David Levine's accidental Monetarism

I confess this is a bit of a "Gotcha!". But it's a bit more than that as well. It illustrates the difficulty that people (even economists) have in "seeing" money.

Brad DeLong flatters me (but he's right that this is right up my street), then sends me to David Levine. Here's the "money quote" (sorry).

"I want to think here of a complete economy peopled by real people who produce and consume things. Let's say four of them: a phone guy who makes phones, a burger flipper, a hairdresser and a tattoo artist. Let's say that the burger flipper only wants a phone, the hairdresser only wants a burger, the tattoo artist only wants a haircut and the phone guy only wants a tattoo - around the circle in effect. We'll suppose that each can produce one phone, burger, haircut or tattoo and that each values the unit of what they want to buy more than the unit of what they can sell. That is, the hairdresser happily cuts hair if he can get a burger and so forth. What happens is clear enough: the phone guy produces a phone, trades it to the tattoo artist in exchange for a tattoo, who trades the phone to the hairdresser in exchange for a haircut, who trades it to burger flipper in exchange for a burger. All are employed, all get what they want - everyone is happy.

Now suppose that the phone guy suddenly decides he doesn't like tattoos enough to be bothered building a phone. Now the circle is broken and this is a complete catastrophe. Everyone is unemployed. Demand is insufficient. There isn't enough consumption - none at all in fact. And notice how this works: one person - the stupid phone guy who is causing the problem by not wanting to buy a tattoo - is "voluntarily unemployed" - he is lazy and doesn't want to work. The other three are "involuntarily unemployed" each one is willing to work in exchange for pay. The burger flipper would like to work making burgers if he can get a phone, the hairdresser would like cut hair if he could get a burger and the tattoo artist would like to work if he could get a haircut and yet all are unemployed." (bold added).

Notice the bit I bolded. Notice how the tattoo artist accepts the phone in exchange for a tattoo, not because he wants a phone, because he plans to use the phone to buy a haircut from the hairdresser, who doesn't want a phone either, but plans to use the phone to buy a burger.

In this model economy, phones are used as the medium of exchange. And they need to use a medium of exchange because there's a Wicksellian triangle (or quadrilateral in this case) with no double-coincidence of wants, so direct barter won't work.

Now if this were my story, I would translate the metaphor by saying that phones are money, so the phone guy who makes phones is the central bank which makes money. And the stupid phone guy who creates the whole mess by not making enough phones is the stupid central bank which creates the whole mess by not making enough money. It's a very monetarist story.

But that's not where David Levine goes with his story.

"Is the basis of Keynesianism that we should assume that the government has a phone to give away? Well maybe not. Maybe the government should follow Keynes advice and print some money (or bury it) and give it to the phone guy. Then the phone guy can buy a tattoo, and the tattoo guy can buy a haircut and the haircutter can buy a burger, and the burger flipper - ooops...he can't buy a phone because there are no phones."

No. The phone guy is the government (or rather, the government-owned central bank). The phone is money. And so the phone guy/central bank does have phones/money to give away (or sell).

And the neat thing about money is that it can circulate round and round the Wicksellian circle forever, with nobody every stopping to ask "Hey, do I really want this intrinsically worthless bit of paper?", because each person knows that the next person will accept it in turn. And because using money reduces transactions costs, people will hold money temporarily even if the real rate of return on holding money is negative (as long as it is not negative to a Zimbabwean extent). And if Mr Ponzi could have produced an asset so liquid that people would want to hold it even at negative real interest rates, then Mr Ponzi's business plan would have been perfectly sustainable forever. People would pay Mr Ponzi for the privilege of holding his IOU's.

There are no free lunches in standard competitive equilibrium theory. But standard competitive equilibrium theory ignores transactions costs. And the only way the real world can get anywhere near the zero transactions cost world of standard competitive equilibrium theory is if people use money to help reduce those transactions costs. Because n-person barter is (usually) very very costly for n > 2. And if the central bank can produce money for free (they usually make a profit from producing money, even after paying for paper and ink), and if producing more money reduces those transactions costs (because barter is very costly), then there is a free lunch. And our job as economists (I think this is an Arthur Laffer saying) is to find those free lunches and make sure they are eaten.

David Levine's model/story is a very Monetarist model/story. (OK, a Keynesian model/story too, if by "Keynesian" we mean theoretically correct Keynesians who recognise the central importance of the medium of exchange.) But he misses seeing the point of his own model/story because he misses seeing that phones are money in his story.

[From one of my old posts:

The unemployed hairdresser wants her nails done. The unemployed manicurist wants a massage. The unemployed masseuse wants a haircut. If a 3-way barter deal were easy to arrange, they would do it, and would not be unemployed. There is a mutually advantageous exchange that is not happening. Keynesian unemployment assumes a short-run equilibrium with haircuts, massages, and manicures lying on the sidewalk going to waste. Why don't they pick them up? It's not that the unemployed don't know where to buy what they want to buy.

If barter were easy, this couldn't happen. All three would agree to the mutually-improving 3-way barter deal. Even sticky prices couldn't stop this happening. If all three women have set their prices 10% too high, their relative prices are still exactly right for the barter deal. Each sells her overpriced services in exchange for the other's overpriced services.

But barter is not easy. There is no double coincidence of wants here, and it is costly to find all three people in the Wicksellian triangle to do the barter exchange. So people use money.

The unemployed hairdresser is more than willing to give up her labour in exchange for a manicure, at the set prices, but is not willing to give up her money in exchange for a manicure. Same for the other two unemployed women. That's why they are unemployed. They won't spend their money.

Keynesian unemployment makes sense in a monetary exchange economy, where money is what Hahn calls "essential" for trade. It makes no sense whatsoever in a barter economy, or where money is inessential.

Keynesian unemployment is an excess demand for the medium of exchange. It's a coordination failure, because if all three spent the $20 to buy what they wanted, all three would find her purse is a widow's cruse. The $20 reappears as soon as it is spent. But the widow's cruse fails unless all three increase spending at once. And, in Nash Equilibrium, none of the three wants to do that. She prefers the $20 in her purse.]

