Clark Johnson on “Keynes: Evidence for Monetary Policy Ineffectiveness?”

Over the last couple of days we have published four guest posts by Clark Johnson on “Keynes:  Evidence for Monetary Policy Ineffectiveness?”. Here you can read the paper in its entirety.

Clark, thank you for your contribution to my blog. I am sure my readers have enjoyed it as much as me.

PS here is Keynes celebrating the UK giving up the gold standard in 1931. Unfortunately at the time her wrote General Theory (1936) he had forgot about how powerful monetary policy can be and instead as Clark has so clearly demonstrated advocated the use of fiscal policy. Maybe the problem was that Keynes thought that devaluation of the pund worked through a competitiveness channel rather than through an increase in the money supply and money velocity. See more on that topic here and here.


Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 4, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson


Keynes essential claim in the General Theory was that unemployment could persist for years, even if wages and other factor costs were flexible.  The point was that even if factor costs fell, the marginal efficiency of capital might not recover because it was driven by market expectations — which were volatile, and trending downward.  Falling costs might even be taken, not as restorative, but as evidence of weak demand and sagging investment prospects.  Investment might then stay below the level needed to maintain full employment.  Keynes was not claiming that general equilibrium was maintained in the face of unemployment, as critics were later to assert.  He used the term “equilibrium” more modestly to mean that unemployment could persist, and that it was not self-correcting.

Keynes never really explained why he thought monetary policy worked mainly through its effect on interest rates, rather than directly on demand.  This paper suggests the hypothesis that he saw accumulation of physical capital as inexorably leading to lower capital efficiency and declining profits.  With this premise, an attempt to reboot investment by increasing money and prices – even if it succeeded in the short run — would just mean more rapid accumulation of capital, and hence more rapid decline in profits, in a self-reinforcing stagnationist circle.  This conclusion was falsifiable, and has been falsified.  To be fair, it pushes Keynes’ suppositions to the edge of what his text might support, and Keynes never wrote it down, not in so many words.

Keynes was more inclined to dodge the whole topic, either by indirection or deliberately.  The best example of his dodge on monetary factors comes near the beginning of the General Theory, where Keynes quotes John Stuart Mill’s description of Say’s Law, the classical doctrine according to which “supply creates its own demand.”  Keynes sets up Say’s Law as a counterpoint for his own theoretical grand design.  Keynes quoted Mill to demonstrate that “classical” economists thought it possible to “double the purchasing power” merely by “doub[ling] the supply of commodities in every market.”[1]  Astonishingly, Keynes then chopped off the rest of Mill’s paragraph, in which was included –

…money is a commodity; and if all commodities are supposed to be doubled in quantity, we must suppose money to be doubled too, and then prices would no more fall than values would.[2]

Algebraically, an excess supply in one market must be matched by an excess demand in another.  A shortfall of demand for goods implies a matching excess (unsatisfied) demand for money.  Mill and other Classics recognized this – it was not Mill but Keynes who typically neglected discussion of such monetary dynamics.  Mundell highlighted this omission decades ago:

…Keynes perpetrated an historical error in the economics profession lasting several years, a distortion of the classical position that to this day remains in the elementary textbooks.  By thus attacking the logic of the central feature of the classical theory through carelessness or mischievous omission of its essential parts, Keynes was able to win disciples over to the belief that there was a fatal logical defect, an absurd premise, in the classical system.[3]

With somewhat more effect, Keynes did provide a critique of the conventional Quantity Theory   of money – which he had himself endorsed in his earlier Tract on Monetary Reform.  In the Treatise, he argued the case over several chapters that some cost and other factor price increases were tied directly to increases in the quantity of money, while price increases that feed into profits might be less correlated with changes in the money supply.  Indeed, where demand for money increases, a higher quantity of money might even correlate with lower aggregate profits and hence with lower prices.[4] Slaying the Quantity Theory, so to speak, was important to many of Keynes’ early followers, in whose understanding it opened the way to an active role for the State and to deploying an array of fiscal “multipliers.”

It is otherwise less important.  Monetary economics has by now moved past the Quantity Theory, or growth of the money supply, as a policy marker.  Lars Svensson and Scott Sumner recommend that central banks stabilize expectations by targeting a steady rate of growth in Nominal GDP.  Svensson has written that Milton Friedman told him late in his life that monetarists should target nominal GDP rather than growth in the money supply.[5]  I would qualify their recommendation with the suggestion, given the dollar’s role as the world economy’s key liquid asset, that US monetary authorities should also target foreign exchange rates during financial crises, especially the dollar-euro rate.  But nothing about moving beyond the Quantity Theory makes monetary policy less important, or makes interest rates the only channel, or they main channel, through which it can be effective.

The historical illustrations in the opening section suggest that economic slumps and unemployment persisted because effective monetary expansion did not occur.  This was true even where interest rates were already very low and where the marginal efficiency of capital was falling sharply.  The de-stabilizing factor was inept monetary policy, or inability to change such arrangements as the international gold standard.  The irony is that Keynes, the acclaimed revolutionary of Depression economics, had so little to say about the uses of monetary policy when interest rates fell to historic lows and anticipated investment returns went even lower.  Perhaps this was because he sought changes in the relationship between State and Market for which considerations of monetary economics were a distraction.

But faced with the aftermath of the 2008 financial sector crisis and the ongoing Euro-zone crisis, we should avoid such distraction.

[1] General Theory, p. 18.

[2] J. S. Mill, Principles of Political Economy, 1909 edition; p. 558.)

[3] Mundell, Man and Economics, 1968; p. 110

[4] See also, General Theory, pp. 208-209.

[5] Lars E.O. Svensson, What have economists learned about monetary policy over the past 50 years?  January 2008.  At

I can hear Uncle Milty scream from upstairs – at James Bullard

The St. Louis Fed has long been a bastion of monetarist thinking, but something has changed at the Eighth Federal Reserve District. Here is St. Louis Fed president James Bullard in an interview with Bloomberg:

“Treasury yields have gone to extraordinarily low levels. That took some of the pressure off the FOMC since a lot of our policy actions would be trying to get exactly that result.”

I can only imagine how Milton Friedman would have reacted to this kind of statement – most likely he would have said something like this:

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy..After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Friedman said that in 1998. 14 years later central bankers still make the same mistakes. It is incredible. It makes you want to scream and it is especially frustrating when you hear it from the president of a Fed district with a strong monetarist traditions. Just sad…

HT Matt O’Brien

Update 1: Josh Hendrickson was so kind to remind me about this Friedman quote from Milton Friedman’s Monetary Framework (1974):

“On still another level, the approach is consistent with much of the work that Fisher did on interest rates, and also the more recent work by Anna Schwartz and myself, Gibson, Kaufman, Cagan, and others.  In particular, the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low interest rates, that money has been tight, in the sense of increasing slowly, rather than the reverse.”

Update 2: Vaidas Urba has the following comment about Bullard:

“Very strange to hear this from Bullard, as he wrote the Seven Faces of the Peril paper where he discussed the low interest rate deflationary equilibrium….Bullard: “To avoid this outcome for the United States, policymakers can react differently to negative shocks going forward. Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low…”

So yes, Bullard once (in 2010) understood and now apparently he seem to have forgot about how monetary policy works.

Lorenzo and Horwitz debate Austrian economics

Back in April our friend Lorenzo did a interesting post on Austrian theory. That has now triggered a response from Steve Horwitz who defends the Austrian position. It is excellent stuff. It is a debate between two clever debaters and I have very strong sympathies for both gentlemen. However, I don’t have time today to go through the entire debate, but I will strongly recommend to my readers to take a look at this very interesting debate.

See here:

Lorenzo: About Austrian Economics

Steve’s response: Thoughts on Lorenzo on Austrian Economics

Lorenzo’s feedback to Steve: Response to Dr. Horwitz’s thoughts

Again, this is excellent stuff. Read it! We can all become more clever by debates like this. Thanks guys.

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 3, by Clark Johnson)

Guest post: Part 3 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the first and second post in this series)

Arguments for Fiscal Activism 

a)    New Money and Money Demand

Keynes’ premise is not credible.  Monetary economics routinely identifies channels other than interest rates through which additional money creation can affect demand.  For example, Frederic Mishkin, former member of the Fed Board of Governors, has identified channels of exchange rates, financial asset prices, real estate prices, wealth effects on consumption, and increase in bank lending capacity (among others) through which demand can be increased.[1]  Pertinent here, Keynes himself sometimes made the argument that monetary expansion could boost demand directly, independent of impact on interest rates.

For example, in the Treatise chapter on “Monetary Factors,” Keynes noted that monetary stimulus might bring together a previously “unsatisfied fringe of would-be entrepreneur borrowers who were ready to borrow … even at the old terms [i.e., without lowering interest rates], and … an unemployed fringe of the factors of production [workers] to offer employment to additional quantity of the factors of production.”  In an additional impact, he wrote that “certain entrepreneurs may now be willing to increase their output even if this means making higher offers than before to the factors of production because (as the ultimate result of the influx of new money) they forsee profits.”[2]  As Keynes here demonstrates, the underlying goal of monetary expansion is to satisfy an unmet demand for money.  The consequence may be to lower interest rates, but it may also work by directly increasing demand for goods and services, and for credit to purchase them.

The General Theory has comparable passages.  In Ch. 11, on the “Marginal Efficiency of Capital,” he linked changes in investment prospects to prior changes in prices.  He wrote, “the expectation of a fall in the value of money [i.e., inflation] stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand schedule.”  Consider that it is just this link between higher prices – as a result of the dollar depreciation — and the large increase in industrial production that Keynes minimized in his earlier-cited comments on the US recovery in 1933.  In Ch. 21, on the “Theory of Prices,” Keynes noted that “new money” could lead directly to increases in effective demand, which would be “divided between the rise of prices, the rise of wages, and the volume of output and employment.”[3]  Turning again to the illustrations in the Section 1, in three of them – the 1890s commodity deflation, the slump of 1930, and the near-depression of 1937-1938 — lack of “new money” was at the heart of the downturn.

