the plan for the future
24 December 2019
Classical economists believe the economy tends to be at full employment because the desires of consumers exceed the capacity of the businesses to satisfy them. People produce in order to consume what they have produced or to exchange what they have produced for what others have produced. They believe that supply creates its own demand. When the economy is not in equilibrium at full employment, they believe that prices are not flexibile enough.
Classical economists have faith in the law of supply and demand. If there is a surplus of goods or services, they drop in price until they are consumed. Lower prices make it more attractive to buy those goods and services while it be less attractive to produce them. And so a new equilibrium is soon achieved. At lower wages, working is less attractive so fewer people are willing to work. At the same time it is more attractive to hire people so employment rises.
Classical economists believe that people save in order to have more in the future. In other words, people have a time preference. They prefer present consumption above future consumption. They only postpone consumption if interest rates are high enough. Lower interest rates make saving less attractive while more projects become feasible so there is more investment demand for money.
Much can be said about this. For instance, lower wages may increase the supply of labour as wage earners need more hours to make a living. And when prices drop, people may postpone spending if they expect further price drops. And if the value of money rises so does the value of debts. For debtors it may not be possible to pay back their debts when they are out of work or receiving lower wages. And so a recession could turn into a depression.
Classical economists never envisioned negative interest rates because of the time preference. The existence of negative interest rates suggest that not everyone has a time preference, and that those who have not, have a lot of money and capital. The situation might be explained by dividing humanity into ordinary people who have a time preference and captilists who save and invest anyway. The absence of time preference with the capitalists suggests that interest rates can be negative.
Keynesian economics sees low demand combined with excess savings as the primary cause of economic recessions and depressions. The national income equals consumption plus investment. If consumption lags then investment rises. If consumption is lower than anticipated then undesired investments are made in unsold inventory. As a consequence production will be lowered as will subsequent investments, resulting in a lower national income and more unemployment.
Keynesians believe that prices aren't flexible. For instance, wages of existing employees are not likely to go down if unemployment rises. Employees will resist lower wages even when prices go down. And Keynesians believe that cutting wages is a bad idea as it will reduce demand further while insufficient demand is the cause of recessions in the first place. Lower prices and wages can deepen a depression as falling prices and wages make debts more difficult to repay.
The most persistent price stickiness existed in the markets for money and capital. Keynessian economics emerged in the 1930s when negative interest rates were still a fringe idea. Keynes himself may have figured that during a depression supply and demand for money and capital might balance at a negative interest rate, but he believed that such an interest rate would be impossible as investors would withdraw their funds from the money and capital markets.
To work around the issue, Keynes advised governments to borrow money to lower taxes or to spend more so that the demand for money and capital increases and the markets for money and capital balances at a positive interest rate. The Keynesian solution of going into debt to increase demand in the money and capital markets during a recession can be seen as a fix for the imagined impossibility of negative interest rates.
According to Monetarists changes in the money supply leads to a proportional change in the price level, all other things being equal, and in the long run. That is because monetarists assume that the velocity of money is relatively stable. Keynesians believe there is a tradeoff between employment and inflation as higher inflation goes together with lower unemployment. Monetarists think this effect only exists in the short run.
At first workers and businesses may confuse a change in price level with a change in real prices and wages and start to produce more. When business owners see their costs rise and their profits drop and workers see their costs of living rise and demand higher wages, unemployment rises again, so there is no tradeoff between employment and inflation in the long term.
Monetarists like Milton Friedman opposed the gold standard because there would be no practical way to counteract recessions. Instead they proposed a fixed monetary rule, where the money supply would be calculated based on macro economic factors and targeting a specific level or range of inflation. The Taylor rule, which a central bank could use to set the nominal interest rate. It is based on changes in inflation, GDP, or other economic conditions.
Natural Money includes a holding fee on currency so interest rates can go as low as needed to stimulate the economy. The maximum interest rate of zero limits the creation of money and credit when the economy is doing well. That is because other investments will be more attractive than debt so there are fewer funds available for lending. As a consequence, inflation will be kept in check and deflation is likely while the economy is stable and doing well.
Supply-side economics is a school of thought favouring low taxes on wealthy people and corporations to stimulate business investment. Supply side economists believe that consumers benefit from a greater supply of goods and services at lower prices and employment will increase. High taxes may deter businesses and wealthy individuals from investing and enterprise as taxes would eat away their profits. This is sometimes called trickle down economics.
Wealth taxes can reduce savings and push up interest rates and in this way limit the supply of capital and the amount of wealth. Lower interest rates could have the benefits of a wealth tax while there is more capital and wealth. With Natural Money the wealthy hand out money to the rest and wealth trickles down. It might be better to curb resource consumption of the rich instead of taxing their wealth and to let it 'trickle down'.
The rational expectations theory states that people make rational economic decisions based the available information and past experiences. When making economic decisions most people try to be rational. People are sometimes wrong but on average they are right. And people learn from their past mistakes. Their decisions are based on their expectations and these expectations are based on the available information and past experiences.
The rational expectations theory argues that rational expectations can make economic policies ineffective. For instance, if the central bank plans to stimulate the economy by printing money, businesses and people expect inflation to rise, so that they increase prices and wage demands. In this way the desired effect of the policy would be undermined. With Natural Money there are no fiscal and monetary policies and no issue of policy ineffectiveness.
Related to the rational expectations theory is the efficient market hypothesis. It states that share prices reflect all available information. As a consequence it is impossible to outperform the overall market through stock selection or market timing. The only way an investor can obtain higher returns is by taking more risk.
The efficient market hypothesis has some serious flaws. For example, it can't explain why certain investors like Warren Buffet make consistently higher returns. It can also not explain stock market crashes. In 1987 the Dow Jones Industrial Average fell by 22 percent in a single day. This proves that stock values can significantly deviate from their fair value. Markets aren't always rational.
That is because human behaviour isn't always rational. This is the field of behavioural economics, a combination of psychology and economics that explores why people make irrational decisions from time to time. Humans are emotional and easily distracted beings sp their decisions aren't always in their self-interest. Emotion also plays a signficant role in the valuations of individual stocks and the stock market as a whole.
The contradiction between efficient market hypothesis and behavioural finance is often about changing perceptions. Changing perceptions make the change in equity prices appear rational. For the market as a whole these perception changes appear rational because of the business cycle and the availability of credit.
Modern Monetary Theory argues that only governments should issue money. If there is unemployment, there is too little money to satisfy the demand for savings, the theory claims. Modern Monetary Theory advocates that governments and central banks should use fiscal and monetary policies to achieve full employment by creating new money to fund government purchases. If the economy is doing well, taxes should be raised and no new money must be printed.
Governments might not stop printing money even when the economy is doing fine. Unemployment signals that excess savings are not returned to the economy. Printing money does not address that issue and it can undermine confidence in the currency. The excess savings can be eliminated by increasing consumption or investments. To make that possible, interest rates should not be allowed to go negative.
1. Monetarism - Wikipedia: http://en.wikipedia.org/wiki/Monetarism
2. Supply side economics - Wikipedia: http://en.wikipedia.org/wiki/Supply-side_economics
2. Rational Expectations Theory. Carla Tardi, reviewer (updated 25 June 2019). Investopedia. https://www.investopedia.com/terms/r/rationaltheoryofexpectations.asp
4. Efficient Market Hypothesis. Justin Kuepper, reviewer (updated 19 February 2019). Investopedia. https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp