Is David Laidler a Quasi-monetarist?

David Laider has another interesting paper.     Even discussed Robertson and Hayek on forced saving.   What was missing?   What would happen if money expenditures grows at a slow steady rate?

Great News! Fourth Quarter Money Expenditures Increase Sharply! Inflation Stays Low!

The estimate for Final Sales of Domestic Product for the fourth quarter of 2010 was $14,865 billion.   This was a 7 percent increase from the third quarter.    Since the sharp decrease in the 4th quarter of 2008, this is the first increase that was greater than the 5 percent trend of the Great Moderation.   In fact, it was the first increase that wasn't less than 3 percent.

If money expenditures had continued on its trend growth path from 1984 to the end of 2007, it would currently be $17,013 billion.    The current value remains 12.43 percent below trend.   However, this is the first quarter since second quarter 2007 that the gap from trend actually decreased  Unfortunately, for it to return to trend by the fourth quarter of 2011, it would need to grow 20 percent from the fourth quarter of 2010.    While 7 percent growth seems quite fast, at that rate, it would take nearly a decade for money expenditures to return to trend.

The chart below shows the trend of the Great Moderation in red and actual money expenditures in blue.   The dashed line is the 20 percent growth necessary to return to trend in one year.

I favor adjusting the target for money expenditures to a three percent growth path starting at the beginning of the recession at the end of 2007.    This would allow for a substantial recovery of money expenditures, while moving to a new growth path consistent price level stability in the long run (at least if the productive capacity of the economy returns to growing 3 percent.)    The target for the adjusted growth path is now $15,809 billion.   The current value of Final Sales of Domestic Product is 6 percent below that target.    In order to return to target within a year, it would need to grow 9.6 percent. (from fourth quarter 2010 to fourth quarter 2011.)   If the current 7 percent growth rate continued, it would reach the adjusted trend by the second quarter of 2012.    Then, to stay on the growth path, the growth rate would need to slow to 3 percent.

The chart below shows the adjusted growth path in red.   The first portion shows the 5 percent growth rate of the Great Moderation and then slows to 3 percent in the fourth quarter of 2007.   Final Sales of Domestic Product is shown in blue.   The dashed line shows the 9.6 percent growth that would be needed to return money expenditures to target.

The other good news is that inflation, as measured by the GDP chain-type price index, showed an inflation rate of less than 1/3 of a percent.    Growing expenditures on output and slow increases in prices should result in rapid increases in real output.   While the real GDP figures showed much slower growth, this means that inventories were being depleted.    In my view, getting the amount that firms can sell (in aggregate) to a predictable growth path is the goal, and that should result in fewer surprises, where sales outstrip production or vice versa.

The low inflation rate implies that the price level is even further below its 2 percent growth path from the Great Moderation.    The current gap is 2.75 percent.    In my view, 2 percent inflation is 2 percent too high, which is why I favor a shift from a 5 percent to a 3 percent growth path for money expenditures.   While there is reason to believe that 9 percent growth of money expenditures over the next year, or 7 percent over the next 18 months, would raise inflation somewhat, the long run goal should be a stable trend for the price level.   Last quarter's estimate is a good start.

Monetary Policy and Bank Profits

Axel Leijonhufvud had a tremendous impact on my understanding of macroeconomics.   Admittedly, I was first exposed to him by Yeager, and I still have a "Keynesian Diversion" take on "Keynesian Economics and the Economics of Keynes."    Still, I am probably one of the more "Keynesian" of the quasi-monetarists.   Interest rates play a much larger role in my version of monetary disequilibrium than that of Scott Sumner, or Yeager, for that matter.

So, what to make of Leijonhuvud's rant about the social injustice of the low short term interest rates?    He argues that banks are borrowing at very low rates, approximately 1 percent.  They are holding government bonds that are paying 3 or 4 percent.    They are making a large margin, and this is unjust, I guess to the depositors who are only earning 1%.

 At first pass, I was a bit horrified.    So, the Fed should do some open market sales, worsen the existing excess demand for money, and hope that a liquidity effect raises short term interest rates?   Banks will have to raise deposit rates to compete, and their excess profits from investing in government bonds will shrink?    What a disaster.  Worsen the recession to make sure that depositors earn high interest rates.   (I hate to admit it, but I worry sometimes about special pleading by great, retired economists whose late stage of life asset portfolios may be earning very low yields.)

The Fed's job should be to keep money expenditures on a stable growth path.   If short term interest rates fall to very low levels, then so be it.  If bank lending rates fall by less, so that bank margins rise, that should be no concern of the Fed.

I suppose it might be a concern for anti-trust policy, but to me, the key issue would be entry.   If banking currently is providing excessively high profits, and there are people who want to organize banks, then let them.  As they bid for deposits and invest the funds, then the margin that banks earn will fall.  If regulators are blocking new entry into banking until existing banks make up for losses from lending against overpriced houses, I will complain as well.

Of course, Leijonhufvud then claims that this situation of banks paying low rates on deposits and purchasing higher yield government bonds is risky and could lead to a future banking crises.  Why?   If interest rates on government bonds should rise, then the banks will suffer capital losses on their portfolios of government bonds.  

To me, this argument contradicts the claim that banks are making excessive profits.    Once the risk of capital loss is taken into account, perhaps the gap between the interest rates banks pay and what they earn is reasonable.   In other words, the banks may be very competitive, and if they expected the current rates on longer tem government bonds to persist, then they would bid up the yields on deposits and/or bid up the prices of long term government bonds and lower their yields.   Perhaps the risk adjusted yield on bank asset portfolios isn't that much higher than what banks pay on deposits.

However, there are two ways in which government policy could reduce the gap between bank deposit rates and the interest rates on government bonds.   In the debate about QE2, some, like Robert Barro, have argued that with low yield T-bills being more or less a perfect substitute for base money, open market operations with T-bills have no effect.   When the Fed purchases long term bonds, on the other hand, this does have an effect, because long term government bonds with 3 to 4 percent yields are not perfect substitutes for base money.    Some have pointed out that this implies that having the Treasury refinance the national debt by selling more T-bills and using the proceeds to pay off longer term bonds as they come due, or even purchasing the longer term bonds on the market would have the same effect as QE2.

This argument seems sound.  When Barro and others express disbelief that the composition of the national debt could possibly have much effect on money expenditures, it seems to me they just failed to understand their own argument.    If T-bills are the same as base money, then a shift in the composition of the national debt is the same thing as creating more money.

Anyway, if the Treasury did refinance the national debt by selling more T-bills and paying off longer term government bonds, the result (ceteris paribus) should be a higher yield on T-bills and lower yields on the long term government bonds.   Banks would have to raise deposit rates to match the higher yields on T-bills, and their earnings on long term government bonds would fall.   The "excess" profits earned by banks would fall.    Presumably, banks would either shrink both sides of their balance sheet or shift from holding government bonds to making more commercial loans.  

Why doesn't the Treasury follow this policy?   Presumably because they want to lock in relatively low long term interest rates.    If they borrow with T-bills, when short term rates (and expected long term rates) rise, they will have to pay more right away.    In other words, by having the Fed and banks purchase long term government bonds, this risk is shifted to them.   Of course, treating the Fed as independent of the rest of the government is a complete illusion, and with deposit insurance, much of the commercial banking system is little different.

A second issue is more narrowly focused on Fed policy.   Following neo-Keynesian precepts, the Fed's solution to the lower bound on its target interest rate was first and foremost to promise that short term interest rates will stay low for an extended period.    This policy does seem like it will leave banks with low borrowing rates for this extended period.    The policy of QE2, on the other hand, involves purchasing long term government bonds.   As I have explained before, it could actually raise interest rates on long term bonds, but to the degree expectations of future growth in money expenditures remain depressed, it would lower long term rates on government bonds.   This would reduce the gap that so concerns Leijonhufvud.

