Arnold Kling  

A Rant Against Monetarism

Statistical Perils: Interpret... The Morning Newspaper...

Starting with Mark Thoma I landed on a comment by Nick Rowe.

My position is that a general glut can *only* be caused by an excess demand for the medium of exchange.

Oy. Such confusion. And this is nothing personal about Nick Rowe. Most economists believe this, or something like it. I used to believe it, or something like it. I think that it is a horrible, horrible, confusion.

Think about the problem of the "double coincidence of wants." If the baker wants meat and the butcher wants bread, they can trade. But what if the baker wants candlesticks, the butcher wants bread, and the candlestick-maker wants meat? Only if they contrive a medium of exchange can they trade.

Today, you have a former construction worker and a new college graduate who are both unemployed. In some sense, there are goods and services that they could be producing and trading, but in the context of a huge, complicated economy, they cannot figure out what to produce and trade. The construction worker's wants do not coincide with the college grad's skills, and vice-versa. There is some very roundabout trading pattern that would work, but they do not know what it is.

If you took money out of the picture, the construction worker and the college student would still be unable to solve their problem. When it comes to the failure of wants to coincide, the existence of money is part of the solution, not part of the problem.

Which is not to say that printing more money is what solves the problem. What solves the problem is a series of entrepreneurial experiments, many of which fail, that ultimately create a roundabout pattern of production that enables the construction worker to produce something that is indirectly of value for the college grad, and vice-versa.

Perhaps my rant should be directed against Walras' Law, which says that excess supply somewhere implies excess demand somewhere else. Who the heck enforces Walras' Law? Nobody. Entrepreneurs are trying to figure out how to make a profit. Their aggregate groping is what discovers a viable pattern of comparative advantage and specialization.

Don't start with Walras' Law. For that matter, don't start with Say's Law. There is nobody around to enforce that one, either. In a complex economy with roundabout production, thinking in terms of Walras' Law will only steep you in confusion.

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CATEGORIES: Macroeconomics

COMMENTS (25 to date)
AC writes:

I am sympathetic to your argument, but I'd like to see you expand on this and describe how you view the effect of changes in demand for money (although I'm sure you have before). Would you still say this is often a source of unemployment (as Scott Sumner would say, I think), perhaps as a secondary effect of a real shock?

Fergus O'Rourke writes:

Great post.

I am totally persuaded by the Recalculation idea at this stage.

Keep up the good work !

Bill Woolsey writes:


Your argument doesn't apply to a world of scarcity. There is huge variety of products, all of which are currently being produced, of which additional quantities could be used by someone for some purpose.

There is no problem coming up with goods and services that people could use. We know this because they have prices greater than zero.

You imagine a world in which we have trouble thinking of things for people to do. A world without scarcity.

People want to work and make money, or more likely, to invest and make money, but there are no new, fancy toys they want. If we come up with some new toys, then people will want to buy them, and then, there will be an opportunity to earn incomes by making them.

People were buying houses to make money. They don't want to do that now. What do they want to do now? We have to come up with something new.

Well, the production of those houses took resources away from the production of many other existing goods that could have been produced in larger quantities instead. That is why houses had a cost of production. They entailed the sacrifice of other goods. The people who could have used those other goods had to be detered from using them by higher prices.

It is those other goods that should be produced. The "problem," is how to signal this. Normally, the demands for them (the spending of money on them) expands. The firms producing them sell more. They need more resources and they try to hire more.

If, as is likely, labor and other resources are not perfect substitutes, the result will be shortages of some resources and surpluses of others. The production of those capital goods with shortages can expand, which allows further expansion of their products.

So, we see expanded hires in many sectors of the economy. We see high vacancy rates, and--sadly--greater layoffs as well. There is _structural_ unemployment.

This is the situation of an economy in prosperity. Most indurtries grow, some shrink. People lose jobs in the shrinking sectors. New jobs are created in growing sectors.

