Category Archives: Monetary Theory

Keynes – The General Theory of Employment, Interest, and Money

Keynes – The General Theory of Employment, Interest, and Money

My undergrad macroeconomics teacher was an avowed Keynesian. Most of what he taught was in this book, except in the forms of Marshallian geometric analysis and Samuelsonian algebra. I could have saved 19-year old me a great deal of time and anguish by simply reading Keynes’ original, mostly verbal explanations of his ideas. In fact, that pedagogical experience was one reason I switched my undergrad major from economics to history, despite my much greater enthusiasm for economics. Depending on who teaches intro classes, economic ideas are sometimes taught more clearly outside of economics departments.

People often forget that Keynes worked from the same quantity theory of money framework his rivals Friedman and Hayek relied on—an insight I was never taught in undergrad, thanks in part to poor standard pedagogical practices.

Nearly all economists, regardless of ideology, agree that tinkering with the money supply can induce temporary booms and busts. Where they differ is that for monetarists and other free-market types, the fact that policymakers can mess with the price system does not imply that they should. There are tradeoffs a boom now comes at the price of a bust later. Picking up one part of the economy comes at the cost of dragging down other parts. Moreover, unintended consequences can be unpredictable, and harder to manage than the original problems.

Keynes and many of the economists he has influenced instead work with idealized models of economics and government. Economists, using increasingly sophisticated techniques, are increasingly able to foresee and adapt to changing circumstances and unintended consequences to maintain economic stability. Fiscal and monetary policies will never be perfect, but with careful management they can outperform unmanaged markets. Also in this model, politicians actually listen to economists. Even more fantastically, politicians use their boom-and-bust power in the public interest. They do not use it to influence their electoral prospects, or give favors to rent-seekers.

On the positive side, Keynes’ remarks about animal spirits remain insightful, though underappreciated. Here Keynes shared important common ground with economists from Adam Smith on down to his rough contemporaries such as Philip Wicksteed, Frank Knight, and F.A. Hayek, who all emphasized human psychology in their works over formal modeling.

Keynes’ followers pursued a different path after Paul Samuelson, preferring instead to confine themselves to quantifiable models, and to study Homo economicus rather than Homo sapiens. The old joke about Keynesians being more Keynesian than Keynes ever was is often true. Fortunately, the behavioral economics movement has done much to revive animal spirits in the wake of MIT-Harvard-Princeton’s sterilizing the profession, though many of them forget that human frailties also apply to policymakers and the policies they make.

This is not Keynes’ fault. But his unintentional legacy has harmed economics as a discipline, which has missed out on important insights and discoveries by largely walling itself off from other, less quantitative disciplines for several decades. Keynesian models have also acted as enablers for policymakers eager to hear justifications for things they want to do anyway, and for excuses to forget that can does not always imply ought.

CEI Press Release on 4.1 Percent GDP Growth in Q2 2018

Cross-posted from The short version: this week’s growth report is good news, but the long-term outlook is less rosy.

The Department of Commerce announced Friday morning the U.S. economy grew by 4.1 percent in the second quarter of 2018.

CEI Vice President for Strategy Iain Murray said:

“Today’s growth numbers are yet more proof that supply-side policies work. Freeing up labor and capital by reducing the burden of government regulation and taxation will lead to high growth, more opportunity, more innovation, and lower unemployment. This rising tide will lift all boats, so it is important both that these policies continue and no new policies, like trade barriers, contradict them.”

CEI Fellow Ryan Young said:

“Four percent economic growth is wonderful news. An economy can double in size in just 18 years at that pace. While President Trump deserves much of the criticism he gets for his economic policies, his slowing of regulatory growth and some short-term benefits from his income tax cut probably helped boost growth.

“The long-term outlook is less sanguine. The extra debt from the tax cut will have to be repaid, dampening growth. And as the economic effects from his tariffs begin to be felt, growth could noticeably slow as soon as this year. Most troubling are Trump’s rumblings about exercising more control over the Federal Reserve, which is supposed to be politically independent. If there is anything economists across the political spectrum hold sacred, it is the price system. Politicians toy with it at our peril, as Herbert Hoover and Richard Nixon found out.

“If President Trump restrains his impulses, the near future will be as bright as today’s report. If not, rough economic times are ahead.”

