Money/Macro: Who is the GOAT?

Tyler Cowen makes a convincing case that when it comes to choosing the greatest economist of all time, what matters is the journey, not the destination.  I’m not qualified to offer an opinion on that topic, but I do have some views on the more limited question of who’s the greatest macroeconomist of all time.

Macro is often defined as including three broad areas:

1.  The determinants of long run economic growth.

2.  The determinants of nominal aggregates such as the price level and NGDP.

3.  The determinants of short run changes in output and employment.

Call these topics growth, inflation and the business cycle.

As far as growth is concerned, it seems like we are all in the shadow of Adam Smith.  He had pretty much figured things out by 1755, a full 21 years before writing his classic book on growth theory, The Wealth of Nations:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.

What more is there to say?

But I’m going to focus on the other two parts of macro, sometimes referred to as the theory of money, prices and employment.  This area is my favorite part of economics, and has attracted many of the very best minds.  While most of growth theory is boring and useless, money/macro is full of fascinating, counterintuitive puzzles and elegant theories.  It is regarded as being less “scientific” than micro, but I don’t believe that is correct.  Yes, we cannot predict the business cycle, but we also cannot predict movements in the price of oil or wheat.

Like Tyler, I won’t name a single GOAT in money/macro, instead I’ll consider three names:  David Hume, Irving Fisher and Milton Friedman.  Those are obviously not the three names that most economists would chose, so I’ll need to explain my choices.

Tyler Cowen somewhat downgraded economists that developed important theories, if he viewed the theories as being wrong.  I will do the same, but even more ruthlessly than Tyler.  Thus I need to begin by explaining what I view as the correct model of money/macro.  I see two fundamental models that have endured the test of time, each of which contains numerous sub-models:

Model #1:  Nominal aggregates are determined by changes in the supply and demand for the medium of account (usually money).  In the long run, an exogenous change in the stock of money leads to a proportionate change in aggregates such as the price level and NGDP.  In contrast, an increase in money demand reduces prices and NGDP.

Model #2:  In the short run, nominal (monetary) shocks also cause employment and output to move in the same direction.  In the long run, money is neutral and employment and output return to their natural rates.

Obviously, there’s much more to money/macro then those two models.  But I see these models as being fundamental, while other useful models explain and extend these two basis theories.  My choice for the three greatest economists in the field of money/macro include the economist who developed the basic framework, and two others who extended these models in some highly useful ways.

Hume:  In economics, it’s almost never the case that an innovator is actually the first to develop an idea. You can almost always find precursors to a “new idea”.  Even so, in the mid-1700s David Hume developed both Model #1 and Model #2 to a level of sophistication that is well ahead of anyone else of whom I am aware.  For instance, consider the famous equation of exchange:

M*V = P*Y

Hume never wrote down that equation, but he discussed the monetary theory using those variables as a basic framework.  More specifically, he observed that:

1. In the long run, an exogenous change in money leads to a proportional change in the same direction in prices.

2. A reduction in velocity will tend to affect prices in exactly the same way as a reduction in the money supply.

3. An increase in real output will tend to cause a proportionate reduction in prices.

Before you say “duh”, keep in mind that even many modern economists do not know these things.  Many economists still believe that rapid economic growth is inflationary.  Here are three quotations from Hume’s writing to support my claims.

Quantity theory of money:

If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.

Effect of real economic growth:

Hume also developed Model #2.  He argued that increases in the money supply cause a temporary boom, and decreases cause a temporary depression:

It’s almost impossible to overstate the brilliance of Hume’s work on money/macro.  Even today, many economists have trouble holding both of these facts in their minds at the same time:

1. More money leads to higher prices and higher output in the short run.

2. More output leads to lower prices.

Now think about the world in which Hume lived.  He couldn’t just look up these ideas in a book, as economics didn’t even exist as a field.  There was very little economic data on variables such as the money supply, the price level and GDP.  Monetary policy didn’t exist in the modern sense of the term.

Hume certainly knew something about the world or else he would not have been able to develop these models.  But more clearly than anyone else, he was able to look at a messy, complicated reality and see the underlying forces driving movements in prices, employment and output.  In my view, that makes him a contender for the greatest macroeconomist in history.  Milton Friedman would almost certainly agree:

Double-digit inflation and double-digit interest rates, not the elegance of theoretical reasoning or the overwhelming persuasiveness of serried masses of statistics massaged through modern computers, explain the rediscovery of money.” (Friedman, 1975, p. 176.)

As I see it, we have advanced beyond Hume in two respects only; first, we now have a more secure grasp of the quantitative magnitudes involved; second, we have gone one derivative beyond Hume.” (Friedman, 1975, p. 177.)

Why is Hume not more highly rated?  Modern economists often whine that they cannot understand a model unless it’s written down as a set of equations.  That tells us more about the poverty of their understanding than about the advantage of “rigor”.  Thus the problem with MMT is not that they don’t have a rigorous mathematical model, the problem is that their verbal model is nonsense.

