Home > The Economics Profession > Why Money? A light-hearted response to Paul Davidson

Why Money? A light-hearted response to Paul Davidson

from Peter Radford

Say what?

I know, you all think I am nuts. Not content with bashing away endlessly at my fixation with Coase and his simple question, now I am asking an even more ridiculous one.

Why money?

Actually it’s not my question, but was posed by that sly Paul Davidson in a comment on one of my posts last week. Davidson is the patron saint and protector of American Keynesian economics, so he darned well knows the answer. 

The question deserves a response so that you, poor readers, can once again marvel at the insanity that is orthodox economics.

You see, just as there are no firms in orthodoxy, there is no money.

Gulp.

Is this for real? This is economics after all.

Obviously I simplify. Greatly. But this is for fun. And here is not the place for a lengthy discussion. Still: you should all be aware of the deep problem that money poses for economics.

Remember all those neat charts about supply and demand? They have price on one axis and quantity on the other. Did you ever focus on why it was “price” and not dollars [pounds, euro, yen etc]? It’s because orthodox economics conducts its enquiries in a world of relative values. A price is a ratio between things to be exchanged. This ratio yields a “real” relationship that needs no mediation. And money is a mediating device. It isn’t needed in a “real” world. Not to be confused with the real world where you and I live.

Orthodox economists are comfortable with this absurdity because they want to study the effects of moving the relative values about. Money would get in the way. Just in case you think I am nuts, allow me to point you to the textbook on my shelf: David Kreps inestimable “A Course In Microeconomic Theory”, a worthy representative of its ilk. This is a 800+ page tome. Its entire second section is devoted to something called “the price mechanism”. Its table of contents has not one – not one – reference to money. Not one. This is a microeconomics textbook that is supposed to describe the magical powers we all rely upon in the free market. Money makes dramatic appearance in macroeconomics textbooks. On my shelf I have Olivier Blanchard’s “Macroeconomics”. Its table of contents is littered with references to money. Most of these references appear to be attempts avoid the subject. Thus money “neutrality” gets a nod. So does a nice section describing how the Fed screwed up the money supply and caused the Depression – well I’m being harsh, but it sure reads that way.

Anyway. You get the picture. At one end of economics, the micro end, where the holy grail is revealed to us all, money is persona non grata. At the other it gets a lot of air, albeit begrudgingly and usually as something that causes problems, as in inflation – “too much money chasing too few goods”. Who knew money was this difficult?

This is even more confusing when you realize that one of the great fads of recent economics has been to make sure that the macro end of things conforms with its micro foundations. Money is not in the foundation, but it pops up – from thin air? – at the macro end.

How come?

Well, it exists in the real, as opposed to the “real” world. So even orthodox economists have to deal with it. Which they don’t do very well.

And why is Professor Davidson rubbing our noses in this little conundrum?

Look again at the Blanchard table of contents, and you see a separate entry: “money illusion”. What, money is an illusion? Not really, except in orthodoxy. The problem is that regular people, like you and me, are not too good at those relative values. In fact we tend to get muddled up when money is in the picture. When the value of things is expressed in money and not in ratios to other things, we tend to lose sight of the “real” world in our real world. We get carried away with the dollar signs and act irrationally. Thus  – and Keynes came up with the phrase – we suffer from an illusion. And this illusion can play havoc with the economy because it induces odd behavior. The kind of behavior that undermines the neat, well oiled and perfect machine called the free market.

In fact it upends the entire edifice. Or what’s left of it after Coase has had his way.

Having tossed this grenade into orthodoxy Keynes had the nerve to go further: he said that money can take on all sorts of other roles too. It doesn’t just act as oil to smooth out exchange. Sometimes we – gulp again – save it. Why would we do such a thing? Doesn’t orthodoxy teach us we know everything in the future? Yes it does. But we still, silly us, save as a hedge against uncertainty. We store it for future use knowing that the future is full of nasty surprises. There are no nasty surprises in orthodoxy. There are lots of them in a Keynesian world. Indeed, the entire Keynes structure is hinged on his acceptance of uncertainty.

This is an even bigger grenade.

