How to Fix the Banks

This post first appeared in the Financial Times Economists Forum on February 9th 2009. I am reposting it here because it is as relevant today as it was then. My argument provides a way to provide a backstop to the banking system as a whole, without generating the incentive for any individual bank to engage in risky behavior and without putting taxpayer funds on the line.

By Roger E. A. Farmer Feb 9, 2009 @ 12:11

We don't need to nationalise the banks. We don't need to guarantee bad assets. We don't need government to own voting shares in private banks. We don't need to create a bad bank full of toxic assets. We just need a little faith in free markets and a little creative intervention. I propose that the central bank should support the price of an indexed fund of bank stocks.

The financial crisis that began in the US subprime mortgage market has spread far and wide. Between January 2007 and January 2009 the top 10 US banks lost two-thirds of their value as market capitalisation fell from $961bn to $333bn. The problem that began when investors were unsure of the value of mortgage backed securities has spread to corporate paper, credit card debt and student loans. These events are not confined to the US. The world financial system is hemorrhaging.

Before trying to solve a problem, it is a good idea to understand its nature. Investors in banks are not irrational. They are placing extremely low values on bank assets because they correctly assess that the economic situation can get much worse. The US economy is shedding 0.5m jobs a month and Europe, Asia and Latin America are not far behind. The loss in value of bank stocks is in danger of becoming a self-fulfilling prophecy as low wealth generates low demand and low demand adds to the unemployment rolls.

Free market economies need help sometimes. In every post-war recession the Fed has lowered the interest rate to restore private demand. That option is now unavailable because the interest rate cannot fall below zero. Policy makers are rightly considering a broader range of options. One option should be price support for bank stock. In a piece published on January 12 in the FT online, I argued for central bank support of a stock market index. A more limited version of this same idea provides a way for a central bank to inject new equity into its national banking sector without owning the banks or nationalizing them. How would this work?

First: Define an indexed fund that would include all publicly-traded bank stocks with weights based on initial market capitalisation. These weights could be revised periodically according to preannounced rules. Second: Allow private financial corporations to create and trade this fund by purchasing bank shares as assets and selling the indexed fund as a liability. Third: Direct the central bank to purchase an initial block of indexed funds - $300bn might be a good starting number for the US - and pay for it by issuing newly created short-term interest-bearing debt backed by the treasury but issued by the central bank. Fourth: At each meeting of the monetary policy committee, announce a price, and a rate of growth for this price, at which the central bank would be willing to buy and sell the indexed fund over the next few weeks.

How much would this cost? Let's take the US case and suppose that the Fed buys the fund at $10 a share under current bank capitalization. Now let the Fed announce that, one week from now, it will stand ready to buy or sell the indexed fund at $15 a share. The announcement will provide private investment companies with an incentive to buy the bank stocks that make up the index in order to profit from the Fed intervention. As these companies buy bank stock, the price of the stock of each bank in the fund will rise until their collective value is equal to the announced value of the index. This scheme recapitalizes the US banking system and could be implemented with little or no cost to the US taxpayer.

Banks are undervalued because there is no market for the ‘toxic assets' that they hold. How will the Fed decide on the correct value of these assets? It doesn't have to. The market will decide what they're worth. The relative price of each bank stock will be determined by marketplace trades and not by the Fed. As new information comes in about the underlying values of a bank's assets, the bank's value will rise or fall. If a single bank is found to have an unusually high proportion of toxic assets, market capital will shift to better managed banks. If a new bank is created, and is found to be efficiently managed, market capital will shift to the new bank and the old ones will fall in value or fail.

What are the advantages of this approach to alternative recapitalisation schemes under consideration? First: It need not cost the taxpayer a penny. Second: It allows the market to determine asset values. Third: It does not reward bad management but allows bad banks to fail without destroying the entire financial system. Fourth: It provides an incentive for the creation of new financial institutions to replace the old.

The world financial system is not illiquid: It is potentially insolvent. This is not a problem of bad fundamentals: It is a problem of market psychology. In the global crisis there is such a thing as a free lunch. By preventing meltdown of the world financial system we can get the global economy back on track. But to get there world government leaders and central bankers need to start thinking outside of the box.

Professor Roger E. A. Farmer is vice-chair for graduate studies in the department of economics at the University of California Los Angeles. He is the author of two forthcoming books on economics with direct relevance to the current crisis: Expectations, Employment and Prices and How the Economy Works

Axel Leijonhufvud Remembered

I learned today that my friend, colleague and mentor, Axel Leijonhufvud passed away on Monday May 2nd. Axel was one of the most creative macroeconomists of his generation and a towering presence in UCLA macro from 1964 until his departure in 1995 when he took up an appointment at the University of Trento.

