If our big macroeconomic problem of deficient demand for currently-produced goods and services were the result of a deficient supply of liquid cash money--the stuff you keep in your pockets and use for clearing and functions as a medium of exchange--then the prices of all alternatives to money would be very low: people would be trying to dump their holdings of other assets to build up their stocks of liquid cash money, and only very low prices of and very high expected rates of return on those alternatives could check that desire. Thus we would expect a downturn caused by a shortage of liquid cash money to be accompanied by very high interest rates on, say, government bonds--which share the safety characteristics of money and serve also as savings vehicles to carry purchasing power forward into the future, but which are not liquid cash media of exchange.
Nevertheless, David Beckworth writes:
Macro and Other Market Musings: Martin Wolf, the Paradox of Thrift, and the Excess Demand for Money: Martin Wolf concludes more borrowing may be just what the economy currently needs.... [His] 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... 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.... [I]ndividual households can save... by cutting back on consumer spending and hoarding money... by spending income on stocks, bonds, or real estate and... by paying down debt.... [I]ncreas[ing] their holdings of money by cutting back on expenditures... 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.... 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.... 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 hole in David's argument is, I think, where he says "the Fed adjusts the money supply" without saying how. Suppose that we have a situation--like we have today--where people are trying to cut back on their expenditure on currently-produced goods and services in order to build up their stocks of safe assets: places where they can park their wealth and be confident it will not melt away when their back is turned. They switch spending away from currently-produced goods and services and try to build up their stocks of safe assets--extremely senior and well-collateralized private bonds, government securities, and liquid cash money. Now suppose that the Federal Reserve increases the money supply by buying government securities for cash. It has altered the supply of money, yes. But it interest rates are already very low on short-term government paper--if the value of money comes not from its liquidity but from its safety--then households and businesses will still feel themselves short of safe assets and still cut back on their spending on currently-produced goods and services and the expansion of the money supply will have no effect on anything. The rise in the money stock will be offset by a fall in velocity. The transactions-fueling balances of the economy will not change because the extra money created by the Federal Reserve will be sopped up by an additional precautionary demand for money induced by the fall in the stock of the other safe assets that households and businesses wanted to hold.
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.
These are all ways of increasing the money supply or of decreasing the effective demand for money by shifting some of the precautionary demand for money-not-as-liquid-but-as-safe-asset over to newly-created other safe assets.
These are all ways that ought to work, the Lord willing and the creek don't rise.
But to say that the problem is an excess demand for money is, I think, misleading, for it suggests that the standard way of increasing the money stock--open market operations that swap liquid cash for other assets while holding the total stock of safe assets in the economy constant--will also work. And by this point I think we have a bunch of evidence that it does not.
And to describe these other policy moves--printing up some extra cash and having the government spend it; dropping extra cash from helicopters; having the government spend and. by borrowing to finance it, create additional safe assets in the form of additional government debt; guaranteeing private bonds and making them safe; conducting open market operations not in short-term safe Treasuries but in other, risky assets and so having your open market operations not hold the economy's stock of safe assets constant but increase it instead--as "monetary policy" seems likely to me to add to the general confusion. When the excess demand for liquid cash money is itself the result of a spillover from a more fundamental excess of (planned) savings over investment or of (planned) safe asset holdings over supply, standard open market operations that are designed to hold the stock of safe assets and the stock of savings vehicles constant are unlikely to work. And when Federal Reserve monetary expansions do work, it is likely to be because they not only increased the supply of money but more important increased the supply of safe assets or increased the supply of savings vehicles.
The point, I think, is that liquid cash money is not only a medium of exchange but it is also a store of value--a savings vehicle--and a hedge--a place of safety that you hold in your portfolio to satisfy your precautionary demand, and so the transactions demand for money is only part of the whole. But because other assets are stores of value and hedges a well, to focus exclusively on the supply and demand for money is to miss much of the action in times like these.
I am still frustrated that all of this seems so clear to me and is to opaque to so many other smart people. Personally, I blame Olivier Blanchard for making us spend three weeks on Lloyd Metzler's "Wealth, Saving, and the Rate of Interest" in my first year of graduate school...
UPDATE: Nick Rowe comments on David Beckworth:
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.
Could I make Nick Rowe happy by saying that there is too a "paradox of thrift," in this sense:
When there is an excess of (planned) savings over investment, savers will be unable to find enough bonds to satisfy their demand and will park the excess demand in liquid cash money instead, which they will hoard. They will thus diminish the supply of money available to meet the transactions demand for money and that imbalance creates the excess demand that breaks Say's Law. Thus even though the problem as an excess demand for money, standard open-market operations will not resolve it: they will increase the money supply, yes, but by diminishing the supply of other savings vehicles they will also increase the amount of the money stock not available for transactions purposes because it is being held as a savings (or a safety) vehicle
Does that make anything clear, or just deepen the darkness?