Allan Meltzer

Earlier this month, I had the privilege of speaking at a conference in honor of Allan Meltzer. It was a great conference with a number of excellent speakers (how I got on the list is anyone’s guess). Meltzer had an incredible influence on the profession through his work on monetary policy and the history of the Federal Reserve.

I was on a panel discussing Meltzer’s views on the monetary transmission mechanism. Anyone who is familiar with Meltzer’s work knows that this was a topic that he thought was of the utmost significance. For those not familiar with economic jargon, this line of research examines the various possible channels through which monetary policy affects economic activity. On the one hand, this research has been pretty influential in the sense that Ben Bernanke often sounded quite Meltzer-esque in his discussion of monetary transmission when justifying the Federal Reserve’s large scale asset purchases. On the other hand, much of the current literature on monetary policy fails to take into account many of Meltzer’s insights because this recent literature focuses too narrowly on the short term nominal interest rate.

I understand that they are putting together a book that collects the contributions of each of the speakers, but some of the material is already available online. I know of 3 papers that have been posted online, including my own (I’ll update this if I hear of others before the book comes out). These papers are linked below. I hope that those interested will take the time to wrestle with Meltzer’s arguments.

Allan Meltzer: How He Underestimated His Own Contribution to the Modern Concept of a Central Bank by Robert Hetzel

Allan Meltzer’s Model of the Transmission Mechanism and Its Implications for Today by Peter Ireland

and my paper:

Monetary Policy and the Interest Rate: Reflections on Allan Meltzer’s Contributions to Monetary Economics

One response to “Allan Meltzer

  1. David Harold Chester

    In my book “Consequential Macroeconomics” I provide a table and long description of ways that the government can influence the rate of progress of the social system by adjusting money related aspects. This book is available as an e-copy if you write to me The aim is to mention ALL of the 7 possibilities.

    The following is an extract:

    15.2 The Methods Available for the GOVERNMENT to Control National-Progress

    With regard to money, the primary financial role of the GOVERNMENT entity is to balance the national annual budget. However, this financial action of regulating the incoming and outgoing amounts of public money also is thought to influence the progress of the rest of the macro-economy. These operations are closely connected with the manipulation of the banking-money, through the ability of the Treasury (and the National Bank) to issue or withdraw bank-notes. Also and less directly, it is due to the capacity of local banks to continuously extend credit for interest from newly-deposited savings. These features of the system apparently provide the GOVERNMENT with certain limited means of regulating the progress of the nation over both short and longer periods of time and to attempt to act as a steadying influence on it.

    When trying to control macro-economic progress, there are available two basic approaches that the GOVERNMENT possibly can adopt, that are called the fiscal and the monetary methods. The fiscal budgetary-control methods act directly and have an immediate effect on the money within the macro-economy. The monetary banking-control methods are slower and are more-closely connected to the money-system, only subsequently affecting the money-supply and the demand for goods etc. They act less directly and require a longer response-time, which may exceed a year before their effect is felt. These methods are summarized in Table 13 and described below. In some countries, the National Bank handles the monetary items on behalf and for the GOVERNMENT.


    15.2.1 The Four Fiscal-Control Methods

    The direct fiscal methods of GOVERNMENT control are briefly described here, for the sake of completeness. Only one of these methods is related to the broader subject being covered in this chapter, namely the greater consequences of the nature and use of money, and of the banks ability to invest and lend it for interest.

    a) Limited Maximum Price of Certain Goods and Services

    This temporary and extreme method of control is used during and shortly after a war of long duration, before the rationing of goods for personal consumption is completely abolished. Whilst certain basic items of consumer goods may still be subsidized, the purpose of the price-control is to ensure that the poorer parts of the community, including fixed-income pensioners, don’t pay much more than the minimum production costs. The price-controls constrain monopolies from their unjustified exploitation of the newly developing markets, before the effects of competition begin to be felt. The entrepreneurs may already have made some price cuts, so as to compete and stay in business. The general result of price-control is a reduction in the quality of the produce, because the producers always aim to operate as economically as possible. The effect of the lower prices is to boost the demand for the particular kinds of goods and this slightly increases the number of employees needed in industry, without (at least) initially creating a rise in the overall value of the goods exchanged.

