What Is Special About Recessions in a “Monetary Economy”: Trollng Nick Rowe: Wednesday Focus for September 10, 2014
Nick Rowe has a nice, intuitive, monetarist take on the core of macroeconomics. But he keeps failing to convince me completely. And I keep failing to make my objections clear in a way that convinces him I have a point rather than simply being a Crazy-Old-Keynesian-Yelling-at-Clouds. Let me try it again:
The way Nick sees it, The key is money demand and money supply (at full employment). When money demand is greater than money supply, people try to cut their spending hello their income in order to build up cash balances. The problem, of course, is that one person spending is another person’s income. So everyone’s income falls until everyone’s income is so low that people in aggregate no longer wish to build up their cash balances right now. And there the economy sits, depressed, until something happens to balance money demand and money supply (at full employment).
This story of Nick Rowe’s is all well and good. But it has one big hole. It strongly suggests that when depressions happen all other assets go to discounts vis-a-vis cash: people are, in addition to trying to cut spending below income, hoping to dump other assets for cash as well. Yet some depressions happen when savings vehicles are not at a discount but at a premium vis-a-vis cash. And other depressions happen when not all but only safe savings vehicles are at a premium vis-a-vis cash.
This suggests that simply characterizing a general glut as a time of excess demand for cash is not exactly wrong but in some way inadequate and incomplete.
Let’s start over. Let’s start again, with Walras’s Law: the sum of planned excess demands for all commodities must sum to zero. And let’s start with a two-commodity economy in equilibrium: lattes and yoga lessons. Suppose there is a shift in preferences so that people want to drink more lattes and take fewer yoga lessons. What happens? On the market day after the shift, the latte-pullers and yoga teachers show up to their jobs. The latte-pullers discover a zoo: more demand than they can possibly meet. Some ration by raising their price. Others ration by rationing. Some customers buy at the price they expected. Some buy at an unexpectedly high price. Some do not get to buy.
The yoga market, by contrast, is slack: some fill up their capacity by cutting their prices, and some wind up with small classes and few classes and sit idle some of the time. In the following days, weeks, and months, the markets for lattes and yoga lessons adjust. Yoga teachers exit the market, retrain as baristas, and start pulling lattes.
On the boom side, the fact the market for lattes is not characterized by long-term fixed-price contracts means that the rationing is quickly ironed out: the price of lattes rises to balance supply and demand, and then gradually falls as retrained yoga instructors show up and add to supply. On the slump side, earnings of yoga instructors are meager and prices of yoga lessons are low until the excess suppliers have exited. Depending on the market structure, there may or may not be something that looks like “involuntary unemployment”.
And as long as the worker migration from yoga instructor to barista is in progress, there will be macroeconomic consequences. The high earnings of the baristas are unlikely to be exactly large enough to offset the low earnings of the yoga instructors, But that is a second-order consequence: the first-order process is the excess demand for lattes balanced by the excess supply of yoga lessons and the necessary process of structural adjustment thus triggered.
OK. Now let us add a third commodity: gold. And let us rerun the scenario, but this time with a shift in demand from yoga to gold: The story would seem to be the same: a structural depression in the yoga lesson industry and a structural boom in the gold mining industry. To the extent that it is more difficult to retrain yoga instructors as gold miners the process of adjustment takes longer. To the extent that gold is a durable good that does not wear out The shift of labor into gold-mining to meet the demand has to be followed by a shift back into yoga once the additional stock demand is satisfied info and returns to its previous level. To the extent that human psychology leads yoga instructors to have a mental block against cutting the prices they charge in gold terms, the disequilibrium sectoral depression and yoga has higher prices, lower quantities, and something that looks very much like “involuntary unemployment”. To the extent that gold is not only a commodity for which there is a stock demand but also a unit of account, a fall in the gold price and quantity of yoga lessons may lead to a wave of costly and pointless bankruptcies that will have other macroeconomic effects. But the fact that the demand for the stock of gold is a demand for a medium of exchange does not seem to be of the essence–the things that make this a macroeconomic problem rather than a sectoral depression, disequilibrium, and structural adjustment problem are (a) downward price stickiness and (b) the unit of account-bankruptcy-credit-channel complex.
OK. Now eliminate the gold: replace it with fiat paper money issued by a central bank. And the shock is that something happens that increases demand for the fiat cash. The story seems to be somewhat different. Instead of the process of meeting the demand for gold being lengthy and painful as labor makes its way from yoga studio to gold mine, there is no high-value alternative for displaced unemployed yoga instructors to shift to. In the presence of yoga lesson price rigidity, there is no market adjustment of the quantity of money. The central bank has to choose to follow the right monetary policy to avoid grinding deflation, or not.
Now let us remove fiat money, but add banks that make loans and accept interest-bearing deposits–they can invest their extra deposits in fruit trees if they wind up with positive deposits. The shock this time is a jump in demand for savings vehicles–for interest-paying deposits. When the shock hits, the interest rate falls–buying a share of a fruit tree becomes more expensive–and we have a depression in the yoga sector and a boom in the fruit-tree planting sector: it looks a lot like the gold-mining boom.
How exactly does the specificity of a “monetary economy” manifest itself in these potted examples? There seems to me to be a continuum between sectoral adjustment (with macroeconomic consequences) in the cashless yoga-latte economy to sectoral adjustment (with macroeconomic consequences) in the yoga-latte with monetary gold economy (in which the demand for gold comes not because it is shiny and pretty but because it was money) to pure macroeconomic distress in the yoga-latte with fiat money economy to pure macroeconomic distress in the cashless yoga-latte-fruit trees economy.