Monetary muddles.

• Author: Leijonhufvud, Axel
• Position: Essay

The stability or instability of the market economy is an issue that has been all but ignored in macroeconomics for several decades. Within monetary economics, the distribution of income has been similarly ignored. The crisis of recent years tells us in no uncertain terms that we have to pay more attention to these two topics.

Changes in financial regulation and in the conduct of monetary policy have not only played a very significant role in generating the financial crisis but have also been important in bringing about a large shift in the distribution of income over the last two or three decades.

Lack of Attention to Financial Stability and Income Distribution

The lack of attention to the stability of the financial system is at first sight surprising. Every economist knows about bank runs, after all. But in the United States, deposit insurance had eliminated runs on deposit banks ever since the Great Depression. Runs on banks in other parts of the world--of which there was a significant number made no impact on an American-dominated economics profession that regarded the problem as solved.

The crisis dictates a reappraisal. It also demonstrates that the problem had metamorphosed, for old-fashioned bank runs were basically not involved. (1) We have much to learn before we can be confident that we know how the present-day financial system can be reliably governed.

For a very long time, monetary economics has been dominated by theories in which money is neutral. In such theories, monetary policy has only evanescent effects on the allocation of resources and affects the distribution of income or wealth only in so far as people fail to anticipate the inflation rate correctly when entering into nominal contracts.

But money is not neutral in the present monetary regime. It is obvious that monetary policy has had very significant effects on the allocation of productive resources in the long run-up to the crisis. It is perhaps less obvious that it has also affected the distribution of income. But I believe it has.

A Look Back

The two great names in monetary economics a century ago were Knut Wicksell and Irving Fisher. Both were intensely preoccupied with the distributive consequences of monetary management. In fact, it was very largely this concern that motivated their work in monetary economics.

Wicksell sought to find a way to manage money so as to stabilize the price level and thus to avoid price changes that would change the real outcome of nominal contracts. Fisher advocated the compensated dollar--a scheme to "correct" the distributional effects of changes in the price level. (2) Both of them saw distributive effects of changes in the price level as offenses against social justice and consequently as a threat to social and political stability.

Wicksell and Fisher were of course both aware of the potential instability of fractional reserve banking systems and of the recessions resulting from bank runs--as were all their contemporaries. But both tended to believe two things: (1) that the economic system was basically stable (3) provided the price level was kept more or less constant, and (2) that (with the same proviso) the distribution of income was determined by the marginal productivity of the factors of production.

Today, distributive issues have not been of interest to monetary economists for many decades. Not only are they no longer a central concern--they are ignored and forgotten altogether.

Turning next to the greats of monetary theory of half a century ago I would single out Friedrich von Hayek and Milton Friedman. It is noteworthy that these two icons of free market conservatism agreed on nothing at all in the field of monetary economics. (4) Friedman always took the basic neutrality of money for granted. Hayek, on the other hand, was one of the two most prominent advocates of the Austrian theory of the business cycle--and in that theory money was anything but neutral but responsible for large and long-lasting effects on the employment and allocation of resources.

Credit-driven boom-bust cycles are temporally asymmetrical. The buildup is slow and long, the collapse quick and sudden. In Hemingway's The Sun Also Rises, one of the protagonists asks his friend: "How did you go bankrupt?" "Two ways," went the answer, "gradually, then suddenly."

The period leading gradually to the recent sudden crisis has the hallmarks of an "Austrian" boom. For a great many years, the Austrian theory of business cycles was kept just barely alive by a small and rather marginal group in the economics profession. For the past 60 or 70 years, macroeconomics was dominated first by Keynesian theory--or, I should say, by what was widely thought to be Keynesian theory--then by Monetarism and most recently by Dynamic Stochastic General Equilibrium (DSGE) theory--an evolutionary sequence of theories that ended up in a fool's paradise conducive to much mathematical elaboration, and thus very congenial to modern

economists. Intertemporal equilibrium models incorporating no financial markets did not offer much help in understanding the events of recent years.

Interest in the Austrian theory will presumably revive. In its original form, however, it predicted that an overinvestment boom would be accompanied by inflation. Mises and Hayek had of course lived through the great post-WWI inflations and knew firsthand not only the great redistributions of wealth that they brought but also the social and political upheavals that followed.

There was not much in the way of CPI inflation in the run-up to the recent crisis. So some modification of the original theory is in order. Moreover, we have to consider whether monetary mismanagement may have significant distributive effects even when the price level does not change significantly.

Losing Control: Structure, Regulation, and Policy

For some 60 years after the Great Depression, the financial system of the United States remained basically stable. The Glass-Steagall regulations successfully constrained the potential instability of fractional reserve banking. A number of developments in the past 20 years undermined this stability and, in 2007-08, the system suddenly proved dramatically, disastrously unstable.

Deregulation and Industry Structure

The financial structure inherited from the 1930s divided the system into a number of distinct industries: commercial banks, savings and loan associations (S&Ls), credit unions, and others. It also divided it spatially. Banks located in one state could not branch across the line into...