In the olden days, economists used to talk about the trade cycle. (They meant a cycle in the amount of all trade, not just international trade). They meant a cycle in the amount of exchange. There are fluctuations over time in the amount of buying and selling that people do. In a boom, trade speeds up; and in a recession, trade slows down.
I think we should resurrect that old term. Thinking about the trade cycle is a better way of thinking about short run macroeconomics than how we currently think about it. Nowadays we don't talk about fluctuations in trade; instead we talk about fluctuations in output. It's not the same thing. We are wrong; the old guys were right. Somewhere, maybe around the 1920's or 1930's (I wish I were better at history of thought) macroeconomics took a wrong turn.
This post is a follow-up to my previous post.
Macroeconomics took a wrong turn when macroeconomists started out their analysis with I=S. Wicksell, the Austrians, Keynes, New Keynesians, and many more besides, all start out with I=S. They all started out in the wrong place. "(Desired) investment" means the (desired) amount of newly-produced capital goods and services. "(Desired) saving" means income from output of newly-produced goods and services minus the (desired) amount of newly-produced consumption goods and services. Is I=S the right way to start thinking about short run macroeconomics? Only if you think that short run macroeconomics is about fluctuations in the output of newly-produced goods and services. If you think that short run macroeconomics is about the trade cycle, then I=S is a bad place to start.
Thinking about fluctuations in output is both too narrow and too broad a way of thinking about fluctuations. And that way of thinking about the question to be answered also distorts the sort of theoretical framework we use to answer it.
Another old term for the subject matter of short run macroeconomics is the "conjuncture". It means a coming together. This word has almost disappeared from economics in English, but it survives in French, Spanish, German, Russian, and maybe other languages too. Short run macroeconomic fluctuations are a conjuncture. A lot of different data series tend to move together cyclically. Lucas drew attention to the conjuncture in his 1975 paper "Understanding Business Cycles". He said that business cycles have different amplitudes and frequencies, and it is only the conjuncture (co-movements) of different things moving together cyclically that allows us to say that all business cycles are alike, and so possibly amenable to a common explanation. If each episode were unique, we couldn't really have a business cycle theory. We would have one theory for the 1982 recession, a different theory for the 1991 recession, and so on. And each theory would have just one data point, so it wouldn't really be a testable theory.
Fluctuations in the output of newly-produced goods and services is a bad proxy for the conjuncture. It is both too narrow and too broad. The trade cycle is a better proxy for the conjuncture.
It is too narrow because it ignores trade in goods that are not newly-produced. Things like old houses and old cars and old furniture and old land.
It is too broad because it includes production of goods and services for one's own use. The unemployed worker is not unemployed. He is employed digging his own garden, fixing his own car, doing his own labour market search. He is not unhappy because he is unemployed. He is unhappy because he is self-employed and doesn't want to be. He wants to sell his labour to someone else, but can't, so has to consume it himself. A recession is not a fall in employment; it is a fall in the amount of employment that is traded. A recession is not a fall in output; it is a fall in the amount of output that is traded.
We could even imagine an economy in which employment would rise in a recession. You might have to work a lot harder to grow your own food to feed yourself than if you could sell your labour and buy food.
A house with nobody living in it is unemployed. A house with somebody living in it, who wants to live somewhere else, but can't sell his house, might as well be unemployed. If something disrupts trade in old houses, so owner-occupiers are living in the wrong houses, and consuming the wrong housing services, because they can't trade, that is a recession in housing. It's just like workers who want to trade their labour but can't, and so are consuming the wrong labour services, their own, when they would rather be trading and consuming someone else's labour services. Comparative advantage, and all that.
A recession is not a drop in output and employment. A recession is a failure to exploit the gains from trade.
Microeconomists start out thinking about trade. And not just trade in newly-produced goods and services. Macroeconomists ought to start out thinking about trade. And not just trade in newly-produced goods and services. Trade is supposed to make people better off. If something makes trade harder, and reduces the amount of trade, that would make people worse off. Maybe that's why people seem to be worse off in a recession. It's because there's less trade. And not just less trade in newly-produced goods and services.
Now, what might that something be? What could cause trade to fall and make people worse off? An increase in transportation costs? Nope. An increase in marginal tax rates? Nope. Those make theoretical sense, but don't work empirically to explain recessions.
