Archive for the Category Monetary Theory


Multiplier mischief

Multipliers are ratios. That’s really all they are. There is the money multiplier (M2/MB), the fiscal multiplier (1/MPS) and the velocity of circulation (NGDP/MB, or NGDP/M2). If you assume these ratios are stable, you can derive some very interesting policy results. Of course the ratios are not completely stable, but may be stable enough to be of some value. Sometimes. My own view is that multipliers aren’t particularly useful, but today I’d like to assume the opposite, and show that the implications are not necessarily what you might assume.  (And please, no comments from MMT zombies “explaining” to me that multipliers don’t exist.)

Milton Friedman faced a quandary when trying to explain how bad government policies led to the Great Depression. If he defined the money supply as “the monetary base” (as I prefer), people would have pointed out that the base increased sharply during the Great Depression. Alternatively, he could have adopted the market monetarist practice of defining the stance of monetary policy in terms of changes in NGDP. Thus falling NGDP during 1929-33 was, ipso facto, tight money. His critics would have objected that this begged the question of how could the Fed have prevented NGDP from falling.

So he split the difference, and settled on M2 as both the definition of money, and the indicator of the stance of monetary policy. He suggested that, “What is money?” was essentially an empirical question, not to be determined on theoretical first principles. His statistical analysis led him to conclude that M2 (which unlike the base did fall during the early 1930s) was the preferred definition of money. And also that growth in M2 should be kept stable at roughly 4%/year.

In my view M2 no longer represents a good definition of money, using Friedman’s pragmatic criterion. Look at M2 growth in recent years:

Screen Shot 2015-10-05 at 3.38.24 PMI don’t know about you, but I see almost no correlation with the business cycle. Indeed M2 growth soared in the first half of 2009, making money look “easy”, which is obviously crazy. So if Friedman were alive today, how would he define money? The base still doesn’t work, as reserves also soared in 2008-09. Nor does M2. I don’t have a good answer, but I suspect that coins might be the best definition. Unlike the base and M1, periods of illiquidity probably don’t lead to massive hoarding of coins.  They are primarily useful for making transactions (although a sizable stock is held in piggy banks.)

Unfortunately, I could not find any data for the stock of coins in circulation. (Which is a disgrace, when you think about the 100,000s of data series the St Louis Fred does carry. As I recall, back in the 1990s coins were almost as important a part of the base as bank reserves.) But I did find data on annual coin output. For simplicity, I chose unit output, but value of output (which counts quarters 5 times more than nickels) would almost certainly lead to broadly similar results. In the list below I will show the change in annual coin output, compared to the year before, and also the change in the unemployment rate at mid-year (June) compared to the year before. The unemployment rate change is in absolute terms:

Year  * Coin Output  * delta Un

2000:   +28.1%           -0.3%
2001:    -30.9%          +0.5%
2002:    -25.7%          +1.3%
2003:    -16.5%          +0.5%
2004:    +9.5%          -0.7%
2005:   +16.1%          -0.6%
2006:    +1.4%           -0.3%
2007:    -6.9%             0.0%
2008:    -29.8%        +1.0%
2009:   -65.0%          +3.9%
2010:   +79.6%          -0.1%
2011:    +28.7%         -0.3%
2012:   +13.9%          -0.9%

Unfortunately my data ends at 2012, but that’s a really interesting pattern. Especially given that I don’t have the data I’d actually prefer.  I’d like the change in the size of the coin stock; instead I have the change in the flow of new coins (but not data on old coins withdrawn.)  It’s more like a second derivative.

In any case, it’s an amazing correlation. The signs are opposite in every case except the one where unemployment doesn’t change at all.  Coin output falls during years when unemployment is rising, even years like 2003 when unemployment is rising during a non-recession year.  And even better, the biggest change by far in coin output (proportionally) is in 2009, which also saw the biggest change by far in unemployment.

If you are not good at math then you’ll have to take my word for 2010 being a smaller change in proportional terms.  Indeed if you look at actual coin output in levels, 2010 was the second smallest in the sample, 2011 the third smallest, and 2012 the 4th smallest.  The decline in 2009 was so great that we never really climbed out of the hole.

