I am reading this book The Oxford Handbook of Post-Keynesian Economics, Volume 1: Theory and Origins and it has some nice chapters!
In his chapter Postkeynesian Precepts For Nonlinear, Endogenous, Nonstochastic, Business Cycle Theories, K. Vela Velupillai has some nice words on Wynne Godley and his book Monetary Economics co-authored with Marc Lavoie:
The subject of money, credit and moneyflows is a highly technical one, but it is also one that has a wide popular appeal. For centuries it has attracted quacks as well as serious students, and there has too often been difficulty in distinguishing a widely held popular belief from a completely formulated and tested scientific hypothesis.
I have said that the subject of money and moneyflows lends itself to a social accounting approach. Let me go one step farther. I am convinced that only with such an approach will economists be able to rid this subject of the quackery and misconceptions that have hitherto been prevalent in it.
– Morris Copeland, inventor of the Flow Of Funds Accounts of the United States, in Social Accounting For Moneyflows, in Flow-of-Funds Analysis: A Handbook for Practitioners (1996) [article originally published in 1949]
Alas monetary myths continue to exist. The above referred handbook was published in 1996 starting with Copeland’s 1949 article and the editor of the book John Dawson himself had an explanation of why myths continue to exists despite some brilliant work such as that of Copeland. In page xx, Dawson says:
the acceptance of… flow-of-funds accounting by academic economists has been an uphill battle because its implications run counter to a number of doctrines deeply embedded in the minds of economists.
In a recent blog post blog post Paul Krugman is dismissive of Wynne Godley’s approach to macro modeling and instead appeals to some Friedmanism. Perhaps Dawson’s quote explains why this is so. However it may not be the only reason, given how Krugman has shown some tendency to be heteredox in recent times but his latest post ends all doubts and we can say he is highly orthodox. And that other reason is professional turf-defence.
Also, Krugman was writing in response to an NYT article Embracing Wynne Godley, an Economist Who Modeled the Crisis highlighting the importance of Wynne Godley’s work. That article was by a journalist who was perhaps unaware of the history of Post-Keynesianism. But Krugman himself dodged Godley’s work as “old-fashioned” – as if there is something fundamentally wrong about old-fashion and as if economics should proceed by one fashion after another.
A bigger disappointment is that Krugman failed to acknowledge that there has existed a heteredox approach since Keynes’ time. As Wynne Godley and Marc Lavoie begin Chapter 1 in their book Monetary Economics:
During the 60-odd years since the death of Keynes there have existed two, fundamentally different, paradigms for macroeconomic research, each with its own fundamentally different interpretation of Keynes’ work…
And Krugman’s usage of the phrase old-fashioned hides the fact that this is so.
Back to Copeland. In the same article Social Accounting For Moneyflows, Copeland is clear about his intentions and the direction he is looking:
When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent? What part do cash balances, other liquid holdings, and debts play in the cyclical expansion of moneyflow?
Copeland’s analysis was not simply theoretical. It led to the creation of the flow of funds accounts of the United States and the U.S. Federal Reserve publishes this wonderful data book every quarter. Although, Copeland was simply looking and proceeding in the right direction, it can be said that a more solid theoretical framework to build upon Copeland’s brilliant work was still waiting at the time.
Of course, in the world of academics, there already existed two main schools of thought very hostile to one another. Keynes’ original work contained a lot of errors and for most economists, a bastardised version of Keynes’ work became the popular understanding. It was however the Cambridge Keynesians who founded the school Post-Keynesian Economics who believed they were true to the spirit of Keynes and this led to a parallel body of extremely high-quality intellectual work which continues to this day – and still dismissed by economists such as Paul Krugman. Of course, in this story, it should be mentioned that there was a Monetarist counter-revolution mainly led by Milton Friedman who was trying to bring back the old quantity theory of money doctrines and was “successful” in permanently distorting the minds of generations of economists to date. Greg Mankiw is quite straight on this and according to him, “New Keynesian” in the “New Keynesian Economics” is a misnomer and it should actually be New Monetarism.
