Adair Turner gave a speech on February 6th, 2013, titled Debt, Money and Mephistopheles: How Do We Get Out of This Mess? The text of the speech can be read here.
In the speech, he talked about a program he calls OMF, Overt Money Finance. He described the program as a "permanent monetization of government debt". It is a way to directly stimulate the economy with money... "a helicopter drop" as he says in his speech.
He mentions that he was criticized by many who thought it would lead to hyper-inflation.Later in his speech he says ... (page 28),
"There is moreover no inherent technical reason (as against political economy reason) to believe that OMF will be more inflationary than any other policy stimulus, or that it will produce hyperinflation.
- It is no more inflationary than other policy levers provided the “independence” hypothesis holds. If spare capacity exists and if price and wage formation process are flexible, the impetus to nominal demand induced by OMF will have a real output as well as a price effect, and in the same proportion as if nominal demand were stimulated by other policy levers. Conversely if these conditions do not apply, the additional nominal stimulus will produce solely a price effect whether it is stimulated by OMF or by any other policy lever."
His reasoning is that if there is spare capacity and price and wage formation processes are flexible, one will see an effect in real output and price. However, if there is no spare capacity and no flexible price and wage formation processes, the effect will only be seen in prices and not real output.
Everyone would probably agree that there is spare capacity in the economy. We have high unemployment and capacity utilization is still below pre-recession limits.
But wait... This research into effective demand is revealing that we are coming up against the limit of effective demand on the utilization rates of labor and capital... meaning that there is very little available capacity left in terms of increasing % utilization of labor and capital in the economy.
Economists do not know about effective demand yet. So Adair Turner talks about nominal demand in his speech, not effective demand. He says that OMF will be an impetus to nominal demand... meaning there will be more money in people's hands to buy things and this will stimulate an increase in sales and consequently production and real GDP.
Effective demand is not a function of the money in people's hands. It is a function of labor share of income and the utilization rates of labor and capital. Effective demand defines the limit and thus the open space above real GDP.
So then I ask the question, does an increase in the money supply increase effective demand? It would obviously raise nominal demand, but would it raise effective demand? This is a crucial point to differentiate effective demand from nominal demand. Effective demand carries with it special economic dynamics capable of limiting utilization of capital and labor. Nominal demand only describes the amount of money to spend. It does not carry any inherent "effective" limits, like effective demand.
Let's back up a bit and ask why some people think Adair Turner's OMF idea will be hyper-inflationary. Well, they use the velocity of money equation.
Quantity of money * velocity = aggregate price level * total output quantity
Look at the right side of the equation. This is what Adair Turner is talking about. The effect of OMF would be to raise the aggregate price level and/or real output. Now let's look at the left side of the equation. OMF is designed to raise the quantity of money in the economy. This should raise the right side of the equation. However, velocity of money is at an all-time low right now. The worry of many economists is that if velocity of money begins to pick up, it is much more likely that aggregate price level will rise before real output.
Now, let's look at the velocity of the M2 money stock plotted against the UT index. When the UT index is low, near zero, the economy is near the limit of effective demand... meaning low spare capacity.
In the last 20 years, velocity of money tends to rise when the UT index is low. It is not happening this time. People expect the velocity to go back up. But I don't think it will. I think the velocity of money has returned to a normal level after 20 years of bubbles and artificially manufactured demand, which over-stimulated consumption. Those days are over.
So in my opinion, the critics of Adair Turner are wrong. Velocity of money will not go back up.
Still, if we increase the quantity of money by monetizing fiscal policy, would real output increase? In effect, could we push away the constraints of effective demand which are binding the economy with low labor share rates?
First, I expect the velocity of money to pick up in the US in the first half of 2013. Second, this will translate into increased utilization of capital and labor within the limits of effective demand. Third, I already see real GDP heading towards $13.800 trillion within the first 4 months of 2013.
So in effect, the changes that Adair Turner is calling for, are already happening. It is a common process as we reach the effective demand limit. But that is going to stop, and a contraction in utilized capacity will eventually follow.
So the answer is no... OMF would not raise real output by much. The reason is simple. When we are up against the effective demand limit as we are now, there is no spare capacity for raising real output.
Thus, would the effect of OMF be simply a rise in inflation? Mostly yes. There will be some rise in real output, but most of the effect will be seen in the aggregate price level. Which is not such a bad thing. We could use a little more inflation for a number of reasons.
Still, even though Adair Turner is not realizing the difference between nominal demand and effective demand, he is aware of the effective demand limits, but attributes them to over-reliance on financial sector growth. He later says in his speech (page 39)...
"UK: Supply constrained as much as demand?
And finally the UK. Here I suggest two reasons for considerable caution about using unconventional measures to stimulate nominal demand.
2. The second is that the UK is the economy where it is least certain that the fundamental problem is one of demand (deficient nominal GDP growth) rather than supply. EXHIBIT 41 shows for the US, the Eurozone and the UK the division of nominal GDP growth since the depth of the 2009 recession, between the price effect (the GDP deflator) and real GDP. EXHIBIT 42 then illustrates the share of ∆ NDGP accounted for by the price effect and by the real output effect in the three zones. The UK division is the least favourable with more of the impetus of increased nominal GDP turning simply into higher prices rather than real output.
It may still be a reasonable judgement that the UK suffers from deficient nominal demand. But EXHIBIT 42 suggests the need to focus on supply factors as well. So too does the only small beneficial impact which the sterling depreciation of 2009 appears to have had on the UK’s net export performance.
The explanation for this phenomenon may be that the sectoral imbalances induced by the UK’s over reliance on financial sector growth, has left non-financial traded sectors (in particular manufacturing) so weak that the economy cannot now respond strongly to nominal demand stimulus. That could suggest that in choosing policy levers which stimulate nominal demand, we should also focus on their potential impact on supply capacity (EXHIBIT 7). Achieving success in such focus is however notoriously difficult."
Well, there is another explanation for the weakness in supply... the effective demand limit. And permanent success in increasing supply capacity is simply a matter of raising labor's share of income. The key to any fiscal stimulus monetized in the OMF style would be projects that provide a higher effective labor share of income, say in the 85% range. This would effectively raise labor share overall in the economy, and would have two benefits, raise nominal demand and raise effective demand. A higher labor share of income is what pushes the effective demand limit up giving real GDP room to breathe and room to raise utilization rates of labor and capital. The result would be to raise real GDP as Adair Turner envisions.
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