My view is that the Fed should cease targeting interest rates altogether.    It should instead target a growth path for money expenditures and commit to expand the quantity of money enough to reach that target.   Interest rates should depend on market forces (and I would like monetary institutions that make negative nominal interest rates on short term government debt possible.)    If expectations of recovery result in higher long term interest rates and lower demands for short term government bonds and other safe financial assets, then it would be a mistake for the Fed to have made some kind of promise to keep short term interest rates low.

In other words, if expansionary Fed policy raises short term rates, and so what bank depositors earn, then great!  On the other hand, if expansionary Fed policy lowers those rates, then so be it.   Fed policy should be aimed at keeping money expenditures on a target growth path, and short term interest rates and bank profits should not be its concern.

What is Quantitative Easing?

Over on Coordination Problem, Steve Horwitz explains why he opposed both QE 1 and QE 2. Basically, he is responding to attacks by Rothbardians claiming that he has shown excessive quasi-monetarist tendencies. (Really, the problem is that Horwitz has deviated from the plumb-line that any increase in the nominal quantity of money, other than an increase in the quantity of gold, is EVIL.)

What is quantitative easing?

Perhaps it is just wishful thinking, but to me "quantitative easing" refers to efforts to increase the quantity of money. Quantitative tightening would be efforts to decrease the quantity of money.

This is as opposed to interest rate targeting, where easing means lowering the target for the federal fund rate and tightening means raising that target.

When the target for the fed funds rate had been reduced to about 2 percent, and many economists, journalists, and politicians were saying monetary policy was out of ammunition (seeing zero so close,) and so we needed fiscal policy, it became clear that this tool of manipulating short term rates, that appeared to work well during the late eighties, ninties and the first part of the 2000s, was breaking down. It was time to focus on the quantity of money rather than interest rates.

I must confess that I have never liked interest rate targeting, but its apparent success during the Great Moderation led me to hold my tongue. I never favored the 2 percent inflation target either, but disinflation to zero just wasn't a priority for me. ( I did write Mark Sanford about it when he was in Congress.)

Unlike Horwitz, I don't support Bagehot's approach to lender of last resort. Rather than have the central bank lend to sound banks at a penalty interest rate if there is an increase in the demand for base money, I favor having the Fed make open market purchases of government bonds to accomodate the increase in the demand for base money. The base money would go to whatever banks sell the bonds, or whatever bank is utilized by the nonbank firms or households that sell the bonds. The market can handle moving reserves to sound banks that need reserves. Banks that cannot obtain reserves will have to default. They should be closed and reorganized. Rapidly.

I suppose I don't trust the Fed to follow rules about only lending to sound banks. Years ago, I was persuaded by Friedman's argument that the discount window should close. I don't think "penalty interest rates" should be part of the process. Interest rates should depend on market forces. If Fed purchases of governement bonds results in lower rates for government bonds, that should not be a worry. Whether the interest rates at which various banks can borrow on the market rise or fall should also not be a concern.

To some degree, my approach is that the Fed needs to offset changes in the money multiplier (in the currency deposit ratio or reserve deposit ratio) by changes in base money, to prevent changes in the quantity of money. However, I don't really favor stablizing the quantity of money, and believe that the quantity of money should change to offset changes in the demand to hold money.

Sometimes rather than break things down between base money, money multiplier, the quantity of money in the hands of firms and households, and the demand to hold that money, I just focus on the quantity of base money and the demand to hold it. It has some value. If the demand for base money rises, the central bank should increase the quantity to match. The market can determine the quantity of deposits people want to hold. On the other hand, the relationship between the quantity of deposits and the demand to hold them plays a key role in the process by which inbalances in the demand for base money and the quantity of base money actually impacts spending on output, prices, and production.

The actual policy of the Fed in 2008 was mostly focused on supporting loan securitization. It did involve an increase in base money, which was what was needed. But it also was directed at supporting markets where banks made loans, sold them, investment banks bundled them, and then sold asset backed securities to mutual funds and other investors. The theory was that the demand for these securities was low because they had become illiquid--they couldn't be sold. If the Fed jump started this market, then everything would go back to where it was before 2008. If people were confident they could sell the securities when they wanted, they would be willing to buy and hold them. If they would hold the securities, then the investment banks could sell them. If the investment banks could sell them, they would buy loans from banks. If the banks could sell the loans, they would make more loans.

From a monetary disequilibrium approach, this would work to solve the problem because people were holding money rather than these asset backed securities, perhaps indirectly through mutual funds. If they went back to holding the asset backed securities, then the demand for money would fall to pre-crisis levels.

The benefit to the Fed's approach had to do with lending markets. If banks hold loans on their balance sheets, regulations require that they fund it partly with capital. And so, by making loans and selling them, the loans can be funded by investors without banks (or anyone) providing capital.

The alternative would be for banks to make the loans, hold them on their balance sheets, fund them with deposits, and sell new stock to meet capital requirements. This process would take time, and in the meantime, lending would be disrupted. The price response to this would be high loan rates and low deposit rates. The increase bank earnings both provides an incentive for investors to purchase new issues of stock and allows banks to build capital with retained earnings.

Of course, banks held large portfolios of asset backed securities, particularly mortgage-backed securities. They suffered losses, and had less capital already, which further caused problems with lending. Because there is no capital requirement when banks hold reserves or government bonds, banks that have suffered losses and so have less capital can meet their capital requirements by cutting back commercial and consumer lending As old loans are repaid, they can hold reserves or purchase government bonds. This reduces their capital requirement.

So, there was method to the Fed's madness. But I was always skeptical that it would work. And it didn't. Asset securitization has not recovered, and the problem remains that the demand for money is extremely high by historic standards. The crash in the stock market also has resulted in a higher money demand. The extremely low interest rates on government bonds has raised money demand. So, there is more going on than just the collapse of securitization. Which is, of course, one reason why I think the Fed's focus on fixing that market was an error.

In the past, my view had been that the Fed should buy T-bills when there is an increase in the demand for base money. If the Fed bought all of the T-bills that exist, and there was still too little base money, they should start moving up the yield curve-- 2 year bonds, 3 year bonds, and so on. If they end up with the entire national debt, then start looking to agency debt, AAA municipal bonds, AAA private securities and so on. But I didn't expect to ever get there. It is difficult for me to imagine that a monetary base of $7 trillion or so would be too small.

Because of the crisis, I have changed my mind. When the yield on an asset gets so low that holding currency is better (which is probably slightly negative,) then the Fed should stop buying and move up the maturity curve to something that still has a positive yield. (I still have trouble imagining that $7 trillion could be too little, I just don't think the Fed should bother buying government bonds with really low yields.)

Also, it is embarrassing to admit this, but I didn't realize to what degree the Fed's asset portfolio was already heavy with longer term government bonds. Open market operations in T-bills was apparently something from textbooks.

So, I think the quantity of base money has been too low for the last several years. And I think the Fed should continue to purchase government bonds with positive yields (which all of them have, but the 4 week ones and even 6 month ones have pretty low yields.)

And so, I support quantitative easing. And, when the demand for base money falls, as I expect it will, and hope it will soon, I will support quantitative tightening.

As I, and all the quasi-monetarists have explained, quantitative easing would be much better in the context of an explicit target for the growth path of aggregate money expenditures. I favor final sales of domestic product. Further, the Fed should stop paying interest on reserve balances, and in fact, charge a bit for them to reflect the interest rate risk it is bearing on its asset portfolio. But the Fed should also stand ready to expand base money however much is needed to get money expenditures to target. And then to contract it again when the demand to hold base money falls.