But if, instead, we see lower demands for nearly all goods, low hires everwhere, low vacacancy rates, reduced production of everything, we _must_ have an excess demand for money.

Of course, this all applies to an economy with scarcity. You know, the one economists study. It doesn't apply to your world where people want to produce, presumably to earn incomes, but not because there is anything they want to buy.

Lord writes:

In a world with sticky prices and demand for money, printing money is part of the solution. Not necessarily all of it, we are interested in real measures as well, but a substantial part of it. Is unemployment fair? Not when many want to work at the prevailing wage.

saltmanSPIFF writes:

Nobody enforces the laws of scarcity, demand, and opportunity cost either. Should we disregard them as well?

Nick Rowe writes:

What Bill Woolsey said. Especially this bit:

"But if, instead, we see lower demands for nearly all goods, low hires everwhere, low vacacancy rates, reduced production of everything, we _must_ have an excess demand for money."

Glad to see people respond to what I say, even if they think I'm totally wrong! Thanks Arnold!

I have responded to Brad DeLong here

I will respond to Arnold a little later.

Matt C writes:

"But if, instead, we see lower demands for nearly all goods, low hires everwhere, low vacacancy rates, reduced production of everything, we _must_ have an excess demand for money."

Calling the problem "excess demand for money" is a clever way of framing the issue. It naturally implies the solution of printing more money.

You could instead say that prices are too high across the board, and the need for recalculation and price adjustments is severe.

The must-print-money story assumes that people are collectively *wrong* by feeling uncertain about the future and wanting to save money today to spend later in some way they're not yet sure about. The recalculation story allows the deferring of economic activity to be a constructive part of the readjustment process. I don't rule out the possibility that people are collectively wrong (they were in the recalculation story too), but I am skeptical that having planners print money to restore the status quo ante is the radiantly correct answer it is presented to be.

I know we're told that if we allow prices and wages to fall we will enter a deflationary spiral and have another Great Depression. Maybe this is correct. A lot of people smarter than me are sure it is correct. However, I'm convinced that *most* people who say this are just parroting what someone else said and haven't studied or questioned the claim for themselves.

Also, there are more recessions and depressions out there besides the Great Depression. Are there any studies that tried to look at recessionary shocks around the world for, say, the last 100 years, and tried to empirically look at different responses and their effects? I think this is an extremely difficult question--people can't even agree on what happened in Japan for the last 20 years--but it would be interesting to read if anyone has tried.

Salem writes:

Bill, Nick, consider the following situation:

Imagine Robinson Crusoe and Friday on their desert island. Obviously, there is no medium of exchange. Friday picks flowers, some of which he uses to decorate his hut, and some of which he exchanges for some of the rum Robinson brews. The situation is at equilibrium.

One day, Robinson decides he doesn't like decorating his hut with the kind of flowers Friday is picking. He's hardly willing to give Friday any rum at all for them, which makes it not worth Friday's while to pick them. So Friday spends half the day picking flowers for himself, and is sad because he has no rum. Robinson spends half the day brewing rum for himself, and is sad because he has no pretty flowers to decorate his hut. We can call this "unemployment" and "fall in output."

We could prime the pump by forcing Robinson and Friday to make the trade, but the basic problem is that the trade is no longer economic, and the longer we do that, the longer we put off the real solution. What really needs to happen is for someone to scour the island until they find some flowers that Robinson actually wants. Then Friday can go pick them, exchange them for rum, and "employment" and "output" will go back to normal.

mick writes:

Great post. Say's law has no exceptions.

WhiskeyJim writes:

To Mr. Woolsey I respond that if we are indeed in a period of scarcity, why not re-open structurally closed industries which have existing demand?

For example, even after discovering the perfect fuel, conversion rates predict our usage of fossil fuels would continue for some 20+ years. Why import it?

This is true of many industries.

