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Deflation

May 31, 2010 6 comments

One of the great timeless questions in macroeconomics is: what are the real effects of changes in the value of money?  The current conventional wisdom (if I may simplify) is that in the long run, it doesn’t matter (money is neutral) but in the short run monetary issues are important.  More specifically, in the short run, inflation is good in some situations and mostly innocuous in others so long as it doesn’t get out of control, but deflation is bad and should be avoided.  The fear of deflation seems to be mostly empirically motivated (we have observed deflation and recessions happen together) and explained mainly by assuming prices (especially wages) are sticky in the downward direction so markets can’t adjust efficiently.  Interestingly, the same progressives who buy into this logic have spent the last century doing their best to create institutions which prevent prices from falling (minimum wage, labor unions, subsidies, bailouts, etc.) but that is a topic for another post.  What I want to do here is establish a distinction between one situation where deflation is not scary and another situation in which it is. 

First let us imagine (sigh…) a free market with real money.  I have already argued that this situation would most likely be characterized by moderate deflation due to the relatively fixed quantity of precious metals compared to output.  In this case the rate of inflation/deflation would be determined in the marketplace.  It would include all expectations of future events and it would be efficient.  What I mean by this is that people would utilize the ability of money to act as a store of value to the extent that this is preferred to their next best option and only to that extent.  In this case the price of holding money would be the difference between the rate of return that one could receive from some other investment and the rate of return on holding money (the rate of deflation).  People would only pay this price because there is a benefit to them of holding money (liquidity preference).  If there were no liquidity preference, then this price would be zero, the rate of deflation would be equal to the real interest rate and the nominal rate would be zero. 

Note that this price is separate from the real interest rate which is the price of consumption now in terms of consumption in the future.  If people did not prefer consumption now to consumption in the future, the real interest rate would be zero.  If this were the case, and there were liquidity preference then there would be some inflation and this would represent the price of holding money.  The important thing to understand is that these rates are manifestations of the real situation in the market including peoples preferences and expectations for the future, they are not random.  In this situation, there is nothing harmful about deflation.  The rate would be determined as exactly that rate which leads to an efficient level of investment, savings and consumption based on people’s preferences and expectations, and it would be relatively predictable so people could plan accordingly.  This wouldn’t mean that people’s predictions would always be right, there is still a random element to the nature of the world, but this system would not add unnecessary distortions or uncertainty.  If a ship full of gold sunk, or a new productive mine were discovered, these rates would change, some people would be worse off and others would be better off but the rates would be changing to the new efficient levels.  They would reflect the new perception of reality faced by the market and the economy would continue on from there in an efficient manner.  I will speak more to the specific ways that these rates would change in a later post.

Now I will transition to the current system.  Let me point out that the explanatory power of the model I am developing here is independent of the motivation for these systems.  However, since this is a blog about freedom and not a scholarly journal, I will take the opportunity to point out some connections which I find interesting.  Keep these things in mind.

1. Progressives and Marxists, rather than observing how the world actually works and trying to design institutions that are desireable in light of that information, begin by imagining how they wish the world worked and try to use government to make nature conform to their whims. 

2. Progressives and Marxists wish they lived in a world with no “rentier class.”  That is, they wish capital was free (not scarce) and you could not make money by lending or investing. 

3. Keynes was a progressive/marxist.  Recall this quote from the General Theory: “Now, though this state of affairs would be quite compatible with some measure of individualism, yet it would mean the euthanasia of the rentier, and consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.”  So was Woodrow Wilson (and like the entire government in 1913…).

4. The government cannot alienate your God-given liberty, but it can manipulate the options which you are at liberty to choose.