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A Rothbardian Critique of Quasi-monetarism

Robert Murphy criticized David Beckworth's conservative case for quantitative easing.

For the most part, Murphy fails to understand the quasi-monetarist position.   Beckworth correctly understands that the purpose of quantitative easing is to expand the quantity of money, correct the imbalance between the quantity of money and the demand to hold it, and so, expand spending on final goods and services--particularly consumer and capital goods.

Beckworth doesn't think the purpose of the policy is to lower interest rates or expand industrial or commercial bank loans.   Murphy's statistics about interest rates on government bonds and the volume of commercial and industrial loans are irrelevant.   As I have explained before, quantitative easing can increase spending on goods and services while real interest rates rise and lending by banks or even total  lending falls.   All it requires is that some of the households and firms that reduce lending use the funds they would have lent to instead purchase consumer or capital goods.

Murphy's argument against the desirability of  expanded spending is almost nonexistent.   Neither Beckworth nor any quasi-monetarist claims that spending creates wealth without production.  Further, we understand the importance of expanding the productive capacity of the economy through saving, investment, and technological innovation   However, we also recognize that in a market system, productive capacity will do no good if firms cannot sell what they produce.   And so, real expenditure must grow with the productive capacity of the economy.  That requires that money expenditures grow or else the level of prices and wages fall.    Our view is that growing money expenditures is a better way to allow firms to sell what they are able to produce than requiring a deflation of prices and wages, particularly a deflation made necessary by a large drop in money expenditures.

We cannot "inflate" ourselves into jobs, says Murphy.    If we assume that the prices and wages are at the level where the real quantity of money equals the demand to hold it, then expanding the quantity of money will do no good.   But if the prices and wages remain too high for the real volume of  expenditure to match the productive capacity of the economy, increasing the quantity of money means that prices and wages don't have to fall as much as they otherwise would.   In the limit, prices and wages don't need to fall at all and, in fact, can continue to rise at their previous trend.

In the end, Murphy criticizes quantitative easing because when the Fed purchases $600 billion in government bonds, it is purportedly distorting the market by providing the Federal government with funds at preferential rates.    By lending to the government, the Fed is distorting the market by directing credit towards the government rather than the private sector.

At first glance, the argument is absurd.   Does Murphy really think that the U.S. government will spend $600 billion more in 2010 and 2011 because the Fed is purchasing $600 billion more government bonds?   That if the Fed instead purchased a portfolio of private securities, the U.S. Treasury would have to sell fewer bonds over the next year because it couldn't find buyers?    And so, the U.S. government would have to limit its spending because of a lack of funds?

I think a much better vision of the current fiscal situation in the U.S. is that the government spends what it likes, collects taxes as it can, and borrows the difference.   The U.S. government has no problem finding buyers for its bonds, and is able to borrow at historically low rates.

However, there is probably one element of truth in Murphy's argument.   If quantitative easing did lower interest rates on government bonds, then this would reduce the government's interest expense.   Because of public concern about budget deficits (which I share,) this reduction in interest expense will reduce the pressure on the government to hold the line on other elements of government spending or increase taxes.  

Still, I am not certain that the alternative of the government paying its bond holders more and spending less on other government programs is especially desirable.    I am sure that paying its bond holders more and raising taxes would be worse.   My own preference is that other government spending should be cut regardless of what happens to the government's interest expense.   If there is any change made to the budget due to lower interest expense, it should be lower tax rates.

However, as explained above, quantitative easing might actually raise interest rates and the expense of funding the national debt. When the economy is depressed, investors seek safety, which includes government bonds.   Since the point of quantitative easing is to increase spending by households on consumer goods and spending by firms on capital goods, and so, generate an economic recovery, investors should feel less need for safety and may move away from government bonds.   That the interest cost on the national debt might rise is a cost well worth paying for economic recovery.

However, having a monopoly central bank direct investment is problematic.   The solution is simple.   Privatize the issue of hand-to-hand currency, abolish reserve requirements, and set the interest rate paid on reserve balances below the interest rate that can be earned on short term government bonds.   This would greatly reduce the demand for base money, and so, minimize the impact of the Fed on investment decisions.   The investment decisions would be made by the banks that issue the private currency and deposits used as money or for saving purposes.

The worst possible situation is for the Fed to pay high interest on reserves, causing an increase in the demand for base money, and then directing credit where it thinks best.   In other words, the worst possible policy was the misnamed QE 1, really an effort by the Fed to "fix" credit markets.    While QE 2 is far from prefect, combined with a commitment to fiscal responsibility, it does not manipulate credit markets in the favor of the government, and is better than leaving the quantity of money below the demand for hold money and real expenditure below productive capacity.

Zero Marginal Product of Labor?

Debate has returned to Tyler Cowen's odd notion that current high levels of unemployment are at least partly explained by some workers having a zero marginal product.  

I find the idea perplexing.   It goes like this.    Both real GDP and employment fell during the recession.   Real GDP was $13,363 billion in the fourth quarter of 2007 and fell 553 billion to $12,810 billion by the second quarter of 2009.    Employment, on the other hand, was 146.3 million  in December of 2007 and fell 8.3 million to 138 million by December 2009.  The decrease in real GDP was 4.1 percent and the decrease in employment was 5.7 percent.

While those figures suggest that some of the lost workers weren't exactly pulling their weight, the real puzzle is with the recovery.    Real GDP has risen by $469 billion to $13,279 billion.   It is only $85 billion less than it was in late 2007.   The 4.8 percent increase by the third quarter of 2010 has brought real GDP up to only .64 percent short of where it was before the recession began.

But what of employment?   Employment has increased by 1.25 million, up  to 139.6 million.   But that is only a slightly less than 1 percent increase, and employment remains 4.8 percent below where it was before the beginning of the recession.     So, .6 percent less output is produced with 4.8 percent fewer workers.

Cowen is claiming that those 7 million workers have zero marginal products.    They must not have been adding anything to production, because what they were producing can apparently be produced without their help.  Or, more exactly, he is claiming that this should be the baseline assumption.

In my view, the proper baseline assumption is that if 7 million of the 14.5 million unemployed were put to work, so that employment returned to the level of late 2007, the 5 percent expansion of employment would result in output increasing by 5 percent too, roughly to $13,942 billion.   This, of course, would assume that the marginal product of the unemployed workers is equal to the average product of the currently employed workers.

It is conceivable that none of these people could contribute anything to the production of any good or service.   They would simply get in the way of existing workers.     Or, it could be that they could generate some physical product, but that it would be of no use to anyone.   The marginal physical product of some or all of those workers might be positive, but the marginal value product would be zero.

I think the most likely result is that the marginal value product of those workers is somewhat less than the average product of all current workers, so that real GDP would rise by less than 5 percent.    (While I favor money expenditure targeting, and so, favor allowing market forces to determine employment and production, I certainly think that what should happen is that employment rise closer to 10 percent and return to its trend growth path of the Great Moderation.)

Now, some might argue that sure, those unemployed workers could produce something, but that their employers won't be able to sell it.     So, the workers have a zero marginal product.

Actually, production adds to real GDP whether it is sold or not.   But the proper determination of whether or not the workers have zero or positive marginal value products depends on what people would be willing to pay for the additional output.     Zero marginal value product workers can either add nothing to physical output, or else, no one is willing to pay anything for what they can add to output.

Of course, outside of perfect competition, firms hire where wages are equal to marginal revenue product, not marginal value product.   For example, if firms hired more workers and produced more output, and could continue to sell current levels of output at existing prices, and charge lower prices for additional output, they might be willing to try.   If unemployed workers were willing to accept lower wages, then perhaps employment would be increased.   Heck, maybe the lower paid employees could buy the lower priced products.

