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« A Polycentric Journey | Main | Why Say's Law Does Not Preclude Gluts and Shortages »


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Mario needs to write all this up for a long piece posted at SSRN site.

This stuff really is terrific.

Steve, I couldn't agree more. Thanks for highlighting Mario's latest contribution.

A few points on Mario's postings. While Keynes certainly spent a bunch of time dumping on his version of Say's Law, his model of the Great Depression in fact looks a lot more like Mill's and some of the other pre-Keynesian economists, particularly the emphasis on a collapse of confidence and problems emanating from the financial system, often driven by the collapse of speculative bubbles. This is very much a focus of Mill.

The second is to remind everyone that Say himself did not strictly believe in his own "law."

Most business cycle theories were variations on the common themes that Barkley brought up. Keynes of the Tract was still a quantity theorist. Keynes of the Treatise moved toward Hayek's sectoral story. I leave it to others to decide whether the GT was a "clean break" or not.

As Schumpeter observed, even real theories of the cycle wrote much about the financial system. (Schumpeter notably characterized Hayek's cycle theory as a real theory.) Most theories talked of confidence. My interpretation of Hayek is that he wanted to explain why confidence changed.

In chapter 8, section IV, of The General Theory, Keynes gives a sort of Schumpeterlesque explanation of the cause of the business cycle based on the large provision of "sinking funds" that firms want to recover after a burst of new investment and which subsequently reduce aggregate demand.

Hayek was also looking at the causal structure of relative prices and production processes and institutions through which changes in confidence operate -- and produce systematic effects, that we can only imagine not operating by positing magic (essentially Kaldor's "counter-example" to Hayek -- magically impossible coordination.)

Jerry writes:

"My interpretation of Hayek is that he wanted to explain why confidence changed."

Hayek discusses changes in "confidence" and optimism in book IV of _Monetary Theory and the Trade Cycle_.

Jerry writes:

"My interpretation of Hayek is that he wanted to explain why confidence changed."

In Hayek there is a sort of virtuous circle / snowball effect of confidence / optimism generating a bandwagon effect that cannot be sustained in the boom period, and a vicious circle / driving off the cliff effect of confidence crushing / optimism snuffing as many plans prove to be uncompletable, and folks begin to realize that the economy is in a serious discoordination and there own production, profit, and consumption plans are in serious trouble.

So, we get both an explanation of how changing confidence changes the structure of production and consumption etc, and how the changing structure of production and consumption changes confidence, in a virtuous or vicious circle of reiterated causal adjustment.

Let me add something about my personal learning process in macro since the crisis began. What amazes me is the high level of sophistication in many of the pre-Keynesian "macro" theories -- including the non-Austrian ones. And then there is the perceptiveness of many of the reviews of Keynes's General Theory. I can really understand why some have called Keynesianism "the great diversion." I just wish macro students today would understand more of this.

Does Economics Have a Useful Past?

The official view is that old, wrong or incomplete theories are replaced by new, better ones. That is Economics as a Science.

The study of the past is then a waste of time. But note that, by not studying the past, economists can constantly "discover" new ideas that are in reality just old wine in new bottles.

Today's policy debates are a rehash of old ones. As Mario suggests, in some cases quite old ones. Ecclesiastes told us that "nothing is new under the sun." Indeed.

I repeat here for good measure my comment on Mario's blog, adding that I, too, think that Keynesianism was an unfortunate "diversion," and that people need to rediscover the great pre-Keynesian macro that Keynesians shoved aside. But I also think that there is a danger in supposing that notions like aggregate demand and supply or general gluts are inescapably Keynesian or otherwise wrongheaded.


I'm sorry to be going against the grain on this forum, but I emphatically believe general gluts _are_ possible, Say's Law notwithstanding, so long as by "general" one means "pertaining to goods in general" and not "pertaining to both goods and money."

Nor do you have to be a Keynesian to think so. You just have to believe that there can be a (temporary) shortage of real money balances. Don't think that any classical economist worth his salt would believe it? Then I suggest you read chapter VIII of Poulett Scrope's excellent 1833 _Principles of Political Economy_, which concludes a discussion of Say's law with a section, "General Glut impossible, except through a Scarcity of Money."

More generally, I worry that the call for ditching macro "in the Keynesian sense" risks becoming in practice a call for ditching both good and bad macroeconomics, and giving flesh and blood to Keynes's straw man view of "Classical" economics.

As for me, I'm planning to stick to speaking in terms of aggregate demand, and aggregate supply, and (yes) even general gluts. I see no basis in recent events for jettisoning any of these concepts, and I hope people will reconsider the frankly naive claim that, just because they are unfit for telling the whole story of economic fluctuations, they cannot be useful for telling any part of it. (Hell: I bet anyone on this list that I can explain more of the Great depression using only those concepts than anyone can explain while consistently refraining from using them.)

