Monthly Archives: September 2009

Measurement Before Theory, Part 2: A Reply to Arnold Kling

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.)

Arnold writes:

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.

Measurement Before Theory

Arnold Kling has been developing a macroeconomic theory that he refers to as “Recalculation”. It is somewhat of a takeoff of real business cycle theory (Kling himself has referred to this as “not your father’s real business cycle theory). David Beckworth highlights three main features of Kling’s analysis:

(1) Monetary policy has no effect on expectations in the short-run.

(2) Monetary policy has no effect on nominal economic activity in the short run.

(3) Monetary policy has no effect on real economic activity in the short run.

What is perhaps most ironic about Kling’s theory is that he has largely taken a position on monetary policy that is consistent with real business cycle theorists, but rather than doing so by assuming rational expectations (as the New Classicals did), he does so by assuming strong habit formation:

Like most economists, I view real GDP in the long run as determined by real factors, such as the supply of factors of production, the state of technology, and the nature of economic and cultural institutions. However, I view average prices in monetary units as reflecting habits. The government can change people’s habitual price behavior only by making significant, long-lasting changes in the amount of deficit that it finances by printing money. On the other hand, changes in money-printing that are modest and short-term have essentially no effect.

Regardless, the points summarized by David Beckworth present testable hypotheses. Luckily, there is a voluminous literature on money and business cycles. Beckworth himself takes up the challenge on his blog and presents evidence against Kling’s theory. (UPDATE: Bill Woolsey shows that Kling’s theory would hold if money demand was not dependent on income. Of course, a large body of empirical evidence shows that it is dependent on income. Also, as Bill notes, it doesn’t make sense when carried to its logical conclusion either.) As a complement to Beckworth’s post, I would like to review some empirical evidence.

There is an abundance of evidence that suggests that Kling is wrong. Let’s begin with point number 2 as it is the easiest to refute. Kling argues that monetary policy cannot affect nominal variables (i.e. the price level) in the short run:

Another way to express my view is that there is a probability distribution for nominal GDP growth. By printing money much faster starting today and persisting for several years, the government can raise both the mean and the variance of the distribution of nominal GDP growth many years from now. However, in the short run, both the mean and the variance are determined by things that have happened in the past, including past monetary policy but also including Recalculations and other factors that affect real GDP as well as past habits of price-setting.

I suppose that this depends on one’s definition of the short-run. We know from the literature using vector autoregressive models that contractionary monetary policy does not affect the overall price level, initially, because prices are sticky. After about a year and half, the GDP deflator persistently declines. Consumer prices do, however, result in a reverse hump-shaped response that begins one quarter after the monetary shock. (For a summary of this literature, see Christiano, Eichenbaum and Evans, 1999.) It is also important to note that in the VAR literature, what one is measuring is a monetary policy shock and not the effect of systematic monetary policy. This evidence thus casts doubt not only on Kling’s hypothesis that monetary policy doesn’t effect nominal variables, but also that a regime shift is necessary to influence price behavior and therefore inflation as these “shocks” are enough to generate the behavior denied by Kling’s model.

The second point in question is whether or not monetary policy effects real variables in the short run. Kling argues that it does not:

So, the question is whether there is a medium run in which M affects Y. My bizarre monetary hypothesis is that the answer is “no.” That is, I believe that the medium run usually looks like the short run, in which changes in M show up as changes in V. The medium run only looks different if the central bank is engaging in a regime shift, changing the long-term trend of M and P.

There is an abundance of evidence, however, that money does affect real output in the short run. The pioneer monetarist, Clark Warburton, published a collection of work that demonstrated that causation flowed from money to output to prices and then to velocity, thereby both demonstrating that monetary policy has short term real effects and that changes in M are not offset by changes in V as Kling suggests. Friedman and Schwartz’s A Monetary History of the United States and Monetary Trends in the United States and the United Kingdom as well as the work of David and Christina Romer (here and here) are also particularly of interest here. What’s more the work on monetary policy shocks shows that a contractionary monetary policy shock results in a reverse hump-shaped response to real output that peaks 4 quarters after the shock. In Allan Meltzer’s paper in the JME in 1986, he uses a multi-state Kalman filter to compare direct and reverse causation of money and output and finds that the evidence is greater for direct causation of money to output. Edward Nelson recently published in the JME in 2002 a paper that demonstrated that changes in the real monetary base are an important and independent factor effecting changes in output. This corresponds with the previous literature of Meltzer and Evan Koenig that changes in the monetary base cause statistically significant changes in consumption (independent of a significant interest rate effect).

