What we should be debating

We should be debating:

1.  Whether to cut the fed funds target from 0.25% to 0%

2.  Whether to put an interest penalty on excess reserves

3.  Whether to do additional QE

4.  Whether to set an inflation or NGDP target

5.  Whether to target growth rates or levels

6.  And of course the key overarching question:  Would the economy benefit from an increase in AD, or nominal spending?

Instead, the blogosphere is full of debate over whether Bernanke should be reappointed at the Fed.  Obviously President Obama gets to choose the Fed Chairman; if he thinks the economy would benefit from additional monetary stimulus, then I presume he would not have picked Bernanke.  Thus I don’t much care either way whether Bernanke is reappointed.  If he is not reappointed then I presume Obama would replace him with someone holding similar views. 

I think we need to step back and think about how the Fed operates.  You cannot expect leadership from a large bureaucracy.  Unless there is dissatisfaction with Fed policy among economists, pundits, journalists, businessmen and politicians, you cannot expect the Fed to suddenly change its policies.  As far as I can see, very few people are calling for additional monetary stimulus.  So why should we expect the Fed to provide such stimulus, with or without Bernanke?

It seems like lots of the discussion of whether Bernanke should be reappointed revolves around issues other than monetary policy.  And I think that fact tells us a lot about how we got in this mess; many people still don’t seem to think the big drop in NGDP was a monetary policy failure. 

Instead we have debates about whether to allow big banks to exist.  Again, doesn’t this miss the point?  If our banking system absorbs trillions in losses you can be sure the government will step in, regardless of whether we have big banks or small banks.  And if our banking system isn’t in crisis, then FDIC is perfectly capable of handling an isolated bankruptcy, even at a large bank.  In any case, I can’t imagine a future where the US doesn’t have any large banks, but Europe, China, Japan and Canada have lots of large banks.  Can you?  Wouldn’t it make more sense to try to prevent the banking system from suffering trillions in losses after a bubble bursts, perhaps by requiring sizable downpayments?

But then I read that the FHA is about to set much tougher standards for FHA mortgages—they plan to require borrowers with a 590 credit score to put down at least 3.5% downpayments.  As Tyler Cowen recently argued, you knew Congress wasn’t serious about global warming when they refused to make Americans pay more for gasoline.  And I would add that you can be sure that the populists who want to “re-regulate the banking system” aren’t serious when all they can do is talk about 3.5% downpayments for bad credit risks.  It is so much more fun to bash big banks.

PS.  In this article David Henderson suggests a better way of imposing discipline on banks; get rid of FDIC.

PPS.  On a more positive note, Barney Frank now proposes that we eliminate Fannie and Freddie:

A top House Democrat on Friday said his committee was preparing to recommend “abolishing” mortgage-finance giants Fannie Mae and Freddie Mac and rebuilding the U.S. housing-finance system from scratch.

And later on there was even better news:

One such report came from analysts at Standard & Poor’s this past week. “It’s hard for us to imagine” how enough capital could be attracted to replace Fannie and Freddie with stand-alone private companies that would be able to offer low-cost funding for 30-year fixed-rate mortgages, the analysts wrote.

Now I’m getting really excited.  Not “enough capital” for lots of low-cost 30 year mortgages?  Please God let’s hope these “analysts” are correct.


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53 Responses to “What we should be debating”

  1. Gravatar of Doc Merlin Doc Merlin
    23. January 2010 at 18:24

    Scott, all politics is personal and all states are ruled by people not law.
    The fact that the main debate is about Bernanke not about actual policy is merely a result of this.

  2. Gravatar of David Pearson David Pearson
    23. January 2010 at 19:07

    What rational debate there is over Bernanke’s nomination is necessary. The constitution gave power of the purse to the House of Representatives, and it in turn made that body more responsive to the popular will. Bernanke’s Fed has usurped that power by threatening Congress with financial collapse if they did not acquiesce. So we have the Fed effectively disbursing public funds to support house prices.

    The Fed’s MBS purchases have put taxpayers on the hook for the bad decisions made by lenders and borrowers. When Congress does this, we humble taxpayers get to vote them out of office. When the Fed does this, our power of the vote counts for very little.

    The Fed can easily use QE to disguise its not-so-quasi fiscal actions. Scott, are you in favor of limiting the Fed’s balance sheet to Treasuries? If so, then you should oppose Bernanke’s nomination on that basis alone.

  3. Gravatar of Dan Dan
    23. January 2010 at 19:25

    Scott, what do you think of DeLong’s argument that the problem isnt Bernanke but rather the FOMC?

    “He is no longer the academic intellectual who advocates inflation targetting. He is, instead, the voice for the consensus of the Federal Open Market Committee–and a member of that committee who can, by his own internal arguments, move that consensus at the margin. So he is going to reflect that consensus.

