Keynes' question and the "Keynesian" answer

How did "fiscal policy" get to be the answer to a question about time and money?

Sophisticated Keynesians will object if I treat "Keynesian" as synonymous with "having a predilection for fiscal policy". But I think they would recognise that the two are correlated. And that correlation is puzzling. The correlation seemed to disappear during the "New Keynesian" era, as the New Keynesians chose monetary policy over fiscal policy; but it reappeared with the recent recession.

Assume a closed economy, for simplicity.

Y=C+I+G is the way we usually do the accounting. But there are many different ways to do the accounting, and each way frames the question differently. Here's a better way:

Y=Cp+Ip+Cg+Ig

C means consumption and I means investment. The subscript p means private and g means government.

And here are two different ways we could aggregate terms:

1. Y= (Cp+Cg) + (Ip+Ig) = consumption spending + investment spending

2. Y= (Cp+Ip) + (Cg+Ig) = private spending + government spending

And there are two different questions we could ask about the composition of output:

1. What is the optimal mix between consumption and investment spending?

2. What is the optimal mix between private and government spending?

Those two questions are orthogonal. They are two different dimensions. Consumption/investment is North/South; private/government is East/West. A change in the optimal mix between consumption and investment spending has no obvious implications in either direction for the optimal mix between private and government spending. (Maybe the government has a comparative advantage in investment spending and the private sector a comparative advantage in consumption spending, or maybe it's the other way around.)

Keynes' question was about the first of those two questions, and how a decentralised economy might not get the answer right, and could cause even worse problems as a side-effect of not getting the answer right.

It would be very surprising if getting the right answer to the first question required us to change the answer to the second question. But that is what the "Keynesians" seem to be telling us.

Suppose the economy initially had the right mix on both dimensions.

Then suddenly people decided they wanted fewer new cars and more new buses. Assume cars are bought privately and buses are bought by the government. People cannot signal that change in preferences through the market. They can only signal it at the ballot box, or by talking to government. But we know what the answer is: a reduction in private spending and an increase in government spending. Suppose the government failed to give the right answer, and didn't increase spending on buses. Would that plunge the economy into recession? I don't think it would. People wouldn't be as happy driving cars as they could have been riding buses, but they wouldn't all be unemployed. That wasn't Keynes' question.

Now suppose people people decided they wanted fewer new cars today and more new cars next year. We know what ought to happen. Car producers should reduce current production of cars, and divert resources into investment so they can produce more cars next year. But will that actually happen? Well, maybe if people placed their orders for next year's cars now, that is exactly what would happen. Car producers would see increased orders for next year, and know they should divert resources away from current production towards future production. But if people don't actually give that signal, how will car producers know what they want? All the car producers know is that demand for this year's cars has fallen. If they think this fall in demand will persist, they will actually reduce investment, not increase it as they should. And that might cause a recession. That was Keynes' question. [Update: see Daniel Kuehn's post where he cites a long passage from the General Theory to back up my claim that this was Keynes' question. I had only vaguely remembered that passage.]

"Let's have the government buy more buses so the car producers switch to producing buses instead" isn't the right answer to that question.

But why did Keynes think the market economy might not be able to answer his question correctly? Where's the coordination failure?

I think there are two reasons: a micro reason; and a macro/money reason.

The micro reason: even if producers knew that people wanted to buy fewer cars this year and more goods next year, they might not know whether people plan to buy more cars next year or more bikes next year. And it might not be next year that they want more cars; it might be the year after next. It would take a good forecast based on a market survey to figure that one out.

The macro/money reason: If people had a choice between spending their income on newly-produced consumer goods and newly-produced investment goods, and nothing else, there would be no recession. Even if we add newly-issued stocks and bonds into the list of things that people can spend their income on, it makes no difference, because the firms that issued those stocks and bonds would be buying the newly-produced investment goods. Even if we add previously issued stocks and bonds, and land, and previously produced goods to the list, it makes no difference. If one person is buying used furniture, another must be selling used furniture. Say's Law almost works.

It's when we add "money" to the list of things people can spend their income on, that Say's Law fails. Because if your income comes to you in the form of money, nobody can stop you spending part of your income on money -- you just don't spend it. And if everyone does the same, then we get a recession.

The micro reason, and the macro/money reason, are related. Money is the most liquid of all goods. We don't want to place an order this year for a new car next year. We want to keep our options open, which means we want liquidity. We don't want to decide now what make of car to buy, especially since we don't even know what will be on the market next year. Or maybe to buy it the year after next. Or maybe to buy a bike instead.

It is very hard to coordinate plans when everyone is waiting for everyone else to make up their minds. We all want to keep our options open, but liquidity has a social cost. Perhaps the answer to Keynes' question is that liquidity is underpriced?

The only defence for giving a "Keynesian" answer to Keynes' question is that you don't know the right answer, and your answer is better than nothing.

(A variation on a Leijonhufvudian theme.)

Comments

[gofx]

Nick,

Its hard to tell whether or not liquidity is "underpriced". Liquidity has private cost too. There is risk/cost to not consuming a particular good today. The price may go up, supply may run out etc. Its not clear why, if there is something called the social cost of liquidity, it is not already internalized.

[Frank Restly]

Nick,

"Even if we add newly-issued stocks and bonds into the list of things that people can spend their income on, it makes no difference, because the firms that issued those stocks and bonds would be buying the newly-produced investment goods."

Not quite. Suppose a company issues stock to repay bond holders. In essence the company is reversing the money creation (credit) process. Obviously a company would only do that if borrowing costs were significantly higher than return on equity capital for profitability reasons. However, a fiscal policy practitioner may also want to do that for productivity / economic efficiency reasons.

[Determinant]

Whoa boy. Where's Paul Krugman when you need him?

1. What is the optimal mix between consumption and investment spending?

2. What is the optimal mix between private and government spending?

Orthogonal? They're not orthogonal. Please do not take the name "orthogonal" in vain. Government is a PARALLEL actor in the economy. The economy, in your formulation, is an area on that graph. If all the other sectors (and they are truly sectors on that graph) contract, the last area MUST expand to in order to avoid overall economic contraction. Or if we're even a little bit clever, we might even expand government spending to tease additional supply. It worked in WWII didn't it? Munitions factories sprang up like rabbits when government said it'd pay for shells, didn't it?

The economy, in the toy model, is an area on that graph and that is the unifying constraint. And the fact that Neokeynesianism can't tell the difference between a loan and an unconditional payment for a private actor is almost as bad as when lawyers who can't tell the difference between a human being and a legal fiction when asked who is a person.

"It hath neither an arse to kick nor a soul to damn (and demands repayment lest you default)"

Good night.

[Frank Restly]

"It worked in WWII didn't it? Munitions factories sprang up like rabbits when government said it'd pay for shells, didn't it?"

Yeah. It worked real well:

http://en.wikipedia.org/wiki/World_War_II

"In a state of total war, the major participants placed their entire economic, industrial, and scientific capabilities at the service of the war effort, erasing the distinction between civilian and military resources. Marked by mass deaths of civilians, including the Holocaust and the only use of nuclear weapons in warfare, it resulted in an estimated 50 million to 85 million fatalities."

[Nick Rowe]

gofx: in general, you are right. Liquidity is priced, and it might be either overpriced or underpriced. But maybe a recession is a sign that liquidity is underpriced?

