dangerous. If they like monetarism, what’s to stop them from being influenced by MMTers? The mainstream isn’t always correct, but it is the safest position in a world of great uncertainty.
Going forward, it is possible that AIs will become smart enough to adjudicate the dispute between Keynesians and monetarists and produce a verdict that is so intelligent that it is convincing to both sides. If and when that occurs, we will have achieved what I view as artificial super intelligence. I doubt I’ll live that long.
In the next post, I will refer to this post when explaining why I disagree with the Keynesian framing used in some responses by Fable.
PS. Because I hate IS-LM, I am not good at using the model. I never taught it. Please correct any mistakes in the comment section.
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