Comments

[Donald A. Coffin]

Exactly what I thought when I read Brad's post (before I read this)--the cell-phone-theory of recessions...

[Jacques René Giguère]

If you have to dig phones to get them into circulation, you're into a gold standard-bitcoin-euro model. So gold-bitcoin-euro are not money. (musing of an humble IO guy.)

[Nick Rowe]

Donald: yep!

Jacques-Rene: if we used gold as money, and if the price of gold was equal to the marginal cost of mining gold, then yes it's not obvious there's a free lunch. But then the unemployed would immediately head off panning for gold.

[Kevin Donoghue]

Keynesian unemployment makes sense in a monetary exchange economy, where money is what Hahn calls "essential" for trade. It makes no sense whatsoever in a barter economy, or where money is inessential.

This is false. To see why, consider the following case. All households consume burgers. Every household specializes in production, supplying either beef or buns. The utility function is inflexible: every burger must consist of one portion of meat and one bun. Any surplus bread or meat goes in the the garbage. It is obvious that if the butchers believe that the bakers have small appetites, or that they are too lazy to do much baking, then they will respond by producing less meat. The bakers will behave similarly. GDP is determined by the gloomier industry. Keynesian unemployment is the result.

This is Keynes's "magneto trouble" in the simplest possible setting. It is not fundamentally a monetary problem. Of course any half-decent monetary system will resolve such a problem, in such a simple economy. If the producers specialize in the manufacture of consumption goods and capital goods things get more tricky, because time plays a bigger role. But once again, although the solution may be a better monetary setup, that's not the heart of the problem. The heart of the problem is coordination.

It's odd that you mention Frank Hahn; as you surely recall, he's on my side of this issue.

[Nick Rowe]

Kevin: what you say is theoretically possible. And we sometimes observe something like that in micro. No boys go to the disco because there aren't any girls; no girls go to the disco because there aren't any boys. No hi-tech firms because there are no hi-tech workers; no hi-tech workers because there are no hi-tech firms.

But business cycles don't look like that. In recessions it's harder than normal to find buyers of illiquid goods (like labour). But it's easier than normal to find sellers of illiquid goods. It is money that is hard to buy, and easy to sell.

[Majromax]

@Kevin:

> It is obvious that if the butchers believe that the bakers have small appetites, or that they are too lazy to do much baking, then they will respond by producing less meat. The bakers will behave similarly.

That's not a stable equilibrium, because you're believing that both bakers and butchers know (with certainty) false information. If they know false information only probabilistically, then iterating this game and updating priors will resolve unemployment.

Imagine that I'm a butcher, and if assured of ample bun-supply I would prefer to set a (work, leisure) point where I make 10 burgers.

However, I falsely believe that the bakers will only make 5 buns because of rumours of a yeast shortage or somesuch. If I know that with certainty, then I'd only make 5 burgers. The bakers, who misunderstood an undergraduate student complaining about grass being hard to find, would make a similar error and bake only 5 buns, and we're in your described situation.

If I act like I only know of your shortage probabilistically, then things are much better. I *expect* a full payoff if I make 5 burgers, and from then on I have a diminishing (but still greater-than-zero) expectation of return. If I make 6 burgers, then I'm trading a bit of leisure time against the reward from being right (extra burger!) times the probability that my guess of 5 buns was wrong.

Bakers (again) would make a similar calculus, and we'd both be surprised to find out on market day that there were 6 burgers to be had, above our expected 5.

If you'd like a more classical interpretation: equilibrium dynamics don't work as well when marginal returns are very discontinuous.

[rsj]

if we used gold as money, and if the price of gold was equal to the marginal cost of mining gold, then yes it's not obvious there's a free lunch. But then the unemployed would immediately head off panning for gold.

This was the old Austrian argument that Keynes mocked when he suggested that if this would work in a gold standard economy, then why can't the government insert pound notes in bottles and bury them in garbage dumps. Then people would be employed digging for money as well. But if that was OK, wouldn't it be better to employ people to build railroads?

Then everyone misinterpreted this to mean the Keynes was advocating to pay people to dig holes in the ground, when he was pointing out that this is what the gold bugs were advocating as a depression cure.

[M.R.]

Nick, I know you've explained this before, but there's something I still don't quite understand.

Doesn't excess demand for money imply excess supply of bonds? Which would imply high interest rates? How is it that yields on, say, BBB corporate bonds (not "safe assets" and not terribly liquid either) have been so low since the start of 2010? People seem awfully eager to part with money to own them.

Doesn't this cut in favor of Kevin Donoghue's argument?

[Nick Edmonds]

I know some of these stories relate to money, but I'm not sure why this one does. It seems the exchange value of the phone here depends critically on the fact that the burger guy values the phone for its own sake.

In fact, as far as I can tell, once the phone guy decides he's out, there are no possible trades that are Pareto efficient, regardless of any co-ordination issues (unlike your own example).

[Jacques René Giguère]

Nick: the unemployed may pan for gold at low cost (untrue given the troble of getting to the Yukon but still). Bitcoin mining is not not for the ordinary unemployed and is costly. But gold and bitcoin are (bad pun alert) bit player.
But there is no way you can mine euro. At least as long as The Amazing Merkel and Her Ordoliberal Circus play at Brussels-Frankfurt auditorium. Tickets are limited and payable only in Golden Delicious apples. Available from Wolfgand Schaüble after he has spread the orchard with Agent Orange.
(God, how I enjoy mixing my metaphors with bad sarcasm.)

[Vaidas Urba]

Sorry for offtopic

Nick, fund manager John Hussman has published an interesting critique of the monetary thermostat. See the chapter "Fed policy, Granger causality, and the intensity-matching fallacy" at this link:
http://hussmanfunds.com/wmc/wmc150316.htm
I had a twitter debate with him last week, and used some of your blog posts to,defend the monetary policy.

[Nick Rowe]

rsj: suppose we take the money=gold literally. Would there be an externality, so it would be efficient for the government to subsidise gold mining?

