Running for Mayor of James Island

I will be filing for Mayor of the Town of James Island today.

The Town of James Island is across Charleston Harbor from the peninsula and downtown Charleston.

The office is nonpartisan.

I served on Town Council between 2002 and 2004. Soon after I was elected to a second term, the town was closed down by the South Carolina Supreme Court due to a successful suit by the City of Charleston. The town has formed again for the third time four years ago.

When I was on council, the Mayor was Mary Clark. She is currently the incumbent, and I am challenging her.

The election is on August 3rd.

My campaign website is www.billwoolseyformayor.com. (It is still a work in progress.)

Campaign contributions are welcome :)

Malinvestment and Monetary Equilibrium

Murray Rothbard and his followers have claimed that any increase in the quantity of money that is matched by bank lending (rather than backed by gold) leads to malinvestment. Joe Salerno's critique of Larry White was superficially about what Ludwig Von Mises thought, but really was about that substantive issue. Along with Salerno, Walter Block, De Soto, and Bob Murphy take this view.

My view is that only an excess supply of money can possibly lead to malinvestment. If the quantity of money and supply of credit rises to match an increase in the demand to hold money, the consequences are the same as an increase in the supply of credit due to an increase in the demand for bonds.

Austrian economists of the monetary equilibrium variant, which includes Larry White, Steve Horwitz, Roger Garrison, Jerry O'Driscoll, (and George Selgin, though he does not claim affiliation with the "Austrian School,") agree with this general conclusion. Their usual approach focuses on a scenario where an increase in the demand to hold bank deposits or banknotes is an increase in saving. Households reduce consumption out of current income and accumulate bank liabilities. The banks expand their lending, issuing new money to borrowers. The monetary equilibrium theorists argue that the increase in the quantity of money just offsets the decrease in velocity, and so there is no addition to the stream of monetary expenditures to cause malinvestment.

The Rothbardians, however, insist that the fiduciary media (money issued to fund bank loans,) still distorts relative prices because it doesn't go exactly to those individuals who demanded more money by reducing their monetary expenditures. They accuse the monetary equilibrium theorists of "macroeconomic thinking."

I side with the monetary equilibrium theorists in this debate. The element of truth in the Rothbardian argument is that there is little doubt that the process of money creation does impact relative prices. Where he and his followers go wrong is in assuming that any changes in the pattern of relative prices resulting from an increase in the quantity of money that matches an increase in the demand to hold money is usefully characterized as malinvestment.

The best way to see this is to compare the effects of a change in the demand for bonds with a change in the demand for money. Following the conventional approach, I will start with a scenario where there is an increase in saving by households. Some particular households spend less of their incomes on consumer goods and services. Those households save. Savings in aggregate increase as well. This saving could take the form of purchasing bonds or it could take the form of accumulating money.

First, suppose that some households increase saving, reducing their consumption out of income and instead use the money they earn to purchase corporate bonds. The demands for the particular consumer goods they would have bought are lower than otherwise. Those firms that would have sold those consumer goods earn less. They demand fewer resources, including less labor. This implies a decrease in the incomes earned by the workers and other resource owners.

The increase in the demand for corporate bonds causes their prices to rise, and their yields to fall. This is a decrease in the market interest rate. This creates a signal and provides an incentive for firms to purchase additional capital goods. Suppose the firms that purchase the capital goods fund them by issuing new corporate bonds.

Then, the firms that sell the corporate bonds use to the funds to purchase capital goods. The firms selling the capital goods earn more money. These additional revenues result in greater profits. The greater profits give a signal and provide an incentive to add capacity to the production of capital goods. The allocation of finance and the demands for resources, including both labor and existing capital goods, will be directed towards producing additional capital goods. The resources needed to produce those capital goods must be purchased. The implied increase in demand for them raises the incomes of the workers and other resource owners.

However, the demands for those resources that had been used to produce consumer goods have fallen. The decrease in demand by the firms producing consumer goods and the increase in demand by the firms producing additional capital goods offset. While some workers and resource owners likely earn lower incomes, other workers and resource owners earn higher incomes. Labor and other resources are shifted from the production of consumer goods to the production of capital goods.

Using the terminology of Austrian economics, the structure of production has lengthened. More resources are devoted to producing goods of the higher orders. Fewer resources are devoted to producing goods of the lower orders. More resources are devoted to producing consumer goods in the more distant future. Fewer resources are devoted to producing consumer goods for the near future. According to some Austrians, the lower market and natural interest rate that first appeared in the bond market play a more central role in the structure of production, as the gap between the prices of resources and the prices of products shrink.

Suppose that the households increase saving by reducing consumption expenditures out of income, exactly as before, but instead of spending the money on corporate bonds, they instead increase their money balances. The effects on those from whom the households would have purchased the consumer goods are the same. They sell less and earn less. The hire less labor and use fewer other resources. The incomes earned by those workers and other resource owners fall.

Assume that the banks expand their lending at this same time, and lend out newly created money exactly equal to the amount of money the households have accumulated. The quantity of money expands exactly the same amount as the demand to hold money.

Further assume that the banks expand lending by purchasing corporate bonds, the exact same corporate bonds that the households purchased in the previous scenario. The market interest rate decreases exactly in the same way as before. The added demand for corporate bonds raises their prices and lowers their yields. This creates the exact same signal and incentive for firms to purchase additional capital goods. As before, the firms purchasing the capital goods finance the purchase by issuing new corporate bonds.

Those selling those same capital goods receive greater profits. The increased profitability of producing additional capital goods creates a signal and incentive, exactly as before, to direct more financing into this field of endeavor, and so raises the demand for labor and existing capital goods to expand the production of capital goods.

Using Austrian terminology, the change in demands, away from consumer goods and to capital goods, and the decrease in the market interest rate, results in as shift in the structure of production away from lower order goods to higher order goods. Less production is directed towards the production of consumer goods in the near future and more towards the production of consumer goods in the more distant future. Again, the gap between the prices of resources and their products shifts to reflect the new lower interest rate.

This particular account has made heroic simplifying assumptions regarding financial markets. In the first scenario, the households purchased corporate bonds, resulting in a lower market interest rate, motivating firms to purchase new capital goods by issuing new corporate bonds. Corporate bonds are treated as homogeneous. In the second scenario, the households accumulated money balances, and the banks purchased the exact same corporate bonds as in the previous scenario. The added demand for those bonds by banks also lowered the market interest rate, which motivated firms to buy new capital goods and sell new corporate bonds, just as before.

More realistically, the households purchase some kind of asset, which tends to raise their prices and lower their yields. Those they purchase from use the money they receive to purchase something else. They may purchase additional consumer goods. The increase in the supply of saving has resulted in lower interest rates, both the natural and the market interest rate, and this results in a decrease in the quantity of saving supplied.

However, it remains true that the lower interest rate will also increase the demand for capital goods. It raises the expected present value of profits from the sale of consumer goods in the future, which makes the expected profit from purchasing capital goods higher. This is the increase in the quantity of investment demanded due to the lower market and natural interest rates.

The firms that actually purchase the capital goods may finance these investments any number of ways, and only one of them is to issue new corporate bonds. Firms might instead borrow from a bank, issue stock, sell off financial assets previously accumulated, or even fund the project out of current cash flow. It is unlikely that the particular firms that invest will fund their activities by selling bonds to the particular households that save, but it doesn't really matter.

Similarly, while banks do purchase corporate bonds sometimes, they usually make commercial or consumer loans. And the usual way that banks expand loans is by lowering the interest rate they charge and then supply the amount of loans that are demanded. Those particular firms and households that borrow from banks are not borrowing from other sources. This decreases the supply of those other securities, raising their prices and reducing their yields. The increase in the supply of credit by banks lowers market interest rates across financial markets.

The increased borrowing motivated by the lower interest rate charged by banks implies changes in consumption and investment by the households and firms obtaining the loans. But the changes in the interest rates on other financial assets also motivate changes in consumption and investment as well. Some of the households that were holding stocks or bonds, may respond to the higher prices and lower yields by purchasing consumer goods. Some firms may respond to the higher prices and lower yields on bonds by an new issue of bonds to fund the purchase of capital goods. Some firms my respond to the higher stock prices by a new issue of stock to purchase new capital goods.

