Arnold Kling has a good "rant against monetarism", triggered by my saying "My position is that a general glut can *only* be caused by an excess demand for the medium of exchange."
Arnold's response:
"Most economists believe this, or something like it. I used to believe it, or something like it. I think that it is a horrible, horrible, confusion."
(I only wish he were right about the first bit, because I can find very few economists who believe it, and I've been trying hard to get them to believe it.)
Let's start with where I agree with Arnold.
"If you took money out of the picture, the construction worker and the college student would still be unable to solve their problem. When it comes to the failure of wants to coincide, the existence of money is part of the solution, not part of the problem."
Bingo! Yes, absolutely. It is hard to solve the economic calculation problem, of who should produce what, with whom, and how, and who should consume what. And without monetary exchange, solving that problem would be much, much, harder. Monetary exchange is part of the solution, not part of the problem.
With monetary exchange, I can concentrate on deciding what to produce, and on what to consume. I don't have to concentrate also on the chain of barter transactions that might eventually lead me from what I produce to what I consume, which depends on all the other things that all the other people might want to produce and consume. That's why we have a monetary exchange economy.
But it is precisely because money is part of the solution, and a very important part of the solution to a very real problem, that when something goes wrong with money, the solution falls apart. If it really were as easy to solve the economic problem with barter as with monetary exchange, it wouldn't matter if something went wrong with money. We would just resort to barter.
If barter were nearly as easy as money, then an excess demand for the medium of exchange would not cause a recession. People would just switch to barter, and the economy would carry on as normal, with a slight increase in transactions costs.
And I also agree with Arnold here:
"Perhaps my rant should be directed against Walras' Law, which says that excess supply somewhere implies excess demand somewhere else. Who the heck enforces Walras' Law? Nobody. Entrepreneurs are trying to figure out how to make a profit. Their aggregate groping is what discovers a viable pattern of comparative advantage and specialization."
Yep. Walras' Law is false. Yes, I know we learn it in micro, and it seems to drop straight out of the budget constraints, when you add them all up. But it's false, horribly false. And it's false because, as Arnold says, there's nobody to enforce it. More precisely, if there were a centralised Walrasian auctioneer, trading every good for every good in one big market, and not allowing trade to begin until he had found the market-clearing vector of prices, then Walras' Law would be true. But there isn't, so it's false.
That Walras' Law doesn't work in a monetary exchange economy is obvious, once we start to count up how many excess demands and supplies there are. Let there be n goods, including money. Walras' Law says that the sum of the values of the n excess demands must equal zero, for any price vector. Rubbish. In a monetary exchange economy, with n goods including money, there are n-1 markets. And in each market two goods are traded: money; and one of the other goods. So there are n-1 excess demands for the non-money goods, and n-1 excess demands for money. That makes 2(n-1) excess demands in total, not the n excess demands in Walras' Law. And each of those n-1 excess demands for money is chosen to maximise utility subject to the quantity constraints in the other n-2 markets. So they aren't even mutually consistent. If you actually succeeded in buying or selling what you wanted in one market, you would want to do something different in all the other markets.
Setting n=2(n-1), we solve for n=2. Yep. Walras' Law would work fine in a monetary exchange economy with 2 goods, one of which was money. But who the hell would need money if there were only one other good? If there are only 2 goods, apples and bananas, how could we even tell whether apples were used as money, or bananas were used as money? If n=3, and we saw carrots exchange for apples, and carrots exchange for bananas, but we never saw apples exchange for bananas, then we would know that carrots are used as money. But n=3 means n is not equal to 2(n-1). So Walras' Law is nonsense in a monetary exchange economy. It's not even false; it's nonsense.
Forget Walras' Law. What about re-calculation?
The calculation problem doesn't solve itself. It takes people to solve it. The price system helps them solve it. Monetary exchange helps them solve it. But it isn't easy to solve. And it never really does get solved, because there's always the chance another entrepreeur could come along and solve it better. And if technology, resources, and preferences are changing as well, people have to keep re-solving it. That's what I take to be the re-calculation problem.
But that re-calculation is happening all the time. What's it got to do with recessions?
Sure, sometimes a really big real shock comes along, like the rise in oil prices in the 1970's, or a war, and it takes a lot more re-calculation than it normally does. And OK, a financial crisis isn't exactly like a change in the underlying tastes, technology, and resources of Walrasian general equilibrium theory. But you don't have to try hard to convince me that it too would require a re-calculation. And maybe output would fall while we are trying to figure out how to re-solve the economic problem. Maybe even employment would fall too. "Hang on guys, don't commit to doing anything quite yet, while I try and figure out where you should best be working now that everythings changed". I'm sure every central planner or local manager has had to say that at some time or another.