Because it causes us to need to worry about savings, the desire to save, and the nefarious effects changes in that desire to save can have on the economy.

Like now, when we need people to be spending more and not saving so much.

So, as you can see, Professor Davidson’s little question: “why money?” is just as inflammatory, in many ways more so, than the Coase question I have been prattling on about.

And I haven’t done it justice, but hopefully you are starting to see why orthodox economists, those who preach market magic, and advocate all sorts of deregulation, anti-government policies, are so divorced from reality. Their world contains neither firms, or money. I wonder which economy they are theorizing about?

One, completely off the wall, way of sealing your allegiance to the alternative world is this:

Back in the run up to the Depression a great economist, Irving Fisher, an early pioneer of the transition from classical to modern neoclassical [i.e. orthodox] economics, spent a great deal of time working on the money illusion and matters related to money generally. He wrote a classic book on the subject in 1928. He also lost his shirt during the Depression, and is famous for issuing a strong statement of support for the stock market just as it was about to go into free fall. This was a disaster for him personally and perhaps his reputation. Nonetheless he occupies an iconic place in the development of modern orthodox theory.

Contrast that experience with Keynes. Far from losing his shirt, he made a fortune for himself and his college, where he administered the funds, during the height of the Depression.

Now, I realize this is entirely unfair and has nothing to do with the efficacy of their respective contributions to economics. But who would you, as an outsider want to listen to more? Fisher, the more orthodox economist? Or Keynes, he of the great uncertainties, and the decidedly unorthodox?

No question. Right?

Just follow the money.

  1. Keith Wilde
    January 24, 2011 at 11:54 am

    This is very entertaining and elegantly done. But as you have affirmed, the message about money has been maintained and discussed by Paul Davidson and a (very) few others. For that reason I continue to find your observations about Coase more original and fundamental. Does he have other reviewers who have perceived the radical nature of his question as clearly as you have?

    • Peter Radford
      January 25, 2011 at 10:17 pm

      Keith: Thank you. The point about Coase is that his 1937 paper was largely buried by orthodox economists because the “Theory of the Firm” is simply outside their remit. They still have a blind spot to it. Luminaries like Alchian and Demsetz declared the firm ‘uninteresting’. Presumably because they didn’t fully comprehend the blow it dealt their system. Or maybe because they knew full well and wanted to dismiss it before the walls came down. I think the latter is more likely.

      Others – Loasby, Witt, Langlois, Foss et al – have worked hard at building theories of the firm, but few have tried to belabor the point I am making. It seems everyone is content to shrug and acknowledge that the Coase challenge is just another example of the absurdity that orthodoxy has become. And as Davidson points out we simply add it to a long list of such absurdities.

  2. January 24, 2011 at 12:35 pm

    Your point about firms not existing in orthodox economics is also made in the following article: Bruce E. Kaufman (). “The impossibility of a perfectly competitive labour market”. Cambridge Journal of Economics, V. 31, Iss. 5 (Sep.): pp 775-787.

  3. January 24, 2011 at 3:18 pm

    I think economists are a little like “movie stars”. They do too much navel gazing and too little real work.

  4. paul davidson
    January 24, 2011 at 4:00 pm

    Nice response Peter. Clerly my “why money?” query did its job to get you steamed up eough to correctly rrspond.

    Paul

  5. antonio garrido
    January 24, 2011 at 4:27 pm

    I dont know what’s the fuss about.
    With perfect knowledge and forecast and no uncertainly (tipicall assumptions of neoclassical/ortodox economist) money plays no role.

  6. Geoff Davies
    January 25, 2011 at 1:34 am

    I’m a physical scientist who’s been delving into economics seriously since about 1998. Each time I think I must have heard all the absurdity I can digest, something else crops up, often even more absurd than what I’ve heard before. The monetary/banking system has been the most absurd.

    I got onto more of this money absurdity through Steve Keen’s work. He claims to demonstrate *for the first time* that a manufacturer could borrow money, make and sell things, and still make a profit. See Solving the Paradox of Monetary Profits, http://dx.doi.org/10.5018/economics-ejournal.ja.2010-31 . Duuh!

