Archive for the Category Monetary Theory


The great unwashed masses (there’s weakness in numbers)

Over at Econlog I have a new post pointing out that back in 2006 New Keynesians like Brad DeLong believed in monetary offset.  I should clarify one point, however. I am basically talking about the New Keynesian elite, the people who follow the latest developments in macroeconomics.

A paper by Daniel Klein and Charlotta Stern (2006) points to a 2003 survey done by the AEA that showed that most economists favored using fiscal stimulus for purposes of fine-tuning the economy.  Read that again, I didn’t say “most Keynesians,” I said most economists.  Fiscal skeptics like Krugman and DeLong were right-of-center economists back in those days.

The problem here is that most economists get their ideas on macroeconomics from studying the Keynesian cross model in EC101, and also using common sense (obviously if G goes up, then C+I+G must go up.)  But by 2006 the Keynesian cross model was horribly outdated, and common sense is almost useless in economics.  Indeed you could argue that it is a lack of common sense that separates the elite economists like Krugman from their mediocre colleagues.

In a 1997 article Paul Krugman called those holding this consensus view “Vulgar Keynesians.” Here Krugman makes the same mistake I made (when discussing the paradox of thrift and the widow’s cruse.):

Such paradoxes are still fun to contemplate; they still appear in some freshman textbooks. Nonetheless, few economists take them seriously these days. There are a number of reasons, but the most important can be stated in two words: Alan Greenspan.

After all, the simple Keynesian story is one in which interest rates are independent of the level of employment and output. But in reality the Federal Reserve Board actively manages interest rates, pushing them down when it thinks employment is too low and raising them when it thinks the economy is overheating. You may quarrel with the Fed chairman’s judgment–you may think that he should keep the economy on a looser rein–but you can hardly dispute his power. Indeed, if you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: It will be what Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.

Krugman and I both believed that there were “few economists” who stilled believed that nonsense back in the late 1990s, when in fact most economists believed that nonsense as late as 2003.  Krugman had the Pauline Kael problem, he didn’t know most economists; he knew Bernanke, Svensson, Woodford and other Princeton economists. My problem was that I didn’t know most economists, I read Bernanke, Svensson, Woodford and Krugman, and assumed they were representative.

Of course Krugman has now joined the vulgar Keynesians, citing the new circumstances of near-zero interest rates.  I suppose he finds strength in numbers, such as the 350 economists who warned that fiscal austerity in 2013 would produce a recession.  Indeed I’ve seen Krugman cite a poll of 50 economists, almost all of which thought fiscal stimulus had a positive effect.

Unfortunately, most economists are far behind the times in macro theory.  By joining up with most economists, Krugman has allied himself with the least informed segment of the profession.  It would be like suddenly becoming a protectionist, and citing the fact that 90% of Americans think Chinese imports cause unemployment.  Come to think of it, isn’t Krugman also making that argument?

Economics is the queen of the counterintuitive sciences.  And no parts of economics are more counterintuitive than stabilization policy and trade.  Krugman was wrong in thinking the majority agreed with him in 1997.  But Krugman’s right that he’s now in with the overwhelming majority of economists.  I’m in the tiny, tiny minority of economists who think the economy has needed demand stimulus but that fiscal stimulus is ineffective.  But this is one case where there is weakness in numbers. I’m perfectly happy being in a tiny minority, if it’s the same minority that Krugman and DeLong and the other elite NKs belonged to a decade ago.

PS.  To be fair, the 350 warned about fiscal austerity slightly worse than the $500 billion reduction in the deficit in calendar 2013 that actually occurred, but still . . .


It turns out that the US was never at the zero bound

Matt Yglesias has a very interesting new post:

Something really weird is happening in Europe. Interest rates on a range of debt — mostly government bonds from countries like Denmark, Switzerland, and Germany but also corporate bonds from Nestlé and, briefly, Shell — have gone negative. And not just negative in fancy inflation-adjusted terms like US government debt. It’s just negative. As in you give the German government some euros, and over time the German government gives you back less money than you gave it.