It is the role of financial markets to facilitate such transfers of funds between and among households and firms. It is certainly true that the particular assets that households accumulate will have some effect on the pattern of expenditures that results, but the general notion that the accumulation of those assets implies an increase in the supply of credit, and lower market and natural interest rates remains true. By assumption, the demand for consumer goods fell. Households reduced their purchases of consumer goods and services initially. The lower market and natural interest rate results in increased demand for various goods and services, including both consumer goods and capital goods. These changes depend on the interest elasticities of demand for those goods. However, the net effect is a shift from consumer goods to capital goods. There remains a shift in the structure of production from production of consumer goods in the nearer future to the production of consumer goods in the more distant future.

As long as the banks expand the quantity of money no more than the increase in the demand to hold money, and so their addition to the supply of credit is no greater than what would have been the addition to the supply of credit if the households had instead spent the money on some financial asset, the effect on the market interest rate is the same. In both situations, the market interest rate falls with the natural interest rate.

Remarkably, some amateur Austrians of the Rothbardian persuasion have responded to these sorts of explanations by arguing that perhaps the increase in the demand for money was not due to a decrease in the demand for consumer goods and added saving, but rather due to a decrease in the demand for other assets. It is actually a bit odd that so much of the debate has been about saving by accumulating money balances and what happens if there is or is not an expansion in the quantity of bank-issued money to match that increase in the demand to hold money.

Suppose households were using income to purchase consumer goods and services and also were saving by using income to purchase corporate bonds. The firms are issuing and selling the corporate bonds to fund the purchase of capital goods.

The households do not change their saving and continue to use income to purchase consumer goods and services exactly as before, but rather than use their saved funds to purchase corporate bonds, they accumulate larger money balances.

This decrease in the demand for corporate bonds will result in a lower price and a higher yield for them. The market interest rate will increase. Since saving has not changed, there has been no change in the natural interest rate. Households save the same portion of income as before, they are just saving by accumulating money rather than corporate bonds. The market interest rate rises above the natural interest rate.

Suppose that instead the banks expand the quantity of money by purchasing the exact same corporate bonds that the households would have purchased. The households continue to spend the same amount of income on consumer goods and services as before. They save exactly as much as they were saving before. They save by accumulating money balances rather than purchasing corporate bonds. While the demand for corporate bonds by the households falls, that is exactly offset by the increase in the demand for corporate bonds by the banks. The price of the bonds and their yields do not change. There is no change in the market interest rate. The firms sell the same corporate bonds as before, but they sell them to the banks rather than the households. The firms purchase the exact same capital goods as before. The firms selling the capital goods have the exact same demand for resources, labor and existing capital goods as before. There is no change in relative prices and no change in the allocation of resources. There is no change in the structure of production between the production of goods of the lower order and goods of the higher orders. There is no change in the allocation of resources between the production of consumer goods for the nearer future and the production of consumer goods for the more distant future.

This scenario also relates to the effects of a temporary increase in the demand for money due to disturbed conditions discussed in my previous post. To some degree, the change in the demand for money is exactly as described above. Households are worried about disturbed conditions, and rather than saving by accumulating financial assets, they save by accumulating money. To the degree that banks purchase the assets with newly created money, the market interest rate remains unchanged along with the natural interest rate.

Further, it is possible that rather than simply impacting the allocation of their flow of saving between money and other assets, unsettled conditions may result in households selling off parts of their existing portfolios of assets to accumulate more money. To the degree banks issue new money and purchase those assets, the market interest rate remains unchanged with the natural interest rate.

Of course, banks may not purchase the exact same assets that households want to sell. But as explained above, these financing changes tend to have balancing effects on credit markets. Those who borrow from banks don't borrow by selling financial instruments, like commercial paper. Finance companies have less loan demand and so less need to sell corporate bonds. Generally, the yields on the financial assets that households are selling rise, and the interest rate that banks charge fall. But these are offsetting impacts on "the" market interest rates and the allocation of resources between the present and future.

Of course, it is possible, even likely, that the response to unsettled conditions will include an increase in the supply of saving. Worries about unsettled future conditions may lead households to reduce current consumption. Further, worries about future economic conditions might reduce the demand for investment. Firms will become more uncertain about what consumers will be willing to pay for various products at future dates, and so be less inclined to purchase capital goods and any given level of interest rate. The natural interest rate almost certainly would fall. And so, the result isn't simply a change in what type of assets households want to hold, either money or stocks or bonds, and how firms will fund purchases of capital goods, whether through bank borrowing or the issue of stocks and bonds. The market interest rate needs to fall with the natural interest rate.

In highly abstract terms, the lower natural interest rate and lower loan rate by banks will tend to result in an increase in the demand for various goods depending on their interest elasticities of demand. These could be consumer goods or capital goods. Because unsettled conditions have lowered the demands for both consumer goods and capital goods, the effect on the allocation of demand between those goods is ambiguous. It is certainly not the case that an expansion of the quantity of money that meets an increase in the demand for money, even at a lower market and natural interest rate, will necessarily shift the allocation of resources away from the production of consumer goods to the production of capital goods.

For example, suppose that unsettled conditions causes people to reduce purchases of new cars. The old cars will have to suffice for a time until conditions improve. The banks lower interest rates so that people less worried about economic conditions borrow money to purchase cars. This reduces the need to shift resources away from the production of cars.

Suppose firms are worried about current economic conditions and decide to postpone purchases of new computer equipment. The banks lower interest rates, and some firms that would have sold commercial paper obtain bank loans. The decrease in the supply of commercial paper results in higher prices and lower yields. Some investors in commercial paper switch to corporate bonds. The corporate bond prices rise and their yields fall. The lower yield on corporate bonds motivates some firms to go ahead and purchase the computer equipment as before. This reduces the need to shift resources away from the production of computer equipment.

Will the pattern of expenditure be unchanged? No. But thinking about what happens when there is an increase in the quantity of money given an unchanged demand for money, supply of saving, and demand for investment is highly misleading in a situation where the demand for money and the supply of savings are both rising and the demand for investment is falling.

Aggregate Demand Failures

Some time ago, Peter Boettke asked, "What Precisely is Aggregate Demand Failure and How Would you Know it if you saw It.." He was reacting to claims by Lawrence Summers and Christina Romer that the key problem facing the U.S. economy is inadequate aggregate demand. Romer, in particular, described some evidence from labor markets suggesting that structural unemployment is not that serious.

In the comments thread on Coordination Problem, I argued that aggregate demand failure exists when the real volume of expenditures is less than the productive capacity of the economy. I argued that this is the same thing as the quantity of money being less than the demand to hold money. And further, it is the same thing as the market interest rate being greater than the natural interest rate.

After stating basic monetary theory, I went on to suggest that if aggregate money expenditures have fallen, and the price level has not fallen in proportion, then you should suspect that there is an aggregate demand failure. The decrease in real output associated with the drop in real expenditures is due to monetary disequilibrium--aggregate demand failure.

If there is a drop in real output in aggregate, there must be decreases in the production of particular goods. There are some questions to ask about the particular markets where real output drops. If there are shortages of the particular good where output has dropped, then the problem probably isn't inadequate aggregate demand.

If, on the other hand, there were surpluses in those markets, and firms reduced output to avoid producing goods they couldn't sell, then it is still possible that the problem isn't inadequate aggregate demand. Perhaps there are other markets where there are balancing shortages and the problem is a need to redeploy resources between markets. This is the most difficult, and probably the normal, situation. A difficult judgement call must be made to determine if the markets where output has fallen due to surpluses are balanced by the shortages in those markets where resources need to be redeployed. Increases in output that don't occur cannot be observed. Of course, to the degree prices rise to close off those shortages, then the volume of expenditure of those goods provide a rough measure of possibly balancing increases in demand.

If, on the other hand, there are absolutely no markets with shortages, so that demand and production has fallen in every market, then there is no doubt. The demand to hold money is greater than the quantity of money. The reduction in production is due to an aggregate demand failure.

In the comment thread, Richard Ebeling noted that he has long accepted the "Austrian" free banking argument that there is a market process by which fractional reserve banks will tend too expand the quantity of money to at least partially accommodate increases in the demand to hold money. He understands that this reduces the need for the purchasing power of money to rise. However, he remains skeptical that this tells us much about the desirability of expanding the quantity of money in the face of a "secondary" depression.

