Wednesday, September 29, 2010

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.


  1. Yes! There is no paradox of thrift. There is a paradox of hoarding the medium of exchange. That's because there are two ways to buy more money: sell more other things; buy less other things. One of those two options is always open to the individual, but not to everyone.

    The *only* case where Say's Law is wrong is when there is an excess demand (or supply) of money, the medium of exchange.

  2. And, the way to reduce debt, without creating a recession, is for debtors to spend less and creditors to spend more. So debtors save, and creditors dissave, while leaving aggregate desired saving the same. For every $1 borrowed, there must be $1 lent.

  3. Nick,

    Even though I read Yeager in grad school, it was reading your blog and Bill Woolsey's that got my thinking straightened out on this issue. Consequently, I was remiss not to mention you in the original post. I remedied that with an update that links to some of your posts on the topic.

  4. Question for you: since the paradox of thrift refers to a flow rather than a stock, i.e., an ongoing reduction in expenditure, does this require the Fed to increase the flow of money?

  5. Question for you: since the paradox of thrift refers to a flow rather than a stock, i.e., an ongoing reduction in expenditure, does this require the Fed to increase the flow of money?

  6. David,

    When a bank loan is paid down, there is a contraction in both bank loans and bank deposits.

    How should one construe this as an excess demand for money?

  7. I disagree with Nick (and with the original post) about this. It is not a paradox of hoarding the medium of exchange; it is a paradox of hoarding any bubble asset in units of whose value sticky prices are quoted – which is to say, it’s a paradox of thrift, provided that such an asset (or assets) exists, because the only way to engage in collective thrift is to purchase such an asset. But the asset need not be the medium of exchange. When you receive the medium as payment, you can immediately convert it into some other form, and if this other form has the same "bubbly unit of account" characteristic, then hoarding it is still a problem.

    2-year US Treasury notes are certainly not the medium of exchange, but at their current yield of 43 basis points, hoarding of them is almost as much a problem as hoarding money. If the Fed buys up all the outstanding Treasury securities with a maturity of 2 years or less, it will result in a huge increase in the quantity of money, but it will have little economic effect, because people who were previously hoarding short-term Treasury securities will start hoarding more money instead.

    What about longer-term Treasury securities? Is hoarding of them a problem? Maybe, but we don’t know until we try to do something about it. Right now it’s conceivable to me that the Fed could buy up the entire national debt without brining aggregate demand back to the full-employment level. And that would be a problem, because there are statutory restrictions on the Fed’s ability to create money in other ways.

  8. JKH:
    There is no excess demand at the point of the bank loan being paid down. The question is what the bank or any creditor does with the money used to pay down the loan. As alluded to by Nick, if the creditor fails to use the money then it creates an excess demand for money. In general, someone or some entity must hoard the money after getting it.

    If I understand you correctly, you are saying any asset can be hoarded to the point that it creates an economy-wide problem. I don't see how. If there is an sudden and sustained demand for say stocks that is not being met, how could it have the same disruptive effects of an excess demand for money? An excess demand for money must lead to a drop in spending and deflation since money is the medium of exchange. Any other asset couldn't do this.

  9. David,

    "In general, someone or some entity must hoard the money after getting it."

    Absolutely not.

    The banking system contracts. Loans decline. Deposits decline.

    There is no hoarding of money, because the money's gone.

  10. I don't think DB and JKH will be able to agree on money demand because they have different views on money supply.
    DB argues in the quantity theory tradition, and believes the money multiplier model to be a valid one. I think JKH has a very different take on the monetary system.
    This is an old debate. Back in the 1970s the British post-Keynesians such as Kaldor mercilessly ridiculed the quantity theory and the idea of there even being an independent demand for money.

  11. ecb,

    I think you're right. I don't mean to be contentious for the sake of being contentious.

    Still, one way I visualize an increased demand for money is an increase in the duration of M1 balances - i.e. duration of the average holding period between velocity blips.

    As demand for M1 balances increases, velocity goes to zero, and duration goes to infinity.

    And then balances disappear when loans are repaid (macro banking system effect).

    How do you connect those ideas?

  12. JKH: If a bank loan is paid down, and so loans and deposits both fall (and stay down, let's assume), and if those deposits were (say) chequable demand deposits, and so a medium of exchange, then the supply of money falls. If the demand for money stays the same, we now have an excess demand for money.


    You lost me on the first paragraph.

    You may well be approximately right in the second paragraph. *If* a *temporary* open market operation increases the demand for money by the same amount that it increases the supply of money, then it won't work. So make it a permanent OMO, or have the Fed buy some other asset, so the supply of money increases, but the demand for money doesn't, or better yet, actually falls.

  13. JKH,

    Luckily for both us we have Nick Rowe!

  14. Right, David.

    Rarely have I read something that is so obviously right.

    And now I have a new anchor for trying to understand what excess demand for money actually means (which I desperately need).

  15. My response, mostly to Paul Krugman, because there's actually less difference, theoretically between me and Brad DeLong on this.

  16. Thanks Nick. I also provided a link to your new post on my latest one.

  17. "Paradox of thrift" is a misnomer. It is possible for an excess demand for money to occur while total savings are actually declining. Consider a case where, all else being equal, spending income on stocks, bonds, etc. decreases while income spent on money balances increases. Should this be called the "paradox of spendthift"? Of course not, because it has to do with money not savings.

  18. Great post David.

    Nick's explanations in the comments were great.

    One point I would add is that David's response about the money supply process looked to base money. If loans are paid down and checkable deposits contract, the banks that issue the checkable deposits are accumulating base money--reserves. The demand for base money has risen.

    Nick's answer, however, was correct. Ignoring base money, if loans are paid down and checkable deposits shrink, then the quantity of money has fallen. If the demand to hold money is unchanged, there is the problem.

    Of course, you don't need to have "quasi" in front of monetarist to blame a decrease in money expenditures on a drop in the quantity of money.

  19. Thinking about a unit of account that is different from the medium of exchange soon becomes very complicated. Still, I am sure that 2 year T-bills are not serving as the unit of account or the medium of exchange in the U.S. today.

    Anyway, if there is an excess demand for anything that serves as unit of account, it does require a deflation of the prices of everything else, and if other prices are sticky that is a problem. Of course, with other prices being sticky, that means that the relative price of the medium of account is sticky too. It's unit of account price must be stuck if it is to actually be the medium of account.

    My view is that the only way for a real market economy to create the necessary signals and incentives to cause the proper deflation is for there to be an excess demand of money one way or another. That implies that there must be some connection between the medium of account and the medium of exchange. Some rule or institution that ties them together.

    If the medium of exchange is the medium of account, that institution covers it. Redeemability rules will do it to. Years ago, I did analysis of imaginary systems where the price of the medium of exchange is set on a market for the medium of account and everyone else uses that price of the medium of exchange. And sure enough, monetary disequilibrium is what forces all the other prices to change so they are consistent with relative supplies and demands and the price of the medium of account being at its defined value.