In my experience, ordinary people are not especially excited about this. But among finance and economic types, I promise you that it’s a huge deal — the economics equivalent of stumbling into a huge scientific discovery entirely by accident.

Indeed, the interest rate situation in Europe is so strange that until quite recently, it was thought to be entirely impossible. There was a lot of economic theory built around the problem of the Zero Lower Bound — the impossibility of sustained negative interest rates. Some economists wanted to eliminate paper money to eliminate the lower bound problem. Paul Krugman wrote a lot of columns about it. One of them said “the zero lower bound isn’t a theory, it’s a fact, and it’s a fact that we’ve been facing for five years now.”

And yet it seems the impossible has happened.

If I wanted to quibble I’d say Yglesias slightly exaggerates the element of surprise here. Some of us knew that US T-bill yields fell a couple of basis points below zero around 1939-40.  But on the bigger issue he’s right.  I never would have expected negative 0.75% nominal interest rates.  In retrospect, I underestimated the cost of storing large quantities of cash.  I’d guess it’s much higher than 100 years ago, when banks routinely dealt with large quantities of gold, and currency notes with denominations as large as $100,000.

And most other economists were even further off base.  Indeed back in 2009 I used the cost of storing cash as an argument in favor of negative IOR, and some Keynesians disagreed with me.  They said negative IOR would merely cause ERs to transform into safety deposit boxes full of currency.  I said the American public didn’t want to store trillions of dollars in currency and coins.  There’d be at least a modest hot potato effect.

As Matt points out, the key takeaway is that the US was never at the zero bound:

The big one is that central banks, including the United States’, may want to consider being bolder with their interest rate moves. For years now, the Federal Reserve’s position has been that it “can’t” cut interest rates any lower because of the zero bound. Instead, it’s tried various things around communications and quantitative easing. But maybe interest rates could go lower? Unlike the European Central Bank, the Federal Reserve pays a small positive interest rate on excess reserves. Fed officials normally say this doesn’t make a difference in practice, but it looks like negative rates on excess reserves may be the key to negative bond rates.

It’s no longer an issue of “just 25 basis points.”  German 5-year bond yields are currently negative, which is considerably lower than the 0.60% that they bottomed out at in America.  If we were never at the zero bound, then the foes of market monetarism have pretty much lost their only good argument for fiscal stimulus.

Now for the curve ball.  I am not saying the Fed should have tried to replicate the negative 5-year bond yields of Germany.  I view negative long term bond yields not as an expansionary monetary policy, but rather as a sign of failure.  Never reason from a bond yield.  A truly expansionary monetary policy might well have raised long-term bond yields.  My claim is different.  I’m saying that for those who do think nominal interest rates are a good indicator of the stance of monetary policy, it’s now clear that the Fed could have cut rates much more sharply.

But that’s not why I believe the Fed was never out of ammunition.  I relied on an entirely different reasoning process.  I noticed that Ben Bernanke never once suggested that the Fed had run out of paper and green ink.

Let me know when our critics respond to our actual ideas

One of the things that makes me believe that we are on the right track is that our Keynesian critics seem unable or unwilling to respond to actual market monetarist arguments, particularly regarding monetary offset of fiscal austerity.  Marcus Nunes directed me to another example, this time from Robert Waldmann at Angry Bear:

In any case, Japanese inflation expectations appear to have been successfully managed and to have caused higher output (including construction) as should be the result of the resulting reduced expected real interest rates. It is important to note that the extremely radical expansionary monetary policy was not enough to prevent a recession starting Spring 2014 following a 3% increase in the value added tax. Monetary policy at the ZLB isn’t helpless, but it can be overwhelmed by fiscal policy. The assertion that a sufficiently determined monetary authority can target nominal GDP has been pretty much disproven (again).

