Saturday, July 30, 2011

Does increasing nominal asset values lead to more spending; increasing money stock lead to increasing velocity; higher velocity to higher price level


Does increasing nominal asset values lead to more spending

The conventional monetary theory is that when you increase the stock of money, you increase the nominal value of everything in the economy. For example, if you had a given quantity level of money, and you had a house worth a hundred grand, doubling the quantity of money results in everything doubling in price, including your house, which is now worth two hundred grand. You are nominally richer now, though in real terms, you’re just the same as before, because everybody in the economy now has double the money they had before.

So the theoretical basis for QE2, which is buying long-term bonds held by the private sector, is to take away their savings vehicle and exchange it for money. Since everyone now has more readily spendable money than before, and because they are now concerned that this will result in a higher price level for goods and/or a depreciation in real value for their money stock, the idea is that this causes everyone to charge out of holding money and exchange it as fast they can into actual goods. In other words, doubling the stock of money will get people to spend their new money as fast as they can.

But Is there a sizeable number of private households that own government bonds, and have a sizeable demand for money for transactions? Aren’t people who buy long-term bonds those who are saving up for retirement and therefore will not sell the bond prior to retirement? Those who may suddenly need money for transactions never buy long-term bonds. There’s too much duration risk and they may end up selling when bond prices are down.

The only agents who buy long-term bonds and who also may have a sizeable demand for money for transactions remain the banks. That’s why banks don’t solicit individuals/households to buy TSecs from them. There’s just not much of them.

Also, even if there were a few who do, at some tradeoff point, selling may indeed become more advantageous to holding bonds. And any households that do (if they can theoretically sell bonds to the Fed, via banks) will probably save the proceeds in alternative ’savings’ investments like equities and commodity funds. They’re not likely to spend their retirement savings on consumption.

People putting money into equities and commodities does not necessarily increase their nominal expenditures, and definitely does not in itself reduce unemployment. Nominal asset values may have increased, but increased expenditure by a majority of people need not follow. Not if new income wasn’t created.

Increase in nominal asset values reduces the burden for existing borrowers, but it certainly INCREASES the burden for new borrowers. So how are new businesses, and new employment going to be created? How does this increase demand for credit, which is the channel for new money created by the Fed to go out into public circulation? Though quantitative easing may strengthen balance sheet of banks, increasing nominal asset values does not increase the number of creditworthy borrowers.

So this new money does not necessarily go directly to those in need of money for immediate transaction. If you ask people who truly needed money for capital investment in the first place, they would have sold any government bonds they had without need for more monetary easing. In fact, the easing, and the resulting higher nominal price level, may have only made the cost of their needed capital investment more prohibitive.

Does increasing money stock lead to increasing velocity

MV=PQ. The conventional monetary theory is that if you increase the stock of money, this increases the price level, holding everything else constant. Further, if you increase the money stock, this causes people to not want to hold on to money, passing it along like a ‘hot potato’ to the next spender by quickly spending it before it loses value (due to inflation).

But the end result could just as well be a decrease in velocity. The resulting high prices could just be that the increasingly few transactions are clearing at the ever increasing price. If the money stock keeps increasing, this supports an increasing price level even though the velocity and the volumes may already be decreasing.

For example, take a look at this statement: “If everybody 'tries' to sell more money they will succeed in doing so. They can’t, in total, get rid of money by selling it, if the total amount is fixed, because it just goes from one person’s pocket to another person’s pocket. But they ‘can’ still sell more, even if everyone else is trying to sell more. They buy output and labour from the unemployed, who are only too happy to “buy” that money in exchange for their labour.”

Completely logical from the point of view from a monetarist. But how about we turn this statement around, to look at it from the other side - the side not of people trying to get rid of money, but of people trying to hoard goods and services.

It becomes something like this: If everybody ‘tries’ to BUY more money they won’t succeed in doing so. They can’t, in total, get rid of LABOUR AND OUTPUT by BUYING MONEY, even if money’s total amount is increasing, because money just stays in a few people’s pocket. But they 'can' still BUY more labour and output, even if everyone else is trying to BUY more of it. They SELL MONEY TO the unemployed, who are only too happy to “SELL” LABOUR AND OUTPUT in exchange for their MONEY.”

