Never reason from a wealth change

A few more comments on the previous post.  Just as one should never reason from a price change, one should never reason from a wealth change.  If there is a shock worth thinking about, it’s the shock that caused wealth to change.

First example:  The huge 1987 stock market crash was almost identical to the 1929 crash, but the “effects” could not have been more different.  The 1929 crash was followed by the Great Depression, whereas the 1987 crash was followed by years of smooth and placid economic growth.  Not even a ripple to real GDP.  Yes, stocks are skewed more towards the rich than houses, but if wealth was really that important, then a gigantic stock market crash should have had at least a small impact on output.  Instead, unlike 1929 the Fed kept NGDP chugging along, so naturally RGDP kept chugging along.  Wealth in and of itself has no effect on output, although the things that cause wealth to change may have an impact.

To consider why wealth is surprisingly unimportant, consider an island country that holds its wealth in the form of British consols.  Each consol pays 100 British pounds per year, forever.  Consumption is also 100 pounds per year.  Now assume interest rates double from 5% to 10%.  The value of the consols (i.e. wealth) will fall in half, from 2000 to 1000 pounds.  Yet consumption will remain at 100 pounds per year.  That’s not a bad model of the 1987 crash–corporate profits didn’t fall, rather the P/E ratio fell (and the E/P ratio rose—which is a sort of interest rate for stocks.)

Next consider a sudden massive drop in housing demand.  There are two possibilities.  One possibility is that the Fed keeps NGDP growing at 5%, and in that case the drop in demand for housing will lead to more demand for other goods and services.  Unemployment will remain unchanged.  That’s sort of what happened between the peak of the housing boom in January 2006, and April 2008, a period which saw about 70% of the Great Housing Construction Crash.  During that period unemployment rose from 4.7% to 4.9%, as resources shifted out of residential construction into other types of construction, and exports.  And even that tiny rise in unemployment was mostly due to a slowdown in NGDP growth.

A drop in housing wealth might reduce overall wealth, or it might be offset by higher stock prices (as happened until late 2007, when NGDP growth really started to slow.)  If the Fed allows NGDP to collapse, then of course all sorts of other industries will suffer, and unemployment will skyrocket.  They can prevent this with a technique called “level targeting.”  An NGDP crash will sharply reduce all sorts of wealth, including residential and commercial real estate, as well as stock values.  But the drop in wealth itself doesn’t cause a recession (as we saw in 1987) rather it is the rise in the ratio of nominal hourly wages to NGDP that causes mass unemployment.  The job market is like a game of musical chairs.  Falling NGDP removes several chairs from the game.

The US economy is really good at re-allocating resources.  After WWII we produced lots less military stuff and lots more houses, cars, etc.  The public is never satiated, as most people want to live like Hollywood millionaires.  If the NGDP is there, the demand will be there, and our nimble firms will rush in to supply more of whatever Americans decide they want after deciding they want fewer houses.  But of course the demand wasn’t there.  Indeed even the last half of the housing slump itself was caused by plunging NGDP.  The latter half of the housing crash wasn’t a reflection of American preference for less housing, but rather recession, as newly-poor 20 somethings lived with their parents.  Only the first half of the slump represented the drop-off from the over-inflated housing boom of 2005-06.  That slump was healthy, and only caused unemployment to rise from 4.7% to 4.9%.

As I pointed out earlier, we don’t have mini-recessions in America (since WWII.)  That’s because real shocks don’t cause recessions; we are really good at re-allocating resources in the face of a real shock.  If we weren’t good at it then mini-real shocks would cause mini-recessions, and big real shocks would cause big recessions.  Since we don’t have mini-recessions, we can infer that recessions aren’t caused by real shocks.

Tyler Cowen added an update pointing out that he wasn’t endorsing Bullard’s argument (as Matt Yglesias suggested.)  I may have also left that impression—although I tried not to, but perhaps didn’t word it very well.  I meant to imply that Tyler found the argument intriguing enough to link to, whereas I found it completely mystifying.  That’s what I was really driving at; I couldn’t even understand the connection between lower wealth and lower potential output.  Tyler’s update suggests that output may have fallen because it was inflated above trend during the housing bubble.  That might be the case, and seems a much more respectable argument that claiming less wealth might somehow cause potential output to fall.  (In fairness to Tyler, that claim was only made explicit in the following paragraph, which Tyler did not quote.)

I doubt we were very far above potential in 2006, as the paths of NGDP and the unemployment rate weren’t showing any sort of highly unusual behavior.  At worst, we might have been 1% or 2% above potential.  Of course that can’t explain the Great Recession.  I think Tyler’s strongest argument would be that if we did adopt a suitable AD policy, it would be likely to produce more impressive results on the employment front than the RGDP front.  Indeed I believe the recent unemployment/RGDP data already point in that direction (although we still are suffering an AD shortfall.)


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44 Responses to “Never reason from a wealth change”

  1. Gravatar of marcus nunes marcus nunes
    10. February 2012 at 06:31

    Another example of why “NGDP rules”. This time contradicting both Rick Santorum and Jim Hamilton on what triggered the “Great Recession”.
    http://thefaintofheart.wordpress.com/2012/02/10/by-blaming-oil-gas-prices-for-the-great-recession-rick-santorum-takes-the-heat-off-the-fed/

  2. Gravatar of ssumner ssumner
    10. February 2012 at 06:59

    Marcus, Yes, I think any impact of the oil shock was indirect. If the Fed targets P instead of NGDP, they’ll tighten inappropriately.

    If their policy instrument is the fed funds rate, they’ll tighten as the Wicksellian equilibrium rate falls because high oil prices lead to less demand for credit to buy cars and trucks.

  3. Gravatar of Morgan Warstler Morgan Warstler
    10. February 2012 at 07:16

    Finally, you are forced to answer MY EXACT POINT, after Tyler falls back on it.

    lulz.

    Scott, under your preferred policy, you are wrong. IF we started at 4% NGDP level in 2000, the housing bubble would not have happened.

    You aren’t being honest.

    The moment that F&F got busy trying to support sub-prime loans, the SMB Main Street / Technology crowd would have gone ape shit politically.

    Because it would mean THEIR rates go up, the futures market running the Fed would have kept ratcheting up and up rates UNTIL F&F either stopped or basically sucked all the oxygen out of the room.

    “Taxi drivers owning 4 houses?!?” the likely voters with pitchforks would scream.

    “Teachers getting raises?!?” nyet. not a chance. Suddenly state budgets are under control.

    A level target is a CAP on economic growth, and it makes PERFECTLY clear to EVERYONE whether that growth is coming from productivity gains, handouts, or inflation.

    If you run trend growth from 4% from 1999, it was more like 6% off course right?