MR: If you expect that money will be tight not just today, but in the future too, it is quite understandable that the price of bonds would rise. Expected inflation will be low; desired saving will be high (bad times ahead); and desired investment will be low (why buy new capital goods to produce more goods you won't be able to sell?). Plus, any fall in the natural rate of interest (for reasons unrelated to tight money, like an exogenous increase in saving) would spill over to increase the demand for money, as well as raise the price of bonds.

As Scott Sumner keeps on repeating, nominal interest rates (or bond prices) are not a good measure of the tightness or ease of monetary policy.

The bond market is just one of many markets in which money is traded. If the price of (say) peanuts is perfectly flexible, we would never observe an excess supply of peanuts, no matter how much of excess demand for money there was.

Nick E: If the phone guy decides he's got enough tattoos, and so stops producing phones, the burger guy will stop *wanting* to work to sell burgers, because there are no phones to buy, and so on. The economy will look like Cuba circa 1994, where many people didn't want to work because there was nothing to buy (for pesos) in the stores, and there was nothing they wanted to buy because they weren't working. It was an excess **demand** for goods and labour, and an excess **supply** of money. That looks very different from capitalist economies in a recession. Jobs were easy to get, but what could you spend your wages on?

[Nick Rowe]

Vaidas: try hitting him with this paper: http://econpapers.repec.org/paper/ottwpaper/0201e.htm

Jacques Rene: "But there is no way you can mine euro."

True. Which is why we are forced to rely on central banks mining the right amount on our behalf.

[Lord]

Apparently burgers have a freshness to them that make them unsuitable to form a burger standard, and no one had thought of IOUs yet.

[rsj]

Nick,

yes, absolutely. But it would be even better to pay people to build railroads rather then pay them to dig holes. It would also be much better because when one digs a hole, it's not clear how much gold one will find, but we can pay a regular wage to build the railroad.

Here, I am ignoring for the moment the important disagreement that it is financial assets, rather than money per se, that people want, and that therefore having the government exchange bonds for money doesn't really do a lot to give people more of what they want. But I don't want to be accused of splittism.

[Chris J]

"Very smart", "highly esteemed".... if this intellectual bromance goes any further...

[Jonathan]

Nick,

How does your story of recessions as excess demand for money square with the "standard" interpretation of Keynes? In a NK model with a ZLB, the problem is that the real interest rate is too high, and can't fall because of the ZLB, and nominal rigidities mean that expected inflation doesn't magically rise to lower the real interest rate.

Is that really equivalent to an excess demand for money? It sounds quite different to me. Sure, it's an excess demand for financial assets, or equivalently insufficient demand for current goods, but what does this have to do with money as a medium of exchange? You need money as a zero-interest store of value (to get the ZLB), but that's it.

[Nick Rowe]

Jonathan: an excess demand for a store of value won't create a recession. It needs to be an excess demand for the medium of exchange. Keynes himself was a bit fuzzy on this, in fact wrong. Gessell got it right. Here is one of my old posts where I lay out the argument.

[rsj]

So Nick, you believe that recessions are impossible in a pure credit economy? The way to end recessions is to ban cash and now we can go on blindly believing that deposits create loans?

Or can an excess demand for bank deposits also create recessions? What if the bank offers to pay interest on the deposit? What if the deposit is really a money market fund? How about a fund based on equities?

[Jonathan]

Nick,

Ah, interesting. I will take a look at that piece.

Is this just your view, or do others hold it? It seems inconsistent with what people like Woodford and Krugman say about money in Keynesian models.

Also, how does it fit in with the modern credit/payment system, where "money" is very different than just pieces of paper that circulates? (Okay, that last question is a bit unfair because I don't think anyone has a good handle on how to properly model money. But the current reality does seem a particular challenge to more "monetarist" positions).

[Nick Rowe]

rsj: is "credit" used as a medium of exchange in a "pure credit economy"?

If we use cows as a medium of exchange, an excess demand for cows (due to a sudden fashion for drinking milk) will cause a recession.

"Credit" is just an obfuscating name for IOUs. There are lots of different sorts of IOUs. In some economies, some of those IOUs are used as media of exchange, and others are not.

[Nick Rowe]

Jonathan: "Is this just your view, or do others hold it? It seems inconsistent with what people like Woodford and Krugman say about money in Keynesian models."

It's a minority view, but I don't think I'm the only one that holds it. Leland Yeager held a similar view. Bill Woolsey too. It is inconsistent with Woodford, who IMHO is wrong. Paul Krugman is harder for me to interpret. Sometimes I think he agrees with me, and sometimes I think he disagrees.

I think Woodford doesn't understand his own model. Here is my explication of Woodford's model.

[rsj]

Nick,

Suppose we have N commodities. And the market structure is such that each commodity can only be bought with a special type of script -- a "commodity credit" assigned to that commodity. Thus there are N different commodity credits. And there is a credit market where you can exchange any single commodity credit for any other according to some floating exchange rate.

Now, this market does not have a medium of exchange, right? But it can have a recession if there is an excess demand to save in one of the several commodity credits.

[rsj]

^^script should be scrip. It's a funny word.

[Nick Rowe]

rsj: No. Forget the scrips. You are talking about a Walrasian economy where any of the n goods can be traded for any of the n-1 other goods. *If* you can find a willing seller.

Suppose everyone wants to hold more land. for some reason the price of land does not rise to eliminate the excess demand for land. So what. You can't buy land, because you can't find a willing seller. So the desire to save in the form of land is frustrated. We can continue to trade all the n-1 other goods for each other.

"Credit" just obfuscates.

I have been through this so many times on this blog.

[rsj]

First, credit doesn't obfuscate because the CB doesn't control it. It's a crucial point when debating the best policy approach. Because bonds are just as good as money, an operation purchasing a bond for money by the CB doesn't really help. However, an operation supplying more bonds (e.g. deficit spending) without decreasing the amount of currency does help. It really is about excess savings demands.

