A tale of two Crises: Keynesianism, monetarism and the mistakes of modern macroeconomics

The British proverb “horses for courses!” is a reminder, we are told, that you need to choose the correct people for any particular task; there is no “best team” only the right team for the circumstances.

So too—or especially so—with macroeconomics. Unlike the physical sciences, where outcomes are invariant to the political or social greenscreen, macroeconomics is all about context. It is all about choosing right framework for the situation at hand, or “choosing the right metaphor.”

And as the contours of the post-pandemic macroeconomic landscape begin to take shape, a failure to pick the right metaphor is emerging with echoes of the post-GFC narrative—revealing the possibility of a policy mistake every bit as consequential as that committed during the recovery from GFC.

Post-GFC: A failure of fiscal policy

The contrast runs roughly as follows. Post-GFC was all about rediscovering Keynesianism and the importance of fiscal policy—in a roundabout and belated way. 

It started with the (correct) fiscal expansion early after the financial crisis. But it ended with fears about debt sustainability (remember Greece?) and austerity. This then led to a period of miserable, sluggish growth—and ended with populism in key Western democracies of the kind that Keynesianism was invented to avoid. 

In other words, post-GFC austerity was a failure of macroeconomics and the eventual rediscovery of Keynesianism.

Post-pandemic: A rediscovery of Monetarism?

Our current landscape is very different, of course. The post-pandemic vista is one where household balance sheets, unlike post-GFC, are stronger than ever (setting aside distributional issues.) It is a world where fiscal policy is more supportive of the recovery (though not all countries.) Knee-jerk fiscal sustainability concerns have been set aside—for now at least. The government balance sheet is playing the role of shock absorber.

Still, that post-GFC failure to recall the lessons of Keynesianism could just as easily give way to the post-pandemic failure to understand the lessons of monetarism.

Let’s step back a moment. The pandemic required an unprecedented fiscal response—meaning saving by households in sheltered industries has been “intermediated” to those working in unsheltered sectors. Alongside this fiscal response, monetary policy through “quantitative easing” de facto required private sector saving to occur through monetary vehicles—that is, household saving has found expression through monetary financial claims to an extent not seen since wartime.

This step increase in monetary claims implies improved net worth of households—whereas post-GFC was about impaired household balance sheets, post-pandemic is about balance sheet strength. And so, whereas post-GFC required a rediscovery of Keynesianism, post-pandemic might bring a revived appreciation of monetarism. But will mistakes emerge on the way?


What happens when there is a discrete jump in the money supply—an improvement in net worth of households, of “outside assets” of the community as a whole? Well, as Tobin explained half a century ago: “If the economy and the supply of money are out of adjustment, it is the economy that has to do the adjusting.”

In other words, since this is outside money, the economy will have to adjust to stronger household balance sheets. Typically, we might think of adjustment of the deflator for money supply being the price of consumer goods—which is already underway—to leave the real money holdings eventually unchanged. But we might also imagine asset prices—house prices, used cars, crypto, other assets—also jumping to deflate the increased nominal stock of money. After all, what is the correct deflator for money holding? Why only consumption goods?

So far so good.

But what happens next? It’s useful to first dispel the myth that the pandemic saving will be “spent.” This might be true for the individual or household, but for the community overall this saving (unless, e.g., used to repay outstanding bank credit in the aggregate) will remain in circulation—only passed from one individual to another. 

That is: when some central banks talk of saving being “spent” once the pandemic ends (ECB and BOE for example) what they really mean is: the act of saving from the pandemic will be passed between actors within the private sector. To a first approximation, the money stock increase will not reverse because of spending. But that stock will support a greater volume and variety of underlying flows.

And as this spending is unleashed the price of currently produced goods and services, as well as asset prices, will adjust higher to reflect this new money stock. It’s already happening. As I sit here in England, house prices are giddy, a pint of beer and side of sausage roll will come to nearly 10 pounds, and milk by the pint is only available at a price that would make your mother red-in-the-face. 

But two things should be clear. First, the additional price pressure from the pandemic saving—which is, in any case, concentrated disproportionality with the wealthy—will only find partial expression in consumption goods. More likely, it will be capital goods that make money balances “balance”—as Tarquin’s school fees are sorted for the next 12 months and Sophie gets that conservatory she always wanted. 

Second, the economy adjusting to a one-off increase in the stock of money is necessary but not permanent. Indeed, such price pressure is not the same thing as a permanent increase in the rate of growth of monetary liabilities (due to credit growth) which would imply a permanently higher rate of CPI growth.

The post-pandemic policy mistake

With this, the stage is set for a post-pandemic monetary policy mistake, much as post-GFC brought revealed fiscal policy failings. And as then, the two main idiots in the story are Summers and Blanchard.

The mistake this time is failure to recognise the adjustment to a higher money stock as being different to a permanent change in the rate of growth of that stock. The latter would require a fundamental change in the disposition of monetary and non-monetary financial intermediaries in the provision to credit for current spending—and corresponding demand for credit for spending by the private sector. While this might happen, there is no evidence of it happening yet and there is no presumption it will happen under existing institutional arrangements.

Still, the necessary adjustment of prices to pandemic saving is enough for the “big names” to weigh in. Sometimes, less is more. 

But what is most annoying about the whole affair is that if modern macroeconomics has contributed anything useful in the past 40 years, it is the importance of dynamic or intertemporal “thinking.” This reveals the possibility of dynamic inconsistency in everyday decision- and policy-making. It requires careful consideration of the impact today (through expectations) of possible future actions. 

In the days of heady inflation, this meant giving control of monetary policy to someone who would not try and exploit any short-term trade-offs between inflation and unemployment—that which would instead only result in inflation with no real gain.

But it might just be the greatest irony of all, the macroeconomic Gods looking down in glee, that at the very moment macroeconomics as a profession discovered the problem of the “inflation bias,” the policy challenge subtly shifted to the need instead to overcome the “deflation bias.” In fact, inflation was on a secular downward path likely for reasons beyond the control of policymakers. Rather than committing to being “conservative” the community needed central bankers who would instead be reckless—willing to overcome the secular forces of deflation and depression.

And so, modern central bankers found themselves unable to create the very inflation over which they claimed to have command. There was indeed a slip between lip and cup, or something like that. 

The very best modern central bankers, such as Draghi, have been those prepared to abandon their perceived conservatism to experiment. Yet it was discovered that base money expansion was no meaningful substitute for broad money growth—that not all money is alike when it comes to impacting the real economy.

And yet, now we at last have some broad money ebullience and the possibility of escaping from the liquidity trap, those same advocates of the rational expectations, inter-temporal optimisation approach choose to fret about the temporary and necessary adjustment of prices to the higher money stock. This is exactly the possibility we ought to embrace to escape our recent malaise!

With this lack-of-imagination, our challenge of overcoming the structural disinflation bias remains.

This makes it incumbent on those of us who believe in macroeconomics as a force for seeing off extremism and fascism to keep pressing for sensible use of the opportunities provided by the pandemic for steering the macroeconomy. But it’s not made any easier by those who would rather engage in mindless self-promotion than serious macroeconomics.


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