Superfreakymacroeconomics
The following post is a sort of response to Raghuram Rajan’s recent post at Freakonomics:
If you are a college econ teacher, you’ve had this experience. You explain how an expansionary monetary policy can boost AD. A student raises his hand:
“But isn’t low interest rates just like the government providing a subsidy to borrowers? And aren’t government subsidies bad?”
The student is so far off base you wonder how you are going to fix things with a short answer. But let’s try anyway.
1. Yes government subsidies are bad for two reasons. They require higher future taxes, which impose deadweight costs. And they distort relative prices.
2. Now let’s think about monetary policy. The first misconception is that the Fed “controls” interest rates. In fact, the Fed controls the monetary base, and targets interest rates. Rates are always allowed to find their free market values, given the setting of the monetary base. So if the Fed wants to reduce rates, it might increase the monetary base until the equilibrium free market rate falls to the desired level.
3. But doesn’t the Fed distort the bond market when they swap cash for T-bills? Maybe a tiny bit, but that’s not really why rates fall when the Fed increases the monetary base. The same liquidity effect used to occur in the old days when the Fed bought gold. The effect occurs because there is more non-interest bearing money in the public’s hands. Until consumer prices have had a chance to rise, the only way to get people to hold this extra money is for free market rates on alternatives assets to fall. These rates are the opportunity cost of holding cash. So monetary policy is fundamentally about the supply and demand for money. Interest rates are just one of many variables that change as a result of changes in the money supply. Exchange rates and consumer prices also change. Imagine someone criticizing a reduction in the inflation target from 3% to 2% on the grounds that it would be a subsidy to consumers!
4. Interest rates are (as a first order approximation) a zero sum game for the public. Lower rates mean one group pays less, and the other group receives less. But isn’t there some sort of “natural rate” and isn’t the Fed messing things up by setting rates below that natural rate? All serious attempts to find a natural rate of interest look at the macroeconomy, especially inflation and NGDP. Obviously credit markets (financial asset prices) can adjust to any inflation rate, but the real economy has trouble when inflation (or NGDP) rises or falls unexpectedly. So if there is a “natural rate of interest” it would be the rate where inflation or better yet NGDP is optimal, where the macro economy is in some sort of equilibrium. Where you don’t have mass unemployment, or overemployment, because nominal wages are temporarily stuck at the wrong level. Even if you don’t believe in sticky wages or prices, and simply support steady 2% inflation, there is still a natural rate; it is the rate that generates that target inflation rate. But one shouldn’t even focus on the natural interest rate, as we don’t have any way of directly estimating it (Taylor Rules notwithstanding.) Instead, the focus should be on NGDP and inflation expectations. Get those variables right, and then interest rates will also be at the proper level.
5. Thus the question is never whether low rates unfairly subsidize borrowers, or whether high rates unfairly tax borrowers, because the Fed is not directly fixing interest rates, or driving any sort of tax or subsidy wedge between lenders and borrowers. Rates are set in the market. The question is whether the money supply is set at a level that produces the sort of interest rates, exchange rates, prices, NGDP, etc, that are consistent with optimal macroeconomic performance.
6. Of course right now expected inflation and NGDP growth are much too low for macro equilibrium, so we need easier money. Does that mean we need lower rates? Here is where things get complicated. If both long and short term rates are very low, it is generally a sign that money has been too tight, and the level of nominal spending is too low to provide optimal macroeconomic conditions. So can you solve this problem by raising rates? It depends what you mean by raising rates. If you mean setting a higher fed funds rate, and implementing it through a reduction in the base, then the answer is no. If you mean trying to raise rates by printing lots of money and promising to do more in the future, or promising higher future inflation, or promising to steadily devalue the dollar, then the answer is yes.
The problem with recent essays by people like Rajan and Kocherlakota is that they don’t seem to understand this distinction. Or if they do, they express their ideas in a rather garbled fashion. They both think that higher rates might be desirable for various reasons. So far so good. But both also strongly imply that the way to get higher rates is through the Fed raising its short term fed funds target. But that requires tighter money–which would be a disaster right now. I’d also like to see higher rates on long term bonds (I’d love to get back to the 4% rates we saw on the 10 year bond a few months back) but want to get there through easier money. Since the fed funds target can’t be lowered much further, I support unconventional methods of boosting inflation and NGDP growth expectations.
Steve Williamson left this comment over at Nick Rowe’s blog, in support of Kocherlakota:
Nick,
Let’s be more explicit. I know you don’t like math and symbols, but they force some discipline on what you do. Suppose this is an infinite horizon, discrete-time model, t = 0,1,2,… . Now, in the first case, the initial money stock is M, the growth rate of the money stock is m. Suppose the environment is stationary (population, technology, preferences constant over time). Suppose in the first case the equilibrium nominal interest rate is R. What do we know about the first equilibrium? (i) M does not matter, i.e. money is neutral, and R is an equilibrium interest rate for initial money stock kM for any k > 0. (ii) As you said, the Fisher relation holds, if I increase m, then R increases one-for-one. Now, consider the second case. Suppose the central bank pegs the interest rate at R. Then there is a continuum of equilibrium money stock paths (and maybe more besides, but there are at least these) with initial money stock kM and money growth rate m that support that interest rate peg. The central bank gets to choose the one it wants. If the central bank choose a nominal interest rate R+x, it can support that with a money stock path kM and a money growth rate m + x. Done.
In a flexible price world Williamson would be correct. If the Fed suddenly increases the fed funds rate by 200 basis points as Rajan suggests, then the money supply growth rate must also increase by 200 basis points. Since the real rate is unaffected (money is neutral) the expected inflation rate also increases by 200 basis points. And that means right away, inflation rises literally overnight.
In the real world prices are sticky. How do we know? Because all the various markets respond to fed funds rate surprises as if prices are sticky. If there is a sudden and unexpected rise in the fed funds target at 2:15 pm, then here is what typically happens at 2:16 PM:
1. Nominal stock prices fall sharply.
2. Nominal commodity prices fall sharply.
3. Foreign currency prices fall sharply.
4. Inflation expectations (TIPS spreads) fall sharply.
So Williamson’s model is not applicable to the fed funds tool that most people refer to when discussing interest rates. Increases in the fed funds target cause short term real rates to rise by at least as much as nominal rates. It is only true as a long run proposition.
It’s funny how right-wingers who supposedly believe in markets go out of their way to lecture markets about how they don’t understand the true model of the economy, which it seems has only been revealed to freshwater economists. Here is Rajan:
Indeed, the Fed is now trapped because of the expectations it has set “” because the market “expects” ultra-low rates, the Fed cannot even return to normal low rates without the market taking fright. And it is hard to find a Wall Street economist who is not urging the Fed to undertake stronger, unorthodox actions.
I’ve spent most of my life studying the 1930s. And I have to agree with Rajan. Just as in the 1930s, the markets are very “frightened” of monetary tightening during a recession.
Here is Kocherlakota:
The FOMC’s decision has had a larger impact on financial markets than I would have anticipated. My own interpretation is that the FOMC action led investors to believe that the economic situation in the United States was worse than they, the investors, had imagined. In my view, this reaction is unwarranted. The FOMC’s decisions were largely predicated on publicly available data about real GDP, its various components, unemployment, and inflation. I would say that there is no new information about the current state of the economy to be learned from the FOMC’s actions or its statement.