But, of course, this is unrealistic.   Few firms could price discriminate in that fashion.   And so, to lower prices to sell more output requires lower prices for their current volume of output.   And operating on that basis doesn't simply require paying less to newly employed workers, but also lower pay for current workers.   In other words, by far the best way to increase the amount firms can sell is for money expenditures to grow so that more can be sold at current prices and wages.  

Cowen's zero marginal product of labor argument is that even if firms could sell 5 percent more, and tried to hire 5 percent more workers, their actual level of production would be unchanged because those workers have zero marginal products.   They would produce nothing.   The firms, then, would respond by raising their prices by approximately 5 percent.    And competition for those workers that are currently employed (because their marginal products are well above zero,) would result in their receiving pay increases of approximately 5 percent.

I don't believe it.

Unemployment and Aggregate Demand

Tyler Cowen writes:

When will people move away from pure AD theories of unemployment?

My short answer is when money expenditures return to the growth path of the Great Moderation.  In the third quarter of 2010, Final Sales of Domestic product were 13 percent below that growth path, and would need to rise about 21 percent to return to the level of that growth path by the first quarter of 2012.

My long answer is--who has a pure AD theory of unemployment? Frictional, structural, technological, and institutional unemployment combine to make up the natural unemployment rate.   Each of those types of unemployment have causes, and those causes are subject to change.   I think the overproduction of homes 5 years ago implies an increase in structural unemployment. Labor and other resources need to be shifted to the production of other things.   (Unemployment due to there no longer being scarcity is not "structural.")

I don't believe that if money expenditures return to the trend of the Great Moderation, employment and output would return to their trends from that period. I also think that the price level would be on a higher growth path, and probably the inflation rate would be higher.  I still favor targeting money expenditures.

But I am very confident that employment, output, and real would be much higher than today!

When money expenditures have returned to that growth path, and employment continues more or less unchanged from its trough, and output remains on an approximate 6 percent lower growth path, I will admit that aggregate demand wasn't the problem.

But don't tell me about growth rates from radically lower levels. The economy is growing. If the economy is on the equilibrium growth path, staying there requires that the real quantity of money grow with the demand for money. It requires that real expenditure grow with real output.   However, just because these growth rates match doesn't imply the economy is in equilibrium.   If you are on the wrong growth path, then having the growth rates balance means you never shift to the equilibrium growth path.

Cowen quotes:

Friday showed that total sales in 2010 were up 6.8 per cent from 2009, marking the sharpest such increase in more than a decade... Industrial output is up by 5.9 per cent year-on-year.

See, just growth rates.   Where are these relative to the growth paths of the Great Moderation?

Of course, if you assume that all changes in real output must be due to productivity shocks, and that growth just resumes from the changed level, then levels don't matter. If you assume that the price level always adjusts each "period" to clear all markets, and that output is only impacted by a misperception of this period's inflation rate, or even sticky prices this period, with prices always fully adjusting before the beginning of the next "period."   then levels don't matter. I think the Great Recession shows that there is something fundamentally wrong with this model.    You know, models that seemed to work quite well in the Great Moderation, when money expenditures remained very close to a 5 percent growth path.   When maybe most of the shocks were small productivity shocks.   When there wasn't a 13 drop in the growth path of money expenditures!

Default?

The Obama administration has said that if Congress fails to increase the legal limit for federal government borrowing, which is currently $14,292 billion, the result will be default on the national debt.

You can't make your debt payments unless you borrow more money?    Superficially, this seems to be a transparent lie or a sign of complete insolvency.    First of all, the government regularly rolls over its debt.  The roughly 14 trillion dollar national debt is made up of government bonds.   As these government bonds come due, the government sells new bonds to pay off the old bonds.    This continual refinancing procedure does not require that the government borrow more money.  

On the other hand, the government has a high interest expense, projected to be  $414 billion in 2011.   If the government collected less than $414 in taxes, then it would be necessary to borrow to cover this expense.    This would be true financial irresponsibility.    Anyone who lent to the U.S. government in such a situation would be a fool.

Fortunately, tax revenues are projected to be $2,567 billion in 2011.   This allows the government to pay the entire $414 billion in interest expense, and have $2,153 billion to spend on other things.    Having interest payments at 16 percent of revenue seems a bit high to me, but that still leaves 84 percent of revenue to spend on other things.

Unfortunately, government spending is projected to be $3,834 billion in 2011.   The projected budget deficit is $1,267 billion.   And so, the government actually wants to expand its borrowing, and so, the national debt, by $1,267 over the coming year.    Failure to increase the legal limit on the national debt will prevent this from happening.

And, of course, that is exactly why the "Tea Party" Republicans newly elected to Congress are balking at the increase in the debt limit.   They want to stop the administration's plan for deficit spending.   They don't want the government to borrow an additional $1.2 trillion and spend it.    Refusing to raise the legal debt limit doesn't require default on existing debts.  It requires that the budget be balanced immediately.

So, when the Obama administration says that if the legal debt limit is not increased, then the U.S. will default on its debt, what they are really saying is that making payments on the national debt (paying interest and paying off bonds as they come due) is less important than other spending.    What they are saying is that they will fix roads, buy military equipment, send out social security checks, and then tell bond holders that we are out of money.

It is simple to understand.   Rather than first making the mortgage payment, and then buying groceries, and if you are short, going hungry or living on rice and dried beans, the government will go with the plan of spending what you like at the grocery store, and then seeing if there is enough money left at the end of the month to pay the mortgage payment.   If not, then don't pay it.

So, suppose government spending is cut immediately to the projected $2,567 billion in revenues.  This is a 33 percent cut.    That is significant.    The resulting level of spending would be a little higher than it was in 2005.    Of course, there has been inflation over that period.    The real volume of government goods and services that could be purchased would be a little more than was purchased in 2003.  (These figures are for outlays which include interest payments and transfers, not just government purchases of goods and services.)

My view is that federal government spending was much too high in 2003, and so, I have no problem with cutting it back to that level and even lower.    Of course, those who believe that all of those government spending programs are essential would favor tax increases, rather than spending cuts.   Ignoring any adverse impact on the incentive to work, save, or invest, (and monetary policy failures,) this would require a 50 percent increase in taxes next year.    

Well, I guess that's why the Obama administration is saying that they would rather default.    A 50 percent tax hike?   Voters will never stand for it.   Cut government spending back to the level of the dark ages (2003,) civilization would collapse.   So, default...

Or, maybe it is just a threat.  

P.S.  Governments default often, as explained by Reinhart and Rogoff, This Time is Different.     Partial default is the usual approach.   For example, stop paying interest and as bonds come due, give new bonds in place of the old bonds.   You had better plan on balancing the budget after that--at least for awhile.   Until lenders decide, that this time is different.

P.P.S.   The Fed should keep money expenditures (NGDP or Final Sales of Domestic Product) on a 3 percent growth path no matter what--including massive sudden drops in government spending (like 33 percent) or a partial or complete default on the national debt.

Money Disequilibrium and Interest Rates

The monetary disequilibrium approach sees recession as an implication of the fundamental proposition of monetary theory.   If the quantity of money is less than the demand to hold money, households and firms will reduce expenditures out of current income.   As they spend less on current output, firms will reduce production, which reduces real income.   Since lower real income reduces the demand to hold money, the amount of money people choose to hold will fall to meet the existing quantity of money.

