A Con Game Too Successful for Its Own Good

As long as you’re willing to assume that the world will end some day and that the end will be known in advance, it’s a simple matter to prove by induction that money is worthless.

Consider the last minute of the world. If you were living in that last minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it, so what good would it be to you? In the world’s last minute nobody will accept money as payment and therefore it will have no value to anyone: it will be worthless.

Now consider some minute in time where it is known that money will be worthless a minute later. If you were living in that minute, would you accept money as payment for anything? Of course not. You wouldn’t have time to spend it before it becomes worthless, so what good would it be to you? A minute before money is to become worthless, it will already be worthless.

Therefore, according to the principle of mathematical induction, money is always worthless. It will be worthless at the world’s last minute; it will therefore be worthless a minute before that; it will therefore be worthless a minute before that; and so on. Go back as many minutes as you need to go back, and you can get to any point in time and show that money is worthless at that point in time.

Thus, fundamentally, money is worthless right now. But even people like me, who are well aware of this proof, are willing to accept money as payment despite its fundamental worthlessness. Money is valuable to us because we expect it to be valuable to someone else. And since we are reasonably confident in the monetary authorities’ ability to recruit new generations of victims in this endless Ponzi scheme, we willingly allow ourselves to become victims. All of which is very convenient because it allows us to use money as a medium of exchange, a unit of account, and sometimes even a store of value. And it allows authorities to manage the supply of money so as to minimize the frequency and severity of economic downturns.

It’s a nice con game, one where we may rightly cheer the operators, given that the success of their game normally results in benefits for everyone involved. Sometimes, usually in small countries where monetary authorities have limited credibility, we see the con game fail, and generally we lament that failure.

But the other danger is that the game can be too successful. If people become too confident in the value of money relative to other assets, the result is hoarding of money and eventually deflation. And since money is neither productive (like a factory) nor useful (like food), the hoarding of something unproductive and useless supplants the creation of productive and useful things. Accordingly, the operators of the game always suffer from a very rational fear of success. And today, it would appear, their fear is coming true.

But this is crazy. There must be a way to stop rational people from hoarding endless amounts of an asset they know is fundamentally worthless. There must be a way to blow the whistle on this con game.

The solution, it seems to me, is to have the operators come clean – not come clean entirely, not admit that money is completely worthless, but declare in no uncertain terms their intention to cheat us out of quite a lot if we persist in having so much confidence in their scheme. Of course even that approach may not work – it’s possible that our collective gullibility has no limits – but it certainly seems worth a try.

What I’m suggesting is something that has already been suggested – in rather less shocking terms, perhaps – by various other economists (as for example in these posts by Greg Mankiw and Nick Rowe): the Fed should announce a price level target for some point in the future. And it should make that target high enough to scare people (and institutions) out of hoarding money.

It’s still a game of chance. Nobody can be sure that the Fed will be able to hit its price level target, or even get anywhere near it. As I said, in terms of the Ponzi scheme, there may be no limit to our collective gullibility. But let’s shift metaphors here: when you’re playing five card stud and you see that one of the other players has four hearts showing, even if you know the odds are against that player’s having a full flush, you’ve got to have a fair amount of guts to make a big bet on your three aces. And guts are in short supply these days. Nobody will know whether the Fed is bluffing; even the Fed itself won’t know whether it’s bluffing; but if the price level target is high enough, if the player with the four hearts throws enough blue chips into the pot, a lot of today’s ultra-risk-averse investors are going to fold.

And if enough of them fold – OK, here I have to shift the metaphor a little bit again, or maybe you have to think about hundreds of poker games being played at once, with some kind of arrangement where the house is allowed to pass cards from one game to another when the players in the first game fold – if enough investors fold, the game is over. If enough investors give up thinking that their three aces, a.k.a.money (or zero-yield T-bills), are a safe asset, if enough investors start instead buying assets that are productive or useful, then the slack in the economy will diminish and eventually give the Fed a chance to push up prices by creating excess demand. And then the Fed can hit its price target and win the pot.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Why are the Fed and the Treasury Working Against Each Other?