Ok, with these things in mind let’s look at what the Fed does.  Actually, I will talk more specifically about what it does later, for now let’s say that they set the interest rate.  But notice that what they set is the nominal rate.  If the real interest rate is determined by real factors (time preference and investment opportunities), then it would be independent of this rate and the difference would manifest itself in the form of inflation/deflation.  If they set the nominal rate lower than what it would be in a free market this means that holding money becomes more expensive.  If they set it lower than the real rate you will have inflation, meaning people, instead of realizing a return on holding money are actually being taxed for doing so.  The lower the nominal rate in relation to the real rate, the less appealing it is to hold money.  This will tend to increase velocity and may drive down real rates.

The effect of this decrease of interest rates on real investment is not as clear as is commonly imagined.  To see this, notice that there are three things you can do with wealth.  Save it (by holding money), invest it, or consume it.  What they are doing is essentially taking one option away (holding money).  But lower interest rates are likely to encourage consumption as it is investment.  This means these two alternate uses will both pull harder on the existing wealth than with a higher interest rate (this is just another way of saying the market is out of equilibrium).  Whether this leads to more or less real investment depends on which one pulls more harder.   This is an issue I do not have a completely satisfactory answer to yet but I will deal with it in more detail later. 

Keynesians handle it by assuming that when more consumption and more investment are demanded, more wealth is magically created at no cost to anyone.  If you assume this then it’s a win-win.  Unfortunately that’s ridiculous.  Even if you believe that this results in greater investment than when interest rates are higher, it is not necessarily more efficient.  In fact, basic economic reasoning indicates that it would be less efficient.  Keynes contrived a complicated and in my opinion flawed theory to try to argue that sometimes it might be more efficient.  Regardless of the effect on investment, what it does do is make it harder to make money by lending money.

There are many interesting things going on here but I want to turn the focus back to deflation.  What happens here is that the government, by setting the nominal interest rate, controls the money supply (this is often stated the other way around but the distinction is unimportant) and this affects inflation.  This has led to a dual mandate.  The Fed often claims that its goal is to use monetary policy (setting of interest rates) to promote whatever they somehow decide is an appropriate amount of economic growth and to keep inflation at low positive levels.  I intend to show eventually that this system necessarily leads to periods of unexpected deflation but for now I just want to consider what the effects of this would be if it happened for some reason. 

With fiat money and the fed doing what it does, deflation would still not be inherently devastating to the economy at large.  If the fed decided to choose the nominal rate that would have been determined in a free market, we would most likely have moderate deflation, it would be predictable and the economy would function fine.  There are two situations which combine to make deflation problematic.  One is when it is unexpected.  This means people find themselves in a situation that would not have been optimal had they known that deflation was going to happen.  This could result in inefficient intertemporal decision-making.  In other words, we may get the wrong amount of investment (too high or too low) and that investment may be in the wrong things.  This is essentially the classic Austrian business cycle story where we get a depression because we have to liquidate and reallocate the malinvestment that we accumulated due to the inappropriate interest rates and unexpectedly low inflation rates.  This story is probably correct but the main criticism of it is that it doesn’t seem like enough to explain long deep depressions and I agree.  Of course Austrians will argue that this is true but when we have had long depressions they have been perpetuated by misguided government intervention which is true but I think there is also something else going on here. 

If you just had households lending to firms and you got unexpected deflation, then firms would be made worse off and some would go out of business but this would not be devastating to the macro economy.  Households would actually be better off.  Even if entrepreneurs defaulted on their loans (provided it was only due to the deflation), they would get back assets worth more than what they would have otherwise (but of a lower nominal value).  The assets would get reallocated and production would go on only mildly interrupted.

The second ingredient in this cocktail is debt.  If the interest rate were at its natural level and the fed came along and offered to loan as much money as people wanted at some rate lower than this, consumers would want to consume more and investors would want to invest more.  Both would want to borrow more money.  If they knew this rate would persist forever and inflation was free to adjust, then the inflation rate would adjust to put this market in equilibrium.  However, if people mistakenly believe that the Fed will maintain a certain rate of inflation which is not compatible with equilibrium given their low nominal rate, then consumers will borrow money in order to consume thinking the price of consumption today is very low in terms of consumption tomorrow because they expect to pay back the loans with cheaper dollars.  Investors will also borrow more for the same reason.  Then, if deflation happens, they will both lose because they are both borrowers. 

