MV = PQ ?

By Jonathan B. Wight

Okay, this will date me.  I learned macro the old fashioned way. Yes, the Keynesian (or Hicksian) IS/LM stuff that went out of fashion by the late 1970s.

Turns out, the old IS-LM model has done pretty well in helping explain life in a zero lower bound interest world with a liquidity trap. 

But I also studied monetarism, the idea that money matters, and that a set growth in the money supply should produce a set change in nominal GDP.  In short:

M*V = P*Q is true as an identity. 

The money supply times its rate of spending or velocity always must equal prices times outputs (nominal GDP).  We know this has to be true because we calculate velocity as PQ/M, hence the equation must be true after the fact.

The Model. Monetarists turn this into a model for predicting the future by making claims about the behavior of money demand, which in turn affects velocity. 

If economic transactions become more efficient over time (think of ATM machines), then it will take less money to conduct the same value of transactions as before.  This means that each dollar works harder, and velocity rises.

Suppose that financial innovation (growth in V) proceeds at about 4% per year.  Suppose also that real output potential (Q) grows by about 2% per year.  This implies that if money grows by 3% per year, the resulting inflation will be:

3 % + 4 % = % P + 2 %

Money growth + velocity growth = Nom. GDP growth = inflation + real output growth.

In this example, nominal GDP will be increasing by 7% and the inflation rate will be 5%. 

This approach sounds reasonable, and monetarism held high sway for a few years in the early 1980s when velocity behaved somewhat predictably.  In fact, some pundits suggested doing away with the Fed entirely and simply replacing it with a monetary rule (increase money by 3% each year, come hell or high water).

[This is a nice fantasy, that we don’t need anyone minding the store of money.  Or alternatively, we should simply do away with government fiat money and return to private bank money (ask Adam Smith about the Scottish banking panics….).]

Downfall of the Model. But by the mid-1980s the whole thing was a mess: no one could accurately predict money demand, and hence no one could predict the impact of money on nominal GDP. 

Come the Great Crash of 2008, the demand for money as a safe store of assets soared, hence the infamous liquidity trap: people and businesses wanted to hold money as an asset on their balance sheets because all the alternatives were too risky.  The Fed cooperated by increasing bank reserves. The result, as shown below, is a massive build-up of money and virtually no inflation.  People are holding money as a hedge against financial market risk.  Since they aren’t spending it, it won’t cause inflation.

The Ethics of the Fed:  Hence, the ethics of the Fed's actions during this crisis can be seen in a new light once we understand that the monetarist vision, while certainly and absolutely true in times of hyperinflation, do not apply to economies in a liquidity trap.  Of course, if sufficient confidence returns, people may decide to spend and the Fed would have to back-pedal.


Given the narrowing of the macro models now taught in graduate school, I had to help a new colleague recently who had never worked with IS/LM and didn’t know where it came from.  Age and maturity has a few perks!

If you’re curious, read Sir John Hicks "Mr. Keynes and the Classics – A Suggested Interpretation", 'Econometrica v. 5 (April 1937): 147–159.

Austerity and Unemployment

Jonathan B. Wight

Austerity causes economic contractions that increase unemployment, as shown in the European economies of late:

The contrary view—that cutting spending magically inspires private demand and positive supply shocks—doesn't seem to be working out so well. Why should business invest when capacity utilization is so low?

For the U.S., capacity utilization plummeted in the Great Recession and although recovering, is still below its pre-recession average of about 81.5 percent.

I remember struggling and deeply digesting the Keynesian IS/LM framework my junior and senior years in college. The four-quadrant diagrams were enough to make my future wife abandon economics for business, but for myself, I was deeply invested. Living through a liquidity trap in the present has been a fascinating experience from a purely intellectual standpoint.

From a human and ethical standpoint, living through a liquidity trap when half the macro-economics profession eschews the basic Keynesian IS/LM framework is deeply depressing because it suggests that much unemployment and the concomitant human suffering is unnecessary. Applying leeches to a patient or bleeding the patient may inspire confidence that one is taking the necessary hard medicine and behaving virtuously, but there is no guarantee that such half-baked ideas will magically work. They usually do not.

