Yesterday I developed a monetary post using a dragon parable. In a bizarre coincidence Frances Woolley has beaten me to it. Here’s my version:
There’s a enormous dragon living just outside a village of peasants. If the dragon is not adequately fed it lashes out and destroys part of the village. If it’s overfed then it produces lots of noxious gases. This is not as damaging as an underfed dragon, but not optimal either. There is a bell that rings whenever the dragon needs to be fed, but the bell often malfunctions.
I’d 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 to provide enough $100 bills for tax evaders, drug dealers and foreigners (TDFs).
It just so happens that TDFs have a growing demand for $100 bills. If the Fed doesn’t meet that demand, we get a recession. If they feed too many $100 bills into the economy, then we get excessive NGDP growth (aka “demand-side inflation.”) Not as bad as a recession, but not optimal either.
This post met with lots of objections. Some pointed out that the Fed can’t control how much of the new base money goes to the TDFs in the form of $100 bills. That share is “endogenous.” Yes that’s true, but has no bearing on my post. The same is true of the M2 money supply. The Fed controls the base, not the ratio of M2/MB. That ratio (called the “M2 multiplier”) is determined by the public (and the Fed via reserve requirements.) And the ratio of $100bills/MB is also determined by the public. However the Fed can target either M2 or the quantity of $100 bills, if it wishes to do so.
My point was that a recession occurred because the Fed did not meet the rising demand for base money in late 2007 and early 2008. And secondarily, that that increased demand came mostly from TDFs wishing to hold more $100 bills. Go back to the dragon analogy, and now assume there are three dragons. The big one represents the hunger for $100 bills by TDFs. Another dragon, less than half as large, represents the demand for currency for transactions. And a third, roughly 1/10th as large, represents the demand for bank reserves in 2007. The villagers throw food into the dragon den, but can’t control how the dragons divy it up. Damage from underfed dragons is proportional to the size of the dragons, and the extent to which they are underfed.
Another criticism was that the entire monetary base is endogenous. Nick Rowe has some excellent posts that clarify the “endogenous money” issue. Whenever the central bank pegs one variable (say exchange rates, gold prices, or M2, or the base, of the fed funds rate, or inflation), then all other variables become endogenous. But once again, that has no bearing on my argument. I wasn’t claiming the Fed targeted the base, much less $100 bills. They don’t, and they shouldn’t. They tend to target the fed funds rate in the very short run, and then adjust the fed funds rate every so often in order to target inflation or NGDP over longer periods of time. But that fact has no bearing on whether a shortage of $100 bills caused the recession.
Let’s see how things change if the Fed has a fed funds target. Some people argued that any extra demand for $100 bills would be smoothly accommodated by the Fed, which would supply enough cash to keep interest rates stable. Like the bell in the dragon example, the fed funds rate often does send out timely signals. But on occasion the bell fails to ring when the dragons are hungry, and on occasion the fed funds rate does not send out a warning that the TDFs need more $100 bills. Late 2007 and early 2008 was one of those failures. You could say the recession was “caused” by a malfunctioning bell, but I prefer to say it was caused by underfed dragons lashing out at the villagers.
The interest rate signalling mechanism only works well if the Wicksellian equilibrium interest rate is constant. In late 2007 and early 2008 the Wicksellian equilibrium rate fell sharply. The Fed did cut the actual fed funds target somewhat, but not enough to keep the TDFs well fed. As a result the supply of currency, which had been trending upward at roughly 5% per year for many years, suddenly stopped growing. And this was associated with a sharp slowdown in the rate of growth of M*V, where M is defined as the monetary base. In an accounting sense, the sharp slowdown in the growth in the base caused the recession.
However this is not my preferred way of thinking about the problem, as it may (wrongly) suggest that if only the Fed had kept the base growing at 5% per year we would have avoided a recession in late 2007. Maybe, but maybe not. It’s quite possible that 5% more base money would have led to 5% less velocity. I prefer to talk in terms of the Fed’s control of M*V, where a monetary policy failure occurs when the Fed allows M*V to grow too fast, or too slowly. But that’s not good enough for most people, they want the process explained using what Nick calls “concrete steppes.” They ask “What caused velocity to suddenly plunge in late 2007 and early 2008?” To those people I say, “Velocity did not plunge, indeed it rose slightly.” If you want “concrete steppes” using the old M*V=P*Y workhorse, then I’d say the recession was caused by sudden stop in base growth, and a failure of V to rise enough to offset this “monetary tightening.”
There are no policy implications from the fact that during normal times most of the growing demand for base money comes from TDFs squirrelling away lots of $100 bills. If the Fed runs a sensible monetary policy, they will smoothly accommodate those shifts in base demand. But that will only occur when and if the Fed replaces the faulty “fed funds target bell” with a much more reliable “NGDPLT futures bell.”
PS. Astute readers like Nick, Bill and Saturos will notice that I’ve avoided the question of whether the MOE role of money is central to the entire process. They might argue that only the smaller two dragons can actually damage the village. At worst, an underfed big dragon takes food away from the smaller two dragons. So the big dragon can be a problem, but only indirectly. I think the big dragon can directly damage the village.