Quasi-Monitarism

Henry Kaspar:

My Discomfort with Quasi-Monetarism
Regular readers of the blog will be familiar with the term"quasi-monetarists": a group of economists that includes Nick Rowe, Scott Sumner or David Beckworth ...is trying to push the following, powerful message (with differing emphasis on the specific elements, depending on the author):

1. The cause of the crisis is excess demand for money (=money hoarding). Excess demand for money implies necessarily insufficient demand for goods (with sticky prices).

2. The way out of the crisis is a monetary policy that brings supply and demand for money back into equilibrium, and thus ends the hoarding of money.

...
Now here is how I see things:

1a. The main cause of the crisis is excess indebtedness -  of private households, [and]of the government. [This cause is called] a “balance sheet recession“ - a hypothesis that was originally popularized by Richard Koo, but by now is almost commonplace.

1b. Excess indebtedness forces debtors to reduce expenditures in order to be able to service their debts – i.e., it forces a transfer from debtors to creditors. The creditors’ propensity to spend is lower than that of debtors; after all this is why they are creditors. They would want to lend on the means transferred to them, but do not find enough households or firms willing and able to take on more debt. To use Brad DeLong’s term: there is a lack of safe assets.

1c. Because of the lack of safe assets creditors hoard money.

It is important to note that I agree with the quasi-monetarists on two points: (i) the problem is insufficient aggregate demand, and (ii) by logical necessity, the counterpart to insufficient demand for goods is money hoarding. But money hoarding is a symptom of the crisis, not its cause. Put differently, causality goes from lack of aggregate demand to money hoarding, not the other way round.
Nick Rowe ...often employs a nice thought experiment that describes the above identity more graphically – but can easily mislead if sloppily given a causal or even economic policy interpretation: suppose there was no money, and therefore also no possibility to hoard money - then there could be no lack of aggregate demand for goods. Does this not suggest that policy makers should focus on ending money hoarding? And aren’t things related to money the task of the central bank, i.e., isn’t monetary policy responsible here?
It does not – as there are more promising options to combat insufficient demand and (therefore) money hoarding (see below). This is the source of my discomfort with quasi-monetarism: a tendency to cut down the characterization of the crisis to the one aspect that helps pushing their (monetary) policy point. And this is important, as they way we present problems affects how we think about their solution.
My characterization suggests the following policy options:

2a. Debt relief. Debt relief reduces the debt payment burden and thus allows debtors to spend more of their income on goods. Hence, in the U.S., for example, schemes are needed that strengthen incentives for lenders to write down mortgage loans. And in Europe some debts of the most overindebted countries need to be cancelled.  

2b. Government indebtedness, i.e. expansionary fiscal policy.  If the private sector is incapable of absorbing all desired savings the government has to jump in – at least temporarily, while the private sector is paying down its excess debts. The government offers savers a safe asset (government bonds) and uses the funds to directly boost aggregate demand. This, however, is only an option when the government is not overindebted itself (as is the case in some GIPS-countries).

2c. Monetary policy comes at best in third place, as it is worst in addressing the crisis’ underlying cause. Monetary policy can stimulate aggregate demand only if it incentivizes the private sector to indebt itself. But the private sector is already overindebted, to a point where even nominal interest rates of zero or close to zero fail to generate enough willingness to take on debt. And, as is well known, at the zero bound monetary policy encounters some difficulties.

In one sentence: lack of demand and (therefore) money hoarding are there only because of
insufficient efforts to (i) reduce the private sector’s debt burden, and to (ii) compensate for the loss in demand from the overindebted private sector by sufficiently increasing demand from the public sector.
If so, policy makers should focus on promoting debt relief and boosting public sector demand, instead of placing all the burden on an instrument – monetary policy – that has hit a constraint.

I would add that monetary policy could produce inflation which would be a good thing for a "balance-sheet recession" because it would reduce the real debt burden for most people.  Much debt has a fixed interest rate.  Higher inflation reduces the real value of the debt and lightens balance sheets. Krugman added a few more comments on the above post:

So: an overall shortfall of demand, in which people just don’t want to buy enough goods to maintain full employment, can only happen in a monetary economy; it’s correct to say that what’s happening in such a situation is that people are trying to hoard money instead (which is the moral of the story of the baby-sitting coop). And this problem can ordinarily be solved by simply providing more money.

But we’re not in an ordinary situation here, we’re in a liquidity trap in which short-term interest rates have been driven to zero, yet the economy still languishes.

What that means is that when people are hoarding money, they’re no longer doing so because of its moneyness — the liquidity it provides, which makes money different from other assets. They’ve already got all the liquidity they want, since liquidity is free — you don’t have to sacrifice interest earnings to get more, so people are saturated. So at the margin, they’re holding money simply as a store of value.

Now, what monetary policy ordinarily involves is open-market operations: the central bank increases the supply of money by purchasing and removing from the market non-money assets. And this has traction because money is different from these other assets. In a liquidity trap, however, money isn’t different: at the margin an open-market operation just exchanges one store of value for another, with no economic effect.

So this is a situation in which the economic problems cannot be solved just by increasing the supply of money.

Now, in principle you can get traction by making money a less attractive store of value. In particular, if you can credibly promise future inflation, that will make the real return on money negative. But getting that kind of credibility is tricky, especially given the normal prejudices of central bankers. And in any case it’s very different from the kind of thinking we normally associate with monetarism, which focuses on the current money supply.

Nor does focusing on nominal GDP instead of M2 or whatever really bridge the gap. The point about M2-based monetarism was that it was supposed to give the Fed a target it could clearly control — although in a liquidity trap it turns out that even that isn’t true. Whatever else it is, and whatever virtues it may have, nominal GDP isn’t that kind of target.