01 Oct 2010

The Second Sign of Insanity: I Agree With DeLong on Money Demand

Economics, Financial Economics 8 Comments

Uh oh, I think you guys may need to organize an intervention. First I say that a general overproduction is possible. Now, even more alarming, I was reading DeLong (from a Krugman link), waiting to pounce, and found myself saying, “Yes, yes, I like what you’ve done here…” (That’s a Mike Myers quote from Wayne’s World 2, I believe, but I can’t find it on YouTube.)

DeLong is criticizing David Beckworth, who had claimed that the economy currently suffers from an excess demand for money, and therefore the Fed just needs to create more money to fix things. Here’s DeLong’s answer:

The hole in David’s argument is, I think, where he says “the Fed adjusts the money supply” without saying how. Suppose that we have a situation–like we have today–where people are trying to cut back on their expenditure on currently-produced goods and services in order to build up their stocks of safe assets: places where they can park their wealth and be confident it will not melt away when their back is turned. They switch spending away from currently-produced goods and services and try to build up their stocks of safe assets–extremely senior and well-collateralized private bonds, government securities, and liquid cash money. Now suppose that the Federal Reserve increases the money supply by buying government securities for cash. It has altered the supply of money, yes. But it interest rates are already very low on short-term government paper–if the value of money comes not from its liquidity but from its safety–then households and businesses will still feel themselves short of safe assets and still cut back on their spending on currently-produced goods and services and the expansion of the money supply will have no effect on anything. The rise in the money stock will be offset by a fall in velocity. The transactions-fueling balances of the economy will not change because the extra money created by the Federal Reserve will be sopped up by an additional precautionary demand for money induced by the fall in the stock of the other safe assets that households and businesses wanted to hold.

So, yes, Beckworth is right in saying that there is an excess demand for money. But he is wrong in saying that the Federal Reserve can resolve it easily by merely “adjust[ing] the money supply.[“] The problem is that–when the underlying problem is that the full-employment planned demand for safe assets is greater than the supply–each increase in the money supply created by open-market operations is offset by an equal increase in money demand as people who used to hold government bonds as their safe assets find that they have been taken away and increase their demand for liquid cash money to hold as a safe asset instead.

Increasing the money supply can help–but only if the Federal Reserve does it without its policies keeping the supply of safe assets constant. Print up some extra cash and have the government spend it. Drop extra cash from helicopters. Have the government spend and. by borrowing to finance it, create additional safe assets in the form of additional government debt. Guarantee private bonds and make them safe. Conduct open market operations not in short-term safe Treasuries but in other, risky assets and so have your open market operations not hold the economy’s stock of safe assets constant but increase it instead.

These are all ways of increasing the money supply or of decreasing the effective demand for money by shifting some of the precautionary demand for money-not-as-liquid-but-as-safe-asset over to newly-created other safe assets.

Now don’t flip out on me, everyone. I am NOT saying that I follow DeLong to the end, and that I think the Fed ought to start dropping money out of helicopters.

But I DO think that the Keynesians have put their finger on a different aspect of why it doesn’t “fix the economy” to have the Fed do its normal open-market operations.

Think of it like this: Scott Sumner says that our current problems are the result of Fed timidity. That is crazy to me; like saying the problem with Michael Jackson is that he wasn’t willing to be weird enough.

So I think the Keynesians actually can talk about the specific problems with normal Fed “easing” operations, in a way that Austrians don’t normally catch. The Keynesians are thinking about this specific problem more than the Austrians. Again, the Keynesian solution is wrong too, but their critique of (some) monetarists is still valid.

One more analogy: It’s like when you read the Donald Rumsfeld memo asking whether US actions are creating more Al Qaeda than they’re destroying. There’s a certain credibility or authenticity that comes from reading it in his memo, compared to reading it on an antiwar blog. But it doesn’t mean you want to hear what Rumsfeld thinks US forces should do.

8 Responses to “The Second Sign of Insanity: I Agree With DeLong on Money Demand”

  1. Yogi says:

    Yes, that’s an excellent point.

    The Keynesians seem to be less crazy than the monetarists on some issues…..

    …… and that is because monetarists, for the most part, are self-hating Keynesians. Their analysis starts from the Keynesian beliefs about aggregate demand….. and they have a very simplistic model of how freshly printed money flows through the economy and fixes the problem.

    I don’t understand how it has become as widely accepted as it is.

    • Ricardo Cruz says:

      > I don’t understand how it has become as
      > widely accepted as it is.

      Their theory seems to be much more straight forward to me.

      The Keynesian premise is that wages don’t adjust downwardly easily. Employees give much importance to nominal wages, employers don’t want to undermine morale, unions and contracts don’t allow for a drop in the wage, etc. Therefore, in a deflationary environmental, you’ll have lots of unemployment, which case more deflation as people put money under their mattresses, which causes more unemployment, ad nauseum.

      The difference between Keynesians and Monetarists is how they tackle the issue, if from the supply or the demand side. Keynesians favour government spending, in order to increase consumer confidence and increase the velocity of money, fighting deflation. Monetarists suggest fighting deflation by simply increasing the quantity of money.

      PS: I missed your joke about Monetarists being “self-hating Keynesians”. Why “self-hating”?

  2. fundamentalist says:

    I have read several Keynesians complaining about the emphasis on the Fed. They correctly point out that Keynes wanted the state to spend because of the liquidity trap.

  3. Martin OB says:

    So, what happens when everyone has switched from treasuries to cash? Do you think this point could illuminate the issue of when and how (if ever) serious price inflation will start to kick in?

    • Contemplationist says:

      Inflation depends on expectations of future monetary policy relative to economic conditions. If the market thinks the demand for money is going to rise to match the supply created by the Fed, there will be no inflation as markets are forward-looking. If the markets think that the money creation by the fed is “temporary” i.e. will be pulled back, then there will be no inflation. Inflation, as any market phenomenon is heavily dependent on expectations and is not a mechanical relationship between the amount of money and the CPI.

  4. Current says:

    Now that you’ve in a receptive mood may I suggest reading a book on free banking?

    • bobmurphy says:

      I have Horwitz’s book but the type is small. 🙁

  5. Matt C. says:

    So….I have to address the Mike Myers quote.

    It’s from the first Wayne’s World. He was looking over the contract that he received from Rob Lowe’s character.