Those taking this approach consider this "recession" state of the economy to be a problem.    Real output, real income, and the employment of resources are too low.    There is some fundamental assumption that the employment of labor and other resources to produce consumer goods and services either now or in the future is the point of economic activity.   Disrupting this market process so that the demand to hold money will drop to meet the existing quantity is undesirable.    Nothing in this scenario implies that there was an increase in the desire for leisure relative to present or future consumption.   

If this change impacted every individual in strict proportion, then the problem would be apparent.   Everyone would earn a lower income, and be consuming or saving less.   No one's money balance would be any higher.   Given their reduced incomes, they would presumably think that they need to hold off on their prior plans to increase money balances until after economic conditions improve and their incomes recover.

In the real world, it is quite possible that some individuals will continue to earn unchanged incomes, continue to consume and save as before, and to have increased money holdings.   The reduced income, consumption, and the reduced money holdings are all problems of other people.      As far as they are concerned, there is no disequilibrium.   While I doubt that economists are especially compassionate relative to other people, most are especially sensitive to what is "unseen," including puzzling sacrifices of output and consumption, even if the sacrificed consumption would have benefited other people.

Regardless, there is some sense in which the reduced real income has corrected the monetary disequilibrium.   The demand to hold money matches the existing quantity of money.   Where is the shortage of money?   Those who focus on monetary disequilibrium must reply that the quantity of money is less than what the demand for money would be if real income was at level consistent with full employment of resources.     The quantity of money is less than it would be if real income were at a level consistent with the productive capacity of the economy.

Generally, if real income and output have fallen, so that the demand to hold money has fallen to meet the existing quantity, quasi-monetarists would advocate increasing the quantity of money to match what the demand would be if real income and output matched the productive capacity of the economy.    Most importantly, that is what the quantity of money should have been.   If the quantity of money had been at that level, then there would have been no shortage of money, so real income and output would not have fallen to a level below what is consistent with the productive capacity of the economy.

Of course, the key benefit of having the quantity of money at that level is that output, real income, and employment should promptly rise to a level consistent with the productive capacity of the economy.   Which would, of course, imply that the demand to hold money would promptly rise to match that appropriate quantity of money.

However, assuming output, real income, and employment fail to rise immediately to this level, there is an excess supply of money given the depressed level of real income.    While there is monetary equilibrium in the sense that the quantity of money matches what the demand for money would be if real income matched productive capacity, real income is below that level.

Suppose that the quantity of money increases through the banking system.   The Fed purchases bonds.  Those selling the bonds have additional money balances, and their banks have excess reserves.  The banks also purchase bonds or make loans until some bank or other is willing to hold the added reserves or else currency is withdrawn from the banking system.    Those selling bonds to the banks, or receiving loans, have additional money balances.   While anyone directly borrowing from a bank is likely to spend the money, those that receive the money from selling bonds have additional money balances.    Those with what are now excessive money balances spend them.  Firms sell more, produce more, and hire more resources.   Real income and employment both rise.  The demand to hold money rises to match the increase in the quantity of money.     If the quantity of money was increased the correct amount, the increase in output and income brings it up to the productive capacity of the economy.    The quantity of money matches the demand to hold money at a level of real income equal to the productive capacity of the economy.

Certeris paribus, all of this bond buying (as well as additional bank lending) should lower market interest rates.   And so, it is plausible that if output, income, and employment have already fallen enough to reduce money demand to match a given quantity of money, increasing the quantity of money to the "proper" level will be associated with lower interest rates.   If this should occur, would these interest rates be "too low?"

What is the relationship between these interest rates and the natural interest rate that coordinates saving and investment?

Consider the paradox of thrift.   The thought experiment starts with an increase in the supply of saving.  This is, simultaneously, a decrease in the demand for consumer goods and services.     Ignoring any effect on the interest rate that expands spending by firms on capital goods while dampening the reduction in consumer expenditure, this results in less spending on currently produced output.  As firms sell less, they produce less.  Output, income, and employment fall.    Because of the reduced income, saving falls.    The effort to save more has the unintended consequence of causing real income to fall enough, that saving doesn't increase after all.

The paradox of thrift is very similar to the fundamental proposition of monetary theory.   What is important here, however, is the behavior of saving.    If saving is positively related to income, so that the lower output, income, and employment decrease saving supply as well as the demand for money, then there is an ambiguity in the concept of the natural interest rate.    Is the natural interest rate the level of the interest rate that coordinates saving and investment at the existing level of real income whatever it might be?  Or is it the level of the interest rate that would coordinate saving and investment at the level real income consistent with the productive capacity of the economy?  

If this second approach is taken, and the natural interest rate is that level of interest rates that keep saving and investment equal when real income equals the productive capacity of the economy, then the level of interest rate consistent with saving and investment being equal with the depressed level of output is greater than the natural interest rate.   In that circumstance, increasing the quantity of money to meet what the demand for money would be if real income matches the productive capacity of the economy, should be expected to reduce market interest rates so they will adjust to the level that will cause investment demand to match the supply of saving  if real income matched the productive capacity of the economy.

A scenario where depressed output and income results in low money demand and saving supply is possible.   An increase in the quantity of money could result in lower market interest rates along with higher output, income, and employment, and saving.   The lower market interest rate would be a shift to the natural interest rate.   In this scenario, it would seem that a central bank could lower its target for some interest rate or else raise its target for the quantity of money.

However, there is a second impact of monetary disequilibrium on the natural interest rate that is far more important.    If income, output, and employment are expected to be depressed in the future because of monetary disequilibrium, this will reduce investment demand and raise saving supply.   Both of these factors will reduce the natural interest rate in the present.     And, conversely, expectations that monetary disequilibrium will be alleviated in the future will result in expectations of higher output, income and employment in the future, and that will result in increased investment demand , reduced saving supply, and so a higher natural interest rate in the present.  

Fortunately, it is possible that an increase in the quantity of money will be associated with higher rather than lower market interest rates, even if the increase in the quantity of money is implemented in the usual way--purchases of bonds by the central bank.   All that is necessary is that when the Fed and the banking system purchase bonds (or make commercial loans,) households and firms sell off some of their current bond holdings or borrow by issuing new bonds.  This decrease in the supply and increase in the demand for credit can result in higher market interest rates.   Do these higher interest rates imply that there is no decrease in spending on capital or consumer goods or both?    Not at all.   It simply requires that households selling bonds use the funds raised to purchase consumer goods and firms selling bonds use the funds to purchase capital goods.   Why would they increase spending?   Again, it because output, income, and employment is expected to be higher in the future.   The natural interest rate has increased.

In conclusion, if output, income, and employment are depressed because of an excess demand for money, an increase in the quantity of money can be associated with falling market interest rates that bring saving and investment into coordination at a level or real income consistent with the productive capacity of the economy.    However, the increase in the quantity of money can be associated with rising market interest rates, that also bring saving and investment into coordination at a levels of both current and future real income consistent with the productive capacity of the economy.

P.S.  As Lee Kelly points out in his comment below, this entire analysis assumes perfectly rigid prices.  I don't consider that realistic, but rather as an analytical tool to focus on the effects of monetary disequilibrium on income and output.    

DeLong on Investment-grade Financial Assets and Recession

Brad DeLong argues that recessions are caused by a shortage of finanical assets matched by a surplus of currently-produced goods and services, and the resources needed to produce them. Quasi-monetarists would agree, except to point out that it is only those assets that serve as the medium of exchange and/or the medium of account that result in such difficulties. DeLong's description of structural unemployment is very good.

A normal gap between supply and demand for some subset of currently produced commodities is not a serious problem, because it is balanced by excess demand for other currently produced commodities. As industries suffering from insufficient demand shed workers, industries benefiting from surplus demand hire them. The economy rapidly rebalances itself and thus returns to full employment – and does so with a configuration of employment and production that is better adapted to current consumer preferences.

