A note on currency depreciation and liquidity traps

Several commenters asked me why the liquidity trap hypothesis implies that countries are unable to devalue their currencies in the forex markets.  There are several ways of answering this.  A liquidity trap implies the central bank cannot inflate, but currency devaluation tends to raise the price level.

But that doesn’t really answer the question.  It seems obvious that countries can devalue, why do the Keynesians think this becomes impossible at the zero bound?

Here’s why people are confused.  We’ve been taught that “liquidity traps” are all about the zero lower bound on nominal interest rates.  That does play a role in the hypothesis, but on closer inspection it’s actually another zero bound that is crucial, the zero lower bound on eligible assets not purchased by the central bank.

Think about the common reply to liquidity trap worries; “The central bank could buy all the assets on planet Earth–surely that would depreciate the currency!”  Yes, but then Keynesians raise practical objections:

1. The central bank can only legally buy certain assets.

2.  The central bank may be fearful of having a large balance sheet.

Those objections then become the real reason for monetary policy ineffectiveness, not the zero bound. Some argue that monetary policy crosses over into being fiscal policy in this area.  I disagree; the EMH implies the expected gains and losses on purchase of foreign government bonds is roughly zero.  Even unconventional OMOs simply do not have the fiscal implications (futures tax liabilities) of government spending.

Now that we understand that the real problem is not enough eligible assets, or unwillingness to expand the balance sheet, it becomes clear why some countries (in their view) cannot devalue.  In order to peg the exchange rate at a lower level they’d have to sell so much domestic currency that their balance sheet would swell to unacceptable levels.  So there is a theory there.

Evan Soltas once showed that as soon as the Swiss National Bank finally bit the bullet, devalued, and then set a firm peg of 1.2/euro, they actually needed to buy fewer assets than before.  So although the worry about balance sheets might provide some sort of theoretical justification for liquidity traps, as a practical matter it’s simply not an issue.  The real problems lie elsewhere–refusal to set a robust enough NGDP target, and do level targeting.

PS.  The exchange rate does help in one respect.  It forces people out of the horrible Keynesian/Woodfordian “rental cost of money” approach to monetary policy, and into a much more enlightening Fisher/Warren “price of money” approach.  By doing so it allows us to think about the problems much more clearly, and suddenly some of those Keynesian interest rate-oriented concerns seem to fade away.


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60 Responses to “A note on currency depreciation and liquidity traps”

  1. Gravatar of Ashok Rao Ashok Rao
    17. September 2013 at 06:45

    What’s the difference between the central bank purchasing future output and the Federal Government doing so financed with debt monetized by the central bank?

    I do feel there is a quasi-fiscal element of unconventional monetary policy. At a more basic level, buying Treasuries requires the Federal Government to sell debt. This might be amplified if the whole safe-asset-shortage/repo collateral points are true. Of course straight spending is purely fiscal in a different way.

    Here’s a good comment Andy Harless left on my blog yesterday:

    “Ashok, I’m not sure your symmetrical Evans rule does the trick. It would certainly work if there were no limits on what the central bank could buy, because the endgame would essentially be fiscal policy done by the central bank: after it had bought up every asset in the world, it would have to start buying newly produced output, and everyone agrees (and would anticipate many steps earlier) that this could get you out of a liquidity trap. But in practice, central banks are quite limited in what they’re allowed to buy. Generally they can’t even buy equity, let alone hard assets, and even most forms of debt are off limits. So the endgame is that the central bank buys every asset that it can legally hold, and it’s not clear that this (or, by extension, its hypothetical anticipation) would necessarily be enough to get you out of a liquidity trap.”

    The point of an exponential-ish Evans rule isn’t that it ever comes into effect, but anchors far more expansionary expectations. The central bank’s balance sheet at the end of easing might, in all reality, be smaller with a more expansionary rule.

  2. Gravatar of benjamin cole benjamin cole
    17. September 2013 at 06:50

    Excellent blogging.

    The arguments against QE have migrated from it will cause hyperinflation to it is inert to it will cause bubbles to “unquantifiable financial risks” (my favorite btw) to it decreases shopping opportunities for risk-averse bond buyers (Woodford and evidently no one in private sector can design a very low risk bond) to “the Fed will have a big balance sheet.”

    Egads.

    I still see no risk in the Fed having a big balance sheet and even positives for taxpayers (interest income forwarded to the Treasury).

    Let alone the economy-boosting role of QE.

    For all I care, the Fed can sit on the balance sheet for 30 years. Would it matter?

  3. Gravatar of Ashok Rao Ashok Rao
    17. September 2013 at 06:50

    I think one difference between Keynesians and MMs (I’m not sure about this, nor about where I fall) is that the former think of depreciation as a means to inflation and the latter as inflation a means to depreciation.

    For example, MMs are more likely to see depreciation’s benefit not through increased exports, but higher domestic consumption spurred by rising price levels of imports.

    Keynesians don’t believe – with some good reason, I think – that inflation is possible without setting the right expectations about the future. And hence see depreciation as a lost cause. (Of course, inflation is by definition possible with the right policy).

    Of course it works both ways, but the perceived primacy might be important as far as debate is concerned.

  4. Gravatar of benjamin cole benjamin cole
    17. September 2013 at 06:56

    There is $16 trillion in US debt out there, and we add to that every day. Really? The Fed will run out of assets to buy and we will still be in a liquidity trap?