The obvious candidate is a shortage of the medium of exchange. If there were a shortage of shopping bags, all trade that required shopping bags would be disrupted, and people would be worse off. If there were a shortage of money, all trade that required money would be disrupted, and people would be worse off. Nearly all trade requires money. The exceptions, barter trades, merely prove the rule. As far as I can tell, barter increases in a recession. People resort to barter, where they can, because there's a shortage of money. But trying to trade without money is like trying to carry stuff home from the supermarket without a shopping bag. It's not as good, so you buy less stuff, and you buy different stuff, and it's very inconvenient.
But somewhere macroeconomics took a wrong turn. We started thinking about the output of newly-produced goods and services, instead of the trade cycle. So macroeconomists started thinking about the demand and supply of newly-produced goods and services, not about trade. So they wrote down "I=S" as their equilibrium condition, and started thinking about what determined desired investment and saving. And they focused on the real rate of interest, defined as the relative price of current newly-produced goods to future newly-produced goods.
If you start out by asking the wrong question, your answer will be wrong, even if it looks right. "What causes fluctuations in the output of newly-produced goods and services?" is the wrong question to ask. "Investment, saving, and the rate of interest" is the wrong answer, because it is an answer to the wrong question.
It's a bit like defining recessions as fluctuations in the output of cars, and explaining the business cycle in terms of the demand and supply of cars, and the relative price of cars. Then trying to explain everything else that happens in business cycles as a side-effect of the fluctuating output of cars.
"What causes fluctuations in the amount of monetary trade?" is the right question to ask. "Money" is the right answer, because it is an answer to the right question.
Worthwhile Canadian Initiative 
So, money causes fluctuations in the amount of monetary trade. Great.
So, what causes fluctuations in the amount of newly-produced goods? 😉
Nick: ‘”What causes fluctuations in the amount of monetary trade?” is the right question to ask. “Money” is the right answer, because it is an answer to the right question.’
Perhaps fluctuations in the amount of monetary trade are caused by gizmos. Joe used to pay Bryan to run a retail store. Bryan used to pay Joe to manage his retirement savings. Then someone came up with a gizmo that allowed Joe to guy goods on-line directly from a warehouse, eliminating the need for retailers. This gizmo also allowed Bryan to manage his own retirement savings, eliminating the need for Joe’s financial management services.
As a result, monetary trade collapsed. But the cause isn’t money, the cause is technological change that reduced the need for monetary trade, by allowing people to do more things for themselves.
An old example something along these lines is the Japan-Sweden comparison. The argument is that a comparison of Swedish and Japanese nominal GDP is misleading, because lots of things e.g. child care, elder care, etc, that are monetized in Sweden are home produced in Japan. Different technology, different amounts of monetary trade.
david: money! Because when it’s harder to trade stuff, including newly-produced stuff, you produce less.
What causes fluctuations in the amount of newly-produced cars?
Frances: theoretically correct. Empirically plausible for cross-section data. Empirically implausible for time-series data.
Nick: “theoretically correct. Empirically plausible for cross-section data. Empirically implausible for time-series data.”
Is that the answer to the question “summarize the difference between micro and macro in 15 words or less?”
Frances: LOL. Yep!
Clearly a stable M2 isn’t “enough”, so one still has questions of why exactly demand for money might vary. And you can’t answer that without invoking more factors.
Besides that. Clearly the composition of what is traded changes over the trade cycle so one still has to provide additional explanations linking those to money; there isn’t one homogenous “goods, service, and labour” aggregate that works here. And these explanations all operate simultaneously with monetary dynamics so arguing that one is more fundamental than the other seems… well, not quite pointless but close. It’s like asking: is New Keynesian economics more about nominal rigidity or about money non-neutrality?
You have instruments, which you control. You have real variables, which you care about. “Money” as an explanation doesn’t suggest anything obvious about choice of instruments or the impact on real variables – all the explanatory work is being done elsewhere.
Frances,
“As a result, monetary trade collapsed. But the cause isn’t money, the cause is technological change that reduced the need for monetary trade, by allowing people to do more things for themselves.”
I would say that in this case the “cause” would still be money, if you defined optimal monetary policy as that which prevents monetary trade from collapsing. But I think you highlight an important source of the disagreement between those who share the Rowe/Sumner/Fisher/Cassel/Friedman view of business cycles and those who do not (eg. Stiglitz). Those who take the Rowe view draw a clear distinction between the “initial shock” and the “cause” of the recession. If technological change leads to decreased monetary trade and leaves people temporarily unable to sell their labour at current wage rates, the appropriate response is monetary expansion which increases monetary trade. According to this view, even if the “initial shock” was a bursting of a housing bubble or an acceleration in agricultural productivity, these “real shocks” can never be the “cause” of a collapse of monetary trade (NGDP). A collapse of monetary trade is always and everywhere a monetary (policy) phenomenon.