Now let me emphasize that there’s an element of luck here.  If we had coin data for 2013 and 2014 I doubt the relationship would hold up.  Coin output seems to be in a steep secular decline.  So it’s partly coincidence that the signs are reversed in virtually every case.  But not entirely coincidence.  Perhaps someone could do a regression (using first differences of logs of coin output—so that the 2009 change will be larger than 2010) and confirm my suspicion that this relationship does show something real.  Falling coin output is associated with recessions.

But does it cause recessions?  If only you knew how tricky the term ’cause’ really is!  Krugman basically called Friedman a liar (soon after Friedman died) for claiming that tight money caused the Great Depression, whereas in Krugman’s view Friedman’s data pointed to the real problem being a non-activist Fed—they didn’t do enough to prevent M2 from falling. But they didn’t cause it to fall with concrete steppes.  The base didn’t fall.

I’ve always believed we should think of “causation” in terms of policy counterfactuals.  Suppose the Fed had acted in such a way that M2 didn’t fall.  And suppose that in that case there would have been no Great Depression.  Then if the Fed was capable of preventing M2 from falling (which is itself a highly debatable claim) then there is a sense in which Friedman was right, the Fed did cause the Great Depression.  Again, that’s if they could have prevented M2 from falling, and if stable M2 would have prevented a depression–both debatable (but plausible) claims.

My claim is that if we use Friedman’s pragmatic criterion for defining money, then coins might possibly be the best definition of money for the 21st century.  If the Fed had acted in such a way that coin output was stable in 2007-09, or at worst declined along its long run downward trend, then there would have been no Great Recession.  So in that sense the fall in coin output “caused” the Great Recession. But I could also find a 1000 other “causes,” such as plunging auto sales.

Can the Fed control the coin stock?  I’d say they could in exactly the same way they can control M2 (or nominal auto sales), via a multiplier.  The baseline assumption is that both the coin stock and M2 move in proportion to the base.  That would be the case if the M2 and coin multipliers were stable.  If the multipliers change, then the Fed simply adjusts the base to offset the effect of any change in the coin multiplier.

No let me quickly emphasize that I view the preceding as an extremely unhelpful way of thinking about monetary policy and the Great Recession.  I still prefer to define money as the base, as the base is directly controlled by the Fed.  And I prefer to define the stance of monetary policy as NGDP growth expectations.  And I prefer to think of tight money as setting the monetary base at a level where NGDP growth expectations fall below target, as in 2008-09.  I’d just as soon leave coins to children with piggy banks and nerdy collectors.  But if you insist on defining money using Friedman’s pragmatic criterion, then coins are my definition of the money stock.

A penny for your thoughts?

PS.  I have a new post on the Phillips Curve at Econlog.

The Fed proposes, the bond market disposes

Here’s what almost everyone is wrong about.  There’s a debate about whether the Fed should gradually “normalize” interest rates over the next few years.  And indeed the Fed has laid out a plan to raise rates into the 3% to 4% range over the next three years.

Unfortunately, the Fed doesn’t get to decide the path of interest rates.  It looks like they do, but that’s a cognitive illusion. The bond market determines the path of interest rates, reflecting factors such as global credit markets, as well as NGDP growth and the level of NGDP in the US.  If the Fed tried to independently determine the path of interest rates it would lead to hyperinflation or hyperdeflation.

Today was another lesson in humility for the Fed.  Bond yields have been plunging, which is the bond market’s way of saying, “Oh no you don’t, there’s going to be no normalization of interest rates over the next few years.”

Resistance is futile.  The more the Fed resists and tries to force rates sharply higher, the more the economy slows, and the more downward pressure on rates in the bond market.  In the end, the bond market always wins.

The Fed should stop focusing on trying to hit its interest rate targets, and start focusing on hitting its inflation target.  It’s not the Fed’s job to set interest rates. Even better, we should make their job much simpler by switching to NGDPLT.

PS.  The most noteworthy aspect of today’s jobs report is that the wage acceleration that everyone’s expecting again failed to show up.

PPS.  Can someone find me a link to where I can observe fed funds futures prices? Thanks. (I’d guess they are moving in a “Kocherlakota direction.”)