    Let’s try it and see what happens….

  5. Gravatar of Ashok Rao Ashok Rao
    17. September 2013 at 06:59

    Social security trust needs debt as well. Remember, a lot of people worried about the Clinton surpluses because the Trust might have to purchase private assets. Not to mention our trade deficit creates important demand for our debt. It’s not like all that 16T is up for grabs.

  6. Gravatar of LK Beland LK Beland
    17. September 2013 at 07:02

    I agree with the point about Fisher/Warren vs Keynes/Woodford. But from a point of view of a policy maker, I believe the “rental cost of money” looks somewhat endogenous (it has the smell of a positive sum game), while an exchange rate approach looks a bit more like a beggar-thy-neighbor approach.

    Using the old “hydrodynamics” approach might be an easier sell and still get rid of the “zero-bound problem”.

  7. Gravatar of Brian Donohue Brian Donohue
    17. September 2013 at 07:12

    Great post, Scott?

    Benjamin, any issue with, say, a $50 trillion Fed balance sheet? Is the sky the limit here?

  8. Gravatar of jknarr jknarr
    17. September 2013 at 08:12

    Excellent post, spot on.

    I’ll point out that the eligible assets are much more flexible than they let on. Maiden Lane, anybody? Just vote another LLC into existence, problem solved.

    For that matter, SDRs? Gold? Foreign Currency Denominated Assets? Treasury Currency? They already hold all these assets, so why not?

    http://www.federalreserve.gov/releases/h41/current/h41.htm

    Hey, even revitalize the old “Discount of commercial, agricultural, and industrial paper” clause.

    http://www.federalreserve.gov/aboutthefed/section13.htm

    There are infinite already-eligible high quality assets available — there is no upper bound to the amount of demand the gold market can absorb, for one, let alone all the other possible Maidens, FX, SDRs, Treasury currency.

    Tight money is an active, clear, and present policy choice — not mistake. Can we acknowledge this? Just how much evidence does it take?

  9. Gravatar of JAS JAS
    17. September 2013 at 08:19

    “The central bank could buy all the assets on planet Earth-surely that would depreciate the currency!”

    If, if fact, a central bank owned all the assets on planet Earth would not their fiat money be the only money worth having?

  10. Gravatar of jknarr jknarr
    17. September 2013 at 08:54

    RE balance sheet size, base money/ngdp was a steady 10% all through the 19th century. After 1914, with the Fed in charge, it was greatly destabilized. That’s your lesson in monetary policy.

    http://research.stlouisfed.org/fred2/graph/?g=mtc

    Page 26.
    http://www2.census.gov/prod2/statcomp/documents/CT1970p2-11.pdf

  11. Gravatar of ssumner ssumner
    17. September 2013 at 09:04

    Ashok, You said;

    The point of an exponential-ish Evans rule isn’t that it ever comes into effect, but anchors far more expansionary expectations. The central bank’s balance sheet at the end of easing might, in all reality, be smaller with a more expansionary rule.”

    That’s exactly right. And if it did come into effect then you’d want to re-evaluate your target. People seem to think fiscal stimulus is an alternative to a big Fed balance sheet. It isn’t. Look at Japan, and look at America 1933-45.

    You said;

    “I think one difference between Keynesians and MMs (I’m not sure about this, nor about where I fall) is that the former think of depreciation as a means to inflation and the latter as inflation a means to depreciation.”

    As Krugman would say “it’s a simultaneous system.”

    You said;

    “Keynesians don’t believe – with some good reason, I think – that inflation is possible without setting the right expectations about the future. And hence see depreciation as a lost cause.”

    This is very misleading. MMs believe in rational expectations, and hence we believe that any policy that produces inflation will be expected to produce inflation. So what’s the difference?

    You said;

    “Social security trust needs debt as well. Remember, a lot of people worried about the Clinton surpluses because the Trust might have to purchase private assets. Not to mention our trade deficit creates important demand for our debt. It’s not like all that 16T is up for grabs.”

    Sure, there’s a NGDP target so low that the demand for base money exceeds the national debt held by the public. But why would you want to target NGDP growth at such a low level?

    Ben, Yes, the excuses are endless.

    LK, Unfortunately you are right, it looks that way. Of course it isn’t really a beggar thy neighbor policy, which is why foreign stock markets soar when the US eases.

    Thanks Brian.

    jknarr, Yes, I should have mentioned that. These rules are all broken in an emergency.

    JAS, Not if they had Zimbabwe-style inflation!

  12. Gravatar of Morgan Warstler Morgan Warstler
    17. September 2013 at 09:06

    Imagine that the CB bought no treasuries ever.

    Either bc is encourages govt to take on debt, or make govt. debt cheaper, or bc the govt is running in balance, etc.

    But then to remove any discretion over what to buy, it used a random number generator to buy and sell single shares of stock.

    And to piss off the Wall Street guys, it forced the traders to rebate their sales commissions on Fed purchases at the end of the month.

    And to further piss off traders, it ran faster than the fastest HFT platform.

    That’s not in any way Fiscal policy right?

    Meaning when we think of Fiscal policy, we tend to imagine discretion and cronyism, and if instead the machine was random, the effect would be purely to lift all publicly traded companies equally, no?

    It’s a technically an easy thing to build. The Fed’s just sitting on a black box full of shares it owns, and it randomly grabs one and sells it, or select one from the market to buy to stick into box….

