Archive for the Category Monetary Theory


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.

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.