"Suppose everyone wants to hold more land. for some reason the price of land does not rise to eliminate the excess demand for land. So what. You can't buy land, because you can't find a willing seller."

Well, that's what happens in a recession -- you can't find a buyer because the price of goods doesn't fall enough, or if you prefer, the price of money doesn't rise enough. It doesn't rise enough because of the zero bound.

[Majromax]

@Vaidas Urba:

Hussman also commits one cardinal sin in his market comment: in his "fed plus other stuff versus growth" chart, he plots the assumed Fed regresion against real output, over multi-decade timescales.

As any regular reader of this blog will know, the Fed cannot target a real variable; monetary policy can only control a (single) nominal variable.

That's not a strict prohibition for two reasons, but neither of them helps Hussman's case:

* The first exception is one of price stickiness. To the extent that prices are slow to adjust, the Fed can drive real output in the very short run. However, we'd expect that to show up in quarter-to-quarter fluctuations rather than year-to-year or decade-to-decade fluctuations.

* The second exception is of stability. If the Fed does its job perfectly and controls nominal output (notwithstanding ngdp non-targeting, etc), then we can reasonably expect a slightly higher long-term real growth rate from a more stable nominal economy. That probably wouldn't show up in Hussman's plot, and it certainly wouldn't look like a first-order effect caused by Fed actions.

An extra half-critique is that Hussman has wholly accepted the "monetary policy is as loose as it can effectively be at 0% interest" argument. It's only a half-critique because the opinion is rather common.

I get the sense that Hussman knows his stuff when it comes to supply-side economics, but he doesn't fully grasp the monetary/demand connection. Reading his market comment and then this blog I can fully appreciate how:

> Start with an estimate of economic growth in the absence of any monetary intervention

is a sensible-sounding comment that is wrong. Just what is "the absence of any monetary intervention?" Hussman goes on to assume it means the Fed Funds rate, but that fails at even the basic Fisher effect: a 5% rate right now would be far too tight, but 5% in 1980 would be far too loose. If you *must* assume that monetary policy means an interest rate, then at least use a proxy of the real fed funds rate.

With regards to his investment practice, I think this is why he got bit by the recent recovery. He planned for another Great Depression, but his methodology discounted that the Fed was actually pursuing a different monetary strategy than the 30s.

[rsj]

^^^ I am wrong about land. I am wrong about the zero bound per se. It's not the same thing as a financial claim. Sorry! I got all heated up.

I think what is getting lost here is the notion that my spending is your income and vice versa. But it is not true that my saving is your investment. I.e. suppose I hold money, as Nick points out. That is not necessarily anyone's investment. But by the same token, if I buy a bond, then that does not need to be anyone's investment either. For example, I can be buying a bond from a short seller -- they sell a bond they don't have, because they believe that I am overpaying for the bond and in a future period, the bond will be worth less. The short seller then keeps the cash against the (negative) bond position. No investment arises from this.

Similarly, if I repay a loan to a bank, then the bank merely marks down my balance with them and also marks down its asset. No investment arises from this either. In the above cases, you need a paper claim. I.e. you cannot short sell a real good, or mark down a real good. Land doesn't work.

My disagreement is not that holding cash can't be a form of savings that does not result in investment but rather that acquisitions of paper claims are the more general thing to consider. And here we want "liquid" paper claims in the sense that they can be shorted easily, so this also means short dated bonds, or risk free bonds. Basically things "close to money", where the closeness need not be that they are mediums of exchange but that they have relatively stable value with respect to money and can be shorted or marked down.

One such example would be if the CB hikes rates and causes a recession. We agree, I hope, that in this case we are not at the zero bound and yet there is a recession. Well, if someone wants to save and tries to bid down the yield of bonds below what the CB sets, a short seller will arbitrage this and create a new bond and sell it to the saver, if the saver tries to buy a bond for less yield than the rate set by the CB. We agree, I hope, that this is the mechanism by which the overnight rate propagates to other rates. The income saved by the bond buyer just disappears. It does not cause any investment to occur. All of the above requires sticky prices, of course.

So (IIRC) Keynes' more general argument, in the sticky price setting and assuming that households save by purchasing paper claims, was that when savings demands exceed investment demand at the going rate, then income adjusts downwards so that the at the lower income, savings is equal to investment. It's assumed that as income drops, savings demands fall.

This seems to me a very nice and coherent story that encompasses the "excess savings of currency" as a special case. But the advantage of the more general case is that the impotence of the CB is clear at the zero bound.

[Richard H. Serlin]

Is there anything intelligent/useful in Levine's post?

And why do you think he could be saying these things?

Example: Casey Mulligan, tenure at Chicago, but read some of the things he writes. There, it's so obviously stupid, I think it has to be either: (1) He's willing to go to great lengths to lie/mislead for his libertarian ideology, (2) He's really detached from reality, but good at math, and an extreme workaholic from childhood, and that got him tenure at Chicago, (3) He really wants to prop up the value of the models that got/get him so much money, position, and prestige by making ridiculously over-literal interpretations, (4) To a large extent the guy's crazy. Or, some combination of the four.

But if you're not too unwilling to be honest on record, what do you think is going on with Levine's reasoning for saying this. You appear to think he's at least largely wrong. Why then is a guy who could get tenure at UWSL saying these wrong things, that Krugman, et. al imply are obviously wrong?

[Nick Edmonds]

"That looks very different from capitalist economies in a recession."

Yes. And when I actually read the Levine article (after I posted my comment here), I realised that his very purpose was to describe a situation which was not a monetary problem. To which my immediate response was: "Well fine, but that's not the problem that Keynesian policies are intended to address".

[Min]

The phones are Gesellian money. They self-destruct in each cycle. :)

[Nick Rowe]

rsj: "But by the same token, if I buy a bond, then that does not need to be anyone's investment either."

If there is an excess demand for bonds, will you actually be able to buy a bond? Nobody wants to sell.