Economics does not progress in a linear fashion, but rather recursively. We plow forward with the new and throw out the old that we think is irrelevant. We later come back to revisit what we threw out that turned out to be important. That is why interest in Adam Smith has been flourishing after perhaps a century of neglect. The same story may one day be true of Keynes.

POSTSCRIPT: Let's not forget the half-baked Keynesianism as well—the erroneous idea that Keynes called for big government in general. Keynes was clear (see last chapter to The General Theory) that when the economy recovers to full employment the fiscal budget needs to move toward a surplus.

iPhones and Keynesianism

Jonathan B. Wight

Frederick Bastiat's wonderful essay, "That Which is Seen, and That Which is Not Seen" (1850), relates the story of a shopkeeper's son who accidentally breaks a window. While the shopkeeper laments his loss, the surrounding public consoles him, saying, "What would become of the glacier if windows were never broken?" Bastiat replies that although the glacier is richer by the six-franc cost of the window, the shopkeeper is poorer by that exact amount. The shopkeeper replaces the window but now can't afford new shoes, which he would have preferred to new glass if the old hadn't broken.

There's no free lunch in this moral tale. I love this story and always teach it in Principles of Micro.

But in Macro the moral might be different. In a Keynesian world of high unemployment, getting people to buy new windows can produce a positive multiplier effect on spending that raises overall incomes—even to the shopkeeper.

Here's a perfect example of the broken window set in modern times: JPMorgan predicts that the new iPhone5 could raise GDP growth by up to one-half percent by the end of 2012. This time it is not a broken window, it is a broken cell-phone; old phones are "broken" because they have become obsolete.

Krugman notes that the economic model used was necessarily Keynesian:

We don't have high unemployment because Americans don't want to work, and we don't have high unemployment because workers lack the right skills. Instead, willing and able workers can't find jobs because employers can't sell enough to justify hiring them. And the solution is to find some way to increase overall spending so that the nation can get back to work.

So where can more spending come from? Businesses are sitting on lots of cash but, for the most part, have seen little reason to do a lot of investment. Why expand your capacity when you don't have enough sales to make full use of the capacity you already have? And because businesses aren't spending a lot, incomes are low, so consumer demand is low, which perpetuates those low sales.

Yet depressions do end, eventually, even without government policies to get the economy out of this trap. Why? Long ago, John Maynard Keynes suggested that the answer was "use, decay, and obsolescence": even in a depressed economy, at some point businesses will start replacing equipment, either because the stuff they have has worn out, or because much better stuff has come along; and, once they start doing that, the economy perks up. Sure enough, that's what Apple is doing. It's bringing on the obsolescence. Good.

But why suffer through years of depressed output and high unemployment while waiting for enough obsolescence to accumulate? Why not have the government step in and spend more, say on education and infrastructure, to help the economy through its rough patch? Don't say that the government can't add to total spending, or that government spending can't create jobs. If you believe that the iPhone 5 can give the economy a lift, you've already conceded both that the total amount of spending in the economy isn't a fixed number and that more spending is what we need. And there's no reason this spending has to be private.

Interestingly, Mitt Romney says he would boost military spending to create jobs. Mr. Romney, are you a closet Keynesian?

U.S. Unemployment is Cyclical After All

Jonathan B. Wight

Krugman points to this paper by Edward Lazear and James Spletzer given to the Jackson Hole Central Bank meeting last week.

The paper addresses whether this is a Keynesian recession driven by lack of demand OR is it a supply-side recession caused by structural mismatch of workers and jobs? The paper concludes:

An analysis of labor market data suggests that there are no structural changes that can explain movements in unemployment rates over recent years. Neither industrial nor demographic shifts nor a mismatch of skills with job vacancies is behind the increased rates of unemployment. Although mismatch increased during the recession, it retreated at the same rate.

The bottom line is: we are not likely in danger of igniting inflation by further stimulation: there is plenty of qualified labor, capital, and other resources to accommodate a faster expansion.

