Paul Krugman and Robin Wells' Approval of Money Manipulation

I am angry at my Macroeconomics textbook (Paul Krugman and Robin Wells, Second Edition).

In the Chapter 15 Appendix, "Reconciling the Two Models of the Interest Rate", the authors discuss how to reconcile the supposedly GDP-enhancing effects of lowering the interest rate in the money market (by way of increasing the money supply) with the "savings-investment spending identity" and the market for loanable funds as explained in previous chapters. Basically, they argue that when people can more easily get their hands on cash, they will both produce more and save more. They must try to give reasons for such an effect because of the savings-investment spending identity, which states that all investment spending in the economy must be backed up by an equal amount of savings.

Krugman and Wells' argument here is this: The Fed increases the money supply. The price of money, which is the interest rate, falls. Cheap loans lead to greater investment in capital. More is produced, which increases the Gross Domestic Product. An increase in GDP means an increase in household income means an increase in savings, and - voila - those are the savings that back up the original increase in investment.

Krugman and Wells argue that the amount of savings at the end of that chain effect will exactly equal the amount of original investment:

...when a fall in the interest rate leads to higher investment spending, the resulting increase in real GDP generates exactly enough additional savings to match the rise in investment spending.

But that is only in a perfect world. The book tells a story of investment leading to savings, but logically, savings comes before investment. The funds that are saved are the funds that are invested and the presence of savings is what determines whether or not it makes sense to invest. If there aren't a lot of saved-up funds, there is a reason for that. When your uncle goes broke, the next thing for him to do isn't to invest in the stock market, it's to get a stable job and start saving! Busts are what happen when we realize that we invested much more recklessly than our savings could ever have justified. Unfortunately when the Federal Reserve increases the money supply, the resulting decrease in the interest rate happens because the increase in inherently worthless cash actually succeeds in mimicking an increase in truly saved-up funds.

Increasing the money supply to lower the interest rate is a tricky way of installing a price ceiling in the money market. Instead of making a law that orange juice can't cost more than a dollar a glass, the government dilutes the orange juice with water up to the point that the price falls to one dollar a glass due to the perceived abundance. Of course the interest rate will fall if people perceive an abundance of savings at hand ready to be invested. The resulting increase in quantity demanded leads to a shortage of true funds. Price ceilings lead to shortages. And they also lead to inefficient allocation. In other words, early-bird shoppers who don't even like orange juice all that much end up buying it simply because it is too hot a deal to pass up, leaving less for those who value it highly.

The authors admit, at the end of the section, "our story about how a fall in the interest rate leads to a rise in aggregate output, which leads to a rise in savings, applies only to the short run" (the short run means the time before people catch on to the lie). However, he maintains that the short run effects are worth it. He justifies the action because the early-bird grocery shoppers, feeling like they got such a great deal, end up spending more on other items as a result. What he ignores is that the increased spending is a direct result of consumers being tricked into acting against their better judgment. And when individuals spend and invest against their better judgment, there is actually a painful long-term effect: the economic bubble and its inevitable burst.

Thomas E. Woods has written a clear, concise article explaining the immorality and inefficiency of expansionary monetary policy titled "Money and Morality: The Christian Moral Tradition and the Best Monetary Regime".

Visit Krugman's blog: "The Conscience of a Liberal"