How Does an Increased Demand for Cash Draw Forth Larger Quantities?
A Campaign for Liberty guy was understandably upset by this recent AEI publication challenging the “myths” about the Fed. I explained that I was too busy to write up a full-scale response. However, I do have time to focus on one passage:
The jump in the US M2 money supply since July has been largely driven by a sharp increase in demand deposits. It appears that many US households that are selling stocks and risky bonds are depositing the cash they accrue in FDIC-insured bank accounts. Firms are adding cash to FDIC insured accounts, as well.
OK, that makes no sense to me at all. People talk like this all the time, but (as I say) this makes no sense to me. There is a conceivable mechanism through which maybe I could see the cause==>stated effect, but it’s way more complicated than such typical explanations acknowledge, and I’m not at all sure that the people who say things like the above realize just how complicated the story would have to be.
I spelled out my concerns on this issue in this article. As is my wont, I walked through really simple scenarios involving just a few people, to illustrate the distinction (in this case) between money and wealth.
Here’s the punchline: First suppose we don’t have banks at all; there are just (say) $1 trillion in actual green pieces of paper in the economy. In this case, it clearly doesn’t matter what the demand for cash is, or whether the stock market is rising or falling. If someone sells his stock holdings for cash, then yes his cash balances go up, but somebody else’s go down by the same amount. At any given time, the quantity of money (M1) is exactly $1 trillion.
Now make it more complicated. Assume there are banks but that they practice 100% reserves on demand deposits. In this case too, the public’s desire to hold cash versus stocks can’t affect M1; there are still $1 trillion in existence at any given time, though the mix between paper currency versus checking account balances can change based on the public’s desires.
Make it yet more complicated. Assume there is fractional reserve banking. Still, the public’s desire to hold cash can only lead to higher M1 if the banks at the same time are willing to see their reserve ratios go down. It’s not the mere fact of some guy selling $10,000 in stock and “putting it in the bank” that does the trick; where did the $10,000 come from, from the guy buying the stock?
I have used M1 in this blog post instead of M2, because I understand the constituents of M1 better. Also, the AEI write says he is focusing on the demand deposit component of M2, which is also in M1. (So his story would be applicable to the sharp increase in M1 since July.)
As I said, you hear this kind of talk a lot. I am not saying that it is necessarily wrong, I’m just saying the usual explanation is either wrong, or it’s leaving out some crucial intermediate step(s).
Discuss.
Keynes’ Total Non Sequitur on Burying Money and Digging Up Gold
There’s a popular passage where Keynes pulls an early version of Krugman’s space alien example by writing:
If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.
That passage has served as either brilliance or absurdity, depending on whether or not you are a Keynesian.
But lately a follow-up passage has been added to the mix. I’ve seen it in a few places, but when Karl Smith touched on it I felt compelled to comment (since Karl I’m sure honestly doesn’t see what a cheap move Keynes is making here). So this is the follow-up from the witty Keynes:
It is curious how common sense, wriggling for an escape from absurd conclusions, has been apt to reach a preference for wholly ‘wasteful’ forms of loan expenditure rather than for partly wasteful forms, which, because they are not wholly wasteful, tend to be judged on strict ‘business’ principles. For example, unemployment relief financed by loans is more readily accepted than the financing of improvements at a charge below the current rate of interest; whilst the form of digging holes in the ground known as gold-mining, which not only adds nothing whatever to the real wealth of the world but involves the disutility of labour, is the most acceptable of all solutions.
All right so it’s the part I put in bold that is the cheap shot. Here Keynes is oh-so-smugly pointing out the apparent contradiction in the orthodox, “classical” economists and statesmen who reject pump-priming public works deficit expenditures on the grounds of efficiency, and yet who also cling to the gold standard. What morons! Don’t they see that they are advocating “digging holes just to fill them back up” on a grand scale? They’re Keynesians and they don’t even know it!
Except they’re not. Nobody to my knowledge in human history has ever said, “My solution to dealing with high unemployment is to keep the currency at its fixed peg to gold. As prices fall, this will stimulate gold mining, which will require more workers. Their higher wages will then lead to more spending, which in turn will generate so much more aggregate income that it will more than offset the loss in labor hours and other resources needed to move gold from the ground into the vaults.”
Now I grant Keynes (and Yglesias, Karl Smith, etc. etc.) that if some free-market economist, or some stuffy wig-wearing British politician, had said that in 1930, then that person would indeed have been a hypocrite if he opposed unprofitable public works spending.