But this is not the type of situation in which we find ourselves today. Here people are not changing their underlying preferences in the same way as my example, above.

They are responding, partly, to the uncertainties, confusions, and delays in adjustments to distortions resulting from misguided monetary (and related policies -- Fannie Mae and Freddie Mac, etc.) that resulted in misdirections of resources and labor, and capital malinvestments.

(And, by the way, this is the context in which John Stuart Mill in his famous essay "On the Influence of Production on Consumption" restated Say's Law by introducing and viewing money as a commodity that is demanded, and for which there may be temporarily an increased demand relative to other commodities in the wake of the confusions and imbalances of an economic crisis.)

What needs "fixing" in this case, I would argue, is not an increase in money for people to hold, but the necessary price and wage and resource adjustments that will restore the balance and coordination so people can be reemployed, once again have profitable investment opportunities, etc., that have market-based possibility and sustainability.

Those are the "real" factors beneath the monetary surface, and manipulating the amount of money in the economy does does nothing, per se, to bring the economy back into order along the lines I've suggested.

As I said in my earlier comment, this merely runs the risk of superimposing new misdirections of resources, labor and capital on top of the prior ones that are still waiting for correction.

At first pass, I would say that Ebeling is wrong. The injection effects of an increase in the quantity of money can only create malinvestment if it is an excess supply of money. If the demand for money has increased, then the effects of an increase in the quantity of money on relative demands, prices, profits, and production is not malinvestment.

However, there is an important element of truth in his argument. The key to that truth is that the change in relative demands is temporary. Responding to a temporary shift in demand by making irreversible investments in specific capital goods is an entrepreneurial error.

Suppose that the unsettled conditions did not result in a temporary increase in the demand to hold money, but rather in a temporary increase in the demand to hold rifles and bullets. To fund those additional rifles and bullets, people purchase fewer flat screen televisions. By assumption, this shift in demand is temporary. Once conditions are again settled, the demands for both rifles and televisions will return to normal.

In the rifle market, the increased demand will raise prices, profitability, and production. This is simply a allocation of resources to produce what people want most given the actual conditions of the time. If the increase in the demand for rifles were permanent, then adding to the capacity of the rifle industry would be profitable. Specific machinery could be constructed to help produce more rifles. This would allow increased production of rifles and added demand for other, complementary factors of production, such a labor. The prices of rifles would tend to fall, as would profitability, due to these long run adjustments of output to the composition of demand.

If entrepreneurs wrongly perceive the temporary increase in the demand for rifles as permanent, and they undertake this expansion of capacity, they will suffer losses when their expectations are proven false. Hopefully, fear of such losses will motivate entrepreneurs to avoid malinvestments.

If there had been some kind of quota system prohibiting any increase in the production of rifles, then rifle markets could clear through higher prices. There would be no short run or long run increase in the production of rifles. Those entrepreneurs who would have mistakenly perceived the increase in rifle demand as permanent and made malinvestments in rifle making equipment are protected from those losses. The rifle industry is protected from overexpansion. On the other hand, some of the people who wanted more rifles must do without.

If disturbed economic conditions lead to an increase in the demand for money, and banks respond to this increase by creating more loans, then this certainly could result in temporary increase in the demands for goods with relatively high interest-elasticities of demand. Just as with the rifle scenario, this increase in relative demands, prices and profits, would result in an expansion in production and employment for those particular goods. If this change were permanent, then it would be profitable for entrepreneurs to purchase various sorts of specific equipment to further expand production and employment, tending to reduce prices and profits in those areas.

Since by assumption, this change in demand is temporary, these would be malinvestments, and the entrepreneurs would suffer losses when their expectations are dashed. It is the prospect of those losses that will hopefully prevent any malinvestments due to a temporary increase in money demand, and so indirectly, an increase in the demand for goods with highly interest elastic demands.

If there had been some quota, preventing the quantity of money from rising, then this process could have been prevented. The firms that made the error of treating the temporary increase in the demand for their products as permanent would be protected from making those errors.

Any firm that myopically projects the pattern of demands that exist during unsettled times into the future deserves any losses they suffer. On the other hand, being an entrepreneur during unsettled times involves more uncertainty than usual, and so perhaps additional malinvestment is to be expected.

Ebeling's worries about the added disruptions created by an increase in the quantity of money are mistaken, confusing the problems created for entrepreneurs because of the uncertainty created by unsettled conditions with something specific to increases in the quantity of money. On the other hand, what are the benefits of a temporary increase in the nominal quantity of money?

What is the alternative? The alternative is for the prices of various goods and services to fall until the real quantity of money rises enough so that some of those holding money choose to spend some of what are now excessive real balances on particular goods and services. Perhaps these will be goods whose prices have fallen more readily. Or perhaps it will be goods that are especially desirable in the unsettled economic conditions. What is important, however, is that there is no reason to believe that the particular pattern of demands for goods and services that occurs because the price level falls temporarily enough so that the temporary increase in the real supply of money matches the demand will somehow persist after the demand for money again falls and prices rise. If entrepreneurs take that pattern of demands and myopically project it into the future, and make specific investments based upon it, they would have made malinvestments.

The equilibrating process involves a temporary increase in the real quantity of money to match the temporary increase in the real demand to hold money. This can be an increase in the nominal quantity of money at unchanged prices. Or it can be an unchanged nominal quantity of money and lower prices. In either situation, real expenditures on current output are kept equal to the productive capacity of the economy. This could be unchanged nominal expenditures and unchanged prices. Or it could be lower nominal expenditures and lower prices. In neither situation will there be reason to expect particular pattern of demands that occur during the process will be permanent.

So, both processes maintain aggregate real expenditure. But the actual pattern of demands during the period of disturbance are likely to be temporary. The demands for some goods will be temporarily high and the demands for other goods will be temporarily low. Given these demands, consumers are best served by adjusting production to reflect this new pattern of demands. I think that rising nominal expenditure, prices, and profits is the best signal for firms to expand the production of goods with higher relative demands.

The alternative, of falling demands for all goods, and falling resources prices, and profits for those goods whose prices fall less than costs so that production expands is a much dirtier signal. Perhaps it should be no surprise that firms respond to an excess demand for money by reduced production and employment.

Like Ebeling, I believe that there has been substantial malinvestment in housing and that construction should contract and the production of other goods and services expand. To say that housing was overproduced, or more exactly, that continued production at rates of the boom would be overproduction, means that there are other more valuable goods and services being sacrificed. In my view, keeping final sales of domestic product on a stable growth path provides the best environment for these redeployments of resources to occur. Those producing these other goods that people demand more than even more houses, should see growing nominal demands, higher nominal prices, and greater nominal profits. This provides a clear signal to produce more and expand employment. To maintain this environment, increases in the demand to hold money, even if temporary, must be accommodated by an increase in the quantity of money.

Increased Productivity, OH NO!

David Beckworth asks whether the current high level of unemployment is cyclical, structural, or both.

My view is that it is both. The speculative bubble in housing resulted in substantial malinvestment. Resources, including labor, need to be shifted out of construction to the production other goods and services. Even if aggregate expenditures had remained on its 5 percent growth path, the redeployment of resources would have involved significant unemployment. This would have temporarily reduced the growth rate of potential income--perhaps even to the point it shrank, resulting in temporarily higher inflation. Eventually, as labor was reabsorbed and appropriate capital goods produced, real output would grow more rapidly and the inflation rate again fall.

However, overlaid upon this needed redeployment of resources was an unnecessary and undesirable shortage of money. While the quantity of money increased, it failed to keep up with the remarkable increase in the demand to hold money. The resulting monetary disequilibrium led to a drop in demand more or less across the board. Most firms faced falling sales and responded by reducing production. Layoffs spiked. New hires dropped off dramatically. Job openings fell dramatically.

Beckworth also agrees with the "both" answer. He focuses on the growth rate of demand, which he measures by the growth rate of final sales to domestic purchasers. This is the spending of U.S. residents on goods and services produced in the U.S. or abroad. He reproduces a chart that shows how the growth rate dropped sharply during the recession and became very negative. He notes that it is now doing better. The chart ends with a 2.5 percent growth rate.

