It’s (almost) all about the Benjamins

In the past I’ve argued that monetary policy mostly consists of Federal Reserve changes in the currency stock. Yes, the monetary base also includes “member bank deposits” at the Fed, but prior to 2008 that was only about 5% of the base.  And even that tiny share was mostly a disguised tax on banks, in the form of required reserves. If we took that requirement away (as we should) then the base would be more than 99% currency (including coins) in normal times.

Several people sent me a link to a recent discussion of the recent big increase in $100 bills in circulation.  Another link shows that the currency stock is currently about 75% composed of $100 bills, and that that share is rising rapidly.  Because these bills are used only rarely in transactions, and because during normal times their rate of return is dominated by equally risk-free FDIC-insured bank accounts, the demand for “Benjamins” is mostly attributed to tax evaders, drug dealers and foreigners.  Let’s call these people “TDFs.”  Also note that this demand has little to do with the famous “equation of exchange,” as most $100 bills are not used in US transactions during a given year, and most transactions do not involve currency.  Instead let’s use the Cambridge equation (M = k*PY) and think in terms of the total demand for Benjamins as a share of US GDP.

Now let’s explain what caused a recession to begin in December 2007.  Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted.  In previous years they had been increasing at a fairly steady rate of about 5% per year.  If the Cambridge k had fallen at this time, this would not have been a problem.  But the TDF’s thirst for Benjamins did not suddenly end in late 2007 and early 2008.  So when the Fed refused to meet that demand, and k did not fall sharply, NGDP growth had to slow dramatically.  The actual and prospective slowdown in growth in the currency stock tipped the economy into a recession in December 2007.

As the economy slowed sharply, market interest rates declined.  This reduced the opportunity cost of holding Benjamins, and after mid-2008 the k ratio began rising.  Now the Fed saw its mistake, and began increasing the supply of Benjamins more rapidly.  But not fast enough, and as a result the recession got even worse.  But this time the culprit was a rising k ratio.

What about the claim that monetary policy is about the control of short term interest rates?  I’d prefer to put it this way; most central banks like to target short term interest rates, and do so by (mostly) adjusting the current and expected future supply of Benjamins.  And I would add that the “expected future supply” is especially important, as economists like Woodford like to emphasize.  (Actually he emphasizes expected future interest rates, but in any case it’s future monetary policy that matters.)  So even if the injections of new base money initially go into banks, during normal times 95% of that extra base money spills out into currency within a few days.  It’s all about the Benjamins.

In normal times the demand for Benjamins by TDFs tends to trend upward at around 5% per year, or even more.  If the Fed refuses to meet that demand, you’ll get a recession, regardless of what they do or don’t do to interest rates, reserve requirements, IOR and all their other policy instruments.  It’s all about the Benjamins.

And remember that Benjamins are rarely used in transactions, so this model isn’t much different from Fama’s famous “spaceship” model, where the medium of account was permits to operate a spaceship.  Fed policy in 2007 mostly consisted of adjusting the quantity of a medium of account that wasn’t even primarily a medium of exchange; it was mostly a store of value.  It really doesn’t matter what you make the medium of account, just make sure that its value falls at a steady 5% per year, where “value” is defined as the share of NGDP that can be purchased with each unit.

PS.  It might be objected that the Fed can no longer control the stock of Benjamins, once rates hit zero.  Extra cash simply goes into bank ERs.  Maybe, but the same objection could be made about M2.  And no one thinks it weird when monetarists talk about control of M2 as the essence of Fed policy.  In fact, the Fed can control the stock of currency even at the zero bound.  The question is whether or not they want to.  And if they went back to the pre-1914 system where the base was 100% currency, then monetary policy would be nothing more than currency control.

Instead, we are headed for a cashless society (however despite pleas by Miles Kimball–it’s at least 50 years away) where the Fed will control policy by adjusting IOR–interest on reserves.  Finally the Keynesians will be right.  And when they are, they’ll (wrongly) insist that they were right all along.  The bad news for Keynesians is that once that happens no one will be able to claim a role for fiscal policy.  And that WAS true all along.

HT:  Chuck E, et al.


Tags:

 
 
 

126 Responses to “It’s (almost) all about the Benjamins”

  1. Gravatar of TravisV TravisV
    27. December 2012 at 11:47

    Mr. Sumner,

    Why do so many emerging markets (such as China) have such rapid increases in their national price level over long periods of time?

    I can grasp that they have rapid productivity and wage growth, which might be the primary explanation. But the U.S. during the 19th Century also had rapid productivity growth. And the national price level stayed largely flat (over the long term).

    What accounts for this discrepancy?

  2. Gravatar of Suvy Suvy
    27. December 2012 at 12:16

    This is kind-of-sort-of related to this post, but I’ll post it anyway because I think it is relevant. There are two types of money, base money and credit money. Right now, the monetary base is around $3 trillion and the total credit market debt/GDP is 350% with GDP a around $15.1 trillion(I’m using 2011 data). Therefore, the amount of credit money in circulation is $52.85 so we’ll say $53 trillion. Therefore, the total money supply is $56 trillion. Right now, the Fed is doing QE 3 and QE 4 which add $45 billion each to the money supply every month so that’s $90 billion/month=$1.08 trillion/year. Therefore, the money supply is increasing by less than 2% every year. Not surprisingly, CPI is also less than 2% a year(it’s been higher, but mainly due to supply side shocks).If the Fed were to print $2 trillion/year, that would lead to a growth in the money supply of 3.57%. The argument that the Fed isn’t doing enough is a very good and reasonable argument to make.

    I think another point to add is that MV=PY and that the change in the money supply can nonlinearly impact prices and output. Not only that, but these variables cause each other to dynamically shift over time. For example, if we were to increase the money supply by 10% starting now, that would impact V and prices/output would go up by much higher than 10%. This nonlinearity could also show up in the sense that you could increase the money supply by 10% and you might not see any inflation for 3 years and the next year, you might see 30% inflation due to the nonlinearity and the fact that these variables shift dynamically over time to many different things.

    Also, I would like to add that this is just a theoretical idea to my thought. Please point out areas that I may be wrong or ideas/viewpoints that I may be missing.

  3. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    27. December 2012 at 12:22

    We’ve done our part, here in Seattle, to improve monetary policy by legalizing marijuana.

  4. Gravatar of Tommy Dorsett Tommy Dorsett
    27. December 2012 at 12:25

    Here’s the Cambridge k (using the base) back to 1929. The demand for base is as high as its been since the 1940s.

    http://research.stlouisfed.org/fredgraph.png?g=e4r

  5. Gravatar of Major_Freedom Major_Freedom
    27. December 2012 at 12:34

    ssumner:

    Now let’s explain what caused a recession to begin in December 2007. Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted. In previous years they had been increasing at a fairly steady rate of about 5% per year.

    “Fairly steady” my eye.

    http://research.stlouisfed.org/fredgraph.png?g=e4s

  6. Gravatar of K K
    27. December 2012 at 12:44

    “The bad news for Keynesians is that once that happens no one will be able to claim a role for fiscal policy.”

    Yeah, that’s right, we’ll be *so* sad when there are no more depressions. What we believe has *nothing* to do with the fact that the math, the EMH, and the rigorous models all happen to be on our side. It’s really because we are intellectually dishonest liars trying to weasel our pet welfare programs in through the back door. In fact, the Wallace irrelevance result is just an elaborate anti-Market Monetarist conspiracy perpetrated by drug-addled welfare Moms. Also, Mike Woodford’s the Antichrist and Paul Krugman *eats* little babies. It’s true!

  7. Gravatar of Becky Hargrove Becky Hargrove
    27. December 2012 at 12:48

    A number of circumstances would need to be tended to, before moving towards a cashless society. Use of cash is not just limited to arms and drug dealers and tax evaders. For instance, many among the long term unemployed tend to utilize mostly cash in ordinary (daily) transactions for groceries, etc. along with bank accounts mostly for a limited set of transactions every month. IOW such informal and often familial transactions would need to be someow cleared through such monetary (cashless) channels or otherwise, and that might serve to further restrict economic freedom for either low income or long term unemployed, if not approached thoughtfully.

  8. Gravatar of Doug M Doug M
    27. December 2012 at 12:50

    Hold on…This flies in the face of everything I have ever learned about monitary policy.

    Monetary policy is about paper currency in circulation!? Open market operations to not change the currency stock, so OMO are irrelvant? The money multiplier?

    “Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted.”

    What happened? was there a fire? Did the federal reserve shred more Benjamins than ususal and not print more of them!

    Currency in circulation $1.1 T
    Other M1 (mostly excess reserves) $1.4T
    M2 $10.3T

    And I still for the life of me don’t know why the Fed discontinued measuring M3.

  9. Gravatar of Suvy Suvy
    27. December 2012 at 12:55

    K,

    “What we believe has *nothing* to do with the fact that the math, the EMH, and the rigorous models all happen to be on our side”

    You’ve gotta be kidding me right. The greatest mathematician of the past 100 years spent a good part of his time debunking the idea that the EMH and the “rigorous models” and the “math” was on “our” side. There is no such thing as rigor in economics. This is not something that is akin to a math proof; it’s a field with human behavior where uncertainty, human action, and randomness play an essential role. No matter how sophisticated or how “beautiful” your math looks, you can’t make it rigorous.

    I’d like to add another point to the EMH. If you slightly change the assumptions, you get very different results. For example, if you recognize there are correlations in the data(look at the Hurst exponent, there clearly are as the Hurst exponent varies over time), then the results you get are vastly different.

    Also, the New Keynesians aren’t really Keynesians and most of them haven’t read a lick of Keynes’s work except for bits and pieces of The General Theory. Keynes knew quite a bit about math and did as much work in probability theory as he did in economics. Unfortunately, none of these “Keynesians” know that. These New Keynesians should be called Old Hicksians.

  10. Gravatar of flow5 flow5
    27. December 2012 at 13:01

    “If we took that requirement away (as we should)”

    The only tool at the disposal of the monetary authorities in a free capitalistic system through which the volume of money can be controlled is legal reserves. The sine qua non of monetary management is total current control by a central monetary authority over the volume of legal reserves held by all money creating institutions, & over the reserve ratios applicable to their deposits.

    Contary to Nobel Laueate Milton Friedman legal reserves are not a tax.

    Paul Volcker said in 1983 that the Fed “as a matter of principle favors payment of interest on all reserve balances”. Volkcer “believes in principle the Fed should pay interest on Reseres held against deposits on rounds of equity’.

    In contradistinction: A brief “run down” will indicate just how costless, indeed how profitable – to the participants, is the creation of new money. If the Fed puts through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits. The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers complain that they are not earning any interest on their balances in the Federal Reserve Banks.

    On the basis of these newly acquired free reserves, the commercial banks can, & do, create a multiple volume of credit & money. And, through this money, they acquire a concomitant volume of additional earnings assets. How much is this multiple expansion of money, credit, & bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system can, & does, acquire about 93 (c. 2006), dollars in earning assets through credit creation.

    I know not.

  11. Gravatar of flow5 flow5
    27. December 2012 at 13:13

    “this time the culprit was a rising k ratio”

    The basic process by which currency is put into & taken out of circulation is through the banking system. This particular procedural practice distinguishes a manged currency system from a fiat currency system & makes our currency self-regulatory.

    I.e., when obtaining currency the non-bank public must give up another type of money (their bank deposits). I.e., the non-bank public can’t increase the money supply by increasing its holdings of currency.

    While bank deposits aren’t self-regulatory & require credit control devices, the non-bank public determines whatever volume of currency is necessary to transact its business.

