I noticed something a bit strange about the responses to my last post.
For the last couple of years I have been writing lots posts saying (in various different ways) that recessions are always and everywhere a monetary phenomena. That Keynesian models do not make any sense except in a monetary exchange economy (which is not, I repeat, a criticism of Keynesian models, except insofar as they ought to make that assumption explicit and show exactly where money fits into the model). And that an excess of desired saving cannot create a recession unless it creates an excess demand for the medium of exchange. With loads of weird thought-experiments involving antique furniture, hairdressers, pro-usury parties, etc., trying to make my point.
And I've always felt that I was pushing against the mainstream view. And I've always gotten lots of pushback in the comments, saying I'm mistaken.
But in my last post I said the same thing, said that Paul Krugman agreed, and got almost no pushback at all (except for two, which I will come to later).
I can only conclude that suddenly my views on this are mainstream. Simply because Paul Krugman says the same thing. (Neither of us really put forward any real arguments to support that proposition.)
Which I think demonstrates that Paul Krugman has a lot of "authority". Which is not to say it isn't warranted authority, because he obviously has a much better economist's track record than me. But I'm still a bit surprised at being suddenly so mainstream on this question.
Greg Ransom is the first honourable exception. But he's an exception that proves the rule. Greg, as an Austrian, naturally won't take Paul Krugman as authoritative on anything about understanding business cycles. Greg argued, to paraphrase, that I was just defining a recession as an excess demand for money. I'm going to come back to Greg's point.
JW Mason is the second honourable exception. He(?) wrote a post questioning the assertion that recessions are all about money, and laid out a simple model of recessions in a barter economy (that did not involve the obvious bad harvest/earthquake shock to supply). [Update: just to show it was possible, not because he necessarily disagreed with the assertion as a matter of fact.]
JW's model contains what is often called a "thick market externality". The more traders there are in a market, the easier it is for each trader to find a trading partner, so the bigger the incentive for each person to become a trader in that market. There's a positive feedback process. And if that positive feedback is strong enough, over some range, you can get multiple equilibria, some locally stable and some locally unstable. A recession is an equilibrium with a lower level of trade than in some other equilibrium.
I like JW's model. And I think it's a useful model of a lot of things. But I don't think it's a useful model of recessions. It doesn't work empirically.
When I look at recessions, this is what (I think) I see: it gets harder than normal to sell stuff; and it gets easier than normal to buy stuff (if you've got the money). In a boom it's just the opposite: it gets easier than normal to sell stuff; and harder than normal to buy stuff (even if you've got the money). This is especially true for labour as the stuff you are trying to buy or sell.
There's an asymmetry in the ease of selling and buying that fluctuates over the business cycle. And that stylised fact seems to me to be equally as important as the stylised fact that output and employment fluctuate over the business cycle.
JW's model does not fit that stylised fact. In his model, because it is a barter model, buying is selling. Both buying and selling are harder in JW's recession than in JW's boom. They are equally hard. They must be equally hard, because they are the same thing.
Another way of looking at it is to say that money gets easier than normal to sell in a recession, and harder than normal to buy. And any model that does not contain monetary exchange simply cannot speak to that stylised fact of the business cycle.
So I reject JW's model on purely empirical grounds.
Which brings me back to Greg. How should we define "recession"? Dunno. How should we define "horse"? Dunno either. But I think I know one when I see one. Most of the time, because there are a few borderline cases where, even if I can see everything clearly, I'm not sure if we should really call it one or not.
If those borderline cases are rare, it doesn't matter much. Economists are like taxonomists who can't yet observe the underlying DNA of what we are categorising. So we come up with a list of observable characteristics that tend to correlate together, and use those characteristics to define categories. And because reality is lumpy, so that borderline cases are rare, this works. If reality were smooth, and characteristics were independently uniformly distributed, we wouldn't be able to talk about recessions or horses at all.
Which of the many characteristics of a horse is the defining, essential characteristic? None. A horse is a collection of empirical characteristics that tend to go together. Same with recessions. But there's something very wrong with a theory of recessions which ignores one of those semi-definitional characteristics. "Recessions are always and everywhere an excess demand for money". Is that a definition, or an empirical statement? A bit of both, really.
But what precisely do we mean by an excess demand for money? And where do we observe it? Is the excess demand for money that causes the recession the same as the excess demand for money we observe during a recession?
(You can stop reading this post now, unless you are really into that sort of stuff.)
I know what it means to talk about an excess demand for apples. It's the quantity of apples people want to buy (given current prices etc.) minus the quantity of apples people want to sell (given current prices etc.)
I know that, if prices are sticky, so that some markets do not clear, and some people are unable to buy or sell as much of some goods as they want, these quantity constraints may spill over to affect their demands and supplies of other goods. So we need to distinguish between the notional and the constrained (effective) excess demand for apples. I go to the supermarket planning to buy 3 apples and 2 pears, but they are out of pears, so I buy 5 apples instead. My notional demand for apples is 3; my constrained demand for apples is 5. I go to the labour market planning to sell my labour and then buy 3 apples. But when I get to the labour market I find I can't sell my labour, so I decide to buy only 1 apple. My notional demand for apples is 3; my constrained demand for apples is 1.