It seems like every other day the last couple of weeks I read about how long Treasuries are tanking because markets are “worried about supply.” Then I read about how the Fed is saying they plan to buy long Treasuries, and they’re trying like heck to convince the markets that it’s really gonna happen, but the markets don’t quite believe it.

Maybe there’s a good reason that the markets don’t quite believe it: it doesn’t make any sense. The Treasury is going to issue a crapload of new long bonds, and the Fed is going to buy them back on the open market? Why? If the Treasury just issued short-term bills, the Fed would buy them anyway. At least it would buy enough to keep the federal funds rate near zero, and after that it doesn’t matter. And when the recession, or the potentially deflationary episode, or whatever it is, ends and the Fed wants to stop rolling over the bills, the Treasury can replace them with long bonds if it so chooses.

Now, you might say, “Ah, but when the recession, or the potentially deflationary episode, or whatever it is, ends, long term interest rates will go up, and the Treasury will have to pay more to borrow than it does now, so why not issue them now while the rates are cheap?” That reasoning seems to make sense, until you realize that the Fed, when this episode ends, is going to want to liquidate its long-term bond portfolio, and if rates have risen, it will have to do so at a loss. Since the Fed’s profits go directly into the Treasury, the loss passes right through, and, in terms of present value, it’s (almost) exactly as if the Treasury had issued new debt at a higher yield. Or the Fed could decide to hold the bonds to maturity, in which case it will be just as if the Treasury had never issued them. (In that case, if the Fed wants to reduce the money supply, it could stop rolling over its T-bills, in which case the Treasury will have to issue new ones at higher rates, just as it would have if it had not issued the long bonds in the first place.)

There are only two differences I can see between, on the one hand, having the Treasury issue long bonds and the Fed buy long bonds, and, on the other hand, having the Treasury never issue the bonds in the first place. And neither difference is really a difference. The first difference is that the Fed might buy seasoned bonds in addition to (or instead of) on-the-run issues. The Treasury, by definition, can only issue on-the-run bonds. But this, as I said, is not really a difference: the Treasury can just as well decide to retire its old bonds as to refrain from issuing new ones. Although most Treasury issues are not callable, the Treasury can retire them at market prices, and it will be just as if the Fed had bought them. And in any case, how much difference is there really between on-the-run and seasoned issues? The maturities are slightly different – no big deal in the grand scheme of things – and on-the-run issues are more liquid – a little bit more liquid, but it’s not like seasoned Treasuries sit on your books unintentionally for months because you can’t catch a bid. It’s a technical difference – one that will affect the details that Treasury traders care about, but not the sort of thing that should make headlines.

The other difference is between current policy and future policy. If future policymakers will be somehow influenced by the distribution of securities between the Treasury and the Fed, then that distribution will of course make a difference. But why should they be influenced by it? I can understand that the Fed and the Treasury may perceive themselves as having different interests, but in this case it doesn’t matter, because each one can undo what the other one does. If the Fed sells off its long bonds 5 years from now, the Treasury can stop issuing long bonds. If the Fed holds onto its long bonds, the Treasury can issue more of them. And if the Fed never buys the long bonds in the first place, then the Treasury can do whatever it wants with its finance policy 5 years from now. Again, there are the technical questions about maturity and liquidity, but I don’t see how these are going to make a difference that macro policy makers or investors (as opposed to traders) should care about. And since the timing of these events is unknown, I’m not even sure anyone would be able to make a reasonable guess as to how these technical matters will play out, so perhaps noone at all should care about them.

So what’s going on here? I really don’t get it. Are the Treasury and the Fed really going to insist on working against each other? Is one of them bluffing? (And if so, which one?) Have the markets misinterpreted their signals? Have the markets, in fact, correctly interpreted their signals as being meaningless?

