Why I don’t believe in liquidity traps

I’ve been asked to summarize my views on liquidity traps in one place, so brace yourself for a long post.  (Longtime readers will definitely want to skip this one.)

For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero.  There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor.  Indeed I know of no case where a central bank that wished to boost inflation and/or NGDP was unable to do so.  Nor do I think we need ever worry about that scenario actually occurring.

On the other hand, I do think the zero rate bound is a real problem for real world central banks.  Because central banks are used to using short term rates as their primary policy tool, policy may well become sub-optimal once rates hit zero.  But that would not be because an economy is “trapped” at a zero bound, rather it is because central banks are reluctant to aggressively use alternative policy tools, including tools that would be much superior to fed funds targeting even if the economy were not up against the zero bound.

Part 1.  Basic monetary framework

Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism.  The liquidity effect is an epiphenomenon, having little impact on investment.  Woodford argues that what really matters is changes in the expected future path of interest rates.  I agree that policy expectations are a key, but find it more useful to think in terms of changes in the expected path of the supply and demand for base money.  Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase.  This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not expected to be there forever. 

Increases in expected future NGDP (my preferred policy indicator) raise current asset prices (foreign exchange, stocks, commodities, commercial real estate, etc.)  Because wages are sticky in the short run, production of corporate fixed assets, exports, commercial and residential real estate, commodities, etc, increase as their prices increase.  The resulting higher real incomes also boost consumption.  The reverse is true during tight money, as in late 2008.

I don’t like the interest rate transmission mechanism because interest rates often move in the “wrong” direction in response to monetary surprises.  An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm.  The fed funds futures market confirmed that the decrease was smaller than expected.  Keynesian theory says T-bond yields should have risen on the news.  Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply.  (And they were in January 2008.)  The action slowed the economy, but not because interest rates rose.

The powerful monetary stimulus of 1933 (dollar depreciation) had little effect on interest rates or the current money supply, but sharply raised future expected NGDP.  This sharply raised current asset prices, and led to rapid growth in output.

If you buy my argument that changes in expected future NGDP (what Keynes probably meant by “business confidence”) is driving current asset prices and aggregate demand, then the next question is whether monetary policy can influence future expected NGDP at the zero bound.

Part 2.  Unconventional policy tools.

My favorite example of an unconventional policy tool is the 1933 dollar devaluation.  In 1932 the Fed had tried open market purchases to boost the money supply, but the policy failed as fears the US would be forced to devalue led to gold outflows, which negated most of the effect of the asset purchases.  This is the only example of a liquidity trap cited in the General Theory.  Unfortunately, Keynes confused two closely related problems.  A liquidity trap is where an increase in the money supply fails to boost NGDP.  In 1932 the constraints of the international gold standard meant that purchases of assets failed to substantially increase the money supply.  That’s gold standard economics 101, having nothing to do with liquidity traps.  As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.

FDR’s policy of raising the price of gold can be seen in one of two ways.  In one sense it was a devaluation of the dollar in the forex markets, as most countries did not follow his action by raising their purchase price of gold.  But even if the US had been a closed economy the Fed could have depreciated our currency by reducing the weight of gold in one dollar.  In ancient times this was called “debasing coinage” and no one worried about the zero rate bound preventing central banks from inflating.  As far back as 1694 John Locke used a reductio ad absurdum argument to criticize monetary ineffectiveness claims. 

Another approach is to do quantitative easing.  But printing money (even under a fiat money regime) will not be very effective unless the currency injections are expected to be permanent.  Why would people bid up asset prices if the central bank was expected to pull the money out of circulation in the near future?  This is why the QE done in Japan around 2003 did not do much, and it is why Paul Krugman is skeptical about QE.  The other problem is that it is hard to make a credible promise to permanently increase the money supply by X%, because once you exit the zero rate bound the velocity of base money will rise sharply, and unless the base is reduced you will get hyperinflation.  Markets know this, and hence don’t expect QE to be permanent.

The solution is to adopt an explicit nominal target such as the price level, or better yet NGDP, and then do level targeting.  This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP.  For instance, they might want to target 5% NGDP growth.  Even if we are at the zero bound and monetary policy appears to be spinning its wheels, a commitment to higher future NGDP will tend to raise current AD.

The Fed made two mistakes.  First, they did not engage in level targeting.  It has long been understood that once nominal rates hit zero the central bank must adopt a level target.  Indeed Bernanke lectured the Japanese on exactly this point back in 2003.  So in September 2008 the Fed should have switched to level targeting, indicating that they wanted core inflation to grow along a 2% path until we were out of the recession, promising to later make up for any near-term shortfalls.  Instead they allowed core inflation to fall well below 2%, and then (implicitly) indicated that they were going to continue inflation targeting, allowing bygones to be bygones.  There was to be no above 2% inflation to catch up for the shortfall.  This actually made their job much more difficult, as it resulted in a more severe recession than necessary in 2009, and then plunging investment pushed the Wicksellian equilibrium nominal rate below zero.  They could no longer use their traditional policy instrument and they were reluctant to aggressively employ alternative measures, because they didn’t know how strong the effect would be.  For instance, when banks needed more liquidity in late 2008 the Fed neutralized the effects of the large monetary base injections by paying interest on reserves at a rate higher than T-bill yields.  Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1.  And only when the recovery faltered during mid-2010 (as European troubles increased the value of the dollar) was the Fed willing to do QE2. 

The best way to avoid the zero rate bound is to create and subsidize trading in a price level or NGDP futures market, target the futures price, and let the money supply and interest rates respond endogenously.  The Fed should be willing to supply an unlimited amount of reserves in order to keep NGDP futures prices rising along a 5% growth trajectory.   Because there is no zero bound for NGDP futures prices, the Fed will always be able to keep NGDP expectations on target. 

The flaw in the Keynesian model is that it assumes sticky wage and prices, whereas only T-bond prices are flexible.  But there are lots of other asset prices that are also flexible, and that don’t have a zero lower bound.  These include commodities like gold and silver, stocks, and foreign exchange.  Unfortunately, all of those asset prices have drawbacks as targets for a major central bank like the Fed.  And the asset price that would work best (NGDP futures prices) doesn’t yet exist.

[BTW, it's a disgrace that the government has not yet set up and subsidized trading in a NGDP futures market.  Contrary to popular impression the Fed isn't trying to create more inflation; they are trying to create more NGDP.  For any given increase in NGDP, the Fed would actually prefer less inflation and more RGDP growth.  We desperately need a real time measure of market NGDP growth expectations in order to know whether AD is likely to exceed or fall short of the target.]

In this imperfect world the best the Fed can do is to focus on TIPS spreads as a crude measure of expected inflation, and a whole range of indicators for expected RGDP growth, such as the relative prices of stocks and commodities, as well as other indicators or real output trends.  The Fed needs to do enough QE to increase expected NGDP growth (using all these imperfect indicators) up to the desired level.  Since we are below trend, they should probably target slightly above 5% NGDP growth for a few years, then 5% thereafter.

Part 3.  Fallacious arguments in favor of the liquidity trap

There are so many, I hardly know where to begin.  One common argument is that swapping cash for zero interest T-bills is useless, because they are perfect substitutes.  I don’t view them as perfect substitutes at all.  When I get in the car to go shopping at Walmart I don’t think “Hmmm, should I take cash or T-bills.”  At this point people will say “Yes, but zero interest bank reserves and T-bills are near perfect substitutes.  And all the recent base injections are going into excess reserves.”  Yes, but there is no zero lower bound on interest paid on reserves (and yes I’m including vault cash in “reserves.”)

But let’s suppose cash and T-bills were perfect substitutes.  Even in that case a permanent injection of new base money would still be expected to raise the future level of NGDP, as liquidity traps don’t last forever.  (If they did we should legalize counterfeiting.)   Yes, a temporary currency injection wouldn’t do anything, but that’s almost equally true when rates on T-bills are positive.  Temporary currency injections don’t matter, permanent ones do.  It makes little difference whether rates are at zero or not.

The second fallacious argument is that monetary policy was ineffective in the Great Depression.  Actually, when the government got serious about inflating they left the gold standard, and then they had no difficulty in raising prices sharply.

The third fallacious argument is that monetary stimulus would not be effective at the zero bound because central banks are conservative and no one would believe their promises to inflate.  In fact, no one can provide an example of a central bank that tried to inflate but failed because they were stuck in a liquidity trap.  Some cite Japan, but that example doesn’t meet any of the criteria for a liquidity trap:

1.  The Bank of Japan has frequently expressed opposition to a positive inflation target.  Because they are not trying to produce inflation, it’s no surprise they have failed to produce inflation.

2.  It’s true that they pay lip service to avoiding deflation, but every time the inflation rate rises above zero percent they tighten monetary policy and go right back into deflation.

3.  Some point to the large QE the BOJ did around 2003.  But their promise to keep prices stable meant the QE was going to be temporary.  The public knew this and quite rationally refused to bid up prices.  Sure enough, when 1% inflation threatened to rear its ugly head in 2006, they promptly reduced the monetary base by 20%.

4.  They passively sat by and allowed the yen to appreciate strongly, even as deflation was accelerating in recent years.

