Archive for March 2014


Academics are rapidly catching up to market monetarists

Market monetarists have consistently argued that:

1.  QE is not risky, stopping QE is risky.

2.  Abenomics would modestly boost NGDP and RGDP.

3.  NGDP targeting wouldn’t just stabilize the labor market, it would also reduce volatility in the credit markets.

Here’s The Economist:

Jitters about market bubbles are one reason the Federal Reserve is dialling down its bond buying. A new study by Gabriel Chodorow-Reich of Harvard University shows that since 2013 Federal Reserve committee members, including Mr Bernanke, have cited concerns over increased financial-sector risk-taking as a reason to mute QE. Their anxiety is understandable: central bankers are still scarred by the lessons of the mid-2000s when banks “searched for yield” amid low interest rates, financing riskier projects and pumping up leverage to improve profits. After five years of shedding risk since the crisis that followed, some fret they could flip back into risk-seeking mode.

But those worries wither under closer scrutiny, as Mr Chodorow-Reich shows. He starts his hunt for a link between QE and risk with banks and life insurers, examining market reactions to 14 Federal Reserve policy announcements between 2008 and 2013. Using minute-by-minute data, and isolating small windows either side of each statement, Mr Chodorow-Reich measures market perceptions of risk. He finds that QE extensions are associated with a drop in the costs of default insurance that protects against a bank or insurer going bust. Markets, then, are not worried about QE, even if the central bank is.

And this:

And bold monetary policy has a big upside, suggests a new paper on Japan’s “Abenomics” by Joshua Hausman of the University of Michigan and Johannes Wieland of the University of California, San Diego. Japan’s monetary boost is huge, including a new 2% inflation target, unlimited asset purchases and a doubling of the money supply. Many worried, however, that it would not work. Japan’s slump is decades old and QE had already been tried. Between 2001 and 2006 the Bank of Japan boosted the cash that lenders held from ¥5 trillion ($46 billion) to almost ¥35 trillion using QE. Yet not much happened. Although inflation nudged above zero, policymakers increased rates too soon. By the time Shinzo Abe took office in December 2012 prices were falling by 0.1% a year and the economy was drifting sideways.

But Abenomics has lifted Japan’s GDP by up to 1.7%, according to Messrs Hausman and Wieland: up to a percentage point of that may be due to monetary policy. The market effects are clear: stock indices jumped and the exchange rate depreciated sharply when the policy was announced (see left-hand chart). The effects on broad money, which rises with bank lending, have been much stronger than with previous QE attempts (see right-hand chart).

Inflation expectations explain the difference. Abenomics was announced not as a temporary boost but a permanent change in policy. People quickly anticipated that prices would begin rising by 2% a year, instead of remaining flat. Long-run inflation predictions have risen too. This means borrowing looks more manageable and gives shoppers confidence to spend more. Nonetheless, Japan’s economy remains weak. Reinforcing the commitment to monetary boldness would give it a boost, the researchers say.

As far as I can tell, Japanese annual inflation rates (CPI) rose above US inflation last November, for the first time in nearly 40 years (excluding a period of a few months after the Japanese instituted a national sales tax in 1997.)  However the plan is still flawed as it does not represent level targeting.  Japan needs to do more to assure that it doesn’t slip back into deflation.  And why not do more?  All the good things predicted have happened, and none of the bad things critics worried about (like higher Japanese government bond yields.)  It was a free bento box. When the world offers free lunches, go to Jiro’s in Tokyo and pig out.

There are even more radical options. Kevin Sheedy of the London School of Economics reckons that gains may be made from replacing an inflation target with a nominal-GDP (NGDP) target. Typically central banks focus on inflation as this helps stabilise the value of pay, which might otherwise be eroded by rising prices. But wages are not the only rigid contracts workers face””their debts are fixed too. This means that a GDP shock which lowers incomes can cause a big jump in their debt burden.

A central bank focused on NGDP would help, Mr Sheedy argues. Take a supply shock, which tends to lower GDP without causing prices to fall. A central bank focused on prices might not respond at all due to the absence of inflation. An NGDP targeter would be bolder, stimulating the economy to generate inflation and keep the value of debt and GDP aligned. Hard-wiring a shift like this into the monetary system will take a lot of persuasion. But household debt-to-income ratios were much lower when inflation targeting was set up in the early 1990s. In today’s high-debt world, an NGDP target looks more attractive.

