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Wednesday, June 12, 2013

George Selgin on Deflation

An interesting and stimulating talk here by George Selgin at the Adam Smith Institute, called “Could Deflation be Salvation?”





Some comments:
(1) The idea of steep price falls and perhaps general deflation this century owing to strong productivity growth is not unrealistic.

Now Selgin makes the case for “good” and “bad” deflation. But is the so-called “good” deflation really good? Specific price falls in individual goods (but not general deflation) that occur from productivity growth are no doubt a good thing. But even here it does not follow that general price deflation, even when solely from productivity growth, is a good thing.

The idea that, since the price fall of an individual good from productivity growth is positive, then general price deflation from the same cause will be positive as well is a fallacy of composition, despite Selgin’s protestations that it is not (from 13.20). It fails to consider the macroeconomic effects of general price deflation, and, above all, debt deflation. This issue is very briefly touched on at 13.05–13.20 and 38.23–40.20. However, I do not see any strong counterargument against the debt deflation objection. What is being assumed is that deflation from productivity growth will not result in involuntary unemployment and downward pressure on wages (see (4) below).

Strangely, Selgin defends by his position by accusing his opponents of being guilty of a “vast reverse fallacy of composition,” whatever this means.

(2) On the so-called Great Depression of 1873 to 1896, I agree it was not a depression in the conventional sense (see Capie and Wood 1997; Saul 1985). It was a period of several businesses cycles, and certainly real GDP in all nations was higher in 1896 than in 1873. Selgin argues that these 19th century periods of deflation from productivity growth were not “harmful,” and that “nobody back” in that century was aware of a depression from 1873 to 1896. While one can recognise that there is a kind of myth about 1873 to 1896, nevertheless I think that these claims are doubtful. I dispute that nobody then thought there was any kind of economic crisis in these years. There was concern from various groups in the years from 1873 to 1896: business people who saw their profits fall, European farmers who saw a real depression (Capie and Wood 1997: 188), and debtors hit by debt deflation.

On the specific economics problems of the 1870s and 1890s, see here:
“US Unemployment in the 1890s,” January 24, 2012.

“US Unemployment, 1869–1899,” January 26, 2012.

“Per Capita GDP Growth Rates During the Gold Standard Era,” September 11, 2012.

“Rothbard on the US Economy in the 1870s: A Critique,” September 24, 2012.
(3) But if the price reductions from productivity growth are not of the type that cause significant falls in the need for labour (unlikely, in my view), then that can only put strong downward pressure on wages as profit margins are squeezed. Selgin denies this (from 15.15) and protests that he is not advocating wage deflation.

But, if wages are cut, then that would induce debt deflation pressures, as the real burden of nominally fixed debts soars.

Even if one wants to assume that there are no really no wage falls, then we still have (4) below.

(4) Alternatively, and more likely, if the productivity growth causes sharp falls in the need for labour and serious unemployment, then, despite the prices falls, involuntary unemployment will result in an aggregate demand problem. Moreover, debt deflation is still a problem for the unemployed, even assuming the employed face no wage reductions. A market economy does not automatically adjust to full employment, and there is no reason to think that large-scale structural unemployment would not cause macroeconomic problems.


BIBLIOGRAPHY
Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia. Garland Pub., New York, 287–289.

Saul, S. B. 1985. The Myth of the Great Depression, 1873–1896 (2nd edn.). Macmillan, London.

31 comments:

  1. By Fisher's equation, deflation adds to the real interest rate: r=((1+i)/(1-Deflation))-1
    It's hard to argue then that deflation is beneficial for society since it makes it more costly in real terms to get credit for doing business. It is even disruptive: it encourages producers to wait and hold onto money, but is impossible for anyone in the supply chain to wait and get richer.

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  2. With all due respect, Daniel, I don't believe that you effectively engage here my arguments for productivity-driven deflation. My remarks to follow explain why.

