Nominal Versus Real Models

Modern economics uses “scientific” methodology, under the assumption that economic laws are invariant across time, space, and society. In previous posts, we saw how this leads to loss of precious insights about money gained from historical experiences (Monetary Economies: A Historical Perspective, Lessons from Monetary History: The Quality-Quantity Pendulum). In this post, we will discuss the modeling strategy we will use to derive lessons from history which extend beyond the particular historical context from which they are derived.

Models are simplified representations of reality. When considering monetary history, the factors driving changes are notably intricate. Over the 20th century, the monetary system underwent significant transformations. World War I marked the breakdown of the gold standard, followed by unsuccessful attempts at restoration. World War II further hindered restoration efforts, leading to the Bretton Woods agreement and the adoption of a gold-backed dollar standard. Nixon’s actions in 1971 severed the link between the dollar and gold, ushering in an era of floating currencies detached from commodities. Distilling broader lessons from the complexity of historical specifics necessitates a methodological approach centered on models. Models abstract from specific historical details to illuminate structures which may be widely applicable across various historical and temporal contexts.

In this text, we will be using realist models – these differ greatly from the nominalist models used in conventional textbooks of economics. The difference can be explained as follows. Our world comprises observable phenomena as well as underlying structures that produce these observations. Nominalism holds that models should focus solely on explaining observables, disregarding whether they accurately reflect hidden reality. This notion, though counterintuitive, emerged due to the belief that hidden reality is unknowable, making the pursuit of matching it futile. Instead, nominalism advocates for assessing a model’s success based on its ability to explain observed phenomena. Conversely, realist models strive to mirror the hidden reality behind observations.

Friedman’s essay on “The Methodology of Positive Economics” strongly advocates the use of nominal models. This methodological principle has been widely accepted by economists. Friedman illustrates nominal models with the example of a skilled pool player. He suggests that even if the player lacks any understanding of physics, assuming knowledge of the laws of physics can lead to accurate predictions of their shots. In essence, the player behaves as if they comprehend physics, making successful shots based on calculations, despite their ignorance of the underlying principles of physics. This is known as the “as-if” methodology, and it is the dominant approach to models in modern economics.

In contrast, realist approaches reject such assumptions. For the pool player, a realist model might study his past experiences, and his skills at different types of shots. Realism aims to understand the internal workings of hidden reality, while nominalism accepts models that predict outcomes, without concern about matching hidden reality. Friedman developed his as-if theory in response to empirical surveys which showed the most firms do not maximize profits. He argued that the assumption of profit maximization, even if it did not match the motivations of the managers of the firms, should be assessed on the basis of its ability to predict decisions about hiring and production. However, by now, this methodology has been in use for several decades, and it has led to repeated failures. A good fit to observations for a particular finite set of data is not a guarantee of the validity of a model. It can, and often does, happen by chance. For a more detailed discussion of the superiority of real models to nominal models in the context of econometrics, see “A Realist Approach to Econometrics” (bit.ly/azrae)

We will use a recently introduced modeling strategy — Agent-Based Models (ABMs) – which has not made its way into mainstream methodology. ABM models have multiple agents – laborer, producer, shopkeeper, government, etc. – each of which has their own economic decisions to make, and behavioral patterns. This strategy has become feasible because of the vastly increased computational power now available, which permits us to run simulations and compute outcomes. The foundations of modern economic methodology, established around the mid-20th century, relied on simplifying assumptions to facilitate manual computations. For example. Leading macroeconomic models have only one agent, who has perfect foresight. Why? Because computations by hand would be impossible with two or more agents. At a Congressional inquiry into the failure of economists to predict the Global Financial Crisis of 2007, Solow testified that the GFC was caused by large scale deception and fraud. Macroeconomists could not predict it because these are impossible in models with only one agent. In contrast, models with heterogenous behavior are much better at capturing the complex internal structures of modern economies, in accordance with the principle of realist models.

Using ABMs, we can capture three Keynesian insights, all of which are essential for the understanding of money, and all of which are missing from conventional textbooks:

Complexity: This technical term refers to a situation where the group behaves very differently from the individuals within the group. For example, that even though laborers and the firms which hire them may seek to lower the real wage, they can only negotiate on the nominal wage. The real wage involves the price level of the economy which is out of their control. Keynes argued that lowering nominal wages at the micro level throughout the group may end up increasing the real wage – a perfect example of complexity. This phenomenon is beyond the reach of conventional economic theory because the textbook models are oversimplified to prevent the occurrence of complexity.

