Money, Savings, and Safety

by: Brad DeLong

Nick Rowe is doing a lot of work to answer a question I did not ask:

Worthwhile Canadian Initiative: Money, interest, employment, and luck: Despite all my brilliant theoretical proofs of the metaphysical necessity of monetarism -- how a general glut can only be caused by an excess demand for the medium of exchange -- Brad DeLong has got the perfect comeback: "OK, the 1982 recession was caused by an excess demand for money, as shown by the very high interest rates. But the recent recession must have been caused by an excess demand for safe assets in general, otherwise we wouldn't be seeing interest rates on safe assets near zero." (He didn't actually say those words, but he might have done.)

So I'm going to sketch a simple model where an excess demand for money causes a recession but no rise in (real or nominal) interest rates ...

I think he may be working too hard. I am not sure that it is necessary.

One way to put it is to say that money is, when short-term nominal interest rates are zero, not just a liquid asset but also both a safe asset and a savings vehicle, a bond, a way of transferring purchasing power from the present into the future.

So I might say that in (for example) 2001, when the problem was that the collapse of the dot-com boom had destroyed wealth and created a desire to cut back on spending to build up stocks of savings vehicles, that the economy had plenty of liquid assets -- plenty of money -- but that some of those liquid assets had been sucked up and were being used as savings vehicles instead, so that the transactions stock of money was too low. (This is Keynes's argument; that's what his blathering about the "speculative" demand for money is about.) In this case, there is no shortage of assets that could be used as liquidity in the economy as a whole; the problem is that the shortage of savings vehicles means that some of the economy's liquid assets have been taken out of circulation.

Or I might say that in (for example) 2008, when the problem was the flight to safety as people realized how bad the risk controls of major financial institutions were, that the problem was that the financial crisis had created a desire to cut back on spending to build up stocks of safe assets, that the economy had plenty of liquid assets -- plenty of money -- but that some of those liquid assets had been sucked up and were being used as safe-asset stores of wealth instead, so that the transactions stock of money was too low. (This is Keynes's argument too; that's also what his blathering about the "speculative" demand for money is about.) In this case, there is no shortage of assets that could be used as liquidity in the economy as a whole -- the problem is that the shortage of other safe assets means that some of the economy's liquid assets have been taken out of circulation.

It matters because when the economy's problem is a shortage of liquidity, the solution is to make more liquidity -- to have the Federal Reserve buy other assets for cash and so increase the economy's supply of liquid assets and thus the transactions stock of money. When the economy's problem is a shortage of duration or safety and you have hit the zero nominal bound, buying other assets for cash will not work if the money you create is then used as a savings vehicle or a source of safety; in that case, you have simply swapped one zero-yield government asset for another and the economy's transactions stock of money is unchanged. You need other policies than expansionary open market operations at the short end of the Treasury yield curve.

And it matters because what is going on with the demand and supply for safety or duration determines whether there is "excess demand" for money or not, even though the quantity theory of money does not fluctuate. With stable money demand, a given quantity of money determines the short-term safe nominal interest rate -- but if that interest rate is below the Wicksellian "natural" rate of interest determined by what is going on in the markets for safety and duration, that stock of money puts upward pressure on employment. And if that interest rate is above the Wicksellian "natural" rate of interest determined by what is going on in the markets for safety and duration, that stock of money puts downward pressure on employment.