I think the relevant criterion is gap between demand and its trend growth path and the appropriate measure is final sales of domestic product. Final sales of domestic product is spending by U.S. residents and foreigners on final goods and services produced in the U.S. It is currently 11.3 percent below its 5 percent growth path from the Great Moderation. While the gap continues to grow, fortunately, final sales of domestic product is growing, about 2.5 percent.

Rather than these long standing differences, a more interesting difference is in the source of the underlying "structural" unemployment that continues to exist, more or less hidden by the shortfall in demand. Beckworth's post focused not on a need to redeploy resources, but rather on increases in productivity. Supposedly, improved productivity has led to structural unemployment. He quotes Catherine Rampell:

Pruning relatively less-efficient employees like clerks and travel agents, whose work can be done more cheaply by computers or workers abroad, makes American businesses more efficient. Year over year, productivity growth was at its highest level in over 50 years last quarter, pushing corporate profits to record highs and helping the economy grow...

I find this sort of argument misleading.

Improvements in labor productivity allow for a given level of output to be produced with less labor. If the amount to be produced is assumed to be given, then, improved labor productivity implies a decrease in the amount of labor needed. Enhanced productivity appears to be a "problem" that is interfering with the ability of the economy to fulfill it's core purpose--create jobs. NOT!

In other words, the argument appears inconsistent with the key principle of economics--scarcity.

Output isn't given. As Beckworth, and the quoted articles note, output is increasing. Perhaps it is natural to ask why the actual increase in output has been associated with such a small increase in employment. And surely, improved labor productivity is a likely part of the answer.

However, the "answer" is never that the improved productivity has resulted in a given increase in output creating too few jobs. The increase in output isn't given. If labor productivity has increased, then output should increase more than it would have if labor productivity had not increased.

Increased labor productivity (and increased total factor productivity,) increases real output and real income. It doesn't reduce the demand for labor or other resources.

With a regime of total expenditure targeting, the effect of more rapid improvements in labor productivity (or total factor productivity) is lower inflation. The growth path of money incomes is unchanged, but the more rapid growth in productivity results in lower unit costs. As competitive firms respond by lowering prices to increase sales, the real volume of expenditures rises, allowing growing purchases to match the more rapid growth in the productive capacity of the economy. Output expands enough so that all of the available resources are utilized. Employment does not decrease.

With inflation targeting, more rapid productivity growth requires more rapid growth in demand. Nominal incomes grow more quickly, money expenditures grow more quickly, and firms sell more at an unchanged growth path for prices. Output expands so that all of the available resources are utilized. Employment does not decrease.

Of course, improvements in labor productivity or total factor productivity are unlikely distributed proportionately across all types of labor, much less all productive resources. This implies that if there is an improvement in labor productivity in one field of employment, the reason why output may not increase enough to leave everyone employed is bottlenecks of complementary resources whose productivity has not been enhanced.

Structural unemployment is unemployment due to a change in the jobs that need to be done. (Not unemployment due to the end of scarcity so there less need for labor.) I believe that the usual term to describe unemployment due to changes in the jobs that need to be done because of an improvement in productivity is technological unemployment.

I don't want to dismiss the hardship resulting from technological unemployment. Nor do I wish to dispute the wisdom of the ages that firms respond to crisis with productivity enhancing changes. Sure, it would have been profitable to make these changes all along, but the need to cut losses enough to survive may focus the minds of managers more than generating greater profits for the owners.

Yet it is essential to always remember the basics. Improved productivity means that output will be higher than it otherwise would. The reason why some are left unemployed by the process is shortages of products or resources that have not had enhancements in productivity. If we have a situation where rapid growth of labor productivity in some sectors has led to higher technological unemployment, we should observe a higher growth rate of output and shortages and bottlenecks somewhere in the economy.

While it is true that job openings have increased over the low point of 2.3 million in July 2009, the current level (March, 2o10) of 2.7 million is well below the 4.8 million before the recession. Hires have also increased during that period, from 3.9 million per month in June 2009, to 4.2 million per month in March of 2010.

When vacancies begin to get close to their their pre-recession level, and hires remain lower than that level, then it will be time to point out that any remaining unemployment is largely structural or technological.

During the heyday of Keynesian fine tuning, the unemployment rate and the level of real output were targeted. If unemployment was high and real GDP low, then expansionary policies would be utilized. If structural or technological unemployment have increased, then responding by efforts to expand money expenditures would be a mistake. If the process of redeploying resources has temporarily reduced the productive capacity of the economy, then responding to lower output by expanding money expenditures would be a mistake. Oddly enough, if technological unemployment due to more than normal increases in factor productivity were the "problem", noting that output continues to grow as usual would not a sign that all is well. Output should grow more than usual. From a Keynesian perspective, an expansionary policy would be in order. (George Selgin's arguments for the "productivity norm" has convinced me that an expansionary policy is unnecessary, as explained above.)

Currently, the Fed follows a neo-Keynesian approach, adjusting the federal funds rate (as long as it isn't "too' low) in order to reduce any gap between real output and the productive capacity of the economy and to keep the expected increase in the core CPI rising 2 percent from its current value. This approach requires an estimate of the productive capacity of the economy. If there is structural unemployment due to a redeployment of resources, the productive capacity of the economy will be at least temporarily depressed. If there is technological unemployment associated with enhanced total factor productivity, then the productive capacity of the economy will be permanently enhanced. Trying to figure out the underlying level of unemployment and its exact source appears to be necessary given the Fed's "output gap" approach to policy.

In my view, targeting unemployment, real output, or output gaps is a mistake. Like Beckworth, I think the least bad approach is to target demand (i.e. total spending, i.e. cash expenditures, i.e. nominal expenditures, i.e. final sales of domestic product.) Real output, the unemployment rate, and the price level should all be left free to adjust according to market forces.

P.S. The purportedly technologically unemployed worker in the story was actually employed at Walmart. While she was only working part time, surely an expansion in demand would allow her to put in more hours. And that, of course, shows the real pain of "creative destruction." Some businesses fail. The owners lose. And it isn't just the entrepreneurs that bear the burden. Some people end up in new jobs that have lower pay and benefits than their old jobs. Yes, there is unemployment associated with technological change, but that is not the real problem. We all benefit over the generations for putting up with creative destruction. But the costs are not distributed fairly. Some people, through no fault of their own, must start over. Maybe as a cashier at Walmart.

Was Mises Wrong?

Joseph Salerno argues that Mises was wrong.

Larry White has tried to find in Mises' writings evidence that he understood that malivestment occurs when there is an excess supply of money. Salerno argues that this evidence comes from Mises' early writings. According to Salerno, in his fully developed thought, Mises came to understand that any increase in the quantity of money, regardless of what was happening to the demand to hold money, causes the money rate of interest to fall below the natural rate.

Salerno's evidence is largely based upon policy. He finds quotations where Mises suggests that prohibiting any further expansion of "fiduciary media" is desirable. Fiduciary media is bank issued money used to fund loans.

I find Salerno's approach odd. From a Virginia School perspective, policy rules are nearly always "least bad" options. It could be that the ideal situation would be a banking system that adjusts the quantity of bank money according to the demand to hold bank money. However, it is possible that the damage resulting from banks creating an excess supply of money is so great that the least bad option is to prevent any increase in the quantity of money, regardless of what is happening to the demand to hold money. Having the price level adjust the real quantity of money to the demand for money is better than the possibility that the banking system would generate an excess supply of money.

But if Mises really did believe that an increase in the quantity of money, say, smaller than an increase in the demand to hold money, would lead to the money rate falling below the natural rate, then he was wrong. And that seems to be Salerno's position. Mises was wrong. (Of course, Salerno is just as wrong as Mises.)

How Much Do European Banks Stand to Lose?

The Greek government, especially, has provided social welfare benefits that it cannot afford. It has paid for them by borrowing money. Those who made the loans have now realized that they cannot be repaid...unless German and French taxpayers pay them back.

Why would northern European taxpayers be willing to pay back those who lent the funds to provide Greeks with general social welfare benefits? It is because it is their own banks that made many of those loans. The worry is that if the banks lose too much money on bad loans to Greece (and Portugal and Spain,) they will be unable to make loans to French and German households and firms. The result will be a return of the economy to recession.

What is the exposure of Euro area banks to these losses?