[Added for clarity: this is the point at which I start disagreeing with Arnold.]
But I just can't buy it as a full story of recessions. It's the general glut thing that's missing. Stuff gets easier to buy in a recession, and stuff gets harder to sell. That's an essential part of what makes it a recession. To say that stuff is harder to sell and easier to buy is meaningless outside a monetary exchange economy. In a barter economy, selling stuff is buying stuff. When you are trying to sell you are trying to buy at the very same time. A thing can't be harder or easier than itself.
What makes a recession a recession, and something more than a bad harvest, or a re-calculation, is that most goods, and most labour, gets harder to sell and easier to buy. And I really want to call that an excess demand for money. Because it is money we are selling stuff for, and it is money we are buying stuff with. And if I've also got a theory as well, which says that an excess demand for money will cause a drop in output and employment, and an excess supply of goods and labour, that's just icing on the cake.
This probably won't convince Arnold. But it's why I believe that general gluts — recessions — are always and everywhere a monetary phenomenon.
Worthwhile Canadian Initiative 
“But if all prices are fixed, the berry producers will not want to sell their land.”
Really, I thought we started in equilibrium?
Adam. You lost me there. We started in equilibrium, where the berry producers are holding exactly their desired quantity of land. Then we fix prices. Then we introduce a shock, so peach producers suddenly want to buy more land. But berry producers don’t want to sell.
But we fixed prices at the euilibrium prices, we had to. If we didn’t fix them at the equilibrium prices then it wouldn’t be true that berry producers are holding exactly their desired quantity of land.
At equilibrium prices berry producers are perfectly happy to trade a unit of land for the appropriate number of peaches, at least the first unit.
So why can’t the peach producers buy some land?
Adam: OK, at equilibrium the berry producers are indifferent to trading the first unit. But they won’t want to trade the second or third units. And the peach producers want to buy thousands of units.
Take the limit of the above as the size of the “unit” goes to zero.
But as soon as they’ve diverted enough peaches out of the berry market and into the land market to cause quantity rationing in that market then they’ve also, by construction, diverted enough peaches out of the berry market to cause a glut of berries.
Here’ my image: They load lots of peaches onto the wagon, and head off to the land/peaches market. They get there, and find they can’t buy land, so turn the wagon around and head off to the berry/peach market.
Here’s my image of your image: They load all the peaches onto the wagon, get to the land/peaches market, and find they can’t buy land. By this time it’s evening, and too late to turn around and head off to the berry/peach market. The peaches rot in the wagon. (And the berries rot in the wagon at the berry/peach market too, because the peaches never show up.)
“They load lots of peaches onto the wagon, and head off to the land/peaches market. They get there, and find they can’t buy land, so turn the wagon around and head off to the berry/peach market.”
But we just established that they can buy some land.
What you seem to have in mind is that they load up the peaches, come to market and try to buy say 100 peaches worth of land. They find that they can only buy 20 peaches worth of land so they leave without transacting.
I say they load up the peaches and go to market trying to buy 100 units of land. They find that they can buy at most 20 peaches worth of land so they do that. They then arrive at the berry market and and buy 40 fewer berries then they otherwise would have (assuming the relative price of 2berries/peach).
So it’s not that all the peaches rot and all the berries rot, it’s that demand for berries falls, replaced by demand for land, while demand for peaches stays the same (in particular doesn’t increase).
Thus aggregate demand has fallen, we get the glut of berries.
Clearly, certain assumptions give rise to Walras’ Law, while others do not. Could one empirically test the hypothesis that Walras’ Law holds?
Nick @ 6:53
Well, the point was not to have a government sector at all, but to show how expectations failures can cause general gluts in a barter economy.
In my model, there are no separate classes of rentiers/workers. There are households that both work and accumulate consols (say for retirement). You can argue that the retirees are the rentiers if you want, but a representative household will have some accumulated bonds and will also be working, and it’s easier to just assume that.
There are two markets: the market for consols in terms of wheat, and the market for labor in terms of wheat. The third market — consols for labor — is fixed by the production characteristics, as it requires 1 unit of labor to produce 1 unit of planted land.
