Archive for the Category Monetary Theory


Inflationistas and liquidity trappers

For six years Paul Krugman has been engaged in an intellectual war against the forces of evil on the right.  Those who claim that monetary stimulus would lead to high inflation.  Over that same period I’ve been engaged in a three-way struggle; market monetarism against the forces of misguidedness on both the left and the right.  (Unlike Krugman I believe my opponents are well intentioned.) Monetary stimulus won’t lead to high inflation, and it’s not ineffective.  For once I’m the sensible moderate.  Now the battle continues—and this time it’s Krugman’s post that needs correcting:

Switzerland has never paid interest on reserves — and lately it has taken to doing the opposite, charging banks 0.25 percent for the privilege of parking their money at the central bank. So has the Swiss National Bank’s huge increase in the monetary base, which dwarfs what the Fed has done, produced inflation?

Well, look at the included chart. Monetary base up by a factor of eight. Money supply up by much less, because banks didn’t lend the funds out. And consumer prices flat, indeed flirting with deflation.

This is all exactly what a basic liquidity trap model — the one I laid out in 1998 — predicted. So the inflationistas are finally going to concede their mistake, right?

As I’ve noted before, the 1998 model doesn’t say monetary policy is ineffective, indeed soon after it was published he was using the model to argue against fiscal stimulus and in favor of monetary stimulus in Japan.

In 2010 the Swiss franc had become too strong for comfort, and the Swiss National Bank was buying up lots of foreign assets to hold down its value.  By then Krugman had become very skeptical of the effectiveness of monetary stimulus at zero rates:

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro — and failed:

Later I pointed out that even that claim was wrong, but at least it was plausible. Beginning in September 2011, however, the claim was no longer even plausible, as the SNB depreciated the franc sharply and then pegged its value to the euro.  As I’ve argued many times, there is much in Krugman’s monetary analysis that is correct, and even ahead of his critics.  But there is one fatal flaw, shared by many of my commenters.  Krugman assumes that if a central bank has done X purchases of assets, and failed to hit its nominal target, then it would have to do more than X to hit its target.  But in the Alice in Wonderland world of monetary economics, it’s exactly the opposite; the more ambitious your target, the less you have to do.  And that’s equally true of exchange rate targets and NGDP targets.  Among the developed countries, Australia had the most ambitious NGDP target in this century, and its central bank has had to do the least to hit it.

In 2012 Evan Soltas provided evidence that as soon as the SNB started pegging the exchange rate, they didn’t need to buy anywhere near as many foreign assets to hold down the value of the SF.

Its credibility is so powerful, in fact, that the SNB has stopped having to buy up foreign currencies with new swiss franc, which it did in earnest to prove its commitment in 2011, increasing its foreign exchange reserves by 177 billion from July to September. It hasn’t had to defend at all the value of its currency against appreciation since September, despite what should be enormous pressures. (See here and here for the data.) That is truly remarkable, when you zoom out for the macroeconomic big picture.

That is the power of credible monetary promises. And we can do the same thing with the price level path, of course, managing correctly the striking strength of market expectations. All it takes is the appropriate use of the expectational channel; re-establish 5 percent annual NGDP growth as did the SNB for its currency, and then the market will do the rest for you.

I found some monetary base data that is quite interesting.  From January to September 2011 the Swiss monetary base soared from 79b SF to 253b SF.  That’s Zimbabwean money printing, and it shows why Krugman is so contemptuous of the inflationistas.  Switzerland got essentially zero inflation.  But then something interesting happened; after the currency was depreciated and pegged at 1.2 SF/euro, the base actually fell to 215b by May 2012.  Once investors stopped thinking the SF was going to move ever higher, they no longer had a strong incentive to speculate in that asset. It became easier to defend the currency.

Alas, there was one more attack in mid-2012, as eurozone investors worried about a collapse in the euro.  Naturally, in that environment the SF would be attractive at even a zero expected rate of return.  The base rose again to 349b SF in September 2012, at which point growth slowed sharply (it’s 376b today.)  More importantly, the 1.2 SF/euro peg held.  Krugman was wrong, currency depreciation is not difficult if it is followed up with a level targeting regime.

With the recent collapse of the Russian economy, the SNB imposed a negative 0.25% interest rate on reserves.  So I suppose you could call that a “problem,” that is, if having the rest of the world be willing to pay you to accept their loans is considered problem.  Personally, I can think of lots of other European countries that would be happy to trade places with Switzerland.  Starting with Greece, and ending with . . . let’s face it, except for Norway wouldn’t any of them rather be in Switzerland’s shoes right now?