    So I am much more interested in moving the FOMC consensus in a constructive direction–in getting two extremely articulate and thoughtful sensible macroeconomists added to the FOMC via recess appointments by Obama to fill the vacant Fed governorships as soon as possible–than in demanding that Bernanke’s public statements deviate from the FOMC consensus: a Fed chair who doesn’t reflect the consensus in public has less power to move the consensus in private. From my perspective, I don’t think that there’s anything wrong with Ben Bernanke’s (private, intellectual, academic) analysis of the current situation. What is wrong is that the FOMC consensus is wrong–and Bernanke’s public statements reflect that wrong consensus.”

    http://delong.typepad.com/sdj/2010/01/the-internets-chief-bernanke-apologist-officer-speaks.html

  4. Gravatar of scott sumner scott sumner
    23. January 2010 at 19:30

    Doc Merlin, Actually in the old days the public used to debate monetary policy. It was the number issue back around 1896, and again in 1933. Too bad that people have forgotten how important monetary policy is, it would be a nice debate to have.

    David Pearson, My point is that the debate over Bernanke’s nomination should revolve around what monetary policy is appropriate. Should it be more expansionary or contractionary? Issues like whether the Fed buys Treasuries or MBSs is of trivial importance compared to what sort of monetary policy we are to have. So where is the debate over monetary policy?

    Obviously I don’t agree with Bernanke’s policies, but that has little to do with whether I should support him or not. As far as I can see most experts support his policies, so what would be the point of replacing him? I’d rather focus my efforts on convincing the experts that they are wrong about monetary policy.

  5. Gravatar of scott sumner scott sumner
    23. January 2010 at 19:31

    Dan, I agree with DeLong.

  6. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 21:52

    If there is a significant output gap, which high unemployment suggests (U6 17.3% Dec 09), the public desires to save more and business is investing less, coupled with a persistent CAD, then it is very likely that NAD is significantly under that needed to meet real output potential. Moreover, it is evident that the automatic stabilizers are insufficient to meet the challenge. Under these circumstances, the question becomes how best to increase NAD. Any proposed fix must act swiftly to alleviate unemployment, which is becoming a matter of social dissatisfaction.

    There are three ways to do this through fiscal policy. Increase spending, reduce taxes, or a combination of them. Warren Mosler advises a payroll tax holiday and a federal grant to all states of $500 per capita, repeated as needed, in “Mosler’s 11 steps to fix the economy.

    Since the payroll tax is large in the aggregate and regressive, it would put a lot of spending power through the economy, much more than any other tax reduction, and it would act quickly. A federal grant to all states equally would be politically feasible since it doesn’t favor any group. This, too, would be disbursed quickly. Both have the advantage of being politically feasible, whereas more targeted spending or tax cuts could be contentious.

    An objection raised that fiscal policy increases the deficit and adds to the debt to GDP ratio. Currency issuance is not a financial constraint for a sovereign government issuing a non-convertible currency. There is admittedly a political constraint requiring $4$ offset, but this is voluntary and unnecessary. (Randy Wray advises paying reserves on reserves instead of issuing debt at all in Memo to Congress.)

    The only real constraint is that NAD not be stimulated in excess of real output capacity, and that is far from a problem presently or anticipated in the immediate future, when the principal challenge is debt deflation after the Ponzi stage of the financial cycle (in Minsky’s sense). Steps can be taken to withdraw net financial assets as needed down the line through reduced spending and tax increases if the automatic stabilizers are insufficient. (For a debate about this view, see Bill Mitchell, Debates in modern monetary macro ….)

    Using monetary policy to create money through lending in the commercial banking system also adds to debt, and this debt must be absorbed by the private sector, which is revenue constrained, whereas government can handle the obligations on its debt through its power of currency issuance. Moreover, debt burden in the private sector reduces NAD since it is generally regressive, while the government’s payment of interest is comparable to other spending, adding to non-government net financial assets.

  7. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 21:59

    SS: “what would be the point of replacing him?”

    Obama is facing Lincoln’s McClellan moment politically. He has to find his economic Grant.

    Bernanke, Geithner and Summers are discredited, rightly or wrongly, in the the public eye, and they have become a political liability that is affecting the president’s ability to accomplish his agenda. He needs to replace his current economic team to restore public confidence that Main Street is his priority, not Wall Street, and that he is a man of the people and not a tool of the Establishment. The outrage is real, and it’s growing. As a practical matter, economics is not independent of politics, and it is a servant of policy, not the master of it.

    “Efficiency is doing things right, and effectiveness is doing the right thing.” Peter F. Drucker

  8. Gravatar of Mike Sandifer Mike Sandifer
    23. January 2010 at 22:46

    I agree that there can be too much public debate about whether to replace Bernanke and that we’d be better off focusing on what kind of monetary policy we should have. Then, the Bernanke question would probably answer itself anyway. But, that’s not the world we live in and while the question is asked, I favor replacing him with someone who will offer more monetary stimulus.