I agree with George about general gluts. There were interesting discussions about that over on Robert Murphy's blog & Gene Callahan's blog recently.

The thing that there can never be a "general glut" of is "things with an opportunity cost". It's not specifically goods or producible goods. Malthus brought up leisure, if everyone demands more leisure then production may fall, that can be dealt with if leisure is made a services that each of us supply to ourselves. We could add to this other things that while scarce cannot be morally or legally traded. It's interesting given all this talk about the Nobel prize that relationship specific knowledge is often like that. But, as George says the really important issue is money.

I think George sees more differences than there are. I thought Mario tried to forestall such a critique by clarifying at the outset that he wasn't criticizing aggregation per se. But I'll let him speak for himself.

Historically, the general glut controversy began as a dispute about whether there was a chronic shortage of demand. Would gains in productivity lead to an excess supply of goods? The classical economists aimed their guns at that fallacy.

At the same time, the classicals had a disequilibrium theory of the business cycle: changes in money demand, changes in confidence, breakdowns of the financial system, etc. The very analysis Barkley brought up.

Were the classical economists and their critics always clear about which they were discussing -- long-run equilibrium theory or short-run dynamcs? No, nor are economists today.

Now to today's controversies. The issue, as George knows, is cause and effect. Are depressions caused by a general excess supply of goods? Or is the generality of the downturn a consequence of a coordination problem?

If one starts with a disproportionality/coordination story, then it is not obvious whether macro stimulus is helpful on net. It may address one aspect of the problem -- a "shortage of money" -- while inetrfering with the correction of disproportionalities.

I think this inherent tradoff is at work today. The economy is awash in liquidity, but repricing -- in housing markets, labor markets, etc. -- has not run its course. Some policies being implemented, including moentary policy (specifically QE), are a spanner in the works.


On the question of the usefulness of the past for economics see

It is a recent working paper on contra-Whig history of thought and the problem of the endogenous past, comments/criticisms welcomed.

Thanks, Pete. I'll look at it.

If Say's law is correct, and if we combine it with the fact that entrepreneurs create new products, which create new demand (this is important, since there was no doubt higher demand for refrigerators when they were first invented and first made inexpensive than they are now, as a percentage of consumers), then all the stimulus in the world won't help, precisely because stimulus can only stimulate demand for currently existing things, while it is entrepreneurship with creates the supply of new things that creates demand in the sense of Say's law.

In my class last Monday, we were talking right on this subject. The way I tackled it was to talk about Say's law and the Quantity theory. Those who confuse Say's Law with Say's Identity, and who have a mechanical interpretation of the Quantity Theory cause the problem here. But those who believe in a "general glut" are forgetting price theory. So I think George your misstating the position. Rizzo has resurrected the pre-Keynesian classical and neo-classical monetary economics and it's interconnectedness with price theory. I also think Blaug's book is good on this.

If you want to see what denial of Say's Law leads to (or by inference what Say's Law is all about)then look at the work of overproductionists like Tugwell and Hobson who claimed that the Great Depression was *caused* by overproduction. This was due, in their view, to a *chronic* inability of the capitalist system to provide the necessary demand for increasing production.

As Jerry and Mario write here and on Thinkmarkets a lot of the problem is that Keynesians think of Say's law as a short-run law that applies to macro aggregates when it's meant to be a long-run law. Mark Blaug wrote a paper about that "Says law of markets: what did it mean and why should we care". Once the possibility of a rise in demand for non-produced goods such as some types of money is recognised then Say's law can't work in the short-term. The other side of this short-run/long-run issue is whether the general glut is of output, reproducible commodities or all tradable goods and services.

The other problem is if it's supposed to apply to the real world or to every conceivable circumstance. People could conceivably suddenly increase their desire for leisure. But, that's not a practical problem.

I think Troy is wrong to suggest that Say's law is an argument against QE. Since, as we have said Say's law is a long-run argument.

From "The 'Paradox' of Saving" by Hayek:

"The assertion that saving renders the purchasing power of the consumer insufficient to take up the volume of current production, although made more often by members of the lay public than by professional economists, is almost as old as the science of political economy itself."

To Current's point, I think the difficulty would be to find an economist who failed to understand that demand for money is different from demand for other goods. In any case, Hayek was explicit that money, and only money, invalidates Say's Law in the short run.

"Those who confuse Say's Law with Say's Identity, and who have a mechanical interpretation of the Quantity Theory cause the problem here."

I couldn't agree more on this point. However, I think most economists who agree with this fail to see why this confusion is so prevalent.

If you wish to avoid the mechanical interpretation of Quantity Theory, then you must take the more hardliner Misesian position that the equation of exchange is, as stated, scientifically invalid.