    "Specific price falls in individual goods (but not general deflation) that occur from productivity growth are no doubt a good thing. But even here it does not follow that general price deflation, even when solely from productivity growth, is a good thing." By posing the matter so, you obscure the crucial questions, to wit: "If the productivity of even just one industry improves, with none suffering equal set-backs, why is it then not desirable that a general index of output prices should itself be allowed to decline? Why, in other words, should the monetary authority take steps such as will force compensating price increases sufficient to keep the index steady?" and "What danger is there in allowing many output prices to decline simultaneously, and hence in allowing a general index of such prices to decline, when productivity in advancing in many industries at once?"

    "I do not see any strong counterargument against the debt deflation objection." You may not see it, but I made it, and make it at greater length in my pamphlet. The argument is simply this: that whereas in the case of unanticipated "bad" deflation it is a simple matter to show that under perfect foresight contracts would have allowed for lower nominal rates than those written for under static P expectations, that's not so in the case of unexpected "good" deflation, for the simple reason that in the latter case the unexpected decline in P has as its precise counterpart a corresponding improvement in the real return to investment. The perfect foresight nominal rate would therefore not differ from the static-expectations rate. Fisher himself understood this.

    (Continued in further post.)

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    1. Quote: "The argument is simply this: that whereas in the case of unanticipated "bad" deflation it is a simple matter to show that under perfect foresight contracts would have allowed for lower nominal rates than those written for under static P expectations, that's not so in the case of unexpected "good" deflation, for the simple reason that in the latter case the unexpected decline in P has as its precise counterpart a corresponding improvement in the real return to investment."


      So you are saying that a decline in real output pricing must always equal to the increase real return investment?

      Why? By what means?

      I'm not seeing an argument just statements. It doesn't make any sense.

      The price I'm getting for selling per good in a deflation is less for every new unit of production so why would I want to invest in diminishing returns?

      Don't say increased volume. Volume doesn't matter in aggregate because the supply of the currency for use in sales is smaller.

      By what means do I make up the nominal rate of loss per unit when everyone else is trying to do the same thing?

      Deflation is contracting the amount of money used for the process of selling and thus making decreases in prices necessary.

      How does one increase nominal profits when there is less nominal currency is available to make said profits in nominal terms?

      How does one become more able to pay back debt since debt is by definition is priced according the nominal price not it's current value in real terms when it is more scarce due to deflation?

      By whats means does deflation make it easier to aquire a more scare good i.e. the currency?

      And how is fair to make everyone pay for old debts when the value of what is repaid greatly exceeds the value in real terms of the loan+ interest at the time of the loan in real terms?

      How is that not unearned rent on the productivity of others? How does that not centralized all the wealth?

      The Austrian School promotes fraud and thievery.

      I haven't even gone into the information theory/thermodynamics of your claims that increasing efficiency in production generates less need for units recording information transfer for every exchange.

      You have no arguments. You are an evil man working for those who are stealing from the work of others.

      Bill Mitchell has destroyed your so-called arguments in a recent post showing that wages fall without regard to productivity directly in line with rate of debt deflation in the private sector enabled by the public deficit.

      An increase in real rate of investment has nothing to do with a decrease in the cost of production for the firm or a decrease in the price of goods it sells.

      If it did then Brits would be experiencing the highest returns on investment right now with high employment given they are largest fall in real wages since records began. People should be banging down the doors to outsource to Britain to take advantage of the expected continuation in wage deflation according to the Austrian theory that productivity efficiency in nominal costs always equals the real rate of investment.

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  3. (Continued from previous post.)

    "Selgin defends by his position by accusing his opponents of being guilty of a “vast reverse fallacy of composition,” whatever this means." A "reverse fallacy of composition" is just what it sounds like, namely, an instance in which someone claims that something true for part or parts of a whole is not therefore true for the whole, when in fact it is. Your own arguments fit this description, notwithstanding your attempt to argue that productivity driven deflation results in the same hardship to debtors as the other sort.

