Thursday, September 4, 2014

Are US Consumers Evil Hoarders?

by Pater Tenebrarum

Another Keynesian Meme Dragged Up

A recent Fed paper reports that the Fed's wild money printing orgy has failed to produce much CPI inflation because “consumers are hoarding money”. It is said that this explains why so-called “money velocity” is low.

The whole argument revolves around the Fisherian “equation of exchange”, as you can see here. Now, it may be true that the society-wide demand for money (i.e., for holding cash balances) has increased. Rising demand for money can indeed cancel some of the effects of an increasing money supply. However, it should be obvious that there is 1. no way of “measuring” the demand for money and 2. the “equation of exchange” is a useless tautology.

Consider for instance this part of the argument:

“Though American consumers might dispute the notion that inflation has been low, the indicators the Fed follows show it to be running well below the target rate of 2 percent that would have to come before interest rates would get pushed higher.

That has happened despite nearly six years of a zero interest rate policy and as the Fed has pushed its balance sheet to nearly $4.5 trillion.

Much of that liquidity, however, has sat fallow. Banks have put away close to $2.8 trillion in reserves, and households are sitting on $2.15 trillion in savings-about a 50 percent increase over the past five years.”

First of all, banks have not “put away” $2.8 trillion in reserves; in reality, they have no control whatsoever over the level of excess reserves. They are solely a function of quantitative easing: when the Fed buys securities with money from thin air, bank reserves are invariably created as a side effect. Credit can be pyramided atop them, or for they can be used for interbank lending of reserves, or they can be paid out as cash currency when customers withdraw money from their accounts. That's basically it.

Now imagine that a consumer who holds $1,000 in a savings account spends this money. Would it disappear? No, it would most likely simply end up in someone else's account. So the aggregate amount of money held in accounts is per se definitely not indicative of the demand for money either – it wouldn't change even if people were spending like crazy. Someone would always end up holding the money. Money, in short, is not really “circulating” – it is always held by someone.

This also shows why so-called velocity is not really telling us anything: all we see when looking at a chart of money velocity is that the rate of money printing has exceeded the rate of GDP growth (given that money printing harms the economy, this should not be overly surprising).

In Fisher's “equation of exchange”, V is simply a fudge factor. As Rothbard noted with regard to the equation, it suffers from a significant flaw:

Things, whether pieces of money or pieces of sugar or pieces of anything else, can never act; they cannot set prices or supply and demand schedules. All this can be done only by human action: only individual actors can decide whether or not to buy; only their value scales determine prices.

It is this profound mistake that lies at the root of the fallacies of the Fisher equation of exchange: human action is abstracted out of the picture, and things are assumed to be in control of economic life. Thus, either the equation of exchange is a trivial truism— in which case, it is no better than a million other such truistic equations, and has no place in science, which rests on simplicity and economy of methods—or else it is supposed to convey some important truths about economics and the determination of prices.

In that case, it makes the profound error of substituting for correct logical analysis of causes based on human action, misleading assumptions based on action by things. At best, the Fisher equation is superfluous and trivial; at worst, it is wrong and misleading, although Fisher himself believed that it conveyed important causal truths.”


“Velocity” of M2 – click to enlarge.

It is of course true that prices in the economy adjust to the supply of and the demand for money. However, low consumer price inflation by itself does also not really mean that one can infer that the demand for money must be exceptionally high.

What if e.g. the supply of goods increases at a strong rate? Then we would ceteris paribus have to expect the prices of goods to decline – if they instead remain “stable”, it is actually indicative of inflationary effects making themselves felt.

Moreover, prices never rise or fall at uniform rates. In today's economy, some prices rise at astonishing rates of change, such as for instance securities prices. These are not part of the consumer price index, but they are nevertheless prices. Their huge rise in recent years is an effect of monetary inflation – and if we were to attempt to infer the demand for money solely from their rates of change, we would have to say that the demand for money cannot have increased a whole lot. So you can see that things are evidently not as simple as “MV=PT” would have it.