But most people don’t see it that way. And most economists don’t see it that way. Even most Fed officials don’t seem see it that way. If you ask 100 economists why unemployment is expected to remain disastrously high in 2012 and 2013 and why inflation is expected to remain below the Fed’s implicit target, most of them will tell you the “cause” is the 1997-2006 housing bubble and the resulting 2008 banking crisis. To Rowe, Freidman, Fisher, Cassel and Sumner, that explanation makes no sense.
david: Yep. My saying “Money” isn’t really an answer. It’s just the beginning of an answer. Just like “I=S” is only the beginning of an answer.
Yep, and the big picture only gets you so far. Eventually you have to disaggregate and start looking at different bits, that are related to the whole in different ways. That’s true for I=S too.
And sure, we care about output of new stuff. But we also care about whether the right people are living in the right houses, or whether they are stuck immobile because the market for old houses has dried up. We care about the gains from trade, and what happens to people when they can’t make those mutually beneficial trades. And that’s both a deeper and more generally way of looking at the problem than output and employment.
marris: those are good questions, and good tentative answers. I wish I had better answers. I don’t really.
Gregor: there’s a difference though. If grandparents all suddenly moved in next door, that would solve e.g. Paul Krugman’s baby sitting model problem without using money. And the “central bank” should presumably reduce the stock of money, because less would be needed now that people have found a different way to trade.
I agree with the rest.
Gregor Bush: ” Those who take the Rowe view draw a clear distinction between the “initial shock” and the “cause” of the recession. . . . According to this view, even if the “initial shock” was a bursting of a housing bubble or an acceleration in agricultural productivity, these “real shocks” can never be the “cause” of a collapse of monetary trade (NGDP). A collapse of monetary trade is always and everywhere a monetary (policy) phenomenon.
“But most people don’t see it that way. And most economists don’t see it that way. Even most Fed officials don’t seem see it that way. If you ask 100 economists why unemployment is expected to remain disastrously high in 2012 and 2013 and why inflation is expected to remain below the Fed’s implicit target, most of them will tell you the “cause” is the 1997-2006 housing bubble and the resulting 2008 banking crisis.”
I think that perhaps Aristotle covered this with his distinction between material cause (medium of exchange) and efficient cause (shocks to the system). 🙂
Very good post, indeed.
Is there even any evidence that the composition of new vs. old in the market varies significantly over the business cycle? I know that inventory stocks vary dramatically with the cycle, but that still entails buyers of the new stuff.
Conjunture survives not only in other languages economics but in political science and politics as well. Union meetings in Québec (and many political reunions) usually begin with an “analyse de conjoncture ( conjuncture analysis). And we definitely don’t conflate that with “cycles”.
For a proletarian ( one who only has his “force de travail”, the origin of the “workforce” concept) the primordial trade, the one without which no other (buying food say) can take place, is the selling of his labor. Proles have no significant assets to sell. If you want to study the problems of por people having income, you must concentrate yourself on newly-produced goods.
In a money economy,selling your labor depends on money being available either in the financial system or in somebody’s willingness to part with it.
That’s why we conflate trade,employment,income and output.
As a point of history, I posit that the focus on newly-produced goods and services that developed in the 1920’s was a reaction to industrialization and the politics that fell out of the First World War and the Russian Revolution.
Manufacturing was seen as the “Great Thing” and it surpassed agriculture as the great pillar of the economy. Manufacturing is almost entirely focused on production of new goods, not remanufacturing old goods. Factory workers formed a large new class of people who had shown themselves to be susceptible to leftist ideas, from the Paris Commune of 1870 to the Russian Revolution of 1917. It is unfashionable to say that Macro is an attempt to understand the economy and thereby control it, but it is true. It is meant to provide a framework for the governing class to successfully carry out policy and therefore remain in power. That’s why macro always has prescriptions for government.
Both the Austrians and the Keynesians show deep traces of their political origins. The Austrian fixation on free markets and stable money is a result of viewing the Austro-Hungarian Empire’s customs union and internal free trade area positively and disapproval of the economic collapse that resulted from the Empire’s breakup. This dovetails with a focus on “solid money” as the Austro-Hungarian Crown was seen as a well-managed currency with gold backing; the successor currencies did not fare as well.
