Monetarism, Debt, and Observational Equivalence

I have heard a number of people say over the years that one of the best things about reading Adam Smith and Henry Thornton and other classical economists is that they argued their points fairly. In particular, Smith and Thornton argued in favor of their own views and against opposing views while taking these opposing views at face value. They did not attack straw men. They did not caricature their intellectual adversaries (in fact, Thornton and Smith were intellectual adversaries to some extent in their views on the role of bank notes, bills of exchange, and the operation of the monetary system).

This characteristic is, at times, missing from contemporary discourse. This doesn’t mean that modern disagreements are fraught with malice. However, sometimes ideas are not given the proper understanding sufficient for critique. Franco Modigliani, for example, once joked that what we would now call real business cycle theory blamed recessions on mass outbreaks of laziness. Similarly, when Casey Mulligan published his most recent book on the recession in which he argued that expansions of the social safety net can explain a significant fraction of the increase in unemployment, others shrugged this off by saying that this was akin to saying that soup lines caused the Great Depression.

My point is not to defend Casey Mulligan or the real business cycle theorists. It is perfectly reasonable to view real business cycle theory as unconvincing without referencing mass outbreaks of laziness. Rather my point is that more care needs to be taken to understand opposing theories and views of business cycles, growth, etc. so that one can adequately articulate criticisms and rebuttals to such views.

The fact that there is little understanding of (or perhaps just little credit given to) opposing viewpoints is never more apparent than when predictions of two different theories are observationally equivalent. To give an example, consider two explanations of the cause of the most recent recession. Please note that these are not the only two explanations and that the explanations that I give are sufficiently broad to encapsulate a number of more nuanced views.

The first explanation of the recession is what I will refer to as the Debt Theory. According to this view, the expansion that preceded the recession was fueled by an unsustainable accumulation of debt. There are many varieties of this theory that emphasize different factors that caused the run-up of debt, such as monetary policy, policies that subsidize housing, etc. Regardless of the reason that “too much” debt was accumulated, the debt eventually reached a point (most often argued as the beginning of the collapse in housing prices) that was unsustainable and hence the beginning of a recession. The recession is largely the result of de-leveraging.

The second explanation is what I will refer to as the Money Theory. According to this view, it is a deviation between the supply and demand of money (broadly defined) that ultimately results in reduced spending and, as a result, a lower level of real economic activity. As a result, when the large haircuts became apparent in the market for mortgage-backed securities, this reduced the supply of transaction assets thereby causing a deviation between the supply and demand for money. The Federal Reserve, in its failure to provide a sufficient quantity of transactions assets, thereby allowed this deviation to persist and resulted in decline in nominal, and ultimately, real spending.

As these brief descriptions imply, there doesn’t appear to be much overlap between the two views. However, they actually produce a number of observationally equivalent implications. For example, advocates of the Money Theory point to the negative rates of money growth in broad measures of the money supply as evidence that the Federal Reserve failed to provide adequate liquidity. Nonetheless, this observation is consistent with the Debt Theory. According to this view, de-leveraging reduces the demand for credit and therefore reduces the need of financial intermediaries to create new debt instruments that are used as transaction assets. Thus, we would expect a decline in money growth in both cases.

On the other hand, advocates of the Debt Theory point out that there is a strong relationship between counties that had higher levels of debt prior to the recession and the reductions in consumption during the recession. Nonetheless, this observation is also consistent with the Money Theory. Most advocates of the Money Theory are intellectual descendants of Milton Friedman. In Friedman’s theory of money demand, money is considered similar to a durable good in that individuals hold a stock of money to get the flow of services that come from holding money. Thus, contra the transactions view of money demand, individuals do not draw down money balances during a recession. Instead individuals make adjustments to different parts of their portfolio, most notably consumer debt. In other words, we would observe de-leveraging under both frameworks.

To distinguish between the two views it is not sufficient to point to characteristics that they have in common (although those observations are still important). It is also necessary to find areas in which the theories differ so that one is able to develop an empirical approach to assess each framework’s validity.

The examples given above are obviously simplifications, but this is what makes being an economist difficult. It is not enough to use inductive reasoning to support one’s theory. One must be able to differentiate between other theories that would produce observationally equivalent results. Admittedly, this is a problem that exists to a greater extent in the blogosphere than it does in academic journals. The reason is obvious. If one submits a paper to an academic journal, a good reviewer is able to spot the ambiguities between testing the predictions of a particular theory and contrasting the predictions of theories with observationally equivalent predictions. In the blogosphere, the “reviewers” are commenters and colleagues. However, the differences don’t often get resolved. Perhaps this is because there is no gatekeeper that prevents the blog post from being published. (Ironically, the lack of a gatekeeper is perhaps the best quality of the blogosphere because it allows discourse to take place in public view.) Nonetheless, given the degree to which blog posts and debates in the blogosphere ultimately spill over into the popular financial press and public debate, it is important to be careful and considerate regarding opposing views.

[Note: For an example of someone who tries to disentangle the issues surrounding the Debt View and the Money View, see Robert Hetzel’s The Great Recession: Market Failure or Policy Failure?]

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