Arnold Kling has a new post that contains several misconceptions about “money multipliers.”
He starts by citing a paper with the following phrase contained in the title:
Does the Money Multiplier Exist?
This is a misleading title, equivalent to asking: “Does the velocity of circulation exist?”
Clearly what the authors meant to say was; “Is the money multiplier stable?” Here is how Kling reacts to their paper:
I think that the popular saying among monetary economists these days is that attention has shifted from the Fed’s liabilities to the Fed’s assets. The old story was that the Fed’s liabilities were currency and bank reserves, and the banks lent out a predictable multiple of their reserves. The new story is that banks hold a ton of excess reserves. Also, if you include retail money market mutual funds in M2 (when did that happen? I’m so out of it, I thought that M2 was still, you know M2), then Carpenter and Demilrap are right that the money multiplier was never so reliable, anyway.
It would be more accurate to say that economists argued that under most circumstances the ratio of deposits to reserves was fairly stable. But obviously not under all circumstances, Friedman and Schwartz showed that the money multiplier was highly unstable during the 1930s, for instance. In the late 1930s this was mostly due to the near-zero interest rates, much like today.
Of course the money multiplier depends on more than the banking system, the behavior of the public also matters:
multiplier = (1 + C/D)/(R/D + C/D), where money = C + D and the base equals R + C.
The fact that reserves are not required for time deposits may or may not make the multiplier highly unstable, just as the C/D ratio might or might not make the multiplier highly unstable. So there’s really nothing new here, the same old questions as before.
Old monetarists tended to assume that the money multiplier was typically fairly stable, and that with sound monetary policy V would also be fairly stable. Thus the monetary base and the monetary aggregates are useful indicators of the stance of monetary policy. Obviously I don’t accept either argument; I think both the money multiplier (however defined) and V are too unstable for the base and M2 to be useful indicators for policymakers.
So far these are minor quibbles, but then Arnold goes dangerously off course:
Anyway, back to the Fed’s assets. When the Fed buys long-term Treasuries, this takes them out of the hands of private investors, who then have to find something else to buy. They bid up the prices of other bonds and drive down interest rates, or so the theory goes.
My own view is that in an enormous world capital market, the Fed is not driving long-term interest rates. I am willing to be wrong. But my null hypothesis is that the Fed is always in an asset substitutability trap. Financial markets work to create substitutability. As a result, you have Goodhart’s Law: if the Fed can control the supply of an asset class (or definition of money), then that asset class will not have much effect on the economy; if an asset class correlates strongly with economic activity, the Fed will not be able to control it.
Another way to put this is that monetary and financial arrangements are endogenous with respect to Fed procedures. The financial markets will evolve ways to insulate the economy from what the Fed does.
Actually “the theory” is very different. According to the liquidity preference theory it doesn’t much matter what the Fed buys. A purchase of gold would drive up the price of Treasuries almost as effectively as a purchase of Treasuries.
Second, Arnold has not described Goodhart’s Law correctly. It does not say that control of an asset class will prevent that asset class from having much effect on the economy. Rather that the “multiplier” or “velocity” (the terms means essentially the same thing) between asset X and NGDP will change unpredictably when the Fed begins to target X.
And this means that there is utterly no reason to presume that “the financial markets will evolve ways to insulate the economy from what the Fed does.” Indeed so far as I know no economist has ever even proposed a model where this is true. And that’s because it would have to be a very strange model. Banks and the public choose the R/D and C/D ratios in order to maximize utility. Ditto for velocity. It would be exceedingly bizarre if the utility-maximizing value of these multipliers moved precisely inversely to the monetary base, thus neutralizing the impact on NGDP. (Except obviously in the case of temporary base injections.) The mistake is to jump from the very reasonable claim that the multiplier and V are unstable and hence not useful, to the totally unwarranted claim that this means monetary policy has no impact on NGDP.
And since wages and prices are sticky in the short run, when monetary policy impacts NGDP it also impacts the real economy. That’s why markets keep freaking out over rumors of tapering, despite dozens of famous bloggers and elite economists telling the markets that QE doesn’t matter. The markets know better.