Archive for the Category Monetary Theory


Monetary policy is not about banking

When I advocate something like QE or negative interest on reserves, I often get people complaining that this will not boost bank lending, or that we shouldn’t even be trying to boost bank lending.  It almost makes me want to tear out my hair. What in the world does banking have to do with monetary policy?  Yes, it may or may not boost bank lending, but it doesn’t matter, as monetary policy is about the hot potato effect.  And yes, the Fed should not be trying to boost lending, any more than it should try to boost sales of microwave ovens.  NGDP is what matters.

Jim Glass directed me to a new study by the Bank of England, which confirms that monetary policy is about the hot potato effect (aka portfolio rebalancing channels) not bank lending.  Here is the abstract.

We test whether quantitative easing (QE) provided a boost to bank lending in the United Kingdom, in addition to the effects on asset prices, demand and inflation focused on in most other studies. Using a data set available to researchers at the Bank, we use two alternative approaches to identify the effects of variation in deposits on individual banks’ balance sheets and test whether this variation in deposits boosted lending. We find no evidence to suggest that QE operated via a traditional bank lending channel (BLC) in the spirit of the model due to Kashyap and Stein. We show in a simple BLC framework that if QE gives rise to deposits that are likely to be short-lived in a given bank (‘flighty’ deposits), then the traditional BLC is diminished. Our analysis suggests that QE operating through a portfolio rebalancing channel gave rise to such flighty deposits and that this is a potential reason that we find no evidence of a BLC. Our evidence is consistent with other studies which suggest that QE boosted aggregate demand and inflation via portfolio rebalancing channels.

PS.  I have a new post over at Econlog that is far more important than this post.  Read the whole thing.

Apart from boosting NGDP and RGDP, euro depreciation will not help Italy

That’s the conclusion of a new paper that Tyler Cowen has linked to.  And I think that’s right.  Many stimulus advocates (including me and Lars Svensson) have pointed out that currency depreciation caused by monetary stimulus would not be expected to boost net exports, as the substitution effect will often be dominated by the income effect (a booming economy sucking in more imports.)

Unfortunately, the paper (by Alberto Bagnai and Christian Alexander Mongeau-Ospina) starts off with a misleading summary of the results:

It is frequently claimed that the current EUR/USD exchange rate is too high and that a depreciation of the EUR against the USD would contribute to relieve the Eurozone economy from the current state of persistent crisis. Evidence provided by the a/simmetrie annual econometric model suggests that this claim is unsupported by the data, at least as far as the Italian economy is concerned. In fact, the size and sign of the trade elasticities show that the increases in net exports towards non-Eurozone countries, brought about by the depreciation of the euro, would be offset by an increase in net imports towards Eurozone countries, brought about by the increase in Italian domestic demand.

And indeed Tyler also assumed that this pessimistic conclusion was their key finding, in his quick summary of the results.  But in fact that’s not at all what the paper says. Here’s the key paragraph:

Before presenting the results, it is worth noting that the simulations proposed were performed using only the foreign trade block of the model, supplemented with the national income identity and the price deflators equations. As a consequence, the results presented have only a partial equilibrium meaning and are still preliminary. In particular, they take into account the feedback on imports following from the expansion of aggregate demand caused by the increase in exports, as well as the inflationary effects following from the increase in import prices determined by the nominal exchange rate devaluation, but they do not take into account the “second round” inflationary effects determined via Phillips curve by the decrease in unemployment, which could possibly offset in the longer run the effect of a nominal realignment.

So if you ignore the fact that monetary stimulus that depreciates the euro will also boost NGDP, and that this will boost RGDP and employment via the “Phillips curve” mechanism, and only focus on the fact that a faster growing Italian economy will suck in more imports and hence stimulus will not improve the trade balance, then it appears a weaker euro will not help Italy.  And I certainly can’t disagree with that!

However I certainly don’t agree with this:

These results have important policy implications.

The euro is still far too strong

The title of this post does not refer to the exchange rate, the importance of which is overrated.

Tyler Cowen has a new post on the euro.  Here’s his conclusion:

All in all, the weaker euro is likely to prove a net benefit to the eurozone, all the more so if monetary policy can drum up some expansionary domestic benefits above and beyond the exchange rate effect.  Still, if you deliberately engineer a depreciation of your currency out of weakness and desperation, the long-run benefits usually don’t match up to that immediate feeling of short-run juice.