  9. Gravatar of Mike Sandifer Mike Sandifer
    23. January 2010 at 22:56

    And I understand that at or near the zero bound, the chairman may not have the option of merely reducing the discount rate unilaterally, but I think Bernanke should make a public case for more monetary stimulus. Yes, the Fed risks losing independence in a number of ways, but the risk may be greater if the economy doesn’t improve. We need a Fed chairman who is larger than the FOMC and the problems he faces, or at least one who is wiling to sacrifice himself if it turns out he’s wrong.

  10. Gravatar of scott sumner scott sumner
    24. January 2010 at 07:18

    Tom Hickey, Interestingly, I am intrigued by a payroll tax cut, but for entirely different reasons, AS not AD. I don’t think temporary tax cuts boost AD very much. But if you cut the employer’s share of the payroll tax, you essentially cut real wages. And this boosts AS.

    You may be right about the politics of Bernanke. But politics is almost infinitely complicated. It is also possible that the markets might be spooked if Bernanke is dumped. Or the hawks at the Fed might be so outraged that they dig in their heels. On balance I’d like to see Obama replace Bernanke with someone more committed to stimulus, but I don’t see it happening even if Bernanke is dumped.

    Mike, I agree with you. My point is that any debate over Bernanke should include a debate over stimulus. Instead I see mostly debates over the Fed’s role in regulation, which is a side issue.

  11. Gravatar of bill woolsey bill woolsey
    24. January 2010 at 08:25

    Scott:

    It is worse than a debate about regulation.

    It is complaining about the Fed failing to stop some kind of financial problems 5 years ago.

    Why didn’t the Fed regulate Goldman, Bear Stearns, Merril Lynch, Lehman Brothers and Morgan Stanley better in 2003? What? These aren’t even banks!

    Supposedly, JP Morgan, which after the merger with Chase Manhattan became a commercial bank, really hasn’t had any financial problems.

    So, it just leaves Citibank. And yes, the Fed had some regulatory authority. And Citibank did do some seriously bad things.

    Bank of America appeared to get into big trouble after it “saved” Merril Lynch after the crisis. If Too Big to Fail is accurate, BoA wanted all along to buy a broker dealer. And so it wasn’t like anyone twisted their arm, but they bought one that was deep in a hole. (And then tried to back out, sensibly, but at that point were pressured by government to keep it up.)

    Wachovia is a big regional bank (but tiny compared to BoA, JP Morgan, or Citi) and it got into trouble. How? Buying a thrift during the crisis–saving a weaker institution. Incredibly, the government was trying to merge them into Citi when both were basket cases.

    The Fed doesn’t regulate thrifts–like Countrywide. And they went broke the oldfashioned way, they held lots of bad loans. For a thrift, having alot of mortgage loans, one way or another, is normal. And risky, of course.

    Now, we do have a “free market” story where we claim that the Greenspan Fed kept interest rates too low, and this caused a speculative bubble in housing. And that the Fed should have increased interest rates in the past to stop the bubble.

    Even if that were true, blaming Bernanke for failing to manage the economy by properly adjusting interest rates in a timely manner is the last message that should be sent.

    No, I blame Bernanke for listening to Geithner last fall and focusing on bailing out investment banks on Wall Street.

    He should be punished.

    As for his wisdom? He is too focused on returning to the past. Something like the Taylor rule. That approach _failed_.

    But who would be better than Bernanke? Well, if we are imagining that Bill Woolsey gets to make the appointment, I would have to advertise. I hope I can do better than you, Scott. But the first qualification would be a target for nominal expenditure and the second dropping interest rate targeting.

  12. Gravatar of Joe Calhoun Joe Calhoun
    24. January 2010 at 09:34

    Scott,

    Could we achieve sufficient NGDP growth through fiscal policy (such as the payroll tax reduction mentioned above combined with other policies which increase the demand for labor?) or is more expansive monetary policy an absolute must? In other words, how big do you think the problem really is? I suspect a lot of people who oppose more monetary stimulus would happily support fiscal policies designed to raise NGDP that don’t involve more direct government spending.

  13. Gravatar of Jon Jon
    24. January 2010 at 11:04

    So the FOMC started with a 75 basis point penalty on excess reserves. The squashed that to zero. What do you imagine their discussion was about when they reached that decision?

  14. Gravatar of bill woolsey bill woolsey
    24. January 2010 at 11:17

    Joe Calhoun:

    You write:

    “I suspect a lot of people who oppose more monetary stimulus would happily support fiscal policies designed to raise NGDP that don’t involve more direct government spending.”

    Why would anyone favor more NGDP and oppose monetary stimulus?

  15. Gravatar of Matthew Yglesias » What We Should Be Debating Matthew Yglesias » What We Should Be Debating
    24. January 2010 at 11:34

    [...] in the Senate—and don’t reveal that much about their views on economic policy. Scott Sumner has better questions: We should be [...]