This is wrong on so many levels one hardly knows where to begin:

1.  Neither the Japanese government nor any other government that I am aware of has ever targeted NGDP.  More importantly, they have never done level targeting of NGDP, which is what everyone from Christina Romer to Michael Woodford to various market monetarists have advocated.  (At the zero bound, level targeting is far more powerful than growth rate targeting.)  How a policy that has never been tried has failed, is beyond my comprehension.

2.  Yes, the BOJ did establish a 2% inflation target.  FWIW the Japanese inflation rate in 2014 was 2.4%.  In fairness to Waldmann, that was partly due to the sales tax increase, it was running at 1.6% before the tax increase, and will likely fall below 2% this year.  Still, it’s better than deflation.  If Abenomics turned deflation into inflation, why not do even more?  As far as I know Japan has not run out of ink and paper.

3.  Japan did experience two quarters of falling RGDP in 2014, but (despite press reports to the contrary) certainly did not experience a recession.  Or if it did, it would be the first recession year in human history associated with a significant fall in the unemployment rate.  If we could have a “recession” that brought down our unemployment rate to 3.4%, I’d be thrilled.

4.  Of course what actually happened is that RGDP soared in Q1 and then fell sharply in Q2, and a bit more in Q3.  This is what roughly I expected, and is completely consistent with the monetary offset model.  Waldmann seems to think that the fact that the Japanese public is smart enough to move April auto purchases up to March in order to avoid the hefty sales tax increase is inconsistent with our model (which incorporates rational expectation and efficient markets.)  Monetary policy is not a surgical tool that can move AD from one month to the next.

5.  In any case, monetary offset refers to the fact that the central bank will prevent a negative demand shock on the fiscal side from reducing inflation below target.  But this tax increase was a negative supply shock that increased inflation.  I’ve consistently argued that if a central bank is targeting inflation then a fiscal action that affects aggregate supply (like a employer-side tax cut or a VAT cut), may impact real GDP without impacting inflation.  Monetary offset does not apply in that case.

6.  And since when is a monetary policy that leads to only 2.4% inflation considered “extremely radical expansionary monetary policy”?  I mean seriously, what is so radical about a government swapping one risk-free near-zero interest rate government liability (reserves) with another risk-free near-zero interest rate government liability (government bonds)?

7.  And what does the phrase “sufficiently determined” mean?  The recent stimulus passed by a 5-4 vote.  That doesn’t seem very determined to me.  There was one quite determined stimulus advocate at the BOJ, but that hardly makes the overall BOJ sufficiently determined.  If we assume they fell a bit short of their inflation target (stripping the VAT out of the inflation rate), then obviously they were not sufficiently determined. Now if someone wants to argue that conservative central bankers are not likely to be sufficiently determined at the zero bound, you’ll get no argument from me.

Meanwhile Paul Krugman continues to complain about critics of fiscal stimulus, without actually responding to our criticisms.

In another post he addresses the challenges faced by Greece:

Now, you might think that 3 percent of GDP is not that big a deal (although try finding $500 billion a year of spending cuts in the United States!)

It just so happens that the US budget deficit declined by $500 billion in calendar year (not fiscal year) 2013 compared to calendar year 2012.  And we all know what happened .  .  . er, didn’t happen.

On the positive side, Krugman’s recent post on high tech firms is excellent.