Raise, Don’t Level: New CEI Papers on Inequality and Poverty Relief

Economic inequality is one of today’s defining issues. How to address it? Iain Murray and I offer an unconventional approach in a new two-part CEI study, released today. The first part frames the issue. The title sums it up well enough: People, Not Ratios: Why the Debate over Income Inequality Asks the Wrong Questions. The second part,The Rising Tide: Answering the Right Questions in the Inequality Debate, outlines a concrete policy agenda to make the poor better off.

Anti-poverty activists routinely fret about the ratio between a CEO’s salary and her lowest-paid employee’s, or how the top one percent’s ratio of national income compares to the bottom one percent’s. Instead of mathematical ratios, we encourage activists to focus on human beings. Again, we plead: focus on people, not ratios.

Ratio-obsessed activists from Thomas Piketty to Naomi Klein ignore some obvious questions due to their monomania:

  • How are the poor actually doing?
  • Is their economic situation improving over time?
  • What policies can make the global poor better off over time?

We seek to fill these disappointing gaps. According to nearly all available data, poor people are better off than ever before in human history—keep at it, then! There is still lots to do, but ignoring the accomplishments people have already made, and what can make more accomplishments possible, only hurts the poor.

Over the course of the 20th century, infant mortality went down by more than 90 percent—just think of how many parents’ broken hearts have stayed whole thanks to modern technology and sanitary practices.

Life expectancy improved by 30 years during the 20th century. And that’s not the only type of length modernity has improved: from 1900 to 1950, the average American became three inches taller, thanks to better nutrition, food security, and health care. The process has only continued since then.

Even if it was only the top one percent that enjoyed zero infant mortality, lived a hundred years, and were all seven feet tall, their best efforts could not bias society-wide statistics nearly that much, despite their most conspiratorial plutocratic efforts. This is what mass prosperity looks like.

According to the Swedish economist Max Roser, since 1960 the number of people living in absolute poverty has declined from nearly two billion to about 700 million—a two-thirds decline. And this happened as total world population more than doubled! This is good news. Today’s most important task is to keep this great enrichment going, and to eliminate absolute poverty altogether.

The poor will never have as much as the rich—every curve has a bottom and a top ten percent, and always will. No changing that. But only the hardest heads deny that most poor people today live better lives than their parents or grandparents did—and that future generations can expect this wonderful trajectory to continue, if they’re allowed to.

This is both a reason to celebrate, and a reason to double down. Now that we haveasked the right questions about inequality, the second part of our study, The Rising Tide, seeks to answer them: what policies can continue to make the world’s poor better off?

There are a lot of answers. We don’t pretend to have all of them, but we offer a few. One is an honest price system: runaway-inflation countries such as Zimbabwe and Venezuela are universally poor. Keeping inflation in check and making sure prices convey honest information will help consumers and entrepreneurs make wise decisions that create value for people.

Affordable energy is another answer, allowing everything from clean home heating (natural gas is somewhat cleaner than dung and logs, especially indoors) to more and better transportation choices, which expands employment options.

Any aspiring entrepreneur needs access to capital—Dodd-Frank-style financial regulations openly insult every person trying to escape poverty. So do many governments’ resistance to granting formal property rights to their people.

Another answer—there really are a lot of them, and no single panacea—is occupational licensing reform. There is no legitimate reason for an interior decorator or a hair-braider to undergo hundreds of hours of training in something they already know how to do, in order to do for pay something they can do for free. Nearly a third of American workers require government permission to begin their day’s work. That is ethically wrong, and should be immediately reformed.

Inequality is a complicated issue. Properly addressing it requires both asking and answering the right questions. Ask how real-world people are doing, not abstract income ratios. And ask about policies that can help people escape poverty. The answers are numerous, and Iain’s and my papers do not pretend to have all of them.

But, we humbly submit, a general ethos of not stamping down on impoverished hands would be a good start. It would also be quite a change from current policy in the U.S. and many other countries.

For more, see our papers, People, Not Ratios: Why the Debate over Income Inequality Asks the Wrong Questions, and The Rising Tide: Answering the Right Questions in the Inequality Debate.

