The University of Adelaide School of Economics

Research Paper No. 2008-05

Keynes, Keynesians and Contemporary Monetary Theory and Policy: An Assessment

Colin Rogers

Keynes,Keynesiansandcontemporarymonetarytheoryandpolicy:an assessment

ColinRogers SchoolofEconomics UniversityofAdelaide Email:colin.rogers@adelaide.edu.au

Abstract: TherehasbeennoKeynesianRevolutionineconomictheorybuttherehasbeenan unacknowledged Keyness Revolution in economic policy. Keyness theoretical revolution restedontheadoptionofmonetaryanalysis andtheapplication ofthe principleofeffectivedemandtodemonstratetheexistenceofmultiplelongperiod equilibria. Keyness policies creating a role for Big Government and the Big Bank followfromhistheoryandhavechangedthestructureofthe laissezfaire economy.ManyKeynesiansfailtoacknowledgeeitheroftheseissuesandcontinue the classical tradition of real analysis and the assumption of unique longperiod equilibrium.Realanalysis,asaspecialcaseofKeynessmonetaryanalysis,provides a distorted perspective of the responsibilities of monetary policy which largely accountsfortheincreasingfragilityandvolatilityexhibitedbyfinancialmarketsover thepasttwodecades.

Papertobepresentedatthe4thInternationalConferenceon KeynessInfluenceon ModernEconomicsTheKeynesianRevolutionReassessed,atSophiaUniversity, Tokyo,1920March.

Keynes,Keynesiansandcontemporarymonetarytheoryandpolicy:an assessment

ColinRogers UniversityofAdelaide

DraftMarch2008

Introduction Tomany,therelationshipbetweenKeynesandKeynesianeconomicsisanenigma. Ontheonehand,Keynesclaimedthatthe GeneralTheory wouldrevolutionisethe wayeconomiststhoughtabouttheaggregateeconomy.Ontheotherhand,inanearly review,Knight(1937)urgedreaderstodisregardtheclaimstorevolutionandtreatthe GeneralTheory asjustanothercontributiontothetheoryofthetradecycle.Many Keynesians,oldandnew,havetakenKnightsadvice.Consequently,Laidler(1999) makesastrongcasethattheKeynesianRevolutionwasafabrication.Laidlerargues, from a classical perspective, that what passes for Keynesian economics does not involve a theoretical revolution at all but rather a repackaging and recasting of classical theoretical ideas and policies. The most obvious illustration of Laidlers thesisisthereliancebyKeynesianeconomicsonthestickinessofpricesandwagesto explainunemploymenttheveryexplanationthatKeynes(1936,p.257)attributesto theclassicaleconomistsintheGeneralTheory!MorerecentlyTily(2007)arguesthat KeynesianeconomicsrepresentsabetrayalofKeynes,echoingalongstandingview

heldbyCambridgesupportersofKeynes,suchasJoanRobinson,RichardKahnand PaulDavidson(1972,2002,2007).Thuswhenexaminedfromeitheraclassicalora Keynes perspective there appears to be no theoretical revolution in much of contemporaryKeynesianeconomics.Thatconclusionissupportedbyareadingof Skidelsky(2003).

Despite the rejection of Keyness theory, Keynes also made two crucial policy proposalsthatfollowfromhisrevolutionarytheoryandthesehaveindeedbeentaken up,but,ofcourse,withoutanappreciationofthetheoreticalframeworkfromwhich theyarederived.Thesetwopolicyproposalshaveleadtoafundamentalchangetothe structureandbehaviourofmanyeconomies postKeynessinfluence oneconomic policyinthelate1930sandearly1940s.Thetwopolicychangesaretheincreased roleofgovernmentinmanagementoftheaggregateeconomyandthecreationof central banksactinginthepublicinterest.Priortothe GeneralTheory,monetary theoristspracticedwhatSchumpeterlabelledrealanalysistheideathatmoneyis somehowaveilandisthereforeneutralinthesensethatithasnoimpactonlongrun equilibrium.Inrealanalysis,longrunequilibriumisdeterminedbyrealforcessuchas productivityandthriftaswasthecasewithWicksells(1898)naturalrate,Fishers (1907) triple equality or Robertsons (1966) loanable funds theory of the rate of interest.ByfollowingKnightsadvice,themajorityofoldandnewKeynesianshave embracedrealanalysis.

By contrast, in the General Theory, Keyness theoretical revolution consisted of abandoning real analysis, the dichotomy between real and monetary factors, and

integrating the role of monetary factors into the determination of longrun equilibrium.Theanalyticalframeworkthatwastobringabouttherevolutioninthe wayeconomiststhoughtabouttheaggregateeconomy,Keynessdubbedtheprinciple ofeffectivedemand.1Theprincipleofeffectivedemandistheanalyticalfoundationof Keynessmonetaryanalysisandthebasisonwhichhispolicyproposalsarederived.I willarguethatmonetaryanalysisandtheprincipleofeffectivedemandshouldchange thewayeconomiststhinkaboutmonetaryeconomicsbecausetheyprovidethegeneral analyticalframeworkwithinwhichmuchofcontemporaryanalysisis,atbest,nested asaspecialcase.Atworst,somecontemporarymonetarytheoryisanillustrationof theworkofremorselesslogicians,who,startingwithamistake,endinbedlam.2

Againstthisbackground,toassesstheinfluenceofKeynessrevolutionarytheoryon moderneconomicstheremainderofthispaperisstructuredasfollows.SectionII providesabriefoutlineofKeynessrevolutionarymonetaryanalysistoillustrateits level of generality and to explain the existence of longperiod unemployment equilibrium and the failure of Says Law in laissez faire monetary economies. Keynesspolicyproposals;thesocialisationofinvestmentandtheabandonmentof gold andits replacement byagreencheesefactoryacting inthepublicinterest (nationalizationofthebankofEngland),thenfollowdirectlyfromhistheory.Minsky (1986)describesthesechangesasintroducingaroleforBigGovernmentandthe
KeyneshasbeencriticisedbyPasinetti(1997)forfailingtospelloutwhathemeantbytheprinciple ofeffectivedemand.ThereissomemerittothiscriticismbecausewhenKeynesfirstintroducesthe conceptinchapter3oftheGeneralTheoryhewasnotinapositionyettostresstheimportantroleof therateofinterestintheprincipleandheemployedasimpleversionofSaysLaw.Nevertheless, Keynes(1936,p.31)clearlyflagstheimportanceoftherateofinterestforlaterapplicationsofthe principleandlaterapplicationsoftheprincipleintheGeneralTheorymaketheanalysisclearasis demonstratedinparticularbyKregel(1976). 2 KeynesisreputedtohavedescribedHayekstheoryofthetradecycleastheworkofaremorseless logicianwho,becausehestartedwithamistake,endedinbedlam.
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Big Bank. Section III applies Keyness monetary analysis and the principle of effectivedemandtoexaminecontemporarymonetarypolicywithparticularemphasis oninflationtargeting.Fromtheperspectiveoftheprincipleofeffectivedemand,price stability, although necessary in a monetary economy, is not sufficient to ensure macroeconomicstability.Theprincipleofeffectivedemandmakesitclearthathaving createdcentralbankstoactinthepublicinterestgovernmentsnowgivethemtoo narrowamandatetotargetpricestabilityonly.SectionIVconcludeswithacalltore instate the analytical framework offered by Keyness monetary analysis and the principleofeffectivedemand.Itwillfreecontemporarymonetaryscienceandpolicy fromtherathernarrowanddistortedfocusinwhichitiscurrentlyoperating.

