Argument for Monetary and Fiscal Stimuli

Miscellaneous General
1

Below is an explanation of the paradox of thrift and basic argument for monetary and fiscal stimuli. Please bear in mind that I do not agree with proponents of monetary and fiscal stimuli. My purpose is to present a view I disagree with as clearly and convincingly as possible. I want to present an argument which a reasonably, well-intentioned opponent might offer.

Feel free to take apart and critique it. I have my own critical comments and observations (hopefully novel and interesting) which I am finishing up at the moment.

I

The paradox of thrift is the primary justification for government to engage in monetary and fiscal stimuli. An unfettered market is intrinsically unstable. Capricious and rapid declines in total spending are responsible for periodic and spiralling recessions. Although prices ordinarily coordinate economic activity toward productive ends, the normal equilibrating properties of markets cease to function. A non-market institution must intervene and combat recession by stimulating total spending. Only government is capable of satisfying this role, and so it must be empowered to pursue monetary and fiscal policy.

II

What is true for a part of an economy may not be true for an economy as a whole. Although an individual may expand his savings by reducing spending relative to income, spending and income must be equal for the economy as a whole. One man’s spending is another man’s income, and vice versa. Any change in total spending must correspond to an equal change in total income. Unlike an individual, it is impossible for the economy as a whole to reduce spending and increase income at the same time, i.e. the economy as a whole to cannot expand its savings.

If an economy as a whole attempts to expand its savings, both spending and income fall and the paradox is revealed. As total income declines, profits shrink or disappear, inventories accumulate unsold goods, and businesses begin laying off workers. A surplus of goods and labour develops, because there is not enough spending to buy all that is produced. Any expanded savings merely result in the unemployment of resources, stifling economic growth and adding to human suffering. The notion of saving for a better future is turned on its head. The seemingly rational response of tightening one’s belt during hard times actually exacerbates the problem by further reducing total spending. As long as one man’s expanded savings are offset by another man’s increased spending, there is no problem. However, any attempt to expand total savings is futile and actually impoverishes the future by creating recession in the present.

III

Basic economics informs us that a surplus of goods reduces prices, and so the price of goods and labour must fall until total spending is again able to purchase available resources. However, prices in a real economy may respond slowly and unevenly, e.g. the unemployed may be unwilling to accept lower wages, producers may hold out for the economy to recover, contractual obligations may enforce old prices, and unions may delay wage cuts to name but a few difficulties. Although a new general level of prices will assert itself in the long run, the interim will likely be fraught with economic distress and political upheaval.

In any case, a recession is unlikely to be accompanied by a long term change in spending habits; the attempt to expand savings is usually just a temporary swing brought about by panic. Businesses will fail and people will lose their jobs, and then, when the economy recovers, those businesses will need to be rebuilt and those people rehired. A recession does not bring about any lasting structural change to the economy, but merely sees it torn down and reconstructed for no economic gain. Prices may equilibrate supply and demand instantly in basic economic models, but prices in the real economy cannot respond accurately and timely to extreme swings in total spending.

IV

The disastrous economic consequences of the paradox can be mitigated by apt government intervention; astute monetary policy can lessen or prevent falls in total spending. All money is owned by someone, and so the supply of money must be equal to the total quantity of money that people own. An attempt to expand total savings is an attempt to increase the total quantity of money that people own, but this is impossible without an expansion of the money supply. A government can stimulate total spending by expanding the supply of money, because surplus money will be spent once the higher quantity of money demanded has been satisfied.

A complementary form of government intervention is a fiscal stimulus; the government can offset a fall in total spending by temporarily increasing its own debt-financed spending. If total spending has fallen because of uncertainty, then money must be considered a relatively safe asset. The government can increase the supply of an alternative safe asset by issuing bonds. Savers who are unwilling to part with their money for anything else may be persuaded to purchase government bonds. The borrowed money can then be immediately spent on public goods to stimulate total spending.

V

An unfettered market is incapable of humanely solving the problems created by the paradox. Government can increase the efficiency of markets by preventing radical fluctuations in total spending. To succeed in its role as macroeconomic stabiliser, the government must be empowered to pursue judicious monetary and fiscal policy. If the business cycle is left unchecked, then it can have ruinous consequences for peace and prosperity. The paradox of thrift presents us with a particularly harmful instance of market failure, and government must do everything in its power to stop the consequences from running their full course.