Daniel Gros and Thomas Mayer provide the following table:

Table 1: Exposure of euro area banks to government as % of capital and reserves, 2009

	Loans	Securities Total
Central government	12	64	76
General government	52	77	129

What this means is that if all the European Union governments refused to pay any of their national debts, on the whole, the European banks would be insolvent. On the other hand, if they had just 29 percent more capital and reserves, they could take that massive loss.

More importantly, they point out that the public debs of Greece, Portugal and Spain make up only a small portion of total European public debt.

Fortunately, the public debt of the three countries most at risk (Greece, Portugal and Spain) amounts to only about 14% of all public debt in the Eurozone.

While it is possible that European banks hold a larger proportion of debt of the countries most at risk, these figures suggest that the European banking system could withstand a substantial write down of Greek debt. Let the Greeks default.

Because of the nature of capital regulation, any bank losses create the possibility of reduced lending--especially to business. Government regulation requires that when banks make loans to business they have more capital than when they instead hold "cash" or government bonds. If a bank suffers a loss, it has less capital. If the regulators press the bank to return to the amount required by regulation, then the simplest way is to reduce new loans to business, and either leave repaid funds on balance with the central bank, or else purchase government bonds (presumably from Germany, France, or the U.S.) This change in the bank's asset portfolio provides no additional capital for the bank, but by shifting to what the regulators consider less risky assets, the amount of capital required is reduced. The unfortunate side effect is that lending to business can be sharply reduced.

I think the solution is to suspend the capital requirements. The reason to have capital is to form a cushion against loss. When losses occur, capital and capital ratios should fall. As banks profit from their remaining good loans, they can and should gradually rebuild their capital and capital ratios.

The notion that governments should bail out those owing money to banks in order to prevent adverse consequences due to the operation of capital requirements is insane. Only slightly less insane is the prospect of the government bailing out banks so that capital regulations don't cause a contraction in lending to sound borrowers. The answer is to quit regulating capital in a way that has these undesirable consequences.

Liquidity and Solvency

During the financial crisis of 2008, some argued that the problem was bank solvency rather than bank liquidity. Why is that important? The conventional approach to central banking is to serve as "lender of last resort." According to that theory, the central bank should lend to illiquid banks. Those banks that are solvent, but illiquid, should obtain the liquidity they need by borrowing from the central bank.

On the other hand, this traditional dictum requires that the central bank not lend to an insolvent bank. An insolvent bank needs to be liquidated or reorganized. If letting an insolvent bank fail would have catastrophic consequences, then perhaps it should be bailed out. (An approach I oppose.) However, bailing out banks is not the role of a central bank as lender of last resort.

The banking system was (and is) heavily invested in real estate, including residential mortgages, commercial mortgages, and various types of mortgage backed securities. Housing prices have fallen 30 percent over the last three years. Many loans are "underwater." That is, the collateral for the loan is worth less than the outstanding balance. Worse, many of the home mortgages were made to speculators, hoping to profit from future price increases. Still worse, some of the loans were made to people who couldn't afford to make the payments, so could only avoid default by refinancing, which would only be possible if their home equity increased due to higher prices. Basically, the banks lent into a speculative bubble, and it popped. This is not a liquidity problem for the banks. It is a solvency problem.

If the sole role of a central bank is to help banks with liquidity problems, then expanded lending during the financial crisis would seem to be an error. However, today's central banks do not simply serve as "lenders of last resort." Helping banks with a liquidity problem isn't their most important role. Central banks serve as monetary authorities. They monopolize the issue of hand-to-hand currency. And since the transactions accounts that form the bulk of the medium of exchange are all redeemable in terms of hand-to-hand currency, they play a dominant role in the determination of the quantity of money.

The key role of a monetary authority is to prevent monetary disequilibrium--an imbalance between the quantity of money and the demand to hold money. If the demand to hold money increases, the most important duty of a central bank is to increase the quantity of money to match that demand.

This primary duty of the monetary authority has no direct relationship with the financial conditions of any bank. Is some bank illiquid or insolvent? Are many banks illiquid or insolvent? Are all banks illiquid or insolvent? These questions are secondary. If the demand to hold money is greater than the existing quantity of money, the central bank needs to increase the quantity of money even if the banks are not illiquid. If the demand to hold money is greater than the existing quantity of money, the central bank needs to increase the quantity of money even if the banks are insolvent.

During the financial crisis of 2008, most measures of the quantity of money increased. Evidently, the demand to hold money rose by even more. We know that because nominal expenditures fell during the fourth quarter of 2008 and then again in the first quarter of 2009. As measured by final sales of domestic product, nominal expenditures are only now approaching the level of the third quarter of 2008. They remain more than 10 percent below the growth path for the Great Moderation. The vast expansion in the quantity of reserve balances at the Fed, the huge increase in the quantity of the monetary base, and the modest increases in M1, M2, and MZM were evidently not enough. The Fed failed to do its duty as monetary authority.

To confuse matters, it is not at all unusual to refer to an increase in the demand for money as an increase in the demand for liquidity. People want to "get liquid." And while this often refers to a much broader set of assets than anything that serves as media of exchange--U.S. Treasury bills, in particular--holding hand-to-hand currency in a vault or FDIC insured transactions accounts are included. From the point of view of banks, funds held on deposit with the central bank also count as being "liquid."

I believe that Greece has a solvency problem, not a liquidity problem. Those banks that have lent money to Greece, therefore, have a solvency problem as well. However, it is likely that worries about the solvency of banks will create an increase in the demand to hold money. The role of the ECB, as monetary authority, should be to accommodate that increase in money demand. Further, it is entirely likely that along with, or instead of, an increase in the demand for euros, there will be an increase in the demand for dollars. The Fed's primary responsibility of monetary authority is to increase the quantity of dollars enough to accommodate the increase in the demand to hold dollars.

If central banks, particularly the European Central bank, but also the Federal Reserve, fulfill their core responsibilities as monetary authorities, the bankruptcy of the Greek welfare state can be weathered without another Great Recession.

Gold and Nominal Interest Rates

With a functioning gold standard, nominal interest rates cannot go much below zero. The lower bound for the nominal interest rate on even the shortest and safest financial assets would be the storage cost of gold. The logic is simple. Why would anyone hold any financial asset, that is, lend, if the nominal interest rate was negative? They could always hold gold--though gold does have some storage cost. While the storage cost for gold is low compared to other goods and services, it is high compared to financial assets, (including paper currency.)

Many advocates of free banking favor a return to a gold standard. While such proposals often include an option clause for banks to temporarily suspend redemptions of deposits and currency, the option traditionally involved paying bonus interest during any period of suspension. The effect would be a dampening of the increase in nominal interest rates that would otherwise be caused by a credit crunch as depositors and banks scramble to accumulate gold coin and reserves. Negative nominal interest rates are unlikely to develop during such a suspension.

If the fundamental nominal value of the economy with free banking is instead a 3 percent growth path for total cash expenditures, then negative nominal interest rates on some financial instruments might not only be possible, but necessary. With free banking, no one is obligated to issue zero-nominal-interest hand-t0-hand currency. If it becomes unprofitable to issue it, no one will. The only remaining money would be transactions accounts. There is no reason why the nominal interest rates on deposits cannot be negative. If the natural interest rate, the real interest rate where saving equals investment, is negative, then keeping total cash expenditures growing on target might require negative nominal interest rates.

Of course, there is nothing to prevent people from responding to negative nominal interest rates (or negative real interest rates,) by purchasing commodities such as gold. Outside of a gold standard, the impact of a greater demand for gold is an increase in the money price and relative price of gold.

In the most plausible scenario, where the natural interest rate is only temporarily negative, and will return to its normal positive value in the future, this run up in the money and relative price of gold would be temporary. At some future time, when real and nominal interest rates are again positive, this source of added demand for gold would disappear, and the money and relative prices of gold would fall again.

Expectations of this process suggest a simple equilibrium condition. The money price of gold would rise to a point where its expected rate of decrease is equal to the negative nominal interest rate. Nothing in that process puts a floor under the nominal interest rate.

Of course, since negative nominal interest rates in this scenario apply only in the near future, so that only short term assets have negative nominal yields, gold would be very unlikely to have a negative yield. Like long term bonds or equities, the process would simply lower its expected positive yield until markets clear. Further, negative nominal yields most plausibly apply to low risk assets. Since commodities speculation is very risky, any flight to gold created by negative nominal yields on short and low risk assets would simply result in a slightly lower expected yield on gold.