    "There was concern from various groups in the years from 1873 to 1896." I conceded as much in my talk, and do so at greater length in my pamphlet. (My suggestion in the talk that everyone was too busy shopoping to have been depressed was of course a rhetorical exaggeration--an unwise one, in retrospect.) But the gist of my argument, which is simply that economists are mistaken in assuming that deflation necessarily implies depression, remains entirely unaffected by the points you emphasize. For more on the basis point see Kehoe and Atkeson.

    "But if the price reductions from productivity growth are not of the type that cause significant falls in the need for labour (unlikely, in my view), then that can only put strong downward pressure on wages as profit margins are squeezed. Selgin denies this (from 15.15) and protests that he is not advocating wage deflation." Of course I must deny it, because it is true by virtue of my definition of "good" deflation, as deflation at a rate equal to but never exceeding the rate of productivity growth. Such growth implies corresponding growth in equilibrium real wages. Under a labor productivity norm this means that w/P grows a rate reflecting labor productivity growth. Since P deflates at that rate, w is constant. (Under a TFP norm the matter is somewhat more complicated, but in practice the tendency in that case is for slight wage rate inflation. I spell all this out in the appendix to Less Than Zero.)

    "Alternatively, and more likely, if the productivity growth causes sharp falls in the need for labour and serious unemployment, then, despite the prices falls, involuntary unemployment will result in an aggregate demand problem." (1) The Luddite assumption that productivity improvements generate unemployment is
    unwarranted;(2) the suggestion that productivity-norm deflation can lead to an "aggregate demand problem" displays a fundamental misunderstanding of what such a norm entail, for it is nothing other than a particular prescription for AD stabilization, the only difference between it and MM prescriptions being that, while they would allow for an NGDP growth of 4-5%, it calls for a rate not exceeding the average growth rate of weighted factor input, that is, 2-3%.

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    1. Thanks very much for the comments.

      If I have really not properly engaged your "arguments for productivity-driven deflation," then indeed I need to do better.

      First, however, are you willing to agree that if (and I do stress "if"), hypothetically, there are downward movements in wages when these productivity-driven deflation episodes occur, then the debt deflation concerns seems a reasonable one, if debts remain nominally fixed?

      Here is not just that (1) debtors repay debt in money of higher value in purchasing power terms, but (2) with falling wages/income the burden of the debt as a percentage of income soars too.

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    2. I'm very aware of the danger implicit in any policy that calls for falling nominal wage rates. But the policy I call for generally rules out deflation in excess of the rate at which real wages progress. So it is begging the question to speak of wages (or nominal incomes) falling in response to productivity-driven deflation--to do so is to overlook a crucial difference between such deflation and the demand-driven sort.

      Also, because under a productivity norm real debt burdens only increase pari passu with real income, such deflation does not increase debt burdens expressed as a percentage of income.

      To repeat what is, after all, an absolutely crucial point, under a productivity norm AD is kept stable. A productivity norm IS a stable NGDP rule, albeit one that involves a lower tend NGDP growth rate than that favored by most Market

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  4. Sorry, Lord Keynes--I wrote "Daniel" by mistake, having also replied to Daniel Kuehn's post a moment earlier. If you can correct the mistake I will be much obliged.

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    1. No problems. Though I can't actually edit comments, this comment will explain it to readers.

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  5. Roman P., I don't find the argument "hard" to make at all, and I make in several places, including in my reply to LK above. As I said, Fisher himself recognizes the difference that productivity growth makes; in essence, such growth increases the _real_ (natural) equilibrium rate, other things equal, and does so regardless of monetary policy. In other words, credit is bound to cost more. You suggestion that it is the productivity-norm policy rather than the change in productivity growth itself that is responsible for a higher real rate is therefore quite mistaken: raise the equilibrium rate of inflation all you like, the real rate will stay the same, except that it will now take the form of a higher nominal rate.

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  6. "Why, in other words, should the monetary authority take steps such as will force compensating price increases sufficient to keep the index steady?"