    I’ve worried that Steve’s claim might be a bit excessive, though I try not to under-estimate orthodoxy’s capacity for abstract absurdity. Thanks Peter for helping to sooth my stretched credulity.

  7. Jorge Buzaglo
    January 25, 2011 at 4:27 pm

    A not very well known fact about Irving Fisher is that he not only was an early pioneer of the transition from classical to modern neoclassical economics, but also was an early pioneer of eugenics and “racial betterment.” The following are quotations from several Wikipedia articles.

    In 1906, together with and Charles Davenport and John Kellogg, Irving Fisher founded the Race Betterment Foundation, which became a major center of the new eugenics movement in America. In 1912 he also became a member of the scientific advisory to the Eugenics Record Office and served as the secretary of the American Eugenics Society established in 1922 to promote eugenics in the United States.

    Today eugenics is widely regarded as a brutal movement which inflicted massive human rights violations on millions of people. The “interventions” advocated and practiced by eugenicists involved prominently the identification and classification of individuals and their families, including the poor, mentally ill, blind, deaf, promiscuous women, homosexuals and entire racial groups — such as the Roma and Jews — as “degenerate” or “unfit”; the segregation or institutionalisation of such individuals and groups, their sterilization, euthanasia, and in the extreme case of Nazi Germany, their mass extermination. …Its most infamous proponent and practitioner was, however, Adolf Hitler who praised and incorporated eugenic ideas in Mein Kampf and emulated Eugenic legislation for the sterilization of “defectives” that had been pioneered in the United States.

  8. George Hallam
    January 25, 2011 at 9:46 pm

    Irving Fisher..”lost his shirt during the Depression, and is famous for issuing a strong statement of support for the stock market just as it was about to go into free fall.”

    “Contrast that experience with Keynes. Far from losing his shirt, he made a fortune for himself and his college, where he administered the funds, during the height of the Depression.”

    I am not sure this is correct. From memory, Keynes lost money, albeit slightly, during the Depression. There is no discredit in this understanding the general course of events is no guarantee that you can make the very fine calls needed in a successful speculation.

    • Peter Radford
      January 25, 2011 at 10:07 pm

      George: Thanks. I was going from memory. I checked in Skidelsky where I discover that Keynes’ record was more patchy than I thought. He ended up in 1936 with a fortune worth [in today’s dollars] about $28 million. But that was after a few ups and downs. Not bad given the circumstances, but not a runaway success either. Still better than Fisher though!

  9. Hannes
    January 26, 2011 at 9:12 am

    Woo, just as in the Coase article: A lot of rhetorics, little stringency. No clear argument for the claim that uncertainty makes money any more necessary than risk or transaction cost considerations do. No, orthodoxy does not “teach us we know everything in the future”, it usually says we form expectations about the future and this involves that we can suffer shocks and think about risks, too. When we keep money as an insurance against shocks of all kind or as against diffuse uncertainty, we still have to trade off against the problem that that money can lose its value and also against the opportunity costs (investing that money). Now show that uncertainty makes money a useful institution individually and socially and risk and search don’t.

  10. merijnknibbe
    January 26, 2011 at 10:25 am

    @ Hannes,

    “Life is what happens to you when you’re busy making other plans”

    1. Uncertainty exists.
    2. Money exists.
    3. Orthodox theory often explicitely does teach us we know everything in the future. Really.
    4. Orthodox theory often abstracts from money. Really.
    5. Using money invokes huge macro costs. Considering all the costs of all the banks and all the accounts and all the pension funds and, well, in fact a lot more. These costs are easily 15% of GDP. Did you choose these costs? Did you choose an ever more expensive banking sector, which has become so unstable that the sovablity of entire states is threatened?
    6. Using money is not a choice: labor markets developed together with the use of money – you’re stuck with this. You did not choose this.
    7. Did anybody know that all this would happen when the first coines were made, about 700 BC (and thousends of years after money started to be used)? No.
    8. You may think that you are hedging against risks – but it’s not always the conscious activity of men which decides how things develop. You may think that you know the risks – while you don’t. But even then, this kind of behaviour may be a hedge against uncertainty which does enable people to survive. People may unconsciously do the right thing. They may think that they hold money as an insurance against risk – while they are in fact making the economy a bit more stable in the face of uncertainty.