You just cannot state a relationship by a mathematical identity and then say 'but don't take it too literally'. This is considered invalid in any other branch of science, and for a good reason.


I agree that all economists understand that money is different. But, even so it's possible for clever people to get confused. See the knots that Mark Blaug and Steve Kates got themselves into over this.

Here is Mark Blaug:

"However, in the paper under examination Kates goes well beyond questions of doctrinal exegesis to argue that the classical economists were quite right to deny that recessions or depressions are ever caused by excessive production in the sense of insufficient aggregate demand relative to supply; in short, recessions always mean misdirected production but never general overproduction. The doctrine of the possibility of general gluts, Kates argues, is not just fallacious as a proposition in comparative statics but false even as a proposition in aggregate dynamics; or, as he himself puts it, 'Say's Law was the classical proposition which ruled demand failure out as a theory of recession' and Say's Law is absolutely correct. Kates, like William Hutt in A Rehabilitation of Say's Law [1974], would have us turn Keynes on his head to argue that what is wrong is not Says Law in any of its versions but Keynes' refutation of Say's Law and Keynes' belief that an insufficiency of effective demand can ever be the cause of unemployment."

The issue here is that it's normal to start an analysis assuming that some sort of equilibrium is occurring at the beginning. Steve Kates is arguing that a recession must be caused by a relative shortage/surplus situation. They are ruling out the possibility of a sudden endogenous rise in the demand for money as a starting point. Kates and Mario are saying that this is the only way to move from that initial equilibrium state to a recession is by first moving through a period where relative supplies are not aligned with demand. But, this is not the same thing as denying that "secondary recessions" exist, or saying that money can never have an influence. Because, those initial relative causes will have further impacts and those can include a rise in demand for money.

Kates and Mario are not claiming that Say's law is true in terms of dynamics by saying that general overproduction can't start recessions. I don't think it can either. But, I think there can be starting points that don't involve relative supply problems in reproducible commodities. What if there a country is threatened by an invasion, in that case demand for money may rise even if all reproducible goods are being supplied in the right proportions.


> You just cannot state a relationship by a mathematical
> identity and then say 'but don't take it too literally'.

That's not really true, you only have to reject a particular set of theories attached to the equation of exchange, not the equation itself. See the long comment I wrote here:

I think an attack on New Classical Economics is more worthwhile even if they are ostensibly free market. The rational expectations episode is far worse for the profession than the residual effects of Keynes.

Professor Rizzo is clearly correct about what macro was before Keynes, but the fairytales told today have more to do with Joan Robinson and Richard Kahn, coupled with the profession's methodological ignorance of history of thought, than they do with anything particular to the Keynesian doctrine, correct?

I leave it to Mario to answer for himself. I'm not familiar with Kates' paper so I won't comment on it.

There are infinite number of possible exogenous events that might cause wealth destruction. The Black Death is an example. Whether those events would look like a traditional business cycle is a separate but important question.

Mario and I and others are trying to explain actual business cycles, such as the housing boom and bust. That is a coordination story.

Tomorrow's Wall Street Journal has an article by Jospeh Stiglitz attacking QE.

I have posted a lengthy excerpt from a paper of mine on Austrian economics and Say's Law that supports the argument George made above. You can find it here:

I agree with Current: a "general glut" cannot explain the business cycle. It may accurately describe particular facts, but it cannot explain how they came to be -- Say's law precludes this. Absent the consequences of monetary disequilibrium, market processes will not systemically produce more than can be purchased. I believe this is Rizzo's point, though it is hard to tell.

Dan, what about the ideal gas law?

I agree with Lee.

I suppose it should be no surprise that when I read Mario's post, I had the same reaction as Selgin. Yes, but... MONETARY DISEQUILIBRIUM!

Perhaps perfectly or infinitely flexible prices don't make sense, but I believe that if all prices, including wages, were as flexible as equity prices of the stock exchange, then there would never be an excess demand for money, and real expenditures would always adjust to the productive capacity of the economy. Well, perhaps not by the second, but on a day to day basis.

I certainly agree that trying to figure out ways to make all prices and wages as flexible as the prices of publicly traded stocks makes no sense. But I also think that since the market process that corrects monetary disequilibrium, given the quantity of money, requires price and wage changes, there is an additional strong argument agains legal price floors and ceilings.

I have explained before that I strongly favor a target for the growth path of money expenditures. I have been thinking that one of the problems with the status quo is that targeting the core CPI to increase 2% from its current value provides an incentive to keep prices and wages rising. If the rule was to keep the quantity of money fixed, then there would be more of an incentive to lower prices and wages in the face of a general glut. By the way, a target for the growth path of the price level would probably create even worse incentives for price and wage cutting in the face of inadquate aggregate demand/an excess demand for money. Oh, and by the way, the incentives for price and wage cutting with a fixed quantity of money might be quite weak if the problem is a temporary increase in money demand.