Just the opposite is true. The market isn’t falling because they think the Fed knows more than they do, in fact the problem is just the opposite. The market understands that there is a serious shortfall in NGDP growth–nowhere near enough to generate economic recovery. It is the Fed that seems clueless, and that is what has markets very frightened. If the Fed really did do something aggressive, more than expected, markets would not fall because they saw the Fed was worried, they’d soar in relief that the Fed was finally doing something. Ironically it is people like Krugman and I that are doing ratex modeling. We have models where the various markets’ expectations are consistent with the predictions of the model. The difference between Krugman and I is that I always make this assumption.
Apologies to commenters–I will be way behind for a while. This is an important moment.
HT: Daniel Carpenter, Marcus
Tags: Sticky wages
26. August 2010 at 10:11
Hear, hear!
1.
It always frustrates, angers and upsets me when I hear an FOMC member stating a reluctance to take action because they think the market will interpret their action as a signal of “inside” knowledge. Didn’t the Fed already play this false confidence game in 2007 and 2008, with their “fundamentally sound” statement. How’d that work out?
2.
TIPS spreads have a serious circularity problem. They embed both the expectations of what the current policy trajectory will due, AND expectations of how policymakers will respond to economic divergences from the policy target. To some degree, falling TIPS spreads reflect a probabilistic assessment that the Fed might tighten in response to sub-target inflation.
3.
Kocherlakota, Hoenig and Rajan all seem to believe in some variant of “monetary neutrality” where money should earn a real risk free return of 1 to 2 percent over the long term. I don’t understand this assertion. First, a serious gold bug (I am not) would argue that gold is the only real risk free money over the long-term. But this logically implies that risk-free money generates a 0 percent real return over the long term. You can water and fertilize your gold all you want, but it will never gain weight. So what is it about fiat that the risk-free real return should be inherently higher than gold? Amber waves of grain? Population growth? Technology? Consumer confidence? Expansionary economic policy? Survival bias? The problem is a model like monetary neutrality is useless if its prescriptions are highly sensitive to assumed but unmeasurable constants.
The need for robustness is something that real scientists understand but dismal scientists always seem to forget.
26. August 2010 at 10:42
At what point does the economy adjust to the new lower inflation rate?
As I understand it real wages will eventually fall back to equilibrium through the .5 to 1.5% inflation the fed seems to be targeting. The real economy is unnecessarily harmed by the transition but cetainly an economy can function just as well at 1% inflation as 2%, at least in the longrun?
26. August 2010 at 11:09
If we were to run a prediction market using the apparent views of the majority of the current Economics profession – should I trust the results of that market?
Empirically, I’m getting a little tired of Bloomberg or Economist polls where 90% or more of “expert” survey participants hover around a consensus that misses the short-term actual result by over a standard-deviation.
But don’t you often express your frustration at the fact that your very persuasive beliefs about proper theory are an almost inexplicably minority position, and that the rest of the profession seems to have either forgotten the lessons of the past or gone slightly mad in some way.
But, we all know, these people are of the highest caliber intellectual talent, have the best and most comprehensive Economics educations, have a certain self-awareness of the danger of becoming overly ideological, and are not actually delusional. So, what other conclusion can we come to then that this hypothetical market of mine is “bad”, its results are not to be trusted.
To use PM terms – it has not been adequately “disciplined” enough to achieve the competitive dominance of the certain market players with correct ideas (i.e. yourself) that can properly deal with the present situation.
When “conservatives” question the markets, they are, of course, diverting from a pure-EMH “market fundamentalism” perspective, but they must be (implicitly, I suppose) saying that one of the market assumptions is not valid in the current case.
A pre-discipline market that takes a long time to mature, to pick winners and losers from among participants with widely varying models. A good example would be a market that operates under changed conditions – which, for some special strange reasons – is behaving in a manner completely anomalous compared to the stable past conditions that formed the ideas, theories, and behavior patterns of most current players.
In just such a place, the results of such a market deserves slightly less deference and slightly more suspicion until all the dust settles. The current market for Economic ideas seems to fit this quite well. The one for houses over the past decade, may fit little. I imagine that some Fed thinking must imagine the current market for equity and debt as being at least somewhat “defective” in some manner.
26. August 2010 at 11:18
I’ll have to agree. As a market participant, I found Kocherlakota’s statement more alarming than the Fed’s official position. It’s as if we are just waiting for the Fed to tell us what GDP is going to be next year before we decide what to do. Seriously? And these guys are running monetary policy? I know Nick Rowe says this guy is smart, but I have my doubts.
On another note, what do you think of Geanakopolos’ paper on the leverage cycle (FRBNY Economic Policy Review, August 2010 http://www.newyorkfed.org/research/epr/2010.html, last link)? I haven’t finished it yet, but it appears to raise some good points about the impact of leverage ratios on asset prices and perhaps indirectly on measured inflation.
26. August 2010 at 11:22
“Imagine someone criticizing a reduction in the inflation target from 3% to 2% on the grounds that it would be a subsidy to consumers!”
Ha! This sounds just as bad as when a liberal talks about a tax cut like it is something “given” to taxpayers.
Scott, let it go. The presumption is your right to save money and NOT have it inflate away. That’s the natural state – just like the natural state is that your money is rightfully yours.
No one signed up for a system that pretends a cut inflation is a GIVE AWAY.
This is not chicken and egg. Things do not occur on a continuum, there is a natural state, a originating state, and starting moral assumption – and then there are taxes and inflation.
26. August 2010 at 11:31
Morgan:
You may well have a right to your money.
But under what right do you insist that I sell you my services for the same price next year as I do this year?
And if I choose to get together with my fellow citizens and coordinate with them that we will all increase our prices (through any kind of coordination mechanism, but let’s call it the Federal Reserve) by what right would you stop us?
26. August 2010 at 11:39
Steve, I agree with your first point.
2. There can be a circularity problem with TIPS spreads, but not in the specific case I cited in this post. I referred to the immediate change in the TIPS spread after a unexpected change in the fed funds rate. That reflects the new information about policy.
3. I basically agree. Lots of points could be made here. I agree that real rates tend to be fairly low on average over the very long run. But they certainly vary quite a bit, and can go negative in depressions. And one thing I have learned is not to rely on historical regularities. Remember how US housing prices used to trend upward? Or how TIPS bonds always had positive yields? So I think we agree.
JPIrving, The economy can adjust to lower inflation, but w/o faster NGDP growth, the adjustment could be very slow. The problem is not so much low inflation, it is falling inflation. We need fast NGDP grwoth to get a quick recovery. If we need 8% RGDP growth to return to trend, and NGDP growth is 3%, then we’d need 5% deflation. That won’t occur. Instead, actual inflation will gradually fall, RGDP growth will be slow, and the recovery will take a long time. If we had 10% NGDP growth we could get a quicker recovery (say 8% RGDP growth and 2% inflation.) Obviously I am pulling these numbers out of a hat, but the point is that if NGDP growth is very slow, it is almost impossible to get a quick RGDP recovery, even if the economy has adjusted to 1% inflation. Recovery would require adjustment to a much lower inflation rate than that.
Indy, Here’s how I look at it. We all know what Friedman and Schwartz wrote about Austrian views of the Depression. We all know what Bernanke wrote about Japan. We all know what Mishkin wrote in his textbook about low rates not meaning easy money–that you had to look at asset prices. The question is not why does Scott Sumner disagree with 90% of the profession, it’s why do Schwartz, Bernanke and Mishkin, et al, no longer believe what they wrote. And why aren’t they admitting that they changed their minds?
My view is that of the economic mainstream circa 2005. It’s fine if people want to change their minds. But first they have to acknowledge they have done so, and explain why. So far the profession seems in denial.
As far as efficient markets, there is no market w/o money on the line. All those conservatives saying Obama’s policies will lead to high inflation? Do they have money on the line? (Robert Murphy does, but how many others?) If they bet their beliefs they’d quickly find they lost all their money to Paul Krugman. So I look at market expectations, not the random opinions of economists. Talk is cheap.
You said;
“I imagine that some Fed thinking must imagine the current market for equity and debt as being at least somewhat “defective” in some manner.”
If only the Fed had paid attention to markets in 2008, when they warned NGDP was falling fast. Instead the Fed was very passive.
26. August 2010 at 11:48
Leigh,
Good question. When our fellow citizens vote explicitly to do that, you let me know. Wave that stick around, and you’ll likely get beaten with it… you do not want total voter control of the Fed. It’s far better, to humble the bankers before the savers, otherwise the Audit The Fed movement will be brutal.
Now within that paradigm Leigh, raise your prices, just hope people will pay them.
Only productivity gains cause growth. Those gains most naturally manifest themselves as lower consumer prices.
That leaves plenty of real saved Money to finance lending from.
26. August 2010 at 11:50
I still say policymakers and pundits may be missing something: A glut of capital.
Supply and demand. There is a huge supply of capital, compared to previous periods. Interest rates should be low. I contend this condition will persist for generations.
If the Fed targets higher interest rates, they will really, really have to crank down on the money supply–but that backfires, and causes deflation and lower rates.
Right now, the Fed should just put the pedal to the metal, and try everything possible to get property values reflated and inflation up above 3 percent.
There was a time when Saddam Hussein was counterfeiting undetectable Benjamin Franklins (or so a story in the New Yorker read).
Can we do that?
26. August 2010 at 11:54
“Rates are always allowed to find their free market values, given the setting of the monetary base.”
Are you *trying* to give Bob Murphy a heart attack?
26. August 2010 at 11:56
“There is a huge supply of capital, compared to previous periods. Interest rates should be low. I contend this condition will persist for generations.”
This will not happen. Sooner then later the rally cry will be “Mark To Market.”
And when it happens all those houses held by the banks will be sold for pennies. The assets will be in the right people’s hands, and AMAZINGLY, things will turn around.
The problem we face is that people will capital do not feel good about things… IMPROVE THEIR PERSONAL BALANCE SHEET, and they’ll feel very good about things.
26. August 2010 at 12:02
Morgan, When I think of “natural state” I think of trees and rocks and bunnies and rainbows, not Federal Reserve policy. I trust you know that there is no such thing as “inflation” which you seem to want to equal zero. You can’t have an overall inflation rate when product quality is changing fast. What is the inflation rate of PCs? And how would you calculate it? Trust me, whatever answer you give I can tear to shreads. Inflation is a number pulled out of the air by nerdy guys with glasses at the BLS. How is zero inflation a state of nature?
26. August 2010 at 12:06
Morgan, I favor 5% NGDP growth which means 4% wage increases for the average guy. You think Americans have some sort of aversion to 4% pay increases? Would they be happier with 2% raises and 0% inflation. I don’t see that.
Benjamin, I agree.
Blackadder. Yes, I am.
26. August 2010 at 12:10
Alan Blinder, not a radical man, mentions CHARGING interest on reserves, rather than paying it, in the WSJ today. So now the idea is really out there in public.
But I don’t think the law actually allows this – sadly.
And what does Obama have to say about monetary policy? Well – actually – nothing at all.
http://online.wsj.com/article/SB10001424052748703846604575448022122679194.html?mod=rss_opinion_main#
26. August 2010 at 12:16
May I just say that this is a beautifully clear post.
26. August 2010 at 12:31
Scott,
I think what Morgan envisions is some sort of monetary supply that is created and just kept the same. Perhaps increase it a little bit because of increasing population. He thinks that this is ideal.
Another way of realizing what people like Morgan think is that this is a common quotation from all of them (and by the way, this includes some real investing heavyweights like Jim Rogers, Michael Panzer, Peter Schiff, Michael Pento)
“The US Dollar has lost 94% of its purchasing power since the Fed was instituted”
Their arguments are very clear, easy to understand and take advantage of the fact that most people don’t know anything AT ALL about monetary policy.
The problem is there are no witty one liners that one can give to their arguments. The best thing you can do is 3,000 word blog posts which most people don’t read or understand. Basically, we are screwed.
26. August 2010 at 12:43
The problem is the incentives in the economics profession. You don’t get rewarded for understanding the economy, or for understanding how your predecessors’ models work. You get rewarded for novelty. So we have this spectacle of certifiably smart Econ PhD’s who have lost touch with the entire framework of analysis used by the previous generation, people like Friedman, Clower, Alchian, and especially Axel Leijonhufvud.
Leijonhufvud’s insights are legion. His contention that high inflation destroys the functioning of many of the nominal mechanisms that society has evolved to solve principal-agent problems as budgets become meaningless, is one example. Another is that in a debt-deflation economy like the Depression, 1980’s Japan, or today’s US, the financial system no longer functions to make it possible to trade tomorrow’s production for the resources needed today to enable that production. You don’t get these sorts of insights out of the kinds of macro models people have been doing for the last thirty years, and this is why the profession seems so out of touch with reality.
26. August 2010 at 12:50
Scott, that $2000 PC that is now $400, in terms you understand (the continuum) imagine it as a $1600 pay bump for the average American. Said another way, Wal-Mart does more for the poor than the Treasury.
The human experience is not subjective, it is objective – you pride yourself on philosophy – see Rawls. The constant reduction of costs in basic staples, brought about by productivity gains, IS THE ONLY THING that raises up human existence. More to the point, over time it reduces the core cost of the needy.
All growth comes from productivity gains. Period. The capital base for legitimate investment comes from savings alone. Period.
If you can’t grow the economy with savings, its because other risk factors are acting as impediments.
This stuff is not complicated. Printing money destroys savings. PERIOD.
Now then, how would people feel who got a 4% raise? Well the people who work to SAVE, would see through the scam as their savings gets depleted. The ones who are DUMB, would cheer for it, and they might not even realize prices went up 4% and they really got squat.
Capitalism is not a system built for the stupid.
—–
Roman we’re on our way there. Mundell is pushing us to the ideal world as fast as he can – a single global currency without any political unions – forcing ALL governments to rapidly adapt and adopt (see Greece).
Just so I’m clear, when’s there’s only one currency, there’s no macroeconomics right?
26. August 2010 at 13:07
In a strange and unexpected way, all of this makes me wish for the old gold standard to return, because then we could devalue the dollar in a sudden, dramatic, credible, but self-limiting way. Under the floating exchange rate system, it is difficult for large increases in reserves at the 0% bound to change market expectations in a sudden, dramatic, credible, but *self-limiting* way. So our Fed leaders, quite reasonably, wonder whether dropping the interest on reserves to zero will accomplish anything at all, while also, quite reasonably, fearing that dropping the interest on reserves to zero could spark a money velocity feedback loop that destroys the value of the US dollar.
Having never before considered myself a “gold bug”, I now find myself thinking the Fed should adopt a gold price target of $2,500, to provide a sudden, dramatic, credible, but self-limiting devaluation of the US dollar.
Although targeting higher inflation or NGDP should, theoretically, accomplish the same purpose, perhaps via a futures market, such things are not as easily grasped by the money-valuing public herd as an old-fashioned currency-peg devaluation.
Last I checked, the Fed still has the statutory power to buy gold at whatever price it chooses. I think they should choose $2,500. (And, no, I don’t own any gold, other than my wedding ring and other such collectible items.)
26. August 2010 at 13:10
Scott:
They aren’t right with flexible price models. They are right if the Fed has operational rules that say use open market purchases to raise interest rates and open market sales to lower interest rates.