How influential these studies will be remains to be seen.

A few comments:

All three papers were published by the Brookings Institution—a respected think tank.

Ben Bernanke recently joined the Brookings Institution.

Even though MM is winning, we aren’t given credit.  But that’s always the way things work.  What matters is that the ideas get adopted. If not being associated with a fringe groups of academics at small institutions helps the ideas gain respect, then I hope we MMs remain completely anonymous.

PS.  Congratulations to Bentley’s women basketball team for winning the national championship (division 2.)  And for the University of Wisconsin (my alma mater) making the Final 4.

PPS.  I have a multiplier post that comments on Nick Rowe, over at Econlog.



The real problem with the money multiplier

David Glasner argues the money multiplier is a useless concept.  I’m sympathetic to that claim, and yet I think he goes to far in his criticism of Friedman and other monetarists.  Although the concept is useless, it’s not wrong, and it’s hard to see how it does much damage.  Here’s David:

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

If I understand David correctly he’s a bit confused about the money multiplier.  It is simply a ratio, regardless of what David was taught in school. In his example the multiplier equals k, which is the ratio M/B.  But unless I misread him, he seems to believe multiplier proponents viewed it as a constant, which is clearly not true. Rather they argued the multiplier depends on the behavior of banks and the public, and varies with changes in nominal interest rates, banking instability, etc.  This is how it’s taught in the number one money textbook, and this is the version Friedman and Schwartz used in the Monetary History, which focuses heavily on explaining changes in the multiplier.

And yet I agree with David that the multiplier is useless, mostly for “Occam’s razor” reasons.  Think about the Equation of Exchange:

M*V = P*Y

If you want to model nominal GDP, and M represents M1, then you have to model both M1 and M1 velocity.  In that case:

M = k*B

So now the equation of exchange is:

B*k*V = P*Y

But in that case why not skip the middleman, and go right for:

B*(base velocity) = P*Y

After all, both k and V are positively related to the nominal interest rate.  You have one thing to model (base velocity), not two (the multiplier and M1 velocity).

In any case, it’s silly to focus on either B or M; focus on the goal/indicator of policy, NGDP.  The multiplier doesn’t help you do that, and hence is useless.  But if people want to use it, they aren’t making any sort of logical error as long as they understand how it changes in response to changes in interest rates and other variables, and the monetarists were able to do that.  The Monetary History is a masterpiece of multiplier analysis.

When people say “there is no such thing as a money multiplier,” they are literally saying there is either no such thing as B, or no such thing as M. Obviously they don’t mean that.  Rather they are trying to say “the multiplier is not fixed, as the monetarists and textbooks believe.” Except the monetarists and textbooks didn’t claim it was fixed.

Here’s Stephen Williamson:

The money multiplier is probably the most misleading story that persists in undergraduate money and banking and macroeconomics texts. Take someone schooled in the money multiplier mechanism, and confront them with a monetary system – such as what exists in Canada, the UK, or New Zealand – where there are no reserve requirements, and they won’t be able to figure out what is going on. Confront them with a system with a large quantity of excess reserves (the U.S. currently), and they will really be stumped.

Interesting.  I wonder if Friedman was “schooled in the multiplier mechanism”?  David Glasner says he was. And yet Friedman obviously would not be perplexed by either a lack of reserve requirements or massive quantities of excess reserves.  In fairness to Williamson, most undergrads would be perplexed, but then they are perplexed by lots of things.  I don’t think my students would be perplexed.

What do the VSP think about the current economy?

This is a sincere question.  Do the Very Serious People think the US economy is deeply depressed, or nearing full employment?  I see conflicting evidence:

1. As far as I can see the policy of tapering has overwhelming support among the VSP, suggesting they think it’s time for the economy to stand on its own two feet, without a crutch from the Fed. Is that correct?

2. As far as I can see most of the press and pundits, and moderate politicians, seem to support an extension of the emergency unemployment benefits? Recall that the proposal would y currently extend them to 73 weeks, which is far more generous than the emergency benefits under Bill Clinton in early 1993, when unemployment was even higher. The call for an emergency extended unemployment benefits program would imply emergency level unemployment rates, where monetary tightening (when inflation is also below target) would be utter madness.

I’m not interested in arguing these two perspectives.  Both are defensible.  Rather I’m trying to get a sense of where the VSP opinion is on this issue. I honestly cannot tell.  Do they think the economy is deeply depressed?  Or not?

