Asymptosis

I’d like to reply to one confusion and one set of pushbacks on yesterday’s post:

Currency and Reserve Balances

I buried one fact: banks can reduce total Fed reserve balances by withdrawing currency — physical cash — from their Fed reserve accounts. I only gestured toward this in a parenthetical and a link. It’s a trivial point for this discussion, but it raises confusion. This is the other thing (besides bonds) that the Fed issues and retires in return for reserve balances. As with bonds, it’s purely an exchange between banks and the Fed (though it’s driven by customers’ cash needs).

Banks actually have nominal control over this. The Fed has to issue currency to them (retiring reserves in exchange) when they ask for it, and they have to retire currency (issuing reserve balances) when banks send it back.

But this in no way suggests that reserve balances are money. You can withdraw currency (notes) from your bank. Does that mean that your checking account contains currency? That checking deposits are currency? No.

This issue is unimportant here because it’s essentially a mechanical function. As long as it’s working properly — ATMs dispense cash and people can deposit cash — it has no effect on things. (And cash is pretty small magnitude in the total system). Banks keep enough cash on hand to handle their customers’ needs, and the Fed accomodates that. Aside from drug dealers, etc., nobody holds much physical currency.

The only reason cash would be an important consideration would be if the Fed starting paying (significant) negative interest on reserve balances — charging the banks to to hold their reserve deposits. Banks might decide to build secure warehouses and drive cash to and from the Fed, trading it for reserve balances, when they needed to fund loans or when loans got paid off. (It’s kinda tricky to fund a $400,000 mortgage with cash…)

Otherwise it’s a nonissue for this discussion. But I should have made it clear.

Whaddaya Mean by M, Buster?

People really don’t like the idea that the Fed’s not printing “money.” MV=PY adherents especially object.

Let’s look at the standard definitions. None of the monetary aggregate definitions M0 through MZM includes reserve balances. By those definitions, reserves are not money. (Ditto the divisia measures.) So by those definitions, when the Fed issues new reserves, it’s not “printing money.”

The one exception is the “Monetary Base,” or “base money.” That definition of money includes currency, coins, and reserves. Here’s a handy chart from Wikipedia:

Type of money	M0	MB	M1	M2	M3	MZM
Notes and coins in circulation (outside Federal Reserve Banks and the vaults of depository institutions) (currency)	✓[8]	✓	✓	✓	✓	✓
Notes and coins in bank vaults (Vault Cash)		✓
Federal Reserve Bank credit (required reserves and excess reserves not physically present in banks)		✓
Traveler’s checks of non-bank issuers			✓	✓	✓	✓
Demand deposits			✓	✓	✓	✓
Other checkable deposits (OCDs), which consist primarily of Negotiable Order of Withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.			✓[9]	✓	✓	✓
Savings deposits				✓	✓	✓
Time deposits less than $100,000 and money-market deposit accounts for individuals				✓	✓
Large time deposits, institutional money market funds, short-term repurchase and other larger liquid assets[10]					✓
All money market funds						✓

So fine: M in the equation of exchange means Base Money. But if you look at the data using that definition, it seems like there’s some serious explainin’ to do. Here’s the velocity of MB:

A 60+% decline since 2008? Hmm…

Cross-posted at Angry Bear.

 

 

Mark Dow had a great post the other day:

There is zero correlation between the Fed printing and the money supply. Deal with it.

He points out (emphasis mine):

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.

As he says:

if you are an investor, trader or economist, understanding—and I mean really understanding, not just recycling things you overheard on a trading desk or recall from econ 101—the mechanics of monetary policy should be at the top of your checklist. With the US, Japan, the UK and maybe soon Europe all with their pedals to the monetary metal, more hinges on understanding this now than ever before.

And, as we saw this week, even many of the Titans of finance and economics have it wrong.

He’s obviously been reading Manmohan Singh and Peter Stella (S&S) over at Vox EU, who cite the very same numbers and add:

In fact, total commercial bank reserves at the Federal Reserve amounted to only $18.7 billion in 2006, less than the corresponding amount, in nominal terms, held by banks in 1951.

S&S also point out (Table 1 and Figure 1) what we’ve known for decades but many seem unwilling to admit: since WWII, reserve levels have had approximately zero correlation with inflation/price levels.

