The abject failure of nearly 200 years of economics to supply valid and objective fundamental theory is best illustrated by the theory relating the supply of money to a nation's economic performance, prices, and employment. I used several sources for the following information --- among them was one from Oswego University study chapters on economics, and various Wikipedia articles.
It is the purpose of this note to briefly show the advent of a fundamental theory of economics and the subsequent development of new theories as the prior ones were found to be invalidated by empirical facts. It covers the period from the turn of the 20th century to the latest theory (1956)... all of which have been invalidated by empirical facts since they were developed.
The end of the note discusses why such theories have been so consistently ill equipped to fundamentally account for precisely that for which they were designed to understand. I conclude that it is predominantly because the existing economic paradigm, in place now for over 200 years is closed by the academic community within it to any outside, heretical new theories in order to sustain and protect the existing paradigm and the economic interests in maintaining it.
This theory, developed by the classical economists over 100 years ago, related the amount of money in the economy to nominal income. Economist Irving Fisher is given credit for the development of this theory: The Nature of Capital and Income (1906) and elaborated on in The Rate of Interest (1907). It begins with an identity known as the equation of exchange:
MV = PY
Where M is the quantity of money, P is the price level, and Y is aggregate output (and aggregate income). V is velocity, which serves as the link between money and output. Velocity is the number of times in a year that a dollar is used to purchased goods and services.
The equation of exchange is an identity because it must be true that the quantity of money, times how many times it is used to buy goods equals the amount of goods times their price.
To move towards the quantity theory of money, Fisher makes two key assumptions:
- Fisher viewed velocity as constant in the short run. This is because he felt that velocity is affected by institutions and technology that change slowly over time.
- Fisher, like all classical economists, believed that flexible wages and prices guaranteed output, Y, to be at its full-employment level, so it was also constant in the short run.
So under the quantity theory of money, money demand is a function of income and does not depend on interest rates.
But Is Velocity Constant? A constant V is key to Fischer's quantity theory of money. For Fisher, the assumption was a leap of faith since data on GDP and the money supply did not exist in 1911. However, looking at data it is very clear that velocity is not constant, even in the short run. In particular, velocity drops significantly during recession.
So much for Fisher's 100 year old theory.. It fails any test of validity.
Next, in 1936, economist John M. Keynes developed another theory.... in other words he scrapped Fisher's theory because it was obviously not in concert with all empirical evidence to date.. i.e. real data rejected the theory as having any validity. So he developed a different theory. In this book he developed his theory of money demand, known at the liquidity preference theory:.
M/P = f(i, Y)
Where M, P, & Y are defined as before, but the velocity of money, V, is no longer a variable. He introduces a new variable, interest rate, i . The Velocity of money still exists but is now a dependent function of the interest rate, i, and aggregate output Y:
V = Y/(f(i,Y)). Since interest rates fluctuate quite a bit, then, according to this theory, velocity must also. In fact, velocity and interest rates will, according to this theory, move in the same direction.
One problem with Keynes' speculative demand is that his theory predicted that people would hold wealth as either money or bonds, but not both at once. That is not realistic.
So recognizing this issue with Keynes' theory, William Baumol (in 1952) & James Tobin (in 1956) added to (adjusted) Keynes' theory of how the transactions demand for money is also related to the interest rate. Tobin & Baumol avoided the problem raised by Keynes' theory (holding wealth as either bonds or money but not both at the same time) by observing that the return to money is much less risky than the return to bonds, so that people will still hold some money as a store of wealth even when interest rates are high. This diversification is attractive because is reduces risk. As interest rates rise, the opportunity cost of holding cash for transactions will also rise, so the transactions part of money demand is also negatively related to the interest rate. Similarly, people will hold fewer precautionary balances when interest rates are high.
Still one problem with money demand remains. There are other low risk interest bearing assets: money market mutual funds, U.S. Treasury Bills, and others. So why would anyone hold money (M1) as a store of wealth? Economist today still try to develop models of investor behavior to solve this "rate of return dominance" puzzle.