The recent success of the SNB and the BOJ in their attempts to depreciate their currencies is pretty conclusive evidence that the liquidity trappers are wrong.  Yet Paul Krugman continues to trumpet his successes against the inflationistas, which quite frankly is like shooting ducks in a barrel, and ignore the monetary theory that is superior to both the crude quantity theory and crude liquidity trap Keynesianism. The only macro theory capable of explaining all of the major stylized facts of the past 6 years.

The theory that didn’t even have a label until Lars Christensen named it in 2010.

Krugman on the limits of monetary policy

Here’s Paul Krugman, in his pessimistic mood:

You might think that it’s a fundamental insight that doubling the money supply will eventually double the price level, but what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all.

And as a result, monetary traction is far from obvious. Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously — and certainly “credibly promising to be irresponsible”, to not undo expansion in the face of future inflation, is a much harder thing to achieve than simply acting when the economy is depressed.

Just to be clear, Krugman is not saying the central bank must promise a specific future money supply on a specific date, he’s saying the expected future money supply must be large enough to produce a specific expected future inflation rate (or price level.)

There are several possible solutions to the credibility problem.  One that both Michael Woodford and I have discussed is level targeting.  Suppose the central bank always falls short of its price level or NGDP target by 1%, due to a lack of credibility.  You might argue that this describes the current situation in Japan, for instance.  If the central bank has a level target, that shortfall only has significant macroeconomic effects in the very first year.  After that the level of the target variable continues to fall 1% below target, but the growth rate of the aggregate (which is what really matters) is always on target (after the first year.)

A second solution is to adjust the monetary base as needed to peg the price of CPI futures, or NGDP futures.  That will keep expected future growth in the nominal aggregate right on target.  If that seems “to good to be true,” it’s because it exposes the fact that worry about “liquidity traps” is actually worry about something else—the size of the central bank balance sheet.  But in the long run the central bank balance sheet will be smaller with a more expansionary policy, and perhaps (as the Swiss central bank showed a few years ago) even in the short run. If the central bank balance sheet is too big for comfort when you are hitting your target for expected future inflation, or expected future NGDP growth, then raise the Price level/NGDP target path or lower the rate of interest on reserves.

In my view this is where Krugman goes off course.  He assumes that if the central bank has done a lot, and has still fallen short, it would have had to do even more to succeed—bleeding into fiscal policy. In fact, just the opposite is true.  The central banks that succeed are those (like the Reserve Bank of Australia) that do the least. That’s because faster NGDP growth leads to a much lower desired ratio of base money to GDP, and hence smaller central bank balance sheets.

Krugman continues:

Just to be clear, I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998 — that central banks can always cause inflation if they really want to — just doesn’t hold up, theoretically or empirically.

I seem to recall that Krugman was quite pessimistic about the ability of the BOJ to succeed in producing inflation, at least a few years ago.  But when they raised their inflation target to 2%, they did succeed in moving from deflation to mild inflation (albeit still short of the 2% goal.)  The good news is that we now know that the Japanese government can sharply depreciate the yen anytime it wishes to (something else that Krugman had originally doubted.)  That means the BOJ can inflate–it’s just a matter of how committed they are to make it happen.  In a sense this is also Krugman’s view (when he’s in the more optimistic mood), and he’d undoubtedly argue that the political push from Abe helped the BOJ.  In the past Krugman seemed to think fiscal stimulus was an easier sell politically.  That may be true in a few cases, but in Japan monetary stimulus has turned out to be the easiest part of the three-part reform project.  And monetary policy doesn’t have to worry about fiscal offset, in the way that fiscal policy must worry about monetary offset.

On the other hand, my recent Econlog post on the ECB shows an almost Krugmanian level of pessimism.  I just don’t see the institutional resolve at the ECB to raise inflation up to their 1.9% target. Europe badly needs to rethink everything they are doing, from the ground up.

HT: Ken Duda

Josh Hendrickson on the problem with “moneyless” NK models

Josh Hendrickson is sort of like my mirror image; he doesn’t post very often, but almost invariably has something interesting to say.  In a new post he discusses a flaw in one common New Keynesian (NK) model, which looks at monetary policy through the lens of interest rates.  But first, a quick review of interest rates and monetary policy.  The easiest way to see the relationship is with the equation of exchange:

M*V = P*Y

When the Fed raises interest rates, pundits tend to call the policy “contractionary.” That’s misleading for all sorts of reasons, but does contain a grain of truth.  The true part comes from the fact that in the very short run, the Fed engineers interest rate increases by reducing the monetary base. Note that by itself the rate increase is expansionary, as it tends to boost the velocity of circulation, by raising the opportunity cost of holding base money.  But that expansionary effect is more than offset by the direct contractionary impact of the lower monetary base.  Here’s Josh, looking at the opposite case, an increase in the money supply:

Now consider the effects of a change in the money supply. As illustrated in the figure above, the increase in the money supply causes the interest rate to decline. This means that when the money supply increases, velocity declines. However, the interest elasticity of velocity is often estimated to be rather small. The initial effect of the increase in the money supply is that the nominal interest rate to fall and nominal spending to rise. The decline in the nominal interest rate is an effect of the change in the money supply, but note that it is not the cause of the change in nominal spending.