In fact, the most pernicious effect of monetary inflation is precisely that relative prices in the economy shift and in the process paint a distorted picture that falsifies economic calculation and leads to capital malinvestment. Money always enters the economy at discrete points, and therefore changes in prices are like the ripples in a pond after a stone has been thrown in. First the goods demanded by the earliest recipients of newly created money rise…then the prices of goods  demanded by the receivers who are second in line, and so forth. The earlier in the chain of exchanges one resides, the more likely one is going to be a winner of the process, the later, the more likely one is going to lose out (as more and more prices rise before the late receivers get their hands on the new money). Needless to say, the number of losers tends to be much greater than the number of winners.

Lastly, a sharper rise consumer price inflation may yet strike with a large time lag. There is no way of knowing for certain, but it wouldn't be the first time it has happened.

TMS-2 with memo-items

Money TMS-2. Obviously, the rate of monetary inflation has been vast. Economic growth meanwhile hasn't been much to write home about (hence “decreasing velocity”) – click to enlarge.

Why Hoarding Isn't “Bad”

Such reports is however do as a rule not merely attempt to explain why  consumer price inflation is apparently low in the face of huge money supply growth (let us leave aside here that the “general price level” is in any event a fiction and cannot be measured. Let us also leave aside that the calculation of CPI such as it is seems highly questionable on other grounds as well). We may for the sake of argument concede that the demand for money (i.e., for holding cash balances) has risen on a society-wide basis after the 2008 crisis. Indeed, it seems quite a reasonable supposition.

The underlying theme of such studies is however invariably that this alleged hoarding somehow harms the economy, because economic growth is assumed to be the result of spending and consumption. This is a bit like arguing that the best way to stay warm is by burning one's furniture. In fact, this is a very good analogy, as burning the furniture will keep one warm for a while, just as people wasting their savings on consumption will for a while make aggregate economic statistics look better. That there might be a problem only becomes evident once all the furniture has been burned. Then it is cold, and there is nothing left to sit on.

Obviously, the argument that consumption drives economic growth is putting the cart before the horse: one can only consume what has been produced after all, so production must come first. If production must come before consumption, then investment must come before production and saving must come before investment. When people save money, nothing is miraculously “lost” to the economy. By saving more, people are merely indicating that their time preferences are lower  – that they prefer consuming more later to consuming less in the present. Their savings can be employed to increase production, so as to enable this later, larger rate of consumption they desire. All that changes is the pattern of spending in the economy – more will tend to be spent on producer's goods and wages instead of on consumer goods.

What about genuine “hoarding” though? What if money is not kept in savings accounts, but instead stuffed under a mattress where nobody has access to it? Isn't that harming the economy?

The answer is actually no.

Let us assume a lone miser takes all the money he earns and stuffs it under his mattress. Given that this money is held in his cash balance and not being spent, prices in the economy must ceteris paribus adjust downward (assuming that no-one else's demand for money changes and that its supply remains fixed). However, all of this continues to fully agree with an expansion in production.

After all, our miser must have earned his money somehow, and he can only have earned it by producing a good or a service. The contribution he has made to the economy's pool of real funding remains “out there”. The fact that he subsequently hoards his money does not alter this fact. He could use his money to exercise a claim on other goods or services, and so consume the portion of the economy's pool of real funding he is entitled to on account of his preceding production. If he doesn't, then whatever he has contributed can be employed to expand production.  The point here is: money is merely a medium of exchange. It is a sine qua non for the modern complex economy as there can be no economic calculation without money and money prices, but money is not what ultimately funds economic activity.

Just think about it: if one is stranded on an island without any real capital – i.e., without concrete capital goods – one can have suitcases full of money and will still be unable to fund even the tiniest bit of production with it.


In short, “hoarding” cannot possibly harm the economy. The same, alas and alack, cannot be said of money printing.

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