Paul Samuelson and Monetary Policy

By now I am sure most of you will have learned of the Paul Samuelson’s death over the weekend. His reputation inside the economics profession is huge, to say the least, with most people rating him as one of the most influential economists of the 20th century, if not all time. For students of my generation his text book was the entry point into the world of economic thinking. Its success marked by the fact that it went into what seems like endless editions, and that it became the touchstone for subsequent text book authors as they tried to shape the subject in more recent decades.

His contribution to economic theory ranges over a wide spectrum and is unlikely to be matched any time soon. Certainly there is no one active today with as wide a set of interests and, given the turmoil into which the subject has fallen, no one is likely to emerge to challenge that breadth any time soon.

My own view is somewhat mixed. He undoubtedly moved economics forward. He was instrumental in managing the subject’s difficult transition from the divisive debates of the 1930’s into the more coherent, some like myself might say overly restrictive, period of the 1950’s. He was the major reason economics is now couched almost exclusively in mathematical terms; he attacked the very difficult subject of preferences; and he acted as a bridge for equilibrium theory before it was fully articulated by Arrow and Debreu in the mid-1950’s. My problem is that each of these huge efforts moved the subject inexorably towards the ‘utopian’ other-worldly state it now occupies. I doubt whether he was as disconnected from reality as most of the subjects leading thinkers are today, but he gave legitimacy to the slide away from reality that so taints the subjects relevancy currently. Things like ‘revealed preferences’ are brilliant intellectual sleights of hand that certainly allow the math to work, but they add a barrier to our understanding of real world human behavior, and a modern economics should surely incorporate the actions of real people. In a way the challenge before us is to steer the subject back through the 1930’s debates, retain the pieces of Samuelson [et al] that work, and get rid of most if not all the theorizing that’s been done since the 1960’s.

One more example of why I have a mixed reaction to Samuelson. He claimed to have incorporated thermodynamics into economics. This may be true as far as equilibrium thinking and the conservation aspects of the first law of thermodynamics. But nowhere in his work do I find an articulated impact of the second law. This is the law that refers to entropy and is thus the very foundation of the ability of all things to change. The second law is the most important of all the laws of physics. He cannot have been ignorant of it. But by eliding or ignoring it Samuelson failed to incorporate uncertainty and all the problems that a disorderly world presents. He thus failed to think through the impact of information. Had he done so the subject would have avoided some of its subsequent folly.

In contrast he was a major factor in bringing Keynesian thought to America. For this we should be grateful, although the Friedman led monetarist revolution would still probably have marginalized Keynes.

In this latter perspective Samuelson shows his true analytical genius. His text book speaks to the problems of monetary policy under today’s circumstances. In particular he discussed, in his chapter on central banking policy, the exact problem we now face: the existence of huge bank reserves that are being hoarded rather than lent.

This phenomenon defeats the major premiss of the strict monetarists.

The problem is this:

As the Fed tries to encourage lending so as to boost the economy it can do two things: first is to reduce interest rates; second is to inject reserves and increase the money supply. These two actions are effectively the same in terms of outcome. Lower rates are obviously designed to encourage demand for loans. Businesses that are hesitant to borrow at a high rate should be more willing to borrow at a lower rate. Once they borrow they have cash to spend on expansion and hiring workers. The idea behind injecting reserves is to pump cash into the banks so that they can meet this increased demand for loans.

The difficulty is, as Samuelson wrote, that no one can force a bank to lend or a company to borrow. If neither inducement works all we have accomplished is to flood the banks with cash that they simply sit on. We have moved their assets from their bond holdings to their cash account, but achieved nothing. Liquidity is high, but activity remains low. The potential is there for a spurt of lending, but in reality it is dormant.

That Samuelson foretold our exact circumstances with such clarity back in 1948, only serves to highlight how far economics has subsequentlywandered from reality. For this we cannot blame him. That dishonor goes to Friedman, Lucas, and Prescott.

But that’s another story.

Today we honor Samuelson.