    The only thing the central bank can really do to try and raise nominal prices is to lower interest rates in the hope that people will choose to borrow, invest and spend more. It can't 'force' price increases to occur.

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  7. y.

    There has never been an example in history of a determined central bank or Treasury that has its own currency and has failed to inflate. Your suggestion is tantamount to the idea that the Fed could buy the entire national debt, private debt, and municipal debt, in other words, the entire bond market, all 50 trillion, and barely nudge the CPI. if that were the case, we should still do it, as it will remove the debt burden.

    Obviously I am being facetious, but you see whats going on, and the weakness of the hyper Keynesian, liquidity trap position?

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  8. LK,


    I can only re-state what Mr. Selgin has said, because he's a smarter man than I am. Nevertheless, one or two more points.

    1. There is no reason whatsoever to expect that nominal profits, in addition to nominal wages, will ever fall under productivity deflation. Selgin's rule takes care of that. Its similar to a nominal gdp target, which allows prices to deflate in a productivity surge. Imagine if nominal profits and incomes were to rise in tandem by 2-3%. But further price decreases of two and three percent occur. Real wage growth and profit growth would be much higher.

    2. Debt deflation only occurs when nominal wages fall. Since they wont fall, it won't occur. (Unless there is a shock, and then the central bank level targets its way out of it. Then fiscal or monetary stimulus is warranted. Its because of NGDP, no the price level, which is hopelessly inaccurate

    3.Increasing technology will lessen the demand for labor? Not likely overall. What it will do is INCREASE the premium that skilled labor has over unskilled. I heard something about the internet, starting in the 90's saying that for every job it killed, it created 2.6.

    4. Might people hoard cash to anticipate falling prices? They might, but it will just be like higher interest rates in a boom. Interest rates were higher in the 90's boom, and the stock market surged above it it. people will invest because they want to earn a return ABOVE the rate of expected deflation.

    5. Liquidity preference might be higher. Wouldn't that be a good thing in moderation? If a recession is by definition an abnormally high demand for cash, shouldn't a bubble be an abnormally low demand for it. Having cash would be a cushion for businesses and workers in the event of a bubble bursting.

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  9. I heard that recently Japan's NGDP grew by 3.5 percent, but prices fell by 0.5% Since income by definition equals expenditure, shouldn't that tell you that Japanese incomes (both companies and workers, and they made up for price falls through increased productivity) rose by 3.5% while prices FELL? Who WOULDN't want that. Good deflation is heaven

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  10. Lord Keynes
    "There was concern from various groups in the years from 1873 to 1896: business people who saw their profits fall" That is true. Businesses were fed up as profits were flowing to labour and not capital. There is of course a zero sum game here hence a Royal Commission (1885) was set up to look into the so called Great depression. Alfred Marshall's evidence was revealing. "A depression of prices, a depression of interest, and a depression of profits; there is that undoubtedly. I cannot see any reason for believing that there is any considerable depression in any other respect." Your argument is therefore rather curious for a social democrat as you are in essence supporting the argument that returns should go to capital at the expense of labour. This is what is happening today and one reason why equity markets are so buoyant as argued by Gavyn Davies in the FT this week (rising share of profits are going to capital and not labour). I suggest you go and take a look at the recent work done on Richer Hecksher Ohlin models on wages. The general downward pressure on nominal wages means that in an increasingly globalised economy real wages are going to rise by falling prices.

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    1. "Your argument is therefore rather curious for a social democrat as you are in essence supporting the argument that returns should go to capital at the expense of labour."

      Not at the cost of causing deep business anxiety or depressed expectations. If business expectations become depressed and pessimistic, then that will likely have an adverse effect on the aggregate level of investment, which can only mean a high level of unemployment and reduced growth -- hurting labour.