So who becomes the owner of all the real wealth in the economy?  The banks of course.  But wait–I hear you cry–aren’t the banks the hardest hit by these downturns?  Why yes, in fact, I should have been more specific.  You see, most banks are actually debtors as well.  They lend money in nominal terms so they stand to gain on the one side by deflation.  The problem is that they also borrow in nominal terms.  Some of this borrowing comes from households but remember that by keeping nominal interest rates low (and inflation expectations high), this type of saving is drastically reduced.  But the demand for lending is increased, so banks make up the difference by borrowing from the Fed.  This seems like a great deal.  The fed loans you money at 2 percent and you lend it out at 4.  How can you lose? 

Well if there is a sudden outbreak of unexpected deflation you lose.  That’s because when prices fall, firms can’t pay back the nominal value of their debts.  This wouldn’t necessarily be a problem.  If they had collateral, the banks would just take the collateral and they would be even better off because even though it wasn’t worth as much as they were owed in nominal terms, it would still be worth more in real terms than the nominal value of the debt would have been worth without the deflation (there are some assumptions involved here but I’m trying not to be too technical). 

So if you’re a bank and this happens, you don’t get the money you thought you would get but you got a farm or a factory instead.  This is ok because while dollars are less valuable after the deflation, these real assets are no less valuable than when you accepted them as collateral.  Except there’s one little problem.  You still owe your creditors a fixed amount of dollars.  So even though the assets of the bank may be worth even more in real terms than before the deflation, the obligations of the bank are worth even more than that.  In this way a bank may become insolvent.  If the Fed decides that a bank is insolvent, it seizes the assets of said bank. 

So the real wealth gets sucked up by the Fed.  Where does it go from there?  Well it would be nice if we could, oh I don’t know…..audit the Fed!  But apparently we can’t, even when a majority of our representatives sponsor a bill to do so.  The paper profits that they accumulate (I should say that they choose to accumulate on a set of books that nobody can look at) go right into the treasury.  The assets that they seize from insolvent banks get sold off.  Usually this is to other banks.  Usually those banks come from a small group of Wall Street banks who always seem to be profitable even during these downturns and whose heads happen to be running the Fed. 

Regardless of the degree of insidiousness involved, a lot of wealth is likely to be destroyed in this process (foreclosed houses don’t tend to be in very great condition).  I don’t know how large it is reasonable to imagine the magnitude of this effect is, but what is probably more problematic is that the wealth becomes concentrated in the hands of a few institutions who don’t really know how to make use of it.  This wouldn’t be much of a problem except that there is very little other wealth left in the hands of the people who do know what to do with it which they could trade to acquire it.  This may result in much of it being underutilized for some time.  Throw in some government sponsored price rigidities and uncertain property rights, and you have a pretty good recipe for depression.  But you can’t claim that the problem is deflation and that’s why we need the Fed to protect us from it.

Categories: Macro/Monetary Theory Tags:

By the Way

In case you are wondering “who’s this Peter Schiff guy and why should I be listening to him?”  Take a look at this little highlight reel.  It’s really quite compelling the way these people were all laughing at him and treating him like a kook.  These are mostly people with pretty sensible mainstream economic views whom I generally respect (Art Laffer, Ben Stein,  Stewart Varney).  Modern macro really conditions you to lose sight of fundamental economic reality and focus on things like what “big guns” the central banks can fire to “stimulate” (manipulate) the economy.  Watch this twice, it’s even funnier the second time.  And pass it on to everyone you know.  For the record, GLD is up 46% since that interview while both of the stocks Charles Payne picked are all gone (poof).

Categories: Uncategorized

Unalienable Rights

May 26, 2010 2 comments

I will return to my macro model shortly but I am feeling philosophical today.  The Declaration of Independence famously states “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”  The idea of a right has been severely distorted over the years and we need to reconnect with the true meaning of the concept.