There are two ways to get more money (medium of exchange): buy more money; sell less money. If you can't buy more money, because money is in excess demand, you can still sell less money (buy less other stuff). It doesn't work with bonds, or anything else, because there is not a steady flow of bonds both into and out of our pockets. But it works with money, because if we can't increase the flow in we can (as individuals) still decrease the flow out. But when everyone reduces the flow out, we get a recession.

Richard: everybody gets stuff wrong. Nobody understands money properly. Because money is weird. I have seen Paul Krugman get money wrong too. I expect I do too, but it's harder to see your own mistakes.

[Richard H. Serlin]

I don't know, this seems like more than just getting money wrong.

How do you explain some of the amazing things Casey Mulligan says? He got tenure at Chicago.

How do you explain some of the incredibly literal interpretations to reality of models you see from professors with tenure at top universities? (Krugman calls this considering the model "The Truth".)

These aren't just trivial questions. Because if we could understand this better, we could perhaps prevent a great deal of harm and confusion.

[Nick Rowe]

Richard: I don't know. (And I haven't read much of Casey Mulligan.) But this is not a right/left thing. Think about some of the daft things Marxists say. Then think of some of the even dafter things post-modernists say. (I'm beginning to suspect that pomo is really just performance art.) Or it may just be that we can't see our own daftnesses, if everyone around us is daft in the same way.

[rsj]

Nick,

"If there is an excess demand for bonds, will you actually be able to buy a bond? Nobody wants to sell."

That is impossible in the bond markets, which always clear. I will write "IOU" on a piece of paper and sell it to you. No one can run out of IOUs like they run out of apples. In fact, just offer to buy a bond for a little more than the expected time path of future short rates, and you will be overwhelmed with arbitrageurs willing to create a new IOU just for you.

"There are two ways to get more money (medium of exchange): buy more money; sell less money."

No, you can create more money on demand. Just borrow it from the bank, which will create it for you. This is just like the bond.

I don't think it's helpful to assume that financial operations, whether the acquisition or disposition of financial assets be assumed to move in some lockstep with real operations of consumption or investment. That would be as erroneous as assuming a fixed velocity of money, or some fixed reserve multiplier.

[Nick Rowe]

Under the gold/wheat/peanut/IOU standard there can never be a shortage of money. You can always get more money by selling gold/wheat/peanuts/IOUs to the bank. Recessions are caused by the price of gold/wheat/peanuts/IOUs being set too low.

[Richard H. Serlin]

Marxists have no power whatsoever in economics academia, or the Democratic party, so it's not relevant. These freshwater economists with the ridiculous over-literal interpretations of models to reality have great power to control economics academia, and in the Republican party. It's nowhere near equivalent on the other side.

[Richard H. Serlin]

Plus, there's much more of an effort by the Saltwater/Democratic side to try to understand the reasoning and theory of the other side, and see if it can be useful, than vice-versa. There's an attitude of pragmatism.

[Roger Sparks]

Your second story has all participants already holding money. They have a problem in that each would rather hold than spend, with the result that all are unemployed.

"Keynesian unemployment is an excess demand for the medium of exchange. It's a coordination failure,................"

I am thinking that there must also be a lack-of-confidence factor here as well. Perhaps it is a 'fear' factor. Perhaps it is a 'momentum' factor. The common element would be the condition (or 'attitude') change between "confident expectation that $20 spent today will be replaced by $20 to be received tomorrow" and "apprehension of irreplaceable loss of the $20 I already have, perhaps due to inflation."

Can government restore confidence with QE programs? The results of examples are not very favorable.

[Richard H. Serlin]

Me personally, I spend most of my five minutes per week of free time on one of the main models the freshwater cite for many of their claims, Wallace '81. After a couple of years I think I really have it nailed (life's achievement post, for me, forthcoming), and behind the opaque wall of math I see very much unmet requirements and assumptions such that its irrelevance proposition can very far from hold in the real world.

[Nick Rowe]

Richard: "Marxists have no power whatsoever in economics academia, or the Democratic party, so it's not relevant."

That is a very economics-centric, and also very US-centric, view of the world. Look outside the economics department in academia. And I'm not exactly sure what "cultural Marxism" is, and whether it really is Marxism, but I read enough US stuff to know there's some weird stuff that gets believed in the Democratic party too, and that they are not very willing to look at the other side of some issues. Or even tolerant enough to let the other side speak. Many Democrats look to me like Blank Slate Creationists, for example. They are certainly not pragmatists. (Canada is no better.)

[M.R.]

Nick, would it be correct in your view to say that tight money (or, excess demand for the medium of exchange) exerts upward pressure on prices of bonds and downward pressure on the prices of everything else?

I need to re-read this post of yours: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/05/islm-money-interest-rates-and-luck.html

[Nick Rowe]

MR: tight money exerts downward pressure on the prices of most things. (But it might exert upward pressure on some goods, like inferior goods for example, the demand for which rises in a recession). With the price of nominal bonds (promises to pay future money), there are two effects: tight money today pushes the price of bonds down, and expected tight money tomorrow pushes the price of bonds up. Net effect can go either way.

[Andy Harless]

Nick (in reply to Kevin):

"But business cycles don't look like that."

Seems to me they do: firms don't hire because nobody's buying; households don't buy because nobody's hiring. It's convenient for the individual firms and households that they have other assets (money &c) to hold when they choose not to hire and buy. It's also convenient for policymakers that they can juice the recovery by making those assets plentiful and hence relatively unattractive at the margin. But it's not clear to me that the underlying problem is about money and wouldn't also occur in a barter economy.

[Nick Rowe]

Andy: think about Cuba 199X. M/P was too high (and prices were fixed). Firms can't hire because nobody's selling labour. Nobody's selling labour because nobody's selling goods. Nobody's selling goods because they can't hire the labour to produce those goods.

It's the exact mirror image of capitalist recessions. (And when I taught macro there I spent a lot of time talking about the Repressed Inflation region, where there is excess demand for both labour and goods.)

[Min]

Richard H. Serlin: "Plus, there's much more of an effort by the Saltwater/Democratic side to try to understand the reasoning and theory of the other side, and see if it can be useful, than vice-versa."

