Scott B. Sumner — The “hot potato effect” explained

So finally Scott Sumner explains himself — sort of — with a thought experiment

In his first point he assumes that increasing the amount of gold will automatically depress its price as a commodity. Yes, if demand remains the same and supply increases that is the case. But why assume that is the case? Is it mathematically necessary or could demand increase to absorb the increased supply?

At the time of the discovery of the New World gold importation vastly increased into Europe. It did not result in a fall in the price of gold but rather increased inflation, due not merely to the increase in the amount of gold but rather due to increase in the level of effective demand and the capacity of economies to meet it. This was the age of empire building and governments spent lavishly. However, this is a special case historically.

For example, India traditionally imports a great deal of gold, much of which is customarily used for temple donations and kept in the temple treasury, or is saved as personal decoration. The increase in the volume of gold does not affect the price level, since much of the gold is saved or used as ornament rather than contributing to effective demand as money. Presently, the Indian central bank is begging people not to save in gold and is also asking temples to free up their gold hoard. However, this is unlikely to have great effect lacking legislation owing to Indians cultural heritage that results in high demand for gold. A similar situation exists in China, where gold is also hoarded as a traditional store of wealth and source of status and prestige.

Professor Summers concluded with:

Did anyone fall off the train on the way to market monetarist enlightenment? I think I see a few MMTers in the ditch along the way, still scratching their heads.

ROFL. We are scratching out heads all right. Someone actually pays you to teach economics? Clear instance of a market failure. Or, to quote Bill Gates, "That's the stupidest thing I've ever heard." Of course, this was a favorites saying of Gates, and I find myself saying it everyday when I read the economics blogs. So I don't mean to single out the good professor for special treatment. When the assumptions are wildly unrealistic, the conclusions are bound to be bonkers when extended outside the limited confines of the model, you know, to reality.

And it's still not explained how the Fed is going to credibly threaten to dump a whole bunch of cash into the economy. That's fiscal in that it increases consolidated nongovernment net financial assets in aggregate, and the Fed has no legal authority to do that.

And President Bush did do something like that with the approval of Congress in sending out checks to everyone. Did the value of money fall? Did it create even a blip of inflation? Just how much would it take to get the result that Professor Sumner proposes?

Oh, and the Bush drop was checks and not cash. Just how is the government going to threaten to distribute that much cash into circulation? What is the credible transmission mechanism that would lead the market to the expectations that are assumed?

But let's even assume that there is a legitimate "helicopter drop" of cash into the economy. People have two choices, spend it as cash or deposit it in their bank account for future use, just as would happen if the drop is by check of electronic payment, which leads to the bank exchanging a lot of vault cash it doesn't need for reserve balances that it can earn some interest on.

What people would spend, use to pay down debt, or save in another form would depend on their economic situation. Those in the lower 80% would be more likely to spend and pay down debt rather than save, while those in the upper 20% would likely increase spending a bit and save the rest. Depending on the amount injected this would lead to an increase in effective demand that would close the output gap and stimulate investment as the economy expanded to meet the demand. If more than that, then the result would be inflationary.

Since the Fed cannot do helicopter drops of cash, how likely is it that Congress would do this fiscally, which would increase the debt, or else permit the Fed to act fiscally on its behalf but without increasing the debt. I'd say about as close to zero as one can get.

This is just nonsense. why are we even talking about it? I would not, if Professor Sumner had not specifically mentioned MMT, and so invites a response.

Finally, a lot of people, including a lot a supposedly sophisticated people, placed bets based on the logic of monetarism at time that the Fed announced QE, greatly expanding what they consider "M." Confident that rising inflation would depress bond prices as yield rose, they shorted the bond market — and lost their shorts. Expectations turned out to be unfounded. But, who knows, maybe the suckers will be taken again by Fed jawboning about what it has no power to do. I wouldn't bet on it though, even through there is a sucker born every minute.

Perhaps Professor Sumner needs to change the subtitle of his blog to "A slightly off-kilter perspective."

The Money Illusion — A slightly off-center perspective on monetary problems.
The “hot potato effect” explained
Scott B. Sumner | Professor of Economics, Bentley University
(h/t y in the comments)

The key difference between Friedman and Keynes is that Friedman makes M in MV=PT the independent variable that is controlling, and Keynes makes effective demand the independent variable that is controlling. Moreover, Friedman defined M as the monetary base, whereas Keynes realized that M is actually spendable money that contributes to effective demand. The monetary base is not spendable and doesn't translate into effective demand as recent events have amply demonstrated.

The quantity view presumes that the total amount of money being spendable will influence the value of money. So if the amount of money is doubled, then the real value in terms of purchasing power is halved by inflation. Increase double M and also double P.

However, there are several issues overlooked here. First, money is not only a medium of exchange but also a store of value and a reckoner of debt. Money is not only for spending but also saving and also for paying down debt. "Cash under the mattress" is out of the loop and doesn't contribute to effective demand for as long as it is saved and not spent. Money that is used to pay down debt to banks reduces the amount of money in that just as loans create deposits, deposits are used to extinguish loans.

So not all "money" figures into the amount of effective demand.

Moreover, the money that does contribute to effective demand doesn't have the same effect independent of time. Increasing effective demand when there are idle resources and an output gap increases supply without affecting price in a competitive environment. Even has maximum production is approached, companies are likely to expand capacity through increased investment.

Effective demand doesn't affect price until the ability of an economy to expand production to meet demand begins to falter and imports cannot meet the increased demand either.

So taking M as the independent controlling variable rather than effective demand is a serious mistake theoretically, and a debilitating mistake when used to formulate economic policy.

The "hot potato effect" is imaginary.