The way Keynes understood monetary policy to work did not require him generally to reject monetary measures in order to boost aggregate demand.  Most likely, Keynes was instead motivated by a deeper structural view of the economic system in crisis, one driven by a transformative vision.  His views on monetary policy and his social philosophy came together in the forecast for a declining marginal efficiency of capital.

In Ch. 16 of the General Theory, Keynes anticipated a future “where capital goods would be so abundant” that the average marginal efficiency of capital would fall to zero.[4]  It was a logical extension of his view of financial markets, driven by fickle expectations, and of what in the early 1930s was growing “bear” sentiment.  He added in the final chapter, “Concluding Notes on the Social Philosophy Toward Which a General Theory Might Lead,” that such an abundance of capital would bring about the  “euthanasia of the rentier, of the functionless investor,” which he described as an “aim” of public policy, one perhaps to be realized “within one or two generations.”[5]   His notion was similar to the Marxian concept of a declining rate of profit — following accumulation of physical capital.  The stagnationist thesis, Keynesian or Marxian, resonated with the Left, especially during the depressionary Thirties.  It was a thesis about the real sector, about production and distribution, about capitalism and power.  Keynes’ proposed remedy was to scale back the reach of market relations, and to replace them with an expanded role for the State.  And there was no room in this vision for anything so apparently skin-deep as expansionary monetary policy to restore growth and boost the marginal efficiency of capital.  It is unusual to find a Marxian or Socialist economist who will consider monetary policy as other than a distraction.  Keynes’ own goals were more moderate – to overcome deficiency of demand and, thereby, to undermine the appeal of Communism and Fascism.[6]

Leaving the longer term horizon and returning to the causes of Depression in the early 1930s, Keynes wrote at the end of the General Theory:  “It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated – and in my opinion, inevitably associated – with present day capitalistic individualism.”[7] Had Keynes proposed monetary easing through open market operations, his inferred premise would have been that the capitalist system was structurally sound – merely that money demand was, for the moment, not being satisfied – hardly the stuff of a self-described revolution in economic thinking.

The case since the 1930s for a collapsing rate of profit following accumulation of capital has little evidence to support it.  Keynes underestimated potential demand for new investment, not to mention ongoing obsolescence of previous investment, in a world with seven billion people, most of them seeking to enhance their material comfort and social status.  A. C. Pigou, Keynes’ oft-times nemesis, dismissed the stagnationist thesis almost immediately, noting “An era that has witnessed the development of electrical apparatus, motor cars, aircraft, gramophone and wireless, to say nothing of tanks and other engines of war, is not one in which we can reasonably forecast a total disappearance of openings for new investment.”[8]

Keynes’ view that the world depression of the 1930s was caused by “capitalistic individualism” has done more damage.  As we have seen, the major downturns during the decade of depression were driven by gold standard rigidity, reserve shortages, inopportune central bank sterilization, and to a lesser extent by anti-market micro-economic policies associated with the New Deal.  Major economic boosts came from currency depreciations against gold and subsequent monetary ease.  The problem was not markets run amuck, irrational pessimism on stock exchanges, excessive capital accumulation, or lack of government stimulus.  Whatever the all-in contribution of the General Theory, it had the unfortunate consequence of diverting attention from the monetary dynamics that had brought depression.  Alas, Keynes’ legacy as received some three generations on has contributed to the confusion that fiscal stimulus is the best way to boost demand, while monetary policy is often perceived as either  ineffective or as just tinkering – when, some would have it — drastic structural change is necessary.

[1] Frederic S. Mishkin, The Channels of Monetary Transmission: Lessons for Monetary Policy, NBER Working Paper 5424, Feb. 1996.

[2] Treatise, Ch. 17 (i).

[3] General Theory, p. 298.

[4] General Theory, pp. 213f, 218.

[5] General Theory, p. 376.

[6] Robert Skidelsky, John Maynard Keynes 1883-1946: Economist, Philosopher, Statesman (2003), p. 538.

[7] General Theory, p. 381.

[8] Pigou quoted in Skidelsky, e.g., p. 539.

“Speaking of Italy”

I got this in my mail box earlier in the week (the author will remain anonymous):

Central bank governors are like the Pope.  They must preserve the survival of the institution.  The necessary legitimacy comes from infallibility.  The church through the Pope because he speaks for God always speaks the truth.  The incompatibility of legitimacy and admission of error means that every statement and action must presume the validity of past statements and actions.  If central banks do commit error, there is no going back, only the compounding of the error. “

That reminded me of my earlier post on “Central bank rituals and legitimacy”.

PS Later today I will be doing a presentation on Milton Friedman at the Danish free market think tank CEPOS in celebration of the re-publication of  the Danish version of “Free to Choose” (“Det Frie Valg”). The presentation is at 1700 Danish time. See here. I have the preface for the book. See here.