They actually have the opposite operational rule, and perfectly flexible prices have explosive results.
Let’s lower interest rates by lending more money (buying bonds,) and increasing the supply of credit. If real interest don’t fall, do it more. The result is hyperinflation and a crackup boom.
I thought the “debate” was between those who both want to raise the target rate and let the Fed’s balance sheet contract as mortgage backed securities are paid off vs. those that want to keep the balance sheet unchanged by purchasing new securities of some sort to replace the maturing ones and keep the target rate at .25 percent.
Well, that doesn’t fit in the scenario of expanding the Fed’s balance sheet and creating higher expected inflation and raising the target federal funds rate to reflect the higher inflation.
26. August 2010 at 13:21
[…] long run (ht Economist’s view) [Lots of others, WCI *, Money blog, Angry Bear, Paul Krugman, Money Illusion]. This seems a little counter-intuitive, but this doesn’t mean anything is wrong – […]
26. August 2010 at 13:25
Wait, I thought monetarists don’t believe the Keynsian focus on “interest rates -> more investment” as the chief monetary transmission process. I was under the impression that you denied it wholeheartedly.
On the other hand, the purpose of created it inflation expectations is to lower the real interest rate, thereby lowering the cost of capital, thereby spurring investment….
26. August 2010 at 13:28
Wrong answer, my freshman.
The “natural rate of interest” is the interest rate that produces an equilibrium time structure of production that is sustainable over time. This was also the original definition of “neutral money”.
See Mises, Wicksell and Hayek.
These other “answers” are subsidiary issues.
Scott wrote,
“So if there is a “natural rate of interest” it would be the rate where inflation or better yet NGDP is optimal, where the macro economy is in some sort of equilibrium. Where you don’t have mass unemployment, or overemployment, because nominal wages are temporarily stuck at the wrong level. Even if you don’t believe in sticky wages or prices, and simply support steady 2% inflation, there is still a natural rate; it is the rate that generates that target inflation rate. “
26. August 2010 at 13:34
I.e. that coordinates long term and short term production processes in a sustainable fashion.
Scott write,
“Thus the question is never whether low rates unfairly subsidize borrowers, or whether high rates unfairly tax borrowers, because the Fed is not directly fixing interest rates, or driving any sort of tax or subsidy wedge between lenders and borrowers. Rates are set in the market. The question is whether the money supply is set at a level that produces the sort of interest rates, exchange rates, prices, NGDP, etc, that are consistent with optimal macroeconomic performance.”
In other words, you don’t want the money supply and interest rates to distort relative prices in a fashion that creates massive malinvestment and over consumption, e.g. too much long period production and investment in housing, and too much luxury consumption financed via second mortgages on inflated housing prices.
This ain’t rocket science.
26. August 2010 at 13:35
And you wonder why “the student is so far off base”?
It’s all so perfectly obvious…
26. August 2010 at 13:54
As to Kocherlakota and Willliamson:
Karl Smith gives a very nice step-by-step explanation of the effects of a permanent 0.25% Fed Funds rate on the real world, to show that the idea that the Fed could use it to produce permanent deflation as per Kocherlakota is both theoretically correct and “bat sh*t crazy”.
That is, the deflation wouldn’t be from today’s price levels, shall we say — and the Fed as we know it could never survive the process of creating it. Little details of real-world application that Kocherlakota and Williamson don’t mention.
The fact that they don’t, but discuss this idea like it is any kind of real world possibility, indicates some people forget economics is about human behavior, and that mathematical models economics in have value only to the extent that the human behavior they model is plausible.
Teachers and Fed bank presidents who forget this and judge models only by the correctness of their math are a danger to us all.
26. August 2010 at 14:42
Scott,
could you explain to this “college student” how you can justify your statements 2), 3) and 4) (the first order approximation one)?
For example, you state that the Fed does not control the interest rate. Ok, so what will happen with the rates (mortgage, LIBOR etc.) should Fed raise its rate to 2% tomorrow? Will they rise?
Can you really prove that the Fed’s market operations only distort bonds prices “a tiny bit”?
Am I right in thinking that for 4) to be correct the total savings should be close to the total debt? If I am then is it really close?
Thank you.
26. August 2010 at 15:42
Scott,
I wanted to elaborate on my point regarding TIPS spreads and circularity. I don’t think I fully articulated my point but it’s an important point.
If the Fed makes a policy announcement that the market deems deflationary, TIPS spreads will *immediately* shrink. Directionally, the market renders an immediate verdict on the Fed decision as you said.
However, the *magnitude* of the reaction depends on circularity: does the Fed trust the market (they will correct their decision next time) and does the market trust the Fed.
If the Fed renders a “bad” decision, but their is mutual trust between the market and the Fed, TIPS spreads will fall a little and stocks will fall a little, even if the decision is terrible. What is the cost of six weeks?
However, if the Fed renders a “bad” decision and says it is smarter than the market, the TIPS spreads and the stocks will both crash. If the Fed thinks it knows better than the market, the market will price in the full extent of any perceived bad decision immediately. See September/October 2008.
As a current example, I will cite Thomas Hoenig. He hawkishly dissented from rate cuts twice in 2001, in a time period NBER eventually dated as recessionary. He also hawkishly dissented in October 2007, which was two months prior to the official NBER start of the “Great Recession”. Finally he has hawkishly dissented five times this year in a time period where we may again be entering a recession.
In addition to favoring higher interest rates, Hoenig recently expressed that too-big-to-fail is still a problem and moral hazard still exists. Does it? Or does Hoenig simply not believe in market prices because the signals that come from the market are “Wall Street” begging for a bailout… and Hoenig wants to stand tough against what the “Wall Street” market wants?
26. August 2010 at 15:55
Scott,
For a couple weeks now I’ve been trying to wrap my brain around the counter-intuitive (to me) Friedman quote you keep tossing out:
“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”
I believe you and I believe Milton Friedman, but my brain keeps getting bent by (seemingly) contradictory statements like this from paragraph #2:
“So if the Fed wants to reduce rates, it might increase the monetary base…”
or this from your final paragraph:
“But both also strongly imply that the way to get higher rates is through the Fed raising its short term fed funds target. But that requires tighter money…”
In both the excerpts, the correlation between money supply and interest rates is negative, in alignment with conventional wisdom. This is the opposite of the postive correlation asserted by Friedman.
Again, I believe you’re right and expect I’m just missing something, but since you’ve probably forgotten what it’s like to be ignorant on these matters I offer this as an example of why there seems to be so much confusion on this issue among civilians such as myself.
26. August 2010 at 16:00
Scott,
“So can you solve this problem by raising rates? It depends what you mean by raising rates. If you mean setting a higher fed funds rate, and implementing it through a reduction in the base, then the answer is no. If you mean trying to raise rates by printing lots of money and promising to do more in the future, or promising higher future inflation, or promising to steadily devalue the dollar, then the answer is yes…. The problem with recent essays by people like Rajan and Kocherlakota is that they don’t seem to understand this distinction. Or if they do, they express their ideas in a rather garbled fashion. They both think that higher rates might be desirable for various reasons. So far so good. But both also strongly imply that the way to get higher rates is through the Fed raising its short term fed funds target. But that requires tighter money-which would be a disaster right now. I’d also like to see higher rates on long term bonds (I’d love to get back to the 4% rates we saw on the 10 year bond a few months back) but want to get there through easier money. Since the fed funds target can’t be lowered much further, I support unconventional methods of boosting inflation and NGDP growth expectations.”