Frank: "Suppose a company issues stock to repay bond holders. In essence the company is reversing the money creation (credit) process."

No it isn't.

Determinant: You missed my point. If people decide the want fewer new cars this year and more new cars next year, we want C to contract and I to expand to give them what they want. That says nothing about whether the private sector should contract and the government sector should expand. (Unless the private sector produces C and the government sector produces I.)

[Frank Restly]

Yes it is, if the bank that originated the loan retains the loan.

[Determinant]

Determinant: You missed my point. If people decide the want fewer new cars this year and more new cars next year, we want C to contract and I to expand to give them what they want. That says nothing about whether the private sector should contract and the government sector should expand. (Unless the private sector produces C and the government sector produces I.)

That's an equilibrium argument tending towards supply-limited assumptions. Austrians have elevated that paragraph to high art. Keynes assumed a glut. In order to overcome a glut, you don't want to contract any sector, you want them all to expand. Demand-limited, supply not a problem. Keynes was quite explicit about it.

Frank:

"In a state of total war, the major participants placed their entire economic, industrial, and scientific capabilities at the service of the war effort, erasing the distinction between civilian and military resources. Marked by mass deaths of civilians, including the Holocaust and the only use of nuclear weapons in warfare, it resulted in an estimated 50 million to 85 million fatalities."

The fact that military spending ended the Depression was not lost on anyone at the end of the war. The fact that such spending probably should be used for peaceful purposes was not lost on anyone either. That's why high government spending in peacetime for peaceful purposes was so popular in all segments of society, powerful and powerless alike.

Do you have another straw man, my cigar just went out.

[Nick Rowe]

Frank: No it isn't, if the people who buy the shares get a bank loan to buy them, which they will need to do if the bank, not they, held the bonds, and the bank will want to make that loan if it doesn't want to contract its balance sheet. Plus, this is a total tangent to my post.

Determinant: of course it's an argument from supply-limited assumptions. If you "answer" the economic question correctly, that answer *is* supply-limited. We are talking about the *optimal* allocation of resources. If your answer is not supply-limited, it's the wrong answer.

[Frank Restly]

Determinant,

Its a simple question. From a cost / benefit analysis - did World War II work? Keynesians love to point at the production (shells and what not) without looking at the damage wrought. Your statement - "It worked in WWII didn't it? Munitions factories sprang up like rabbits when government said it'd pay for shells, didn't it".

What worked was winning the war. It made the U. S. a major exporter to several war torn regions. It gave the U. S. a significant presence in setting up the Bretton Woods agreement.

This was not a straw man. It was a response to a flippant comment regarding WWII. If I read too much into it, then I apologize.

[Frank Restly]

Nick,

Okay, I will try something more direct to your point.

"Perhaps the answer to Keynes' question is that liquidity is underpriced?"

Or illiquidity is overpriced.

[Ralph Musgrave]

“What is the optimal mix between private and government spending?” That is a purely POLITICAL question: it’s not one that economists ought to consider. It’s a question that the electorate answers.

Next . . to say that “liquidity is underpriced” and is causing unemployment is very near to saying “we have paradox of thrift unemployment”. The solution is to meet the demand for liquidity: i.e. stuff cash into household pockets (to use sophisticated economics jargon).

That solution can be classified as monetarist. But how is the cash actually channelled into household pockets? It can only be done by for example upping government spending or raising the state pension, or cutting payroll taxes. That’s “fiscal”. So the best solution is part monetarist and part fiscal.

The classic monetarist solution on its own (cutting interest rates) is not brilliant because it skews spending towards investment (a skew which must later be unwound). As to a pure fiscal solution, namely having government borrow and spend, that might not work because the deflationary effect of the resulting interest rate rise might cancel out the stimulatory effect of the government spending (crowding out).

MMTers tend to advocate the latter “create new money and spend it (and/or cut taxes)” solution, don’t they? Certainly that solution kind of feels right to me.

[Anon]

Frank: WWII certainly worked economically for countries that managed to escape much of the damage, such as the U.S.

The argument isn't that WWII was economically beneficial for the planet as a whole - it wasn't, it was hugely destructive.

The argument is three fold:

1) the U.S. grew its government spending massively in 1940 and did exceptionally well. Massive government investment and a top tax bracket of 90% for annual income over 1 million dollars did not crowd out private spending and did not stifle job creation, it did the exact opposite: it enabled, facilitated, expanded private spending, it created millions of new jobs and ended the Great Depression.

2) once in 1950 this newly created, recursively growing production capacity was switched over to peaceful purposes, joined by most other fresh modern democracies, it led to an unprecedented, decades long growth period in citizen welfare not just for the U.S. but globally as well.

3) this is hypothetical but still true: had the initial investment not been into blowing things up far away, but into things like building roads, bridges, dams, schools and hospitals, the damaging aspect could have been avoided globally as well.

This is why Krugman half-jokingly suggested that if you are ideologically opposed to the idea of protecting citizens from recessions via government investment, perhaps what we need is an imaginery threat from Mars that would allow us to ramp up infrastructure investment and production, like Roosevelt did it in 1940.

[Nick Rowe]

Ralph: If people's preferences change away from stuff bought privately and towards stuff bought by the government, most economists would say that the optimal allocation of resources should change too, and we would wonder about the mechanisms (like the ballot box) that would implement that change. If people's preferences change away from apples towards bananas, we would say the optimal allocation of resources should change too, and we would talk about how a fall in the relative price of apples to bananas would implement that change. If people's preferences change away from consuming goods today and towards consuming goods in future, we would say the optimal allocation of resources should change too, away from consumption towards investment to create that future consumption, and we would talk about how a fall in the real interest rate (the relative price of current to future consumption) would implement that change.

[jonny bakho]

Somewhere in there is an assumption about full employment; that an economy will automatically return to its "Natural Rate of Unemployment" which is full employment.
Economies do no such thing in the absence of labor and workforce training policy.

Y is also a function of employment. If more people are working, Y will be larger. Yet the model you use is not accounting for changes in numbers of people in the workforce.
Consumption is a function of distribution. Fiscal spending changes the distribution of goods and services. Employment also affects Velocity of money, which affects Y. Less employment = less velocity if transfer payments are not a perfect substitute for wages (and no one thinks they even come close).

The Keynesian fiscal stimulus intervenes by increasing demand for goods, services and labor directly and thus increasing the velocity of money. A recession occurs when velocity of money falls rapidly. Inflation is the opposite, the velocity of money is too high. Negative velocity sets off a self reinforcing downward economic spiral of lower employment, lower demand, deflation (which when wages are sticky lowers employment), lower employment....
Keynesian fiscal intervention must be large enough to reverse the spiral: increase demand, increase velocity, increase employment, increase demand... in an upward economic spiral.

Monetary policy is good at putting a lid on the upward spiral to prevent runaway inflation. Away from the ZLB, monetary policy can stimulate demand by lowering return needed on investment. At the ZLB, the margin is at a negative interest rate which means that investors must be subsidized to invest. (This is the equivalent of fiscal policy).