Well, it seems to me that there is much more of an effort on the Republican side to try to understand the theory of the other side, because of the Inner Lawyer effect. You can see that clearly in opposition to climate science among conservatives, where opposition increases with education level. The educated opponent studies the reasoning of the other side intensely in order to come up with counter-arguments. OTOH, Palinesque rhetoric is easy for Democrats to dismiss.

[Majromax]

@Roger Sparks:

> Can government restore confidence with QE programs? The results of examples are not very favorable.

There are two critiques here.

The first is that we have a 1930s counterfactual, where the government initially didn't do any sort of QE. Tight money in a monetary recession made things far worse than in the recent financial crisis.

The second is that QE is not terribly well-implemented at first instance. It's better than nothing, but QE comes with the expectation that somewhere between nearly-all and all of the easing is temporary. That means that QE may be "money today but not money tomorrow." The feedback is even strongly negative, in that signs of an improving underlying economy are a signal that QE will be withdrawn faster than anticipated. (However, QE does mean "a bit of money today and not less money tomorrow")

The expectation is more sensible with a level target, either of NGDP level or price level. There, everyone has the expectation that the central bank will "make up" for an unanticipated deficiency, so 'no money today' actually means 'more money tomorrow.'

[Nick Rowe]

Roger: I missed seeing your comment. But Majro gave a good answer.

[rsj]

"Under the gold/wheat/peanut/IOU standard there can never be a shortage of money. "

OK, that is one way of looking at things. But, it's always about nominal IOUs, as that is what firms use to determine when to invest and what households use for smoothing their consumption or purchasing durables. If you decide to target the current price of peanuts, then you end up making the interest rate tied to the transformation of peanuts, which is going to make economic management difficult. E.g. if there is a productivity shock that improves the peanut-own-rate via a shift to the MPP, then that corresponds to an interest rate hike and the economy goes into a recession. So since you are going to be responding to changing savings and investment demands anyways, you might as well use the interest rate directly as your target.

In the gold standard era, for example, the primary tool of maintaining the peg was interest rate policy, not quantity shifts in the buying and selling of gold. When nations wanted to attract more gold inflows, they raised rates.

[baconbacon]

Phones aren't money in this case because the Burger guy wants the phone for its function as a phone- all people in the example are unemployed under either condition because they all get what they want and stop working, or can't get what they want and stop working. This matters because when you replace phone guy with a CB the CB has no idea who to give the phone to. In the example each of the tattoo, burger and hairdresser (T, B, H) each have identical demand for a phone, but giving the phone to B leaves T and H unemployed. If the CB held an auction somehow B would also be the highest bidder since he wouldn't incur the transaction costs that T and H do, as the phone is his end good. What looks like money in the early stages of exchange, looks like not money once it hits B's hands.

We can stretch this example a little further. If the CB produces 1 phone and gives it to B the demand for money has been met just as much as if they had given it to T. With B's desire for a phone met H no longer wants one, so T no longer wants one. As far as the CB knows they have produced exactly the right amount of money and all UE is voluntary.

We have seen real world examples of this recently. When banks hold cash as reserves for the sake of meeting requirements or as collateral then money stops flowing away from these institutions. Again, due to transaction costs, the banks that want the money the most are the ones that plan on doing nothing with it. Satisfying the liquidity demands of these institutions doesn't add cash to circulation but "converts" it (for lack of a better term) into a phone in B's hands. It is no longer a medium of exchange, but a good in its own right.

[Jussi]

This was interesting: "one of my old posts where I lay out the argument."

Make sure you read comments too if you find it confusing like I did.

[djb]

"Keynesian unemployment is an excess demand for the medium of exchange"

I'm impressed

sometimes people have something to barter (rather sell) for the medium of exchange, sometimes they only have their labor to exchange, sometimes they are so disabled or elderly that they dont have anything to exchange

but either way, sounds good to me

[Nick Rowe]

bacon: there are commodity moneys too. If we use cows as money, some people might still want to eat a cow, or want it for the milk.

But in today's world, we don't use commodity money. So if David Levine's story is a parable about the real world, the "phone" is just a bit of paper.

Jussi: thanks. I think that was one of my better posts.

djb: yep. But if some people are too disabled to work and earn income, it's not a problem of insufficient money or AD in the economy. There would be a problem even in a barter economy. We need taxes and transfer payments to fix that problem.

[baconbacon]

Nick: the phone is clearly not money when B receives it, and it is limited in its "moneyness" depending on whe gets the phone first between H and T. Giving money to B in this scenario actually destroys H and T's demand for money without employing them- this has serious implications for monetarism (especially with regard to paying IOR to raise rates in the future).

[Too Much Fed]

"The unemployed hairdresser is more than willing to give up her labour in exchange for a manicure, at the set prices, but is not willing to give up her money in exchange for a manicure. Same for the other two unemployed women. That's why they are unemployed. They won't spend their money.

Keynesian unemployment makes sense in a monetary exchange economy, where money is what Hahn calls "essential" for trade. It makes no sense whatsoever in a barter economy, or where money is inessential.

Keynesian unemployment is an excess demand for the medium of exchange. It's a coordination failure, because if all three spent the $20 to buy what they wanted, all three would find her purse is a widow's cruse. The $20 reappears as soon as it is spent. But the widow's cruse fails unless all three increase spending at once. And, in Nash Equilibrium, none of the three wants to do that. She prefers the $20 in her purse.]"

Let's say there is $20 total in this economy with $0 being saved.

Now the hairdresser decides to save $20. The saving causes the recession?

[Too Much Fed]

Jonathan said: "Is that really equivalent to an excess demand for money? It sounds quite different to me. Sure, it's an excess demand for financial assets, or equivalently insufficient demand for current goods, but what does this have to do with money as a medium of exchange? You need money as a zero-interest store of value (to get the ZLB), but that's it."

What if "money" gets redirected from NGDP of goods/services to "NGDP" of financial assets/saving vehicles?