Although I disagree with much of what you write about the relationship between interest rates and the monetary base, I agree with much of what you’ve written above.
The key characteristic is that you’re making a distinction about interest rate determination along the yield curve. You seem to acknowledge at least implicitly the Fed’s role in interest rate determination at the short end, while recognizing the market’s more comprehensive role further out the curve. If that’s what you’re doing, I agree, although it seems inconsistent with how you write about the role of the monetary base otherwise.
In any case, the way you write about it here on the surface is the only way I can think about the subject being discussed. And it seems to be key to the discussion in general, which I don’t understand otherwise.
26. August 2010 at 16:01
Scott Sumner:
You think Americans have some sort of aversion to 4% pay increases? Would they be happier with 2% raises and 0% inflation.
I think I’m beginning to understand why the blog is called ‘The Money Illusion’.
26. August 2010 at 16:10
@SSumner:
— “The question is not why does Scott Sumner disagree with 90% of the profession, it’s why do Schwartz, Bernanke and Mishkin, et al, no longer believe what they wrote. And why aren’t they admitting that they changed their minds?” —
Exactly. But what is the answer to that question? Or, since we are speculating, what is your answer? I submit that the answer to this particular query is of critical importance.
My wild-guess is that, suddenly, the field is not “Merely Academics”. Scholars get very comfortable making all kinds of speculative claims about unlikely events when the actual object of their study is stable and healthy – and therefore – most ordinary people aren’t paying much attention to academic work. Also, there’s safety in error when speculating about extraordinary conditions where empirical data is limited or unavailable.
When that unlikely event actually arrives, however, everyone suddenly is paying close attention to you and your pontifications – and they will hold you to your word and judge you by the success or failure of your forecasts. There’s no place to hide – because since you’re now *in* the crisis you were formerly only speculating about, and you can actually be proven right or wrong and held accountable. Your status and reputation are now threatened as they never were before.
Something similar would happen in the field of predictive-seismology after a series of minor tremors along the San-Andreas. “Professor Dryasdust, your theory says that the time-sequence of these tremors almost certainly indicates the imminent “Big One” – an event which has not happened for at least 100 years and for which we have no good seismological record. Care to comment? By the way, we’re also asking all your colleagues, especially all the ones that have continued a vicious rivalry with you for decades.”
All of a sudden, Dryasdust isn’t so forthcoming, or so eager to make bold, unhedged assertions, or to challenge a new emerging normative convention judgment (safety in numbers!). That is, unless he’s got an irrepressibly enormous ego and a prime-time CNBC call-in show called “MAD-EARTHQUAKES”.
My point, at any rate, is that there is a rough analogy between the assumptions of conditions that under-gird a healthy infrastructure for the competition in ideas (which, if not a ‘market’ with real money on the line, then a struggle for reputation, status, power, and influence), and the assumptions that make the EMH so powerful in real markets.
The fundamental question is really whether you believe that, on occasion, those assumptions can become invalid, the proper conditions temporarily absent, and some kind of anomaly come to emerge. Maybe a “bubble”.
I know that you and others (Andy Harless?) are skeptical of the bubble narrative, but I think bubbles, herd-reinforcement cycles, over-optimistic manias, unjustified and baseless positive expectations, etc.. are indeed real phenomena – that markets can, on rare occasions, become “distorted from fundamentals” for a long period leading to catastrophic correction. As Keynes said, “Markets can remain irrational a lot longer than you and I can remain solvent.”
One of the conditions that can create a bubble is when almost all participants are operating under a set of erroneous conceptions – wrong ideas – but ones that are nevertheless close approximations that work in most ordinary circumstances. When you change the circumstances – the ideas don’t work anymore and all is thrown into chaos for a time until the dust settles.
Rare events where all the old rules seems to go out the window are ideal occasions for the preponderance of such wrong ideas – before reality intervenes to inevitably “correct” the market. The history of Physics in the 20th century provides some good examples in the “ideas” realm.
Pushing the rough analogy as far as it can go – it seems that, right now, Economics is in an “idea bubble”. I await the eventual correction and your eventual huge payoff. At least, I hope for that.
26. August 2010 at 17:01
Morgan Warstler:
Those gains most naturally manifest themselves as lower consumer prices.
Except that natural monies are themselves produced commodities, which grow along with the rest of the economy. It’s my impression that historically they have usually grown fast enough for the price level to be stable over the long run. In the short run prices may rise or fall.
Between 1897 and 1914, the U.S. had annualized inflation between 2 and 2.5%. (Friedman and Schwartz, A Monetary History of the United States, Princeton University Press, Ninth Paperback Printing, 1993, p. 135) This was largely due to the discovery of the cyanide process in 1887, plus other technical developments and gold discoveries in various parts of the world.
26. August 2010 at 17:20
Brad Delong just gave Dr. Sumner some love in this post.
26. August 2010 at 18:05
Scott Sumner:
I trust you know that there is no such thing as “inflation” . . .
A lot of folks in Zimbabwe will be thrilled to hear this.
26. August 2010 at 18:23
@Greg Ransom
The “natural rate of interest” is the interest rate that produces an equilibrium time structure of production that is sustainable over time. This was also the original definition of “neutral money”.
See Mises, Wicksell and Hayek
I’ve seen Wicksell, and his “natural rate of interest” is the rate that results in no tendency for the price level to rise or fall. Which is to say, if your target inflation rate is zero, it is “the rate that generates that target inflation rate.” But since the inertial inflation rate is arbitrary, it could just as well be the rate generates a 2% inflation rate, if that is the target.
26. August 2010 at 18:37
Scott,
In response to this section of your post: “In a flexible price world Williamson would be correct. If the Fed suddenly increases the fed funds rate by 200 basis points as Rajan suggests, then the money supply growth rate must also increase by 200 basis points. Since the real rate is unaffected (money is neutral) the expected inflation rate also increases by 200 basis points. And that means right away, inflation rises literally overnight.
In the real world prices are sticky.”,
is this akin to saying there’d be no inflation if Say’s Law held for monetary economies?
26. August 2010 at 22:21
“the difference between Krugman and me” not I.
Sorry, but grammar bugs me sometimes.
26. August 2010 at 22:32
David, I appreciate historical references to currency – when the micro-needle gets good enough for tattooing I’m getting a 1913 $50 gold cert done on my back – at 100%, its a felony don’t you know.
But I say this a lot here, but if they were able to pull off 2-2.5% inflation in 1897-1914, TODAY we should be able to run sub-1% – hell I’ll even let the government print money to keep us neutral+population, hows that? I’m nothing if not magnanimous.
Historical references to economics are cool, but really our great grandparents, our grandparents – they were pretty dumb. For christ’s sake they elected FDR. They had an average IQ 20+ pts below ours.
In the modern age, we have no excuse for accepting anything less than real time price discovery. We are NOT dumb people. Even if we have can [rove with fMRIs that the Money Illusion exists, SO WHAT, we can prove with fMRIs people are racists too – it doesn’t excuse bad thinking.
Looking at the arc of technology, it seems virtually impossible that inside of 50 years, currency isn’t a set number digital units uniquely numbered, registered at all times to someone. That tracking the historical trade lifetime – the velocity of every single unit of currency – is incredibly important data to pricing.
I’m just hoping to see a number of global currencies usable locally that relieve people of a bad currency manager’s behavior in my lifetime, such that governments are neutered into efficiency and conservative spending / tax policies.