PPPS.  Some die hard opponents of “The Great Stagnation” had held out hope that a fall in U-6 unemployment (the broadest measure) would propel future growth.  Now even that option is mostly gone, as it plunged to 10.0% in September, the same level as in February 1996.)  It will go a bit lower, but it no longer represents a large cache of workers waiting in the wings to propel us forward.  Get ready for the new normal—3.0% NGDP growth—it’s coming soon.

Nominal shocks have real effects

Michael Darda sent me a graph that provides another good example of how nominal shocks have real effects.  The graph compares the spread between Baa bond yields and T-bond yields (white line) with an inverted measure of 30 years TIPS spreads (orange line).  The TIPS spreads are inverted because the BAA/Treasury spread is a countercyclical variable, whereas TIPS spreads are procyclical:

Screen Shot 2015-09-23 at 10.52.52 AM

I really love this graph, because it shows an underlying relationship that many people over look.  Always focus on the deep forces driving the macroeconomy, not the symptoms of those deep forces.

So here’s what’s going on.  Tight money leads to lower expected future NGDP growth.  I don’t think that can be disputed.  And I’d also claim that slower expected NGDP growth usually leads to lower TIPS spreads.  In addition, slower nominal GDP growth usually leads to increased fears of debt defaults.  Recall that NGDP represents total gross nominal income, the total resources that people, businesses and governments have available to repay nominal debts.  Squeeze that amount and defaults increase.

When NGDP grows more slowly, TIPS spreads fall and debt defaults increase.  That is even true in an economy where wages and prices are flexible, but debt is denominated in nominal terms.  But it’s even worse in the actual economy we live in, where wages are sticky.  In that case slower NGDP growth also leads to lower RGDP growth, which puts even more pressure on borrowers, leading to even more defaults.  Hence the Baa/Treasury spread widens.  And note that the Baa/Treasury spread is a real variable. Hence nominal shocks have real effects.

Of course the correlation is not perfect because TIPS spreads aren’t really the variable we care about, it’s NGDP expectations that really matter.  Notice the gap in the first half of the recession (roughly the first half of 2008.)  That was a period where inflation diverged sharply from NGDP growth.  Money was tighter than the inflation numbers suggested.

Asking too much of a central bank

Here’s an article discussing Bill Gross’s views on monetary policy:

Bond guru Bill Gross, who has long called for the Federal Reserve to raise interest rates, urged the U.S. central bank on Wednesday to “get off zero and get off quick” as zero-bound levels are harming the real economy and destroying insurance company balance sheets and pension funds.

In his October Investment Outlook report, Gross wrote that the Fed, which did not raise its benchmark interest rates at last week’s high-profile policy meeting, should acknowledge the destructive nature of zero percent interest rates over the intermediate and longer term.

“Zero destroys existing business models such as life insurance company balance sheets and pension funds, which in turn are expected to use the proceeds to pay benefits for an aging boomer society,” Gross said. “These assumed liabilities were based on the assumption that a balanced portfolio of stocks and bonds would return 7-8 percent over the long term.”

But with corporate bonds now at 2-3 percent, Gross said it was obvious that to pay for future health, retirement and insurance related benefits, stocks must appreciate by 10 percent a year to meet the targeted assumption. “That, of course, is a stretch of some accountant’s or actuary’s imagination,” he said.

Not only are Bill Gross’s views wrong, they aren’t even defensible.  Let’s look at several perspectives:

1.  Money is neutral.  In that case the Fed can only impact nominal returns.  If it wants higher nominal returns then it needs to adopt a more expansionary monetary policy. That’s the opposite of what Gross is proposing.

2.  Money is non-neutral.  In that case the Fed can raise nominal returns on debt with a tight money policy, but only in the short run.  And Gross says the problem is that long-term returns are too low.  However to raise them you need to raise NGDP growth, which means easier money.  Even worse, a contractionary monetary policy that raises the return on T-bills will reduce the return on stocks.

Why is there so much confusion on this point?  Perhaps because people forget that most central bank decisions are endogenous, on any given day or week the Fed usually follows the market.  Here’s a perfect example of why people get confused, look at the first paragraph of a recent Reuters article:

Euro zone government bond yields dropped by more than 10 basis points on Friday after the U.S. Federal Reserve prolonged the era of nearly-free money amid concerns about a weak world economy.

