Friday, October 3, 2014

Happy 90th to Leland Yeager

October 4, 2014  will be Leland B. Yeager's 90th birthday.  He has made many contributions to economics and political economy.

Like the other charter members of the Virginia School of Political Economy, he is a mainstream libertarian.   However, he has been a consistent supporter of a rule-utilitarian approach to moral and political philosophy.   He has always worked to weave together the best insights from the neoclassical and Austrian  traditions.     But perhaps more importantly,  his contributions to Chicago-school monetarism  provided tremendous insight into the essential role of money in the economy--what he described as monetary disequilibrium.   Finally, when monetary innovation made the definition of quantity of money problematic and measured velocity lost its remarkable stability, Yeager did not follow the rather convenient shift in Chicago-school monetarism, towards rational expectations and market clearing.  Rather he turned towards free banking and privatized money.

Yeager took the view that the most important and interesting macroeconomic problems involve the process by which a market economy adjusts to imbalances between the quantity of money and the demand to hold money.  In particular, inflation is the equilibrium result of  a quantity of money greater than demand and recession is part of the adjustment process of a quantity of money less than the demand.   While for many years Yeager favored a money supply rule, suggesting he judged that shifts in the demand for money were unlikely to be a serious problem,  he always considered possible a recession due to an increase in the demand to hold money.  

In an early paper, "A  Cash Balances Approach to Depression" (1956,) he discussed a possible scenario where an increase in the demand for short and safe government bonds might spillover to an increased demand for money, leading to a recession.    That a recession might occur despite an increase in the quantity of money and in combination with exceptionally low interest rates would be no surprise to those who grasp Yeager's view of monetary disequilibrium.

Yeager always argued that economists understood the importance of aggregate demand and sticky prices and wages long before Keynes.   The review of earlier textbook economics in "The Keynesian Diversion" (1973)  is instructive, but I greatly appreciated his discussion there of what I like to describe as the "Yeager Effect."    Because the demand to hold money is positively related to real income, any reduction in real income results in a reduced demand to hold cash balances.   Starting from a condition of monetary equilibrium, as long as the quantity of money doesn't decrease as well, the result will be excess money balances and so increased spending on output.   In one sense, this just shows how adverse productivity shocks are inflationary.  However, it is more important when considering supposed "demand shocks" that are not associated with changes in the quantity of money or the demand to hold it.  

Consider the paradox of thrift.   Does an increase in saving result in reduced real output and income?   Unless that increased saving involves either directly or indirectly an increase in the demand to hold money, then any reduction in real output and real income will result in reduced money demand and increased expenditures on output.    For another example, suppose that one firm reduces its investment expenditure because it is building capacity to sell to some other firm, and weak animal spirits cause it to fear that the other firm will not undertake the investment expenditures necessary for the planned sales to materialize.   Supposedly, the reduced expenditure then leads to reduced output.   However, unless these firms are holding money rather than spending on capital goods, the reduced real output and income would lead to a reduced demand to hold money, and increased expenditure on output.    Coordination failure accounts of demand constrained production, absent an imbalance between the quantity of money and the demand to hold it, are self-contradictory.

The "Yeager Effect" is dependent on the monetary regime.  The assumption is that real output and real income shift, the demand to hold money changes the same, but the quantity of money remains unchanged.    Yeager was certainly aware that a banking system might respond to depressed economic conditions by reducing the quantity of money rather than holding it steady.    This points to an additional major emphasis of his work--the distinction between money and credit.   For Yeager, money is the medium of exchange.   The quantity is the amount that exists and the demand is the amount that people would like to hold.   Credit, on the other hand, involves borrowing and lending.   Banks can lend money into existence, expanding the quantity of money even if there is no one who wants to hold the additional balances.   And those wishing to hold additional money balances have no directly reason to show up at a bank seeking to borrow.   The interest rate that clears credit markets does not necessarily keep the quantity of money equal to the demand to hold it.    It is the price level for goods and services, along with the prices of resources, including nominal wages, that must adjust to keep the real quantity  of money equal to the demand to hold it.