    So could the Fed effectively pull market caps and GDP into line? Increasing the wealth effect or decreasing monthly as the transmission mechanism for staying on NGDP’s level target?

    I assume I’m wrong here, but I don’t know why.

  13. Gravatar of ssumner ssumner
    17. September 2013 at 09:10

    jknarr, Do you have a link for GDP in the 1800s?

  14. Gravatar of Scott Sumner Is of Two Minds When It Comes to the Monetary Approach of Michael Woodford Scott Sumner Is of Two Minds When It Comes to the Monetary Approach of Michael Woodford
    17. September 2013 at 09:11

    […] why I was intrigued to read today, September 17, Scott write the following in a post about whether a central bank can depreciate its currency in the midst of a […]

  15. Gravatar of Ashok Rao Ashok Rao
    17. September 2013 at 09:43

    Scott you said “This is very misleading. MMs believe in rational expectations, and hence we believe that any policy that produces inflation will be expected to produce inflation. So what’s the difference?”

    I never said MMs didn’t believe that – I said MMs tend to emphasize depreciation more in terms of domestic consumption which, from my reading, has been the case.

    It’s a simultaneous system, certainly, but the points different groups emphasize are different. Of course, everyone (reasonable) agrees both inflation and depreciation are good goals right now, I’m not denying this.

  16. Gravatar of jknarr jknarr
    17. September 2013 at 09:43

    I’ve used this for RGDP, NGDP, population back to 1790. UK, Aussie, wages, dollar-sterling FX also.

    http://www.measuringworth.com/usgdp/#

  17. Gravatar of JAS JAS
    17. September 2013 at 10:01

    I’ll try again. From my primitive layman understanding of money it is a medium of exchange and a store of value. (Your Medium of Account explanations have not worked for me in terms of adding any new practical understanding given we have fiat money.) If a central bank has all the wealth in the world (thought experiment) they would not have Zimbabwe inflation, since by definition that was uncontrolled inflation. They can change the nominal value of their units of exchange at will. Since they have all the wealth in the world, they have the store of value to back their currency. The full faith and credit of the currency of a bank that holds all the wealth in the world would be total. If they print one bill that bill will have the value of all the wealth in the world. If they print one hundred bills they will each have the value of 1/100th of the wealth of the world. They have total control over the value of currency.

    Extrapolating from this narrow line of reasoning buying assets may not have any impact on the medium of exchange, since you are just exchanging one store of value for another. It only has an impact on the medium of exchange if buying assets also increases the number of units (creates money) of the medium of exchange or if it changes the perception of the store of value backing the medium of exchange. In fiat money that perception is key.

  18. Gravatar of jknarr jknarr
    17. September 2013 at 10:04

    …and the 1970s pdf version of the “Historical Statistics” does not allow copy-and-paste for the 19th century monetary base. The 1945 version does, but barely. Page 284. 285 for breakdown between coins, certificates, bank notes.

    http://www2.census.gov/prod2/statcomp/documents/HistoricalStatisticsoftheUnitedStates1789-1945.pdf

  19. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. September 2013 at 11:11

    Scott,
    Off topic but well worth reading. It’s NBER Working Paper No. 19418 but here’s an open copy:

    http://capitalism.wfu.edu/pdfs/BankFailuresandOutput.pdf

    Bank Failures and Output During the Great Depression
    Jeffrey A. Miron and Natalia Rigol
    September 2013

    Abstract:
    “In response to the Financial Crisis of 2008, macroeconomic policymakers employed a range of tools designed to prevent failures of large, complex financial institutions (“banks”). The Treasury and the Fed justified these actions by arguing that bank failures exacerbate output declines, rather than just reflecting output losses that have already occurred. This view is consistent with economic models based on credit market imperfections, but it is an empirical question as to whether the feedback from failures to output losses is substantial.

    This paper examines the relation between bank failures and output by re-considering Bernanke’s (1983) analysis of the Great Depression. We find little indication that bank failures exerted a substantial or sustained impact on output during this period.”

    Pages 6-7:
    “We reconsider this issue by reporting regressions that drop March, 1933 from the sample entirely (along with appropriate lags). Columns (5)-(8) of Table 2 show the results. In this specification, the bank and business failure variables still enter negatively, consistent with Bernanke’s hypothesis, but the coefficients are no longer statistically significant. Thus, exclusion of the Bank Holiday does not reverse Bernanke’s results but it weakens them substantially.”

    Page 9:
    “The results we have presented, by themselves, shed interesting light on our understanding of the Great Depression. As Bernanke confirmed, monetary factors do indeed appear to have played a major role in the downturn, consistent with the work of Friedman and Schwartz. But the main avenue through which bank failures mattered seems to have been through their impact on the money supply, rather than via a credit intermediation channel.”

  20. Gravatar of Basil Basil
    17. September 2013 at 11:23

    Hi Professor —

    I apologize for hijacking this post a bit, but I have a question about the liquidity trap in general, where “liquidity trap” means the expectations trap identified by Krugman 1998 and your 1993 paper.

    In your post explaining the hot potato effect (which was one of your best, IMO), you noted for case 5c – when cash is the medium of account, and nominal rates are zero but are expected to be positive in the future – the following: “A temporary increase in the base? Little or no effect, but then that’s true even if rates are positive.”