DeLong then explains the problem:

By contrast, a gap between supply and demand when the corresponding excess demand is for financial assets is a recipe for economic meltdown. There is, after all, no easy way that unemployed workers can start producing the assets – money and bonds that not only are rated investment-grade, but really are – that financial markets are not adequately supplying. The flow of workers out of employment exceeds the flow back into employment. And, as employment and incomes drop, spending on currently produced commodities drops further, and the economy spirals down into depression.

Leaving aside that the problem is a bit narrower--money rather than "financial assets," this is also a good description of the problem. And then DeLong explains the solution:

Thus, the first principle of macroeconomic policy is that because only the government can create the investment-grade financial assets that are in short supply in a depression, it is the government’s task to do so. The government must ensure that the money supply matches the full-employment level of money demand, and that the supply of safe savings vehicles in which investors can park their wealth also meets demand.

I strongly agree that somehow allowing that "the money supply matches the full employment level of money demand" is essential. Given the monopoly power of the Fed over base money, I would agree this is a "government responsibility" under current conditions. However, I do not favor having the government guarantee that "the supply of safe savings vehicles in which investors can park their wealth also meets demand."

DeLong continues:

In North America, governments appear to have muddled through. They have not provided enough bank guarantees, forced enough mortgage renegotiations, increased spending enough, or financed enough employment to rebalance financial markets, return asset prices to normal configurations, and facilitate a rapid return to full employment. But unemployment has not climbed far above 10%, either.

I do not favor having the government provide any safe assets for investors to purchase. In an ideal world, the national debt would be zero, and so there would be no government bonds, short or long term, to provide "safe" investments. As for "bank guarantees," I oppose those as well. Admittedly, getting the national debt to zero isn't too likely in the foreseeable future. And I have never favored going "cold turkey" on deposit insurance. Still, expanding government guarantees during recessions is something to be avoided.

So, what do we make of the claim that recessions involve excess demands for financial assets matched by excess supplies of currently produced goods and services. Has there ever been a recession where people were calling their brokers asking to get into the stock market, and the reply was, "sorry, just can't find any stock for you to buy?" Of course not. Many stocks are traded on organized exchanges and any "shortage" results in higher prices, with prices rising minute by minute. Firms can't sell products and workers can find jobs all because of a booming stock market? Absurd.

But, of course, DeLong really isn't worried about all financial assets, just those that that are "investment grade" that only government can create during a recession. Because of its power to tax, the government's debt or guarantees are always investment grade. Leaving aside the long record of government default on debt, cataloged in Reinhart and Rogoff's This Time Is Different, is it really true that a government that had no debt and refused to guarantee private debt would be subject to recession? Would it be perpetual recession?

Nick Rowe's discussion of the disastrous impact of unobtainium seems to apply. If people suddenly think of a nonexistent and desirable good, does that result in surpluses of existing goods as people sell them in order to fund purchases of "unobtanium?" Rowe argues that this is implausible and that the problem with surpluses of currently produced output, along with the labor and other resources used to produce it, isn't shortages of any old kind of asset (financial or unreproducible real,) but rather with money--assets that are used as the medium of exchange.

So, what does DeLong's argument amount to? As Yeager pointed out in 1956, an excess demand for bonds can push down their yields to very low levels. If the yields on those assets become so low that holding money is a better alternative, then an excess demand for them "spills over" into an excess demand for money. Quasi-monetarists have never claimed that recessions are only caused by increases in the demand to hold money that appear as a bolt from the blue. Generally, an excess demand for money would be caused somehow, and a spillover from an excess demand for some other sort of asset is possible.

It is true, however, that if an excess demand for government-guaranteed assets is spilling over to create an excess demand for money, then an increase in the supply of such assets would solve the problem. Budget deficits and government bailouts would correct the excess demand for money. Of course, those policies might cause other problems as well. Further, the sensible rule that a central bank should never make open market purchases of assets with zero yields can involve a type of government guarantee. For example, quantitative easing with long term to maturity government bonds implies, at the very least, the central bank is risking its own capital to protect those holding reserve balances or currency from interest-rate risk.

To emphasize again the monetary nature of the problem, consider the following alternative monetary order. Hand-to-hand currency is solely issued by unregulated, uninsured "free banks." Think of them as shadow banks. Conventional banks can offer insured transactions deposits and other savings vehicles. Hand-to-hand currency, checks, and electronic payments are cleared through the central bank. The reserve balances at the central bank pay interest. The Treasury funds some of its debt by Treasury bills. There are various short and long term government bonds.

As DeLong suggests, there is a decrease in the demand for currently-produced output and an increase in the demand for government guaranteed financial assets. Hand-to-hand currency is not one of those assets, and worries about the financial conditions results in a reduction in the demand for hand-to-hand currency.

Some of the financial assets in demand are traded continuously on dealer markets, and so, their prices rise and yields fall to clear their markets. Suppose that at the "zero-bound," there remains a shortage. What happens? The most likely scenario would be that their prices rise and their yields fall below zero.

But what about the zero nominal bound? Who would lend at a negative interest rate? Won't they just hold money? No, because "money" is not a government guaranteed financial asset. Or, at least, the zero-nominal-interest, hand-to-hand currency, isn't a government guaranteed, low risk, financial asset.

Of course, in the scenario described above, banks have a variety of interest bearing, government-insured deposit accounts. Households and firms may well choose to hold those rather than government bonds. The transactions deposits issued by conventional banks even serve as money.

However, like everyone else, these banks demand more of the government guaranteed assets, and are facing a progressively lower yield on their asset portfolios. This reduces their demand to raise funds by issuing deposits of all sorts, and so the interest rates they are willing to pay on those deposits. As the yields on their low risk earning assets fall, they lower the yields on the low risk liabilities they issue. If those yields are reduced and go to zero, there is nothing to prevent the yields from continuing to fall below zero.

But won't banks that try to "pay" negative interest on insured deposits suffer a currency drain? Not if the hand-to-hand currency is issued by risky, uninsured "free banks."

Finally, banks keep interest bearing accounts at the central bank. Won't banks faced with progressively lower yields on government bonds and other "investment grade" assets just hold reserves? Won't excess reserves just build?

That depends on what happens to the interest rate the central bank pays on reserve balances. If the central bank lowers those rates along with other interest rates, particularly with the interest rates it earns on the short term to maturity government bonds it holds, then the interest rate banks can earn on reserve balances will fall with other interest rates. Again, to less than zero if necessary.

But won't the central bank face increased currency demands? Won't banks simply hold vault cash? Won't the banking system face a currency drain? Again, no. In this alternative monetary institution, currency is solely issued by free banks. There is no reason for anyone to accumulate currency as a store of wealth.

Suppose that there was a surplus of currently produced output and a shortage of government guaranteed financial assets. The result would be negative yields on those assets, so that people would have to pay for the privilege of having their savings guaranteed by the taxpayer. Those who wanted to earn a yield on their financial holdings would have to bear risk. They could buy stocks, BAA corporate bonds, or maybe even long term to maturity government bonds. With the market for "safe" assets clearing, along with the markets for other financial assets, there is not a surplus of currently produced output. While there might be a shift in the composition of demand, from capital goods to consumer goods, or even a reduction in the supply of labor, nothing like a general glut of goods could appear.

This alternative monetary institution has much to recommend it as a reform. (Think of it as a step along the path to a currencyless payments system.) However, exploring such systems also help us understand the real world by way of contrast. What is the aspect of the existing monetary arrangements that makes surpluses of currently produced output possible? The central bank stands ready to issue zero-interest bearing currency on demand. This limits the possible decrease in the interest rate paid on balances at the central bank. And that is what creates the lower bound on the interest rate and upper bound on the price of "investment grade" financial assets.