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

What are Illiquid Assets Really Worth?

For the most part, I agree with Paul Krugman’s take on the “Bad Bank” proposal. But I think he takes the case a little too far:
It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it
But isn’t it obvious that the toxic assets are worth much more than anyone is willing to pay? The value of an asset depends on the rate at which one discounts its cash flows. For assets that are risky and illiquid, the discount rate includes a risk premium and a liquidity premium. By any measure I can think of, risk premia and liquidity premia today are stratospheric, which means that asset values in terms of reasonable risk and liquidity premia are much higher than in terms of the wild and crazy premia we’re seeing today.

Moreover, the toxic assets are particularly illiquid – and therefore demand a particularly high liquidity premium – because the technology for valuing them has proven faulty. Over time, presumably, the bugs will be fixed, and some of the liquidity will be restored. And by the way, what better way to fix the bugs than to create a buyer that has $350 billion to spend? Such a buyer – if its objective were to make a profit – could easily afford to spend a few hundred million on research to find out how much it should be paying for the assets.

There remains the philosophical question of how much an asset is inherently worth. But surely to the federal government – which can afford to be patient, and which can afford to absorb a lot of risk, and which can afford to sit on these assets until they mature or until someone is willing to buy them at a profitable price, and which doesn’t have to worry about capital requirements or even about solvency – these assets really are worth a lot more than any private entity is willing to pay for them.

Moreover, the government’s risk-free discount rate is probably negative. Today it can print all the T-bills it wants, and there will be no ill effects. At some point in the future (or so one hopes!), the government will once again have to pay for the money it borrows. For the private sector, a negative discount rate doesn’t make sense, because anyone can just hold assets in cash and receive zero interest. But the government cares about the effects its actions have on the economy as well as about its own financial health. It isn’t willing to hold its assets as cash, because that doesn’t help the economy. For the government, a negative discount rate does make sense. So add a negative risk-free rate to some reasonable risk and liquidity premia, and the government should be willing to pay quite a lot more for these assets than the private sector pays.

But should the government actually pay what it should theoretically be willing to pay? I’m inclined to say no, or at least, not necessarily. Demand curves slope downward, supply curve slope upward, and most people, under most circumstances, pay less for whatever they buy than what they would be willing to pay. In a competitive market, buyers pay only as much as the marginal seller is willing to accept. (Granted, the market for illiquid assets is, by definition, not competitive, but if a major buyer emerges, there will be competition among sellers.) If the government pays more than a similarly mandated private investor would have to pay, then it is merely transferring public wealth to the banks’ stockholders. And I’m confident that I speak for the majority of Americans when I say, “To hell with the banks’ stockholders!” What the government should be willing to pay for $350 billion worth of assets is whatever the market price would have been if there were additional $350 billion of private sector funds buying those assets.

And not even that, perhaps. Part of the reason these assets are so illiquid is that banks are reluctant to sell them because that would force them to own up to how little the assets are worth. If the government bid a little higher, presumably, more banks would be willing to sell, but there would still be an incentive for the banks to hold out for book value. My view is that banks should get the stick as well as the carrot. Instead of relaxing accounting standards, we should go the other way and be aggressive about forcing banks to write down their toxic assets, so they won’t have an incentive to hold out for unrealistic book values. When all is said and done, the government can recapitalize the banks that survive, and hopefully they’ll be willing to lend again.

I think the call that many economists made, when the original TARP came out, for recapitalization rather than reliquification, was misinterpreted. The idea, I think, was that banks need more capital because much of their existing capital will disappear once they write these assets down to a reasonable value. If you give them a token amount of capital without forcing them to write down the assets, it doesn’t solve the problem: their balance sheets may look good now, but they’re still afraid to lend if they’re uncertain about the value of their existing assets.