In 2006 I was privileged to organize a conference in Axel’s honor at UCLA that was later published as a Festschrift, Macroeconomics in the Small and the Large, with contributions from his friends and admirers, one of whom, Ned Phelps, was a Nobel Laureate and two more, Tom Sargent and Lars Hansen, went on to win the Nobel Memorial Prize subsequently.

UCLA Faculty at the 2006 conference in honor of Axel Leijonhufvud

This photo was taken at the conference dinner on the evening of August 30th 2006. It features, from left to right, Joe Ostroy, Gary Hansen, Roger Farmer, Axel Leijonhufvud, Ken Sokoloff, John Riley and Mike Intriligator.

I first came across Axel’s writing as an undergraduate student at Manchester University where we were taught from his doctoral dissertation, Keynes and the Keynesians; a book that shot Axel to intellectual rock stardom. He argued in that book that Keynes’ General Theory had nothing to do with sticky wages and prices but was instead about inter-temporal coordination failure. Here is a link to a 2004 interview with Brian Snowdon that provides an excellent introduction to Axel’s thought.

Axel was part of a long UCLA tradition of independent thinking and he was responsible for recruiting me to UCLA in 1987. He never accepted mainstream interpretations of macroeconomics and was wary of consensus. And although Axel’s work was non-technical in nature, he recognized the importance of mathematics and was attracted to the formalism of theories in mathematical models. His view of the rational expectations revolution was one of amused bemusement. I recall a conversation with him in which, to paraphrase,

‘My view of modern macroeconomics is much like my view of modern Hollywood movies. The pyrotechnics are spectacular but the plots are sadly lacking.

Although Axel recognized the importance of mathematical methods, he also recognized the limitations of formalism and he insisted that a good economist must be aware of the past. To this end he was a strong supporter of the teaching of economic history and the history of thought as part of the core curriculum.

Economic history disappeared as a core subject from many economics departments in the 1980s. UCLA was an exception largely due to Axel’s insistence that a good macro economist needs to understand the past before she can understand the present or the future. He was instrumental in bringing Ken Sokoloff to UCLA and in supporting Ken’s successful efforts to attract Naomi Lamoreaux and Jean-Laurent Rosenthal to UCLA

Axel’s support of the history of thought was deemed anachronistic by many of his contemporaries who viewed economics through the lens of a linear progression of knowledge. In contrast, Axel viewed science — and particularly economics as a non experimental science — as a tree in which herd behavior led often to persistent treks down roads to nowhere. Here is an excerpt from his 2004 interview with Brian Snowdon,

… the history of economics [is like] a decision tree. … That's exactly why those who are working at the frontier of the subject should know some history of economic thought. This is a different reason than just wanting to know the history of the subject for antiquarian interest. This view also suggests that economics itself exhibits very strong path dependence. So if you take the wrong path, the errors can be with you for a long time.

Axel was a follower of Imre Lakatos and his view of the progression of economics was heavily influenced by Lakatos’ methodology and the concept of progressive and degenerative scientific research programs. In his view, modern macroeconomics is a degenerative research program that took a wrong turn in the 1950s. Axel was right about this and it is a theme that has influenced my own research agenda. Time will tell if the profession will eventually agree.

Yours Truly with my friend and teacher David Laidler, Axel Leijonhufvud and Axel’s wife Earlene Craver

Axel Leijonhufvud: September 6 1933 — May 2nd 2022

An Interview with Roger Farmer by Phil Armstrong: Part 4 of 4: On Modern Monetary Theory

An excerpt from Chapter 5 of  Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.  

“If the question is ‘what determines the price level?’, which I do take to be a useful question, I’m probably in bed with modern monetary theorists. My view is that beliefs determine the price level. But the reason that I’m able to make that statement and live in two worlds at the same time, is because the equilibrium models I build contain lots of interacting agents of different types.”
“There are many pluralistic views. I’m not sure why anyone would put a label on themselves, I refuse to be labelled as anything. I don’t know why anyone would want to be labelled as an ‘MMT person’ as opposed to someone who seriously considers the ideas in Modern Monetary Theory and tries to integrate them with other things that they found useful. ”
— Roger E. A. Farmer

PA: You remind me of Charles Goodhart, who also has sympathies and criticisms of various schools. I’d like to turn next to Modern Monetary Theory. You’re a very experienced economist, I’m interested to know what you’ve picked up about MMT?  If you’ve not come across MMT, that tells me a lot about its outreach.