What does it mean to say that a right is “unalienable?”  From the Oxford American Dictionary, inalienable is defined as “not able to be given away or taken away.”  The key word is able.  These are rights which come from “their Creator” and cannot be subverted by man.  They did not say “certain rights which should not be alienated.” This distinction is very important.  To understand the significance let’s examine the particular rights mentioned.

Life, liberty, and the pursuit of happiness are rights which every man brings into the world with him simply by virtue of being born into it.  No decree is required by any other man for you to have these rights.  Furthermore, no decree by any other man can take them away.  If you are living, then you are alive (a is a) and if you are alive, you are free.  That is to say that you and only you control the actions of your body and mind.  Nobody else can control them for you.  No law can be passed wich makes you, through no volition of your own, wiggle your pinky or invent the lightbulb.  So what can laws do? 

Laws and governments change the options you face.  Another man can decree that if you do not wiggle your pinky, he will kill you.  Actually to put this more precisely, he can decree that he will try to kill you.  This gives you the following options: wiggle your finger or don’t wiggle it and face the threat of death.  You still choose one or the other.  You still have the liberty to make your own choice and you still have the ability to choose the option which is most conducive to your own happiness.  What’s more, if you choose not to wiggle your pinky, you may choose to fight for your life.  You have a right, by your very existence, to hold onto your life as long as you are physically able.  Another man cannot make you sacrifice your life, he can only give you a set of choices where death is the most appealing option. 

The Declaration goes on to say:

That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.

They are not saying that it is the job of government to grant these rights to the people.  They are saying that these rights exist regardless of government and that because of this, government should not be organized in a way such that it is in conflict with them.  When government secures your right to live, accumulate and use property, and generally pursue happiness in whatever way you see fit so long as it does not interfere with another’s inherent right to their life and property, government acts in harmony with these unalienable rights.  When government alters the options you face in such a way that you must choose between one form of destruction and another, it is in conflict with them.

Now consider what progressives mean by “rights.”  Take the idea that healthcare is a fundamental right.  To say this is to say that you are entitled to be kept alive by means completely disassociated with your own judgement, ability, or choices.  This is not an unalienable right.  You are not born with the guarantee that you will survive no matter what you do.  In order for a human to survive, it must learn to make decisions which are conducive to its survival.  You are not born with a guarantee of survival, you are born with the right to choose to survive.  If you make choices which are not conducive to your survival, you are choosing your own destruction.

Progressives want to live in an alternate reality.  They want to live in a world where life is guaranteed and no choice is necessary.  They think they can create this world by decree–that if they decree that healthcare is a fundamental right, then survival will no longer be dependent on choosing the actions which are conducive to survival.  They try to replace the liberty to choose that which is most likely to lead to your happiness with the liberty to choose whatever you want and still be happy.  But this system is in conflict with the true unalienable rights.

Healthcare must be produced.  If you have a “right” to it which is independent of your ability to create it or to create something of value that can be traded for it in a mutually voluntary manner, then someone else’s options have to be restricted in order for you to get it.  This is because the person who must produce it has an unalienable right to choose what is in his best interest from the available options.  If giving you healthcare for free is not what he considers the pursuit of happiness, then the options he faces must be altered to induce him to choose this.  This may be done by decreeing that he must produce healthcare for free or go to jail.  Or it may be done by telling others that they must give up a portion of what they produce so that the doctor may be paid enough to induce him to produce healthcare or else they will go to jail.  Or it may be done by giving you a “right” to “healthcare” but restricting the type and amount of healthcare you may receive to only that which others choose to provide for free (or for whatever price government decides is “fair” to pay out of the pockets of others in the second way) and if you try to negotiate a mutually voluntary trade for any further care, you will go to jail. 