We didn’t change change the implications of the statement, we only changed the viewpoint. But now it makes sense to think of increasing money as not necessarily resulting in inflation. It may just end up lowering people’s value for goods and services, labour and output. Hence, it can lead to a deflation and/or recession. It can lead to less transactions. It can lead to less velocity. Less people trying to get rid of goods and services, labour and output.

Does higher money velocity lead to a higher price level

In the same vein, the same stock of money flowing more quickly should not in itself lead to higher price levels unless people are bidding up the prices while getting rid of money. But people can only bid higher if they already have more money to pay with. This necessitates a growing money stock. But how do people get to more money? By earning it or by borrowing it. Whether you earn it or you have to borrow it, sufficient income prospect is the more important consideration than increasing nominal values. But higher nominal values will only happen AFTER people already have in their hands the higher money stock level to buy more dearly with, not when it's still in banks as newly-created reserves.

Saturday, July 23, 2011

What determines the price level

The price level is determined by aggregate demand. If there already is enough existing demand for all supply, then the more demand, the higher the price level.

Demand is determined by income, and access to credit. The greater the income, the greater the demand (unless one is uncle Scrooge).

Access to credit (assuming banks are prudent lenders avoiding NINJA loans) is determined by expected future level of income.

So the next question is where does income come from? It comes from other people’s spending. Other people’s spending is determined by their own income and access to credit.

So the real question to ask is how does income keep on generating itself? Aggregate confidence in the stability of markets, in the currency, in the belief that income will continue. What makes this confidence possible? The paradigm that answers this best is the true economic paradigm. You be the judge.

Commented at The Money Illusion. And here's me previously on why monetary policy won't work to stimulate demand this time, also here.

Update: Nick Rowe gives the monetarist explanation for the price level, Eric Tymoigne reiterates the MMT view.

Sunday, July 17, 2011

What is the purpose of raising the debt ceiling when they plan to cut the budget deficit anyway?

The public budget deficit is a function of private sector deleveraging and cannot be cut without further undermining the economy. If they plan to undermine the economy anyway by cutting the budget deficit, why bother raising the debt ceiling? Without further budget deficits, public debt should stop growing anyway. Is it to allow further trade deficits?

Sunday, July 3, 2011

For those who advocate shifting to a full reserve system

Our current system already has the structures and insitutions for you. If you absolutely abhor the possibility of the bank losing your money in a bad loan, it has an option for you. It's called a safety deposit box. You can be certain that the bank NEVER lends your money out. You are assured that the money you put in is also the money you put out. You never have to endure sleepless nights wondering whether the bank will still have your money when the time comes for you take it out, because it never lends your money in any 'inflationary' debt ponzi schemes.

And to those discerning full reservers who want to earn a rate of return on their money, the current system also has an option for them. They're called Money Market Funds. These institutuions are GUARANTEED to have no ability to 'counterfeit' your money by creating it out of thin air. They can only lend the money that people put in them. They have no magical reserve accounts with the central bank, and are never never constrained by its heavy hand of regulation. They have no need for the Fed, and never have to bow down to its dictatorial wishes.

You have doubts that they may be counterfeiting your money? Case in point, when people move their money out of these funds, these funds have to liquidate their asset holdings in order to pay them out. Even more telling, if more people move their money out, the more they have to liquidate, even if they have to sell long term debt at a loss. The fact that the net asset value of your share in these funds goes down when this happens is proof positive that no counterfeiting ever happens at these funds. Another case in point, if too many people move their money out, these funds will gate your money in so you can't get it out. This proves that your 'bank' never blemishes its reputation by involving itself in the crass activity of 'Fractional Reserve Banking'. The good news is that, in the last run-up to a credit bubble, most lending in the system was already being done by these 'non-inflationary, non-fractional' substitutes.

If you're the type who has to make sure his money is safe and is never lent out in ANY debt ponzi scheme, our current system also has the option for you. It's called hiding your money under your mattress. You see, capitalism is a wonderful system that allows all sorts of institutions to flourish, that serve to enable everyone to have the liberty to choose their method of safeguarding their money. The free market system has always made sure that every consumer gets what he wants, and always attains the outcome that he deserves.

Why change the system?