Every so often I make a list of economists who recognized that money was actually rather tight last year; or at least that a more expansionary policy could have greatly reduced the severity of the recession. Of course it is hard to draw sharp lines, as there are almost as many different views as there are economists. For instance Tyler Cowen recently suggested that about 1/3 of the downturn was due to the drop in nominal spending.
I recently came across two more economists that I think we can add to the list. I was contacted by Michael Belongia, who teaches at the University of Mississippi. In an unpublished paper entitled “The Frozen Pond of Liquidity,” Michael Belongia and William Barnett (of the University of Kansas) argued that monetary policy last year was actually rather contractionary. Here is a passage from that paper, which discusses how this situation came about:
The reason for this starvation is a classic and repeated mistake Fed officials have made during each business cycle since the end of World War II. Believing that it, and it alone, controls activity in the federal funds market, the Fed interprets changes in the funds rate as the product of its policy actions. Thus, if the funds rate declines, it must be the result of an expansionary monetary policy action; if the funds rate rises, it must be because the Fed has taken actions to be more restrictive. How else, the thinking on Constitution Avenue goes, could the funds rate move, without actions on their part?
Missing from this analysis is the entire other side of the reserves market: If the Fed is the only supplier of reserves, those who demand reserves must have some ability to affect the price – the fed funds rate – at which reserves trade. Those demanders are banks, and banks see the demand for reserves rise and fall along with the demand for loans: When the demand for loans rises, the demand for reserves by banks rises; when the demand for loans falls, the demand for reserves by banks declines. What all of this means is that the fed funds rate can decline – because of declines in the demands for loans and reserves – without the Fed taking any policy action. But, if the Fed interprets the world as its oyster, it will interpret this type of decline in the funds rate as “evidence” of an easy policy stance, when, in fact, the real signal in the market is that the economy is weakening and, if anything, the Fed may be starving the banking system of much-needed liquidity.
This was written right before the large upsurge in bank reserves last fall. It could be argued that the failure of that increase to lead to high inflation, or at least high inflationary expectations, tends to discredit their monetarist approach. But of course most monetarist models did not assume any interest was going to be paid on reserves, so it is hardly fair to criticize them for failing to predict the resulting increase in the demand for reserves.
Michael is more of a monetarist than I am, but he does make some good points about widely held anti-monetarist views. For instance, he argues that much of the evidence against monetarism was based on faulty data, as even the Federal Reserve relied on dubious estimates of the monetary aggregates. He advocates a theoretically superior “superlative index,” which would account for the heterogeneous nature of the various components of the aggregates. For instance, some types of “money” now pay interest, while cash is still interest free. He also argues that Keynesians use a double-standard, calling the 1979-82 period a “failed” monetarist experiment, and yet clinging to the new Keynesian model despite the fact that its “Taylor Rule” broke down for an even longer period from 2003 through 2005. Here’s what Michael has to say in Public Choice (2007):
In that case, what seems to be most interesting is the three-year period of 2003-2005 where, taken literally, the Fed appears to have had an objective for the inflation rate of six percent or higher. Moreover, assuming that this was not the Fed’s goal, the three year period of sustained “model failure” was much longer than the leash given to the so-called “failed” monetarist experiment.
Michael Belongia is a monetarist worth checking out. I haven’t had a chance to check out William Barnett’s research, but his vita also looks impressive, and includes studies of optimal monetary indices.
I am no expert on money demand studies, but I have been rather surprised that despite the near-zero interest rates, the demand for cash has been fairly stable. Between the beginning of the 2001 recession and the beginning of this recession, currency held by the public increased by about 5 1/2% per year. Since this recession began in December 2007 currency in circulation has increased about 7 1/2% a year. Thus currency demand is about $20 billion above trend. I would have expected the near-zero rates to have produced an even larger surge in currency demand.
Thus I can’t help comment on Krugman’s recent claim that the Fed would need to inject $10 trillion into the economy to get the needed stimulative effect:
Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.