RF: It has very little outreach in terms of mainstream economics and my initial reaction to the definition is that it’s confused. [1] My work is heavily influenced by conventional neoclassical economics – that makes me mainstream. And with my mainstream hat on; I insist on constructing coherent models that are based on individual maximising behaviour. 

When you start thinking about monetary theory and monetary economics in that context, what you might say immediately is, “Yes, but general equilibrium theory has no role for money”, which is partly true. But to the extent that it forces you to construct logical chains of reasoning, the arguments about endogeneity of money – that’s where I’ve met MMT – I find critiques of mainstream monetary theory to be misplaced. Of course, money is endogenous! But what does that mean? 

If the question is ‘what determines the price level?’, which I do take to be a useful question, I’m probably in bed with modern monetary theorists. My view is that beliefs determine the price level. But the reason that I’m able to make that statement and live in two worlds at the same time, is because the equilibrium models I build contain lots of interacting agents of different types.As a consequence, I end up with situations where the model is not determining prices, I need something else. So there’s clearly room for a marriage of that idea with notions of endogenous money from modern monetary theorists, and I suspect that if I actually sat down with Stephanie Kelton, or you, or some other modern monetary theorist, and had a debate about that, we’d find that we had a lot in common. I’m simply more willing to use the apparatus of traditional microeconomic theory to explain those ideas.

PA: Yeah, I get the feeling, having heard you speak before, that you are open to dialogue with what I would call heterodox views. More so than most.

RF: I think that’s essential! 

PA: One of the things about MMT- which leads me onto my next point – is its ‘unique selling point’ in the non-academic world: this idea that taxes drive money, the idea that the government must spend money before it can tax. For modern monetary theorists, taxes have two functions: one, to give value to state debt, because without taxes underlying the value of the currency people wouldn’t accept state money in payment for delivering services to the state. And secondly, by adjusting spending and taxes, the government can adjust aggregate demand. The government, in order to fund spending, must acquire money from the private sector and/or borrow it.

RF: I believe that this is related to the debate, in the standard theory, on the Fiscal Theory of the Price Level. Government spending, taxation and borrowing are connected by an accounting identity.  In any period of time, the difference between the amount the government spends and the amount it takes in in taxes has to be funded by issuing some kind of debt. It could be money, it could be short bonds, or it could be long bonds. Treasuries spend and create liabilities. Central banks decide on the composition of those liabilities between the different categories. 

There is currently a lot of angst in modern macro circles about what determines the price level. And the government accounting identity can be viewed in two ways. In one way it’s a budget constraint, which the government has, just like you and I have budget constraints.  We spend, we borrow, we get income, we die, and as a consequence of eventually dying, over our lifetime we can’t spend more than we earn. That places a constraint on how much we can borrow.

Now you and I can shift resources over time by borrowing and lending, so one way of seeing the government accounting identity is that it’s just the analogue of what you and I do. Now, that’s clearly false because the government doesn’t die, and the revenues are coming in from different people from those who benefit from the spending. 

One group of economists sees the government accounting identity as analogous to a household constraint. Government spending plans must be consistent with its income plans over a very long horizon. In this view, the government must make spending plans that are consistent with taxation. There is an extreme version of that argument, called Ricardian equivalence, which says that it doesn’t matter whether a given government expenditure plan is financed by debt or taxes. Different plans simply rearrange the timing of the payments, and the representative agent who must pick up the tab, is the other side of that borrowing and lending. Now, most people think that’s probably wrong.

PA: Yeah, certainly MMT-ers!

RF: Indeed. Now, the other way of looking at this accounting identity is that it is a debt valuation equation. The government has a stream of primary surpluses that it will be running for the conceivable future. It has some existing debt in dollar terms. The price level must adjust to make sure that the value of the nominal debt is equal to the discounted present value of the surpluses. So, the sequence of accounting identities is a price level determination equation.  I suspect that some of these issues arise in modern monetary theory. Perhaps you could say more about what modern monetary theorists mean by money?[2]

PA: Well, I think that what modern monetary theorists would argue is that money is credit and nothing but credit.

RF: Fine, so a treasury bill is money. Or not?

PA: Well, no – a treasury bill isn’t money, because money is simply a ledger entry. For example, what a modern monetary theorist would conceptualise is that there is no government budget constraint, it’s simply an ex-post description of what’s happened. So, in other words, if the government wants to spend, if you want to conceptualise as a model, the first thing it has to do is spend by issuing new money, i.e. new debt, and that doesn’t have any corporeal existence.