They continue:

This suggests either that there is something wrong with:

• the theory of money neutrality;
• the theory of the money multiplier; or
• how money is measured.

Or, I would say, all of the above. I’d actually replace all three: there is something wrong with the (nonexistent) definition of “money.” But that’s another post.

I’m going to go even farther than Dow and say: the Fed is not printing money. (It can do that, but the result is stuff you can hold in your hand.) That’s a confusing and actually incoherent misconception. The Fed is issuing new reserves and exchanging them for bonds. Those bonds are effectively retired from the stock of assets circulating in the financial system (though perhaps only temporarily), as if they’d expired.

Reserves are not “money” in any useful sense. Or, they’re only money (whatever you mean by that word) within the Federal Reserve system. We probably just shouldn’t use the word at all here. It’s only confusing.

The key to understanding (and to avoid misunderstanding) this is to think about the banking system, not individual banks. The dynamics are totally different, because individual banks can affect their reserve positions (though under various market and regulatory constraints). The banking system can’t.

Because: Reserves only exist (can only exist) in banks’ accounts at the Federal Reserve Banks (and only members — banks plus GSEs and other large institutions like the IMF — can have accounts there). The banking system can’t remove reserves from the system by transferring them to the nonbank sector in exchange for bonds, drill presses, or toothpaste futures.

One bank can transfer reserves to the account of another entity with a Fed account, in exchange for bonds or whatever, but total reserves are (obviously) unchanged. And that exchange has no direct effect outside the Fed system. (That exchange can, does, have second-order, indirect, portfolio-rebalancing effects on the rest of the market. More below.)

And here’s the key thing: the banking system can’t lend reserves to nonbank customers by somehow transferring them to those customers’ deposit accounts (thereby reducing total reserves). They can’t “lend down” total reserves. The banking system doesn’t “take money” out of total reserves, or reduce those reserves, to fund loans.

This is why it’s so crazy to worry about those reserves eventually “flooding out into the real sector” in the form of new loans (and resultant spending), with all the hyperinflationary hysteria attached to that notion. (Equally: those reserves are not “unused cash” on the “sidelines” that the banks are “sitting on.” See Cullen Roche on this.) Reserves can’t leave the system, whether in a flood or a trickle. The banking system will lend (creating new deposits in its customers’ accounts out of thin air), if bankers think it will be profitable. But increased lending if anything forces the Fed to increase total reserves. Viz:

A bank issues a billion dollars in new loans, creating a billion dollars in deposits in its customers’ accounts. The borrowers spend the money by transferring it to sellers’ banks. When all the transactions net out at night at the Fed, the issuing bank is short on reserves that need to be transferred to the sellers’ banks (or sees that it will be short). So it borrows reserves from other banks. If reserves are tight, this pushes up the interbank lending rate. The Fed doesn’t want the interbank rate to increase, because it thinks interest rates are where they should be to fulfill its mandates. So it issues new reserves and trades them for banks’ bonds (which it retires, at least for the time being).

Short story: more lending increases total reserves. Slightly longer story: more lending forces the Fed to increase total reserves (or abandon its mandates).

In the current situation, of course, there’s no shortage of reserves. Banks are holding extraordinary quantities in excess of regulatory requirements. So the Fed instead controls the interbank lending rate within a corridor by setting the rate it pays on reserves (bottom) and the rate at which it will lend to banks (top). Read it all here from the FRBNY.

So how can the banking system reduce total reserves? Only in one significant way: by buying bonds from the Fed. Send some reserves over, and the Fed retires those, (re)issuing bonds in exchange. But of course the Fed isn’t selling these days; it’s buying.

Fed asset moves just issue and retire reserves and bonds. And those moves are purely at the discretion of the Fed (the Fed “enforces” this on the system by buying/selling at prices that individual banks will take up). So the Fed is in complete control of the level of total reserves. Again: there is no way for the banking system to turn existing reserves into deposits in its customers’ accounts. It can’t “lend down” total reserves.

When the Fed issues and retires bonds and reserves, it’s not “printing money,” so it’s not playing some kind of simplistic MV=PY game. It’s adjusting the balance of the banking system’s portfolio (“forcing” it to change exchange bonds for reserves) — and by extension, affecting the mutually interacting portfolio preferences of all market players (via interest-rate/yield-curve effects, and also, more psychologically, by imparting the optimistic notion that there’s adult supervision — that this frat party won’t turn into Animal House).