I know where to look if i want to see if there's an excess demand for apples. I look in the apple market. And I know that what I will see there is the excess constrained demand for apples, not the excess notional demand for apples. Unless by sheer fluke there is exact market clearing for all the other goods.
What about the excess demand for money (the medium of exchange)?
We are of course talking about a desired stock of money. And that desired stock of money is like a desired stock of inventory. And we desire to hold a stock of inventory because it is costly to exactly synchronise the flows in and the flows out, especially if those flows are lumpy. (Pedants might insist that a lumpy flow is not strictly a flow, but never mind.) But we adjust the actual stock to the desired stock by adjusting the flow in and/or out.
I understand what it means to talk about an excess notional demand for money. People desire to hold a larger stock of money than they actually hold, and so will want to increase their flows of money in by selling more goods and/or will want to decrease their flows of money out by buying less goods. And I understand that this notional excess demand for money, if unresolved, will create an excess supply of goods. A general glut. Because we live in a monetary exchange economy, where all goods (OK, the goods I'm talking about) are bought and sold for money.
And I understand that if goods are in excess supply, people will be unable to sell as much as they wish. The sales of goods will be demand-constrained. So individuals will be unable to implement their plans to increase their stocks of money by increasing the flow in.
And I understand that individuals will nevertheless be able to implement their plans to increase their stocks of money by buying less, and reducing the flow out. And that this plan, even though it works for each individual, cannot work in aggregate. Because one person's purchases of goods is another person's sale of goods. On person's reduced flow out is another person's reduced flow in.
But the attempt by each individual to increase his stock of money by reducing the flow out will result in a reduction in sales of goods. A recession.
OK so far.
But at this point we need to stop talking about an excess notional demand for money. When people realise they cannot sell as much as they want, when people realise they are quantity constrained, they will adjust their demands and supplies of goods in response. We switch from notional to constrained demands and supplies. And that includes the demand for money. We must stop talking about the notional demand for money and start talking instead about the constrained demand for money.
We observe an excess (constrained) demand or supply of apples in the apple market. But money doesn't have a market of its own. Every market is a market for money. We have to look at all markets to observe the excess (constrained) demand for money.
The excess constrained demand for money will be bigger, probably much bigger, than the excess notional demand for money that was the original cause of the recession. In the labour market, we observe an unemployed worker laid off from a $30,000 per year job. He wants his job back. He wants to sell $30,000 of labour per year but can't. He has an excess supply of labour of $30,000, and an excess flow demand for money of $30,000 too. But if he got his old job back, he wouldn't keep all of that $30,000 in money. He would want to spend (say) $29,000 on other goods, and keep only $1,000 in money. And in the second year, having rebuilt his stock of money to his desired level, he might spend all $30,000 on other goods.
In that example, the notional excess (stock and temporary flow) demand for money of $1,000 creates an (indefinitely long flow) excess constrained demand for money of $30,000 per year.
Worthwhile Canadian Initiative 
I wonder if you’re dismissing Mason a little too quickly. To me, many characteristics of a “hard to sell” world could still show up with barter. Divide the world into 2 sectors, things that are flexible and cheap to store (mostly commodities), and things that are inflexible and difficult to store (services, but also finished goods to varying degrees). A futures curve for the former will tend to be well-behaved (in particular, contango is constrained by storage arb), while the latter can be sharply contangoed, or “hard to sell”, in the short run. The good equilibrium involves lots of inter-sector trade, while in the bad equilibrium, the first sector likely accumulates inventory and the second must search for intra-sector trade or for ways to migrate.
I’ll try to develop this thought further later, it seems very incomplete.
Krugman: “an overall shortfall of demand, in which people just don’t want to buy enough goods to maintain full employment, can only happen in a monetary economy; it’s correct to say that what’s happening in such a situation is that people are trying to hoard money instead (which is the moral of the story of the baby-sitting coop).”
Keynes:
Nick, you seem to be saying that Krugman is repudiating Keynes. Maybe so, but I think we need a “wonkish” post from him addressing that specific point. It is noticeable that he usually traces his ideas to Hicks rather than Keynes.
The $ 1,000 is definitely a stock demand.
The $ 30,000 is definitely not a stock demand.
What is your objective in trying to reconcile the two?
Hey, thanks for the discussion!
I should be clear, the point I was trying to challenge wasn’t that recessions always, in practice, involve excess demand for money, but that they logically must involve excess demand for money. I was trying to describe a situation without money, where we nonetheless can speak of output as being demand-constrained, in the sense that a change in desired expenditure would lead to a corresponding change in output. Is this model descriptive of something that happens in the real world? Maybe, maybe not. But I hope we can at least agree that the fact that aggregate demand is holding actual output below potential, does not imply that there is excess demand for money as a matter of logic.