This is correct.  There are many examples of Latin American or Mediterranean countries devaluing their currency, and merely ending up with higher inflation in the long run.  But it’s also important to point out that the euro is still far too strong. Unfortunately there is no single measure of the strength of a currency, but surely it is more meaningful to talk about it’s ability to purchase a basket of all goods and services, as compared to its ability to purchase a pound of zinc, a share of Apple stock, a US dollar, an Australian dollar, or a Zimbabwean dollar.  I’d argue that a still better measure would be the fraction of a year’s eurozone NGDP that can be bought with a single euro.

In any case, whether you use the price level or NGDP as your metric, the euro is far too strong.  So while there are many examples throughout history of countries debasing their currency, the eurozone is not currently one of those examples.

PS.  If in fact the ECB has engineered a weaker euro in the forex markets, then ipso facto it has engineered “some expansionary domestic benefits above and beyond the exchange rate effect” relative to a tighter monetary policy stance. When using monetary policy, you can’t have one without the other.

Update:  Marcus Nunes has a related post on the yen.  Yes, there are actually people claiming the yen is too weak (not Marcus!)  Isn’t the yen right up there with the Swiss franc, vying for the title of the strongest fiat currency in the history of the world?

Russ Roberts interviews Lawrence H. White

Over the years I’ve sometimes complained about “internet Austrians.”  Larry White, who teaches at George Mason University, is definitely not an internet Austrian. Russ Roberts at Econtalk has a very good podcast interview of Larry (designated “guest”), and also provides a written summary (I’m not sure if it’s exactly verbatim.)  Here’s the portion on GDP targeting that starts a bit after the 40 minute mark:

