The view from the Antipodes (1): A response to Arnold Kling

Things look different from Downunder.

Rodion Kutsaiev, Unsplash.

I recently read what economist Arnold Kling regards as the best thing he has written: Memoirs of a Would-be Macroeconomist (pdf). I would heartily recommend said memoir to anyone interested in recent economic history or the state of macro-economics.

I found myself in substantial agreement except on two points. I do not agree that money is not a control variable and I do not agree with his Schumpeterian creative-destruction theory of economic fluctuations. I do not agree on those two points because I am an Australian.

A perennial annoyance for any policy-wonkish Australian is how Atlantic intellectuals so often ignore the achievements of a highly successful society: the Commonwealth of Australia.

If, for example, you are interested in a theory of the business cycle, that Australia managed, until the disruptions of the lab-leak pandemic, the longest recorded period without a recession in modern history is surely a relevant case to consider.

It is not that Australia did not have a business cycle in that period, it did. It just had a very, very flat one.

Monetary policy

The proper role of monetary policy is straightforward:

to minimise disruptions to expectations about the output-value of money and expectations about the path of total spending in the economy.

“To mininise disruptions to” can be read as “Maintaining stable” if one prefers.

The Great Recession occurred because the Federal Reserve (“the Fed”), the European Central Bank (ECB), the Bank of Japan, and the Bank of England managed the first but not the second.

Why do I say the above is the proper role of monetary policy? Because this is precisely what the Reserve Bank of Australia (RBA) managed to do to achieve that long period of a very flat business cycle.

Hence, Australia avoided the Great Recession. Indeed, until the disruptions of the lab-leak pandemic, Australia was the country where the Great Moderation continued.

So Australia provides a rather useful natural experiment.

If there are stable expectations about the output-value of money (aka the Price Level), then increases in inflationary expectations will not lead to inflationary spirals. (At least, not over the target level of inflation.)

If there are stable expectations about the path of total spending in the economy, then those transaction crashes we call “recessions” do not occur, as one does not get flight to safe assets, or surges in other deferrals of spending, with consequent falls in income.

This is not a theoretical judgement. It is straightforward observation of the Australian experience. Observation that is informed by the market monetarist analysis, but does not depend on it.

Hence, I do not agree that money is not a control variable.

Money matters

Money is one side of all transactions in a monetised economy.

In a subsistence economy, folk worry about having enough stuff: particularly food. In a monetised economy, as economist Hyman Minsky pointed out, folk worry about having enough money.

Analysis of the actions, the strategies, of conscious agents should probably focus on what they focus on.

Anything whose use-value is its exchange-value is being used as money. Money provides exchange services. In particular, it provides a mechanism of final payment.

Legal tender laws basically declare some currency to be the instrument of final payment. Meir Kohn provides a particularly useful and clarifying history (pdf) of the evolution of money and credit in the European economy as a series of innovations to systems of payment.

Money is also the photon of commerce — it is both a good that provides exchange services and an asset: something that can be held across time. It operates as the hinge between the goods-and-services or output economy (the this-time period economy) and the assets or wealth economy (the across time-periods economy).

The willingness of people to hold on to money, or not, deeply affects the patterns of transactions.

If money becomes the worst store of value in the economy, as it does in hyperinflation, folk will unload it as quickly as possible. Hence, hyperinflation spirals as money prices spiral upwards while the output-value of money heads towards zero.

Notice that even while money is the worst store of value in the economy, even by orders of magnitude, folk still use money. This is because it retains an unparalleled capacity to provide exchange services, to reduce transaction friction — the rate at which transaction costs slow down transactions.

If money becomes too good a store of value — so folk expect its output-value to continue to rise — they will tend to defer spending, to hold it as an asset for future use. Spending falls, so incomes fall, so debts become more onerous, so folk start defaulting, so financial firms become insolvent are driven into bankruptcy. This is the debt-deflation cycle.

The Great Depression

The Great Depression was caused by contractionary monetary policy that created credit collapses that then exacerbated the contractionary effect. The contractionary monetary policy was the Bank of France hoarding gold, so effectively taking it out of the monetary system, so gold rose in value.

But gold set the output-value of money. So as the output-value of money rose, prices fell, so people deferred spending, so incomes fell, so … This debt-deflation spiral continued until a country either left the gold standard (the UK solution) or inflated against gold (FDR’s solution).

So, yes, money is a control variable.

The Great Recession

The Great Recession was caused by contractionary monetary policy that became contractionary because of the financial crash of the Global Financial Crisis.

Economists search around for the definitive response of economic agents to uncertainty. This is a vain search.

Knightian uncertainty is the realm that is not calculable. Why would we except a definitive response to such uncertainty, to what can’t be calculated?