Theory # 3 in 1956--- In Keynes' theory changes in interest rates have a dominant effect on money demand. Milton Friedman didn't buy Keynes' theory. In 1956 Friedman embraced the techniques of treating the entire economy as having a supply and demand equilibrium. However, because of Irving Fisher's equation of exchange, he regarded inflation as solely being due to the variations in the money supply, rather than as being a consequence of aggregate demand. He argued that the "crowding out" effects [of government fiscal introductions would hobble or deprive fiscal policy of its positive effect. Instead, the focus should be on monetary policy, which was considered ineffective by early Keynesians Other than the fact that Friedman was an ideological libertarian & thus an opponent of gov't fiscal involvement in an otherwise laissez-faire economy there is little Friedman writes that finds any empirical evidence of fault with Keynes' theory as adjusted by Baumol - Tobin. so he developed a another theory based on the general theory of asset demand. Money demand, like the demand for any other asset, should be a function of wealth and the returns of other assets relative to money. Friedman's theory shows that changes in interest rates have little or no effect on money demand.
His money demand function is:
[M / P] = f(Yp , rb - rm, re - rm, pi(e) - rm)
where M & P are defined as before, and
Yp = permanent income (the expected long-run average of current and future income)
rb = the expected return on bonds
rm = the expected return on money
re = the expected return on stocks
pi(e) = the expected inflation rate (the expected return on goods, since inflation is the increase in the price (value) of goods)
In this theory
money demand is positively related to permanent income. However, permanent income, since it is a long-run average, is more stable than current income, so this will not be the source of a lot of fluctuation in money demand.
Thus in this theory money depends dominantly on the returns between bonds, stocks, and expected inflation, each relative to the return on money, such that:
the higher the returns of bonds, equity and goods relative the return on money, the lower the quantity of money demanded. The return on money depended on the services provided on bank deposits (check cashing, bill paying, etc) and the interest on some checkable deposits.
How do Keynes' and Friedman's theory's compare?
Friedman's money demand function is much more stable than Keynes'. Why? Consider the terms in Friedman's money demand function:
- permanent income is very stable, and
- the spread between returns will also be stable since returns would tend to rise or fall all at once, causing the spreads to stay the same. So in Friedman's model changes in interest rates have little or no impact on money demand. This is not true in Keynes' model.
If the terms affecting money demand are stable, then money demand itself will be stable. Velocity will also be fairly predictable.
Do either Keynes' or Friedman's theory's stand up to empirical data?
Data over time shows that money demand IS sensitive to interest rates, So Friedman's theory fails to hold water on that count, while Keynes' theory predicts the relationship.
Tobin did some of the earliest research on the relationship between interest rates and money demand and concluded that money demand IS sensitive to interest rates. Later research in the 1950s and 1960s backed up his findings. Furthermore, the sensitivity did not change over time. Many researchers looked at this question and their findings are remarkably consistent
So what about the stability of money supply? It was stable from the 1930's (after the1929 crash), supporting Friedman's theory... until the mid-1970's that is when it became increasingly unstable. Since the money supply measure was based on M1, and it's finding of being unstable after the mid-1970's, it was attributed to a narrower than real definition of the money supply... so M2 began to be used since that remained stable (again, thus broadly supporting Friedman's theory)... but in the 1990's that too fell apart as M2 began fluctuating widely.... and since.
Thus Friedman's theory also turns out to not hold any water on both counts of it's difference to Keynes' theory --- The money supply responds with high sensitivity to interest rates (Friedman's theory says it shouldn't) and the money supply is only stable over short runs (Friedman's theory says it must be stable over long runs).
So of the three major and different theories developed over a 50 year span from the turn of the century of how an economy's money supply relates to it's output/incomes, only Keynes' theory (as adjusted by Baumol - Tobin) appears to stand the tests of time and data, although not in its entirety... especially as indicated by the period of stagflation during the 1970's.
One can only conclude that even the thus far best theory of the fundamental relationships of money supply and an economy's output and prices is not supported by empirical data... hence even the best one is not valid. What does this say about the field of economics and it's economists? In over a century of academic study of the three major theories proposed two are patently and undeniably rejected by actual data and facts on their theory's most fundamental basis, and the one remaining fails to account for all the facts as observed over time.
One must conclude that those academics in the field of economics have been undeniably unable to present a coherent, valid theory upon which the entire basis for the macro-economic observations depend... so either the economists are too narrowly focused on the independent & dependent variables they believe are involved, or they are totally off track in their pursuits of foundations of economics as it actually works in practice.
