Martin Wolf, the Paradox of Thrift, and the Excess Demand for Money

Martin Wolf reminds us why good macroeconomic analysis is not always intuitive:

Analysis of the economy is not the same thing as analysing a single household. What is true of the latter is not true of the former. The unwillingness to recognise this truth will lead to serious policy mistakes.

The policy mistake to which Martin Wolf is referencing is the call for more economic austerity.  He notes that though increased austerity may be a good idea for a given household it is not necessarily true for the entire economy. He is alluding here to the Paradox of Thrift, the idea that if everyone tries to save--which makes sense individually--during a recession, then aggregate spending will fall.  In turn, this will lower both aggregate income and total saving (i.e. there would be less income from which to save). As a result, the economy will tank even more making it harder to service the existing debt.  Thus, Martin Wolf concludes more borrowing may be just what the economy currently needs.  

While provocative, the paradox of thrift idea is really nothing more than another way of saying there is a monetary disequilibrium created by  an excess demand for money.  And, of course, an excess demand for money is best solved by increasing the quantity of money.  The painful alternative is to let the excess money demand lead to a decline in total current dollar spending  and deflation  until money demand equals money supply.  Another way of saying this, is that the paradox of thrift requires the Fed to be asleep on the job.

Let me explain why the Paradox of Thrift is really just an excess demand for money problem.  First, individual households can save three ways: (1) by cutting back on consumer spending and hoarding  money, (2) by spending income on stocks, bonds, or real estate and (3) by paying down debt.  In the first  case, all households attempt  to increase their holdings of money by cutting back on expenditures.  However, if there is a fixed amount of money  this will create an excess demand for it and a painful adjustment process will occur.  If , on the other hand, the Fed adjusts the money supply to match the increased money demand then the painful adjustment is avoided and  monetary equilibrium is maintained.  In the latter two cases where assets are bought and debt is paid down the money is passed on  to the seller of the assets or to the creditor.  Here, the only way to generate the painful adjustment is for the seller or creditor--or any other party down the money exchange line--to hoard the money.  If the creditor or seller does not hoard the money then  it continues to support spending  and price  stability. All is well.  Increased austerity, then, only becomes an economy-wide problem when it leads to an excess demand for money. Bill Woolsey sums it up best:

[S]aving can only generate the sort of cumulative rot that would create a paradox of thrift if it either directly or indirectly creates an excess demand for money. There is nothing to the paradox of thrift other than a distorted version of the fundamental proposition of monetary theory.  

The fundamental proposition of monetary theory is that an individual household can adjust its money stock to the amount demanded, but the economy as a whole cannot.  The economy must adjust its money demand to the given stock of money and this can be very painful.  The question then is how best to maintain monetary equilibrium. My answer is to have the Fed stabilize aggregate spending.

Update I: Nick Rowe responds in the comment section.  Along with Bill Woolsey, he is one of the resident experts in blogosphere on the importance of money as  a medium of exchange and its implications for monetary disequilibrium. For example, see this post and this one on his blog. 

Update II: If you hang around long in the economic blogosphere you likely to get the famed Brad DeLong smackdown applied to you.  I got my own today and it actually was quite pleasant. Here is Brad:

The hole in David's argument is, I think, where he says "the Fed adjusts the money supply" without saying how... 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.

I agree with Brad's concern that something more than normal monetary policy is needed here to accommodate the excess money demand.  I have discussed some of these ideas before on this blog. Interestingly, Brad's discussion takes us full circle back to Martin Wolf's solution of more government borrowing.  All I would add is that fundamentally this is still an excess money demand problem.