Archive for the Category Monetary Theory

 
 

Reply to Mike Sproul

Mike Sproul has a new post (at JP Koning) that compares his “backing” theory of the value of money with my “quantity theoretic” approach.  (Just to be clear, market monetarism does not assume V is fixed, like some simple textbook models of the QTM.)

I’ve argued that US base money was once backed by gold, but no longer has any meaningful backing.  It’s not really a liability of the Fed.  Mike responds:

Scott’s argument is based on gold convertibility. On June 5, 1933, the Fed stopped redeeming FRN’s for a fixed quantity of gold. On that day, FRN’s supposedly stopped being the Fed’s liability. But there are at least three other ways that FRN’s can still be redeemed: (i) for the Fed’s bonds, (ii) for loans made by the Fed, (iii) for taxes owed to the federal government. The Fed closed one channel of redemption (the gold channel), while the other redemption channels (loan, tax, and bond) were left open.

The ability to redeem dollars for government bonds, at the going market price of bonds, has very different implications from the ability to redeem cash for a real good like gold, at a fixed nominal price.  I’d prefer to say cash can be “spent” on bonds, just as cash can be spent on cars or TVs. Indeed even during the Zimbabwe hyperinflation, the Zimbabwe dollar could still be “redeemed” for gold at the going market price of gold in terms of Zimbabwe dollars.  But that fact has no implications for the value of the Zimbabwe dollar.  If you increase the quantity of Zimbabwe dollars their value will fall, as they will buy fewer ounces of gold.  In contrast, before 1933 an increase in the quantity of US base money did not impact the amount of gold that could be purchased with one dollar (it was 1/20.67 ounces).  That’s the sort of “redemption” that matters for the price level.

Once we understand that both convertible and inconvertible FRN’s are a true liability of the Fed, it is easy to see that the quantity of inconvertible FRN’s could also be increased by any amount, and as long as the Fed’s assets rose in step, there would be no effect on the value of the dollar. (There is a comparable result in Finance theory: that the value of a convertible call option is equal to the value of an inconvertible call option.)

I don’t agree.  If the Fed doubles the monetary base by purchasing an equal amount of government debt at going market prices, the price level will double in the long run.  This is why I don’t accept the backing theory–I believe it is rejected by the evidence.  Here’s just one example.  In the early 1960s “Phillips Curve” ideology took root in America.  It was (erroneously) decided that we could trade-off more inflation for less unemployment.  So the Fed exogenously increased the monetary base at a much faster rate after 1962.  At first RGDP growth rose, then both RGDP and inflation, but eventually all we got was the Great Inflation, with no extra output.

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We can also observe the inflationary impact of open market purchases of bonds by looking at the response of financial market indicators.  If OMOs didn’t matter because the new money was fully backed, then financial markets would shrug off any Fed money printing. Indeed we can ask how central banks were able to achieve roughly 2% inflation once they set their minds to it.  Keep in mind that 2% inflation is not “normal.”  There is no normal inflation rate. Inflation averaged zero percent under the gold standard, and 8% from 1972 to 1981.  Then about 4% from 1982 to 1991.  Much more in some other countries.  There is no normal rate of inflation. In a related note, here’s Nick Rowe criticizing John Cochrane’s fiscal theory of the price level:

The Bank of Canada has been paying interest on reserves for 20 years. And when it wants to increase the inflation rate, because it fears inflation will fall below the 2% target if it does nothing, the Bank of Canada lowers the interest rate on reserves. And the Bank of Canada seems to have gotten the sign right, because it has hit the 2% inflation target on average, which would be an amazing fluke it if had been turning the steering wheel the wrong way for the last 20 years without going off in totally the wrong direction.

The Great Inflation was certainly not caused by deficits, which became much larger after 1981, precisely when the Great Inflation ended.  It was caused by printing money and buying bonds with the newly-issued money.

Mike continues:

But if the Fed issued billions of new dollars in exchange for assets of equal value, then I’d say there would be no inflation as long as the new dollars were fully backed by the Fed’s newly acquired assets. I’d also add a few words about how those dollars would only be issued if people wanted them badly enough to hand over bonds or other assets equal in value to the FRN’s that they received from the Fed.

This is where things get sticky, because Scott would once again agree that under these conditions, there would be no inflation. Except that Scott would say that the billions of new dollars would only be issued in response to a corresponding increase in money demand.