[Too Much Fed]

rsj said: "Or can an excess demand for bank deposits also create recessions?"

I'm going to say yes here because "bank deposits" are both MOA and MOE.

Jonathan said: "Also, how does it fit in with the modern credit/payment system, where "money" is very different than just pieces of paper that circulates? (Okay, that last question is a bit unfair because I don't think anyone has a good handle on how to properly model money. But the current reality does seem a particular challenge to more "monetarist" positions)."

I'm going to say "bank deposits" and currency are both MOA and MOE. The commercial banks do not allow their "bank deposits" to rise in value. The central bank and deposit insurance do no allow the "bank deposits" to fall in value. The "bank deposits" stay fixed in value to currency. It just happens to be fixed 1 to 1.

[Too Much Fed]

"As Scott Sumner keeps on repeating, nominal interest rates (or bond prices) are not a good measure of the tightness or ease of monetary policy."

I don't agree with that. Let's assume pre 2008 in the USA. "Monetary policy" used market interest rates and the fed funds interest rate thru the commercial banks. I am pretty sure the true commercial banks can't hold stocks and commodities. Market interest rates and the fed funds interest rate were attempts to control the amount of bonds issued and repaid. The amount of bonds issued and repaid affected mostly demand deposits in circulation, MOA and MOE (money).

I've ignored levered hedge funds here. I've ignored "friend" borrowing or as Steve Keen has recently said peer to peer borrowing (Some entity saves and another entity borrows that saving 1 to 1).

[na]

It's commodity money, not fiat money. Big difference. Levine added an addendum which you may want to read. Clearly he "knows" what money is in his own model.

[Nick Rowe]

na: thanks. I have now read the addendum.

Let's run with it. The phone guy really is a producer of phones, and not the central bank.

Compare David's parable to a world where we use gold as money, and there's a supply of new gold from the mines, but also an industrial demand for gold for dentistry. What happens if the gold miners stop mining gold. So the money supply drops. What happens next depends on whether prices are sticky or flexible:

If prices are sticky, there's a standard recession, due to an excess demand for money. That's the trouble with a gold standard. The solution is to have the central bank produce paper gold, buy assets to get the paper gold into circulation. And if the supply of gold increases again in future (or if the demand for gold drops) it can buy back the paper money.

If prices are perfectly flexible (as David assumes in his addendum) prices drop until the real stock of money is restored to its original level. There is no recession.

***The reason David gets a recession is that he assumes the money supply drops to zero. There are no phones at all. *** Yep, that will do it. You can't have monetary exchange if there is zero money.

[Nick Rowe]

I see Steve Williamson has joined in. OK. I'm just heading off for the weekend. So this will have to wait till I come back. But yes, if gold producers stop producing gold, that is indeed a problem for people who want gold to fix their teeth, or for airbag switches. But it doesn't have to cause a recession, by disappearing the money supply.

[Majromax]

I find David's addendum flawed for another reason, where he posits two different scenarios:

>> On the other hand, if the phone guy decides he doesn't want to make phones, giving him a second dollar doesn't seem to solve the problem - he could trade the extra dollar around the circle, but in the end he would have to exchange a phone for a dollar - which we just agreed he doesn't want to do.

This is a supply side recession -- stuff doesn't get traded because nobody can buy phones. If prices are a bit flexible, the prices of phones will go up, and the quantity of phones supplied will go down.

If prices fully adjust and the market clears (say, the phone guy agrees to sell half a phone), then the number of goods exchanged goes down from the original equilibrium.

>> The idea seems to be that the phone guy decides - because of the loss of his retirement portfolio or whatever - that he wants to have a second dollar more than a tattoo. So indeed the economy collapses.

This is a demand side recession -- stuff doesn't get traded because the phone guy isn't buying anything. He's still willing to sell as many phones as he can make, so the price of phones goes down (in terms of tattoos or haircuts or dollars) and the quantity supplied may or may not go up.

If prices fully adjust to an equilibrium level, then the number of goods exchanged does not go down. (It might go up, or it might return to the prior equiilbrium with all the prices re-marked in terms of dollars).

The latter is a monetary recession. A monetary economy can function no better than an N-way barter economy, where everyone purchases and sells all goods simultaneously with our Walrasian auctioneer to manage things.

>> Perhaps if the government gives everyone an extra dollar - and so prices double - the phone guy will decide on account of inflation that he really wants four dollars not two for his retirement?

If we're thinking in real terms, then let's think in real terms. Wanting two original dollars for retirement means that the phone guy wants two tattoos in retirement. On the barter market, that means that the relative price of goods will adjust such that one phone trades for 2 "IOU 1 tattoo" chits, or some other point where everyone is mutually dissatisfied.

That adjustment is easier if the price level increases, since prices can change at different rates.

>> What does it mean that there are "glutted markets" in Kamchatka?

That Kamchatkan workers are idle, that Kamchatkan factories are rusting, and that Kamchatkan fields are going fallow, but that all of these things could be resolved if Kamchatkans could sell their efforts at a lower price.

[Market Fiscalist]

In Levine's model, after the phone maker's desire for leisure increases , then the optimum situation becomes the situation where no goods are produced and any actions by the government will make things worse.

Move from an economy based on phones being the commodity money to one where there is fiat money. What happens if the authorities target NGDP? By increasing the money supply they can probably keep economic activity going and NGDP on its target path. But it can only do this by fooling the phone maker into thinking he can sell his phone for more real goods than he actually can. Targeting NGDP actually moves the economy out of equilibrium.

Levine has identified a situation (changing relative demand for leisure over work by some people in the economy) where targeting NGDP is sub-optimal.

[Majromax]

NGDP targets in the sense we mean here are not possible in Levine's model, since he's assuming essentially fixed prices (especially relative prices). Without a meaningful price level, NGDP targets are RGDP targets, which are themselves not possible as a long-term goal of monetary policy.

[Min]

Richard H. Serlin: "And why do you think {Levin} could be saying these things?"

