Monetary disequilibrium theorists must face this question: "If this recession was caused by an excess demand for money, how come interest rates are so low? Doesn't an excess demand for money mean an excess supply of bonds and rise in interest rates?"
[Warning: this post is long, rambling, and unclear. I ought to tear it up and write a couple of shorter and clearer ones. I may do that later, when (if) I get my head clearer. Read at your own risk. Maybe skim it first.]
Despite all my brilliant theoretical proofs of the metaphysical necessity of monetarism -- how a general glut can only be caused by an excess demand for the medium of exchange -- Brad DeLong has got the perfect comeback: "OK, the 1982 recession was caused by an excess demand for money, as shown by the very high interest rates. But the recent recession must have been caused by an excess demand for safe assets in general, otherwise we wouldn't be seeing interest rates on safe assets near zero." (He didn't actually say those words, but he might have done.)
So I'm going to sketch a simple model where an excess demand for money causes a recession but no rise in (real or nominal) interest rates.
The basic idea is simple. An excess demand for money causes unemployment for the "unlucky". The unemployed can't borrow (nobody will lend to the unemployed), and can only spend down their money balances by buying from those who are "lucky" and remain fully employed. The lucky employed get the money that used to be held by the unlucky unemployed. So nothing changes for the employed. And the unemployed are shut out of all markets, so can't affect the equilibrium. And if unemployment causes expected deflation, nominal interest rates will fall via the Fisher effect.
[Warning to lefties: before you get too excited by this model, remember that the distribution of money is not the same as the distribution of wealth. This model is much closer to Milton Friedman than to Karl Marx.]
Before getting started on building the model, I need to talk about loanable funds vs liquidity preference, the ISLM model, and take a sort of cheap shot at Paul Krugman to illustrate my point. (It would be a cheap shot if I didn't admit it were a cheap shot, if you can handle the Liar Paradox.)
Digression on loanable funds vs liquidity preference and ISLM and Paul Krugman and stuff.
The price of apples (if it is flexible) is set in the apple market to equilibrate the demand and supply of apples. If there's an excess demand for apples it rises; if there's an excess supply of apples it falls.
OK. So where is the rate of interest set? What market? What are the demands and supplies it is supposed to equilibrate?
Liquidity Preference says it is set in the money market, to equilibrate the demand and supply of money. Which is totally stupid, because there is no money market. Or rather, in a monetary exchange economy every market is a market for money plus one other good. When finance guys talk about the "money market" they are really talking about the market for short-term loans. When you lend someone money, you get an IOU in return. That IOU is a bond. So when we talk about "the money market" we are really talking about the bond market. So let's call the thing by its proper name. The "apple market" is the market where money is exchanged for apples; the "bond market" is the market where money is exchanged for bonds.
But isn't the "bond market" just another name for the market in "loanable funds"? If so, what the hell is the difference between the liquidity preference and loanable funds theories of the rate of interest?
Another way of describing the loanable funds theory is to say that the rate of interest adjusts to equilibrate desired savings and desired investment. OK. But since (closed economy) national savings is defined as Y-C-G, we can do some trivial math and re-write S=I as C+I+G=Y. So loanable funds says that the rate of interest adjusts to equilibrate desired consumption plus desired investment plus desired government spending to desired sales of newly-produced goods? In other words, loanable funds says that the rate of interest adjusts to equilibrate the output market?
Which is weird. Sure, the demand for output may depend on the rate of interest. But can we jump from that to saying that the rate of interest is set in the output market? Can we say that an excess demand for output will put upward pressure on the rate of interest? The rate of interest is the (reciprocal of) the price of bonds, not the price of output. The demand for apples may depend on the price of pears. But we don't say that the price of pears is determined in the apple market.
The ISLM model was supposed to reconcile the liquidity preference and loanable funds theories of the rate of interest. IS shows the loanable funds answer, as a function of Y; LM shows the liquidity preference answer, as a function of Y. In the short run, with M/P fixed, Y adjusts until both curves give you the same answer. In the long run with P and hence M/P flexible, and Y fixed by the LRAS curve, M/P adjusts until the two curves give the same answer.
But the ISLM is trying to reconcile two opposing theories of the rate of interest, neither of which make any sense.
Here's my cheap shot at Paul Krugman:
No it can't. At least, not if one of the three goods is called "money". In a barter economy, with n goods, there are n(n-1)/2 markets. So if n=3 that means three markets. But in a monetary exchange economy with n goods (including money) there are (n-1) markets. So if n=3 that means two markets.
Paul also says: "Although there are three curves, Walras' Law (if all markets but one are in equilibrium, that market is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for the economy as a whole."
But Walras' Law is wrong in a monetary exchange economy. It only works in a Walrasian General Equilibrium model with a single market in which all n goods can be traded for each other and no agent is ever unable to buy or sell as much as he wishes. That's very different from a model of a monetary exchange economy used to explain excess supply recessions where people can't sell as much labour as they want.
This is a cheap shot because lower down Paul says: "Sixty years on, the intellectual problems with doing macro this way are well known. First of all, the idea of treating money as an ordinary good begs many questions: surely money plays a special sort of role in the economy."