As for the real world, I would be willing to agree that in recessions, there is always — even definitionally — an excess demand for money, or in your terms, it’s harder to sell (or borrow against) goods for money, and easier to turn money into goods. But only if we drop the implicit assumption that the only states of the economy are recessions, and output at/near potential, and allow for extended periods of growth in which output is nonetheless demand-constrained. I think it is definitely true that there is excess money demand in recessions proper, or during the transition from a higher-output equilibrium to a lower-output one. I’m not sure it’s true once the new equilibrium is established, and a new set of expectations is in place.
I think part of the difference here is that for you (and I think for Krugman, and definitely for DeLong) the barter foundation on which the money and aggregate-demand upper stories are built, is firmly Walrasian. People have secure, true expectations about the (unique) path of lifetime income that their endowments will provide, and the corresponding optimal consumption path. So in any period in which consumption departs from that path, you need a monetary explanation. On the other hand, if that’s not the case — either because people are myopic, or because there is no lifetime income path out there to be known, independent of the current state of demand — then it’s more natural to think in terms of a positive feedback loop where current income determines current expenditure, and current (or recent) expenditure determines current income. In which case you can imagine stable equilibria at many different levels of activity, without any markets failing to clear.
That’s the intuition I was trying to get at with the barter babysitting co-op example. Of course it would need a lot more work before it’s a story you can tell about the real world.
To my mind the crucial question is whether the Keynesian worry about money relates to (1) the fact that money is the medium of exchange, or (2) liquidity preference, which just happens to show up as demand for money, the most liquid of assets. My take on the following paragraph is that Krugman doesn’t think we should spend much time on such questions:
Which is fine; he’s not interested. But some of us are. For me, it’s still an open question and an interesting one.
fmb: you might be onto something there. But my hunch is that if you developed it further, and added transactions costs as well as storage costs into your model, in the final analysis of the equilibrium to that model your “flexible” commodities might end up being indistinguishable, functionally, from “money”. The “inflexible” goods would almost always be bought and sold for your “flexible” goods (with just a few “barter” trades on the side where the double-coincidence of wants just happens to line up right). In other words, you are doing monetary economics with deep microfoundations of money, while I am just assuming (shallowly) that people have to use monetary exchange.
Kevin: that quote from Keynes is where he is arguing against Gessell, right?
“Nick, you seem to be saying that Krugman is repudiating Keynes.”
I agree with Gessell against Keynes (on that point). I think Paul Krugman is also agreeing with Gessell against Keynes. Unless land becomes used as a medium of exchange, an excess demand for land cannot cause a recession, unless it causes an excess demand for the medium of exchange. All my wonkish posts about antique furniture (substitute “land” if you like) are arguing for Gessell against Keynes. Yep, I would like to see a wonkish post from Paul Krugman on the same subject. Dunno how his readers on the NYT would react.
Of course, I might have misunderstood PK. Or maybe, like most of us, he doesn’t have hard and fast fixed views, and sometimes sees ducks and other times sees rabbits.
(Funny that Gessell was a totally out-of-the-mainstream nut, right?, unlike Keynes.)
“What about the excess demand for money (the medium of exchange)?”
What if there is more than one type of medium of exchange?
JW: Yep, I got what you were trying to do, and it was the right thing to do. But I should perhaps have been a bit clearer in my post about what you were claiming for your model, so it’s good you clarified it here.
I’ve gotta disagree a bit on this point though:
“I was trying to describe a situation without money, where we nonetheless can speak of output as being demand-constrained, in the sense that a change in desired expenditure would lead to a corresponding change in output.”
Trouble is, in a barter economy, an increase in desired expenditure (AD) is an increase in desired sales (AS) at the very same time. We can only distinguish the two on a monetary economy because we don’t (normally) think of “buying” or “selling” money. In your model, because output is sold for output, output in a recession is both demand-constrained and supply-constrained at the same time.
I can imagine a world like yours in which supply dries up because demand dries up, and vice versa, and there is no unique path like in the Walrasian world, because of the difficulty of finding trading partners. And I see this happening across space, and across commodities at the micro level. But it doesn’t look like recessions.
Funny thing is, Menger’s story of why we use a unique good as money is very much like your story of positive feedback and thick-market externalities. We accept this good because everyone else accepts this good. We buy money because it is easy to sell it again.
“We observe an excess (constrained) demand or supply of apples in the apple market. But money doesn’t have a market of its own. Every market is a market for money. We have to look at all markets to observe the excess (constrained) demand for money.”
What about the retirement market?
And, “The excess constrained demand for money will be bigger, probably much bigger, than the excess notional demand for money that was the original cause of the recession. In the labour market, we observe an unemployed worker laid off from a $30,000 per year job. He wants his job back. He wants to sell $30,000 of labour per year but can’t. He has an excess supply of labour of $30,000, and an excess flow demand for money of $30,000 too. But if he got his old job back, he wouldn’t keep all of that $30,000 in money. He would want to spend (say) $29,000 on other goods, and keep only $1,000 in money. And in the second year, having rebuilt his stock of money to his desired level, he might spend all $30,000 on other goods.”