Most likely in practice it will be some combination of all of these, but they are all in conflict with the real unalienable rights in two fundamental ways.  On one side, they seek to restrict the options someone faces in order to get them to choose an action which would not be in their interest otherwise.  On the other they try to disconnect the real consequences of people’s choices from those choices so that the pursuit of happiness is no longer required for its attainment.  Frankly that world sounds crummy to me, but even if it sounds good to you, you can’t have it.  Your beef is with God not government, please let the rest of us live in the real world.

Categories: Uncategorized

More Fear Mongering

May 26, 2010 1 comment

Here’s another fun video with Peter Schiff and some other people.  I especially like the explanation of the American stranded on an island with a bunch of Asians.  It sums up the absurdity of Keynesian “demand side” economics quite clearly.  There is getting to be a lot of stuff like this on youtube.  Not sure how significant that is since there is a lot of a lot of stuff on youtube but it seems to my casual observation that people are becoming very aware of the potential for the dollar to collapse.

Categories: Uncategorized

Critique of the Existing Model

So far I have only begun to lay out my model but I want to stop at this point and compare my approach to the Keynesians.  This critique focuses on the work of Keynes and his immediate followers.  The fundamental defects persist in the thinking of more modern economists, though often the really egregious parts have been cleaned up a little.  I will start with a broad philosophical view and then zoom in on the economics.

Keynes was a progressive and his theories have been the main academic justification for progressive policies for 75 years.  The fundamental flaw made by every progressive when evaluating the world is that they see it first for what they wish it were rather than what it is and think that they can transform it from the latter into the former via the power of the state.  Economics is the study of decision-making in the face of scarcity.  Scarcity is the fundamental law of nature that motivates the entire field of economics and it is this concept which Keynes tries to wish away.  Not surprisingly, this is also the concept which stands in the way of the socialist utopia envisioned by progressives.  Here is Keynes on the subject.

Interest to-day rewards no genuine sacrifice, any more than does the rent of land.  the owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce.  but whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant.

The only problem with this theory is that the individual propensity to consume is of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant (what he means by sufficiently abundant is so abundant that the marginal rate of return is zero, which would mean the interest rate would have to also be zero).  We know this because we have always observed a positive interest rate whenever there has been something resembling a free market for investment.  This is because there is a real sacrifice involved with loaning money (the liquidity preference mentioned in the previous post).  Notice that I am not saying that capital should be scarce I am saying that based on all our observations of reality it is scarce.  Keynes is saying that capital should not be scarce and the fact that we observe things in reality that are only consistent with it being scarce indicates a defect in our economic system.   He is not using the power of observation to discover the laws of nature, he is assuming what the laws of nature should be and then using the fact that nature doesn’t conform to his assumptions to argue for government intervention.  But government can’t change the laws of nature to fit its whims, this merely puts man in constant conflict with nature. Incidentally, the reason he thinks it should not be scarce is that this would mean “the euthanasia of the rentier, of the functionless investor.” 

Scarcity means that there is less of a good available than what would be demanded if price were zero.  When this is the case, and there is a free market, the allocation of such a good is achieved by the price being bid up to some positive level where just as much is demanded as supplied at that price.  The positive price is endogenous and a manifestation of the scarce nature of the good.  The more scarce (to use the term loosely) the good, the higher the price.  The great task undertaken by progressives was to create an economic system in which the government controls the degree of scarcity.  Of course, this is impossible, so in reality they are just creating a system where they seem to control scarcity.  The way they did this was by seizing control of the effect of scarcity, namely the price.  The price of investment is the interest rate.  The way they seized control of it was by creating the federal reserve who has the power to set the interest rate.  Once they did this, they fundamentally changed the nature of the system.  They turned price into an exogenous variable.  Now price changes arbitrarily and the market adjusts to these changes in some way.  It is impossible to evaluate how it will do this in a traditional framework where price is an allocative tool. 

Keynesians and progressives would have you believe that lowering the price actually makes the good less scarce.  Here is Keynes again.