Radical Uncertainty: In a model with heterogeneity, each agent has access to a limited amount of information. The economic outcomes depend on the actions of all agents, which can never be known to the agents. As a result, the agent operates in an environment where the outcomes of the decisions he takes are not predictable. Standard textbook models use intertemporal optimization, where the agent knows his future incomes, potential consumption bundles and prices. This is simply impossible in our agent-based models. Similarly, profit maximization is impossible for firms because they incur production costs in current period, but will produce and sell goods in the next period. The price at which they can sell will depend on decisions others make, and cannot be predicted. So profits are subject to radical uncertainty, and cannot be maximized.

Non-Neutrality of Money:  Once we take into account heterogeneity and uncertainty, new insights into the role of money emerge, not available in conventional textbooks. Workers save money, and firms acquire money profits, but, due to radical uncertainty, no one knows what the value of money will be in the next period. A stable value of money allows for some degree of planning, but the QQ-pendulum shows that this stability cannot be relied upon. The assumptions of full information made in conventional textbooks make money merely an accounting unit, which does not play an essential role in the economy. However, with radical uncertainty, and differential information and behavior of different agents, money plays an essential role in the economy. Workers save money as insurance against adverse outcomes in the job market, and firms save money to guard against future losses. These different motivations for holding money, and the psychological aspects which relate to public trust in the future value of money, will come to the fore in our ABM models.   

To wrap up, we have discussed two types of models – nominal and real. Nominal models dominate mainstream economics, and are judged for their ability to match observations. In contrast, Realist models are judged on whether or not they match the hidden structures of reality which produce the observations. In the next section, we will build some simple realist monetary models, and show that these produce results and yield insights outside the range of orthodox monetary models.

Links to Related Materials

• Bit.ly/ME01  Monetary Economies: A Historical Perspective
• Bit.ly/MONE02 Lessons from Monetary History: The Quantity-  Quality Pendulum
• Bit.ly/MONE03 Nominal and Real (Monetary) Models
• Bit.ly/WEAmar  Models and Reality

Lessons from Monetary History: The Quality-Quantity Pendulum

In the previous section, we saw how economic theories changed from Classical to Keynesian to Monetarist over the course of the 20^th century. These changes were driven by historical events. Taking this historical context into account deepens our understanding of economic theories. This contrasts with the conventional methodology of economic textbooks, which treats economic theories as scientific laws, which are universally applicable to all societies. In this section, we describe one of the central lessons which emerges from the study of money over the millennia.

The transition of economic theories from Classical to Keynesian to Neoclassical can be seen as a miniature illustration of the Quality-Quantity Pendulum, which is a consistent pattern relating to money observed over millennia. Modern economic theory strips theories of their historical context, depriving us of critical insights into both theories and history. Before studying the QQ Pendulum, we will pause to discuss how this defective methodology was adopted by economists.

The Battle of Methodologies: As Geoffrey Hodgson has detailed in his book entitled “How Economists Forgot History”, a challenger to the dominant historical and qualitative methodology emerged in the late 19^th century. The new methodology was quantitative, mathematical, and empirical, in imitation of scientific methodology. The devastation of World War 1 destroyed the prestige of the traditional approach to social science, so that this scientific approach became the dominant methodology in economics by the 1950s.  This ahistorical approach blinds us to the fact that all social theory is developed to analyze a particular society situated in a particular historical context. Treating it as a universal scientific law, invariant across time and space, is hugely mistaken.

Lessons from History: In this section, we will discuss some insights about the nature of money, and monetary economies, derived from the study of history by Glyn Davies in “A History of Money: From Ancient Times to Modernity”. Davies writes that: “… despite the antiquity and ubiquity of money its proper management and control have eluded the rulers of most modern states partly because they have ignored the wide-ranging lessons of the past or have taken too blinkered and narrow a view of money.” For example, Keynesians and Monetarists agree that a contraction of the money supply was the immediate cause of the Great Depression of 1929, whose ill effects persisted until the outbreak of World War 2 in 1942. From a broader perspective, a study of the history of money should have made both the nature of the depression, and the remedy, abundantly clear. Unfortunately, as the previous quote indicates, policymakers ignored the lessons history teaches us about the role of money, and made errors which caused misery to millions for decades.

