The Post-Keynesian View of Monetary Policy

Article of the Week from Fixing the Economists

by Philip Pilkington

Among Post-Keynesians there is a general consensus about interest rate policies: they are not, unless used in extreme form to generate recessions, very effective at regulating the volume of output or even inflation. Of all the Post-Keynesian arguments that I have come across this is the most mind-bending for neoclassicals.

The reason for this is that neoclassicals have a very unsubtle way of looking at the economy. They are mechanists who genuinely believe in prices that clear markets; and given that they believe that the price for, say, apples clears the apple market why would it not be the same for the capital markets?

I really want to stress this mechanistic aspect of neoclassical theory. Neoclassicals are generally students who were good at mathematics and not very good at creative thinking. These are the types of students for whom a differential equation made a great deal of sense, but who would be butchered in an argument about the subtleties of, say, a debate on theology or political strategy. They are generally people who like “correct” answers for things and have very little appreciation of nuance.

The discipline, in the way it has structured itself since the Second World War, encourages these students to carry through their studies and discourages more creative thinking students who prefer intuitive and empirical arguments with real-world consequences. This is deeply unfortunate as it has led to a whole generation of extremely mediocre economists and a discipline that is completely and utterly rotten and irrelevant.

Anyway back to the interest rate thing. The easiest way I have found to sum up the Post-Keynesian argument about monetary policy to neoclassical economists is to say that it is “non-linear”. In mathematics that basically means that a change in variable x that leads to effect y in one period instead leads to effect z in another. This often generates naval-gazing on the part of the neoclassical who then fusses and frets about the supposed “meaning” of such non-linearities — sometimes it leads to them contemplating the “meaning” of non-linearities more generally.

It is at such a point that you begin to really understand how these people think and why it is probably pointless to debate them on methodological issues or on issues regarding uncertainty. Such is like trying to debate English grammar with a Martian.

Nevertheless, it might be worth pointing to a fantastic summary I’ve come across recently of one Post-Keynesian perspective on the reasons that monetary policy in modern economies is a completely inadequate tool to regulate aggregate demand. It comes from Nobel prize winner — yes, so far as I know, the only Post-Keynesian Nobel prize-winner — William Vickrey in a fantastic essay entitled Fifteen Fatal Fallacies of Financial Fundamentalism; an essay which is worth reading in full. Vickrey writes:

In the heyday of the industrial revolution it would probably have been possible for monetary authorities to act to adjust interest rates to equate aggregate planned saving and aggregate planned investment at levels of GDP growing in such a fashion as to produce and maintain full employment. Generally, however, monetary authorities failed to recognize the need for such action and instead pursued such goals as the maintenance of the gold standard, or the value of their currency in terms of foreign exchange, or the value of financial assets in the capital markets. The result was usually that adjustments to shocks took place slowly and painfully via unemployment and the business cycle.

Current reality: The time is long gone, however, when even the lowest interest rates manageable by capital markets can stimulate enough profit-motivated net capital formation to absorb and recycle into income over any extended period the savings that individuals will wish to put aside out of a prosperity level of disposable personal income. Trends in technology, demand patterns, and demographics have created a gap between the amounts for which the private sector can find profitable investment in productive facilities and the increasingly large amounts individuals will attempt to accumulate for retirement and other purposes. This gap has become far too large for monetary or capital market adjustments to close.

On the one hand the prevalence of capital saving innovation, found in extreme form in the telecommunications and electronics industries, high rates of obsolescence and depreciation, causing a sharp decline in the value of old capital that must be made good out of new gross investment before any net increase in the aggregate market value of capital can be registered, together with shifts from heavy to light industry to services, have sharply limited the ability of the private sector to find profitable placement for new capital funds. Over the past fifty years the ratio of the market value of private capital to GDP has remained, in the U.S., fairly constant in the neighborhood of 25 months.

On the other hand, aspirations for asset holdings to finance longer retirements at higher living standards have increased sharply. At the same time the increased concentration of the distribution of income has increased the share of those with a high propensity to save for other purposes, such as the acquisition of chips with which to play high stakes financial games, the building of industrial empires, the acquisition of managerial or political clout, the establishment of a dynasty, or the endowment of a philanthropy. This has further contributed to a rising trend in the demand of individuals for assets, relative to GDP.

The result has been that the gap between the private supply and the private demand for assets has come to constitute an increasing proportion of GDP. This gap has also been augmented by the foreign trade current account deficit, which corresponds to a diminution of the stock of domestic assets available to domestic investors. For an economy to be balanced at a given level of GDP requires the provision of additional assets in the form either of government debt or net foreign investment to fill this growing gap. The gap is now tentatively and roughly estimated for the U.S. to be equal to about 13 months of GDP. There are indications that for the foreseeable future this ratio will tend to rise rather than fall. This is in addition to whatever role social security and medicare entitlements have played in providing a minimal level of old age security.

Although these are certainly not the only reasons that monetary policy is a largely ineffective tool in modern economies, they are certainly some very interesting ones. And considering them is much more interesting than having to play the neoclassical game and hand-wave about something abstract called “non-linearities”. Don’t expect the Martians to get it though!