Monday, November 8, 2010

Memo to the Fed: Fix the Aggregate Demand Externality

Paul Krugman makes an important point in his NYT column: there is an excess money demand problem (my bold below):
For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little... The only way the Fed might accomplish more is by changing expectations — specifically, by leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash.
Yes, somewhere there are households and firms that are sitting on excess money balances.  And understand these are not the debt-strapped households and firms that should be refraining from further spending.  No, these are the households and firms that are creditors and thus the beneficiary of the debtors who are now saving more.  Instead of spending their growing stock of money they are sitting on it because they see an uncertain economic future.  Here is the rub: it doesn't have to be this way.  If these creditor household and firms all simultaneously started spending their excess money balances this would increase aggregate spending and in turn spur the real economy.* Moreover, knowing that the real economy would improve going forward would feed back and reinforce current aggregate spending. A virtuous cycle would take hold and push the economy back toward full employment.  But this not happening,  there is still an excess money demand problem.  No creditor household or firm wants to be the first mover and spend his/her money for a good reason: there is no guarantee anyone will follow.   This amounts to a negative aggregate demand (AD) externality.  

In order to fix this AD externality one needs an entity powerful enough to incentivize all the creditor households and firms to start spending their money simultaneously. Enter the Federal Reserve. It alone can change inflation expectations and thus motivate these creditors to start spending.  Note that by changing inflation expectations the Fed is really changing expectations of future aggregate spending, the source of  expected inflation.  And by changing expectations of future aggregate spending it is changing the economic outlook for the better too.  The Fed, then, is the one entity that can kick-start this virtuous aggregate spending cycle.  However, in the absence of an explicit nominal target to shape inflation expectations it is not clear to me the Fed will be successful in fixing this aggregate demand externality.   

*It is not always the case that an increase in total current dollar spending will shore up the real economy.  But it is the case now because (1) there is resource slack and (2) there are sticky wages and prices.  


  1. Generating perceived inflation in real estate would do wonders....

  2. inflation expectations doesnt have much to do with AD...

    keeping interest rates low for boomers approaching retirement & seniors on fixed incomes (ie,CDs) creates anxiety and inhibits spending...

  3. I'm one of these creditor households. QE2 won't produce inflation. Ben Bernanke saying it will won't make it be true. The Federal Reserve System is designed not to allow inflation. The only way we get inflation is for the U.S. government to actually start the printing press up and using cash to buy services versus incur debt. Everything you know about economics is a lie to generate inflation expectations without actually doing anything that would create inflation.

  4. If we seriously wanted to get nominal spending going, it would be most effectively produced by a large scale government job creation scheme, financed by Treasury bonds which the Fed could buy.
    I don't see you advocating this...why not? Politically infeasible?

  5. ECB:

    Monetary policy could get nominal spending if really if it were committed to it. But it hasn't yet. Note that I did discuss a proposal along those lines you suggest awhile back with Right Kind of Helicopter Drop post. But yes, now it is politically infeasible.

  6. RJS:

    Inflation expectations have a lot to do with AD. It is true they can also be shaped by AS shocks, but in the current context where AS don't appear to be very important inflation expectations change based on an understanding that the Fed's policies will affect nominal spending in the future. Thus, when Fed officials starting talking up QE2 in September they were implicitly talking up an increase in future nominal spending. As a result inflation expectations responded.

  7. maybe you have to think outside the economics box, david, and try to understand how the situation affects real people...imagine someone 63 with less than 1/4 million saved, & most of it is in interest yielding investments...if the Fed keeps interest rates low & increases inflation expectations, this prospective retiree will save more and spend less, because he expects to earn less on his savings & expects to need greater future purchasing power...

  8. rjs:

    Not everyone is a retiree on fixed income. There are many non-retiree households and firms sitting on highly liquid assets simply because of the economic outlook. (See the graphs at the bottom of this post )As I noted in the above post, the Fed can get these non-retiree entities to start spending by changing their economic outlook. The retiree would actually be better off if the Fed were successful in doing this. And that is because the increase in inflation expectations would increase aggregate spending that in turn would increase REAL economic activity and push up real interest rates. The retiree would actually find an increase in their fixed income.

    This has happened before. The 1929-1933 downturn was far worse and not only were there retirees on fixed income, but a deflationary mindset had taken hold of most folks. The task back then to change expectations was ever more challenging. But FDR did it by devaluing the gold value of the dollar. Inflation expectations shout up and there was a recovery. See this post here for more.The key is for the Fed to be aggressive enough to change expectations. I am fearful it will not be and we will remain stuck in this mess.

    Scott Sumner had a recent post that discusses why some inflation would actually be good for savers. Take a look.

  9. rjs:

    one more thing--if the retiree is saving more than someone else should be getting more money. The retiree's saving must go somewhere. The recipient of those funds can use them to spend more. The Fed's job is to get the beneficiaries of the retiree's saving to spend more. And that happens by changing expectations.

