Interest Rates, the Money Supply, and Say’s Law

Andy Kessler at the Wall Street Journal wrote an interesting column about the perils of stimulating demand in a supply-constrained environment. He argues, correctly, that expansionary monetary policy is more likely to create inflation when the economy’s supply side is flagging. He exaggerates, however, the power the Federal Reserve (and by extension any central bank) has over global capital markets. He also fails to connect Say’s Law to the unique conditions that cause aggregate demand instability.

Mr. Kessler begins with the low-interest-rate environment over the past decade. “Since the fall of 2008, with a brief respite in 2019, the real federal-funds rate has been negative, meaning interest rates have been below inflation,” he writes. But it stretches credulity to contend that the Fed kept interest rates below normal levels for more than a decade. 

It’s true that central banks can create short-run deviations in market interest rates from their natural (market-clearing) levels. If the Fed conducts expansionary policy via open-market operations, its asset purchases increase the supply of loanable funds, lowering the interest rate. Now, of course, the Fed primarily uses interest on reserves, rather than open-market operations, to influence rates. The feedback mechanism here isn’t as strong, since IOR is an administered rate. Yet even here, the Fed’s power is circumscribed. Set IOR too high and remittances to the Treasury fall, making politicians grumpy. There are also a host of global asset classes that are largely insensitive to the fed funds rate, meaning they are largely insulated from most interest rate policies.

The problem isn’t so much with interest rates as money growth. From March 2020 to 2022, the M2 money supply grew by a whopping 33 percent. Divisia M3 and M4 grew almost as much: 28 and 29 percent, respectively. These latter measures weigh the components of the money supply by their liquidity services (basically, how “money-like” markets perceive them to be), making them a particularly useful indicator of broad monetary conditions. These money-supply increases far outpaced money-demand increases. Result: the worst inflation in 40 years.

Astonishingly, Kessler does not once mention the money supply. His focus is entirely on interest rates. He misses an opportunity to land a knockout punch when he makes the otherwise-sensible decision to use Say’s Law. Contra Kessler (and many economists), Say’s Law does not say, “Supply creates its own demand.” Instead, it says, “Supply of Good X indicates demand for goods Not-X.” A cobbler’s supply of shoes reflects his demand for food, clothing, shelter, and myriad other goods. But it reflects only weakly, if at all, his demand for shoes and close substitutes for shoes.

This matters, because Say’s Law, rightly understood, demonstrates the incoherence of general overproduction (or underconsumption). If markets are supplying too much of one good, they must be supplying not enough of other goods. What we think of as an aggregate demand shortfall (nominal GDP falling below its trend growth rate) is not an exception to Say’s Law, but a further illustration. You can only have falling demand in the aggregate if there is an excess demand for money itself! Total spending shortfalls happen when everyone in the economy is trying to stock up on money or money-substitutes.

So what happens when there’s an excess supply of money? If the central bank shovels liquidity into the economy, Says’ Law tells us an excess demand for all other goods and services will quickly follow. That’s going to boost all prices at once — in other words, ratchet up inflation. Say’s Law absolutely helps us understand booms and busts on the demand side, but because of its emphasis on money, not interest rates.

I agree with Mr. Kessler on the importance of putting the supply-side first. I also think many of the economic problems he identifies at the end of his article are spot-on: “Public-sector unions are too powerful. Companies have social-justice handcuffs. Merit is moot. Regulations are wrapping green tape over red tape: alternative-energy requirements, water restrictions, electric-vehicle subsidies, windfall-profit taxes, and years to obtain permits. These are all deadweights.” Just so. But we need to keep an eye on supply and demand both to understand the aggregate implications of all this. Interest rates alone won’t cut it.

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