Twentieth Installment
Credit and Productivity
"Price rigidity" behind the disappearance of money
The New Keynesian Model founded on price rigidity proved ineffective in analyzing the financial crisis. While the neo-classical model considers the Friedman Rule--a policy of setting the nominal interest rate at zero, i.e., a zero interest rate policy--to be the optimal monetary policy at all times, this diverges from actual monetary policy practice. In this article, I would like to address this issue by making some notes on the issue of credit and productivity.
The logic behind the proposition of the neutrality of money is that credit money disappears because of a financial crisis, and that nothing would change in the real economy by a halving of the volume of money if price levels also fell to half; consequently, changes to the quantity of money have almost no impact on the real economy when prices are extremely flexible. If the neutrality proposition of money is correct, it naturally follows that price rigidity explains why the disappearance of money had an impact on the real economy. This logic presupposes that credit money and cash money fulfill exactly the same function. Is this view indeed correct?
Cash and credit money (bank deposits, etc.) are certainly equivalents in the sense that they both function as mediums of exchange for goods. Nevertheless, goods exchanged for cash (cash goods) and goods exchanged via credit money (credit goods) differ in nature, and this difference seems to have been given very little consideration in the world of monetary theory.
Put simply, goods exchanged for cash are commodities produced concurrently with the customer's arrival, at which time an immediate exchange of the goods for cash takes place. As the production of order-made goods must await an advance order from the customer, a credit transaction, however, is inevitably required, as the producer must buy the raw materials and produce the goods before receiving payment from the customer. Lunch served for cash payment at a local diner is a standardized ready-made product, whereas a full-course French meal prepared in advance according to the customer's tastes can be called a good traded on credit.
In other words, the difference in transaction format between cash transactions and credit transactions could alter options in the production process of goods and modify productivity. (Interpreting the difference in monetary format between cash and credit money as the difference in transaction format between cash transactions and credit transactions is somewhat of a theoretical leap but, as it is not a fatal problem, I will use this interpretation to proceed with the discussion.) Though this fact had not been discussed in monetary theory, it is an extremely important problem in real-world economics.
Monetary theory models assume that all goods are ready-made goods, and that exchanges of goods and money can be carried out immediately upon the arrival of a customer. Order-made production, in which there is a significant time lag between the customer's order and delivery of the final goods, is excluded by supposition from these models. In an economy in which only ready-made goods exist, the productivity of goods is the same regardless of transaction format, be it cash transaction or credit transaction.
Loss of credit causes economies to suffer in financial crises
Let us say that a financial crisis has occurred in such an economy. As has been argued in this series of articles, a financial crisis can be viewed as a situation in which large quantities of toxic assets have emerged in asset markets as a result of a bubble bursting, the provision of credit has become difficult due to the asymmetry of information (the lemon market problem) among other factors, and credit money has disappeared. If the productivity of credit goods and cash goods is the same, then the productivity of goods would not change even if credit money were to disappear due to the financial crisis (this is inextricably linked to the decline in credit transactions). Consequently, if there is no price rigidity, then the real economy is unaffected, leading to the conclusion of the "neutrality of money."
Unlike goods in cash transactions (cash goods), though, goods in credit transactions (credit goods) are created in response to customers' orders in a time-consuming production process and, if their productivity is also deemed higher, "the neutrality of money" no longer holds. If credit declines during a financial crisis, credit goods can no longer be produced and will be replaced by cash goods. If the productivity of credit goods is higher than that of cash goods, the outbreak of a financial crisis will cause the productivity of the economy as a whole to drop. When this happens, the real economy will deteriorate even if prices are not rigid. The production of credit goods will not recover and cash goods will increase despite price flexibility.
If the supposition is correct that the transaction format changes the productivity of goods, then it is apparent that monetary policy (an increase in money supply) alone is not a sufficient countermeasure in a financial crisis. If credit transactions cannot be carried out in the financial crisis, then the economy's productivity will fall because the production of credit goods is not possible. Even if the supply of cash is increased via monetary policy in response, this will not resolve the asymmetry of information and other issues; credit transactions will not recover nor will the production of credit goods.
The increase in the supply of cash will only boost the demand for cash goods with low productivity. Consequently, increasing cash money during a financial crisis cannot improve the productivity of the economy as a whole nor can it restore the economy to its ordinary state.
I believe that meticulous research is needed on the relationship between the interposition of credit in transactions and the production process for goods.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the the January 18, 2010 issue of Kinzai Financial Weekly