[Merijn Knibbe]

As I understand it - money is an endogenous variable. Read all about it in the statistical manual of the ECB on estimating 'money'. Paying down loans to MFI's literally destroys money. Investing in paying down a loan is very deflationary ('Friedmans nightmare') - at least, as we look at what actually happens when a loan is paid down, like the statisticians of the ECB do. this especially happens when the banks, for instance after a 'Minsky moment' feel themselves constrained to make new loans. http://www.ecb.int/pub/pdf/other/manualmfibalancesheetstatistics201204en.pdf Deleveraging leads, when deposits are used to do this, to a decrease of money (in this case defined as (M-3 + 'financial capital', financial capital in the old Bundesbank sense i.e. longer term deposits not included in M-3). 'Loanable funds' is a red herring, in the real world. Though it might be said of many an economist: ""He eteþ no ffyssh But heryng red."

[Ralph Musgrave]

Nick: Re your last sentence, what you propose is certainly A SOLUTION. That is, if people decide to consume less for three years and more for the next three years (with the cycle repeating itself if you like) then full employment can be maintained by upping investment in the years when consumption is low. But that shift involves inefficiencies: it dislocates the labour market. I suggest it’s better, where consumers cut spending, to encourage consumers to keep their spending constant. As a result, investment spending will also be more constant.

Ideally that brings the same result in that full employment is maintained, but the above inefficiencies are avoided.

[J.V. Dubois]

I think that we see the history repeating itself here again. I think that you correctly answered the real Keynesian question - it is about investment/consumption dichotomy, where investment is depressed due to wrong signal that fall in consumption causes. And the market force that should remedy this via (real) interest rate channel because money makes an economy to behave in a weird way. Zero lower bound presents us with two multiple equilibra regarding the real interest rate:

1. It is too high (short term) due to the zero lower bound - which is caused by cash
2. But more importantly, by supposedly *trying* to make real interest lower via increasing inflation expectations you can actually make it higher long term, because you can jump into a different equilibrium where real economy picks up and you are again introduced into the world outside of the money constrained one (zero lower bound)

I think that the point #2 is the gist of what MM are trying to say. It is all your post about central bank having a plate on the pole and all that. The real answer is obvious to anybody willing to look close on the subject - it is all about money and inflation expectations. Keynes blidned by his gold standard experience did not think that CB can create inflation sufficient to bring the economy to a good equilibrium - and he was wrong.

Similarly Keynesians nowadays think that zero lower bound makes CB unable to create inflation so they look up to government spending to make up for this. But they are wrong again. And more, they are terribly confused - as for instance Ed Balls who claimed that the role of CB in depressed economy is to keep inflation stable at 2%.

I think that in the end many popular Keynesians who push for fiscal stimuli are unknowingly or even deliberately guilty of the same sin they accuse people like Paul Ryan (or ECB, BIS) they see a recession and they thing it would be a wasted recession if it was not used to their preferred political agenda.

[Nick Rowe]

jonny: "Somewhere in there is an assumption about full employment; that an economy will automatically return to its "Natural Rate of Unemployment" which is full employment."

Implicit in my post (I didn't feel it necessary to make it explicit) is the assumption that full-employment (leaving aside precisely what that means) is *optimal*. But one of the very points of the post is to explain why the economy may move away from full employment/the natural rate of unemployment. Is my writing that bad that you can't see what I'm trying to say?? Or did you just come to this post with the view that "Nick Rowe is some sort of monetarist who doesn't like fiscal policy, therefore he must assume full employment", and read into it what you thought you would read??

Ralph: three points:

1. A reallocation of resources away from apples towards bananas also involves those same "inefficiences" of dislocating the labour market away from apple production towards banana production. Does that mean the government should buy more buses?

2. Having the government buy more buses also causes those same "inefficiences" of reallocating resources away from apples towards more buses.

3. "I suggest it’s better, where consumers cut spending, to encourage consumers to keep their spending constant. As a result, investment spending will also be more constant." That's like saying that the government should encourage consumers to keep their spending on home heating constant Summer and Winter, to avoid the "inefficiences" that result from adjusting fuel deliveries every 6 months.

[Nick Rowe]

Merijn: "X is endogenous" simply means "X depends on stuff, and so when stuff changes X will change too". Of course money is endogenous (unless the central bank targets the stock of money successfully and so makes it exogenous). Under an inflation target, and NGDP target, or almost any other target (like the gold standard, or fixed exchange rates), the stock of money is endogenous. Why do people keep saying "money is endogenous!" as if it is some massively important and controversial point?

(BTW, TypePad put your comment into spam; you may notice a similar problem in other typepad blogs.)

JV: I tend to agree with your comment, of course, though I am still a bit unsure about the last part. Is it a political "let's not waste a good crisis, but use it as an opportunity to increase G!"? Or is it a result of bad framing: "Y=C+I+G" therefore we must increase G if Y is too low!"?

[W. Peden]

Nick Rowe,

"Why do people keep saying "money is endogenous!" as if it is some massively important and controversial point?"

Do they perhaps mean something like "the central bank CANNOT target the stock of money successfully"?

Of course, if that's the case, then statements like "central banks set interest rate targets, not money stock targets" is utterly irrelevant to the question of whether or not money is endogenous, yet they often come up in these sorts of discussions.

So we have a statement with which most economists concur, being used to mean a statement with which many would not concur. To make it more complicated, some people (including Merjin in this case, perhaps?) use "the money stock is endogenous" to mean "the loanable funds model is false". Quite a stramash.

[Benoit Essiambre]

Wow Nick, you always describe the situation exactly as my non-economist intuition sees it. It's nice to be validated. :-)

Two points you make so eloquently are:

-We _can_ have fiscal stimulus and shrink the government at the same time. For example, just have the stimulus be tax cuts.

-It is critical that cash, since it doesn't have intrinsic value, should lose its value faster than safe, short term investments. Otherwise those private investments can't compete with artificially high (compared to negative) 0% returns on cash and the cash gets hoarded even though it is not backed by real economic activity. You get a gridlock in the investment market which leads to a vicious circle of people being unemployed feeling poor and wanting to save even more cash.

I am no economist, I am a developer that came to these conclusions when I was planning to build a virtual economy with virtual population for a mobile game. I learned tons about economy but I'm not sure I'm going to end up making the game because implementing the economy would be more complex than I first expected.

There is one other important conclusion I came to when trying to understand a liquidity trap like situation in my game's economic model that seems to me is often overlooked by economists.

There are four ways of saving for the future that I could see the economic actors could use in my game:

The two good ways: Buying stocks and buying bonds.

One bad ways: Hoarding cash or cash like stuff.

The last one I'm not sure about and I would like to hear the opinion of a real economist: Buying stuff you will need later.

That is stockpiling real stuff with intrinsic value instead of, dollars, bitcoins or gold.

The problem with buying stuff is that the return is at most the rate of inflation (around 2%) but in reality there are costs of storage, maintenance, obsolescence and risks that technology will make some stuff cheaper to manufacture and buy later.

There are also more risks of bubbles with stuff if people decide to buy the same thing at the same time. This is what happened to houses in the US with much help from corrupt banks prior to the 2008 crash. Plus houses might not be the best candidate of things to stockpile because they last for longer than people need the extra way of saving and they can't really be moved if they are no longer needed where they are.

But in theory if you have some spare space and you can buy a variety of stuff in discounted bulk, stockpiling what you will need later might not be a bad strategy especially when you consider all the transaction fees and management fees that can come with other types of investments. It seems to me that when you are saving by buying stuff, you are actually stimulating the economy at the same time you are saving. Wouldn't the effect on the economy be similar to governments doing infrastructure spending but on a private, personal scale?