The moral implications are pretty stark: Young people are disproportionately bearing the pain of this recession (see graph). The longer they stay out of the labor force the more likely that their skills (and moral resolve) will degrade with a permanent effect on their careers.

Do we permanently scar the lives of current graduates and other young people by allowing unemployment to remain high? Or, do we bite the bullet, as the generation did after WWII (with very high debt ratios), and invest in people and infrastructure while interest rates are at all-time lows? [Yes, there is an argument to eliminate or reduce the minimum wage which effects entry-level workers; I don't find that idea convincing for reasons I don't have time to expand on here—but your comments most welcome.]

Keynesian or Stalinist?

Jonathan B. Wight

Via Krugman comes a link to Jared Bernstein and a chart from Jay Shambaugh (long pedigree).

The chart appears to demonstrate that countries with larger increases in government spending after the Great Recession of 2008 tended to have faster economic growth.

What are the ethical implications of this chart? Is it necessarily a good thing that GDP rises because of a growth in government?

In some circumstances we might be appalled by that outcome. Under Stalinism, many western economists feared that the Soviets would outstrip us economically because all investment was done by the state and was not subject to market fluctuations. A growing economy would not be a good thing if we had to give up basic freedoms and human rights to achieve it!

And during the Reagan era the U.S. massively built-up military spending. That made the U.S. the unrivaled military leader in the world, but the unintended consequences may have provoked our enemies to the 9-11 bombing and ourselves to the hubris that led to the second invasion in the Gulf. Many oppose a rise in income that is produced by a massive military build-up.

Is either scenario the context of the current debate? Is Krugman calling for a Stalin-like government take-over of the private sector or a military build-up? Hardly. The ballooning government debt since 2007 was caused by… the decision to save the private banks! The bailout of GM was small by comparison, and deliberately short-term. While long-term problems of Medicare, Medicaid, and Social Security need solutions, they are not the immediate deficit problem, which can be related to trying to preserve a capitalist financial system.

The kinds of programs Keynesians have called for are road building and other infrastructure that are traditional functions of government (and could be enhanced by partnerships with private sector investors). This is not Stalinism, although one could argue the camel's nose is always there.

Should We Become Keynesians Again?

Jonathan B. Wight

I've been pushing fiscal conservatism for a long time. I decried the fiscal budget deficits that ballooned under Ronald Reagan, and I celebrated the budget surpluses eventually achieved by Bill Clinton and the Republican Congress by the late 1990s. I decried again the profligate waste of that surplus under Bush II (see graph).

But while I'm a fiscal conservative I'm also a modified new Keynesian. Counter-cyclical fiscal and monetary policies can and should be used during severe downturns to bolster aggregate demand. Stimulus should be withdrawn during boom periods, producing a fiscal surplus (as happened during Clinton's second term).

Critics, though, have a good point: Keynesian is a dangerous tool. Government programs create political constituencies; stopping a program once started is nearly impossible. That can lead to ever-growing government entitlements and ballooning spending. Hence, counter-cyclical fiscal spending should be tied to specific, limited projects with sunset clauses, e.g., road construction, port construction, and so on. If you can't trust Congress and the President to agree to these limits then critics argue (with some justification) that nothing is better than something.

But others oppose Keynesianism by advocating a reverse Keynesian model—arguing that austerity policies (cutting federal, state and local spending) can be used to magically revitalize demand in the private sector. This is a wonderful idea, but flouts all the evidence when we are in a recession.

Businesses have no incentive to expand when they have excess capacity and demand is weak. Austerity in the face of recession increases unemployment, lowers growth, and further undermines consumer and investor confidence—and hence may increase the very deficits austerity is supposed to cure. That seems self-evident.

Krugman has been beating this drum and it is worth repeating: Ignoring the economic theory of demand in favor of wishful thinking isn't very scientific—nor is it ethical. This week's Economist notes that austerity policies are rapidly running up against the wall of conflicting data in Europe.