    Under your plan, we’re talking about having NEITHER the Tech or Housing bubble, right?

  4. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 07:31

    Is there a more unhelpful, obfuscating word in all of macro than “shock”?

    It’s as if macroeconomists do everything they can to block themselves from thinking.

  5. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 07:37

    There it is again. Assume magic, assume “a miracle occurs”. If we are constantly invoking cheats like “and then a miracle occurs” how are going to advance? Has any science progresses in the face of folks who counter with “factual scenarios” where miracles are occurring?

    Scott writes,

    “Next consider a sudden massive drop in housing demand. There are two possibilities. One possibility is that the Fed keeps NGDP growing at 5%.”

  6. Gravatar of Charlie Charlie
    10. February 2012 at 07:37

    “Charlie, If he’s making an argument that output falls because people are between jobs, why does that last so long? Why aren’t other industries growing?

    And as I argued in another post, why don’t we ever see mini-recessions? After all, we see way more mini-real shocks than big real shocks.

    I’m fine with actual growth being less than measured growth, if people want to make that argument. But that doesn’t get you unemployment.”

    I agree with all this. And if you look at Bullard’s speech it’s very hand wavy about unemployment and doesn’t make sense. That’s why I invoked Andolfatto, he realizes that a wealth shock alone doesn’t get you unemployment. He invokes these sort of PSST arguments. I don’t think they are right, but I think that is the story there. You could create it in an internally consistent model using an RBC, a capital shock and a productivity shock, so in some sense it’s coherent. Is the model the RIGHT model? I don’t think so. The problems with RBC are long and have been well known for a while (see Mankiw 1989 in the JEP, for example), but it’s still widely “believed.” If you want to know why, well that’s a much harder question.

  7. Gravatar of StatsGuy StatsGuy
    10. February 2012 at 07:41

    “That’s what I was really driving at; I couldn’t even understand the connection between lower wealth and lower potential output.”

    OK, let me repeat the post from the other link… But first, PLEASE DEFINE OUTPUT. Do you mean the dollar-value of output? Do you mean “real” output, and if so what is real? Is it the gross quantity of stuff, or is it the “real” utility that we derive from that stuff? And who is “we”? Are you aggregating “wealth” by adding up the stuff and applying the “average” utility for the stuff, or are you aggregating “wealth” by looking at the utility of wealth enjoyed by the individual people who actually consume it?

    The real question: can a large nominal negative wealth shock (all things equal) leads to a real negative wealth, and how? There are two, and possibly ONLY two mechanisms:

    1) An AD reduction – ssumner asks why NGDP targeting doesn’t fix this

    2) Distruption, which (I will argue) is due to DISTRIBUTIONAL changes in wealth not changes in OVERALL wealth. Note that if all nominal wealth (including expected future earnings capacity) drops equally why should real consumption change?

    Even if AGGREGATE demand stays the same, if the composition of demand changes rapidly due to shifts in wealth distribution, then real wealth decreases. A dramatic shift in the DISTRIBUTION of wealth translates into a dramatic shift in AGGREGATE preferences. If the country wakes up one morning and discovers that it no longer likes big houses (because all of the individuals who like big houses suddenly can’t afford them and those who can afford them don’t like them as much) the expected future value of consumption has declined at the aggregate level.

    This is an argument about heterogeneity in utility.

    This argument then propagates to structural impacts – those with the skills to build large houses find them less valuable and need to retrain (“real” wealth reduction, whatever that is), those with house building tools may need to repurpose them to less demanded pursuits and write down losses, etc.

    In this sense, stabilizing AD does NOT fix all of the problem – the economy must “recalculate” due to a massive change in the distribution of wealth, which IS PERCEIVED AS “MAL-INVESTMENT”, and massive wealth shocks NEVER HIT EQUALLY. Even if they affect all asset classes equally (which they do not), this still changes the relative distribution of wealth between asset holders and those who own future production potential (e.g. the current workforce vs. the retired workforce).

    So let me summarize:

    DISTRIBUTION

    DISTRIBUTION

    DISTRIBUTION

    The evil, evil D-word.

    Deal with it.

  8. Gravatar of Ken Ken
    10. February 2012 at 07:58

    I’d love to read Scott’s view on Kling’s post:

    http://econlog.econlib.org/archives/2012/02/wealth_and_the.html

    If we are below “potential GDP”, what is it exactly that we should be producing more of? If you can’t answer that, what is the meaning of “potential GDP”?

  9. Gravatar of Becky Hargrove Becky Hargrove
    10. February 2012 at 08:03

    Scott,
    There are a number of issues here that need addressing and you have left me quite perplexed. First and foremost, I thought that the missing output from these past years MATTERED TO YOU. I thought that was a major part of the passion you have for the work that you do, and it almost sounds as though you don’t really care if a lot of wealth disappeared. What am I missing? It’s not everyday I try really hard to pay attention and learn and end up knowing less than I started with.

  10. Gravatar of Major_Freedom Major_Freedom
    10. February 2012 at 08:09

    The 1929 crash was followed by the Great Depression, whereas the 1987 crash was followed by years of smooth and placid economic growth. Not even a ripple to real GDP. Yes, stocks are skewed more towards the rich than houses, but if wealth was really that important, then a gigantic stock market crash should have had at least a small impact on output. Instead, unlike 1929 the Fed kept NGDP chugging along, so naturally RGDP kept chugging along.

    Ergo the fiat US dollar bubble was extended, and has brought about further unsustainable distortions, this time in the global economy.

    Just imagine if China, Japan, and Saudi Arabia (and we should include the Fed today as well), stopped accepting inflated US dollars, and stopped buying US debt with inflated US dollars.

    The fiat US dollar bubble will be revealed, and the world’s economies will undergo the massive correction that is so desperately needed and should have been done decades ago, as sustainable growth is once again brought about by real savings and investment, not inflation financed investment.

    What monetarists don’t seem to want to accept is that these corrections will inevitably take place sooner or later. You can’t erase them with inflation. It has already brought about the 1987 collapse, the 1991 collapse, the 2001 collapse, the 2008 collapse, and the next one.

    I am calling for tremendous pain to be experienced in the present and less pain in the future, rather than less pain in the present and even worse than tremendous pain to be experienced in the future (which is where monetarists are leading the world).

    I hope you realize your words are going on the public record, and the name Scott Sumner is going on record as intellectually associated with the cause of the tremendous future pain that is inevitably building up in the present because of undue inflation. You’re going to be like the Trotsky to Friedman’s Stalin.

  11. Gravatar of Becky Hargrove Becky Hargrove
    10. February 2012 at 08:15

    I have to reason from a wealth change. Wealth is an aggregate term and is not the same thing as a price. If we don’t reason from a wealth change, what is left to reason from?