It might also be easy for central banks to trigger this behavior by making inflation slightly overshoot its target. The more inflation is high, the more advantageous it is to stockpile stuff instead of cash.

[Lord]

Perhaps the problem is the price of liquidity can't be raised that much or that fast.

[J.V. Dubois]

Nick: I actually meant "do now waste a good crisis to push my ideas" - and those may even be contrarian ones like increase taxes and simultaneously build new bridges "because of low demand". Ed Balls was one extreme example - austerity in Britain depresses demand and simultaneously BoE should be focused like laser on 2% inflation (in an environment where inflation was actually higher than 2% which means he proposed monetary tightening). So it is about increasing G, increasing taxes, supporting renewable energy - you name it. All I know is that it has no relevance to anything remotely resembling something that is supposed to be a remedy to a mess we are in.

What is frustrating is that Ed Balls is not alone in this. Take this article from Noah Smith as an example, especially this part:

"But here's the thing. If either the Fiscal Stimulus Proposition or the Public Capital Proposition is true, we need to boost government spending"

I wanted to shout that "Fiscal Stimulus Proposition" works by increasing aggregate demand and thus must be wrong unless "Monetary Stimulus Proposition" accommodates it. So in practice all you are left with is Public Capital Proposition, which is not related to the main reason of this crisis and which is the one I am perfectly in agreement by the way. But should we really have discussion about what pet Public Capital Projects Noah Smith thinks make sense whenever we talk about what to do about unemployment?

[WNY-WJ]

Any chance there are diminishing marginal returns to government spending, such that a fiscal multiplier should be higher when government spending as a % of gdp is low? or, when the private sector's spending is low and excess capacity is high, could the fiscal multiplier rise because of production factors lying "fallow"? It is likely that each point in time has different multipliers, and that different outlets for government spending have varying multipliers as well. "Static" analysis - analysis that does not account for potential differences and changes to multipliers - is probably deficient.

[J.V. Dubois]

Nick: "Why do people keep saying "money is endogenous!" as if it is some massively important and controversial point?"

This has almost a status of internet meme, many people feel the need to lecture other people how "modern banking works". After several frustrating discussions I found out that this confusion is just misunderstanding that CB has two goals - short term when it targets interest rates (and does not care about money supply as it is readily provided to defend this rate) - and long term when it targets inflation which is of course caused by hot potato effect even by this endogenously created money. That central bank can work in this roundabout way seems to be an endless source of confusion for masses readily delivered by self-taught financial experts all over the interwebs. Just count it as another victim of confusion by interest rates.

[W. Peden]

J.V. Dubois,

That would seem to make sense.

[Ron Ronson]

Great Article !

The premise is that when people start spending less on C then businesses don't know what this means about the size and shape of future C and hold off on invetsing in the present.

I'm not sure I get "If people had a choice between spending their income on newly-produced consumer goods and newly-produced investment goods, and nothing else, there would be no recession". What if business is uncertain about the future so it buys newly produced investment goods of the most long lasting and generic kind and just stores them. Employment still falls and we still have a recession till the uncertainty resolved itself.

Introduce money and then people get liquid just by holding more money. If prices are fixed then other things being equal the effect will be the same as in the example with no savings except that rather than investment goods being bought and stored, they just don't get sold at all.

You can see why fiscal policy is attractive: Just have the govt buy up those unsold machine and use them for building buses and problem solved. But what happens if the govt buys the wrong machines or spends them on things that are harmful ?

That's just a workaround to the real problem of business not knowing what a fall in C means. The challenge (I think) is to distinguish between a fall in C due to a desire for greater liquidity and a fall in C due to a desire for greater savings to be spent in the future. Flexible prices would solve this problem. So would monetary policy that stabilizes the value of money by varying the money supply just enough to offset the effects of price stickiness. If this works perfectly the outcome is the same as in a flexible-price model. But if it works imperfectly it may just further distort prices and add to the desire for greater liquidity.

[Jim Glass]

It's not clear that Keynes himself bought the "Keynesian" solution, at least according to the Palgrave...

“Despite the fact that the economics of deficit finance began with the Keynesian Revolution, it has been conclusively established by Kregel (1985) that Keynes himself did not ever directly recommend government deficits as a tool of stabilization policy. Keynes played a conservative political hand and viewed budget deficits with a ‘clearly enunciated lack of enthusiasm’.”

[Lord]

Nick, how do you think automatic stabilizers work? Are they the answer to the wrong question?

[Steve Roth]

Just did a post on this, responding to your old Reflux post... The gist:

Kay so "people" (real-sector actors, aka households and nonfinancial businesses) have the choice of "spending their income on":

1. "newly-produced consumer goods and newly-produced investment goods"

2. "newly-issued stocks and bonds"

3. "previously issued stocks and bonds, and land, and previously produced goods"

This ignores #4: They can "buy" reduction in their debt to the financial sector. (Don't have to be lump-sum payoffs. Just keep up your monthly payments and use your debit card instead of your credit card, don't draw on your business line of credit, don't issue new corporate bonds, etc.)

When the real sector uses their money to pay off debt to the financial sector, the financial sector, collectively, burns that money. (Should we subtract those payoffs from real-sector "demand"? Should we add net borrowing?)

Both real-sector and financial-sector balance sheets shrink. Cue Koo.

"If one person is buying used furniture [borrowing], another must be selling used furniture [lending]." True for used furniture; wrong for debt.

For every borrower there's...a bank.

Banks are nothing like "people" (real-sector actors). 1. They're licensed to print and burn money on demand. 2. Their reaction functions and business models have nothing to do with "time preferences for spending/consumption." They don't lend ("save") because they're "patient."

Given that additional "spending" option, the only way this post's thinking makes sense, I think, is if "the" interest rate always instantaneously adjusts so that real-sector actors are instantaneously induced (collectively "forced") to borrow more/less in response to other real-sector actors borrowing less/more. IOW, the real sector has no choice but to "pick up" and "hold" money.

But that doesn't happen. Just one example: credit-card rates went up '08-'10 (lots relative to Fed Funds, which dove), even while demand for credit plummeted.

W. Peden is right: It's not so much about endogenous money (though it is about that) as the loanable funds model, which I'm now calling the Lump Of Money Fallacy. IS/LM embodies, is inescapably dependent on, the logic derived from that fallacy, even while it rather schizophrenically acknowledges endogenous money. (Which is why intro econ should at least teach IS/MP instead.)

Thanks,

Steve

[Steve Roth]

Friedman: "Let us suppose therefore that we substitute a furnace for a helicopter."

The Optimum Quantity of Money, p. 16.

He's talking about government furnaces, but it banks have them too.

[Alex Godofsky]

@Nick

Is my writing that bad that you can't see what I'm trying to say?

For what it's worth, I thought your point was perfectly clear and I'm not sure anyone is really addressing it (though Determinant comes closest).

[JCE]

"Even if we add newly-issued stocks and bonds into the list of things that people can spend their income on, it makes no difference, because the firms that issued those stocks and bonds would be buying the newly-produced investment goods."
Why would those firms be buying newly-produced investment goods? i don't get that part

[Steve Roth]

@JCE: Why would...firms that issued those stocks and bonds ... be buying newly-produced investment goods?

