By Rick Kelo
Money is only useful for exchange value, true, but it is not only useful at the actual moment of exchange. This truth has been often overlooked. Money is just as useful when lying "idle" in somebody's cash balance, even in a miser's "hoard."
~ Murray Rothbard, “What Has Government Done to Our Money”
This is the third article in a series discussing the economic theory behind why economies expand & prosper. Previous articles are viewable here:
On Economic Progress: Raising Standards of Living
On Economic Progress: Sustainable Capitalism & Bubbles
One particular concern that’s mentioned frequently is the notion of groups hoarding money. So let’s take a look at the economics behind hoarding. Universities are known to “hoard” endowment funds during recessions. Its also common to people assert that corporations are “hoarding” cash: "If only these misers were forced to consume, instead of save, the economy would recover!" - or so the narrative goes.
Now when people say “hoarding” they’re applying a value judgment to a value-neutral action. This is the issue of “Normative” versus “Positive Economics.” I’m going to give you the Positive Economics: the value free presentation of one major theory on how this works. You can decide for yourself what is “good” and “bad.” So from here on out, instead of “hoarding,” I will refer to this behavior as the demand to hold money.
First, we have to understand a couple motives for holding money:
- Transactions Demand for Money = This is the money people keep around for things they routinely buy. People buy groceries, firms pay their bills, therefore, each demands money to conduct those transactions. The econ abbreviation for this is TD, DMT or MDT
- Speculative (& Precautionary) Demand for Money = all that is earned is not spent in the same period. Sometimes agents choose to hold onto money today on the belief it is wiser to invest it in the future. (Or conversely they believe they're avoid a loss they would take if they invested it today). Other times agents hold onto a certain amount of money believing they could encounter unexpected future expenses… an “emergency slush fund” if you will. Speculative demand is abbreviated SD, DMS or MDS
EFFECTS OF INTEREST RATES ON MONEY DEMAND
The first thing to note in this theory is that when the interest rate goes down, the amount of money demanded goes up. In other words, low interest rate = more “hoarding.” That's because the "cost" of holding onto cash is the foregone interest you'd have instead earned. The reason why this happens is a little more confusing. I’m going to give you the explanation according to one of the 3 main schools of economic thought, Keynesian economics:
The speculative demand for money has a negative relationship with the prevailing interest rate. That means one goes the opposite direction of the other. So, if the current interest rate is considered “low” the market believes it will rise in the future more than it has risen previously. Those conditions also mean that bond prices are believed to fall in the future. (Bond prices share a negative relationship with the prevailing interest rate, which means they move in opposite directions to one another). That means it is more optimal for individuals to hold onto money right now than to invest in bonds because bond prices are expected to fall.
HOW INTEREST RATES ARE DETERMINED
Now let’s look at the role that the speculative demand for money plays in setting the current interest rate in the Keynesian system. This theory is called the Theory of Liquidity Preference, and originated in Chapter 13 of Keynes' General Theory. Not only does the speculative demand for money have a negative relationship with the interest rate, but it also plays a role in setting that rate because it is one of the two factors that set the market rate of interest:
- The speculative demand for money
- The amount of money (the money supply; MS)
Since we’re adding in money supply as well I’ll mention the impact it plays: if the money supply goes up, then the interest rate goes down.
Above I mentioned that if the market thinks the current interest rate is “low,” then it is bearish on bonds… meaning a “low” interest rate today is bad for bonds in the future (the term "bonds" is used broadly by Keynes to mean all less liquid assets so stocks and other time deposits in the money market). This is important because when you think about buying an investment your future expectations determine whether you buy that bond or keep your funds in cash. So when people are “bearish” on bonds they hold onto cash and there’s more money available in the money supply. See Figure 1 below. That shift means that investors want to hold onto more money at every possible interest rate, consumers want to spend more, and businesses will take out more loans for expansion. This is how the economy starts to get "over-heated" since production takes place at a time long after the money supply changed. This is not much different than the way artificially lowering interest rates pushes past the Production Possibility Frontier (shown here).
|Figure 1. Speculative demand along w/ amount of money determine the interest rate|
Think of it from a common sense perspective: if you need to borrow money and you’re having a hard time getting someone to lend to you then you’ll agree to pay a higher interest rate on the loan than you would if you had 20 offers from lenders. Think of it that way when you look at Figure 1. If there is $600MM of money available to circulate in the economy at a given point in time, and given the current speculative demand for money, then that tells us that the interest rate is going to be 2%. But, if that changed in the future and the money supply increased to $800MM that means there’s a larger pool of money that people are able to hold as speculative demands, but that money can only make it into idle cash balances if the interest rate is bid down (or bond prices are bid up). An influx of money into the system puts more money in people’s hands than what they wanted to hold onto before, and that implies they will then choose to invest that money, bid up the price of assets like bonds, and drive the interest rate down from 2% to 1% in response to the money supply increase from $600MM to $800MM.
ENTER THE FED
Below is Figure 2. It shows you what happens if the money supply stays the same, but the Central Bank sets the interest rate artificially low. In this case the amount of money demanded increases. Because there is no more money available consumers respond to this incentive by borrowing. When the Central Bank sets interest rates artificially low it makes it cheaper to borrow since loans & credit cards now have lower interest rates. It also makes the alternative, saving, less attractive because savings accounts now pay less interest. There are several other ways the Central Bank can create this exact same increased money supply shown in Figure 2:
|Figure 2: When the Fed pushes interest rates artificially low it fuels debt-drive over-consumption|
WHEN SPECULATIVE DEMAND TO HOLD MONEY INCREASES
Now to the other possible change: people become more bearish on bond prices. When that happens the money demand curve shifts right at every possible rate of interest. See Figure 3 below. This implies that individuals now hold onto more money for speculative purposes. Since the money supply remains constant the only way to satisfy this increasing need to hold speculative cash balances is through an increase in the rate of interest and a fall in bond prices.
ENTER BIG BROTHER
There's an awful lot of ways that a Central Bank influences this whole process. The Central Bank can create money out of thin air, and they do. The Central Bank can also force the interest rate artificially low, and they do that as well. However, the two main policy actions always parroted as a response to increased demand to hold money aren't, in any way, implied as legitimate responses to too much perceived "hoarding." Those being that neither deficit spending nor stimulus plans necessarily follow in response to existence of the demand for money. The policy action that does logically follow is to remove the Central Bank distortions (low interest rates, QE, etc) that impact this behavior.
Let's finish where we started.
Many like to vilify “hoarding” in a way to compare very rational time preferences & money demand to Scrooge the miser. Except that holding onto money, really withdrawing those funds from circulation, doesn’t harm anyone else. Even in a closed economy with a fixed money supply there is no harm created by agents holding idle cash balances. Therefore there certainly cannot be any harm in a fiat regime like ours where the Federal Reserve is always increasing the money supply. In fact, in recent years under Bush in 2001, 2008 and then Obama in 2009, we’ve seen government give people a lot of money to spend in the various demand-side fiscal stimulus like the tax-rebate checks in response to the Dot Com Bubble. Telling people to unhoard (AKA to spend) is easy; what's difficult is producing goods not consuming them. Consuming is easy. The only way to have more goods produced is to increase savings and reduce the proportion of funds used for consumption, and that means more "hoarding" not less.