Interestingly, one of Morris Copeland’s ideas was to show how the quantity theory of money is wrong. According to Dawson (in the same book referred above):
[Copeland] himself was at pains to show the incompatibility of the quantity theory of money with flow-of-funds accounting.
Meanwhile, in the 1960s and to the end of his life, James Tobin tried to connect Keynesian economics with the flow of funds accounts. While a lot of his work is the work of a supreme genius, he couldn’t manage. Perhaps it was because of his neoclassical background which may have come in the way. According to his own admission, he couldn’t connect the dots:
Monetary and financial data, so far as they are based on institutional balance sheets and prices in organized markets, are abundant. Modern machines have made it possible to improve, refine and expand the compilation of these data, and also to seek empirical regularities in financial behavior in the magnitude of individual observations. On the aggregate level, the Federal Reserve Board has developed a financial accounting framework, the “flow of funds,” for systematic and consistent organization of the data, classified both by sector of the economy (households, nonfinancial business, governments, financial institutions and so on) and by type of asset or debt (currency, deposits, bonds, mortgages, and so on). Although many people hope that this organization of data will prove to be as powerful an aid to economic understanding as the national income accounts, this hope has not yet been fulfilled. Perhaps the deficiency is conceptual and theoretical; as some have said, the Keynes of “flow of funds” has yet to appear.
– James Tobin in Introduction (pp xii-xiii) in Essays In Economics, Volume 1: Macroeconomics, 1987.
After having written a fantastic book Macroeconomics with Francis Cripps in 1983 and which has connections with the flow of funds, Wynne Godley thought he had to try hard to unify (post-)Keynesianism and the flow of funds approach which James Tobin was trying. Wynne Godley had the advantage of being close to Nicholas Kaldor who very well understood the importance of Keynes and was himself an economist of Keynes’ rank. Godley also had the advantage of having worked for the U.K. government and doing analysis using national accounts data and advising policy makers. Wynne Godley is the Keynes of “flow of funds” which Tobin was talking about!
A recent blog post by Matias Vernengo on Wynne Godley is extremely well-written.
In his later years (and his best), Wynne Godley worked with Marc Lavoie, one of the faces of Post-Keynesianism and one who had previously made highly original contributions to Post-Keynesianism and this led to the book Monetary Economics. Marc’s earlier work was also highly insightful and he highlighted – in the spirit of Morris Copeland – how poorly money is understood by economists in general and it was natural he and Wynne would meet and work together.
One of the things about Wynne Godley’s approach is how to combine abtract theoretical work and direct practical economic issues. This actually led him to warn of serious deflationary consequences of economic policy in fashion before the crisis.
Lance Taylor (in A Foxy Hedgehog: Wynne Godley And Macroeconomic Modelling) had a nice way to describe Wynne Godley:
Wynne has long been aware of the stupidity of models when you ask them to say something useful about practical policy problems. He has spent a fruitful career trying to make models more sensible and using them to support his policy analysis even when they are obtuse. As we have seen, this quest has led him to many foxy innovations.
But there is an enduring hedgehog aspect as well. Wynne has focused his energy on combining the models with his acute policy insight based on deep social concern to build up a large and internally coherent body of work. He has disciples and is widely influential. One might wish that he had pursued some lines of analysis more aggressively and perhaps put a bit less effort into others. And maybe not have written down so damn many equations. But these are quibbles. His work is inspiring, and will guide policy-oriented macroeconomic modellers for decades to come.
In this post, I have tried to provide the reader with references to go and verify how flow of funds1 cannot be separated from Keynesian Economics – Keynesian approach in the original spirit of Keynes, not some bastartized versions. It is as if they were made for each other2. While it is true that like other sciences, Macroeconomics is always work in progress, it doesn’t mean one should bring fashions such as inter-temporal utility maximising agents (read: future knowing economic actors) in the approach which Paul Krugman prefers.