I don't pretend that stable growth path of money expenditures is perfect, but the alternatives look bad.

P.S. There is plenty of liquidity? Compared to what? The past? Or relative to demand? On a similar note, market interest rates are plenty low. Compared to what? Past levels? Or compared to the levels necessary to keep saving equal to investment given Obama's policies?

As Mario suggested elsewhere, folks are raising a lot of issues at once and some are too big to settle with blog commentary. There is much to chew over in Bill's comments. I just want to tackle his P.S.

Ther is plenty of liquidity relative to demand. What is deficient is capital in financial services firms ("banks"). Supply more of the former does not make up for the latter.

Market interest rates on low-risk paper (especially short-term) are negative in real terms. For me, equilibrium real rates are always positive. Future values are worth less than current values.



This is a mathematical equation. Do you know what a mathematical equation is?

A=A means just that, A=A. It is not a description of a trend or whatever between the two sides. It is an equation. A=A.

As far as describing the dynamics between all 4 variables in the economics system. It is mathematically false! The dynamics cannot be described by any mathematical formula. I realize of course that the equation is nothing but a useless accounting truth when it is not taken as an equation that describes some dynamic system.

Too many issues and not enough time.

What would the interest rates look like if the market were, in fact, determining them? Would they not be (much) higher -- reflecting the fact that banks need people saving their money so that they can lend it out, and the fact that banks now only want to lend to people and companies that really, really, really believe in what they are doing (and therefore are willing to pay higher interest rates to do what they need to do with the money)? Isn't the negative interest rates we have (between the low interest rates and inflation), then, part of the problem of why we're still in this recession?

I don't agree that all equilibrium interest rates are always positive. For example, a policy that protects savers, particularly those buying government bonds, while imposing anti-capitalist regulations on business, could result in negative equilibrium real interst rates on government bonds in the short run. I am making no claims about what would happen in the long run, as depreciation reduces the capital stock, retirees spend their savings and die, and so on.

There is a large capital stock and a large stock of accumulated wealth. Any intuition that begins with those things at zero may have false implications.

While I can imagine negative real interest rates as a long term equilibrium phenomenon, it is certainly puzzling and not relevant.

I think the only situation for negative interest rates worth worrying about is one where short and safe assets have negative equilibrium yields, and the long and risky assets still have positive ones. My notion that long assets would have positive equilibrium yields, (which means that future short yields on average will be sufficiently positive to offset any times they are negative) is probably based upon the same intuitions that suggest interest rates must "always" be positive.

It is all about timing the flow of expenditures to match the flow of productive capacity.

Perhaps inadquate capital by financial institutions continues to hamper financial intermediation. This should result in higher rates on loans and lower rates on deposits--a larger spread. That would include those deposits that serve as money. If there is a zero nominal bound (or .2% because of interest on reserves,) then the quantity of money must rise to meet the demand--to avoid monetary disequilibrium.

So, there is a situation where perhaps their should be negative interest rates--on deposits used as money. The banks lost money and have too little capital. Not all interest rates are negative--the lending rates for banks rise. But their borrowing rates turn negative to cover the needed spread, but more importantly, the reduce teh demand to hold money to match the quantity of money implied by the amount of lending the banks do at the high interest rates they charge on loans.

And if everything is based on zero-interest currency, then there is more or less a zero nominal bound. Fundamentally, currency must expand enough to meet the demand to hold it--or else there is monetary disequilibrium.

Money expenditures are about equal to their 2008 peak. They are about 13% below the trend growth path of the great moderation. To me, that suggests there is not plenty of liquidity relative to the demand to hold it.

To say interest rates are low suggests a confusion of money and credit. So what if interest rates are low? What does that have to do with the quantity of money and the demand to hold it? Sure, if the interest rate on money is low enough, the demand to hold money will be lower. And it seems to me that the problem is the reverse. A more efficient banking system would raise the demand to hold money as interest rates paid on deposits rise.

Of course, I realize that banks have massive excess reserves. And also that the interest rate paid on reserve balances is low. And perhaps if banks were better capitalized they would lend more and this would reduce the demand for reserves.

If you think that any monetary disequilibrium/equilibrium theorist is arguing that the purpose of quantative easing is to increase bank reserves and so increase the quantity of bank loans, you are mistaken.