    The maximum rent is also limited on land and premises that are leased or hired-out for agriculture, residence, commerce or industry. Consequently, these temporary draconian measures find application in controlling the unbalanced rate of national recovery in the poorer sectors, although they also encourage the development of the black-market in scarce luxuries.

    b) Taxation Changes

    b1) The amount of GOVERNMENTAL money-income is controlled (exogenously) by modifying the total sum taken in taxation. This income is collected from the four possible kinds of taxes that were previously described, namely Th, Tl, Tp and Tc (see Table 3 in Chapter 6). The changes to the total amount of national income find use in connection with the national expenditure, see item c) below.

    b2) The short-term effects of making a modification to each of Th, Tl, Tp and Tc are different, as was shown in Chapter 11 and Appendix D. This includes any innovative taxation methods and their overall effects. The various proportions of the tax with respect to each of these methods are the significant means for directly controlling certain parts of the national progress, in the short-run. However, most of the longer-term effects are less significant due to money re-distribution, see Chapter 16.6.

    It is a frequent claim by the consumers simply wanting to reduce their income tax payments, that this would provide them with greater funds and the subsequent effect on the whole economy would be beneficial. However, after considering all of the macroeconomics system, the actual short-term effects of doing this were found to be the opposite, see Chapter 11.1 Example 2. With lower taxes there is a reduction in the number of government employees and after considering together all the consumers, it is found that there is a reduction in the GDP. By adopting this broader-attitude, the greater needs of the community are better-judged. The same kind of result occurs whenever a law favours one part of the community. The classic example of an artificially raised demand for the produce of the Candle-Makers, see F. Bastiat [11], does not benefit more than this small fraction of the population, in spite of their erroneous claim that this innovation creates greater macro-economic activity throughout the whole social system. This fallacy neglects what otherwise happens, without the introduction of this change. It was well-described by Henry Hazlitt in [19], where he showed that the subject becomes more involved.

    As was seen in Chapter 11.1 (Table 10), by examining the effect of tax changes on the complete system, the different taxation methods have transitory beneficial or harmful effects on various parts of it, and on it as a whole. In particular, comparing the effects of raised taxation in Example 3 and 4 proves that the introduction of a land-value tax stimulates the overall system by 3 times as much as what results from the same fiscal rise in income tax.* Using the comprehensive macro-economic model given here and by applying the methods of calculation shown in Appendix D, the inquisitive reader may explore these kinds of results in greater depth, many of which are not obvious.

    * N. Gregory Mankiw et al in the third edition of his book “Essential Economics” [47] (page 168) quotes Milton Friedman: “In my opinion, the least bad tax is the property tax on the unimproved value of land, the Henry George argument, many, many years ago.”

    c) National Expenditure Changes

    The GOVERNMENTAL money-outflow is controlled by (exogenously) modifying the total national expenditure. This is due to the various kinds of payments covered by Cg, for the costs of running the various ministerial offices such as defence, justice, public-health, national insurance, education, etc. as well as the expenditure on national projects. These activities are necessary for managing the country as a whole, the poorer parts of which would otherwise lack the services, whilst the more affluent parts would have to pay more without necessarily obtaining better treatment. Whilst being a part of this activity, the subsidy given to the “deserving poor” is already included in our model by its subtraction from personal income tax Th before it passes into the analysis.

    Thus the Treasury or Finance Ministry has the responsibility to decide, govern and control the rates at which the nation’s money is both gathered and used. During periods of rapid economic growth the amount of tax collected becomes greater and a surplus occurs in the budget. The balance of this money may then be stored in the vault of the National Bank or used to reduce the National Debt. In times of depression or slump less tax is gathered. Then a deficit budget can draw on this surplus or increase this Debt. Thus the Government has a limited control of the National Debt by this means see below. Otherwise the money would be loaned or invested elsewhere.