1My usage of “flow of funds” is more generic than the usage which distinguishes income accounts and flow of funds accounts and hence my usage is for both.
2The ties between the flow of funds approach and Post-Keynesiansism is argued in Godley and Lavoie’s book Monetary Economics from which I have borrowed a lot.
Correction
I am mistaken about Jonathan Schlefer’s background. He is in academics.
There’s a nice new article on Wynne Godley today in The New York Times.
An interesting thing in the article is the mention of intuition via models while mentioning his book Monetary Economics.
Why does a model matter? It explicitly details an economist’s thinking, Dr. Bezemer says. Other economists can use it. They cannot so easily clone intuition.
That is so right. The models in the books of Wynne Godley – both Monetary Economics with Marc Lavoie and Macroeconomics with Francis Cripps give a good idea about the authors’ intuitions. Of course, needless to say the man was bigger than his models.
Joe Firestone’s gun
Joe Firestone has a blog post critiquing Marc Lavoie’s critique of Neochartalism.
Among other things, he seems to have issues with Marc Lavoie’s critique of the Neochartalist claim [which he quotes] that
. . . the creation of high powered money requires government deficits in the long run; . . .
Firestone states:
High-powered money includes cash money and reserves emanating from the Government, including the Federal Reserve. If there’s no deficit spending the Government is destroying as much money through taxation as it is spending/creating.
The trouble with Neochartalism is that Neochartalists and “MMT” fans go to over-overkill levels to show the importance of fiscal policy. In general it is a mix of doublespeak and outright incorrect statements and it is highly unacademic and unscholarly.
Firestone is mixing various things. HPM or “high powered money” is different from the net financial assets created by deficit spending of the government.
To see this point, first imagine an open economy in which there is a current account balance of payments surplus of say around 4% of GDP for over 10 years or so (some proxy for “long run”) and the (domestic) private sector “NAFA” – net accumulation of financial assets is around 2% of GDP. The government budget will be in surplus – as a matter of accounting. This needn’t cause any trouble for the private sector.
Of course this doesn’t take away the role of fiscal policy and in no sense is the above statement meant to propose a policy for the government to be in surplus. In fact since the government’s budget balance is endogenous, it could well be the case in the above situation that the government’s fiscal policy is expansionary.
HPM is a different matter. The central bank can easily provide banks with reserves via open market operations or direct lending. Deficit spending is not really needed.
It may also be the case that while taxes flowing into the account of the government at the central bank is “destroying” more HPM than what expenditures is creating, net redemptions of government bonds (as the government is retiring debt) is creating HPM.
Now consider another case but a closed economy. Assume that the private sector NAFA is negative for many quarters/years and the government’s budget is in surplus. This by itself is not a problem for HPM but may become unsustainable because the nonfinancial sector can start to have liquidity pressures – i.e., financial assets/income of the private nonfinancial sector may start to deteriorate even though net wealth/gdp is not falling (wealth includes nonfinancial assets such as firms’ fixed capital and households’ houses) and this may lead to more financial fragility.
Again, fiscal policy can be expansionary even with a surplus budget because the government budget balance is endogenous. Cannot be found from the above given data.
But Firestone blurs such matters giving the reader an impression that the private sector is losing assets and sees a reduction in output and income. And to the basic point, this has really little to do with HPM.
Firestone is highly confused and muddled when he says
Lavoie seems to think that net high powered money creation isn’t necessary for an economy, even if it is good to have.
Net HPM creation is not equal to private sector NAFA.
In fact typically the government’s cash flows do not affect the HPM when looked over larger time intervals. Expenditures add to HPM as the government moves its balances from its account at the central bank and taxes do the opposite. Bond issuances reduce HPM and redemptions increase it. Over short intervals, the flows are offset by central bank operations. Also for the wonkish, this needn’t always be the case: when there is a flow out of the government’s account at the central bank, it can simply lead to reduction of banks’ daylight overdrafts instead of increasing HPM. Firestone confuses cash flows with deficits.