26. August 2010 at 22:46
Andy, you must have missed the part where Wicksell discusses Bohm-Bawerk’s capital theory and the equilibrium conditions of capital production. What is more, it is well known that there are internal contradictions between Wicksell’s discussion of the equilibrium conditions of capital production and Wicksell’s claims about “the price level”, in relation to money and interest changes. (Hayek and Mises go through all this, if the topic is new to you.)
Here’s a refresher on Wicksell, capital and “the natural rate” from Formaini:
“While working on his grand synthesis .. Wicksell made improvements .. for which he is remembered today. The most important is probably his distinction between the natural and money rates of interest.
The money, or market, rate of interest is the observed rate at which banks carry on credit transactions. The natural rate is a bit more complicated. Wicksell variously defined it as the rate that is neutral for commodity prices and the rate at which the supply and demand for capital are in equilibrium in an economy not using money at all.
The tie-in between Wicksell and the Austrians is straightforward: In the Austrian business cycle theory, a boom emerges when the natural rate of interest is higher than the market rate, which is subject to manipulations by humans using sophisticated financial institutions and credit instruments that drive the market rate below the natural, equilibrium rate.
This is Wicksell’s “cumulative process” model of business cycles. When the loan (market) rate of interest is below the natural rate, the demand for loans by entrepreneurs exceeds the quantity of savings in the economy. Banks expand credit by creating checking accounts (demand deposits) rather than by supplying savings, and an economic expansion occurs that must, other things being equal, drive up prices. Although Wicksell’s process does not demand a monetary change to begin, it is perfectly consistent with a lowering of the market interest rate through central bank monetary injections.
Ludwig von Mises and Hayek took Wicksell’s cumulative cycle process much further.[3] They combined it with the doctrine of forced savings to create a monetary theory of cycles in which the money interest rate divergence from the natural rate, generated by expansionary central bank policy or by an unanticipated inflow of gold specie working its way through the banking system, creates a distortion in the time structure of production between capital goods and consumer goods that cannot be maintained. This results in a necessary economic downturn during which all of the boom’s “malinvestments” have to be liquidated. The Austrians’ extension of Wicksell’s analysis was the major business cycle theory innovation before John Maynard Keynes .. and it remains an alternative money-generated cycle theory today.[4]
Understood within the context of Wicksell’s model, the interest rate divergence phenomenon was crucial for understanding the differences between Wicksell’s treatment of the quantity theory of money and the view held by his main rival, American economist Irving Fisher. For Fisher, changes in the quantity of money fully explained changes in long-run prices; for Wicksell, the quantity of money was but one aspect of the mechanism that changed prices because the flow of goods and services worked its way through the economy by first changing interest rates.”
Andy writes,
“I’ve seen Wicksell, and his “natural rate of interest” is the rate that results in no tendency for the price level to rise or fall. Which is to say, if your target inflation rate is zero, it is “the rate that generates that target inflation rate.””
27. August 2010 at 07:17
Morgan, I’ve said to you elsewhere that 10% inflation is as good as 0% or -10%, in some idealized world. But in the real world I’ll agree that 0% or 2% is better — hell, I’ll give you 0%, let’s not quibble over trivialities. But can you concede that if everybody circa 2008 was counting on 2.5% long-term, and today expecting 1% long-term, there can be real, unpleasant, and most importantly unfair and needless effects on the economy?
The policy you advocate ignores the fact that the Fed explicitly promised to achieve 2% inflation, and everyday people counted on that broken promise.
27. August 2010 at 07:27
Scott:
This is a good post, but it’s less clear than usual. It might be more clear (and controversial!) if you started from this:
The fed doesn’t set interest rates — it increases or decreases the money supply, and one of the many effects is that rates change. There are two ways for the fed to achieve a desired interest rate:
1) increase the money supply
2) decrease the money supply
27. August 2010 at 07:27
Hi Sumner
My impression is that high(er) interest is indeed a must, primarily for 3 reasons:
1) inflation expectation – Bernanke, if anything, has successfully set and committed himself to long-run deflation expectations. The market might expect low rates, but doesn’t mean Bernanke have to honour their expectation. A shock right now would signal a huge change from current operation, even if it means some temporary price deflation, this will be the small price to pay if you insist on raising inflation expectation, along with whatever unconventional method you wish to pursue in expansionary policy. Because upon the working through making easy money available, the earlier high interest rate signal will become credible(it’s the action that reinforce/adds substances to earlier guidance).
2) Expectation anchoring tool – interest rate is the primary anchoring tool for central banks, and as you tirelessly said, something like NGDP target will be better. For me shifting to a new target would be healthy in regauging/resetting both policy and market expectations. Until then, the best way (most familiar) to feed back to the market would be a higher interest rate.
3) Just as in boom times (easy money, high interest rate), malinvestment happens, the same occurs during period of low interest rate. Just look at bonds right now, all the money getting tied up in bonds and not doing anything productive because of deflation/low growth expectation guidance (this is consistent with prior recessions).
Now I don’t favour low interest rate as part of easy money
because within a expansionary policy (easy money), setting a low interest rate is effective counter-productive. Low interest rate transmits low inflation expectations, making the cost of borrowing and sitting very low and therefore not urged to use the borrowing/capital/money productively. They will think “it’s easy to get loan, always there. Doesn’t really cost more if we borrow later. Or because of low inflation expectation, they can afford to sit on cash with little loss in nominal and real terms (price/wage stickiness only plays into this well). To me this is the real liquidity trap that JP stuck in, due to these combination of two factors, and not due to the size or speed as likes the Krugman claimed (Fed has BoJ beaten soundly in both speed and size of QE in same time frame, yet the situation is practically the same). A higher interest rate guids higher inflation expectation, and therefore would make it much more costly to sit or not use money productively (hot money into bonds would fly out as well). The patient is weak because he is trying to recover after an over-hang/collapse, and yet the doctors are prescribing the wrong combination of drugs due to trying too hard. Sometimes it’s best to let the patient rest ad pass out the bad chemical on their own, this is increasingly feel like the preferred option.
tweet.
27. August 2010 at 10:31
So nice to have you back.
27. August 2010 at 12:23
RobF, Scott is probably busy responding to all our comments and Ben Bernanke’s at the same time, so let me try and shed some light:
In simple terms, it’s just about the order things happen in.
Low interest rates generally mean money has previously been tight (and interest rates has been lowered to try and compensate).
A reduction in interest rates causes money to be less tight.
An analogy: high apple prices probably mean there have been too few apples to go around (that’s why prices got high).
But if the supermarket increases the price of apples, it will result in more apples being available to go around (because farmers will produce more, and consumers will buy less).
So do high apple prices correlate with too many apples, or too few? Neither – there is no direct correlation. Instead, there are two separate causal relations: too few apples cause high prices; and high prices cause more apples. This is the nature of an equilibrium system – it self-corrects.
(there could be a debate about whether the Fed is interfering in this self-correction – but in my view it is just like a big apple farmer – or maybe a supplier of fertiliser to apple farms. Therefore, it’s behaving correctly when it increases or decreases production [of money] in response to market prices).
I’m going mad on analogies this week. Maybe it’s time to stop.
27. August 2010 at 13:22
JimP, Thanks, I saw that too.
Lorenzo, Thanks.
Liberal Roman, I have yet to perfect the art of the short blog post.
Jeff, Last year I did a post praising David Laidler, which lamented the lack of economists with a broad knowledge of policy, theory and history.
Morgan, You said;
“Scott, that $2000 PC that is now $400”
Wrong, I can’t buy “that” PC in any store. It doesn’t exist. So what’s the inflation rate of PCs?
You said;
“This stuff is not complicated. Printing money destroys savings. PERIOD.”
The Japanese have printed a ton of money in the past 20 years, and their cost of living keeps going down and down and down.