Most readers probably think there is a connection between these two events.  And there may be one.  But it’s not the connection you might assume at first glance. It’s obviously not that case that the Fed deciding to keep rates steady on Wednesday caused eurozone bond yields to fall on Friday.  That makes no sense. Instead both the Fed and the bond market are reacting to the same facts—a weakening global economy.  People see short and long-term rates rise and fall at about the same time, and draw the erroneous conclusion that Fed policy is causing those changes.

The Fed can’t magically produce strong long run real returns on investment for insurance companies, especially with tight money.  That’s far beyond their powers, according to all models I’m aware of (monetarist, Keynesian, Austrian, etc.)  If Bill Gross has a new model, I’d love to see it.  In the 21st century, insurance companies will have to learn to live with lower returns.  They may have to raise the price of insurance. If they lose business, then . . . well, tough luck!

Off topic, Tyler Cowen recently noted that China’s September PMI fell to 47, and then asked:

How quickly do services have to be expanding for the entire Chinese economy to be growing at anything close to six percent?

Since I’m on record predicting 6% RGDP growth, I’ll address this question.  First we need to determine how fast industrial production is growing.  Here’s a graph of the growth rate of IP since 1990:

Screen Shot 2015-09-23 at 11.12.40 AMOther than the post-Tiananmen crash, China’s industrial production has maintained a strong upward trend.  However there are three notable slowdowns.  The slowdown in the late 1990s was caused by China’s currency being overvalued due to its peg to an appreciating dollar, at the same time the emerging markets were struggling and devaluing, and at the same time the US and Europe were growing. Sound familiar? And notice that the gradually slowdown since 2012 looks a lot like the late 1990s.  And then there was a sharp but brief slowdown during the global recession of 2008-09.

The most recent figures show 6.1% growth (YOY) in August, and September may show further deterioration.  After than I expect Chinese IP growth to begin recovering, although the YOY figures may worsen for some time.

So to answer Tyler’s question, if industry is growing at 6%, then services would also need to be growing at roughly 6%, in order to produce 6% GDP growth.  Is it plausible that China’s industrial production could be growing at 6% with such horrible manufacturing PMIs?  See for yourself, here’s the PMI index as far back as I could find:

Screen Shot 2015-09-23 at 11.20.34 AM

The recent numbers are a bit worse than usual, but as you can see the PMI often dipped to 48, with no obvious ill effects on the China boom.  I believe that this time China is slowing a bit more than usual, which explains my bearish forecast of 6% growth in 2016, vs. the consensus of 6.7% by China experts.  So like Tyler I’m currently bearish on the Chinese economy, just not as bearish.  My bearishness comes from the fact that I believe China experts are underestimating the impact of the strong dollar, which is making China’s currency overvalued.

I’m also more bearish than the Fed on the US economy, for much the same reason.

Williamson on NeoFisherism (define “loosening”)

Stephen Williamson has a new post that interprets recent monetary history from a NeoFisherian perspective.  It concludes as follows:

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP produces low inflation. We should also not be surprised that NIRP produces even lower inflation. Further, experience with QE should make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than having a nominal interest rate target well above zero, on average. To get there from here may require “tightening” in the face of low inflation.

I partly agree, but disagree on some pretty important specifics.  I thought it might be instructive to start out by rewriting this paragraph to express my own view, with as few changes as possible (in bold):

What are we to conclude? Central banks are not forced to adopt ZIRP, or NIRP (negative interest rate policy). ZIRP and NIRP are choices. And, after 20 years of Japanese experience with ZIRP, and/or familiarity with standard monetary models, we should not be surprised when ZIRP results from low inflation. We should also not be surprised that NIRP results from even lower inflation. Further, experience with QE and inflation forecasts embedded in TIPS should not make us question whether large scale asset purchases, given ZIRP or NIRP, will produce higher inflation. The world’s central bankers may eventually try all other possible options and be left with only two: (i) Embrace ZIRP, but recognize that this means a decrease in the inflation target – zero might be about right; (ii) Come to terms with the possibility that the Phillips curve will never re-assert itself, and there is no way to achieve a 2% inflation target other than eventually having a nominal interest rate target well above zero, on average. To get there from here may require “loosening” in the face of low inflation.