II

Keynessgeneralmonetaryanalysisandtheprincipleofeffectivedemand

ThemostimportantaspectofKeynessGeneralTheorytorecogniseisthenatureof the generality to which it lays claim. Keynes aims to offer a general analytical frameworkthatcanbeappliedtoanalysetheaggregatebehaviourofanymonetary economy,irrespectiveofitsinstitutionalarrangements.Furthermoretheanalysisisto applytosituationsofuncertaintyandriskwhereriskallowstheapplicationofthe probabilitycalculusbutuncertaintyrequiresinadditiontheapplicationofweightto probabilitiesandtherecognitionthatrulesofthumbandconvention mayreplace rationalcalculationinsomecircumstances.Minsky(1976,pp.6467)describesthis approachtodecisionmakingunderuncertaintyasKeynessdualdecisionscheme(not tobeconfusedwithClowers(1965)conceptthatusesthesameterminology).The economicanalysisisaggregateMarshallianinstructureandexplicitlyincorporatesthe

fallacy ofcompositionasthebasisofthedistinction betweenmicroeconomic and aggregateanalysis.

Thus, as Davidson (2007) has recently stressed, Keynes was offering a general analyticalapparatuswithwhichtoanalysetheaggregatebehaviourofamonetary economy.Bycomparison,classicaltheoryisbasedonanarrowersetofassumptions or axioms that preclude elements that Keynes explicitly included. 3 In that sense classicaleconomicsisaspecialcase,onethatmaysometimesnestwithinKeyness generalanalyticalframework.Thisfeatureitselfisthecauseofmuchconfusionabout Keynessvisionasitinvolvescasesofobservationalequivalence.

Keynessmonetaryanalysisandtheprincipleofeffectivedemand ThekeyanalyticalinnovationoftheGeneralTheory,Keynessprincipleofeffective demand, is itself a generalisation of classical ideas that he had employed in the Treatise. The essence of Keyness insight is the recognition that a laissez faire economy can settle into longrun equilibrium before full employment is reached becauseemployersreachalimittotheprofitableexpansionofoutput.Onceinsuch equilibrium,entrepreneurshavenoincentivetoincreaseaggregatedemandandSays Lawfails. Theprincipleofeffectivedemandoutlineswhythishappens.Keyness building blocks fortheprinciple ofeffective demand;the propensity toconsume, liquidity preference and the marginal efficiency of capital are generalisations of
3

Keynes(1936,p.34)wascriticalofclassicaleconomistsforexcludingdifficultissues.Contemporary classicaleconomistsadoptthesamestrategywhentheyarguethateconomictheorycanbeappliedto situationsofriskbutnotuncertainty.Keynessadoptedacontraryattitudeand,asCarabelli(1988,p. 219)explained,didnotconsideruncertaintytobeintractablebutproposedatheoryofactionwith limitedknowledge.Soalthoughuncertaintywasnotreducibletocalculableorinsurableriskthatdid notimplythatbehaviourwasirrational.Decisionmakersfollowedexistingconventionsorfollowedthe informedopinionmuchasfundmanagersdotodaywhentheirbehaviourisdescribedasherding.

classical concepts and reflect relatively stable behavioural characteristics of householdsandfirms.Considertherelationshipbetweentherateofinterestandthe marginalefficiencyofcapital.

Keynes(1936,p.228)explains,inplainEnglish,therelationshipbetweentherateof interestandthemarginalefficiencyofcapitalinthefollowingterms(i.e.describing thepointofeffectivedemand): Nowthoseassetsofwhichthenormalsupplypriceislessthanthedemandpricewill benewlyproduced;andthesewillbethoseassetsofwhichthemarginalefficiencyof capitalwouldbegreaterthantherateofinterest..Asthestockofassetsis increased,theirmarginalefficiencytendstofall.Thusapointisreachedatwhichit nolongerpaystoproducethem,unlesstherateofinterestfallsparipassu. InMarshallianlanguage,Sayslawfailsinamonetaryeconomybecausetherecan existalimittotheprofitableproductionofcapitalgoodsbeforefullemploymentis reached.Unilateralattemptsbyentrepreneurstoincreasesupplywillresultonlyin losses unless the point of effective demand is shifted. Increased supply does not automaticallyincreasedemandsufficientlytoselltheincreasedoutputatanormal profit, whenthemarginal propensity toconsumeis less than oneandthe rate of interestdoesnotfallautomatically.

In terms of Kregels (1976) taxonomy of Keyness models, multiple longperiod equilibria arepossibleandwehavelongperiodunemployment equilibrium inthe staticmodel.4LongperiodequilibriumisclearlynotuniqueintheGeneralTheoryas Keynes(1936,p.242)makesclear,againinplainEnglish.Withonlyconventionto
4

ThedynamicbehaviourofKeynessmodelofshiftingequilibriumwasbestcapturedbyShackless conceptofKeynesianKaleidics.InalaissezfaireeconomyKeynessmonetaryanalysisleadstothe conclusionthatflexibilityoftheeconomyislikelytoleadtodestabilisingdeflationorinflationrather thananautomaticreturntofullemploymentaspostulatedbyclassicaleconomics,Rogers(1989).

guidethem,financialmarketparticipantscouldmistakethenormestablishedbyan inappropriateconventionforonebasedonrealobjectivemarketforcesbutthepoint ofeffectivedemandmaynotbeconsistentwithfullemployment.

