Arnold Kling  

Bizarre Monetary Theory, Once Again

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Bill Woolsey writes,

it is not difficult to see that a large shift in the composition of demand would result in larger shifts in resource utilization, higher structural unemployment, and slower growth in the productive capacity of the economy.

For monetary disequilibrium theorists, this would be described as a higher natural unemployment rate, along with slower growth in potential income.

Woolsey is trying to take the Recalculation story and rework it into the MV= PY framework. While the economy is Recalculating, potential GDP goes down. Accordingly, if the monetary authority maintains a high MV, we will get inflation and not more real output.

I think that is a pretty fair description of what happened in the 1970's. But right now, I am saying that the Fed cannot raise MV. It raises M and V goes down. If the Fed really worked at it for a long period of time, I am sure that they could bring back inflation, like in the 1970's. However, I do not think that they can cure the Recalculation problem by raising nominal expenditure. If anything, I think more inflation would make the Recalculation problem even harder for the economy to solve.

I should say that there are a lot of policies that are making Recalculation harder. Cash for Clunkers made it hard to figure out the true underlying demand for new cars. All the foreclosure mitigation policies have made it harder to figure out who really can afford the houses they are inhabiting and who can't.

Maybe I'm wrong to keep pushing this Recalculation thing. But if it happens to be right, then all sorts of conventional macroeconomic wisdom is not helpful right now.

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COMMENTS (7 to date)
Adam writes:

The recalculation process is central to what's going on in the economy. Do keep working on it and writing about it.

winterspeak writes:

ARNOLD: You cannot cure the recalculation by raising nominal expenditures, but you sure can ease the unemployment caused by credit destruction. The replacement rate for cars did not increase to 20 years because real estate agents are thinking hard about a second career!

Woolsey and Sumner are convinced that the money multiplier is real, whereas anyone who manages reserves in a bank can tell you that bank lending is simply not reserve constrained. The most casual of M0, and M1, M2 etc. will tell the same story, as well as any temporal tracking of these metrics. But let's not let practitioners and reality get in the way of some academic theory.

V has fallen, and M has not increased enough because Obama gave it to banks and not to households, who desperately want to increase their paid-in equity, and improve their household balance sheets.

P cannot fall much at an economy level because of debt deflation (Fisher) and because falling P necessarily decreases incomes and increases real debt burdens, neither of which are winners when a sector is trying to save. Only higher unemployment, through the automatic stabilizers, is increasing the money the Federal Govt is paying into the private sector, so private sector debt has a large equity cushion to sit on. (I exaggerate here, the stimulus package is lousy, but it's something).

If the Treasury had given $800B to households, they would have done 1 of 3 things with the money. One: paid down debt (making bad loans good, and helping to recapitalize banks), two: spend it (stimulating the economy, and maintaining aggregate demand), or 3) saved it (generating more cheap liabilities for banks, but not triggering inflation since savings, by definition, has no inflationary impact).

Instead, the Treasury gave the money to banks, who don't have enough quality credit demand to make loans to (to support aggregate demand). So it's sitting there keeping bank jobs intact, while consumer credit remains too much for the sector to service out of income.

Higher private sector savings is part of the "recalculation". For the private sector to net save, the Fed must net dissave (or more precisely, for the private sector to rebuild its balance sheet by building up the equity liability entry, the Govt must pay-out more equity through running higher deficits). Right now, overly tight fiscal policy is jamming the signal, and preventing the recalculation from happening.

q writes:

the idea of recalculation implies that businesses that businesses that are profitable succeed not during a crisis but during normal times (ie when the economy is near an equilibrium). a crisis itself can cause miscalculation.

if the fed hadn't attempted to add liquidity to the economy we would probably have had quite a few business bankruptcies of profitable but cash strapped companies unable to refinance short term debt.

a lot of those companies would have had to liquidate, and they would have had to liquidate even profitable lines of business (no DIP loans would have been available).

it seems to me that a lot of this would have been miscalculation, driven by an unexpected quick pullback of financing liquidity. a lot of this would have worked AGAINST recalculation.

Lord writes:

I second Q. Recalculation cannot occur when the economy is collapsing, only when it is growing, even if at only a pittance.

Jack Miller writes:

How about stimulating the US economy by lowering P via a broad tax cut, perhaps a payroll tax cut to be recouped in out years by a carbon tax? More work, more profits, more Y, higher V, lower M and incentive to become more energy efficient?

Greg Ransom writes:

The realtors I've talked to say this stuff has been a true nightmare, and much worse than most people think:

"All the foreclosure mitigation policies have made it harder to figure out who really can afford the houses they are inhabiting and who can't."

prakash writes:

I second winterspeak.

Giving money directly to people is probably the best idea never tried. As Mish has mentioned in his blog, for the bank multiplier to work, banks have to be willing to lend. The marginal consumer on the other hand, is almost always in the need of some extra money.

The payout could have been made irrespective of individual debt conditions, so that excessive debt taking was not rewarded.

This would have helped the recalculation process as people would have got a buffer which could have kept them fed, clothed and housed when they were looking for new jobs.

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