  10. david, im aware that households and corporations are sitting on a lot of cash & marketable securities, and can understand that to the extent that QE inflates the stock market there will be a knock-on wealth effect...but a lot of those saving for retirement moved out of stocks into income producing investments during the recent market i still think there's a large percentage of the 76 million baby boomers and 39 million already over 65 who will have their spending constrained by inflation expectations and the Fed's promised "extended period" of low interest rates...

  11. maybe the thinking is that it doesnt matter if the masses participate anyhow, since 37% of spending is produced by the top 5%...trickle down effect?

  12. rjs,

    Again, where is the retirees savings going? They may be spending less, someone somewhere else is the beneficiary of their higher saving. The question is what are these other folks doing with the money? To the extent these other folks are sitting on the money the Fed can change their behavior.

  13. you hope the Fed can change their behavior, david, you hope...

    banks are already sitting on more cash than in history and i dont see lines forming at the entrances to borrow; and the nonfinancial corporations who are hoarding almost a trillion have no incentive to expand when they're already running way below capacity...

  14. Yes, I do hope a lot... but seriously, the point is that Fed has the ability to change the economic outlook and cause lines to form at banks and cause non-financial firms to start using that cash. If everyone woke up tomorrow believing a robust recovery was on the way this would happen. It's the Fed's job to make this happen. Whether it will is a different question.

  15. David, rjs, the importance of of rjs's argument depends on the relative proportions of elderly, middle-aged, and young as well as their expected or planned consumption over their remaining lifetimes. On the credit supply side, it's going to be a long time before QE inflates us to where the bad stuff on bank balance sheets isn't the bulk of what they are holding. The banks know this and are no doubt chasing risk and building houses of cards with low cost borrowed money even as I type, all in an effort to rebuild balance sheets quickly.

    Also on the supply side, I had occasion to speak with a former CEO of a Fortune 500 right after Lehman failed when the credit markets froze. He told me that his friends (most of them CEOs of large corporations) were preparing for bankruptcy, drawing up papers (no kidding), because they couldn't borrow short-term to meet payroll. They aren't going to get caught like that ever again...nor are the American people.

    It's a whole new world, imho, with a significantly contracted economy as long as we all think we have to self-insure against economy-wide shocks induced by bank misbehavior. Moving the inflation rate from 1.2% to 2% isn't likely to light a fire under anyone who was staring at bankruptcy two years ago (or who is staring at it now either in the form of their own or a neighbor or friend's foreclosed home).

    We'll all start spending when we have some confidence that we don't need a large reserve or when money starts flowing our way again (which will likely only come from the public sector at first), or when inflation hits double digits (which I don't think is what we're aiming for).

  16. Thanks for reminding me of the helicopter post from September 1st.
    A job creation scheme would be substantially different from that of course. It would require some significant planning, about what sort of jobs to offer and where.
    Professor Randall Wray has written a lot on the subject.
    With a quite unconscionable 15 million plus out of work, it really goes to the heart of what sort of society America is that would find this acceptable. Unemployment of this magnitude has graver consequences than the same level in Europe because Europe has a functioning welfare state that offers health care and benefits to those shoved in the ditch by capitalism.
    I believe that you are a religious man and you must be appalled as I am by the callous disregard that the American political elites show toward their fellow man.

  17. The increased desire by the private sector to hoard cash (as opposed to rely on bank loans)is hardly surprising. It is now clear that banks are run by a collection of fraudsters, criminals and incompetents. It will be a decade or more before the private sector forgets that banks dished out NINJA mortgages, placed bets on those mortgages failing, and then lost the paperwork relating to them.

    Of course increased inflation, as advocated by David Beckworth, will increase AD. But this is a slippery slope. Inflation is difficult to stop once it gets going. Plus how much inflation do we need: 5%? 10%?

    I suggest that those who are currently deleveraging and hoarding cash have got their heads screwed on more tightly than those who advocate inflation. And the latter view gains additional support from the strong arguments that exist for a drastic further clamp down on numerous bank activities. For example there is plenty of support for banning fractional reserve, and banning maturity transformation.

    Obviously banning the latter two would be deflationary, but that can be compensated for by a big increase in the monetary base (channelled to Main Street, not to the crooks that inhabit Wall Street). I.e. the cash hoarders are (unknown to themselves) moving making moves towards a better banking system than currently exists.

    As Mervyn King, governor of the Bank of England recently said, “Of all the many ways of organising banking, the worst is the one we have today.”

  18. I'm puzzled as to why rjs seems so fixated on the relative impact of the fixed income segment on the aggregrate economy. I'm an undergrad econ major, so I'll defer to anyone's knowledge on this subject. I would tend to believe that their impact is minor. Doesn't a fixed income imply that income is fixed relative to inflation? Social security ajusts for cost of living and if they're generating income from interest on investments and interest stays low, then doesn't that mean real income is "fixed" or actually declining because if interest is lower than inflation then aggregrate real income is negative?

  19. Big G: it's actually a fairly tricky task to figure out. To do it correctly, you would need to do an overlapping generation model with money and financial frictions.
    There's an accessible textbook for undergraduates on these models, called Macroeconomics by Auerbach and Kotlikoff. It will at least get you started thinking on the right lines.