5.  If it walks like a duck . . .

Some point to the alleged failure of the Fed to inflate, despite trying hard.  Yet a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea.  The Fed had worked so hard to bring inflation down to low levels.  If you heard an answer like that, would you expect the Fed to produce higher inflation?  It’s no surprise inflation expectations have remained low.  Admittedly the Fed doesn’t want deflation either.  My view is that when core inflation falls to about 1%, warning bells go off and the Fed grudgingly does some QE to boost inflation a bit closer to 2%.  If that’s not what they are trying to do, I’d love to know their policy goal. 

There’s another problem with the view that QE is ineffective at the zero bound.  Even if the Fed couldn’t reduce nominal rates, they could always reduce real rates.  Indeed Mishkin’s textbook suggests about 10 different transmission mechanisms other than nominal rates.  Yet liquidity trap proponents ignore them all.  Even worse, when the mechanisms are shown to work they go into denial, asserting that it just can’t be true because their theory says it’s impossible.  So for instance during September and October there were more and more rumors of aggressive QE (and possibly even level targeting) emanating from various Fed officials.  Mishkin’s text says this should boost stock prices, it should depreciate the dollar, it should raise commodity prices, it should raise inflation expectations in the TIPS markets, and it should lower real interest rates.  And all of those things happened.  For years Paul Krugman has been arguing that what the Fed really needed to do was to raise inflation expectation.  Well they did it.  And his response seemed to be incredulity, as if the markets were nuts in thinking QE could actually raise inflation expectations.

Although Krugman and Robert Barro are poles apart ideologically, they both suffer from one weakness–relying too much on what their models tell them.  Both expressed skepticism about whether QE would do very much, because they looked at QE from a mechanistic perspective.  But QE is much more than that;  it is an implicit commitment by the Fed to seek (slightly) higher inflation.  Of course they need to do much more, but they did succeed in terms of their very conservative goals.  They did generate about 0.5% higher inflation expectations over 5 years.  The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP.  In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target.  The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not.  Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to. 

Part 4.  Reductio ad absurdum arguments

I can’t take anyone serious who actually believes in a complete liquidity trap–i.e. that no amount of monetary base injections would be inflationary.  Taken literally, that would imply the Fed could buy up all of Planet Earth without creating any inflation.  Among serious economists the debate is over magnitudes.  The skeptics will say that the amount of QE required would be unacceptable, it would expose the Fed to excessive risks if they later had to resell assets in order to prevent runaway inflation. 

In fact, there are all sorts of reasons why this “risk” argument is bogus.  First of all, the high base demand is itself a product of the Fed’s contractionary policies, which allowed NGDP to fall in 2009 at the sharpest rate since 1938.  That’s why banks hoard reserves.  A much more aggressive monetary policy would mean less real demand for base money.  Second, the demand for base money has been artificially bloated by the IOR policy; the public is not hoarding much cash and they certainly would not do so if the Fed set a much higher inflation or NGDP target path.  Most importantly, any capital losses suffered by the Fed would be tiny compared to the gains the Treasury would get from much faster NGDP growth.  Remember that the big drop in NGDP is the number one reason the deficit ballooned in 2009—more important than even the fiscal stimulus.  Furthermore, many of the Fed’s purchases have been medium term T-notes, for which price risk is not that significant.  If people are actually worried about this issue, the Fed could buy equities and foreign bonds, which would appreciate with an expansionary monetary policy.  But in my view those (controversial) steps would not be necessary, as the risks are greatly overblown.

Maybe I should stop there—I feel like I am beating a dead horse.  Does anyone still believe in liquidity traps?  Is there even anyone still reading this post?


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109 Responses to “Why I don’t believe in liquidity traps”

  1. Gravatar of Bogdan Bogdan
    24. November 2010 at 16:53

    You can be very convincing! :)

  2. Gravatar of Benjamin Cole Benjamin Cole
    24. November 2010 at 17:22

    “Is there even anyone still reading this post?”

    Yes, I am still reading your posts, all of them, each one to the very end.

    Excellent commentary, should be required reading.

    Sarah Palin? I hope this post flies with her, since she, Rush Limbaugh and Glenn Beck seem to have our entire right-wing cowed into abject submission.

    I still wonder if even so prominent an economist as John Taylor is simply playing politics. They want Obama to fail, so they shout down QE.

    If you are wealthy enough, and invested in bonds, maybe you want QE to go away, bringing on a sickly economy and lower interest rates, and then a “right-wing” President in 2012 to cut top tax rates. I guess that is a viable game plan from some perspectives.

    But for people seeking work or invested in real estate, this recession is a killer–and for the nation. The threat of Japan-itis is real.

    Keep blogging Scott Sumner.

  3. Gravatar of scott sumner scott sumner
    24. November 2010 at 17:28

    Bogdan and Benjamin, Thanks for sticking with my blog.

  4. Gravatar of Shane Shane
    24. November 2010 at 17:39

    Of course there are no such things as liquidity traps. But there’s also no such thing as society, or money, or for that matter, Santa Claus–all that matters is that sometimes people act like these thing exist.

    The Fed likes to use marginal incentives to change behavior. But one of the features of our current situation is that people are behaving in all sorts of odd ways that go counter to what marginal incentives would suggest they do.

    One perfect example is government spending. Marginal incentives suggest a massive front-loading of government spending on things that would be bought anyway, or on needed services. And yet there is a huge outcry against this because of a certain style of thinking that says “marginal incentives be damned–I know the government is bad and wasteful and we should thus use this revenue crisis to drown government in the bathtub!” rather than to sensibly borrow on needed things while rates are low. Even if this would have no effect on NGDP because the central bank would counteract it–a doubtful proposition when the Fed is cowering in the corner like a scared child–it is still a sensible idea.

    Marginal incentives also suggest massive borrowing and investment by the private sector. The economy can’t stay bad forever, and so why not risk some potential short term losses in order to ensure long term savings before prices start rising again?

    The problem is that the country does not need changes in marginal incentives. It needs an economic guidance counselor who will boost confidence and convince people that it will all work out in the end if they just have faith. This suggests a curious analogy of the division between head of state and head of government. Bernanke sees himself as monetary head of government, not the monetary head of state, the person who speaks to the nation’s economic soul. Of course, Bernanke could essentially take on this role by announcing some bold action. But then he’d be doing a different job, and on some level he knows it.

    The very essence of libertarian economics, it seems to me, is the notion that we don’t need any kind of economic head of state (as suggested by the title of Tyler Cowen’s blog). I don’t think targeting an NDGP futures market would solve the problem, though, because as the current situation demonstrates, at a certain point the Fed realizes that it is stepping beyond its comfort zone when it just does its normal job.

    People don’t even need to know what NGDP is to fall in line behind Sarah Palin when she starts declaring that it is not the government’s job to be determining how much of it we have. And boom–the Fed starts undershooting that target too.

  5. Gravatar of W. Peden W. Peden
    24. November 2010 at 19:23

    I like this, because it ties together a series of things that I was trying to work out and couldn’t quite piece together. It’s also a useful aide if I need a quick reference for this subject.

    Do you think that, since the argument that “monetary policy can’t do anymore when interest rates hit zero” is so intuitively persuasive right now, it will take a long time (if ever) before liquidity traps cease to have political power? Just because economists almost all agree that something is mistaken, it doesn’t mean that this will tend to translate into policy. Look at rent controls, for example.

  6. Gravatar of Doc Merlin Doc Merlin
    24. November 2010 at 19:43

    I don’t agree that the Fed can always use QE effectively. If people are expecting an increase in inflation, I don’t believe that QE will boost aggregate demand.

  7. Gravatar of PirateRothbard PirateRothbard
    24. November 2010 at 20:09

    Thank you, I like this blog much better than Marginal Revolution.

  8. Gravatar of Joe Joe
    24. November 2010 at 22:06

    Professor Sumner,

    As I’ve gotten deeper in my understanding of money, I’ve realized that the key difference, I think, between Keynesians and Monetarists is the extent to which they believe interest rates represent changes between Ms/Md. Monetarists believe most, not all of course, but most changes in interest rates are due to changes in the credit markets. Asset prices are more important to them.

    Brunner/Meltzer’s alternative to IS/LM is a model of asset equilibrium with interest rates vertically and prices horizontal, with an upward sloping MM curve and downward sloping CM curve. Leland Yeager, my favorite economist (except for you of course….) uses precisely this model in his writings on monetary equilibrium theory.

    Are you familiar with it? Do you use it? What is your opinion of it? Like Keynesians use IS/LM to teach students basics, is this asset model a good pedagogical tool for me when learning monetary stuff?

    Thank you,

    Joe

  9. Gravatar of Joe Joe
    24. November 2010 at 22:19

    Also, I forgot, there’s been some talk about Congressman trying to change the Fed’s duel mandate. They want to change it to only focusing on price stability and inflation. They are all of course conservatives and libertarians, who seemingly always greatly overestimate the welfare losses from inflation.

    I would be interested in hearing your opinion on this.

    Joe

  10. Gravatar of Rod Everson Rod Everson
    24. November 2010 at 22:27

    Frankly, I don’t believe that QE, as I understand it, has any chance of ever working when the fed funds rate is so close to zero.

    Look at it this way. If, in a QE the Fed buys $500bn of T-bills from the banks, then the banks’ balance sheet, instead of carrying a $500bn T-bill asset earning interest, will now carry a $500bn Excess Reserve asset earning the IOER rate. The IOER must be kept at least as high as the T-Bill rate or banks will circulate the Excess Reserves by repurchasing T-Bills in the open market. When both rates approach zero, they’re indifferent to owning either asset.