In other words, it’s a much deeper game than many monetarists would have you believe. It’s especially deep because neither the Fed nor the markets understand it properly. Certainly the Fed governors have strong disagreements about how it works. (Arguably, nobody understands, very much including me. There are many interacting understandings and reaction functions out there, many based on complete misunderstandings of the system dynamics. But I think we’re getting closer these days, with the slow but increasingly widespread and accelerating dismissal of silly notions like the money multiplier.)

Dow explains these portfolio effects and reaction functions very nicely:

…why is the Fed doing QE in the first place?

By keeping rates low well out the yield curve and providing comfort that the Fed will be there to fight the risk of recession and deflation…we start feeling better about putting our getting our money back out of the mattress and putting it back to work.

…it is the indirect psychological effects from Fed support and the low cost of capital—not the popularly imagined injection of Fed liquidity into stock markets—that have gotten investors to mobilize their idle cash from money market accounts, increase margin, and take financial risk. It is our money, not the Fed’s, that’s driving this rally. Ironically, if we all understood monetary policy better, the Fed’s policies would be working far less well. Thank God for small favors.

…

The other, more mechanical, implication is that financial sector lending is neither nourished nor constrained by base money growth. … The main determinant of credit growth, therefore, really just boils down to risk appetite: whether banks and shadow banks want to lend and whether others want to borrow. Do they feel secure in their wealth and their jobs? Do they see others around them making money? Do they see other banks gaining market share?

These questions drive money growth more than the interest rate and base money. And the fact that it is less about the price of money and more about the mental state of borrowers and lenders is something many people have a hard time wrapping their heads around—in large part because of what Econ 101 misguidedly taught us about the primacy of price, incentives and rational behavior.

I certainly make no claim to a deep understanding of those portfolio effects. (If I had such an understanding, I’d be far richer than I am.) But I do have some thoughts I’d like to share.

• When the Fed issues reserves and retires bonds, it’s 1. reducing the net flow of newly-issued (treasury and GSE-mortgage) bonds into the market, or even causing a net reduction. And if the latter is true, it’s 2. reducing the total stock of bonds available for trading in the market.

Since the flow of new bonds is obviously much smaller than the outstanding stock, you would expect flow effects of Fed actions to have much greater immediate influence on bond markets than stock effects.But it’s unclear what their long-term effects might be. A steady flow reduction, on the other hand, will eventually have cumulative effects on the total stock — again with uncertain future effects.

Jake Tepper, quoted in this post by Cullen Roche (read the comments too), gives us this:

…The fed is going to purchase $85 billion of treasuries and mortgages a month. So over 500 billion in six months…. the net issuance [by Treasury] versus refunding is a little over 100. That means we have 400 billion, 400 billion that has to be made up.

Whatever “made up” means. But Tepper’s also ignoring the Fed’s other big buys: mortgage-backed securities issued by government-sponsored enterprises (Fannie, Freddie). I would like to see as long a time series as possible of the following:

Net MBS issuance by GSEs (issuance – retirement)

Plus:

Net Treasury issuance (new issues – retirement)

Minus:

Net Fed ”retirement”

Also have to include Fed repos, I think? But maybe trivial over the long term.

In other words: net Net NET consolidated flow of new bond issuance to the private sector by Treasury, Fed, and the GSE gods.

Then: that measure as a percent of GDP? Of total Treasury/GSE bonds outstanding? Total Credit Market Debt Outstanding (TCMDO)? Other measures to compare it to?

• Contrary to what you often hear, even today when reserves and bonds are paying nearly equivalent interest rates, they are not equivalent assets. Because: bonds have expiration dates, and variable market prices/interest rates. So bonds carry market/interest-rate risk and reward for their holders — the potential for cap gains and losses. Reserves don’t.

As you can read in this must-read 2009 paper from the Bank of International Settlements, reserves are the Final Settlement Medium. They’re what it comes down to every night when all the day’s bank transactions are consolidated, netted out, transferred, and resolved. A dollar of reserves is always worth a dollar. There’s no possibility of capital gains or losses on reserve holdings. Reserves are inexorably nominal. (Even more so than $100 bills, which are worth less relative to reserves if they’re sitting in a Columbian drug-dealer’s suitcase.)

