Should we print, not print? Stimulate, not stimulate? Is austerity the right or wrong policy? Is government spending or printing effective? If we ask two economists these questions, we will likely get three opinions for each question. Economists seem confused, yet these questions are more important today than ever. Where does this confusion come from? Doesn’t economic theory give us clear-cut answers? It does, but poor terminology and a lack of focus have muddied the waters. Many macroeconomic disagreements can be elucidated with a better understanding of the role played by holding cash, or hoarding, in economics.
To a large degree, Keynes is to blame for much of this confusion by using a double entendre. In his “General Theory,” he did not clearly distinguish between savings (correctly defined) and hoarding. The paradox of thrift is a misnomer. Thrift is both savings and hoarding. It should correctly be called the “paradox of hoarding”. Economists should not be this careless with terminology.
Even today, confusion persists. When Paul Krugman discusses thrift he is alluding to the impact of hoarding. When Austrians talk of thrift they are referring to savings. Keynesians and Austrians seem to be on different planets and some of the blame can be attributed to poor terminology.
In a circular flow economy, the value of output must be equal to income. Income represents claims on goods and services, and can be divided into three categories. It can be consumed, saved or hoarded. Consumption is using claims on goods and services for personal satisfaction. The correct narrow definition of savings is a transfer of claims from one group to another. This is the definition found in the classical loanable funds theory of interest rates. The saver is giving up his claims to be able to consume more goods and services in the future. He makes this transfer to investors who use these claims to purchase plants and equipment to produce goods and services in the future. The last category is hoarding, or holding cash, which is the equivalent of stuffing money in your mattress. From income, it is the only claim that is not used to purchase currently produced goods and services. Keynes, and his followers, constantly uses the word “savings” to imply two very different and distinct acts: the activity of transferring claims and the activity of holding claims. Classical economists were never this careless.
Since these claims are unused, Keynesians fear, in a circular flow economy, the value of output would be higher than the amount of claims used to purchase that output. Since some output would remain unsold, inventories would rise, output would be curtailed, and a downward spiral in output would ensue. Any future shift in hoarding will create another spiral in output. In this scenario, prices do not fall to bring the value of output in line with the value of claims. In a Keynesian framework, prices are sticky downward.
Let me explain this point with a very uncomplicated example. Suppose you have 10 pencils and $10. What is the price of a pencil? It can’t be $2 since we would have pencils that remain unsold, so the price would tend to fall. It can’t be 50 cents since people would have money and nothing to buy. Prices would be bid up. This would lead to equilibrium where pencils would be sold for $1 each.
Since the government does not create pencils, the only way it can obtain pencils is by taking claims from others by borrowing, taxing or printing. If it prints $10 and used it to buy pencils, the price of pencils will increase to $2 (inflation) since we now have $20 chasing 10 pencils. The government will obtain 5 pencils by lowering the purchasing power of money. It has taxed cash balances the equivalent of 5 pencils. The same logic applies to taxes or borrowing. Every dollar printed, borrowed or taxed to finance government spending displaces an equivalent purchasing power from private consumption or investment spending. Government spending is robbing Peter to pay Paul. It rearranges the deck chairs, but does not add deck chairs.
Most economists would agree with this “crowding out” example. Why then do some economists advocate more government spending if government spending displaces an equivalent amount of private spending? The answer lies in the role played by hoarding.
From our initial example, suppose we hoard $5. The price of output will fall to $0.50, a period of deflation, since we now have a money supply of $5 chasing 10 pencils. If input prices also fall proportionately from $0.80 to $0.40, we are still making the same profit rate and the economy has simply adjusted input and output prices to a new level of hoarding. Hence, the level of hoarding is immaterial and the economy is operating as though we had started out with a money supply of $5 and 10 pencils.
The Keynesian fear is twofold. If output prices are sticky, the price of a pencil will remain stuck at $1, or will only drop with a long lag. In this situation, with $5 chasing 10 pencils at a price of $1, we will be left with 5 unsold pencils. This excess output will lead businesses to curtail output, fire workers, until we are left with a new equilibrium of maybe only 5 pencils. The entire adjustment process has been in output and not in price.