  12. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 08:25

    Arnold Klling has some helpful comments on all this here:

    http://econlog.econlib.org/archives/2012/02/wealth_and_the.html

    Worth quoting:

    “Suppose that some of our capital becomes suddenly and unexpectedly unproductive. (I think this is closer to what Tyler has in mind.) Then we have lower potential output along with lower wealth. The effect on the output gap is ambiguous, but I could imagine consumers not adjusting so much right away, which would make the output gap smaller at first. Moreover, if macroeconomists fail to account for the reduced capital productivity on potential GDP, they will over-estimate potential GDP.”

  13. Gravatar of dtoh dtoh
    10. February 2012 at 08:26

    A few quick points.

    It’s not just interest on an asset that influences spending, it’s also the principal. Think of it like an annuity where the asset holder expects to spend down the principal over the life of the asset.

    A drop in the price of assets raises the return (and the return of all assets). Thus the cost of credit goes up resulting in less spending by businesses and consumers.

    On the unemployment rate, I think there may be some hysteresis effect where the drop in AD causes (or gives businesses a chance) to shed excess workers. There is probably some overshoot, and then businesses need to rehire to reach a more optimal level of staffing.

  14. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 08:28

    Major_Freedom, you forget that a core part of the game is switching back and forth between a closed-economy perspective and an open-economy perspective whenever it serves the argumentative aims of the macroeconomist.

    Macroeconomists would have zero to say on “the gold standard” if they weren’t constantly invoking this cheat.

  15. Gravatar of dtoh dtoh
    10. February 2012 at 08:32

    One other thing, as I have frequently argued in this space, if the Fed could directly set minimum and maximum bank equity/asset ratios by asset class, you wouldn’t have had the housing bubble in the first place. The fed could simply have jacked up the capital reserve ratios for new housing loans and mortgage securities.

  16. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 08:33

    Here are some poster catch phrases for the classroom:

    Being a macroeconomists means never having to take open-economy economics seriously.

    Being a macroeconomist means never having to take international monetary & trade cycle economics seriously.

  17. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 08:42

    “If we are below “potential GDP”, what is it exactly that we should be producing more of? If you can’t answer that, what is the meaning of “potential GDP”?”

    The vulgar Keynesians have already answered this question.

    We should be producing more government workers (the vulgar Keynesians constantly argue that government employment by the states needs to expand.)

    And perspective perfectly fulfills the basic formula going straight back to Keynes:

    AD = demand for labor.

    The is the heart of Keynes, and the basic premise is that full employment can be be directly produced by a central planner manipulating the commanding heights of the economy. Krugman’s magic Asimov Button.

    And you can’t fulfill or “make true” this “insight” any more directly than by centrally directly employment directly financed by the central government.

  18. Gravatar of bill woolsey bill woolsey
    10. February 2012 at 08:46

    Ken:

    Whatever additional goods or services that people want most.

    Rather than imagining that some new product needs to be developed, a bit more production of all the goods and services currently being produced is more likely. But which ever people want most.

    Now, if people choose to work less because there is nothing they want to buy, then this will result in less labor input and reduced potential output.

    But implicit in much of the bad PSST theorizing is that people producing things that people do want to buy earn incomes that they save because they have nothing they want to buy. There is nothing to invest in so the saving is an accumulation of money. Less is produced, in particular less of the things people don’t want to buy are produced.

    And now, we must wait for entrepreneurs to come up with something these money accumulators do want to buy, and then they will employ the workers that used to produce what people used to want to instead produce what they do want.

    This is called PSST, but it is really just the paradox of thrift. People want to save more and the result is less income and output. Or, better yet, it is monetary disequilibrium, because the added saving is an accumulation of money. Output and income falls until the demand to hold money matches the existing quantity.

    The “old classical” response to this _nonsense_, is that when people want to buy less houses and rather than buys something else, they save, the interest rate falls enough so that the quantity of saving supplied falls, and quantity of consumer goods demanded rises, and the quantity of investment demanded rises (and so the quantity of capital goods demanded rises) so that the demand for these other goods rises to offset the decrease in the demand for houses. Which goods to those who save less because of the lower interest rats buy? Which capital goods are produced because of the lower interest rates? I don’t know, but there is no need to come up with some new product. More of some of the consumer goods currently produced and more the sorts of captial goods currently produced that help produce those consumer goods. A lower quantity of saving supplied (and increase in quantity of consumer goods demanded) can include individual dissaving, including debt funded purchases.

    But what the the demand for those capital goods and consumer goods is highly interest inelastic? Suppose that an interest rate of zero still leaves saving greater than investment. What if we hit the zero nominal bound? Notice that we are still doing Keynesian economics here, right?

    Well the zero nominal bound is just the extreme of a case where people save by accumulating money balances rather than financial assets funding capital goods. It is certainly possible.

    And what is the “old classical” response to that? Well, the shortage of money leads to a higher purchasing power of money. Prices and wages fall (being bid down by the unemployed workers,) and this increases the real value of money balances. While nominal incomes fall, and so the nominal demand for output, the increase in real money balances, when large enough, leads some people to purchase consumer goods, which creates a demand for capital goods too, to help produce them. Which consumer goods? Which capital goods? The ones that those with higher real money balances want to buy.

    There is no–let’s wait until we come up with some new type of good that those working and investing and earning an income now but using the income to add to money balalances want to buy, and have the workers produce that.

    There are many, many people who want additional amounts of the goods that are being produced now. There are market processes that result in making it so that the people who want those goods can be employed producing them and purchasing them.

    Now, if there is any change in demand–people want less of some currently produced goods, and more of other currently produced goods, there are adjustment costs. But that has nothing to do with waiting to figure out what to produce. It is about shifting resources to produce more of what people want more of.

  19. Gravatar of dtoh dtoh
    10. February 2012 at 08:59

    One more thing, it may be useful to think of real interest rates not in terms of the differential between the nominal interest rate and the rate of inflation but rather in differential between the nominal interest rate and the rate of NDGP growth. From the borrowers perspective, the calculus behind the decision to borrow is probably more strongly influenced by expected future demand than by expected inflation.

  20. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 09:06

    Scott, you seem to be thinking of “wealth” as merely an arbitrarily fluctuating money measure.

    In the economic way of thinking (e.g. Menger) wealth is the flow of real stuff fulfilling or not fulfilling real needs, evaluated at the margin.

    If you screw up, and plant a billion new apple trees, and value each tree by mistake at the value of an apple tree when you have only 10 trees, when you suddenly have a Trillion unwanted and un-needed apples, and almost a billion unwanted apple treas, you find that your “wealth” in value terms isn’t what you had mistakenly thought it was.

