Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.
His post is quite a long one – over 3000 words, all his own – so I won’t try to summarize it, but the main message is that what characterizes money economies – economies in which there is a single asset that serves as the medium of exchange – is that money is involved in almost every transaction. And when a coordination failure occurs in such an economy, there being lots of unsold good and unemployed workers, the proper way to think about what is happening is that it is hard to buy money. Another way of saying that it is hard to buy money is that there is an excess demand for money.
Nick tries to frame his discussion in terms of Walras’s Law. Walras’s Law is a property of a general-equilibrium system in which there are n goods (and services). Some of these goods are produced and sold in the current period; others exist either as gifts of nature (e.g., land and other privately owned natural resources), as legacies of past production). Walras’s Law tells us that in a competitive system in which all transactors can trade at competitive prices, it must be the case that planned sales and purchases (including asset accumulation) for each individual and for all individuals collectively must cancel out. The value of my planned purchases must equal the value of my planned sales. This is a direct implication of the assumption that prices for each good are uniform for all individuals, and the assumption that goods and services may be transferred between individuals only via market transactions (no theft or robbery). Walras’s Law holds even if there is no equilibrium, but only in the notional sense that value of planned purchases and planned sales would exactly cancel each other out. In general-equilibrium models, no trading is allowed except at the equilibrium price vector.
Walras’ Law says that if you have a $1 billion excess supply of newly-produced goods, you must have a $1 billion excess demand for something else. And that something else could be anything. It could be money, or it could be bonds, or it could be land, or it could be safe assets, or it could be….anything other than newly-produced goods. The excess demand that offsets that excess supply for newly-produced goods could pop up anywhere. Daniel Kuehn called this the “Whack-a-mole theory of business cycles”.
If Walras’ Law were right, recessions could be caused by an excess demand for unobtanium, which has zero supply, but a big demand, and the government stupidly passed a law setting a finite maximum price per kilogram for something that doesn’t even exist, thereby causing a recession and mass unemployment.
People might want to buy $1 billion of unobtanium per year, but that does not cause an excess supply of newly-produced goods. It does not cause an excess supply of anything. Because they cannot buy $1 billion of unobtanium. That excess demand for unobtanium does not affect anything anywhere in the economy. Yes, if 1 billion kgs of unobtanium were discovered, and offered for sale at $1 per kg, that would affect things. But it is the supply of unobtanium that would affect things, not the elimination of the excess demand. If instead you eliminated the excess demand by convincing people that unobtanium wasn’t worth buying, absolutely nothing would change.
An excess demand for unobtanium has absolutely zero effect on the economy. And that is true regardless of the properties of unobtanium. In particular, it makes absolutely no difference whether unobtanium is or is not a close substitute for money.
What is true for unobtanium is also true for any good for which there is excess demand. Except money. If you want to buy 10 bonds, or 10 acres of land, or 10 safe assets, but can only buy 6, because only 6 are offered for sale, those extra 4 bonds might as well be unobtanium. You want to buy 4 extra bonds, but you can’t, so you don’t. Just like you want to buy unobtanium, but you can’t, so you don’t. You can’t do anything so you don’t do anything.
Walras’ Law is wrong. Walras’ Law only works in an economy with one centralised market where all goods can be traded against each other at once. If the Walrasian auctioneer announced a finite price for unobtanium, there would be an excess demand for unobtanium and an excess supply of other goods. People would offer to sell $1 billion of some other goods to finance their offers to buy $1 billion of unobtanium. The only way the auctioneer could clear the market would be by refusing to accept offers to buy unobtanium. But in a monetary exchange economy the market for unobtanium would be a market where unobtanium trades for money. There would be an excess demand for unobtanium, matched by an equal excess supply of money, in that particular market. No other market would be affected, if people knew they could not in fact buy any unobtanium for money, even if they want to.
Now this is a really embarrassing admission to make – and right after making another embarrassing admission in my previous post – I need to stop this – but I have no idea what Nick is saying here. There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about. However, even though I can’t follow Nick’s reasoning, I totally agree with him that Walras’s Law is wrong. But the reason that it’s wrong is not that it implies that recessions could be caused by an excess demand for a non-existent good; the reason is that, in the only context in which a general-equilibrium model could be relevant for macroeconomics, i.e., an incomplete-markets model (aka the Radner model) in which individual agents are forming plans based on their expectations of future prices, prices that will only be observed in future periods, Walras’s Law cannot be true unless all agents have identical and correct expectations of all future prices.
Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world. When they don’t, Walras’s Law does not hold. When Walras’s Law doesn’t hold, things get messy; people default on their obligations, businesses go bankrupt, workers lose their jobs.
Nick thinks it’s all about money. Money is certainly one way in which things can get messed up. The government can cause inflation, and then stop it, as happened in 1920-21 and in 1981-82. People who expected inflation to continue, and made plans based on those expectations,were very likely unable to execute their plans when inflation stopped. But there are other reasons than incorrect inflation expectations that can cause people to have incorrect expectations of future prices.
Actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is go great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?
Nick invokes Hayek’s paper (“The Use of Knowledge in Society“) to explain how markets work to coordinate the decentralized plans of individual agents. Nick assumes that Hayek failed to mention money in that paper because money is so pervasive a feature of a real-world economy, that Hayek simply took its existence for granted. That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.
Uneasy Money 
“I have been reading a month-old post by Nick Rowe”… good idea. Let the dust settle first.
LikeLike
Very good post; meaning, I agree.
“…for some reason [Nick Rowe] seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination.”
I do think Nick has a blind spot there. I’ve been nagging him for years about the fact that he cites Barro & Grossman (1971) in support of his claim that you must have money in a model if you want to generate Keynesian unemployment. But the “money” in that model isn’t really money at all! It could be a stock of rubies that agents are hoarding. With sticky prices and no by-passing the “auction” via side-deals, the upshot would be the same.
One way to tackle this might be to consider a coordination game, using a buns-and-burgers model of the sort Krugman (chanelling Ricardo) uses to discuss trade. There’s just two agents, a butcher and a baker, who need to produce matching quantities of their goods if they are to maximize utility. But they can’t communicate. They have to guess each others’ demands when they decide how much to supply. Obviously that setup can generate a Nash equilibrium where they each guess the other’s output correctly, yet they may trade lower-than-optimal quantities.
Would that thought experiment enable Nick to see things rightly, i.e. my way? 😉
LikeLike
“That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.”
David,
In “Economics and Knowledge”, Hayek does say that markets tend to approximate equilibrium, which fits well with his thesis from “The Use of Knowledge in Society” that prices reflect knowledge, not simply about scarcity, but substitutes and particular knowledge of the man on the spot. That is, individuals adjust plans and expectations as they receive new information. This information is reflected in prices, which includes the interest rate.
What exactly do you mean that “there is simply no market mechanism to ensure that intertemporal equilibrium is achieved”? I can understand if you mean this in the sense that there is no market mechanism to ensure that intertemporal equilibrium is perfectly achieved. Or are you making a broader, more powerful statement?
LikeLike
Tom, Hahaha. I’m not that strategic.
Kevin, That’s definitely allowed, even in your case.
Jim, In “Economics and Knowledge,” Hayek says that there is empirical evidence of a tendency for markets to clear and for decentralized plans to be reasonably consistent, but he also observes that this tendency is not deducible from what he calls the pure logic of choice, i.e., the theory of general equilibrium. The theory of general equilibrium says that an equilibrium exists. You can imagine a tatonenment process that would achieve an equilibrium (and even that process is not guaranteed to reach equilibrium), but in the context of incomplete markets, all we know is that intertemporal equilibrium requires correct expectations of future currently unobservable prices. The theory provides no clue about the nature of a market mechanism that would bring such agreement into existence. That part of the theory is totally empty.
LikeLike
David,
Thanks for the detailed response.
Would you say that the aggregate of these expectations as represented by the market rate, even if prone to error, represent the best information available concerning the equilibrium rate of interest? Or perhaps the conversation is confused by the concept of equilibrium since, as you say, the market is incomplete and will not consistently achieve the equilibrium rate. I find Hayek to be most confusing when he tries to integrate equilibrium theory into his Austrian paradigm.