What if this person was able to retire with a pension of $30,000 per year?
JKH: “The $ 1,000 is definitely a stock demand. The $ 30,000 is definitely not a stock demand. What is your objective in trying to reconcile the two?”
The $1,000 is definitely a stock demand but also, by assumption, a flow demand per year. I assumed he is planning to rebuild his stock at the rate of $1,000 per year, which means he will get to his target stock in 12 months. (I could easily have assumed 6 or 24 months.) And the $30,000 is a flow demand that lasts for as long as the recession lasts. I’m not trying to reconcile the two. I’m trying to do the exact opposite. I’m trying to show that a small flow excess notional demand for money ($1,000 per year, or $2,000 per year if it’s 6 months, or $500 per year if it’s 24 months) could be compatible with a much larger and longer-lasting flow excess constrained demand for money. Because he’s not trying to get a job just to put more money in his pocket. He’s planning to spend most of it.
Kevin: “Which is fine; he’s not interested. But some of us are. For me, it’s still an open question and an interesting one.”
Me too. And I can’t think it’s totally separate from the policy question. But I see his point. He’s writing in the NYT, there’s a recession on, he’s a policy guy rather than a philosopher.
“Which I think demonstrates that Paul Krugman has a lot of “authority”.”
The role of authority in terms of what is believed and not believed is worth a blog post of its own….
I think you can have a Keynesian coordination failure recession in a model without money. When George-Marios Angeletos was presenting his paper http://www.econ.umn.edu/macro/papers/2011_Angeletos-LaO.pdf at the Minnesota Macro Workshop in July, Bob Lucas pointed out that this is exactly what’s going on in their model (which has no monetary exchange).
I had thought a bit about this and wondered if recessions should be viewed that previous accounting didn’t adequately capture future assets and liabilities? We see in hindsight that GDP growth gets ahead of itself and companies and households improperly book future liabilities. When those liabilities come along, boom, GDP falls and a “recession” — a few consecutive quarters of falling GDP — happens.
“And that an excess of desired saving cannot create a recession unless it creates an excess demand for the medium of exchange.”
What about buying the highest yielding asset that won’t go down in value and won’t be defaulted on? Is that considered medium of exchange? For example, I buy an FDIC-insured CD yielding 1% for 6 months.
Frances: yes, but do I have the necessary authority to write such a post credibly? I don’t think so.
Joe: Yep. I would describe JW’s model as just such a coordination failure model. But:
1. All models of inefficient recessions are, in a sense, “coordination failure” models.
2. Whether they are “Keynesian” models seems to me to be stretching things a bit.
3. There is something that seems very fishy to me about that paper you linked. Either the preferences and technology are somehow very special, so the results are extremely “fragile”, or there’s something wrong with the derivation, or there’s some extra twist in the intuition that is not spelled out in the paper. Those results just seem wrong to me, but it would take me some time to try to figure out exactly where and how, or what it is I’m missing. But I wouldn’t trust those results at all. Something is very wrong with that paper. My Spidey sense is ringing alarm bells.
jesse: optimism and pessimism probably do have a lot to do with the business cycle. But how to get from that to a fluctuation in excess demand for money, and excess supply of output, is the next step.
I think it’s reasonable to call a model-generated recession Keynesian if it can occur in the absence of any shocks to “fundamentals” like technology, preferences, endowments, etc. A recession generated by an aggregate shock to expectations that makes people more likely to believe a bad equilibrium will occur is a Keynesian recession in its most basic form in my mind.
But yeah, the model is a little funny. Without the one-to-one island-matching construction it doesn’t seem like any of the results would work out.
TMF: No.
Joe: OK. The “animal spirits” sense of Keynesian. That’s reasonable.
It’s more than that one-to-one island matching. Something’s seriously wrong there. But I would have to wade through thickets of math to try to figure out what exactly. My hunch is there should be a unique, efficient, rational expectations equilibrium in that model. Labour supply slopes up. VMP of labour slopes down. I think. So even if they all start out pessimistic, they ought to be pleasantly surprised when the two islands get matched, and expectations should converge to the REE as they learn. Unless it’s because they only live 2 periods so can’t learn?
I see what you mean now. I can’t figure out why there’s no learning either.
Analytically, it’s hard to dispute Nick’s points here. But something still doesn’t feel right to me. One reason, is the aggregate demand shortfall=excess demand for money view, invites responses like this. If you don’t have a story about how demand constraints can produce a stable low-output equilibrium, then at some point the mere persistence of high unemployment becomes evidence that it’s a supply-side problem. Or in other words, in terms of the previous post, we’ve done an awful lot of 7, 8 and 9 over the past couple years, with limited effect. So if you think that doing 1 would be effective — and I do! –, you need to be able to argue that it’s somehow different.
I get the focus on money, but what if it’s not money, but wealth. Money is one type of claim on resources and production, but so are property rights. I really like your examples of constrained demand, but I thought you were going the opposite way, to discuss the constrained demand for goods and services, rather than the constrained demand for money.