Excellent question, pointing out the other key flawed assumption here. See:

"from the fourth quarter of 2004 through the third quarter of 2008, companies in the S.&P. 500 showed:

Reported earnings: $2.42 trillion
Stock buybacks: $1.73 trillion
Dividends: $0.91 trillion

As a group, every dime they made, and more, went to shareholders."

http://economix.blogs.nytimes.com/2008/12/10/shareholder-value/?_r=0

Where did all that extra money come from? New borrowing.

[Nick Rowe]

W Peden @9.36, and JV Dubois @10.10: good comments. I agree. You two keep me (relatively) sane.

Benoit: "I am no economist, I am a developer that came to these conclusions when I was planning to build a virtual economy with virtual population for a mobile game."

What you call "building a virtual economy" is very similar to what economists call "building a model". It forces you to try to think coherently, and makes sure all the bits add up to what you thought they added up to.

"The last one I'm not sure about and I would like to hear the opinion of a real economist: Buying stuff you will need later."

Buying newly-produced goods now, and storing them for later consumption, is economically equivalent to investment. But you are right that it is a form of investment that usually has a low rate of return. It only makes sense when either: real interest rates are negative; the good you store will increase in price relative to other goods. (A simpler way to say the same thing is that the nominal interest rate minus the rate of inflation of the good you store gives you a sufficiently negative real interest rate to offset storage costs.) Think of things like jam, which is made when fruit is cheap.

Lord: "Perhaps the problem is the price of liquidity can't be raised that much or that fast."

Keynesians who cite the Zero Lower Bound are making precisely that argument. But raising the inflation target (or better yet the NGDP growth target) would be a way to raise the price of liquidity.

JV @9.50: Yep. Noah's "Public Capital Proposition" is a pure micro judgement call, and has nothing to do with AD.

WNY-WJ: "Any chance there are diminishing marginal returns to government spending, such that a fiscal multiplier should be higher when government spending as a % of gdp is low?"

There are perfectly good *microeconomic* reasons to accept diminishing marginal returns to many or all forms of spending, including government spending. But these have nothing to do with macro. Are there diminishing returns to increasing AD? Sure, because eventually you hit supply constraints. But that has nothing to do with whether fiscal vs monetary policy is used to increase AD.

[Frank Restly]

JCE,

Because a firm also manages its mix of debt and equity, a conversion from one to the other (newly issued stocks in place of previously issued bonds or vice versa) will not result in newly produced goods being bought. In addition, some firms use their own equity as part of employee compensation. And so an employee receives compensation in the form of equity shares in the company where no money trades hands and no newly produced investment goods are bought.

[K]

Nick,

"Perhaps the answer to Keynes' question is that liquidity is underpriced?"

I'd just say that the cost of deferring consumption is underpriced (the real rate is too high). You don't need "money" for that to happen. You just need a dis-equilibrium high real rate courtesy of an excessively hawkish central bank (or courtesy of the ZLB). As soon as you permit *someone* to control the real rate between private agents (and it would take a radical redesign of our financial system to avoid that), you are going to have the potential for a recession. You don't need any quantity of outside money to make it so.

Apart from that, I totally agree with your (orthogonal?) point that it's crazy to produce buses because everyone wants to defer bike purchases. The answer, of course, is to lower the real rate to make them buy bikes *now*. If the ZLB is in the way, there are plenty of good technocratic solutions for getting rid of it.

[Nick Rowe]

Ron: thanks!

"What if business is uncertain about the future so it buys newly produced investment goods of the most long lasting and generic kind and just stores them. Employment still falls and we still have a recession till the uncertainty resolved itself."

If people are directly bartering the services of their labour, land, and machines to buy the goods those services can produce, there is no deficiency in demand, so why should employment fall? It is true that some sorts of investment will be less productive than others, so productivity growth will be slower, but that isn't a recession in the normal sense of the word.

Jim Glass: Important comment, that reinforces my distinction between Keynes' question and the "Keynesian" answer. I had suspected as much, but wasn't confident enough in my history of thought to say so.

Lord: automatic *fiscal* stabilisers, if done for *macro* reasons, are the wrong answer too. But there are very good *micro* reasons for running deficits in recessions (at least, don't try to balance the budget annually).

Steve: "This ignores #4: They can "buy" reduction in their debt to the financial sector. (Don't have to be lump-sum payoffs. Just keep up your monthly payments and use your debit card instead of your credit card, don't draw on your business line of credit, don't issue new corporate bonds, etc.)...When the real sector uses their money to pay off debt to the financial sector,..."

Hang on. You have introduced money. I too introduced money in my version of #4, and said it changes everything.

"For every borrower there's...a bank."

No there isn't. Not all borrowing is borrowing from banks.

And what's important about banks is not their assets -- it's their liabilities. Because a bank is a financial intermediary some of whose liabilities are used as media of exchange. As the macro half of the intro textbooks say: banks create money. ;-)

"Given that additional "spending" option, the only way this post's thinking makes sense, I think, is if "the" interest rate always instantaneously adjusts so that real-sector actors are instantaneously induced (collectively "forced") to borrow more/less in response to other real-sector actors borrowing less/more."

In other words, the only way the economy can avoid excess supply (or excess demand) for goods is if the central banks instantaneously adjusts the actual market rate of interest to equal the natural rate of interest. Which is how New Keynesians would describe it.

"IS/LM embodies, is inescapably dependent on, the logic derived from that fallacy, even while it rather schizophrenically acknowledges endogenous money."

No. The ISLM model can be used (I use it for this every time I teach it) to demonstrate why the loanable funds theory of the rate of interest is false (or, better, a half-truth).

"(Which is why intro econ should at least teach IS/MP instead.)"

Nope. We leave IS-LM (or IS-MP, same difference) to second year.

"He's talking about government furnaces, but it banks have them too."

Yep. See any first year macro textbook!

Alex: thanks!

JCE: "Why would those firms be buying newly-produced investment goods? i don't get that part"

What else would firms be doing with the proceeds of issuing new stocks and bonds?

[Nick Rowe]

Frank: " And so an employee receives compensation in the form of equity shares in the company where no money trades hands and no newly produced investment goods are bought."

Nope. I can issue shares to buy a machine. or I can issue shares to pay the workers to build me a machine. Same difference.

Steve: "Where did all that extra money come from? New borrowing."

See that word there, that you are just throwing around? *"money"*.

K: "The answer, of course, is to lower the real rate to make them buy bikes *now*."

Yep. Or machines that help build future bikes.

[Ralph Musgrave]

Hi Nick,

I agree that shifting production away from apples and towards bananas involves dislocations and inefficiencies, but that’s inevitable given that we allow consumers to change their preferences. But raising the proportion of GDP allocated to investment vis a vis consumption so as to deal with a recession is different.

When consumers in the aggregate try to spend less this year with a view to reverting to normal levels of consumption in a year or two, that’s explained purely or largely by their desire to build up a stock of cash isn’t it? Indeed we’ve been in that situation for a few years now: everyone over-extended themselves before the crunch and now they’re building up cash reserves, paying off debts, etc.

But the latter problem can be solved simply by channelling cash into household pockets, which is a costless exercise in real terms. So there’s no need for the dislocations that derive from expanding the proportion of GDP allocated to investment.

