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

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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