Nineteenth Installment
Network Externalities and the Non-neutrality of Money
Have the network externalities of financial activities been verified?
The global disruption of financial markets due to the Lehman Shock revealed the network externalities of the financial system in a dramatic fashion. "Network externalities" refers to the effects that individual entities have on distant third parties via networks. In systems connected through a network (electric power transmission networks and the settlement networks of financial institutions), the breakdown of any single constituent entity (a transformer or a financial institution) has an impact along the network on distant parties not directly connected to that entity. In the current financial crisis, the "lemon problem" arising from the asymmetry of information caused the market to collapse, offering an extreme example of network externalities.
In my earlier articles, I conceptualized financial system services as inside money. To reiterate the key point, the financial crisis showed that there are strong network externalities in the production of inside money. As I use the term "inside money" interchangeably with the settlement services provided by financial institutions, i.e., financial intermediation services, this is the equivalent of saying that there are strong network externalities in the production of financial intermediation services.
I have sought out existing research verifying whether or not there are externalities in the production of settlement services at financial institutions (financial intermediation services), but I have not yet been able to find any such papers, be they theoretical or experimental studies, in the macroeconomics literature. This is quite a mystery, as it seems that the presence of network externalities in financial intermediation activities is conventional wisdom among economists and central bank officials. In the context of macroeconomics, however, there is no apparent trace of any study being devoted to the construction of a theory or the validation of data on whether or not externalities exist in the production of financial intermediation services. The network externalities of financial activities are an important research topic for understanding the nature of a monetary economy.
Macroeconomic hints provided by the financial crisis
Another matter of interest is that the network externalities of financial intermediation could become an important key in envisaging a new macroeconomics paradigm, as it might well be possible to derive the Philips curve (the correlation between rises in the inflation rate and drops in the unemployment rate) from the network externalities of financial intermediation.
The Philips curve was a nagging concern for macroeconomics. The appearance of inflation and a drop in unemployment in an overheating economy (and conversely a decline in the inflation rate and an increase in unemployment in a sluggish economy) is a relationship regularly experienced. The positive correlation between inflation and declining unemployment was summarized in the Philips curve and has been regarded as one piece of evidence validating the correctness of Keynesian economics. In light of the U.S. economy in the 1970s, a period that saw high inflation and high unemployment rates side-by-side, a consensus formed that the Philips curve may be valid over the short term but not over the long term.
That said, however, the Philips curve has been strongly confirmed in the actual economy, even if just for the short term, and is unquestionably a basis for the effectiveness of monetary policies (the macroeconomics theory of the neo-classicists who ignored the Philips curve does not arrive at the conclusion that monetary easing during an economic slowdown is an effective economic countermeasure). The short-term Philips curve is also called the non-neutrality of money. Carl Walsh's famous textbook declares that the non-neutrality of money over the short term--the shock of increasing money (creating inflation) lowers unemployment--has been robustly established in the U.S. economy.
It was necessary to recreate theoretically the short-term Philips curve relationship in order to carry out a practical analysis of monetary policy, and the New Keynesian Model was successful in this regard. The theoretical underpinning of the New Keynesian Model is the hypothesis that the rigidity of prices produces the Philips curve. However, the financial crisis renewed awareness of the effect of financial intermediation network externalities, presenting a major problem for making the Keynesian hypothesis, i.e., price rigidity causes the Philips curve, the basis for the standard model. If network externalities are also seen as the cause of the short-term Philips curve, then the single factor of network externalities could be used to create a theoretical macroeconomics framework capable of analyzing both ordinary business cycles and financial crises.
The following hypothesis could work as a means of deriving the short-term Philips curve from network externalities (with a more exacting theorization to be undertaken at some future point). Let us suppose that consumers are required to pay either in cash or in inside money (or financial intermediation services) when purchasing consumer goods. If the inflation rate rises, it would be to the consumers' disadvantage to hold cash (cash quickly drops in value when the inflation rate is high because cash loses value vis-à-vis consumer goods at the same rate as inflation), spurring demand for inside money. If there are network externalities in the production of inside money (financial intermediation services), rising demand for inside money will lead (unexpectedly) to an increase in the supply of inside money (this is the meaning of externalities). Thus, the purchase of consumer goods will become unexpectedly easy, and demand for consumer goods will also grow unexpectedly. As a result, both the production of consumer goods and employment will rise.
In essence, when network externalities exist, the unemployment rate might perhaps fall due to the monetary shock of boosting the inflation rate. It could then be possible to obtain the short-term Philips curve from network externalities. A theoretical framework for analyzing economic cycles, monetary policy and financial crises in a unified fashion could thus be constructed based on the hypothesis of network externalities rather than the rigidity of prices. The financial crisis can be said to have provided economists with some significant hints.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the the December 21, 2009 issue of Kinzai Financial Weekly