  16. Gravatar of Alex Alex
    24. January 2010 at 11:56

    I make a comment that is slightly off topic but concerns monetary policy.
    In Europe what happened to many firms in everyday business since the crisis unfold is that the interest rate on loans and mortgages is no longer set with reference to the market interest rate (Euribor). Instead, these interest rates are “administratively” set by the bank (whatever this means). I can imagine that if this is the case, the monetary transmission mechanism is not working anymore and cutting rates might not have any effect on AD. May be worse, monetary policy may not be as neutral as before because large firms may contract better conditions than small ones.
    Am I right?

  17. Gravatar of Krugman to the Fed: proof that you can spring the liquidity trap « Freethinking Economist Krugman to the Fed: proof that you can spring the liquidity trap « Freethinking Economist
    24. January 2010 at 12:12

    [...] and low rates, how can Bernanke be accused of doing too little?  Here again I must refer people to Sumner’s blog.  Monetary policy is not just about the current interest rate. It is not even just [...]

  18. Gravatar of Joe Calhoun Joe Calhoun
    24. January 2010 at 12:29

    Bill Woolsey,

    I am thinking here of politicians primarily and they will be reluctant to support more monetary expansion when there is already an intense focus on the Fed. Republicans cannot support a further expansion of the Fed’s balance sheet, but they can support a payroll tax cut or corporate tax cut. Considering the difficulty the Democrats have had getting Bernanke confirmed, they can’t support it either. For that matter, they can’t even support tax cuts at this point since they’ve spent the last 8 years demonizing them.

    My larger point is that the focus here on monetary solutions is fine but there is a political reality in the country that has to be considered. If monetary solutions are verboten right now what are the alternatives? Surely, you aren’t saying there are no alternatives are you? Personally, I can’t figure out why we aren’t using monetary policy to address the short term need for growth to prevent mass unemployment and working on the fiscal side to address the long term issues. Monetary policy can maintain nominal growth but don’t we have some real issues that need to be addressed? If fiscal policy remains a wreck, won’t sufficient monetary expansion to maintain nominal growth ultimately lead to inflation? Surely you don’t believe that Congress will suddenly balance the budget if the Fed decides to do what is necessary to raise NGDP to the old trend do you?

    Look, I might not be using NGDP properly; I’m not an economist. All I’m trying to say is that there is a bias against more aggressive use of monetary policy at this point. We can debate forever whether the bias is correct, but the reality is that the bias exists. So what are the alternatives? Obviously, we need to reduce the real cost of labor (or anything else that stimulates demand for labor), but aren’t there ways to do that other than having the Fed buy more mortgages? What are they? Are they anymore politically feasible than the monetary solution? If not, will the Fed implement QEII despite the potential backlash? I happen to believe that is exactly what will happen by the way. The politicians won’t do anything substantive and the Fed will be forced to act. But it’ll probably take another mini crisis to provoke them into action. It would be better for all of us if they acted pre-emptively, but I don’t expect it.

    Is the market already starting to anticipate the end of QE in March? The dollar has been rising since the beginning of December and gold peaked at the same time. Early warning?

  19. Gravatar of What we should be debating…."It is so much more fun to bash big banks." « Economics Info What we should be debating…."It is so much more fun to bash big banks." « Economics Info
    24. January 2010 at 20:15

    [...] Source [...]

  20. Gravatar of Words of wisdom | India News Blog, Latest News From India, Latest Blogs From India Words of wisdom | India News Blog, Latest News From India, Latest Blogs From India
    25. January 2010 at 06:39

    [...] You could construct a whole blog of mishnah on Scott Sumner, but no, I cannot link to every post he writes.  Nonetheless I especially liked this passage: [...]

  21. Gravatar of Jim Longmire Jim Longmire
    25. January 2010 at 07:09

    If the fed concentrated on one key target, the underlying rate of inflation over the business cycle, monetary policy would work with much more certainty. Other countries do this now. Inflation targetting gives much greater certainty on where US monetary policy stands. The fed should announce an underlying inflation target and set policy to meet it. What about 2% per annum as a starter.

  22. Gravatar of scott sumner scott sumner
    25. January 2010 at 07:59

    Bill, Those are all good points, especially the point about doing better than me. :)

    In a new post I linked to a new Brad DeLong post on Bernanke that I think was pretty good.

    Joe, I just don’t understand that argument:

    1. Fiscal policy increases the deficit, monetary policy reduces it.
    2. Fiscal policy is less effective than monetary stimulus

    I can’t see any reason for preferring fiscal stimulus. If we can’t get any monetary stimulus I’d try to boost AS with a payroll tax cut for business.

    Jon, I know what their discussion was. They’ve told us. They wanted to prevent the free market fed funds rate from falling below their target rate.