I am sure you know better than that. The purpose is the raise the quantity of bank liabliities--the monetary ones--relative to the demand to hold them given the current level of monetary expenditures, generate more monetary expenditures, which will, other things being equal, raise the demand to hold money so that it balances the larger quantity. Of course, we all know that everything else would not be equal, and that a quantity of money sufficient to get monetary expenditures equal to a reasonable target, will almost immediately become excessive, and the quantity of money will need to fall again. Or, more likely, a committment to raise the quantity of money enough, will result in an increase in money expenditures, with the actual quantity of money rising modestly, or even falling.

P.S. How exactly are interest rates to be increased to get us out of recession?

If interest rates were allowed to go up naturally, banks would be more willing to lend the money, meaning the small businesses which create the new jobs in the economy would be able to start up and get the economy going again. It's Say's Law + entrepreneurship which will get us out of this recession. That means banks need to be comfortable giving out loans, and higher interest rates will make them more comfortable. Further, people will put their money into savings accounts at a higher interest rate (at current interest rates, there is little difference between keeping it under your matress or in a savings account), making it available to lend out. Without new loans to provide new capital to new companies, the economy will remain in recession.


> MV=PT This is a mathematical equation. Do you know what a
> mathematical equation is?

Yes, I know very well. I'm a Radio Frequency electronic Engineer I dare say I know more math and more advanced math than anyone else on this forum.

> A=A means just that, A=A. It is not a description of a trend or
> whatever between the two sides. It is an equation. A=A.

Yes, it's an identity. If the entities that it describes exist then it is automatically true.

> As far as describing the dynamics between all 4 variables in
> the economics system. It is mathematically false! The dynamics
> cannot be described by any mathematical formula.

Whether mathematics can describe dynamics of economies is a different question.

The equation of exchange can never tell us how cause leads to effect in an sense, a dynamic or quasi-static. It contains no cause and effect. But, this equation however does tell us about dynamics. Because, every theory about dynamics must be consistent with it.

For example, suppose a economist proposes a theory whereby demand in some particular market rises and all other markets stay the same. The equation of exchange reminds us that this economist is proposing a rise in V, or equivalently a fall in the demand for money.

> I realize of course that the equation is nothing but a useless
> accounting truth when it is not taken as an equation that
> describes some dynamic system.

I don't think that just because it's an accounting truth that makes it useless. A lot of Mises praxeology is about understanding that certain statements are simply obvious truths recast in unfamiliar guises.

What I want to make sure is that people don't forget the implicit restrictions that the equation of exchange implies. There are other ways of achieving the same goal that don't require the equation of exchange, but I think it's useful for that purpose.

One day someone is going to have to explain to me why some self-identified Austrians think that good economics requires trashing MV=PY and thinking that any and all aggregates are inherently useless. I just don't get it. Good economics does not require that all aggregates are bad or that the identity expressed by MV=PY is utterly useless. Like all ways of organizing thought, it needs to be used carefully and judiciously, but it's not "un-Austrian" (whatever that might mean) to use aggregates. The key is always offering explanations of those aggregate relationships in terms of individual human action and seeing those aggregates as emergent outcomes.

And before anyone says anything... yes, I know what Mises has to say about the equation of exchange. He's wrong. It happens. Deal with it. :)

Steve, it's like Jews not eating pork.


And if the minimum wage is increased, then unskilled workers will be motivated to work more, and so employment will increase...


Having the Fed sell off securities might raise interest rates, but it is unlikely to result in banks lending more to small business.

If small business decide to borrow more and the added demand for credit raises interest rates, then the increase in the quantity of credit supplied will allow for more projects to be funded. However, if the supply of credit were perfectly elastic, and there was no incease in interest rates in respond to the added loan demand, the amount of projects to be funded would rise by more.

It's not like monetary policy creates a price ceiling and a shortage of loans.

Anyway, I oppose all interest rate targeting and fully expect that a commitment to raise money expenditures to a reasonable growth path can and should result in increased market interest rates.

Bill, Troy,

Bill and Arash have convinced me that below zero market interest rates and below zero natural interest rates are possible.

I think that what we should look at currently is the question: why are market interest rates so low? As I was just saying over at Thinkmarkets I think that the reason is regime uncertainty:

My comment is three from the bottom, Ed Dolan's comment is relevant too.


Please note that I did not say that interest rates should be artificially raised, like they are being artificially lowered now. I said we should allow the interest rates to rise naturally -- as they no doubt would. Hayek observed that when interest rates are low, risk is encouraged, because money is cheaper to come by; but when interest rates are high, risk is discouraged, because money is more expensive. Interest rates are thus a signal to entrepreneurs to either take more or less risks. More, willingness to borrow at a certain interest rate is a signal to the banks of the risks involved in a venture. Everyone is borrowing at low interest rates, but only those who have really thought through their ideas, etc., are borrowing at higher interest rates.