The justification for a moderately high rate of interest has been found hitherto in the necessity of providing a sufficient inducement to save.  But we have shown that the extent of effective saving is necessarily determined by the scale of investment and that the scale of investment is promoted by a low rate of interest, provided that we do not attempt to stimulate it in this way beyond the point which corresponds to full employment.

Essentially what he is saying here is that the demand for investment is downward sloping in price (the interest rate) while his predecessors believed that the supply is upward sloping.  Both of these views make perfect sense.  In a free market, the price and quantity would move together when demand changed and opposite when supply changed.  But when you make price exogenous, you have to deal with the question: when price arbitrarily changes, do you move along the supply curve or the demand curve.  Neither one of these is really more appropriate than the other and they lead to opposite conclusions.  In assuming that you move along the demand curve, Keynesians have implicitly claimed that by controlling price, the government controls the scarcity of the good.  That is to say that whenever they lower the price, more of it is magically created.  If they lower the price to zero, they have eliminated scarcity and we can all live in a paradise where we lounge around looking at art while robots tend to all of our needs and we won’t need those pesky capitalists any more. 

In the IS/LM model developed by Keynes’ followers, there is no inherent scarcity.  The only thing keeping output from approaching infinity is peoples’ annoying desire to save money.  Their solution to scarcity was to get people to invest as much of their savings as possible.  At the same time they were setting interest rates at levels lower than what would be determined in a free market.  This depresses the incentive to invest.  When people have the ability to hold real money instead of investing, it will soak up much of the demand for savings.  This meant they had to eliminate the ability to do this.  The way they accomplished this was by getting rid of real money and replacing it with imaginary paper money.  The important difference is that they can control the quantity of paper money (remember the relatively fixed quantity was wat allwoed money to function as a store of value).  This means they can print more of it to cause inflation.  The inflation is a cost to holding money.  This makes holding money less attractive and drives funds into other investments.  When they first did this, people put gold clauses into contracts to protect against this inflation so they had to make them illegal which they did in 1934.

The bubbles we observe in stocks, housing, precious metals, etc. are a manifestation of people’s “propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant.”  This is a reality of nature not a flaw in the capitalist system and all attempts to combat the natural effects of it simply cause other unintended distortions.  These distortions are what my model will attempt to explain.

Categories: Macro/Monetary Theory Tags:

A Bit of Finance

If there is an asset that will produce $100 of profit in ten years, how much is it worth today?  The price depends on the interest rate that you can get on other assets.  If the market rate of interest is five percent, then every asset (once you adjust for risk) should yield that same rate of return.  In this case, that would make the asset worth about 61.39.  You wouldn’t pay more for this because you could get a better rate of return on some other investment and if the price were lower than this, everyone would want to buy it so they would bid the price up.  Next year, the value will be higher since the $100 will not be as far off.  In fact it will be about 64.46 or about 5% more.  This is pretty basic stuff but the thing we need to notice is that the change in the value of an asset over some period of time when it doesn’t produce any direct benefits or costs should be equal to the market interest rate.  This logic can also be extended to situations like resource extraction (see Hotelling’s rule).

With this in mind, let us consider a particular asset–money.  Historically, money has served two main purposes.  It has been a medium of exchange which streamlined trade by reducing transaction costs and it has been a store of value.  The most appropriate materials for these purposes have been precious metals for several reasons.  Among them, are the facts that they are durable and the quantities of them are fixed by nature.  This is important precisely because it prevents the value of money from falling over time.  To see this consider an economy where money actually does grow on trees.  I have always found this an amusing expression because things that grow on trees don’t tend to be free.  If we went to the store and bought our groceries with cashews, it wouldn’t change the nature of the economy very much except for one thing.  As we got better at producing other goods, cashews would become more valuable.  When this happened, people would devote more resources to growing cashews which would increase the quantity of them and put downward pressure on their value.  Now it isn’t true that this is impossible with gold.  Surely some gold is harder to mine than other gold and as the value of it increases, people will go after the harder to mine stuff but the marginal cost is surely increasing at a much faster rate than it is for cashews or almost any other agricultural or manufactured commodity.  The effect of this is that when the production of their goods goes up, the quantity of gold in the economy doesn’t increase as fast.  This means that gold gets more valuable in the sense that it can purchase more real goods. 