    Why didn’t they cut the target rate further? Now there would be a very interesting discussion. My guess is that in retrospect my views will look way, way, way better than the Fed’s views when they decided not to cut rates more sharply in the fall of 2008.

    Alex, No, you are not right. Interest rates don’t play an important role in the monetary transmission mechanism. Instead, money stimulus affects the expected future money supply, the expected future NGDP, and the current price of all sorts of assets. That is the transmission mechanism.

    Joe#2, The Fed does not have to increase the size of their balance sheet to ease policy. Indeed they could reduce it if they’d stop paying interest on reserves, and drastically reduce it if they’d put a penalty on reserves.

  23. Gravatar of James Hogan James Hogan
    25. January 2010 at 09:14

    What Tom Hickey said above @ 21:52 and 21:59.

    The states are in a very dire condition now and if some outside assistance is not forthcoming, many of them will cease to function in the near future.

    Direct aid to the states is the quickest, most effective way stimulate the economy.

  24. Gravatar of Dilip Dilip
    25. January 2010 at 09:17

    Krugman is reading you:
    http://krugman.blogs.nytimes.com/2010/01/25/issues-versus-people/

  25. Gravatar of A paralysed nation – Economics - A paralysed nation - Economics -
    25. January 2010 at 10:02

    [...] Boxer (D-CA) and Jim DeMint (R-SC) would both prefer to Bernanke?A good question! It reminds me of this very good passage from Scott Sumner (which I saw at Marginal Revolution):If our banking system [...]

  26. Gravatar of Joe Calhoun Joe Calhoun
    25. January 2010 at 11:53

    Scott,

    Well I didn’t say it made sense, just that it is reality. By the way, did you see this quote from Bernanke?:

    “[I]f monetary policies are chosen optimally and the
    economic structure is held constant, there exists a longrun
    tradeoff between volatility in output and volatility in
    inflation.

    The ultimate source of this long-run tradeoff is the
    existence of shocks to aggregate supply…Hence, in the
    standard framework, the periodic occurrence of shocks to
    aggregate supply (such as oil price shocks) forces policymakers to choose between stabilizing output and stabilizing inflation. Note that shocks to aggregate demand do not create the same tradeoff, as offsetting an aggregate demand shock stabilizes both output and inflation.”

    http://www.federalreserve.gov/Boarddocs/Speeches/2004/20040220/default.htm

  27. Gravatar of Larry Beck Larry Beck
    25. January 2010 at 12:41

    What exactly is it that your against with ” low-cost 30 year mortgages”?

  28. Gravatar of TheMoneyIllusion » Looking to economic analysts for guidance TheMoneyIllusion » Looking to economic analysts for guidance
    25. January 2010 at 14:18

    [...] a bit of fun.  My post was entitled “What we should be debating,” and note the term ‘we.’  Krugman responds: Scott Sumner arguesthat we should [...]

  29. Gravatar of Roland Buck Roland Buck
    25. January 2010 at 19:14

    As far as I can see, very few people are calling for additional monetary stimulus.”

    Perhaps one reason is that Krugman has convinced people that the economy is in a liquidity trap, and that therefore monetary policy has lost its effectiveness.

  30. Gravatar of Roland Buck Roland Buck
    25. January 2010 at 19:20

    “We should be debating:

    2. Whether to put an interest penalty on excess reserves”

    At the very least, the Fed should not be paying interest on excess reserves when one of our most serious problems is the lack of lending by bank. They are actually being rewarded for sitting on the exess reserves instead of lending them out.

    But an interest rate penalty on them would be a better idea. Who says you cannot have negative interest rates? You can definitely have one on excess reserves. Could that produce a negative federal funds rate?

  31. Gravatar of Roland Buck Roland Buck
    25. January 2010 at 19:38

    “But if you cut the employer’s share of the payroll tax, you essentially cut real wages. And this boosts AS.”

    But lack of supply is not the problem. If aggregate demand were stronger so that firms could sell more, they would produce more. So how does stimulating aggregate supply help? It would, however, put downward pressure on the price level, so that if the economy is already below the Fed’s inflation target, and especially if an imminent deflation is a threat, it would make that worse.

  32. Gravatar of Is Obama to Blame? Is Obama to Blame?
    26. January 2010 at 00:27

    [...] a bit of fun.  My post was entitled “What we should be debating,” and note the term ‘we.’  Krugman responds: Scott Sumner argues that we should be debating [...]

  33. Gravatar of It’s All About Monetary Policy | Reaction Radio It’s All About Monetary Policy | Reaction Radio
    26. January 2010 at 06:06

    [...] regarding Bernanke’s reappointment as Fed Chairman is monetary policy. To be precise, Sumner writes that the key economic issues [...]

  34. Gravatar of scott sumner scott sumner
    26. January 2010 at 07:37

    Jim, Inflation is a bad target for all sorts of reasons I’ve discussed in this blog. NGDP growth is a better target. The growth track has been 5% a year for decades, and suddenly turned negative after mid-2008. Big mistake.