What is happening is that the harvesting firms have promised to deliver, say, 1 ton of wheat to households as interest payments. And the household sector also gets, say, 3 tons of wheat as wage payments. The households will consume whatever wheat they want and will turn around and roll over some of their wheat income by purchasing more consols with whatever consumption of wheat they want to defer.
The new consols purchased will correspond to new firms planting land in that period, and that exact amount will correspond to the wages paid to households employed by the new firms that are planting.
Therefore I am sneaking in an endogenous money economy, hopefully with proper accounting, into a barter economy, where consols play the role of money.
When the discount rate falls, households want to consume less wheat in the present, the amount of wheat that a consol buys goes up, and households obtain more of their wheat in the form of wages paid by planting firms as more wheat is used to pay workers making planted land.
When the discount rate rises, then households want to consume more wheat in the present, the amount of wheat that a consol buys goes down, and households earn more of their income working for harvesters, with less employment and investment by planters.
However, the price of a consol in terms of wheat is not determined just by the discount rate, but is also determined by the numerator — the expected future profits earned by harvesters — and only by harvesters — that are being discounted.
And in this economy those profits are exactly equal to the amount of total borrowing each period by the new planting firms.
So if, for some reason, there is a belief that expected future profits of harvesters will be higher, you can get excessive investment in terms of more planters today wishing to become harvesters tomorrow. These planters will buy more wheat today from harvesters without creating any wheat themselves, causing wheat prices to rise, and profits to rise in a self-fulfilling prophecy.
If, on the other hand, there is a belief in low future profits, you get a self-fulfilling prophecy of falling investment, meaning less non-wage demand for wheat, meaning that harvester profits fall, and they have no option but to reduce employment (if they can increase MPL by doing so) in order to meet their bond obligations.
The underlying assumption here is that in the sum
NPV consol = P_1/(1+R) + P_2/(1+R)^2 + …
the numerators — the P’s — are volatile — whereas the denominator — the R — is relatively constant. And in that case, you would get volatile employment and investment even in a barter economy, and without any government fixing of interest rates, or any price fixing at all. I am assuming perfectly flexible prices, but imperfect future knowledge of the P_s.
And in the downturn, this does correspond to a fall in aggregate demand for wheat because there are fewer planters desiring to buy wheat on credit, meaning a glut of wheat matched by an excess demand for consols.
And perhaps the easiest way to think about this is that, even though each individual household wants to defer some consumption of wheat, it is impossible, in aggregate, to defer consumption of wheat that has been harvested.
This is unlike the macro assumption that income is some “goop” that is transmuted into capital or consumption. It’s a different accounting.
When household A decides to defer consumption of the wheat income that it receives, it purchases a consol and then household B is provided this wheat as wage payment for working for the firm that sold the consol. So even if 100 tons of wheat are harvested, to say that households succeed in “deferring” the consumption of 50 tons of wheat means that 50 tons of wheat are re-sold in exchange for consols, with wheat aggregate income equal to 150 tons of wheat. It’s still the case that 100 tons of wheat were produced and 100 tons of wheat were consumed. But 50 tons of wheat were successfully “saved” only because wheat incomes increased in excess of actual wheat production.
When household savings demands are too high, then they fail to save wheat and wheat incomes decline up until households succeed in saving a portion of their (smaller) wheat income, even if the amount of wheat produced by the production function is unchanged.
This is the exact same paradox of thrift effect that you see in a monetary economy.
The more I think about it, the more it seems the conclusions drawn depend on the model used and how one thinks about it.
In the simple 2 good model with wheat (storeable) and berries (perishable), it’s possible that an increased desire to save leads to a price shift that causes the market to clear.
It’s also possible that there’s a maxium total demand for berry consumption that places an upper bound on berry demand. (Think of this as an individual’s demand curve that goes flat below a certain price. This doesn’t really show up in economics textbooks, but if you think about it, most of us could only consume a certain amount of berries even if they were free.) Depending on what this upper limit is and the ratio of wheat growers to berry producers, it’s possible that this mechanism (or something similar) would limit the demand adjustment.
Er… I think I’m getting bogged down in details. I think the main point is that if anything makes prices sticky, the higher demand for savings/investment causes production of perishable goods to fall. Money isn’t required to come up with a story that justifies sticky prices. If the durable goods sector can’t absorb the extra labour, you get unemployment. (When production requires land or some sort of capital accumulation, it’s possible that the employment in the durable goods sector can’t just instantly increase.)