    When b) and c) are combined, the GOVERNMENT is in the process of balancing the budget. This is usually achieved with the open-market operations described below, as a supplementary method of fiscal control. These fluctuations hopefully keep steady the average amount of national progress, when taken over a span of many years.

    d) Open-Market Operations for Annual Balancing of the Budget

    The action starts by the GOVERNMENT (exogenously) releasing or recalling Treasury-Bills to or from the National Bank. In turn this agency issues or withdraws National Bonds M that are held for limited periods in the common banks at the investor’s level. These changes are known as open-market operations, money being either borrowed or returned to the community through various bank-related transactions. It is a refined way by which the GOVERNMENT adjusts the size of the National Deficit whilst completing its annual balance-sheet.

    The banks are usually eager to invest in these long-term “guilt-edged” securities, due to their high reliability compared to public company shares. From the current budgetary proposals, the quantity of these bonds likely to be offered or redeemed each year to adjust the annual size of the National Deficit, can be estimated by the banks, together with the rate of interest in anticipation of the annual rate of progress.

    (Open-market operations should not be confused with the printing or withdrawal of money from circulation which causes deliberate inflation or deflation of the currency over a longer time. These can be combined with open-market operations too, but it is better to categorize and describe this combined activity as a monetary function, see below.)

    These above four methods a) to d) are regarded as being the direct means of fiscal control, where in their initial phases they all act immediately or almost so.

    15.2.2 The Three Monetary-Control Methods

    These three monetary methods of GOVERNMENT control are described below. They are slower-acting, being closely connected to the nature of the banking-system. These three monetary methods are treated here in greater detail than the fiscal ones above, since they are more relevant to the main subject of this chapter.

    e) Changing the Prime-Rate of Interest of the National Bank

    In cooperation with the (somewhat independent-acting) National Bank, a change in the Prime-Rate is made. This is the rate at which interest is paid on the nominal value of the recently issued (renewed) bonds M that are covering a part of the National Debt (M) or deficit that has just been redeemed. The Prime-Rate is usually set at the lowest rate that the National Bank can reasonably offer, when the sale of renewed bonds competes with the other shares in the stock-exchange. The aim is to make the cost of the loan to the tax-payer as small as possible. The greater reliability in these government-based holdings allows this rate to be slightly lower than the average dividends being returned on shares, but it is usual for new issues of the bonds to be for long-terms and the new rate anticipates the rate of inflation, that otherwise reduces the ability to attract investors.

    The three kinds of rates of interest r are on savings (S), on bonds (M) and from dividends on shares (I) . They are normally of about the same size and their variations are in parallel. Whenever a change is made in the Prime-Rate of renewed bonds, even though the percentage is small, it has a big influence on the spread or withdrawal of recent investments by the entrepreneurs in their production activities. Public companies whose shares produce high dividends are less seriously influenced, but those whose dividends are below the average are likely to experience more significant changes in their stock-market trading prices and may even go out of business.

    If the rate of progress of the macro-economy is thought to be too rapid, the National Bank, with cooperation from the Treasury, raises the interest rate on its latest bonds issue. (The raised rate encourages greater amounts of savings, which increases the bank-reserves, so money is withdrawn from circulation. However, the higher interest rate also encourages people to retain smaller amounts of free-cash. So with both effects acting together, it is unlikely that additional currency needs to be issued.) The action draws money away from new investment in company shares. This is adverse from the CAPITALIST’S viewpoint, but it is necessary so as to slow down economic progress and to reduce the growth in company share values. Conversely, the reaction of the Treasury to an economic slump in trade is to reduce the Prime-Rate on the renewed bonds. This affects savings too, which yield less interest, so it encourages the consumers to keep more money in their pockets (and to spend it) and to put less in the bank. Cheaper money instigates the CAPITALIST to invest in durable capital goods too.