RF: You said new money and new debt in the same breath.

PA: For a modern monetary theorist, credit and debt are the same thing, made at the same time. Therefore, new money is new debt.

RF: Perfect, I’m totally on board. In the models I write down, that’s true because there are multiple equilibria and because the actions the government takes help to select one of the equilibria. Maybe I should write a paper called ‘Modern Monetary Dynamic Stochastic General Equilibrium Theory.’

PA: If the government spent money, what would you think would happen to the balance sheets and the economy, or do you not think in those terms? So if the government bought, say, a new nuclear submarine from a private defence contractor, what would be the monetary movements in that? 

RF: The government has a bank account that it uses to purchase new nuclear submarines. I’m honestly bemused by the question.

PA: A modern monetary theorist, would say that if the government buys a new submarine, its balance at the Bank of England goes down. The receiving bank’s reserves would go up, which would mean there’s an internal transfer on the liabilities side of the Bank of England, there’s a reduction in the reserve account of the government, and an increase in the reserves held by the receiving bank. The asset total value of the Bank of England balance sheet remains the same. 

Regarding the bank which holds the account of the company that makes the submarine, that bank’s balance sheet will expand. It will have liabilities – say it was £5 billion, and now that company has a liability at its own bank of £5 billion and on its assets side, the receiving bank’s reserves have gone up. That’s how a modern monetary theorist thinks. But you won’t be surprised to know that when I ask economists that question, they don’t answer it in those terms. 

RF: How does a modern monetary theorist deal with the difference between the world we live in now and the Gold Standard?

PA: Under the Gold Standard, the government’s ability to issue debt, or to spend, is limited by its gold stocks. Because, for example, if the government runs a deficit under the Gold Standard - say it’s spent a billion pounds and took in £800 million, there would be £200 million’s worth of convertible gold currency.

RF: So, its an entirely different world.

PA: Yes. Under the Gold Standard, the interest rate was determined by the central bank to compete with the option of conversion, which is why big deficit countries under the Gold Standard would raise the bank rate.

RF: So, the question about buying a nuclear submarine would have very different implications in an economy under the Gold Standard than it would under the current standard.

PA: Yes, it would. I don’t know if you’re familiar with the employer of last resort (ELR) policy?

RF: No, I’m not.[3]

PA: Modern monetary theorists don’t believe that the main policy tool for maintenance of price stability should be interest rates, they don’t believe this approach is effective. And an ELR also maintains full employment. Under an ELR policy the state offers an unlimited number of jobs and hence, unemployment effectively falls to zero. If a person were unemployed, the government would provide one. It is, in effect, a stock control policy – in times of recession – people move into the employed labour buffer stock.

RF: I am sympathetic to both points.  I agree that the state has a responsibility for maintaining full employment. But full employment is not easily defined. It is possible to have too much employment just as it is possible to have too little employment.  A job for everyone who wants one is a meaningless concept for someone who thinks in terms of search. 

You ask, “Do you consider the employer of last resort policy to be a viable means to ensure full employment and price stability?” I’m certain it could be a successful means of ensuring full employment, we saw that in Soviet Russia. I don’t think it was very efficient – the state allocating people to jobs is not my ideal society. Also, I don’t think that full employment, implemented by this policy, would guarantee price stability.

PA: The final question is what role do you consider that MMT might have to play in the practise of heterodox, or indeed any economics? Do you see it as something that’s so far from what economists are thinking about that you don’t even see it on the horizon?

RF: There are many pluralistic views. I’m not sure why anyone would put a label on themselves, I refuse to be labelled as anything. I don’t know why anyone would want to be labelled as an ‘MMT person’ as opposed to someone who seriously considers the ideas in Modern Monetary Theory and tries to integrate them with other things that they found useful. 

PA: Well, that, in a sense, is just as good an answer as any other. That if you kind of pick apart the question, that’s really what I want to do with the questions, if you see what I mean. Well, that concludes the formal interview. Many thanks, Professor Farmer.

[1] This statement was true when I spoke to Philip in 2018. A lot has changed since then and MMT is now being more widely discussed as a policy approach to government finance.

[2] For a more complete account of my views on the Fiscal Theory of the Price Level see my recent working paper with Pawel Zabczyk (Farmer & Zabczyk, 2020). 

[3] I certainly know now as a consequence of the impact of MMT on the 2020 US presidential campaign. 