In contrast Keynesianism’s focus on employment comes from British policy after the First World War to return to the prewar unemployment rate of 6%. Demobilized soldiers were provided with a one-year Out-of-Work Donation Policy to tide them over. But the British economy never returned to that 6% rate in peacetime until the late 1940’s. Britain had a single, well-established currency and a unified government and still couldn’t make it’s goals happen. That is the historical motivation for Keynesianism and it is quite different from Austrian economics.
Nick, thanks for the interesting re-casting of the theory.
I guess when I think of why firms layoff employees, it is because of shortage of money: a shortage of revenue sufficient to compensate the suppliers of labour while still providing an adequate return to capital.
You said that in unemployment, a worker is consuming his own labour because he is unable to trade it to others because of lack of money. I would think that, upon initial consideration, an unemployed worker generally consumes very little of his own labour though. Instead, unemployment is more like being forced to allocate more time to leisure than one would otherwise. Is leisure essentially consumption of one’s own labour product?
To put it differently, every individual has preferences in which they can experience utility by consuming the product of their own labour (leisure?) and/or the labour product of others (goods & services). The actual description of the utility function doesn’t matter so much, except that at some point on the indifference curve defined by the utility function, there is declining marginal utility to consuming an additional unit of one’s own labour product. Each individual rationally seeks to maximise their utility subject to the budget (time) constraint. In unemployment, the individual is unable to exchange their labour product for money, which is used to buy the labour product of others. So instead, the individual consumes more of their own labour product, which because of declining marginal utility, makes the individual less happy than they could be if they were not unemployed.
Excellent post as always but I have two different strands of questions.
What causes fluctuations to money? Can the thing that causes money to fluctuate be smoothed out therefore preventing the fluctuations in money altogether or is it better to smooth out money by directly adjusting the quantity of moeny? Assuming that we can and should smooth out money directly rather than smooth out the underlying source of fluctuations, are there welfare implications based on how we choose to smooth out money (perhaps some methods of smoothing money are better than others?) or is that immaterial?
Could waves of pessimism and optimism cause the trade cycles? Perhaps in a recession, there is a coordination problem such that people don’t think there are any good opportunities for trade (they would rather consume or invest in the next period) and so they hold on to money instead. The total number of pieces of paper floating has not changed (so money has not fluctuated) but the extent to which they are being exchanged has reduced. Such a situation could be fixed by increasing the number of pieces of paper so that it is no longer worthwhile to hold on to pieces of paper for the purpose of future transactions OR it could be fixed by directly creating enough opportunities for trade that dislodge the economy from the bad equilibrium in the coordination problem.
Min: “I think that perhaps Aristotle covered this with his distinction between material cause (medium of exchange) and efficient cause (shocks to the system). :)”
I gotta try to remember that.
Luis: thanks!
david: “Is there even any evidence that the composition of new vs. old in the market varies significantly over the business cycle?”
Good question. Not that I know of. I think that both new and old house sales are procyclical, AFAIK. If they were both equally pro-cyclical, so that the ratio of new to old didn’t have any obvious cyclical tendency, that would suggest it would be very strange to look at only new house sales. Which is what theory does now.
Jacques: “That’s why we conflate trade,employment,income and output.”
Maybe, yes. It would perhaps be different in a peasant economy.
Determinant: Maybe. But I wonder how much it also comes from measuring GDP for a war economy? I can’t remember when GDP accounting started.
Robillard. I basically agree. I don’t think the labour/leisure distinction can really carry the weight we try to put on it. I can use my time myself, or try to sell it to someone else. If I spend time fixing my car or digging my garden, I think of it as leisure. If I were unable to sell my labour, and so were fixing my car or digging my garden because I couldn’t earn the money to hire a mechanic or buy food, I might think of the same activities as labour.
National accounting was pioneered, unsurprisingly, by the communists in the Soviet Union crafting industrial policy. It became widely implemented in the West in response to the Great Depression.
primedprimate: Thanks!
Those are both good questions. They aren’t off-topic, since they are the very sorts of questions to which this post would lead. But I’m still going to duck them, because they are beyond the somewhat narrow scope of this post. (Plus, I don’t have any really good answers either!).
david: Hmmm. Which roughly coincides, I think (not sure) to the rise of I=S in macroeconomics.
Ok, so money is big, but I’m still curious about the Stiglitz article:
Do you think you might be taking Stiglitz too literally, like he doesn’t literally mean monetary measures can’t help at all. He just means that the big root of this is a huge structural shift, and if you don’t address it, don’t speed the transition, then you’ll just keep getting this drip, drip, drip, over decades.
