Congratulations to Scott Sumner (who teaches economics at Bentley University, Mass) for explaining the so called “hot potato” effect. The hot potato effect is a phenomenally simple and obvious idea, though it seems to be beyond the comprehension of many so called professional economists.
I’ll explain the HP effect, using about one tenth the number of words used by Scott Sumner.
Let’s start with the very simple and blindingly obvious point that if you give someone a bundle of money, they’re likely to spend a significant chunk of it.
Not too difficult that, is it?
Next, let’s move up the macroeconomic level and assume that EVERYONE is given a bundle of freshly printed £20 notes or $100 bills. The result is that EVERYONE will try to spend some of their newly acquired money. If the economy has sufficient spare capacity, the result will be increased output rather than increased inflation. Conversely, if the economy is at capacity, the result will just be inflation.
The phrase “hot potato” results from the fact that it is impossible to get rid of money: i.e. if I spend money, someone else must be a recipient. At least that’s true of monetary base. Or to be accurate, it’s impossible for the private sector to get rid of monetary base: it can only be disposed of if the government / central bank machine DECIDES to reduce the amount of monetary base.
Commercial bank created money is different: when someone repays a debt to a commercial bank, money is destroyed. But the £20 notes and $100 bills mentioned above are base, not “commercial”, so base money has the hot potato characteristic.
And that’s it. Not difficult is it?
My only criticism of Sumner’s article is his final and completely ridiculous sentence where he says “I think I see a few MMTers in the ditch along the way, still scratching their heads.”
The reality is that the HP effect has been inherent to MMT for a long time. MMTers refer over and again to what they call “private sector net financial assets”, a phrase which means what it says. And one of the few ways of altering PSNFA is to have the government / central bank machine create new money and spend it into the economy.
And if you don’t believe that, Google: MMT and “private sector net financial assets”.
Sumner’s criticisms of MMTers are probably due the fact that as a “professional” economist he’s upset by the fact that MMTers (many of whom are amateurs (like me)) are smarter than the professionals.
P.S. (Same day): Having done a bit of Googling, I've discovered there is less agreement amongst MMTers on this than I thought there was. Since MMTers are always emphasising the importance of "private sector net financial assets", they need go get their act togther on exactly WHY PSNFA is important. I've always said it's the hot potato effect (which in turn isn't much different to Keynes's "paradox of thrift" point). If the hot potato effect does not explain why PSNFA is important, can some MMTer tell me what does explain its importance?