An Interview with Roger Farmer by Phil Armstrong: Part 3 of 4: On Heterodox Economics

An excerpt from Chapter 5 of  Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.  

“I wrote a paper with Andreas Beyer of the ECB where we showed that New Keynesian models are unidentified. The implication of our work is that the parameters of the mainstream NK model are identified by theoretical restrictions and not by data. That may work well as a description of past data. But if the model is wrong, it will not help to predict future data nor is it a good laboratory for conducting policy experiments.”
“… as I have consistently argued since 1993 we should be embracing multiple equilibria as a way of integrating key ideas from the General Theory with General Equilibrium theory. Once you realise that economic fundamentals – technologies, preferences and endowments – are not enough to pin down the equilibrium, you open the door for psychology and sociology to come in and to close an economic model with a theory of beliefs.”
— Roger E. A. Farmer

PA: Now I’ll move on to heterodox economics, and I’m looking for your personal opinion and your perception of the environment in which you work. So, what do you personally understand by the term ‘heterodox economics’, and could you give me any examples of groups of economists that you would identify as heterodox?

RF: Well, for anyone in a major university in the UK or the US, ‘heterodox’ is an insult used to put down people who don’t agree with you. For anyone in non-mainstream universities, it’s a badge of honour, a term used to identify the fact that they really are guardians of the truth. 

PA: So it’s a very loaded term, then!

RF: I don’t think it’s a very useful term. Let’s take post-Keynesians. I wrote a piece recently – it was called ‘Post Keynesian Dynamic Stochastic General Equilibrium Theory’ (Farmer, 2017) – which was an attempt to unite post-Keynesians and orthodox economists. In that article I pointed out that post-Keynesians kept alive a flame of truth from Keynes’ General Theory that had been lost by the mainstream. 

The world moves on, thought moves on, and Keynes would not be a Keynesian today. There were ideas in the General Theory that were kept alive in heterodox circles. The split came in the 1950s with Samuelson, who was a dominant figure on the East Coast of the US, who rejected certain ideas of the General Theory – in particular, a central idea from the General Theory that there are multiple equilibrium unemployment rates. That idea got thrown out, and that’s the point where what we now call New Keynesians and Post Keynesians diverged.

PA: Thank you. I think you’ve accurately covered questions 11, 12 and 13, so I might ask you question 14. Do you consider yourself to be heterodox, firstly, and secondly, do you work in a university department, do you teach undergraduates? What’s your current role?

RF: That’s an interesting question for me, because I always considered myself mainstream but slightly on the edge. 

PA: The fact you’re talking to me shows you must be somewhere near the edge, I think!

RF: So, what am I doing? I no longer teach undergraduates, I teach graduate students. I teach two graduate courses at Warwick. I’m also the Research Director at the National Institute of Economic Social Research in London, and as part of that, a bunch of my time is spent running a programme called ‘Rebuilding Macroeconomics’, which is an ESRC funded initiative. 

After the financial crisis, the ESRC decided that macroeconomics was broken, but they weren’t sure how to fix it. So, they asked for bids from teams to allocate funds. A group of people – myself and four other people on the management team – won that bid. Whereas initially I thought that I was kind of on the edge, I soon realised otherwise. 

The management team consists of me; Angus Armstrong, who’s an economist at NIESR; then we have an anthropologist, Laura Bear, from LSE,  a psychologist, David Tuckett, from UCL and a complexity theorist, Doyne Farmer, from Oxford. And once I started interacting with them, I realised that my role was not to map out new territory – it was to ground the project and interactions with mainstream economists. There was a danger the project would move so far from orthodox theory that none of the mainstream economists would listen to what was being said. Having said that, I guess I must be a heterodox economist, because I’m entertaining notions of introducing psychology,  sociology, anthropology, and complexity theory into mainstream economics. It’s a fascinating conversation with people from outside the discipline. 

PA: That’s great. This one relates to the new consensus macro; however you want to interpret that, and the global financial crisis - do you consider that the GFC gave any evidence to contradict the NCM, the rational expectations, new Keynesian, new classical school of thought? 

RF: Yes, I think so.

PA: OK, and how can they get away with it then? How can they remain in this position of ascendency if evidence of the GFC wasn’t what they expected, they were caught by surprise? I think the Queen said, “How come none of you guys saw it coming?” – how do you think they’ve managed to remain on top, all the Nobel Prize winners who’ve still got their status?

RF: Oh goodness, we need to get into the philosophy of science. Max Planck said that ‘science progresses one funeral at a time’. He meant by this that established scientists do not change their minds in the face of contradictory facts. They simply amend their theories. And eventually, established research programmes die out because they fail to attract the best new students. 

