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description= Commentary on monetary policy in the spirit of R. G. Hawtrey;
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fiscal theory therefore seem contingent on blurring the distinction between inside and outside money outside money is created either by the government or the central bank instruments convertible into outside money such as commercial bank deposits and treasury debt are alternatives to outside money and may therefore affect the demand to hold outside money so even if treasury debt is classified money it is properly classified as inside not outside money as long as the demand of the public to hold high powered money is distinct from its demand to hold other assets the monetary authority has sufficient leverage over the price level to conduct monetary policy if there s no distinct demand for outside money aka the monetary base then differences during a given time period between the quantity of outside money demanded by the public and the stock created by the monetary authority have no macroeconomic price level consequences but if there is a distinct demand the stock of outside money contrary to the presumption of the fiscal theory isn t a net liability of the monetary authority or the government it s an asset constituting part of the net wealth of the community nevertheless cochrane is right that financial innovation over time has steadily increased the importance of inside money compared to outside money a process that nineteenth century monetary economists notably the currency and banking schools were already trying understand as bank deposits began displacing banknotes as the primary monetary instrument used to mediate exchange and to store liquidity continuing financial innovation and the rapid evolution of electronic payments technology especially in this century have again transformed how commercial and financial transactions are executed and how households make purchases and store liquidity the fiscal theory described by cochrane therefore provides insight into our evolving and increasingly electronic monetary system while cochrane emphasizes the payment of interest on reserves held by banks at rates equal to or greater than the yields on short term treasury debt an alternative arrangement in which the fed paid little or no interest on bank reserves could also operate efficiently by means of an overnight interbank lending market the amount of reserves held by banks would fall drastically as the banking system adjusted to operating with minimal reserves sufficient to meet the liquidity needs of the banking system with the fed discount window available as a backstop thus in our modern monetary system the fed can either operate with a large balance sheet of treasury and other highly liquid debt while paying competitive interest on the abundant reserves held by banks or with a small balance sheet while treasuries and other highly liquid debt are held by banks holding only minimal reserves the size of the fed balance sheet per se is relatively insignificant as a matter of economic control what matters is that by paying competitive interest on bank reserves held at the fed the fed has rendered itself as cochrane correctly argues incapable of conducting an effective monetary policy awash in reserves banks have become unresponsive to changes in the fed s policy rate by significantly reducing or eliminating interest on bank reserves the fed would not only shrink its balance sheet it would increase if only to a limited extent the effectiveness of monetary policy by making banks more responsive to changes in its policy rate however given that most banks can operate effectively with reserves that are a small fraction of their deposit liabilities cochrane may be right that the fed s monetary policy in the modern system would still be limited because changes in the fed s interest rate target would induce only small adjustments in banks lending practices and policies while it s true that the huge stock of currency now in the hands of the public likely held mostly abroad not in the us would continue to provide a buffer against inflationary or deflationary fiscal shocks the demand for currency is likely not very responsive to changes in interest rates so that fed policy changes would have little or no macroeconomic effect on the demand for us currency indeed any effect would likely be in the wrong direction an increase in interest rates for example tending to reduce the amount of currency demanded thereby reducing the dollar exchange rate and raising not reducing inflation almost 40 years ago in my book free banking and monetary reform written in the wake of 1970s inflation and the brutal volcker disinflation i argued for a radical monetary reform after discussing the early manifestations of the financial innovation then just starting to transform the monetary system i proposed a free banking regime in which competitive banks would pay interest on demand deposits which was then prohibited an important impetus for financial innovation was then to avoid the implicit taxation of bank deposits imposed by legal reserve requirements the erosion of the tax base by financial innovation caused reductions in and eventual elimination of those reserve requirements as i pointed out p 169 as long as there is a demand for high powered money the fed can conduct monetary policy by controlling either directly or by using an interest rate target as its policy instrument indirectly the quantity of high powered money since there is a demand for high powered money apart from the demand to hold required reserves reserve requirements are not logically necessary for conducting monetary policy nor is control over the overall quantity of money necessary for the fed to operate a monetary policy all it needs as noted is to control the quantity of high powered money and it would have that control even if required reserves were zero but as we just saw the stability of the demand for high powered money is also important if the demand for required reserves is more stable than the demand for other components of high powered money reducing demand for required reserves makes the overall demand for high powered money less stable and as i pointed out earlier the less stable the demand for high powered money is the greater the risk of error in the conduct of monetary policy will be so although the fed could even with a greatly reduced stock of bank reserves as a basis for conducting monetary policy still control inflation the risk of destabilizing policy errors might well increase one response to such risks would be to reimpose at least a modest reserve requirement thereby increasing the stock of bank reserves on which to conduct monetary policy the effectiveness of reimposing legal reserve requirements in the current environment is itself questionable but in my book i proposed adopting earl thompson s idea inspired by irving fisher s compensated dollar plan for a labor standard stabilizing a wage index using the price of gold as a vehicle for a system of indirect convertibility see chapter 11 of my book for details an alternative for achieving more or less the same result might to adapt thompson s proposal to stabilizing nominal gdp as scott sumner and others have been advocating since the 2008 financial crisis so despite my theoretical reservations about the fiscal theory of the price level it seems to me that in practice we have a lot in common my article ralph hawtrey a forgotten pioneer of macroeconomics has been published in economic affairs