What if a large component of the issue really is, simply, that so many claims are tied up in the hands of a few, and, to the extent that they demand to exchange their claims, the majority of the claims they exchange flow right back to the hands of the few. Once this situation obtains, how are claims channeled to those who have no claims (or, even worse, owe claims they do not even have).
To use your language, the prices of goods and services are set not by notional demand, but by constrained demand. If the amount of money available to those who demand a good or service increases, then the constrained demand for that good or service increases, and thus the price of that good or service can increase (assuming steady supply, etc.). However, if the amount of money available to those whose demand for that good or service was previously unconstrained, then demand for that good or service does not increase.
That is, it would seem to follow that increasing the stock of money only increases aggregate demand for non-money goods and services (primarily) to the extent that it goes to those whose demand for non-money goods and services was constrained by a lack of money.
Thus, the answer to the question how do you increase constrained aggregate demand seems trivially simple: give money to those whose demand is constrained by lack of money. Obviously, however, politically this is a nightmare, which is why you see technocratic proposals such as Steve Waldman’s to utilize sovereign equity to mitigate “the tyranny of zero”. Alternatively, you can let millions languish doing nothing productive while millions of others would love to have the benefit of the goods and services they could have produced and provided.
(Well, OK, mostly 9 rather than 8 or 7. And really more 10 — buying the liabilities of the institutions that are financing the investment projects. But the same logic applies.)
The chief problem I still have is visualizing in my head how a Keynesian recession is really a monetary recession. I just can’t see how all that stuff about IS/LM, liquidity preference, savings > investment, actual interest rate > natural natural rate, etc. is really just describing a monetary recession. Even after all your valiant attempts, I can’t see how Monetarist and Keynesian recessions are just two different correct ways of looking at the same thing. After several years, this is the last area of macro that I keep banging my head against the wall about.
For example, doesn’t the theory of liquidity preference assume that the money market is always in equilibrium? Won’t interest rates dropping make savings equal to investment? How can money demand be determined by both interest rates AND NGDP/Wealth at the SAME time?
In fact, concerning the income accounts, Consumption, Savings, and Investment are all really metaphysically the act of purchasing some asset in some marketplace. Yet, no one ever actually defines precisely what those three entail, especially savings. They are simply “spoken of,” without being given a precise definition of which categories of assets fall under which terms and markets.
For example, is the quantity/horizontal axis of the loanable funds market the same thing as capital goods purchased, or is it something different? If it is the same, then all savings automatically becomes purchased capital goods by firms and thus savings must always equal investment… but if they are different, then obviously savings does not always equal investment. But if THAT is the case, then the model requires a separate “capital goods” market in addition to the loanable funds market.
Sorry for rambling.
Nick: I’m with you for garden-variety recessions, but with JW for the Greats – Depressions or Recessions. Years and Years of depressed activity will surely undo any stickiness in prices or the rate of inflation. Here I agree with Tyler Cowen and Casey Mulligan ( a sentence I never thought I would write!). But the Keynesians and Monetarists are absolutely right – contra RBCers – that a Depression is a great tragedy of wasted potential – not a long coffee break (was it Blinder or Tobin or someone else altogether who used this phrase to describe the RBC explanation of the Great Depression?) It is because they must see the silliness of sticky price explanations of a Depression, as opposed to a recession, but reject, rightly, the supply-side, Panglossian RBC account, that Keynesians are forced to put so much weight on the idea of a Liquidity Trap. I don’t think it can bear that weight (although I used to think so). So that’s why I think we need to take seriously the multiple real equilibria stories. I think some of what Farmer is doing – to the extent that I can understand it – is interesting. But I was struck recently re-reading Diamond’s Wicksell Lectures on Search Theory by something he says in passing. After presenting his famous coconut model, he says that a more realistic source of strategic complementarities might be the credit market, because a lender’s willingness to lend might well be increasing in the number of others who lend.
JW: To my mind, the persistence of unemployment and low output invites the question: why don’t wages and prices fall? That’s the question that worries me. Because if they did fall, and this didn’t cure the problem, we could always argue that the AD curve is near-vertical in {P,Y} space. Or even slopes the wrong way due to Fisherian debt-deflation effects. Or say that falling P and W lead to expected future deflation which shifts the AD curve left. But they don’t fall, they only rise a bit more slowly, or stop rising. So I have to fall back on some sort of absolute wage and price stickiness assumption. Or say that (somehow) the demand curves for goods and labour become less elastic in a recession, for which I have little or no independent evidence.
JCD: There is one (out of many) versions of Say’s Law that is correct. The income we could collectively earn from selling the goods we produce and offer for sale must be sufficient to buy those same goods. Now, that doesn’t mean we will want to spend all that income on buying those goods. And different people may have different propensities to want to spend. But you have to do something with your income, unless you decide to hold it in the form of money. We can all try to buy non-produced goods like antique furniture, land, bonds, etc., but we can’t all succeed, if nobody wants to sell. So, ultimately, it’s hold our income as money, or buy the newly-produced goods that people want to sell.
