I somehow failed to actually post this post earlier. Consider this to be a prequel to Silas against spending 2:
Notable internet guy Silas Barta thinks calls for stabilizing spending (via the central bank) are ridiculous (link). I have looked for a good explanation of the fundamentals of monetary economics, but I haven’t found something I really like and can point people to. Sumner’s blog used to discuss such fundamental issues more often, but lately he focuses on the politics of monetary policy. I usually tell people skeptical of increased spending to read Sumner’s old blog posts, but that’s quite a bit of work, so it is not a very satisfying answer.
Anyway, in a recent comment, he makes a decent attempt at explaining the most important way that monetary disequilibrium affects economic activity (link)
When the Fed increases the money supply permanently, expected future NGDP will rise due to the “hot potato” concept. People don’t want to sit on a lot of cash forever. But then the fallacy of composition comes into play, what is true for the individual is not true for the group. As individuals we think we can get rid of excess cash holdings, and in a sense we can. But the group cannot, as the money is just passed from one person to another. So it the individual level the attempt to get rid of excess cash seems unimportant, we just swap if for some other good, service or asset. But as the group level if we are all trying to get rid of extra cash, it drives up AD and NGDP.
To summarize:
1. A permanent increase in money tends to raise future expected NGDP due to the “hot potato” process.
2. Higher future expected NGDP means more business confidence, higher current asset prices and more current investment.
The exact opposite occurs if there is an increase in money demand, not supply. Now people try to accumulate more money. This is what happened in late 2008. Even though the Fed did supply more, it was all demanded, and then some, partly because of fear, partly because of interest on reserves.
Both processes seem mysterious because they are based on expectations. The public and investors is looking at a complicated picture, and trying to forecast NGDP growth when we don’t even know exactly what the Fed’s future plans are.
An excess supply of money causes spending to rise and a deficient supply of money causes spending to fall. The hot potato concept is also called ‘monetary disequilibrium’, ‘excess cash balance mechanism’ and probably a bunch of other things.
So if you add more money to the economy when spending starts to fall then you will counteract monetary disequilibrium; this is why Sumner advocates stabilizing some measure of nominal spending. You can also think of stabilizing nominal spending as stabilizing the fraction of total (traded) output that a dollar will get you as opposed to stabilizing the quantity of output that a dollar will get you.
I agree that macroeconomists do a generally poor job of communicating their core theory of monetary economics. I haven’t seen such theory presented in my textbooks and I don’t see many macroeconomists emphasize it, but Sumner and Kling argue that up until about 3 years ago this was basically the macroeconomic consensus, and no one seems to dispute this. Until I started reading Sumner, I was, like Silas, very skeptical of macroeconomics, but Sumner changed my mind.
To respond to one specific question Silas asked: “But I don’t see how it’s responsive to my point that any method of increasing the money supply involves, in effect, bankrolling projects that couldn’t get private funding (or public support), and therefore will, on average, just compound the pain of any existing inefficiency.” I guess I don’t have a very satisfying answer to this except to say that just because a project cannot get funding does not mean that it doesn’t make real sense; for example if people don’t fund it because of how it will affect their money holdings.
I doubt that this will convince Silas that monetary disequilibrium is important, but I do hope this will convince him that it’s not ridiculous.
Good Morning, Economics 
23 comments
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August 3, 2010 at 6:13 pm
Silas Barta
Thanks for posting the prequel! Here is how I see the exchange:
You: The Fed should print up lots of and loan it below market rates to large, clumsy institutions that just failed at their jobs very badly.
Me: Why?
You: To get aggregate demand back up.
Me: Why is it good to get aggregate demand back up?
You: To get total spending back up.
Me: Why would it be good for total spending to go back up?
You: So that businesses and consumers are more confident.
Me: Why should they be more confident, rather than reading the market signals as signs that the economy has lost real production capability?
You: Because this is how they’ve always done it. (?)
***
Also, note that the “hot potato” point you quote from Sumner assumes away the very premise I’m disputing: that spending, in and of itself, is good, whether or not it’s causing resources to be allocated toward things people want.
August 3, 2010 at 6:59 pm
jsalvati
When I claim that you must have “some policy” I don’t mean that the Fed must do something; I just mean that the price level must be determined somehow; it could be determined a variety of ways, you could have free banking and let private banks determine it; it could be determined by the Fed; it could be determined by some culturally accepted medium of exchange (say gold), but it must be determined otherwise it’s not really money in any interesting sense. Yes?
Do you have a preference for how the price level is determined (or some other nominal variable)? Do you think it matters?
August 4, 2010 at 4:46 am
Silas Barta
Do you have a preference for how the price level is determined (or some other nominal variable)? Do you think it matters?
Yes, I have a preference, and yes, it matters. They should be determined by the interplay of preference of individuals, like any other price or quantity, not by a central agency that deliberately manipulates the economy until the everyone’s incentives are such that the values stay at a desired level.
August 4, 2010 at 6:27 am
jsalvati
I think this is a bit of a non answer. Do you mean it doesn’t matter what kind of monetary system we use as long as it’s a private system? There are many ways nominal variables could “be determined by the interplay of preference of individuals”.