Higher wages crowd out low-skilled workers in the same way that higher interest rates crowd out high-risk takers. Lower wages allow everyone to get a job in the same way that lower interest rates allow everyone to borrow. The problems arise when wages or interest rates are kept artificially high or low. When they are at the rates they are in response to the market -- which is to say, when they are at their natural levels at any given time, in any given place -- then you don't end up with the problems created by keeping them either artificially high or low.

Right now the Fed is busy keeping interest rates low, while at the same time, banks are afraid to lend out money. In some ways, this is the same effect as high interest rates, except that no judgment is being made on who to loan out to -- a judgment that would be possible if interest rates reflected banks' uncertainty and desire to play it safe. The result is that nobody is getting loans, so one of the sources of money for new businesses has dried up (as have others, for reasons of regime uncertainty). Without new companies starting, we're going to continue to face high unemployment.

It is a bit puzzling that the prime interest rate remains pegged at 3% above the federal funds rate. Perhaps this just reflects the meaninglessness of the prime rate. (Though it has personal meaning to me, since the home equity loan I have used to fund my son's college education is pegged to the prime rate.)

Anyway, current Fed policy is keeping the opportunity cost of commercial lending low. T-bill rates, the interest rate paid on reserves, the interest rates to be earned by lending overnight to other banks are low. At least by historical standards.

Further, the Fed's policy keeps the interest rates that banks pay on deposits low as well. This works in several ways. If T-bill rates were higher, then banks would need to pay higher deposit rates on CDs and savings accounts as well. With overnight interbank borrowing rates low, banks have no need to pay high rates on deposits to obtain funds.

As O'Driscoll mentioned, on this or the other related thread, banks are required to fund commerical loans partially with capital--stockholders's funds. And this does tend to limit commercial lending. As far as I am aware, however, none of the Fed's low interest rate policy is keeping banks from charging higher interest rates to small businesses that want to borrow.

Anyway, why do you think interest rates would naturally rise? Why do you assume that Fed policy is now keeping interest rates unnaturally high? Perhaps it is the opposite.

Credit demand is depressed because of the poor state of the economy. The Fed is paying interest on reserves to keep interest rates from falling too low. When they instituted the policy they said they were doing it because the Federal Funds rate was below target.

As I explained before, I oppose interest rate targeting and believe that getting money expenditures up to a reasonable level would result in higher market interest rates. Expectations of recovery would reduce saving and raise investment. Or, one might say, credit demand would recover.

Still, I don't think that...well, I don't understand what you think the Fed should do in place of targetting interest rates. Freeze the quantity of base money? Introduce gold redeemability at some price? I am not at all sure what would happen to interest rates if these sorts of things occurred.

Please understand that I am perfectly aware that interest rates can be "too low" as well as "too high." But to me, that always is in the context of some sort of market clearing--supply and demand.

My point (joke?) about the minimum wage is that the bad argument I made only looked at the quantity of labor supplied. Higher wages improve the incentive to work. It ignored the demand for labor. Prices, like wages and interest rates, need to coordinate.

Higher or lower prices (including wages and interest rates) always provide advantages of some sort. But they are too high or too low depending on whether they coordinate. It is supply _and_ demand.

A simple point, but one that should be considered when claiming that higher interest rates would end the recession.

"Why do you assume that Fed policy is now keeping interest rates unnaturally high? Perhaps it is the opposite."

I don't. I said that interest rates are unnaturally low. There are any number of incentives the Fed and the federal government both are using to keep interest rates artificially low, on the belief that this will help the economy. If bank's weren't afraid to take risks in the current climate, one could make the argument that it would at least get us out of the recession by creating yet another bubble. If banks aren't behaving as one would expect them to in raising interest rates to a rate where they would be more comfortable loaning the money out, you have to ask why. It makes no sense to sit on money when you can loan it, especially when there is a way -- higher interest rates -- that will make you more comfortable doing so. So if banks aren't doing what makes sense from those looking at it from the outside, what is happening that they know about that is making their decision rational? What are their incentives?

I'm against Fed targeting too. Fed targeting assumes that the Fed knows what the interest rate should be. They don't. I don't. That should be worked out by the market, which can process that information efficiently. I don't see that that is in fact taking place.


I think banks can raise their lending rates all they want. The Fed policy of "low" rates is keeping their cost of funds low. This includes the opportunity cost of making commerical loans and the cost of obtaining funds to lend to businesses.

The only exception is paying low interest on reserve balances. That is actually keeping these rates higher than they otherwise would be. Still, all of them are quite low by historical standards.

The standard theory about why banks wouldn't raise commerical lending rates and lend more to riskier borrowers is that those borrowers who plan to pay the money back won't pay the higher interest, and those borrowers who don't plan to pay the money back are happy to promise any interest rate the bank likes. With uncertainty, the situation doesn't involve fraud and is not nearly so stark, but my simple story gives the intuition as to why banks refuse to make loans to poor credit risks rather than just charge them higher interest rates.