And if we believe in the Keynesian multiplier, why not give the poor money instead of subsidizing housing and food stamps? I am obviously confused by the money arguments.

fundamentalist writes:

1. Why do economists focus on excess demand instead of excess production? Because they have drunk the Keynesian Kool-Aid. Austrian theory says that bad investment decisions cause excess production in some areas.

2. There is no general glut of goods/services. The glut happens by far in capital goods, with a tiny amount in consumer goods. The glut today is in capital goods production and the glut has been in that sector since Cantillon first noticed it 300 years ago. Why? Excessive investment in capital goods caused by cheap credit. Economists will never make any progress on business cycles until they begin to disaggretate goods into at least capital and consumer goods.

3. The destruction of capital in capital good production destroys jobs for those who depended on the capital for employment.

fundamentalist writes:

PS, there is no general glut. Economists forget marginal analysis all the time. Prices fall at the margin. When the stock market falls, it doesn't mean that half the nation values stocks less. It means nothing more than that the people who were engaged in buying and selling on that day valued stocks less on average. The same goes for housing. Falling housing prices happened because most of the buying and selling was done by speculators flipping houses. When they saw that housing prices would not continue to rise they quit speculating and prices fell. Very few home owners were part of the market at the time. My point is that it doesn't take a general glut to change prices, only a change of mind for the people actually participating in the market at a particular time.

Lord writes:

There is no interest or intent to restore the status quo ante. Only an interest in writing off sunk costs and an intent to move forward. There is no general glut on the island, only a excess of flowers and a shortage of rum. Is there a general glut? Very close to it if not it. Disinflation has continued, and while oil, the ultimate consumer good is higher in expectation of recovery, investment in increased production is falling. The only areas of growth have been those funded largely by government.

Two Things writes:

"The only areas of growth have been those funded largely by government."

When the government grows, the private sector shrinks. You cannot fix a slow economy by making government bigger; that's pouring gasoline on the fire.

This is particularly true when the government is growing by spending capital confiscated via inflation (excuse me, "quantitative easing").

Lord writes:

False. It is due to its lack that government is growing. The greater the failure of the Fed, the greater the need of fiscal policy to handle its shortcomings.

Salem writes:
There is no general glut on the island, only a excess of flowers and a shortage of rum.
Hold on. There is no shortage of rum, Robinson can make more if he wants, but he doesn't because the price is too low to be worth his time. And similarly, Friday can pick more flowers, but he doesn't because the price is too low to be worth his time. Output and employment has halved in both the rum and flower industries. Resources are sitting idle. This is exactly what a glut looks like.
Lord writes:

There is no glut of rum. A glut of rum means Robinson wants to produce and sell more than he can. There is a shortage of rum or Friday would not be upset. This could be due to crop failure of sugar cane or Robinson's changing taste. If the latter, Friday would do better to produce his own rum and let Robinson collect his own flowers. Specialization is supposed to enhance output. If it doesn't, it has no point. If the former, there is a reduction in production, but not one anyone can do anything about.

Salem writes:

Lord, you have this backwards. No-one "wants to produce", they want to consume. People produce in order to pay for their consumption. And the fact that Friday wants rum but isn't prepared to pay for it doesn't mean there is a shortage of rum! If I value a Ferrari at $10,000 but it costs $50,000 to make a Ferrari, does that mean we have a shortage of Ferraris?

You are right that specialisation has broken down in my example - that is the whole point. A pattern of sustainable specialisation and trade has become unsustainable. Until Robinson and Friday can find a new PSST, everyone will be poorer than they were, and no amount of intervention can change that.

Sawbilly writes:

One factor that seems missing to me in the Friday-and-Robinson scenario: desire/interest/willingness/boredom etc -- the internal, subjective factor. What if Friday just doesn't feel like gathering flowers any longer? His interests have gone elsewhere. What if Robinson would rather spend a few days taking walks than brewing anything?