2

One observation I wish to add:

The purchase of producer goods is customarily considered a form of saving. Savers may increase spending on producer goods directly or indirectly by lending. When money is handed from lender to borrower, the lender’s decrease in spending is offset by the borrower’s increase in spending. If producer goods are purchased instead of consumer goods, then any fall in spending on consumer goods is equal to a rise in spending on producer goods. Thus, an individual may expand savings by either reducing spending and increasing income or increasing spending on producer goods.

Although it is impossible for an economy as a whole to reduce spending and increase income at the same time, it can reduce spending on consumer goods and increase spending on producer goods at the same time. Sellers of consumer goods see incomes decline, profits shrink, inventories accumulate unsold goods, and workers laid off, but sellers of producer goods see incomes rise, profits grow, inventories sell out, and workers hired. If producer goods are purchased instead of consumer goods, then any fall in income to sellers of consumer goods is equal to a rise in income to sellers of producer goods.

The paradox does not concern saving per se, but the saving of money. If money is saved by withdrawing spending on producer goods, then the paradox may hold though total savings remains constant. If money is saved by withdrawing spending on producer goods while also increasing spending on consumer goods, then it is actually possible for the paradox to hold while total savings contract. Thus, “the paradox of thrift” is a misnomer; an attempt to expand total savings of money may occur while savings of all kinds are expanding, but it might also occur while they are constant or even contracting.

3

I could not read the whole thing. But after reading the first couple of paragraphs, nothing was mentioned about capital, capital structure, production or production technology. I searched for it and the word “capital” does not appear anywhere in the text. Capital Structure, the entire assemblage of people, equipment and processes to make stuff consumers desire is what drives the economy. Consumers can only buy things that are already produced. And most things take long times to produce.

So it is the period prior to the economic slowdown where the problems take place as entrepreneurs fail to build the capital structure to make the things consumers want absent the presence of cheap money and/or credit.

Your argument for government spending spending on random stuff does not satisfy the current and future demands of consumers. So the spending is simply a loss of scarce resources that reduces the available scarce resources for entrepreneurs who are trying to change the current capital structure to be in line with consumer demand.

Also, the statement “Although prices ordinarily coordinate economic activity toward productive ends, the normal equilibrating properties of markets cease to function.” is false. What has change is not the economic process but the consumer demands. So there is capacity to make stuff that consumers in their current conditions do not desire. So suppliers reduce prices to reduce inventory. That is the market equilibrating. It is the Non-Market people who believe otherwise.,

4

It should be about time already that economists recognize that it is savings that pays a man’s wage and not spending.

5

Bogart,

The position of stimulus proponents is typically that no systemic misallocation of resources need precede a recession. The structure of production might be distorted in some way or other, but a recession can occur with nothing but a general economic panic–the notorious animal spirits. Fear and uncertainty are like a virus and, every now and then, the economy catches a cold. For proponents of this view, “recession does not bring about any lasting structural change to the economy, but merely sees it torn down and reconstructed anew for no economic gain.”

Whether a specific recession conforms to this view is an empirical matter. As a matter of pure theory, it seems possible that a recession could occur without any significant malinvestment during a boom. Although the Austrian story of the business cycle is a good description of what causes recession, and perhaps normally the correct one, I think it would be a mistake to conclude that it is the only possible cause of recession.

6

Didn’t I critique this one once?

In this thread.

7

I don’t quite understand what you mean. Unless someone exchanges money for another’s labour, the latter has no wages. Clearly, the purchasing of anything requires spending, and that includes the toil of other men. If such spending is directed toward investments, then it could be spending and saving simultaneously, but no man’s wages can be paid by one who doesn’t exchange with him.

8

You made the dichotomy of spending vs. savings in your essay. So I am to understand that spending refers to consumption, and savings refers to forgoing consumption. Am I correct? is this how you defined the terms in your essay?

9

DD5,

I apologise for the confusion. Please bear in mind that I do not agree with the views expressed in my essay. The dichotomy of spending vs. saving is often an implicit assumption of proponents of monetary and fiscal stimuli, and so I retained that assumption in my essay. My own view is that reducing spending is just one form of saving. Alternatively, saving can occur by shifting spending from consumer to producer goods, either by direct purchase or lending. This distinction is important, because with it we can see how an economy as a whole can increase its savings despite the paradox of thrift. Although an economy cannot save by reducing spending, it can save by shifting spending from consumption to production.