There is a second effect of increased gold demand that does tend to put a floor under the nominal interest rate. Gold is an outside asset. It represents wealth to those holding it, but it is not a liability of anyone. If the money price and relative price of gold rises, those who are holding gold earn capital gains. They are wealthier. No one is poorer.

This added wealth makes increased present and future consumption possible for those individuals earning the capital gains. Assuming that some of those wealth holders face binding budget constraints, then they will consume more now. This is a decrease in current saving. A decrease in the supply of saving raises the natural interest rate. If the natural interest were negative, this makes it less negative. If the effect is strong enough, the natural interest rate will rise above zero. (This is the same thing as the "Pigou effect" in the context of a gold standard.)

Of course, a better way to understand this process is that there is a wealth effect that makes saving more interest elastic. As the natural interest rate falls, capital gains on gold results in more current consumption and a smaller quantity of saving supplied. And there is nothing special about gold. Land is probably the most important outside asset, but silver, jewels, and artwork should have similar effects. The notion that nominal (or real) interest rates might be permanently negative with certainty is very implausible because of this effect. (Though if that is the effect keeping real yields positive in the long run, it would be enough to make make one into a Georgist.)

It is conceivable that increases in the money and relative price of gold could have disruptive as well as equilibrating effects. The process by which the expected nominal yield on gold falls (perhaps turning negative,) involves an initial increase in its price. If there are foolish investors who project past price increases in to the future, and then invest in gold on that basis, an unsustainable bubble might develop. Such a bubble would be exacerbated if investors who understand the fundamentals adopt a "greater fool" strategy aiming at separating the foolish investors from their wealth. Perhaps even more troubling is the prospect of many "greater fool" investors playing poker with one another, speculating on when the bubble will burst. Since such a bubble appears as an investment opportunity, it could even raise investment demand and the natural interest rate!

With a gold standard, changes in the supply or demand for gold still impact its relative price, but the "money price" of gold is fixed by definition. The price level changes with the supply and demand for gold.

For example, if low nominal interest rates on short and safe assets result in an increase in the demand for gold, the equilibrium relative price of gold rises, and the equilibrium price level falls. If prices, including the prices of resources like labor, are perfectly flexible, the actual price level falls with the equilibrium price level. Where does it stop?

If the natural interest rate is negative over a short time horizon--i.e. the real interest rate needed to keep saving and investment equal over a short time horizon is negative--then the relative price of gold rises to a point where its expected future rate of decrease is equal to the negative real interest rate. With a gold standard, the price level falls to a point where the expected rate of inflation is equal to the absolute value of the negative natural interest rate. The nominal interest rate is approximately zero, and the real interest rate is sufficiently negative to keep saving and investment equal in the short run.

In a world with perfectly flexible prices, holding gold is no more risk free than it is in a world where the money price of gold is free to adjust with supply and demand. However, with an effective gold standard, all debt contracts are tied to gold. If the relative price of gold falls and the price level rises, not only gold, but all debt contracts denominated in gold take the same real loss. It is not so much that using gold as a standard makes it a safe investment absolutely, it is rather than it exports any unexpected real loss from gold to otherwise short and safe financial instruments.

The second effect is that the lower price level increases the real value of existing stocks of gold. With a gold standard, some of the gold may be held as currency--full bodied gold coin. Some may be held by banks as reserves. The increase in the real value of gold, monetary or otherwise, increases wealth. This allows for increased consumption both now and in the future. The increase in current consumption is a decrease in the supply of saving. The natural interest rate rises. If it were negative, it becomes less negative.

Therefore, the equilibrating process occurs through two channels. The price level falls to a point where its expected future rise makes the real interest rate on short term and safe financial instruments negative, and the increase in real balances reduces the supply of saving so that interest rates don't need to be as negative as otherwise. Saving equals investment, and real expenditures equals the productive capacity of the economy.

As before, along with these equilibrating effects there could be disruptive consequences. If people project current deflation into the future, and so assume that prices will be still lower, the demand for gold might rise further, generating an unsustainable speculative bubble in gold. The relative price of gold rises to unsustainable levels, which is the same thing as the money prices of other goods fall too low. To the degree there are "greater fool" speculators, trying to separate the fools from their wealth, gold hoarding might be exacerbated. Worse, these "greater fool" investors might play poker with one another, gambling about when the bottom will hit and real assets can be purchased cheap--leaving others with the gold that will soon be losing value.

Leaving aside such catastrophic scenarios, sticky prices and wages and added default risk on what would otherwise be low risk debt instruments due to deflation, add complications to the simple parallel with the impact of a negative natural interest rate on the gold market when the nominal price of gold is free to vary. However, I hope this argument shows that a gold standard in no way guarantees savers a low risk, short term, positive real rate of return. And rather than a correction process that first involves recession and deflation, and then inflation, negative nominal interest rates on safe, short term financial assets is the least bad option. That a gold standard puts a floor on nominal interest rates is a weakness, not a strength.

Gov. Gary Johnson on Hannity

Former New Mexico Governor Gary Johnson visited Charleston, South Carolina last Tuesday and spoke to the Bastiat Society. Last night, Fox news aired an interview with Sean Hannity. It is on youtube. The first segment is here. The second segment is here. (HT to David Beito at Liberty and Power.)

At the presentation Tuesday night, many of the questions were about whether Gov. Johnson might run for office in the future. Hannity "asked" him if he is running for President in 2012. David Beito's headline is "possible GOP presidential candidate."

Gary Johnson is running for President. However, no one directly involved in the " Our America: The Gary Johnson Inititative" can say anything about it because it is a 501(c). Currently, funds to support the promotion of his views can be raised independent of any campaign finance limitations. (Sadly, contributions do not appear to be tax-deductible.)

However, everyone else can say what they want. And that means you. Spread the word. Gary Johnson is running for President of the U.S in 2012. He is seeking the Republican nomination.

Personally, I am very confident he will appear in the Republican Presidential debates. This will require that he announce that he is seeking the nomination, filing for primaries, and the like. (I have no idea about the timing of these things. Further, my confidence about the debates is based upon common sense rather than private assurance. I also believe that if he is unable to obtain much support in the early primaries and caucuses, he may drop out. Again, that is based upon common sense.)

Gov. Johnson plans another trip to South Carolina--next month. He is spending a good bit of time in New Hampshire as well. I expect to see some trips to Iowa. Get the picture?

Interest Rates as a Market Price

Last March, Charles Schwab had an op-ed in the Wall Street Journal criticizing low interest rates. When laymen, even bankers and other financiers, write about economic topics, I sometimes read the most shocking things. Schwab sees the current situation as the Fed keeping interest rates low to enhance the profits of banks. The problem he sees is that senior citizens are earning too little on their savings.

In April, Toby Baxendale, of the free-market Cobden Center echoed these remarks. He claims:

The imposition of negative interest rates is one way to totally devastate the poor, pensioners, and all people on fixed income. A Keynesian sees this as the lesser of two evils – getting out of the deflation in Japan. Thrifty people who have provided for themselves and for their future should be punished: this is the world of Keynes.

To me, these are perfect examples of the layman's approach to price, supply, and demand. That prices provide the information and incentives necessary to coordinate the plans of households and firms just never crosses most minds. Instead, prices are what the buyer pays the seller. A higher price means the buyer pays more and the seller receives more. The buyer is worse off and the seller is better off. A lower price means the buyer pays less and the seller receives less. The buyer is better off and the seller is worse off.

From this perspective, a low interest rate is about punishing those who have saved. What is the proper level of the interest rate? Presumably, it would be a level that fairly distributes benefits between seller and buyer. In this situation, the seller is the saver. And the buyer? Who is that? The banks?

From an economic point of view, the role of the interest rate is to provide intertemporal coordination between and among households and firms. Roughly, if the demand for investment is less than the supply of saving at the current level of the interest rate, then the interest rate is too high to do its job--coordinate. While it is true that a lower interest rate may "punish" savers and benefit others, providing a just distribution of benefits cannot be the role of market prices if they are too provide for coordination. If saving is greater than investment, the interest rate needs to fall enough until saving and investment are equal.

What is saving? Saving is income less consumption. To save is to spend less on consumer goods and service than is earned from contributions to the production of goods and services. Saving is a flow through time.

