Tuesday, 24 September 2013

I drop a clanger in the FT.

Must try to think before I speak.

I argued in this letter in the Financial Times that an interest rate cut pulls investment forward in time (a point also made by Mervyn King) and that that effect works for perhaps two years. Thus Mark Carney’s announcement that interest rates will stay low is of little relevance since the “pull forward” effect is probably no longer operative in the UK right now.

Unfortunately I forgot something else: the “hot potato” effect, which is a PERMANENT effect. That is, to cut interest rates, a central bank prints money and buys up government debt. That increases the amount of cash in private sector hands and increases the value of government bonds. The owners of said cash and bonds then have a surplus of cash and a surplus of net financial assets (or they are NEARER having such a surplus than they previously were). Thus they will tend to try to spend away that surplus, which causes a rise in demand.

But that’s not to say that monetary stimulus is better than fiscal. One big drawback of monetary stimulus is that the potato effect channels stimulus into the economy via the rich. Apart from social considerations, there is no logic in channelling stimulus into the economy exclusively via the rich any more than there is via people with blue eyes or long legs.

I am indebted to Scott Sumner who is keen on hot potatoes and who lets me think aloud and put my foot in it on his site. That has sharpened up my ideas on potatos, however I don’t think MMTers have ever been totally unaware of the potato effect, because MMTers are always on about what they call “private sector net financial assets”. And I don’t see any possible reason why increasing PSNFA could be stimulatory other than via the potato effect.


P.S. (28th Sept): Desperate attempt to save face....  I wish to point out that Mervyn King made the same mistake as I did, I think: i.e. he omitted the potato effect. 


  1. "Thus they will tend to try to spend away that surplus, which causes a rise in demand."

    Not necessarily - since they are down on income. What you fear requires 'rational man' - and they don't exist. Rich people are only interested in the size of their portfolio.

    There's not a great deal of evidence for the wealth effect on Bonds or Stocks - probably because ordinary people tend not to hold them.

  2. Fair point. Monetary policy works via the rich. And as you say, they don’t change their weekly spending habits much in response to a change in net assets. In contrast, fiscal works via a cross section of the population, so that’s better (all else equal).

    And MMTers tend to advocate creating new money and spending it into the economy (and/or cutting taxes) when stimulus is needed, which is a mix of monetary and fiscal, so ….. MMTers right yet again.

    But there are others who advocate that “create and spend” policy, e.g. Positive Money.


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