August 4, 2010 at 7:41 am
Silas Barta
Okay, then let’s go back a step. Imagine I asked you, “How should the number of tricycles produced by an economy be determined? (or their price, or other goods, etc.)”
What answer would you give? I’m not asking because I don’t know of plausible answers, but because I want to know which answer you think is salient here, and how the case differs from money.
August 4, 2010 at 7:55 am
jsalvati
Clearly, the number should be determined by the tricycle czar.
More seriously, I would say that it should be determined by the supply and demand for tricycles.
I suspect your answer would be something like “Free Banking” http://en.wikipedia.org/wiki/Free_banking, where there is competition between different private currencies. But in that case, the individual banks must have some nominal anchor, and choose how they manage their currency. Is that something along the lines of what you were thinking?
August 4, 2010 at 8:44 am
Silas Barta
Yes, I think that supply and demand should determine prices and quantities of (any kind of) money, and to the extend that that implies free banking, yes, that’s what I want. (I hedge only because “free banking” has different variants, but I don’t think those distinctions are relevant to the discussion.
People make decisions that change the quantity and price of money based on signals they receive from the economy. These signals (ideally, though they are often distorted) reflect genuine relative scarcities in the economy. Decisions to hold more or less money (which affects quantity and price level) themselves send signals to others; to the extent that a powerful organization forces these values to stay at certain levels, it’s erasing these signals and dis-coordinating patterns of economic activity.
The decisions by customers (and anyone else a bank interacts with) tell banks how to manage their currency, as they tell anyone else how to manage their operation. What additional necessity do you believe is satisfied by the nominal anchor you refer to?
August 4, 2010 at 9:34 am
jsalvati
I think maybe I gave the misimpression that I was trying to make a more substantial point about the need for a nominal anchor than I actually was. I merely meant that whether the price level is $10 or $1000 is not very important but must be determined in some way; it must be determined by some other nominal quantity in the economy.
My impression is that most Free Banking advocates think that competitive currency issuer’s would do some kind of nominal income targeting. The reason is that there really is a money externality: an increased demand for money increases the value of money and forces all other markets to undergo the costly process of changing their prices. The cost to the currency issuer of changing the supply of money in response to changes in money demand is relatively low, and the cost of adjusting prices for the same reason is relatively high. The desirability of Free Banking hinges (for me) on whether competitive currency issuers internalize and respond to this externality or not. It seems plausible, but not obvious that they would.
Another way of stating this is that changes in the demand for money should not send signals because money is not scarce (or need not be anyway) in aggregate.
Independent of the desirability of Free Banking, we are stuck with government money for the time being. The issue at hand is what kind of policy the Fed should have. In a practical sense, going back to a gold standard or fixing the quantity of money or targeting the price level would be *less* like a well functioning Free Banking system (where the money externality is internalized so monetary disequilibrium is avoided) than what Sumner advocates. Monetary disequilibrium is a real and costly thing, so we should seek to avoid it.
August 4, 2010 at 9:47 am
jsalvati
For example, George Selgin (http://en.wikipedia.org/wiki/George_Selgin) who I linked to earlier is apparently “one of the founders … of the Modern Free Banking School”. He is an advocate of both Free Banking and a kind of nominal income targeting. I have seen it mentioned elsewhere that he thinks currency issuers would do some kind of nominal income targeting, though I haven’t read his material on that.
August 4, 2010 at 10:29 am
Silas Barta
That’s why I was cautious about saying free banking matches my view — it does in the sense that I want “banking that is unrestricted [except by standard trade law]”, but not in the sense that I advocate particular enterprise strategies that are historically associated with the free banking movement.
And I think your recent comment allows me to finally identify where exactly we disagree:
The cost to the currency issuer of changing the supply of money in response to changes in money demand is relatively low, and the cost of adjusting prices for the same reason is relatively high. … changes in the demand for money should not send signals because money is not scarce (or need not be anyway) in aggregate.
I disagree. Changes in the demand for money *should* send signals. Whatever desirable condition you might associate with a stable price level (or NGDP, etc), any decision on the part of anyone to spend money will send a signal. There is no such thing as “just spending money”; the money is always spent on *something*. And likewise, not spending money on anything at a given time is another signal.
When the Fed tries to make people spend more, it is making people buy things they otherwise wouldn’t, and therefore destroying the signal that would otherwise be sent by their decision not to spend that money. These additional purchases are just as much (contributory toward) an inefficiency as if you prohibited people from cooking their own food. (Incidentally, can you explain to me what precisely is wrong with such a policy as a stimulus? After all, it sure would get people spending…)
With this in mind, I dispute that it is somehow a “negative externality” for prices to have to adjust as demand for money changes. That would only be true (in the sense you meant) if the resultant changes in prices served no function, and, as you see now, I don’t think that’s the case.
(Also, I’m not sure if this is responsive to something you meant with your remarks, but just in case: Money does need to be kept scarce in order to have value. That is one reason couterfeiting has to be stopped, claims of “information wants to be free” notwithstanding.)