LikeLike
Jim, First, we are talking about more than expectations of future interest rates. Indeed, expectations about future interest rates can be inferred from currently observed yields on long-term instruments. But there are no markets that tell us what the prices of all kinds of goods and assets and services will be in future time periods. At any rate, I don’t believe that the market forecast of future prices is always the best forecast. If it were, entrepreneurs would not be able to make profits. Entrpreneurs make profits by anticipating future demands or by identifying undervalued resources. It is possible to beat the market, but you have to be very good, or very lucky, to do so.
LikeLike
That makes sense! I didn’t realize that your claim related to own rates of interest, not just money rates.
LikeLike
Nick considers money piling up in creditors coffers an excess demand for money. It is more a lack of demand for anything else and awkward to refer to it as an excess demand, but that is what Nick calls it.
LikeLike
I’m surprised Nick hasn’t been by to make a comment on this yet…
Also, if you’re reading month old posts, you might fast forward a bit to this one (only two weeks old):
http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/08/a-simple-question-about-walras-law.html
I think he agrees with you about barter economies in there.
LikeLike
David: thanks for this. I am slowly composing a response to you and Brad. But I am a bit snowed under with admin work this new term, and it’s taking longer.
Good point about Walras’ Law being wrong if different agents have different beliefs about (future) prices. I hadn’t thought about that before, but it’s clearly right. Which prices do we use to evaluate those excess quantities demanded or supplied?
One small point: “There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about.”
Can’t there be a demand for a good whose supply is zero at any price? Suppose there is a demand for dodo meat, but the dodo is now extinct? And suppose there is an old law still on the books, that puts a price control on dodo meat. So there is an excess demand for dodo meat. By Walras’ Law, that creates an excess supply of some other goods. The recession might have been caused by the extinction of the dodo.
LikeLike
Kevin: “But the “money” in that model isn’t really money at all! It could be a stock of rubies that agents are hoarding. With sticky prices and no by-passing the “auction” via side-deals, the upshot would be the same.”
Let there be 3 goods: apples, bananas; and rubies. If there are only 2 markets (one where apples trade for rubies, and one where bananas trade for rubies) then I say that rubies are being used as money. Because apple producers who want to consume bananas must first sell their apples for rubies, then sell those rubies for bananas. And that’s a very different economy from a barter economy where there is also a third market, where apples can be traded directly for bananas, without using rubies as a medium of exchange. It will have a very different allocation, if prices are sticky.
Whether there is also a demand for rubies as jewelry (the “industrial demand” for rubies) is a side-issue.
LikeLike
Nick, if an apple costs a rubies and a banana costs b rubies then the barter price of an apple will be a/b bananas.
The only way to escape that is to have an “unofficial” market where the arbitrage mechanism doesn’t operate. But Barro & Grossman explicitly rule out side-deals like that: all exchanges take place in an auction setting. (It’s basically just Walras with sticky prices.)
LikeLike
Nick,
On second thoughts please disregard that reply. I pretty much said all I had to say about that a few years ago; it’s really just a matter of mucking about with the constraints (& at this stage I think that’s just a distraction):
http://anyoldbullshit.blogspot.ie/2011/02/nick-rowes-critique-in-pictures.html
LikeLike
Check out Hayek’s (1928) “Intertemporal Price Equilibrium and Movements in the Value of Money”. Hayek does discuss the role of relative prices across time and how money can distort the signals. He also mentions Hawtrey’s business cycle theory in his “Currency and Credit” in a positive way.
LikeLike
Jim, My claim goes beyond own rates, it’s about all future prices.
Lord, I agree that creditors demand money that they are willing to hold. Where is the excess demand?
Tom, Give the guy a chance.
Nick, You’re welcome. I am still thinking about your new post replying to mine. It may take me another day or two before I can write something up. Glad that you agree with me about Walras’s Law, but I would be surprised if the point hasn’t already been made. I don’t have an answer to your question about which prices to use to evaluate excess demands or supplies when price expectations differ.
About dodo meat, it just seems to me that your thought experiment is a distraction. An excess demand for a non-existent good cannot have any effect on the tatonnement process. Period.
Justin, Agreed. Hayek introduced the concept of intertemporal equilibrium in that 1928 paper. He certainly believed that money does distort price signals. My point is that divergent expectations among individuals that give rise to disequilibria are possible apart from any distorting effects from money.
LikeLike
Don’t expected future prices affect own rates? Or do you mean future prices ex post? I am guessing the latter as ex ante expectations may be in disequilibrium.
LikeLike