In any case, the whole enterprise should be, and can be, carried out in such a way as to be profitable – in an average expected return sense – for the government. The government can force banks to write down assets, and then it can buy those assets at a price that will leave a reasonable expected return. The banks that no longer meet capital standards will disappear. Of the remaining banks, many of them will need capital, and those will make up a substantial fraction of the banking sector. Banking – when one is willing to do it – is generally a profitable activity, and over time those banks should generate sufficient profits to compensate the public for the risk it is taking. If there’s anything left over for the stockholders, that’s gravy.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Oh, No, Not Again

Yes, I'm back with yet another post about the Fama/Stimulus issue. I promise this will be the last one...unless there are more.

In general, for an argument like Professor Fama's to work, there has to be some finite resource that is being fully utilized, so as to impose a binding constraint on the economy. That is, when the government borrows, it must be using up something – some actual, definite thing, not just a vague "funds" (which could mean any number of things depending on how we interpret it). The government must be using up some limited resource that is no longer available to businesses seeking to invest. What is that resource?

As I understand Greg Mankiw's interpretation, the limited resource is labor. In the classical model to which Greg refers, the availability of labor is what usually constrains an economy, the reason you cannot do more of one thing without doing less of something else. Now Professor Fama says explicitly that his argument applies "even when there are lots of idle workers." On the face of it, that would seem to contradict Greg's interpretation.

But perhaps Professor Fama is referring to frictional unemployment, and perhaps he believes in a theory in which recessions are associated with increased frictional unemployment. For example, today's unemployment could just reflect the difficulty in reassigning all the people that have been laid off in construction, finance, and other industries related to the mortgage boom. I can think of a number of empirical arguments as to why that's not the case, but the position is logically sound and does not rely on any assumptions that are inherently unreasonable. If that's what Professor Fama has in mind, I wish he would be clearer about it.

Nick Rowe has a different interpretation. He thinks the finite resource is money. If that's the intended interpretation, then there is an overwhelming empirical case against Professor Fama, as he will perhaps realize if he clarifies what he is trying to say. Money is not a finite resource today: there is nothing to stop the Fed from printing more money to finance any additional federal deficit, thus leaving plenty of money for those who want to use it for investment. (The argument goes beyond this, and I'm going to retell, in different words, the story I take Nick to be telling. Our argument shall be all things to all men, that we might by all means save some.)

Even if the Fed refuses to finance the deficit, and the money supply is fixed, the empirical case is still overwhelming, once you appreciate the nature of money and the relevance of a zero interest rate. The critical point is that money, even if it is limited in quantity, is a reusable resource. Money isn't like paper towels, where you use them once and then have to throw them away, and if my wife uses up all the paper towels and I can't get to the store then the dishes will have to sit in the drainboard. Money is more like cloth towels. If my wife uses up all the cloth towels, I can just put them in the washing machine and the dryer and use them again. Similarly, my wife can use money to buy a hamburger, and to the burger cook, it is as if the money had already been cleaned and dried. (Ah, yes, laundered money!) Even though my wife has already used the money, the cook can immediately go and use it again to buy something else.

Arguments that the quantity of money matters rely on some mechanism that limits the number of times money can be reused in a given year. The usual assumption (a controversial one, to say the least, but one we can accept for the sake of argument) is that people will hold money in proportion their incomes, regardless of the interest rate. In that case, if you try to raise aggregate income (for example, by a stimulus program), there won’t be enough money to go around. The excess demand for money will cause interest rates to rise until someone reduces their demand. The classic example is a business that is contemplating building a factory. When the interest rate rises, the factory becomes more expensive to finance, building it is no longer profitable, and the business decides not to build it. As that sort of thing happens across the economy, the demand for construction is less than it would have been, construction workers are laid off, and aggregate income goes back down to where it was before the stimulus program. Since we have assumed that the supply of money is fixed, and the demand for money is proportional to income, aggregate income has to go down to exactly where it was before the stimulus program in order to equate supply with demand.