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 2, by Clark Johnson)

Guest post: Part 2 – Keynes: Evidence for Monetary Policy Ineffectiveness (continued)

By Clark Johnson

(See the previous post in this series here)

a)    The 1937-38 Contraction in the US

A few years later, Keynes disregarded evidence of the role of monetary policy in triggering a sharp relapse into near-depression conditions in the US during 1937-1938.  The dollar depreciation of 1933 and the formal increase of the gold price to $35/ ounce in 1934 meant automatic revaluation of central bank gold stocks and gave impetus to increased gold exploration and production – concentrated, as it happened, in the Soviet Union.  (Keynes noted the irony that increased Soviet efficiency in mining of gold was bailing out world capitalism!) He also noted that new gold reserves were bringing increased effective demand to the world economy that might result in “abnormal profits.” [1]  Keynes understood (at least some of the time) the role of growing liquidity in the economic recovery of the mid-1930s.

In what now appears as one of the worst mis-steps in its history, the Federal Reserve, responded to rising wholesale prices in 1936 by deliberately sterilizing new gold inflows.[2]  A money supply measure (M2) that increased by 12 percent annually during 1934 -1936, suddenly turned flat and even slightly negative from about January 1937 to July 1938.[3]  Real GDP fell by 11 percent during this period, and industrial production fell by 30 percent.  Rather than sterilize gold, had the Fed intervened in financial markets to target a modest rate of increase in any of a number of variables – a price index, industrial production, either real or nominal GDP growth, even a money supply indicator – most of the 1937-1938 contraction could have been avoided.  By August 1938, the sterilization policy was jettisoned, and economic recovery resumed.

In February 1938, Keynes offered advice in a private letter to President Roosevelt that mentioned little of this.  He did acknowledge that addressing “credit and insolvency problems” was an essential step toward recovery, as this created a necessary “supply of credit” – while, one infers, demand for that credit would have to come from elsewhere.  This comment reflected Keynes’ ongoing view that expected returns on investment – the schedule of marginal efficiencies of capital — was independent of monetary policy.  He went on the recommend that the US could “maintain prosperity at a reasonable level” only through “large-scale recourse to … public works and other Investments aided by Government funds or guarantees.” [4]

Despite Keynes’ recommendations, the lesson of all four of the illustrations here is that increasing money balances – through open market purchases, or through new gold or foreign exchange reserves – does affect expected returns on investment in plant and equipment, in equities, and in real estate.


We could stop here, having assembled evidence of Keynes’ dubious conclusions about relative un-importance of monetary factors in specific pivotal events.  Indeed, evidence from these cases points strongly in the opposite direction, toward the crucial role of such factors.  But the prominence of Keynes’ fiscalist legacy requires that we go further.   Evidence aside, what was Keynes’ argument?   In fact, he had a sequence of arguments.

In 1929, Keynes offered a comparative argument in favor of fiscal stimulus, and against monetary stimulus, specific to economic circumstances in Britain at the time.[5]  Keynes anticipated some portion of an argument Robert Mundell was to make decades later regarding the “policy mix,” that is, the appropriate mix of monetary and fiscal policy to meet both domestic output and external exchange rate targets.[6]  Britain in 1929 was on the international gold standard, hence was constrained externally by the need to maintain gold reserves.  The Bank of England could not simply create credit, because, Keynes reasoned, “such credit might find its way to foreign borrowers, with the result of a drain of gold out of the Bank.”  Hence Keynes proposed fiscal stimulus to increase domestic demand and employment, alongside monetary constraint to maintain Britain’s reserve and exchange rate targets.

This well-grounded argument also offers possible insight into the 1890s, where demand for gold reserves among central banks generated monetary contraction.  Keynes, as we saw, did not make that argument – but we can construct it post facto.  While the best solution might have been some international agreement to increase demand by modifying the international gold standard, a purely national approach could have looked to a fiscalist demand boost.  But Keynes soon abandoned this policy-mix argument.

a)    Removing external constraint on Monetary Policy

The US had freedom of action in monetary policy in 1933 and 1934.  By March 1933, the dollar had been floated against gold, hence removing the external policy constraint – and, in any event, the US had by then accumulated vast gold reserves.  In Keynes’ comments in January 1934, he had moved beyond his 1929 analysis.  His newer interest was to argue that fiscal activism was preferable to monetary expansion even if the latter was not constrained.

Keynes in the General Theory (Ch. 15, “Incentives to Liquidity,”) offered the argument that monetary policy was specifically unsuited to boost economic demand when interest rates approached zero percent.  In conditions where interest rates could not be lowered further, he reasoned, a condition of “absolute liquidity preference” held, later dubbed a “liquidity trap.”  He observed, “In this event, the monetary authority would have lost effective control over the rate of interest.”  This argument is cited endlessly by later-day Keynesians in support of a fiscalist agenda.  (For example, see the reference to Summers mentioned at the outset.)

But the argument establishes much less than Keynes needed for his fiscalist agenda.  Near-zero interest rates did not prevail in any of the four situations discussed earlier – yet Keynes wanted fiscal activism in all of them.  So his case against monetary activism went beyond situations of absolute liquidity preference.

As noted earlier, Keynes pointed to a collapse in the marginal efficiency of capital as the trigger for the “slump of 1930.”  The General Theory does much more to advance the concept that investment volume is unstable.   Much of Keynes’ vision for government intervention, including fiscal activism, follows from his discussion of the fickleness of financial markets (Ch. 12, “Long Term Expectations.”)  Noting the instability of private sector investment volume, he advocated a larger role by the government in stabilizing investment demand, often through direct outlays.