    The Fed’s balance sheet now shows $500bn in T-Bill assets that are offset by a $500bn liability in the form of Excess Reserve deposits on which the Fed is obligated to pay the IOER rate.

    Virtually the same situation would arise if banks simply sent the $500bn in T-Bills to the Fed for safekeeping. Instead of the current situation where the Fed collects the interest on the T-Bill position and pays a similar interest rate to the banks as IOER, the Fed would collect the interest from the government and forward it to the banks at each maturity date of the T-Bills. Same difference.

    The banks would have the same asset balance and the Fed’s balance sheet would show that they held $500bn T-Bills as an asset and had an equal liability to return the T-Bills to the banks on demand. But how is sending $500bn, or a trillion, or five trillion to the Fed for safekeeping any sort of stimulation to the economy? It isn’t, nor is QE as long as the fed funds rate is zero.

    If QE is supposed to stimulate via a different mechanism, e.g., that people “think” it’s stimulative, well, one or two more failures like the last one should disabuse them of that notion for all time. And frankly, that might be a good thing, progress of a sort.

    That’s how I see it anyway. Ironically, I don’t think liquidity traps are really traps either, unless you don’t know the way out of them. Then they can look very much like a trap and all sorts of weird ways of getting out of them might be tried before the escape path is found.

    Just reverse QE1 to remove the ridiculous level of Excess Reserves now in the system, do away with at least the IOER, if not the entire IOR concept, and manage the funds rate to 2 percent with a couple of appropriate draining operations, keep it there and then any and all excess reserves supplied will again be aggressively circulated.

    And, as long as they’re at it, they might as well clean up the mess created since 1980 and prohibit banks from paying interest on all demand balances (not a tough transition right now, with NOW accounts earning little or nothing); raise the reserve requirement to levels of the 70′s so that a small mistake in funds provision doesn’t become a big mistake in money supply generation; restore the old bi-weekly reserve requirement regimen to make the link between excess reserves and money circulation even tighter; and then sit back and manage the money supply with the iron bar that will have thereby been created, instead of using all these creative, but ineffective tools recently devised.

  11. Gravatar of Niklas Blanchard Niklas Blanchard
    24. November 2010 at 23:28

    I’m convinced that Paul Krugman leads the most extraordinary life ever, brimming with traps and paradoxes.

    It must take everything he has to navigate to his bathroom in the morning.

  12. Gravatar of Lorenzo from Oz Lorenzo from Oz
    25. November 2010 at 00:25

    Shane: rather than to sensibly borrow on needed things while rates are low. Taxpayers see the debt as becoming a burden on them and lack confidence in the federal government’s spending. This does not strike me as irrational: particularly given the government debt travails Europe is going through.

    also suggest massive borrowing and investment by the private sector.What, accumulate even more debt?

    The economy can’t stay bad forever, and so why not risk some potential short term losses in order to ensure long term savings before prices start rising again? Interest rates suggest people lack expectations of rising prices: that is rather the point. As for not staying bad forever, sure. But what sort of risks are people going to take with their money in a situation of considerable uncertainty? Particularly when the lack of expectations of rising prices in the midst of considerable uncertainty suggests hanging on to your money is safe.

    If you want to consider the problems of a “managed” economy, I suggest you read up on Japan’s economic problems. It has had the most “managed” capital market in the Western world. Also the most corrupt and dysfunctional — features which go together. In Europe, the “managers” of European integration decided the euro would be a great idea, they could “manage” it. They “managed it” into Irish insolvency, Greek debt disaster, Spanish mass unemployment …

    Of course, it is easy to me to speak. Australia has one of the lowest rates of public debt in the world and almost every cafe and restaurant in my local suburb (Seddon) has a “waiting staff wanted” ad in the window. On the other hand, we didn’t do it by “managing” the economy except by effective monetary policy, strong prudential regulation of the financial sector and a history of liberalising economic reforms. Indeed, the greatest danger point in the economy is the housing sector, where governments have “managed” land use into ridiculous price levels. (Australia and New Zealand have copied the British model of land use regulation by official discretions: also used by such recent housing success stories as California. I wish we had not done so and instead kept with the German/Texan system of officials not being permitted to “manage” land use.)

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    25. November 2010 at 00:50

    Thanks to you Scott I look for the Liquidity Traps in the aisle containing the Unicorn Steaks.

  14. Gravatar of Shane Shane
    25. November 2010 at 01:05

    @ Lorenzo From Oz

    One of my best friends is from Australia, and the vast majority of his stories consist of anecdotes about manipulating “the dole,” about how they used to be able to scam their way onto it, about how famous actors like Nicole Kidman and Cate Blanchett lived off of the dole while they were making their careers.

    So where exactly is the liberalizing reform? From the perspective of an American, Australia looks like a commie-pinko love fest. And yet, despite this ostensibly “anti-business” climate, the economy prospers–why? Because there is a national consensus that the economy SHOULD prosper, in a way that is lacking in the United States. The American right is so dysfunctional and hypocritical that it will literally sacrifice every principle it once held in order to win a few elections. If the President were Republican, there would be bipartisan support for massive payroll tax holidays, until unemployment diminished. But because one party is rabidly self-interested, they will sacrifice prosperity for their own short term gain.

    I can’t help but notice that Australia has the remnants of a constitutional monarchy. This means that to a certain extent, policy makers have a level of protection provided by the sense that the national spirit is with them–that when they win an election, they don’t just win a 51+% stake in the legislature, but that they have a 100% mandate as provided by the blessing of the head of state, which is necessary to form the government. But in the United States, Presidential legitimacy has declined to the point that this short circuit between the majority and the national will no longer holds. Thus, a marginally more “pro-business” climate here leads to continued stagnation, because a significant percentage of the population has a real stake in a recovery not taking place.

  15. Gravatar of Roger Expat Roger Expat
    25. November 2010 at 01:10

    I need to do more browsing in your archives. I stumbled across your blog and bookmarked it because your arguments seemed to make sense, but since then I haven’t had time to come back often enough. I’m not an economist, and I’ve been trying to catch up for about six months now. I usually believe what is presented as Keynesian theory, but haven’t read his book yet.

    I have a serious problem with one of your statements in this post. Near the beginning you write, “An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm. The fed funds futures market confirmed that the decrease was smaller than expected. Keynesian theory says T-bond yields should have risen on the news. Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply.”

    OK, i haven’t researched the event in 2008, but your statement seems to me to be contradictory. I took Econ 101 back in 1959, probably from Samuelson’s textbook (don’t remember), and my understanding, which I struggled with, is that when bond prices fall their yield rises; when bond prices rise, their yield (interest rate) falls. So if the price on the market was depressed, the yield must have risen. Granted, this was the opposite from what the Fed wanted,and I suppose it is counter to what Keynesian theory would predict — I don’t know (yet) what Keynes had to say about too timid actions.

    I’m surprised I don’t see more discussion of the fascinating chart available from the St. Louis Fed showing the level of excess reserves (EXCRESNS). It shows a constant amount from 195o until the end of September 2008, when it shoots up, almost vertically, to a little over $1 TRILLION dollars. Now as I understand it, that came from QE I, but it also happens to be exactly the time when the Fed started paying interest on excess reserves. Since this is not my field I might be wrong, but my understanding at the time was that the Fed had NEVER paid interest on excess reserves before that. Granted, they are only paying about 25 basis points, but wince they were able to borrow the money at essentially zero interest, they are making a profit.

    I have a lot to learn about MMT, but in the Money and Banking course I took in 1960 I was taught that the money supply is created by THE BANKS, not by the Fed, through the fractional deposit system, so if the banks had been lending that $1 trillion in excess reserves should have increased the money supply by… well, I don’t know the current reserve requirement, but I would guess $8 trillion. Only it didn’t do that. It’s sitting there, like a lox. Now at the time I understood the Fed made the decision to pay this unprecedented bounty to the banks because they were afraid they had injected too much liquidity into the system, they were terrified of the inflationary prospect, and hoped that their interest payments would lead the banks to lend out the money in driblets that would stimulate the economy without shocking it

    So, like you, I don’t expect a lot from QE 2. But I’m a Keynesian — I think what we need large government spending programs based on borrowing. Tax cuts are unproductive because the tax rates are already too low, especially on the top 20% of… I was going to say “earners”, but I think most of them are unproductive rent-seekers.

  16. Gravatar of A. Carraro A. Carraro
    25. November 2010 at 01:37

    I have read this blog with much interest for some time.

    I have a question about the risks of QE. It seems to me that the main objection raised by Barro that capital losses on purchased assets could stop the Fed from draining liquidity is very weak. Even if purchased assets went to zero, couldn’t the Fed always raise reserve requirements? Not an orthodox instrument of monetary policy, but it seems available to me. The Fed has so many tools to control inflation that such risk should not enter in their decison making process.

  17. Gravatar of marcus nunes marcus nunes
    25. November 2010 at 03:11

    Bernanke is “reliving” his famous 2002 speech. From the NYT:
    “Tucked into minutes released this week by the Federal Reserve was a disclosure that came as a surprise to economists and historians alike: on Oct. 15, Fed policy makers discussed whether to set a target for interest rates on certain government bonds”.
    From his 2002 speech about what could be done if FFr fell to zero:
    “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well”.
    According to his metric, the program is not successful because 10 year rates have gone up significantly since Nov 3!

  18. Gravatar of Michael Turner Michael Turner
    25. November 2010 at 03:46

    “For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero.”