A Problem with "Austrian Economics"

The Austrian Theory of the Business Cycle is just one element of "Austrian Economics." Unfortunately, in the context of the Great Recession, "Austrian Economics" has become short hand for that one aspect of the contributions of Menger, Mises, and Hayek and those working in their tradition.

As with most perspectives on the economy, I believe there is an important element of truth in the theory, but I believe that even otherwise sound economists are led astray by an excessive focus on the approach. In particular, there is too much focus on the thought experiment of an increase in the quantity of money given the demand to hold money, the supply of saving, and the demand for investment.

In that circumstance, the natural interest rate is given (coordinating saving and investment) and any increase in the quantity of money is an excess supply of money. There is usually a plausible institutional assumption that the increase in the quantity of money is lent into existence. Given all of these assumptions, the expansion in bank loans results in the market interest rate decreasing. Given even more assumptions, the lower interest rate impacts the composition of demand across industries, and leads to specific investments that depend on this lower level of the interest rate. These are malinvestments. Ceteris paribus, they will generate losses in the long run.

When the theory is used to interpret history, like the housing boom of the last decade, the assumptions, given demand for money, given supply of saving, and given demand for investment, are imposed, so that a decrease in observed market interest rates is taken to be a sign of an excess supply of money. The problem is less with complaints about interest rates in a boom, but instead with a completely wrongheaded notion that because the problem was interest rates that had fallen too low during the boom, recovery should be associated with higher interest rates.

The problem is a confusion of the thought experiment of a given demand for money, supply of saving, and demand for investment and the real world. In the real world, the demand for money, the supply of saving, and the demand for investment are all subject to change. First of all, suppose the demand for investment is rising and the demand for money is falling. Even if the market interest rate is rising and the quantity of money is falling, it would be possible for there to be an excess supply of money, and a market interest rate below the natural interest rate. Malinvestment would be generated even though observed interest rates rose and the quantity of money fell. The problem would that interest rates failed to rise enough and the quantity of money failed to fall enough.

Now, if the demand for money remained low, and the demand for investment remained high, then as the purchasing power of money falls, the real supply of credit decreases along with the real quantity of money. The market interest rate will rise to meet the natural interest rate and any malinvestents will lose money and be liquidated.

More importantly, suppose there was a boom generated exactly according to the traditional assumptions. The quantity of money rose, the demand for money was given as was the supply of saving and demand for investment. The market interest rate did fall too low, and malinvestment was generated. In the "long run," the purchasing power of money would fall, reducing the real quantity of money and the real quantity of credit. Other things being equal, the market interest rate would rise. The malinvestments would lose money. Remarkably low interest rates in 2002 results in too many single family homes being built, and when the purchasing power of money falls, interest rates rise and the housing construction industry must shrink. Sawmills lose money.

But, suppose, during this period, the supply of saving rose or the demand for investment fell, or both. While one can imagine that these would be indirect effects of problems associated with losses on malinvestment, they don't have to be. Things happen. The natural interest could fall. While it would be true that the problem is that interest rates fell during the boom, it would be wrongheaded to assume that during the recovery interest rates should be at pre-boom levels.

It is true, of course, that if an excess supply of money is created, this would push the market interest rate below the natural interest rate. But the natural interest rate could be below the level of market interest rates that existed during the boom.

Similarly, there is no way to look at any measure of the quantity of money and use that to determine whether malinvestments are being generated. In particular, if the demand to hold money rises, the supply of saving rises, and the demand for investment falls, then an increase in the quantity of money and a reduction in market interest rates maintains monetary and credit market equilibrium. While too much money and excessively low interest rates might create malinvestments, malinvestments can also be generated by too little money and excessively high interest rates. The particular capital goods appropriate to the resulting pattern of demand may be in appropriate to the pattern that will exist when the purchasing power of money adjusts, the real quantity of money rises to meet the demand, the real quantity of credit rises, and the market interest rate falls to the natural interest rate.

And, of course, it is possible that in the period after a boom, a decrease in the supply of saving, an increase in the demand for investment and a decrease in the demand to hold money would require that market interest rates rise and the quantity of money fall. Perhaps market interest rates must rise to levels higher, and the quantity of money should fall to levels below, those that prevailed during the boom.

In my view, the solution is simple in abstract. Keep the quantity of money equal to the demand to hold money, and let market interest rates adjust. Don't impose preconceptions based on history. Prices and quantities can and should change--and that certainly includes market interest rates, and I believe the quantity of money too.

Investment and Leverage

Some have argued that monetary policy is ineffective sometimes, (like now) because business is already too leveraged. Their assumption is that an expansionary monetary policy involves an increase in lending. Firms are supposed to borrow this money and invest--purchase new capital goods. Because firms have already borrowed "too much," they don't want to borrow more. Instead, they are busy using current earnings to pay down debt. Perhaps, one day, after firms have paid down their debts, they will be willing to borrow again and purchase additional capital goods.

While there is surely some element of truth in this account, it is shot through with intuitions that come from a fallacy of composition. Most importantly, for every borrower there is a lender and for every debtor there is a creditor. This basic truth is essential for any decent macroeconomic analysis of debt, leverage, and investment.

Suppose Firm A is earning $60,000 per year in profit. The managers can purchase additional capital goods and anticipate a rate of return of 6%. If they retain the $60,000 profit and use it to purchase those capital goods, then investment spending is $60,000. There is no debt and no leverage.

What is the problem with leverage? Apparently the morality play is that tempted by the lure of easy money, the managers of Firm A do more than reinvest their profits. They borrow, say, $40,000 at an interest rate of 5%. Total investment expands from $60,000 to $100,000. And now Firm A has $40,000 in debt and is leveraged.

If Firm A had assets of $1,000,000, then its leverage ratio is pretty microscopic--just under .04. Still, if we imagine really easy money and that Firm A is unaware of the dangers of debt, then it might borrow $5,000,000 and investment expenditure would expand from $60,000 to $5,060,000. The leverage ratio is now 4.72. An excessive increase in investment is matched by excessive leverage.

However, this story ignores that there must be lenders who fund the borrowers. This ignores that the debts of the firms that borrowed are assets to some lender. To a remarkable degree, businesses lend and borrow one to another.

Suppose that there is a second firm, Firm B. It makes $40,000 per year profit. The managers can purchase new capital goods, and they anticipate a return of 4%. Investment for this firm is $40,000, and there is no debt and no leverage.

Looking at Firm A and Firm B together, total investment is $100,000. Firm A spends $60,000 on capital goods, anticipating a 6% rate of return and Firm B spends $40,000 on capital goods, anticipating a rate of return of 4%.

There are gains from trade available. Firm B can lend $40,000 to Firm A at 5% interest. Firm B now invests nothing. And Firm A invests its $60,000 profits and the $40,000 it borrowed from Firm B. Total investment is unchanged at $100,000. However, the rate of return increases. The average rate of return was a bit over 5% and it is now 6%. The owners of Firm B gain $400 from the exchange, and the owners of Firm A gain $400 as well.

As explained above, this transaction creates only a tiny bit of leverage for Firm A, a bit over .04. Firm B has no leverage, but rather has accumulated assets, the corporate bonds of Firm A. The total leverage ratio for the two firms together is very small, just under .02. If the real assets of the business sector, $1,100,000 is compared to the debt, then the leverage ratio is slightly above 2%.

Suppose Firm A and Firm B repeat this process year after year, with Firm B lending not only its $40,000 earnings from operations but also its growing interest income to Firm A. Firm A takes is growing profit and reinvests that as well. After ten years, Firm A would have a total debt of $441,063, but its assets would have grown to $2,149,132. Its leverage ratio is .26.