    I’ll note first that I find this analysis very compelling. However, I have a question related to modeling this claim. In the model Krugman uses in his paper, he argues that this expectations trap can only occur when the nominal rate is at the ZLB. See figure 1 in the paper: http://i.imgur.com/BKpQZt5.png

    And I think he’s right – in the context of his model. In cash-in-advance models, which Krugman uses, the price level in period t is a function of the money supply in period t: P_t = M_t/y_t.

    The price level in period t is *not* a function of the path of the future money supply. Am I correct to say that in your interpretation, the price level in period t SHOULD be a function of not just the current money supply but also expectations of future supply in t+1, t+2, t+3…?

    If so, why isn’t it the case? My only thought is that it may have something to do with the fact that cash in advance models are discrete time models?

    Let me know if the above doesn’t make sense.

  21. Gravatar of dbeach dbeach
    17. September 2013 at 11:52

    I’d like to request a follow-up post where you explain the difference between the “Keynesian/Woodfordian” and “Fisher/Warren” approaches to monetary policy.

  22. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 12:53

    Regarding “buying up the world” I thought this was interesting:

    “Market monetarists and “buying up everything”” (JP Koning’s)

  23. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. September 2013 at 13:09

    Cullen Roche comments on this post:

    http://pragcap.com/the-liquidity-trap-myth-and-the-central-bank-as-a-fiscal-entity

    “If the Fed could just buy anything then what differentiates it from fiscal policy? I say not much. And here’s where the accounting, which Sumner hates so much, comes in handy. You see, when the Fed buys something on the open market like a US government bond it is just swapping cash for bonds. The private sector doesn’t end up with a higher net worth. Its balance sheet composition changes, but its net worth is the same (assuming no capital gains). But let’s say the Fed could buy something truly worthless, like say, “Roche’s Bag-O-Dirt” (copyright, Tom Brown).”

  24. Gravatar of Ashok Rao Ashok Rao
    17. September 2013 at 13:44

    If the federal government sold debt to buy equity I wouldn’t think of that as fiscal policy. It’s not monetary, but it’s not fiscal in the sense of “expansionary fiscal policy”.

    Expansionary fiscal policy is the purchase of future output – that is hiring someone to build a bridge, or cutting taxes thereby increasing consumption.

    Maybe my understanding of this is wrong, but thinking of the government and central bank as a single entity seems to reduce confusion.

  25. Gravatar of Britmouse Britmouse
    17. September 2013 at 13:56

    A common objection to devaluation I hear from Keynesians is that it would hurt trading partners – I think I have read decade-old papers from both Svensson and McCallum debunking that, but there you go.

    Sophisticated Keynesians like Mervyn King have very complicated ideas about how devaluation is only a way to “shift” aggregate demand around between countries, which I’ve never been able to understand properly; they talk about “global imbalances” which need to be fixed somehow.

  26. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 14:08

    Mark, yep, “Roche’s-bag-o-dirt” was what I dubbed that. But I think there’s a relation there (conceptually) to a “Sproulian Purchase” … (not that Mike Sproul even advocates such a thing). JP actually coined the “Sproulian Purchase” which just means the Fed paying the wrong price for something (which is a violation of their charter, I understand). I’d provide a link, but I’ve had trouble linking to JP’s pages. The title is:

    “Give Bernanke a long enough lever and a fulcrum on which to place it, and he’ll move NGDP”

    I wanted to dub that a “Sproulian Lever” but Mike’s wife nixed that terminology. 😀

    I understand that MM doesn’t advocate either (bag or lever).

  27. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 14:17

    Mark O/T: I’d love to see you directly address Vincent’s positive feedback hypothesis sometime.

  28. Gravatar of jknarr jknarr
    17. September 2013 at 14:38

    OK, OT, RE Roche’s Bag, can someone please take this idea — that government bonds and base money are the same — out behind the barn, and gently put it out of its misery?

    “…when the Fed buys something on the open market like a US government bond it is just swapping cash for bonds.”

    http://pragcap.com/mechanics-qe-transaction (in more detail)

    OK, government bonds are of finite duration, base money is perpetual. There is a liability- and asset- side to all debt that nets out to zero. Base money has no counterparty — no deliverable. Debt references, and is a promise to deliver, base money. Base money is not a promise to deliver debt.

    When the Fed expands the base, it dilutes the basis for all MOA accounting, including debt.

    Treasury debt, by contrast, is net neutral — the government absorbs funds from the private sector, and then re-emanates them.

    Central bank absorption of Treasurys and emanation of base money: not a swap. Not a swap. Not a swap.

    The problem before us is, if you think that it’s a swap, then QE becomes entirely an asset/rate question — lowering Treasury yields — and that’s all. When rates hit zero, monetary policy impotent, so sorry.

    But, (if you aren’t irretrievably thick), you might realize that base money is what makes the world go around — it determines the MOA value of all things. As an experiment — in the MOE/MOA vein — increase the amount of Treasury debt to 10x NGDP, or increse base money to 10x NGDP, and consider price action under both scenarios.

    When you create bank reserves, these are not neutral financial instruments like bills. It is proto-currency that has not yet been demanded into FRN currency form (yet — zero rates usually gets the job done, sooner or later).

  29. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. September 2013 at 14:50

    Tom Brown:
    “yep, “Roche’s-bag-o-dirt” was what I dubbed that. But I think there’s a relation there (conceptually) to a “Sproulian Purchase””

    Roche is a dirt-bag, er, I mean “Roche’s bag-o-dirt” is catchier than “Sproulian Purchase” or “Lever”.

