Tuesday, July 12, 2011

I Hate to Keep Making This Point, But It Needs to Be Said

The anemic economic recovery can be tied to the ongoing elevated demand for safe and liquid assets.  Paul Krugman and Brad DeLong refer to this phenomenon as a liquidity trap; I like to call it an excess money demand problem.  Either way the key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.  (Note, that since term structure of neutral interest rates is currently low, it makes no sense to talk about raising interest rates soon.  That would push interest rates above their neutral level and further choke off the recovery.)  

As Scott Sumner notes, the weak aggregate demand also makes structural problems more pronounced.   Many observers, for example, claim that firms are not hiring because of all the regulatory uncertainty--e.g. Obamacare--coming from the federal government.  This may be true, but consider how firms would be acting if their sales were rapidly growing. At some point, the marginal benefit of another employee would exceed the elevated marginal cost of that worker coming from the regulatory uncertainty.  Firms flush with growing revenues and expected higher sales would feel less constrained by the regulatory changes when hiring workers.  To the extent, then, that regulatory changes are causing problems for the labor market, it is highly exacerbated by the low level of aggregate demand. 

Again, the weak aggregate demand can be traced back to the elevated demand for money and money like assets.  Here is one figure that is consistent with that claim.  This figure shows monthly job openings for the U.S. economy along with monthly money velocity, an indicator of the demand for money.  The relationship is surprisingly strong and is consistent with the implications of the figures shown in my previous post

The question then is how to change the dreary economic outlook that is causing households, firms, and financial institutions to hold relatively large shares of money and money-like assets.  The best way to do it would be for the Fed to adopt a level target, such as a nominal GDP level target.  It would go a long ways in appropriately shaping nominal expectations and in bringing aggregate demand back to a more robust level.   Finally, ignore all those naysayers who say it cannot be done in a balance sheet recession or who say there is no magic lever that can revive the economy.  They don't know their history.  It worked for FDR in 1933-1936 and could work now too. 

UpdateHere and here are some posts that explain how a nominal GDP level target could restore aggregate demand to a robust level.


  1. "The anemic economic recovery can be tied to the ongoing elevated demand for safe and liquid assets. Paul Krugman and Brad DeLong refer to this phenomenon as a liquidity trap; I like to call it an excess money demand problem." -Beckworth

    They're not the same thing. An elevated demand for safe and liquid assets will not reduce aggregate demand unless,

    (1) The demand for safe and liquid assets spills over into money.

    (2) The increasing money demand is not matched by increasing supply.

    By fixing the interest rate earned by base money at about zero, the Fed creates a nominal bound for all interest rates. If the equilibrium rate on safe and liquid assets falls below the nominal bound, then the market rate cannot follow. There will be a shortage of safe and liquid assets at the nominal bound, and the frustrated demand will spill over into money.

    This is not enough to reduce aggregate demand unless the Fed fails to increase the supply of money to meet the new demand.

    DeLong as Krugman do not seem to understand

    (1) The nominal bound is an artifact of a centrally planned monetary order where the interest rate on base money is fixed.

    (2) Unless the elevated demand for safe and liquid assets spills over into money, then it will not reduce aggregate demand.

    Money demand is important. Liquidity demand is important only insofar that we have institutions which create a nominal bound on interest rates.

    The excess demand for money is the underlying problem, and I still don't think Krugman and DeLong understand that. If frustrated demand for safe and liquid assets spilled over into flat-screen televisions, then it wouldn't have anything to do with aggregate demand. It is only because such frustrated demands tend to spill over into money, especially with a lower bound, that safe and liquid assets are important at all.

    Of course, I realise that some safe and liquid assets get used as media of exchange on a limited basis. To that extent, they are money proper. However, it is my understanding that the vast majority of safe and liquid assets do not circulate as money at all.

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  3. It seems to me that the best and most way to increase aggregate demand is to get more income into the bank accounts of those with relatively high propensities to spend their income on consumption. That way they can accommodate their currently elevated desire to save, and spend more money at the same time.

    And on the politics of this expansion of fiscal policy initiatives .... ? I ignore all the monetarist naysayers who say it can't be done.

  4. Dan:

    I am open to fiscal policy actions like this one: http://macromarketmusings.blogspot.com/2010/09/right-kind-of-helicopter-drop.html

  5. David
    Never tire of making the point!
    I´ve reinforced it;

  6. I'm probably missing something about Lee Kelly's post but it appears that our current situation is precisely that demand for liquid assets is spilling over into money and the Fed can't supply enough money. How else can one explain the ZIRP situation we're in? And that, from my reading of them, is what Krugman and Delong argue.

    That's if Kelly's distinctions hold. In my view, a huge increase in what I call 'undifferentiated' savings requires a corresponding drop in consumption and/or investment.

    Most of what we've done so far is to provide cash to both individuals and businesses via tax cuts in an effort to shore up falling demand. Insofar as employment is concerned this type of fiscal policy is having too little effect--or at least the lag is longer than anticipated.

    I think hiring directly would be more recuperative, particularly when we have large trade deficits that are sucking productive employment out of the domestic private economy.

  7. Business hire when they get orders.

    I have never met a business guy who says,"You know, I am so feeble that I cannot hire anyone until I know what that tax code is going to look like next year."

    When you get orders, you hire.

    Structural problems? Oh, we have 'em. How about our ethanol boondoggle, our ag subsidies, and our $1 trillion-a-year defense-homeland security-VA complex?

    But should we starve the economy to force reductions in federal programs? Should you shoot yourself in the balls to calm down your sex drive?

  8. Lee,
    Take a look at the M1 Multiplier and tell me what you state in point 1 hasn't occurred. Or, am I missing your definition of money?
    David, I'd like to see a follow up on the effects of QEII on interest rates. I remember back in December there was a post on what the Fed's intent was. Remember?
    Benjamin: I am going to steal that line. Good one!

  9. Lee,

    You are right, I was being sloppy there. The demand for safe and liquid assets only becomes an issue to the extent it spills over into safe and liquid assets that serve as a medium of exchange.

  10. Nice to see David Beckworth agreeing (in the “right-kind-of-helicopter-drop” post) that a payroll tax reduction funded by new money would raise demand. Advocates of Modern Monetary Theory, Warren Mosler in particular, have been saying this for years.