Playing with toy models

Back in 2002, Bennett McCallum did a really nice survey piece on contemporary monetary economics.  The best parts are his insights into some of the controversial issues, but I’d like to focus on something else (in the equations I changed the style a bit—I can’t do subscripts and deltas).  Here’s McCallum, with adjustments:

A striking feature of the typical models in the NBER and Riksbank conferences is that they include no money demand equations or sectors. That none is necessary can be understood by reference to the following simple three-equation system.

yt = α0 + α1Et(yt+1) + α2(Rt − Et(dpt+1)) + α3(gt − Et(gt+1)) + vt (1)
dpt = Et(dpt+1) + α4(yt − ynt) + ut                                           (2)
Rt = µ0 + µ1(dpt − dp∗) + µ2(yt − ynt) + et                               (3)

Here equations (1)–(3) represent an expectational IS equation, a price adjustment relationship, and a Taylor-style monetary policy rule, respectively. The basic variables are yt = log of output, pt = log of price level, and Rt = nominal one-period interest rate, so dpt represents inflation, Rt − Et(dpt+1) is the real interest rate, and yt − ynt ≡ ˜yt is the fractional output gap (output relative to its capacity or natural rate value, whose log is ynt). Also, gt represents the log of government purchases, which for present purposes we take to be exogenous. In this system, Et denotes the expectations operator conditional on information available at time t, so Et(pt+1) is the rational expectation formed at t of pt+1, the inflation rate one period in the future.

(In the original dpt was “delta” pt.  I also corrected a typo in equation 2.)

Now let’s do something similar in the MM model.  In equation 3 we will replace R in the previous model with NGDP futures prices (NGDPF), which is the instrument of monetary policy.  (It’s not really the instrument, the base is.  But then the fed funds rate is also not really the instrument, the base is. Both NGDPF and R are financial market variables that are observable and controllable in real time.)  The NGDP futures price equals the target value, plus a systematic error (SE).  The systematic error is the predictable part of the central bank’s policy failure.

In equation 2, actual NGDP reflects both the predicted value (previous NGDPF), and an unforecastable error term (et.)  The employment gap in equation 1, more specifically the gap between actual hours worked and the natural rate of hours worked, is alpha times the NGDP gap. Alpha is probably roughly one.  The hours worked gap is thus roughly equal to the difference between actual and target NGDP growth.  Between mid-2008 and mid-2009, NGDP fell about 8% below trend, and hours worked also fell about 8% below trend

(Ht – Hnt) = α(NGDPt – NGDPTt)      (1)

NGDPt = NGDPFt-1 + et                      (2)

NGDPFt-1 = NGDPTt + SEt-1            (3)

And all this boils down to:

(Ht – Hnt) = α(SEt-1 + et)                    (1)

Where the monetary policymaker determines SEt-1.

If they do NGDP futures targeting, then SE = 0.  Let’s use an inflation targeting analogy.  The ECB is targeting inflation at 1.9%, and last time I checked the 5-year inflation forecast in the German TIPS market was about -0.1%.  So in the eurozone SEt-1 is roughly negative 2%.  If the ECB pegged CPI futures prices at 1.9% inflation, then the SE would rise from negative 2% to zero.  Actual eurozone inflation would be 1.9% plus et.  Under NGDP futures targeting, SE is equal to zero and the hours worked gap is a random walk.

Of course this oversimplifies everything (but then so does the 3 equation model described by McCallum.)  Hours worked would actually depend on Wage/NGDP, or even better Wage/(NGDP/person). Further refinement would include shocks to labor’s share of national income.  Nominal wages depend on expected future NGDP, but are also very sticky, adjusting slowly when pushed away from the desired Wage/NGDP ratio.  That would all have to be modeled.

The NGDPF market could be modeled as follows.  Define the ratio of next period’s NGDP and the current monetary base as “quasi-velocity” (QV.):

Mt*QVt = NGDPt+1

Then create a futures market in QV, and tell traders that the base will be set at such a level that the base times equilibrium QV (in the futures market) is equal to target NGDP (NGDPT.) That replaces the Taylor rule. And by using a velocity futures market, you avoid the circularity problem discussed by Bernanke and Woodford (1997). QV is obviously a function of the nominal interest rate. (This is based on a 2006 Economic Inquiry paper I did with Aaron Jackson.)