But the critical point now is that the process also works in reverse, but it runs up against a brick wall when the interest rate gets to zero. Suppose incomes drop for some exogenous reason (like, for example, that housing prices collapse and throw the banking system into disarray). When incomes drop, the demand for money goes down. Therefore interest rates go down, and a bunch of businesses suddenly want to build factories.

So far, so good, but suppose that demand for commercial construction (and all the other demand that results from lower interest rates) doesn't create enough income to replace that which was lost. In theory, interest rates should go down even further, but suppose the interest rate goes all the way down to zero, and there still isn't enough aggregate income. There could be a very large excess supply of money, but interest rates can't go down any further, and thus incomes won't go up any further, and there is nothing to increase money demand and relieve that excess supply. (And please note that the interest rate on 3-month T-bills today is approximately zero.)

Now suppose the government institutes a stimulus program to raise incomes. As incomes rise, the demand for money increases. And then what happens? Well, nothing. There is an excess supply of money, and part of that excess supply gets used up by the new demand, but some of it remains – provided the stimulus program is not too large – and the interest rate remains at zero, and there is no reason for anyone to reduce investment, and there is no offsetting decline in income: aggregate income has risen; the stimulus has worked.

But suppose the stimulus program is too large. In that case you can think of the stimulus as being in two parts. The first part is just enough to use up the excess supply of money, and that part will raise incomes by some amount. The second part will create an excess demand for money, and ultimately it won't raise incomes any further. Overall, therefore, incomes will rise to a certain level and no further. But that certain level is still higher than where they were before the stimulus program. Thus the stimulus program has again been successful in raising incomes.

QED, if Professor Fama is using the word "funds" to mean "money" in the literal sense. I wonder if he will explain what he does mean.

I'll conclude with another point concerning the savings-investment equation that Professor Fama uses. In the National Income and Product Accounts, that equation holds more or less by definition. To the extent that there is causation involved, that causation seems to go from investment to savings rather than the other way around. In other words, any increase in investment immediately and automatically creates the increase in savings to finance it. In the national accounts, savings is a residual calculated by subtracting consumption from income. Consumption comes from the product side of the accounts; income comes from the income side. When an increase in investment takes place, it is entered as an increase in income on the income side, and it is entered as an increase in investment on the product side. In other words, income increases, but consumption does not. By definition, therefore, savings increases. So whenever a business chooses to invest, savings must necessarily increase as a result.

I'll leave you to ponder that argument. To be honest, I don't really buy it. I think there is an inherent flaw in national income accounting that allows a bit of Keynesian sophistry, and perhaps I'll write about that in the future. I'd rather fall back on my earlier argument about how the people in the chain from those who receive the government stimulus end up saving the total amount of the stimulus. I don't see how that argument can be refuted – again, unless Professor Fama means something different from what he says. And if he means money, I think Nick and I have pretty much buried his argument.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

More about Stimulus and Eugene Fama

Continuing from my previous post to address subsequent arguments...

Eugene Fama acknowledges a point that Brad DeLong made about inventories (that much or all of the reduced investment from a fiscal stimulus is unintended inventory investment, which is technically counted as investment but which is not useful). Professor Fama argues that the amount of unintended inventory investment is not very large.

But again I take issue with both the original Fama argument and the DeLong counterargument. First, consider the latter. The Keynesian model does not depend on inventories. Economists often teach the model to undergraduates without mentioning inventories. And yet in the Keynesian model (in the simple version, or when there is a liquidity trap), private investment does not get displaced by the increased federal deficit. Rather private savings increases just enough to finance the increased deficit.

For example, suppose there is $100 billion tax cut, and suppose the marginal propensity to consume is 0.8. The people who receive the cut save $20 billion. The people in the first round of multiplier effects get $80 billion in extra income and save $16 billion of that. And so on. As I hinted in my previous post, if you calculate the infinite sum (or estimate it by simulation, if you don't like calculus), it comes to exactly $100 billion. It's no accident that the additional savings exactly compensates for the government's additional borrowing.