    Now, I know at this point, Scott, you would invoke magic, i.e. you would pretend that the economy is constantly able to perfectly coordinate, you would insist that “a miracle occurs” at every moment in time, perfectly eliminating any systematic malinvestments across the heterogenous structure of production taking place across time caused by systematic relative price distortions made possible by ponzi operations, non-transparency in financial markets, systematic and pandemic financial fraud, investment bandwagon effects in long term investment projects, interest rate and credit price distortions generated by Fed policies and bandwagon riders, etc., etc.

    But the fact of the limits on our knowledge make it impossible for anyone to know every dimension of the systematic distortions of the economy — and facts about the sensitivity of non-linear dynamic phenomena to initial conditions make it impossible for anyone to perfectly time any particular dimension of the yo-yo causal back and forth of the market.

    So your presumption that all “information” is always perfectly coordinated in every heterogeneous and alternative-time consuming production plan is a scientific fraud — nothing that is remotely possible outside of not-of-our-world math construct or Flatland science fiction.

    Malinvestment happens. Systematic distortions of all relative price relations across time happen (e.g. involving interest rates, credit, leverage, expectations, and alternative production plan processes creating greater or lesser output as a factor of more or less time consumed).

    There is no “given” output trend line, and estimations of “wealth” and the relative pricing of things prove in time to be based on illusions.

    And math constructs and Asimov Button “hypotheses” only blind people from understanding the causal processes of the real world, as the “and a miracle occurs” hypothesis of Divine Creation blinded people for thousands of years to the causal process of adaptation and the origin of species by descent.

  21. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 09:12

    Bill, this is a colossal and disingenuous trashing of the Principle of Charity:

    “But implicit in much of the bad PSST theorizing is that people producing things that people do want to buy earn incomes that they save because they have nothing they want to buy. There is nothing to invest in so the saving is an accumulation of money. Less is produced, in particular less of the things people don’t want to buy are produced.

    And now, we must wait for entrepreneurs to come up with something these money accumulators do want to buy, and then they will employ the workers that used to produce what people used to want to instead produce what they do want.

    This is called PSST, but it is really just the paradox of thrift. People want to save more and the result is less income and output. Or, better yet, it is monetary disequilibrium, because the added saving is an accumulation of money. Output and income falls until the demand to hold money matches the existing quantity.”

  22. Gravatar of Greg Ransom Greg Ransom
    10. February 2012 at 09:20

    BIll, if your mis-characterization of the PSST argument reflects your understand of the argument, then we have no reason to keep pretending that you understand the argument well enough to have a cogent reason not to believe it — e.g. a typical Creationist shows a complete lack of understanding of the explanatory scheme and detailed mechanics of Darwinian biology, and we therefor have no reason to take their “objections” very seriously. Your account of the PSST slides into the territory where you are like the Creationist without a comprehension of the Darwianianexplanation of biological patterns who opposed Darwin on un-credible grounds.

  23. Gravatar of ssumner ssumner
    10. February 2012 at 10:19

    Greg; You said;

    “Is there a more unhelpful, obfuscating word in all of macro than “shock”?”

    How about “inflation?”

    OK, Assume the Fed pegs a NGDP contract at 5% growth. I still say that prevents a severe recession.

    Charlie. Sure you can write down RBC models that get you recessions, but as you say they aren’t plausible. To begin with, real hourly wages rose in 2009.

    statsguy, You said;

    “OK, let me repeat the post from the other link… But first, PLEASE DEFINE OUTPUT. Do you mean the dollar-value of output? Do you mean “real” output, and if so what is real? Is it the gross quantity of stuff, or is it the “real” utility that we derive from that stuff? And who is “we”? Are you aggregating “wealth” by adding up the stuff and applying the “average” utility for the stuff, or are you aggregating “wealth” by looking at the utility of wealth enjoyed by the individual people who actually consume it?”

    Let’s just skip all this and talk about employment. Why does that plunge?

    You said;

    “Even if AGGREGATE demand stays the same, if the composition of demand changes rapidly due to shifts in wealth distribution, then real wealth decreases. A dramatic shift in the DISTRIBUTION of wealth translates into a dramatic shift in AGGREGATE preferences. If the country wakes up one morning and discovers that it no longer likes big houses (because all of the individuals who like big houses suddenly can’t afford them and those who can afford them don’t like them as much) the expected future value of consumption has declined at the aggregate level.”

    Except that we know this is completely false, as it doesn’t happen during periods where wealth crashes and NGDP doesn’t, like Jan 2006 to April 2008. You need an NGDP crash.

    Ken, God, I hope he didn’t say what you said. I’ll look later.

    Becky, I just meant that it doesn’t explain lower output. I’d rather wealth not disappear.

    Major Friedman, You said;

    “I hope you realize your words are going on the public record, and the name Scott Sumner is going on record as intellectually associated with the cause of the tremendous future pain that is inevitably building up in the present because of undue inflation. You’re going to be like the Trotsky to Friedman’s Stalin.”

    I’m honored by the comparison to Friedman.

    Becky, Reason from the thing that caused wealth to change.

    Greg, The data from 2006-08 says Kling is wrong.

    dtoh, You said;

    “A drop in the price of assets raises the return (and the return of all assets). Thus the cost of credit goes up resulting in less spending by businesses and consumers.”

    I certainly agree that there are monetary regimes where less wealth leads to less AD. Obviously I oppose those sorts of monetary policies.

    hysteresis comes from 99 week unemployment comp and SSDI and other things like that.

    As far as the housing bubble, the Fed had plenty of other ways to stop the housing bubble, but they had no desire to do so. Giving them even more tools doesn’t solve that problem.

    Greg, I think we both agree the government shouldn’t be deciding what we produce more of.

    dtoh, You said;

    “One more thing, it may be useful to think of real interest rates not in terms of the differential between the nominal interest rate and the rate of inflation but rather in differential between the nominal interest rate and the rate of NDGP growth.”

    Exactly, I’ve made this argument many times, but don’t seem to be persuading any of my fellow economists.

    Greg, No, I mean real wealth.

  24. Gravatar of Becky Hargrove Becky Hargrove
    10. February 2012 at 10:33

    Scott,
    You got to the comments before I could get back. Absolutely, reason from the thing that caused wealth to change. Even as I was already doing that in my mind I didn’t realize the difference.

  25. Gravatar of Kevin Dick Kevin Dick
    10. February 2012 at 10:42

    Scott. I apologize if I’ve made this comment in the past but here’s how I think of PSST vs AD:

    - The economy is a reallocation engine. Money is the lubrication that allows it to operate smoothly. Not enough lubrication and it slows down, perhaps even seizing. (Too much is bad too of course).