Doug, I thought about that too, but it wouldn’t work very well today. The devaluation of 1933 was so effective precisely because people expected us to go permanently back on gold at the new rate. Which we did for 35 years.
Nobody would expect the gold price to say up at $2500, it would not be credible. It might help a little, but they’d have to buy a lot of gold, and wouldn’t get much punch. Currency devaluation would work, but it would be really controversial.
more to come. . .
27. August 2010 at 15:53
Bill, You said;
“They aren’t right with flexible price models. They are right if the Fed has operational rules that say use open market purchases to raise interest rates and open market sales to lower interest rates.”
But that can only happen if prices are flexible. With flexible prices an OMP can raise rates via the Fisher effect.
Joe, You said;
“Wait, I thought monetarists don’t believe the Keynesian focus on “interest rates -> more investment” as the chief monetary transmission process. I was under the impression that you denied it wholeheartedly.”
That’s right. I see monetary expansion as raising future expected NGDP, current asset prices, and current output (due to sticky wages.)
Greg, I’ve seen Wicksell, He said it is the rate that stabilizes the price level.
Paul, It’s actually a very intelligent question—but he is far off base.
Jim Glass, Yes, that’s a good post.
Joseph, You asked:
“Ok, so what will happen with the rates (mortgage, LIBOR etc.) should Fed raise its rate to 2% tomorrow? Will they rise?”
Long term rates might rise (liquidity effect) or fall (income and inflation effect) It depends which effect is stronger. Either way the policy is contractionary.
The direct effect of OMOs on bonds is usually tiny, as they buy very few. Obviously to the extent that OMOs affect macro conditions, that can have a huge effect on bond yields and prices. For instance, a policy of hyperinflation would make bonds worthless. But that would be equally true if they bought gold rather than bonds.
You asked:
“Am I right in thinking that for 4) to be correct the total savings should be close to the total debt? If I am then is it really close?”
I’m not sure I follow. Saving is a flow and debt is a stock variable. They are not comparable. Maybe someone else can help here.
Steve, I do understand the circularity issue you raise, and it is a good one. It is true that when the market renders a verdict, the verdict includes any likely make-up calls by the Fed. And the Fed might do that in reaction to a market verdict. Thus the verdict may underestimate the impact of a decision, judged purely on its merits.
I’m not sure I follow the Hoenig question. He is concerned about moral hazard, and so am I. But monetary policy is a horrible way to address the issue.
RobF, This is confusing, I don’t blame you. The problem is that there is actually more than one monetary policy tool. So when I say money has been tight, I don’t mean the Fed has been raising rates, I mean their implicit reaction function (similar to a Taylor Rule), has been too hawkish. Consider the following scenario:
1. When rates should be 3% the Fed sets them at 4%. The economy weakens. Now we need 2% interest rates to get macro equilibrium, but the Fed only cuts them to 3%. The economy weakens more. Now assume we need 1% rates to get macro equilibrium, but the Fed cuts them to 2%. The economy weakens more. Now we need minus 1% rates to get macro equilibrium, but the Fed cuts them to 0% (which is all they can). The economy weakens.
2. At each stage of the process the rate cut was better than leaving the rate unchanged. In that sense it was expansionary on the day it was cut. On the other hand the general overall policy reaction function was too slow, hence policy as a whole has been too contractionary. Notice Friedman said “has been contractionary”—that’s what he is refering too.
Policy has two components. The current setting of the fed funds target, and the reaction function used to adjust rates. The easiest way to see a reaction function is consider an inflation target. A country that targets inflation at 2% will usually have lower interest rates than one targeting inflation at 7%. But even though the 7% country has higher interest rates most of the time, they actually have easier money. This is because their reaction function is based on the 7% inflation target. The BOJ is acting like they want minus 1% inflation. That is tight money despite low interest rates. But in the short run, raising interest rates in Japan would make deflation even worse.
I don’t blame people if they are confused by all this. But I do expect more from a Fed president.
JKH, I’m glad you agree there. Maybe in the future you can point out where I talk in a way inconsistent with that paragraph. It may have been unintentional, or where I wasn’t explaining myself well.
David Tomlin, I hate to say this, but I find a lot of complaints about inflation seem to suffer from money illusion.
Indy, Last year I did a post about Vermeer where I discussed this issue. I think real world negative monetary shocks seem very different from how they look in the textbook. Late 2008 was tight money, but it seemed like a bank crisis was driving the economy into a recession, not tight money. You almost have to be a bit autistic. Every fiber in your body is screaming that money is easy, but if you think about it logically it is really too tight. I think even the best get fooled. (Or else maybe I’m the fool.)
I also pointed out that economists who favored targeting the forecast were much more likely to have my point of view.
David Tomlin#2, That’s right.
more to come . . .
27. August 2010 at 16:22
JTapp, That would be the first time. (The link didn’t work.)
David, Except in Zimbabwe. But even there inflation equals NGDP growth, which is my preferred nominal indicator.
Andy, That’s right.
Mike, No, there’d be inflation, it’s just that real variables would be unaffected.
TimK. Grammar is my weak point. I make lots of errors.
Morgan, You said;
“They had an average IQ 20+ pts below ours.”
The Flynn effect. I have my doubts. They didn’t seem dumber when I read the 1930s NYTs.
Greg, You can have your Wicksell, and I’ll take mine. Do you know that Woodford considers his masterwork “neo-Wicksellian?”
jj, That’s funny, Lorenzo (above) described it as “beautifully clear”.
No, there are more than two ways. They can change the current money supply, but also money demand, future money supply and demand, etc.
tweeting, I think your proposal would cause a depression. Is that your goal?
D Watson, thanks.
Leigh, Thanks. That’s a different example, but a good one.
28. August 2010 at 10:31
Scott,
Thank you for your answers.
2) >> Long term rates might rise (liquidity effect) or fall (income and inflation effect) It depends which effect is stronger. Either way the policy is contractionary.
It is possibly contractionary but that was not the question. I find it very hard to believe that should the Fed raise its rate to 2% the mortgage rates are going to stay at 4.5% but of course there is no way to have a controlled experiment, is there? I can only assume that since the current mortgage rates are called lowest in a long time there must be a link to the Fed rate being at its lowest level as well. Hence I think in reality Fed does have some control (i.e. is able to affect) over some interest rates.
3) >> The direct effect of OMOs on bonds is usually tiny, as they buy very few.
Hmm… I saw the article stating Fed purchased more then 50% of total issuance in Q2/2009. According to Wiki (sorry!) the US govt debt grew by about 3000bill in 2 years and the Fed has expanded its holdings (of this debt) by at least 1250. That is more then 30%, does not seem tiny to me. Are these wrong numbers to look at?
4) >> I’m not sure I follow. Saving is a flow and debt is a stock variable. They are not comparable.
Sorry, of course I am unable to use the correct wording. What I meant by total savings was… well, cash savings, i.e. the money I (and all other people taken together) have in savings accounts, not the monthly/yearly increment. Tried to find a proper definition for it but failed, hope there is one. So what I was trying to say was for the interest rate to be zero sum game the amount of total cash held by the public has to be comparable to the amount of debt of the same public. Does it make any sense?
28. August 2010 at 13:00
The perfectly justified question with contemporary math economists always is: has Woodford actually read any Wicksell?
Krigman admits he can’t bring himself to read any economics written before the 1970s, and we know that graduate students for decades haven’t learned any history of economic thought. The AEA’s Committee on Graduate Education 20 years ago was using the term “Idiot Savant” for the nano-narrow education the “rocket science” math geeks were getting at the top 5 econ graduate schools.
