Archive for the Category Monetary Theory


Banking theory disguised as monetary theory?

[I wrote this yesterday but held off--as I often do for "spacing" reasons.  In the interim Nick Rowe did a post on the same paper.  I recommend you read his reaction if you only have time for one.  It's much better.]

The Bank of England was kind enough to send me a new report explaining monetary policy.  Unfortunately I think the report is way off target. On the other hand if they knew anything about my blog they would have known that would be my reaction.  Let’s start here:

This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy — through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation.

I hate the term ‘modern.’  The money directly produced or “printed” by the central bank is called base money. I don’t know about Britain, but in America the share of total money that is base money is actually higher than 100 years ago.  So there is nothing “modern” about our current system.  And the BoE does directly control the amount of base money, at least in the sense of “directly control” that the BoE uses when they describe direct control of short term interest rates.  Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous.  However changes in the supply and demand for base money remain the lever of monetary policy.  And notice the BoE implies that once they stopped targeting interest rates they were no longer even doing monetary policy (or perhaps it’s just misleading language.) The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such as way as to produce 2% inflation.  And yet in that long chain interest rates are singled out as “monetary policy.”

Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.

Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’  Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.”  So it would have been more accurate to talk about central banks injecting coins into the system.  And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system.  Banks were not important for monetary policy, although of course they were a key part of the financial system.

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves.  While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves — that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them — which will, crucially, depend on the interest rate set by the Bank of England.

I’m not a fan of the money multiplier model, but it’s sometimes unfairly maligned. Textbooks don’t treat it as a constant, any more than they treat velocity or the fiscal multiplier as constants.  They may do an example where it is constant, but then they discuss reasons why it changes.

The real problem here is “binding constraint.”  In economics there are almost never binding constraints on anything.  If you at a binding constraint position then odds are you are not optimizing.  A reduction in the supply of apples will generally raise apple prices even if not at the binding constraint where one less apple would cause starvation.  By (permanently) adjusting the supply of “reserves” (again base money is what they actually mean) the central bank can affect the value of the medium of account (base money), and hence all nominal variables in the economy.  That includes the nominal size of the toilet paper industry, the nominal size of the steel industry, and the nominal size of bank balance sheets. Most importantly NGDP. If wages and prices are sticky they can also affect real GDP in the short to medium run.

Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries.  Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry!  Why not focus on those industries?

The deeper problem here is the BoE mixes up microeconomics (the relative size of the banking industry) with macroeconomics (the determination of nominal aggregates), in a very confusing way.  You need to model the medium of account to have any sort of coherent explanation of monetary policy.  The interest rate approach combined with a banking sector and a “slack/overheating” model of inflation just won’t cut it.  Certainly the BoE report is not as bad as some of the things you see from MMTers, it nods to the old-style monetarists in its discussion the problems that might arise from of excessive growth of the aggregates.  But it nonetheless fails to come up with a model of the price level or NGDP. It can’t tell us why Britain has 20% inflation one year, and 2% another.  You need to explicitly model the supply and demand for base money to do macroeconomics.

PS.  And why doesn’t the BoE subsidize and run a NGDP prediction market?

PPS.  Perhaps my report was too negative. I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.

Watch what they predict, not what they say

Lots of commenters make a big deal about the fact that some Fed officials, and Ben Bernanke in particular, often make statements implying that they don’t engage in monetary offset.  One response is that they also make statements implying that they do engage in monetary offset.  Talk is cheap, and there’s no doubt the Fed would prefer that Congress do more of the heavy lifting, so they could do less (and hence be less controversial.)

But actions speak louder than words.  How does the Fed change its forecast of RGDP growth in 2013, as a result of the big tax increases plus sequester?  Take a look at the following, from The Economist:

Screen Shot 2014-03-06 at 9.32.43 AM

Lots of people have noticed that actual GDP growth accelerated in 2013, as compared to 2012, despite all the austerity we were warned about.  But of course lots of unexpected things can happen over a 12 month period.  I find it much more interesting to look at the expected effect of austerity. Notice that expected 2013 growth is identical to expected 2012 growth.

Now some will argue that that’s only because other things were changing to offset the effect of austerity.  For instance, the Fed did QE3 and forward guidance in late 2012.

Which is exactly the point.