    Anticipation of these changes has been made harder in recent years due to the decision of the Bank of England (the British National Bank) not to continue to announce the new Prime-Rate at the stock-exchange, as was done before. The same changes will occur to the share-prices, but after a slightly longer delay. This innovation is thought to reduce the degree of nervous response by the speculators. The subsequent variations in the Prime-Rate and in the average dividend-rate are unlikely to be much different.

    When there is pressure to borrow more money than currently available, the viable Prime-Rate rises naturally and reduces this demand. Similarly this rate falls when too much money accumulates within the banking-system. These adjustments depend on the degree of business activity (as expressed by the aggregate dividends paid on shares). Consequently, the system automatically regulates itself (by negative feed-back) against any pressure for the economy to inflate or deflate.

    A sensible Treasury will not issue nor withdraw money to specifically cover these changes, because of the natural way that the revised rate of interest stabilizes with the altered amount of currency in circulation. This idealized theory is the classical approach that was taken before J.M. Keynes in 1936 showed the need for governmental control to override these natural trends. He claimed that this control is advantageous. However, experience has shown that this somewhat useful feature of our social organization degenerates when the system receives too much interference from the Government.

    A finer degree of control of the progress of the macro-economy can be obtained by more frequently adjusting the Prime-Rate of interest slightly above or slightly below its natural level (as determined by the average share performance). This implies that the Prime-Rate is both an effective means of control and a useful measure of the rate of progress of the whole system.

    A decision to raise or lower the Prime-Rate of a major country’s National Debt also creates a world-wide response in its company stocks that are traded internationally due to a re-assessment of the value of these investments. The foreign investors may decide to add to the amount involved or alternatively to withdraw their money. To these investors, the value of the home country’s currency has altered. If large sums are involved, it will affect the exchange rates, unless the National Bank trades sufficient of its reserve foreign-currency (or gold), to compensate for the change in the effective value of its currency.

    f) Adding or Removing Currency from Circulation (Deliberate Inflation or Deflation)

    When money is printed and released into circulation, or when currency is withdrawn and secluded, these activities also are regarded as monetary. With greater sums being issued, the amount of GOVERNMENTAL subsidies and expenditure on national projects Cg is increased. Alternately after the Treasury withdraws money, this excess is placed in long-term storage or destroyed. Then the subsidies and projects are curtailed. Money can be added to the system by means of open-market operations that reduce the size of the National Debt. This involves buying back National Bonds (or redeeming them without reissue). It combines this monetary activity with a fiscal one, as described in d). However, the sale of bonds followed by the removal of the resulting currency from circulation, are unreasonable operations and the theory is asymmetric here. When money is to be withdrawn other fiscal processes must precede this activity. In most countries this Debt is continuously growing as the population increases and/or progress is made. Limitations in the magnitude of this Debt have never been prescribed for very long, but since the country pays interest on it, there clearly is a need for some constraint in its size.

    After money is added to the system, the initial response of the community is for greater demand. This suggests that the GOVERNMENT’S deliberate expansionist action is a useful way to recover from economic depressions, but today its long-term effects are recognized as being adverse. Unfortunately, this action subsequently cheapens the value of the nation’s money including what is in savings, which greatly exceeds the amount of currency in circulation. After wages catch up with prices the initial stimulation that came from inflation is lost. Generally there is reluctance to use this monetary instrument. Deliberate money-inflation is regarded as a dishonest form of behaviour by central-acting Governments, who use it to stimulate demand and simultaneously to reduce the effective size of their National Debts. J.M. Keynes was well aware of this and he even quoted Lenin: ”By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens” [49] –a shocking admission of deceit.

    These open-market operations also apply pressure to adjust the Prime-Rate. Similarly, when this rate is changed (see above e)), the bond’s market will be affected. Consequently a Government wishing to control the degree of national growth should allow for the influences in both of these quantities, so as to avoid conflicts.

