Mankiw's Error or Why Are Harvard Graduate Students So Dumb?

First, let me point out that when I teach Principles of Microeconomics to freshmen, I use Greg Mankiw's book. It is a great educational tool.

On Saturday, Professor Mankiw wrote this in the New York Times:

"At one of my recent Harvard seminars, a graduate student proposed a clever scheme to [make holding money less attractive]... Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent."

For now I'll ignore the bigger picture of Mankiw's grand scheme. Almost always, it is in the details where importance finds its home.

Money exists because its existence reduces transaction costs. Thus ends the list of fundamental functions of money.

Now, I am not trying to pretend that money does not serve other purposes. It is used, for example, as a store of wealth and as a unit for accounting. But, every society that has ever decided to invent or adopt money (every successful society has) has done so for one reason: It is less expensive* to trade with money as a medium of exchange than not to. Other functions of money, including those listed above, are ancillary.

Let us say that you work at a pasta making company. Any job - accountant, buyer, farmer, laborer, secretary, CEO - it doesn't matter. Without money, you would have to paid in the firm's output - pasta. So if you want to consume something other than pasta - say, a house - you must trade pasta for that house. Or if the builder doesn't want pasta, you trade pasta for, say, a piece of land in Nevada. Then give the Nevada land to the builder in exchange for the house.

We can all see how quickly this barter system could get very complicated. It would suck away from all of us our greatest resource - time. A great many trades that would benefit both buyer and seller would not happen under this system because the time cost of finding trading partners would exceed the potential benefits.

Enter money. Money alleviates the need to find trading partners that match perfectly with me. If I produce pasta and I want a cup of coffee, I give Starbucks 2 dollars for a cup of coffee. I need not worry if the owners of Starbucks want my pasta. Because money is universally accepted, it can always serve on one side of every transaction. Not to overstate things, this massively reduces transaction costs.

Back to Mankiw's graduate student. This proposal takes the clear benefit of money and REDUCES it. And that is only the beginning. Under this proposal, the sellers of goods would have to examine closely every bill that is paid to them. Any bill that contains the 'selected digit' would be worthless. There are other problems.

First, under this policy, the expected value of every piece of U.S. currency would be 90% of face value. Or would it?

Actually the expected value would be much lower. Once the Fed adopts this policy people would expect a similar thing to happen again. Perhaps once a year. There are many digits in the serial number of a 20-dollar bill.

If the expected value (that is, the future value at some specific time - in this case, the date of the FED policy enactment) of money declines, what happens to the present value of money? It declines as well. If the value of money declines, sellers must receive more of it, so prices will rise.

This is Mankiw's error. We at Life At The Margin, though educated at lesser institutions than Harvard, are shocked that Dr. Mankiw fails to recognize that the MOST important attribute of money is its present value. Money can serve its function as a medium of exchange only if sellers are confident that they can exchange that money for something of tangible value.

The chain of events gets uglier from there. Not all money is currency, so not all money is affected by this policy. People would rush to get rid of cash. They might buy some gold. They might buy goods and services. They might just put it into the bank. The banks would rush to turn cash in to the Fed in exchange for electronic money and the vaults would empty. Ultimately, all cash would go out of circulation. Hardly the intended result.

The policy is also unconstitutional since it expropriates wealth without due process.

Greg Mankiw is a professor of Economics at the top Economics department in the world. It is not his job to take a graduate student's ridiculous idea and put it in The Times; it is his job to encourage the student's creativity, then point out the massive flaws in his thinking.

But, to my dismay, Mankiw's misunderstanding of Economics runs deeper than this. Let's return to the big picture. He likes this policy because it enables another - making nominal interest rates negative. Mankiw believes that negative interest rates will discourage saving - about that, he is right. He also thinks that reduced saving will bring us out of recession. Oh what a tangled web.

Mankiw writes, "recessions result from an insufficient demand for goods and services."

But there is no such thing as an insufficient demand for goods and services. Recessions happen when the aggregate cost of producing goods and services exceeds people's willingness to pay for them. That is our current condition. It can only persist if demand is artificially preserved.

Ask yourself this question: Do I consume because it gives me a reason to work or do I work because it gives me the means to consume?

The answer is no different for the macroeconomy. Production enables consumption. There is no other way. Mankiw wants interest rates to be low because that effectively means "free money." He wants people to consume even if they do not produce.

Because foreigners are willing to lend to us in the short run, we have "learned" that consuming more than we produce is possible. But the defining characteristic of the short run is that it ends, and in the long run supply must equal demand. Mankiw's clever tricks cannot change that.

Let's allow interest rates to adjust to their natural place. For now, that means much higher. Only then will we go through, and thus get through, the proper recession.

*Less expensive means "requires fewer resources"