Joe: “After several years, this is the last area of macro that I keep banging my head against the wall about.”
Join the club! I’ve been doing it for 40 years!
“For example, doesn’t the theory of liquidity preference assume that the money market is always in equilibrium?”
Yep. But think about it. There isn’t a “money market”. All markets are money markets. Why does the fact that one particular market, the bond market, clears (for most people, since some people can’t borrow) tell us everything we need to know about the demand and supply of money? I tried to tackle that point in my post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/07/the-peanut-theory-of-recessions.html
“In fact, concerning the income accounts, Consumption, Savings, and Investment are all really metaphysically the act of purchasing some asset in some marketplace. Yet, no one ever actually defines precisely what those three entail, especially savings. They are simply “spoken of,” without being given a precise definition of which categories of assets fall under which terms and markets.”
Exactly! It’s “saving” that is the problem. It includes: demand for newly-produced investment goods, demand for land, and antique furniture, and demand for stocks and bonds, and it also includes, crucially to my mind, the desire to accumulate a flow of the medium of exchange.
Kevin: “It is because they must see the silliness of sticky price explanations of a Depression, as opposed to a recession, but reject, rightly, the supply-side, Panglossian RBC account, that Keynesians are forced to put so much weight on the idea of a Liquidity Trap.”
To my mind, there are two separate questions:
1. Why don’t wages and prices fall?
2. If they did fall, would that help?
In the ISLM model, the liquidity trap makes the LM horizontal, and this makes the AD curve vertical. All that does is provide an answer to question 2. If the AD curve were vertical, or didn’t cross the vertical AS curve, prices and wages would fall at an ever-accelerating rate. Now I know that some P and W did fall quite a bit during the 1930’s. But they didn’t keep on falling faster and faster.
I was struck recently re-reading Diamond’s Wicksell Lectures on Search Theory by something he says in passing. After presenting his famous coconut model, he says that a more realistic source of strategic complementarities might be the credit market, because a lender’s willingness to lend might well be increasing in the number of others who lend.
Now this is interesting.
(Not that the rest of the conversation isn’t interesting too.)
Nick: I agree with you, I think. One of the reasons I don’t think the liquidity trap can’t bear all the explanatory weight it is given is that it would predict accelerating disinflation, which we don’t see.
In response to me (first comment), Nick replies:
fmb: you might be onto something there. But my hunch is that if you developed it further, and added transactions costs as well as storage costs into your model, in the final analysis of the equilibrium to that model your “flexible” commodities might end up being indistinguishable, functionally, from “money”. The “inflexible” goods would almost always be bought and sold for your “flexible” goods (with just a few “barter” trades on the side where the double-coincidence of wants just happens to line up right). In other words, you are doing monetary economics with deep microfoundations of money, while I am just assuming (shallowly) that people have to use monetary exchange.
Let me try a more concrete example:
In JW Mason’s model, people essentially are bartering custom forward contracts: Adam will babysit for Barbara next Tuesday if Barbara agrees to babysit the following Friday. Given the nature of babysitting, there will inevitably be a period where one of these is closed and the other is still pending (e.g. next Wednesday). If we further allow Adam to propose to Charlie: babysit for me on Thursday and Barbara will babysit for you on Friday, then I think we have a situation where we can have a glut of current production: the clearing price for long-dated babysitting forwards in terms of short-dated forwards might start out at an equilibrium of 1:1, but, the Krugman argument about tokens can work about the same for long-dated forwards. If prices are sticky (lots of reasons that could happen here), it becomes hard to sell babysitting tonight in an attempt to accumulate future babysitting.
Perhaps you’ll tell me that long-dated babysitting forwards for specific dates with specific sitters are money in this economy. If so, I think I might agree. But, wouldn’t that be true of any remotely interesting barter economy?
[I may need to introduce credit constraints on some people to fully make this work: if Dan wants to hold a long-dated contract for its flexibility properties (he doesn’t intend to use it on the date it is actually for, but has plenty of time to trade it for a better date), then he could just create one where he is the provider. However, if Dan is not trusted, then he can trade his service today for Ed’s service tomorrow, but not vice versa. Clearly Dan needs to hold someone else’s liability if he’s ever to get an emergency sitter with no notice.]
The Great Depression’s easy to explain (in the US.) Wages and prices fell quite a bit from 1929-33. That fits. Then we got a pretty good recovery, but it was delayed by some atrocious supply-side policies that sharply raised wages. So wages and prices stopped falling despite still high unemployment.
I’m still having trouble with the idea of excess demand for money. For some reason I keep thinking in terms of increased demand for money during recessions, not excess demand. Suppose you have an economy of affluent stockholders, like Singapore. But they also work and nominal wages are sticky. Now suppose the Cambridge K suddenly doubles, but the central bank adds no base money. Is the money market out of equilibrium for very long? I don’t see how. Who has trouble getting all the base money they need? Not me. I’d just sell some stock. Remember that base money is a tiny percentage of total wealth.