Household wealth is net worth--assets minus liabilities. Other things being equal, saving adds to net worth. Households save by accumulating assets, like stocks, bonds, real estate, bank balances, or currency, or else by paying down existing debt.

Households with positive net worth can earn interest income--interest on some or all of the assets they hold less any interest they must pay on their liabilities. The senior citizens and others worrying Schwab and Baxendale have saved and accumulated wealth and are earning interest income.

For a single household, saving provides a valuable service in two situations. In the first situation, other households may value the consumer goods and services more. That is, other households may want to dissave. Dissaving is consumption greater than income. To dissave to to spend more on consumer goods and services than is earned from contributions to the production of goods and services. A household can dissave by borrowing or else by funding current consumption out of accumulated wealth.

In the second situation, the resources that would be necessary to produce the consumer goods and services can instead be used to produce capital goods. The production of capital goods is valuable because they add to the ability to produce consumer goods and services in the future. While the additional output that capital goods can generate is objective, this is only signaled through the market process by particular firms demanding capital goods, and their demands include estimates of the real volume of product they will be able to generate in the future combined with their estimates of what households or other firms will be willing to pay for those products in the future.

If there are no other households who want to consume now and no firms that want to use the capital goods that could be produced with the resources that could be freed up by reduced consumption, then a household's saving is providing no value to anyone else. While thrift, including past thrift, no doubt involved sacrifice, the market doesn't reward people for making sacrifices. Market prices are paid to people for contributing something of value to others.

Suppose an individual household wants to save anyway? They aren't providing any service to anyone else--at least not one that anyone is willing to pay for. Surely, they should be able to save if they are willing to accept zero interest?

Perhaps they "should" be able to save at zero interest--as a matter of "social justice," but the role of market prices isn't to provide for such justice. If an individual household refrains from consuming now and saves, they are building up net worth and an ability to consume in the future. At some future time, whenever they intend to use the saved funds for consumption, there will be a claim on resources to produce those consumer goods. But the people earning income at that time will have every right to use their income to purchase those consumer goods. The person who saved in the past will be making some claim on those future efforts.

Of course, if the saving of one household had been used to provide consumption to other households who had dissaved, then there are others who are obligated to give up consumer goods in the future. Similarly, if the saving had been used to fund investment in capital goods, then those capital goods would be producing extra consumer goods in future.

But suppose the individual household wants to exercise the virtue of thrift and no other household wants to dissave and no firm wants to use the freed up resources for capital goods? Does the saving household simply exploit future households?

Not necessarily.

All that is necessary is that the interest rate become negative. The household who wants to save provides an incentive for other households to dissave through borrowing by paying them. The saving household gives up consumer goods today in exchange for fewer consumer goods in the future. The dissaving households receive consumer goods today in exchange for fewer consumer goods in the future. Similarly, firms using resources freed up by the decrease in current consumption will find projects using capital goods profitable, even if what people are expected to pay for the consumer goods produced in the future are worth less than the current resources used in the project.

For those households earning the bulk of their income from labor, the negative interest rates make saving costly--perhaps prohibitively so. If a household is "saving" because no current consumer goods or service have any value, then the solution is obvious--work less. Enjoy leisure and restrict work hours to what is necessary to purchase the consumer goods and services demanded. Minimize saving and so the interest cost of saving. On the other hand, if households are saving for future expenditures that cannot be pushed into the present, then they will simply have to pay.

I don't want to dismiss that hardship that is faced by those living off of accumulated wealth--from their interest income. With negative interest rates, they have no interest income. All consumption for such households would be dissaving. They would have to sell off assets and use the proceeds to maintain consumption. Those who greatly value future consumption and are willing to pay the negative interest would be buying these assets. It is their competition for those assets that would be driving the yields down to the point where interest rates are negative.

Unfortunately, many people, including some economists, have difficulty thinking about negative interest rates because they assume that people will hold money with a zero nominal yield rather than hold assets with negative yields. Of course, the obvious response is that this entire analysis should be understood in real terms. The lower limit to the real interest rate is the negative of the inflation rate. With an inflation rate of 2 percent, the real interest rate can fall as low as minus 2 percent. With higher inflation rates, even more negative real interest rates are possible.

The current monetary regime has the Fed manipulating short term interest rates to control the inflation rate. The current target for the inflation rate appears to be 2 percent. That means that if the Fed targets short term rates below 2 percent, it is choosing a negative real rate of interest. The lower limit is approximately -2 percent. The current target for the federal funds rate between zero and .25 percent implies a target for the real interest rate (on short and safe assets) of somewhere between minus 2 percent and minus 1.75 percent. Of course, the actual inflation rate has been lower than 2 percent. Still, both the realized and any plaustibe expectation of real interest rates have been negative for some time.

I do not favor having the Fed manipulate nominal interest rates and the inflation rate at all, and certainly not in order to generate expectations of inflation so that some real interest rates are sometimes negative. Market forces should control all nominal market interest rates, and while the Fed should not intervene to lower them, neither should it raise them to keep real interest rates from being negative. Promoting some version of social justice where savers must receive fair compensation for their thrift is not an appropriate role for the monetary authority. If saving equals investment at a negative real interest rate, then the Fed should not intervene in credit markets to keep real interest rates positive.

I favor keeping cash expenditures on a 3 percent growth path. If the productive capacity of the economy grows 3 percent, this provides for price level stability--both zero inflation and a stable price level. However, if the productive capacity of the economy should grow more slowly, or even shrink, then the result would be inflation during that period. If the productive capacity of the economy should return to a 3 percent growth rate, but on a lower growth path, the price level would be higher and the inflation rate would return to zero.

Similarly, if the productive capacity of the economy should grow more rapidly than 3 percent, my preferred monetary regime would generate deflation. If the productive capacity of the economy then returns to a 3 percent growth rate, but on a higher growth path, then the price level will be lower, but the inflation rate will return to zero.

I believe that nominal interest rates should change with supply and demand. The real interest rate, then, would be the market determined nominal interest rate less the expected inflation rate determined by the given rule for aggregate cash expenditures and expected changes in the market-determined productive capacity of the economy.

Given this alternative monetary regime, even if nominal interest rates remain greater than zero, then negative real interest rates would be possible when the productive capacity of the economy is growing less than trend. Of course, there is nothing to prevent nominal interest rates from being greater than the expected inflation rate, so that real rates could be positive in that scenario as well. It depends on supply and demand--saving and investment.

More troubling are the scenarios where productive capacity is expected to remain at trend, but the real interest rate necessary to keep saving and investment equal is negative. Or worse, perhaps productive capacity is expected to grow faster than 3 percent, leading to expected deflation. If the real interest rate where saving equals investment is less than the expected growth rate of the productive capacity of the economy, then the only way for market interest rates to properly coordinate saving and investment is for nominal interest rates to fall below zero. (I am aware that rapid growth in productive capacity plausibly results in high investment demand and low saving supply and so a higher natural interest rate--with perfect information.)

The current monetary regime is based upon tangible, hand-to-hand currency with a zero nominal yield. While other forms of money are quantitatively more important, ultimately, these other forms of money (and for that matter, all debt instruments) are tied to zero-nominal interest currency.

If, on the other hand, the monetary regime is not based upon hand-to-hand currency with a zero nominal interest rate, then nominal interest rates can become negative when necessary to coordinate saving and investment. If other nominal interest rates are negative, and it is impractical to have negative nominal interest on currency, then maintaining an issue of hand-to-hand currency would involve losses for the issuer(s.) With privately-issued hand-to-hand currency, the most likely result would be that no one would issue it. The only money remaining would be transactions accounts, presumably with negative nominal interest rates. Since hand-to-hand currency is especially useful for some types of transactions, these benefits would be sacrificed. It is possible that the conveniences of hand-to-hand currency are inconsistent with low inflation and a real interest rate that coordinates saving and investment.

If, on the other hand, a central bank issues hand-to-hand currency at a loss, then these benefits could be kept. Of course, it is difficult to see how a central bank could avoid having people use currency as a store of wealth. And so, simultaneously, the central bank would be providing a subsidy to savers. In practice, central banks keep nominal market interest rates slightly above zero, but this just means that they generate whatever monetary disequilibrium needed to keep the real rate no lower than the negative of the expected inflation rate.

