Arnold Kling has posted a lengthy reply to David Beckworth, Nick Rowe, and myself. I will first respond only to his criticism of my previous post. (Hopefully, if I have time later, I will respond to the broader arguments that he puts forward.)
This issue of causality is a natural segue to the empirical issues raised by Josh Hendrickson. What if we can show that fluctuations in GDP are preceded by fluctuations in money demand or money supply? Would that not be strong evidenced against my monetary theory? Hendrickson points to a long tradition of economists, including Friedman and Schwartz, Allan Meltzer, and others, who claim to have found such evidence. While I recognize that this work is formidable, I retain some influence from the late Franco Modigliani, who conducted the Money Workshop at MIT. Modigliani was so frustrated by the way that monetarists would search for a definition of money that correlated with nominal GDP that Modigliani mockingly referred to M1, M2, and so on as Milton1 and Milton2.
All of the different Miltons lead me to say this: there is no single medium of exchange. Instead, there is a lot of substitutability in media of exchange. Think of all the different ways you have to pay for stuff. The way I see it, there is a lot of substitutability among stores of value, including among temporary stores of value. Because substitutability is not perfect, the Fed can fiddle around in asset markets and change the relative values of some assets. By a little bit. For a little while. But I don’t equate this fiddling with being able to hit a precise GDP target.
I think that my theory leads to a view of inflation as a fiscal phenomenon. Certainly, that works for hyperinflations–you cannot have a hyperinflation without an out-of-control government budget. The question is (and I guess we’re about to find out) whether you can have an out-of-control government budget without a lot more inflation. The monetarist view would be that if you don’t monetize the debt, you don’t get more inflation. The view that assets are close substitutes would suggest that whatever liabilities the government issues to pay for its deficits will eventually cause inflation.
There are three main points that need to be addressed. First, Kling references Modigliani’s complaint that monetarists like to choose the measure of the money supply that fits the data best. This is a legitimate criticism, to some extent, of the early work of monetarists. Nonetheless, I would point out that Modigliani himself wrote that “the stock of money has a major role in determining output and prices” (1977). Of course, showing that Modigliani said as much is not a sufficient response to the criticism. Thus, going back to the empirical evidence, it is important to address how monetary policy is measured as the Fed has more control over base money than it does the broader money aggregates. The results from the VAR literature that I referenced in my previous post has taken this into consideration by using non-borrowed reserves and the federal funds rate as the measure of monetary policy. In doing so, they are directly measuring the change in monetary policy conducted by the Federal Reserve. In this respect, the results I referenced regarding monetary policy shocks are immune to criticism that they have been chosen to fit the data.
The second point that Arnold raises is in regards to money as a medium of exchange. Money is indeed a medium of exchange. Market interaction is costly. When there are costs associated with information and transactions, individuals have to try to identify the best possible process of exchange. Money is used as a medium of exchange because it reduces the costs associated with acquiring information and allocating time to searching for optimal trading partners and arrangements. The evolution process of money as a medium of exchange traces back to Menger, but the points emphasized above have been sufficiently argued by Armen Alchian, Jack Hirshleifer, and Karl Brunner and Allan Meltzer in developing the theory of exchange.
This idea of money as a medium of exchange is rendered moot if we assume perfect information, no uncertainty, or that money and other assets are perfect substitutes. Arnold argues the latter that there is a lot of substitutability in the medium of exchange. Really? I don’t think so. Sure, one can pay for transactions with credit or checkable deposits, but these payments ultimately are settled through the exchange of money. As Brunner and Meltzer (1993: 68n) note, “Credit cards, for example, reduce a seller’s cost of acquiring information about the buyer and encourage the separation of payments and purchases. This increases (relatively) the use of deposits as a medium of exchange but does not eliminate the use of money.” Although he believes that money cannot be seen as a medium of exchange, he does concede that substitutability is imperfect and that monetary policy can affect asset prices, but that this impact is minor and short-lived. This concession, however, is important because it would seem to fly in the face of two of his main points: (1) that money is not a medium of exchange, and (2) that monetary policy cannot have real effects.
In Arnold’s final point above, he advocates the fiscal theory of the price level. Some variation of this theory has been used by economists like Sims, Cochrane, and Woodford. Carlstrom and Fuerst summarize the fiscal theory as follows:
Weak-form FT [ed. note: FT = fiscal theory] begins with an obvious link between monetary and fiscal policy. Since seignorage (revenue from money creation) is a possible revenue source, long-run monetary and fiscal policy are jointly determined by fiscal budget constraints. Whether monetary or fiscal policy determines prices involves an assumption about which policymaker will move first, the central bank or the fiscal authority. Weak form FT assumes that the fiscal authority moves first by committing to a path for primary budget surpluses/deficits, forcing the monetary authority to generate the seignorage needed to maintain solvency. Sargent (1986) describes this as a “game of chicken.”
This version of the fiscal theory predicts that fiscal policy determines future inflation as well. Although this is true, it does so only by determining future money growth. The traditional version of the FT, therefore, is not at odds with
the quantity theory, in the sense that prices are still driven by current or future money growth.
More recently, a stronger version of the fiscal theory has been posited. Strong-form FT maintains that fiscal policy determines future inflation, but independent of future money growth. Unlike the weak theory, where inflation is still (ultimately) a monetary phenomenon, strong-form FT maintains that fiscal policy affects the price level and the path of inflation independent of monetary policy changes.
It is unclear to me which theory Kling is advocating, but he sounds like he is advocating the strong-form of the fiscal theory as he seems to suggest that we have to have high inflation with an out of control budget. If that is indeed the case, it is problematic for Arnold’s view as Carlstrom and Fuerst’s examination concludes that “this is little more than an intellectual curiosity.”
Ultimately, I do not believe that we can reconcile Arnold’s theory with the empirical evidence unless he is willing to make serious concessions regarding the role of monetary policy. I would argue that it is possible to minimize the role of money and monetary policy without eliminating it from analysis. This, however, puts Arnold’s theory in a bit of a bind. If money is included, I fail to see how his theory can be distinguished from the natural rate hypothesis. Couldn’t the process of recalculation simply cause the natural rate of unemployment to rise for a period thereby limiting the ability of monetary policy to alleviate unemployment without causing inflation? Arnold theory differs only in the sense that he wholeheartedly rejects the ability of monetary policy to have any effect on unemployment and inflation in the short run.