So when the Fed gives the banks reserves and retires bonds, it’s taking on market risk/reward, replacing it with absolutely nonvolatile, risk/reward-free assets (at least in nominal terms). It’s removing leverage and volatility from the banking system. (MMTers might well ask why our government system requires the injection of that volatility in the first place, when the Treasury could simply be issuing “dollar bills” with no expiration dates or interest payments, instead of treasury bills. [Or consols.] But that’s an aside.)

• I have to address notions like this one from Lee Adler, in a comment on Dow’s post:

The correlation between Fed and other central bank money printing with market behavior is clear and direct.

Yeah: while the Fed is on a bond-buying spree, it buoys bond prices and depresses yields. Especially when bond yields are historically low, market players shift their portfolio preferences from bonds to equities in a “reach for yield,” so equities go up too. (This presumably yields a wealth effect of [rich] people spending more — perhaps the only transmission mechanism to the real economy for Fed balance-sheet changes.)

This says exactly nothing about those balance-sheet moves as an impact on the stock of “money,” or inflation. It just says that while Fed asset purchases/sales are ongoing (and expected to continue), they will raise or lower the value of financial assets. It’s either orthagonal to Dow’s assertions, or  in fact demonstrates exactly what he’s saying about psychological effects.

• It doesn’t make sense to say that the Fed is “monetizing” the debt (because reserves aren’t money). If you think in terms of consolidated Treasury/Fed net issuance/retirement of government bonds, it’s retiring debt — removing bonds from the market and absorbing them into the Treasury/Fed complex. The bonds still exist, of course, and the Treasury still pays interest — to the Fed, which kicks it right back to Treasury. But as far as the markets are concerned, those bonds are essentially dead and gone (at least for now).

It seems that the Fed could simply burn a whole pile of those bonds, no? It would have no effect on flows, aside from the rather pointless interest flows back and forth between Treasury and Fed. And it would only affect the stock of “dead” bonds — ones that have been retired into the Fed. (The notion’s been discussed by people as diverse as Ron Paul and Mervyn King – Paul with the misconception that this would be “declaring bankrupcy,” and King with the misapprehension that it would be “monetizing the debt.”)

• It’s not at all clear what the flow effect would once the had Fed stopped net-buying bonds, while Treasury and the GSEs continued issuing new bonds in excess of retirements. Financial asset prices might stay at their then current levels. Who knows.

• The question, of course, is whether the Fed will ever sell all those bonds back to the market (thereby reducing reserve holdings). The average maturity of the Fed’s bond holdings is >10 years, so they’ll naturally expire and disappear, but only slowly. We’ve entered a brave new monetary world, in which central banks exert themselves not just through reserve management/interbank lending rates, but through balance-sheet expansion and contraction. (See the two “schemes” in the BIS paper linked above.) I don’t know if anyone knows what to expect in that regard. The Fed’s certainly talking about reducing its bond purchases in the future, which will affect net bond flows into/from the market, but it’s not at all clear whether it will ever shrink its balance sheet to pre-crisis levels (in absolute terms or relative to other measures), thereby reducing banks’ reserve holdings to those earlier levels.

• The $10-trillion question: If the Fed did sell off all its bond holdings in an effort to get back those halcyon days when banks didn’t hold any excess reserves — so the Fed could control the interbank rate with small open-market operations — what in the hell would happen? Whether slowly or quickly, bond prices would fall as the sales continued, yields would rise (compared to a counterfactual in which the Fed wasn’t selling off their holdings). Markets would shift their portfolio preferences from stocks to bonds, so equity prices would fall along with bond prices. Disastre?

Again, I don’t think anybody knows.

Cross-posted at Angry Bear.

 

 

 

This graph speaks volumes:

Profits as a Percent of GDP: Financial Corporations vs. Nonfinancial Corporations

We saw a big decline in real businesses’ profit share in the 40s, then a slower semi-steady decline through the 70s, as wages constituted a larger share of GDP. Financial corps doubled, expanding and increasing profits, but they remained small in the big picture.

