Faux Free Market Macroeconomics

Perhaps it is my imagination, but there appears to be a notion among some conservatives and libertarians that the "free market" response to an increase in saving is for production to fall to match demand, and for firms to lay off their least productive workers. The more productive workers remain employed and continue to consume and save as they choose. If the more productive workers choose to consume more (and there is no reason they should) then production will expand and the least productive workers will again be hired.

Usually, this account is combined with the notion that the saving involves paying down excessive debt accumulated in the past. The suffering of the unemployed today is the inevitable consequence of the excessive debt built up in the past. Only after those who remain employed have paid down their excessive debts can they begin to spend again, so that employment can recover.

WRONG!

Perhaps a primer on basic "classical" free market economics is in order. If people choose to continue to work and not consume, they are saving. This change in preferences is an increase in the supply of saving. The price that coordinates the decisions of households to save and firms to invest is the interest rate. An increase in the supply of saving "should" result in a lower interest rate. The lower interest rate reduces the quantity of saving supplied, which is the same thing as an increase in spending on consumer goods and services. The lower interest rate also results in an increase in the quantity of investment demanded, which is an increase in spending by firms on capital goods.

And so, what "should" happen is that interest rates fall, the decrease in consumption is dampened, and the demand for capital goods expands. Total spending doesn't change. The demands for some products fall and the demands for other products grow. Production in some industries shrink, and production in other industries grow. People are laid off in shrinking industries but more people are hired in growing industries. While this process of adjustment may involve reduced production and higher unemployment for a time, there should be strong employment growth in many industries and ample vacancies.

Suppose that the problem instead is that businesses choose to invest less, perhaps because of uncertainty. It could be uncertainty regarding public policies--environmental regulation, income taxes, or health care mandates. There appears to a variant of conservative and libertarian macroeconomics that sees this "regime uncertainty" as causing less spending on capital goods, and so less employment in that sector. The least productive employees are laid off and they must wait to get new jobs, presumably when economic conditions are more settled and firms begin to invest again. As the firms purchase capital goods, more are produced, and the least productive workers are again hired.

Returning to basic free market principles, what "should" happen when there is a decrease in the demand for investment is that the interest rate falls. The lower interest rate reduces the quantity of saving supplied, which is an increase in consumption. The lower interest rate also dampens the decrease in investment demand. And so, consumption expenditure "should" rise, and spending on capital goods should fall by less. Total spending should not fall. Instead, there is a shift in the composition of spending, away from purchases of capital goods and towards purchases of consumer goods and services. Some industries shrink and others grow. While such a redeployment of labor and other resources may involve temporarily reduced production and higher unemployment, this will be in the context of strong employment growth in some sectors and high vacancies.

The Keynesian scenario, where faltering animal spirits lead to reduced production and employment is just not consistent with free market economics. Keynesian economics with the caveat that politicians are to blame for creating uncertainty (instead of uniformly consistent pro-business policies, I guess) is not free market economics. ( The complaint consistent with basic free market economics would be that the return on investment, such as interest and profits, is low because of excessive uncertainty.)

Oddly enough, if there is a simultaneous increase in the supply of saving and decrease in the demand for investment, the result should be lower interest rates and little or no change in the allocation of resources between consumer and capital goods industries. Of course, there may be changes in the composition of expenditure on different consumer and capital goods.

Notice, that having the least productive workers unemployed until someone decides to spend is not "free market" economics. And lower interest rates resulting in more consumer expenditures (and investment expenditures) is a key part of the market response.

Nearly everywhere in the world, interest rates are set by a central bank, like the Fed. Central banks create and destroy money, but they typically do so at a rate aimed at keeping interest rates at a targeted level. If a central bank were to keep interest rates fixed in the face of an increase in the supply of saving or decrease in the demand for investment, or both, then spending does fall as does production. The least productive workers are laid off. But this is due to the central bank's wrongheaded intervention--failing to allow interest rates to fall enough.

Leaving aside getting rid of the central bank, lowering interest rates in this circumstance at least approximates the market process. That the central bank lowers interest rates to stimulate consumption and investment does sound manipulative and artificial, but the market process that accommodates increased saving or reduced investment does involve lower interest rates which does "stimulate" consumption and investment.

While a hard core free market approach might demand the abolition of the central bank, in the mean time, the notion that a central bank should keep interest rates high in the face of higher saving and and lower investment is wrongheaded. In fact, such a foolish intervention could result in ever deepening recession.

Keynesian economists have argued that the market process of lower interest rates fails because changes in interest rates impact the demand to hold money. Free market economists have often granted that interest rates have some impact on the demand to hold money, but have argued that the effect is small. Keynesian economists have responded that changes in the interest rate only have a small effect on saving (and so, consumption) and investment. If large changes in interest rates are needed, then even a small effect of a changing interest on the demand to hold money will add up. In particular, if the interest rate needed to equate saving and investment falls to anywhere near zero, then a significant impact on the demand for money is likely.