PS.  I’m a bit less sure on point two, but a number of GOP lawmakers recently indicated that they would support extended unemployment benefits, which suggests that the center of gravity political was for extension–that’s certainly the overwhelmingly popular view among press and pundits.

PPS.  Totally off topic, but this comment by Greg Mankiw intrigued me:

In this case, the issue is the reduction in capital taxes during the George W. Bush administration.  Paul [Krugman] says that the goal here was “defending the oligarchy’s interests.”

Really? As Paul well knows, there is a large literature in economics suggesting that an optimal tax system imposes much lower taxes on capital income than on wage income (or consumption).

Why should we assume that Paul Krugman is aware of that literature?  You would think he would be aware of the literature—other progressive bloggers like Matt Yglesias and Brad DeLong obviously are.  But I don’t recall reading a single Krugman column that showed any awareness of the need for replacing our current tax system with a progressive consumption tax.  I don’t recall a single post pointing out that taxes on capital should be much lower than taxes on labor income, if not zero.  I don’t recall a single post pointing out that nominal tax rates on capital income are meaningless, and that real tax rates on (for instance) Treasury bonds are now well over 100%.  Or that corporate income is triple taxed, making nominal corporate tax rates utterly meaningless as indicators of progressivity.  Or that Warren Buffet was spouting utter nonsense when he claimed his tax rate was lower than that of his secretary.  If such Krugman posts exist then please show them to me, I’d love to read them.

Either he is unaware of the literature, or he is aware of it and is knowingly spouting misinformation. I’d prefer to be charitable and assume that he’s not aware of the literature.

Mark Sadowski on Cullen Roche

Here’s Mark Sadowski (much of the following is Mark quoting Cullen):

I want to focus on one particular claim by Cullen Roche which he repeats three times in various forms at two different posts.

Cullen Roche
“Depends on the banking system and the “money” you’re referring to. “Federal Reserve Notes” are not actually issued by the CB even though they’re a liability of the CB. They are purchased by the CB and printed up by the Bureau of Engraving. Reserve Banks purchase coin at face value from the US Mint (who is determining your “conversion” rate there – a branch of the US Tsy or the Fed?). So, in a strange sort of way, the Treasury acts as a banker to its own bank and charges that bank quite a bundle in fees to deal in “legal tender”. There is this circuitous/hybrid relationship here that I think gets bungled by a lot of people.

So, when Scott Sumner refers to reserve notes as “paper gold” he’s really not referencing the power of a Central Bank. He’s actually referring to the issuer, the US Treasury which makes Sumner an ironic/funny kind of way. And this is the problem with parts of Market Monetarism. If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system.”

Cullen Roche:
“…1) I think you overstate the exchange rate concept given that the Fed buys coin and currency from the US Tsy and the fact that there’s deposit insurance via FDIC. US bank deposits are at a very low risk of ever trading below par. The “value” of commercial bank money has been backstopped for all intents and purposes and the Fed is far from the only cause of this effect…”

Cullen Roche
“I understand Nick’s point. The thing is, the “unit of account” in Sumner’s theory is not even created by the CB. It’s created by the Bureau of Engraving. All cash and coin is sold to the Fed at face value by the Bureau, a department of the US Tsy. The alpha bank, if we’re going to use such a term, is actually the US Treasury in the Market Monetarist model and they don’t know it because they don’t actually describe the reality of how money is created. Sumner’s “paper gold” is a creation of the US govt, not the Fed…”

For this point forward it’s mostly Mark’s reply:

In a word, this is wrong.

“The distribution of coins differs from that of currency in some respects. First, when the Fed receives currency from the Treasury, it pays only for the cost of printing the notes. However, coins are a direct obligation of the Treasury, so the Reserve Banks pay the Treasury the face value of the coins…”

The cost of printing the notes has averaged approximately 0.325% of their face value in the past 11 years:

Of course the Federal Reserve pays 100% of the face value for coins. What proportion of the value of the currency in circulation consists of coins?

“…The value of U.S. coins in circulation as of May 31, 2010, was approximately $40.4 billion, or about 4.3 percent of total currency and coin in circulation.”

So the Treasury only gets paid about 4.6% of the face value of the nation’s currency in circulation by the Federal Reserve, which is appropriate if the Treasury is really in the role of performing a service for the Fed.

As Cullen says:
“If you don’t respect specific institutional arrangements you end up saying things that make no sense when you consider the actual design of the system.”