I am sympathetic with those who worry about the size of government and its deficits. But I'd rather we borrow at current low rates to fix infrastructure when labor and materials are cheap rather than waiting to do this in five years when the opposite may be the case. And I also worry about a generation of lost workers who will be permanently scarred by a really bad job market—particularly the young—pushing down labor participation rates as people become discouraged. This is bad for families, bad for communities, and bad for the long run financial health of the country.

Dow Plunges 634 Points

Jonathan B. Wight

The Dow Jones Industrial Average plunged 600 points today and more than 1300 points since the debt deal was announced last week (about an 11 percent drop in value).

What is the cause of this collapse? One theory is that the debt deal did not go far enough in cutting spending. If this view is correct, the markets are reacting to the debt downgrade by S&P and the fear that further insolvency looms.


But if this theory were true, this scenario should be accompanied by a rise in Treasury interest rates. Instead, the ten-year interest rate remains exceedingly low.

The alternative theory is that the markets are suffering from an eye-popping wake-up call—that another recession lies ahead because government is retrenching and the private sector is unable to pick up the spending slack. This would be a classic demand-side downturn. In addition to the United States, Europe is also facing a huge slump.

The ethics of fiscal expansion versus fiscal austerity is admittedly complex. But ethical discourse should be guided by a consensus on the facts, and by theories that can explain the facts. Rising unemployment—and long term unemployment—is of great concern for human capital formation, even if one is unconvinced by any moral obligation to help the less fortunate. With interest rates so low, one can make a strong case for badly needed infrastructure investments that would also boost labor demand. While austerity is a good thing in thinking about one's childrens' long term future, many of our children need jobs and training more than they need Medicare guarantees.

Meanwhile, the outrageous rioting in London (click on video) does little to warm the hearts of those who would seek to aid the less fortunate.









Keynes on China’s Currency War

Jonathan B. Wight

Whether you like Keynes or not, he had a genuine knack for prescience.  This week President Obama appointed the head of GE to lead the new Council on Jobs and Competitiveness—presumably aimed at fighting off our international challengers, especially China.  This portrays a view of trade as a game of win-lose.

The failure of macro policy to maintain full employment was the subject of Keynes’ book, and here’s a timely quote on trade from the concluding chapter of The General Theory (1936):

But if nations can learn to provide themselves with full employment by their domestic policy… there need be no important economic forces calculated to set the interest of one country against that of its neighbours.

There would still be room for the international division of labour and for international lending in appropriate conditions.

But there would no longer be a pressing motive why one country need force its wares on another … with the express object of upsetting the equilibrium of payments so as to develop a balance of trade in its own favour.

International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home….

Can anyone doubt that China is using trade as “a desperate expedient to maintain employment at home….”?  The question is whether President Obama, in his declarations over the past year, is also heading in that direction.

Keynes on Individualism and Freedom

Jonathan B. Wight

I’m re-reading the final Chapter of Keynes’ The General Theory (1936) to prepare for a seminar class on the Great Recession of 2008.  Aside from Keynes’ push for death taxes and for nationalizing the banking system (!), and aside from the complete manipulation of income taxes and interest rates—okay, if you can get beyond that—here is what he says about individualism and freedom:

But, above all, individualism, if it can be purged of its defects and its abuses, is the best safeguard of personal liberty in the sense that, compared with any other system, it greatly widens the field for the exercise of personal choice. It is also the best safeguard of the variety of life, which emerges precisely from this extended field of personal choice, and the loss of which is the greatest of all the losses of the homogeneous or totalitarian state.

So, in other words, Keynes is the great moderate, saving liberalism from the communist threat.  At the macro level all is controlled by the government to maintain aggregate demand at full employment.  But at the micro level markets can work under laissez faire to produce whatever they want to satisfy individual desires. 

Now, there is that one modifying phrase above I’ve bolded:  how do we purge individuals of their defects and abuses?  I suspect Keynes had something in mind like Adam Smith’s moral sentiments:  it would take self control and social norms.  But I don’t know Keynes well enough to say. 

Does anyone else have an answer to that question?