Quasi-monetarists argue that if changes in interest rates (or anything else) causes a change the demand to hold money, then the central bank should simply change the quantity of money to accommodate the demand. That will allow interest rates to make the needed adjustment to keep saving and investment equal. However, if the quantity of money doesn't change, and lower interest rates (due to a higher saving supply or reduced investment demand) cause a higher demand to hold money, then there is a second market process that returns the economy to equilibrium.

Basic free market monetary economics explains that if the demand for money rises (because of lower interest rates or any other reason,) and the nominal quantity of money remains unchanged, then the price level (the prices of consumer good and services and capital goods) must fall enough so that the real quantity of money will rise to match the demand. As the real quantity of money rises to match the demand to hold money, real expenditures on goods and services rise, resulting in a higher volume of real sales, more production, and more employment.

How does a rising real quantity of money cause an increase in real expenditure? One pathway by which the "real balance" effect operates is that as the real quantity of money rises, people take some of their added money balances and lend them out, perhaps by purchasing bonds. This lowers interest rates, and the lower interest rates result in a lower quantity of saving supplied and more consumption. While the flow of money expenditures on consumer goods doesn't rise, the real volume of consumer goods purchased increases. Similarly, the lower interest rates result in more investment demand. Again, the flow of money expenditures on capital goods doesn't expand, but the real volume of spending on capital goods rises.

Notice that if the quantity of money is held fixed, then the market process involves lower interest rates, which results in an increase in real expenditure on consumer goods and capital goods. The process does not involve the least productive workers waiting until people decide to go back to consuming and investing at unchanged interest rates.

But suppose that interest rates have fallen as close to zero as they can get, and still interest rates are too high to coordinate saving and investment. There are two possibilities. The "Pigou" effect is that as the real quantity of money rises, people are wealthier, and so they choose to save less and consume more. Again, the volume of money expenditures on consumer goods and services don't rise, but the real volume of consumer goods purchased rises.

And, it is possible that the price level will fall "too low," below a level consistent with long run equilibrium. At this low price level, it will be expected to rise. This expected inflation results in lower real interest rates, and so results in more consumption and investment.

Of course, firms can only reduce the prices of final products like consumer goods and capital goods if the prices of the resources they use fall as well. In other words, money wages must fall with other prices. So, if the lower interest rate due to increased saving and/or reduced investment results in an increase in the demand to hold money, and the quantity of money is held constant, then the firms that sell fewer consumer goods and capital goods must lower prices. In order to continue to make a profit, they must lower the wages and other resource payments they make. With all firms offering lower wages, workers have no alternative but to accept the pay cuts. (Quasi-monetarists, like just about everyone, are skeptical that this scenario of cutting prices and wages works smoothly or quickly.) Because prices and wages both decrease, real wages are not affected. The typical person can afford to purchase exactly what they were before. But the expansion in the real quantity of money results in more consumption spending. And except in the most special circumstances, it also results in lower interest rates and increased investment expenditure too.

So, the market process that corrects for an increase in the supply of saving or decrease in the demand for investment always involves an expansion in real consumer expenditure. Something is going to stimulate real consumption. (Yes, if saving supply increases, this is a dampening or partial reversal of a decrease in consumption.) Except in the most unusual circumstances, there is a decrease in interest rates which also stimulate real investment expenditure. Decreases in prices and wages are possible, but not necessary. That depends on how interest rates impact the demand for money, and how monetary institutions accommodate changes in the demand to hold money--through a higher nominal quantity of money or through a lower level of prices and wages.

The quasi-monetarist approach is consistent with basic free market economics. If there is an increase in saving or decrease in investment, then market forces should be allowed to lower interest rates. If the lower interest rates result in an increase in the demand to hold money, then the quantity of money should increase, so that interest rates fall enough to coordinate saving and investment. While there may be a change in the composition of expenditure between consumption and investment, money and real expenditures should be maintained. While a shift in production between consumer and capital goods may involve a temporary reduction in output and employment as resources are redeployed, spending should not fall. In other words, the process should work exactly as it would if the decrease in interest rates did not impact the demand to hold money and the quantity of money remained unchanged.

But even if the quantity of money is held stable and the demand for money rises, then the end result will be similar. As wages and prices fall, interest rates will fall, and real expenditures on consumer goods and capital goods will be "stimulated." The notion that lower interest rates and expanded expenditure on consumer goods and capital goods is artificial is just an error. Any notion that the market system requires that spending, production, and employment be reduced for a time is an error. It is an error of "faux" free market economics.