    Unlike during the Great-Depression, people were always able to convert their bank deposits into currency during the downswing of the Great-Recession.

  12. Gravatar of Max Max
    27. December 2012 at 13:20

    I don’t understand this post at all. If the Fed were really refusing to supply base money in 2008, then short term interest rates should have skyrocketed. But as you note, this didn’t happen; short term rates fell instead. So how can you blame the recession on a shortage of base money? Besides, I thought your theory was that the recession was caused by a fall in expected GDP. The cure for that isn’t supplying money that nobody wants given GDP expectations, it’s to change the expectations.

    If you want to say that changing the supply of base money is how the Fed ‘communicates’ expectations, this is easily refuted by noting that the historical relationship between base money and GDP is completely gone, ever since the Fed began using base money to finance its credit market interventions. It’s not communicating anything.

  13. Gravatar of flow5 flow5
    27. December 2012 at 13:40

    “Instead, we are headed for a cashless society”

    Despite technological innovation, the volume of currency held by the non-bank public has risen ever since 1930 (& recently at accelerated rates).

  14. Gravatar of flow5 flow5
    27. December 2012 at 13:48

    “If the Fed were really refusing to supply base money in 2008″

    Milton Friedman’s “monetary base” is actually not a base (never was) for the expansion of new money & credit.

    See Thornton: “Quantitative Easing and Money Growth: Potential for Higher Inflation”

    Thus the system’s expansion coefficient (see M1 MONEY MULTIPLIER), is also fictional.

    (1) Increases in currency held by the non-bank public are contractional — unless offset by open market operations of the buying type.

    (2) Increases in remunerated excess reserve balances have no expansion coefficient either. They are simply idle & unused deposits (bank earning assets courtesy of the Fed).

  15. Gravatar of Major_Freedom Major_Freedom
    27. December 2012 at 13:54

    http://research.stlouisfed.org/fredgraph.png?g=e4E

    From 1996 to 2000, the monetary base growth accelerated from annual growth rate of about 3%, to an annual growth rate of about 16%. Steady 5% growth? Don’t make me laugh.

    This acceleration of monetary base inflation was, IMO, required to coax investors into continuing to invest and continuing to maintain the increasingly distorted capital structure that was caused by the inflation itself. This distorted capital structure had associated with it particular relative supplies and prices, and in order to maintain the “spending” and CPI associated with this new relative structure, accelerating monetary inflation was necessary.

    One of the great errors of monetarist theory is treating money as neutral in such a way that it is believed that a constant X% monetary inflation growth rate is able to generate a constant Y% aggregate spending or price level growth rate. This is not the case. Since inflation distorts the capital structure of the economy, more inflation is required to maintain what prior inflation has caused.

    Thus, in order to bring about a 5% aggregate spending growth rate, say, a continually accelerating monetary inflation is required. Since the US has had relatively fluctuating NGDP, I present M3 and NGDP for Australia, 1992-2008 (the time period many MMs consider as close to optimal):

    http://research.stlouisfed.org/fredgraph.png?g=e4H

    In order to maintain a constant “spending” growth on an increasingly distorted Australian capital structure, the aggregate money supply had to accelerate. If it did not accelerate, then NGDP would have fluctuated downwards as the distorted structure is revealed and the market induced “spending” falls.

  16. Gravatar of flow5 flow5
    27. December 2012 at 13:55

    The manager of the System Open Market Account & the FRBNY’s “trading desk” (our Central Bank) stated the FOMC’s policy:

    The policy formula used on the front-end of the yield curve is periodically adjusted to “set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding” — William C. Dudley, the president of Federal Reserve Bank of New York, and vice-chairman of the Federal Open Market Committee.

  17. Gravatar of flow5 flow5
    27. December 2012 at 14:11

    Keynes understated it when the declared:

    “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

    What happened in 2008 was very simple (monetary flows collapsed taking non-bank liquidity down with it).

    The Fed’s new tool on the other hand is very complex (highly conceptual), completely misunderstood, & disastrous to our economic health.

  18. Gravatar of Bill Woolsey Bill Woolsey
    27. December 2012 at 14:13

    I think this is wrong.

    Your statistics come from a period where currency is issued to accomodate the demand to hold currency.

    Under such a circumstance, it should be no surprise that currency almost immediately jumps outside the banking system. Any excess currency is deposited back at the Fed and no long “counts.”

    Under your prefered system of having banks clear checks and electronic payments with bags of currency,then currency that doesn’t leave the banking system would be either in a bank’s vault or the clearinghouse’s vault.

    What makes it jump out?

    If you assume there is a fixed currency deposit ratio, then when banks purchase securities from people other than banks, they have higher deposit balances. The fixed ratio implies that they make currency withdrawals. So, Smith sells $1,000,000 in T-bills to BBT, and he takes $400,000 of currency in a sack, and keeps a $600,000 balance in his bank, Bank of America.

    Absurd.

    From a market monetarist perspective, what mostly happens is that expectations of higher future sales lead firms to spend more on capital goods and households to spend more on consumer goods. They probably make all of these expenditures with their existing balances in checkable deposits. Some of the car salesmen then celebrate with some coke, and have to withdraw some benjamins to make their purchase.

    That is how the benjamins are involved.

    The quantity of base money is not fixed.

    The quantity of base money does not change from time to time by exogenous amounts.

    If there were a system where the quantity of base money were exogenous, then it doubtful that banks would hold the same amount of reserves as they do when the Fed adjusts the quantity of currency to meet demands and the quantity of reserves to meet demands.

    With the quantity of base money endogenous, even when the goal is for nominal GDP or inflation, then the effects are not the same as one where base money makes exogenous shifts. Expectations are different.

    Suppose that the Fed had an explicit mandate to target nominal GDP and had a good record.

    It quits printing $100 bills. What happens?

    It quits issuing currency. What happens and why?

  19. Gravatar of flow5 flow5
    27. December 2012 at 14:19

    “the monetary base growth accelerated”

    Currency has no expansion coefficient. Money velocity is more applicable.

  20. Gravatar of cucuracha cucuracha
    27. December 2012 at 14:39

    Miles is complicating too much… Britain should only tax paper money withdraws (or allow a bank tariff) some percentage points and deposits another percentage points. The charge should be equivalent to two or three years of the negative interest rate imposed by the BOE at the time of the withdraw or deposit.

    Relearning Silvio Gesell ?

  21. Gravatar of cucuracha cucuracha
    27. December 2012 at 14:41

    P.S.: Irving Fisher, author of a book called “The Money Illusion”, was a strong defender of so called currency demurrage.

  22. Gravatar of flow5 flow5
    27. December 2012 at 14:42

    Monetary policy objectives should be formulated in terms of desired rates-of-change in monetary flows (MVt) relative to rates-of-change in real-gDp. Rates-of-change in NOMINAL-gDp can serve as a proxy figure for rates-of-change in ALL transactions. Rates-of-change in real-gDp have to be used, of course, as a policy standard.

  23. Gravatar of cucuracha cucuracha
    27. December 2012 at 14:47

    PS2: I mean, Miles should be more explicit when proposing to tax or impose a fee on bank withdraws/deposits. He does not need to get ashamed when proposing a good idea.

  24. Gravatar of flow5 flow5
    27. December 2012 at 14:51

    “impose a fee on bank withdraws/deposits”

    that should support a black market

  25. Gravatar of Doug M Doug M
    27. December 2012 at 14:58

    Is the US going to lose its place as the reserve curency for “TDFs”?

    Benjamins are kind of bulky. If you want to carry around $1 million in Bennys that weighs about 10 pounds. There are 500 Euro note and 1,000 CHF notes that pack several times the value in the same sized piece of paper.

  26. Gravatar of cucuracha cucuracha
    27. December 2012 at 15:03

    “that should support a black market”

    No bigger than what it is today…

  27. Gravatar of Lorenzo from Oz Lorenzo from Oz
    27. December 2012 at 15:09

    TravisP: The C19th was dominated by commodity money based on gold and/or silver. The price level was constrained by the level of monetised precious metal. (From the 1870s to 1914, that was basically gold; prior to then silver was was a more important monetary metal and had been since coins were invented — don’t tell the goldbugs, who think a system that was dominant for 40 years, and never operated in China, is somehow the “proper” monetary system.)

    Paper money systems lack that constraint, so the price level grows faster. Also, productivity growth puts downward pressure on the price level — think IT prices.

  28. Gravatar of Max Max
    27. December 2012 at 15:22

    cucuracha, if you allow an exchange rate between base money and currency other than 1.0, then the CB can set an arbitrary rate of interest on currency, positive or negative, by steadily increasing/decreasing the (fixed, not floating) exchange rate. This is Miles’s proposal.

  29. Gravatar of cucuracha cucuracha
    27. December 2012 at 15:56

    “This is Miles’s proposal.”

    Yep. After reading carefully, I understand that he has a different idea. But his proposal only reaches the flow of paper currency and the exchange between electronic and paper money. Paper currency today makes only for a small amount of all money funds.

    Sufficiently high fees on withdrawals and deposits of paper currency, on the contrary, would be a stimulus to keep money on its “electronic” form and would make possible to apply negative interest rates (or demurrage) on pratically all money funds available.

    P.S.: There could be a certain period of time before fees on deposits were charged in order to stimulate people to convert their paper currency int bank/electronic money deposits…

  30. Gravatar of Scott Sumner Scott Sumner
    27. December 2012 at 16:59

    Travis V, The Chinese currency stock grows faster than ours grew in the late 1800s.

    K, You said;

    “Yeah, that’s right, we’ll be *so* sad when there are no more depressions.”

    As is often the case with insulting comments, you completely misread my post. I suggest reading the post again, this time trying to actually understand what you are reading.
    I never said anything about there being no more depressions.

    As far as Woodford is concerned, I agree with his argument that it is expected future monetary policy that matters, and also that the Fed should do NGDPLT. So I can’t understand why you think I regard him as the Antichrist. But I’m sure you have good reasons.

    As far was “Wallace neutrality” Is that a joke? Do people still believ ethjat stuff? Tell that to the people who have been investing in Japanese stocks over the past 6 weeks.

    Bill, If 100% of the base was currency then banks would still hold very little ERs, as the oppotunity cost is too high in terms of foregone interest on T-bills. When rates are near zero, then banks may hold large amounts of ERs.

    The quantity of currency may be endogenous in the sense that the Fed is targeting something other than currency, but if they had supplied enough currency in late 2007 and early 2008 to prevent a recession from occurring, we’d have been much better off. We went into recession because the Fed suddenly began supplying much smaller quantities of currency.

    Max, You said;

    “I don’t understand this post at all. If the Fed were really refusing to supply base money in 2008, then short term interest rates should have skyrocketed.”

    This misconception helps to explain the current recession, and the failure of monetary policy more broadly. Check out the market reaction to the Fed’s caontractionary surprise of December 2007–rates fell from 3 months to 30 years on the announcement.

  31. Gravatar of TravisV TravisV
    27. December 2012 at 17:06

    Prof. Sumner,

    Is it optimal for China’s currency stock to grow much faster than the U.S. currency stock did in the late 1800′s? If so, why?

    After all, even with slow currency growth, the U.S. still experienced incredibly rapid innovation, productivity growth, superior living standards, etc back then.

  32. Gravatar of Major_Freedom Major_Freedom
    27. December 2012 at 17:26

    ssumner:

    This misconception helps to explain the current recession, and the failure of monetary policy more broadly. Check out the market reaction to the Fed’s caontractionary surprise of December 2007–rates fell from 3 months to 30 years on the announcement.