For the most part, I have been discussing the possibility that "the" interest rate needed to coordinate saving and investment is negative. But, of course, there is not just one interest rate, there are many interest rates. Personally, I am not too interested in possible worlds were the real interest rate needed to coordinate saving and investment remains negative forever. I think this generates paradoxes for the site values of land and perhaps even "treasure" like gold and jewels. I am confident that the real interest rates needed to coordinate saving and investment are usually positive. It is rather that it is possible that the real interest rate needed to coordinate saving and investment over some short run time horizon might be negative. The implication is that long rates should generally remain positive, though short rates might sometimes need to be negative to keep saving and investment equal in the short run.

Further, there is the question of risk. The service that is provided by the individual household who saves is to give up consumer goods now. This either allows dissaving households to obtain those consumer goods now or else frees up resources to produce capital goods which can produce consumer goods in the future. Households that save are making claims on consumer goods in an uncertain future. Risk is necessarily involved. For some household to be able to save without risk requires that someone else bear the risk. If those who bear the risk require more compensation, then those whose risks are covered have less return remaining. While the interest rate that coordinates saving and investment may be positive if the savers are bearing the risk associated with the investment, it is possible that low risk real interest rates need to be negative.

In conclusion, if the real interest rate necessary to coordinate saving and investment is negative, then those providing saving are not providing a service for which anyone is willing to pay. Quite the contrary, they acting now to make claims on others in the uncertain future. Coordinating saving and investment requires that they pay. The real interest rate needs to be negative.

In practice, however, the savers who worry Schwab and Baxendale, are people who are trying to play it safe by keeping their wealth in short term, low risk assets. Over the last few years, the real interest rate on 10 year, BAA corporate notes increased sharply during the worst of the crisis, and remain relatively high. They have remained well above zero. People willing to share some risk and make the sort of commitment of resources through time needed to fund real investment projects can earn a real return. The "problem" is that those who want to bear little or no default risk or make any commitment of time are unhappy about the negative real yields on Treasury bills and FDIC insured bank deposits.

Who is supposed to bear this risk for them? In my view, no one. Sometimes some real interest rates should be negative.

Charles Rowley on the Financial Crisis

I enjoyed Charles Rowley's account of the financial crisis.

Quite humorous, and negative regarding our Treasury Secretary.

Geithner has a fascinating vita. B.A. from Dartmouth in government and east Asian studies. M.A. in international economics and East Asian studies from Johns Hopkins. Worked for Kissinger's lobbying firm. Then to Treasury where Larry Summers became his mentor. Some say he was a protege of Robert Rubin. Off to the Council of Foreign Relations. (It's enough to turn you into a Bircher.) Then to the IMF for a time. Finally President of the New York Federal Reserve. And now Secretary of the Treasury.

It seems to me that his on-the-job training was focused on bailing out foreign countries. Of course, that means bailing out lenders to foreign countries. Maybe that is what the Board of Directors of the New York Fed looks for in a President?

Global Savings Glut: Is it Possible?

Some have argued that the low market interest rates in the early naughties were associated with a "global savings glut." Some have responded that this could not have been true because there was no increase in the global savings rate.

Of course, even if there is a constant saving rate, an increase in income will result in an increase in the supply of saving. If the demand for investment is unchanging, then the result is a lower natural interest rate.

The response regarding the saving rate is really an implicit claim that the demand for investment should also rise in proportion to current real income. If that is true, then growing real income and equal saving and investment rates results in the supply of saving and demand for investment increasing in proportion. The natural interest rate would remain unchanged and the amount saved and invested grow together. Spending on consumer goods and capital goods grow in proportion. (I must admit that this is the way I think of dynamic equilibrium.)

And so, this line of criticism naturally suggests that the failure of investment demand to grow at the same rate as real income is characterized as a "decrease" in the demand for investment. With saving supply growing with income and investment demand growing more slowly than real income, the natural interest rate falls.

Interestingly, while the amount saved and invested rise together with income in this scenario, the slower growth in investment drags down the realized saving rate. Both saving and investment become a smaller proportion of real income and real output if the growth of investment demand slows.

Simplifying the analysis by assuming a given level of real income, an increase in the supply of saving combined with a decrease in the demand for investment results in a lower natural interest rate and the amount saved and invested ambiguous. It is, of course, possible that they exactly offset, leaving the amount saved and invested unchanged. (If this is all treated as fractions of real income and real output, then the savings and investment "rates" are unchanged, with both the amount saved and invested growing in proportion to real income and output. However, the natural interest rate is lower.)

If consumer goods and capital goods are each homogeneous, then there is no change in the allocation of resources. The demand for consumer goods and capital goods are unchanged (or are growing in proportion.)

However, capital and consumer goods are not homogeneous. Goods with relatively high interest elasticities of demand (both capital and consumer goods) should expand relative to goods with relatively low interest elasticities of demand (again both capital and consumer goods.) If these conditions are expected to persist, then all sorts of specific capital goods might be constructed whose profitability depend on this particular pattern of demands.

Suppose that rapid growth in one part of the world economy leads to rapid increases in real incomes both in that area and in aggregate. While the consumption of those reaping these gains increases remarkably, it rises less than their incomes. Their savings rates are high, and this pushes up the world saving rate.

Other things being equal, this lowers the natural interest rate. One of the normal effects of this would be a decrease in the quantity of saving supplied as a response to lower interest rate. While this may just dampen the rise in saving by those receiving the large increases in income, it may, and really "should," be expected to lower savings rates in the rest of the world. It becomes cheaper to finance the purchases of new cars, microwaves, pools, porches, home computers, and any number of things.

If this was the entire story, then the world saving rate rises. The lower natural interest rate also stimulates expanded investment expenditure. The production of new capital goods rises, which will allow for increased production of consumer goods in the future--when those who have been socking away these savings finally begin to use them to fund more consumption.

However, suppose that at the same time, wildly optimistic estimates of the benefits of computer technology in enhancing factor productivity are dashed. The demand for investment, especially computer equipment and software, falls off. This decrease in investment demand lowers the natural interest rate even more and at least partially offsets the impact of the greater savings supply.

While the lower natural interest rate may at least partly dampen the enthusiasm for saving by those with the rapidly growing incomes, it should be expected to also further reduce the saving of everyone else. Financing consumer durables is even more attractive.

As for investment, the lower interest rate should partly dampen the decrease in demand for computer equipment and software, but it will also tend to expand the demand for other sorts of capital goods. If purchases of new single family homes are counted as "residential investment," then the lower natural interest rate should be expected to raise both the prices and the production of new single family homes.

If this pattern of demand is expected to persist, it could result in the construction of a variety of specific capital goods aimed at better accommodating the pattern of production to this pattern of demand. If those expectations are wrong, then slower growth in saving supply and more rapid growth in investment demand could result in substantial structural unemployment and losses on specific capital goods.

Yes, it is a "just so" story. I call it "history." There is no reason why saving supply cannot rise at the same time investment demand falls. And there may be historic episodes where both happen to grow rapidly, both more slowly, or investment demand grows more rapidly while saving supply grows more slowly.

Finally, suppose this new "low natural interest rate" pattern of demand and allocation of resources is faced with a new increase in the demand for investment. Sadly, the increase in investment demand is created by an illusion--a speculative bubble, where foolish investors myopically project past increases in housing prices into the future.

I don't want to deny that the Federal Reserve could keep the market interest rate above the natural interest rate. It is almost certain that by creating monetary disequilibrium and falling or slower growth in cash expenditures, the Fed could deter entrepreneurs from making investments that will turn out to be mistakes. But why focus on interest sensitive demand? An entrepreneur who thinks that he has a great idea for a soft drink might be protected from actually carrying out the project only to discover that no one likes the beverage. If it weren't for the Fed causing a recession, he would have sunk a lot of money into a failed project. Specialized nasty tasting beverage production equipment would have been a waste of resources.

My view is that total cash expenditure--Final Sales of Domestic Product--should be kept on a 3 percent growth path and the market should determine interest rates. I have little doubt that temporary changes in market interest rates, and even speculative bubbles, could still lead entrepreneurial error. But those are just one of many possible sources of structural unemployment and losses on specific capital goods. The notion that fixing the level or growth path of some measure of the quantity of money, or worse, manipulation of market interest rates by central banks to prevent or "pop" bubbles, are appropriate policies to avoid these sorts of problems is a mistake.