Consequently,theGeneralTheoryismorethananothertheoryofthebusinesscycle; itisprimarilyatheorythatexplainspersistentsuboptimalperformancebyalaissez faireeconomy.Keynessawafundamentalstructuralflawinalaissezfaireeconomy (onoroffthegoldstandard).A laissezfaire economyisoneinwhichtheprivate sectorsliquiditypreferencewouldholdinterestratestoohigh,giventheaggregate propensitytoconsumeandthemarginalefficiencyofcapital,thepointofeffective demand would generally not coincide with full employment. As Keyness (1936, p.204,emphasisadded)explains,whendiscussingfluctuationsintherateofinterest aroundadurablelevel,thelaissezfaireeconomycouldfluctuatefordecadesabouta levelofactivitytoolowforfullemployment: But it [the rate of interest] may fluctuate for decades about a level which is chronicallytoohighforfullemployment;particularlyifitistheprevailingopinion thattherateofinterestisselfadjusting,sothatthelevelestablishedbyconventionis thoughttoberootedinobjectivegroundsmuchstrongerthanconvention,thefailure ofemploymenttoattainanoptimumlevelbeinginnowayassociated,intheminds eitherofthepublicoroftheauthority,withtheprevalenceofaninappropriaterange ofratesofinterest. Keynes(1936,p.204,emphasisadded)thenwentontomakeastatementthatturned outtobeanoveroptimisticassessmentofmanyofhisreaders: Thedifficultiesinthewayofmaintainingeffectivedemandatalevelhighenoughto providefullemployment,whichensuefromtheassociationofaconventionaland fairly stablelongtermrateofinterest,withafickleandhighlyunstablemarginal efficiencyofcapital,should,bynow,beobvioustothereader.

ThusKeynesemploysMarshalliantoolstopresentinplainEnglishtheviewofan economythatfluctuates,asaconsequenceofavolatilemarginalefficiencyofcapital, aboutalevelofeconomicactivitytoolowtosustainfullemploymentbecausetherate ofinterestistoohigh.Thereisa structuralandacyclicalproblem.Furthermore, contra much of Keynesian economics, no amount of flexibility in the rest of the systemcouldautomaticallyshiftthepointofeffectivedemand,whichdeterminesthe level of activity around which the economy fluctuates, to be consistent with full employmenteveninthelongrun.Harrod(1947,p.69,emphasisadded)summedthis upbestwhatKeynes(1936)hadinmind. Thetheoryofinterestis,Ithink,thecentralpointinhisscheme.Hedepartsfromthe oldorthodoxyinholdingthatthefailureofthesystemtomovetoappositionoffull activity is not primarily due to friction, rigidity, immobility or to phenomena essentiallyconnectedwiththetradecycle.Ifacertainlevelofinterestisestablished, whichisinconsistentwithfullactivity,noflexibilityormobilityinotherpartsofthe systemwillgetthesystemtomovetofullactivity.Butthiswrongrateofinterest,as wemaycallit,isnotitselfarigidityorinflexibility.Itisnatural,durable,and,ina certainsense,inafreesystem,inevitable. Themaintenanceofhighemploymentwasthereforenotsomethingthatwouldoccur automatically,inalaissezfaireeconomy,eveninthelongrun.Itsachievementrested onaparticularsetofcircumstancesand/orrequiredastructuralchangetotheway governments, the monetary system and central banks behaved. The principle of effectivedemandisthereforetherevolutionaryanalyticalinnovationofthemonetary analysis presentedinthe GeneralTheory anditprovidesananalytical framework relevanttoanymonetaryeconomy,beithistoricalorcontemporary.

OfrelevancetothefocusofthispaperisKeynessgeneralisationoftheclassical psychological concept of time preference by splitting it into two elements; the

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marginalpropensitytoconsumeandthestateofliquiditypreference.Itisthelatter whichplaysakeyroleindeterminingtherateofinterestinamonetaryeconomyand itisthiselementwhichismissingfromrealanalysis.

Liquidity,liquiditypreferenceandliquiditytransformation The concept of liquidity is fundamental to Keyness monetary analysis and the conceptofliquiditypreferenceintheprincipleofeffectivedemand.AsWray(2006) hasrecentlystressed,liquiditypreferencetheoryisbestinterpretedasatheoryofasset pricing. It is a theory of asset pricing distinct from that of real analysis where fundamentals are often described as Fisherian.5 In the General Theory monetary factors arepart ofthefundamentals. Keynes (1936,p.168)alsostresses that the existence of uncertainty is a necessary condition for the existence of liquidity preference. The liquidity of an asset as a function of risk and uncertainty is determinedbytheabilityoftheownertoconvertitintomoneyatanytimewithout significantloss. Asallsecuritiesaretitlestofuturecash(money)flows,whether coupons,dividendsorrentstheyaresubjecttotheuncertaintyandriskattachedtothe processofliquiditytransformation. Individualsneedthesecurityofliquiditythe abilitytosellsecuritiesatshortnoticewithoutsignificantlossinorganisedmarkets, while producers need continuing and durable finance. Financial markets are an inventionthatallowsfortheseconflictingneedstobereconciled.Organisedmarkets allowtheliquidityneedsofindividualinvestorstobereconciledwiththedurableand lumpycapitalneedsofspecialisedproductionprocessesandtheconstraintsimposed bytime.
5

SeeLucas(1990)whonotesthatassetpricesoftendontseemtoreflectFishersfundamentals.For Keynes,monetaryfactorsarepartofthefundamentals.

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Thusallformsoffinancialintermediationareengagedinreconcilingthelongterm needsofborrowerswiththeshorttermneedsoflenders. Thisprocessofliquidity transformationappliestoallfinancialtransactionswheresecuritiesareexchangedfor money. Liquidity transformation is an unavoidable characteristic of a monetary economywithfinancialmarkets. But,asKeynes(1936,p.160)pointedout,this arrangement, liquidity transformation in organised markets, although the best of possibleoptions,raisessomedifficulties.Individualinvestors needtobelievethat theirinvestmentsareliquidbutthiscannotbetrueinaggregatesothatindividual liquiditymightvanishinamarketpanic.Thefundamentalandunavoidableproblem thatindividualliquidityisnotthesamethingasaggregateliquiditycannotbeavoided byeithermarkets orinstitutions. Thisisnothingmorethananillustrationofthe fallacy of composition on which the distinction between microeconomics and macroeconomics ultimately rests. This fallacy, Imight add, has disappeared from muchofcontemporaryrealanalysisbasedasitisonmicroeconomictheory.

Banks and financial markets are therefore all unavoidably engaged in liquidity transformation.But,ofcourse,inasituationwherelossofconfidencestrikes,the liquidityoffinancialmarketsevaporatesunderawaveofsellorders.Similarly,abank engagedinliquiditytransformation,facesaliquiditycrisisinthecaseofabankrun, thatwillresultininsolvencyunlessithasaccesstoalenderoflastresort.Thebanking collapses ofthe1930slargelyreflectedabankingsystembasedongold.Leading banks,eveniftheyhadwantedtodoso,wereeffectivelyconstrainedfrompreventing

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the collapse. (See Eichengreen (1992) and Wray (2006, p. 279) for further explanation).