Banks being more willing to take risks could very well improve economic performance. But, there would be a larger risk of loss by banks. (right?)

Expectations that the economy will improve will reduce the perception of downside risk by banks, and so increase their willingness to lend. I think that is the better approach. And so, a clear committment to a reasonable growth path for money expenditures.

But they are not making loans even to those who are not poor credit risks. The banks need several ways of figuring out who to make a loan to. We are not talking about the rare person who doesn't plan to pay their loan back (a person who presumably cares nothing about his credit rating, getting future loans, being sued, etc.), but about those who do plan to pay the loan back, but may not be able to do so because their plans didn't pan out.

In an environment where "obscene profits" and "predatory interest rates" are part of the regular parlance -- not to mention various legal policies, and the threat of government takeover if you don't play the game as they call the shots (so they can sell you to those who will play the government's game) -- one shouldn't be surprised the banks are unwilling to raise interest rates. We have to remember that banks are among the most regulated of all industries and, more than that, finance and money are clearly seen as ways of manipulating the economy to the benefit of politicians, so I don't buy that the government and the Fed aren't involved in keeping interest rates low. (This is aside from the fact that inflation is also pushing the interest rates below zero, which will benefit those of us with a lot of loans -- if and when wages catch up, of course -- but harm the economy overall, and the poor in particular.)


I think you are mistaken when you say, "they (banks) are not making loans to firms that are not poor credit risks."

I realize that there is a story that goes that current economic problems are caused by the banks not being willing to lend, but I think that story is mostly false.

Most business say that they reason they aren't producing and hiring and so on is poor sales. They aren't saying that they just can't borrow the money they need to expand in order to obtain expanded sales.

There are firms that want to borrow and cannot. Many of the ancedotes _clearly_ involve firms at death's door, foolishly expecting that someone will lend to them so that they can keep their doors open a bit longer, hoping and against hope that things will turn around.

There are many more firms than usual in a recession and slow recovery in that sad state of affairs. No one is going to lend to them, except maybe the government.

The banks say they are more than happy to lend. They complain about not finding enough qualified borrowers. The businesses that are financially sound say that they don't want to expand, which means they have less need to borrow, because their sales are poor.

Your argument, which is, of course, made by many people, is one more example of money and credit confused.

The problem is a shortage of money. The problem isn't a shortage of credit.

The shortage of money leads to reduce spending on output. Firms sell less. And so they produce less. They employ fewer workers. Some households and firms are distressed, and they need to borrow. No one lends to them. Other firms and households are doing OK. They still have jobs. The firms maybe selling less than in the past, but they survived and now are covering costs at current levels of output. They are making money, but they don't see how expanded sales will make them more money. These households and firms are good credit risks, but they have no desire to borrow. Perhaps they worry that they could be next.

Nothing in this story _requires that banks cut back loans from historical levels or that interest rates rise high relative to historical levels. Only certain "certeris paribus" assumptions require that.

Now, because money is mostly a liability of banks, and bank balance sheets match assets to liabilities, there is a connetion between money and credit. I not only don't deny that, I emphasize that.

But bank commercial loans can expand or contract while the quantity of money contracts or expands. That is because banks can and do hold bonds and banks can and do fund commercial loans with nonmonetary liabilities. Market interest rates can rise or fall while bank credit expands or contracts and the quantity of money expands or contracts. That is because bank credit isn't the only source of credit.

While more money, more bank lending, more total lending, lower interest rates, and more spending is a plausible enough line of causation, none of these connections are "iff."

In my view, the "answer" to the current economic problem is not so much that banks should lend more to small business (Obama's theory?), though that might be a good thing, it is rather that firms and households (particulary rich ones) need to sell bonds they already hold and buy capital goods and consumer goods. This will raise market interest rates and increase money expenditures on output, and I believe raise both production and employment. Prices may rise too, but that is an unfortunately side effect.

While an explicit target for money expenditures is by far the best way to get this done, even with the target, the Fed needs to commit to purchase whatever amount of long term government bonds are needed, to make sure money expenditures will reach the target. That committment, could, and probably would, result in more spending and higher interest rates--both long and short.

How can the Fed buying bonds result in higher interest rates? Private bond holders sell more than the Fed buys. If they sell them to fund purchases of capital goods and consumer goods,then we get recovery in output and employment.

In my view, the alternative is for money wages to fall, and prices to fall too. Once the fall enough below their expected long run level, then the real interest rate on short and safe assets will turn negative enough, that households and firms will sell those and buy consumer and capital goods. And, they may also buy long term bonds, lowering their real yields too, motivating purchases of consumer and capital goods indirectly.