Then post-80, we saw two big moves: a dive in real business profit share below any historical norm, and the beginning of the long secular rise in financial corp profits share (quadrupling between 1980 and 2010).

How did financial corps achieve this? Simple: they’re licensed to print money, and they devoted that money to paying off the managers of real businesses to hand over those businesses’ profits. The C suite of America’s corporations went from being managers of real businesses creating real value, to being financial prestidigitators. And those individuals were handsomely rewarded for their obeisance to the financial corps.

The people who work for those real companies, of course — the vast pyramid of sub-C-suite toilers who don’t get a share of the kickbacks…haven’t gotten a share of the kickbacks.

Compensation of Employees/GDP

That 4% or 5% of GDP income flow — remember, that’s every year – was transferred from households to financial corporations, courtesy of bought-and-paid-for real-corp CEOs.

Got incentives?

Cross-posted at Angry Bear.

The OECD has finally updated their national account data with 2011 info for most countries, so I thought I’d update this post from a couple of years ago.

If you’re thinking that the current (overblown) hoo-ra-ra about U.S. government deficits is a result of too much spending, or that U.S. taxes are insanely high and always going up, you might want to think again (click for larger):

While the U.S. number is up from its low or 24.1% in 2009, it’s still hovering at the bottom of the OECD league table.

Got tipping points?

Cross-posted at Angry Bear.

Wow:

 

I’ve ground the axe quite a bit over the years for the argument that Kevin Drum makes — and dismisses — here.

In brief: poorer people spend a larger share of their income/wealth than richer people. So if poorer people have more income/wealth — if the distribution is more equal — there will be higher money velocity/more spending/more production/higher GDP.

(Search for “marginal propensity” and follow Related Links to see my stabs at this.)

But Kevin — who certainly has the political inclination to make this argument — says:

This sounds pretty plausible, doesn’t it? Higher inequality should generate less consumption, which in turn produces a weaker economy. Unfortunately, the data says something else. “I wish I could sign on to this thesis,” says Paul Krugman, “and I’d be politically very comfortable if I could. But I can’t see how this works.”

Me neither. I spent a couple of months trying to write a magazine piece based on this thesis, and I finally gave up. By the time I was done, I just didn’t believe it. So I gave up and spiked the idea.

I’ve tweeted him and posted a comment, but haven’t heard: what made him give up on this? What convinced him otherwise?

And in response to a recent post where I ground this axe, Scott Sumner responded:

But you really need to give up on that MPC stuff, it was discredited decades ago. Monetary offset rulz.

This in keeping with his seeming assertion that nothing matters except monetary policy, because monetary policy will (or at least should) always offset it.

But still: Sumner, Drum, and Krugman all seem to think that the distribution/MPC/velocity argument has no legs. They’re quite categorical about this.

SRW took a stab at the subject recently, telling a story that I find quite convincing. But didn’t really explain to me why so many feel so certain that it’s not true.

Can folks (especially those who don’t believe this argument) point me to what might be considered definitive takedowns? I have notions about what they might say, but want to see the best argument(s) out there.

These takedowns should, just for instance, convincingly debunk this paper (sorry, gated), which suggests that rising income inequality ’67-’86 resulted in 12% lower consumption spending in ’86 than would have occurred if inequality had remained the same.

Cross-posted at Angry Bear.

He’s only been blogging since March. His credentials? “Independent Researcher on the equation for Effective Demand.”

That may explain why, aside from a lonely Steve Randy Waldman link, I’ve seen no mention of his work out there. Just another internet econocrank?

I’m wildly unqualified to pass judgment, but Lambert’s built what strikes me as a very interesting, cogent, and coherent model of effective demand, labor share, unemployment, and capacity utilization in growing economies. And he’s extending it fast, including into optimal monetary policy. (Mark Sadowski has been challenging him on the model in comments here.)

I won’t try to summarize his modeling or poke holes — go look at it. I’ll just give you a picture and a few post titles to whet your appetite.

Here’s his UT (“Unused Total”) Index:

The regularity of its coincidence with recessions (especially the ends of recessions), at least, seems like it should raise eyebrows.

Here are some posts to peruse:

What is Effective Demand?