Keynesspolicyproposals Based on his application of the principle of effective demand under uncertainty, Keynesproposedatwoprongedstructuralchangetothelaissezfaireeconomy.These werethesocializationofinvestmentandthereplacementofgoldbygreencheese withthegreencheesefactoryunderpubliccontrol. ThefirstofKeynesspolicyproposalshasreceivedsomeattentionintheliteraturebut has generally been interpreted by Keynesians, who cannot see the principle of effective demand, as something equivalent to theuseofcountercyclical policy to smooth the business cycle. It should be apparent now that Keynes intention was somewhat different. Keynes proposed a greater role for government investment measuredasapercentageofGDPsoastoreduceuncertaintyfacingentrepreneursby stabilising aggregate demand. Kregel (1985)has provided aclear outline ofwhat Keynes had in mind. The intention is to lift entrepreneurs perceptions of the sustainablemarginalefficiencyofcapitalandcrowdinprivatesectorinvestment.The ultimateobjectiveistoproduceafundamentalchangeintheeconomybyproducinga morebenignenvironmentinwhichtheanimalspiritsofentrepreneurscouldprosper andbelessvolatile.Inthatwayboththevolatilityofthecycleismoderated andthe averagelevelofeconomicactivitymademoreconsistentwithfullemployment.

IntodayslanguageKeyneswasproposingastructuralchangetotheeconomythat wouldshiftitsgrowthpathclosertothatconsistentwithhighorfullemployment.The 13

onusisonusinggovernmentasapermanentbuiltinstabiliserratherthangovernment respondingtocyclicaldownswingsviapublicworksandtaxcuts.Thelatterresponse couldbedeployedinanemergencybutmightprovedifficulttoimplementintermsof timing and magnitude and would signify that the builtin stabilising role of governmenthadfailed.Paradoxically,onereasonforthisfailuremightbethesuccess ofthebuiltinstabilisingroleofgovernmentitself!Wewillreturntothisthemebelow afterconsideringthesecondelementofKeynesspolicyproposaltheneedfora greencheesefactoryunderpubliccontrol. ThisaspectofKeynesspolicyproposalsisoftenoverlooked,perhapsbecauseofthe crypticwayitispresentedinthe GeneralTheory andperhapsbecausemanyearly Keynesians neglected Keyness monetary theory and saw little role for monetary policyrelativetofiscalpolicy.AsTily(2007)pointsout,thisissurprisinginviewof Keynessadvocacyofwhatisknownasacheapmoneypolicy,i.e.theneedtokeep thelongtermrateofinterestlowandstableasthecontributionofmonetarypolicyto shiftingthepointofeffectivedemandclosertofullemployment.Keyness(1936,p. 235)callforgreencheesetoreplacegoldandthegreencheesefactorytoactinthe publicinterestwasthereforeaimedatshiftingthepointofeffectivedemandtoalevel consistentwithhighemployment.Keynes(1936,p.235)presentstheargumentas follows: Unemploymentdevelops,thatistosay,becausepeoplewantthemoon;mencannot beemployedwhentheobjectoftheirdesire(i.e.money)issomethingwhichcannot beproducedandthedemandforwhichcannotbechokedoff.Thereisnoremedybut topersuadethepublicthatgreencheeseispracticallythesamethingandtohavea greencheesefactory(i.e.acentralbank)underpubliccontrol.

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Theneedforacentralbankunderpubliccontrolarisesfromtheneedtokeepinterest ratesatalevelsuchthatthepointofeffectivedemandisconsistentwithahighlevel ofemployment.Keynesarguedthatunderagoldstandardinalaissezfaireeconomy withagivenquantityofgold,therateofinterestwouldeffectivelybeinthehandsof theprivatesectorandinevitablysetataleveltoohighforfullemployment.Two developmentswererequiredtoovercomethisproblemabandoninggoldasabasefor themoneysupplyandreplacingitwithbankmoney(greencheese).Thelatterwould beinmoreelasticsupplyandtherateofinterestwouldbeunderthecontrolofthe centralbankinafashionnowfamiliarunderelectronicsettlementsystems.Oncethe greencheesefactoryisinthebusinessofproducinggreencheeseitshouldalways beinapositiontoimposelossesontheretailersofgreencheese,theprivatebanks, andtherebymaintaintherateofinterestatthedesiredlevel.

Theproposaltoreplacegoldwithgreencheeseandplacethegreencheesefactory underpubliccontrolwasimplementedbyBritainin1946andmanyothercountries havefollowedthismodel.PriortothisitisfarfromclearthattheBankofEnglandor theFederalReservewasawareoftheneedtoactinthepublicinterestorevenwhat that would entail. Thus Keyness twopronged policy proposals sketched in the GeneralTheory wereintendedtobringaboutapermanentstructuralchangetothe laissezfaireeconomyandpermanentlyshiftthepointofeffectivedemandcloserto thefullemploymentpotential.Minsky(1982,1986)deservesthecreditfordrawing ourattentiontotheimportanceofwhathecalledtheBigGovernmentandtheBig Bankinchangingthebehaviourofthelaissezfaireeconomy.

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AlthoughthereisnogeneralcounterfactualagainstwhichKeynesspolicyrevolution canbetestedIwouldarguethatitisatleastoneoftheexplanationsforthesuperior economic performance overthepast70years.Certainly,technical innovation and advancehasproceededatapacethatwasunimaginedbyKeynesbutthereissome evidencethatgovernmentsizedoesimpactonmacroeconomicperformance.6

III

The principle of effective demand and contemporary monetary theory

andpolicy ItisclearthatKeynessprincipleofeffectivedemandisabsentfromcontemporary monetarytheoryandplaysnopartinguidingcontemporarymonetarypolicy.Recall thatmostKeynesianshaveretainedrealanalysisandthisisevidentinthecontribution ofthosenewKeynesianstothenewconsensusmodelformonetarypolicy.Thecore theoreticalmodelofthenewconsensusemployedforpolicyanalysisconsistsofa Phillips curve,IStypecurveandaninterest raterule.Arestis andSawyer(2005) provideanexcellentsurveyofthepropertiesofthismodel.AsexplainedbyPalley (2006) and Rogers (2006c) the model reflects classical or real analysis and not Keynessmonetaryanalysisdespitesomeelementsofobservationalequivalence7.The problemwithrelyingonrealanalysisisthatitdistortsthewayinwhicheconomists thinkaboutmoneyandmonetarypolicy.Evenifitisinterpretedasaspecialcase,real analysishasledmonetarytheoriststooverlookimportantelementsoftheirdiscipline.

Thereissomeempiricalevidencethateconomieswithalargegovernmentsectoraremorestablethan economieswithsmallergovernmentsectors.SeeGali(1994)andArestiset.al.(2004)whoshowthat financialstructureexertssignificanteffectsonmosteconomiesintheirsample. 7 ThoseKeynesianswhoemploymonetaryanalysishadargued,wellbeforethecurrentembraceof interestraterulesbyKeynesianrealanalysis,thatthemoneysupplywasendogenousandtherateof interesttheinstrumentofmonetarypolicy.