The Improvisational Fed, and Unpredictable Regulations

Improvisation can be a wonderful thing when performed by talented hands—Charlie Parker, Miles Davis, and the like. The Federal Reserve, especially for the past several weeks, has fancied itself an improvisational talent on that level. But like most humans, Janet Yellen is no Charlie Parker. They should consider a return to the Paul Volcker/early Alan Greenspan adherence to a defined rule. But that isn’t the end of the story—any substantive Fed reforms will fail unless they are coupled with a thorough program of regulatory reform reaching through the entire executive branch. This post will examine a few worthwhile Federal Reserve reforms, then some regulatory reforms, most of which have already passed the House.

The rest of the executive branch has a similar lesson to learn—more complexity and an ever-increasing stock of rules means less predictability and more uncertainty for businesses, investors, and consumers. Agencies’ increasing tendency to regulating through non-transparent “dark matter” means only makes the problem worse.

As far as the Fed goes, the point is not so much which rule a central bank should adopt, but that it must have a rule in the first place, and follow it consistently. Here are three possibilities.

One is a Taylor rule, which the U.S. Federal Reserve followed for the better part of the 1980s and 1990s, with good results. A Taylor rule raises interest rates when growth and inflation are high, and lowers interest rates when growth and inflation are low. In other words, if the economy looks like it might be overheating, the Fed automatically touches the brakes a little bit. And if it looks sluggish, the Fed pushes the gas pedal a little bit, by predictable, predefined amounts.

The Taylor rule can even be summarized in a single equation, making it easy for central bankers to know how they should react to a given set of economic conditions. The Taylor rule worked pretty well when the Fed was following it, but its attempts at managing the business cycle rub this analyst the wrong way—hubris at worst, spitting into the wind at best.

Another possibility that doesn’t have those problems is NGDP targeting, most famously advocated for by Scott Sumner. Instead of interest rates, NGDP targeting directly targets the money supply itself. If Nominal Gross Domestic Product (NGDP) goes up by 5 percent, then so does the money supply, in lockstep. It attempts to keep each dollar describing the same amount of wealth, which should result in stable, predictable prices. Some central bankers prefer having, say, a 2 percent inflation rate in perpetuity. Why someone would prefer such a thing is beyond me, but the NGDP targeting equation can easily be modified to build in a small inflation or deflation as bankers wish. The important thing, again, is not so much what the inflation level is, but that it is steady, and the Fed sticks to principle, even during a crisis.

There are also significant measurement problems with finding out exactly what GDP is at any given time, but an NGDP targeting rule is still far preferable to the Fed’s whim on any given day.

A third possibility is the Friedman rule, named for Milton Friedman. A Friedman rule deflates the currency at the same rate as the prevailing interest rate on government bonds. The goal is to make people indifferent about keeping money in their wallet, versus a savings account. This means people will make those allocation decisions based on economic efficiency, not the vagaries of inflation. Deflation is unsustainable in the long run, and central bankers are hyper-wary of deflation in general, ironically because of Friedman’s own work. He, along with Anna J. Schwartz, convincingly argued that rapid deflation was the Great Depression’s single largest cause.

Each of these rules—and there are others—has its own advantages and drawbacks. The larger point is that the Fed needs to follow some kind of rule, and stick to it. Its inept free-jazz improvisational approach makes entrepreneurs and investors skittish, and results in far less long-term investment.

Regulatory agencies have similar problems. Would you invest in a 30-year project if you had no idea if the EPA would confiscate your land, or if some other agency finds some obscure rule to kill your project? That’s why regulations to be simple and predictable.

Fortunately, a number of reforms are now winding their way through Congress. The REINS Act, as regular readers know, would require Congress to vote on all executive branch regulations with annual costs of more than $100 million.

The SCRUB Act could save nearly $300 billion per year if it works as planned. It would set up an independent commission to comb through all federal regulations, and send Congress a repeal package for an up-or-down vote, with the goal of trimming at least 15 percent from annual compliance costs, currently estimated at $1.9 trillion.

The ALERT Act would establish a one-in, one-out rule similar to what Canada has had for several years. If an agency wants to issue a new rule, it must first get rid of a similar dollar amount of old rules.