Well, I finally had a look at Levin's post, and it seems to me that he intends his toy economy to be a counter-example of Keynesianism, specifically the idea that the gov't can cure general involuntary unemployment by injecting (gov't) money into the economy. It is important for his argument that phones are not considered money, even if they are the medium of exchange. Otherwise the gov't could give the tattoist a phone in each cycle and keep the economy going. (But how does the gov't get or produce the phones?)

Levin makes it clear that he does not consider his toy economy to be anything like a real economy. He is using it to make a logical argument.

However, does he have Keynesianism right? Does it apply to his toy economy? I don't think so, because the toy economy lacks gov't money to start with. The diagnosis of John Stuart Mill does not apply, and, I guess, neither does Keynes's policy.

[Min]

It seems to me that Levine makes another couple of slips in the quoted material. (Sorry, it's Levine, not Levin.)

Levin: "What happens is clear enough: the phone guy produces a phone, trades it to the tattoo artist in exchange for a tattoo, who trades the phone to the hairdresser in exchange for a haircut, who trades it to burger flipper in exchange for a burger."

Beg pardon, but that that happens is not at all clear. In fact, we have a nice classroom experiment here, where you can use tokens to represent the different goods and services. For instance, the hairdresser can write "Haircut" on a slip of paper and hand it to the customer. My guess is that each player will succeed, but not in the manner Levine posits. I also guess that if you have longer chains, you will reach a limit to the length of the chain beyond which there is no solution in a reasonable length of time.

Levin: When no phone is produced, "Everyone is unemployed. Demand is insufficient."

That is correct, but it gives the impression that the problem is one of demand. Yes, the demand for tattoos is insufficient, but so is the supply of phones. Supply is also insufficient.

[Min]

Note also that Levine indulges in some rather strange moralizing.

Levine: "And notice how this works: one person - the stupid phone guy who is causing the problem by not wanting to buy a tattoo - is "voluntarily unemployed" - he is lazy and doesn't want to work."

The phone guy is stupid? He is also lazy? Where is that coming from?

[Niveditas98 .]

I read this post and some other unobtainium posts, and I must confess I don't understand the "unobtainium" controversy over Walras's law.

Walras's law says that if there is an excess demand for unobtainium, there must be an excess supply of other goods. This is true when agents reveal their notional demands, since they wish to sell other goods and purchase unobtainium at any price vector that includes a finite price of unobtainium.

You say that well the agents are smart, realize that unobtainium has no supply, and hence do not demand unobtainium and instead plan to purchase other goods with their production. But if this is the case, then there is no excess demand for unobtainium: the demand (zero) equals the supply (also zero); and hence there is no reason to expect excess supply in the other goods.

The other argument, that in the presence of money, there is not one price vector for n goods that agents see, but rather n 2-price vectors (for each good vs money), and this can result in an excess supply (or excess demand) of all n goods, makes sense. In this context, though, I don't understand the distinction that some people draw between a medium of account and a medium of exchange. It seems to me that anything that is to have value as a medium of exchange, must also have value as a medium of account (or be instantly convertible into the medium of account, which amounts to the same thing). If you had scrip that only had value as a medium of exchange, but could not be "stored", it would be useless in solving the coincidence of wants problem, since you would only accept scrip in return for a haircut if you simultaneously had arranged to exchange that scrip for a manicure, and the manicurist would only accept the scrip if she had simultaneously arranged to exchange that scrip for a massage, and the masseuse would only accept that scrip if she had simultaneously arranged to exchange it for a haircut. The scrip adds no value whatsoever over a pure barter economy in this case.

[Nick Rowe]

Nive: Suppose I want to buy 100 apples, but I am rationed and know I can only buy 60 apples. I might buy 40 pears instead, but if you asked me if I wanted to buy 40 extra apples I would still say yes. If we say it your way, then all excess demands (and supplies) are always zero, as soon as people realise they cannot buy (or sell) as much as they want to buy (or sell).

[Niveditas98 .]

Nick, I think my point is that you're defining excess demand in one way for the apples, but excess supply in a different way for pears.

i.e. if I were to ask you, "at these prices, would you want to buy apples and sell pears", you would say yes to both those questions. If I asked you, "at these prices, knowing that you cannot buy more than 60 apples, would you want to buy more apples and sell pears", you would answer no to both questions.

[Niveditas98 .]

To put it another way, once you've hit your constraint, apples are no longer meaningfully part of the market. This is entirely clear in the case of unobtainium -- if you are accounting for the fact that it is in zero supply, there is no meaningful sense in which there is an unobtainium market -- everything is the same as it would be if there were no such good.

[Nick Rowe]

We observe a line of unemployed workers looking for jobs. We do not observe a line of unemployed workers at the car dealer telling them about the cars they would want to buy if they could get a job.

[Min]

Nick Rowe: "We observe a line of unemployed workers looking for jobs. We do not observe a line of unemployed workers at the car dealer telling them about the cars they would want to buy if they could get a job."

So you are saying that there may be a desire for cars by the unemployed, but not a demand for cars?

[Nick Rowe]

Min: Using the normal terminology, there is a "notional" demand for cars but not an "effective" (or "constrained") demand for cars. Clower is the man on this.

http://en.wikipedia.org/wiki/Effective_demand is not bad.

[Min]

Thanks, Nick! :)

[Niveditas98 .]

Nick, I don't understand your comment about jobs and cars.

My point is that you are comparing an unconstrained excess demand for apples with a constrained lack of excess supply of pears, which makes no sense.

You have to pick one or the other for all the goods. Either say that because you say you would trade pears for apples if given the chance, there is both excess supply of pears and excess demand for apples; or say given the constraint, you are not trying to buy apples, nor are you trying to sell pears.

You can't have it both ways, saying you want to buy apples, but you don't want to sell pears because you recognize the apple constraint.

[Niveditas98 .]

Remember that this is still a barter economy -- you cannot say you want to buy apples without specifying what you want to sell in exchange. If given the constraint all other markets were clearing, your statement that you want to trade pears for apples, is equally a statement of excess demand for apples and excess supply of pears.