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Contemporarymonetarytheory;engineersandscientists Contemporarymonetarytheoristsinthetraditionofrealanalysiscanbedividedinto twogroups,engineersandscientists,alongthelinessuggestedbyMankiw(2006).8 The engineers are thosewho deal with policy and the groupincludes academics, centralbankersandregulatorswhoemployaversionofthenewconsensusmodel referred to above. By contrast, the scientists aim to provide the theoretical foundations fortheconsensus model tobeimplemented bytheengineers. Inthis respectderegulationoffinancialmarketsisofteninspiredbythemonetaryscientists who employ the ArrowDebreu model interpreted by many as the foundation of monetaryscienceandthebasisforthebeliefinefficientfinancialmarkets. 9 Iwill brieflyoutlinethedistortionstoclearthinkingonmonetarytheoryproducedbythe useofrealanalysisonthepartofscientistsandengineers.

Taking the scientists first, Allen and Carletti (2007, p. 2089, emphasis added) illustrateanapplicationoftheArrowDebreuphilosophyofefficientmarketstothe discussionofliquidity: The essential problem with incomplete markets is that liquidity provision is inefficient.Thenatureofriskmanagementtoensurethatthebankorintermediaryhas the correct amount of liquidity changes significantly from the case of complete markets.WhenmarketsarecompleteitispossibletouseArrowDebreusecuritiesor equivalentlyafullsetofderivativesordynamictradingstrategiestoensureliquidity isreceivedwhenitisneeded.Thepricesystemensuresadequateliquidityisprovided ineverystateandispricedproperlystatebystate.Tounderstandhowthisworksit ishelpfultoconceptualisecompletemarkets intermsof Arrowsecuritiesthatare tradedattheinitialdateandpayoffinaparticularstate. Inthiscasebanksand otherintermediariesbuyliquidityinstateswhereitisscarcebysellingliquidityin stateswhereitisnotscarce.
8

Theremaybesomeoverlapwithsomeengineersclaimingscientificstatus.SeeClaridi,Galiand Gertler(1999). 9 Forexample,Wallace(2001)regardstheArrowDebreumodelasthedevelopedpartofeconomics andmonetarytheoryasundeveloped.

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Incontrast,whenmarketsareincomplete,liquidityprovisionisachievedbyselling assetsinthemarketwhenrequired.Assetpricesaredeterminedbytheavailable liquidityorinotherwordsbythecashinthemarket. ThisdescriptionbyAllenandCarlettiofthetheoreticalvisionthatunderpinsmuchof contemporaryfinanceandmonetarytheoryillustratesthenatureofthedistortionsin thewaymonetaryscientiststhinkaboutamonetaryeconomy.Twoexamples will suffice to illustrate the point. First, monetary theorists who employ a complete markets ArrowDebreu model suffer from conceptual dissonance. They confuse propertiesofthehypotheticalArrowDebreumodelwithfeaturesofrealitythatdonot existintheArrowDebreuworld.Second,asacorollaryofthefirstpoint,itisnot possible to employ the complete markets ArrowDebreu model to assess the efficiencyofliquidityprovisionbymarkets,banksandcentralbanksinincomplete marketsasthereisnobasisonwhichsuchacomparisoncanbemade.ContraAllen andCarletti,referencetotheArrowDebreumodelofcompletemarketsdoesnothelp usunderstandtheconceptofliquidity.

Toillustratethefirstpoint,considerthestatementbyAllenandCarlettithatthenature of risk management by banks or intermediaries changes between complete and incompletemarketmodels.Inatrivialsensethisistrue.Butitistrueinatrivialsense becausenobanksormoneyexistinthecompletemarketsArrowDebreueconomy andhencethereisnosenseinwhichbankscanengageinriskmanagementorbuyand sellliquidityinthatmodel!AsHahn(1980)andLucas(1984,1990)madeabundantly clear,theArrowDebreumodelhasnoplaceformoney,liquidityorbanks,letalonea

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centralbank.10ConceptualisingcompletemarketsintermsofArrowsecuritiesthatare tradedunderanArrowDebreuinitialdateauctionasAllenandCarlettisuggestisto precludeanyneedformoney,banksorliquiditydefinedastheconversionofassets intocashatshortnoticewithoutsignificantloss.11Itisasimplesemanticmistaketo talk aboutliquidity,definedastheconversionofassetsintocash(money),inthe contextofanArrowDebreucompletemarketsmodel.AsLucas(1984)makesclear, underanArrowDebreuauctionallcommoditiesareequallyliquid.Thestatement: In this case [the complete markets ArrowDebreu model] banks and other intermediariesbuyliquidityinstateswhenitisscarcebysellingliquidityinstates whereitisnotscarcethereforedescribesasituationundertheArrowDebreuauction thatappliestoanycommodity.Callingsuchacommodity,liquidityisasemantic sleightofhand.

Yetintheincompletemarketsworldassetsmustbetradedforcashmoneyhasnow appearedandalongwithittheconceptofliquidityastheabilitytoconvertasecurity into cash without significant loss. Turning to the second point, it appears that economists thinking is distorted when they fail to start from a world where inefficiency,incompletemarketsormarketfailureisthenormandanysemblanceof efficiency is the exception! From any reasonable perspective, money, credit and financial institutions and markets engaged in liquidity transformation are all
10

Wallace(2001)attemptstoinsertacentralbankintoacashlessArrowDebreumodel.Needlessto saytheattemptfailsasWallaceacknowledges. 11 Lucas(1990,238,fn2)usesthetermliquidityasasynonymformoneyorcashinacashinadvance modelandliquiditydefinedastheabilitytoconvertasecurityintomoneyatshortnoticewithoutloss isnotdefinedinhismodel.Heexplainsasfollows:Thetermliquidityisalsousedinanentirely differentsense,torefertothemoneynessthatdifferent,nonmonetarysecuritiesaresupposedto possesstovarydegrees.Inthispaper.,thissecondsenseofliquidityisentirelyabsent.Inthis papermoneynessmeanstheabilitytoconvertasecurityintomoneyatshortnoticewithoutloss. Liquidfinancialmarketsofferthisfeaturetoindividualsbuttothemarketinaggregate..

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efficiencyenhancinginnovationsandinventionsthatcannotbeinterpretedfromthe perspective of the complete markets ArrowDebreu world where none of these concepts exist. In this context the relevance of the concept of Pareto efficiency collapses.Itisnotpossibletoevaluatetheefficiencyofincompletemarketmodels with money and banks from the perspective of the efficiency of the complete marketsArrowDebreumodel.

Consequently, the Allen and Carletti description of the inefficient allocation of liquidity by banks and intermediaries when markets are incomplete is simply misguided.Incompletemarketsarethenormbuttheycannotbereconciledinany sensiblewaywiththeArrowDebreumethodologybecausetheyareinconsistentwith theunderlyingauctionwithoutwhichtheArrowDebreumodelcollapses.12 Arrow Debreumodelswithincompletemarketsareincoherentacceptanceofincomplete marketsrequiresanalternativetheoreticalmodel.AndasAllenandCarletti(2007,p. 211) acknowledge, despite the empirical importance of the relationship between liquidity andassetprice bubblesandfinancial fragility, thereisnowidelyagreed theoryofwhatunderliestherelationship.TheArrowDebreumodelcanbeofnohelp here, contra AllenandCarletti. ItistimetoreturntoKeynessgeneralvisionof monetaryanalysis.