    No, not a very neo-classical thought. But you might want to read Hayek on this – I’m not as much a libertarian as he is (surely not always but sometimes, governments might intentionally do something good, I think, soon Cameron will learn that he has to spend money to improve the British sewer system and other infrastructure), but he wrote very good things against rationalism.

  11. Hannes
    January 27, 2011 at 8:54 am

    “1. Uncertainty exists.
    2. Money exists.
    3. Orthodox theory often explicitely does teach us we know everything in the future. Really.”

    I only know two versions of “orthodox theory” you could mean. The first would be models consciously simplified to reach tractable approximations. The second would be “what-if” mathematics à la Arrow-Debreu: “If everybody could and would enter contracts about every possible state of the world, then…” But still there is no change in the analysis if we introduce “uncertainty” – even if I do not know what the true probabilites are for me having an accident tomorrow or whatever, I have to choose whether or not I want a liability insurance.

    “4. Orthodox theory often abstracts from money. Really.”

    Yes. So what? So does “heterodox theory”. I’ve read Marc Lavoie’s foundations book. In large parts of the book, you don’t need money more explicitly than you do it in an orthodox ISLM model. If you don’t need money in general equlibrium models, then you don’t need it in Sraffa’s system (especially not if you define money as something about uncertainty). “Orthodox theory” often abstracts from money, and it often abstracts from that fine restaurant downtown. It depends on what you want to analyse.

    “5. Using money invokes huge macro costs. Considering all the costs of all the banks and all the accounts and all the pension funds and, well, in fact a lot more. These costs are easily 15% of GDP. Did you choose these costs? Did you choose an ever more expensive banking sector, which has become so unstable that the sovablity of entire states is threatened?”

    No, I did not choose these costs. Now what strange kind of methodological individualism is this?

    “6. Using money is not a choice: labor markets developed together with the use of money – you’re stuck with this. You did not choose this.
    7. Did anybody know that all this would happen when the first coines were made, about 700 BC (and thousends of years after money started to be used)? No.”

    Yes, fine. Using money is social convention. So what is your point?

    “8. You may think that you are hedging against risks – but it’s not always the conscious activity of men which decides how things develop. You may think that you know the risks – while you don’t. But even then, this kind of behaviour may be a hedge against uncertainty which does enable people to survive. People may unconsciously do the right thing. They may think that they hold money as an insurance against risk – while they are in fact making the economy a bit more stable in the face of uncertainty.”

    While it might be true that many economists think that their model agents do take every decision consciously when you ask them, I do not believe that that is an essential part of (neoclassical, orthodox or whatever) economics. In fact, the consciousness of “economic man” is not modelled at all – economic man is just an algorithm, not even considering the question what is decided consciously or unconsciously.

    And while modelling of evolution and modelling of limited decision capacity might indeed be interesting (especially when we ask ourselves where some preferences do come from that were introduced into utility functions pragmatically in some models: empirical DSGE models today almost always contain habit persistence; in models of voting behavior you usually need some preferences to be altruistic or social satisfaction), I do not see any serious hint into this direction in Peter’s article. It’s more like “You know there’s uncertainty, that’s why there’s money (and the firm), and so neoclassical economics must be somewhat wrong, and now I can claim whatever without real derivation.”

  12. Pandora
    January 27, 2011 at 7:32 pm

    For us “lay persons” with an awakened interest in economics and economic theory, would you professional economists give us a quick primer on what is meant/referred to with the terms “classical economical theory, orthodox e.t. and neoclassical e.t.”? (also, maybe a few recommended texts as well, so we can get “up to speed.”)

    After a rather dull and frustrating undergrad experience with a Microeconomics class (taught by a grad student high on weed–and himself) and a Microeconomics class that I only enjoyed slightly more (I remember the basics as well as “opportunity costs”) I found the Real-World Economics Review (I liked the old name of “Post Autistic” better) while searching for “alternatives to capitalism” online. Reading the blogs here are more educational, informative and inspirational than those college econ classes I ended up dropping!

    Thanks!

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