The paradox of thrift can hold when the natural mechanism for translating money-savings into expenditure on production breaks down, and what is the primary cause of this severence? Government intervention.

10

There is no paradox of thrift regardless of the type of savings. Shifting spending between consumer and producers goods occurs due to price differentials between the two. It is the relative prices between the different goods that coordinate the market and not their nominal prices. It makes no difference if a man saves by increasing his cash balance or if he directly invests in capital goods.

11

If one man saves by increasing his cash balance it is of little consequence. A problem can emerge when many men increase their cash balances–when total cash balances demanded is greater than the supply of money. Even this might not be an issue because prices adjust, but if it occurs to a significant degree in a short amount of time, the interim period before prices adjust fully can be very problematic. In such a situation, resources freed for investment purposes by increasing cash balances are not redeployed to produce future goods, but rather neglected until prices fall. I do not consider that a desirable circumstance, nor do I believe it is a natural market response. After all, it is a rather peculiar good (money, in this instance) where an increase in demand did not create an incentive to increase supply, but without a free market in money, we just have to hope the central bank gets it about right.

12

Allow me to make sure I summarize your position correctly before we continue.

You are saying that there are three things to consider: 1. spending on consumer goods, 2. spending on producer goods, and 3. not spending at all.

1 is pure spending. It is the life blood of the economy, what keeps us all employed and happy.

2 is also spending, but those silly Keynesians think it is saving. That’s why they look to other means to get spending going. If they only knew!

3 is not spending at all. It is the death toll for an economy, and the paradox of thrift truly applies right here.

Have I got it right?

13

I hpoe are not calling maintaining monetary equilibrium monetary stimulus.

14

Assume you are correct that there could be a cause of a recession in a modern economy not from mis-allocated resources, I am interested in an example as I do not believe there one short of real Armageddon. That still does not prove the need or superiority of commanding economic decisions (government stimulation) to reallocate scarce resources versus free market allocations of scarce resources. There goal during a recession is to increase real economic activity which is to increase the production of real goods and services. Government allocations of resources, known as spending programs, are still not as effective as free entrepreneurs as these bureaucrats must still overcome informational and other issues that plague command economies.

15

It is the exact same “problem” as when many men shift their spending from consumption to investment. In both cases, prices must adjust on both ends; consumption and production.

Again, prices need to adjust also during direct shifts in spending. It is the exact same problem for the entrepreneurs. Each concerned with his own business, must adjust his behavior due to changes in consumer preferences.

Again, the above two replies refute this false assertion. Prices fall or rise in either case. People make decisions based on relative prices and not nominal prices. That prices need to adjust for coordination to take place does not support your case since price adjustments must take place in both forms of savings.

Too bad! Are you for a free market or are you for a free market with Lee Kelly as dictator in charge?

How is an increase in cash holdings in a unhampered market not a natural response?

16

Smiling Dave,

The “Keynesians” have an odd habit of equating all saving with a reduction in spending. Since one who purchases a bond is clearly saving and spending, it is lazy and misleading to assume that one can only save by reducing spending. The paradox of thrift concerns a fall in total spending. In the case of a reduction in spending, total spending obviously falls (and at least one precondition for the paradox of thrift holds), but the purchase of a bond merely alters the composition of spending (not the total). Therefore, the paradox of thrift does not concern saving per se.

In fact, consider a reduction in total spending. Spending has declined on either consumer goods, producer goods, or both. Assume that spending has declined on producer goods, but more than can be accounted for by the decline in total spending. That means some spending on producer goods has shifted over into consumer goods. In this case, the paradox of thrift may hold even though people desire less savings, not more. It really has nothing inherently to do with “thrift,” but the saving of money. Even then, other special conditions must hold for the problems to take effect.

17

I suggest that a monetary stimulus is, at best, a crude attempt by government to emulate what a market would do better in its absence.