    Tom Brown:
    “I’d love to see you directly address Vincent’s positive feedback hypothesis sometime.”

    You mean Vincent Cate’s hyperinflation hypothesis? I only read his FAQ webpage in the past week and he was surprisingly willing to make changes in response to my criticisms.

    Vincent’s hypothesis seems well grounded theoretically but in my opinion he is too willing to stretch various definitions in his somewhat quixotic crusade against government debt.

  30. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 15:01

    “You mean Vincent Cate’s hyperinflation hypothesis?” — yup, that’s the one. I’m a skeptic, but Vince does happily accept feedback.

    “he is too willing to stretch various definitions in his somewhat quixotic crusade against government debt.”

    Beyond what you’ve already corrected him on? Examples?

    But I think he’s doing more than that: he’s making specific predictions regarding Japan in the next few months for example. Unfortunately I can’t drum them up right now )c: … I’m sure Vincent will be along shortly to back that up/set me straight soon.

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    17. September 2013 at 15:11

    Tom Brown,
    “Beyond what you’ve already corrected him on? Examples?”

    I did get him to insert text on Phillip Cagan’s hyperinflation definition and to correctly state International Accounting Standard 29, but he hasn’t abandoned his 26% annual inflation threshold. The difference between 50% inflation per month and 26% per year is enormous.

    “…he’s making specific predictions regarding Japan in the next few months for example.”

    Well, frankly, that’s just nuts.

  32. Gravatar of Vince Vince
    17. September 2013 at 15:33

    I contend that if you go to any country with 30% inflation the public will say they have hyperinflation. This will be millions of people. The fact that one guy back in 1956 used a higher threshold to reduce the number of cases down to a managable level is no grounds to say these millions of people are wrong.

    My main goal it to understand and explain hyperinflation. I am not on a “quixotic crusade against government debt”. You might argue that I have crusaded against MMT and MR because I think they don’t get hyperinflation.

    I think I understand the feedback that makes hyperinflation. I even think I do a reasonable job of explaining it. However, predicting when a human panic starts is a higher level of difficulty and I don’t claim mastery of that.

    I have a collection of 16 different ways to explain hyperinflation and am looking for more. If anyone knows any more please let me know.

    http://howfiatdies.blogspot.com/2013/09/hyperinflation-explained-in-many.html

  33. Gravatar of ssumner ssumner
    17. September 2013 at 15:45

    Ashok, Perhaps I misread you.

    Thanks jknarr.

    JAS, You said;

    “If a central bank has all the wealth in the world (thought experiment) they would not have Zimbabwe inflation, since by definition that was uncontrolled inflation.”

    There is nothing “by definition.” One can have very high inflation in a country with no fiscal problems at all, such as the US 1965-81. It’s up to the central bank; having lots of assets doesn’t prevent inflation if you print money.

    I’m not sure why the MOA means nothing to you. It’s the measuring stick of value. If it means nothing, how could you explain understand the concept of an exchange rate?

    Thanks Mark, That sounds really interesting.

    Basil, Krugman is right that if there really is an “expectations trap” (I don’t believe in them) the interest rate would fall to zero. My point is that even when rates are positive a temporary monetary injection may have little or no impact on the price level. I wasn’t basing that on any sort of expectations trap, just an expectation that the currency injection would be temporary.

    Regarding the time path of money, Krugman typically assumes that money and bonds are perfect substitutes at zero rates. I don’t make that assumption. But even in my model the future expected money supply is far more important than the current money supply.

    dbeach, It’s simple. Keynes viewed monetary policy as control of interest rates. For Fisher and Warren it was all about control of the price of gold. Those who use exchange rates, or NGDP futures are also using a price of money approach. The third approach is the quantity of money approach (old monetarism.)

    Mark, He says the private sector doesn’t end up with a higher net worth? I hardly know where to begin.

    Britmouse, They miss the fact that currency depreciation and easy money are not alternative policies, they are two ways of describing the same policy. One tool/one target. You can’t say “we are going to do easy money, but not depreciate the currency (unless combined with fiscal perhaps.)

  34. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 15:45

    Alright Vincent! Right on cue. (pssst. what about Japan? Aren’t you gonna straighten out the lies I told about you there?)

  35. Gravatar of Negation of Ideology Negation of Ideology
    17. September 2013 at 15:48

    “Yes, but then Keynesians raise practical objections:

    1. The central bank can only legally buy certain assets.

    2. The central bank may be fearful of having a large balance sheet.”

    If those are the objections they should call it a “political trap” instead of a “liquidity trap”.

  36. Gravatar of Vince Vince
    17. September 2013 at 15:50

    So to be clear, I do think Japan is going to get hyperinflation but I don’t have any good theory to say when it starts. My “educated guess” is in less than a year, but “educated guess” is about all I will claim.

  37. Gravatar of Vince Vince
    17. September 2013 at 16:04

    I think Hussman shows that the lower the interest rate the lower the velocity of money. I think this is the right way to think about a “liquidity trap”. Not to “suspend the normal laws of economics” as Krugman says.

    http://www.hussmanfunds.com/wmc/wmc110124.htm

  38. Gravatar of Morgan Warstler Morgan Warstler
    17. September 2013 at 16:20

    Ashok

    “thinking of the government and central bank as a single entity”

    Leads you astray.