    James, The federal government is already providing massive aid to the states. It won’t work. Only monetary stimulus can get states out of this hole by boosting the economy quickly.

    Thanks Dilip.

    Joe, Yes, and that is a pretty good argument for NGDP targeting.

    Larry, That was half-joking. I am not against low cost mortgages provided by the free market. I am against all these government programs like FHA, Fannie, Freddie, etc, trying to encourage more low cost mortgages through implicit Federal subsidies. Why am I against those? Just read the newspapers. Even Barney Frank (a big defender of Fannie and Freddie) now wants to abolish them.

    Roland, Exactly, indeed that is the argument in my new post on Krugman.

    Roland#2, I agree, but it would not produce a strongly negative fed funds rate. The reasons are complicated. But the basic idea is nominal rates can only go slightly negative as long as the public has the option of holding cash. Instead the interest penalty would encourage banks to exchange reserves for Treasury securities and loans, which would make the reserves go out into circulation as cash.

  35. Gravatar of Roland Buck Roland Buck
    26. January 2010 at 22:40

    “Instead the interest penalty would encourage banks to exchange reserves for Treasury securities and loans, which would make the reserves go out into circulation as cash.”

    That is true in general, which is why there should be such a penalty when the problem is that banks are not lending enough. But banks are likely to have some excess reserves at the end of the day. With a high enough penalty, wouln’t some banks be willing to pay other banks to take the excess reserves off their hands overnight?

  36. Gravatar of Roland Buck Roland Buck
    26. January 2010 at 22:46

    What Krugman is calling a liquidity trap is very different from what Keynes called a liquidity trap. Keynes’ liquidity trap would arise when the long-term rate reached a floor significantly ABOVE zero below it would not go because the demand for money, due to the workings of a speculative demand, becomes infinate at that rate. Keynes, writing in 1935, after the trough of the depression had been passed, stated that while this may happen in the future, to the best of his knowledge this had not occurred.
    That is very different from Krugman’s liquidity trap, which is the federal funds rate hitting a 0% floor.

  37. Gravatar of Roland Buck Roland Buck
    26. January 2010 at 22:51

    “The federal government is already providing massive aid to the states. It won’t work.”

    As long as the velocity of money depends significantly on the rate of interest it should work. Why do you maintain that it does not?

  38. Gravatar of scott sumner scott sumner
    27. January 2010 at 20:05

    Roland, I don’t understand your point. if reserves are lent to another bank, then that other bank must pay the penalty. It stil lreduces the total of ERs in the entire system.

    Roland#2, Keynes was very confused about liquidity traps. What he called a liquidity trap was actually a central bank constrained by its currency being pegged to gold. The example he cited in the GT was the Feds OMP program of the spring of 1932. Krugman has a much more sophisticated model.

    Roland#3, Two reasons. First, fiscal aid to the states had little impact on nominal interest rates, at least according to all the studies I have seen.

    Much more importantly, it ignores the Fed’s reaction to fiscal shocks. The Fed is clearly setting monetary policy with some sort of nominal objective. Of course it is possible that fiscal policy could have some effect, but it would require a strangely dysfunctional Fed. (On the other hand. . . . maybe you are right.)

  39. Gravatar of Roland Buck Roland Buck
    28. January 2010 at 22:13

    “I don’t understand your point. if reserves are lent to another bank, then that other bank must pay the penalty. It stil lreduces the total of ERs in the entire system.”

    I don’t disagree that this would greatly reduce the ERs and make banks lend more and/or buy more securities, bringing interest rates down. I am only referring to the relatively small amount of excess reserves left at the end of the day due to normal operations. Some banks might find it profitable, due to differences in cost structures, to take these overnight, earn the negative federal funds rate, and pay the penalty on excess reserves.

  40. Gravatar of Roland Buck Roland Buck
    28. January 2010 at 22:25

    “fiscal aid to the states had little impact on nominal interest rates, at least according to all the studies I have seen.”

    Assuming that the supply of money was an exogenous variable in the studies, instead of being endogenous as a result of the central bank engaging in interest rate pegging, and the aid was large enough to have a significant impact, the studies would seem to imply a higly interest elastic demand for money, so that the aid would be very effective.

    The same is true if the central bank is adhering to an interest rate target.

  41. Gravatar of Roland Buck Roland Buck
    28. January 2010 at 22:46

    “Keynes was very confused about liquidity traps. What he called a liquidity trap was actually a central bank constrained by its currency being pegged to gold. The example he cited in the GT was the Feds OMP program of the spring of 1932. Krugman has a much more sophisticated model.”

    My argument is based on page 207 of the General Theory. What page are you referring to?

  42. Gravatar of ssumner ssumner
    29. January 2010 at 14:44

    Roland, I just don’t see fiscal aid to states having much impact on the demand for money. But in any case, the Fed is not passive, and its likely feedback must be taken into account when thinking about fiscal stimulus.