I don't see these behaviors as needing economic explanations or accounts, but at the same time I see them as 1) more than plausible (I see people behaving in this way all the time) and 2) important. They're gonna have an impact on the way this island's economy develops (or doesn't develop).

So my conclusion is that any account of economic life that doesn't factor in people's moods, whims, energy levels, desires, fantasies, mistakes, boredom attacks, resentments, even their attacks of disliking having to engage in trade or act sensibly or be productive (there's much fun to be had in acting a non-sensibly) isn't worth paying attention to. Lots of people don't like working, y'know? Other people are willing to work and earn up to a certain point and then lose interest in working any further.

Another hunch is that these hard-to-predict, zigzagging energies and factors will gum up any attempt to create a systematic account of how economies work.

But I'm just a fan of economics. Still, can anyone tell me why I'm wrong in my hunches and conclusions?

Shade Tree Economist writes:

Hmmm - a shortage of money? Must mean the price mechanism (interest rates) is somehow faulty, being that real interest rates have been negative for quite some time, that would signal a glut of money.

But, that should mean rampant inflation! Ah - but only if the money is out in the economy. Where is all this QE1/QE2 "stimulas"? Why, locked up in bank reserves, puffing up bank balance sheets. But isn't a bank's profit stream the interest differential (+ fees)? Surely, if banks are lending to the public; but that lending is frought with default-risk.

Better to take that "free money" and buy risk free treasuries and make 350 basis points profit!

Then there's the question of world wide commodity prices - are they signaling impending economic recovery, or impending inflation?

No - somehow, we seem to be missing the distorting effects of "activist" monetary and fiscal policies in these discussions.

Which is it that ultimately creates wealth, the relative supply of money, or the exchange of value?

parviziyi writes:

Nick Rowe says "a general glut can *only* be caused by an excess demand for the medium of exchange." No matter whether that sentence is correct or not, "fundamentalist" has a reply that makes it merely academic: We don't have general gluts. Paraphrasing "fundamentalist" above: There is no general glut of goods/services. The glut happens by far in capital goods, with a tiny amount in consumer goods. The glut in a capital good, which might be better explicitly labelled as "falling price" rather than a "glut", is brought on by excess investment followed by disinvestment, brought on by a change in reasoning by some people who previously were demanding the capital good and now don't want it. In the senario where there's an excess demand for the medium of exchange, printing money is the superb solution. But it doesn't solve the problem that Arnold was talking about.

Krzys writes:

This only makes sense where wants are independent of prices. In other words, where quantity demanded is the same as demand, but that's obviously never the case. It looks to me like you don't believe in the price system. Time to find the faith ;)

Yonas writes:

Walras Law suggests I don’t believe that there is a correlation between excess supply somewhere implies negative excess demand somewhere else. I think countries use their comparative advantage to produce more products. We can’t say that excess production here in America means that there is Negative excess demand in India. I believe there is a reason why it is like that we call it Competitive Advantage. I just don’t think there is direct correlation.

Vasile writes:

@Bill Woolsey

You imagine a world in which we have trouble thinking of things for people to do

Sorry, Bill, but that's not the problem. The real problem is figuring out which things could be produced with a profit. Now houses, those can not be. See?

But if, instead, we see lower demands for nearly all goods, low hires everwhere, low vacacancy rates, reduced production of everything, we _must_ have an excess demand for money.

Well, _must_ is, usually, a code word for sloppy reasoning. (Sorry) But for the sake of argument, let's suppose that problem is really an increased demand for money. (I'm not saying excess demand for obvious reasons)

But.. Is this excess demand.. demand for nominal money? As they say, for green pieces of paper with portraits of dead presidents??? Those damn fetishists!!!

Now, seriously, increased demand for money is increased demand for future goods, and I do not see how it can be quelled by increased supply of (nominal) money.

don writes:

The quote seems to imply that an episode that creates severe structural adjustments cannot spill over into malaise for the economy as a whole, even for a temporary period, if monetary policy is sufficiently loose. That can't be right.

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