It’s like monetary policy helped in the 2000’s, but you had to keep doing it for years and years. You didn’t really address the cause of the constant drip, drip, drip. You didn’t actually re-surface your roof, you just kept bailing with buckets. Sure it had an effect, it kept your house from molding and rotting, but it would be a lot better to really get the roof in good shape.
Certainly I strongly prefer Stiglitz’s solutions. These are really high return investments of the kind the pure free market will grossly underprovide due to externalities, asymmetric information, coordination problems,…
Growth economists Charles I. Jones of Stanford and John C. Williams of the San Francisco Fed wrote in a 1998 QJE paper:
Is there too much or too little research and development (R&D? In this paper we bridge the gap between the recent growth literature and the empirical productivity literature. We derive in a growth model the relationship between the social rate of return to R&D and the coefficient estimates of the empirical literature and show that these estimates represent a lower bound. Furthermore, our analytic framework provides a direct mapping from the rate of return to the degree of underinvestment in research. Conservative estimates suggest that optimal R&D investment is at least two to four times actual investment [emphasis added].
– Vol. 113, No. 4 (Nov., 1998), pp. 1119-1135
The first inkling of National Accounting, as well of input-output matrix, dates from the physiocrat François Quesnay’s 1759 Tableau économique.
He credits no value to industry or commerce as they are not “producing” anything. Interestingly, the communist National accounting (Gross Social Product) still used in Cuba,based on XIXth century concepts of who produces value, credits industry but not services.
Today, we recognize the value of commercial services but , funnily, ask Chamber of Commerce types and a lot will tell you that indeed farmers,industrialists and merchants (along with their employees) produce value but nurses or teachers are “consumers” (in the sense of “moochers”). How they reconcile that with private schools or hospitals, I have no idea.
The CofC types are always a step behind in their thinking. God knows what they make out of scientific research and ,even worse, artists and philosophers).
” “What causes fluctuations in the amount of monetary trade?” is the right question to ask. “Money” is the right answer, because it is an answer to the right question.”
So if the cause is money, why not use another money instead? If the recession in the US is due to a shortage of people not getting enough green pieces of paper with dead white males on the, why don’t they use different pieces of paper? Surely, there must be people somewhere who because they cannot get dollars, will substitute these for another medium of exchange?
There is no good reason, aside from legal tender, why people do not accumulate different pieces of paper. Well, to be honest, I can think of one good reason and that is transaction costs of bargaining with people to accept different pieces of paper and have people agree to switch, but is that really equivalent to an excess demand for money or is that something else?
This brings to mind something I read in the WSJ yesterday. Some bond traders were complaining about reduced trade volumes in the short term treasury bond market, and attributed it to lower Fed uncertainty, and hence less disagreement between speculators.
So this is something else that can cause trade: speculative disagreement.
Richard: “Do you think you might be taking Stiglitz too literally,…?”
Possibly. The Vanity Fair piece perhaps wasn’t very clear. And sure, some problems are not caused by money, and can’t be cured by good monetary policy. (Though bad monetary policy won’t help.)
Jacques: my father, a farmer, had physiocratic leanings at times. The key ratio was between the number of people working on the land compared to the total population. That was a measure of surplus value created. Factory workers didn’t produce a surplus, they just transformed value. You put food in one end, and cars come out the other.
Martin: “Well, to be honest, I can think of one good reason and that is transaction costs of bargaining with people to accept different pieces of paper and have people agree to switch, but is that really equivalent to an excess demand for money or is that something else?”
That’s the reason I would give too. Money is like language. We want to use the same money as everyone else we trade with. It is very hard for a new money, like LETS, to get off the ground. But, AFAIK, new monies like LETS do tend to get more use during a recession, which tends to confirm my perspective.
Max: A lot of things can cause trade to increase or decrease. But when you see a generalised synchronised decline in trade, plus when you see that it gets harder to sell goods for money and easier to buy goods with money, one should suspect a monetary cause.
Martin,
Under certain conditions, people DO use different currencies. Businesses engaged in international trade have foreign currency holdings. In countries where the currency reaches the level of being unusuable e.g. hyperinflationary countries like Zimbabwe, people use either another fiat currency like the dollar or cigarettes/cognac etc.
(I can’t think of any examples of a currency undergoing severe and unstable deflation being abandoned by its users for another currency as opposed to reverting to barter/gift economics. In recessions, it does seem as though “good money” drives out bad.)
