Would a sudden fad for antique furniture cause a recession? If, like Paul Krugman, you believe in the paradox of thrift, and if you follow the remorseless logic of your mistaken model, you should answer "yes". I don't believe in the paradox of thrift, and would answer "no".
There is no paradox of thrift. There is a paradox of hoarding. Hoarding is a subset of thrift. "Thrift" means saving. "Saving", as defined in macroeconomic models, means anything you do with your disposable income other than spend it on newly-produced consumer goods and services. "Hoarding" means saving in the form of money. And "money" means medium of exchange.
We need to be clear on the distinction between thift and hoarding. Hoarding can lead to a general glut of newly-produced goods and services -- like the current US recession. Thrift, unless it leads to hoarding, cannot cause a recession. A desire to buy antique furniture is a form of saving, because antique furniture is not newly-produced. But a sudden fad for antiques is very unlikely to cause a recession, because it is very unlikely to lead to hoarding (unless I'm wrong in my judgement that hoarding money is a very poor substitute for buying antique furniture). A desire to buy government bonds is also a form of saving. It is more likely to lead to hoarding, because hoarding money is a closer substitute for buying government bonds. And that's what makes a desire to buy government bonds more likely to cause a recession than a desire to buy antique furniture. A desire to buy government bonds is more likely to lead to hoarding, and the hoarding is what causes a recession.
Yes, this is very wonkish. It looks like angels dancing on pins. But it also has real policy implications.
Keynesian macroeconomics makes no sense whatsoever in a barter economy. Unemployed workers want jobs, so they can buy goods? Firms won't hire them, because they can't sell goods? What's the problem? Why can't the firms just pay the workers in goods?
The problem is: we live in a monetary exchange economy. We don't do barter. And we don't have a Walrasian autioneer trading everything for everything in one big market. Unemployed workers want to sell their labour for money, and firms want to sell goods for money. And if everybody wants to hoard their money, it ain't going to happen.
Yes, I'm a quasi-monetarist. And all Keynesians too should be quasi-monetarist. Because Keynesian economics makes no sense otherwise. It only works in a monetary exchange economy, where workers sell their labour for the medium of exchange, and firms sell their goods for the medium of exchange, and nobody swaps goods for labour in direct barter. It's an excess demand for the medium of exchange - hoarding - that causes an excess supply of labour and goods.
Start in full employment equilibrium. Then suppose there's a sudden fad for antique furniture. Specifically, people desire to spend less of their income on buying newly-produced consumer goods and services, and more of their income on buying antique furniture. That, by definition, is an increased desire to save. It's thrift. Does that fall in demand for newly-produced goods and services cause a recession? According to the simple Keynesian Cross model, or the slightly more sophisticated Keynesian ISLM model, that is exactly what it should do. The marginal propensity to consume falls, the AE curve shifts down, the IS curve shifts left, and AD falls, causing a recession.
But that prediction makes no sense whatsoever. This is what would happen instead. The supply of antique furniture is fixed. Either the price of antique furntiture rises to equilibrate the market, or it does not. If it rises, then the quantity of antique furniture demanded falls back to its original level, and people decide to buy newly-produced furniture instead, so there's no recession. If it does not rise, then people will be unable to buy the antique furniture they want to buy, because nobody wants to sell. Unable to buy antique furniture, people have to buy newly-produced furniture instead, so there's no recession.
Repeat the above paragraph, and substitute anything else (except money) for antique furniture, and the argument still works. Land, old houses, government bonds, whatever. Either the price rises until people stop wanting to buy it, or it doesn't rise, and they can't buy it, so they buy something else instead. And no matter what they try to buy instead (unless it's hoarding money) the only thing whose supply can expand to meet that demand is newly-produced goods and services. Unless people decide to hoard money, you cannot get a general glut of newly-produced goods and services. Unless people decide to hoard money, Say's Law is true. There is no paradox of thrift.
Now suppose people decide to hoard money. Or, suppose people decided to buy antiques, land, or bonds, and then switched to hoarding money because the price of antiques, land, or bonds rose, or because it didn't rise, and they couldn't buy any antiques, land, or bonds.
There is one way for an individual to get more antiques, land, or bonds, and that's to buy more. But money is different. Money flows both into and out of our pockets. There are two ways for an individual to get more money: sell more other stuff; or buy less other stuff. The first way won't work, if everybody else is trying to do the same thing. Individuals find themselves unable to sell more stuff, because everybody wants to sell more and nobody wants to buy more. You can't sell more unless someone else is willing to buy more. But the second way will always work, for an individual. You can always buy less stuff. Nobody can stop you buying less stuff. The short side of the market is what determines quantity traded. It's always the lesser of quantity demanded and quantity supplied. And when everybody is trying to get more money, quantity demanded is less than quantity supplied. So it's quantity demanded that determines actual quantity traded.
The logic of the paradox of hoarding is inexorable. If the total supply of money is fixed, individuals must fail in aggregate to hoard more money. But each individual can succed, given what others are buying and selling, by simply buying less stuff. So demand for stuff falls, and the quantity of stuff traded falls. And it keeps on falling until people stop trying to hoard. We get a recession.