    Speaking of misconceptions.

    http://research.stlouisfed.org/fredgraph.png?g=e52

    There was no “contractionary surprise” in Dec 2007. There was an announcement of a reduction in the fed funds rate. The Fed doesn’t reduce inflation in order to reduce the fed funds rate. It increases bank reserves, i.e. inflates, in order to bring about lower rates. It doesn’t matter if NGDP is going up or down. Rates are set by short term Fed influences on bank reserves, not aggregate spending. No investor even cares about aggregate spending.

  33. Gravatar of Bill Ellis Bill Ellis
    27. December 2012 at 18:13

    MF says…”Rates are set by short term Fed influences on bank reserves, not aggregate spending. ”

    If so then there can be no “crowding out” .

  34. Gravatar of flow5 flow5
    27. December 2012 at 18:21

    “if they had supplied enough currency”

    The banking system doesn’t work that way. The public determines its needs for trade. The cash-drain factor makes a good trading tool (it forecast the top of 2011 in stocks) but currency is not something the Fed can, or should, control.

  35. Gravatar of Saturos Saturos
    27. December 2012 at 19:51

    So here’s another way to test the difference between Scott’s view of the economy and mine (and Nick Rowe and Bill Woolsey’s). Suppose we create an excess demand for Benjamins, whilst ensuring that there is no excess demand (in nominal dollar terms) for other assets used as media of exchange within American borders (checking, savings accounts, etc.), which basically means no excess derived demand for the reserves which back them and settle those payments. I predict that there will only be a very mild recession. And the reverse should also be true: excess supply for currency only without excess supply of other money assets as the rest of the base also expands shouldn’t lead to too much inflation. Only if the oversupply of currency causes the nominal stock of major transaction money assets (the ones that actually appear on markets for exchange of final goods) to increase beyond the demand to hold them, perhaps by increasing the nominal value of reserves in terms of currency (how that would happen I don’t know) would there be much inflation.

    (And isn’t it a bit disingenuous to say that other money only matters because they are priced in terms of the base, when they too have fixed nominal face value and could just as easily be called the medium of account as well?)

    Bill Woolsey, the base is endogenous? Nick Rowe will have a few words to say about that… I actually agree with Scott on this point.

    MF, what do you think about this? I hope you weren’t denying that inflation causes nominal rates to rise…

  36. Gravatar of Saturos Saturos
    27. December 2012 at 19:54

    Inflationary expectations cause nominal rates to rise, rather.

  37. Gravatar of K K
    27. December 2012 at 20:36

    Scott,

    You said:

    “The bad news for Keynesians is that once that happens no one will be able to claim a role for fiscal policy.”

    Let me spell out in more detail why I find that annoying:

    I’m a Keynesian: I believe that at the zero bound there may be an important role for fiscal policy in optimal demand management. Please tell me why it would be “bad” for me if that fails to be true, when what I *want* is optimal demand management. Are you not implying that I have ulterior motives for countercyclical fiscal policy? Why else would the end of it be “bad news” for me?

    When we eliminate cash and we can have negative rates then we *will* end depressions *and* distortionary countercyclical fiscal policy (like asset purchases). And I will find that to be a *good* thing.

    “As far as Woodford is concerned, I agree with his argument that it is expected future monetary policy that matters”

    When he says “monetary policy” he is talking about *rates* policy. He must have spent at least 30 pages of the Jackson Hole paper detailing why he doesn’t believe in QE both from theoretical and empirical standpoints. You will not find *any* statement by Woodford or any other respected New Keynesian that suggests that they believe that the exchange of reserves for T-bills, present or future, at the ZLB in any quantity has *any* effect on anything.

    “As far was “Wallace neutrality” Is that a joke?”

    Kind of a sick joke. Read Curdia and Woodford 2010:

    QE doesn’t do anything *unless* you introduce credit constrained financial intermediaries. Then:

    1) Purchases of treasuries: still irrelevant
    2) Purchases of real assets: relevant to the extent that it relieves credit constraints of financial intermediaries
    3) Purchases of real assets financed by money *no different* from swapping treasuries for said real assets. I.e. it’s *not* monetary policy, it’s credit policy.

    So *targeted* asset purchases *can* work, but only to the extent that it’s a bail out of financial intermediaries.

    Let me quote the conclusion:

    “But we have found that explicitly modeling the role of the central-bank balance sheet in equilibrium determination need not imply any role for “quantitative easing” as an additional tool of stabilization policy, even when the zero lower bound on the policy rate is reached. While different results might be obtained under alternative theoretical assumptions, our reading of the Bank of Japan’s experience with quantitative easing leads us to suspect that our theoretical irrelevance result is likely close to the truth.”

    And on targeted asset purchases:

    “Our analysis indicates that there may, instead, be a role for central-bank credit policy (or for targeted asset purchases), when private financial markets are sufficiently impaired. It is worth stressing that the central bank’s asset holdings should also be irrelevant for macroeconomic equilibrium in the case of well-functioning financial markets that can be accessed at low cost by any economic agents who would benefit from such trades. Hence credit policy is only a relevant additional dimension of central-bank policy to the extent that
    private markets are not already effectively eliminating most of the potential gains from trade in financial instruments; and while we recognize that there are circumstances, such as those arising during the recent crisis, in which it is arguable that financial markets fail to fulfill that function, we are inclined to suspect that it is only at times of unusual financial distress that active credit policy will have substantial benefits.”

    Note that this means that the CB must be able to *identify* a failure of market efficiency that it can then set out to rectify via “appropriate” credit policy. A joke indeed.

    Bottom line: To the extent that asset purchases are monetary policy, they don’t work. To the extent that asset purchases work, it’s because they are activist credit policy. You choose. Money has *nothing* to do with it.

  38. Gravatar of Benjamin Cole Benjamin Cole
    27. December 2012 at 20:49

    Ouch, I get a headache when I think about this.

    “But the TDF’s thirst for Benjamins did not suddenly end in late 2007 and early 2008. So when the Fed refused to meet that demand, and k did not fall sharply, NGDP growth had to slow dramatically. ”

    Also, most “experts” say most Benjamins are in circulation outside the USA.

    You mean global black marketeers can cause a recession by wanting more $100 bills than the Fed provides? Are Afghan drug lords hurting the US economy?

    Could we make things easier for black marketers by printing $1000 bills? How about we give any bona fide drug lords and black marketeers several million in cash—ethics aside, would that hep the recovery?

    I’ll say this: One never gets bored reading Scott Sumner!

  39. Gravatar of JP Koning JP Koning
    27. December 2012 at 21:53

    The Fed always accommodates the public’s demand for paper Ben Franklins. How could it do otherwise? The patterns we see in this chart don’t come from the Fed choosing (or not) to emit Ben Franklin’s – the public chooses how much paper money to hold and is always obliged.

  40. Gravatar of jknarr jknarr
    27. December 2012 at 23:37

    This is a great post, Scott.

    Physical currency is the ultimate deliverable to all derivative currency contracts, including higher forms of “Ms”. The scarcity of currency is the root scarcity of all other derivative forms of cash.

    I’d say that zero rates augments the demand for currency – there is negative utility in holding funds in the bank after fees and accounting for counterparty risk. In the absence of interest income, there is little incentive to hold the inferior asset of demand or savings deposits.

    The flow of funds L204 says that some $440b of the $1.2t currency base is held outside the US. There is even less base money active in the US than we imagine.

    I’ll also point out that regulations limit the amount of currency you or I are allowed to utilize, and this has shrunk fast in real terms. This lowers the realized demand and use for currency in the economy, and in fact pushes currency abroad where it has more utility.

    A cashless society is a turnkey totalitarian society. Let us hope that 50y is a pessimistic forecast.

  41. Gravatar of Benjamin Cole Benjamin Cole
    28. December 2012 at 00:42

    A tough question for MM’ers:

    Okay, we believe in freedom of expression.

    But, we want Fed credibility.

    And we have Richard Fisher (Dallas Fed President) running around like a loose cannon, inciting fears of an inflationary volcano at any moment. The guy is border-line hysterical at any moment (he is the Fed official who traveled to Japan, and warned them about the lethal perils of…inflation. You guessed it. You can’t make stuff like this up).

    Is it time to reconsider, even end the FOMC? Should Fed policy rest only with the Fed Chairman? We need clarity, we need credibility, we need conviction. And Fisher?

    Perhaps the days of the FOMC are best over…..

  42. Gravatar of ZHD ZHD
    28. December 2012 at 02:44

    Major_Freedom,
    Empirically, we know that a monetarist approach of increasing bank reserves does not affect the price level—as reserves don’t create lending. If △M is entirely concentrated in bank reserves then △V will be 0, therefore balancing out the right side of the quantity equation. Yes, this also coincides with much of your arguments about how ineffectual contemporary monetary policy has been and will be.

    However, I think you are cleverly masking latent anarcho-capitalist leanings (à la David Friedman) in over-specified critiques of other liberal policies like Scott’s.

    Even though your argument centers on a “constant” edict, an expansion of the monetary base makes the most sense for consistent growth. Let the rate be a free parameter determined by some lag; arguing over how that parameter might be fixed is SILLY.

    Cheers

  43. Gravatar of W. Peden W. Peden
    28. December 2012 at 05:16

    Doug M.,

    Re: US M3, you can mostly reconstruct it using FRED-

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=ALLMON_LTDACBM027SBOG&scale=Left&range=Max&cosd=1967-01-01&coed=2012-11-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=pc1&transformation=lin_lin&vintage_date=2012-12-28_2012-12-28&revision_date=2012-12-28_2012-12-28

    (Frankly, I don’t see why repos or eurodollar deposits are significantly relevant to expenditure decisions anyway.)

    The primary problems with the series are (a) the growth of bond and stock funds as deposit-substitutes in the early 1990s, (b) the flight-to-safety after 9/11, and (c) the reintermediation in 2008. These factors not only distorted the figures in the years in question, but also for some years afterwards.

    More generally, as financial intermediaries have grown as a proportion of non-bank deposit-holders over the past 40 years or so, the relation of broad aggregates to expenditure decisions has broken down.

    Major Freedom,

    “Thus, in order to bring about a 5% aggregate spending growth rate, say, a continually accelerating monetary inflation is required. Since the US has had relatively fluctuating NGDP, I present M3 and NGDP for Australia, 1992-2008 (the time period many MMs consider as close to optimal):

    http://research.stlouisfed.org/fredgraph.png?g=e4H

    In order to maintain a constant “spending” growth on an increasingly distorted Australian capital structure, the aggregate money supply had to accelerate. If it did not accelerate, then NGDP would have fluctuated downwards as the distorted structure is revealed and the market induced “spending” falls.”

    Now, why wouldn’t you have continued that line beyond 2008?

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=MYAGM3AUM189S,AUSGDPRQDSMEI,CP0114LUM086NEST&scale=Left,Left,Left&range=Custom,Custom,Custom&cosd=2000-07-01,2000-07-01,2000-01-01&coed=2011-08-01,2012-04-01,2012-11-01&line_color=%230000ff,%23ff0000,%23006600&link_values=false,false,false&line_style=Solid,Solid,Solid&mark_type=NONE,NONE,NONE&mw=4,4,4&lw=1,1,1&ost=-99999,-99999,-99999&oet=99999,99999,99999&mma=0,0,0&fml=a,a,3.5&fq=Quarterly,Quarterly,Monthly&fam=avg,avg,avg&fgst=lin,lin,lin&transformation=pc1,pc1,pc1&vintage_date=2012-12-28,2012-12-28,2012-12-28&revision_date=2012-12-28,2012-12-28,2012-12-28

    Oh, I see why.