    ECB and the Fed are separate and distinct from the governments.

    BOTH CB and GOVT are created to help neutralize each other by the hegemony.

  39. Gravatar of benjamin cole benjamin cole
    17. September 2013 at 16:20

    Brian-
    Maybe $60 trillion would be a bit much…but really, I think tapering up towards $120 billion a month ought to do the trick…I think we would have better luck if the QE debt was legally classified as permanently monetized…

  40. Gravatar of Tom Brown Tom Brown
    17. September 2013 at 16:38

    “ECB and the Fed are separate and distinct from the governments.

    BOTH CB and GOVT are created to help neutralize each other by the hegemony.”

    Shoot, I’m going to have to agree w/ Morgan on that.

  41. Gravatar of Morgan Warstler Morgan Warstler
    17. September 2013 at 16:41

    If those are the objections they should call it a “political trap” instead of a “liquidity trap”.

    It’d be more helpful to call it a political trap, bc then we could also have a political trap that keeps us from spending more.

    Eventually, it all comes down to doing things within the boundaries of what the hegemony wants.

    There LOTS of stuff they will approve, if you sell it to them the right way.

  42. Gravatar of Geoff Geoff
    17. September 2013 at 16:43

    “why do the Keynesians think this becomes impossible at the zero bound?”

    It’s because their model of the channel of inflation is that inflation of the money supply takes place to the extent that additional credit is lent by the banking system (with the help of the Fed increasing bank reserves).

    If interest rates are close to zero, then bank lending is mitigated, and hence inflation of the money supply that enters exhanges (which raises prices) is mitigated.

    I thought this was obvious.

    If on the other hand you consider a model of the central bank not relying on the banks to lend money into existence, but for the central bank to circumvent dependency on credit expansion, then the zero bound ceases to be a barrier to further inflation.

  43. Gravatar of JAS JAS
    17. September 2013 at 17:25

    Thank you very much for responding to comments. If the units of Medium of Account are the same as the units of medium on exchange (dollars) I can’t understand why you want to parse the two.

    I see exchange rates reflecting the ratio of the units of medium of exchange to the perceived wealth of the country. Assume two countries have equal wealth (i.e. same population with the same tangible and intangible per capital income). If one country prints twice the bills as the other the exchange rate is two to one. If the country with twice the bills growths to have twice the perceived wealth as the other, I expect the exchange rate will move to one to one. No need to talk about Medium of Account here.

    “By definition” was a sloppy term. I have a simple view of money, inflation, and deflation that I suspect is pretty widely held by the average non-economist. When the supply of money grows at the perceived rate of growth of an economy there is little inflation or deflation. If the money supply grows faster than the perceived growth of the economy there is inflation. Shrink the money supply relative to the economy and you get deflation.

  44. Gravatar of Jim Glass Jim Glass
    17. September 2013 at 18:11

    I have a simple view of money, inflation, and deflation that I suspect is pretty widely held by the average non-economist.

    Indeed. Although what that doesn’t mean it is right. What the uninformed general public thinks in its simple view about any technical subject is very likely to be wrong.

    As indeed this is.

    When the supply of money grows at the perceived rate of growth of an economy there is little inflation or deflation. If the money supply grows faster than the perceived growth of the economy there is inflation. Shrink the money supply relative to the economy and you get deflation.

    Now all you have to do is square that simple view with the actual facts of the money supply and prices moving in opposite directions — e.g., deflation hitting as the money supply rockets upward — or moving by highly disproportionate amounts is the same direction.

    As a first step, recognize that the market value of money, its price in terms of goods and services (and thus the general price level, and thus changes in the price level that constitute inflation/deflation), like price of everything else, is determined via the law of Supply and Demand — while you have posited the common simple view that it is determined by supply alone.

    The demand for money, and changes in the demand for money, matter a lot.

  45. Gravatar of JAS JAS
    17. September 2013 at 18:14

    Perhaps I’m beginning to see something in MOA from my response above. A measure of the perceived wealth of the two countries? But clearly I still don’t see the big picture of why that concept is so significant to you.

    I suspect that if you want to have maximum influence you will need to have a narrative that has clarity to the lay person as well as the economist. People understand interest rates, they have a real life connection to them. Money supply different, effecting it via unconventional OMO is very far from what most people understand. So perhaps my confusion will have some usefulness to you.

  46. Gravatar of JAS JAS
    17. September 2013 at 19:03

    Jim Glass:
    Thanks for the link to the plot of M1 versus CPI during the great recession. So the FED pumped M1 up, but the demand for money was low, so no inflation (actually deflation). I suppose Prof. Sumner would say that pumping M1 up more would have… what? Pump it up high enough to create inflation even with the lower demand and thereby spur activity through the hot potato effect?

  47. Gravatar of Jim Glass Jim Glass
    17. September 2013 at 20:04

    Thanks for the link to the plot of M1 versus CPI during the great recession. So the FED pumped M1 up, but the demand for money was low, so no inflation (actually deflation)…

    No. The demand for money went *very high* so the price of money went up in terms of goods and services, which means their price went down in terms of money: deflation.

    Such increasing demand for money means, in terms of the common ‘simple view’, that the quantity of money effectively falls (even if it is actually rising, as in 2008) because there is no longer enough of it to go around. Too little money relative to demand for it means deflation, even if there is more money than before. In 2008 the Fed did not increase the supply of money by enough to avoid deflation.

