Why Money? A Light-Hearted Response to Paul Davidson

Say what?

I know, you all think I am nuts. Not content with bashing away endlessly at my fixation with Coase and his simple question, now I am asking an even more ridiculous one.

Why money?

Actually it’s not my question, but was posed by that sly Paul Davidson in a comment on one of my posts earlier this week. Davidson is the patron saint and protector of American Keynesian economics, so he darned well knows the answer.

The question deserves a response so that you, poor readers, can once again marvel at the insanity that is orthodox economics.

You see, just as there are no firms in orthodoxy, there is no money.

Gulp.

Is this for real? This is economics after all.

Obviously I simplify. Greatly. But this is for fun. And here is not the place for a lengthy discussion. Still: you should all be aware of the deep problem that money poses for economics.

Remember all those neat charts about supply and demand? They have price on one axis and quantity on the other. Did you ever focus on why it was “price” and not dollars [pounds, euro, yen etc]? It’s because orthodox economics conducts its enquiries in a world of relative values. A price is a ratio between things to be exchanged. This ratio yields a “real” relationship that needs no mediation. And money is a mediating device. It isn’t needed in a “real” world. Not to be confused with the real world where you and I live.

Orthodox economists are comfortable with this absurdity because they want to study the effects of moving the relative values about. Money would get in the way. Just in case you think I am nuts, allow me to point you to the textbook on my shelf: David Kreps inestimable “A Course In Microeconomic Theory”, a worthy representative of its ilk. This is a 800+ page tome. Its entire second section is devoted to something called “the price mechanism”. Its table of contents has not one – not one – reference to money. Not one. This is a microeconomics textbook that is supposed to describe the magical powers we all rely upon in the free market. Money makes dramatic appearance in macroeconomics textbooks. On my shelf I have Olivier Blanchard’s “Macroeconomics”. Its table of contents is littered with references to money. Most of these references appear to be attempts avoid the subject. Thus money “neutrality” gets a nod. So does a nice section describing how the Fed screwed up the money supply and caused the Depression – well I’m being harsh, but it sure reads that way.

Anyway. You get the picture. At one end of economics, the micro end, where the holy grail is revealed to us all, money is persona non grata. At the other it gets a lot of air, albeit begrudgingly and usually as something that causes problems, as in inflation – “too much money chasing too few goods”. Who knew money was this difficult?

This is even more confusing when you realize that one of the great fads of recent economics has been to make sure that the macro end of things conforms with its micro foundations. Money is not in the foundation, but it pops up – from thin air? – at the macro end.

How come?

Well, it exists in the real, as opposed to the “real” world. So even orthodox economists have to deal with it. Which they don’t do very well.

And why is Professor Davidson rubbing our noses in this little conundrum?

Look again at the Blanchard table of contents, and you see a separate entry: “money illusion”. What, money is an illusion? Not really, except in orthodoxy. The problem is that regular people, like you and me, are not too good at those relative values. In fact we tend to get muddled up when money is in the picture. When the value of things is expressed in money and not in ratios to other things, we tend to lose sight of the “real” world in our real world. We get carried away with the dollar signs and act irrationally. Thus – and Keynes came up with the phrase – we suffer from an illusion. And this illusion can play havoc with the economy because it induces odd behavior. The kind of behavior that undermines the neat, well oiled and perfect machine called the free market.

In fact it upends the entire edifice. Or what’s left of it after Coase has had his way.

Having tossed this grenade into orthodoxy Keynes had the nerve to go further: he said that money can take on all sorts of other roles too. It doesn’t just act as oil to smooth out exchange. Sometimes we – gulp again – save it. Why would we do such a thing? Doesn’t orthodoxy teach us we know everything in the future? Yes it does. But we still, silly us, save as a hedge against uncertainty. We store it for future use knowing that the future is full of nasty surprises. There are no nasty surprises in orthodoxy. There are lots of them in a Keynesian world. Indeed, the entire Keynesian structure is hinged on his acceptance of uncertainty.

This is an even bigger grenade.

Because it causes us to need to worry about savings, the desire to save, and the nefarious effects changes in that desire to save can have on the economy.

Like now, when we need people to be spending more and not saving so much.

So, as you can see, Professor Davidson’s little question: “why money?” is just as inflammatory, in many ways more so, than the Coase question I have been prattling on about.

And I haven’t done it justice, but hopefully you are starting to see why orthodox economists, those who preach market magic, and advocate all sorts of deregulation, anti-government policies, are so divorced from reality. Their world contains neither firms, nor money. I wonder which economy they are theorizing about?

One, completely off the wall, way of sealing your allegiance to the alternative world is this:

Back in the run up to the Depression a great economist, Irving Fisher, an early pioneer of the transition from classical to modern neoclassical [i.e. orthodox] economics, spent a great deal of time working on the money illusion and matters related to money generally. He wrote a classic book on the subject in 1928. He also lost his shirt during the Depression, and is famous for issuing a strong statement of support for the stock market just as it was about to go into free fall. This was a disaster for him personally and perhaps his reputation. Nonetheless he occupies an iconic place in the development of modern orthodox theory.

Contrast that experience with Keynes. Far from losing his shirt, he made a fortune for himself and his college, where he administered the funds, during the height of the Depression.

Now, I realize this is entirely unfair and has nothing to do with the efficacy of their respective contributions to economics. But who would you, as an outsider want to listen to more? Fisher, the more orthodox economist? Or Keynes, he of the great uncertainties, and the decidedly unorthodox?

No question. Right?

Just follow the money.