  44. Gravatar of W. Peden W. Peden
    28. December 2012 at 05:25

    (This comment will make sense after my second comment is posted.)

    Also, I doubt that institutional money market funds would have much relation to expenditure decisions either. M2 + large time deposits would be better; M2 + large deposits less non-bank financial intermediaries would be better still, and close to the old M2 series.

  45. Gravatar of Bill Woolsey Bill Woolsey
    28. December 2012 at 06:14

    Scott:

    It is true that holding T-bills is an alternative to holding reserves. Further, it is true that a higher yield on T-bills reduces the demand for reserves.

    However, with exogenous base money, what happens if there is an increase in the demand for base money? You have to sell the T-bills, and that requires that there be buyers. Where do the buyers get the base money to pay of them?

    With exogenous base money, short term interest rates (like on T-bills) can fluctuate alot. Holding reserves avoids high borrowing costs or suffering capital losses from selling bonds.

    With a central bank targeting interest rates, this isn’t a problem. If everyone starts selling bonds or borrowing because there is an increase in the demand for base money, the central bank creates more base money.

    In the simplist scenario, a bank can simply hold zero reserves, and cover claims by negative interday clearing and borrowing from the central bank when the central bank insists that it settle up.

    T-bills work great because when they need to be sold, the central bank is out there making sure that someone is buying. If needed, they will buy them.

    If you have a central bank targeting interest rates, short term money market instruments are a much better substitute for reserves than when base money is exogenous.

    Now, I think the sort of system we favor, where base money is endogenous, but varies to keep nominal GDP on target, would be intermediate. The central bank isn’t trying to keep interest rates on some kind of target, but the quantity of base money is adjusting according to the demand to hold it.

    In that scenario, an increase in credit demand (an increase in investment or decrease in saving) would result higher interest rates. The regime would not create an excess supply of base money to dampen the increase in interest rates. That interest rates might spike in this way provides an incentive for banks to hold more reserves at all times.

    On the other hand, an increase in the demand for base money would be accomodated. There would be no need for banks to sell off assets in an effort to accumulate more base money. The spike in interest rates due to the increase in the demand for base money would not occur.

    Figuring out whether the shift is a change in credit demand (saving or investment) or else the demand for base money is not easy. But I think a regime that is committed to interest rate targeting (just about every actual central bank) is going to have less variation in short term interest rates than one that puts no weight on that.

    I grant that getting rid of reserve requirements would reduce the demand for base money. However, some of your data is from the heyday of sweep accounts. They make it possible to reduce required reserves to whatever the banks want.

    Reserve balances were tiny. Most reserves were vault cash. Why? It is because banks need vault cash to pay out currency to customers.

    Sure, a bank can sell T-bills, get funds in its reserve balance, and withdraw currency, but that takes time, and the banks need to keep the ATM machines full every day.

    I think that required reserves were approximately equal to the banks inventories for currency distribution and actual reserves about the same.

    In the national banking system, bank reserve ratios were very high. Of course, they also had draconian reserve requirements.

    P.S. It is much better to allow banks to hold base money in the form of deposits. By allowing the interest rate on deposits to vary with other interest rates, then changes in interest rates don’t impact the demand for bank reserves. If banks must settle up interbank clearings with claims to currency in a vault, then changes in interest rates become a factor leading to shifts in the demand for base money.

    P.P.S. I think the monetary authority should get out of the business of issuing hand-to-hand currency. Let private industry deal with it. With private currency, then shifts in the demand for currency are no longer a factor impacting the demand for base money. In other words, the TDF factor would simply shift the composition of private monetary liabilities.

  46. Gravatar of "It’s all about the Benjamins". What caused the recent big surge in $100 bills in circulation — and the recession. « Economics Info "It’s all about the Benjamins". What caused the recent big surge in $100 bills in circulation — and the recession. « Economics Info
    28. December 2012 at 07:04

    [...] Source [...]

  47. Gravatar of Saturos Saturos
    28. December 2012 at 07:09

    Ben Cole, if we could explain to enough people in our democracy why Bernanke should be given absolute power over the money supply, we could also explain to people why inflation doesn’t matter, why they are suffering from money illusion. I find these proposals to be idle speculation – what happens happens because that’s the equilibrium solution to everyone’s incentives. If you want change then pick a point of leverage and get persuading, as Scott is. If Scott succeeds in changing professional opinion then one guy like Richard Fisher won’t matter.

  48. Gravatar of Tom Tom
    28. December 2012 at 07:45

    Scott, you claim, frequently, that monetary policy at the Fed relies on expectations. Forecasts about the future.

    And I would add that the “expected future supply” is especially important, as economists like Woodford like to emphasize. (Actually he emphasizes expected future interest rates, but in any case it’s future monetary policy that matters.)

    I’m sure this is mostly right.

    But you continually and inappropriately denigrate the “expectations of future Net Worth”, as represented by buying decisions of homeowners whose “money” is, to a large part, determined by their house price equity.

    Between July of 2007 and May of 2008 growth in both the monetary base and the stock of currency in circulation suddenly halted.

    What did the Fed do to suddenly halt the growth in the monetary base?

    http://research.stlouisfed.org/fredgraph.png?g=e52
    Interest rates went gradually up from 2005 to 2q 2006, then level thru the 4q 2007 and then dropped.

    When the Fed lowers interest rates, the monetary base increases (is supposed to). No sudden halt.

    What really happened is that the house prices which peaked in 2006 and began falling, caused human decision makers to “realize” that they had less money … than they had been expecting to have. And bigger, wider drops, so more homeowners realized they still had their jobs, but were much, much less wealthy than they had “expected” they were.

    So they stopped buying some or many optional/ almost luxuries; plus some 5 mil (my number, you claim less, I don’t believe you) illegals leaving the construction industry and becoming unemployed (mostly w/o unemployment benefits), all reducing demand to buy stuff, and thus to make stuff. (Yes, AD shock).

    Suvy #2 seems more correct — the Credit money was less.
    And credit money is much larger than printed dollar bills.

    When Net Worth goes down, “money” goes down.

    On fiscal policy — MORE tax cuts/ more Fed borrowing — would help even more, but not wasteful new gov’t boondoggle spending mistakes like Solyndra. Let the Fed print money to pay Federal workers, and let productive workers keep more of the money they’ve earned, but no increase in (already too big) gov’t.

  49. Gravatar of Saturos Saturos
    28. December 2012 at 07:53

    Someone needs to show Tom the graphs… I can’t be bothered.

  50. Gravatar of flow5 flow5
    28. December 2012 at 08:04

    “The scarcity of currency” ???

    It was not until 1933 that we began to unshackle our paper money from the numerous & unnecessary restrictions pertaining to its issuance. With the numerous types of paper money in circulation at the time, this would seem to have been a non-problem. Here is the list: gold certificates, silver certificates, national bank notes, United States notes, Treasury notes of 1890, Federal Reserve Bank notes, & Federal Reserve notes. With that array of paper money there should have been plenty to meet the liquidity demands placed on the banks by the public. But the volume of each type that could be issued was so circumscribed by restrictions that even the aggregate group could not begin to meet the panic demands of the public.

    The last vestige of legal reserve & reserve ratio requirements against the Federal Reserve Note, demand deposit, & inter-banks demand deposit liabilities of the Reserve banks was eliminated in 1968. Now the Federal Reserve Note has no legal reserve requirements, & the capacity of the Fed to create IBDDs has no legal limit. These IBDDs are owned by commercial banks; they are free-gratis reserves & can be converted dollar-for-dollar into Federal Reserve Notes.

    The volume of IBDDs is almost exclusively related to the volume of Reserve Bank credit. When Federal Reserve Banks expand credit, for example by buying U.S. obligations, the balance sheets of the Banks reflect an increase in earning assets & an equal increase in IBDD liabilities, i.e., free-gratis (excess & required) reserves.

    Actually the issuance of Federal Reserve Notes is deflationary, other things being equal, since the issuance diminishes clearing balances & the free-gratis legal reserves of the commercial banks. The Fed recognizes this fact & uses its open market power to replenish CB’s reserves & prevent any unwarranted contraction of bank credit.

    The issuance of our paper money contains no inflationary bias. Its issuance does not increase the volume of money. It merely substitutes one form of money for another form.

  51. Gravatar of Chuck E Chuck E
    28. December 2012 at 08:06

    I have no charts to back this up, but since demand and savings accounts are paying .25% interest, it makes no sense for the people on the lower rungs of the economic ladder to keep their money in banks. Looking at the long lines of people at the tellers cashing their paychecks, leads me to think that more Benjamins are being stored under mattresses. A 100 million people with a couple thousand dollars of cash savings are off the “radar.” The printing of so much currency, struck me as a “helicopter drop” injection of money into the system.

  52. Gravatar of flow5 flow5
    28. December 2012 at 08:14

    See latest money supply #’s on ZEROHEDGE:

    “Savings Deposits Soar By Most Since Lehman And First Debt Ceiling Crisis”

    http://bit.ly/TunrxK

    Scaling back FDIC insurance coverage will help boost gDp. The expanded FDIC insurance coverage induced dis-intermediation within the non-banks. This will reverse the trend.

    Savings formally impounded within the CB system will flow through the intermediaries (between saver & borrower) where they are “put to work” (matching savings with investment). Savings held within the CB system are “lost to investment”. I.e., every time CBs make loans or invest they create NEW money. Contrary to the framers of our financial markets, CBs do not loan out existing deposits, saved or otherwise.

    I.e., the payment of interest on excess reserve balances induces dis-intermediation (where the size of the non-banks shrink, but the size of the CB system remains the same).

  53. Gravatar of Philo Philo
    28. December 2012 at 08:32

    @ Benjamin Cole:
    “Are Afghan drug lords hurting the US economy?” If Afghan drug lords (or any other group) increase their demand for U.S. currency, ceteris paribus, *and the Fed responds inappropriately*, that hurts the U.S. economy. But I wouldn’t blame the drug lords.

  54. Gravatar of ssumner ssumner
    28. December 2012 at 09:08

    TravisV, Yes, but with slightly faster currency growth we might have done even better.

    Saturos, I don’t think your thought experiment has any bearing on my claim. I am assuming the money market is in equilibrium; my claim has no implications for a situation where there is excess demand for Benjamins. (Or excess demand for coins, or excess demand for bank reserves, or checking account balances, etc.) My claim is that if the Fed doesn’t supply enough Benjamins, the value of Benjamins will rise. This will occur through deflation, not “excess demand.” The market for money will clear, the labor market will not clear. The recession occurs because there is deflation (of NGDP) and sticky wages, not because there is a lack of $100 bills to spend, or a lack of any other type of MOA to spend.

    K, The problem with Keynesians is that they keep moving the goal posts. First they say OMOs can’t work at the zero bound. Then when they do work they say they are working for the wrong reason, because they somehow change the expected future path of monetary policy. Duh, monetary policy has always been about the expected future path of policy. Do you think anyone ever believed that doubling the monetary base with the commitment to pull all the money out of circulation two weeks later would increase the price level? So now people like Krugman claim that QE might work by increasing the future expected money supply. That makes the entire “liquidity trap” argument depend on there being an expectations trap. But in all of human history there has never been an expectations trap under fiat currencies. So the Keynesians end up with a nice little theory that has zero relevance for the real world. Don’t get me wrong, I like Krugman’s 1998 paper, it’s just that the policy implications are exactly what he correctly claimed in 1998 and 1999 (use monetary policy not fiscal policy at the zero bound) and not the policy implications he later erroneously claimed to be true.