What Non-inclusive Growth Looks LIke

When Labor Share does not rise in the Growth Model

Effective Demand Monetary Policy: the z coefficient

AS-ED Model: Raising Labor Share of Income

Update on AS-ED model: The future has a problem

Given Scott Sumner’s recent reversion to labor share as the appropriate target for monetary policy, I’m thinking that Market Monetarists might find Lambert’s work as interesting as effective-demand-obsessed Keynesians will. MMTers and other Post-Keynesians? His results certainly comport with their political predilections.

Cross-posted at Angry Bear.

I’m quite tongue-in-cheek in asking that question, but nevertheless: I present for your delectation what at first blush seems like a revealing bit of chart porn (hat tip: Zero Hedge):

You could flip this upside down and replace “Earning Yield” with “PE ratio.”

The data displays a remarkably regular relationship. Equity investors seem to be most optimistic about future economic (or at least earnings) growth when the inflation rate is 4.3%. (It would be interesting to see: did this relationship hold, albeit with the inevitable noise from smaller samples, in shorter sub-periods — and if so, which sub-periods? In particular curious: did it hold equally pre- and post-1971?)

Can we draw any conclusion from this? i.e.:

• Market conditions that are most conducive to economic growth are revealed by a 4.3% inflation rate.

• Equity investors display the most “irrational exuberance” when the inflation rate is 4.3%.

I’d love to hear whether Market Monetarists and MMTers think this has any useful import.

Cross-posted at Angry Bear.

I’m joking of course. He’s still grinding the supply-side axe (though judiciously here, IMO). But you gotta admire a fellow when he follows the logic of the data where his own logic requires him to go. He’s just done three posts about Germany’s growth and unemployment rates through the great recession:

Annualized change, Q1 2006 – Q4 2012:

RGDP: 1.3%
NGDP: 2.4%

But the unemployment rate fell from about 12% to 5.4%.

Lackluster GDP growth coupled with a damned impressive drop in unemployment. How do you account for that in Scott’s long-argued model, where NGDP growth drives employment growth?

As he says, he buries the lede in his first post. Here it is, from the end of the post (I’m reversing these two paras to make it flow even better; emphasis mine, correction his):

Recessions are not caused by less spending; they are caused by less income going to workers.  Usually the two go hand-in-hand, but the German miracle tells us that when they diverge, it is employer employee income that matters most.

When I started blogging I assumed wage targeting would be politically impossible, and knew that NGDP targeting was already a well-regarded concept.  So I latched on to NGDP targeting.  But in retrospect I wish I’d latched on to aggregate employee income.  Call it “income targeting.”

Did I mention admirable? Speaking of the very argument he’s been making doggedly and insistently for years, he says:

I took some shortcuts, instead of staying true to the “musical chairs model.”  In the past I’ve often argued that a fall in NGDP causes unemployment because there is less income to pay workers, and yet hourly wages are sticky.  Some workers end up sitting on the floor.  The logic of that model suggests that the real problem is not unstable NGDP, but rather instability in a component of NGDP, namely total wages and salaries.

And speaking of the school of economics based on that thinking, a school that he’s been primarily responsible for creating and popularizing, he says:

Now that market monetarism riding high, I figured it was time for a vicious internecine struggle for the soul of market monetarism.  Consider this the first shot. 

The fruit doesn’t fall far from the tree, of course; in his second post he attributes the “miracle” largely to “structural”/supply-side factors:

Germany did lots of labor market reforms, which I’ve discussed in previous posts, and this opened up lots of low wage jobs.

The basic idea: the Hartz reforms beginning in 2003 resulted in more jobs, though often with shorter hours and/or lower wages, all netting out to a larger share of GDP going to employee compensation.

This is not crazy. But it’s incomplete. And he even acknowledges that in a nod to his commenters:

Many commenters pointed to various job sharing programs, or subsidies to keep workers employed during the recession. Libetaer used the metaphor of putting 2 workers in one chair.  The one chair reflects relatively meager growth in NGDP, and the two workers represent job sharing.

The key problem I find in his thinking is his glossing over a key word in the preceding: subsidies. He only discusses job sharing, which fits neatly in his musical-chairs analogy. (How about musical benches instead? When the music “stops” — national income is weak — workers squeeze in more tightly.)