No, that is not my view.  The Fed might well increase the money supply even if the real demand for money did not rise.  There is always some price of bonds at which the Fed can induce people to exchange bonds for cash, even if they do not want to hold larger real cash balances.  They’ll spend the new cash almost immediately after being paid for the bonds.  That’s the famous “hot potato effect” that underlies the quantity theory.  I’d point to the 1960s and 1970s as an example of the Fed injecting new money in the economy far beyond any increase in desired real cash balances.

Scott is clearly wrong when he says that the backing theory doesn’t have much predictive power. It obviously has just as much predictive power as Scott’s theory, since every episode that can be explained by Scott’s theory can also be explained by my theory.

This is a tough one, because the identification problem is obviously a big problem in macro.  Not everyone might accept my claim that the Great Inflation was caused by an exogenous increase in the base, or my interpretation of market reactions to money announcement shocks, or my claim that successful 2% inflation targeting supports the assumption that Fed OMOs influence the price level.  But I wouldn’t say the QTM has no extra predictive power, rather it has predictive power that might be contested.  Central bankers would be in the best position to test the theory, as they can engineer exogenous changes if they wish.  I suspect that fact explains why most central bankers don’t adhere to the backing theory.  They think they see signs of their power.

Mike ends with 4 specific objections to the QTM:

(i) The rival money problem. When the Mexican central bank issues a paper peso, it will get 1 peso’s worth of assets in return. The quantity theory implies that those assets are a free lunch to the Mexican central bank, and that they could actually be thrown away without affecting the value of the peso. This free lunch would attract rival moneys.

We occasionally do observe rival monies taking hold during extreme hyperinflation. The mystery is why doesn’t it happen with other inflation episodes.  Fiat currencies have survived some pretty high rates of trend inflation, especially in Latin America.  My best guess is the answer is “network effects.”  There are huge efficiency gains from using a single currency in a given region.  It’s hard to dislodge the incumbent.

(ii) The counterfeiter problem. If the Fed increased the quantity of FRN’s by 10% through open-market operations, the quantity theory predicts about 10% inflation. If the same 10% increase in the money supply were caused by counterfeiters, the quantity theory predicts the same 10% inflation. In this topsy-turvy quantity theory world, the Fed is supposedly no better than a counterfeiter, even though the Fed puts its name on its FRN’s, recognizes those FRN’s as its liability, holds assets against those FRN’s, and stands ready to use its assets to buy back the FRN’s that it issued.

When I teach monetary economics I ask my students to think of the Fed as a counterfeiter.  I say that’s the best way to understand monetary economics.  And there is some ambiguity to the “stands ready” in the final line of the quotation. Was that true during the Great Inflation?

(iii) The currency buy-back problem. Quantity theorists often claim that central banks don’t need assets, since the value of the currency is supposedly maintained merely by the interaction of money supply and money demand. But suppose the demand for money falls by 20%. If the central bank does not buy back 20% of the money in circulation, then the quantity theory says that the money will fall in value. But then it becomes clear that the central bank does need assets, to buy back any refluxing currency. And since the demand for money could fall to zero, the central bank must hold enough assets to buy back 100% of the money it has issued. In other words, even the quantity theory implies that the central bank must back its money.

There are two ways to address this.  One possibility is that the central bank does not reduce the base when needed to hit a particular inflation target.  That describes the 1960s and 1970s. But what about when they are successfully targeting inflation at 2%?  In that case they’d need some assets to do open market sales, but they might well get by with far less than 100% backing.  The last point (about a 100% fall in money demand) feeds into his final objection:

(iv) The last period problem. I’ll leave this one to David Glasner:

“For a pure medium of exchange, a fiat money, to have value, there must be an expectation that it will be accepted in exchange by someone else. Without that expectation, a fiat money could not, by definition, have value. But at some point, before the world comes to its end, it will be clear that there will be no one who will accept the money because there will be no one left with whom to exchange it. But if it is clear that at some time in the future, no one will accept fiat money and it will then lose its value, a logical process of backward induction implies that it must lose its value now.”

There are two possibilities here.  One is that the public never believes the world will lend with certainty, rather that each year there is a 1/1000 chance of the world ending.  In that case people would still hold cash as long as the liquidity benefits exceeded 0.10% (10 basis points), which seems quite plausible given the fact that people still hold substantial quantities of cash when inflation reaches double digits.

Now let’s consider a case with a definite end of the road, say the German mark or French franc in 2001.  In that case the public would expect redemption for a alternative asset with a relatively similar real value (euros in the case.)  I’m actually not sure whether it matters if the central bank holds the assets used for redemption, rather than some other institution like the Treasury.  But yes, they would expect some sort of backing in that case.  But even so, OMPs will still be inflationary, which contradicts the claims made by backing proponents.