    As far as your motives, I don’t recall making any claims about your motives in my post. If you think I did, perhaps you are a bit delusional.

    In any case, the issue of whether OMOs “work” has never been the right question. The real question is “what is the public’s demand for base money as a share of GDP when expected NGDP growth is on target and the nominal rate is zero?” Because Keynesians have never to my knowledge confronted that question, they flail around helplessly with meaningless models like Wallace Neutrality.

  55. Gravatar of ssumner ssumner
    28. December 2012 at 09:26

    JP, I think you missed the point of this post. I understand that the Fed sets the base, and then the share in $100 bills is endogenous. That has nothing to do with my argument. My argument is that changes in the base relative to base demand drive NGDP, and since most base demand is for $100 bills (during normal times) the TDFs are far more important than the banking system in monetary policy.

    By the way, it’s not true that the Fed always accommodates the public’s demand for each denomination. In 1964 there was a huge shortage of the sorts of coins used to make many purchases, and it had zero effect on NGDP. Recessions aren’t caused by a lack of MOE, they are caused by a lack of MOA.

    jknarr, Let’s hope so.

    Benjamin, I’d go with the NGDP futures market approach. We both know that right now the markets favor monetary stimulus much more than do the Fisher’s of the world.

    Bill, You said;

    “However, with exogenous base money, what happens if there is an increase in the demand for base money? You have to sell the T-bills, and that requires that there be buyers. Where do the buyers get the base money to pay of them?”

    The price will fall until there is a buyer of the T-bills. I don’t see the problem. Even in a depression people can always get cash from banks or ATMs, when they need to buy something. That’s not the problem. The problem is that the asset price level that clears the money market does not clear the labor market.

    Tom, I don’t denigrate the effect of house prices. I think they do impact spending patterns somewhat, but I doubt they impact AD.

    You are confused on monetary policy in much the same way everyone else is confused (so don’t feel bad.) You can’t look at what the Fed is doing to rates if you want to determine whether money was easy or tight. If the Fed cuts rates, but the Wicksellian equilibrium rate falls even faster, then policy has tightened. That’s what happened.

  56. Gravatar of StatsGuy StatsGuy
    28. December 2012 at 09:42

    Scott:

    “It really doesn’t matter what you make the medium of account, just make sure that its value falls at a steady 5% per year, where “value” is defined as the share of NGDP that can be purchased with each unit.”

    You need to keep this quote. It is the essence of a great many arguments.

    The only challenge is that people will seek alternative mechanisms to store value – this is the risk of “asset bubbles”. I’ve called attention to this in carry trade concerns, and they have played out to some degree, but I think not to the extent people feared. Gold is not becoming the default currency. The vast majority of asset bubbles are supply constrained – eventually supply catches up (more gold can be mined, land can be reclaimed – private markets are very ingenuitive). And in the process of building supply, investment happens, restoring final demand. If assets eventually collapse in prices, then people flee back to money (medium of account), which sustains its value.

    But I think we overstate one thing – if the Treasury were not running a trillion dollar deficit with 15 trillion in outstanding debt, I think injection would be a bigger issue, in so far as the Fed would need to seek other assets to purchase (which might create credibility problems due to political constraints in what it can buy).

    I’m still questioning how much of 2007 was a failure of economic theory vs. political institutions.

  57. Gravatar of Scott Sumner Scott Sumner
    28. December 2012 at 09:48

    Statsguy, You said;

    “But I think we overstate one thing – if the Treasury were not running a trillion dollar deficit with 15 trillion in outstanding debt, I think injection would be a bigger issue, in so far as the Fed would need to seek other assets to purchase (which might create credibility problems due to political constraints in what it can buy).”

    This is an important point. I’ve nibbled around the edges, but perhaps need to address it head-on.

    The implication is that hard money and budget surpluses leads to socialism.

  58. Gravatar of cucuracha cucuracha
    28. December 2012 at 10:12

    “Now let’s explain what caused a recession to begin in December 2007″

    The banks were too leveraged, they had a very low proportion of risk free assets (currency + t-bills) compared to their liabilities (deposits).

    Interest rates from risk free assets (t-bils) was low, but the rates from non-risk free assets (including interbank loan related) were soaring. There was no more room for the banks to continue lending or incorporate/underwrite (under Gramm-Leach Bliley act mixed commercial/investment banks could create corporate securities against the creation of deposits in their liability side), because the discount (rates) on non-risk free assets was too high…

  59. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 10:37

    Bill Ellis:

    MF says…”Rates are set by short term Fed influences on bank reserves, not aggregate spending. ”

    If so then there can be no “crowding out”.

    I don’t consider “crowding out” in nominal terms, but rather in real terms. Every dollar the state spends, even if it is directly from a printing press, while it may not reduce nominal spending in the private sector, nevertheless redirects that which is purchased by money, to the ends of those in the non-private sector, rather than the ends of those in the private sector. So in real terms, there is always crowding out, even if there is no reduction in “spending” in the private sector.

    If I had to choose between my spending not nominally falling but having control over fewer resources to serve my ends, and my spending falling but having control over no fewer resources, or more resources, to serve my ends, then I would choose the latter in a heartbeat. I am ultimately better off or worse off in real terms, not nominal terms.

  60. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 10:37

    Saturos:

    MF, what do you think about this? I hope you weren’t denying that inflation causes nominal rates to rise…

    I don’t know why we keep going over the same point over and over again.

    For the millionth time:

    Inflation makes rates rise, but only to the extent that the rates reflect inflation from the side of an increased price level, after the increased supply of loans has been spent and respent throughout the economy and raising price levels.

    Inflation makes rates fall to the extent that the rates reflect inflation from the side of an increased supply of loans, before the increased supply of loans has been spent and respent throughout the economy and raising price levels.

    In other words, inflation into the loan market makes rates fall in the short run, and, if the central bank stops there and shuts its doors, then rates will eventually rise as the new money is spent and respent, raising prices throughout the economy and widening the spread between demand for factors of business and demand for products of business.

    But if the central bank continuously inflates, and does so in an accelerating manner, then the rates will be kept low because the central bank is offsetting the upward pressure of rates from the side of increased prices and profits, with even greater downward pressure of rates from the side of increased supply of loans.

    Since the Fed cannot keep accelerating inflation forever, it has historically always chosen to slow down the required inflation that would keep rates low, which of course then leads to rising interest rates, and positivist oriented people like Sumner will conclude “See that? Rates are higher because money has been loose.” In reality what is happening is that rates are rising because the upward pressure from the side of increased prices is greater than that downward pressure from the side of increased supply of loans. So in these instances the current inflation is putting downward pressure on rates, while past inflation is putting upward pressure on rates (because the price level pressure is a function of past inflation, not current inflation).

    Single track mentalities cannot accommodate the multi-faceted processes taking place with inflation and interest rates. Some people think inflation lowers rates only, while other people think inflation raises rates only. Nobody is comparing the current inflation which decreases rates with past inflation which increases rates. Whichever force dominates will reveal to use the temporal trend of rates. If rates are rising over time, it’s because the upward pressure from the side of increased prices dominates downward pressure from the side of increased loan supply. If rates are falling over time, it’s because the downward pressure from the side of increased loan supply dominates upward pressure from the side of increased prices.

    Rates were rising during the 1970s because the upward pressure from the side of prices dominated the downward pressure from the side of increased loan supply. But that upward pressure from the side of increased prices was a function of past inflation, which originally put downward pressure on rates from the side of increased loan supply.

  61. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 10:40

    ZHD:

    However, I think you are cleverly masking latent anarcho-capitalist leanings (à la David Friedman) in over-specified critiques of other liberal policies like Scott’s.

    You wouldn’t notice that if you weren’t cleverly masking latent anti-anarcho-capitalist leanings (à la Friedrich Hayek)

    Even though your argument centers on a “constant” edict, an expansion of the monetary base makes the most sense for consistent growth. Let the rate be a free parameter determined by some lag; arguing over how that parameter might be fixed is SILLY.

    But a constant base growth does not generate a constant spending growth, as I said. It doesn’t do it because money is not neutral, and each dose of inflation loses its effectiveness in maintaining the increasingly distorted capital structure of the economy.

    Feel free to deny that money is non-neutral.

  62. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 10:45

    ssumner:

    The implication is that hard money and budget surpluses leads to socialism.

    As with most things uttered on this blog, the truth is literally the exact opposite of that claim.

    It is inflation and deficits (as well as the extension of the statist philosophy that grounds the central banking inflation and treasury deficits) that leads to socialism.

    Central banking is a socialist institution. To say that introducing a socialist institution that has such far reaching power so as to influence one half of every single trade, can stop socialism, is about the most absurd, nonsensical assertion I’ve ever seen. You might as well say war is peace, freedom is slavery, and ignorance is strength.

  63. Gravatar of Doug M Doug M
    28. December 2012 at 11:43

    We have always been at war with Eastasia.

  64. Gravatar of pct pct
    28. December 2012 at 12:53

    The recession was actually caused not by a shortage of Benjamins, but by a shortage of pennies, which TDFs need to put on the eyes of their victims. Penny mintage plunged from 7,401,200,000 in 2007 to 5,419,200,000 in 2008 and 2,354,000,000 in 2009.

  65. Gravatar of Brock Brock
    28. December 2012 at 13:13

    “But I think we overstate one thing – if the Treasury were not running a trillion dollar deficit with 15 trillion in outstanding debt, I think injection would be a bigger issue, in so far as the Fed would need to seek other assets to purchase (which might create credibility problems due to political constraints in what it can buy).”

    Helicopters. Bags of cash. Done.

    Or in a way that wouldn’t cause mob stampedes, wire everyone their share of 2% of GDP directly to their checking account. Call it “Free Money”. This might be the most popular government program ever.

  66. Gravatar of K K
    28. December 2012 at 13:47

    Scott,

    “As far as your motives, I don’t recall making any claims about your motives in my post. If you think I did, perhaps you are a bit delusional.”

    I may well be delusional, but I certainly didn’t think you were talking specifically about me. I took offence as a member of the group you were maligning.

    “The real question is “what is the public’s demand for base money as a share of GDP when expected NGDP growth is on target and the nominal rate is zero?” ”

    The short answer is: the path from here to there is a disequilibrium that could easily lead through debt/deflation if inflation expectations don’t jump to the reflation equilibrium. I wrote the long answer in response to one of your posts a couple of months ago.

  67. Gravatar of Doug M Doug M
    28. December 2012 at 14:11

    PCT,

    The penny is a joke. It doesn’t even buy a gumball any more. The matalic value of the penny was debased, and it still isn’t worth the metal it is stamped on.

    The only reason pennies exist is a function of sales tax. If we didn’t need to pay some strange percentage of our purchase price to the state government every but food and gasolene would be priced to a round number.

    If I ran the zoo, my platform would be to eliminate the penny. I would be the candidate against change. I would phase out the nickle if I could, but then dimes and quarters would become incompatible. requireing either the quarter be replaced with a 20 cent piece, or the dime be replaced with the bit (1/8th of a dollar — 12.5 cents).

    I personally preffer the the bit, but most people seem prefer decimals to fractions — darn metric system.

  68. Gravatar of Negation of Ideology Negation of Ideology
    28. December 2012 at 17:12

    “The implication is that hard money and budget surpluses leads to socialism.”

    Hard money causes depressions which causes a reaction, because voters don’t like starving to death. I’m not sure if the reaction is always socialist – it could be fascist, or redistributionist.