That is the title of Chapter 1 (by John E. King) of this book which has just come out.
The Routledge website is here.
I just got the book and flipped through to come across this at the beginning of Frederic Lee’s article (Chapter 6):
HETERODOX CRITIC: We want to change heterodox economics.
HETERODOX ECONOMIST: What kind of change are you talking about?
HETERODOX CRITIC: The kind that does not mess with the mainstream status quo.
Matias Vernengo had a post a while ago (when the book was finalized) and it has links to articles by Marc Lavoie and Fred Lee (quoted above).
I found this reference to an article by Fischer Black in Marc Lavoie’s article in the book. It was written in 1970:
click to view the pdf file
Philip Pilkington’s interview of Marc Lavoie on his textbook Monetary Economics is available to read at Naked Capitalism. New Directions in Monetary Economics: An Interview with Marc Lavoie – Part I
Part 2 appears here: New Directions in Monetary Economics: An Interview with Marc Lavoie – Part II
Wynne Godley used to think that Keynesians were being defeated by Monetarists because they (the Keynesians) simply could not answer how money (in general assets and liabilities) is created and hence wrote the book Macroeconomics with Francis Cripps. After that he wanted to make it even more solid.
Marc Lavoie says:
… it is clear that Wynne wished to depart from neoclassical economics, and start from scratch, which is what he did to some extent already when Wynne and his colleague Francis Cripps wrote a highly original book that was published in 1983, Macroeconomics. This book was written because Wynne got convinced that the Keynesians of all strands were losing their battle against Milton Friedman and the monetarists, because Keynesians could only provide very convoluted answers to simple questions such as: “Where does money come from? Where does it go? How do the income flows link up with the money stocks? How is new production financed?”
Our book Monetary Economics also tries to provide appropriate answers to these questions. We agonized for a while between trying to engage in a constructive dialogue with our mainstream colleagues and targeting a non-mainstream audience, or perhaps trying to achieve both goals. In the end, we figured that it would be very difficult to please both audiences, and we chose to focus on a heterodox audience. In any case, I have spent most of my academic career trying to develop alternative views and alternative models of economics – what is now called heterodox economics; this is the literature we know best. So we took our book as a formal contribution to this heterodox literature and more specifically as a contribution to post-Keynesian economics.
Marc Lavoie at the Levy Institute, May 2011 (Photo Credits: me 😉 )
In an article today Europe Mulls Major Step Towards “Fiscal Union”, Reuters reports that Angela Merkel is pushing for a “giant leap forward”:
After falling short with her “fiscal compact” on budget discipline, German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice.
She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say.
Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a “banking union” with cross-border deposit guarantees – steps Berlin says could only come in a second wave.
“Kaldorians” jumped to highlight the serious defects in the European plan for integration when officials were working on the Maastricht Treaty. One of the implicit assumption on which the dogma of “free trade” is pushed is that current account deficits do not matter. The government’s task is to only make markets free in this view. The Euro Area was formed with the highly incorrect notion (among various others) that nations can simply solve their “balance of payments problem” by getting rid of it altogether.
I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).
There appear to be six different lines of argument to the effect that the current account deficit can be ignored …
… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …
… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays plus the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.
The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:
… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.
References
Let us take the public sector budget equation:
G – T = ΔH + ΔB
Inspired by Milton Friedman’s popularity in the 1970s and the 80s, most textbooks and journal articles incorrectly claim that the central bank “controls” the money stock (such as M0, M1, M2 etc). Simultaneously they also claim – rightly – that the central bank targets the short term interest rates.