But there’s also the fallacy of composition. If everyone doubles their Cambridge K, and the base is unchanged, then NGDP must fall in half–really fast. Indeed almost right away. And if wages and prices are sticky you have mass unemployment when NGDP falls in half. But the money market is quickly back in equilibrium, it’s the goods and labor market that are out of equilibrium. The unemployed workers sell stock when they need base money, and stock prices are perfectly flexible. No one has less base money than they want. NGDP has fallen in half, base money is unchanged, and people have the doubled Cambridge K they seek.
For two years the recession grinds on, until wages and prices fall in half and restore full employment. During that entire period the money market is in equilibrium–except the initial few weeks when NGDP plunged as people frantically tried to double their Cambridge K.
OK, I must be making a mistake somewhere, but I don’t see where. Someone help me out.
Scott: “Who has trouble getting all the base money they need? Not me. I’d just sell some stock.”
Why do you want base money? Sell some stock to the banks and get some new deposits. No fallacy of composition: everyone can get all the deposits they want.
Scott: the stock market is not the money market. Every market is the money market. The stock market may clear (since stock prices are perfectly flexible) but the excess demand for money still shows up in the labour market and the output market (and any other market that has sticky prices, but not in markets that have perfectly flexible prices). People are trying to sell labour for money, and if they were to succeed would plan to spend most of that money in the output market (and other markets, like the stock market). But they don’t succeed, so we never observe that notional (flow) supply of money in the output market.
Exactly, these arguments quickly fall apart once the economy contains institutions (e.g. banks) that can supply as much money to the non-financial sector as they want. The purpose of central banking is to ensure that this happens, so if the CB is doing its job, bank liabilities are perfect substitutes for currency (and in may ways are superior to currency). At that point, the non-financial sector can easily double its money holdings without any increase in base money, merely by shifting their claims on the financial sector away from bond claims and towards deposit claims.
The fact that this has not happened shows that households already (and at all times) hold the proportion of money that they demand. There can never be an excess demand for money.
There can, however, be an excess demand for market wealth. Market wealth is extremely volatile. It is constantly re-valued up and down, and households see their real savings move up and down as a result, which causes them to adjust their consumption plans. Moreover, returns demanded for risky investments can be excessively high, so that firms will employ and invest less.
All sorts of things can go wrong, but the one thing that cannot go wrong is an excess demand for money. In fact, money is the only thing that is perfectly demand determined in the short and long run.
All other things — the real capital stock, wages, prices — take time to adjust. But the money holdings of the non-financial sector adjust in real time to exactly equal money demanded.
fmb: If I’ve got it right, I think Barbara’s services are being used as a medium of exchange in your example, to resolve a case where there isn’t a double coincidence of wants. If everyone’s services can be used the same way, it’s a barter economy, because every good can be traded against every other good.
rsj: assume the price of peanuts is perfectly flexible, but every other price is fixed. Then the peanut market always clears. Therefore there can never be an excess demand for money, since you can always get more money by selling peanuts.
Nick: Therefore there can never be an excess demand for money, since you can always get more money by selling peanuts.”
If you have assets, you can just borrow the money. It’s all borrowed anyways. No need to sell peanuts.
K: “borrowing money” = selling bonds. Peanuts are a metaphor for bonds, or anything else that has a flexible price.
OK. But I thought peanuts also meant something you couldn’t sell to a bank. Therefore selling them doesn’t increase the supply of money, which is the fallacy Scott was talking about (I think). Borrowing money from a bank can increase the money supply as much as we want.
RSJ,
Bank credit creates money.
If there is an unsatisfied demand for bank credit (due to lack of creditworthiness or insufficient bank capital), does that imply an excess demand for money, notwithstanding other adjustments in the system?
Or is that what you mean by the CB doing its job.
We need to distinguish “selling bonds” from “borrowing”. If I sell you a bond that does nothing to the money supply. If I borrow money from a bank (sell a bond to a bank, if you want) then the money supply goes up.
K: OK, let me extend my original peanut theory of recessions slightly. Suppose there is a banker who will create as much money as we want, in exchange for peanuts. So the total stock of money is not fixed. And suppose the price of everything, except peanuts, is sticky. Does that mean there cannot be a recession? Does it really make any significant difference to the model? Start in equilibrium. Then destroy half the existing stock of money. All prices except peanuts stay fixed. The price of peanuts gets driven up as everyone sells their peanuts to the banker to get more money. Other than a few more workers who get jobs producing peanuts, it doesn’t affect the equilibrium much.
Hmm. I’m not sure if that thought-experiment is at all clear. Never mind. It’s late.
“Assumme the price of peanuts is perfectly flexible, but every other price is fixed. Then the peanut market always clears. Therefore there can never be an excess demand for money, since you can always get more money by selling peanuts.”
How many peanuts you sell and at what price has nothing to do with the quantity of money held, nor with the quantity of money demanded.