PS.  In fairness, I’m not sure how fully they understood the extent of fiscal austerity in their December 2012 forecast.  They did cite looming fiscal austerity when justifying their monetary stimulus of late 2012, so it was clearly understood that austerity would occur.  But in March they lowered their RGDP growth forecast from 2.65% to 2.55%, perhaps because of more information about the severity of the austerity.

The Fed lowered its GDP forecast slightly downward in the March FOMC meeting

The Fed is forecasting from 2.3% to 2.8% in GDP growth for 2013, taking down the top end of the range from 2.3% to 3.0%. The Committee noted that the private economy was growing a little faster than anticipated, and that would nearly offset the fiscal drag imposed by the Jan 1st tax hikes and the sequester. They did adjust their 2014 and 2015 forecasts lower as well, although not dramatically.

On the other hand Q1 growth was very weak, so it seems equally likely that that triggered the downgrade in forecasts, not the sequester.  Fiscal austerity might or might not have lowered the Fed’s growth forecast by 10 basis points.  That’s far from the apocalyptic forecasts of the Keynesians. 

How much longer?

Some questions for various old monetarists, Austrians, gold bugs, and other conservatives:

1.  Japan has had interest rates near zero for nearly 2 decades.  Is this easy money, despite an NGDP that is lower than in 1993?  Despite almost continual deflation?  Despite a stock market at less than one half of 1991 levels.  Despite almost continually falling house prices?  If it’s easy money, how much longer before the high inflation arrives?

2.  The US has had near zero interest rates for more than 5 years.  Is this easy money?  If so, how much longer until the high inflation arrives?  If rates stay near zero for 2 more years, and inflation stays low, will you still call it easy money?  How about 5 more years?  Ten more years?  Twenty?

I constantly hear conservatives complain that elderly savers can’t earn positive interest rates because of the Fed’s “easy money” policy.  Is there any time limit on how long you will make this argument, before throwing in the towel and admitting rates are low because of the slowest NGDP growth since Herbert Hoover was President?  Or is your model of the economy one where decades of excessively easy money leads to very low inflation and NGDP growth?

In other words, is there some sort of model of monetary policy and nominal interest rates that you have in your mind, or do you see easy money everywhere and tight money nowhere?  What would tight money look like?  What sort of nominal interest rates would it produce?

Noah’s snark?

I’ve consistently made the following arguments about Abenomics:

1.  The data suggests that the new BOJ policy has raised inflation, and inflation expectations.  There is a mountain of evidence on that point.

2.  Japanese inflation is likely to fall short of 2% (except for the sales tax bounce) unless the BOJ takes further steps.  That’s less clear than the first point, but seems a reasonable way to read market indicators such as long term bond yields.

3.  It really doesn’t matter whether they hit 2% inflation, they shouldn’t even target inflation. Rather what matters is if they can move NGDP growth into positive territory–at least 2% to 3%.  It’s still unclear if they will achieve that, but they’ve made progress.

Many commenters sent me a Noah Smith post that correctly pointed out that the more reliable “core-core” inflation rate is only running about 0.7%.  Mark Sadowski pointed out that just three weeks back Noah Smith had a post that showed the core-core rate had recently risen, and was at the highest rate since the 1990s.

Noah concluded with this odd assertion:

So basically, Abenomics has not yet shown that a central bank can hit a 2% inflation target after a long period of deflation. That proposition remains an article of faith. Perhaps the target will be hit…perhaps not. (Of course, if it’s not hit, expect a few supporters of monetary easing to say that the Bank of Japan was just not committed enough to hitting it…)

As I said, I never expected Japanese inflation to hit 2%, but I’m more interested in the question of whether the failure to do so would indicate that the BOJ did not do enough.  Hmmm, let me think about it.  Let’s see . . . I’m probably not a complete moron.  So yes, I guess I’d have to say that if inflation falls short of 2.0% then the BOJ would not have done enough to hit 2.0%.  After all, if doing X moved inflation up to the highest levels since the 1990s, then it stands to reason that doing 10X or 100X would boost inflation even more.  If moving the yen from 80 to 100 to the dollar boosted inflation, then it stands to reason that pegging the yen at 100 million, or 100 trillion to the dollar would do the job.  If not, how about 100 quintillion yen to the dollar?  (I stole this argument from John Locke–I only steal from the best.)

Or maybe I made a mistake somewhere.  The NK model says “overheating” causes inflation.  So if a currency peg of 100 quintillion to the dollar didn’t lead to overheating, then I guess it could not boost inflation above 2%.