    It is not the quantity of money that sets the price level, but the quantity of money relative to the demand for it — the price of money is determined by the Law of Supply and Demand, not The Law of Supply, as so many believe.

    I suppose Prof. Sumner would say that pumping M1 up more would have… what? Pump it up high enough to create inflation even with the lower demand and thereby spur activity through the hot potato effect?

    Prof. Sumner has been over this countless times. I’m not going to deign to speak for him. Perhaps you should read some back posts — instead of spending so much effort trying to figure out how to reinvent the wheel here in terms of this discussion, a lot less effort spent reading a few back posts will get you to what he “would say” about all this PDQ, with no “suppose” about it. You could hardly avoid it!

    (Suggestion: Look on the right where it says “Quick Intro to My Views”)

  48. Gravatar of Cory Cory
    17. September 2013 at 23:14

    Professor Sumner,

    I wanted to ask you a question with regard to your reply to Mark A. Sadowski concerning the response by Cullen Roche.

    You said this;

    “Mark, He says the private sector doesn’t end up with a higher net worth? I hardly know where to begin.”

    If I understand correctly, folks like Cullen Roche view the FED buying a treasury bond to be not that different than, say, my bank debiting my Savings Account/Time Deposit and then crediting my checking account for the same amount. My portfolio is different but I have the same amount of financial assets

    So, Roche says that there is no “new net worth” i.e. no new net financial assets…I just have a demand deposit instead of a time deposit.

    If the Federal Government decided to deficit spend cut a check to some Crony in the amount of $1,000,000.00…as I understand it, this would happen by;

    1. The FED crediting a member bank’s reserve account and that bank would then credit Crony’s checking account.

    2. The Treasury issue’s a bond in that amount. Suppose it’s bought by Jp Morgan Chase. The FED would then debit JP Morgan’s reserve account by $1,000,000.00 and credit JP Morgan’s Securities Account at FED in that amount.

    So, in the Deficit Spending scenario the bond buyer still has a $1,000,000.00 asset while Crony has $1,000,000.00 in new financial assets.

    In the case of OMO’s, the FED would just buy JP Morgan’s bond and exchange it with a credit to Jp Morgan’s reserve account in the same amount. There’s no Crony getting fresh new financial assets.

    I’m just a layman but this seemed intuitively correct to me but that could very well be wrong.

    I have great respect for your views and you say “you don’t even know where to begin” with respect to the notion that QE doesn’t add new wealth to the private sector.

    So I thought I might ask if you might so inclined elaborate further.

  49. Gravatar of Morgan Warstler Morgan Warstler
    18. September 2013 at 02:31

    Cory,

    Cullen is the first to admit, say out loud, that if the Fed bought other things, like a bag or dirt, that there would be real effects.

    His example is a poor one bc the bag os dirt is destroyed. There’s no way to remove money, you cant sell a burnt bag of dirt. Pretty soon, Cullen will be into MMT saying, tax the bag of dirt back out of the economy.

    So above I gave an example where the Fed just puts money into and takes it out by creating money, buying stock, and then then later selling stock and deleting the money.

    I’m pretty sure at this point, no one can say this would be fiscal policy.

    Cory, you have to search hot potato effect or HOE here at scott’s site.

    As too the public net worth…

    Scott will note HOE is real bc when the Fed does QE, the value of the stock market goes up.

    You can call this a placebo effect like John Carney on CNBC yesterday. But placeboes work bc the mind actually heals the body, it isn’t fake.

    Again, it is is easier, just imagine the Fed creating and destorying money – buying and selling stock.

  50. Gravatar of Prakash Prakash
    18. September 2013 at 03:03

    Morgan,

    Your scheme would encourage very frequent splitting of stocks, since that increases the probability of a stock being chosen for the “bonanza”. In a few months/years maybe, every stock will be trading at the smallest allowable price. ($0.01?)

    Prof Sumner,

    I mentioned much earlier to you that I feel that market monetarism may end up facing its own zerobound when there are no safe assets to buy and the CB has to buy risky assets. Looks like a lot of people are driving to that point here.

    Forgive me for saying so, but even after regularly following your blog, the point you drew out today – purchase of foreign government bonds – It seems arbitrary to me. It is my fault for not listening closely. All I’ve heard is on one side there is purchase of own government bonds, on the other end, there is buy the entire earth, with nothing filled out inbetween.

    Please, for clarity’s sake, could you fill out the following list.

    In a good rule based monetary policy, what is the order of purchase of assets for the purpose of monetary expansion, that is most compatible with stable macro?

    1. Own government bonds
    2. Foreign government bonds (how do you decide the order?)
    3. ..?
    4..?
    ..
    somewhere down the line
    X. Bags of dirt

  51. Gravatar of 123 123
    18. September 2013 at 04:42

    Keynesian/Woodfordian “rental cost of money” vs. Fisher/Warren “price of money” approach.
    ZLB should do something at both approaches. If your instrument is price of money (for example, the exchange rate),and you are at ZLB, does it mean some paths of exchange rates are unavailable, or does it mean that all paths are available, but the central bank will lose money along some paths. I guess it is the second. Suppose the optimal Swiss peg from the monetary equilibrium point of view is 1.80. So we should expect the Swiss central bank would lose money when exiting from the peg.