There is nothing at all like the IS relationship, as equation 2 is simply an application of the EMH (plus the assumption that the NGDP futures price is an unbiased forecast of future NGDP.) The hours worked gap is the closest thing to a Phillips Curve.  If you want output gaps, you can derive them from the hours gap equation using a variant of Okun’s Law.  Once you have real output, you can also derive the price level, as NGDP is already determined.  But why would you want those things?  The hours gap equation measures the business cycle, and NGDP is superior to the price level as a proxy for the welfare costs of inflation.  And if it’s long run economic growth you are interested in, then why mess around with monetary models?

I see several differences between the standard approach and my toy model:

1.  I use NGDP futures prices, which is not subject to the ambiguity associated with nominal interest rates.  NeoFisherites will not misinterpret my policy equation.  And it’s more efficient, as it cuts out the middleman and uses open market operations to directly target NGDP futures, which is what you care about.

2.  My “Phillips Curve” uses NGDP and not inflation (the switch from unemployment to hours is not so important.)  Inflation is problematic, because it might reflect either demand or supply shocks. So the standard model needs to account for supply shocks.  NGDP is better, as it only reflects demand shocks, which are what drive any Phillips Curve relationship.  It simplifies things.

This is just a toy model; perhaps someone else can create a real model along market monetarist lines.  As a blogger this is the approach I like best.  As director of the Mercatus Monetary Policy Program, I want the model that the rest of the profession finds most convincing.  I imagine that would be something more along the lines of a Nick Rowe model.

Cash and the zero lower bound

Let’s review the (alleged) zero bound problem.  The nominal interest rate falls to zero.  The Fed injects base money, and banks choose to hold it as excess reserves.  The Fed could try to force banks to lend it out with negative interest on reserves (IOR), but in that case deposit rates would go slightly negative and the public would pull the money out and hold it as cash.  The existence of cash creates an effective zero lower bound on nominal interest rates, or perhaps a lower bound of a few basis points negative, as there are costs of holding cash.

Many Keynesians think that this in some way makes monetary stimulus ineffective.  This is wrong, but let’s put that issue aside and consider another issue—does eliminating cash solve the zero bound problem, at least from the perspective of monetary policy ineffectiveness?  And the answer is clearly yes.  If you eliminate cash then the medium of account is 100 percent bank reserves.  If the Fed charges a negative 6 percent rate on bank reserves then the demand for bank reserves would plunge much lower, and AD would soar much higher. What happens to market interest rates in that scenario?  I’m not sure, but it doesn’t matter.  Eliminate cash and you definitely eliminate the zero bound problem on the policy rate.  The Fed can again use interest rates (IOR) as their policy lever.

Tyler Cowen links to a John Cochrane post that discusses the Keynesian argument for eliminating currency.  I agree with Cochrane that eliminating cash is a really bad idea, for standard libertarian reasons.  But Cochrane misses the point when he argues that people can still earn zero rates of return on other assets, such as stamps, gift cards and prepaid taxes, even if cash were eliminated.  Stamps,  gift cards and prepaid taxes are not the medium of account, only cash and bank reserves count.  If you eliminate cash and charge a strongly negative rare of bank reserves, the hot potato effect kicks in with a vengeance. Monetary policy is all about changes in the supply and demand for the medium of account.

Ironically, despite the fact that Cochrane teaches at the University of Chicago, he uses a strongly interest-rate oriented approach to monetary economics.  Milton Friedman used to insist that Keynesians kept making basic mistakes by assuming that monetary policy could be thought of in terms of market interest rates. Friedman was right, focusing on interest rates causes nothing but confusion.  (And recall the neo-Fisherian debate, which also got on the wrong track by assuming that changes in fed funds interest rates were “monetary policy.”)

PS.  I’m skipping over the dubious assumption that investors would be able to park trillions of dollars in zero interest gift cards in a negative IOR scenario.  My point is that even if they could, it would not prevent negative IOR from solving the zero bound “problem,” which of course all market monetarists already know is not actually a problem.