But we don’t need to worry about it, since nobody (to my knowledge) ever said such a goofy thing. In fact, you have lots of pro-gold-standard economists explicitly acknowledging the “social waste” of having to dig up gold. Yet they thought it was worth it for the other advantages it provided–and those advantages did not include “fostering employment and hence more income due to the multiplier during downturns when the labor market otherwise wouldn’t clear.”
Catching Krugman in an Accounting Mistake?
I gave y’all time to convince me otherwise a few weeks ago, and I didn’t see any convincing cases. So I ran with my claim that Krugman–when ripping on David Cameron’s ignorance of “arithmetic”–smuggled in modeling assumptions about the economy, without realizing it. I run through a simple fable involving Larry the Landowner, Cathy the Capitalist, and Willy the Worker, and then conclude:
The old-school, commonsense solution to an economy plagued by excessive debt is for people to work hard and save more. Keynesian economists have been saying throughout our current crisis that this folk wisdom overlooks basic accounting tautologies, but these pundits are smuggling in a Keynesian theory without realizing it.
Contrary to the assertions of these pundits, an economy does not need mountains of debt — whether government or private — in order to grow. Corporations can still raise needed financing through issuing equity. There are pros and cons to debt financing, but it isn’t necessary for a strong economy.
Vote for the Most Astounding Statement I Heard This Week
Once again, it’s time for one of the more popular features on Free Advice, where you the reader get to vote on The Most Astounding Statement I Heard This Week.
Our first contestant is documentary maker Ken Burns, who said the following in a Reason interview with libertarian bad boy Nick Gillespie:
[M]y politics are in some ways irrelevant…[We] work with people of different political persuasions to just tell films that are just general…We have lost this ability to have a civil discourse and history is still a table around which we can agree to have that civil conversation. I don’t know anybody that doesn’t like Abraham Lincoln…
In fairness Burns was saying something particular about why every person to his knowledge liked Abraham Lincoln, but Gillespie cut him off with a snide remark. Then a few moments later Burns said:
Well I think history is sometimes used as a kind of propaganda tool, a superficial, sanitized Madison Avenue celebration of, you know, the ‘goodness’ of America and the good old days, and I’m clearly not interested in that.
Clearly not, Mr. Burns.
Our next contestant hails from New Jersey and is here in the studio today with his lovely wife, Robin. Paul likes cats, number puzzles, and science fiction. In a recent blog post defending “technocrats,” Paul said:
The line from people there, including the president, has been that it was too technocratic. But the real technocrats — people like Christy Romer and, well, me — were saying right from the beginning that the stimulus was too small, etc.; people like Geithner who opposed stronger action were basing their position on gut feelings about confidence, not number-crunching.
And by and large, people who did the numbers have gotten it mostly right; it’s precisely because we’re ruled by crats who trust their guts rather than the techno that we’re in such trouble.
Now this one might be over the heads of some of the members of our studio audience, so we’ll give you a hint. You know how in the debate over the Obama stimulus package, the #1 Smoking Gun of the right-wingers–the thing that all “true” Keynesians have had to disown and throw under the bus, claiming that they would never in a million years have endorsed such a thing–was the report prepared by Obama’s economic team, touting the benefits of his stimulus plan? Surely you remember, this was the document that contained the infamous graph showing how unemployment would peak at 8 percent with the stimulus, and 9 percent (the horrors!) if Obama did nothing.
The report begins with this introductory paragraph:
A key goal enunciated by the President-Elect concerning the American Recovery and Reinvestment Plan is that it should save or create at least 3 million jobs by the end of 2010. For this reason, we have undertaken a preliminary analysis of the jobs effects of some of the prototypical recovery packages being discussed. Our analysis will surely evolve as we and other economists work further on this topic. The results will also change as the actual package parameters are determined in cooperation with the Congress. Nevertheless, this report suggests a methodology for ensuring that the package contains enough stimulus that we can have confidence that it will create sufficient jobs to meet the President-Elect’s goals.
Sure, the report nowhere says, “Obama’s proposed stimulus package is the exact right thing. It’s just what the doctor ordered. No more stimulus could conceivably be needed.” But go skim that thing, and tell me if you get the sense that the author was warning the reader that it wasn’t enough, and that guts were overruling Keynesian analysis.
Last point: Who was the head of the Obama economic team at the time, and whose name is on the cover of that document?
Sumner Needs to Watch Some Film and Hit the Gym
I used to say that Scott Sumner would be a far more formidable debating opponent than Paul Krugman, but lately I’m not so sure. I think for our debate, I just may print out 5 of Scott’s posts and ask the judge if I can submit them as exhibits.