Perhaps I’m overreacting to an italicized word (enough), but I couldn’t help thinking that there was a bit of snark directed at those who would claim that a failure to hit 2% inflation was due to insufficient monetary stimulus.  What else could it be due to?  Japan has the world’s largest budget deficit outside Egypt and Venezuela.

Perhaps a more interesting question is whether the reason Japan did not do enough (should it fail to hit 2% inflation) was that there were political barriers to currency debasement.  Say they worried that the US would send in the Marines if the yen was pegged at 100 quintillion to the dollar.  But as far as technical barriers, I’m pretty sure that if the Zimbabweans found a way, the Japanese could as well.  They aren’t morons.

PS.  The earlier Noah Smith post that Mark linked to ends as follows:

Monetary policy skeptics will doubtless still find no end of reasons to denigrate Abenomics, but so far their warnings have not been borne out.

Yes, that’s MUCH better.

PPS.  Just want to make it clear that Noah is not a moron–indeed he’s smarter than me.  Nor is he a phony.  I always try to inject a bit of humor into Noah Smith posts, and the Batman reference was already used.  Keeps me sane.

PPPS.  John Locke is definitely not a moron.

Channels to nowhere

When there is a big crop of apples, the value of apples tends to fall.  There is no need to discuss obscure “channels” such as bank lending.  Apples are worth less for “supply and demand” reasons. When there is a big crop of money, the value of money tends to fall.  Again, no need to talk about “channels.”  This post was motivated by a recent comment, which is something I see pretty often:

The CB [central bank] interacts with counterparties that have little or no propensity to spend and the lending channel is blocked.

That’s a fairly common view, and yet it contains no less than three serious fallacies.  This is what the commenter overlooked:

1.  Counterparties don’t matter.  The Fed buys assets from counterparty X, who almost always immediately cashes the check and the new base money disperses through the economy almost precisely as it would if the Fed had bought assets from counterparty Y, or counterparty Z.

2.  The propensity to spend doesn’t matter for the same reason.  Once counterparties get rid of the new base money, the impact on NGDP depends on the public’s propensity to hoard money, and any change in the incentive to hoard.  In the long run money is neutral and NGDP changes in proportion to the change in M, regardless of whether the person receiving the money has a marginal propensity to consume of 90% or 10%.  Either way they’ll almost always “get rid of” the new money, either by spending it or saving it.  Saving is not hoarding, it’s spending on financial assets.

3.  The lending channel doesn’t matter.  In the long run all nominal prices rise in proportion to the change in M.  In the short run sticky wages and prices cause the new money to have non-neutral effects.  Those non-neutral effects reflect wage and price stickiness, not “channels” of spending.

Here’s where the confusion comes from.  As soon as we move from a world of flexible prices and money neutrality (as with a currency reform) to a sticky-price world, real effects become the most noticeable short run effect of monetary shocks.  This causes many observers to reverse causality. They assume that easy money boosts real GDP, and if output rises enough it eventually triggers inflation. Thus they see real shocks triggering nominal changes.  If that’s your view of the world then channels of causation would seem to make lots of sense.  Why does RGDP change?  And which types of output change first?  Does more real lending cause more RGDP?  Do changes in interest rates cause more RGDP?  These are the questions you would ask.

If instead you think in terms of nominal shocks having real effects then the “channels” approach is totally superfluous.  A change in M causes a change in NGDP for supply and demand reasons, and if wages and prices are sticky then the change in NGDP triggers a change in RGDP.  Because NGDP affects RGDP, it will also affect all sorts of other real variables like real lending quantities and real interest rates.  But those are the effects of monetary shocks, they aren’t monetary shocks themselves.

Because money is a durable asset, expectations of the future value of money play an important role in its current value.  I suppose that is a channel of sorts, but it’s merely a channel connecting future expected NGDP to current NGDP.  To go from there to real variables such as output and employment, you simply need sticky wages and prices; channels like lending and interest rates add no explanatory power.

PS.  Ramesh Ponnuru has an excellent new post on monetary offset.

PPS.  Totally off topic, have other bloggers picked up this story:

The latest attempt by academia to wall itself off from the world came when the executive council of the prestigious International Studies Association proposed that its publication editors be barred from having personal blogs. The association might as well scream: We want our scholars to be less influential!