The New Keynesian paradigm has simply adapted. And to use an idea from the philosopher Imre Lakatos, it’s a degenerative research agenda.[1] It’s amazing – people are taking the models they were using before the Great Recession, and they’ll say, “Well, we’re just missing a piece. We really should have had the financial market in – well, let’s just tack it on!” And now it’s there, they go back, and they say that their model works. 

It’s much like Ptolemaic astronomy. When Copernicus came along, Ptolemaic astronomy continued to predict the movement of the planets better than Copernicus, initially, because followers of Copernicus were using circles instead of ellipses in the description of planetary movement. The new Keynesians are doing much the same thing. I wrote a paper with Andreas Beyer of the ECB where we showed that  New Keynesian models are unidentified.[2] The implication of our work is that the parameters of the mainstream NK model are identified by theoretical restrictions  and not by data. That may work well as a description of past data. But if the model is wrong, it will not help to predict future data nor is it a good laboratory for conducting policy experiments. 

PA: How would you describe your relationship with new Keynesianism? You obviously have some aspects in common, like methodological individualism, rational expectations – but from hearing you speak I sense that you’re quite willing to criticise new Keynesianism. If there is such a thing as New Keynesian orthodoxy, you seem to have quite an uneasy relationship with it.

RF: Yes. I use the same methods, but I’m willing to give up on some of the assumptions. The big difference I have with New Keynesians goes back to the split that occurred in 1955 between New Keynesians and Post-Keynesians. In a sense, I am a Post-Keynesian who uses neoclassical methods. But even that description is not quite right because my research has also led me to be critical of Post-Keynesian policy prescriptions. For example, I believe an asset market intervention to support equity prices is a better cure for a big financial contraction than traditional fiscal policies.[3]

 Samuelson’s new-classical agenda of combining Keynesian economics with equilibrium theory was a great idea. But he made a huge mistake by assuming that Keynesian economics was about sticky prices. Keynesian economics was never about sticky prices. My own work reconciles Keynes’ General Theory with Walrasian or temporary equilibrium theory in a different way. 

There are two principle aspects of the New Keynesian model that I disagree with. Most New Keynesian economists writing  before the 2008 financial crisis modelled the labour market as an auction.  In an auction model, the labour market is always in equilibrium. The quantity of labour demanded is always equal to the quantity of labour supplied.  The real wage and the volume of employment are determined by the intersection of the labour demand and supply curves. That’s not a good assumption for a variety of reasons, not least of which is that it jettisons the concept of involuntary unemployment.  Prior to 2008,  most New Keynesian economists gave up on unemployment entirely. That was a big mistake. 

After the 2008 financial crisis some New Keynesian economists reintroduced unemployment into NK models using search theory. But they are doing it the wrong way. The right way is as ‘Keynesian Search Theory’, a version of search theory originally developed in my own work. This is a way of closing search models that leads to the potential for a continuum of steady state equilibrium unemployment rates. That’s one area where I have a difference with mainstream New Keynesian economists. 

My second point of disagreement is with mainstream models of financial markets. Writing in 1972, Lucas threw away all of Keynesian economics and replaced it with Walrasian general equilibrium theory. But he did it in a way that  made microeconomic theorists who worked in general equilibrium theory –  I have in mind Frank Hahn and Ken Arrow – absolutely horrified. Instead of thinking about an equilibrium as something that the economy was tending towards, for Lucas the market was in equilibrium at all points in time. That was a massive transformation. 

Ironically, I think that Lucas’ shift in viewpoint was a useful one. Moving to the ‘Lucasian’ view was the right way to go. But what Lucas knew,  but glossed over, is that once you take that route you can no longer pin down equilibrium in terms of economic fundamentals. As I explain in my forthcoming encyclopaedia entry, `The Indeterminacy School in Macroeconomics’ (Farmer, 2020), there are always multiple equilibria in monetary general equilibrium models.

Not only are there multiple dynamic paths, there are also  multiple steady states. Lucas was unhappy with me promoting that view argued in my book, The Macroeconomics of Self-Fulfilling Prophecies, and he wrote me a letter at the time saying, ‘why are you doing this?’.[4] For more than forty years, mainstream economists have been trying to purge multiple equilibria from their models. In contrast, as I have consistently argued since 1993 we should be embracing multiple equilibria as a way of integrating key ideas from the General Theory with General Equilibrium theory. Once you realise that economic fundamentals –  technologies, preferences and endowments – are not enough to pin down the equilibrium, you open the door for psychology and sociology to come in and to close an economic model with a theory of beliefs. For me, beliefs should be modelled as fundamentals which have the same methodological status as preferences, endowments and technologies.  So that, in a nutshell, is where I differ from most mainstream New Keynesian economists.