Why do we reach such differing conclusions?  I think it’s because I have a different understanding of recent empirical data.  For instance, Williamson’s skepticism about monetary stimulus in Japan is partly based on his assumption that the recent sales tax increase raised the Japanese price level by 3%. But there’s never a one for one pass through, as it doesn’t cover major parts of the cost of living, such as rents.  So the Japanese price level (net of taxes) has risen by considerably more than Williamson assumes (albeit still less than 2%/year).  Even more importantly, Japan had persistent deflation prior to Abenomics.  And if Williamson is going to point to special factors such as the sales tax rise, it’s also worth mentioning that his recent data for Japan (and the other countries he considers) is distorted by a large one-time fall in oil prices.  Almost all economic forecasters (and the TIPS markets) expect inflation to soon rise from the near zero levels over the past 12 months.  Abenomics drove the yen from 80 to 120 to the dollar—-is that not inflationary?

In the Swiss case Williamson mentions low rates and asset purchases, but completely misses the elephant in the room, the huge upward revaluation of the franc earlier this year, which was widely condemned by economists (and even by many Swiss).  This policy was unexpected, unneeded and undesirable.  It immediately led forecasters to downgrade their forecasts for Swiss inflation, and those bearish forecasts have turned out to be correct.  I hope that’s not the sort of “tightening” of monetary policy that Williamson believes will lead us to higher inflation rates.

Seriously, I’m confident that Williamson would agree with the conventional view that currency appreciation is deflationary. That should send out warning signals that terms like “loosening” are very tricky.  Before we use those terms, we need to be very clear what we mean.  You can achieve higher interest rates through either loosening (a crawling peg devaluation forex regime) or tightening (open market sale of bonds), it all depends how you do it.  More specifically, it depends on the broader policy context, including changes in expectations of the future path of policy.

I think he also gets the Swedish case backwards.  The Swedish Riksbank tried to raise interest rates in 2011.  Instead of producing the expected NeoFisherian result, it led to what conventional Keynesians and New Keynesians and Market Monetarists would have expected—falling inflation. It led to exactly the type of bad outcome that Lars Svensson predicted. So Svensson was right.  And contrary to Williamson, the Riksbank did not turn around and adopt Svensson’s preferred policy, which is actually the “target the forecast” approach; rather they continued to reject that approach.  They continued to set rates at a high enough level so that their own internal forecasts were of failure. Once a tight money policy drives NGDP growth lower, the Wicksellian equilibrium rate falls and policy actually tightens unless the policy rate falls as fast or faster.  That did not occur in Sweden.

Let me try to end on a positive note.  I have a new post at Econlog that took a position roughly half way between the NeoFisherians and the Keynesians.  Brad DeLong had noted that Friedman often claimed that low rates are a sign that money has been tight. I’d emphasize, “has been.”  Krugman said this was wrong, at least over the time frame contemplated by Friedman.  I disagreed, defending Friedman.  I believe that Keynesians overestimate the importance and durability of the so-called “liquidity effect” and underestimate how quickly the income and Fisher effects kick in.  At the same time, as far as I can see the NeoFisherians either ignore the liquidity effect, or misinterpret what it means.  (My confusion here depends on how literally we are to take the “tightening” claim in the quote above.)

Question for the NeoFisherians:

I often discuss the Fed announcements of January 2001, September 2007 and December 2007.  That’s because all three were big shocks to the market.  In all three cases long-term interest rates immediately reacted exactly as Irving Fisher or Milton Friedman might have expected.  In the first two cases, easier than expected policy made long-term rates (and TIPS spreads) rise.  And in the last case tighter than expected policy made long-term rates (and TIPS spreads) fall.  Please explain.

To me, that’s the Fisher effect.  But here’s the problem, the Fed produced those three results using the conventional manipulation of short-term rates.  Thus in the first two cases the Fed funds rate was cut more than expected, and vice versa in the third case. From a Keynesian perspective this is really confusing—why did long-term rates move in the “wrong way”? From the NeoFisherian perspective this is also really confusing—why did moving short-term rates one way, cause TIPS spreads (and long term rates) to move the other direction?  From a market monetarist perspective this all makes perfect sense.  (It doesn’t always play out this way, but if you look at the really big monetary shocks the liquidity effect is often swamped by the long-term effects.)

HT:  Marcus Nunes