  52. Gravatar of ssumner ssumner
    18. September 2013 at 05:38

    JAS, As far as I can tell you assume V is constant, which is not true. I want to distinguish between the MOA and MOE roles because I’d like to know which role is crucial in the transmission mechanism. The better we understand the mechanism, the more effective the policies we can design.

    Cory, There are at least two problems with his argument. First, if it was merely swapping on asset for another, and had no macroeconomic effect, then (even during periods when interest rates are positive) changes in the money supply would not be inflationary.

    More importantly, we know that OMPs raise asset prices, whether we are at the zero bound or not. (How would the stock market react to an complete end to QE today?) Since we know this, why even discuss a theory that implies they cannot.

    And third, that doesn’t address the hot potato effect.

    Prakesh, I’ve addressed the “no safe assets to buy” issue 100 times. First, it’s not a practical, real world concern. If it was, society would have several choices:

    1. Raise the NGDP target path.
    2. Lower IOR, below zero if necessary. (This may not be enough)
    3. Buy less safe assets, like AAA corporate bonds index funds or German/Japanese/Australian/Canadian/British/French government bonds.

    I’d favor number one. And it’s a moot point, as it would probably never happen in the US under 5% NGDPLT.

    123, All paths are available, and you would not expect to lose money. I expect the SNB to earn profits from its defeat of speculators.

  53. Gravatar of Morgan Warstler Morgan Warstler
    18. September 2013 at 05:54

    Prakash,

    nice catch

    So instead odds weight to share price to avoid issue. this solves it, no?

  54. Gravatar of Morgan Warstler Morgan Warstler
    18. September 2013 at 06:18

    Prakash, was reminded of this story about Voltaire:

    http://www.todayifoundout.com/index.php/2013/05/how-voiltaire-made-a-fortune-rigging-the-lottery/

  55. Gravatar of 123 123
    18. September 2013 at 07:21

    Scott, yes, with 1.20 peg Swiss central bank will earn money.

    But suppose the optimal path of Swiss exchange rate is 1.30 for two years, and 1.10 after two years. Assuming zero rates for euro and using uncovered interest parity equation, we can calculate that Swiss rates should be negative during these two years. But this is impossible, Swiss central bank cannot pay negative rates, so it should expect to lose money if it follows such a strategy.

    What is the solution for Switzerland in such a scenario? Peg at 1.20 for three years. AD would be a bit too low during the first two years, and it would be a bit too high during the third year. So by using foolproof method of exiting the liquidity trap, the Swiss central bank has basically promised to be irresponsible during the third year. There is no difference between Krugman and Svennson.

  56. Gravatar of Mark A. Sadowski Mark A. Sadowski
    18. September 2013 at 07:37

    Incidentally Bulgaria and Denmark have been pegged to the euro since before the Great Recession. Bulgaria and Denmark’s policy interest rates fell below 1% in October 2009 and November 2011 respectively and fell below 0.3% in February 2010 and July 2012 respectively.

    And yet the Bulgarian Lev has traded at exactly 1.9558 to the euro everyday throughout:

    http://sdw.ecb.europa.eu/quickview.do?node=2018794&SERIES_KEY=120.EXR.D.BGN.EUR.SP00.A

    And the Danish Krone has traded between 7.43 and 7.465 to the euro throughout:

    http://research.stlouisfed.org/fred2/graph/?graph_id=114406&category_id=0

    If the liquidity trap were real would that even be possible?

    P.S. A trip to the Bulgarian and Danish central bank webpages reveals they have not had to engage in unusually large open market operations to maintain their pegs either.

  57. Gravatar of Prakash Prakash
    18. September 2013 at 09:39

    Prof Sumner,

    I agree with point 2. Point 1 requires an established credibility. It can work for a developed country CB. Not sure how applicable it would be in India. I completely agree on having a NGDP and average income futures market to answer these questions better.

    I asked that question only from the perspective of being prepared for the next crisis. Thanks for the explicit answers and your patience.

    Morgan,

    Weighting just by share price may not be enough. In Pragcap, Cullen replied that he didn’t want a panic in share price. I tend to agree with him. I would also weight it by market capitalization or the sum of the last 10 year dividends, which would remove speculative stocks.

  58. Gravatar of Sina Motamedi Sina Motamedi
    18. September 2013 at 11:39

    ” EMH implies the expected gains and losses on purchase of foreign government bonds is roughly zero.”

    Can you explain this one?

  59. Gravatar of ssumner ssumner
    18. September 2013 at 17:49

    123, I don’t agree. You peg NGDP expectations, and let the EMH take care of the rest. You buy and sell assets at market prices. The expected gains or losses are roughly zero.

    Prakesh, The liquidity trap problem doesn’t apply to India in any case.

    Sina, The EMH says prices are roughly a random walk.

  60. Gravatar of 123 123
    18. September 2013 at 23:47

    Scott, there is nothing in the EMH that says the expected nominal market returns are always positive.
    When you have the ZLB problem, the EMH says the expected risk-adjusted nominal market returns are negative. When there is no ZLB problem, these expected returns are positive.

    When there is no ZLB problem, you have the hot-potato effect (which should not exist in your version of EMH) – expected return on cash is zero, and expected return on other assets is positive. The situation is opposite when optimal interest rates are negative.

    This should not be a frequent problem for large mature economies targeting 5% NGDP. But for Switzerland this is a real issue.

    “You buy and sell assets at market prices. The expected gains or losses are roughly zero”
    No, the expected gains or losses are equal to equilibrium market returns.

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