    Roland, Bottom of page 207 and top of 208. The phrase “certain dates” refers to April through June 1932. Those open market purchases failed due to an outflow of gold, not a liquidity trap.

  43. Gravatar of Roland Buck Roland Buck
    29. January 2010 at 20:51

    “Bottom of page 207 and top of 208. The phrase “certain dates” refers to April through June 1932. Those open market purchases failed due to an outflow of gold, not a liquidity trap.”

    Precisely, that was not a liquidity trap. Keynes’ model of the liquidity trap is explained in the paragraph above that.

    And Krugman is not asserting that we are facing a crisis caused by an outflow of gold, he is asserting that we are in a liquidity trap, which is what Keynes explains in the previous paragraph. My point is that when Krugman is talking about a liqidity trap, he is talking about something very different than what Keynes was talking about.

    The chief obstacle to longer term interest rates on government bonds and mortages coming down more to give the economy more stimulus is item 1 on page 201 of the General Theory, not a liquidity trap. In item 2 Keynes speaks of the unwillingness of most monetary authorities to deal boldly in debts of long term. It’s deja vu all over again.

  44. Gravatar of Roland Buck Roland Buck
    29. January 2010 at 21:00

    “and its likely feedback must be taken into account when thinking about fiscal stimulus.”

    I fully agree. The size of fiscal demand-side multipliers depend crucially on the response of the Fed. At a time when the Fed is detemined to keep the federal funds rate from rising and the is making some half hearted efforts to hold long-term rates down, fical multipliers should be relatively strong. This would be the case even if the demand for money did not depend on the rate of interest because if this is the case, under such monetary conditions expansionary fiscal policy will result in an increase in the money supply since a monetary policy of interest rate pegging makes the money supply endogenous.

  45. Gravatar of Roland Buck Roland Buck
    29. January 2010 at 21:08

    “I just don’t see fiscal aid to states having much impact on the demand for money.”

    If the demand for money did not depend on the interest rate and the supply of money were exogenous, a significantly large increase in any fiscal stimulus would cause a significant increase in the interest rate. Putting this in Keynesian terms by using the IS-LM model, if the supply of money is exogeonous and the demand for money does not depend on the interest rate you get a vertical LM curve. In that case any significant shift in the IS curve to the right due to fiscal aid to the states would cause a significant increase in the interest rate. (The IS-LM model continues to be a useful EXPOSITORY DEVICE for seeing the relationship between monetary and fiscal policy. An expository device is all Hick intended the IS-LM model to be used for.)

  46. Gravatar of scott sumner scott sumner
    31. January 2010 at 07:50

    Roland, You said;

    “Precisely, that was not a liquidity trap. Keynes’ model of the liquidity trap is explained in the paragraph above that.”

    I don’t follow your point. He explained it above, and then used the US in 1932 to illustrate his point. But the US in 1932 did not illustrate his point.

    If we had more stimulus long term interest rates would probably rise, not fall. Long term rates are procyclical. I hope they rise. They are low because the economy is weak.

    You said;

    “I fully agree. The size of fiscal demand-side multipliers depend crucially on the response of the Fed. At a time when the Fed is detemined to keep the federal funds rate from rising and the is making some half hearted efforts to hold long-term rates down, fical multipliers should be relatively strong.”

    This is Krugman’s mistake. He assumes low interest rates are indicative of easy money. If that were so, he would be right. But in fact interest rates are an exceedingly poor indicator of the stance of monetary policy. If we had not done the fiscal stimulus, I think it likely the Fed would have been much more expansionary than it has been. And as a result interest rates might have been much higher.

    The simple IS-LM model doesn’t account for the role of expected future policy, and thus is almost worthless for monetary policy evaluation. Woodford claims that changes in expected future policy are far more important than changes in the current stance of monetary policy. In a forward looking IS-LM model an expansionary monetary policy can easily raise both nominal and real interest rates.

  47. Gravatar of Roland Buck Roland Buck
    31. January 2010 at 19:52

    “I don’t follow your point. He explained it above, and then used the US in 1932 to illustrate his point. But the US in 1932 did not illustrate his point.”

    On pages 207 and 208 Keynes lists 4 different limitations on the ability of the monetary autority to establish any given complex of interest rates.

    The liquidity trap is reason number 2.

    Reason number 3 is a DIFFERENT reason for a the liquidity function flattening out: a financial crisis. This has nothing to do with the liquidity trap in reason 2.

    Reasons 1 and 4 are still different reasons. Each reason is independent of the other.

  48. Gravatar of scott sumner scott sumner
    1. February 2010 at 13:00

    Roland, I disagree, I think most scholars consider a liquidity trap to be a flattening out of the liquidity function at near zero nominal rates, for whatever reason. In addition, it is clear from Keynes’s writings at he time that he thought US monetary policy was ineffective back in 1932. He said fiscal stimulus was the only way out of the Depression, as monetary policy had lost its effectiveness once rates fell to low levels.