    I don’t think anyone would dispute the PSST claim that the economy constantly needs to reallocate resources and that sometimes there is a relatively sudden need to reallocate big chunks of resources. But as you say, the US economy seems to be really good at this most of the time. It only has a problem when you pump in too little or too much lubrication.

  26. Gravatar of Major_Freedom Major_Freedom
    10. February 2012 at 12:16

    ssumner:

    “I hope you realize your words are going on the public record, and the name Scott Sumner is going on record as intellectually associated with the cause of the tremendous future pain that is inevitably building up in the present because of undue inflation. You’re going to be like the Trotsky to Friedman’s Stalin.”

    “I’m honored by the comparison to Friedman.”

    Nice. You’re clever.

    I’m sure Trotsky was honored to be associated with the red shirts.

  27. Gravatar of Donald Pretari Donald Pretari
    10. February 2012 at 13:59

    You need to figure in the Impact on Investment from the S & L Debacle. For example, there was a Housing Bubble in CA from, say, 83 to 90 or so. I know because I bought my house in 91 near the bottom of the bubble.

    In other words, I was clearly aware of Housing Bubbles in the late 80s. I was also very tuned in on how the S & L Crisis played out. Just based on knowing those 2 things, I haven’t been surprised by much since 2005, but for the fact that the Political Economic Response has been Far Worse than even I imagined, & I thought things would get bad. Sadly, when I read Bernanke’s early 2000s talk on Debt-Deflation, I actually thought for a few months we’d get out of this much than I’d thought. So much for Optimism.

  28. Gravatar of ssumner ssumner
    11. February 2012 at 06:36

    Thanks Becky.

    Kevin, Good point.

    Donald, I also thought Bernanke understood this stuff. I was wrong.

  29. Gravatar of Morgan Warstler Morgan Warstler
    11. February 2012 at 07:06

    Regardless what Greg says, Bill…. this is EXACTLY RIGHT:

    “And now, we must wait for entrepreneurs to come up with something these money accumulators do want to buy, and then they will employ the workers that used to produce what people used to want to instead produce what they do want.”

    And that is the GREATEST moral good in the universe.

    We drop PSST on society, and now we use Bill’s desperate loathing of waiting for entrepreneurs…

    To make laws and taxes easier on entrepreneurs.

    Bill, an entrepreneur is a priest of the great god market, he divines the will of the consumer (god) and he takes on all the personal risk, the personal suffering in the blind hope of god shining down his love for his agency.

    Bill, I don’t think you can complain about having to wait for entrepreneurs, I think you are only noting that right now we don’t have enough of them by your estimation to FEEL INTUITIVELY that this clearing waiting process is near instantaneous (compared to the waiting we currently have).

    Meanwhile, I who am surrounded by entrepreneurs all day long, where almost every conversation is based on creating something the god wants, know intuitively this fact as true.

    Your optics are off Bill, you don’t know enough priests.

    So to fix that, you are just saying we need more priests to satisfy god.

  30. Gravatar of Bill Woolsey Bill Woolsey
    11. February 2012 at 16:44

    Ransom:

    I have never seen much evidence that you know any microeconomics other than the supposed microeconomic distortions that supposedly follow monetary disequilibrium.

    I am sure that Scott knows plenty of microecnomics, and I know that I had way more coursework in microeconomics than macroeconomics. Scarcity and the role of prices and profit and loss signals to reallocate resources is second nature to most economists. And that includes me.

    Rather than just calling me a Creationist, please explain where my microeconomic, supply and demand, account of PSST when wrong.

    People want to spend less on houses? Find, they spend more on other goods. The demand for houses fall? The demand for something else rises. I don’t know what exactly.

    There are idle capital goods and laid off workers in the construction industry.

    But some other industry is booming, making profits, hiring new people, ordering capital goods.

    There is no waiting around deciding what to do. There is rather a need for a reallocation of resources.

    Why not? What is it that the special microecnomic analysis of monetary disequilibrium tells you instead?

    My analysis above is basic microeconomics. Change in demand.

    What am I missing?

  31. Gravatar of Bill Woolsey Bill Woolsey
    11. February 2012 at 16:55

    Major Freedom:

    You don’t understand the difference between nominal and real.

    All of the capital goods over the last 20 years were generated out of real savings, and nearly all of them were constructed based upon desired real savings.

    The malinvestment that might be generated by an excess supply of money is not the equal to the entire nominal supply of money, much less the entire nominal supply of credit. When the prices of capital goods get higher, then the higher nominal supply of credit purchases a smaller real quantity of capital goods. This is the real quantity of credit moving back to equilibrium with the real saving. As prices rise, the nominal demand for credit rises to return to equilibrium with the higher nominal quantity of credit, which matches the higher nominal quantity of money. The increase in the nominal demand for credit brings real market interest rates back up to equilibrium. This brings investment back to real saving.

    My view is that this process works quickly, so malinvestment is insiginficant. The other view is that it happens slowly, so there is malinvestment. However, your apparent view, that that the entire growth in the nominal quantity of credit represents malinvestment is wrong.

  32. Gravatar of Morgan Warstler Morgan Warstler
    11. February 2012 at 20:08

    “People want to spend less on houses? Find, they spend more on other goods. The demand for houses fall? The demand for something else rises. I don’t know what exactly.”

    Bill, when the economy hits the shitter, people may or may not decide to buy different goods…. but:

    They are still able to want to just save cash. Some things, most things, everything – is immediately over-priced.

    When people don’t want to buy things, it is because those things are over-priced.

    Manufacturers may NEVER be able to make that thing again, because they can’t do it under the price people pay.

    —-

    Above, you specifically lamented the WAIT – the time it takes for the music to stop, and the losers who are left standing to get gutted, and the new ideas to be spawned.

    Then in your last post, you say “My view is that this process works quickly, so malinvestment is insignificant.”

    So which is it?

    Does it happen fast or slow?

    BTW, the argument about growth of money supply = malinvestment is that the savers in a zero inflation system GET MORE UPSIDE when the more frequent liquidation sales happen.

    When you add +2% new money YOY, you:

    1. create less fear on the part of bulls than in a zero inflation system in the long run.

    2. increase the power of gvt. – this is the killer disad.

  33. Gravatar of Valley Valley
    11. February 2012 at 22:20

    At the same time that this is all going on; what with the poor and those on welfare having roughly a few hundred is it?] more spending dollars per year than the rich… how does this explain the stock market stagnant if not but going down; yet comic book sales are doing quite well?

    0.o

  34. Gravatar of Bill Woolsey Bill Woolsey
    12. February 2012 at 05:24

    You mistunderstood. I am not lamenting the wait.

