Knut Wicksell's (1898, 1906) theory of the "cumulative process" of inflation remains the first decisive swing at the idea of money as a "veil" as well as Say's Law. The Quantity Theory still held in his system, but the dynamics of adjustment of prices to money supply, the "reason" for the Quantity Theory to hold, is fundamentally based on money having very real short-run effects. Recall that Fisher's Quantity Theory spoke of exogenous increases in supplies of money leading to "bidding wars" for commodities, as agents try to get rid of excess money holdings, thereby raising their prices. However, as Wicksell noted, there was nothing inherent in the Neoclassical theories of value and output which implied any of this could make sense. In fact, he clearly recognized that Say's Law, which prevents aggregate demand for goods and factors from exceeding real aggregate supply under all circumstances, implied that the Quantity Theory mechanism was contradictory:
We can see this differently. Say's Law says that real aggregate demand (Yd) is derived from real aggregate supply (Ys), thus Yd = Ys at all times. Yet, in a Walras' Law constraint, we must remember that:
where Md and Ms is money demand and supply respectively. Thus, by Say's Law, left side falls to zero, and thus Md = Ms at all times: there can never be excess or insufficient money supply necessary to make the Quantity Theory work. We can look at this in terms of investment and savings. Now, by definition, Yd = C + I + G where C is consumption, I is investment and G is government spending and Ys = C + S + T where S is savings and T is taxation, then assuming a balanced government budget, (G=T), to claim that Say's Law states that Yd = Ys at all times is the same as saying that I = S, i.e. investment is equal to savings at all times. Our Walras's Law constraint becomes:
which is identical to our previous constraint. However, again, by Say's Law, I = S so that necessarily Md = Ms, i.e. money demand is always equal to money supply. This way we can see the force of Wicksell's criticism of Say's Law and its inoperability in a theory of money. Say's Law is in essence "dichotomy" as it separates the real and monetary sides completely - i.e. disequilibria in money markets cannot spill over into disequilibria in goods markets. But then, Fisher's whole story of the Quantity Theory arising from a "bidding war" for goods as a result of an excess supply of money is precisely why Fisher contradicted himself: as Wicksell claims, you cannot simultaneously assume Say's Law and the Quantity Theory. This fundamental insight of Wicksell's was resurrected in the Patinkin Controversy of the 1950s and 1960s. Wicksell's solution is to make investment independent of savings so aggregate demand is free to rise above or below a given aggregate supply. This breaking of Say's Law is done via "finance" or "credit". Wicksell's process has its roots in that of Henry Thornton (1802). Recall that the start of the Quantity Theory's mechanism is a helicopter drop of cash: an exogenous increase in the supply of money. Wicksell's theory claims, indeed, that increases in the supply of money leads to rises in price levels, but the original increase is endogenous, created by the relative conditions of the financial and real sectors. With the existence of credit money, Wicksell argued, two interest rates prevail: the "natural" rate and the "money" rate. The natural rate is the return on capital - or the real profit rate. It can be roughly considered to be equivalent to the marginal product of new capital, therefore let us simply call it r. The money rate, which we shall refer to as i, in turn, is the loan rate, an entirely financial construction. Credit, then, is perceived quite appropriately as "money". Banks provide credit, after all, by creating deposits upon which borrowers can draw. Since deposits constitute part of real money balances, therefore the bank can, in essence, "create" money. This idea was put simply in later years by Dennis Robertson:
Indeed it might be considered a "sleight-of-hand". But, as Robertson and Wicksell go on to note, without this type of "fraud" one remains constrained by Say's Law - and this is inconsistent with the implied "bidding war" mechanism of the Quantity Theory. It is finance, Wicksell argued, which liberates investment from a given supply of saving to become the wild card that can take aggregate demand above (or below) aggregate supply - a maneouvre which anticipates and influences Keynes (1936). Wicksell's "cumulative process" works as follows. Put simply, the finance demand for money is set by the difference between the money and natural rates of interest. Let us propose that the natural rate is greater than the money rate (i.e. r > i). In short, the marginal product of capital is greater than its cost. Consequently, it will be to the advantage of every entrepreneur to borrow funds from the bank and invest it in capital. That means I > S, i.e. finance investment will rise above savings as the bank, by its "magic wand", can create the deposits upon which borrowers can draw. In short, the money supply increases as a result. Now one may accept that investment is independent of savings - at least initially. Banks, after all, give credit out first and then verify if the funds are available. Thus, like Keynes and unlike modern Neoclassical economics, Wicksell does not think investment is constrained by savings. But eventually, surely, the savings have to come eventually to equality - the goods market must eventually clear. Keynes had his multiplier to do this. What did Wicksell have? Wicksell actually had no self-correcting mechanism other than a reserve constraint. The logic works as follows: when r > i, then I > S. This extra investment demand then bears down on the capital goods industry. Assuming full employment, the