Keynes’ argument often shifted from the instability of the investment function to concern that investment was and would remain chronically weak – hence the conclusion that high unemployment was not self-correcting, but could persist for years.  In Ch. 17 on the “Essential Properties of Interest and Money,” Keynes noted situations where the:

…rate of interest declines more slowly, as output increases, than the marginal efficiencies of capital-assets measured in terms [of the same asset].[7]

As formulated in one of several instances in Ch. 22 (“Notes on the Trade Cycle”):

A more typical, and often the predominant, explanation of the crisis is, not primarily a rise in the rate of interest, but a sudden collapse in the marginal efficiency of capital.[8]

This pattern of falling marginal efficiencies of capital made Keynes increasingly skeptical of monetary remedies.[9]

A counter-argument is that adding liquidity – through open market purchases, gold inflows, or variations on these – might directly boost demand, and hence boost the marginal efficiency of capital, by increasing cash balances.  But Keynes usually argued, to the contrary, that monetary policy worked mainly through raising or lowering interest rates –this was certainly a premise of the “liquidity trap” argument in Ch. 15.  Further on, he wrote that “the primary effect of a change in the quantity of money on the quantity of effective demand is through its effect on the rate of interest.”[10]  In the Treatise chapter on “Control of Investment,” where he calls for open market operations a outrance, the goal is to bring “the market rate of interest … down to the limiting point.”  In 1937 articles on “finance,” where Keynes stressed the crucial role of monetary policy, he again emphasized the channel of lowering interest rates.[11]

[1] Keynes, “The Supply of Gold,” Economic Journal, Sept 1936.

[2] That is, coupling purchases of gold with offsetting sales of other central bank assets to drain liquidity

[3] Doug Irwin, Gold Sterilization and the Recession of 1937-1938,  NBER Working Paper No. 17595, Nov 2011.

[4] In Collected Works of JM Keynes, Vol 21, pp. 434-39.

[5] Keynes, “A Program of Expansion (General Election, May 1929),” in Essays on Persuasion (1931), p. 124f.

[6] For ex., Robert Mundell, The Dollar and the Policy Mix (1973)

[7]Keynes, General Theory of Employment, Interest, and Money (1936), p. 236.

[8] General Theory, p. 315.

[9] Axel Leijonhufvud offers a variation on this argument with the comment that in in Ch. 37 of the Treatise “the assumption that entrepreneurs are right was dispensed with” – that is, entrepreneurs became, in Keynes’ judgment, excessively bearish.  In “Keynes and the Effectiveness of Monetary Policy,” Information and Coordination (1981).  Leijonhufvud argues that Keynes’ subsequent arguments therefore relied more on fiscal intervention.

[10] General Theory, p. 298.

[11] For ex.,Keynes, “The ‘Ex Ante’ Theory of the Rate of Interest,” Economic Journal 46 (1937)

Guest post – Keynes: Evidence for Monetary Policy Ineffectiveness? (Part 1, by Clark Johnson)

I am extremely happy to announce that my blog this week will feature four guest posts by Clark Johnson. I have for some time tried to convince Clark to write something for my blog so I was very happy when Clark’s manuscript for his paper Keynes:  Evidence for Monetary Policy Ineffectiveness?” arrived in my in-box recently. Clark and I have decided to split up the paper in four parts which will be published in the coming four days.

Clark Johnson is not only a brilliant economic historian and author of the great book “Gold, France, and the Great Depression, 1919-1932”, but he is also a clever observer of the current monetary policy debate. Clark last year authored an insightful paper on the causes of the Great Recession, which in my view already is a Market Monetarist classic.

Lars Christensen

Guest post 

Keynes:  Evidence for Monetary Policy Ineffectiveness? (Part 1)

by Clark Johnson

Lawrence Summers, who was President Obama’s chief economist during 2009-2010, and who by accounts continues to be an important advisor, recently called on the US and other government to increase borrowing at current very low interest rates.[1]  He observes that, based on inflation-protected bond rates, current Treasury borrowing costs for securities of five and ten year maturities are negative.  He adds that interest rates elsewhere in the world – Germany, Japan, and Britain – are also extremely low.  He then argues that governments should look on such rates as an opportunity to borrow cheaply and thereby improve their long-term fiscal positions.

Summers is presumably correct from a fiscal management perspective about benefits of borrowing when interest rates are low.  But as a macroeconomic strategy for recovery, that is only the beginning.  Whether we turn to John Taylor on the right or Paul Krugman on the left, the essential element for fiscal stimulus to succeed is to stabilize expectations: will the stimulus continue for long enough to drive expectations, so that market participants know the boost will ongoing and not soon withdrawn?    Summers’ then shifts to monetary policy, where his case is weaker.  He says there is no point in “quantitative easing”, the open-market mechanism the Federal Reserve uses to inject reserves, as interest rates are already rock-bottom – and monetary easing works, he explains, through the mechanism of lowering interest rates.  Presumably, this is what he has been telling Obama since 2009.