    There is no weight. There is reduced output because of reduced demand due to an excess demand for money. If the quantity of money rises enough to match the demand to hold money, there is no reduced demand. Nominal GDP targeting _is_ raising the quantity of money to match the demand to hold money, and if nominal GDP stays on a constant growth path, there is no reduction in demand. There is a change in the composition of demand.

    If th quantity of money is held constant, and there is an increase in the demand to hold money, then the market process that fixes it is lower prices and wages. If all wages and prices were perfectly flexible, there would be no decrease in real demand, just a change in the composition of real demand.

    The fundamental principle of economics is scarcity. There is no problem with there being enough things to produce. However, there are problems with reallocation of resources to the most valued use.

    Now, as an entirely seperate question, what happens when there is an excess supply of money? Given plausible institutions, an excess supply of money is matched by an excess supply of credit. This will reduced the real market interest rate. Since saving and investment have not changed, it is pushed below the natural interest rate. While this implies a shortage of currently produced output, it is at least conceivable that the composition of demand for output is changed. And it is also conceivable that this will impact the composition of output. However, the shortage of output raises prices, raises the nominal demand for credit and pushes the real market interset rate back up. Does the temporary distortion in the composition of demand lead to elaborate projects that are only profitable with the low interest rate? I think, not very much.

    Now, back to PSST. The argument that people decide they don’t want to buy good, and so, we must wait for entrerpreneurs to come up with something new that strikes those people’s fancy fails to take into account the ability of the market system to allocate resources to the most valued use.

    These people who are waiting for someone to come up with something they want to buy are saving. If saving is greater than investment, interest rates fall until they are equal. This doesn’t just effect our people who are waiting for something new that strikes their fancy, it impacts everyone, including the millions of people who would like additional quantities of the consumer goods that are currently being produced. It also increases the demand for capital goods, adding to all of those that help produce the consumer goods that are already being produced.

    If some people want to save more for any reason, market signals and incentives are created so that currently available resources are used to produce goods and services that people want.

    If lower interest rates raise the demand for money, then the market process requires a lower price level. With outside money, it creates a pigou effect. With both inside and outside money, if the price level is mean reverting, the current price level falls enough to reduce real interest rates enough to get saving and investment equal.

    The problem is that prices and wages are not prefectly flexible. And so, increasing the nominal quantity of money enough to match the demand, and so maintain nominal expenditures is better. And that will be associated under plausible conditions with lower interest rates and increased demand for existing goods.

  35. Gravatar of Morgan Warstler Morgan Warstler
    12. February 2012 at 09:27

    W: “If the quantity of money is held constant, and there is an increase in the demand to hold money, then the market process that fixes it is lower prices and wages.”

    I agree.

    W: “The fundamental principle of economics is scarcity.”

    This used to be true, and I’m a giant believer in property rights because of it – BUT ONLY around the atomic.

    The digital however is by definition not scarce, what’s more each copy increases in value the more it is copied.

    This is the fact: You cannot OWN the digital. Not under currently accepted property rights. If we could copy oil and food, we’d riots if we fought it.

    What’s even more, every year a bigger part of our economy and consumption revolves around the digital.

    What’s even more plus, even 3D printing is pushing the boundaries to the atomic here…

    I mention all this, because it is obviously screwing up your past assumptions about labor re-organizing.

    Meaning, we can see a future where 80% of consumption is digital, and it is produced by 10% of the population.

    And in my mind, that means near zero friction in future labr pricing.

    I mention this routinely, but your entire thinking on monetary policy assumes that “wages” on labor is the way we provide “income” to the 80% in future.

    My plan is to guarantee income as a social safety net, precisely so we can let the private sector pay correct wages – by auctioning off all “excess capacity” every single week.

    The digital can clear labor overnight.

    When I read your analysis, I hear, “since I assume labor can’t be auctioned off… we should use monetary policy.”

    But there are ill effects to printing money, and there are none to auctioning off labor.

    Why do you not go for less ill effects?

    And if you think the system still won’t be perfectly flexible, isn’t there a moral obligation to be as flexible as possible BEFORE we print money.

    Doesn’t not printing money FORCE us to become more price flexible for the long term?

    W: “If saving is greater than investment, interest rates fall until they are equal.”

    Doesn’t Sumner freak out and scream S = I.

    “This doesn’t just effect our people who are waiting for something new that strikes their fancy, it impacts everyone, including the millions of people who would like additional quantities of the consumer goods that are currently being produced.”

    So since I’m not happy with the current set of goods, I should have my money destroyed since other people don’t have my high standards?

  36. Gravatar of Morgan Warstler Morgan Warstler
    12. February 2012 at 10:36

    Bill,

    Here is Buffett (chief rent seeker) telling America to buy stocks because cash is so risky…

    When THAT is wisdom, you have a moral obligation to side with anything that drives greater price flexibility.

    http://www.businessinsider.com/warren-buffett-the-investment-everyone-thinks-is-safe-is-actually-the-riskiest-in-the-world-2012-2

  37. Gravatar of Becky Hargrove Becky Hargrove
    12. February 2012 at 10:45

    Bill,
    We have to be careful when we define all economic activity as scarcity, because that makes a lot of people want to trash the open (and efficient) marketplace of the world. In terms of money of course this is true because of what money has to accomplish. Resources have to be extremely distilled for money to even be able to do its job. So the challenge is to be able to find ways of using resources that do not always have to be distilled to that same degree, so that openness in the marketplace can be maintained.

  38. Gravatar of Sculeeto Sculeeto
    12. February 2012 at 13:28

    Scott,
    Though I like the idea of NGDP targeting, there are several models describing how a change in wealth affects output: Bernanke, Gertler and Gilchrist 1999, Iacoviello 2005, papers by Kiyotaki,…

  39. Gravatar of josh josh
    12. February 2012 at 14:14

    “First example:  The huge 1987 stock market crash was almost identical to the 1929 crash, but the “effects” could not have been more different.  The 1929 crash was followed by the Great Depression, whereas the 1987 crash was followed by years of smooth and placid economic growth.  Not even a ripple to real GDP.”

    The 1929 Crash was also preceded by many years of personal debt rising much faster than income. Much of what drove the stock market bubble was people buying stocks on margin. Like with the housing bubble, people came to believe that the economy had matured to the point where stocks would never go down. So as was the case with our recent housing bubble, people borrowed to invest in stock with the intention of flipping that stock later. When the stock market crashed, it meant many people were heavily indebted with no means of paying off that debt.

    The 1987 stock market bubble seems largely the result of rich people who got a lot richer gambling some of their new income in the stock market. For them, a loss in wealth would have no effect on their spending. For the people who borrowed to invest in the stock market in the 1920s, it meant high debt obligations that they only took on with the anticipation of rising stock prices.

    “Yes, stocks are skewed more towards the rich than houses, but if wealth was really that important, then a gigantic stock market crash should have had at least a small impact on output.”

