Cowen on Sumner

In his blog, Marginal Revolution*, Tyler Cowen discusses Sumner's view of the crisis.

He argues:

1. Scott's recommendation of higher price inflation, or higher nominal gdp
growth, would have eased the crisis, in my very rough guesstimate by one-third
and in absolute terms that is a lot. It's the best free lunch I've seen in
years.

Good. One small quibble. Sumner doesn't really think that higher price inflation is the goal. Increased production is the goal, which results from more rapid nominal GDP growth. The increase in price inflation is a side effect that he believes likely due to his emphasis on sticky wages.

Anyway, that leaves 2/3 of the drop in real output to be due to some kind of "real" problem. What are the real problems?

Cowen continues:

Yet, in my view, easier money would not have eliminated most of the crisis, given the partial or total insolvency of many financial institutions, the negative AD shock from the collapse of the housing bubble, and the need to halt and reverse the ongoing accumulation of debt, among other
factors.

I believe that there is a need to reallocate resources, and can accept that the partial or total insolvency of many financial institutions can impact the productive capacity of the economy. Bankruptcy involves real costs. If operations stop during liquidation, that obviously reduces productive capacity. And even if operations continue, it is difficult to believe that the process doesn't impact the effective allocation of resources.

However, I totally reject the view that there is such a thing as an AD shock independent of monetary disequilibrium.

Cowen continues:

2. Scott's account does not deny (but does not emphasize) that the initial
downturn was accompanied by a fall in monetary velocity. This opens up
room for real shocks, resource reallocations and recalculations,
and animal spirits to be driving the broader story.

Obviously, there is some difference in perspective here. Apparently, Sumner has not emphasized enough that it was an increase in money demand/drop in velocity that was the problem.

The monetary disequilibrium approach is that imbalances between the quantity of money and the demand to hold money cause changes in nominal expenditure. Imbalances can be generated by changes in the quantity of money, changes in the demand for money, or both simultaneously. Because prices are not perfectly flexible, changes in nominal expenditure disrupt production.

Apparently, Cowen and many others are inclined to read into what monetary disequilibrium theorist actually say an assumption that it is changes in the quantity of money that are causing all the disturbances. In other words, some kind of assumption that monetary disequilibrium theorists assume that demand to hold money balances always remains on a constant growth path.

In other words, that all of the orthodox monetarist arguments that a money supply rule will stabilize nominal expenditures, the price level, and the growth rate of real output are correct.

No.

In particular, a decrease in housing wealth can plausibly result in a decrease in consumption and an increase in saving. From a Keynesian perspective, where the implied increase in the demand to hold money is hidden in a back closet somewhere, the result of the reduced consumption is a decrease in aggregate demand. (Hummel's response to Sumner on Cato Unbound is exactly correct in summarizing the monetary disequilibrium perspective.)

If the quantity of money adjusts to meet the increase in the demand for money, then aggregate demand, real or nominal, will not decrease. It is possible that some households will increase saving and reduce consumption because of their loss in housing wealth. Other households will increase consumption and decrease saving, perhaps even dissaving. If, on net, households save more, then firms increase investment.

The changes in the composition of demand may temporarily depress the productive capacity of the economy, but if there is no monetary disequilibrium, there will be sectors of the economy with growing demand, rising prices, rising profits, rising production, and employment. The reason why total output falls would be bottlenecks that slow the expansion of those sectors with growing demand. The shrinking sectors shrink quickly, the growing sectors expand slowly, so productive capacity is temporarily depressed.

Obviously, there must be some mechanism for added saving by some households to generate offsetting reduced saving (or dissaving) by other households or else increased investment by firms. The usual process involves lower interest rates. If this requires real interest rates to become negative, the problem is the "liquidity trap." And, of course, Sumner, like every monetary disequilibrium theorist, is perfectly aware of that issue and tries to deal with it.

A second issue Cowen discusses is the need to reduce debt. However, net debt is zero. The only way that a reduction in gross debt reduces nominal expenditures is if it results in a decrease in the quantity of money or an increase in the demand for money. Generally, a superficial analysis of excessive debt and aggregate demand just leaves the monetary disequilibrium in some back closet. For example, if bank loans are repaid, and the banks respond by shrinking their issue of monetary liabilities, this results in monetary disequilibrium. However, bank loans are only a small fraction of the total credit market, and it is entirely possible for total debt to decrease while the share of credit funded by bank-issued monetary liabilities expands. The quantity of money can remain constant or grow.

The alternative avenue for monetary disequilibrium is an increase in money demand. Those who repay debts are saving more. Those who receive the debt repayments can save less or dissave. If we just imagine that those receiving debt repayments accumulate money balances, then this is an increase in the demand to hold money and debt repayments will cause monetary disequilibrium. Similarly, if firms are "overleveraged" and repay debt, those households receiving repayments can save less or dissave. Or, perhaps they could save by purchasing equity stakes in firms. Firms could deleverage by funding their activities by less debt and more equity. Again, if the assumption is instead that those receiving the debt repayments just accumulate money balances, then the result is monetary disequilibrium.

Sumner's argument, typical of monetary disequilibrium theorists, is that if the quantity of money rises to meet any increase in the quantity of money demanded, even if the increase in money demand is indirectly caused by added saving aimed at offsetting the effects of reduced asset prices or else aimed at paying down excessive debts, the result will be stable nominal income growth, along with successful efforts to save and reduce debt. It is entirely possible that this will be associated with changes in the composition of demand and the needed allocation of resources. The best environment for such adjustments is stable growth of nominal expenditure.

*Thanks Tyler, for giving my new blog a plug!