    So much the worse for ‘simplicity’, however you define *that*’ term. A liquidity trap is one in which people prefer to hold cash rather than spend or invest it. It can happen in gold-standard economy, in one with a pegged currency, and one without a central bank at all.

    Now: tell us why *that’s* impossible.

    “… a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea.”

    It wasn’t “a few months back.” It was almost a year ago. And Bernanke didn’t say it would be a “horrible idea” (he has been an advocate of a higher inflation target for Japan in the past, after all), but instead … well, fedspeak is inimitable, so go read it for yourself.

    http://blogs.wsj.com/economics/2009/12/17/sen-vitter-presents-end-of-term-exam-for-bernanke/

    Depending on which school of Fedspeak interpretation you went to, you might hear Bernanke saying, “because we’re not quite that desperate — yet.”

    That was then. And since then? QE2. At some point over a year ago, you might have been able to very loosely paraphrase Bernanke as saying that any further QE was a “horrible idea.”

    So what’s the problem here? Obviously: very loose paraphrase, combined with very loose chronology. On top of a “simple” definition of liquidity trap that’s actually too complex by half, and very possibly only begs the question when you work out its implications.

  19. Gravatar of Bill Woolsey Bill Woolsey
    25. November 2010 at 05:12

    “This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP.”

    I think you don’t want _price_ in “higher price level of NGDP.”

  20. Gravatar of Bill Woolsey Bill Woolsey
    25. November 2010 at 05:21

    Your argument about the liquidity trap not being permanent, because we can legalize counterfiting is in error. While I don’t think liquidity traps will be permanent, counterfeiting is equivalent to a tax cut/transfer increase funded by money creation. In practice, Congress gives a tax cut or an increase in transfer payments and the treasury sells T-bills. The Fed buys the T-bills, creating money out of thin air. Whether this will increase money expenditures involves questions of people saving the tax cuts or transfer payments, not the liquidity trap.

    Liquidity trap arguments are about open market operations. The private sector gets more money but has less other assets (as your describe in other parts of your post.) The more money might tend to raise spending, ceteris paribus, but the less other assets decreases spending.

  21. Gravatar of Lucas Lucas
    25. November 2010 at 05:28

    Superbly argued Scott. The logical consistency and empirical validation of your position is convincing.
    It seems to me that mental fixation to policy tools (funds rates), prices (interest rates) and phenomenons (inflation) is clouding the mind of even the most sophisticated economists.
    FDR was right when he said that the only thing we have to fear is fear itself: many economists were in panic mode in 2008 and some of them are still there.
    I have a welfare maximizing policy in mind: swapping central bankers between Argentina and USA. In one stroke, we solve weak NGDP growth in America and excessive NGDP growth here.
    I think we have a comparative advantage in exporting central bankers to deflationary economies ;)

  22. Gravatar of septizoniom septizoniom
    25. November 2010 at 05:31

    i have faithfully been reading your posts for the last two years.
    please outline the main weaknesses in your analysis, or please write a post that explains how/when you would be wrong.

  23. Gravatar of AndyfromTucson AndyfromTucson
    25. November 2010 at 05:31

    I still believe in liquidity traps!

    They way I see it, investment spending is driven by the market’s perceptions of the rate of return from real investment. Or put more simply, people will make capital investments when they think they will make a reasonable profit from the investment. No profit, no investment, regardless of interest rates.

    When aggregate demand is soft and existing capacity is not being fully used, what is expected profit from spending on capital investment? Isn’t it zero? Why would you spend on capital items to increase your production capacity when you are not using all of your existing capacity?

    How would increasing the money supply change the expected profit from investment spending when there is a large amount of unused existing productive capacity? If I have 30% of my factory/floor space/computers/desks/phones/whatever going unused why would I buy more just because some banks and investors somewhere now have a lot of cash on hand instead of bonds because of QE? Regardless of my expectations about future interest rates, future aggregate demand, future inflation, or future whatever, I am simply not going to buy more capital stuff until I am using all of my existing capital stuff.

    Cheap money might, however, convince me to use other people’s money to buy assets on speculation of future price increases, but that is not investment spending (spending to create productive capacity), that is just gambling. If we were having this discussion 10 years ago I might say that QE might have an effect via the gambling route, but with the recent bursting of the housing bubble I just don’t see people buying into speculative bubbles for a few more years.

  24. Gravatar of ssumner ssumner
    25. November 2010 at 07:55

    Shane, You said;

    “I don’t think targeting an NDGP futures market would solve the problem, though, because as the current situation demonstrates, at a certain point the Fed realizes that it is stepping beyond its comfort zone when it just does its normal job.”

    This is exactly why we need NGDP futures, the Fed is too shy to do its job–let the market do it.

    W. Peden. I agree. The idea will probably end in a few more decades when we go to all electronic money. At that point there is no more zero lower bound.

    Doc Merlin, An increase in inflation does mean higher AD, unless it results from a supply shock. But the Fed influences AD, not AS.

    PirateRothbard, Thanks, but I much prefer MR.

    Joe, I’m embarrassed to say that I am not familiar with the MM/CM model. But I agree with their view that asset prices are a key factor–more important than interest rates.

    A single mandate of inflation would be much better than what we have now. If we had a 2% inflation target then no one could deny we needed easier money. But even better would be a single mandate of NGDP growth.

    Rod, You said;

    “Frankly, I don’t believe that QE, as I understand it, has any chance of ever working when the fed funds rate is so close to zero.”

    The goal of QE was to create inflation expectations. We already know it worked–the question is why? As I said in the post I agree that from a mechanistic point of view it doesn’t do anything, but monetary policy can never be analyzed from a mechanistic view, it is ALWAYS about expectations. If during normal times when interest rates are 5% the Fed were to triple the money supply, it might cause hyperinflation, or have no effect at all. It would entirely demand on expectations. If the increase is viewed as permanent, it will be inflationary. If it is expected to be reversed next Tuesday, asset prices won’t change. It’s (almost) all about expectations.

    Niklas, Ironically, if Krugman was Fed chairman there’d be no more liquidity trap. No one would doubt his determination to inflate!

    Lorenzo, I completely agree about fiscal stimulus–and land use as well. Ironic that two countries with near infinite supplies of land per person, have such restrictive zoning.

    Mark, Yes, and it can also be filed under “Great insights from Post-Keynesians.” :)

    Shane; You said;

    “One of my best friends is from Australia, and the vast majority of his stories consist of anecdotes about manipulating “the dole,” about how they used to be able to scam their way onto it, about how famous actors like Nicole Kidman and Cate Blanchett lived off of the dole while they were making their careers.
    So where exactly is the liberalizing reform? From the perspective of an American, Australia looks like a commie-pinko love fest. And yet, despite this ostensibly “anti-business” climate, the economy prospers–why?”

    I love comments like this. Data shows that Australia has some of the lowest taxes of any developed economy, and among the most neoliberal economic policies. And you decide it as commie based on stories you heard about actresses living off the dole.

    Roger, I never said bond prices fell, I said bond yields fell

    And the top 20% in family income are almost all middle class workers–cops, nurses, teachers, that sort of thing. Very few live off investments. You only need a COMBINED income of $100,000 or so, maybe even less. In Boston cops alone earn over $100,000 on average. Nurses in the high 5 figures.

    A Carraro, Yes, I guess the argument is that this would be inefficient. But as I said, the actual capital losses are likely to be small. Indeed the Fed has done very well so far in this crisis, although it would take modest capital losses in a surprisingly vigorous recovery (which I don’t see.) But it has vast assets, and is in no danger.

    Marcus. Exactly. I hate the interest rate approach to monetary policy.

    Michael, You said;

    “So much the worse for ’simplicity’, however you define *that*’ term. A liquidity trap is one in which people prefer to hold cash rather than spend or invest it. It can happen in gold-standard economy, in one with a pegged currency, and one without a central bank at all.”

    And you thought my definition was vague? Which people? Every single person? Or what percentage? And how much cash? Their current holdings? Double current holdings? Triple current holdings? If the term ‘trap’ means anything, it means a central bank is trapped, is unable to stimulate AD. Your definition doesn’t even mention central banks.

    It’s absurd to use the term in a gold standard context; of course central banks are trapped by the gold price peg–that’s the whole idea!

    You said;

    “It wasn’t “a few months back.” It was almost a year ago. And Bernanke didn’t say it would be a “horrible idea” (he has been an advocate of a higher inflation target for Japan in the past, after all), but instead … well, fedspeak is inimitable, so go read it for yourself.

    http://blogs.wsj.com/economics/2009/12/17/sen-vitter-presents-end-of-term-exam-for-bernanke/

    Depending on which school of Fedspeak interpretation you went to, you might hear Bernanke saying, “because we’re not quite that desperate — yet.”

    That’s nitpicking. A few months back or 11 months, what difference does it make? And he didn’t say “yet.” He simply said it was a bad idea, with no implications that he might change his mind. I’ll admit I should have said bad idea, not horrible idea. But in the end it makes no difference.

    You said;

    “That was then. And since then? QE2. At some point over a year ago, you might have been able to very loosely paraphrase Bernanke as saying that any further QE was a “horrible idea.””

    Bad analogy. Last December Bernanke said we need to stick to the target, not go for 3% inflation. The implicit target is around 2%, or a bit less. The recent QE was to boost inflation up from 1% to 2%. It was not in anyway buying into DeLong’s suggestion. Please find a quotation where Bernanke says QE is a bad idea at the zero bound. They did lots of QE in late 2008 and early 2009. This was QE2.

    septizonium.