So far so good.  But here’s where NKs get into trouble.  Josh says that their models imply that a higher interest rate is contractionary, even if there is no change in the money supply:

The New Keynesians, however, countered that they didn’t need to use open market operations to target the interest rate. For example, Michael Woodford spends a considerable part of the introduction to his textbook on monetary economics to explaining the channel system for interest rates. If the central bank sets a discount rate for borrowing and promises to have a perfectly elastic supply at that rate and if they promise to pay a rate of interest on deposits, then by choosing a narrow enough channel, they can set their policy rate in this channel. In addition, all they need to do to adjust their policy rate is to adjust the discount rate and the interest rate paid on reserves. The policy rate will then rise or fall in conjunction with the changes in these rates. Thus, the New Keynesians argued that they didn’t need to worry about money in theory or in practice because they could set their policy rate without money and their model showed that they could get a determinate equilibrium by applying the Taylor principle.

Nonetheless, what I would like to argue is that their ignorance of money has led them astray. By ignoring money, the New Keynesians have confused cause and effect. This confusion has led them to believe that they know something about how interest rate policy should work, but they have never stopped to think about how interest rate policy works when the central bank adjusts the nominal interest rates in a channel system versus how interest rate policy works when the central bank adjust the nominal interest rate using open market operations.

Unfortunately the post is hard to excerpt; you really need to read the whole thing.

This does not mean that NK interest rate policies will not “work.”  Rather I would argue that they work for reasons that NKs don’t understand, and when they fail they will fail for reasons NKs don’t understand.  Other economists such as Peter Ireland (who is cited by Josh) have pointed out that even with interest on reserves (IOR) you can never really ignore the quantity of money, and that certain quantity theoretic claims continue to hold true.

For me, the easiest way to understand this issue is to think about (non-interest-bearing) currency. Back in 2007 the base was about $850 billion, with about $800 billion of that being currency.  Now suppose Ben Bernanke had been instructed to use interest rates to double the price level over the next 30 years.  He was not allowed to use the monetary base.  For simplicity, assume he never ran into the zero bound problem.  Even in that case, where positive interest rates allowed him to continually use a Taylor Rule-type approach, it’s easy to see that the policy objective would be impossible to achieve.  There would not be enough base money to match the demand for currency at a price level double its current value.  I think this simple truth sometimes gets overlooked in models that focus on bank reserves and IOR, and/or periods of history where there are plenty of excess reserves.

I said that NK policy might work despite its theoretical weaknesses.  That’s because asset markets would probably (correctly) interpret a rise in the IOR rate as part of a broader Fed strategy to reduce future growth in aggregate demand.  Thus markets would assume that the base would also be adjusted over time in whatever direction was necessary for hitting the central bank’s target. (Surely there must already be a Nick Rowe analogy involving steering wheels and social conventions.) As always, monetary policy is 98% expectations, and 2% concrete steps.  What are those expectations about?  They are about future concrete steps, i.e. future changes in the supply of base money, relative to changes in the demand for base money.

PS.  I have a post criticizing Charles Plosser, and 99% of other economists, over at Econlog.  And also a libertarian rant.

Other things equal, lower prices cause consumers to buy less of a good

I still see confusion about the never reason from a price change concept.  So let’s try again, looking to see whether “other things equal” helps.

Most people accept that fact that lower prices caused by less demand means something different from lower prices caused by more supply.  But what about lower prices, “other things equal?”

Screen Shot 2014-11-12 at 8.30.25 AMAs you can see the quantity demanded exceeds the quantity supplied. In that case the actual quantity bought and sold and consumed equals the quantity supplied, unless demanders put a gun to the head of suppliers.  So “other things equal” lower prices will reduce the amount that consumers purchase.  If either supply or demand shifts, then other things are not equal.  My “never reason from a price change” refers to equilibrium movements, you certainly can reason from a price or wage control set by the government, which moves prices away from equilibrium.  But as this case shows, not necessarily in the direction that you might assume.