Failure to recognise these facts has led to much confusion in post war monetary theory that continues to distort thinking in contemporary monetary theory. Well knownhistoricalexamplesarePatinkins(1965)attempttoincorporatemoneyinto
12

Anotherillustrationofthelimitationsofthemethodologyistheexclusionofdefaultinmodelsof incompletemarkets.AsGoodhart(2005)remarks,thisratherdefeatsthepurposeofusingsuchmodels toexaminequestionsoffinancialstability.

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theutilityfunctionwhenitisnotrequiredunderaWalrasianauction(i.e.moneyhas noidentifiableutilitydifferentfromanyothercommodityundersuchanauction)and Clowers (1967) attempt to impose a cashinadvance constraint under the same auction. The latter simply converts money from an invention that overcomes the frictionsofbarterintoanunnecessaryconstraintthatreduceswelfareinthemodel; contracommonsenseandtwohundredyearsofconventionalwisdom.Tohiscredit Clower (1984) recognised the problem but the same cannot be said for many contemporarymonetarytheoristswhocontinuetorepeattheseconceptualerrors.13

Inthisrespect,thecompletemarketsArrowDebreuvisionstillhasastronginfluence in Woodfords Interest and Prices which he describes as a neoWicksellian foundationforatheoryofmonetarypolicy.Althoughmuchofthisworkisintended tolaythefoundationsforthenewconsensusmodelofmonetarypolicyitcontainsthe samefundamentalconceptualerrorssketchedaboveasitattemptstomeldtheideasof WicksellwiththoseofFisherandWalras.Forexample,Woodfordcontinuallyrefers to monetary frictions caused by the cashinadvance constraint without Clowers recognition that this is contrary to common sense and 200 years of conventional wisdom.MorestartlingisWoodfordsclaimthathisfrictionlesscompletemarkets model, where money does not exist, can provide the foundation for a theory of monetarypolicyorthatitispossibletocalibratemonetaryfrictions!Rogers(2006a, 2007a, 2007b) outlines the conceptual contortions generated by such models and argues that the conceptual dissonance produced by these models invalidates their
13

Lucas(1990)addsacashinadvanceconstrainttoanotherwiseWalrasianmodelinanattemptto explainwhyassetpricesoftenfailtoreflectwhatheregardsasFisherianfundamentals.Asnoted below,thismodelisincoherentitconvertsmoneyintoafriction.Earlier,Lucas(1984)soughtto restricttheuseofsuchmodelstothegenerationofpredictionsthatwereempiricallytestableinsome way.

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usefulnessasafoundationformonetarytheoryandpolicy. Essentiallymostofthe issuesofinteresttomonetarytheoristsareprecludedbyconstructioninthisextreme formofrealanalysis.Interestingly,Keynes(1936,p.192)waswellawareoftheform ofabstractthinkingexhibitedbycontemporarymonetaryscientistsasthefollowing quoteaboutRicardomakesclear: Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits,ofadoptingahypotheticalworldremotefromexperienceasthoughitwerethe worldofexperienceandthenlivinginitconsistently.Withmostofhissuccessors commonsensecannothelpbreakinginwithinjurytotheirlogicalconsistency. LucasaspirestoRicardosstandardbutmanyothersarelesssingleminded. Inthatrespect,itisbecomingincreasingapparentthatrealanalysisisalsoproducing distortionstothewaymonetaryengineersthinkaboutthewayinwhichmonetary policyinfluencestherealeconomy.Thebeliefintheneutralityofmoneyinparticular hasledtoadistortioninperceptionsaboutthefunctionandscopeofmonetarypolicy andthisbeliefhasbeenreinforcedbythemonetaryscientistsbeliefthattheArrow Debreu model is the core of economic science that provides the model for deregulationofefficientfinancialmarkets.

Contemporarymonetarypolicyinflationtargetingandfinancialmarketderegulation A convenient way in which to illustrate this assessment of the current state of monetarytheoryandpolicyistoconsiderthecurrentfocusoninflationtargeting. Several, including Palley (2002), from the perspective of monetary analysis, and White(2006),fromaregulatorsperspective,haverecentlyquestionedtheexclusive focusofmonetarypolicyoninflationtargeting. Thisquestionhasbeenposed,not becauseofthefailureofinflationtargeting perse,butbecauseofthefrequencyof

22

assetprice booms and busts that have occurredover thepasttwodecades during whichinflationtargetingiscreditedwithkeepingconsumerpriceinflationlow.

Asnotedabove,inflationtargetingisbasedonmonetarytheoryinthetraditionofreal analysisandrestsonthebeliefthatthereexistsaunique(notnecessarilyconstant)14, aggregate,longrunequilibriumconsistentwithfullemployment.Thisequilibriumis determinedbyrealfactors,independentlyofmonetaryfactors,thatis,someformof theclassicaldichotomyholds15.Hence,moneyistreatedasneutralinthelongrunand thishasledtothebeliefonthepartofmonetaryengineersthatcentralbanksshould onlytargetinflationasthatistheonlyvariabletheycaninfluenceinthelongrun.The principleofeffectivedemandrevealsthatthisbeliefismisguided.Targetinginflation isnecessarybutnotsufficienttoensuremacroeconomicstability.Keynesspolicy proposalsmaykeeptheeconomyclosetoitsfullemploymentpathbutthatisnota confirmation of long run monetary neutrality and it is not sufficient to achieve financialmarketstability.Thisconclusionissupportedbycurrentdevelopmentsin financialmarkets.

Thecurrentprocessofevolutionandderegulationinfinancialmarketsisdescribed variouslyasthemarketizationoffinancebyBorio(2007)orasfinancializationby Palley(2007)andothers.Tobeuseful,Keynessgeneralanalyticalframeworkmust applytothesecontemporarydevelopmentsanditmustapplyalsotosituationswhere eventswithanapparentlytinyprobabilityofoccurrence,socalledtailevents,doin

14

Kirman(1989)explainsthatthereisnotheoreticalbasisforbeliefinuniqueaggregateequilibrium inWalrasiangeneralequilibriumsystems.Aggregateexcessdemandfunctionsarenotmonotonic. 15 Dougherty(1980)explainswhathecallsthelooseformoftheclassicaldichotomyasthe reconciliationoftheKeynesianshortrunwiththeFisherianlongrun.