    I think budget surpluses could lead to socialism once the debt is paid off – if the Treasury started buying up all the assets in the country with the proceeds. When the government paid off the national debt in the 1830′s, partly because of dividends from the Bank of the United States, Congress passed a law that surpluses would be paid to the States as a quarterly dividend. I have no idea if that law is still in effect, but I think it would be a good idea. Maybe a citizen dividend would be better.

    Of course, the surplus didn’t last long, because Andrew Jackson caused the worst depression in our history by killing the Bank of the United Stated and issuing the Specie Circular. Thanks to hard money, we went back into debt and never again climbed back out.

  69. Gravatar of flow5 flow5
    28. December 2012 at 17:37

    “The real question is “what is the public’s demand for base money as a share of GDP when expected NGDP growth is on target and the nominal rate is zero?” ”

    ? there’s no linkages within those parameters.

  70. Gravatar of Doug M Doug M
    28. December 2012 at 17:54

    Negation,

    Killing the Bank of the United States made for easy money. It allowed state chartered banks to print money freely.

    Specice Circular was an attempt to harden money, but it only applied to land speculators. What it did do was highlight the detiorating quality of the printed money.

    Then the banks collapsed.
    And then we had several years of hard money.

  71. Gravatar of Doug M Doug M
    28. December 2012 at 18:03

    I see how massive defecits lead to socialism. I have a tough time seeing how Government surplusses do the same. Negation suggests that it is because the Government would be buying private assets. But would they? First the Government would buy back its own debt. Then it would buy gold and the buys debts of its trading partners.

    Supposing that we accept the idea that Government purchases of private assets is socialism. Then wouldn’t massive quantitative easing lead to socialims. After the Fed buys up all of the Treasury debt, what does it buy?

  72. Gravatar of Major_Freedom Major_Freedom
    28. December 2012 at 20:01

    Negation of Ideology:

    Hard money causes depressions which causes a reaction, because voters don’t like starving to death.

    It’s the opposite. Soft money causes recessions/depressions, because soft money distorts economic calculation and makes it necessary to accelerate inflation in order to avoid correction (which of course cannot last without currency collapse). Hard money (100% gold) does not cause recessions/depressions.

  73. Gravatar of bobdrat bobdrat
    28. December 2012 at 20:34

    I really wish I would finally just “get it.” OK, so

    M = kPY. So if M falls and k is constant, PY must fall.

    But what is the mechanism? How does it work? People find themselves with less money than they want to have and… do what? Refuse to buy other goods in order to hold onto their precious cash, causing a recession? Is that how it works? And how do people actually find themselves short of cash? If I want to convert some of my value into cash I can always just sort of get it really easily…

  74. Gravatar of jknarr jknarr
    28. December 2012 at 21:00

    Most money is credit. Gresham’s law says that credit money (demand deposits) circulate, while currency is hoarded. Volume of usage is beside the point. The scarcest, strongest, most counterparty free form of currency is now FRN benjamins — which are backed on the Fed’s balance sheet by Treasury bonds.

    Bank credit money disappears in a hyperinflation, and currency abides – but is never available in sufficient volumes to purchase goods. When currency is printed, the scarcity of base money is diluted, full stop. Bank credit is what we call money, debt is what we call term credit, and derivatives are systemic credit. Monetary policy efforts to defend notional values of this credit will grossly dilute the currency.

    The failure of massive reserve formation to call out creditworthy NGDP lending thus far is a precursor to a mass currency monetization of debt. Economies that cannot create new debt cannot sustain past debt.

  75. Gravatar of Ron M Ron M
    28. December 2012 at 21:45

    That Yahoo story is bogus.

    Production of $100 notes was up in 2012 because is was down in 2011.
    http://bep.gov/uscurrency/annualproductionfigures.html

    The production slowdown in 2011 does not seem to have lowered the quantity of $100 notes in circulation. But the data for 2012 is not it yet.
    http://www.federalreserve.gov/paymentsystems/coin_currcircvolume.htm

  76. Gravatar of cucuracha cucuracha
    29. December 2012 at 04:00

    Scott is right

    Just compare the reserves of depository institutions with the whole monetary base in 13 december 2007:

    http://www.federalreserve.gov/releases/h3/20071213/

    Only some 40 billion dollars were in the reserve banks, of a total of more than 800 billion.

    The commercial banks had a total of less than 300 billion dollars at that time:

    http://www.federalreserve.gov/releases/h8/20071228/

    Thus it is not only a problem of too much leverage, it is also currency that is really spilling out of the system making it difficult to the banks to have an adequate reserve ratio. The consequence was a decoupling in interbank loan rates from the federal funds rate with a much higher risk premium.

  77. Gravatar of cucuracha cucuracha
    29. December 2012 at 04:22

    Today, the ratio of currency with the reserve banks to the whole dollar currency base is about 60%:

    http://www.federalreserve.gov/releases/h3/current/h3.htm

    In december 2007, it was about 5%:

    http://www.federalreserve.gov/releases/h3/20071213/

    Today, the ratio of currency with commercial banks to the whole dollar currency base is about 63%:

    http://www.federalreserve.gov/releases/h8/current/default.htm

    In december 2007, it was about 33%:

    http://www.federalreserve.gov/releases/h8/current/default.htm

    Which points to an underestimation of the demand for paper currency for a myriad of purposes. Maybe this underestimation comes because us monetary authorities didn’t take into account the higher GDP growth rate of other countries. This higher GDP growth probably increased the demand for us dollar paper currency from those countries.

  78. Gravatar of TravisV TravisV
    29. December 2012 at 06:48

    New report shows close linkage between unemployment & median family income; one goes down the other up. http://www.sentierresearch.com/reports/Sentier_Household_Income_Trends_Report_November2012_12_28_12.pdf

  79. Gravatar of flow5 flow5
    29. December 2012 at 07:17

    This isn’t rocket science. The unregulated, prudential reserve, Euro-dollar (Yen-dollar, etc.) banking system collapsed first (July) – where there are no Central Bank backstops (& the E-D system’s liabilities are many times those in the U.S.). Then our Federal Reserve authorities failed to supply an adequate volume of reserves to the member banks in the U.S. It was the magnitude of this shortfall that created the liquidity runs within the non-banks (the customers of the member banks). It was criminal.

    The money supply can never be managed by any attempt to control the cost of (i.e., thru pegging the interest rate on governments; or thru “floors”, “ceilings”, “corridors”, “brackets”, IOeRs, etc). . Keynes’s liquidity preference curve (demand for money) is a false doctrine. We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about.

    Lawrence K. Roos, Past President, Federal Reserve Bank of St. Louis & past member of the FOMC (the policy arm of the Fed) as cited in the WSJ April 10, 1986 “…I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always & still is, a preoccupation with stabilization of interest rates”.

    Our excessive rates of inflation (since 1965), has been due to irresponsibly easy monetary policies. Our monetary mis-management has been the assumption that the money supply can be managed through interest rates.

  80. Gravatar of flow5 flow5
    29. December 2012 at 07:54

    “making it difficult to the banks to have an adequate reserve ratio”

    Milton Friedman’s “monetary base” is not, & has never been, a BASE for the expansion of new money & credit. Thus the “money multiplier” is also bogus (SEE THORNTON).

    For those who need a reminder, the equation of exchange is an algebraic way of stating a truism; that the product of the unit prices, & quantities of goods & services exchanged, is equal (for the same time period), to the product of the volume, & transactions velocity of money. It is self-evident from the equation that an increase in the volume, & or velocity of money, will cause a rise in unit prices, if the volume of transactions increases less, & vice versa.

    I.e., inflation cannot occur unless fueled by a chronic increase in the volume &/or transactions velocity of money. A chronic increase in means-of-payment money cannot occur unless the FED, through e.g., excessive open market operations of the buying type, supplies the commercial banks with an excessive volume of legal reserves, (excessive, of course, in terms of rates-of-change in real-output, & changes in the transactions velocity of money).

    The Manager of the Open Market Account should regulate his operations in terms of the proper volume of legal (required) reserves which the member banks should hold (except for those periods when Treasury debt management requires “support” operations from the FED). After support operations have passed the excessive expansion of legal reserves can be “washed out”.

    What is the proper volume of legal reserves? This depends on THORNTON’s “multiplier”, the transactions velocity of money, & the rate-of-change in real-GDP. These variables can be estimated with a high degree of accuracy, & the rate-of-change in real-gDp (Y) serves as a proxy to rates-of-change in total physical transactions (PT), both goods & services.

    The FED can project with a high degree of reliability the probable rate of increase of monetary flows in the economy (MVt), relative to the probable rate of increase in real-gDp. Because of the widespread existence of monoplistic & other elements in the structure of our economy the first rate (monetary flows) should exceed the latter. How much? That is a policy judgment involving trade-offs, but perhaps by no more than 3%.

  81. Gravatar of cucuracha cucuracha
    29. December 2012 at 07:59

    “Then our Federal Reserve authorities failed to supply an adequate volume of reserves to the member banks in the U.S.”

    I think I understand your point: as the Fed was concerned with the rates, and the open market operations necessary to effectively put more money in the system could make it harder to keep the Fed’s target rate, the demand for currency was not satisfied accordingly, and the system broke.

    P.S.: I think Miles idea should be put in reverse: A 100 cash withdraw would correspond to, for instance, a 105 current account debit. A 100 cash deposit, on the opposite direction, would correspond to a 102 current account credit. Then cash holders would have an interest to make deposits before every purchase they would make (bringing the cash back to the banking system) but would face a high charge (higher than the gain with the deposit) to withdraw the cash out of the system…

  82. Gravatar of Saturos Saturos
    29. December 2012 at 08:07

    Scott, I was only trying to say that if the equilibrium value of cash was pushed up by an increase in demand for cash, whilst there was no upward pressure on the value of other moneys predominantly used as media of exchange, then I would expect to see only a mild recession. And I think Nick and Bill would agree with me.

    pct nails it. A reductio ad absurdum, nicely done.

    MF, your story doesn’t describe the Great Depression very well does it?

    jknarr, check out the share of household portfolios being held as non-currency liquid assets right now…

  83. Gravatar of TravisV TravisV
    29. December 2012 at 08:08

    Holy smokes! I just noticed this post! It’s not getting nearly enough attention! “Some Thoughts on Housing” by Karl Smith: http://www.forbes.com/sites/modeledbehavior/2012/11/20/some-thoughts-on-housing

  84. Gravatar of Negation of Ideology Negation of Ideology
    29. December 2012 at 08:29

    Doug M – I agree that removing the restraining influence of the Bank of the US led to expansion of state issued notes. And I agree that Specie Circular caused the banks to collapse and the resulting depression.

    But I’m puzzled by this -
    “Negation suggests that it is because the Government would be buying private assets. But would they? First the Government would buy back its own debt. Then it would buy gold and the buys debts of its trading partners.”

    Since when is gold not a private asset? The government buying up huge amounts of gold, and controlling the price of gold, is socialism. That’s why I don’t call it the Gold Standard, I call it Socialized Gold.

    “After the Fed buys up all of the Treasury debt, what does it buy?”

    That is a great question. My preference would be to buy any other Treasury backed debt. After that, I’d buy state bonds – after all, the federal government was chartered by the states. There’s about $3 Trillion in state and municipal bonds outstanding, and well over a $Trillion in Treasury backed loan, and the Fed balance sheet is something like $2.8 Trillion. So even if the national debt was $0, the Fed could operate without buying any private assets (including gold).

  85. Gravatar of cucuracha cucuracha
    29. December 2012 at 08:30

    “Milton Friedman’s “monetary base” is not, & has never been, a BASE for the expansion of new money & credit. Thus the “money multiplier” is also bogus (SEE THORNTON).”

