The paradox of thrift is generating a considerable amount of attention this week. I’ll give a brief summary of the debate and then my thoughts.
This was started by our friend David Beckworth (inspired by Martin Wolf):
He is alluding here to the Paradox of Thrift, the idea that if everyone tries to save–which makes sense individually–during a recession, then aggregate spending will fall.
David then goes on to note that:
Let me explain why the Paradox of Thrift is really just an excess demand for money problem. First, individual households can save three ways: (1) by cutting back on consumer spending and hoarding money, (2) by spending income on stocks, bonds, or real estate and (3) by paying down debt. In the first case, all households attempt to increase their holdings of money by cutting back on expenditures. However, if there is a fixed amount of money this will create an excess demand for it and a painful adjustment process will occur. If , on the other hand, the Fed adjusts the money supply to match the increased money demand then the painful adjustment is avoided and monetary equilibrium is maintained.
Nick Rowe chimes in with this in the comments:
Yes! There is no paradox of thrift. There is a paradox of hoarding the medium of exchange. That’s because there are two ways to buy more money: sell more other things; buy less other things. One of those two options is always open to the individual, but not to everyone.
The *only* case where Say’s Law is wrong is when there is an excess demand (or supply) of money, the medium of exchange.
Brad DeLong has taken umbrage with these statements:
The hole in David’s argument is, I think, where he says “the Fed adjusts the money supply” without saying how. Suppose that we have a situation–like we have today–where people are trying to cut back on their expenditure on currently-produced goods and services in order to build up their stocks of safe assets: places where they can park their wealth and be confident it will not melt away when their back is turned. They switch spending away from currently-produced goods and services and try to build up their stocks of safe assets–extremely senior and well-collateralized private bonds, government securities, and liquid cash money. Now suppose that the Federal Reserve increases the money supply by buying government securities for cash. It has altered the supply of money, yes. But it interest rates are already very low on short-term government paper–if the value of money comes not from its liquidity but from its safety–then households and businesses will still feel themselves short of safe assets and still cut back on their spending on currently-produced goods and services and the expansion of the money supply will have no effect on anything. The rise in the money stock will be offset by a fall in velocity. The transactions-fueling balances of the economy will not change because the extra money created by the Federal Reserve will be sopped up by an additional precautionary demand for money induced by the fall in the stock of the other safe assets that households and businesses wanted to hold.
In addition, we also get perspective on the framework that DeLong is operating within:
I am still frustrated that all of this seems so clear to me and is to opaque to so many other smart people. Personally, I blame Olivier Blanchard for making us spend three weeks on Lloyd Metzler’s “Wealth, Saving, and the Rate of Interest” in my first year of graduate school…
Regardless of what anyone has said to this point in the debate, the key to understanding the differences between folks like David Beckworth, Nick Rowe, and Scott Sumner and those like Brad DeLong and Paul Krugman is encapsulated in a key assumption made by Lloyd Metzler (that persists in the New Keynesian framework).
In Metzler’s analysis, bonds and capital are assumed to be perfect substitutes. As a result, we can focus all of our attention on the interest rate. Monetarists and quasi-monetarists, however, do not accept the view that the sole effect of monetary policy is given by its effect on “the” interest rate. This was the primary source of criticism of Monetarists of Keynesian models. Brunner and Meltzer spent a great deal of time and effort emphasizing that exclusive focus on the interest rate could be misleading. In fact, if you read the papers in Jerome Stein’s Monetarism, it is clear that this is the central focus of the debate from the monetarist perspective — although not from the Keynesian perspective. What’s more, the paper in that volume by Tobin and Buiter even notes that a useful extension to their model would be to drop Metzler’s assumption.
Why does this matter? It matters for a variety of reasons, but most importantly, it matters for the concept of a liquidity trap as DeLong describes above. Brunner and Meltzer (1968) showed that when the demand for money and other assets are a function of an index of interest rates rather than just the short-term interest rate, one can rule out the existence of a liquidity trap. (So long as money and the other assets are not perfect substitutes, an index of interest rate is necessary for analysis.)
Thus, it is not that David and Nick haven’t read Metzler, it is that their framework implicitly, if not explicitly, rejects Metzler’s assumption. Relative prices matter.
P.S. Much of the New Keynesian paradigm, at least that espoused by Woodford, highlights the importance not only of actual central bank policy, but expectations about central bank policy. For a discussion about expectations, see this post by Scott Sumner.