Money as a Social Institution: A study of history shows that money has played a central role in shaping history across the centuries. Also, history teaches us money is not purely a transaction technology; it is deeply embedded in the social fabric of society. The use of money requires building social consensus on the trustworthiness of monetary institutions. Building this trust requires building high-quality institutions and mechanisms that guarantee the value of money in the eyes of the public. The quality of money refers to the public trust and social consensus both on the value of money, and the stability of this value across time.

High Quality Money: History provides us with an incredibly diverse set of examples of monetary institutions which provided society with trustworthy money with stable value across time. Cattle and cowries in Africa, paper money in China, Wampum in America, and Yap stones in the Pacific Islands, were used as money for centuries. Many systems even survived in competition with modern monetary systems. So, we conclude that there are a wide variety of ways to create high-quality money.

The Gold Standard: One of the ways to create high-quality money is to use gold or silver. These metals have characteristics – discussed in textbooks – that make them particularly suitable for use as money. There is very little public awareness that there are many different varieties and conflicting interpretations of what the “gold standard” means. The best reference for this is Morrison’s England’s Cross of Gold: Keynes, Churchill, and the Governance of Economic Beliefs. The strictest form of the standard – the use of actual gold – has been very rare, historically. Coins of minted gold have been far more popular. The mint certifies the quantity and quality of gold in the coin, making it far more convenient for public use.   

Minted Money and Token Money: The highest quality of money comes from minted coins, which have a value equal to the content of the metal (gold or silver). This is because the coin itself is the guarantor of its own value. There is still the question of what it is about gold and silver that creates a nearly universal consensus on their intrinsic value. Perhaps the answer is that love of gold and silver has been built into human nature, as Quran (3:14) suggests.

The numismatic evidence from buried coins shows that high quality gold coins are almost always followed by “debased” coins – coins with significantly less gold content than the face value of the coin. History tells us of the varied reasons for such debasements. Most often, the high expenses of wars require vast amounts of money, beyond the available stocks of gold. Governments resort to debasement to get more money from the same gold stock. Since gold is very valuable, even the smallest gold coins are not useful for daily transactions. So, token monies, made of copper or other cheap metals, are often used for small change. The metal value of these coins is not equivalent to their market value; instead, these coins are considered as fractions of the gold coins, and can be exchanged for them.

From Quality to Quantity: The Quality-Quantity Pendulum is a theory that illustrates the historical shifts in economic focus between the quality and quantity of money. The lesson of history, repeated across the globe, and across the centuries, is that the temptation to expand the stock of money – more quantity – proves irresistible in the long run. A modest expansion of money stock via small dilutions of gold content or small issues of token money, brings major economic benefits. Small expansions of money stock beyond gold content do not cause noticeable changes in public trust which is the central guarantor of the value of money. However, over a longer period of time, the temptation to expand the quantity beyond safe limits becomes irresistible. Events like wars, private greed, or government needs, lead to over-expansion of the money stock. An excessive quantity of money causes inflation, a loss of value, and a breakdown of public confidence in money. The drive to expand the money stock leads to a low quality of money. But large fluctuations in the value of money disrupt lives, and cause distress to all members of a monetary economy. As a result, consensus builds on monetary reforms required to create high quality money. Eventually, excess money is removed from circulation, and a high-quality money is restored, to complete the swing of the pendulum between quality and quantity.

The Pendulum of Economic Theories: Many authors have noted that history is a battle between the creditors and the debtors. In eras of high-quality money, money is scarce, and the creditors are few and powerful. They propagate pro-creditor economic theories which favor “sound” money: high quality with restricted quantity.  However, the need for expansion of money stock becomes overwhelming in many different scenarios. Then, pro-debtor economic theories emerge. These favor the expansion of the money stock, and cite numerous advantages from doing so. Creditors argue in vain against these theories and warn that they will lead to ruin. The benefits from expansion are immediate and obvious to all in the short run. But in the long run, the creditors’ gloomy predictions turn out to be valid. Over-expansion destroys the quality of money, and also the reputation of the pro-debtor economic theories.