[Noah Smith]

Those two questions are orthogonal. They are two different dimensions. Consumption/investment is North/South; private/government is East/West. A change in the optimal mix between consumption and investment spending has no obvious implications in either direction for the optimal mix between private and government spending.

There is no reason to think these are orthogonal, because there is no reason to think that govt. and private investment (or consumption) are perfect substitutes. Just because the accounting identity is additive does not mean the utility function, or the production function, is additive.

[Nick Rowe]

Ralph: "When consumers in the aggregate try to spend less this year with a view to reverting to normal levels of consumption in a year or two, that’s explained purely or largely by their desire to build up a stock of cash isn’t it?"

That wasn't the question in my post.

Assume people are initially planning to consume 100 each and every year. Then they decide to consume 90 in this year, and 111 next year, then back to 100 again every year after that. (I'm assuming r=10%).

Or, same 100 every year benchmark, assume people decide to consume 90 this year, then 101 next year and 101 every year after that.

You are going to need to increase investment by 10 to deliver this extra goods in the future.

As I said before in a previous post, we should abolish the word "saving".

[Steve Roth]

@Nick: "See that word there, that you are just throwing around? *"money"*."

Guilty!

Don't have time to address this more now...

[Ron Ronson]

"If people are directly bartering the services of their labour, land, and machines to buy the goods those services can produce, there is no deficiency in demand, so why should employment fall?"

In a barter economy where optimism is low why would an owner of investment goods hire labor to produce goods he may not think he can sell? If labor offers to work for less goods than before then this will increase output , but as workers will want to work less hours at this lower rate then output will still be depressed.

I can see how an inelastic money can make things worse by causing confusion between nominal and real values. I can even see how an inelastic money may actually cause the drop in optimism for reasons similar to those given in the post. But in theory I can't see why bad expectations ("animal spirits") couldn't cause a recession (defined as a a drop in output below the optimum level) even in a barter economy.

[Nick Rowe]

Noah: if private and government consumption were perfect substitutes, and if private and government investment were perfect substitutes, then the optimal size of government would be indeterminate (OK, I'm ignoring distorting taxes). It wouldn't make any difference if G were 0% of GDP or 100% of GDP. And my case against fiscal policy would collapse. (On second thoughts, it wouldn't collapse, because if Cg were a perfect substitute for Cp, and Ig were a perfect substitute for Ip, then Ricardian equivalence would apply to increases in G too (the new Keynesian fiscal multiplier would be zero, even if it's a temporary increase in G, even at the ZLB.)

I'm assuming Cg and Cp are not perfect substitutes. I have to assume that.

[Nick Rowe]

Ron: "In a barter economy where optimism is low why would an owner of investment goods hire labor to produce goods he may not think he can sell?"

Those workers, by offering to sell labour, are ipso facto offering to buy goods. The car factory pays car workers in cars.

[edarniw]

Really interesting post. IMO, question #1 gets at the heart of the disagreement between "pure" free marketers and advocates of certain kinds of policy. The former tend to think that there is a mechanism in place to produce the optimal mix, while the latter tend to think that under certain conditions (or in general) the feedback mechanism is absent.

I've read some Hayek and can say that he spent a lot of time studying and writing about how a decentralized system handles the example you gave. That is, if people reduced their orders for present cars in favor of orders for future cars, without specifying those particular future orders, how could producers get it right?

His answer to that example was the "Ricardo Effect". In short, if there is a reduction (increase) in the present money flow in exchange for goods, there will be differential effects on different kinds of producers. Producers with high turnover would experience relatively larger reductions (increases) in revenue compared to producers with lower turnover. This will shift the relative advantage (in terms of resources) to producers with lower (higher) turnover, and in turn shift the economy towards a structure with lower (higher) turnover (or to an economy with a greater proportion of production accruing in the future (present)).

There are some kinks to work out but it's an interesting theory. And I think assuming that there's no mechanism in place to handle the example you gave ignores pieces of information that are present in the economic system.

I'd also argue that, at least in this case, it can be misleading to think of an economic system as a person. That is, asking how a person (or producer) could get a future order right when he/she doesn't know that order. Instead, think of the system as composed of many competing units of different unchanging types (more like an evolutionary system). Then ask yourself what would happen in response to changes of present orders in favor of unspecified future orders. What would happen? Would the system adapt to the change in intertemporal demand?

[Lord]

The solution to monetary policy failure is monetary policy success? Tautological isn't it? Perhaps if we adopted my suggestion of full board resignations upon a recession, I might believe this might work in the real world.

[Ron Ronson]

"Those workers, by offering to sell labour, are ipso facto offering to buy goods. The car factory pays car workers in cars."

Here is my point at the simplest level. A produces apples and B produces bananas. They produce 10 of each and trade 5. One year A and B each fear the other is not going to trade. They produce 8 each and only swap 3. Each would rather consume 10 and not 8, but uncertainty leads to a sub-optimal outcome. You can add in workers who A and B pay in apples and bananas but I don't think it changes the fact that pessimism can drive bad outcomes even without money.

[Nick Rowe]

Ron: Agreed. But your apple and banana producers are unemployed in the same way that discouraged workers are unemployed. They aren't offering their labour for sale, because they don't think anyone would want to buy. We wouldn't actually observe an excess supply of apples and bananas in your economy.

[Frank Restly]

Ron,

"Here is my point at the simplest level. A produces apples and B produces bananas. They produce 10 of each and trade 5. One year A and B each fear the other is not going to trade. They produce 8 each and only swap 3. Each would rather consume 10 and not 8, but uncertainty leads to a sub-optimal outcome."

That is why contracts and the legal system (provided by a fiscal authority) exist. If A and B want to ensure that each produces 10 and trades 5 for a given period of time, they arrange a contract that either can use to seek damages if the other does not hold up his / her end of the arrangement.

[Ron Ronson]

"We wouldn't actually observe an excess supply of apples and bananas in your economy."

I agree that all market would be in equilibrium and clearing unlike in monetary disequilibrium where that is not the case. I'm fine with defining "recessions" as only the latter case. But it seems there will be multiple equilibria(?) depending upon the state of expectations about the future. This will be true in both a barter and a money economy. Some equilibria will be sub-optimal with all parties benefitting from a shift to a different one (such as in my simple example).

[Anon]

Nick:

it's not just about not offering up work for sale. Bananas and apples take time, effort and resources (investment) to produce.

If a pessimistic outlook caused both producers to grow only 8 bananas and apples, then it will cause decreased trade and decreased consumption for the next production cycle: which to them feels very similar to a monetary recession.

Does this scenario lack any key feature of a recession? If not, why not call it a recession?

[James]

"Now suppose people people decided they wanted fewer new cars today and more new cars next year".

Economic messes like the one we're in don't occur because people "decide they want to buy fewer new cars today and more next year''. For some endogenous reason the economy goes into a tailspin and then all of a sudden masses of people find themselves on the street without a job, and investors are running for the hills in fear. The monetarist solution always seems to be "get people borrowing more by lowering interest rates", or "make the very rich even richer by pushing up the value of their assets so they feel a bit more confident". So you've got people kicked out of their jobs and homes, the economy collapsing all around them, and monetarists are preaching that people just need to get more into debt or the rich have to get richer and everything will be okay.

A more sensible approach might be, not to "produce extra buses", but to keep producing as many buses as you had planned on producing, and for the government to increase its budget deficit by lowering taxes and just giving money to people to spend AS THEY SEE FIT.

