“Modern Market” Monetarism?

by Mario Rizzo

Douglas Irwin, a very fine economist at Dartmouth College, has a very puzzling opinion piece in yesterday’s Financial Times. The root of the puzzle is that Irwin seems to accept what I consider the naïve monetarist view, yet calling it by a new name “market monetarism,” that the effectiveness of monetary policy largely revolves around portfolio adjustment effects that are induced by an increase in real balances. (Isn’t this warmed over Pigou, and 1970s monetarism?)

What seems to be new is the “Divisa monetary indexes” which weight the different components of the monetary aggregates by their monetary services. In principle, this is what Milton Friedman talked about in his course “Money: The Demand Side” in the early 1970s. He said then that he thought it would be a good idea to weight the various components of the money supply by their “degrees of moneyness.” He did wonder, as I recall, if these weights would be stable over time.

Now, by this new measure, monetary policy has been tight. In fact, the money supply is no higher today than in early 2008. We must not confuse the level of interest rates with the degree of tightness of policy. Interest rates are low but money is tight. The policy conclusion seems to be that QE3 is (or will be) too little.

What view of the monetary mechanism does this imply? Changes in the money supply (credit?) affect the real economy via spending and since employment is low, more spending will boost this and economic growth. Spending on what? Hey, it doesn’t matter. Spending is spending. (We are all Keynesians now?!)

Does it not matter that in an extremely low interest-rate environment that spending is likely to be channeled in directions different from where they would be in a higher interest-rate environment? Movements of money toward higher risk assets, to the stock market, to real-estate markets in other countries and so forth are important. How much of this is sustainable?

The “market monetarist” paradigm, as explained by Professor Irwin, focuses on a weighted monetary aggregate in the same way that many economists focus on the price level. If neither is changing very much then nothing much of interest is happening. But I guess this is what aggregate economics is all about.

What I find especially confusing is that market monetarists agree with Keynes that while relative prices of commodities matter, the price of credit – the interest rate – doesn’t allocate anything to anything. Now the first point our market people better believe, or else the Ghost of Friedman will drive them insane. But the second is a real puzzle for a market (fill-in-the-blank).

I know about liquidity traps and all that. But that is first-year Keynesian macroeconomics.

The only thing new here seems to be the weighted monetary aggregate. But, new or old, I cannot believe how simplistic this is.

P.S. Can I make consulting money with this kind of stuff?

14 thoughts on ““Modern Market” Monetarism?

  1. I agree that Doug Irwin is a very fine trade economist. The FT piece strikes me as warmed-over Scott Sumner, however.

    Interest rates are the most important prices in a capital-using economy. I don’t know how one can call a theory “market” anything if it wants interest rates to be subject to manipulation by a government instrumentality.

    Milton Friedman disparaged using nominal interest rates as an indicator of monetary ease or tightness. I don’t know any traditional monetarist who is indifferent to a prolonged period of negative real interest rates.

    All of the traditional monetarists I know are strongly opposed to Bernanke’s policies. To name just a few, they include Allan Meltzer, John Taylor, and, while she was still alive, Anna Schwartz.

    I cannot understand what is either “market” or “monetarist” about this theory.

  2. “the price of credit – the interest rate – doesn’t allocate anything to anything. ”

    Mario – who says that is the case? The components of interest rates are widely taught and accepted (e.g. liquidity preference, inflation expectations etc). Interest rates are a price like any other. The fact that the market clearing interest rate is negative today says more about the failure of institutions than it does about the role of interest rates.

    IMO – tightening money from 2006-2008 caused a collapse in inflation/NGDP expectations first. Second, the lasting damage to portfolios of imminent retirees (and similar profiles) has greatly increased liquidity preferences. Effectively the only things that will allow ‘normal’ interest rates to prevail are: some sort of level targeting; time and growth.

  3. “the price of credit – the interest rate – doesn’t allocate anything to anything. ”

    Mario – who says that is the case?

    You do, cthorm. You talk about the components of the interest rate–“liquidity preference, inflation expectations, etc.” You don’t say anything about how interest rates allocate resources.

    If I tell you the constituents of an apple pie, I haven’t demonstrated my understanding that apple pies help coordinate the structure of production. Same with the Keynesian and market monetarist treatment of interest rates (at least in the blogosphere discussions I’ve seen).

  4. A problem I see with simplistic monetarism is that its proponents remove it from any possibility of analysis. The writer whose initials are RA over at the Economist blog Free Exchange champions Sumner’s economics. I have learned most of what I know about it from him.

    Rabid monetarists like RA and Sumner follow Friedman’s gas pedal analogy as if it were revealed from heaven, much like Krugman obsesses over his baby-sitting co-op. Depressing the gas pedal of a car is the analogy of interest rates and I guess gas flow represents money. Friedman said you can’t tell from the position of the gas pedal whether the supply of gas is sufficient or not. Only the speed of the car (equivalent to gdp I guess) matters. If the goal is to maintain 60 mph, then sometimes the gas pedal has to be depressed more and sometimes less.

    If climbing a hill, (a gdp depression) the pedal needs to be depressing more. If cruising down hill, the pedal needs less depressing.

    So how does one test the theory empirically? You can’t. It assumes that money makes the wheels on the bus go round, so if the wheels aren’t turning then there isn’t enough money. How much money is enough? Depends on the obstacles. Greater obstacles require greater amounts of money. If money pumping didn’t work in the past, then it obviously wasn’t enough.

    Of course, that violates the principle of diminishing marginal returns, but who cares about micro economics.

  5. Bob – No, I don’t. I didn’t say anything about allocation, just about the theoretical composition of interest rates. But interest rates are a price like any other and obviously influence allocation. Interest rates influence the allocation of capital and consumption over time, and also between people with different capital/consumption requirements (I won’t go so far as to say ‘determine’ because I think fundamental factors like demographics & culture are also important).I don’t see how that is inconsistent with market monetarism, in so far as ‘market monetarism’ is a coherent school of thought; their only really uniting idea is that monetary policy should be non-discretionary and promote a constant value of currency relative to nominal income.

  6. I wait every day for a post by Prof. Rizzo or from Dr. O’Driscoll. The daily letdown is discouraging.

  7. I am just being lightheartedly selfish. You are my favorite blogger/commentor. I am following your work closely at Cato.org.

    Please, just keep up the great work!

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