PA: And if you were to identify yourself with a school of economics, are new Keynesians, with reservations, as close as you would come?

RF: I refuse to be labelled. I’m a ‘Farmerian’! 

Stay Tuned for Part 4 on Modern Monetary Theory

[1] (Lakatos & Musgrave, 1970).

[2] (Beyer & Farmer, 2008).

[3] (Farmer, 2010).

[4] For background on this interaction see Cherrier and Saïdi, (2018).

An Interview with Roger Farmer by Phil Armstrong: Part 2 of 4: On Conventional Theories of Money

An excerpt from Chapter 5 of  Can Heterodox Economics Make a Difference, published by Edward Elgar in 2020. Here is a link to the Table Of Contents, and a link to the biographies of all those interviewed for the project.  

“[Then] there is the question of whether central banks should intervene by controlling the yield curve. … [My] answer is yes and, I would go further. Central banks should control the price of a basket of risky assets. Policies of this kind are not currently in the remit of the Bank of England or the Fed. But they should be. I remain optimistic that my work is leading them in that direction.”
— Roger E. A. Farmer

PA: Are you familiar with the credit and state theories of money?

RF: Peripherally. I’ve been following a debate going on right now on Twitter. Some non-mainstream economists, Jo Michell at Bristol is an example, have been critical of textbook theories of money.

You gave us a set of questions we would discuss in this interview. I laughed when I saw question 7 which reads, “Do you consider the quantity of money to be determined exogenously or endogenously?”, to which my answer is “Yes.” Here’s what I mean by that.

I’m a general equilibrium theorist, in the sense that I want to conceive of the things I observe in the macroeconomy – this comes back to methodological individualism – as choices made by individuals in markets. To answer the question of exogeneity, you have to ask, first of all, what money is. That’s a hard question and there are many different ways of thinking about it. If you go back to worlds where there were commodity monies – gold and silver – it’s quite clear that the quantity of money was exogenously determined. At a point in time, the quantity of precious metals is fixed. There have always been trading mechanisms, trade credit for example, whereby other objects would serve as a medium of exchange. In today’s world where gold and silver have been replaced by fiat money provided by national governments, the distinction between exogenous and endogenous money depends very much on the policies that central banks follow. 

I’ve never understood the criticism of traditional monetarist thought by advocates of modern monetary theory. Orthodox monetary theorists, and here I would include most of the New Keynesians, would agree with the statement that money is endogenous in modern fiat money systems when the central bank pegs the interest rate on short-term debt. But there is a sense in which asking if money is endogenous is the wrong question. The right question is: what determines the absolute price level? Here there is an active debate centred around the question of uniqueness, or non-uniqueness, of equilibrium in macroeconomic models. In all models where the central bank sets the interest rate, as opposed to the quantity of bank reserves, the quantity of money is endogenous. 

Let me return to the question; what is money? A bank is an institution that allows many more objects to be used in exchange than in economies that don’t have banks. In that sense, private banks create money.

If you hold shares in Apple and you go into a  car show room and you try to buy a new Honda by offering them shares in Apple, you’re not going to be very successful because the value of the shares in Apple fluctuates on an hourly basis and nobody really knows quite what they’re worth. Now, imagine an institution –  a bank – that lends to firms and households. The bank holds liens on machines and factories to back its loans to firms and it holds liens on houses to back its loans to households. The banks acts as a guarantor of the value of these assets. 

Take the example of a mortgage.   You go to the bank and you borrow money for a mortgage on your house. The bank manager (at least in the past) knew who you were and had a relationship with you and realised that you were capable of repaying the mortgage. The bank manager’s guarantee turns your house into a negotiable asset that appears on the liabilities side of the bank’s balance sheet and the account that is created by lending you money can then be used in exchange. In that sense, banks create money.  

Bank lending is profitable because the interest rate earned on long-term loans is higher than the rate that banks must pay on their short-term liabilities. The quantity of money that banks create is limited by the need to hold cash and other liquid assets to meet the needs of their customers. The amount of available liquid assets is limited by central bank actions that control the price of credit by buying and selling assets in the markets for short-term funds. Before the 2008 financial crisis, cash and bank reserves did not pay interest, but short-term government bonds did. In that period, there was a positive opportunity cost of holding money. 