[Nick Rowe]

Anon: "Does this scenario lack any key feature of a recession? If not, why not call it a recession?"

Good question. My answer: in a recession, stuff gets harder to sell and easier to buy (money gets easier to sell and harder to buy); in a boom, stuff gets easier to sell and harder to buy (money gets harder to sell and easier to buy). That to me is an important stylised fact about the business cycle. A barter model, obviously, could not exhibit that stylised fact. Recessions are always and everywhere a monetary phenomena.

James: let me just take one misconception from the many in your comment:

"The monetarist solution always seems to be "get people borrowing more by lowering interest rates",..."

If the Bank of Canada wanted me to spend more, it would have to lower the rate of interest I paid, to persuade me to borrow more to finance my extra spending. That is true for each individual, but it is not true in aggregate. Because one person's spending is another person's income. If we all spent more in aggregate, we would be surprised to discover our aggregate income had increased by that same amount. Our extra spending would be financed by our extra income. Your comment displays a massive fallacy of composition.

Where the hell did you pick up those daft and confused ideas??

[Max]

"But it seems there will be multiple equilibria(?) depending upon the state of expectations about the future. This will be true in both a barter and a money economy."

Yes. It's strange that some economists assume that if the economy is below its potential, there must be a disequilibrium. But disequilibrium can be the solution rather than the problem.

[James]

"Our extra spending would be financed by our extra income".

like in the recent (and ongoing) private debt crisis, where debt wasn't a problem because extra debt equaled extra income? So the solution to the private debt crisis is more private debt because that will mean more income?

And QE has really done F-all other than make wealthy asset owners even wealthier.

[Too Much Fed]

Nick's post to James: "Where the hell did you pick up those daft and confused ideas??"

I'd say from past and present observation of the economy. I don't consider them daft and confused. I would say some to most monetarists don't seem to believe in more borrowing as a solution, but that means going to defining "money" and how banks work.

"If we all spent more in aggregate, ..."

It is not about all. It is not about patient and impatient. It is more like the rich few and the many others.

[rescued from spam filter NR]

[Anon]

Nick:

You are right, with your definition recessions are necessarily monetary.

But isn't that argument employing circular logic, the result of an overly restrictive definition? You define recessions as something necessarily involving money, hence, per definition, recessions are monetary. Q.E.D.

In economic analysis, wouldn't it be more meaningful to define recessions based on the investment, production, trade and consumption patterns - thus allowing barter based economies to exhibit them as well, at least in theory?

Furthermore, wouldn't it be more meaningful to take existing historic recessionary episodes of monetary economies and analyse whether if those initial conditions are fed into a barter economy, they would produce similar (recessionary) outcomes? That way we wouldn't even have to define recessions, the data series defines them.

[Anon]

James, "Too much Fed":

In your replies you have not addressed Nick's criticism of your views and you have not addressed the fallacy of composition mistake you committed.

If you are interested in a scientific discussion please respond to Nick's criticism directly, instead of mostly just repeating your previous statements.

[A H]

Keynes's answer was to pay people to bury gold in the ground and dig it back up again. It's still the best answer to the problem.

[Nick Rowe]

Anon: You are right of course, down to your "QED". And sometimes I do think there might be something to those multiple equilibrium/barter models (like the dance, where the boys go if they expect the girls to go, and the girls go if they expect the boys to go, so we may get multiple equilibria). Those models do explain some things well, and maybe they explain business cycles too?

In response to your questions: Dunno. There's something weird about ignoring data (OK, maybe more stylised impressionistic facts than hard data). A theory that fits data A plus B is better than a theory that fits A and is silent on B. Plus, we might simply be interested in explaining data B in it's own right. I sort of did a post on this once.

Dunno. I'm still thinking about that one.

[Nick Rowe]

AH: But it would be much better just to give them the (paper) gold, rather than make them work to dig it up. Sure, the latter "creates jobs", but those are totally pointless jobs, that don't produce anything. Leisure beats work, unless the work actually is productive.

[Ralph Musgrave]

Nick, OK – so your question was what to do when consumers want to consume “90 this year, and 111 next year, then back to 100 again every year after that.” I agree that in that case investment spending can make up for the lack of demand “this year”.

But the really important question here (particularly as far as maximising GDP goes) is whether consumers ever actually try to do that. As I intimated above, I doubt it. That is, I see no reason why consumers in the aggregate should decide to consume less this year OTHER THAN because of an attempt to build up cash reserves or pay off debts (which is what they’ve been doing for two or three years now.)

And assuming that’s what they’re trying to do, then I think my solution (channelling cash into household pockets) is better than upping investment spending.

Please note I greatly appreciate the time you devote to discussions with me and others on your blog.

[Nick Rowe]

Thanks Ralph. And i find it rewarding (as well as sometimes a little frustrating!) arguing with you.

In this particular case it's rewarding, because you sort of have a point:

Imagine a very simple economy. People live forever, and are identical. Initially there is no saving or investment, and nothing ever changes over time. And everybody holds some (central bank) cash (and I mean "cash" literally, in the sense of currency they use as money).

Let's now imagine two different ways things could change:

1. For some reason, people decide they need to hold a larger average stock of cash. (The desired velocity of circulation has fallen).

2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future.

In both cases desired "saving" has increased from zero to some positive number. (But "saving" is such a bad word, because it doesn't distinguish between 1 and 2, and I would prefer to use the word "hoarding" instead for 1.)

One solution in 1 is to print more cash and hand it out. (There may be others, like an open market operation that sells them cash in exchange for bonds, and which is best may depend on whether the increased demand for cash is temporary or permanent, and on whether there are lump-sum or distorting taxes, etc.)

The solution for 2 is to increase investment above zero. Because it delivers the extra consumption in future periods.

Are we on the same page? I think we are.

[Anon]

Ralph: channeling cash into public investments is pretty close to channeling cash into pockets: the government does not hoard, thus public spending will be private sector income.

It also doesn't have the moral hazards of giving people money directly: the money is given to build stuff citizens find useful (roads, tunnels, bridges, hospitals, schools, etc.) - and distributed to a large group of people in the private sector.

[derrida derider]

"Assume a closed economy ..."

Well there's your problem right there. That's a remarkable assumption for a Canadian or an Australian (like me) - we are heavily dependent on (volatile quantity) capital inflows and (volatile price) commodity outflows. Whatever the results in the US why wouldn't our fiscal stimulus just be frittered away in a devaluation?

[Ralph Musgrave]

Hi Nick, Yes: we’re on the same page. The real $64k question here is: when consumers spend less, is that a desire to consume less now and more in a year or two, or is it a desire to build up stocks of cash / pay off debts? I suspect it’s the latter, but I can’t prove it! And that $64k question is one that would never have occurred to be but for this little debate.

[Frank Restly]

Nick,

I think Ralph introduces a third possibility here:

1. For some reason, people decide they need to hold a larger average stock of cash. (The desired velocity of circulation has fallen).
2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future.
3. For some reason, people decide that they need to reduce their outstanding debt. (The desired velocity of circulation has still fallen).

In 1., there may be a perception of money as a store of value causing people to retain money. In 3., there may be a collapse in net worth inducing people to repair their balance sheets.