And, of course, Eastern Bloc type economies have two parallel economies: a hard currency grey/black/official hard currency economy and the official economy proper. For all the supposed link between the rouble and the pound in the Soviet era, a bit of sterling went a long way in the USSR if you could find the right people.
Nick wrote:
“So they wrote down “I=S” as their equilibrium condition, and started thinking about what determined desired investment and saving. And they focused on the real rate of interest, defined as the relative price of current newly-produced goods to future newly-produced goods.”
Do you really mean that the Wicksellian natural rate is the discounting of newly-produced goods. I don’t remember it that way–and I don’t mean that with confidence to contradict you, but I definitely never thought about it as being a rate DEFINED by newly-produced goods. In Austrian literature, it was referred to ‘time preference’ which is certainly presented a universal rate not something restricted to newly produced goods and services.
So who defined it to be such a thing?
“He said that business cycles have different amplitudes and frequencies, and it is only the conjuncture (co-movements) of different things moving together cyclically that allows us to say that all business cycles are alike, and so possibly amenable to a common explanation.”
Yes, but I don’t think they are all alike at all. This cycle is quite different in its nature from most cycles since the Great Depression (Japan 1990 being the obvious exception). A balance sheet recession is quite different from a recession started by the Fed to reduce inflation. In this case I think your argument is wrong.
W. Peden,
I know they do, that’s why I find it difficult to call it an excess demand for money. I implied as much here,
“Surely, there must be people somewhere who because they cannot get dollars, will substitute these for another medium of exchange?”
When we’re talking about an excess demand for money, it seems to me that we’re talking about transaction costs of switching (or changing prices..). I don’t know whether it is correct to say that we’re dealing with an excess demand for money rather than that we’re dealing with rigidities that can be overcome by treating it as if.
Nick,
Speaking of metaphors, have you heard of the paper by Narayana Kocherlakota ‘Money is Memory’ http://ideas.repec.org/p/fip/fedmsr/218.html ?
John,
I don’t quite understand why you think “the real rate of interest” and the “Wicksellian natural rate of interest” are the same thing.
Martin,
“There is no good reason, aside from legal tender, why people do not accumulate different pieces of paper. Well, to be honest, I can think of one good reason and that is transaction costs of bargaining with people to accept different pieces of paper and have people agree to switch, but is that really equivalent to an excess demand for money or is that something else?”
Try debt – and money as a unit of account. It doesn’t help to offer Cyranian crowns (or whaever) if my contract says I have to pay US$.
Reason,
If your contract specifies $US, you could just as well give them a different currency, buy them a put with the premium you get for selling a call. No damage done. There can only be trouble when there are transaction costs, frictions in the market. Is the problem then an excess demand for money or the frictions? In the absence of frictions this is what you can do, even if there is an excess demand for money.
This is Say’s Law by the way: only rigidities can cause gluts. In this view, an excess demand for money only becomes a problem when the transaction costs of switching are too high.
Nick
Sorry if I’m being daft here, but isn’t ‘output’ as defined for national income accounts exactly equal to output traded? Re-sale of a house at a higher value is GDP. Cleaning your own house is not. This is true in a recession or otherwise.
Jon (and reason): in New Keynesian macro (which is now really Neo-Wicksellian macro, after forgotten his name’s famous, canonical book [I haven’t had coffee yet]) the Euler equation IS curve has saving and investment depending on the real interest rate, which is the nominal rate minus expected inflation. And expected inflation means the expected rate of change on the GDP deflator, which is new goods.
In Wicksell, savings and investment depend on the gap between the market rate of interest and the natural rate of interest.
The rate of time preference proper, which you are talking about, is one of the things that determines the Wicksellian natural rate of interest.
reason: “A balance sheet recession is quite different from a recession started by the Fed to reduce inflation. In this case I think your argument is wrong.”
Why? Suppose we bartered old houses, as opposed to buying and selling them for money. Why would a “balance sheet recession” stop people from swapping houses when they wanted to move?
Martin: I’ve heard of it, but haven’t read it. But I vaguely remember Hicks (or someone) making a similar sort of argument decades ago. I find it an interesting argument, but I disagree on, well, sort of philosophical grounds. It’s a “functionalist” explanation.
reason: “Try debt – and money as a unit of account. It doesn’t help to offer Cyranian crowns (or whaever) if my contract says I have to pay US$.”
But, why did you originally agree on a contract to pay US$, as opposed to crowns?