So who advanced the field beyond Hume?  Who pushed it one derivative further?  Who wrote the classic studies of the “quantitative magnitudes”?

There are two names that stand far above all others, Irving Fisher and Milton Friedman.  Hume looked at what happened when there was a change in the price level.  Fisher and Friedman considered the effect of a change in the rate of inflation.  Hume had very little data to work with.  Fisher and Friedman helped develop some extremely important data sets, and did brilliant analysis with their data.

Fisher:  I am not expert on the history of economic thought, but I am aware of several important contributions of Irving Fisher:

1. The Fisher equation:  Nominal interest rate = real interest rate + expected inflation.  This is where he went one derivative beyond Hume.

2. The Phillips Curve:  In 1923 and 1925 he published papers showing a strong correlation between employment/output and a distributed lag of inflation.  It wasn’t until 1973 that economists recognized that Fisher had preceded Phillips by 34 years.

3. A model of the real interest rate based on time preference (saving) and investment.

4.  An outstanding history of the “stable money” movement.  Fisher was an advocate of price level targeting, to be accomplished by adjustments in the dollar price of gold.  FDR adopted this approach in 1933.

5.  Although Hume developed the idea behind the Equation of Exchange, it was Fisher who first wrote down the equation.

6.  Fisher wrote “The Money Illusion” in 1928, a brilliant analysis of the concept.

I’ve argued that there are three basic approaches to monetary economics, the quantity of money approach, the price of money approach, and the interest rate approach.  While most economists only use one approach, Fisher did high quality work using both the quantity of money approach and the price of money approach.  (He wisely avoided the interest rate approach, which is the weakest of the three.)

David Henderson has a very nice summary of Fisher’s achievements in a wide variety of areas.  I was especially gratified to learn that Fisher opposed income taxes and instead favored a consumption tax.  (BTW, by the standards of the 1920s, Fisher was a “progressive”.)  Joseph Schumpeter, James Tobin and Friedman all called Fisher the greatest American economist.

Friedman:  Milton Friedman added one derivative to the Hume/Fisher “Phillips Curve” model.  In my view, the Natural Rate Hypothesis (developed independently by Friedman and Phelps) was Friedman’s most important theoretical innovation.  Of course he also did a great deal of high quality empirical work, notably the Monetary History, co-authored by Anna Schwartz.

Hume and Fisher both lived in a world dominated by commodity money, where it was natural to think in terms of one-time changes in the price level (up or down.)  Friedman lived in a fiat money world, where people began thinking in terms of changes in the trend rate of inflation.   At the time Friedman did his best work, the field of macro was dominated by Keynesian theory.  But this proved to be something of a dead end in a world of fiat money, and Friedman was able to revive the old quantity theory of money, updated for a world of fiat money.   Importantly, Friedman developed this approach before the gold price peg was abandoned in 1968, and inflation took off.  His model did extremely well “out-of-sample”.

I won’t say any more about Friedman, as his greatness is pretty well understood.  I recently did several long Econlog posts (here and here) explaining his importance to money/macro.

PS.   I have a few observations on some other important macroeconomists who did work in money/macro.  (I’m not an expert on the history of economic thought, so this list is incomplete.)

1. Next to Fisher, Ralph Hawtrey is my favorite interwar economist.  Gustav Cassel and George Warren were also excellent.  Keynes’s Tract on Monetary Reform is outstanding, but he fails to make my top three due to the General Theory, which is a highly flawed book.  People defend the book by pointing to some supposedly brilliant insights.  Those insights do exist, but they are not the ones usually cited.  Thus his comparison of asset markets to a beauty contest is nonsense.  He is extraordinarily unfair to the so-called “classical” economists, who did not believe what he says they believed.  His “multiplier” approach to aggregate demand is useless, and his attempt to defend arguments for things like fiscal stimulus and protectionism is worse than useless.  He had little understanding of the importance of the Fisher effect or supply shocks.  He was wrong about monetary policy being ineffective at the zero lower bound, confusing that issue with the constraints on monetary policy under a commodity money regime.  And the book is often confusing, poorly written by the standards of its highly talented author.  (In contrast, the Tract is very clear and easy to follow.)

2. During the period when Friedman did his best work, his closest rival was Robert Mundell.  In contrast to Friedman’s quantity theoretic approach, Mundell used a price of money approach.

3. In the final decades of the 20th century, Robert Lucas was the dominant figure in macro.  Bennett McCallum did the best work updating macro theory based on the insights of Friedman and Lucas.  And Earl Thompson was hugely underrated, doing some of the most interesting work.

4. In the 21st century, the Princeton School has done the most important work.  The key paper here is Paul Krugman’s 1998 article on monetary policy at the zero lower bound.

Happy New Year!

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