August 4, 2010 at 10:42 am
jsalvati
I would oppose a “no personal cooking” bill because it would like be horrifically inefficient, even if it was a way to get people to spend more (though I kind of doubt this as it would put additional burden on them and their low money holdings relative to what they desire).
I think I would understand your argument better if you gave an example (could be extreme) of the kind of benefit you see from the signal from a change in the demand for money.
August 4, 2010 at 12:15 pm
Silas Barta
Sure thing, John. That sounds like a great way to better understand each other.
Hypothetical situation: Let’s say a few scientists have announced that they’ve discovered an effectively unlimited/costless energy source (like the cold fusion situation). A few of their friends have gotten it to “work” too, in that it appears they’re really on to something — perhaps energy problems are about to be solved forever.
On the other hand, most claims like these turn out to be fraudulent or mistaken. And even if they’re doing everything properly, it could be that they’re not tabulating the energy flows correctly (i.e. not realizing that something critical is consumed in the process, meaning it requires more resources and energy input to keep it going indefinitely, which they hadn’t accounted for on deeming it costless). But still, there is much evidence for and against, and the truth or falsity of the claims really matters.
In this situation, it would be very wise not to commit resources to narrow uses, as the eventual unveiling of the truth about the energy claim will obviate many kinds of economic activities. If it turns out to be true, huge sectors of the economy become worthless: the drilling equipment for oil, energy prospecting equipment, coal mines, natural gas pipelines, equipment for maintaining these pipelines, transportation networks that exist because all of this, and, of course, all of the specialized workers and knowledge sets so related. Investing *more* in these will mean you’re “caught with your pants down” when the claims are verified to be true.
On the other hand, investment in the *opposite* direction will be painfully obviated if the claims turn out to be false. So all investments and most purchases carry an additional risk-cost, and so holding off on doing so is a rational response to the economic realities involving high uncertainty about the usefulness of particular goods. In this situation, if you got people to spend and invest for the sake of propping up spending and investing, you’re causing a huge waste of resources: since people don’t yet know which course of action is right, many more goods than otherwise are going to be committed to wasteful production structures.
I had commented along these lines in a LW comment: if people are forced to spend, they prop up inefficient production methods which will have to liquidate anyway at some point, and the propping up just “digs you deeper” in terms of specialization that needs to be undone.
Now, this is obviously a contrived scenario, and I don’t claim we’re in a situation as severe. But the same basic thing is going on: many of the “patterns of specialization and trade” (as Arnold Kling calls them) look uncertain, and there is very good reason to be hesitant about purchases or investment, so forcing them to happen will introduce inefficiencies and worse the readjustment for the same reason.
August 4, 2010 at 2:27 pm
jsalvati
I have to think about this, but one point I want to make is that hoarding money by itself does not transfer resources into the future. Could you elaborate on how reduced income signals people to transfer real resources into the near future?
August 4, 2010 at 2:30 pm
jsalvati
er, I should specify that hoarding money does not by itself transfer real resources into the future, in aggregate; it can for individuals, but it’s more like an agreement to get resources later in exchange for resources in the future.
August 4, 2010 at 2:54 pm
jsalvati
This Worthwhile Canadian Initiative post is related (http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/07/cash-as-the-real-real-option-to-do-anything.html) to this topic.
August 4, 2010 at 3:17 pm
Silas Barta
Okay, I’m looking forward to your longer reply. As for your question, by spending less in the aggregate, fewer resources are committed to questionable modes of production that (in all likelihood) will then become worthless as new patterns of production are inconsistent with them.
So the decision to hoard does not *itself* “transfers resources to the future”, but by holding back consuming and investing, then fewer resources are locked up in bad uses, allowing for more future resources than would otherwise exist.
August 4, 2010 at 7:47 pm
Silas Barta
Update: Wow, Worthwhile Canadian Initiative post you linked says it much better than I could. Do you have a post of disagreement with the analysis therein?
August 11, 2010 at 10:10 am
Silas Barta
Still working on this?
August 11, 2010 at 10:23 am
jsalvati
Yes, I am. I’ve also been a bit distracted. I will try to respond substantively soon. I don’t think I have anything to say particularly satisfying for either side of the argument.
August 11, 2010 at 11:10 am
Silas Barta
Okay, thanks. 🙂 Saw you on facebook…
August 19, 2010 at 8:41 am
Silas against spending 3 « Good Morning, Economics
[…] 19, 2010 in economics | by jsalvati Silas poses the following question in the comments (link) Let’s say a few scientists have announced that they’ve discovered an effectively […]
January 2, 2012 at 8:26 am
Debating Silas Barta « Good Morning, Economics
[…] 7, 2010 in macroeconomics | by jsalvati Silas Barta and I have a long ongoing debate (part 1, 2,3 part 2 actually comes before part 1) about monetary economics, 2008 recession policy and the […]
December 7, 2013 at 10:20 pm
washingtonfreeman
Smashing debate, chaps!