The Sunshine Act would rein in a practice called sue-and-settle, under which activist groups sue agencies for missing deadlines or not enforcing rules strictly enough. Since the agencies are often on the same side, and may in some cases be collaborating behind the scenes, they are only too happy to reach a settlement expanding the agency’s power and authority.

Other options include a regulatory budget, similar to the spending budget the federal government is supposed to issue each year. Each agency would have a “budget” of regulatory costs it is allowed to impose, and must prioritize its rule enforcement so it doesn’t exceed its cap. Finally, automatic sunsets for new regulations would automatically scrub old rules from the books unless Congress sees fit to renew them. This would prevent obsolete or harmful rules from becoming immortal.

The Fed’s improvisational approach does no favors to entrepreneurs, investors, or consumers. Nor does the increasingly arbitrary and capricious approach many regulatory agencies are turning towards. Just as the Fed should bind itself to a predictable and stable rule, so should agencies embrace reform to keep their regulations as simple and predictable as possible.

Economics Humor

fed rate hike of 2015

Click the image to enlarge.

Towards a Humbler Monetary Policy

Is it possible for opposite policies to both be wrong? Over at the Washington Examiner, I argue that it is. The U.S. is ending its quantitative easing program just as Japan is ramping its up. Those seemingly opposite policy paths are rooted in the same mistaken philosophy. I argue instead for a humbler monetary policy:

 Both Yellen and Kuroda should move their focus away from stimulus, exchange rates and constant tinkering, and toward stability, honesty and predictability in their price systems. Easing of $1.66 trillion has had almost no effect on the U.S. economy. How reality will stack up against the Bank of Japan’s predictions, no one knows.

Along the way there are discussions of Keynesian liquidity traps, the Taylor rule, NGDP targeting, and Bitcoin. The larger point is that central bankers are barking up the wrong tree. Instead of manipulating various economic indicators, they should concentrate on creating a stable, predictable, and honest price system that enables more investment, better investment decisions, and more innovation. Entrepreneurship, not interest rate tinkering, is what causes economic growth and mass prosperity.

Read the whole thing here; see also a facsimile of the print edition here, starting on p. 26.

No Triple Mandate for the Fed

In a recent speech, Fed Chair Janet Yellen sent a signal that the Fed might be considering expanding its mission to include reducing economic inequality. Seeing as the Fed already has a dual mandate, this would amount to a triple mandate. Over at the American Spectator, Iain Murray and I explain why that wouldn’t work as planned, and instead offer a humbler vision for the Fed:

 If there is a guiding principle to effective Fed policy, it is that simplicity is beautiful. A complex, contradictory, unpredictable, and unstable triple mandate does the poor no favors. If the Fed seeks to maintain a stable, predictable, and honest price system as its sole monetary policy objective, it will do more to lift people out of poverty than any double or triple mandate.

Read the whole thing here.

How Regulations Cause Inflation

Over at, I have a short piece explaining how regulations cause inflation:

Imagine a simplified economy that consists of just two things: 100 dollars and 100 apples, with the price of an apple being one dollar each. If new regulations pass that make it harder to produce apples, the next year there are only 90 apples produced. Their price goes up from $1 to $1.11.

Read the whole thing here.

OC Register on Yellen as Fed Chair

I didn’t see this until today, but earlier this month the Orange County Register was kind enough to cite me in an editorial about Janet Yellen shortly after her confirmation vote.

Two Cheers for Tapered Quantitative Easing

The Federal Reserve made waves when it announced it was rolling back its quantitative easing program. Looking more closely, one finds it’s actually a very minor policy change, moving from $85 billion to $75 billion per month. Over at the Washington Times, I encourage the Fed to taper back the rest of the QE program, and point out that the Fed may be sending a subtle political message about how presumptive incoming Fed Chair Janet Yellen will approach inflation:

Johns Hopkins University economist Steve Hanke argues that Ms. Yellen is more hawkish on inflation than her dovish reputation suggests. The tapering announcement seems to confirm Mr. Hanke’s thesis. As the Fed’s current vice chairman, she already has significant say on Fed policy. She has publicly supported the new Basel III reserve banking standards, which would require banks to hold more of their capital in reserve. That would decrease the amount of money in circulation — the exact opposite effect of quantitative easing — and help keep inflation in check.

There are plenty of problems with the Basel III standards, but this would be one positive effect. Read the whole thing here.