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factoccurandhaveapparentlydisproportionatelylargerealeffectsontheeconomy.I haveinmindheresocalled9standarddeviationeventsoreventswith1:10000year chanceofoccurringthatseemtooccurwithafrequencyofatleastonceadecade. Theseissuesraisefundamentalquestionsaboutmonetaryandfinancialtheorythat reflectthedifferencebetweenrealandmonetaryanalysisandthedistinctionbetween risk and uncertainty. Onthe latter scoreit is important to remember that Keynes (1936,p.240)employstheconceptofweighttoexplaintheconfidencethatattaches toprobabilities.Thelatterisimportantwhenexaminingtheliquidityofassetsand providesKeyneswithamoregeneralperspectivethanthatincontemporaryuse. 16In particular, any useful analytical framework requires a clear understanding of the properties of a monetary economy and the concept of liquidity, liquidity transformation,theroleofmarketsandinstitutionsinthatprocesstogetherwiththe roleofthecentralbankinmanagingthemonetaryandfinancialsysteminthepublic interest. Keynes provided such a framework that remains useful for interpreting contemporaryeventsinfinancialmarkets.

Tobeginwith,itisoftenoverlookedbymonetarytheoriststhatresponsibilityfor financialstabilitywasexplicitlywrittenintotheconstitutionoftheBankofEngland. TheBankofEnglandwasentrustednotonlywiththemaintenanceofpricestability, butwasalsoinstructed toensurethestabilityofthefinancialsystem.TheBankof EnglandFinancialStabilityReport(2007,p1.)explicitlystatesthattheBankhastwo core purposes; monetary stability and financial stability. (The responsibility for a
16

Goodhartet.al(2006)areexploringwaystomodeltheprocessoffinancialfragilityunderthe processofliquiditytransformationoutsideoforthodoxapproaches,asdothosewhoemploysearch theory.However,thelatter,initsquestforaunifiedapproachfallsintoinconsistencywhenattachedto aWalrasianorArrowDebreuauction.SeeRogers(2007a)

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contribution to the maintenance of full employment now receives less attention) However, today, under the Bank of England Act of 1998, the responsibility for financialstabilityhasbeenpartiallycontractedoutbythegovernmenttotheTreasury andtheFinancialServicesAuthority(FSA). Asimilarmodelhasbeenadoptedin many other countries that have implemented inflation targeting in deregulated or unregulated financial markets. From the perspective of the principle of effective demandthisraisessomequestions.

First,ifgovernmentshaveentrustedthegreencheesefactorywithmonopolypower tobeexercisedinthepublicinteresthowdoesthatrelatetothepushforcompetition andderegulationoftherestofthefinancialsector?Attheveryleast,secondbestisof considerationhere.Consequentlythereisnoprimafaciecaseineconomictheoryfor increased competition in financial markets. If the green cheese factory is to be regulated inthe public interest thesame logic should applyto retailers ofgreen cheeseparticularlyiftheyhavethecapacitytoinducethecentralbanktocreate greencheese.Allformsofliquiditytransformationrequiresomeformofregulation toensurethatfinancialfragilitydoesnotupsetmacroeconomicstability.Second,if the power of the green cheese factory is to be exercised effectively it must be recognised that the central bank, the producer of green cheese, must have responsibilityandcontrolover all theretailersofgreencheese. Althoughgreen cheeseisendogenouslycreatedinsuchbankingsystems17,neithertheTreasurynor theprudentialregulatorhasthecapacitytosupplygreencheeseintheeventofa systemicliquiditycrisisanaggregateshortageofgreencheese.Responsibilityfor the stability of the financial system that requires the provision of aggregate net
17

Palley(2002)explainswhymoney,greencheese,islogicallyendogenousinsuchsystems.

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liquidityshouldthereforenotbedividedbetweeninstitutionssomeofwhichcannot providethatliquidity.TherecentconfusionbetweentheTreasury,FSAandBankof EnglandoverNorthernRockthatgeneratedarunonthatinstitutionmakesthepoint. Thecentralbankisresponsibleforfinancialstabilityandshouldbegiventhetoolsto dothejob.Marketscanprovideindividualliquiditywhenthereisabalancebetween bulls and bears but they cannot provide aggregate or net liquidity in the face of systemiclossofconfidenceandthisiswhatisrequiredinafinancialcrises.

Consider,forexample,theprocessofsecuritizationseenfromKeynessperspective. Securitizationisoftenpresentedasameansofdispersingrisktothosewhocanbest accommodate it; an efficient allocation of risk. But it is often overlooked that aggregate or systemic risk cannot be reduced by securitization it can only be redistributedbetweenfinancialinstitutions.Systemicriskcannotbediversifiedaway andifsomeisshiftedtomarketsorinstitutionsthatliebeyondthesphereofinfluence ofthegreencheeseproducerthensystemicriskmayinfacthaveincreased.Inan uncertainworldwithincompletemarketsKeynesdistinctionbetweenindividualand aggregateliquidityisrelevant,allinstitutionsandmarketsareengagedinliquidity transformation and liquidity preference can have a dramatic impact on aggregate liquidity.Marketscannotacttoincreaseaggregateliquidityonlythegreencheese factory can do that. These concepts are, it seems, now recognised by regulators responsibleforstabilityoffinancialmarkets.

Economists like Borio (2007) writing in the field of financial market regulation confrontmanyoftheproblemsraisedbyliquiditytransformationandwouldbeat

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homewithKeynessmonetaryanalysis.Forexample,whenBorio(2007,p.17)notes thatfinancialmarketscansufferaruninthesamewayasbanksandmarketliquidity cansimplyevaporate,heisrestatingKeynessobservationthatmarketoraggregate net liquidity is a mirage; it vanishes when you most need it. As all financial institutionsandmarketsareengagedinliquiditytransformationitisaninescapable featureofamarketeconomywheneveryoneattemptstosellorwithdrawdepositsthe marketorthebankisintrouble. Thusmarkets,likebanksareonlyliquidwhen individualsmakesalesorwithdrawdepositsandthereisabalanceofopinionbetween bullsandbears.Thisfragilityisaninevitableconsequenceofliquiditytransformation thatisinturnanunavoidablecharacteristicoffinancingproductionthroughorganised securities markets as Keynes explained. Why it comes as such a surprise to contemporary monetary theorists is itself surprising. Minsky (1975, 1986), in particular,hasbeenprominentinexplainingwhyfinancialmarketsandinstitutions designed to enable liquidity transformation are prone to endogenous instability. Contemporaryevaluations,suchasthatbyRajan(2006),confirmthattheevolving financialmarketshaveperverseincentivesfortradersthataggravateprocyclicaland potentiallydestabilisingbehaviour.SeealsoKregel(2007)andWray(2007b).Failure topayattentiontotheconsequencesofderegulationonthefragilityofthefinancial sectorhasalsoledcentralbanksintoadditionaldifficulties.