There is a paradox of hoarding; there is no paradox of thrift, unless thrift happens to be hoarding, or thrift leads to hoarding.
And this has policy implications.
Yes, the in the current US recession there is indeed a very high demand for safe nominal assets, like government bonds. That's thrift. And that shortage of safe nominal assets, and the high prices and low yields on safe nominal assets, has spilled over into an increased demand for the medium of exchange, because that too is a safe nominal asset. That's hoarding. And that hoarding has caused the recession.
But that shortage of safe nominal assets is as much a consequence of the recession as a cause of the recession. When firms' sales are falling, and when there's fear of deflation, previously safe nominal assets become less safe, and the remaining safe nominal assets pay a higher real return.
How to get the US out of the recession?
Brad DeLong suggests fiscal policy. By running large fiscal deficits to increase the supply of government bonds, you can reduce the shortage of safe nominal assets, and reduce the spillover from that shortage into the demand for money. Satisfy the excess desire for thrift, and you eliminate the spillover into hoarding. I'm not sure it would work, though I think it probably would work. But it might come at a very high cost. I don't know how big an increase in the debt would be needed. It might be very large indeed. And it's not so much that the US government debt is already quite large, but that the US has a very "structural" deficit to begin with, and this would make it worse. I mean a "structural" deficit in the political sense, more than the economic sense. If the policy eventually worked, US fiscal policy would need to reverse course very quickly with some very big tax increases and/or spending cuts. Those would be very costly. Tax increases and spending cuts have real, microeconomic consequences. And I don't follow US politics that closely, but my hunch is there would be serious political problems in doing what would have to be done. The "exit strategy" to a fiscal solution looks very ugly.
Brad also suggests increasing the supply of safe assets by government policies that would make risky private assets safer. Again, the logic makes sense, and this sort of policy would probably help, but I worry about the costs.
If I thought that those were the only policies that would work, I would probably still argue that the benefits were worth the costs, because a recession is even more costly. But I think monetary policy could do the job more surely and with much lower costs. Maybe even negative costs.
I want a radical solution, and since the root of the problem is hoarding money, the radical solution is monetary policy. To the extent that fiscal policy works to end a recession, it's because fiscal policy is just monetary policy by other means. It works by increasing the supply of or reducing the demand for the medium of exchange.
I think we all agree with Scott Sumner that a temporary increase in the money supply will have little or no effect. If the Fed buys a 90 day Tbill, and promises to buy it back 90 days later, it's really just swapping one Tbill for another.
But a permanent increase in the money supply would have an effect, because it increases the expected future price level, and possibly expected future real output too. That will reduce the current demand for money (reduce hoarding). In fact, a permanent increase in the money supply will cure the liquidity trap in Paul Krugman's model too. How does the Fed make it permanent, which means perceived as permanent? By announcing a price level path target. A permanent increase in the price level would require a permanent increase in the money supply to support it. (Same with a nominal GDP level path target.)
If the Fed had had an explicit inflation target over the last 20 years, and had built up credibility, the announcement of a price level path target might have been enough. But in current circumstances, it might not be credible enough (Though it would certainly be better than the cacaphony of mixed signals currently coming out of the Fed). People need to see that the Fed is doing something concrete, and see that the Fed is moving some market signal, and see that market signal moving in the direction that indicates recovery from the recession.
If I had my druthers, the Fed would buy stocks. Something like the S&P500 index. The increase in stock prices, and increased money supply would have a direct effect on reducing the incentive to hoard. More importantly, when people see stock prices rising, that shows the Fed's policy is having an effect, and the expectation of recovery causes a further increase in stock prices, in a positive feedback loop. Bond price don't have this feature. If the Fed buys long bonds, bond prices should rise. But if the Fed's policy causes people to expect recovery, bond prices should fall. Bond prices give contradictory signals of the Fed's success. Low interest rates are not a simple signal of loose monetary policy; they are a signal that monetary policy has been tight in the past, and is expected to be tight in future.
The high demand for safe assets didn't spring out of nowhere. It is primarily a consequence of expected deflation and expected recession. If monetary policy can reverse those expectations, it can reverse that high demand for safe assets.
Fiscal deficits, if they work, will have future costs. The higher debt will mean very difficult future spending cuts or tax increases. Monetary policy, if it means buying assets that will rise in value if it works, like stocks, will have future benefits. The Fed, and thus the government, will make a profit on the deal.
Coda: Yes, it's fair to call me and David Beckworth "quasi-monetarists". I would accept that tag. But you must also recognise I'm at least quasi-Keynesian too. The funny thing is, the literature that has been most influential on forming my views in this area was all begun by Robert Clower, as an interpretation of Keynesian economics. It was he who insisted that monetary exchange was essential to understanding Keynesian macroeconomics and why Say's Law was wrong, and that money really was special. This isn't just quasi-monetarism. This is real Keynesian macroeconomics, as it should be done.