Unfortunately, with inflation targeting, when the price level falls, the long run expected price level falls too.

The second process is that the lower price level results in higher real money balances. This raises real wealth, reduces saving, and raises consumption. However, the problem here is that most money is inside money and so matched by private debt. The lower price level just makes a transfer from debtor to creditor. Base money is the debt of the government. And, of course, there is plenty of government debt of other sorts whose real value rises with a lower price level. This represents liabilitilies to future taxpayers. To the degree ricardian equivalence is correct (which I doubt) this process doesn't work either. But, I think it does work, because I don't believe that households and firms adjust reduce current expenditures to reflect higher real tax burdens from future government debt.

Now, to the degree that the current existing level of prices and wages are keeping real expenditure equal to the productive capacity of the economy, as they would if they were perfectly flexible and after 3 years of depressed conditions, perhaps should, then there is no monetary disequilibrium. The productive capacity of the economy must have shifted to a much lower growth path and the natural unemployment rate has increased massively.

If this were true, then firms would be complaining that they cannot expand because of capacity constraints. Sure, there might be some areas in the economy where sales are a problem, but the biggest story would be firms producing flat out at capacity, but they cannot expand. I just can't get bank loans to expand my plant, which is going 24/7 to meet sales. I need skilled workers, and I just can't find them. I have a stack of applications, but none of them can be used at my plant. I have back orders on key capital goods...

Now, there are some areas of the economy expanding strongly. But I don't think capacity constraints are the big issue. Money expenditures are way below the long term trend of the Great Moderation. That change was due to monetary disequibrium. I am not sure why prices and wages haven't adjusted to correct it after three years. But I favor targeting money expenditures anyway. And so, they need to be much higher. If the productive capacity of the economy fell a lot, then the price level "should" be higher. That is the implication of money expenditures targetting. It isn't really a good thing, but it is a disadvantage that must be accepted to obtain the benefits.

If this were the story, it seems to me that a Keynesian stimulus would be exactly what we need. If what we need is more spending, then stimulus money would help solve that problem. I have read that the vast majority of new jobs comes from new small businesses. You observe that Obama is talking about small business. Indeed. Already-established small businesses. I am talking about startups. Where it the money for startups -- the source of new jobs?

Also, there has been some economic growth -- just not jobs being created. There is little doubt that people are putting off buying cars and refrigerators, but so long as Apple comes up with a new product, they sell those products well -- even in the recession. This suggests to me that it is new things that drive growth -- not the creation of things most people already have, and can put off buying if necessary.

You point out that banks can't seem to find anyone they are willing to loan to. Well, that was my point. Who wants to take a chance of a new idea in an economy like this? Make it financially worth their while, and the banks might be more willing to lend out.

If I am right, one would expect goods that everyone already has to not be selling, and those companies to not be expanding (or worse), while those companies that are creating new products still doing well (and not needing loans to expand). Thus, the only ones who need the loans -- those who want to start new companies -- would find getting money difficult because of the risk. Is that what we are seeing?


What needs to happen is that the price level and wage level needs to fall enough so that its expected future rate of increase motivates people to spend now. Or, the real quantity of money and so real wealth rises so much that people want to spend.

That is how a surplus of labor gets fixed.

Lower wages, lower prices, more real expenditures, more sales, more production, more employment.

An increase in the quantity of money does this without the lower wages and prices. Money exenditures rise, real expenditures rise, etc.

Now, call this a Keynesian stimulus if you wish, but I sure don't think this is the same thing as borrowing more money to produce more roads and bridges.

We agree that prices need to fall. I never said they didn't. I've never said one way or another, because that's a separate issue of the government's interference in interest rates. And if people are willing to spend money on new things, but not on new models of things they already have, then the problem is that we need new businesses to really get things jumpstarted. And, yes, wages need to fall in many of our established companies.

Increasing the quantity of money causes monetary inflation, which will result in another bubble. That's like putting someone with a fever in a sweat lodge.


Government can interfere with interest rates by not printing enough money.

There are many ways of interfering with interest rates by government. However they do it, it will result in a situation that is not optimal to the current situation -- as the Fed either over-reacts or under-reacts, or reacts too slowly, etc. With free banking, we wouldn't have these problems.

Actually, the alternative solutions to a shortage of money are an increaces in the nominal quantity of money or lower prices. I prefer an increase in the nominal quantity of money.

My point was that getting interest rates up is hardly the solution.

If the quantity of money is fixed, the way a shortage of money is fixed is through a lower price level, including the prices of resources like labor, so that the real quanttity of money rises. Some of the market process by which the lower price level and higher real quantity of money will lead to higher real expenditures involve lower nominal and real interest rates.

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