Recently, Alan Blinder – formerly Vice Chairman of the Federal Reserve Board – said this in New York Times’ Room For Debate (h/t wh10):
Remember “conventional” monetary policy? The Federal Reserve shortens recessions by creating more bank reserves (“printing money”), which fuels a multiple expansion of the money supply and credit because banks don’t want to hold excess reserves. So they get rid of them making more loans and deposits, which also lowers short-term interest rates. Compare that to current reality: Banks are content to hold over $1.6 trillion in excess reserves, short-term interest rates are stuck near zero, and Fed policy often works on long-term interest rates instead. No, this is not your father’s monetary policy, and the old ways of teaching about it simply won’t do.
Einstein declared that everything should be made as simple as possible, but not more so. The crisis has made the “but not more so” part more important.
Alan Blinder is a good economist, but I guess the best way to put it is that the usual story is pure fantasy.
(To be a bit technical, let us assume – in what follows – till the next section that the central bank is targeting overnight interest rates using a corridor system)
Apart from the chimerical money multiplier story, neoclassical economists also bring in the government’s budget into the story. So the story goes that if the government wants to increase its expenditures, it will sooner or later ask the central bank to “monetize” its deficit. So the government’s Treasury and the central bank can decide the proportion of the deficit which is financed by issuing H (high-powered-money or currency notes and reserves/bank settlement balances) and B (government bills and bonds). This – higher issuance of H will cause a sequence of events involving higher private expenditure inevitably resulting in price rise and higher inflation in this story.
In my post Open Mouth Operations, I discussed two kinds of open market operations – temporary and permanent. As we saw, when the private sector needs more currency notes, the central bank must neutralize this outflow by engaging in permanent open market operations. The central bank just targets/sets the short term interest rates and simply cannot be anything but defensive.
Neoclassical economists however, think of this as purely being decided by the central bank (or the central bank acting under pressure by the government) and the process is called debt monetization. Since this involves purchases of government bonds, debt monetization is a process of purchases of government bonds by the central bank (directly from the government or in open markets) in order to increase the stock of money.
We however saw that this decision of the central bank is based purely on the private sector’s needs for currency or banks’ need for higher reserves/settlement balances and the central bank must act defensively.
This was understood well by members of the “New Cambridge” School and some of their critics. In an article attempting to show the full working of their model, New Cambridge Macroeconomics And Global Monetarism – Some Issues In The Conduct Of U.K. Economic Policy, 1978, Martin Fetherston and Wynne Godley say:
… It will further be assumed that domestic monetary policy involves supplying cash and bonds in whatever amounts necessary to maintain private (and overseas) portfolio equilibrium at given (i.e., baseline) rates of interest…
This was from a conference Public Policy In Open Economies and Alan Blinder understood this – in a reply to the New Cambridge model, Whats New And Whats Keynesian In The New Cambridge Keynesianism (same link as above) he said:
Fiscal policy can, therefore, have no immediate effect on these asset demands. (It has a longer-run effect through raising net wealth.) The central bank monetizes just enough government debt to keep interest rates from rising, so there can be no “crowding out.”
on the New Cambridge model. i.e., as we move forward in time, because the private sector has higher wealth, the Bank of England will purchase government debt depending on how much of this wealth the private sector wants in the form of money.
Hence we can say that monetization is endogenous. So if the central bank purchases more government bonds than it is supposed to, banks will have more settlement balances and the central bank’s target will fall to the lower end of the corridor and will be forced to sell bonds in equal quantities. The description of the corridor and floor systems can be found in the post Open Mouth Operations.
The Floor System And Central Bank Large Scale Asset Purchases
In recent times (since the last three years), central banks especially the Federal Reserve – who have adopted a floor system – have been purchasing a lot of domestic government bonds in the open markets (and also other securities such as “agency debt” and “agency MBS”). This is also called “QE”, and it’s a bad phrase. However does this mean the private sector has “excess money”? The private sector’s wealth allocation decision depends on its portfolio preferences between various forms of wealth and since purchases also lead to a reduction of long term government bond yields (as compared to the case when the asset purchase program hadn’t been carried out) and hence the private sector wishes to hold less of its wealth in the form of government bonds and more in the form of money – hence sold the bonds the Federal Reserve intends to buy!