Summers’ reasoning draws at least in part, on John Maynard Keynes’ discussion about “absolute liquidity preference” that occur when interest rates are very low, and demonstrates a key argument used in policy circles against more aggressive use of monetary policy.   I believe Keynes was, and Summers is, mistaken.  Literature on Keynes is abundant.  To gain a different perspective, I want to look at various evidence Keynes adduced against monetary remedies.  I will then return to arguments he used in the General Theory (1936) and elsewhere, hopefully with fresh perspectives.


A portion of Keynes’ reputation as an economist, and of his place in history, rest on his diagnoses of crisis situations and his proposed remedies.  Well-known examples include his tract on the post-World War One Versailles Conference, The Economic Consequences of the Peace (1921), and subsequent writings on hyperinflations and then on British deflation during the 1920s.   Another, less well-known, was his discussion of French monetary and political crises during 1925 and 1926, which I credited in my own work on the period.[2]  His two-volume Treatise on Money (1930) provided detailed and often shrewd observations on a wide range of economic policy matters.

In contrast, the General Theory, the heart of Keynes’ contribution to economic ideas, is light on historical or even contemporary illustration.  So the reader seeks to fill in the gaps by turning to other writings.  Consider four prominent cases as they reflect on Keynes’ view of roles of monetary and fiscal policy.

a)    British Deflation in the 1890s

An unexpected embrace of fiscal activism comes in the Treatise discussion of the deflation of the early 1890s, where Keynes argued that the Bank of England’s gold reserves were abundant and credit was easy.  But prices in Britain and the world nevertheless went into decline, which undermined profit and investment and reduced employment.  He wrote:

I consider, therefore, that the history of this period [1890-1896] is a perfect example of a prolonged Commodity Deflation – developing and persisting in spite of a great increase in the total volume of Bank-Money.  There has been no other case where one can trace so clearly the effects of a prolonged withdrawal of entrepreneurs from undertaking the production of new fixed capital on a scale commensurate with current savings.

Keynes then concluded (anticipating his arguments a few years later, including in the General Theory,) that monetary expansion does not always work, and that there might therefore be a role for public investment projects to boost demand.[3]

Keynes’ discussion of the 1890s misses the point.  Britain in the late nineteenth century was part of an open world economy, with easy movement of goods, people, and especially capital.  Keynes neglected to mention that system-wide demand for gold rose much more than the supply from the 1870s through the 1890s as nearly two dozen countries adopted or re-adopted the gold standard, and hence needed to accumulate reserves.  Indeed, demand drove the commodity-exchange value of gold to the highest level it was to reach in four centuries of record-keeping[4] — the flip-side of commodity price deflation.  The commodity price decline reduced profits and chilled investment demand; but commodity prices were determined in international markets, not in Britain.

While demand for gold was surging, the world’s monetary gold supply in the mid-1890s was at its lowest point it was ever to reach relative to its 1800-1920 trend line.[5]  As the mines in the South African Rand cranked up production in the 1890s, relative gold supply and commodity prices increased, nearly in tandem after 1896 – thus ending the Commodity Deflation, and initiating a gentle inflation.  A growing money stock affected not just the supply of credit (as reflected in a declining interest rate), but also the demand for it.  A result was nearly two decades of economic growth in all of the industrial powers, which was sadly interrupted by the First World War.

Monetary events were at the heart of both the origins of and recovery from the depression of the early 1890s.  Keynes himself gave this backhand acknowledgement with his comment a few paragraphs later that, “the fall of prices [in the early 1890s] could only have been avoided by a much greater expansion of the volume of bank-money.”  It is revealing that Keynes could discuss price trends during that period without mentioning the geographic expansion of the gold standard – easily the most important monetary development of the era.

b)    The onset of the Great Depression

Moving to then contemporary events, Keynes’ discussion of the “slump of 1930,” also in the Treatise, builds on similar themes.[6]  Gustav Cassel and Ralph Hawtrey had argued a few years earlier that the undervaluation of gold following restoration of gold standards at prewar gold prices would force world-wide monetary contraction, especially as former belligerents Britain, France, Germany, and Italy restored their gold standards.   Keynes, in contrast, told the Royal Commission on Indian Currency in 1926 that central banks would adjust their currency reserve cover ratios if  their gold stocks became inadequate – which allowed him to dismiss the danger.  Keynes underestimated what we might call the mystique of gold money.

Keynes listed factors driving interest rates higher during the 1920s: corporate borrowing for new industries; governments borrowing to pay reparations and war debts; central banks borrowing to add reserves; and speculators borrowing to buy shares of stock.  He identified but was less able to explain the collapse internationally in anticipated returns in investment – what he would later call the marginal efficiency of capital — that occurred in the mid-1920s.  As in considering the early 1890s, he did not connect the fall-off in real yields on new investment with systemic monetary constraint.  Parallel to what happened in the 1890s, the middle and late 1920s saw a commodity deflation as key countries adopted or returned to gold standards.  He thought monetary expansion worked through lowering interest rates, without directly affecting demand for goods and services.  He wrote that the only ways to boost demand were by lowering interest rates, especially long rates, further – or by government fiscal activism.  He did not understand that the world required a higher gold price to restore gold-to-currency reserve ratios, or perhaps needed a departure from gold money altogether.