Ritwik: you are not being daft. I thought about talking about this in the post, and decided against.
1. GDP, as defined, includes some output that is not traded. Unsold inventory and imputed rents to owner-occupiers of houses are two examples. There may be more.
2. Resale of an old house at a higher price is not included in GDP. (But if you hire builders to improve the house that is included in GDP.)
3. The theoretical concept of output we use does include output we produce and consume ourselves, without selling it. Economists complain that GDP doesn’t measure output the way we want it to be measured (because it’s too hard to measure some stuff).
So, it’s messy. There are three different concepts:
1. Theoretical output of newly-produced goods and services, whether traded or not. (I=S macro theory).
2. All transactions of both new and old goods. What I’m talking about.
3. GDP as measured. Which is mostly, but not fully, newly-produced goods and services that are traded.
“Why? Suppose we bartered old houses, as opposed to buying and selling them for money. Why would a “balance sheet recession” stop people from swapping houses when they wanted to move?”
Is this relevant? And the answer is yes – because they don’t own them anymore.
“The obvious candidate is a shortage of the medium of exchange.”
Knew you would say that. Reminds me of a remark about Roger Scruton: there’s no fun in reading his essays about sexual morality, because you just know he’s not going to end up advocating free love. There’s no suspense.
It’s only ‘obvious’ because that’s the way you’ve been thinking for years. Think of something else instead: credit. I do believe that’s what Stiglitz thinks about. As he says, there’s something special about lending. You don’t lend your money to the highest bidder, because the highest bidder almost certainly won’t repay the loan.
A cyclical downturn comes when lenders are suspicious. It’s not money that’s scarce, it’s trust. The market in used bicycles can be quite brisk. But the market in used houses dries up. It’s the big-ticket items – new and old – which trade less freely, because buyers ordinarily require credit to purchase them.
The “trade cycle” concept is useful, but I don’t think we can conclude that the medium of exchange, as such, is responsible for the trade cycle. In general, a failure of trade is the result of some price being stuck at a level that does not clear the market. In general, such a distortion will result in certain beneficial trades not being done. More specifically, the trade failures that we call depressions (or recessions) occur when the exchange rate between perishable and non-perishable goods is stuck at a level that does not clear the market, such that a surplus of perishable goods develops.
Labor is infinitely perishable: each person-nanosecond of labor, if it doesn’t get used in its particular nanosecond of availability, becomes completely useless in the subsequent nanosecond. Other goods have varying degrees of perishability. But there is one particular good — which, just coincidentally, happens to be the medium of exchange — that is both low in perishability and sticky in price. When people decide they want to consume more in the future and less in the present, they shift their demand toward non-perishables. If all goods had perfectly flexible prices, this would simply mean that the price of all non-perishables would rise relative to all perishables until people were satisfied with their consumption path at the available exchange rate. But since one non-perishable good is sticky in price, when people get too patient, they will keep trying to buy this good even when there is no more available. Thus there is a failure of trade.
The solution is to make the sticky-priced good perishable — in other words, have the central bank target a high inflation rate.
“reason: “A balance sheet recession is quite different from a recession started by the Fed to reduce inflation. In this case I think your argument is wrong.”
Why? Suppose we bartered old houses, as opposed to buying and selling them for money. Why would a “balance sheet recession” stop people from swapping houses when they wanted to move?”
Nick, surely that’s clear. Suppose I bought my house by borrowing $100 (the house was worth $100, I made no downpayment). Now the house is worth $50.
My only asset bother than the house is a cash holding of $2.
I do however have enough income to service my current mortgage.
I’d like to sell the house and buy a different one that’s also worth $50, or $40, or some other amount greater than $2.
So, can I do this? I’d submit that the obvious answer is that yes I can, which make’s it sound like Nick is right.
However, it would appear that I can only do this within the context of my current mortgage. If the bank that holds my current mortgage allows me to switch the house that secures the mortgage then there’s no problem, I sell the current house for $50 and use that to finance the purchase of the house I’m moving to. The bank and I are in an unchanged financial position with each other. I still owe $100 against an asset worth $50.
This implies that certain transactions costs have risen on average, what if the house I’m moving to is in another state and the holder of the mortgage doesn’t do business there? What if the mortgage was sold in the boom and I can’t find out who the current owner is? There are all sorts of reasons why I may want to finance the new house with a different mortgage and this will not be possible without defaulting on the first mortgage and if I do that then this will surely increase the cost of getting a new mortgage.