One final point.  We all agree that gold need not be “backed” to have value.  The QTM implicitly thinks of cash as a sort of paper gold.  It’s a real asset that has value because it provides liquidity services.  As an analogy, gasoline makes cars go.  Motor oil doesn’t propel a car forward.  But motor oil has value because it lubricates engine parts.  It’s harder to model the value of motor oil than gasoline, because the advantages are less obvious.  Similarly, it’s harder to model the value of cash than gold or houses or stocks.  But cash lubricates transactions, and hence a medium of exchange has value.  But once you have that monetary system in place, having twice as much cash adds no extra value.  Instead all prices double, and the value of cash falls in half.  It’s the monetary system that has real value.

Reasoning from multiple price changes

There’s been a lot of recent discussion about the disconnect between the stock and bond markets. Stocks are hitting records (suggesting strong growth ahead) while bond yields are falling (suggesting slow growth ahead.)  I don’t have any definitive answers, but a few words of caution:

Many factors affect stocks and bonds, not just growth.  Some of those factors affect the two markets in very different ways.  For instance, suppose the investment schedule shifted to the left due to slower population growth, while the global saving schedule shifted to the right because of growing Asian prosperity.  In that case global real interest rates might fall sharply:

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Indeed this is pretty much what happened to real interest rates on 10 year Treasury bonds over the past 33 years.  They have fallen from about 7% to about 0%. And yet saving and investment haven’t changed all that much as a share of GDP. Some of the recent drop was caused by weak economic growth, but the big drop from 1981 to 2007 cannot be explained by slower growth.

Now let’s suppose that real interest rates dropped for some reason unrelated to slowing economic growth. How would that affect the stock and bond markets?  Stock prices would obviously rise, and bond yields would fall. Indeed this might even occur if expected real GDP growth slowed slightly.  So while economic growth often causes stock prices and bond yields to move in the same direction, there are plenty of exceptions to this pattern.  The current mix of high stock prices and low bond yields might be a bit unusual, but it’s hardly unprecedented.  Even if the factors I cite are not correct, dozens of other factors might explain the paradox.

Some people have asked me about a paper by John Cochrane, which advocates making permanent the policy of a large Fed balance sheet combined with interest on reserves.  I’d slightly prefer the old system of no IOR, but I don’t really have any strong objections to the policy.  The real issue is what sort of policy target should the Fed have, and how should they achieve that target.  I seem to recall that Cochrane likes my futures contract targeting proposal, but prefers a CPI target to a NGDP target.

Cochrane’s analysis is based on the “fiscal theory of the price level.”  I think that theory makes sense for a place like Zimbabwe, but not the US.  In the US it seems to me that the Fed is the dog and fiscal policymakers are the tail.  The Fed determines NGDP growth, and the fiscal policymakers must live with that constraint.

I also believe that Cochrane exaggerates the impact of IOR:

However, interest on reserves, together with the spread of interest-paying electronic money, radically changes just about everything in conventional monetary policy analysis. Standard answers to fundamental questions like the determination of inflation, the ability of the Fed to control real and nominal interest rates, the channels of the effect of monetary policy especially on the banking system, and so forth all change dramatically in a regime of interest on reserves and large balance sheet. The Fed anticipates some, but not others. Old habits die hard, and clear thinking is needed to dispel them.

I guess I’m too old for clear thinking, because I don’t see how anything important changes.  In the old days the Fed controlled the price level by controlling the supply of base money (through OMOs and discount loans) and influencing the demand for base money (by changes in reserve requirements.)  Now they’ll have two tools for influencing base demand; RRs and IOR.  The quantity theory still holds–a permanent doubling of the base will, other things equal, cause the price level to be twice as high as it would otherwise be.  MV=PY will still be perfectly true each and every second, because it’s a DEFINITION.  However (base) velocity will be far less stable.  The velocity of the broader aggregates that the old monetarists care about would presumably be about the same.

Money will still be neutral in the long run, and short run non-neutralities will come from sticky wages and prices.  Irving Fisher and even David Hume would have had no trouble understanding a world of IOR.

But it will become harder to teach monetary theory.  Zero interest base money makes the “hot potato effect” really easy to explain.

If the Fed had a meeting, how would that affect inflation?

Does that question seem incomplete?  Then try this one (from a commenter):

If the Fed raised interest rates how would that affect inflation?

Still maddeningly incomplete?  Then how about this one:

If the Fed adopted a more expansionary monetary policy, how would that affect inflation?

