Weak Micro Foundations, Ugly Macro Houses

March 1, 2016

bad foundations

Macroeconomics is a house built upon shaky foundations.

While most economists assume that the microeconomic foundations of economics are solid, the view of The Money Enigma is that there is a critical piece missing from these foundations that endangers the entire macroeconomic structure that has been built upon them.

Arguably, macroeconomics is more like a block of several different houses, all of which are built on the same shaky foundations. And it is these shaky foundations that can explain why none of the macroeconomic houses ever look “quite right”.

For example, each of the major macroeconomic houses offers alternative theories regarding one of the most important questions in economics: what causes inflation? Keynesians argue that inflation is caused by too much demand; Monetarists argue that inflation is caused by too much money; while fiscal theorists argue that inflation is caused by too much government debt.

Interestingly, none of these macroeconomic theories talk to each other, i.e. they are very difficult to reconcile with one another. Moreover, central bankers, the high priests of economics, seem to be constantly surprised by price level outcomes that were not forecasted by their models.

What is anomalous about this macroeconomic complexity is that, in microeconomics, price determination is presented as a very simple process.

There is almost universal agreement in economics that the price of a good is determined by supply and demand for that good. Yet somehow, at a macroeconomic level, everything becomes much more complicated.

So, why are macroeconomic theories of price level determination so dissimilar from microeconomic theories of price determination? And why is there such a difference between the seeming simplicity of microeconomics and the endless complexity of macroeconomics?

The view of The Money Enigma is that the answer to this question lies not in macroeconomics, but in microeconomics.

Modern macroeconomic theories of price level determination are ugly and confusing because the microeconomic foundations upon which they are built are weak. More specifically, current microeconomic models of price determination present an incomplete view of how prices are determined.

In simple terms, microeconomics has a piece missing. Unfortunately, it is a critical piece, especially when we begin to contemplate how prices are determined at the macroeconomic level.

The Missing Piece in Microeconomics

What is the critical piece that is missing from current microeconomic theories of price determination? Well, in a nutshell, current theories are missing a second set of supply and demand.

The view of The Money Enigma is that every price is determined by not one, but two sets of supply and demand.

Price Determination Theory

In every transaction there are two goods that are exchanged: a primary good and a secondary good. The price of a transaction depends on the relative market value of both the primary good and the secondary good.

Price as Ratio of Two Market Values

The market value of each good is determined by supply and demand for that good. Therefore, every price is determined by two sets of supply and demand: supply and demand for the primary good and supply and demand for the secondary good.

We can apply this concept to the determination of “money prices”. In a money-based transaction, we exchange one good (the primary good) for money (the secondary good). The price of the primary good, in money terms, is a function of both supply and demand for the primary good and supply and demand for money.

Price Determined by Two Sets Supply and Demand

Those readers trained in mainstream economics will probably look at the diagram above and say, “That’s not right, supply and demand for money determines the interest rate”. Unfortunately, this Keynesian nonsense, otherwise known as liquidity preference theory, has acted as a cornerstone of economics for nearly 80 years. From a structural perspective, it is a cornerstone that is hopelessly compromised.

The view of The Money Enigma is that supply and demand for money determines the market value of money, not the interest rate. In turn, the market value of money acts as the denominator of every money price in the economy: all else remaining equal, as the market value of money falls, prices as expressed in money terms rise.

In order to understand why this must be the case, it helps to abstract ourselves from our experience of a money-based economy and think about how prices are determined in a barter economy with no money.

Let’s imagine we live in a barter economy with two goods: apples and bananas. What determines the price of apples in banana terms? Traditional economics would say “supply and demand for apples”.

OK, so let’s assume that answer is right and ask another question. What determines the price of bananas in apple terms? Once again, traditional economics would answer “supply and demand for bananas”.

But, this creates a problem. Why? Well, the price of apples in banana terms is simply the reciprocal of the price of bananas in apple terms. For example, if the price of apples is two bananas, then the price of bananas must be half an apple.

Can you see the problem that traditional microeconomics has created? In essence, it is saying that the ratio of exchange (apples for bananas) is determined by supply and demand for apples if the price is measured in banana terms, and by supply and demand for bananas if the price is measured in apple terms.