The second fear is even if output prices adjust, input prices do not adjust quickly enough. If input prices remain at $0.80 while output prices are at $0.50 we are producing at a loss, which leads to less output, more hoarding, and a downward deflation-depression spiral in the economy.
The Keynesian prescription to avoid this depression in output is to have the government substitute its own claims for those being hoarded. The government’s claims are substituting for claims not being used. The price of pencils would remain at $1, with $5 of private demand and $5 of government demand. The government would have to print and use $5. It can neither borrow nor tax to finance this government spending since that would be mostly displacing claims that are not being hoarded.
According to the well know Keynesian balance budget multiplier, if the government spends $1 and taxes $1, output will rise by $1. This output magic occurs because the amount taxed reduced consumption and hoarding. If, instead, the amount taxed had reduced savings, in the place of hoarding, $1 of government spending will displace $1 of consumption and (savings) investment spending: the multiplier is zero, and government spending, fiscal policy, has no direct aggregate demand influence on output. Of course, if we consider the supply side, the multiplier is negative. As Murray Rothbard eloquently said, this is a transfer of “resources from the productive [private sector] to the parasitic, counterproductive public sector.”
Much of Keynes’s economic analysis was to disproportionately elevate the importance of hoarding. Classical economist considered the level of hoarding inconsequential, and its changes even less so.
From this analysis we can draw the following conclusions from a Keynesian perspective. Government spending is only effective if it substitutes for claims that are being hoarded. This spending must occur while the public is increasing its desire to hoard, such as after a crash such as 2000 or 2008, and only justifiable if there is a slow adjustment of both output and input prices. Also, this substitution is only effective if it is done through monetary and not fiscal policy.
Of course, this analysis has only looked at the direct aggregate demand effects of such printing, and has not examined the microeconomic impacts, supply side and other negative effects of printing money.
Such printing is distortive (altering absolute and relative prices) and will cause a misallocation of resources since the new money will not be spent in the exact same areas or proportions as the money that is now being hoarded. Furthermore, even if the government could find the right areas or proportions, it would still lead to misallocations, since the hoarding reflects a desire to realign relative prices closer to what society really wants to be produced. The printing of money may actually increase the desire to hold cash, as we see today. Holding cash may be the preferred choice over consumption or investment (savings) when relative and absolute prices have been distorted by the printing press.
Of course, no one is asking the critical questions. Why did holding more cash, or hoarding, change the money supply, and why did the public and banks decide to increase their cash holdings in the first place? Without fractional reserve banking, neither the public nor the banks could significantly change the money supply by holding more cash, nor could banks extend credit faster than slow-moving savings. The boom and ensuing malinvestments would be a thing of the past and, thus, so would the desire to hold more cash during the bust phase of the business cycle.
If Keynesians are really concerned about this deflation-depression spiral, they should be addressing the cause — fractional reserve banking — and not the result. Telling a drunk that he can avoid the hangover by drinking more is simply making the situation worse. The real solution is to have him stop drinking.
In addition, what happens when the economy improves and people reverse their hoarding? We will now have 10 pencils and $15. Other things being equal, prices will rise from $1 to $1.50, unless the government retires the $5 it put into the system. If they do, this will create another round of altered relative prices. The medicine is likely to be worse than the disease.
While Keynesians may have been able to make a case for printing press money as a substitute for hoarding in 2008, it is impossible to do so today. Current government spending or printing is simply displacing claims from the private sector. Today, there is no theoretical justification for the current overzealous printing, borrowing and taxing. Economists should be united against this displacement of claims. Growth and employment are simply more likely if claims are in private hands than in public hands.
Surprisingly, Keynesians and Austrians should be uniting to achieve the same goal, albeit for different reasons. Austrians fear the boom caused by excessive credit growth, while Keynesians (and Monetarists) fear the bust created by increases in hoarding. End fractional reserve banking and satisfy two birds with one stone.