Firm A is earning 6% on its assets, which is approximately $128,000. It has to pay interest to Firm B, of approximately $22,000. This leaves Firm A with a profit of $106,000. Firm B, on the other hand, keeps the same real assets and operating income ($1,000,000 and $40,000,) but has total assets of $1,441,063 and interest income of about $22,000. It's total profit is then $62,000. Firm B has no debt and a leverage ratio of 0.

With the assumption that all earnings are lent or invested, total investment has increased substantially. Firm A invests all of its profit, but borrows from Firm B, so that its investment is $168,000. Firm B invests nothing, and so total investment is $168,000.

If the total assets of both firms are added and compared to the total debt, then the leverage ratio is approximately .13. And if only the real assets of the two firms is compared to the debt, then this leverage ratio is approximately .18. Of course, if the net assets are compared to the net liabilities of the two firms together, then the leverage ratio is zero.

Now, suppose that Firm B no longer wants to lend to Firm A. It looks at Firm A's leverage ratio of .26 and worries that it won't be able to pay the money back. Or, perhaps it is willing to lend more funds, but only at an interest rate of 7%. Firm A no longer wants to borrow additional funds at 7%. Alternatively, suppose it was Firm A that became worried about its excessive leverage. It no longer is willing to borrow. Or, again, perhaps it will borrow, but only at an interest rate of 3%. Perhaps both occur at the same time. So, rather than making loan transactions that benefit both parties at 5%, the lender now wants 7% and the borrower is only willing to pay 3%. They don't trade.

Now that Firm A is no longer borrowing, clearly investment expenditure must fall. There is too much leverage and borrowers or lenders or both are not willing to expand debt. All that Firm A can invest now is its profit of $106,000.

So, total investment must fall from $168,000 to $106,000 (approximately 50%) Right?\

WRONG!

Firm B no longer lends its earnings to Firm A and now invests the funds internally. That is its $40,000 in operating income and $22,000 in interest income for a total of $68,000 in profit. Firm A invests $106,000 and Firm B invests $68,000 for a total investment of $168,000. Investment remains unchanged, and total debt and leverage is not increasing.

Perhaps the problem is deleveraging? If Firm A begins paying down its outstanding debt, then surely investment must decrease. Of course not. The profits of Firm A are ample, but $106,000 is not nearly enough to pay off its $441,063 debt all at once. But suppose it pays off $106,000 per year. While Firm A invests nothing, Firm B continues to earn $22,000 in interest, plus receives $106,000 in loan repayments. Firm B can now invest the $106,000 funds received in repayment, its $22,000 interest payment, and its $40,000 earnings from operations. It adds up to $168,000.

During this period of develeraging, Firm A invests nothing. But Firm B, the creditor, does the investing. Total investment is unchanged. Each year, the interest payment made by Firm A is smaller and the interest earnings of Firm B are smaller. After about 4 years, Firm A has no more debt and its leverage ratio is zero. Firm B has no financial assets and earns no interest income, but it has substantially more real assets.

If it is really true that Firm A can earn a 6% return and Firm B only can earn a 4% return, the unwillingness to increase leverage involves the sacrifice of future real income. Worse, all of the deleveraging would involve a shift from projects providing a 6% return to projects only providing a 4% return.

Notice that the excessive leverage caused credit markets to "freeze." Firm A will only pay 3% and Firm B will only accept 7%, and so there are no credit transactions. From a real business cycle theory approach, the problem of this frozen credit market would be the reduced real return. From a technocratic perspective, coming up with a way to motivate Firm B to continue to lend to Firm A, (perhaps some kind of government guarantee to Firm B against loss on its loans to Firm A) would be the solution.

From a quasi-monetarist perspective, what is important is that total spending be maintained. In particular, that as Firm A reduces investment as it borrows less or repays debt, then Firm B, which is no longer lending and perhaps receiving funds in repayment of loans, invests more. Whether leverage grows, stays the same, or shrinks is not important. While the particular investment projects undertaken are important, the key role for government is to enforce debt contracts and let each firm determine whether it is best to invest directly or else lend so that another firm can invest more. The other side of the coin is that each firm needs to decide for itself whether it is willing to borrow money and "leverage up" to better exploit investment opportunities.

With thousands of large firms (and millions of firms altogether,) the notion that the government can determine what are the true returns and direct investment is a chimera. The market price that coordinates the movement of funds among firms is the interest rate. Those firms with strong current earnings and low yield investment opportunities can lend. Those with investment opportunities beyond their current earnings borrow.

If there is a sudden determination that many firms are overleveraged, then the effect on credit markets is ambiguous. If the problem is that creditor firms, like Firm B, don't want to lend, then the decrease in the supply of credit results in a higher interest rate and a decrease in the quantity of credit. On the other hand, if the problem is that the overleveraged firms, like Firm A, no longer want to borrow, then the result is a decrease in the demand for credit. If both occur at the same time, then effect on the interest rate is ambiguous and the quantity of credit falls.

Of course, there is not really a single interest rate but rather many interest rates, depending on, among other things, perceived risk. For example, as creditor firms reduced their loans to highly leveraged and risky debtor firms, they would likely increase the supply of credit to other creditor and less leveraged firms. The interest rate for those firms would fall and the quantity of credit should rise. On the other hand, for the more highly leveraged firms, their quantity of credit would still fall, but their interest rates could rise or fall depending on to what degree the highly leveraged firms want to reduce their debts.

Some interest rates fall, and others are ambiguous. The quantity of credit for firms with little leverage rises, but the quantity of credit for highly leveraged firms falls. The likely net effect would be a smaller quantity of credit as firms reduce lending, collect on loans, and use the funds for internal investment.

For example, when Firm B ceased lending to Firm A, either because it was worried about the excessive leverage, Firm A didn't want to borrow, or both, then it would be willing to lend to some other firm, that had little or no leverage. But if the interest rate falls enough, below 4%, then Firm B would stop lending and instead spend on capital goods.

Why the view that overleverage leads to reduced investment? The reason is simple. The lenders are ignored, with the implicit assumption being that funds that aren't lent are held. That is, a reduction in the supply of credit is the same thing as an increase in the demand for money. For example, suppose when Firm A stopped borrowing and began paying back loans, Firm B received the money. Rather than spending it on capital goods (or lending it to some other firm that wasn't so highly leveraged,) suppose Firm B just left the money sitting in its checking account. If the quantity of money is unchanged, the increase in the demand for money results in less spending. Since the actual reduction in spending was by Firm A, it is investment spending that falls.

An alternative situation would be that Firm A didn't borrow from Firm B, but rather from a bank. When it repays the loan, then the quantity of money falls. Given the demand for money, this results in a decrease in spending. Again, it is Firm A that is spending less, and it is a reduction in investment spending. Of course, if the bank makes a new loan, perhaps by purchasing bonds, then the quantity of money doesn't fall after all.

From a quasi-monetarist perspective, the key is to prevent deleveraging from reducing total spending. And what that means is that to the degree that those who lend less choose to hold more money, the quantity of money should be increased to match.

To say that there is "too much" leverage, means that firms should invest internally rather than shift funds by borrowing and lending to take advantage of higher returns. Alternatively, it is to say that firms should use equity rather than debt financing. Firm A should issue new shares to fund its investment, which Firm B should buy. To identify overleverage with excessive investment is to take what is true of the debtor firm (Firm A,) and generalize to the entire economy. It is to ignore the creditor Firms. It is to ignore that for every borrower there is a lender. it is to ignore that for every debtor there is a creditor.