    1. There aren’t any weakness. :)

    2. Commenters do that already.

    3. Seriously, that is a good idea. I’ll try to do that sometime. But I do think that commenters like Andy Harless are my strongest critics. He makes the arguments I’d make if you put a gun to my head and forced me to defend Keynesian economics. In other respects people like 123 are equally good critics, in this case from a non-Keynesian direction. And there are many others–I won’t try to name them all, as I’d end up slighting certain people accidentally.

    Andy from Tucson, You said;

    “I still believe in liquidity traps!”

    How about the Easter bunny?

    Seriously, I see two counter-arguments to your point.

    If QE raises asset prices, people have more incentive to produce assets, as long as nominal wages are sticky.

    Asset prices reflect expected future demand, and construction projects often have a long duration. If the Fed can raise expected future NGDP, and this boosts current asset prices, then firms may want to make investments even if current sales have not risen. The investments reflect expected future sales.

  25. Gravatar of monximus monximus
    25. November 2010 at 08:13

    Did you catch this article on cnbc Scott?

    Here’s Why the Fed Plan Is Failing: We’re All Austrians Now

    http://www.cnbc.com/id/40340227/Here_s_Why_the_Fed_Plan_Is_Failing_We_re_All_Austrians_Now

    “A conspiracy theorist might point out that this ignorance served the purposes of central bankers very well. It made it possible for central bankers to use interest rates to manipulate the economy. They could lower interest rates and count on businessmen to respond as they expected—by starting and expanding business lines.

    This brings me around to my point today. I think that we may have entered a new era.

    All of which points to me to the possibility that Austrian business cycle theory has gone mainstream. I think it is very likely that businessmen are finally waking up to the dangers of malinvestment”

  26. Gravatar of marcus nunes marcus nunes
    25. November 2010 at 10:28

    DeLong is “shocked”:
    http://www.project-syndicate.org/commentary/delong108/English

    “Today, the flow of economy-wide spending is low. Thus, US Federal Reserve Chairman Ben Bernanke is moving to have the Fed boost that flow by changing the mix of privately held assets as it buys government bonds that pay interest in exchange for cash that does not.

    That is entirely standard. The only slight difference is that the Fed is buying seven-year Treasury notes rather than three-month Treasury bills. It has no choice: the seven-year notes are the shortest-duration Treasury bonds that now pay interest. The Fed cannot reduce short-term interest rates below zero, so it is attempting via this policy of “quantitative easing” to reduce longer-term interest rates”.

    Could have left “reduce long term interest rates” out.

  27. Gravatar of OGT OGT
    25. November 2010 at 10:57

    You know, of course, how controversial FDR’s devaluation was even in the depths of depression era deflation and how long the BOJ has floundered with only intermittent pressure to act. Any economic model that doesn’t for political and sociological forces is, at best, a partial equilibrium model.

    Is there a reductio ad absurdum liquidity trap? No.

    Is there one for the medium term in the confines of central bank policy’s political running track in the US, Europe and the BOJ? I think it’s quite arguably so. The political incentives on the right have already pushed the economists opposed to more easing to the fore, even in the face of a demonstrably inadequate Fed response in QE2. There is very little incentive for the Fed to do more as long as the economy skims along the bottom without crashing, and I suspect the markets will factor this in soon.

  28. Gravatar of Shane Shane
    25. November 2010 at 11:35

    Professor Sumner:

    You nailed me. There are lies, damn lies, and then personal anecdotes. As a sociology major, I should be ashamed. Although as a sociology major, I was already pretty ashamed, to tell the truth.

  29. Gravatar of Cameron Cameron
    25. November 2010 at 12:59

    Interestingly, since QE2 officially started, fed funds futures have predicted a much higher probability of the fed raising rates in 2012.

    Just more evidence that conservatives and liquidity trappers are wrong about monetary policy. The more the fed does now the more quickly it can return to conventional policy.

  30. Gravatar of scott sumner scott sumner
    26. November 2010 at 08:17

    monximus, You can google a money illusion post entitled we’re all Austrians now. I made this argument last year, but I still don’t think the Austrian model explains our current situation. I prefer the AS/AD model.

    marcus, Yes, it is shocking how controversial it is.

    OGT, Models have different purposes. This post is aimed at changing Fed behavior. It is addressed to a specific person who has influence at the Fed.

    There are people at the Fed (Janet Yellon) who don’t believe the Fed can stimulate the economy once rates hit zero. She sees a technical problem. That’s very different from 1933, when people did know how to stimulate, but it was very controversial because of the gold peg. The Fed could have reduced the IOR rate, for instance, a move that would have attracted no attention from Sarah Palin.

    If I was writing a post predicting the effects of zero rates, it would have been very different. Then I’d need the political model you describe. I’d have said that zero rates reflect a market prediction that the central bank will not take the actions required to stimulate demand.

    The BOJ was not under strong political pressure to maintain a deflationary policy. There was no gold standard constraint. If they had refrained from tightening monetary policy in 2000, it would not have been controversial. If they had refrained from tightening monetary policy in 2006 it would not have been controversial. Indeed the Japanese government has been pressuring them to ease policy. The US was not pressuring Japan to revalue the yen a few years ago when it was 115. Now it is 83—so that’s not a problem either. Their problems are definitely self-inflicted.

    Of course if Japanese society really does want deflation, then there is no “trap”, they would be getting what they want.

    Shane, Don’t worry, I sometimes do the same,

    Cameron. That’s very interesting–perhaps worth a post. Do you have a link where I could find the data, including times series data showing how it has changed since August?

  31. Gravatar of Doug Bates Doug Bates
    26. November 2010 at 08:42

    I don’t believe in liquidity traps either. But the people who do are afraid to leave through an open door. In fact, their beliefs may arise directly from their fears — that’s often how psychology works.

    To leave the liquidity trap, the Fed can scrap interest on reserves and make significant open market purchases of *depreciating* assets. People fear this because they fear — not inflation — but being confronted with the potential worthlessness of their dollar-denominated debtpiles of “wealth”. If somebody, Fed or not, can just print money at will, then such an act might create a phase-change in the public’s attitude toward money, and hyperinflation could result.

    Now, you and I know these fears are unlikely to bear fruit. But the insistence that QE is both ineffectual and risky is the result of such fears. Don’t do it, they say, because it is ineffectual. Don’t do it, they say, because it might spark hyperinflation. Of course, it can’t be both ineffectual and cause hyperinflation — and in between these two extremes is where we find the the way forward, out of the trap. The fear of losing wealth is the actual trap, and is the underlying reason for the economy-killing cash hoarding we are hoping to end.

  32. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 09:20

    Doug, you wrote: “Don’t do it (QE), they say, because it is ineffectual. Don’t do it, they say, because it might spark hyperinflation. Of course, it can’t be both ineffectual and cause hyperinflation”

    Perhaps not at the same time, but it’s easy to argue that QE introduces both possibilities over time.

    Today, it’s ineffectual in that it doesn’t seem to be resulting in the circulation of the excess reserves it directly created. (Scott argues that it’s raised inflation expectations; I would argue that the longer it remains ineffectual at the bank level the more those expectations will diminish.)

    But the future is another matter. If and when the economy does start to accelerate, for whatever reason, at some point the funds rate will rise above zero, though that point in time might be pushed back by the huge level of excess reserves. If the Fed, by that time, has decided a high level of excess reserves is no longer something to be concerned about, then rapid money supply creation followed by something approaching a hyperinflation could occur because banks would once again be faced with an opportunity cost of holding the excess reserves. It’s going to be difficult to reduce the level of excess without appearing contractionary, but that’s exactly what the Fed will have to do if and when a recovery gets underway. That should really go over well.

    By the way, all of this casting about by the Fed for solutions to economic stagnation has political implications. The more creative the Fed gets in trying to get the economy going, the more likely it becomes that Congress will shrink the box within which the Fed is allowed to operate. They risk their autonomy with all this creative meddling.

  33. Gravatar of Shane Shane
    26. November 2010 at 10:00

    Thanks for understanding my moment of weakness.

    Anyway, my real concern was NGPD targeting. In a sense, the fed is already bound to target NGDP, because in order to target full employment, it has to target some proxy of national income/spending.

    How would the NGDP futures market fix it? The fed could no doubt conduct policy simply by intervening in this market. But once there was another demand shock, and NGDP futures started undershooting the target, a new version of the “liquidity trap” would appear: NGDP futures prices would be stuck–or a new “bound” would appear, if you will–at whatever level the market thinks the Fed is actually willing to support with unconventional open market operations. Additional interventions into the NGDP market itself would simply be moving money around without changing prices. The fed could buy up all the exiting contracts without changing the price.

    Meanwhile, the Fed and Krugman would say that interventions in the NGDP futures market have lost traction. Of course this is only because they are not willing to raise expectations using alternate means. Conservatives would start pointing to Fed/Fiscal stimulus as creating “uncertainty.”

    You could object that they have a “mandate” to target NGDP. But they have a mandate now to target full employment. What’s the difference?

  34. Gravatar of Doug Bates Doug Bates
    26. November 2010 at 11:57

    Rod, so long as the Fed continues to pay interest on reserves (IOR), it can effectively neutralize all these excess reserves by continuing to pay an above-market rate of interest. The excess reserves are effectively a form of short-term debt. And if the Fed had never paid IOR, then it wouldn’t have needed to create trillions of excess reserves to move the NGDP needle a few inches, a hundred billion of new reserves per year over the next 4 years would’ve been plenty.

