“I apprehend that bank notes, bills, or cheques, as such, do not act on prices at all. What does act on prices is Credit, in whatever shape given, and whether it gives rise to any transferable instruments capable of passing into circulation or not.” John Stuart Mill, 1848 “The relation of changes in M (money) to Y (income) and r (the interest rate) depends, in the first instance, on the way in which changes in M come about.” John Maynard Keynes, 1936 John Cochrane has an interesting post about a Milton Friedman article. But the post does, fifty years after Friedman published the article, still not address the Main Monetarist Mistake: ignoring credit. The entire discussion if money is neutral is redundant as money creating credit is not. Definitely not. Changes in credit – to be more
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“I apprehend that bank notes, bills, or cheques, as such, do not act on prices at all. What does act on prices is Credit, in whatever shape given, and whether it gives rise to any transferable instruments capable of passing into circulation or not.”
John Stuart Mill, 1848
“The relation of changes in M (money) to Y (income) and r (the interest rate) depends, in the first instance, on the way in which changes in M come about.”
John Maynard Keynes, 1936
John Cochrane has an interesting post about a Milton Friedman article. But the post does, fifty years after Friedman published the article, still not address the Main Monetarist Mistake: ignoring credit. The entire discussion if money is neutral is redundant as money creating credit is not. Definitely not. Changes in credit – to be more precise: in the stocks of debt, in the flows of new credit and in the terms of availability of credit – do influence the short and the long term development of an economy. Debts and credits make a large difference to the long run development of countries. Here a fine Reinhart and Rogoff working paper about this, which also shows that financial crises are not rare. This is not just about bank credit – Microsoft financed the transfer of its intellectual property by intercompany payables which do show up in the statistics on international capital flows! Credit is an essential part of a capitalist and even a market economy. And, as Keynes suggested, it makes quite a difference if banks provide credit to enable households to buy existing houses or to enable companies or governments to invest in new roads and houses.
At the time, Mill as well as Keynes of lacked the data to back their ideas – and they were still right. Nowadays as well as fifty years ago we such data: the Flow of Funds (FoF). But instead of using such data, Friedman as well as Cochrane seem to be content to only use a very limited subset of these FoF and to ignore credit, debt and ‘the way in which changes in M come about’. The text below (from the 1945 yearly report of the NBER) can be understood as the birth certificate of this statistical system:
At the suggestion of the Committee for Economic Development a study of the flow of money payments was planned in 1944. It is now authorized for 1945-46 with contributions from the Committee and with the cooperation and collaboration of public and private agencies. Morris A. Copeland has accepted appointment to the staff to undertake it and will begin work as soon as he can be released from his duties at the War Production Board. The objective is to improve the understanding of the workings of our economic system by measuring the flow of payments and comparing its fluctuations with those of goods. In a money economy, where economic activities are organized chiefly in business enterprises, employment of resources, production of goods, their distribution to consumers, and hence public welfare depend upon the circuit flow of money payments to and from enterprises, individuals, and government agencies. Within the last decade, approximations to the flow of goods and services that make up the national product have been developed and compared with estimates of the counter-flow of national income. The Department of Commerce is currently estimating both flows. About the circuit flow of payments and its relation to national income and output, our knowledge is exceedingly vague. We do know, however, that the flow of payments does not adjust itself automatically to the flow of goods men are able to produce and need to consume. Indeed, several theorists have argued that cyclical fluctuations in business activity are due primarily to recurring changes in the relative size of these two flows. The findings this investigation promise should put us in a far better position to diagnose our recurrent chills and fevers, and to: seek remedies.
Morris Copeland finished his task in the fifties and central banks all over the world were quick to make this system the cornerstone of their monetary statistics. One would have expected that the FoF would have become a cornerstone of academic macro-economic analysis. This, however, did not happen. First, another NBER project (constructing monthly series of money) which in 1948 was assigned to Milton Friedman resulted, in 1963, in the book by Milton Friedman and Anna Schwartz ‘A monetary history of the United States‘. This is a very good but also a very limited book. Time series on monetary aggregates like M1 money (cash) or M2 and M3 money (cash plus different kinds of deposit money) are a limited subset of the FoF. The FoF shows, in detail, why this money is created, which (sub-)sectors are borrowing and where it goes (cash, deposit money, abroad, whatever). And it’s not just about bank money but also about other liquid items. It is fully consistent with the intuitions of Keynes and Mill. It matters if money is created to finance purchases of existing houses or to invest in new roads or AI. Friedman and Schwartz do not mention the FoF even tough Friedman had been a colleague of Copeland at the NBER. Friedman stated that money was neutral in the long run but to be able to do this, he had to ignore the main part of the monetary system! In a sense, all the monetary action is outside the scope of monetarism as defined by Milton Friedman (look here for nifty FoF graphs). John Cochrane should have addressed this. He doesn’t – and stays mired in a kind of economics which was already outdated in 1963 (see also this 1963 article of Hyman Minsky about the Friedman/Schwarz project). Aside of this, one can pose the question why especially USA many academic economists were and are loath to embrace the wealth of data of the FoF and instead opted for a monetarist view and loanable funds economics or, a little later, even for a view of the economy as a barter system.