But the Hartz reforms did more than make it easier for firms to hire cheap (create more chairs/bench space); they increased subsidies for low-wage and part-time jobs. This 1) makes it easier for employers to hire lower-productivity workers for low wages, 2) gives those lower-productivity workers sufficient incentive to take those jobs, and 3) increases the share of national income going to lower-income workers.

And since those workers have a high propensity to spend their income, all things being equal that distributional shift should mean there’s a higher average velocity of money, aggregate demand, NGDP, etc., all in a virtuous cycle. (See JW Mason here and me here.)

Scott says much the same thing from a different direction:

The welfare loss to a society from a 5% RGDP shock is much greater if 5% of workers lose their jobs, as compared to all workers staying employed, but working 5% less hard.

This is a statement about absolute utility, but (hence, because spending is driven by the desire for utility) it’s also a statement about different policies’ distributional effects on spending and aggregate demand. Because subsistence has (very!) high utility, cutting some subsistence incomes (which would surely be re-spent) results in a bigger hit to aggregate demand than cutting many marginal incomes (which are less likely to get re-spent). It’s straightforward Marginal Propensity to Spend out of income thinking.

I’m here to suggest that the same logic, rather inevitably, applies to subsidies for low-wage jobs (paid for by better-off taxpayers). We redirect disposable income at the margin from higher-income folks, and flow it into the hands of lower-income folks who will spend it on. Got velocity?

Which brings me back to the axe that I’m forever grinding: the best and most feasible structural labor-policy change we could make in the U.S. to improve long-term macroeconomic performance would be to greatly expand the Earned Income Tax Credit (while streamlining its tortured administration and — to increase its “salience” — delivering the credit on weekly paychecks as we do with payroll tax deductions).

If these subsidies were sufficient to make low-wage work/workers attractive for both employers and workers (and perhaps if they subsidized hourly compensation rather than annual family income), we might even be able to do what the Germans, with their generous low-wage subsidies, have been able to do: do without minimum-wage laws.

I bet Scott would like that.

And we still haven’t talked about national compensation/income targeting by the Fed, which promises to be a very lively discussion indeed. (I can just see Ben Bernanke slapping his forehead and looking heavenward.)

Cross-posted at Angry Bear.

At risk of stating the obvious, in this post I’d like to highlight a pernicious misunderstanding that I find to be widespread out there in the world.

This is not new thinking. You’ll find a more sophisticated historical account, stated very clearly though in somewhat different terms, in the first few pages of this PDF. Still, despite decades of debunking, this misconception remains ubiquitous. I’d like to explain it in the simplest and clearest terms I can.

Start here:

GDP = Consumption Spending + Investment Spending

Consumption Spending = Spending on goods that will be consumed within the period.

Investment Spending = Spending on goods that will endure beyond the period.

Looking back at a period, from an accounting perspective, it’s obvious that if there’s less consumption spending, there’s more investment spending. This must be true, because that’s how we tally things up, once they’ve happened. There are two types of spending; every dollar spent last year must be one or the other. If there’s less of one, there’s more of the other.

But people conclude: if there is less consumption spending, there will be more investment spending. (So we’ll increase our stock of real stuff, and we’ll all be richer!)

They’re confusing (and confuting) a backward-looking, historical, accounting statement with a forward-looking, causal, predictive statement. Because looking back, GDP is fixed. It has to be; it’s already happened! But in that very instant of thought, people abandon that fixed, historical perspective and think: if one component is smaller, the other will be larger.

This makes no sense at all. Think about it: If people spend more on consumption goods next year, that will cause more production — including production of long-lived goods to increase production capacity. Investment won’t go down because people spend more on consumption. GDP will go up. Next year’s GDP (obviously) isn’t fixed.

Likewise, people tend to think that less consumption spending means there will be a higher proportion of investment spending (so, relatively, more real-wealth production). Wrong again. The backward-looking Y = C + I accounting identity tells us exactly nothing about why people will make their spending decisions — what causes them to choose consumption vs. investment spending. They might choose to increase or decrease either or both, for myriad reasons. One doesn’t cause the other in some kind of simple arithmetic manner.

This seems very obvious. But if you hold this firmly in your head as you peruse people’s statements out there in the world, I think that you will find that many of them do not have it fixed very firmly in their heads.

Cross-posted at Angry Bear.