It's not a new field of study, this! It's over a century old... nearly two... fer christ's sake. That's on the order of 7 - 8 generations of academics! There aren't even any sub-sets of theory's that hold water over time and different economic geographies... even the so called "long term" empirical "facts" being promoted as quasi-economic law keep being found in substantial error given broader observations over time. Very obviously then, some or several fundamental independent variables that have significant & dramatic effects on economic outcomes are wholly unknown and unaccounted for by the academics that have been leading the profession for nearly 200 years. I'd say then that this supports my view that the field of study is too narrowly focused on things they believeare the independent variables, but have at the same time systematically excluded their efforts applied to search for and find the independent variables they lack. But why? That has to be the over-riding question.
There are several possibilities.
One is found in other academic fields and has been found to have been due to what I'll call academic protectionism. This occurs when the leading academic community retains and has a vested interest in maintaining their existing schools of thought... and this precludes the entrance of new (aka heretical) research and publications.
One would think this protectionism would therefore be substantially eroded over multiple generations of academics... but in the field of economics this hasn't been the case. It seems therefore that entrance to the field and thence getting any support within the field requires adherence to the existing paradigm which has been promoted and the same for over two hundred years. In other words perhaps a credential of academic validity depends on joining the existing club and promoting it's existing thought. This is what can be referred to as a closed society. Those outside this society and who get any attention (by whatever means) in the field are vehemently attacked to ostracize their heretical theories or foundations... giving them a "bad" name so that any others in the field who might think to pursue further work along the heretical lines are dissuaded from such pursuit. This is basically a coercive from of compliance.
Another possibility is that economic support for academic pursuits in the field of economics is grossly limited to those pursuits which further the interests of those providing the economic support. Thus Schools of Economics and their academic staffs at colleges and universities are supported by grants from corporate and other economically based institutions and endowments from wealthy donors. Both the former and the latter have a vested interest in the existing economic paradigm... that is those theories that support continued and increased ability to capitalize / profit from policies which promote that ability --- and hence academic theories and hypotheses that run counter to such supporting foundations are as well funded, if at all... or their funding depends on limiting publication and efforts applied to counter the existing domination of theory that continues to support the economic interests of owners.
Another possibility is that the new theories and hypotheses are only published by the major academic publications only when peer reviews prior to publication acceptance are given thumbs up. Unless the new theories and hypotheses substantially support (read as don't reject) existing thought, peer's are not likely to provide give the thumbs up required. This is an offshoot of the first possibility above, but is done outside the economic institutions of learning... limiting distribution of publication. Since most of the publications are supported by member subscriptions (a substantial proportion by corporate and other financial institutions), then such subscriptions would substantially decline if the publication accepted papers that countered the interests of existing member subscriptions.
The latter possibility above is probably less of a restriction on non-conventional theory publication as it was in the past since the advent of internet blogging and alternative internet publication has become more prevalent as a communication venue among academics in the field. At the very least it opens up the field somewhat to contrarian theories becoming more well known... hence subverting to some extent the absolute adherence to existing economic thought and research.
I mentioned in the note I'm replying to that not only have theories failed to to be supported by empirical data, but that some quasi-economic laws have also failed to stand rigorous tests of comparison's with real world facts.
One of these is the Phillips curve... a relationship of unemployment to inflation... which is attributed to the observations of A. W. Phillips in 1958. It of course failed to predict the stagflation conditions of the 1970's so has had to be modified by new theories on the relationship (if indeed one is causal of the other at all). In other words both variables were dependent on others... the implied causation of unemployment by inflation was completely false.
However, it turns out that Phillips was not actually the first to publish the empirical relationship between inflation and unemployment levels.... the first to publish this relationship was actually Irving Fisher (the same Fisher who's theory of money supply to national output was the first to fail the test of real world data). Fisher published his statistical analysis of the relationship of unemployment to inflation rates in June 1926... fully 32 years earlier than Phillips (source).
I only mention this because it shows that the same information, observed at two entirely different points in time (a generation or more apart), both by favored economists at their respective times, tend to reinforce a flawed belief and understanding. Neither economist was able to show causation ... hence their empirical observations could only be described objectively as "interesting", but not significant in the context of economic "law" which both were proposing was "likely" the case (of course as always, "subject to further investigation"... a classical and oft used caveat).
So it is thus illustrative of the fact that "further investigation" found the same relationship, drawing the same conclusions (one favored economist supporting a former one), but that no economist (published widely in national journals) called either Fisher's or Phillips' conclusions to account before the clear-cut empirical evidence showed these so-called "laws" were absolutely without foundation... twenty years later. This also illustrates the fundamental failure of the economics profession to use science in derivation of validity of their proposed "laws" and "theories" of economics.