The Keyensian model is a reasonable special case in which the compensation is exact. More generally, I think it would be unreasonable to expect private savings not to rise at all in response to an increased deficit, and indeed, in the case where there is a liquidity trap, I think the exact compensation in the Keynesian model is a very good approximation to what would actually happen.

Per Professor Fama:
I want to restate my argument in simple terms.
  1. Bailouts and stimulus plans must be financed.

  2. If the financing takes the form of additional government debt, the added debt displaces other uses of the funds.

  3. Thus, stimulus plans only enhance incomes when they move resources from less productive to more productive uses.
Are any of these statements incorrect?
As to the first point, it depends on what you mean by "financed." Certainly the government needs to obtain cash, but that's a rather trivial matter. The Fed can create any cash the government needs, and as I argue elsewhere, such money creation isn't even necessary when the interest rate is zero, because T-bills have become essentially equivalent to money. In the purely monetary sense of the word "finance," the Treasury can effectively finance the stimulus by printing its own money.

But I don't think the argument is about financing in the strictly monetary sense. The savings-investment equation, which is presented as central to the argument, says that
in any given year private investment must equal the sum of private savings, corporate savings (retained earnings), and government savings (the government surplus, which is more likely negative, that is, a deficit)...
The issue is whether the government has reduced its savings in the sense of having reduced its net assets. The answer depends on whether you believe in Ricardian equivalence (as an underlying fact about government borrowing, not necessarily as a description of household behavior). If you do, then the government is using its future power of taxation to create a new asset called "deferred revenue," which it can set off against its new liability, leaving its net assets unchanged. It's like when someone borrows money to buy stock on margin: they haven't reduced their savings, they've merely added an offsetting asset and liability to their balance sheet. In that case, government savings (or rather dissavings) is unaffected by the stimulus. If you don't believe in Ricardian Equivalence, then yes, the deficit does need to be financed, but...

As to the second point, it depends on what you mean by "displaces." If you mean there is displacement ceteris paribus for the changes in the total amount of funds available, then yes, it does displace other uses of funds. But my point is that it is unreasonable to assume that the total amount of funds available will be constant. Rather, it is almost certain to rise significantly, as the government's debt is itself a vehicle for net private savings (in contrast, for example, to personal debt, which is savings for one private party and dissavings for another). In the absence of Ricardian Equivalence, new wealth has been created, so there is more to save. To avoid saving more, people would have to increase their consumption dramatically.

Thus, as to the third point, no:   unless people behave in accordance with Ricardian Equivalence, the stimulus almost certainly also mobilizes idle resources, by increasing total income (i.e. adding to total wealth), thus allowing private saving to rise even as consumption also rises. Aside from Ricardian Equivalence, and excluding the very special and unlikely case where private savings do not rise, the only way the stimulus would fail to mobilize resources is if those resources were not really idle in the first place (in which case the stimulus would only cause inflation).

UPDATE: More from Brad DeLong, and the story is starting to sound a little bit more like one I recognize:
...increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead to firms to expand production, which leads to increases in income and saving.
The initial inventory disinvestment (in response to demand created by the stimulus) is only a minor part of the story. And inventories only matter at all because they happen to be the way firms get products to market. My logic would work even in a world without inventories, where firms could instantaneously change production in response to demand. In real terms, the new demand would result immediately in more production, which would raise real incomes and lead to more real saving out of those incomes.

That's the "real" story, but I understand Professor Fama to be telling a financial story rather than a "real" one. He uses words like "funds" that have meaning only in a financial world. The nominal national income accounts are compiled in financial terms -- based on accounting statements and the like -- so the national income identity must hold in financial terms, and I take that to be the basis of Professor Fama's argument.