Of course the result is that banks have more central bank reserves than they wish to hold, but as a whole the banking system won’t convert these settlement balances into currency notes unless the non-bank private sector wishes to hold them. If the non-bank private sector needs more currency notes, banks will easily accommodate this need and so will the central bank and this need is not a function of how much settlement balances the banking system holds. And it won’t cause price rises either because “money” doesn’t lead to inflation. The strategy of the central banks in reducing long term bonds comes with asking the banks to hold the settlement balances for some time (and keeping them happy by paying interest on the reserves) and the Federal Reserve may sometime phase out the program by an “exit strategy”. However this has nothing to do with “inflation expecations” or some chimerical story about runaway inflation waiting to happen.
The Federal Reserve’s strategy has been to create more demand by reducing long term rates so that depending on the interest elasticity (as opposed to income elasticity) of investment by the private sector and/or its animal spirits, there may be higher activity. But since income elasticity effects are stronger, the LSAP hasn’t really worked as desired.
Private expenditure depends mainly on private income and LSAPs do not directly affect private expenditure. There can be indirect effects due to portfolio preferences – because LSAPs may induce the private sector to purchase other asset classes such as corporate equities leading to a rise in stock prices, leading to wealth effects via capital gains. Hence we see a lot of references to James Tobin’s work in central bank papers on this.
There were other effects which didn’t work as desired – such as refinancing of existing mortgages due to lower interest rates and this leading to extra demand because it was thought that households will be able to refinance in huge numbers and this will lead to higher consumption because they will spend the difference they gain due to lower monthly outflows to the banking system.
Of course, none of this has anything to do with the fantasy story that there is an excess of money appearing out of nowhere and which will be eliminated via higher expenditures resulting in a permanent price rise and fantasy stories such as that.
To summarize, stories around money leading to inflation, excess money due to central bank government debt purchases etc have all led to tragic debates around macroeconomic issues.
Here’s from Marc Lavoie’s Changes In Central Bank Procedures During The Subprime Crisis And Their Repercussions On Monetary Theory (working paper here):
The financial crisis has made these features of the real world even more obvious and it should make clear that nearly all of mainstream monetary theory as applied to central banking is nearly worthless, as is for instance the infamous money multiplier fable and the presumed causal relationship running from bank reserves at the central bank to price inflation.
Also, while central bankers simply did not know that a crisis was going to hit but did good work (in my opinion) in preventing an implosion of the financial system, there is simply no need to congratulate them for having purchased government debt such as as done by Paul McCulley here and as done by Adair Turner here at the recent INET conference. Their arguments sound something like: central banks prevented a deflation of prices by purchasing government debt!
SMP
A qualification needs to be made in the above analysis on the purchases of Euro Area governments’ debt by the Eurosystem under the ECB’s Securities Markets Progam (SMP). Here some government debt markets have/had the potential to become “dysfunctional” (ECB’s phrase) and NCBs purchase(d) government bonds in the secondary markets to prevent government bond yields from rising forever as a result of a self-fulfilling prophecy of financial markets and its inability to absorb government debt because of suspicions that some governments could become insolvent in the long run. This is useful because it just postpones the day of reckoning or buys some time to reach an economic state of lower activity to keep some Euro Area nations’ net foreign indebtedness in check.
The ECB website and communications stress that these operations are being “sterilized” and hence keeps price stability in check but the explanation is right if there is a Monetarist causality from money to prices!
I got my copy of Monetary Economics by Wynne Godley and Marc Lavoie yesterday. I know some people were waiting for the second edition of the book, and had postponed their purchase to get the newer edition – so they can get it now!
There aren’t any changes in this edition – except for correction of some typos and that this edition is a paperback while the first one was hardcover. I already knew this as Marc Lavoie told me “don’t buy it” – but of course how can I not!
One thing I noticed is a nice summary by Wynne Godley which he wrote after the first edition was published.