So there can be no presumption that any working macroeconomists has actually read even the work of Keynes, much less that of Wicksell or any of the other great scientists who pioneered the marginalist revolution in money and trade cycle theory.
You yourself have never read Mises or Hayek, which I’m guessing is typical.
Wicksell had no better students developing and criticizing his work than Mises and Hayek, but who in your profession has any working understanding of this scientific literature?
Maybe a handful.
28. August 2010 at 21:32
Formaini and others point out that Wicksell defined “the natural rate” in multiple ways, not simply in the one fashion you remember. Here’s Formaini:
“The natural rate is a bit more complicated. Wicksell variously defined it as the rate that is neutral for commodity prices and the rate at which the supply and demand for capital are in equilibrium in an economy not using money at all.”
Here are some other sources:
http://www.google.com/search?hl=en&client=firefox-a&hs=4ov&rls=org.mozilla%3Aen-US%3Aofficial&q=Wicksell+%22the+natural+rate%22+interest+capital&btnG=Search&aq=f&aqi=&aql=&oq=&gs_rfai=
Here’s an example:
“The standard view of the quantity theory before Wicksell was that increases in the money supply have a direct effect on prices””more money chasing the same amount of goods. Wicksell focused on the indirect effect. In elaborating this effect, Wicksell distinguished between the real rate of return on new capital (Wicksell called this the “natural rate of interest”) and the actual market rate of interest. He argued that if the banks reduced the rate of interest below the real rate of return on capital, the amount of loan capital demanded would increase and the amount of saving supplied would fall. Investment, which equaled saving before the interest rate fell, would exceed saving at the lower rate.”
Wicksell — famously — was not just a price level theorist. What makes him important was that he was not Irving Fisher.
Scott says,
“Greg, I’ve seen Wicksell, He said it is the rate that stabilizes the price level.”
29. August 2010 at 09:35
Joseph, You said;
“I find it very hard to believe that should the Fed raise its rate to 2% the mortgage rates are going to stay at 4.5% but of course there is no way to have a controlled experiment, is there?”
There are controlled experiments, they occur in the bond market reactions to Fed announcements at 2:15 pm. And those experiments show that when the Fed raises short term rates unexpectedly, long term rates (mortgage rates) sometimes fall immediately.
You said;
“I can only assume that since the current mortgage rates are called lowest in a long time there must be a link to the Fed rate being at its lowest level as well. Hence I think in reality Fed does have some control (i.e. is able to affect) over some interest rates.”
This confuses cause and effect. If the Fed raises short term rates to 2%, it will mean lower short term rates 2, 3 and 4 years out. So long rates can easily fall.
3. Regarding debt purchases, you are correct, but in the earlier discussion I was talking about how monetary policy works in normal times, when the Fed only buys a tiny amount of bonds during OMOs.
4. Now I think I understand. You are actually describing the same thing from two different perspectives. All interest-bearing instruments are on assets (what you call saving) to one side, and liabilities (what you call debt) to the other. Thus savings accounts in a bank are a asset to the saver, and a liability to the bank. A rise in rates helps one and hurts the other.
From a country’s perspective it balances out, unless you borrow from overseas. From a world perspective it definitely balances out.
Greg, I agree that modern economists would benefit from reading the classics. I actually have read a bit of Hayek, just not a lot.
Greg#2, Wicksell says saving doesn’t equal investment? How is that possible?
If Wicksell used different definitions of the natural rate, a modern economist is entitled to use the one that they think is best.
29. August 2010 at 15:16
Only if that “modern economists” wishes to gut Wickell.
As Mises and Hayek pointed, out, the most significant fact in Wicksell was that “the price level” wasn’t really a coherent concept from the point of view of marginal valuation theory, and the part of Wicksell which took the logic of marginalist valuation seriously was the part that derived from Bohm-Bawerk on capital and interest.
The key insight was that the capital / natural rate arguments in Wicksell were not logically compatible with “price level” stuff.
One example of the logical inconsistency in Wicksell — with stable money and rising productivity in some sectors, equilibrium demands a _falling_ price level, and changing relative prices among various sectors.
I’ve always wondered why economists weren’t more embarrassed by the use of vulgar “price level” thinking.
Scott writes,
“If Wicksell used different definitions of the natural rate, a modern economist is entitled to use the one that they think is best.”
29. August 2010 at 15:41
The proof is in the pudding.
“Modern economists” — who almost universally work with some sort of “gutted Wicksell” model — have made a wreck of the economy.
And the economist who most prominently and correctly warned your peers of we were heading — William White — used an _actual_ (not a fake) “neo-Wicksellian” model derived directly from an economist working with the “full Wicksell”.
After driving the bus into a brick wall, maybe it’s time “modern economists” reconsidered how that “gutted Wicksell” is working out for them.
And I should think the only folks really entitled to anything at this point are all of the millions of victims of modern “macro”, who are legitimately entitled to withdrawal the title and authority of “respected science” from the “modern economists”.
And I’d suggest the people also entitled to ask all of the “economic scientists” taking their tax money to step back and rethink what they are doing.
Scott writes,
“If Wicksell used different definitions of the natural rate, a modern economist is entitled to use the one that they think is best.”
29. August 2010 at 15:43
Make that:
“.. the economist who most prominently and correctly warned your peers of where we were heading “” William White ..”
30. August 2010 at 07:55
Greg, I agree that the price level is vulgar and that we should use NGDP as our nominal indicator. I believe Hayek agreed.
White appraently favors tighter money, whereas it is tight money that drove our economy into the ditch.
30. August 2010 at 10:51
What believes in the “first, do no harm” principle .. i.e. he believes in doing what is necessary so you are not driving the bus into the brick wall in the first place.
White’s argument is that once the bus has smashed into the brick wall, it’s really far too late for macro economists to be “fixing” things.
This is essentially Hayek’s deep insight.
Get your macro right BEFORE you smash the bus.
After you’ve smashed the bus — and if you are using the same macro that drove the bus into the brick wall — then most likely what you will be doing trying to “fix” things is steering the bus crazily into the NEXT brick wall.
This applies to the Keynesians, and not so much to those who are thinking about what is necessary to have a stable supply of money (sometimes that is what you seem to be arguing, sometimes, not so much .. i.e. sometimes you seem to be selling the pure magic of Keynesian “stimulus” and the pure magic of non-disequalibriting, costless, out-of-nothing, inflation-made economic growth.)
30. August 2010 at 10:52
Make that,
“White believes in the “first, do no harm” principle .. i.e. he believes in doing what is necessary so you are not driving the bus into the brick wall in the first place.”
30. August 2010 at 10:55
As far as I can tell, White believes in non-disequalibrating money — stable money — and I don’t recall seeing any belief in “tight” money. And he disbelieves in magical non-disequalibrating loose money that creates wealth and growth out of nothing.
Scott wrote,
“White appraently favors tighter money, whereas it is tight money that drove our economy into the ditch.”
30. August 2010 at 11:38
Scott,
The main reason why I pay so much attention to 3) is that you seem to base some of your arguments (not just in this post) on the fact that market does not expect inflation or market rate for US govt debt is low. I just think it is difficult to rely on data so mightily affected by Fed’s operations.
1. September 2010 at 10:48
Greg, You make White sound like he has no idea how to run monetary policy. Surely he must have some target, like prices or NGDP? Or does he just think it should be completely random, purposeless.
Joseph, I don’t rely on bond market data; CPI futures data says essentially the same thing.
1. September 2010 at 10:50
Greg, BTW, I support NGDP targeting, just like Hayek