This drama has played out over the centuries in many different guises, and with different terminologies in use to describe the two opposing schools of thought about money. Confusingly, the quantity theory of money (QTM) advocates the maintenance of high-quality money, and argues against expansions of the money stock to bring prosperity to the masses. As opposed to it, the Real Bills Doctrine (RBD) argues that the money supply should be expanded to finance productive investment.

The RBD versus the QTM, the Anti-Bullionists versus the Bullionists, the Banking School versus the Currency School, Keynesians versus Monetarists, and most recently, Minsky’s Financial Fragility Hypothesis versus the Real Business Cycle theories, are all illustrative of the quantity-quality controversy which spans centuries of monetary history.

Long-Run Versus Short-Run Perspectives: Davies emphasizes that this quantity-quality pendulum becomes discernible only in the long run. Over any short period of time, spanning a few decades, the immediate benefits of one or the other school of thought seem overwhelming. When tight money is creating recession and unemployment, the benefits of looser money seem obvious to all, and tight money adherents find little support for their positions among the masses. However, in periods of high inflation, the harms of loose money again appear obvious, and tight money policies gain public support. Over any short period of time, one or the other policy seems obviously superior. It is only a long-term examination of history which shows the regularity with which the pendulum swings between the two poles.

There are three conclusions we would like to draw from the quantity-quality pendulum, which emerges from the study of millennia of monetary history.

1. The study of equilibrium in monetary economics is an illusion. A stable and high-quality money creates an irresistible temptation towards expansion, leading to a breakdown in quality. Excessive money stock destabilizes the value of money and creates powerful forces which seek to stabilize its value and create high-quality money. At no point in the trajectory of the monetary pendulum do we see any resting place, or equilibrium.
2. The value of money rests on the social consensus created by confidence in the monetary institutions governing the creation of money.  History is full of examples where this confidence was weakened or strengthened, leading to changes in the value of money. Recently, a crisis of confidence in the Euro was stemmed simply by an announcement by Mario Draghi that he would do “whatever it takes” to stabilize and protect the Euro. Conventional treatments of money pay no attention to these psychological aspects of money.
3. The historical perspective provides deeper insights into monetary theory than conventional methodology. When the Great Depression created tight money, Keynesian theory favoring expansion of money stock emerged and became popular. Inflation in the 1970’s led to rejection of Keynesian theory and a return to the tight-money policies implemented by Volcker. Conventional methodology searches for absolute scientific truths, without realizing that truth may be relative to a particular historical context.

Monetary Economies: A Historical Perspective

{bit/ly/ME01} A Monetary Economy is one in which the use of money is essential to the functioning of the economy. That is, without money, people would starve, and massive amounts of economic misery would result. Since monetary economies have dominated the world for centuries, this seems to us like a natural state of affairs. However, a study of history reveals that monetary economies came into existence only a few centuries ago, and eventually came to dominate the globe. Most pre-modern societies were not monetary economies. For instance, a feudal economy was not a monetary economy. The landlord owned the land, and workers on the land would receive all necessary support – food, clothing, housing, etc – from him. In return, they would work the land and produce crops, and provide other services. No money was needed for the basic necessities of life. The landlord could sell excess crops for money, and buy fineries from foreigners, but this was not essential for existence. Even today, in many areas of the world, rural subsistence economies far from urban centers are often self-sufficient, and can function without money. These non-monetary economies are excluded from the scope of our study.

Our goal in this textbook will be to clarify how monetary economies function, and how they have evolved over time. This is important because conventional modern textbooks of economics do not correctly describe monetary economies. In these textbooks, money does not serve an essential function. This point is recognized and articulated in these textbooks using the terminology “neutrality of money”. For instance, a popular textbook by Mankiw states that:

Over the course of a decade, for instance, monetary changes have important effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP). When studying long-run changes in the economy, the neutrality of money offers a good description of how the world works.

Exactly contrary to this, Keynes stated clearly in his landmark book entitled The General Theory of Employment, Interest and Prices, that money plays an important role in both short and long run – it is not neutral. If money is neutral, then money plays no essential role in the economy, and so there is no essential difference between monetary and non-monetary economies. In this textbook, we will explain how money, far from being neutral, is a central driver of economic activity. Conventional textbook analysis, which takes money as neutral, leads to deep misunderstandings about modern real-world economies.