Therefore I state my counterargument in financial terms: financially speaking, the increase in income occurs as soon as money changes hands. The most straightforward case is a tax rebate. As soon as people receive the money, it is income, whether or not anything new has been produced, and whether or not any change in inventories has occurred. (Certainly the people who receive the rebate think it is already income, as do their accountants, as do the people who compile the income side of national accounts.) They have a choice whether to save or spend that income. Any income they spend will go to someone else, who will have the same choice, and so on until it all gets saved. Technically, some of what I call saving will take the form of inventory disinvestment, but that's a minor point. It would work the same way if all production were done on the spot.

UPDATE2: Leigh Caldwell's comment makes me realize that I have exaggerated the importance of the government's creation of new wealth, because my same logic applies when the source of the increased consumption is a change in consumer behavior. The general principle is that every act of consumption by one entity (household or government) is an act of saving (or inventory reduction) by someone else.

When I take money out of savings to purchase something from a company, the company records part of the purchase as a profit and part as a reduction in inventory. The profit immediately becomes part of retained earnings and thus corporate savings. If the firm hires another worker in order to replenish its inventories, the cost of replenishing those inventories becomes the worker's income. Any part of that income that the worker chooses to spend becomes part of someone else's income (or someone else's inventory reduction), and so on until there is an overall increase in savings just large enough to offset exactly the original reduction in my savings. (I'm assuming all inventories are eventually replenished. Otherwise part of my purchase becomes not savings but a reduction in unproductive inventory investment, but the funds available for productive investment are unchanged.)

Ultimately, the only way to change the quantity of savings is by investment. For example, suppose a company decides to hire a programmer to develop a major piece of custom software that it will use in its business. The programmer's pay becomes part of his or her savings (until it is spent and becomes part of someone else's savings), but there is no reduction in retained earnings (savings) on the part of the company, because the company records the software as a capital asset. Thus the company's decision to make an investment has resulted in an increase in total savings. The same process works in reverse, if the company decides to lay off a programmer that would have been developing software. In the more general case, investment typically involves purchases from other businesses, and then the same logic in the paragraph above applies, except that purchaser does not reduce its savings, since it books the investment as a capital asset.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Is He Serious?

Eugene Fama, a giant in the world of financial economics, argues against a stimulus (hat tip: Greg Mankiw) for reasons that...to put it politely, I don’t understand. Maybe he is trying to satirize the way Keynesians often ignore or dismiss alternative theories – giving the Keynesians a taste of their own medicine. Or maybe he is deliberately making a wrong argument, as a pedagogical technique, to see if we spot his error. Or maybe (as Greg suggests) he is actually arguing something different from what he is literally saying, but he thinks that the rigorous argument is too complicated to discuss in a short article. Or maybe he just hasn’t thought through the issue. Or...your guess is as good as mine, but, as far as I can tell, if you take his words in their plain sense, they don’t make any.

In a nutshell:
...bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use
Which makes perfect sense if you assume (as he seems to) that bailouts and stimulus plans have no effect on the total amount of private savings. I understand the need to make simplifying assumptions in any discussion of economic phenomena, but there is a difference between the usual “not quite true but perhaps close enough to make a reasonable argument” assumption and one so far from reality as to be thoroughly ridiculous. The aforementioned assumption is in the latter category.

Bailouts (usually) and stimulus plans (almost by definition) raise someone’s disposable income. Is it even remotely plausible that an increase in disposable income would not have a significant effect on someone’s savings? (By “someone” I mean the generic, average person who might be receiving funds from a bailout or stimulus plan; I don’t deny that there may exist some individuals for whom the assumption would almost be valid, but the funds from bailout and stimulus plans seldom go to a single, unusual individual.) Think about it. Suppose you received an unexpected check for $1000. Would you go out and spend the entire $1000 immediately?

That fact is, even if you wanted to, you couldn’t. Perhaps, with today’s technology, you could spend it within a few seconds, but the instant after you receive the funds, your savings necessarily increase. More likely, though, even if you intended to spend all of it quickly, it will take at least a matter of days to do so. In the mean time, there are more savings to finance the government deficit.