    Are you considering the demand for currency from the banks depositors ? A drug dealer, for instance, won’t accept a direct deposit in his account. He will demand cash, so a drug addict will have to eventually convert a part of his bank deposit into currency to buy his/her drugs (just an example).

  86. Gravatar of Saturos Saturos
    29. December 2012 at 09:26

    Update: once again, Nick Rowe has written a post so good it’s beautiful. MF in particular should take a look, it’s the best explanbation of capital, time and interest I’ve ever seen. I wish he had taught me economcs. http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/12/capital-in-the-steady-state.html

  87. Gravatar of Saturos Saturos
    29. December 2012 at 09:42

    Quora.com (brilliant site) has added a Market Monetarism section (HT Lars Christensen). Scott, do you want to take this one?

    http://www.quora.com/Market-Monetarism/How-is-market-monetarism-supposed-to-work-in-simple-terms

  88. Gravatar of Saturos Saturos
    29. December 2012 at 09:46

    Justin Merrill believes in Cantillon effects: http://marketmonetarist.com/2012/12/29/guest-post-cantillon-and-central-banking-by-justin-merrill/

  89. Gravatar of jknarr jknarr
    29. December 2012 at 10:30

    Saturos – I follow that series regularly. Higher forms of credit-money are imploding, or at least artificially sustained, and cash is fleeing to perceived safety in insured demand deposits. Won’t work, of course.

    Demand is fleeing from equity into treasurys into demand deposits. Next step is a flight to physical cash. Then out of the world of financial assets and into gold, energy, and food.

    Reserves on bank balance sheets slowed this flow, but will only work for a couple of more years. It is an excellent time to front run the demand and position.

    There has already been near-hyperinflation in the notional of various “credit money/assets”. Consider that the numerator. At zero rates, that demand begins to flow into the denominator of physical assets.

    Increased demand for cash is just one more step on this spiral staircase. Legal tender law forces all the financial cattle through this chute and pen – the fed can accommodate this demand or not. Central banks usually do.

  90. Gravatar of jknarr jknarr
    29. December 2012 at 10:58

    Saturos – Justin also sees the incompatibility of reserves and NGDPLT.

    As far as i can tell, i’m the only other guy banging on about this problem

    I’d like to see the issue addressed. Or we could keep living the dream.

  91. Gravatar of Max Max
    29. December 2012 at 11:06

    Taking another swing at this…if the Fed didn’t target interest rates in between meetings, then a surprise demand for currency could cause tight money which could in turn cause a recession. But this never happens, because even if the Fed doesn’t do any OMOs to accommodate the currency demand, banks can take an emergency loan from the Fed, which puts a limit on how tight money can get.

    Alternatively, if the banking system has excess reserves, then shifts in the demand for currency simply change the level of excess reserves, which has no effect on interest rates.

  92. Gravatar of Max Max
    29. December 2012 at 11:09

    A little point on terminology: you call base money the medium of account. It is the MOA from the point of view of the banking system because bank accounts are convertible into it, but from the point of view of the public, the MOA is a price index.

  93. Gravatar of Doug M Doug M
    29. December 2012 at 12:50

    “After the Fed buys up all of the Treasury debt, what does it buy?”

    In the late 90′s when there was a suggestion that there may be a shortage of Treasuries, Greenspan suggested the Fed would buy the debts of the GSE’s (while they were still private companies), and MBS (there were more MBS in circulation than government bonds anyway).

    But at that time the Fed’s balance sheet was tiny compared to today.

  94. Gravatar of cucuracha cucuracha
    29. December 2012 at 13:25

    “But this never happens, because even if the Fed doesn’t do any OMOs to accommodate the currency demand, banks can take an emergency loan from the Fed, which puts a limit on how tight money can get”

    If the Fed accepts private debt as collateral, maybe. But again, it is not different from a bank being capitalized by the Treasury. I mean, it is disguised fiscal policy without legislative approval…

  95. Gravatar of maximillienne maximillienne
    29. December 2012 at 15:15

    and that is why it is now time to present the scott sumner dollar:

    http://kinecis.com/ssDollar.png

    in scott we trust..

  96. Gravatar of cucuracha cucuracha
    29. December 2012 at 15:25

    (now wait for the Austrians)

    US CONSTITUTION, Article I, Section IX:

    No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.

    Federal Reserve Act:

    Section 16. Note Issues
    1. Issuance of Federal Reserve Notes; NATURE OF OBLIGATION; Where Redeemable
    Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be OBLIGATIONS of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues. They shall be redeemed in lawful money ON DEMAND AT THE TREASURY Department of the United States, in the city of Washington, District of Columbia, or at any Federal Reserve bank.

    [12 USC 411. As amended by act of Jan. 30, 1934 (48 Stat. 337). For redemption of Federal reserve notes whose bank of issue cannot be identified, see act of June 13, 1933.]

  97. Gravatar of ssumner ssumner
    29. December 2012 at 16:07

    bobdrat, You asked:

    “But what is the mechanism? How does it work? People find themselves with less money than they want to have and… do what? Refuse to buy other goods in order to hold onto their precious cash, causing a recession? Is that how it works? And how do people actually find themselves short of cash? If I want to convert some of my value into cash I can always just sort of get it really easily…”

    This is far and away the most important question in macroeconomics. People who don’t understand the answer, don’t understand macro. Period, end of story. A good place to start is to consider what happens to NGDP measured in apple terms, not dollar terms, if there is a huge apple harvest that causes the dollar price of apples to fall in half. The answer is that NGDP in apple terms doubles. Then ask yourself why this happens. The answer is obvious. Nothing has happned to “the economy,” what has happened is that our measuring stick has shrunk. Thus the economy seems twice as big.

    But that’s just part of the answer. The second step is to recognize that nominal wages and prices are sticky in dollar terms. So extra dollars not only cause the value of the dollar to fall, and NGDP to rise, in the short run they also cause RGDP to rise because wages and prices are sticky.

  98. Gravatar of ssumner ssumner
    29. December 2012 at 16:18

    pct, If you search in my search box you might find a post of mine where I claimed the recession was caused by the government producing too few nickels. Indeed I also made the offhand observation that too few coins caused the recession in my “autistic macroeconomist” post, which is my personal favorite.

    And I’ve never been more serious in my life.

    Saturos, I was not able to access the website you linked to, but I’d say this:

    “You implement NGDPLT by setting the monetary base at a level that equates the forecast of 12 month forward NGDP with the target level of 12 month forward NGDP.”

    There are of course many ways of forecasting NGDP, I prefer futures markets. Svensson prefers the internal central bank forecast.

  99. Gravatar of ssumner ssumner
    29. December 2012 at 16:20

    Max, The Fed can get as tight as it wishes. It can close down the discount window.

  100. Gravatar of ssumner ssumner
    29. December 2012 at 16:21

    maximillienne, I like that.

  101. Gravatar of ssumner ssumner
    29. December 2012 at 16:23

    Saturos, As long as all forms of money trade at par, it makes no difference where the extra demand comes from. The value of the MOA will rise.

  102. Gravatar of Max Max
    29. December 2012 at 16:50

    “The Fed can get as tight as it wishes. It can close down the discount window.”

    I don’t recall that happening in late 2007!

    Can we at least agree that a surprise withdrawal of currency from the banking system is automatically accommodated? That is, if total money demand (bank accounts + currency) doesn’t change – only the demand for currency – then there can’t be any problem?

    If you agree with that, then I don’t see how you can claim that drug dealers have some extra special power to influence the price level, just because they use currency.

  103. Gravatar of Max Max
    29. December 2012 at 17:20

    I read the Fama article, and it’s pretty bad. He thinks we went from a gold standard to a paper standard. In reality, we went from a gold standard to a price index standard. Things make so much more sense when you realize that base money, just like commercial bank money, is a financial asset. It’s not a commodity with an artificial demand. It’s the debt of the central bank, and if the CB’s debt is trusted, then its value doesn’t depend on a coerced demand for it.

  104. Gravatar of Bill Woolsey Bill Woolsey
    30. December 2012 at 05:12

    Scott:

    You are assuming a Walrasian Auctioneer.

    The Walrasian Auctioneer calls out a set of prices.

    Everyone decides how much currency they want to hold and tell the Auctioneer.

    The Fed tells the Auctioneer how much currency it wants to create.

    The Auctioneer then addes up how much currency each person wants to hold and compares to what the Fed wants to create.

    If there is a shortage, then the Auctioneer calls out a new, lower set of prices.

    With the lower price level, each person finds it necessary to hold fewer dollars, but regardless, each person reports to the Auctioneer what they want to hold.

    You are assuming the Fed keeps base money the same.

    Anyway, when there is a match–no surplus or shortage, then the price level has been determined.

    Now, we take those prices and the various quantities of goods consistent with full employment and calcluate nominal GDP.

    But, you don’t think the Walrasian Auctioneer calls out wages, those are fixed.

    And so, nominal GDP is divided by wages and that determines the hours worked.

    And the hours worked determine output.

    This has no connection with real market economies.

    And if apples served as the medium of account, there would still be no Walrasian Auctioneer causing all prices and quantites in the economy to adjsut to clear the apple market.

  105. Gravatar of Bill Woolsey Bill Woolsey
    30. December 2012 at 05:17

    Scott:

    The demand for base money depends on the monetary regime.

    We do not have a monetary regime where base money is exogenous.

    We have a monetary regime where base money is endogenous. Your statements about the demand for base money (little in the form of reserve balances in “normal times,” refers to a regime where base money is endogenous.

    If we did have a monetary regime where base money was exognenous, the demand for base money would be different. You claims about the demand for base money are not relevant.

  106. Gravatar of Becky Hargrove Becky Hargrove
    30. December 2012 at 08:12

    Bill, you said:
    “We do not have a monetary regime where base money is exogenous.”

    That raises two questions for me. Is U.S. currency held by other countries (also) considered endogenous, and how might that seeming discrepancy be accounted for, should a country adopt NGDPLT?

  107. Gravatar of flow5 flow5
    30. December 2012 at 08:19

    “as the Fed was concerned with the rates, and the open market operations necessary to effectively put more money in the system could make it harder to keep the Fed’s target rate, the demand for currency was not satisfied accordingly, and the system broke”

    The public didn’t want more currency. AD was below trendline (Fed’s fault). The Fed can’t, & shouldn’t, control the volume of currency in circulation. The Fed is supposed to control our means-of-payment money. Transaction deposits fell sharply. That caused non-bank runs (liquidity problems) & the ensuing recession.

    A greater demand for currency reflects higher levels of economic activity (transactions velocity), in the “Underground Economy” (estimated c. 9% of nominal gDp), or too, illegal activity in the Black Market (where record-keeping & taxes are deliberately avoided), i.e., whatever is required to meet the “needs of trade”.

    AD flucuations will become more frequent as the Fed’s monetary transmission channel (with IOeR) is now clogged. You can look to the ECB to correct their problem first: “Draghi’s zero deposit rate policy put an end to euro money market funds”

    http://soberlook.com/2012/07/draghis-zero-deposit-rate-policy-put.html

  108. Gravatar of flow5 flow5
    30. December 2012 at 08:54

    The “autistic macroeconomist” post was fun to read. Your observation that “rare coin dates” reflect subpar AD growth is no doubt true. But the litmus test for 2008 is the roc in non-bank held currency. That incontestably fails the test.

    After looking at the data my guess is higher levels of currency outside the banks is more related to real interest rates.