Here’s an autograph from Marc Lavoie I got last year in May – live to tell!
I hope I live up to it 🙂
The first time I saw something called the Transactions Flow Matrix in a Levy Institute paper, I rushed to buy the book. When I started reading it, it became clear that nobody has ever come close to it! After a while – and solving the models on a computer gives one greater intuition – it slowly started becoming clear to me why so much effort has been put in.
Wynne Godley always wanted to write a textbook to help others understand Cambridge Keynesianism, as he often thought that while top economists from Cambridge knew how economies work together, they never attempted to share this knowledge. I think his aim was also to sharpen his own knowledge and to think of scenarios which one may not be able to foresee using simple arguments.
With this aim, he made a first attempt with his partner at “New Cambridge”, Francis Cripps.
I really like this from the book’s introduction:
… Our objective is most emphatically a practical one. To put it crudely, economics has got into an infernal muddle. This would be deplorable enough if the disorder was simply an academic matter. Unfortunately the confusion extends into the formation of economic policy itself. It has become pretty obvious that the governments of many countries, whatever their moral or political priorities, have no valid scientific rationale for their policies. Despite emphatic rhetoric they do not know what the consequences of their actions are going to be. Moreover, in a highly interdependent world system this confusion extends to the dealings of governments with one another who now have no rational basis for negotiation.
This was a great book but didn’t receive much attention except for a small group who thought (rightly!) it was a work of genius. He wanted to do more and so we see him mention in an article on him – praising his prescience on writing the fate of the British economy on the wall in the 70s and the 80s. Here’s from the Guardian:
… What I’m doing is abolishing economics as currently understood, conducting an enormous sanitary operation upon a very clogged profession. I’m going to push a dose of salts through that system. It is a ruthless application of logic and accountancy to macroeconomics.
(click to enlarge and click again)
When Wynne Godley lost the partnership of Francis Cripps (whom Wynne called the smartest Economist he ever met), he was forced to do a lot of things himself and probably felt somewhat alone. After writing some amazing papers in the 1990s, he needed someone like Cripps to write a book. Fortunately he met Marc Lavoie and they collabrated for many years in writing papers and articles and finally the book.
Marc Lavoie recalls the memories in this article from the Godley conference last year.
In an article A Foxy Hedgehog: Wynne Godley And Macroeconomic Modelling – reviewing the book and Wynne Godley’s models, Lance Taylor says:
The fox knows many things, but the hedgehog knows one big thing.
… Surely someone who puts so much effort into one complicated construct is more like Plato than Aristotle, Einstein than Feynman, Proust than Joyce.
The recent debates of Post Keynesians with Neoclassical/New Keynesians has highlighted that the latter group continues to hold Monetarists’ intuitions. Somehow the exogeneity of money is difficult for them to get rid of, in spite of their statements and rhetoric that money is endogenous in their models.
So there is an excess of money in their models and this gets resolved by a series of buy and sell activities in the “market” (mixing up decisions of consumption and portfolio allocation) until a new “equilibrium” is reached where there is no excess money.
Two-Stage Decision
While the following may sound obvious, it is not to most economists. Keynes talked of a two-stage decision – how much households save out of their income and how they decide to allocate their wealth. In the incorrect “hot potato” model of Neoclassical economists and their New “Keynesian” cousins, these decisions get mixed up without any respect for the two-stage decision. It is as if there enters an excess money in the economy from somewhere and people may consume more (as if consumption is dependent on the amount of deposits and not on income) till prices rise to bring the demand for money equal to what has been “supplied” (presumably by the central bank).
In their book Monetary Economics, Wynne Godley and Marc Lavoie have this to say (p 103):
A key behavioural assumption made here, as well as in the chapters to follow, is that households make a twostage decision (Keynes 1936: 166). In the first step, households decide how much they will save out of their income. In the second step, households decide how they will allocate their wealth, including their newly acquired wealth. The two decisions are made within the same time frame in the model. However, the two decisions are distinct and of a hierarchical form. The consumption decision determines the size of the (expected) end-of-period stock of wealth; the portfolio decision determines the allocation of the (expected) stock of wealth. This behavioural hypothesis makes it easier to understand the sequential pattern of household decisions.