    (These adjustments also affect the international exchange-rates, which are expressions of the value-ratio of imported to exported goods. In the case of inflation, prices rise and fewer goods are exported compared to the country’s increased and cheaper imports. After the exchange-rate has become stable again, and the foreign currency is more expensive to acquire, the situation returns closer to what it was previously. Deflation works in the opposite manner.)

    g) Changing the Minimum Reserve-Ratio on Savings-Deposits

    In theory, the credit that banks extend comes from their savings-deposits. Not all of the money that is being kept for the savers by the banks is allowed to be used for this purpose. Each bank is required to hold a reserve for use when there is a sudden demand for its liquid assets. The reserve is a small proportion of the total savings-deposits (and may include part of certain current accounts too.) The banks store this reserve sum, which typically is 10% of the total, in their vaults (or those of the National Bank). The introduction by the Government of changes to this reserve-ratio, is supposed to control the amount of business activity, allowable beyond the degree to which credit has already been extended. However, in practice the strict enforcement of this restriction has recently given way to “bail-out” loans from the Treasury, on which the discount-rate of interest is deliberately set usually high but sometimes unusually low too! (as in the US during the 2008 bank crises). Temporary regulations are sometimes introduced, to freeze certain other bank reserves.

    It is easy to blame the banks for allowing their reserves to become too low and (since they collaborate in investment with the land-owners and speculators) for being unable to determine when the land-value bubble is about to burst. But banks often are too close to the money action to be willing or able to see the bigger picture. The bank’s job is to supply as much credit as possible and it is difficult for them to decide how much savings will need to be returned at any specific moment. Some banks even find ways to disregard the minimum sums that they should be reserving and they are likely to be in difficulty when a depression arrives, so the Government applies a less critical constraint here, which causes losses rather than failures.

    As seen in Equation (35) in Chapter 14.2, the amount of credit that is provided by the banks is also due the effect of the money-multiplier. If we make the same assumption, suppose that the Government decides to increase the reserve-ratio res from 10% to 12.5%. Then a diminished proportion of (12.5% – 10.0%) / (1 – 0.125) = 1.625% of the savings-deposit money is involved, it no longer being available for new investment. The direct effect of the greater reserved sum is that it reduces the total future credit by this proportion too.

    The money-multiplier also changes from 2.14 to (1 – 0.25) / (0.25 + 0.125) = 2.00 due to Equation (35). This causes a reduction of 1 – (2.00 / 2.14) or 7.14% in future investment. Thus the total effect is 2.35 times greater than the initial change made to the reserve-ratio of 2.5%, which suggests that this method of GOVERNMENTAL control is a powerful device. However, this control instrument is not often used, due to a strong reluctance to change the requirement and also due to the use of discounting on loans by the Treasury.

    The reserve is basically intended to cover a flood of customer withdrawals that follow a sudden lack of confidence in the banking system. This can occur after the economy becomes depressed and more money is needed, or during the start of inflation, when the demand for money is high and/or the consumers want to stock-pile goods before their prices rise. When a bank finds itself with money reserves that are too low, it can try to borrow from another bank. If this is not possible, for a short duration the bank may also borrow from the National Bank at the “window of last resort” (whilst simultaneously calling-in some of its heaviest loans). Borrowing from this window is discouraged and the “discount” rate of interest is not intended to provide the debtor bank with the means for direct investment, only to help it cover its immediate (and temporary) financial needs. The effect of extending credit to a bank in general and from this window in particular, is to soften the impact of the unexpected shocks.

    In extreme circumstances where a run on the major banks is likely to subsequently bankrupt a large part of the community (due to the resulting panic to obtain a greater liquidity of funds) it is possible for the Government to print or issue and lend these ailing banks “bail-out” sums (for short time intervals), in order to avoid a national financial collapse. The effect of this action is the opposite of the Government deciding to increase the savings reserve-ratio. It can only be applied for a limited time before the effects of the freer-moving money causes the currency to inflate, so it should be very carefully controlled.

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