## DeLong Smackdown Watch: Nick Rowe Metaphysical Necessity of Monetarism Edition

The thoughtful and intelligent Nick Rowe asks:

Ultimately there are only two things an individual can do with his income, if everybody else is trying to do the same thing: buy newly-produced goods, where there are plenty of willing sellers in a general glut; or hoard money, by not buying things, which nobody else can stop you doing.

And:

What Does Cutting-Edge Macroeconomics Tell Us About Economic Policy for the Recovery?: OK Brad, a challenge for you:

A general glut means an excess supply of newly-produced goods. You say that a general glut can be caused by an excess demand for financial assets: which could be money, bonds, or safe assets. Is it theoretically possible for a general glut to be caused by an excess demand for something that is neither a financial asset nor a newly-produced good? For example, could it be caused by an excess demand for: land, old houses, old books, antique furniture etc.? Or, what about intermediate cases, like an excess demand for gold, where new and old gold is identical, but new production is very small and inelastic compared to the existing stock?

My position is that a general glut can only be caused by an excess demand for the medium of exchange. An excess demand for any of those other assets can only cause a general glut if it spills over into an excess demand for the medium of exchange. The distinction between financial and non-financial assets is irrelevant. Why should it matter?

I'm trying to smoke out your inner quasi-monetarist!

Let's try to think through whether it is money that matters or rather financial assets...

Since I am in Berkeley let's think of an economy with two occupations: baristas and yoga instructors. Baristas make lattes and yoga instructors teach you how to do the Downward-Facing Dog. Can there be a situation in which baristas have brewed more cups of coffee than than yoga instructors want to buy who are offering more yoga lessons than baristas want to take? The way Say expresses it in 1803 is roughly as follows: nobody makes anything unless they intend to use it or sell it, and nobody sells anything unless they intend to buy something with the proceeds of the sale. Thus, "by the metaphysical necessity of the case," as John Stuart Mill was to put it, there has to be the purchasing power to buy everything offered for sale--there can be particular gluts of commodities, but every market in which there is excess supply must be balanced by another in which there is excess demand.

This is an anticipation of what we now call Walras' Law: that the sum across all markets of all excess demands must equal zero.

And here Mill comes in: it is perfectly possible for there to be an excess supply of goods and services—for the current flow of aggregate demand for goods and services to be less than the cost of the goods and services currently being produced--if there is an excess demand for financial assets. As Mill put it:

Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells.... [I]t may very well occur that there may be... a very general inclination to sell with as little delay... accompanied with an equally general inclination to defer all purchases.... It is true that this state can be only temporary and must even be succeeded by a reaction of corresponding violence... [but] this is no more than may be said of every partial over-supply.... It must, undoubtedly, be admitted that there cannot be an excess of all other commodities and an excess of money at the same time. But those who have... affirmed that there was an excess of all commodities never pretended that money was one of these commodities.... What it amounted to was that persons in general... liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute...

Now does it have to be an excess demand for money?

Consider, first, a normal shift in demand: Berkeleyites decide that they want to spend somewhat less on lattes that make them jumpy, irritable, and stressed. Berkeleyites decide they want to spend somewhat more on yoga lessons in order to seek inner peace. Baristas find that they have brewed more lattes than they can sell. Some cut their prices and see their incomes fall, some cut back on hours, some find themselves unable to buy the shade-grown beans for their next round of production and are unemployed.

Yoga instructors find demand booming.

They schedule extra classes.

They work late into the night chanting “om mani padme hum” to satisfy demand.

They raise their prices.

They take on extra apprentices to help them carry the load.

Prices fall in the coffee industry. Prices rise in the fitness industry. Excess supply of coffee and baristas comes with excess demand for yoga lessons and yoga instructors.

In a short time the economy adjusts.

Labor exits the coffee industry and enters the yoga industry. And in a short while the economy has rebalanced with fewer baristas and more yoga instructors, the structure of production has shifted to accommodate the shift in demand, and there is no more excess unemployment.

But now consider, instead, what Jean-Baptiste Say and John Stuart Mill were talking about in 1829 with an excess demand for financial assets.

Consumers decide that they want to spend somewhat less on lattes purchased from baristas and to hold more bonds and more cash. Those with less than their new higher target of financial assets simply spending until somebody buys some of what they have to sell.

What happens in the coffee industry is the same thing that happened when there was a shift in demand from caffeine to inner peace. Baristas find that they have brewed more lattes than they can sell. Some cut their prices and see their incomes fall, some cut back on hours, some find themselves unable to buy the beans for their next round of production and are unemployed. Inventories of unsold beans and cold coffee pile up. Entrepreneurs looking at their growing piles of unsold inventory cut back on hours and production even more.

But there is no countervailing increase in spending, employment, and hours for yoga instructors.

Things then snowball. The unemployed baristas now have no incomes. They cannot afford to buy as many yoga lessons or, indeed, as much of the coffee made by other baristas. Employers cut back production and employment even more. Thus there is a second-round fall in demand which renders even more people unemployed--and then there is a third round. Moreover, everybody sees rising unemployment and falling incomes around them. Can you imagine a better signal to make you decide to try to hold onto more cash? Instead of cutting back on spending on coffee when you have less than $20 in your pocket, people start cutting back on all spending when they have less than$40 in their pocket. And the more the prices at which you can sell your goods falls and the higher unemployment climbs, the more desperate people are to pile up more cash in their wallets.

In a normal market adjustment--a fall in the demand for lattes and a rise in the demand for inner peace--the workers fired from the coffee industry would rapidly be hired into the yoga instructor industry. But this is not a normal market adjustment: this is depression economics.

Things would be different if we were on a gold standard there were a bus to Sacramento. Unemployed baristas would then say: "I'm unemployed, and the economy is way short of financial assets--I know! I'm going to take the bus to Sacramento and enter the gold-money producing industry by panning for gold!" Then labor would flow out of latte-making and into money-production, and we would have a normal adjustment process.

But our currently-unemployed have little ability to go down into their basement and make the assets of which the world economy is currently short--whether they are Federal Reserve notes or 30-Year Treasuries.

I cannot see that it makes a good deal of difference whether the financial excess demand is for liquid cash money, or for bonds as savings vehicles, or for the class of safe nominal assets. In each of these three cases it seems likely that you get downward pressure on demand for those industries that can fire people and little if any upward pressure on demand in any industries that can hire people.

You will respond that what I call a "shortage of bonds" is really a shortage of money, as the spending velocity of money will fall as demand for currently-produced goods and services falls. I would say that the spending velocity of money has fallen because people are short of savings vehicles, and so are holding on to their money as a second-best to holding bonds. I would then say that if we had the same amount of money but more savings vehicles--if the government sold bonds and bought a dam, things would be fine, but if we had the same amount of savings vehicles but more money--if the central bank bought bonds for cash--we would not be fine. It seems distinctly odd to call that situation a shortage of money...