There is an overwhelming body of empirical evidence that suggests that Kling is incorrect about monetary policy. Nonetheless, I felt the need to respond to his posts because I think that recalculation is important. However, I think that Kling has taken the argument too far in terms of his discussion of monetary theory and policy. One could argue that monetary policy (and indeed fiscal policy as well) are limited in their ability to correct for unemployment when resources are being reallocated without making the claim that monetary policy is unimportant. Monetary policy clearly has effects on output and prices in the short run. Denying this leaves Kling’s theory precariously in contradiction to the facts.

Hamilton on Repos

James Hamilton has written an excellent post on Federal Reserve repos. I would also recommend his contribution to The Road Ahead for the Fed if you are interested in this sort of analysis of the Fed’s balance sheet.

Quote of the Day

“Thomas Friedman talks a good game. He speaks as if he is sure he has identified the growth industries of the century, but has he put his money where his mouth is? If he is so certainly right, has he mortgaged his house(s) and invested accordingly? I’d bet he has not.”

Roger Koppl

Costs and Benefits of Cash for Clunkers

An abstract from a new paper from The Economists’ Voice:

Burton Abrams and George Parsons of the University of Delaware evaluate the efficiency of the recently introduced ‘Cash for Clunkers’ program and conclude that the cost exceeds the benefit by approximately $2000 per vehicle.

(Sorry, the link is gated.)

The Tire Tariff

Brad DeLong on the tire tariff:

Let’s see… 250 million cars in America… need 4 tires per car… need new tires every 2.5 years. 400 million tires a year… $1.4 billion dollars a year… 10,000 worker jobs saved… $140,000 dollars per worker-job per year.

Looks like we could (a) let the Chinese sell us tires, (b) tax each tire by $2.50, (c) pay each tire worker who loses his or her job $100K a year, and we come out ahead: American households have more money to spend on other things, China has more jobs to help what is still a very poor country grow, and tire workers have higher incomes and more leisure as well.

But, you say, it would be stupid to impose a $2 a tire tax and use the money to pay each laid-off tire worker $100K a year.

That’s the point: when the policy you are adopting is worse for everybody than a policy you agree is stupid, the policy you are adopting is best characterized as really stupid.

Read the whole thing. It is excellent.

Graph of the Day

David Beckworth revives his excellent summary of the Depression debate — in graphical form.

Cato Unbound: Monetary Lessons

This month’s Cato Unbound looks especially promising. It is entitled, “Monetary Lessons from the Not-So-Great Depression” and features a lead essay from Scott Sumner and will have contributions from James Hamilton, George Selgin, and Jeffrey Hummel. You can read Sumner’s lead essay here.

Friedman, Schwartz, Keynes, and Bernanke

Penn Bullock has written a piece for Reason explaining that, despite being called such by the popular press, Bernanke is not a Keynesian. Quite the contrary, Bernanke is following the prescriptions laid out in Friedman and Schwartz’s Monetary History of the United States. Unfortunately, while Bullock is correct in claiming that Bernanke is following Friedman’s economics, he gets the story regarding The Great Contraction wrong. (Two Notes: First, The Great Contraction is a text that was released after F&S’s monetary history. However, it is actually just the chapter on the Great Depression. Henceforth, all references will be referred to as F&S. The second point is that it is a bit unfair for me to criticize Bullock here as he is not an economist and therefore I do not expect him to be acquainted with some of the literature that I reference. Nonetheless, it is my view that certain points raised in his piece need a proper rebuttal.)

Bullock begins his argument as follows:

Friedman and Schwartz, however, denied that speculation had ever posed a problem, or that there had even been a credit bubble in the 1920s. In their narrative, a paranoiac Federal Reserve had needlessly constricted the money supply and thereby crashed an otherwise prosperous economy.