Since the financial crisis of 2008, the interest rate on short-term liabilities has been very low and, in some cases zero. And central banks began to pay interest on reserves.  In that environment reserves, which are part of the monetary base, become perfect substitutes for short-term government debt and theories of endogenous money come into their own.  When the opportunity cost of holding money falls to zero, monetary general equilibrium models have even less to say about the determination of the price level than they do when money is scarce. 

When the interest rate is zero, money and bonds become perfect substitutes and there is a continuum of price levels and a continuum of associated values for the stock of money, all of which are equilibrium values in a monetary general equilibrium model.  In those environments, the supply of money is determined by the public’s perceptions of future prices. Beliefs become fundamental in the way I described in my books, The Macroeconomics of Self-Fulfilling Prophecies (Farmer, 1993), Expectations Employment and Prices (Farmer, 2010) and Prosperity for All (Farmer, 2016).[1] The same phenomenon occurs when the central bank pays interest on reserves. Although cash is still costly to hold, cash is a shrinking component of the monetary base.  When the interest rate on reserves is roughly equal to the interest rate on Treasury bills, the economy is in a liquidity trap similar to the one that characterized much of the period in the 1930s in the United States.  The payment of interest on reserves puts us in a whole new world. 

PA: I think your interpretation [of monetary theory] is thought-provoking…. I might go slightly away from the original script to a question that’s very interesting from my perspective: when you talk about equilibrium, do you see it as an ‘ultimate end’ of a tendency, like a point that a force that will take you towards but may not actually reach? Or is it a set point that things adjust to and what would be the adjustment speed of the pathway?

RF: To answer that question, let me use the concept of temporary equilibrium theory. 

PA: …I think it’s called a ‘traverse’, the idea of how quickly you get there, what happens on the way.

RF: Indeed. In the temporary equilibrium story, we all meet in a market every Saturday. When we meet, there must be a mechanism to determine what gets traded. That could be Walrasian market clearing, it could be sticky price equilibrium, or it could be some version of search theory, for example,  ‘Keynesian Search Theory’, a term I coined in my book Prosperity for All. On Saturday we observe the trades that take place, we observe the prices that take place, and we record those trades as a list of numbers on an Excel spreadsheet. Now, if nothing in the world ever changed, our models predict that the list of numbers we record will converge to a constant list. I would call that a steady-state equilibrium. A physicist would simply call it an equilibrium. 

The reason that these uses differ is that the word ‘equilibrium’ in economics is used to mean a Nash equilibrium, which is a set of plans and prices that are consistent with each other in a sense that was made precise for temporary equilibrium models by Roy Radner (Radner, 1972). In a Nash equilibrium, the values of the list of numbers in the Excel spreadsheet may be changing from one period to the next. What qualifies them as ‘equilibrium numbers’ is that at each point in time the numbers record prices at which the quantity of each good demanded is equal to the quantity of each good supplied.  

PA: You’ve really answered the question about banks, so how would you consider interest rates to be determined in theory and practise? Do you think there’s a disconnect between theory and practise?

RF: Well, there’s at least one interest rate that’s set by central banks, which is the overnight rate. Then there’s a whole spectrum of interest rates that are determined in markets. Traditional monetary theory argued that central banks could control only one interest rate but, in the 2008 financial crisis, central banks appeared to exert influence over a whole range of rates. So, in that sense yes, there was a disconnect between traditional monetary theory and practice. 

PA: Would you consider that the central bank could control the spectrum of rates? I’m not saying it should, but if it wanted to, would you think it a feasible thing?

RF: OK, those are two separate questions. I have never subscribed to traditional monetary theories that are set in the context of a single representative agent and in all of my work, central banks can control a whole spectrum of interest rates at different points in the yield curve. 

Second; there is the question of whether central banks should intervene by controlling the yield curve. Again, my answer is yes and, I would go further.  Central banks should control the price of a basket of risky assets. Policies of this kind are not currently in the remit of the Bank of England or the Fed.  But they should be. I remain optimistic that my work is leading them in that direction.

[1] See my entry in the Oxford Research Encyclopedia of Economics and Finance on ‘The Indeterminacy School in Macroeconomics’ (Farmer, 2020). The Indeterminacy School is an approach to macroeconomics that was initiated at the University of Pennsylvania and at CEPREMAP in Paris in the 1980s. It has continued to evolve over the last forty years. The identifying feature of the Indeterminacy School is the willingness to embrace models with multiple equilibria to explain real world phenomena.