    Perhaps a fundamental misunderstanding of the function of IOR feeds people’s fears of eventual hyperinflation (though I think these fears would’ve existed anyway). IOR effectively transforms excess reserves from a component of the monetary base or M0 into a substrate component of M2 — so what looks like a huge increase in the monetary base is actually a relatively small-to-moderate increase in M2. Our cultural labeling and understanding of IOR/QE haven’t yet caught up with the reality, even within the economics profession.

    So, you could view IOR/QE improperly, as a form of monetary base expansion, and then look at the current economic data, and think — this IOR/QE isn’t having any effect. And then worry that, uh oh, this tripling of the monetary base must eventually cause hyperinflation. And then worry that, uh oh, what happens when the Fed unwinds?

    But if you view IOR/QE properly, as a substrate component for M2 — not essentially different from *private* bank lending — then the Fed’s action looks like a prudent backstop to the recent slow growth in private bank credit, and it need *never* be unwound.

    Certainly the Fed will face political risks when it tries something new, but it would face similar political risks if it did nothing but sit inside the presumed liquidity trap and plead ignorance.

  35. Gravatar of Shane Shane
    26. November 2010 at 12:15

    Oops, I just realized what was wrong with that question. Obviously people would enter into NGDP futures contracts with the Fed if they expected it to undershoot target. Duh. I’m really striking out today.

    But it seems to me, and maybe you’ve already addressed this point, that if the Fed pays interest on the deposits needed to enter into a NGDP futures contract, then this would be IOR on steroids. Obviously the Fed would want to move to counteract the losses to the government that this would create–but then again, you’d think that they would want to do that now, as the recession is incredibly costly to the government in the form of future Fed balance sheet losses and lost tax revenue. Plus, couldn’t this create a contractionary spiral as the Fed becomes the ultimate in “dumb money,” producing a kind of mega-bailout that rewards failure to invest in the real economy?

    So isn’t the real problem that those in the Fed have no real reason to act as long as their jobs are linked to political incentives rather than economic incentives? Bernanke’s behavior is logical if you see him as a man trying to please his bosses and his colleagues rather than to fix the economy, and recent history has shown that there is literally no end to the irrational and destructive ideas that his potential future bosses might come up with. The government is already losing trillions, and they are standing around twiddling their thumbs. Would extra losses really do anything?

    I guess what I’m really saying is that if Kocherlakota and other hawks had a significant percentage of their pay determined by their effectiveness in achieving both full employment and price stability, do you think they’d be arguing that buying government debt creates deflation? This could be equally effective and would not expose the Fed to huge losses brought on by institutional paralysis of the type that is already creating huge losses for the government.

    I guess we could also create legislation that says we are really, really, really serious about the Fed actually doing what it is supposed to do. But unless there is some kind of enforcement mechanism, how can you ever ensure the Fed will operate properly? I guess we could always bring a lawsuit against the Fed to get it to do its job.

    Hey, does anyone know if you we could do that now? Anyone know about the prospects for taking legal action against the Fed to get it to comply with its full employment mandate?

  36. Gravatar of OGT OGT
    26. November 2010 at 13:24

    Sumner-My point is that it’s not monetary policy that moves last, as you and Beckworth sometimes write, but politics. This is not say that exploring theoretical options of economic policy is not a valuable exercise, since that may help shape the political expectations as well., and you can only do so much

    In the case of the BOJ, I don’t think they’ve faced pressure to allow deflation. They’ve faced intermittent pressure to ease, but at the zero bound there is also a countervailing pressure against “unorthodox” policy options. So it would seem that even if everyone ‘wants’ 1% inflation there is a political structure that incentivizes timidity and missing the target. And, of course, after twenty years BOJ credibility is such that even more dramatic action may necessary to gain market credibility for rising NGDP.

    It would be interesting to see a post outlining the different structures of the BOJ, ECB, Aussie CB, BOE, and the Fed. How do they understand their mandate, where were nominal rates at the beginning of the crisis, what tools did they use, and so on.

  37. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 14:11

    Doug,

    I agree with your assertion that as long as the IOER is set high enough, the present massive excess reserve position is not necessarily inflationary. It’s not necessarily anything, as the Fed will have lost control of the money supply. We could get deflation, inflation, or, much less likely, steady as she goes.

    I’m not at all sure that the result of all this effort will result in moving “the NGDP needle a few inches” though. Perhaps expected NGDP is higher, but the reality might turn out quite different.

    I also agree that the Fed could choose to “never” remove the excess reserve balances. However, if they do so, my point is that they will then have relinquished the most powerful policy tool in their arsenal, i.e., management of a modest excess reserve position in such a manner as to have an iron grasp on the level of the money supply.

    We will then be condemned to Fed “creativity” forever, or until Congress decides that enough is enough. When dealing with a fractional reserve system, someone has to manage the fraction. The Fed won’t be doing that if they refuse to return to past procedures.

    Oh, and yes, 100bn a year for four years would certainly do it. I’d estimate a 8x to 10x increase in the price level would eventually be the result.

  38. Gravatar of Rod Everson Rod Everson
    26. November 2010 at 14:23

    Shane, you wrote: “Hey, does anyone know if you we could do that now? Anyone know about the prospects for taking legal action against the Fed to get it to comply with its full employment mandate?”

    My guess is that it will be a moot issue in a couple of years anyway. Congressman Ryan will, by then, have succeeded in straightening out the Fed’s mandate by limiting their responsibility to maintaining a steady price level, as it should have been all along, and once was. As I said earlier, all this Fed creativity is going to cause political problems. And Ryan, in a couple of years, is going to have a lot of credibility; he already does.

  39. Gravatar of Doc Merlin Doc Merlin
    26. November 2010 at 15:21

    @Rod Evarson:
    “Congressman Ryan will, by then, have succeeded in straightening out the Fed’s mandate by limiting their responsibility to maintaining a steady price level, as it should have been all along, and once was.”

    Thats a really bad thing. The Fed shouldn’t look at price level, it should look at per capita NGDP. When it looks at price level and tries to maintain it, it will end up compounding a supply side shock with an NGDP shock.

  40. Gravatar of Shane Shane
    26. November 2010 at 18:29

    Bring on the deflation congressman Ryan!

  41. Gravatar of JP Koning JP Koning
    26. November 2010 at 19:36

    Scott, I agree that there is no trap at 0%. I get to that conclusion by a different (and perhaps shorter) route. Say the Fed is buying t-bills maturing in 10 days for $99.999. Instead it starts to buys them for 100.0001. Repeat as desired, and at higher prices. Voila, the 0% bound has been penetrated.

  42. Gravatar of 流動性トラップを信じない理由 by Scott Sumner – 道草 流動性トラップを信じない理由 by Scott Sumner – 道草
    26. November 2010 at 20:21

    [...] Sumner のブログから Why I don’t believe in liquidity traps(November 24th, [...]

  43. Gravatar of Shane Shane
    26. November 2010 at 22:35

    The only test of any targeting regime is what happens during the next demand shock. If we switch to NGDP targeting with the Fed pegging the dollar to a certain NGDP futures price, then there are three options for what will happen:

    1. The Fed will both continue the level targeting peg of the dollar, and it will continue to support that with adequate open market operations.

    2. The Fed will continue the level targeting peg of the dollar, but will not provide adequate open market operations to support that target.

    3. The Fed will not continue level targeting of the peg of the dollar. It will revalue the currency as soon as there is a demand side shock.

    Based on what we know from empirical evidence, why would we possibly think that anything other than option three would occur? And based on empirical evidence, why would we actually think that option one is more likely than option two-it seems that option one is, unfortunately, the least likely.

    In the current system, Fed jobs depend on political incentives. And political incentives suggest that the Fed will always do the safest possible thing, which is to revalue the currency rather than to keep the peg in place and risk undershooting the target at the cost of massive balance sheet losses.

    In other words, we don’t need NGDP futures targeting with guaranteed convertibility of the dollar. We need a Fed that has some skin in the game when it comes to the economy actually performing.

  44. Gravatar of 123 123
    27. November 2010 at 03:08

    Scott, you said:
    “Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase. This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not
    expected to be there forever. ”
    The reason is different. Cash and T-bills can be perfect subsitutes forever (this can happen with IOR and a little bit of financial innovation), but increased expected supply of cash will be inflationary, because zero interest rates are not expected to persist forever.

    You said:
    “Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1.”
    QE1 was a replacement of credit easing. On one hand, an extention of credit easing programs would have provided more stimulus, on the other hand, QE1 was a better option than doing nothing when credit easing expires. The point is that in March 2009 a powerful but expiring program (credit easing) was replaced with a less powerful but more permanent program (QE). The Fed felt the need for non-traditional monetary policy instruments as early as May 2008. In May 2008 Bernanke wanted to
    use non-traditional monetary stimulus to reduce the risk that zero rate bound will be reached – he wanted to make sure that traditional monetary policy is available for finetuning.

    You said:
    “There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor.”
    At a zero rate bound there is a big problem in deciding which assets to purchase when implementing non-traditional monetary policy. Sometimes this problem has a legal character, but more important are problems associated with risk and return characteristics of purchased assets. The result of such problems is suboptimal monetary policy associated with slow recovery. For this reason Bernanke has called for fiscal stimulus so the monetary policy can move to the comfort zone.