Finally we have a real question!  People often seem to forget that changes in interest rates are an effect of “the thing the Fed does” whereas monetary policy is “the thing itself.”

The first question should have been:

If the Fed adopts an expansionary monetary policy how will that affect interest rates?

Because of the liquidity and Fisher effect, there is no unambiguous relationship between interest rates and inflation.  But there is an unambiguous relationship between monetary policy and inflation.  Easy money leads to higher inflation (ceteris paribus) and vice versa.  But exactly what is easy money?  And why can’t we talk about changes in the fed funds rate as being “the thing itself?”

First of all, the fed funds rate is not always equal to the fed funds rate target, so obviously there are forces beyond Fed policy that influence that rate.  It is affected by Fed policy, but it isn’t the thing itself.  Here’s what I mean by easier money:

A policy that increases the supply of base money or reduces the demand for base money is expansionary.  Here are ways to increase the supply of base money:

1.  Open market purchases

2.  Discount rate cuts

Here are ways to reduce the demand for base money:

1.  Lower reserve requirements.

2.  Lower interest on reserves.

None of these policy changes will have much effect if temporary.

And here is a very reliable way to signal an intention to adopt an easier monetary policy (usually an intention to boost the base through open market purchases):

1.  Lower the fed funds target, relative to expectations.

That signaling device has been so reliable over the years that central banks have been able to see a clear connection between their policy signaling and asset prices linked to inflation expectations (such as stock and commodity prices, or TIPS spreads.)

It is that reliable response of asset prices to unexpected fed funds changes, i.e. unexpected changes in the expected future path of the base, that causes central banks to be absolutely confident the neo-Fisherites are wrong.  They see evidence of their policies “working.”  But here are two facts that lead to confusion:

1. The vast majority of the time interest rates and inflation are positively correlated—the Fisher effect dominates the liquidity effect.

2.  Central banks and their supporters in the academic community often talk as if interest rates are “the thing itself.”  That’s incorrect, and it leads them to often confuse easy and tight money, because of point 1.

Combine those two facts, and it’s easy to understand how intelligent, freethinking economists might reject the conventional wisdom, and end up as neo-Fisherites.

The solution is not to throw out mainstream Keynesian monetary theory and embrace neo-Fisherism, the solution is to throw out mainstream Keynesian monetary theory and embrace market monetarism.

Like Coke, it’s the real thing the thing itself.

PS.  Off topic, but I only hate Noah on days where he insults me or my friends on Twitter, otherwise I like his blog a lot.  Love the sinner, hate the sin.

And a person Miles and Izabella like can’t be all bad.  :)

Noah Smith on the Neo-Fisherites

Here’s Noah Smith:

First, the basic idea. The Fisher Relation says that nominal interest rates are the sum of real interest rates and inflation:

R = r + i

That’s not an assumption, that’s just a definition (actually it’s an approximation, but close enough). What I call the “Neo-Fisherite” assumption is that in the long term, r (the real interest rate) goes back to some equilibrium value, regardless of what the Fed does. So if the Fed holds R (the nominal interest rate) low for long enough, eventually inflation has to fall. This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Noah Smith is making a very subtle error here, but before getting into the details let’s blow the neo-Fisherite model right out of the water.  We can do so with a couple points made in the comment section.  First Nick Rowe:

Here is one very big bit of empirical evidence against the “Neo-Fisherite” theory:

For the last 20 years the Bank of Canada has been targeting 2% inflation. And the average inflation rate over that same 20 years has been almost exactly 2%.

The Bank of Canada has said it has been doing the exact opposite to what Neo-Fisherites would recommend: whenever the BoC fears that inflation will rise above 2% it raises the nominal interest rate, and whenever it fears that inflation will fall below 2% it cuts the nominal interest rate.

If the BoC had been turning the steering wheel the wrong way this last 20 years, there is no way it could have kept the car anywhere near the centre of the road. Unless it was incredibly lucky. Or was lying to us all along.

No, they aren’t lying.  And if you don’t believe me, do you think financial and commodity market participants are also “lying,” and hence intentionally losing lots of money.  Here’s Kevin Donoghue, responding to Noah:

If the Neo-Fisherites are right, then not only is the Fed massively confused about what it’s doing, but much of the private sector may be reacting in the wrong way to monetary policy shifts.

The NFs are committed to RatEx, so if the private sector is reacting in the wrong way their theory has a serious problem.