Yes. Money does play a special role. For one thing, money does not have a market of its own. It is traded in every market against every other good; and all the other goods are traded only against money. For a second thing, if we lump all output into one good, we have to recognise that every agent is both a buyer and a seller of that good. We sell our own output for money; and use money to buy others' output. We don't barter our own output for others' output.
So let's start from scratch.
A sketch of my model.
There are three goods: backscratches; bonds; and money. There are two markets: the output market, where backscratches are traded for money; and the bond market, where bonds are traded for money. The rate of interest (aka the price of bonds) is perfectly flexible. It adjusts instantly to excess demand or supply for bonds, so the bond market always clears. The price of backscratches is sticky, or fixed if you like, in terms of money. So the market for backscratches may not clear.
People must trade, because you can't scratch your own back. And you can't barter backscratches, or trade them for bonds (promise to pay later) because you can't see a person's face when you are scratching his back. (OK, so cook up your own silly story for the microfoundations of monetary exchange).
That makes the output market very different from the bond market. Each agent is either a buyer of bonds or a seller of bonds. But each agent is both a buyer and seller of output.
All agents are identical, except: agents differ by "luck". Luck is distributed along a continuum. In the event of an excess supply of backscratches, where demand is only 60% of supply, the luckiest 60% of agents will be able to sell as many backscratches as they want, and the unluckiest 40% will be able to sell none.
Unlucky agents, who are unemployed, are unable to access the bond market. Everyone knows they are unemployed, and therefore unlucky, so they cannot borrow money from lucky agents because they might stay unemployed and not be able to repay the loan. (OK, this assumption could be relaxed a bit, but shouldn't affect the results too much).
In advance of a recession, agents don't observe their own luck, so all agents are identical ex ante, and the unlucky won't save more than the lucky.
Start in full-employment equilibrium. All agents are buying and selling backscratches for money. But no bonds are traded, because all agents are ex ante identical. In full-employment equilibrium, it's a representative agent model.
Now let's shock the model.
Shock 1. This example is very contrived, but is also the simplest. Assume that a fire destroys all the stock of money held by the unluckiest half of the population. In this example, the unlucky are doubly unlucky. They are unlucky in the market for backscratches, and they are unlucky in the fire too. What happens?
In the new equilibrium the economy carries on exactly the same as before for the lucky half of the population, while the unlucky half of the population is shut out of all markets, and so has no effect on the equilibrium. The rate of interest initially stays the same.
The unlucky unemployed have no money, so can't buy backscratches. They will want to borrow money, but nobody will lend to them, because they are unemployed. They want to sell backscratches, but the lucky employed are already buying as many backscratches as they want from each other, and the unlucky are at the end of the queue supplying backscratches, so the demand runs out at the halfway point. The fire that destroyed their money might as well have destroyed them too, in terms of how it affects the equilibrium in the luckier half of the economy. Except:
Of course, the excess supply of backscratches will slowly cause the price of backscratches to fall (assuming it's sticky but not stuck). Given long enough, this fall in the price level will increase the real money supply by enough to restore full employment. But in the meantime the expected deflation will lower the equilibrium nominal rate of interest.
Shock 2. Now assume half of each agent's stock of money gets destroyed by fire. (So, unlike Shock 1, the unlucky agents are only unlucky in the market for backscratches, not in the fire.) What happens?
Initially, each agent will respond in three ways. He will supply more bonds. He will supply more backscratches. He will demand fewer backscratches. All to try to rebuild his stock of money. But since the stock of money is fixed, they must collectively fail.
Since there is an excess supply of backscratches, some agents near the unluckiest end of the spectrum will be unemployed. They cannot sell backscratches to earn income. They cannot sell bonds to tide them over till the recession ends. They can slowly run down their stocks of money, which is earning 0% interest. Or they can sell some of that money to buy bonds, to earn positive interest, then slowly run down that stock of bonds. Either way, the money once held by the unemployed will, immediately or over time, end up in the pockets of the employed.
What does the new equilibrium look like?
To a first approximation, the equilibrium in Shock 2 will look exactly the same as the equilibrium in Shock 1. The only difference between the two shocks is a small change in the distribution of wealth. The unlucky half of the population is slightly better off, and the lucky half of the population slightly worse off, in Shock 2 than in Shock 1. At the previous equilibrium rate of interest, the unlucky unemployed will want to buy bonds with money, and the lucky employed will want to sell bonds for money. So both the demand and the supply of bonds will increase relative to Shock 1. This small change in the distribution of wealth will have an ambiguous effect on the rate of interest, compared to the equilibrium in Shock 1. And that effect will be small anyway, since stocks of money are such a small part of total wealth.
So, in Shock 2 as in Shock 1, the initial impact of the excess demand for money will be to leave the rate of interest (approximately) unchanged. And since the excess supply of backscratches will eventually cause expected deflation, the nominal rate of interest will fall.
Relaxing the key assumption.
What happens when we relax the assumption that the unemployed cannot borrow by issuing and selling bonds? The unemployed would want to borrow to smooth their consumption stream over time, and will be able to pay back the loan if the recession is short-lived. But the IOUs (bonds) they issue will be riskier, and will have to pay a higher rate of interest, than the safe bonds issued by employed agents. That might be a way to reconcile my model with Brad DeLong's theory that the recession was caused by an excess demand for safe assets. But, I would want to insist that it was the recession that caused previously safe bonds to become unsafe, and the recession was caused by an excess demand for money.