The appearance of assetprice booms and busts over the past two decades is the manifestationofthisprocyclicalbehaviourandhasledtothegrowingrealisation, evenamongexponentsofrealanalysis,thatinflationtargetingisnotenoughandthat perhaps central banks should both include assetprices in the inflation target,

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Goodhart(2001),and/oracttoburstassetpricebubbles.Centralbankshavegenerally heededtheargumentsagainsteitherofthesesuggestions.Butfromtheperspectiveof monetaryanalysisandtheprincipleofeffectivedemandthesequestionswerebadly posed.Thequestionisnothowthecentralbankshouldrespondtotheseeventsbut howtheyshouldbepreventedinthefirstplace.Thecurrentpracticeofnotresponding toassetpricebubblesontechnicalgroundsisnotsustainablebecausetheydohave permanent real effects that impinge on perceptions of fairness and equity in a democraticsociety.BothGoodhart(2005)andPalley(2002,2006)havetherefore proposed that central banks need to take back their control over stability of the financial sector and be given an additional instrument, in Tinbergen fashion, to achievetheadditionaltargetorobjectoffinancialmarketstability.18

Thecontemporarypolicyofinflationtargetingandderegulationoffinancialmarkets, basedasitisonvarietiesofrealanalysis,thusleavesbothgovernmentsandcentral banksexposedtoanincompletediagnosisandtoprescribingthewrongmedicine.The factthatfinancialstabilityhasbeenneglectedisreflectedbytheemergenceofasset priceinflationwhichhasforcedareactionbycentralbankstocleanupthemesswhen theseassetpricebubblesburst.Thathasledtotwoadditionalproblems.

First,byimplementingpolicyonthebasisofrealanalysis,lookingonlyatconsumer price inflation, central banks have been drawn into actions that are potentially destabilisingthemselvesandincreasemoralhazard.AsPalley(2006)explainsvery
18

Palley(2006)alsoendorsesaformofinflationtargetingbutarguesthatitisnotenoughtomaintain macroeconomicstabilityandsomeformofcountercyclicalreserveratiosarerequired.Tobe successfultheseproposalswouldhavetoapplytoallfinancialinstitutionsandmarketsandfacethe factthattheyincreasetheincentivesfordisintermediationthroughthecreationofnewfinancial instrumentsandinstitutionsnotsubjecttoexistingregulations.

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well,theneglectoffinancialmarketstabilityhasresultedinseveralassetpricebooms andbuststhatcentralbankshavetakennoactiontoheadoff.Butthehandsoff attitudeisimmediatelyabandonedwhencentralbanksacttopreventnegativereal effectsonceabubblehasburst.Thisasymmetricalpolicyresponsethenactsasan implicitguaranteeandovertimechangestheperceptionofriskanduncertaintyin financialmarketsplayersbegintofactorinthebailoutandtheirappetiteforrisk increases,onlyencouragingthecreationofwhatRajan(2006)callsfalsealpha,and alongwithittheprobabilityandpossibilityoffuturecrises.

Althoughactionbycentralbankstoheadoffthenegativerealeffectsofassetprice bustsisjustifiedonthegroundsthatitwillhavenegativeeffectsontherealeconomy realanalysissuggestthattheseshouldwashoutinthelongrun.Butpoliticiansdonot havethefaithtoputthistheorytothetest.Also,itisneverexplainedbyexponentsof realanalysishowthesenegativeshortruneffectswouldbereversedinthelongrun. Clearlytherewillbelastingrealeffectstothecomposition,distributionandlevelof thecapitalstock.Furthermore,itisoftensuggestedthatcentralbankscannotidentify bubblessituationswhereassetpricesdiffersignificantlyfromfundamentalssothey shouldnottakeaction tointerferewithindividualinvestment decisions. Thereis sometheoreticalbasisforthisviewasitisrecognisedinthetraditionofrealanalysis that assetprices oftendonot correspondtoFisherian fundamentals (Recall Lucas (1990)).Fromtheperspectiveofmonetaryanalysisthisishardlysurprisingandisnot avalidargumentinfavourofinaction.Therearefewassetpricebubbleswhereithas notbeenpossibleforanobjectiveobservertoconcludethatabubblewasinplay.A centralbankisjustsuchanindependentobserverthatcanbedelegatedtotakeaction.

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Monetaryanalysissuggeststhatthesensiblecourseofactionistopreventassetprice boomsandbustsfromarisinginthefirstplace.

Arelateddifficultyconcernsthemovementsininterestratesthathavebeeninduced bytheburstingofassetpricebubbles.Asmanyhavenoted,volatilityininterestrates leadstovolatilityinassetpricesandfeedsthespeculativebehaviourofsomefinancial marketparticipantsofwhichHedgeFundsarethemostvisible.Wray(2007b)argues that theincreasingvolatility ininterestratesisultimately counterproductiveasit stimulatesspeculationanddestabilisesfinancialmarketsinducingafurtherresponse fromthecentralbank.Thus,byfollowingtheprescriptionsofrealanalysiscentral banksareunintentionallycontributingtoinstabilityandvolatilityinfinancialmarkets. Volatility in financial markets generated by speculation serves no useful social purpose,hasnothingtodowithallocativeefficiencyandservesonlytoundermine confidenceinthecentralbankastheguardianoffinancialstability.

IVConcludingremarks The general conclusion that follows from the discussion presented above is that Keyneshasanunacknowledgedlegacyintheformof apolicyinducedstructural changetothelaissezfaireeconomyintheformofBigGovernmentandthegreen cheesefactoryactinginthepublicinterest.TheKeynesiansareemployingaloose formoftheclassicaldichotomybasedontheuniquenessoflongrunequilibriumand moneyneutralityandthatvisionsupportstheconcentrationoninflationtargetingas thesoleobjectiveofmonetarypolicy.Moreextremeproponentsoftheneutralmoney doctrine (effectively a money irrelevance doctrine) apply the ArrowDebreu

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methodologyforassetpricingtheoryandthebasisforatheoryofefficientfinancial markets.Thosemodelsprovidethetacitbasisforbeliefinderegulationofefficient financialmarketsthathasleddirectlytotheseriesofassetpriceboomsandbuststhat haveraisedtheconcernofcentralbankers.

TheprincipleofeffectivedemandinKeynessmonetaryanalysisrevealsthenarrow andtacitspecialassumptionsthatsupportthebeliefinneutralmoneyandefficient financialmarkets.Ofparticularcurrentconcernistherolethatrealanalysisplaysin deflecting attention away from the central banks role in maintaining financial stability.Thecentralbank,asthemonopolysupplierofgreencheeseistheonly institutionthatcanprovidethenecessarygreencheeseinacrisis.Consequently,ifit is to avoid being drawn into creating moral hazard and facilitating fragility in financialmarketsitmusthavesomeresponsibilityandthereforesomeinstrument(s) formaintainingfinancialmarketstability.Thereisgrowingrecognitionthatmonetary policymustagainbeextendedinthatdirection.Theprocesswillbebetterunderstood andtherightmedicinedeliverediftheperspectiveofKeynessmonetaryanalysisis adopted.Thereisnothingtolosebytakingthisstepasitrequiresageneralmonetary analysisperspectivethatwillremovemanyofthedistortionsineconomiststhinking inducedbytheuseofrealanalysis.

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