That’s right, $10 trillion, not billion. I guess if you are a Nobel Prize winner you are allowed to pull numbers out of thin air. Where did he get this number? I have no idea. Perhaps he looked at the fact that the base had already increased by nearly a trillion dollars, with little apparent effect on the economy. But if the Fed was actually trying to stimulate the economy, rather that inject another $9 trillion isn’t it more likely that they’d first stop paying interest on reserves? And perhaps even follow the Swedish policy of charging a penalty rate on excess reserves? As James Hamilton recently noted:
The Fed has never wanted to see the huge volume of reserves it created end up as currency held by the public, for fear this would be inflationary. It has relied on several devices to keep that from happening. One was use of the Treasury’s account with the Fed, another traditional feature of Fed operations that ballooned as it became adapted to new purposes. The Fed asked the Treasury to borrow funds that it simply left in deposit in its account with the Fed. These idle reserves held by the Treasury absorbed some of the vast increase in new reserves created by the Fed.
A more important tool was that the Fed started paying interest on reserves in October 2008, and by November had increased that rate to the target fed funds rate itself. This created a very strong incentive for banks to simply hold reserves idle at the end of each day rather than lend them out on the overnight fed funds market. In effect, by paying interest on reserves, the Fed is borrowing directly from banks and using the proceeds for the various asset expansions detailed above.
And if you look at the relatively small increase in currency demand, which is only about $20 billion above trend even at near zero rates, it’s not hard to understand the Fed’s fear. So it’s not like the Fed needs to inject trillions more dollars to create inflation, the existing reserves are more than enough if they stopped paying interest, especially if an interest penalty was imposed.
Now I suppose Krugman could argue that this would drive the yield on T-bills slightly negative, and that Americans would suddenly decide to stuff $10 trillion dollars worth of Federal Reserve notes into safety deposit boxes. A bit of this did occur in Japan (of course on a far smaller scale.) But this just begs a much more fundamental question: What is the Fed’s goal? It’s rather silly to talk about the Fed being unable to boost AD when almost every day Fed officials are discussing “exit strategies” to prevent a breakout of high inflation. If the Fed really did wish to boost AD, they could set an inflation or NGDP target high enough to boost velocity. In that case they wouldn’t need to inject any more cash into circulation. Indeed they’d need to remove some.
The problem with Krugman’s post is that for the uniformed reader, i.e. 99.99% of his readers, he seems to be saying that the Fed would need to inject $10 trillion if it wanted to adopt a sufficiently expansionary monetary policy, when in fact $10 billion would be more than enough if an explicit inflation target was set. And without an explicit inflation or NGDP target? Well what would be the point?
When Krugman refers to the Taylor Rule, he is referring to a backward-looking rule that takes no account of the impact an extra $10 trillion would have on inflation expectations. Suppose the Fed prevented a buildup of ERs with a Swedish-style interest penalty. And suppose all the extra $10 trillion went into circulation. Recall that the total amount of cash in circulation is now much less than $1 trillion. So cash in circulation would increase more than 10-fold. Under those circumstances how likely is it that inflation expectations would remain unchanged, even if the Fed issued no explicit inflation target? Not likely? Well that’s just one of the assumptions that underlies Krugman’s estimate. And I haven’t even discussed the fact that there aren’t $10 trillion in T-bills in existence, so the Fed would have to buy a lot of longer term bonds, i.e. bonds with yields well above zero.
The only purpose I can see for Krugman throwing out the $10 trillion figure is to scare the public into thinking that nothing can be done with monetary policy. Why does he keep doing this? Your guess is as good as mine. Whatever the reason, the effect is to take the pressure off the Fed. Especially in the liberal community, which tends to defer to his expertise. In the 1930s there were plenty of liberal populists calling for easier money. And with FDR they got it. And it did revive the economy. But that liberal tradition has been lost.