The false assumption of neutrality of money led to the failure of economists to understand the causes of the Global Financial Crisis in 2007, and also to their failure to take corrective actions which could have prevented the Great Recession which followed. The battle of ideas, embodied in economic theories about money, is described in “Completing the Circle: From the Great Depression of 1929 to the Global Financial Crisis of 2007”. It is useful to briefly outline how economic theories changed over the course of the 20^th Century:

1. Classical Economists argued for the neutrality of money, along with other ideas, which lead to the conclusion that unemployment can only be a short-run phenomena. In the long run, unemployment will be eliminated by the workings of the free market.
2. Following the Great Depression of 1929, large amounts of unemployment which persisted for long periods of time was observed. This was directly in conflict with theories of classical economics.
3. Keynes then came up with a new theory, which had many revolutionary ideas, dramatically different from the assumptions of classical economics. One of the central ideas was that money is not neutral. In particular, in the labor market, the supply and demand for labor, and hence the rate of employment is strongly affected by the quantity of money available.
4. Keynesian ideas came to dominate macroeconomics for about three decades following World War 2. In particular, the idea that free markets will not automatically eliminate unemployment, leads to the necessity of the government policies required to create full employment. Application of Keynesian policies led to full employment in USA and Europe for about three decades.
5. The oil shock of the 1970’s led to the failure of Keynesian policies. Development of monetarism by the Chicago school of economists led to the re-instatement of pre-Keynesian ideas about the neutrality of money and the idea that free markets lead to elimination of unemployment. This came to be known as neoclassical economics, because it rejected Keynesian ideas, and went back to classical economics. See The Keynesian Revolution and the Monetarist Counter-Revolution
6. A concerted campaign was carried out by monetarists to discredit Keynesian theories and rebuild Economics on neoclassical foundations. See Understanding Macro III: The Rule of Corporations. This was highly successful. The Monetarists went from a minority and eccentric school to mainstream orthodoxy by the early 1990s. It became impossible to publish Keynesian and post-Keynesian views in mainstream top-ranked journals.
7. Over the decade of the 1990s economic performance in the Western world became flat – fairly low growth, but no ups and downs of business cycles which had been characteristic of capitalist economies for a long time. This led to celebrations of “the Great Moderation” by the monetarists. Robert Lucas, Nobel Laureate and leading Chicago school economist, announced triumphantly in his Presidential Address to the American Economic Association in 2003, that we economists have conquered the business cycle, and from now on, recessions will not happen.
8. The Global Financial Crisis of 2007 took the economics profession by surprise, just as the Great Depression of 1929 had come as a surprise. Paul Krugman wrote the book “The Return to Depression Economics” arguing that insights of Keynes continued to be valid, and to provide deeper insights into the GFC than was available from leading neoclassical macroeconomic theories of the time. Paul Romer wrote a scathing article entitled “The Trouble with Macro” in which he argued that modern macroeconomics is based on fundamentally flawed doctrines, and leads to wildly incorrect predictions.

This is more or less the current state of affairs, as good alternatives to conventional macroeconomics are unavailable in the mainstream. The mainstream macroeconomic theories are based on assumptions which have no relation to reality. For more details, see “Why Do Economists Persist in Using False Theories?”

We will conclude this introduction to monetary economies by discussing some of the key elements of the approach we will be using. First, while mainstream macroeconomics rejected Keynesian ideas, a group of theorists known as Post-Keynesians have continued to develop the ideas of Keynes, building on his fundamental insights. This has led a branch of macroeconomics which provides much deeper insights into modern economies then the monetarism which dominates universities today. Our text borrows from these ideas. However, the critical innovation of this textbook is to study economic theory within its historical context.

As described earlier, historical events, and economic crises, have played a major role in shaping economic theories. In fact, we cannot understand economic theory as an abstraction, removed from its context. This is in conflict with the claim implicit in the use of the word “science” – lessons from study of European societies are universally applicable to all societies across time and space (see: The Puzzle of Western Social Science). In fact, all social theory is developed as an attempt to understand historical experiences of a particular society, and cannot be understood as an abstraction, detached from this historical context. Studying economics within its historical context requires a methodology radically different from that currently in use, in both orthodox and heterodox textbooks of economics currently in use around the world. We will discuss this methodology in the next section.