Kind of “ironic/funny”, eh?

I just have one question for Mr. Roche.  If the Fed buys currency at par, how did the Fed earn its seignorage prior to 2008?

Could we have had a severe recession without the 2008 financial crisis?

Paul Krugman argues that it would have taken a dramatically different set of policies back in 2007 to prevent the Great Recession, and Brad DeLong argues that a much more modest set of initiatives might have sufficed.  There is much to agree with in both posts.  First here’s Krugman, quoted by DeLong:

What It Would Have Taken: “Think of it this way: what would a really effective set of policies be right now? First… aggressively reverse the fiscal austerity of the last few years…. Monetary policy should accommodate that boost; interest rates should not go up even if inflation goes somewhat above 2 percent. In fact, there’s an overwhelming prudential case for raising the inflation target…. Say for the sake of argument that the right policy is two years of fiscal expansion amounting to 3 percent of GDP each year, plus a permanent rise in the inflation target to 4 percent. These wouldn’t be radical moves in terms of Econ 101 “” they are in fact pretty much what textbook models would suggest make sense given what we have learned about macroeconomic vulnerabilities. But they are completely outside the bounds of respectable discussion. That’s the sense in which we are “doomed” to long-term stagnation. We have met the enemy, and it’s not the economic fundamentals, it’s us.

And here’s DeLong’s reply (or more precisely the response of Brad’s Greek friends):

Thrasymakhos: Oh, Krugman’s 100% right about today…

Khremistokles: He is indeed. We are totally tracked…

Thrasymakhos: Very few members of congress or FOMC participants seem to spend any significant time talking to anybody who is not a plutocrat…

Khremistokles: But he is wrong about how aggressive and radical the needed policies back in 2007 were. As a share of GDP, the bad shopping-mall and office-tour debts of Houston, etc, in 1989 were as large as the bad mortgages of 2007…

Thrasymakhos: But back in 1989 the political power of the princes of finance was much less than in 2007…

That’s probably right, but I have trouble with DeLong’s implicit assumption is that the financial crisis caused the Great Recession.  DeLong points out that the recession of 1990-91 was far milder, despite equivalent bad debt (as a share of GDP.)  And that the 1990 crisis was handled better. Krugman’s comment points to one overlooked factor.  In 1990 we did have a de facto 4% inflation target.  The years leading up to 1990 saw Australian-level NGDP growth, if not more.  So even if lending standards tightened sharply in the wake of the 1989-90 crisis, there still would have been no possibility of hitting the zero bound.  Rates fell to about 3% in the recession, still a bit higher than in Australia this time around.  With no zero bound in prospect, there’d be no reason for markets to expect an NGDP collapse.  Elsewhere I’ve argued that growing realization of plunging NGDP tanked the asset markets in the second half of 2008.

Even if we had managed the 2007-08 subprime crisis very well from a regulatory/resolution perspective, there is no question that banks would have tightened lending standards sharply.  That effectively reduces the demand for credit. And of course house prices were plunging even before Lehman, and then we got a “secondary deflation” of house prices when NGDP plunged.  It’s quite plausible that the Wicksellian equilibrium natural rate would have fallen to zero in late 2008, even with a better resolution of the banks.  On the other hand if we’d gone into 2007 with Paul Volcker’s de facto 4% inflation target (a policy he now opposes), then the Great Recession would have been a 1990-style mild recession.

One area where I slightly disagree with Krugman is his focus on inflation.  A 5% NGDPLT target path would have been enough; we didn’t need 4% trend inflation.  Nor do we need fiscal stimulus. On the other hand the supply side fundamentals of the economy were so poor after 2008 (for reason I don’t fully understand) that 5% NGDP growth would have led to some unpleasant stagflation. So we might have gotten Krugman’s 4% inflation anyway.  Indeed if my preferred policy had been adopted, it would have been widely judged a failure, partly because (as DeLong correctly pointed out) almost nobody back in 2007 envisioned a recession as severe as the one we got.

People see bad outcomes, and have trouble envisioning it could have been much worse.  That’s one reason why my preferred policy was not politically feasible in 2008.  But thanks to the NGDP targeting boomlet, it will be somewhat more feasible next time around.  Next time people will be able to envision a worse alternative.

All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office.  The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon.  NGDPLT would have given us just that in 2008-09.

PS.  I have a new post on Jeremy Stein over at Econlog.

HT:  TravisV