As financial innovation made measurement of the quantity of money problematic, Yeager became more interested in free banking and privatized monetary alternatives.   Along with Robert Greenfield, he introduced the Black-Fama-Hall Payments System in "A Laissez-Faire Approach to Monetary Stability" in 1983.    The emphasis was on a medium of account separate from the medium of exchange.   They suggest that the medium of account sould be  a broad bundle of goods and services.    This would be roughly similar to a gold standard, but with a bundle of goods defining the dollar rather than a specific quantity of gold.   With the relative price of this bundle of goods stable, there would be no need for shifts in the price level to clear markets.   There could be no significant inflation and no need for a painful recession to generate necessary deflation.

The competing media of exchange were to take the form of checkable mutual fund shares.   The prices and yields on each, as well as the quantities, would adjust to keep the quantity supplied and demanded equal for each monetary instrument.   Monetary disequilibrium would be avoided without the need for adjustments in prices of goods and services or wages and other nominal incomes.   Interestingly, there would be no zero nominal bound on interest rates with such a monetary order.   The nominal yields on these mutual-fund like monetary instruments could be less than zero, along with the yields on any other financial instruments.   Of course, that would only be true if such negative nominal yields were necessary to equate quantity demanded and quantity supplied for the monetary and other financial instruments.

As Yeager and others explored this alternative regime, it became clear that the market processes that would apply are similar to a conventional monetary order than appeared at first glance.  In particular, indirect convertibility received more emphasis.   Checks made out in dollar amounts, and especially inter-bank clearings, would need to be settled.  Indirect convertibility is the notion that a dollar claim would be settled with some financial asset, or perhaps even gold, that has a current market value equal to the sum of the market prices of the items in the bundle of goods defining the dollar.    The process that would reverse any deviation of the price level from the equilibrium implied by the definition of the dollar would involve shortages of money if the price level were too high and surpluses of money if it is too low.    And while individual issuers of mutual funds competing for market share would make appropriate changes in prices and yields as well s quantities to reflect the demands for those using the monies, the entire monetary system would be constrained through at least incipient pressure on the price level, particularly the prices of the items defining the dollar.

While mutual-fund type monetary instruments have some potential advantages, the growing emphasis on indirect convertibility made it clear that the BFH system was consistent with more conventional checkable deposit accounts.   The yields and quantities of those could adjust just as well as those on mutual fund shares.    And while Yeager and Greenfield had mentioned the possibility of some subsidiary role for privately-issued hand-to-hand currency from the start, the growing emphasis on indirect convertibility suggested that the quantities of banknotes could be limited to the demand to hold them even if the nominal yield on such currency were always zero.  Of course, if banks found it unprofitable to issue such currency, then there would be none and all payments would be made by some type of checkable account--deposit or mutual fund.

In working out some of the practical issues in choosing an appropriate bundle of goods to define a dollar, Yeager proposed that monetary instruments be redeemed partially on demand, and then a remainder be settled up subsequent to the measure of the price of the bundle.   This pointed to redeemability with futures contracts on a price index, an approach that was pursued by Kevin Dowd and which also pointed to Scott Sumner's parallel work on index futures targeting.   Yeager, working again with Greenfield, also explored a "real GDP dollar." which directly points towards a stable value for nominal GDP.

Finally, Yeager not only traced concern with monetary disequilibrium and aggregate demand to pre-Keynesian economics, he also maintained a common sense view that economics is about explaining the real world.   He was critical of what he called "hyperclassical" doctrines that in the name of rigor or methodological presuppositions ignore the reality of nominal stickiness and instead seek to explain business cycles as optimal responses to real factors.    While better explanations of wage or price stickiness should be welcomed, the absence of such explanation is no excuse to imagine that prices adjust continuously to clear all markets.  

I have learned a tremendous amount from Leland Yeager and I hope to learn more.   I would encourage other economists to do the same.  Happy 90th Birthday!


  1. Very good post Bill.

    "Of course, if banks found it unprofitable to issue such currency, then there would be none and all payments would be made by some type of checkable account--deposit or mutual fund."

    Suppose that initially banks find it profitable to issue 0% interest convertible paper currency. And then something changes (e.g. market interest rates fall) and banks no longer find it profitable. Would they be able to insist that existing paper currency be brought in and converted into demand deposits?

  2. I think a call option would be wise, but with a privatized system, it is up to the issuers, right?

    1. I think the call option would be the only credible way to manage it. The alternative is to have a positive risk of default, or else the option to redeem at less than face value (which creates a moral hazard problem).

  3. I think there is a positive risk of default with bank issued currency. The interest rate on T-bills or central bank deposits could be more negative than a situation where with government currency.