The monetary core of the Famous Fama Fallacy
I finally read the famous blog in which Eugene Fama, at the moment hyped as a future receiver of the economics Nobel, commits the ‘ex ante/ex post’ fallacy. What is this fallacy? An example: ex post (after the facts), total expenditure (as defined in the national accounts) is necessarily equal to total production (including change in inventories, an involuntary increase in unsold inventories is classified as an investment and therewith as ‘saving’, i.e. not-consumption. Note that re-classifying the purchase of cars by households as an investment instead of consumption will rise the level of investment as well as the level of saving!). Whatever – the ex post accounting identities do not in any way imply that the nominal or ‘real’ level of expenditure and production are set ex ante. The amount of water entering the Netherlands via the Rhine is equal to the amount leaving Germany – but the level of the Rhine can change. According to Fama, however, the level is pre-ordained, though it may take another course, as the amount of money (water) is fixed. Is he right about this? No. At least not according to the people who estimate the amount of money (picture 1). The green lines in picture 1 show what’s defined as ‘money’ by the statisticians of the ECB, the arrows show how the amount of money can increase or decrease. Clearly, when banks create credit the amount of money increases, while the same thing holds when households change part of their long term savings into deposit-money (happens a lot, these days). This definition of money is not beyond criticism but the great advantage of this system is that it shows that money is not some kind of good created by the government or the central bank but something created by us (by emitting debt and with a little help from the MFI’s).
Picture one: money in the Eurozone, billions, MFI’s are Monetary financial Institutions i.e. banks which are allowed to create legal tender.
Fama clearly doesn’t understand this and his implicit concept of money smacks of ‘the cash in advance’ idea. The what? According to Wikipedia (as always a reliable source for ‘received folly’) the cash in advance idea (people carry around money because they need it to pay) is a hypothesis used by economists to explain away the awkward fact that the ‘most basic’ mainstream models do not have a place for money:
“The cash-in-advance constraint … is an idea used in economic theory to capture monetary phenomena. In the most basic economic models (such as the Walras model or the Arrow-Debreu model) there is no role for money, as these models are not sufficiently detailed to consider how people pay for goods, other than to say everyone has a budget constraint. To be able to say anything about the money supply, inflation or monetary policy and so on, economists must therefore introduce additional assumptions into their models. One possibility, and the more popular one, is to introduce a cash-in-advance constraint i.e. a requirement that each consumer or firm must have sufficient cash available before they can buy goods. An alternative assumption would be a ‘Money-in-the-Utility-Function’ assumption, which states that people have a tendency to hold a certain amount of cash because they derive utility from holding it. Without these (or similar) assumptions economic theory would find it difficult to explain why people carry around a good (money) which takes up space in their wallet, can’t be consumed and does not earn any interest.”
What’s wrong with that? Well, according to Hellwig, who wrote a supposedly very neo-classical PH. D. thesis (which I did not read) about this but then wrote an article (which I did read) in which he also asked ‘where do monies come from’ had to state:
While the previous section discussed the existence and uniqueness of a fiat money Cash-in-Advance equilibrium as an evolutionarily stable steady-state, it does not consider the emergence of fiat money. Existing search-theoretic models also remain silent about this questions, since they consider steady-state equilibria, where fiat objects have been around forever in the past, and are valued, because they are expected to be valued forever into the future. The purpose of this section is to illustrate how fiat money may come into circulation in a ”free banking” equilibrium, and to further discuss the conditions under which a fiat object becomes a generally accepted medium of exchange. For this purpose, I adapt the model by enabling intermediaries to issue debt certificates on which they promise to pay a unit of physical goods in the future” (emphasis added)
Right. Fama is sticking to a theory which is based upon a concept of money which excludes the genesis of money, which as he takes the model at face value leads him to state that the amount of money can’t change. Well, we all make mistakes. But an economist who makes mistakes which are pointed out in introductory macroeconomic textbooks (In my case: Korteweg and Keesing, ‘Het moderne geldwezen’, part 1 (Groningen 1978)) and does not repent does not deserve a Nobel. Not even the economics one.