    Note that as written, point three doesn’t seem to bring forth any new theoretical concepts, but merely to illustrate concepts already discussed. He dives right in to two examples. And the language is very similar to point two:

    “scarely anyone could be induced to part with holdings of money” (3)

    “almost everyone prefers cash to holding a debt” (2)

    Hicks argued in 1937 that the flattening of the liquidity function was the key assumption that underlay the novel conclusions of the GT.

  49. Gravatar of Roland Buck Roland Buck
    1. February 2010 at 19:27

    1. Keynes said in his discussion of reason 2 “But whilst this limiting case might become important in the future, I KNOW OF NO EXAMPLE OF IT HITERTHO.” This shows that he could not have considered item 3 to be an example.

    As to why monetary policy would not get the economy out of a recession, he offers the following explanation on the bottom of page 266 – top of 267. “Just as a moderate increase in the quantity of money may exert an INADEQUATE influence over the LONG-TERM rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence …” This is in the context of why a reduction in money wages would not do the job of restoring the economy to full employment, and he may have made a similar statement at another location that I have not found, but this indicates that he believed that a moderate increase in the money supply would have some influence and a large increase of the money supply could reduce the long rate, in which case there is no liquidity trap.

    Also another reason Keynes gave that monetary policy could not be counted on to get the economy out of the Depression, is Reason 1 on page 207. In Reason 2 he talks about “the unwillingness of most monetary authorities to deal boldly in debts of long term.”

    Keynesians, starting with Hicks, took a minor remark by Keynes about something that MIGHT happen in the future and made it a major element of Keynesian economics.

  50. Gravatar of Roland Buck Roland Buck
    1. February 2010 at 19:41

    It is also important to note that in Keynes’ discussions of this issue that it is always about the long-term rate not coming down far enough. It is never about very short-term rates like the federal funds rate.

  51. Gravatar of ssumner ssumner
    3. February 2010 at 14:06

    Roland;

    I still disagree about 207, I think the example at the bottom is clearly intended as example of a liquidity trap.

    You said;

    “As to why monetary policy would not get the economy out of a recession, he offers the following explanation on the bottom of page 266 – top of 267. “Just as a moderate increase in the quantity of money may exert an INADEQUATE influence over the LONG-TERM rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence …” This is in the context of why a reduction in money wages would not do the job of restoring the economy to full employment, and he may have made a similar statement at another location that I have not found, but this indicates that he believed that a moderate increase in the money supply would have some influence and a large increase of the money supply could reduce the long rate, in which case there is no liquidity trap.”

    I don’t read it the same way. I don’t think he is necessarily arguing a huge increase in the money supply would reduce long term rates. Remember he recently lived through the German hyperinflation. The comment about a lack of confidence almost surely refers to the fear of devaluation. This would only be a barrier to raising NGDP if you were under a fixed exchange rate regime, which is why I have argued that the Keyensian model is basically a gold standard model.

    In any case Keynes was wrong, easy money does not boost NGDP by reducing long term rates. Indeed easy money often raises long term rates.

    Modern Keynesians have a big problem trying to apply his model to our modern economy. The Keynesian model doesn’t apply to a fiat money world. The central bank can always boost NGDP if it wishes to, so there is no reason to rely on fiscal stimulus. This was learned after 1982, and then forgotten again in 2008.

    Keynes’s discussion of monetary policy during the 1930s is very confused and inconsistent. It is difficult to know what he meant, because he changed his mind so often, and expressed his ideas in such an obscure fashion.

  52. Gravatar of Roland Buck Roland Buck
    3. February 2010 at 18:23

    Thank you for your thorough replies to my arguments. I learned a lot from this, but I still think that the liquidity trap is irrelevant to the economics of Keynes, as opposed to Keynesian economics.

    We do appear to agree on the main points, however: The the economy is not in a liquidity trap, that monetary policy has not lost its effectivenss, and that the Fed should be following a more expansionary policy to bring the unemployment rate down faster.

    “I have argued that the Keyensian model is basically a gold standard model”

    Is there some paper of yours that I should be reading with respect to this?

  53. Gravatar of ssumner ssumner
    4. February 2010 at 06:34

    Roland, Yes, I have a 1999 paper in Economic Inquiry. You might find it interesting.

    I am sorry to tell you that two comments you sent to an old post were sent to the old blog platform, and I can’t access it anymore. If you still have them, try to find the same post on my new platform (i.e. this one) and repost. (I think it was the “if not now when” post, unfortunately google probably takes you to the old platform.) You might first check the date of the post you commented on, and then go to the “months” column on the upper right of this page, to find the post. Then you can find it on this platform.

    Let me know what you think of my EI paper. If you can’t find it, email me at Bentley and I’ll send you a word file.

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