published june 27 2024 r g hawtrey uncategorized 2 comments the published version of the article is now available on the economic afairs website https onlinelibrary wiley com toc 14680270 2024 44 2 here s the abstract this article considers the contributions of ralph hawtrey to monetary theory and macroeconomics focusing on his monetary business cycle theory and his monetary explanation of the great depression unlike milton friedman s us centred explanation of the great depression hawtrey s was focused on the international gold standard that collapsed with the outset of world war i and the attempt to restore it hawtrey urged that after restoration of the gold standard increased monetary demand for gold be restrained to prevent gold appreciation and deflation but deliberate french gold accumulation in 1928 and interest rate increases by the federal reserve led to the ruinous deflation foreseen by hawtrey the article then critically evaluates recent discussions of hawtrey s contributions in books by hetzel 2023 and mattei 2022 an earlier version of the paper is available on ssrn https papers ssrn com sol3 papers cfm abstract_id 4766602 my new paper on hawtrey is available on ssrn published april 18 2024 clara mattei great depression milton friedman robert hetzel uncategorized 1 comment last fall and early winter i posted a series of four blogposts here here here and here about or related to ralph hawtrey as i was trying to gather my thoughts about an essay i wanted to write about hawtrey as a largely forgotten pioneer of macroeconomics who has received the attention of two recent books by robert hetzel and clara mattei after working on and off on the essay in the winter and spring receiving helpful comments and advice from friends and colleagues i posted a draft on ssrn here is the abstract hawtrey_paper i conclude the paper as follows hawtrey s discussion of the fear of inflation refutes the key contentions about hawtrey made by hetzel and by mattei first that hawtrey believed that monetary policy was powerless to increase aggregate demand and stimulate a recovery from the great depression hetzel and second that hawtrey was instrumental in designing a treasury policy agenda of austerity using deflation and unemployment to crush the aspirations of the british working class for radical change providing a model emulated by fascists and authoritarians upon coming to power mattei a slight non substantive revisions of the essay is now being reviewed by ssrn before replacing the current version now available after some further revisions the essay will appear later this year as an article in economic affairs t c koopmans demolishes the phillips curve as a guide to policy published february 4 2024 arthur burns irving fisher t c koopmans wesley c mitchell 2 comments tags cowles commission national bureau of economic research nobel laureate t c koopmans wrote one of the most famous economics articles of the twentieth century measurement without theory a devastating review of an important and in many ways useful and meritorious study of business cycles by two of the fathers of empirical business cycles research arthur f burns and wesley c mitchell measuring business cycles burns was then the head of the national bureau of economic research which had been founded by mitchell burns s mentor to promote the empirical study and measurement of business cycles koopmans who was then head of the cowles commission another foundation dedicated to the study of business cycles but with a theoretical rather than a purely empirical orientation explained why attempting to gather empirical facts about business cycles and to measure aspects of business cycles in an atheoretical manner would fail to produce knowledge that useful for trying to understand business cycles as a characteristic feature of modern economic activity or for devising policies mitigate their undesirable effects koopmans s review a rhetorical masterpiece brilliantly deploying his analytical skill and erudition as a ph d physicist compared the work of burns and mitchell to pre newtonian attempts to develop theories of planetary motion through the accumulation of data from planetary observations largely shut down the program of the national bureau as a center for business cycle research though it has continued to function usefully as a sponsor of a variety of important research efforts on business cycles and other fields of study whether the shift in emphasis from atheoretical empirics and data accumulation to theoretical research was a positive development is still controversial but that discussion is not the point of this post all i want to do here is to reproduce a single paragraph from koopmans s review in which without mentioning the phillips curve which had still not been discovered apologies to irving fisher who almost completely unnoticed actually discovered it about 30 years before phillips did beautifully explains why the phillips curve cannot be used as a guide to conducting monetary policy or countercyclical policy of any kind economic theories are based on evidence of a different kind than the observations embodied in time series knowledge of the motives and habits of consumers and of the profit making objectives of business enterprise based partly on introspection partly on interview or on inferences from observed actions of individuals briefly a more or less systematized knowledge of man s behavior and its motives while much in these theories is incomplete and in need of reformulation and elaboration particularly in regard to behavior over time under conditions of uncertainty such theory es we have is an indispensable element in understanding in a quantitative way the formation of economic variables for according to that theory the relevant economic variables are determined by the simultaneous validity of an equal number of structural equations of behavior of law or rule of technology the very fact that so many relations are simultaneously valid makes the observation of any one of them difficult and sometimes even impossible for any observed regularity between simultaneous and or successive values of certain variables may have to be ascribed to the validity of several structural equations rather than any one of them the mere observation of regularities in the interrelations of variables then does not permit us to recognize or to identify behavior equations among such regularities in the absence of experimentation such identification is possible if at all only if the form of each structural equation is specified i e in particular if we can indicate the set of variables involved in each equation and perhaps also the manner in which they are to be combined in each case a preliminary study of the system of structural equations held applicable is required to decide whether the specifications regarding any particular equation are sufficiently detailed to permit its identification without such identification measurement of the structural equation involved is not possible and should therefore not be attempted one might object why should measurement of the behavior equations of consumers workers entrepreneurs be necessary if observed regularities are due to the simultaneous validity of several behavior equations these regularities will persist as long as each of the underlying unknown behavior patterns persists however there are important arguments to counter this objection sheer scientific curiosity still urges us on to penetrate to the underlying structural equations this c...
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