For example, here’s Scott’s latest post that is quite clever, but ends up leading him into absurdity. (This is a metaphor for Scott’s entire program.) I reproduce it in full:
RMS Queen Elizabeth 2
“Attention passengers. Due to wind and currents, the ship has been pushed 12o miles north of its expected path.
The captain met with the QE2’s officers (the Frequently Off-course Mariners Committee), and decided that the setting of the steering wheel was still ‘appropriate.’ Thus rather than change our steering, we are changing our forecast. We no longer expect to make our scheduled arrival in New York, and instead expect to reach Boston on Tuesday. Unless we hit an iceberg. Enjoy the rest of your cruise.”
[Memo to Fed: Your job isn't to change your forecast, it's to change your policy in such a way that you don't need to change your forecast.]
Funny stuff, to be sure. (Note the FOMC reference.) But, as is Scott’s wont, he ends up in CrazyVille.
First let’s make sure we understand the context. The Fed today lowered its forecast for economic growth next year, and raised its forecast for unemployment. So Scott is saying, rather than refusing to pump in more money, and resting content with a worsening forecast, the Fed should do what it needs to do, so that it doesn’t have to give the public the bad news about gloomier prospects for next year.
OK, now that we understand what Sumner is doing in his cute analogy, we are ready to get knocked onto the floor by how wrong the analysis is. Even on Sumner’s own terms, his critique of the Fed makes no sense. The Fed folks aren’t revising downward their projections for NGDP (though in fairness that could be backed out of their statement), rather they are revising downward their projections of real GDP growth. And the reason (officially) they give for not doing more, is that they think to do so would push inflation unacceptably high. So on Scott’s own terms, given the Fed’s current view of the world, he is asking them keep pumping in money to raise NGDP even though that might show up (in the Fed’s eyes) largely as an increase in prices, with little impact on real output or a drop in unemployment.
And just to show that the Fed isn’t doing something outrageous with its acknolwedgement that it isn’t omnipotent, look again at Scott’s analogy. He is actually making fun of the idea that people running a ship might announce, “We’re going to be late.” Scott thinks this is a BS invention of central bankers, to admit that we might have to change forecasts, rather than altering the universe to make our previous forecasts correct.
Would you step onto a plane where the pilot adhered to Scott Sumner’s philosophy? “Don’t worry folks, I promise I will do whatever it takes to make sure we land in Boston at 3pm. Let’s just hope there isn’t congestion at Logan when we get there, because I’m not going to adjust my forecast. We are landing in Boston at 3pm, period. You can take that to the bank. And don’t worry about these so-called ‘mid-air collisions’ that the airline bloggers are always talking about. I’m going to ban that phrase from my flights from now on, because any problem allegedly due to a ‘collision’ is really a problem with kinetic energy.”
While I’m on the topic of Sumner’s superficial argumentation ability, look at this response he gives to Greg Ip. Now some of Ip’s arguments are goofy, but at least one of them is pretty good: Ip points out that the Fed hasn’t been inflating more, because it feels constrained by inflation hawks. So Ip is asking, why does Sumner think that switching to targeting NGDP would suddenly give the Fed more backbone to print money?
Scott answers:
Ip’s data shows that Fed policy was disastrously off course in October 2008…. They weren’t even expecting to hit their own policy goals.
Think about the Fed’s dual mandate; low inflation and high employment. In October 2008 they forecast inflation of 1.5%; below their 2% implicit target for “stable prices.” And they forecast a sharp rise in unemployment. The Fed should never make that sort of forecast, as it implies their policy is far too tight….The Fed should always set policy so that either both variables are on target, or if one variable calls for easier money, the other variable calls for tighter money. And yet both the inflation and unemployment forecasts called for easier money….
Check and mate. Scott just proved Ip’s whole point. Look at what’s happening here:
(1) Ip says that Sumner thinks the Fed needs to inflate more, but that Sumner is naively thinking the Fed will suddenly have the will to stand up to the inflation hawks if it changes from its current framework (where it strikes a balance between unemployment and inflation) to one in which it targets NGDP.
(2) Scott says no way Ip, you’re crazy. The Fed isn’t inflating enough even with its current framework. That’s why, if the Fed switched to an NGDP framework, the Fed would begin inflating more in order to satisfy its framework.
Let’s at least put on a show, Sumner. I think you need to watch some more film and hit the gym.
I Like This Guy’s Enthusiasm
…though I’m not sure those are the three takeaways I would have attributed to our book. (Plus I would have given myself 5 stars.)
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