Question

Discuss the following statement: Wicksell’s analysis of the pure credit economy belongs in the Keynesian rather than the quantity theory tradition, so that Wicksell’s analysis should be taken as the precursor of Keynesianism in monetary economics.

Answer 1

In a Wicksellian pure-credit economy, with no basic monetary aggregate to anchor it, credit is endogenously created or destructed and in principle unbounded. Since the end of the seventeenth century, this was understood by monetary theorists who took the credit approach to money. Once it is understood that money is essentially the unit of account of a debit and credit system in which prices are quoted, monetary aggregates no longer anchor credit and prices. This result was rediscovered in modern macroeconomics, at first by Sargent and Wallace (1975), and later, in the 1990s, by neoKeynesian macroeconomics.

The neo-Keynesian macro model of the twenty-first century, along the lines adopted by Woodford (2003), pushed money aside and adopted the interest rate as the monetary policy instrument. Although self-declared Wicksellian, the Woodfordian approach left also credit, the financial sector and the investment function out of the picture. This is a major sin with respect to Wicksell’s original “coherent alternative” to the QTM. Wicksell’s original and sophisticated description of macroeconomic dynamics was based on the interplay of the financial market interest rate and the real return on capital. It results in an endogenous and “cumulative” mechanism of credit creation, which is eventually reversed, leading to the destruction of credit and liquidity. This endogenous and cumulative character of credit is crucial to explain economic cycles in economies with developed financial markets. The failure to understand the endogenous, cumulative and eventually brutally reversible character of credit misses completely the central point of Wicksell’s pure-credit economy. Given that the contemporaneous developed economies are closer to the pure-credit ideal-type, a model that does not incorporate the financial system and Wicksell’s cumulative process misses the point. It can certainly not serve as a reference to guide monetary policy. Monetary policy based on a true Wicksellian model would adopt countercyclical macro-prudential measures way before the credit cycle reverses itself. The endogenous reversal of the credit cycle may lead to bubbles and traumatic liquidity crashes. That is why leverage limits and asset price targeting are clearly advisable. The cyclical instability of financial markets has been stressed by Charles Kindleberger and takes central stage in Hyman Minsky’s financial theory, but until very recently, when not completely ignored, they have been treated as no more than a curiosity by mainstream macroeconomics