[Footnote]: In his simulation work, but not in his theoretical work, Tobin endorsed the sequential decision that has been proposed here: ‘In the current version of the model households have been depicted as first allocating income between consumption and savings and then making an independent allocation of the saving among the several assets’ (Backus et al. 1980: 273). Skott (1989: 57) is a concrete example where such a sequential process is not followed in a model that incorporates a Keynesian multiplier and portfolio choice.
Constant Money?
So even if one agrees that loans make deposits, there is still a question of deposits just being moved around and the (incorrect) intuition is that someone somewhere must be holding the deposit and hence similar to the hot potato effect. The error in this reasoning is the ignorance that repayment of loans extinguishes money (meant to be deposits in this context).
Nicholas Kaldor realized this Monetarist error early and had this to say
Given the fact that the demand for money represents a stable function of incomes (or expenditures), Friedman and his associates conclude that any increase in the supply of money, however brought about (for example, through open-market operations that lead to the substitution of cash for short-term government debt in the hands of discount houses or other financial institutions), will imply that the supply of money will exceed the demand at the prevailing level of incomes (people will “find themselves” with more money than they wish to hold). This defect, in their view, will be remedied, and can only be remedied, by an increase in expenditures that will raise incomes sufficiently to eliminate the excess of supply over the demand for money.
As a description of what happens in a modern economy, and as a piece of reasoning applied to situations where money consists of “credit money” brought about by the creation of public or private debt, this is a fallacious piece of reasoning. It is an illegitimate application of the original propositions of the quantity theory of money, which (by the theory’s originators at any rate) were applied to situations in which money consisted of commodities, such as gold or silver, where the total quantity in existence could be regarded as exogenously given at any one time as a heritage of the past; and where sudden and unexpected increases in supply could occur (such as those following the Spanish conquest of Mexico), the absorption of which necessitated a fall in the value of the money commodity relative to other commodities. Until that happened, someone was always holding more gold (or silver) than he desired, and since all the gold (and silver) that is anywhere must be somewhere, the total quantity of precious metals to be held by all money-users was independent of the demand for it. The only way supply could be brought into conformity, and kept in conformity, with demand was through changes in the value of the commodity used as money.
[boldening: mine]
from Nicholas Kaldor wrote a major article in 1985 titled How Monetarism Failed (Challenge, Vol. 28, No. 2, link).
In his essay Keynesian Economics After Fifty Years, (in Keynes And The Modern World, ed. George David Norman Worswick and James Anthony Trevithick, Cambridge University Press, 1983), Kaldor wrote:
The excess supply would automatically be extinguished through the repayment of bank loans, or what comes to the same thing, through the purchase of income yielding financial assets from the banks.
Here’s the Google Books preview of the page:
click to view on Google Books
In his article, Circuit And Coherent Stock-Flow Accounting, (in Money, Credit, and the Role of the State: Essays in Honour of Augusto Graziani, 2004. Google Books link) Marc Lavoie showed how this precisely works using Godley’s transactions flow matrix. (Paper available at UMKC’s course site). See Section 9.3.1
The fact that the supply of credit and demand for money appeared to be independent
… has led some authors to claim that there could be a discrepancy between the amount or loans supplied by banks to firms and the amount or bank deposits demanded by households. This view of the money creation process is however erroneous. It omits the fact that while the credit supply process and the money-holding process are apparently independent, they actually are not, due to the constraints or coherent macroeconomic accounting. In other words, the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side.
So if households wish to hold more deposits, firms will have to borrow more from banks. If households wish to hold less deposits, they will purchase more equities (in the model) and hence firms will borrow lesser from banks and/or retire their debt toward banks.
Other References