c)     The Roosevelt Recovery in 1933

Keynes’ comments in January 1934 on the monetary-fiscal mix in the US were baffling.  In one of his initial acts after Roosevelt’s accession to power in March 1933, the dollar was allowed to depreciate against gold.  This was a momentous event in monetary history – the underlying cause of the interwar deflation had been removed, and the gold standard was never restored with the same conviction.  Keynes nevertheless wrote:

One half of [Roosevelt’s] programme has consisted in abandoning the gold standard, which was probably wise, and in taking various measures … to depreciate the gold value of the dollar… [But i]t is not easy to bring about business expansion merely by monetary manipulation.  The other half of his programme, however, is infinitely more important and offers in my opinion much greater hopes.  I mean the effort to cure unemployment by large-scale expenditure on public works and similar purposes.[7]

This summary scarcely acknowledges the results of the real-time experiment in expansionary monetary policy undertaken in the US within the previous year.  Depreciation succeeded at least to the extent any advocate could have hoped.  Industrial production soared by 57 percent during the first four months of the Roosevelt Administration beginning in March 1933 – this was the actual increase, not an annualized rate — making up half of what had been lost since 1929.  It was the fastest four-month rate of expansion in industrial production in the history of the US. Yet Keynes apparently considered this event to be “infinitely” less important than the boost to come from fiscal borrowing for public works programs.

Had the experiment continued for a few months more, pre-crash production levels might have been recovered.  Unfortunately, the NIRA (National Industrial Recovery Act, announced in July 1933, brought micro-policy changes that had the effect of stopping the recovery in its tracks.  The NRA (National Recovery Administration), set up under NIRA, then negotiated specific sets of codes with leaders of the nation’s major industries; the most important provisions were anti-deflationary floors below which no company would lower prices or wages, and agreements on maintaining employment and production. Within a short time, the NRA reached agreements with most major industries. In a phrase, the NIRA wanted to increase prices by restricting output rather than by increasing demand.   Scott Sumner provides several rounds of evidence for the contractionary impact of NIRA policy in his soon-to-arrive book, The Midas Curse: Gold, Wages, and the Great Depression.

Lest this appear suspect as a predictable right-wing narrative of the New Deal, consider that Keynes himself pointed to the “fallacy” of the NRA approach: He noted that “rising prices caused by deliberately increasing prime costs or by restricting output have a vastly inferior value to rising prices which are the natural result of an increase in the nation’s purchasing power.”  He added that it was “hard to detect any material aid to recovery in the National Industrial Recovery Act.”[8]  Within six months after the NRA went into effect, industrial production had dropped twenty-five percent,[9] erasing nearly half of the gains recorded during Roosevelt’s more successful initial months in office.

So here we are.  We saw an historically sharp recovery for four months during 1933, driven almost entirely by a decision to break the straightjacket imposed on monetary policy by the international gold standard.  Keynes had previously been an able critic of the gold standard, for example in the Tract on Monetary Reform (1923) and then in several chapters in the Treatise. The 1933 recovery was then stalled by micro-policies of which he was explicitly critical.  Yet Keynes seemed to dismiss this entire episode in his call a few months later for fiscal stimulus!

[1] Lawrence Summers, “Look beyond interest rates to get out of the gloom,” Financial Times, 3 June 2012

[2] H. Clark Johnson, Gold, France, and the Great Depression, 1919-1932  (Yale, 1997)

[3] John Maynard Keynes, Treatise on Money (1930), Ch. 30 (ii).

[4] Roy Jastram, The Golden Constant (1977)

[5] League of Nations chart, reproduced in Johnson, p. 52.

[6] Treatise, Ch. 37 (iv) “The Slump of 1930.”

[7] Keynes, “Roosevelt’s Economic Experiments,” The Listener, 17 January, 1934.

[8] Keynes, “Mr. Roosevelt’s Experiments,” London Times, 02 Jan 1934.

Time to try WIR in Greece or Ireland? (I know you are puzzled)

The ECB so far has refused to sufficiently increase the money base to meet the increase in the demand of money and as a result euro zone money-velocity has contracted. We are basically in a monetary disequilibrium. Normally we would say an excess demand for money can be reduced in two ways. Either you can increase the money supply or the price of money can increase sufficiently to reduce the demand for money until it matches the supply of money. An increase in the price of money of course means a drop in all other prices – deflation.

However, there is a third option – we could also increase the supply of money substitutes. This could be in the form of free banking – privately issued money – or through different forms batter systems. I have also earlier examined the impact ofthe so-called M-Pesa system in Kenya and how M-Pesa likely has increased money-velocity (reduced money demand) dramatically in Kenya. I suggested that could offer a partial solution to the euro crisis. A similar idea could be to create a system similar to the Swiss Wirtschaftring system (WIR).