After the Great Crash of 1929, the Federal Reserve drastically cut interest rates; but, on occasion, the Fed was forced to abruptly raise them again in complicated maneuvers to stem outflows of gold into Europe. Friedman and Schwartz blamed these sporadic interest rate hikes for smothering several incipient recoveries, opening a vortex of deflation, and turning a recession into the Great Depression.

Friedman and Schwartz’s overarching thesis was that the Depression would have never happened if the Federal Reserve had inflated the American economy.

Bullock makes three specific points here. First, he states that F&S reject the claim that there was a credit bubble in the 1920s. I suppose that this depends on how one defines a credit bubble. Nonetheless, most consider the rising stock market as the impetus behind the Fed’s decision to tighten monetary policy. People routinely mock the great Irving Fisher for claiming that the stock market was at “what looks like a permanently high plateau” and claiming that stocks would likely move higher shortly before the stock market crash. The question regarding whether the stock market was overvalued, however, is not as crystal clear as many perceive. For example, Eugene White’s JEP paper entitled, “The Stock Market Boom and Crash of 1929 Revisited”, shows that the Dow Jones Index closely tracked dividends throughout the 1920s until roughly April of 1928. More recently, Ellen McGrattan and Ed Prescott have suggested that Irving Fisher was correct at the time that he made his statements.

Bullock’s next point is that while the Federal Reserve reduced interest rates, there were times when they raised interest rates and that is what F&S attribute as the Fed’s failure. This is incorrect. In fact, what F&S emphasize (as Bullock mentions later in the article) is the decline in the money stock. From 1929 – 1933, the money supply fell by one-third. Thus, the main failure of the Federal Reserve was to allow the money stock to decline so drastically. What’s more, what F&S are really emphasizing is that the Fed’s actions were often too little and too late in responding to shocks. In essence, the stock market crash, a series of banking failures, and Britain’s abandonment of the gold standard produced declines in the currency-deposit ratio thereby resulting in multiple deposit destruction and a decline in broader measures of the money supply (broader, that is, than the monetary base). It is F&S’s view that the Fed could have expanded the monetary base to offset the increase in the demand for base money. (Paul Krugman recently argued that such an increase would not have been possible given the fact that the US was on the gold standard in the Journal of Monetary Economics, which Anna Schwartz and Ed Nelson thoroughly refuted in the same publication.) Thus, while F&S mention the initial policy failure of a tightening of monetary policy as well as other policy errors, the main error that they emphasize is the failure to prevent the decline in the money stock, not changes in the interest rate. In fact, monetarists have long argued that the nominal interest rate was not a reliable indicator for evaluating the stance of monetary policy. Frederic Mishkin’s paper on real interest rates provided empirical support to this point by showing that real interest rates were quite high. Taking this point further, Allan Meltzer has shown that the behavior of real money balances is a better gauge for the business cycle than the real interest rate.

Bullock’s final point mentioned above is that the Federal Reserve needed to inflate the American economy. This is either a misuse of terms or an incorrect view of inflation. The context suggests the latter as he quotes Anna Schwartz:

“What the Fed had to do was increase the money supply. By taking that action, it would’ve revived the economy. That’s the lesson of the Great Depression.” In The Great Contraction, she and Friedman argued that the Fed had an infinite capacity to inflate. “The monetary authorities,” they wrote, “could have prevented the decline in the stock of money — indeed, could have produced almost any desired increase in the money stock.”

The concept of inflation is defined by a sustained increase in the price level. What F&S were emphasizing was not inflation, but rather increasing the monetary base to prevent a decline in more broadly defined money stocks.

So while Bullock is largely correct to consider Bernanke a follower of Friedman, his description of the work of F&S is somewhat lacking in specific areas. While it is not my intention to come across as criticizing Bullock, I do nonetheless believe that these points are all fundamentally important to assessing Ben Bernanke’s performance as Federal Reserve chairman. Thus, it is imperative that we get these facts correct.

What I’m Reading

1. The Purchasing Power of Money by Irving Fisher

2. The Road Ahead for the Fed