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It’s the PSST, Stupid!

Ultimately it’s an empircal question – or, rather, a series of empirical questions.  The most germane of these questions is this two-part one:

Is the decline in demand for the outputs of many industries throughout the economy (1) chiefly the consequence of an increased demand for money, an increased demand (2) caused not by any structural mal-adjustments in the economy or by actual or anticipated destructive government policies but, instead, simply caused by an intensification of people’s desires to hold larger money balances?

If the answer to this question is “yes,” then the economy will indeed suffer a problem that can fairly be described as “inadequate aggregate demand.”  A better term, though, is “excess demand for money.”

As my great teacher, Leland Yeager, explained – for he is an able advocate of this “monetary disequilibrium” theory – because money “has no market of its own,” attempts by people to satisfy their demands to hold larger money balances have economy-wide repercussions in ways that people’s attempts to satisfy their demands to hold larger inventories of, say, apples do not.

Overlooking the important question of to what extent should consumption patterns, and patterns and techniques of production, in the “real” economy change as a result of people’s increased demand for money, we can nevertheless reasonably conclude that, ceteris paribus, a simple taste-driven or increase in the demand for money does not imply that patterns of resource allocation, production plans, and consumption plans are seriously out of whack.  Likewise for an increased demand for money driven by animal spirits.

The microeconomic conditions in this scenario are, by assumption, healthy.  All that must be done to avoid the negative external effects of each of us attempting to increase the real value of our money balances is for the nominal money supply to grow in order to accommodate this increased demand.  (In a fairytale world, prices of all goods and services and inputs would all adjust in unison downward to achieve the same goal.  But coordination problems make such price declines too unlikely to rely upon.)

In principle, increasing the supply of money will avoid the problem of inadequate aggregate demand.  I say “in principle” because the practical problem of how to get the increased supply of money into the market is real, although typically overlooked.

If the central bank simply injects this new money, (1) how do the central bankers know how much to inject? and (2) how do they avoid what Hayek called “injection effects”?  [The new money must enter somewhere, at least potentially distorting relative prices and then causing genuine resource misallocations and malinvestments.]  Indeed, how do central bankers know (with reasonable-enough certainty) that the observed declines in demands-for-output economy-wide are in fact the result of a taste-driven (or animal-spirits driven) increase in the demand to hold larger money balances rather than a reflection of serious microeconomic misallocations and malinvestments, or of greater concerns that government’s economic policies have taken a turn for the worse?

So back to my starting claim that it’s an empirical question.  Only if the above conditions – along with some other, smaller and not-worth-mentioning conditions – hold true does it make sense to talk of restoring “aggregate demand.”

But if the decline in GDP growth and in the rate of employment are caused, not by a taste- or animal-spirits-driven increase in the demand for money but, instead, by a large enough disruption in what Arnold Kling calls “patterns of sustainable specialization and trade,” then kicking up aggregate demand won’t solve the problem.  Neither kicking it up, or trying to, through monetary policy or through fiscal policy will work.  The problem is not originally one of widespread inadequate demand.  In this case, inadequate aggregate demand is a symptom; treating the symptom will not cure the disease and, indeed, will only worsen it.

Without venturing here an opinion on the underlying source of each and every recession throughout American history, I will express an opinion about the current recession: it is clearly the result of distorting government policies, regulatory and monetary, leading up to 2008 as well as of the symptom-treating policies since then that only worsen matters.  (And not to mention yet other actual and threatened policies – e.g., Obamacare –  that distort microeconomic patterns of sustainable specialization and trade.)

Curing the current recession simply with more money or more stimulus spending is as likely to restore the U.S. economy to health as would dumping more money on Chadians, and raising government spending in Chad, to start that nation on the path to genuine economic growth.


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