But clearly, this is logically inconsistent. Why would the market forces that determine price be different simply because of the way the ratio of exchange is being measured!

How do we reconcile this situation? The obvious and logical answer is that the ratio of exchange, apples for bananas, is determined by two sets of supply and demand.

Example of Price Determination Barter Economy (1)

Think about it. What happens to the price of apples if there is a shortage of apples? Clearly, the demand curve for apples shifts to the right and, all else remaining equal, the price of apples rises.

Example of Price Determination Barter Economy (2)

Now, what happens to the price of apples in banana terms if there is an increase in demand for bananas? Intuitively, we know that if bananas become more valuable, then it will require less bananas to acquire each apple, i.e. the price of apples will fall.

This is hard to represent on a standard supply and demand diagram with the price of apples on the y-axis. But it is very easy to represent in the following diagram where market value is measured in absolute terms on the y-axis, i.e. in terms of a “standard unit” for the measurement of market value.

Example of Price Determination Barter Economy (4)

In the diagram immediately above, the demand curve for bananas shifts to the right and the equilibrium market value of bananas V(B) rises. The price of apples must fall as the price of apples is a ratio of the market value of apples V(A) divided by the market value of bananas V(B).

How does this reconcile with traditional supply and demand analysis? Well, using the traditional representation, with price of apples in banana terms of the y-axis, both supply and demand curves for apples, as expressed in banana terms, move lower as bananas become more valuable (see below).

Example of Price Determination Barter Economy (5)

If you are feeling a little confused by all the talk about apples and bananas, the key point is this: the price of one good in terms of another good is determined by market forces for both of the goods. Not just supply and demand for one of the goods, but supply and demand for both!

This basic theory of price determination applies to the determination of any price, including prices as expressed in money terms. Money is a good that possesses the property of value: money must have value in order for prices to be expressed in money terms. Moreover, the value of money is constantly changing, a process that is driven by supply and demand for money (or more specifically, supply and demand for the monetary base). The price of a good, as expressed in money terms, is determined by both supply and demand for the good itself, and supply and demand for money.

Price Determined by Two Sets Supply and Demand

If you accept that each price in a barter economy is determined by two sets of supply and demand, then it is very difficult to mount the argument that somehow this basic economic process changes just because of the goods exchanged is now “money”. Money can only act as a medium of exchange because it has value and there must be a simple economic process that determines this value, i.e. supply and demand.

Building a Better Macro House

Once the foundations are solid, it becomes much easier to build a house that is not only more functional and attractive, but one that can incorporate many of the intuitively appealing ideas that offered some aesthetic appeal to the old, poorly constructed macroeconomic houses.

At the most basic level, our new and more comprehensive microeconomic theory allows us to illustrate a simple macroeconomic truth: the price level is a relative expression of the market value of the basket of goods in terms of the market value of money.

Ratio Theory of the Price Level

If every “money price” in the economy is a relative expression of the value of a good and the value of money, then an index of these prices can be broken down into an index for the market value of all goods (as measured in absolute terms) and the market value of money (again, measured in absolute terms, i.e. in terms of a standard unit for the measurement of market value).

Moreover, the price level itself is a function of two sets of supply and demand: aggregate supply and demand for the basket of goods determines the market value of the basket of goods, and supply and demand for the monetary base determines the market value of money. The price level is then simply the ratio of these two equilibrium market values.

Goods Money Framework

By utilizing this basic macro framework, a framework built on much stronger microeconomic foundations, we can now identify the strengths and weaknesses of each of the existing macroeconomic houses and think about ways in which we could merge, improve and refine their intuitively appealing, but somewhat half-baked, theories regarding the causes of inflation.

Let’s quickly think about the strengths and shortcomings of each of the three major schools of thought (Keynesianism, monetarism and fiscal theory) in the context of the framework just presented.

Keynesianism, at least in most traditional form, focuses nearly entirely on the left hand side of the Goods Money Framework. Indeed, Keynesianism doesn’t even recognize the right side of the framework because it doesn’t recognize the simple, but critical, principle that supply and demand for money determines the market value of money.

In the Keynesian world, supply and demand for goods is the primary driver of inflation. If the economy overheats, then excess demand drivers the market value of goods higher and prices rise. The view of The Money Enigma is that excess demand can lead to temporary fluctuations in the price level, but “too much demand” is not the primary driver of inflation over time (see “Does Excess Demand Cause Inflation?”)