A positive take on uncertainty is a crucial element in tech booms. More information becoming available about the implications of the new technology leads to an end of the boom, as the level of uncertainty shrinks and it is no longer being so strongly positively read.

Keynes’ “animal spirits” = how (Knightian) uncertainty is being currently read.

That uncertainty cannot be eliminated is why there is herd behaviour in asset markets, in the wealth economy.

What is not calculable leads to herd behaviour, for exactly the same reason you get flocking/herding/shoal behaviour in animals, birds and fish. Folk attempt to piggyback off what information others may have while trying to avoid being a vulnerable outlier.

The Global Financial Crisis (which Australia also avoided, through much more effective prudential regulation) generated a massive surge in negatively-read uncertainty.

The Fed, the ECB, and other Central Banks were successfully anchoring expectations about inflation. They were not anchoring expectations about the path of total spending. There was thus a massive flight to safe assets, leading to a collapse in spending.

The dramatic increase in negatively-read uncertainty meant that monetary policy which, in the previous situation, was not contractionary became so. Hence the Great Recession was caused by monetary policy becoming contractionary due to the financial crisis.

Arnold Kling’s notion of financial firms tending to be contingently solvent is a nice descriptor for the interactive feedback that is such a feature of economic action across time. (Interactive feedback being a rather clearer term for what George Soros calls reflexivity.)

Creative-destruction

As monetary shocks are a recurrent reason for recessions and depressions, in rejecting the claim that money is not a control variable I am also rejecting Arnold Kling’s Schumpeterian creative-destruction analysis of economic fluctuations.

But I am only rejecting the notion that such creative-destruction technology shocks are the cause of economic fluctuations. I do not reject the claim that Schumpeterian creative-destruction can help us understand the consequences of monetary shocks and the subsequent path of the economy.

On the contrary, such shocks reveal what patterns of production and commerce have been weakened or undermined by technological change while encouraging shifts to new patterns of production and commerce. The shock both intensifies the creative-destruction process and, by the reduction in economic activity, and so income, weakens folks’ ability to adjust to them.

Obviously, I do not think that Australia avoided the Great Recession because it was much less cursed by Schumpeterian creative-destruction than the US, the UK or the EU. On the contrary, as Australia has relatively high minimum wages, it tends to be more pervasively technological than other countries.

Hence, I reject these two claims because I am Australian.

But, with those limited caveats, Arnold Kling’s Memoirs of a Would-be Macroeconomist (pdf) is well worth your time.

References

Books

Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk, John Wiley & Sons, [1996] 1998.

Charles W. Calomiris and Stephen H. Haber, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit, Princeton University Press, 2014.

Edward Chancellor, The Price of Time: The Real Story of Interest, Penguin, 2022.

George Cooper, The Origin of Financial Crises: Central Bank, Credit Bubbles and the Efficient Market Fallacy, Harriman House Ltd, [2008] 2010.

Frank H. Knight, Risk, Uncertainty and Profit, Cosimo, [1921] 2005.

Daniel H. Neilson, Minsky, Polity, 2019.

Carmen M. Reinhart & Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 2009.

George Soros, The Alchemy of Finance, John Wiley & Sons, [1987, 1994] 2003.

Scott Sumner, The Money Illusion: Market Monetarism, the Great Recession, and the Future of Monetary Policy, University of Chicago Press, 2021.

Scott Sumner, The Midas Paradox: Financial Markets, Government Policy Shocks, and the Great Depression, Independent Institute, 2015.

A. Hingston Quiggin, A Survey of Primitive Money: The Beginnings of Currency, Routledge [1949], 2019.

Articles, papers, book chapters, podcasts

Nicholas Barberis, Robin Greenwood, Lawrence Jin, Andrei Shleifer, ‘Extrapolation and bubbles,’ Journal of Financial Economics, 2021, 129, 203–227.

Claudio Borio and Piti Disyatat, ‘Global imbalances and the financial crisis: Link or no link?,’ BIS Working Papers, No 346, May 2011.

Claudio Borio, Piti Disyatat, Mikael Juselius and Phurichai Rungcharoenkitkul, ‘Why so low for so long? A long-term view of real interest rates,’ BIS Working Papers, No 685, December 2017.

Satyajit Chatterjee, ‘A Theory of Asset Price Booms and Busts and the Uncertain Return to Innovation,’ Philadelphia Fed Business Review, Q4 2011, 1-8.

Milton Friedman, ‘The “Plucking Model” of Business Fluctuations Revisited,’ Economic Inquiry, Western Economic Association International, vol. 31(2), April 1993, 171-177.

Arnold Kling, ‘Macroeconometrics: The Science of Hubris,’ Critical Review, 2011, 23:1-2, 123-133.

Douglas A. Irwin, ‘The French Gold Sink and the Great Deflation of 1929–32,’ Cato Papers in Public Policy, Vol.2, 2012.