So how come all these brilliant neo-Fisherite economists are making an elementary mistake?  It’s partly because the mainstream never really internalized Milton Friedman’s insight:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

At first glance that looks almost neo-Fisherite.  But of course Friedman had quite conventional views on the liquidity and Fisher effects.  Still it makes sense that if Friedman’s insights were mostly ignored, later economists who discovered the strong correlation between low rates and low inflation might easily draw the wrong conclusion.  Friedman believed that a tight money policy would initially raise rates, but over time would lower both interest rates and inflation.  So over the vast majority of time you’d see inflation move in roughly the same direction as the short term interest rate directly controlled by the central bank.  That’s the Fisher effect—conventional macroeconomics.  But because it was not internalized (remember how crazy everyone viewed me in 2009 when I said money was tight?), it pushed the door wide open for the neo-Fisherites and MMTers, and lots of other odd critters to walk into the house.

And now we can see the subtle error that Noah Smith made in the passage quoted at the beginning of the post:

This is exactly the opposite of the “monetarist” conclusion that if the Fed holds R very low for long enough, inflation will trend upward.

Reasoning from a price change!!!  If I had a crystal ball, and peered into that ball, and saw that Yellen was going to hold short term rates at zero for the next 10 years, I’d absolutely predict ultra-low inflation, condition on that interest rate forecast.  So no, the monetarist prediction is not that inflation will trend upward.  As Milton Friedman said, the monetarist prediction is that inflation would trend downward.

Noah Smith is thinking like a Keynesian.  He’s trying to translate monetarist ideas about monetary policy into a Keynesian (interest rate) language.  He knows that we think easy money is associated with higher inflation, so he assumes we must also think that an extended period of low interest rates is associated with higher inflation.  Not so.  We don’t think low rates imply easy money.

Noah Smith and the neo-Fisherites are confusing the situation described by Friedman, with a subtly different case. Suppose a madman is put in change of the Fed who is committed to zero rates over the next 10 years, come hell or high water.  Then I might forecast an upward drift in inflation; indeed I think hyperinflation would be quite possible.  It depends on what else the madman did. But if you simply told me that rates would be low over the next 10 years under Janet Yellen, I’d assume that inflation would be low, and that low inflation is precisely the reason why Yellen held rates down.

There are no paradoxes to be explained, and that’s why we need to keep the “market” in market monetarism.  Markets tell us that all theories of monetary policy ineffectiveness at the zero bound, and also all reverse causation theories, are wrong. (I.e. RBC, MMT, Neo-Fisherite, old Keynesian, etc., are all wrong.)  It doesn’t matter if your model predicts that a change on monetary policy should have X effect on the price level.  If commodity markets respond in the “wrong way” then you’ve lost.  Game over. Case closed.

PS.  Edward Lambert comments:

Noah,
You sense the same thing that I do. I commented on Williamson’s post pretty much your thoughts. I am in agreement with the Fisher effect.
I simply want to thank you for having sufficient wisdom and constitution to write this post.

Yikes, if Noah has a friend in Edward Lambert then he doesn’t need any more enemies.

HT.  Tom Brown, TravisV.

Aggregate demand and regional demand shocks

Here’s Jordan Weissmann:

The blue line traces the consumer-spending trend in states where home prices fell the least, while the red line traces it in states where they fell the most. Each group contains about 20 percent of the U.S. population. And as you can see, the crash states are still well behind.  .  .  .

Sufi and Mian have made the academic case that spending before the recession really was driven by the “wealth effect” of rising home prices. People saw their housing values rocket up, and felt richer. Often, they took out second mortgages to spend. When the market crashed, so too did their finances. It may sound like an intuitive point to some, but it’s a key part of understanding why the recovery has been so underwhelming. The difference between states that got the full brunt of the housing collapse and states that didn’t, as shown in this chart, suggests that its scars are still very much with us. And they probably will be for a long while.  (emphasis added)

It’s important to distinguish between regional shocks and aggregate shocks.  All parts of the US use the same type of money, and hence all are affected by the same monetary shocks.  On the other hand the relative performance of various regions is dependent on all sorts of real variables. The factors that cause some regions to do worse than other regions play absolutely no role in the slow growth in aggregate demand since 2008, which is 100% a monetary policy failure.

The following analogy might be helpful.  Imagine a lake where the water level is controlled by the operators of a dam.  Also assume that the surface of the lake is very choppy, due to high winds.  The factors that explain the peaks and troughs of each wave have nothing to do with the factors that explain the average level of water in the lake.  In the same way, Federal Reserve policy determines the rate at which NGDP rises in the typical state, whereas local real factors explain why NGDP grows faster in some states than others.