When I said price changes have no effect, I should have said “other than to subjective states of mind.”  A price change, in and of itself, will change the amounts that people prefer to buy and sell. But a price change doesn’t affect any observable economic variable, unless it is an artificial price change that moves you away from equilibrium.

Ditto for interest rate changes and investment.  Many people stubbornly refuse to stop thinking in terms of “interest rate change equals interest rate change caused by the Fed,” and even worse, “interest rate change equals interest rate change caused by the liquidity effect of a Fed action.”  The latter claim isn’t even close to be true.  It’s not even true 20% of the time.  But it seems to be what many of my commenters and most economists assume is the case.  Here’s a typical comment from my previous post:

If interest rate rises stifle investment . . .

Stop right there; interest rate rises do not stifle investment.

I’m not sure why so many economists are confused on this point.  Perhaps they think: “The liquidity effect impacts rates in the short run.  The term ‘short run’ means roughly what’s going on right now.  And a long time series is just a long series of ‘right nows.'”  If that’s not what they are thinking, I’d love to hear alternative theories.

PS. The term “short run” does not in any way mean “what’s going on right now.”

In economics, price changes don’t have any effect, they are effects

I don’t know how many times I have to keep saying this before the rest of the profession figures it out.  Never reason from a price change.  [Update:  I mean an equilibrium price change.] It makes no sense to argue whether a higher price will increase or decrease quantity.  Here is a S&D diagram.  I dare you to show me how price changes affect quantity.

Screen Shot 2014-11-11 at 10.56.48 AM

And here is an IS-LM diagram.  Interest rates are the price of credit.  Changes in interest rates do not have any effect on quantity of output, price of output, or any other variable.  It’s not even an “other things equal” deal; price changes have no effect.

Screen Shot 2014-11-11 at 10.57.43 AM

At this point some economists will say; “I meant an interest rate change caused by a change in monetary policy.”  The problem is that higher interest rates can be produced by both easier and tighter monetary policy.  And easier and tighter monetary policy have opposite effects on prices and output.  So I’m sorry, but it’s still a meaningless debate.  It’s not that there is a right or wrong answer; there is no coherent question.  Monetary policy can shift the LM curve, the IS curve, or both.

Consider this analogy:  A debate over whether high oil prices increase or decrease global oil consumption.  The debate is meaningless.  Price has no effect.  Here’s how the issue should be discussed:

A.  An Arab oil embargo caused higher prices and lower consumption in 1974.

B.  Booming Chinese auto sales caused higher oil prices and higher consumption in 2007.

Prices are not a cause of anything; they are an effect.  And interest rates are a price.  So please stop these silly posts discussing the impact of a change in interest rates.  Talk about the effect of expansionary and contractionary monetary policies—that’s an interesting question.

This criticism applies to both sides of the debate.  John Cochrane and Noah Smith should not be discussing the possibility that higher rates lead to higher inflation, and Paul Krugman should not be claiming that the standard model suggests that higher rates lead to lower inflation.  Actually, both claims are true in specific situations.  But without specifying the specific situations in which each claim is true (especially the path of the money supply and IOR) the claims becomes utterly meaningless.

Truly a debate about NOTHING.

PS.  If you are still having trouble with this, consider the following.  A 1/4% rise in the fed funds rate today can be accompanied by a near infinite number of simultaneous expected changes in the future expected path of variables like the fed funds target, the monetary base, the interest rate on reserves, the reserve requirement, and all sorts of other policy levers.  Those variables in turn have a near infinite number of effects on all sorts on market variables other than short term interest rates, including TIPS spreads, commodity prices, forex prices, future expected real estate prices, stock prices, corporate bond risk spreads, etc., etc.  And all that happens immediately.

Here’s another example.  Assume Japan has run zero percent inflation for 20 years while the US has a credible 2% inflation target.  Zero inflation is expected to continue in Japan.  Suddenly they depreciate the yen 17% and set up a rigid currency board with the US.  PPP tends to hold in the very long run; so long term Japanese inflation expectations immediately rise from 0% to 2%. Interest parity holds even in the short run, so Japanese interest rates immediately rise to US levels. That’s a case where Cochrane is right, and it’s 100% consistent with IS-LM.  In contrast, in January 2001 the Fed cuts rates more than expected, and TIPS spreads rise sharply on the news.  That’s a case where Krugman was correct, and it’s 100% consistent with IS-LM.

The correct answer is “it depends.”

PPS.  Question for Nick Rowe.  Does my yen/dollar peg solve the coordination problem you discuss in this post?

HT:  TravisV.