04 Jan 2010

Mankiw’s Baseless Arguments

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My article at Mises today is a bit long, but only because it has everything: Sarcastic quips about Greg Mankiw’s logic, a discussion of M0 versus M1 and M2, and a fun story about a real estate developer (Shady Slick) who is ruined by a bureaucrat. I would have put in a love triangle but the editors cut me off.

Seriously, I had an epiphany about the deflationist camp’s arguments concerning bank balance sheets and the money supply. Here’s the kicker for that part of the article:

Now here’s where the deflationists go wrong: I think many of them assume that somehow the money supply must have shrunk in the economy because of Slick’s default on his loan. But that’s not true.

The checking accounts of the union contractors, shingle manufacturers, and so forth still have (collectively) the $900,000 that Slick originally spent on their products and services. Thus, even though the total value of outstanding loans dropped by $990,000 because of Acme’s write-down, the total value of checking or demand deposits didn’t drop at all. This is true, even though it took a loan to originally push up the total value of demand deposits. (In contrast, if Slick had paid off his debt rather than defaulting, and then Acme didn’t extend new loans, it is true that the money supply [M1] would have shrunk by $900,000.)

As I said before, I’m not trying to make an empirical case for what is currently happening in the US economy. I’m just pointing out that some of the glib deflationist arguments are incomplete. People who are expecting the money supply to collapse are overlooking some serious gaps in their argument.

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