Now consider how the interest rate is determined in a free market.  Investments exist that will provide some positive rate of return over some amount of time.  In order to get this return though, someone must forego the ability to consume over that period of time.  People aren’t willing to give up this opportunity for free but they are willing to give it up for some amount of return.  If there is a project that returns enough to get someone to give up the ability to consume over the amount of time it takes for it to come to fruition, they will negotiate some rate of interest that is mutually beneficial and the investment will take place.  This will go on until all remaining projects have a rate of return lower than the amount the marginal lender would require to invest.  The marginal rate of return determined in this market will be the real interest rate.

To see the relationship between this market and money, we have to think of money as an asset–that is, as a store of value.  This means that productive investment must compete with the holding of money.  So if there were no direct benefit to holding money (and there were no risk involved in other investments), the value of money would have to be increasing at the same rate as the real interest rate determined in the market for investment.  If it were increasing faster, nobody would invest in anything because they could just hold money.  If it were increasing slower, nobody would hold money because they could do better by investing.  In other words, there would be deflation.  In this case, there would be nothing destructive about the deflation.  It would be a sign of economic growth. 

In reality, the two things we assumed above (there is no direct benefit to holding money or risk involved with investing) are not true.  In fact, there is likely to be some risk premium involved with investment which is greater than holding money.  The odds of a project failing are most likely higher than the odds of your gold being stolen from your safe deposit box.  In addition to this, if you hold money, you are able to spend it at any time, whereas, if you invest it, you cannot consume until the investment matures (at least not without liquidating the investment which may carry some cost).  In this sense there is some risk associated with demand uncertainty that also comes with investment.  If your car breaks down next month, it will be easier to get it fixed if you have cash in the bank than if you have stocks.  This is what Keynes called “liquidity preference.”  Essentially, liquidity preference is just an additional form of risk premium though, so I will lump these together.  The risk premium on investment will mean that the return on holding cash will be somewhat lower than the return on investment.  If this risk premium is large, there might be inflation, however, this seems unlikely to me.  At any rate, in a free economy with real money, the rate of inflation and the rate of interest are determined by the market int his fashion. 

The thing that drives this wedge between the rate of return on money and the rate of return on other investments (liquidity preference) is represented in the equation of exchange by velocity.  Presumably, people have an increasing marginal cost of velocity.  To see this, consider the case of the Weimar Republic where people had to take their paychecks (often a wheelbarrow full of cash) and immediately take it to the store and buy food because it would be worthless the next day.  This is a state of very high velocity.  Certainly, this would be pretty annoying.  The reason they do this is because the value of money is decreasing rapidly so the cost of holding it is very high.  People would prefer to hold more cash which would mean a lower velocity.  As the cost of holding cash increases, they will hold less but as they hold less, the price they are willing to pay to hold it goes up.  This price is the risk premium on investment.  So if something (exogenously) causes the demand for cash balances (supply of loanable funds) to increase (decrease), this will cause velocity to decrease and the risk premium on investment to increase.  If something causes the demand for investment to increase, the risk premium will increase and velocity will increase.  This framework allows us to distinguish the relationship between interest rates and investment assumed by Keynes and the relationship assumed by his predecessors.

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More Than 10% of Mortgage Holders Missed a Payment Between January and March!

A new record.

When I first started writing regularly on this blog, I told a friend of mine that I would explain the macro model that I was working on.  I never really got around to doing that.  Lately though, I am starting to feel like most of the things I would want to point out about current events are being pointed out by others.  This is a good thing but it saps my motivation to come on and rant about things when I’m just adding my voice to the cacophony.  So I will shift gears a little bit and use the blog to finally start developing said model. 