      In particular, the 1870s and 1890s were periods of recession, economic crisis and stagnation during this period of deflation from 1873-1896:

      http://socialdemocracy21stcentury.blogspot.com/2012/09/rothbard-on-us-economy-in-1870s.html

      http://socialdemocracy21stcentury.blogspot.com/2012/01/us-unemployment-in-1890s.html

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    2. I've mainly looked at UK data where investment continued throughout the period without much change in the rate of unemployment. So its' difficult to equate this scenario to an "economic crisis". Sure there are always debates on data quality going back that far and Ive seen criticism of Gordon's data from Alex Field. That said, I think it pays to look at the accounts of contemporary economists such as Marshall. His successor Pigou in fact argued that a depression set in during this period when prices started rising. Why? Real incomes fell.

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    3. "I've mainly looked at UK data where investment continued throughout the period without much change in the rate of unemployment."

      I beg to differ on UK unemployment in the 1873-1896 period:

      http://socialdemocracy21stcentury.blogspot.com/2013/06/alfred-marshalls-judgement-on.html

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    4. If you take a look at table 4 in Hatton's 2002 paper it shows average unemployment rate between 1871 - 1891 was 5.48% and between 1892-1913 was higher at 6.18%. Labour productivity figures were higher during the "Great Depression" at 1.07% vs 0.77% during 1892-1913. Also the bank of England has a series on real GDP growth that is useful. If you take the average real GDP growth rate of each decade you get:
      1850s = 2.02%
      1860s = 1.84%
      1870s = 1.92%
      1880s = 2.43%
      1890s = 2.24%
      1900s = 0.99%

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    5. OK, if by "Hatton's 2002 paper" you mean George R. Boyer and Timothy J. Hatton. 2002. “New Estimates of British Unemployment, 1870–1913,” The Journal of Economic History 62.3: 643–667, then I am confused.

      Table 4 on p. 662 in Boyer and Hatton (2002) shows "British unemployment rates, 1870-1931: Four variants and the Board of Trade Index", but no averages. In any case, the contemporary Board of Trade Index (created from 1888) was not complete, and the adjusted figures of Boyer and Hatton are higher (as they say on p. 669).

      Table 5 on p. 663 shows some averages, but they do not match the ones you cite.

      On GDP, I use Angus Maddison, 2003. The World Economy: Historical Statistics. OECD Publishing, Paris. p. 47, but here I do not think GDP figures show you the full picture without also looking at unemployment.

      In any case, my new post gives direct citation of Boyer and Hatton (2002)'s estimates for unemployment.

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    6. Here is the link to the Hatton paper which I think he published after the Hatton Boyer paper as it cites Hatton Boyer as the source but he does calculate the averages for what its worth.

      http://homepages.strath.ac.uk/~hbs00107/public_html/docs/31220%20Hatton_Unemployment%20and%20the%20Labour%20Market,1870%20to%201939.pdf

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  11. Lord Keynes
    "Alternatively, and more likely, if the productivity growth causes sharp falls in the need for labour and serious unemployment, then, despite the prices falls, involuntary unemployment will result in an aggregate demand problem."
    Not sure why you would think that rising productivity growth and rising real wages would have no impact on increasing AD and hence employment.One potential issue might be that firms' expectations of deflation jumps might lead to cut backs in production leading to rising unemployment. However as the greatest social democrat economist, Gunnar Myrdal, said significant price movements in both directions must be avoided. Myrdal like the rest of the Stockholm school all supported the productivity norm. They were the first 21st century social democrats.

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  12. "Myrdal like the rest of the Stockholm school all supported the productivity norm." Well, Cassel and Wicksell were (very important) exceptions.

    I can't help adding that the very thoughtful comments make we wish that more social democrats would visit Freebanking.org!

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  13. @George Selgin
    Maybe I got your argument wrong, but it seems to me the productivity norm posits that as prices fall, people will buy more in terms of quantity, to keep the level of nominal spending stable. Now, I accept the the argument that people will postpone spending to benefit from future price falls is far-fetched, but why do you think people will not only keep on spending as they used (in terms of quantity purchased) but actually increase their consumption in response to falling prices. That is to say, what happens to your predictions if people just consumer the same quantities as before?