  109. Gravatar of Bill Woolsey Bill Woolsey
    30. December 2012 at 09:00

    Becky:

    With NGDPLT, base money remains endogenous.

    If foreigners want to hold more currency, then it is necessary to issue more.

  110. Gravatar of flow5 flow5
    30. December 2012 at 09:02

    And the unregulated, prudential reserve, Euro-dollar banking system doesn’t make coins or print paper money. Flucuations in its liabilities reflect flucuations in AD.

  111. Gravatar of flow5 flow5
    30. December 2012 at 09:11

    “With NGDPLT, base money remains endogenous”

    No its not.

    http://research.stlouisfed.org/publications/review/80/06/Eurodollars_Jun_Jul1980.pdf

    ANATOL B. BALBACH and DAVID H. RESLER Eurodollars and the U.S. Money Supply

  112. Gravatar of flow5 flow5
    30. December 2012 at 11:04

    “For some reason, the lag time of interest rate changes having their effect on the stock market has been lengthening”

    http://pragcap.com/another-use-for-the-yield-curve/comment-page-1#comment-133626

    The FED’s monetary transmission mechanism (the manipulation of interest rates), is antithetical to the control of the money stock.

  113. Gravatar of Major_Freedom Major_Freedom
    30. December 2012 at 11:19

    maximillienne:

    and that is why it is now time to present the scott sumner dollar

    in scott we trust..

    You forgot to draw a gun pointed at an innocent person in that picture. After all, a gun is required for paper notes from either the state, or from Sumner, to be used by everyone as medium of exchange.

    I know I would not accept paper if there were no guns pointed at me. Unfortunately however, even if I accepted only precious metals as payment, I still have to pay taxes in paper notes at gunpoint, which means I have to go out and earn paper notes from others who also have to pay taxes in paper notes at gunpoint. Hence, even if I tried to compete with paper notes in the market, I could not do it without getting intimidated by IRS and SWAT team thugs.

    ——————–

    ssumner:

    I recommend that at the top of this blog, besides “TheMoneyIllusion”, you put in a picture of a thug pointing a gun at an innocent person. It would be more honest. You are honest, aren’t you?

  114. Gravatar of cucaracha cucaracha
    30. December 2012 at 14:39

    “A greater demand for currency reflects higher levels of economic activity (transactions velocity), in the “Underground Economy” (estimated c. 9% of nominal gDp), or too, illegal activity in the Black Market (where record-keeping & taxes are deliberately avoided), i.e., whatever is required to meet the “needs of trade”.”

    Currency outside us commercial banks nearly doubled (100% increase) from about US$ 500 billion in december 2007 to almost US$ 1 trillion now. Meanwhile, NGDP grew only 11% in the same period…

  115. Gravatar of Les Cargill Les Cargill
    30. December 2012 at 16:51

    Question: How does the Treasury/Fed regulate the supply of
    $100 bills? I thought that retail banks ordered currency
    as they saw fit, exchanging electronic money for it.

    Do the Fed member banks/Treasury refuse those orders in a mechanism reacting to policy changes?

  116. Gravatar of flow5 flow5
    30. December 2012 at 19:46

    “Currency outside us commercial banks nearly doubled”

    Should have been more careful. I haven’t studied this thoroughly. There are multiple reasons to hold more cash. Maybe it would make more sense if I qualified my answer by saying that, in general, the non-bank public holds more cash during periods where real-gDp exceeds a certain growth rate.

    There are other reasons. The “Daily Treasury Real Yield Curve Rates” demonstrates one.

    http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=realyieldYear&year=2011

    When Lehman Brothers filed for bankruptcy in September 2008 would be another.

    But I wouldn’t say that the non-bank public holds more currency during recessions.

  117. Gravatar of ssumner ssumner
    30. December 2012 at 20:10

    Bill, No, I assume that prices are sticky. I agree that in the apple example prices are flexible in apple terms. And I agree that the difference is important when thinking about the effect of changes in NGDP on RGDP. But I’m focusing on the question of why NGDP changes. I was responding to a commenter who didn’t understand why more money means more NGDP. The apple example is a starting point, and only a starting point. It gets at the hot potato intuition.

    Bill, The question of whether the demand for base money is exogenous or endogenous has no bearing on my post. From a certain perspective everything in the universe is endogenous. That’s not the issue. The question is whether the Fed accommodated the increase in the demand for base money from TDFs in late 2007 and early 2008. They did not, hence we had a recession.

    cucaracha, Your data is wildly inaccurate–better double check.

  118. Gravatar of cucaracha cucaracha
    31. December 2012 at 04:47

    “cucaracha, Your data is wildly inaccurate–better double check.”

    I took the monetary bases in December 2007 and now (FED H3) and then subtracted the cash assets with US Commercial Banks (FED H.8) at the same reference dates.

  119. Gravatar of flow5 flow5
    31. December 2012 at 06:29

    “whether the Fed accommodated the increase in the demand for base money”

    How can any observer deny this? Greenspan might have set Bernanke up – but Bernanke’s directly responsible for this shortfall (& the severity of the recession/depression).

  120. Gravatar of flow5 flow5
    31. December 2012 at 07:12

    No money supply figure standing alone is adequate as a guide post for monetary policy. If velocity was a constant it wouldn’t matter. But velocity has varied more than money has fluctuated. Transactions velocity (demand deposit turnover) grew 2.5X faster than M1 over a 37 year period (1959-1996). Conducting a contractionary money policy forces a reduction in both money & velocity.

  121. Gravatar of flow5 flow5
    31. December 2012 at 08:17

    (1) Roc’s in currency times velocity don’t match roc’s in gDp.
    (2) Roc’s in bank deposits times velocity do match roc’s in gDp.
    (3) Currency increases during depressions, not recessions.

    Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it is superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure included AMBLR plus the volume of currency held by the nonblank public (Milton Friedman’s “high powered money”).

    Any expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the non-bank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW or ATS accounts, into currency. But this shift does reduce member bank legal reserves by an equal, or approximately equal, amount.

    An expansion of the public’s holdings of currency will cause a multiple contraction of bank credit & checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type (e.g., purchases of governments for the portfolios of the 12 Reserve Banks). The reverse is true if there is a return flow of currency to the banks. Since the trend of the non-bank public’s holdings of currency is up (ever since 1930), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.

    I.e., all currency gets into circulation, directly or indirectly, through the liquidation of time deposits, by the cashing of demand deposits. There is one exception in demand deposit creation; those historical instances when the U.S. Treasury borrowed from the Federal Reserve Banks. However, it cannot be said (as of time deposits), that increases in the public’s holdings of currency reflect prior commercial bank credit creation. It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve Bank Credit.

    Although the DIDMCA of March 1980 made all depository institutions maintain uniform reserve requirements (thereby expanding the “source base” from 65% of the commercial banks to 100% of the money creating depository institutions), Paul Volcker’s unconventional reserves-based-operating-procedure” was unsuccessful. This was because the BOG attempted to target only non-borrowed reserves (when at times, 10% of all legal reserves were borrowed). I.e., $1b of reserves in 1980 (borrowed or otherwise), supported $16b of M1. I say Volcker “attempted” because legal reserves grew at a 17% annual rate-of-change, from April 1980, until the end of that year. Contrariwise, this so-called “operating procedure” (monetarism), was never “abandoned”, it was never tried.

    Between 1942 and September 2008, member commercial banks operated with no excess legal reserves of consequence. However legal reserves were only “binding” between c. 1942 until 1995. Since 1995, increasing levels of vault cash (larger ATM networks), retail and commercial deposit sweep programs, fewer applicable deposit classifications (including the “low-reserve tranche” & “exemption amounts”), lower reserve ratios, & the Reserve Requirements Simplification Rule have combined to remove most reserve, & reserve ratio, restrictions.

    In our Federal Reserve System, 90 percent of “MO” (domestic adjusted monetary base) is currency. There is no “expansion coefficient” assigned to the currency component. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (& declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 (where 54% is currency), is, yes, to measure currency vs. currency (cum hoc ergo propter hoc); in probability theory & statistics, not a cause & effect relationship.

    Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation, to domestic currency circulation. The FED’s research staff estimates that foreigners hold one half to two thirds of all U.S. currency (this spread can result in a wide margin of error). Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are attributed to political, & price instability (as well as to seasonal flows), & all are immeasurable in the short run. I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency.

    The “shipments proxy” estimate of foreign-held U.S. currency uses data on the receipts & shipments of currency, by denomination, at the Federal Reserve’s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds “Flow of Funds Accounts of the United States” & in the BEAs estimates of the net international investment position of the United States.

    The volatility of the (1) K-ratio, the public’s desired ratio of currency to transactions deposits (or currency-deposit-ratio), and the volatility in (2) the ratio of foreign-held, to domestic U.S. currency, both influence the trend rate for the cash drain factor (the movement of the domestic currency component of the DAMB). And the evidence points to sizable (& unpredictable), shifts in the money multiplier (MULT – St. Louis), for the constantly changing shifts in the composition of the “M’s”.

    The Federal Reserve Bank of Chicago uses legal reserves (“t”-accounts), exclusively, to explain the creation of new money and credit in the booklet “Modern Money Mechanics”. The booklet is a workbook on bank reserves & deposit expansion (changes in a bank’s deposits-loans resulting from open market operations). The stated purpose of the booklet is to “describe the basic process of money creation in a “fractional reserve” banking system” – the monetary base plays no role at all in this analysis.

    It is therefore both incorrect in theory, & thus inaccurate in practice, to refer the DAMB figure as a monetary base. The only base for an expansion of total bank credit & the money supply is the volume of legal reserves supplied to the member banks by the Fed, in excess of the volume necessary to (1) offset currency outflows from the banking system & (2) offset fluctuations in the level of member bank’s reserve balances (diverted & detained via the remuneration rate), in the 12 District Reserve Banks. The adjusted member bank legal reserve figure is that base.

  122. Gravatar of flow5 flow5
    31. December 2012 at 08:21

    “90 percent of “MO” (domestic adjusted monetary base) is currency”

    I.e., prior to the payment of interest on reserves.

  123. Gravatar of TheMoneyIllusion » Feed the dragon (but not too much) TheMoneyIllusion » Feed the dragon (but not too much)
    31. December 2012 at 10:05

    [...] like to use this parable to better explain my post from a few days back, where I argued that the recent US recession was triggered in late 2007 by the Fed’s failure [...]

  124. Gravatar of ssumner ssumner
    31. December 2012 at 10:10

    cucaracha, You should have subtracted bank reserves, not cash assets.

  125. Gravatar of cucaracha cucaracha
    31. December 2012 at 11:30

    “cucaracha, You should have subtracted bank reserves, not cash assets”

    You mean depository institutions reserves with the FED ?

    They don’t show the entire picture. In December 2007 there was no IOR, so there was no interest from the Commercial Banks which were not depository institutions to hold reserves in the FED. So the number that points to currency with the public then has to be derived from the difference between the base and the cash assets of all Commercial Banks.

    Reserves of depository institutions was a much smaller number than cash with Commercial Banks then, so it disguises the base (currency with the public in 2007 gets bigger than it really was) from which the change is calculated.

    The right parameter is really Monetary Base minus currency in commercial banks.

    But now the reserves with the FED can be used because now they are practically equal the commercial banks cash assets.

  126. Gravatar of Doug M Doug M
    31. December 2012 at 12:14

    A comment on the “Autistic Economist” piece — you identified that rare coin dates coincide with recessions. My intuition tells me that coin production falls as a result of the recession, rather than the other way around.

Leave a Reply