Consider three things that happened today.  Gold and silver prices are down.  Stock prices are down.  Housing prices are down and foreclosures and missed mortgage payments are up.  What could cause the values of everything to go down at once?  There’s a simple answer to this question–deflation.  When the value of a dollar measured in terms of real goods goes up, the value of all real goods, measured in dollars goes down.  This raises two more subtle questions though.  Why does deflation (or inflation) happen and is it good bad or neutral? 

The simplest explanation is the quantity theory of money.  This theory basically says that the quantity of money (M) times the velocity of money(V) equals the price level (P) times the quantity of output (Y).  Keynesians have been hostile to this theory, in fact Paul Krugman once criticized another economist’s model by saying that there seemed to be some form of the quantity theory of money underlying it.  But there is some form of this theory underlying any model.  In fact as stated so far, it is not really a theory, it is an identity.  Given the way the terms are defined, it must be true.  The theorizing comes into play when people assume certain things about how these different variables react to changes in the others, specifically to changes in the quantity of money. 

Classical economics typically assumes a frictionless economy, or in other words, that there is perfect information and no transaction costs.  If this is the case, when you change the money supply, output shouldn’t change because it will be determined by real variables and there is also no reason for velocity to change (interestingly, in a frictionless economy, there is really nothing determining velocity.  If you tried to make it endogenous, it would explode to infinity and prices would do likewise).  So by assuming this, classical economists came to the conclusion that any change in the money supply should only change prices and have no real effect.  This result is referred to as “money neutrality.”

Keynesians use this theory to make different arguments.  For instance, when they want to argue that deflation is bad, they make an argument which (most likely implicitly) assumes that the money supply and velocity are fixed and the price level just magically changes for some reason.  If this happens, it must decrease output, but that is only because you assume away any other possible effect.  Similarly, when they want to argue that money is not neutral, they invoke “sticky prices” meaning that prices don’t adjust automatically to changes in the money supply.  Put another way, they assume that when the money supply changes, prices (and velocity) are fixed and so then you will obviously get an increase in output when you increase the money supply but only because you assumed it.  The extent to which prices are sticky is an ongoing debate but it’s interesting to point out here that the main reasons for sticky prices are completely overlooked by Keynesians, namely government intervention in markets.  During the depression, they claimed the free market was flawed because prices don’t adjust fast enough, while the government was preventing industry from lowering wages and paying farmers to destroy their crops.  So this equation is underlying Keynesian theories as well, they just don’t like to get too specific about it because it highlights the inconsistency in their treatment of monetary issues.

The problem with all of these theories is that they arbitrarily decide what variables in the equation of exchange are held constant, which are changing exogenously, and which are changing endogenously.  In reality, there is only one exogenous variable–the money supply.  The other three are all endogenous.  A sound macro theory should allow a change in the money supply to affect any or all of them.  It should also be able to predict the effect on the other two of a change in one of them due to a change in some other exogenous variable.  It should never deal with questions like “what happens to output when there is deflation?” or “what happens to the price level when velocity magically changes for some unspecified reason?” since this is asking what the effect of one endogenous variable will be on another endogenous variable.  It is like asking what happens to equilibrium quantity when equilibrium price increases (a common mistake among laymen). 

When I ask a macro person what happens to inflation when the Fed lowers interest rates, they say something like “well, in the long run you get higher inflation but not in the short run.”  This analysis seems to be based on the assumption that prices are sticky in the short run but not in the long run which is tantamount to saying inflation is fixed in the short run for some reason and in the long run the quantity theory of money must hold, so they have to adjust eventually.  The forces causing inflation and deflation are somewhat more subtle than that though and they require a more careful modeling.  My approach, in fact, leads to the exact opposite conclusion and a new interpretation of the liquidity trap.  To understand it though I have to start with a bit of finance.

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