Mike Woodford still does not understand ‘endogenous money’ (4 graphs)
Update. Below, I state that Biggs and Mayer should have mentioned Steve Keen, as they mimic his method. Oops. Michael Biggs reminded me by mail that Steve Keen actually was inspired by their work and that of Andreas Pick in stead of the other way around (and, by the way “has been typically good about referencing it“). I should have checked, this is the crucial Biggs-Mayer-Pick article.
from Merijn Knibbe
Mike Woodford has written a kind of master thesis about the Zero Lower Bound, the Liquidity Trap and all that. People like Paul Krugman and John Cochrane are very enthusiastic about it. Let’s assume that they are right and that it’s an apt summary of the present neo-classical state of the art. If so, the paper, though indeed a step ahead, also clearly shows the incoherent, ad-hoc character of neo-classical thinking.
Anybody who thinks about monetary policy should of course think about the monetary aggregates: the total amount of deposits, the total amount of cash, the total amount of “lending for house purchase” and the like. These variables are of course spelled out in detail by the flow-of-funds, a systematic, complete and estimated oversight of lending and borrowing per sector of the economy as well as per purpose. The Woodford paper shows that neo-classical thinking does not use this model and these data in a consistent way.
According to Woodford, central banks can, in a situation of a Zero Lower Bound (i.e. very low policy interest rates of central banks which can not be lowered further) either try to talk non-policy rates down (the recent Draghi example is already a classic) or to buy non-policy rates down (Quantitative Easing, balance sheet policies and the like). The ratio behind this is that lower non-policy rates will entice people and companies to lend and spend more, which will improve the economic situation. But will it? Let’s take a look at the Woodford paper.
1. There indeed is a little more coherence to the neo-classical ideas than there used to be…
The policy of the European Central Bank (ECB) is, though Mario Draghi steers it away from the most extremist “Robert E. Lucas style” versions of it, still heavily influenced by neo-classical thinking. As we know, neo-classical thinking is characterized by ad-hoc definitions of variables like the price level or ‘general equilibrium’. Compare some neo-classical articles with each other – and it will show that they often use entirely different definitions of inflation, prices or whatever (if these variables are defined at all!). This shows in ECB policy. The Harmonized Index of Consumer Prices (HICP) inflation metric targeted by the ECB is, as a policy variable, rather ad-hoc. It’s a specific kind of consumer price index which leaves out, among other things, prices of investments. Woodford however proposes Nominal GDP targeting instead of HICP-inflation targeting, therewith leaves the concept of general equilibrium and implicitly uses the GDP deflator as a target variable (see his graphs). This is not consistent with neo-classical thinking (which, again, does not have a clear definition of the price level) but it is of course consistent with NGDP targeting and, as the GDP-deflator is quite a bit broader that the HICP, as a target variable quite a bit better than the HICP-index. These differences are not trivial (graph 1): differences can be as large as 2% (or, in the USA around 1980, even 4%).
2. But we’re not there yet: the Irish liquidity abyss. Even then, incoherence-problems remain. Let’s take Ireland as an example. As we know, Ireland experienced a housing and building bubble. Do not underestimate the extent of the bust: value added of construction went down with about 85%…. See graph 2.
However – the devil is in the statistical details. The graph shows value added which is, looking at it from the income side, about equal to: wages+profits/losses+interest. The data are from the recent 2011 Irish national accounts (table 2, page 3). And these show that value added in construction in 2011 was caused by +3,729 millions of compensation of employees (read: wages) and -1,835 millions ‘other’ (read: mainly losses). Yes, losses in construction were about 50% of the wage bill… No conceivable short- or long-term interest rate will solve such problems. This is not a liquidity trap, it’s a liquidity abyss, a void. Central banks are not able to solve such problems but more importantly: such problems are hidden by aggregate nominal GDP (not the same as aggregate expenditure, by the way). One can therewith doubt the relevance of GDP targeting – especially in extreme situations when a high quality compass is needed most. But the irrelevance of low-interest rates in countries like Ireland and Spain is not my main point. My main point is that neo-classical thinking about these rates, money and prices is inconsistent and ad-hoc – and a more consistent analysis of thee variables might, to an extent, have led to policies which, to an extent, might have prevented the Irish bubble (to avoid misunderstandings: I do favor low interest rates at the moment).
3. The flow-of-funds show that low interest rates can lead to an increase of money – but that this increase is not always used to increase spending on new stuff. Which means that we should not just look at even the GDP-deflator but at asset price inflation too.
Let’s again take the Irish example and use the Irish flow-of-funds, as compiled by the Irish central bank (Source, click on the links at the end of the pdf). Graph 3 clearly shows that quite a lot of lending/money-growth in Ireland was caused by an increase in “lending for house purchase”:
And as we all know, “loans for house purchase” are not just used for buying new houses (which show up as “production” in the nominal GDP) but also to buy existing houses. And this might very well lead to runaway asset-price inflation (and subsequent deflation), as happened in Ireland (graph 4).
The point: interest rate policies and the like do not only influence nominal GDP and prices and production of new stuff. They also influence asset prices. A consistent monetary model has to take account of this: not all money is created equal. We do not just have to look at nominal GDP but at asset prices and at asset-prices related and induced lending and borrowing and growth of the stock of money, too. See also this recent Voxeu article by Biggs and Mayer about the inconsistency of Central Bank thinking (
the authors by the way might have mentioned Steve Keen, as they mimic his method of analysis see the update above). The Woodford ideas, though a necessary step away from the concept of neo-classical General Equilibrium and ill-defined target variables like the HICP, still does not do this. They are still not yet based upon a systematic and coherent definitions of prices, monetary aggregates, sectors or purpose of lending and borrowing – definitions (and accompanying statistics!) which are readily available.