Keynesianism limits the role of money in macroeconomics to the determination of the interest rate. In other words, money can only cause inflation if an excess supply of money drives down the interest rate, triggering a burst of economic activity. In short, Keynesianism sees absolutely no role for the “value of money” in the determination of the price level.

This fundamental oversight is perhaps not surprising if you consider the environment in which Keynes developed his theories. Under the gold standard that existed at the time Keynes was at his “intellectual peak”, the value of money would have been fairly stable. Why? The value of money was stable because it was tied directly to the value of gold! In that world, it is easy to see why Keynes didn’t immediately equate supply and demand for money with the value of money and rather jumped to the obvious, but wrong, conclusion that supply and demand for money determines the interest rate.

In summary, the Keynesian house is a horribly lopsided house because it completely fails to recognize the role of the value of money in the determination of money prices. Any theory of inflation that can’t get its head around the fact that money has value and this value matters to the determination of prices is destined to fail.

This shortcoming also explains why modern day Keynesian theorists have been forced to add so many extensions to the Keynesian house, such as “inflation expectations”, in order to have a model for inflation that has any chance of explaining the dramatic swings in inflation over the past 80 years.

Monetarism is another ugly and frankly rather simplistic looking house that has only survived because of the strong appeal of its most basic tenet: the supply of money matters to price determination.

Unfortunately, monetarism is a theory that has been hijacked by Keynesianism. I have discussed this phenomenon extensively in recent posts including “Saving Monetarism from Friedman and the Keynesians”. In short, monetarists have whole-heartedly swallowed the bad idea at the core of Keynesianism, namely that supply and demand for money determines the interest rate. In effect, this has left monetarism sitting on the edge of road and monetarism has largely become the “lame duck” of macroeconomics.

This is a tragedy because monetarism has some important observations to make about the relationship between money and inflation over time. If monetarism simply recognized the right side of the Goods Money Framework as presented above, then monetarists could engage in some very productive debate regarding the primary determinants of the value of money and, more specifically, how the historic and expected path of the monetary base might impact the value of money.

While the façade of monetarism is aesthetically appealing, monetarism is a house that is not only built on bad microeconomic foundations, but is also built upon one of the structurally comprised cornerstones of the house next door, i.e. Keynes’ liquidity preference theory.

The view of The Money Enigma is that money does play a critical role in the determination of inflation. More specifically, expectations regarding the long-term outlook for monetary base growth relative to real output growth determine the value of money. Moreover, the primary transmission mechanism from money to inflation does not act through the interest rate and aggregate demand channel, i.e. the left side of the Goods Money Framework, but rather through the value of money, i.e. the right side of the Goods Money Framework. [Please see “A New Perspective on the Quantity Theory of Money” for an extensive discussion of the monetary transmission mechanism.]

Goods Money Framework

Finally, we have the smallest house on the block, fiscal theory of the price level. At the heart of fiscal theory is the idea that the level of government debt matters to inflation: if a society accumulates “too much” public debt, then the rate of inflation can accelerate dramatically.

This core tenet of fiscal theory is also intuitively appealing: after all, hyperinflation is, in essence, a form of sovereign default. However, fiscal theory struggles to explain the transmission mechanism from debt to inflation.

The view of The Money Enigma is that government debt does play a critical role in the determination of inflation. More specifically, the perceived sustainability of government debt has a direct impact on expectations regarding the future growth of both the monetary base and real output. In turn, these variables directly impact the value of money.

In essence, as the fiscal situation of a nation becomes more unsustainable, the value of money falls and the price level rises. Those who are interested in this relationship should read the very popular “Government Debt and Inflation” post written in 2015.

In conclusion, while the various macroeconomic schools of thought all contain elements of intuitive appeal, they are all compromised by their weak intellectual foundations. Moreover, it can be argued that it isn’t the macroeconomists themselves that we should be blaming. Rather, it is the bastions of microeconomics, who in a state of sublime hubris, have failed to recognize the very fundamental limitations of their most basic and yet most important theory: the theory of supply and demand.

Author: Gervaise Heddle