FIrst, peanut selling and buying is a flow, and changes in flows do not cause changes in stocks.
The quantity of money is a stock. Demands for money are demands for stocks.
You cannot add a demand for a flow to a demand for a stock and conclude that the sum of these demands must be zero (or non-zero). The sum is not defined.
You can talk of walras law for flows or for stocks, or both, but you cannot combine the two as they have different units.
More importantly, whether the price of peanuts rises or falls has no effect on household deposit holdings. The failure of the peanut market to clear will not cause household to have more or less money.
What is important is that the household sector, as a whole, owns the discounted future earnings of the peanut producers — whatever those earnings happen to be. That is the wealth of the household sector. This sector can choose to allocate and re-allocate that wealth in whatever proportion of deposits or bonds that it wants.
And this is the only way that the household sector can increase or decrease its money holdings. It must sell a bond for a deposit or buy a bond with a deposit. Flows of peanut sales can neither increase nor decrease household money holdings.
If, for some reason, the peanut market fails to clear and the NPV of the peanut producers dramatically falls, then household wealth declines as well. It is re-valued.
That will be borne by the non-deposit portion of household wealth (typically 80% of total wealth, with 20% of wealth held as deposits). If such a decline causes households to want to hold even more of their wealth as deposits, then they can do that.
As long as total wealth exceeds the quantity of money demanded, then households can shift their portfolios out of claims on peanut producers and into claims on banks. The peanut producers then sell bonds to banks instead of to households, and banks buy the bonds of the peanut producers and sell deposit liabilities to households.
It’s a general portfolio re-allocation that can be performed at any time, and this re-allocation is not helped or hindered by the price of peanuts or whether the peanut market clears.
You would only get into problems when total wealth falls below the deposit wealth, in which case the government needs to backstop the banks. By definition, banks are insolvent in such a scenario. At that point, you can talk about a demand for money that the household sector cannot meet, but only at that point.
JKH,
Yes, that’s what I meant.
Operationally, bank credit credit creates money, the repayment of debt destroys money, the purchase of bank non-deposit liabilities destroys money and the redemption of bank non-deposit liabilities creates money.
Therefore additional bank capital is not required to cause the quantity of deposits to increase or decrease. However, if the banks are insolvent, then yes, you can get into real problems.
rsj: but we also own a stock of peanuts. I can sell part of my stock of peanuts for a stock of extra money. And if we want to increase our stock of money over time, at so many dollars per month, that is a flow of dollars per month, and can be met with a flow of sales of peanuts.
BTW, you do realise I was being ironic, when I said “Therefore there can never be an excess demand for money, since you can always get more money by selling peanuts.”?
fmb: If I’ve got it right, I think Barbara’s services are being used as a medium of exchange in your example, to resolve a case where there isn’t a double coincidence of wants. If everyone’s services can be used the same way, it’s a barter economy, because every good can be traded against every other good.
Your restatement sounds approximately right. More precisely, though: Barbara’s promise to deliver a specific service on a specific future date is, ex post, being used as a medium of exchange, though at the time Adam bartered for it he might have intended to consume it (possibly even with high probability). My intent was that anyone who can produce a credible and transferable promise to deliver something in the future presumably could find their promise re-bartered, even if that was an unusual occurrence. Every good can be traded against every other, but only some can be re-traded, and not everyone can produce goods with that property.
So I think you’ve agreed that my set up counts as barter. Do you also agree that it has the “hard to sell” feel I’m trying to create? It may be a stretch, I’m not completely sure I agree myself, but I can’t yet pin down a specific flaw. Obviously you can’t have stuff that’s hard to sell without other stuff that’s easier to sell, but I think that (in any non-trivial barter economy) there’s a spectrum from use-it-or-lose-it goods (like spot labor) to slightly re-barter-able goods (like apples, or promises to provide future services), and that price stickiness between ends of that spectrum can make either end “hard to sell” while the other is “easy”. To me, when spot labor and similar goods are hard to sell (and rebarterable goods easy), it will feel like a recession, and when it’s vice versa, it will feel like a boom.
Note that the current recession has this counter-balancing flavor, too: credible claims on future production are hard to buy.
Nick: I think it matters whether they sell the peanuts to the bank (QE) or just borrow with peanuts as collateral. In the first case, the banks deposits become a proxy for the value of peanuts. In the latter, the value of money can still be independent of the price of peanuts. If bank assets could truly be made up of the consumer basket and we could exchange deposits for that basket on demand, we’d obviously have no more money problems. Alas.
Nick, if you get a chance to look at my lengthy reply to you on the Response to Paul Krugman post, I would be very grateful. rsj, there’s a (minor) comment for you there too.
Nick’s post said: “Suppose there is a banker who will create as much money as we want, in exchange for peanuts. So the total stock of money is not fixed.”
I’m going to skip the peanuts part. Does that mean for the amount of medium of exchange (demand deposit(s) for banks) to increase that someone has to go into debt?
EDIT: “debt” to “currency denominated debt”.