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    1. Paolo Siciliani: as the norm calls for having P decline only to an extent corresponding to that by which enhanced productivity results in an increase in output (y), it makes the product Py invariant to such output changes. It follows logically that as prices decline more goods (in the sense meaning a larger real quantity) are purchased. Any tendency for aggregate spending (Py) to decline would not be consistent with the norm, and hence would call for more monetary expansion.

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  14. Monetary expansion to, presumably, increase prices. In the meantime, I presume there is the risk for unemployment to rise (i.e., since firms could produce the same aggregate 'quantity' more productively), which might ultimately ignite a depressing spiral, one could argue.

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    1. Not "to increase prices" but to prevent them from declining further than the productivity-norm rule calls for. And firms are obviously not producing the same aggregate _real_ quantity when productivity rises. (I hope we can agree to stick to reasoning consistent with the equation of exchange.) So I cannot see what the employment issue is here, or how it leads to any sort of "spiral."

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  15. Ok, let's try again. Monetary expansion to keep prices from declining further than the productivity norm call for means that if people consume the same quantity of output, in spite of the technical ability to produce more at the same cost, price ought to increase to keep nominal spending costant (as disctated by the productivity norm)?
    Now, that will take some time I suppose, as any monetary expansion has a time lag, right? So in the meantime, is there not a risk that firms might react to the lack of volume increase (in spite of falling prices) by reducing capacities? In that case I presume, unemployment will rise, otherwise productivity will fall due to labvour hoarding. Hence the risk of a spiral. Hope this makes sense.

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  16. "Ok, let's try again. Monetary expansion to keep prices from declining further than the productivity norm call for means that if people consume the same quantity of output, in spite of the technical ability to produce more at the same cost, price ought to increase to keep nominal spending constant (as disctated by the productivity norm)?" I'm sorry, Paolo, but I still don't get your argument. If y is increasing (_ex hypothesi_) and policy is such as Py is kept stable (ditto), P must surely _decline_; this ios indeed the very meaning of a "productivity norm." Yet you continue to insist on the need for p (or "price" in the quoted passage) to _increase_. Surely there is some confusion here. I do not think it is mine.

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  17. Last attempt.Your entire edifice is reliant on the following: y is increasing (_ex hypothesi_). If this doesn't occur - because people keep consuming the same quantities notwithstanding falling prices - your norm would require monetary expansion to keep Py stable (ditto) - hence, P must surely increase.
    Now, the problem with your proposition is that although your rule is automatic - to keep Py costant - monetary expansion will only be triggered when evidence that y is costant emerges. This plus the normal time lag of monetary expansion means that there is a risk that firms would react to constant y by downsizing to maintain higher productivity - otherwise they would have to hoard labour which would nullify the increase in productivity.
    The resulting increase in unemployement might trigger a depressive spiral.
    In short, it is fair enough to dismiss the argument that people will stop/postpone consumption in response to falling prices, but to argue that, instead, people will consumer more in terms of quantities (rather than save)is equally far-fetched, hence not a sound basis to advocate for a radical shift in monetary policy.

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  18. Edward,

    "Your suggestion is tantamount to the idea that the Fed could buy the entire national debt, private debt, and municipal debt, in other words, the entire bond market, all 50 trillion, and barely nudge the CPI".

    That's called lowering interest rates "...in the hope that people will choose to borrow, invest and spend more".

    I'm not sure it's legally permitted to do what you suggest though.

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  19. Dear Lord Keynes,

    How about we engage in a theoretical experiment: start from a equilibrated economy with everything staying the same. No growth, no price changes, all the revenues rebuilt the beginning conditions. Now imagine we have a computer innovation, which is recognized by many. Production becomes higher, therefore with supply effects producers are going to have more goods at their hands. They decide to lower their prices, just like computer and cell phone producers do. They still employ lots of people, and they still witness very high rates of profits.

    Please, please, explain to me how this can be harmful (debt re-payment is actually working perfectly).

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