    I think there are two key differences between housing and stocks. First, people know that stocks are volatile, thus rising stock prices probably would not have an effect on levels of consumptions, whereas people believe that housing prices are fairly stable, meaning that rising housing prices gives the illusion of savings, thus encouraging higher levels of consumption. At the peak of the Housing Bubble in the US, for instance, the housing savings rate fell to nearly zero, meaning households were spending 100% of their income (for about 80% of households it was about 110%).

    Once they realized that the wealth in their houses was an illusion, they permanently reduced their spending levels to save more. Even if housing prices begin to rise again, people still won’t trust housing equity as a form of savings, so the levels of consumption will never return to what they were during the housing bubble. Under no conditions can I see 80% of households spending 110% of their income as was the case during the housing bubble.

    Second, stock prices entail no real misallocation of capital, whereas housing is a real good that requires labor and other forms of capital. Thus, rising housing prices means more resources allocated to the housing sector, which is not the case with stocks.

    And It’s not like someone can just go from being a construction worker to a software engineer. Whereas there used to be lots of low entry manufacturing jobs, rising levels of productivity means it only takes a fraction of the population to produce all necessary goods, and low entry jobs are saturated. In other words, there is more friction in the reallocation of labor than there used to be. There are much fewer low entry jobs relative to workers, and the barriers to good paying jobs are higher than they have ever been before. Even supposing there were lots of jobs in say, IT, a construction worker is not likely to immediately try to find a job in a new industry. Instead, he’ll continue to look for work in construction while running down his savings. There is also the issue of aptitude as well. Housing provided an outlet for this glut of labor, but now that the bubble has gone bust we have millions of construction workers without jobs.

  40. Gravatar of Bill Woolsey Bill Woolsey
    13. February 2012 at 04:26

    Josh,

    You are confounding two issues.

    One issue is a misallocation of resources to housing. Market monetarists grant that this sort of thing is possible, but it happens all the time in areas other than housing (that is why the market system is called one of creative destruction) and in fact the reallocation of resources away from housing was not that large. Karl Smith has some figures. Sumner always points to timing. We say what the slow down in production and employment and increase in unemployment were like due to the needed reallocation of resources.

    The second issue is changes in saving. People reduce their flow of saving because of capital gains in their assets. Rising housing prices resulted in more consumption and less saving. (You mix this in with debt, but debt financed consumption is dissaving and paying down debt is saving.)

    Well, econ 101. More saving, lower interest rate, decrease in quantity of saving supplied and increase in quantity of investment demanded. The composition of demand and production shifts from consumer to capital goods. However, I think that the most likely scenario is that most of the shift in resource allocation will be from housing to capital goods.

  41. Gravatar of ssumner ssumner
    13. February 2012 at 06:51

    Sculeeto, This post wasn’t directed at the argument that wealth can affect output, but rather the argument that changes in wealth affect potential output.

    Josh, Most of your post has no bearing on the issue of potential output. This point might in theory:

    “And It’s not like someone can just go from being a construction worker to a software engineer.”

    But in practice it’s of trivial importance. I have done many posts showing that is was not in fact the problem in 2009–unemployment rose in almost all sectors of the economy. Conversely, most of the housing construction crash occurred between Jan 2006 and April 2008, and unemployment was almost unchanged. Housing simply isn’t big enough to effect the business cycle. The problem was falling NGDP in late 2008 and 2009, which affects all industries.

  42. Gravatar of Major_Freedom Major_Freedom
    13. February 2012 at 20:55

    Bill Woolsey:

    You don’t understand the difference between nominal and real.

    That’s hilarious.

    All of the capital goods over the last 20 years were generated out of real savings, and nearly all of them were constructed based upon desired real savings.

    False. A substantial portion of capital goods over the last 40 years have been financed by credit expansion, fiduciary media from the banking system that is not financed by a prior increase in real savings, but created ex nihilo. Credit money granted ex nihilo is not financed by real savings.

    The malinvestment that might be generated by an excess supply of money is not the equal to the entire nominal supply of money, much less the entire nominal supply of credit.

    Nobody argued it was.

    When the prices of capital goods get higher, then the higher nominal supply of credit purchases a smaller real quantity of capital goods.

    The prices of capital goods get higher in large part BECAUSE of the higher nominal supply of credit representing a higher monetary demand for those capital goods.

    This is the real quantity of credit moving back to equilibrium with the real saving.

    You’re just arbitrarily postulating an increase in the prices of capital goods without asking why.

    As prices rise, the nominal demand for credit rises to return to equilibrium with the higher nominal quantity of credit, which matches the higher nominal quantity of money.

    Prices don’t rise unless there is an increase demand in terms of money spending, or a decrease in supply.

    The increase in the nominal demand for credit brings real market interest rates back up to equilibrium. This brings investment back to real saving.

    No, you have it exactly backwards. An increase in credit expansion brings about investment and purchase of durable consumer goods that exceed what is possible through real savings only. This increases aggregate business profitability, and thus increases interest rates. In the absence of further credit expansion, real savings and real time preferences will reassert themselves, and the increase in profitability will disappear, and market interest rates will come back down.

    My view is that this process works quickly, so malinvestment is insiginficant. The other view is that it happens slowly, so there is malinvestment. However, your apparent view, that that the entire growth in the nominal quantity of credit represents malinvestment is wrong.

    No, it’s correct. Any investment that is made without a prior increase in real savings is investment that consumers were not willing to “wait” for in the sense of sustaining the investments. It is possible ex post that some of the malinvestment ends up being valued given that it exists, but we cannot know this ex ante.

  43. Gravatar of Bill Woolsey Bill Woolsey
    14. February 2012 at 04:52

    Major Freedom:

    The amount of credit expansion matched by money creation was not a significant fraction of total credit creation.

    Credit is now about 37 trillion. The quantity of money created by banks is about 1.6 trillion. The amount of money held by the public that was created by the Fed is about $1 trillion.

    But more to the point, it is only the excess supply of money that creates an excess supply of credit. Any increase in the quantity of money that its matched by increases in the real demand for money, or even keeps up with actual inflation (avoiding a decrease in the real supply of credit,) does not create an excess supply of credit.

    As for the capital goods, you are missing the increase in their current nominal value because of the increases in the prices of their future products because of the inflationary policy. You are implicitly assuming that future prices of products are staying the same. They don’t. If you ignore that factor, your analysis is way off.

    Imagine all of this money creation were reversed and the quantity of money falls by 90%. The prices of consumer goods and services all fall by 90%. Capital goods, which are valued according to the future consumer goods they can produce, fall in value 90%.

