I notice that lots of commenters insist that bondholders gain when the Fed injects money by buying bonds. Even if this were true, it would have no bearing on my criticism of Richman. That’s because any effect on bond prices would be identical if the Fed injected money by paying government salaries in cash, rather than buying bonds. But there’s a much bigger problem with this fallacy. It’s unlikely that monetary injections would raise bond prices at all.
It’s always a mistake to use microeconomic intuition in macro. People think; “If I buy a few bonds the bond price will rise, so surely the laws of supply and demand tell us that if the Fed buys lots of bonds then bond prices will go up a lot.” Before telling you why this is false, let me provide some evidence:
During the first couple decades after WWII the Fed bought modest amounts of bonds. Then after 1965 bond purchases exploded, and the Fed absorbed vast quantities of T-securities. And yet between 1965 and 1981 we saw an epic collapse of bond prices. One of the worst bear markets in all of American history. Is there a cause an effect relationship?
Yes, there most certainly is. The huge bond purchases caused the monetary base growth to accelerate sharply. At the end of 1945 the base was $33.7 billion. At the end of 1965 it was $49.9 billion. But over the next 16 years the Fed bought bonds at a furious pace, and the base rose to $150 billion by the end of 1981. This explosion in base growth drove NGDP growth rates and inflation much higher, which raised nominal interest rates sharply. That’s why bond prices fell sharply.
Is there another explanation? Could it be big deficits that did the trick? No, debt as a share of GDP fell. The big deficits began after 1981, when Reagan took office. It’s inflation and NGDP growth that determines bond prices, not what the Fed buys.
Why is it different at the individual level? Because when I buy bonds I don’t increase the money supply. When the Fed buys them the money supply rises. Supply and demand still hold true, but we must think about two markets, bonds and money. It’s not like a microeconomic S&D problem. The value of money falls when the supply increases, at least in the long run. Expectations of a decline in money’s value reduce the expected real value of future interest and principal, which is paid out in nominal dollars. That’s why more money means lower bond prices, other things equal.
Do monetary injections always reduce bond prices? No, just most of the time. Obviously there are special cases that relate to how the injection changes expected future policy, and very small effects depending on which maturities are purchased. But the dominant effect is that more money means lower bond prices.
Bob Murphy concedes I was right when I criticized the mechanism by which Richman believed monetary injections would matter—who gets the purchasing power first. But he also argues that it matters what the Fed buys. I’ve always agreed with that. He also argues that one of my blog post titles was misleading:
The problem is, the market monetarists overstepped. Scott Sumner could have said, “I agree with Sheldon Richman, the central bank certainly can make some connected players wealthy at everyone else’s expense, for example by buying up toxic assets or taking over AIG. Clearly it matters very much where the new money is injected into the economy. However, I don’t at all like the mechanism Richman cited. He said it has to do with people getting the money at an earlier date than other people. That’s totally wrong, and here’s why…”
But no, Scott didn’t say that. Instead he wrote a post with the palpably false title, “It makes very little difference how new money is injected.” On a plain English reading of that sentence, it is false; Scott doesn’t believe it for one second. If the new money is injected into the Tomahawk missile sector versus the MBS sector versus the Treasury sector, of course it will make a huge difference. That’s why some of us flipped out and were asking Scott questions that must have struck him as an absurd waste of time.
I plead not guilty. As I made clear in my recent posts, I was holding fiscal policy constant. I still think that if the Congress doesn’t authorize different tax rates or spending levels on the basis of monetary injection, that is if monetary and fiscal policy are handled by different groups, then it matters very little whether the Fed buys T-bonds, or MBSs, or injects money into public employee salaries. And I think that’s a very reasonable thing to assume for two reasons:
1. Over the years my comment section has been loaded with misconceptions on this very point. In the real world the Fed agonizes over whether to spend the new money on MBSs, discount loans, T-bonds, etc. Bernanke doesn’t agonize over whether to spend the new money on Tomahawk missiles. So I am dealing with monetary policy as it is, not some alternative world where the Fed might buy a trillion dollars in bananas, and drive up banana prices. It’s so obvious that fiscal policy can have sectoral impacts that I saw no need to insult readers’ intelligence by stating the obvious.
2. Many readers argue the Fed purchases enable the spendthrift Congress by holding down rates. The problem here is that an even tighter monetary policy would push us toward the Japanese scenario, with even lower long term rates. Any enabling comes via stronger NGDP growth, not lower rates. If the only way to stop Washington from spending is to drive the economy into such a deep depression that Washington has to spend less, then I’m not on board. And in any case, how’d that “tight money saves us from big government” work out for the conservatives who ran monetary policy in the early 1930s?
Perhaps my previous post was too pessimistic about influence. Here’s commenter MikeF:
When I first heard this Cantillon argument I actually though it made sense (I didn’t think about it very hard) but it’s pretty obvious that Scott Sumner is right about this. I wish Austrians would do some self-assessment and realize that the reason they haven’t done anything important in half a century is that they can’t seem to bring themselves to let go of their dogma even when it is essentially proven to be nonsense. If this were a worthwhile economic movement, there would be some adults in the school somewhere who would stand up and say “alright, alright, look, we thought this at one point but it turns out to not be correct, or circumstances changed or whatever, now we need to move on.” No science has ever moved forward without admitting it was wrong in the past. I’m saying this sincerely as someone who wishes there were a decentralized, free-market, school of macroeconomic thought that someone could take seriously.
Time for me to watch It’s a Wonderful Life one more time?
PS. I’m certainly not suggesting all Austrian economists are wrong about Cantillon effects—I am reacting to the Austrians that comment over here, and some media commentary I’ve read. Although Milton Friedman was my favorite economist, I was wrong in initially supporting his money targeting idea (when I was in grad school.) All schools of though need to constantly re-invent themselves. Even MM.
PPS: For instance, here’s an Austrian economist who does understand Cantillon effect.
The Austrian understanding of injection effects cannot be separated from its understanding of the price system and capital theory. It doesn’t matter so much WHO gets the money first. What matters is that SOMEONE does and that the dispersion across the price system is not even. THAT matters because it ripples through the capital structure with real, not just nominal, effects. The Austrian theory of the business cycle is one kind of systematic real effect, but there can be others.
HT: Greg Ransom