Guest: Many constraints are better than no constraint. And so, a popular constraint which a lot of central banks have adopted in the last 30 years is an inflation target. And it seems to me that that’s better than no constraint. And the Fed has adopted an inflation target now, explicitly; except that the Fed adopted it, rather than Congress imposing it on the Fed. So the Fed could abandon it at any time. It’s not a constraint in the same way as a legislatively- or Constitutionally even better-imposed constraint. But I’m persuaded by arguments in the volume and elsewhere that as far as fastening a rule on the Fed, a nominal income rule would be better, one that says– Russ:Explain how that would work. Guest: Yeah. So, what the Fed should be concerned about is the total amount of spending in the economy, not just the stock of money and not just the price level. Guest: And not the interest rate or the overnight Federal Funds rate. Guest: Certainly not interest rates, that’s right. But what that would mean is if there isn’t any additional hoarding going on, or any dishoarding going on, then the Fed just pursues even money growth. But if people want to, for whatever reason, want to hold money–they want to hold more money balances relative to their spending, then the Fed should supply the additional money that people want to hold, because the alternative is that spending drops off; and that has real repercussions that we’re better off avoiding. It’s true that if the price level adjusted instantly, the market would clear– Russ:It would be irrelevant– Guest: and we’d be fine. But prices are sticky, I think is a fact about the world we are living in. Russ: Well, and information is imperfect. A bunch of people show up at your store; you don’t know if they are there because they have more money in their pocket or less desire to hoard money, keep money, or whether your product is really great. So you could make a lot of real mistakes in the short run– Guest: That’s right– Russ: trying to figure out what’s going on. You can’t ever figure out what’s going on. So you will inevitably make mistakes. So, the argument I think is it would be better if what I saw coming into my store was real rather than nominal–that would be one way to put it, right?Guest: That’s right. And actually stabilizing nominal income is a better way of reducing that signaling problem that people have, that sellers of goods have, than stabilizing the price level. So, some people who want to stabilize the price level acknowledge this in the case of an adverse supply shock. So, there’s an oil price rise, let’s say, and the United States is an oil-importing country. The price of oil goes up; the price of gasoline goes up; the price of things made with oil go up. If you want to stabilize the price level, you have to push other prices down so that the average level of prices doesn’t rise. But the rise in the price of things made with oil is providing information. It’s not clear why you want to cloud that information by pushing other prices down, because that means a tight monetary policy, tighter than people expected. Russ: At least in the short run. Guest: So you’re hitting the economy with a double whammy. It’s got a real shock and now it’s got a monetary shock on top of that. Both of them negative. And some people who favor a stable price level will say, ‘Okay, yeah, we grant it in that case.’ But then they should also grant it in the other case. If you have an increase in the productivity of the economy, either a positive supply shock or improvements in technology, improvements in labor productivity or total factor productivity, you should let the prices of those particular goods that are now being produced more cheaply, let those prices fall. Don’t try to offset that by raising other prices. Russ:Is that going to happen naturally? An oil price shock doesn’t cause inflation; the Fed wouldn’t have to do anything. Or are you talking about in the short run, when the signals are confused, right? Guest: Yeah. Russ: Those prices are going to have to fall–the Fed doesn’t have to drive down the other prices. They are going to go down anyway, on their own, right? Guest: Oh. Eventually they’ll go down on their own if people are spending more on oil. Russ: Yeah. Guest: Depends on the elasticity of demand for oil. But if they are spending more on oil, right–they’ll be spending less on other things. Russ: So the Fed wouldn’t intervene there. To me, the issue is just measuring price indices accurately in a time where we are blessed to live, where quality is changing every day. Every day, almost, the world is getting better and the products are getting better. And so assessing what’s actually happening, the overall price level, seems to be much more difficult than it was 25, 50 years ago, when the economy was much more static. So to me the question is, given that uncertainty, that measurement uncertainty, is nominal GDP (Gross Domestic Product) targeting–are they going to be better? I’m not sure. I’m not sure it makes any difference. I’m not sure that really gets around that. Guest: Yeah, it actually is easier on that score, because you don’t need to know the right price index to do it. Russ: You don’t need to, but the question is are you still–are you doing the right thing? Guest: Yeah. I think for the reasons we talked about earlier. It is a problem if you want to stabilize the price level that you have to take account of quality changes, and that’s difficult. There are all kinds of, as you’ve been saying, quality changes that goods experience. So, if it’s a simple thing like your tire lasts 60,000 miles instead of 40,000 miles, you can make an adjustment. But what if it gives you a better ride? How do you adjust for that? Russ: What if it has a microwave oven in it? While you’re driving along? How do you weight that? Guest: So, some people are under the misapprehension that it’s harder to stabilize or to target nominal income because it’s the product of real income and the price level. But that’s actually not how it works. First the statistical authorities gather information on nominal income and then they derivereal income by dividing by a price level. Russ: Which they also have to derive.Guest: Which they have to construct by going out with clipboards and writing down prices and then trying to make adjustments for quality changes. So you save yourself that trouble if you are just looking at total spending.

Notice Larry’s emphasis on the symmetry in the argument that NGDP targeting is better than price level targeting.  This suggests that there are times where you want to undershoot the average inflation rate because productivity is growing fast. His comments can be seen (I think) as an implied criticism of Paul Krugman’s recent claim that monetary policy was not too easy in the late 1990s, as inflation was pretty much on target. I don’t think money was far too easy at that time, but given the very strong productivity growth during the tech boom, somewhat tighter money would have been appropriate, and of course easier money in 2008 when oil prices soared but NGDP did poorly.

HT:  Michael Byrnes

The criminalization of currency and the zero bound

Evan Soltas has a very good post on the surprisingly low interest rates observed in several European countries.  He points out that there are significant costs of holding currency:

But nobody really seems to have a good handle on what the new, negative lower bound might be. So how much would it actually cost, I wondered, to store $10,000 in currency for a year?

This seems to me a decent, and admittedly entertaining, way of getting a rough estimate of a lower bound. I picked $10,000 because it’s about twice the average balance of a savings account in the U.S., giving me a conservative estimate of the average percentage cost.

A safe deposit box at a bank seems to cost around $100 a yearafter insurance. Then the average cost of storing currency is about 1 percent annually — maybe a bit more if you buy a safe.

Yet, rather obviously, having $10,000 in a deposit box is not the same thing as having $10,000 in a bank account. You can spend from your bank account using a credit card, or you can go to an ATM and withdraw cash. You can’t do the same with a safety deposit box.

