The Giant Logical Hole in Monetarist Thinking: So-Called “Spending”

May 3rd, 2017

Ralph Musgrave, who knows a thing or two about modern economic thinking, perfectly articulates the giant logical hole in monetarist thinking in a recent comment (emphasis mine):

If the private sector’s stock of saving is what it wants at current rates of interest, then additional public spending will push savings above the latter desired level, which will result in the private sector trying to spend the surplus away (hot potato effect).

Really? People/households say to themselves, “Wow, I’ve got too many assets, too much net worth. I’d better spend more to get rid of it.”

Here’s the verbal and logical sleight of hand that monetarists pull to hide this obviously inane assertion, and that Ralph doesn’t seem to have spotted: they game the word “spending.”

When government deficit-spends, it deposits (helicopter-drops) new assets, created ab nihilo, onto private-sector balance sheets. And since that deficit spending doesn’t create new private-sector liabilities, voila: there’s more private-sector net worth.

Those new assets hit balance sheets in the form of “cash”: checking-account deposits, money-market fund balances, etc. So people might end with a higher proportion of cash in their portfolios than they would like.

But they don’t try to “spend it away” to get rid of it. They rebalance their portfolios by buying riskier/higher-return financial instruments — bonds, equities, titles to real estate. This drives up the prices of those instruments.

These market runups create new balance-sheet assets (and net worth) — while leaving the collective stock of fixed-price “cash” unchanged. (That’s pretty much the definition of “cash”: financial instruments whose price is pegged to the unit of account — the instruments that monetary aggregates try to tally up.)

With a larger percentage of bonds, stocks, etc in their portfolios, and the same amount of cash, people have the portfolio mixes they want. Full stop. No hot potato. Likewise this is no game of musical chairs; market runups create more chairs. This is how “liquidity preferences” play out in the markets.

Those purchases of riskier financial instruments are not “spending.” People aren’t “spending down” their balances on newly produced goods and services. They’re just asset swaps — cash for Apple stock (and the reverse), or whatever. Through the magic of market-makers’ bid/offer order books, these asset swaps create new assets, collectively achieving investors’ preferred or “desired” portfolio mixes.

(Note: investors could also adjust their portfolios by paying off debt, simply shrinking their individual, and the collective private sector’s, balance sheets by disappearing both assets and liabilities into a hole in the ground. As Milton Friedman said, banks have both printing presses and furnaces.)

Now you might suggest: when people bid up Apple stock, that “causes” there to be more investment spending, spending to create more long-lived goods. I’m hoping I don’t have to explain all the logical flaws in that thinking, or point out the empirical disproofs. (It’s basically a freshman error: confusing “investment” with investment.)

Sure: when people buy into IPOs and new private bond issues, or buy titles to new (spec-built?) houses, there’s a quite plausible causal link between those asset swaps and actual increased investment spending. An excess proportion of cash in investors’ portfolios could certainly drive this economic effect.

But: 1. These purchases of newly issued financial instruments constitute a tiny proportion of the portfolio rebalancing we’re talking about; the magnitude of holding gains on existing instruments swamps these measures, and 2. It has nothing to do with investors trying to “spend down” and get rid of their balances, cash or otherwise. That notion is individually implausible, and collectively incoherent.


  1. Effem
    May 3rd, 2017 at 09:08 | #1

    Agreed. Essentially we have to push the wealth/GDP ratio to hig levels to achieve a certain level of spending. Since “unspent wealth” has utility, it is in fairly high demand..therefore wealth/gdp may have to go quite high for enough to trickle into actual spending. That creates an inherently unstable situation as wealth is simply a function of future spending (and a discount rate)…as the ratio gets high valuations get extreme, bubbles form, etc.

    Now, lets imagine spending reacts asymmetrically to wealth shocks. As wealth rises, spending rises slowly. As wealth drops, spending falls quickly. I believe you have now created a scenario where to smooth spending (avoid recessions) you essentially have to push wealth/gdp to higher and higher levels with each iteration.

    Until…? Political volatility forces redistribution? Capital starts to flee into inflation hedges?

    • May 5th, 2017 at 09:43 | #2

      Hey Effem:

      This doesn’t make sense to me. There is a declining marginal propensity to spend out of wealth. (Both theory and empirics support this in spades.) So broader distribution would result in greater velocity of wealth, more spending. Concentrated wealth, the reverse. ??

  2. Effem
    May 8th, 2017 at 07:35 | #3

    Yes, in the presence of high inequality you need greater levels of wealth to achieve a desired level of spending. Which is why we need to keep pushing up aggregate wealth to ever-greater levels (via low real rates).

  3. May 8th, 2017 at 07:51 | #4


    Alternative: We need to prevent and ameliorate excessive wealth concentration to cause more spending, hence production, hence surplus from production, hence…wealth creation.

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