    You said:
    “Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism. The liquidity effect is an epiphenomenon, having little impact on investment.”
    Attractiveness of government bonds as an investment at the zero rate bound is a huge problem, and of course it is exploited by the proponents of government spending.

  45. Gravatar of scott sumner scott sumner
    27. November 2010 at 07:04

    Doug, Yes, I agree that many people worry about those two extremes. I’d like to think the Fed knows better–certainly Bernanke does.

    Rod, This begs the question of why the Fed wasn’t more aggressive when the risk of zero rates arose in 2008. Paul Krugman was warning about the possibility long before it actually occurred. The Fed seemed totally clueless about the risk. Even as late as October 2008. Yet, T-bill yields were already near zero.

    Shane, You said;

    “How would the NGDP futures market fix it? The fed could no doubt conduct policy simply by intervening in this market. But once there was another demand shock, and NGDP futures started undershooting the target, a new version of the “liquidity trap” would appear:”

    That can’t happen under NGDP futures targeting, because the Fed pegs the price. No one would ever sell NGDP futures for below the target price, because the Fed is willing to buy unlimited amounts at the target price. So that becomes the market price.

    On your second post, I don’t think Bernanke is trying to please his bosses. First of all he is the boss. Second, if Obama is really the boss then Obama would prefer easier money.

    OGT, You said;

    “In the case of the BOJ, I don’t think they’ve faced pressure to allow deflation. They’ve faced intermittent pressure to ease, but at the zero bound there is also a countervailing pressure against “unorthodox” policy options. So it would seem that even if everyone ‘wants’ 1% inflation there is a political structure that incentivizes timidity and missing the target. And, of course, after twenty years BOJ credibility is such that even more dramatic action may necessary to gain market credibility for rising NGDP.”

    Actually, if the BOJ had done nothing in 2000 and 2006, they probably would have created inflation. Instead they took the action of raising interest rates several times, and they also reduced the monetary base by 20% in 2006.

    BOJ officials are now warning about the renewed inflation threat, even as the rate of deflation has accelerated in recent years. That’s not politics, that’s stupidity.

    Regarding the Fed, I’d say fiscal stimulus is off the table. The Fed is still active, so its the only game in town. This blog is trying to make it more active.

    Rod, A $100b per year injection for 4 years is only about a 10% growth rate in the base. How does that raise the price level 10 fold?

    Ryan has little chance of getting an inflation mandate. The Dems would never allow that. Some Republicans might even oppose it.

    Shane, If Ryan did get his way, the Fed would have to do far more QE to get inflation up to 2%.

    JP Koning. That would simply be a subsidy to the private sector. The rate on cash would stay at 0%, which would be the op. cost of loanable funds.

    Shane, Current events tells us absolutely nothing about what would happen in a future demand shock if the Fed was doing NGDP targeting, level targeting.

    123, I’m not sure what you mean by “a little financial innovation.” If you mean interest on cash, then there is no zero bound in the first place.

    You said;

    “At a zero rate bound there is a big problem in deciding which assets to purchase when implementing non-traditional monetary policy. Sometimes this problem has a legal character, but more important are problems associated with risk and return characteristics of purchased assets. The result of such problems is suboptimal monetary policy associated with slow recovery. For this reason Bernanke has called for fiscal stimulus so the monetary policy can move to the comfort zone.”

    I don’t agree that the problem ever has a legal character. Can you provide an example?

    Regarding “comfort zones” Are you more comfortable with the Fed buying lots of safe 5 year bonds and lowering the IOR, or the fiscal authorities massive bloating our national debt and creating huge future tax liabilities?

    You said;

    “Attractiveness of government bonds as an investment at the zero rate bound is a huge problem, and of course it is exploited by the proponents of government spending.”

    I strongly disagree. I see the problem as attractiveness of cash as an investment at the zero bound. So far not very much cash has been hoarded. So it’s not a huge problem. And there is also the problem of reserves being hoarded because the Fed set the IOR far to high.

  46. Gravatar of Shane Shane
    27. November 2010 at 10:54

    Professor Sumner said “That’s not politics, that’s stupidity.”

    That sentence is increasingly becoming a distinction without a difference, I’m afraid.

  47. Gravatar of Cameron Cameron
    27. November 2010 at 13:39

    For the data search “CME Fed funds” on google. It should be the first result. (I think when I post the link my comments are being marked as spam and not showing up)

    Click on the price chart for any month for time-series data.

    I guess the fact that markets didn’t respond until early November weakens my point.

    The expected fed funds rate in January 2012 fell dramatically from 2% to a little above 0.5% in late August. It then fell to 0.25% in early November but has increased 0.4% since. The market seems to have responded more to the October employment report(released November 5th).

    But if you see the good October report as reflecting optimism as a result of an easier monetary policy, it still kind of works out. But why didn’t expected rates increase until November? Could be monetary policy wasn’t expected to make an impact so quickly…

    I would love to see data on expected fed funds rates during the example you give during late 2007. Did expected future rates fall after the fed only cut a disappointing 25 basis points?

  48. Gravatar of 123 123
    27. November 2010 at 16:45

    Scott, you said:
    “I strongly disagree. I see the problem as attractiveness of cash as an investment at the zero bound. So far not very much cash has been hoarded. So it’s not a huge problem. And there is also the problem of reserves being hoarded because the Fed set the IOR far to high.”
    The root problem is attractiveness of cash as an investment at the zero bound, but it causes many other problems. Government bonds are priced according to EH, and if zero interest rates are expected to persist for three years, hoarding of three year government bonds is a huge problem. I strongly agree with the word “far” in the phrase “the Fed set the IOR far too high.”

    You said:
    ” I’m not sure what you mean by “a little financial innovation.” If you mean interest on cash, then there is no zero bound in the first place.”
    I was more interested in distinction between T-bills and reserves. With IOR and repo transactions the day when T-bills and reserves become perfect substitutes is very close, but of course this is not a problem for monetary policy.

    You said:
    “I don’t agree that the problem ever has a legal character. Can you provide an example?”
    Some experts say QE1 was in a grey legal zone. Lehman bailout would have been a perfect monetary stimulus, but it did not happen because of the legal problems.
    There is another problem related to the risk of central bank assets and threats to central bank independence. Legal frameworks that increase the risk that central bank will lose independence if central bank’s asset portfolio loses value constrain the monetary policy. One example is Bank of England. It has a very thin capital cushion, and the only reason BoE was able to do QE was because BoE was indemnified by the Treasury for potential losses (UK was lucky they had no local Sarah Palin – imagine the potential for outrage).

    “Regarding “comfort zones” Are you more comfortable with the Fed buying lots of safe 5 year bonds and lowering the IOR, or the fiscal authorities massive bloating our national debt and creating huge future tax liabilities?”
    This is a false dichotomy. The first priority is to buy lots of safe 5 year bonds and lower the IOR (this is much less important as zero rate bound is very close). But if you buy lots of 5 year bonds, you encourage fiscal incontinence, so perhaps Bernanke should consider bonds of McDonalds for QE3, as credit risk of McDonalds will be lower that sovereign default risk when the time for QE3 comes. Another problem is that zero IOR and QE2 do not guarantee a speedy recovery (even in the presence of level targeting – it needs to be combined with strong stimulus in order to be 100% credible). I see two possible solutions – one is credit easing, another solution is temporary tax holiday that is offset with a slight tax increase afterwards.

  49. Gravatar of ssumner ssumner
    28. November 2010 at 06:34

    Shane, Good point.

    Cameron, I don’t see where you got the 2.0%. To me it looks like 0.6% in August, then 0.25%, then 0.4%. But perhaps I misread the graph.

    I agree that it would be interesting to see the december 2007 data.

  50. Gravatar of ssumner ssumner
    28. November 2010 at 06:44

    Cameron, I share your puzzlement over the fed funds movements–I don’t follow that market and hence don’t know if I am interpreting the data correctly. The only thing I can imagine is that all the talk about level targeting, although not formally enacted, was seen as a sign the Fed would tolerate a bit more inflation before raising rates.

    123, I agree that the hoarding of cash and T-bonds can be linked.

    On the legal question, there may have been issues regarding QE1, but there were plenty of other perfectly legal ways that the QE could be done.

    I don’t know much about the BOE. Presumably if there are any technical barriers, the government would simply change the rules. I can’t imagine that being a serious constraint. In the Great Depression the government passed a rule allowing the Fed to hold a smaller amount to gold, when gold reserves seemed to be inhibiting their ability to do expansionary policies.

    I’m not sure what you mean by fiscal incontinence. Does that mean it’s easier to run up big deficits? My view is that more monetary stimulus would promote recovery and encourage smaller deficits.

  51. Gravatar of 123 123
    28. November 2010 at 13:17

    Scott, I think legal problems are very important. The Fed could create more monetary stimulus within the legal limits, but I think legal limits prevent the kind of stimulus needed to close NGDP gap within 12 months.

    Often governments relax legal limits needed to provide more monetary stimulus, but sometimes they don’t (Lehman), or sometimes they are too late (Bernanke’s request for IOR in May 2008).

    On one hand QE encourages smaller deficits. On the other hand, QE encourages higher government expenditures. Credit easing encourages smaller deficits without encouraging higher government expenditures.