But what happens when you do spend it? Someone else must be receiving the money from you as income. And just like you, they won’t be able to spend it instantaneously. Your savings have been reduced, but the savings of the vendor have increased by the same amount. The vendor has received income and is saving that income in the form of money. And the vendor will either save it or spend it, and in the latter case it will immediately become part of someone else’s savings, and so on. So the very act of implementing the bailout or stimulus plan creates the savings that are necessary to finance it.

One might try to argue that, since the money necessary to finance the stimulus must come from somewhere, someone’s savings must be reduced by the amount of that money. But that argument is wrong. When the government sells, for example, a T-bill, the purchaser of the T-bill has the same savings as before. It’s just that some of the savings they were previously holding in the form of money, they now hold in the form of a T-bill. The T-bill itself is a form of newly created wealth, so by the very act of issuing it, the government causes personal (or corporate) savings to rise.

You might argue that the T-bill is not in fact net wealth, because people will realize that the government borrowing raises their future tax obligations, and they will accordingly consider their wealth to be reduced by the amount of the T-bill, thus offsetting the increase in wealth resulting directly from the issuance of the T-bill. (This is what some economists call Ricardian Equivalence.) In that case, though, those people will choose to save more of their income to provide for the increased future taxes, so private savings will still rise in response to the stimulus.

Granted, in that case the stimulus doesn’t work, since people will have to reduce their consumption by the amount of the stimulus, thus offsetting its effect. That argument is theoretically valid, although the empirical evidence tends to indicate that people do not generally behave in accordance with Ricardian Equivalence. In any case, that is not the argument that Professor Fama is making. According to him (using the example of a tax cut),
Suppose the recipients of the tax reduction from the stimulus don't know about Ricardian Equivalence, and they use the windfall to buy consumption goods. Does this increase economic activity? The answer is again no. The composition of economic activity changes, but the total is unchanged. Private consumption goes up by the amount of the new government debt issues, but private investment goes down by the same amount.
And here he is clearly wrong. Private investment does not go down. When he says that “recipients...don't know about Ricardian Equivalence,” that is equivalent to saying that government debt is (from their point of view) net wealth. By consuming more, people have indeed reduced what they save out of their old income. But by issuing debt securities (new wealth) and using the proceeds to cut taxes, the government has given people new income, so their total quantity of savings has remained the same. Therefore, for any private investment that was financed out of that savings, it can still be financed.

Greg Mankiw and Brad Delong have been discussing this issue, and I disagree with both of them. Brad says:
Fama mistakes the NIPA savings-investment accounting identity for a behavioral relationship that constrains the behavior of investment
As I see it, Professor Fama has simply got the accounting wrong: he is ignoring the fact that newly issued government securities constitute new wealth and therefore new savings. (Or, if you want to look at it in terms of Ricardian Equivalence, he is ignoring the deferred revenue asset that the government “saves” to offset the increase in the deficit.)

It has nothing to do with behavioral relationships. You can see this by considering a simple Keynesian multiplier model: the amount of private saving created by an increase in the government deficit is independent of the behavioral parameter. (lf you don’t believe the algebra, do the calculus: calculate how much new saving is done by each individual in the chain of income recipients, and take the infinite sum. Or just do a finite sum, and recognize that the remainder must be saved. Or take it far enough out and ignore the remainder.)

Greg says:
I think Fama's arguments make sense in the context of the classical model
I don’t see how that can be the case. For one thing, the reduction of investment is supposed to happen “despite the existence of idle resources.” In the classical model, market clearing would prevent those resources from being idle. (Unless by “idle” he means intentionally devoted to leisure.) Moreover, in the classical model, Ricardian Equivalence holds, but Professor Fama argues that investment will decline even in the absence of Ricardian Equivalence. (Unless he means to say that Ricardian Equivalence holds in fact even if people don’t act accordingly. But then, as I said above, he’s ignoring the government’s deferred revenue asset.)

Maybe Greg can explain this to me, but I find no way to make sense of what Professor Fama writes, unless he means something very different from what he says.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.
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