WIR is basically a barter club of corporations and households and in a sense WIR functions as a parallel currency in the Swiss economy. Here is a description from a paper by Wojtek Kalinowski:

“The Swiss currency known as the WIR is by far the oldest and most important complementary currency presently in circulation. It remains, however, largely unknown. Created in 1934, it is currently used by approximately 60,000 small and medium-sized businesses found in all economic sectors, but primarily building, commerce (wholesale and retail), and manufacturing … In 2008, the volume of WIR-denominated trade was 1.5 billion Swiss francs …a figure that makes it far superior to any other parallel currency but which is still only an insignificant portion of the global monetary mass (0.35% of M2 in 2003).”

What I find particularly interesting with the Swiss experience is the counter-cyclical nature of the use of WIR. In a 2009 paper by James Stodder “Complementary Credit Networks and Macro-Economic Stability: Switzerland’s Wirtschaftsring”  it is demonstrated that there is a clear negative (positive) correlation between GDP growth (unemployment) and the turnover of WIR. Hence, this indicates that WIR tends to help equate money supply and money demand (reduce monetary disequilibrium). If you have studied George Selgin’s theory of Free Banking then you should not be surprised by this result.

Time for WIR in Greee or Ireland?

The deflationary trends are very strong in some euro zone countries such as Ireland or Greece. So what is needed is an increase in the money supply, but as the national central banks do not determine the local money supply (that is firmly in the hands of the ECB) that option does not exist. However, a WIR style system could be a second or third best solution for doing something about the monetary disequilibrium in these countries.

Obviously, it will likely be far too little to end the crisis and the best solution obviously still would be for the ECB to significantly ease monetary conditions. However, that should not stop deflation and crisis hit euro zone countries from removing legal barriers to the introduction of WIR style systems. Furthermore, one could easily imagine that euro zone governments and central banks could move to facilitate the creation of WIR style systems in their countries.

Obviously, this kind of discussion would not be necessary if the ECB moved to reduce monetary disequilibrium, but times are desperate – and that is why you for example see the reemergence of the old Irish punt certain places in Ireland (See here).

Finally I should add that some proponents of local currencies and WIR systems see them as a kind of “small is beautiful” system and a system to protect local producers. I strongly disagree with this kind of protectionist view and in that sense I completely agree with the views of George Selgin. See here.


Update: See also this paper by James Stodder.
Update 2: In the comments below James Stodder recommends Irving Fisher’s book on “Scrip Currencies” and Georgiana Gomez’s recent book (2009) “Argentina’s Parallel Currency: The Economy of the Poor”. I knew Fisher’s book before, but was unaware of Gomez’s book (so I ordered it…)

Liaquat Ahamed should write a book about Trichet, Draghi, Weidmann & Co.

The author of the great book  ‘Lords of Finance: The Bankers Who Broke the World’ Liaquat Ahamed has a comment on on the euro crisis and the parallels of the behavior of today’s European central bankers with that of the central bankers of the 1930s. I have been making the argument many times that we are in the process of making the same mistakes as we did in the 1930s – particularly in Europe. Ahamed agrees.

Here is Ahamed:

“The situation in Europe today bears an eerie similarity to that of Europe in the 1930s. Ironically, Germany was then in the position of the peripheral European countries today. It was weighed down with government debt because of reparations imposed at Versailles; its banking system was severely undercapitalised, the result of the hyperinflation of the early 1920s; and it had become dependent on foreign borrowing. It was locked into a rigid fixed exchange rate system, the gold standard, which it dared not tamper with for fear of provoking a gigantic crisis of confidence. And so when the Depression hit and international capital markets essentially closed down, Germany had no choice but to impose brutal austerity. Eventually, unemployment rose to 35 per cent.

Like today, in the 1930s there was one major economy in Europe doing well. It was France. While the rest of Europe was suffering, unemployment in France, as in Germany today, was in the low single figures. And France, again like Germany today, had large current-account surpluses and was in a financial position to act as the locomotive for the rest of Europe. But the French authorities of the 1930s, refusing to accept responsibility for what was happening elsewhere in Europe, would not adopt expansionary policies. Nor would they lend directly to Germany, fearing that they would be throwing good money after bad. The effect of French policy eventually brought down the whole financial system of western Europe”

I completely agree. The PIIGS are the Germany of the 1930s and Germany of today is France of the 1930s. In that regard it should be noted that despite France initially avoided being hard hit by the Great Depression, but the crisis eventually caught up with the French economy in 1931-32. Let that be a lesson for Merkel and Weidmann. Unfortunately today’s policy makers seem completely unaware of the parallels to the mistakes of the 1930s.

Maybe it is time for  Liaquat Ahamed to write a book on today’s Lords of Finance – the central bankers who are in the process of killing the European economy.


For an overview of some of my posts on the 1930s see here.

Book recommendation of the week: I just received in the mail what seems to be a very interesting book on Exchange Rate Regimes of small states in twenties-century Europe. The book “Fixed Ideas of Money” by Tobias Straumann tells the story of why European small economies such as the Scandinavian countries, Belgium, the Netherlands and Switzerland have been so attracted to pegged exchange rate regimes. From what of the book I have read so far I must say it is very interesting and the book is full of interesting anecdotes from European monetary history. The book is extremely well-researched and it is clear that Straumann has had access to local sources for information about monetary policy in for example Denmark or Belgium in the 1930s.

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