extra demand for capital goods by loan-backed entrepreneurs cannot be met by the makers of capital goods. On the contrary, the extra volume of demand will have to be siphoned off by raising the price of capital goods. But just as they rise in the capital goods industry, so too must they rise elsewhere - including consumer goods and, as a result, wage demands by workers. A spiral ensues, a "cumulative process" whereas prices will rise and rise without limit as long as loan-backed entrepreneurs keep borrowing from the banks and coming to market. And they will continue doing so as long as the natural rate of interest (the marginal product of capital) remains above the money rate of interest (the loan rate). Thus, the demand for loans will continue accumulating, and the banking system's deposit creation forthcoming, indefinitely - with savings never really catching up. Money supply will expand endogenously without limit and prices will rise also without end. [Note: thus we get what Keynes (1930) called the "Gibson Paradox": the fact that Wicksell's theory tells us interest rates and the price level move in opposite directions but empirical evidence contradicts this; Wicksell (1906: p.202) claimed to have resolved it by noting that the money rate lags behind the natural rate.] Will this cumulative process ever end and the goods market brought back into equilibrium (i.e. I = S)? Two reasons can be given to ensure that it will. Firstly, the process ends when banks decide to raise their loan rate to equate the natural rate. Theoretically, this will eventually happen given the limited supply of reserves. Since each deposit, by law or prudence, must be backed by a certain amount of "reserves" (i.e. cash, gold or central bank liabilities), then new deposits will be created as long as the banks can find the reserves to back them up. The moment the banks run out of their own reserves, they will have two options: either they stop making loans or try to purchase reserves on the money market. Both options lead to rising loan interest rates. A second reason for the ending of the cumulative process was actually not thought of by Wicksell but only much later. Indeed, we can argue that the process should be brought to an end quicker before the reserve constraint is reached by recognizing that the marginal product of capital (the "natural rate") really refers only to that on new capital. Expressed in monetary terms, then, the rise in the inflation implies that the "costs" of new capital goods have risen - consequently, the attractiveness of investment should diminish. In modern terms, the marginal efficiency of investment (MEI) curve would shift down - not due to falling marginal efficiencies of capital but rather to rising supply price of capital, i.e. marginal adjustment costs. In other words, inflation should also eat away at the natural rate so that as the cumulative process gathers pace, there will be a decline, in real terms, of the natural rate. Thus, loan demand collapses. This second effect, by and large ignored by Wicksell, provides a self-adjusting mechanism to the system. It is no longer necessarily the case that inflation can only be stifled by the banks, feeling a reserve crunch, moving the money rate up to the natural rate, as Wicksell posited, but also we can consider the corresponding decline of the natural rate to meet the money rate as a result of inflation. Thus, the cumulative process is not without end. Interest rates on the loan market will clear up the mess. Nonetheless, the fundamental result of Wicksell's story, then, is that the dichotomy (short-run neutrality) is very much broken. Primarily, Wicksell regarded that the disparity between the natural and money rate arises largely because "the normal rate rises or falls whilst the loan rate remains unchanged or only tardily follows it" (Wicksell, 1906: p.205). In other words, the root cause of inflation and deflation is real and not monetary. We should qualify this statement: Wicksell (1898: p.167; 1906: p.204-5) did accept the possibility of exogeneous money supplies while Irving Fisher (as we saw with his credit cycle (Purchasing Power of Money, 1911) and also in his Theory of Interest (1930: p.330-6)) did accept that of endogeneity, but both regarded the alternative to be more common. For Wicksell, an exogenous increase in the supply of gold, for instance, does lead to a rise in reserves which might lead to a collapse in the money rate of interest below the natural rate as banks have greater ability to make loans. Nonetheless, adhering to Wicksell's main thesis, the disequilibrium engendered by real changes leads endogenously to an increase in the demand for money - and, simultaneously, its supply as banks try to accommodate it perfectly. Given full employment, (a constant Y) and payments structure (constant V), then in terms of the equation of exchange, MV = PY, a rise in M leads only to a rise in P. Thus, the story of the Quantity Theory, the long-run relationship between money and inflation, is kept in Wicksell. However, the story is told in an entirely different and enriched way. Primarily, Say's Law is violated and abandoned by the wayside.
Namely, when i Finally, the endogenous creation of money, and how it leads to changes in the real market (i.e. increase real aggregate demand) is fundamentally a breakdown of the Neoclassical tradition of a dichotomy between monetary and real sectors. Money is not a "veil" - agents do react to it and this is not due to some irrational "money illusion". However, we should remind ourselves that, for Wicksell, in the long run, the Quantity Theory still holds: money is still neutral in the long run, although to do so, we have broken the cherished Neoclassical principles of dichotomy, money supply exogeneity and Say's Law.
|
TopAll rights reserved, Gonçalo L. Fonseca