Thus, a “balance sheet recession” is nothing more than an increase in average transactions costs for transactions requiring credit intermediation. It’s just the Bernanke-Gertler effect, an increase in the external finance premium for a set of economic actors, an increase in the cost of credit intermediation.
Most importantly it has nothing to do with a lack of real money balances, there is no excess demand for money, and thus it shows why MV=PY or MV=PT is a bad place to start doing macro.
Nick,
“But, why did you originally agree on a contract to pay US$, as opposed to crowns?”
I don’t quite understand your point – history matters we use dollars now because we used dollars in the past.
Martin
“If your contract specifies $US, you could just as well give them a different currency, buy them a put with the premium you get for selling a call. No damage done. There can only be trouble when there are transaction costs, frictions in the market. Is the problem then an excess demand for money or the frictions? In the absence of frictions this is what you can do, even if there is an excess demand for money. ”
Does this make sense? If I can buy the put I can buy the currency – but that is exactly the problem isn’t it. The currency is too expensive so I make a loss on the deal. It is not that dollars are unavailable – it is that there is excess demand for them. You see you made a deal in the past and you expected you could get the dollars. But the other party knowing that crowns are cheap and dollars are expensive is not just going to let you off the hook.
Kevin Donahue – good comment.
Martin,
I don’t think you are really getting it. In order to obtain a different currency – say crowns, I have to sell the services I provide for crowns. But in (say) the US nobody uses crowns so nobody has them. And as nobody has them they are pretty useless for exchange in the US. And everybody at the moment wants more cash and so everybody is trying to save. What you are saying effectively is we should increase exports. Agree entirely. But the international financial system won’t play ball and price dollars so that that happens.
Adam, Kevin, reason: OK, so you are arguing that the transactions costs due to negative equity and difficulty in getting credit is what causes house sales to decline.
My theory is different. House prices are sticky, especially downwards. So when demand falls, the actual price fails to fall quickly to the new equilibrium, and so there’s an excess supply of houses, and fewer houses get bought and sold, and the inventory of houses for sale (“unemployed” houses) increases. The fall in demand for houses might be a local or microeconomic problem, or it might be part of a general decline in demand for goods due to a monetary problem.
Now, how could we empirically test between those two theories? (BTW, I would not deny that there is some truth in your theory.) That’s a genuine question; I can’t think of a good answer right now.
Kevin: “Knew you would say that.”
Yep, I’m sort of predictable like that! I need more sycophantic commenters, who will instead say: “Brilliant insight! I would never have thought of ‘money’, but now you say it, it’s obviously right!” (Just joking.)
“As he says, there’s something special about lending. You don’t lend your money to the highest bidder, because the highest bidder almost certainly won’t repay the loan.”
I don’t think that’s special to credit. You don’t (always) buy the cheapest good, because it might be very low quality. General market for lemons problem. It’s the medium of exchange that’s special.
Andy: I’m not sure about your distinction between perishables and non-perishables. Don’t we see a decline in sales of both perishable and non-perishable goods in a recession?
reason: “I don’t quite understand your point – history matters we use dollars now because we used dollars in the past.”
Aha! forget my point. I think I now understand your point. Let me restate it, as I understand it. If we were all using dollars in the past, and if we all thought we would all be using dollars in the future, then in the past we would have signed loan contracts payable in dollars. And when the future arrives, that makes it harder than it otherwise would be to switch from dollars to something else. So that creates additional inertia in using any given type of money, over and above any inertia caused by the difficulty of coordinating everybody switching at once.
Good point. Obvious, now you say it. God knows how I missed it in the past, until you made it. You taught me something. Kudos!
“You don’t (always) buy the cheapest good, because it might be very low quality.”
True, but I don’t think the BMW/Skoda premium has much to do with the trade cycle. Rationing of BMWs does happen, but I don’t think it’s a matter of great consequence from a macro viewpoint. Credit rationing surely is.
Nick,
I actually agree with you about sticky prices on houses. I don’t think it is either/or, it is both.
Nick,
” So that creates additional inertia in using any given type of money, over and above any inertia caused by the difficulty of coordinating everybody switching at once.”
If you’d be thinking about the process of a country leaving this Eurozone, this should be obvious.
“”You don’t (always) buy the cheapest good, because it might be very low quality.”
True, but I don’t think the BMW/Skoda premium has much to do with the trade cycle.”
Yes, and most importantly the BMW/Skoda premium presumably is to a certain extent a difference in production costs.