18

DD5,

When spending shifts from consumer goods to producer goods, sellers of consumer goods see incomes decline, profits shrink, inventories accumulate unsold goods, and workers laid off, but sellers of producer goods see incomes rise, profits grow, inventories sell out, and workers hired. If producer goods are purchased instead of consumer goods, then any fall in income to sellers of consumer goods is equal to a rise in income to sellers of producer goods.

However, when a significant portion of spending on consumer (or producer) goods stops altogether, sellers see incomes decline, profits shrink, inventories accumulate unsold goods, and workers laid off, and that’s it. Until prices throughout the rest of the economy adjust, no other industry can afford to redeploy the labour, goods, equipment, and whatever else freed up by the decline in spending. Although resources are “saved,” i.e. released from their previous applications, they are not reallocated to other ends, because nobody else as the enough money to purchase them. In this case, the nominal interest rate will be higher than the natural rate, i.e. interest rates are signalling that fewer resources are available for investment than is really the case.

Just saying “prices will adjust” seems rather naive, because while true in the long run, a great deal of time and resources would have been wasted in the meantime. It is this rare situation, when the nominal interest rate is higher than the natural rate, when monetary expansion is appropriate. i would rather this be achieved by a free banking system, but given the existence of central banks, the least bad policy would be to emulate what a free banking system would achieve in its absence. Some may call this a “monetary stimulus,” though I think it a highly misleading name. If Honda increased the supply of automobiles in response to an increase in demand, would we call it “automobile stimulus”?

19

This is a good presentation of the opposing argument, but, unfortunately, its underlying premise is fallacious. There is no relationship between the aggregate demand of final goods and employment. But the central problem is that this analysis begins in the middle of the game (ignores the misdirections of resources brought about by inflation), when massive structural imbalances have already accumulated (malformed capital structure of heterogeneous capital goods), and which have to be liquidated. The increased savings rate is exactly what the economy needs in order to finance and finish some of the investments which were begun during the boom phase, and economic failures free up capital and labor for more warranted productions. Furthermore, Keynesian remedies are no remedies at all, and can only exacerbate the malinvestments and misallocations. The government and the central bank are non-market institutions which lack the ability to engage in rational economic calculation; they operate completely in the dark. You analyze the wrong scenario, and ask the wrong questions.

But this analysis is not entirely defunct. It is true that expectations and price rigidities do indeed make this process more dramatic than it otherwise needs to be. Businesses may over-compensate and lay off too many workers, and the precautionary demand for money will take hold. The banks should expand the money supply in order to meet the increased demand for money (as money), so that the economy does not contract more then it already has to.

The law of markets refutes the claim that recessions don’t restructure the economy.

No it’s not. Producer goods are the result of saving, and purchasing them constitutes investment. Saving and investing are two different things, though the latter depends on the former (and there is no identity). This argument is circular in its reasoning; you’re saying that a person may increase his savings by cutting consumption (true) but also by investing, which is a function of saving. Basically, the Keynesians are saying that monetary injections into the the loanable funds market (inflation) actually increases real savings, which allows for real and completable investment (the magic theory of money).

Also, real capital are not lent and borrowed in the loanable funds market. Capital goods are created in the higher phases of production and circulate amongst the real economy. The amount of funds available to purchase capital goods, for the most part, is determined by societies willing to save, that is, by the natural rate of interest. But this natural rate is rarely, if ever, actually presented in the loanable funds market. This is because the introduction of money, which can be demanded as a good in itself, exerts an active influence. Total investment and total savings are only equal when the market rate of interest equals the natural rate of interest . But a planning monetary authority (central bank) which does not operate within the system, and which has no way to accurately measure the demand for money and credit, is unable to bring about this condition (NR=MR).

20

All changes in the structure of production take place by the adjustments of prices. So calling it “naive” is rather silly.

How can the interest rate be regarded as not natural (or artificial?) when all transactions, thus far, have been conducted by voluntary means?

There is no reason why the interest rate should be higher then what it should be. If demand for money has increased (hoarding) by forgoing consumption, then the increase in purchasing power of the money unit will increase the total purchasing power available for lower stages of production since the aggregate amount of money in the capital market has not changed. The interest rate must fall.

There is no such thing as “not enoug money to purchase them”. This fallacy dates back to the mercantile era and is refuted by Says law. Do you like Keynes, deny the validity of says law?

Pirces drop until their new market value is found. Once you realize this, you will realize that your entire analysis is based on false reasoning.