How much is that convenience worth? It seems like a hard question, but we have a decent proxy for that: credit card fees, counting both those to merchants and to cardholders. That’s because the credit-card company is making exactly the same calculus as we are trying to make — how much can we charge before we make people indifferent between currency and credit cards? The data here suggest a conservative estimate is 2 percent annually.

So my rough guess is that the average depositor is probably better off keeping their money at a bank up to a nominal interest rate of -3 percent annually. (This is also what other people said, in an extremely informal poll, would be the most they would accept.) But, from an economic perspective, what we really care about is the marginal depositor — that is, who has the lowest cost of currency storage?

And here, I am at a loss. Are there are efficiencies of scale in currency storage? What does the marginal cost curve for currency storage look like?

I’ve only seen safety deposit boxes in pictures, but I’d guess they could hold considerably more than $10,000, in packets of crisp $100 bills.  Maybe $100,000. On the other hand there are risks such as fire and theft, which don’t occur with T-bills.  But even those risks may be fairly low.  So I think Evan is correct to emphasize the convenience factor.  However, Paul Krugman raises some other good points:

In normal times, we invoke the convenience of money — its extra liquidity — to explain why people hold money at zero or at any rate low interest rates when there are other safe assets offering higher yields. We think of money demand as determined by people increasing their holdings up to the point where the opportunity cost of holding money, the interest rate on other safe assets, equals its utility from increased liquidity.

Once interest rates on safe assets are zero or lower, however, liquidity has no opportunity cost; people will saturate themselves with it. That’s why we call it a liquidity trap! And what this means is that the marginal dollar of money holdings is being held solely as a store of value — the medium of exchange utility is irrelevant.

I like this argument, but I have a nagging feeling that Soltas must be right about the convenience factor.  I just can’t think of any other reason for the surprisingly large negative rates in Europe.  So let me throw out one other way of thinking about the vague term “convenience.”  Here are some things you should know about currency:

1.  Bringing more than $10,000 in cash into the US triggers alarm bells at the border.

2.  Taking more than $10,000 in cash out of a bank triggers alarm bells.  Indeed frequent cash transactions of $5000 can be enough to trigger a report to the government, under the “know your customer” rules.

3.  If you are pulled over for a missing taillight and have an envelope with lots of cash in your car, the police in the US can seize the money.  If you’ve committed no crime and are willing to spend a lot of money on attorneys and many months of your time, you can eventually get the money back.  But it’s very costly to do so.

Just to be clear, there is no law against holding large amounts of cash in the US. But the government considers it to be a sort of quasi-crime, evidence of wrongdoing.  They strongly dislike people who deal in large amounts of currency.

Why should it matter if the government is very hostile to your behavior, as long as you’ve committed no crime?  It shouldn’t matter, but let’s not be naive.  If you are a wealthy person or a business, it’s almost impossible to go through life without breaking laws.  The tax code and other regulations are so complex that wealthy people and businesses are easy pickings for any prosecutor that wants to make his name nailing the next Michael Milken.  (Disclosure: I’ve gone through life with just one email account, and today I find out that you aren’t supposed to use your job email for personal use.  Hillary, I feel your pain.)

I may be totally off base on this, but I’d like to hear from people that work in the investment banking world.  How would your boss feel if you suddenly suggested investing billions of dollars or euros or francs in currency, and then storing this currency in hundreds of safety deposit boxes?  And suppose you justified this investment on the basis that the return would be higher than you’d earn on government debt?  I suspect the idea of all that currency would give most big institutions a queasy feeling, and would make wealthy individuals worry that the government might begin to take a very close look at their books  . . .  if you know what I mean.

What do you think?

PS.  Back in the old days it was acceptable to hold large amounts of currency, indeed banks held $100,000 currency notes.  That was before the US government criminalized all sorts of business behavior that used to be acceptable.   Perhaps that’s why even during the worst of the Great Depression, the interest rate never went more than one or two basis points negative, if my memory is correct.

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PPS.  I also recommend Alex Tabarrok’s post on the police in Ferguson, which shows that innocent low-income blacks and Hispanics also have plenty to fear from the police.  The people with the least to fear are academics, government bureaucrats, and others of that type.  No wonder they are so naive about the downside of big and powerful governments.