    Debtors have 90% (and everyone else) has a 90% drop in nominal income. While there would likely be some real transfers, the larger effect is that creditors would collect about 90% on the dollar in bankrupcty. This leaves them 90% less money to lend. But with prices 90% lower, this means they can buy just amount the same of goods and services as before, which includes capital goods. They can finance the same amount of capital goods as before.

    With equitiy finance, it is simpler. The stocks are claims to future profits. The nominal value of those profits fall by 90%. So the stock falls by 90%. But the prices of the capital goods also fall 90%, and so stock woth 90% less finances the same amount of real capital.

    The banks collect 90% on the dollar on loans. Their CD holders and saving account holders get 90% on the dollar. But with all goods and services worth 90% less in nominal terms, those 90% less of CDs and savings accounts funds the same amount of real capital goods.

    And so, we are getting down to the checking accounts. All of these applies to them too, if checking accounts still are used to fund loans.

    Of course, I am perfectly aware that you have a 100% banking ax to grind, with a gold standard outside money base. And so, this gets us down to the real effect. The 5% of credit that is funded by money would now fund gold. (If we still have a fiat currency, it funds the national debt, but your paradigm is based on gold standard thinking.) Now, the real value of gold is higher with this massive deflation (again, assuming a gold standard.) To the degree that people use the real capital gains on the gold appreciation to purchase consumer goods, this reduces the real capital stock. To the degree that they instead use the real capital gains to purchase stocks or bonds or provide some other credit, then those new loans or stock holdings will fund some of the existing real capital goods. The effect of appreciated base money (gold in your case) on consumption is called the Pigou effect.

    Anyway, your error was to ignoret that the amount of nominal credit necessary to intermediate a given amount of real savings depends on the prices of goods and services. As I said before, I think your most important error is ingoring the effect of future prices of consumer goods and services on the prices of capital goods.

    Focusing on interest rates again, your argument would imply that a high price level requires a low real interset rate. It doesn’t. Further, a growing price level doesn’t require a low real interest rate. And it actually requires a higher nominal interest rate.

    However, monetary policy aimed at lowering the real interest rate in an inflationary environment, does involve an excess supply of money and an excess supply of credit (plausibly, anyway,) and it could lead to malinvestment. But it isn’t all the increase in money and credit that involves malinvestment. Much less that all of the existing amount of debt represents malinvestment.

  44. Gravatar of Major_Freedom Major_Freedom
    1. March 2012 at 23:19

    Bill Woolsey:

    The amount of credit expansion matched by money creation was not a significant fraction of total credit creation.

    Yes, this is the pyramiding aspect of our monetary system.

    Credit is now about 37 trillion. The quantity of money created by banks is about 1.6 trillion. The amount of money held by the public that was created by the Fed is about $1 trillion.

    That’s just north of $34 trillion in fiduciary credit backed by zilch.

    But more to the point, it is only the excess supply of money that creates an excess supply of credit.

    “Excess” relative to what standard?

    Any increase in the quantity of money that its matched by increases in the real demand for money, or even keeps up with actual inflation (avoiding a decrease in the real supply of credit,) does not create an excess supply of credit.

    Yes, it does. There is always a desire for people to earn more money. The demand for more money is always there, until hyperinflation. Credit created out of thin air, is excess credit. Credit backed by prior real savings, is not excess credit.

    As for the capital goods, you are missing the increase in their current nominal value because of the increases in the prices of their future products because of the inflationary policy.

    No, they are rising in price because their prices are bid up because of actual inflation.

    If everyone were told that inflation would rise 100% next year, and they believed it, then they wouldn’t be able to increase prices 100% this year because the money doesn’t exist yet to add to demand to raise prices.

    You are implicitly assuming that future prices of products are staying the same. They don’t. If you ignore that factor, your analysis is way off.

    I am not presuming any constancy in future prices.

    Imagine all of this money creation were reversed and the quantity of money falls by 90%. The prices of consumer goods and services all fall by 90%. Capital goods, which are valued according to the future consumer goods they can produce, fall in value 90%.

    So costs and revenues all fall by 90%? That means the rate of profit is unchanged.

    Nominal changes across the board means real standards of living remain intact.

    Debtors have 90% (and everyone else) has a 90% drop in nominal income. While there would likely be some real transfers, the larger effect is that creditors would collect about 90% on the dollar in bankrupcty. This leaves them 90% less money to lend. But with prices 90% lower, this means they can buy just amount the same of goods and services as before, which includes capital goods. They can finance the same amount of capital goods as before.

    With equitiy finance, it is simpler. The stocks are claims to future profits. The nominal value of those profits fall by 90%. So the stock falls by 90%. But the prices of the capital goods also fall 90%, and so stock woth 90% less finances the same amount of real capital.

    The banks collect 90% on the dollar on loans. Their CD holders and saving account holders get 90% on the dollar. But with all goods and services worth 90% less in nominal terms, those 90% less of CDs and savings accounts funds the same amount of real capital goods.

    Egads Woolsey, you’re speaking my language. We have more in common that I think you realize.

    And so, we are getting down to the checking accounts. All of these applies to them too, if checking accounts still are used to fund loans.

    Of course, I am perfectly aware that you have a 100% banking ax to grind, with a gold standard outside money base. And so, this gets us down to the real effect. The 5% of credit that is funded by money would now fund gold. (If we still have a fiat currency, it funds the national debt, but your paradigm is based on gold standard thinking.) Now, the real value of gold is higher with this massive deflation (again, assuming a gold standard.) To the degree that people use the real capital gains on the gold appreciation to purchase consumer goods, this reduces the real capital stock. To the degree that they instead use the real capital gains to purchase stocks or bonds or provide some other credit, then those new loans or stock holdings will fund some of the existing real capital goods. The effect of appreciated base money (gold in your case) on consumption is called the Pigou effect.

    Agreed top to bottom.

    Anyway, your error was to ignoret that the amount of nominal credit necessary to intermediate a given amount of real savings depends on the prices of goods and services.

    I notice you have a penchant for accusing me of making errors even though I am not actually making those errors. I am not ignoring prices in any way.

    As I said before, I think your most important error is ingoring the effect of future prices of consumer goods and services on the prices of capital goods.

    I am not ignoring that either. I know of imputed value theory. I just think it’s a special case, not a general price theory.

    Focusing on interest rates again, your argument would imply that a high price level requires a low real interset rate.

    No, it doesn’t imply this at all.

    However, monetary policy aimed at lowering the real interest rate in an inflationary environment, does involve an excess supply of money and an excess supply of credit (plausibly, anyway,) and it could lead to malinvestment. But it isn’t all the increase in money and credit that involves malinvestment. Much less that all of the existing amount of debt represents malinvestment.

    ANY credit expansion unbacked by prior real savings makes malinvestment inevitable.

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