[Nick Rowe]

Ralph and Frank: we want to pay down debts to increase our future consumption relative to our present consumption. If my income is $100, my debt is $50, and r =10% my C will be $95 forever if I don't pay down my debt. If I pay off my debt, my current C drops to $50, but my future C rises to $100. "Paying down debt" is not a third category. It is either 1 or 2.

(And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more.)

[Nick Rowe]

Derrida: "Whatever the results in the US why wouldn't our fiscal stimulus just be frittered away in a devaluation?"

I think you meant *re*valuation.

Depends on the model. Sometimes it will, sometimes it won't. Specifically, it depends on expectations of the future exchange rate and on the degree of capital mobility. (Also depends on whether there's a coordinated multi-national fiscal policy.)

Yes, but that's an aside from the main point of my post.

[Frank Restly]

Nick,

"We want to pay down debts to increase our future consumption relative to our present consumption."

Double talk. If my income is $100, my debt is $50, and r=10%, my C can still be $100 as long as I continue borrowing.

Period 1: Income is $100, debt is $50, r=10%, interest expense = $5.00, new borrowing = $5.00, C = $100
Period 2: Income is $100, debt is $55, r=10%, interest expense = $5.50, new borrowing = $5.50, C = $100

The limiting factor on how much I can borrow is the market value of the assets that I own (what I put up for collateral on a loan). And so I can continue borrowing as long the market value of my assets exceeds the value of my liabilities. Your description misses the balance sheet aspect.

[Frank Restly]

Nick,

"And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more."

Also remember that banks have furnaces as well as helicopters. A bank may not "want" its balance sheet to contract, but it may not have a choice in the matter.

[Frank Restly]

Nick,

Period 1: Income is $100, debt is $50, r=10%, interest expense = $5.00, new borrowing = $5.00, C = $100, Market Value of collateral is $200, Asset / Liability ratio is 200/50 = 4:1

Period 2: Income is $100, debt is $55, r=10%, interest expense = $5.50, new borrowing = $5.50, C = $100, Market Value of collateral is $210, Asset / Liability ratio is 210/55 = 4:1

Period 3: Income is $100, debt is $60.50, r=10%, interest expense = $6.05, Market value of collateral is $100

Here I am faced with a choice. I can either try to rebuild my asset / liability ratio or I can try to maintain my consumption. Rebuilding to 4:1 would require me to pay back $35.50 of the loan (leaving $25.00 in outstanding loan balance) or I can try to maintain my consumption (C) of $100.

1. For some reason, people decide they need to hold a larger average stock of cash. - This does not apply to my situation. I was spending more than my income before my asset crashed in value.

2. For some reason, people decide to become more patient, and would prefer to consume less now and more in the future. - This does not apply to my situation. My consumption preference has not changed. I would still like to consume $100 both now and in the future. However, my consumption preference is constrained by the amount of money I can borrow to fund that consumption. My bank also sees that the value of my assets has collapsed and starts getting fidgety on lending me more money.

[Too Much Fed]

Nick, thanks for “rescuing” my post. I believe there are others in spam.

Anon, I'll try again.

"If we all spent more in aggregate, …"

From observation and economic stats, I see some to many spending more on goods/services than they earn and the few spending a lot less on goods/services than they earn.

[Too Much Fed]

"And remember the national income accounting identity. If one person is spending less than his income from producing goods (to pay interest or pay down debt) another person must be spending more."

1) I think there is something wrong there.

2) After listening to JKH and others about accounting, I think paying down debt is flow of funds accounting.

“Ralph and Frank: we want to pay down debts to increase our future consumption relative to our present consumption. If my income is $100, my debt is $50, and r =10% my C will be $95 forever if I don't pay down my debt. If I pay off my debt, my current C drops to $50, but my future C rises to $100.”

Or I could continue to have a C of $95 and only need to have an income of $95.

[Too Much Fed]

Nick, thanks for “rescuing” my post. I believe there are others in spam.

Anon, I'll try again.

"If we all spent more in aggregate, …"

From observation and economic stats, I see some to many spending more on goods/services than they earn and the few spending a lot less on goods/services than they earn.

Sorry if this is a repeat.

[JKH]

Interesting post, Nick. You had me at "orthogonal".

I'm surprised, but I don't know the GT so well.

Are you/Kuehn confident that while Keynes asked that question at that particular chapter in the GT, he also didn't ask the other question somewhere else?

I.e. that he didn't pose orthogonal questions?

Separately, just an observation on one aspect:

"It's when we add "money" to the list of things people can spend their income on, that Say's Law fails. Because if your income comes to you in the form of money, nobody can stop you spending part of your income on money -- you just don't spend it. And if everyone does the same, then we get a recession."

You know this, but that scenario would be depicted with the increase in money balances as a "use of funds" (micro) in macro flow of funds accounting. The "source of funds" would be an increase in household net worth (micro), other things equal. The "spending" you refer to would be classified as a flow of funds but not NIPA expenditure. Perhaps you would view this as accounting getting in the way of the economic explanation, but I would view it as clarifying it.

[Nathanael]

"JCE: "Why would those firms be buying newly-produced investment goods? i don't get that part"

"Nick Rowe: What else would firms be doing with the proceeds of issuing new stocks and bonds?"

Increasing CEO salaries, probably. (Eventually the company would go bust, but that would happen later.) This is the classic stock/bond scam, get a lot of people to lend you money or buy your stock... then walk off with the money. It happens all the time.

his means that it's possible that this "saving" would have purely redistributionary effects -- transferring money from the 99% to the 1%.

[Nathanael]

Nick Rowe: "If the Bank of Canada wanted me to spend more, it would have to lower the rate of interest I paid, to persuade me to borrow more to finance my extra spending. That is true for each individual, but it is not true in aggregate. Because one person's spending is another person's income. If we all spent more in aggregate, we would be surprised to discover our aggregate income had increased by that same amount. Our extra spending would be financed by our extra income. Your comment displays a massive fallacy of composition."

BZZT. You're wrong, Nick, and the guy you were responding to is right, and for one and only one reason.

There are two classes of people: creditors and debtors, or if you prefer, the 1% and the 99%. Aggregates which combine the homeless with Bill Gates are irrelevant. And the problem with most "monetarist" thinking is *precisely* that it ignores the distributional issue.

If the Bank of Canada wants you to spend more money, it has several options, including giving you money outright and hiring you. These are *different* from the option of trying to persuade you to *borrow* more. They are different in an important way. You know what that way is. It's distributional.

Someone who is already deep in debt, and whose expenses exceed his or her income -- that person is simply not influenced to borrow more by interest rates. If that person is crazy enough to borrow more, the bank may not be crazy enough to lend it.

And that sort of person *is the 99%*.

If they are both crazy enough to do so, eventually the bank is going to have to forgive the loan or the borrower is going to have to declare bankruptcy, and while these are both "money-creating" activities which boost the economy, they're very disruptive to people's *trust* in each other and institutions.

That's why in our current situation, it's better to use what is generally known as *fiscal policy* -- the difference between this and so-called "monetary policy" is fundamentally whether there is some expectation that the money will be "paid back".

In monetary policy, there is such a "payback" expectation, and with our economy structured the way it is, that is a disastrous expectation which creates trouble. In fiscal policy, there isn't such an expectation; therefore fiscal policy works in situations like ours, while borrowing-based policy doesn't.