  52. Gravatar of tomrus tomrus
    28. November 2010 at 18:40

    “Unfortunately, Keynes confused two closely related problems.”
    Poor Maynard. he never did grasp elementary monetary economics.

  53. Gravatar of JTapp JTapp
    28. November 2010 at 18:58

    I thought a statement you made in a previous post put it more simply. Paraphrasing you: “Do you really believe that if the Fed dropped money from the sky that nobody would spend ANY of it?” That’s what liquidity trap proponents have to believe.
    Even using liquidity preference model, the idea that money demand becomes completely elastic is nuts. As Brad Delong recently wrote to someone else, he can hear Milton Friedman chiding him “demand curves are always downward sloping.” And many posters/commenters have pointed out that Keynes never believed the US was in a liquidity trap.

  54. Gravatar of Lucas Lucas
    28. November 2010 at 23:01

    @tomrus,
    “Poor Maynard. he never did grasp elementary monetary economics”
    Did you read Keynes’s Tract on Monetary Reform? You should do so [1]

    1- http://delong.typepad.com/sdj/2007/03/a_review_of_key.html

  55. Gravatar of Pravin Pravin
    29. November 2010 at 06:20

    Can someone explain why the FOMC operations (thru Goldman and friends) are required to boost the NDGP?. Why is it different from asking all bank accounts in the nation to electronically increase by say 10% ?or whatever percent you deem fit.

    I mean to say if the latter is the ultimate aim,why cant we bypass evil wallstreet while being at it.

  56. Gravatar of Bill Woolsey Bill Woolsey
    29. November 2010 at 06:41

    Andy from Tucson:

    When quasi-monetarists say, “the Fed needs to increase the money supply,” you apparently read, “the Fed needs to make it easier for people to get loans at lower interest rates.”

    Then, you argue that the demand for investment is perfectly inelastic with regards to interest rates if they already have excess capacity. Producing more capital goods with excess capacity (over the life of the capital good) means that it generates zero profit. If it generates zero profit, even if interest rates are zero, it will do no good.

    Well, this requires that capital goods never wear out and that the current level of sales later forever. But, even with those assumptions, you are also assuming that interest rates cannot be negative. If interest rates are negative, then you still buy capital goods as long as the expected profit is less negative.

    More fundamentally, the problem is _why_ don’t interest rates turn negative. And the reason is that people will instead “invest” in zero-interest hand-to-hand currency rather than hold securities or capital goods with negative expected yields. And, that is the problem. Too little money.

    Of course, in reality, not all firms have excess capacity. And not all interest rates are at zero. And so, more lending to some people would result in more spending on some capital goods. And those who sell those capital goods now press more tightly against their production constraints, and some of them are not motivated to borrow.

    But, more importantly, the point of quantitative easing is the increase the amount of money in the hands of households and firms, in the hope that some of them will spend the money on consumer goods or capital goods respectively. That means they are lending less (they were lending to the government by holding the bonds, and now rather than lend in some other fashion, they will spend the money.) Of course, if all the firms that are selling the bonds to the government have excess capacity, so profits are zero, then they will hold some other security, and perhaps just currency. But it is still possible that households will spend on consumer goods. And that raises sales of firms, which results in some of them pressing against their capacity contraint.

    Anyway, the “can’t push on a string,” really doesn’t work in the end.

  57. Gravatar of scott sumner scott sumner
    29. November 2010 at 08:25

    123. You said;

    “Scott, I think legal problems are very important. The Fed could create more monetary stimulus within the legal limits, but I think legal limits prevent the kind of stimulus needed to close NGDP gap within 12 months.”

    I don’t think they should do it that fast, but I strongly disagree. Put me in charge of the Fed and I could create hyperinflation within 12 months. No IOR, $10 trillion in OMPs, a 100% inflation target. A promise to leave the new money in circulation forever. Massive purchases of foreign government bonds.

    How do you think commodity/equity/forex markets would react to that? Inflation expectations would soar, and that would boost base velocity.

    JTapp, Money dropped from the sky is fiscal stimulus, so it doesn’t really answer the charge that monetary stimulus alone might be ineffective.

    Lucas, Yes, he was a good monetary economist in 1923, and a bad one in 1933.

    Pravin, Your idea wouldn’t work, because there’d be no way to remove the money when it was no longer needed. Or perhaps I should say it would work too well, creating high inflation.

  58. Gravatar of 123 123
    29. November 2010 at 09:29

    Scott, you said:
    “I don’t think they should do it that fast, but I strongly disagree. Put me in charge of the Fed and I could create hyperinflation within 12 months. No IOR, $10 trillion in OMPs, a 100% inflation target. A promise to leave the new money in circulation forever. Massive purchases of foreign government bonds.”

    I agree that legal problems are not an obstacle for various suboptimal policies such as deflation or hyperinflation. My point was that they constrain optimal policies that result in a defined NGDP path with low deviations.

  59. Gravatar of 123 123
    29. November 2010 at 09:42

    Addendum – my point is that the Fed should try to steer AD along a defined NGDP path even with the current legal base. But with legal improvements it could do it with lower macroeconomic volatility.

  60. Gravatar of scott sumner scott sumner
    30. November 2010 at 06:33

    123, I don’t follow. If the law allows them to produce deflation and hyperinflation, it also allows anything in between. If you target expectations and keep them stable, there is no better macro policy. Stable NGDP growth expectations is the best we can do.

  61. Gravatar of Lorenzo from Oz Lorenzo from Oz
    30. November 2010 at 16:08

    Shane: Scott has already dealt with your ignorance of Australian economic history. I would just add that liberalising reform is a “from where you start” thing. We had a highly regulated and protectionist economy: let me assure you, there has been a lot of economic liberalising.
    I can’t help but notice that Australia has the remnants of a constitutional monarchy. … Another case of not letting facts get in the way of a blind prejudice. Take the UN Human Development Index: 7 of the top 10 countries are constitutional monarchies. (Australia regularly comes in the two three countries.) A few years ago we had a vote on whether to change to a republic: the vote for change lost in every State, largely because the republicans were not good enough democrats and would not have an elected President.

    Australia pioneered adult suffrage, female suffrage, the secret ballot. Our preferential voting system works rather better than “first past the post”. You can only amend the Australian Constitution by referendum (and idea we cheerfully took from the Swiss.) I will stack our democratic credentials against anyone’s. Particularly given we are one of the longest running uninterrupted democracies in the world and the only continent that federated by referendum.

  62. Gravatar of Lorenzo from Oz Lorenzo from Oz
    30. November 2010 at 16:09

    That should say ‘top two or three countries’.

  63. Gravatar of 123 123
    1. December 2010 at 06:55

    Scott, You said:
    “I don’t follow. If the law allows them to produce deflation and hyperinflation, it also allows anything in between. If you target expectations and keep them stable, there is no better macro policy. Stable NGDP growth expectations is the best we can do.”

    The problem is with the “keep them stable” part. After Lehman, the Fed failed with a much simpler task, as markets were expecting higher interest rates than were set by the FOMC. The same problems that have crashed the interest rate expectations peg would have crashed the NGDP expectations peg.

  64. Gravatar of 収入: 無意味でミスリーディングで有害な概念 – 道草 収入: 無意味でミスリーディングで有害な概念 – 道草
    2. December 2010 at 04:35

    [...] 原文はScott Sumner のブログから Income: A meaningless, misleading, and pernicious concept(Sep 21st, [...]

  65. Gravatar of scott sumner scott sumner
    2. December 2010 at 07:58

    123, They weren’t willing to adjust the base to hit the interest rate peg. If they are serious about NGDP targeting then the base becomes endogenous.

  66. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    10. December 2010 at 04:43

    Scott, ultimately they decided to increase the base without any upper limit, and the peg was restored. The problem with increasing the base is deciding what to buy. At some point short term government bonds become a perfect substitutes to the monetary base, and the central bank has to select other public or private sector assets in order to restore the peg. This is where the legal problems become interesting.

  67. Gravatar of ssumner ssumner
    11. December 2010 at 15:25

    123, I don’t see any legal problems buying T-notes.

  68. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. December 2010 at 06:46

    Scott, T-notes are not the complete solution. At some point, QE drives the term risk premium to zero and further QE has no impact.

  69. Gravatar of ssumner ssumner
    12. December 2010 at 10:23

    123, In the real world we do not need to worry about T-note yields falling to zero. Inflation expectations would soar long before that happened. They are already rising.

  70. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. December 2010 at 14:15

    Scott, the worry is not about the T-note yields falling to zero. The worry is about the term risk premium falling to zero. This means investors in T-notes receive no compensation for the uncertainty about the future path of interest rates.

  71. Gravatar of ssumner ssumner
    13. December 2010 at 18:11

    123, I don’t see why that’s a problem, as long as expected future NGDP is rising.

  72. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    14. December 2010 at 04:10

    Scott, when the term risk premium is zero, additional T-note purchases do no good, as T-notes and cash become the perfect substitutes.

  73. Gravatar of ssumner ssumner
    18. December 2010 at 05:38

    123, I don’t agree, as one is useful in small transactions and the other is not. One is the medium of account and the other is not. One had a fixed nominal price and the other does not.

    But even if there were perfect substitutes that doesn’t mean monetary policy is ineffective, unless they were expected to also be perfect substitutes in the future, which seems highly unlikely. Remember monetary policy works through expectations.

  74. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    19. December 2010 at 06:42

    Yes, so they are not expected to be perfect substitutes in the future. But we have to distinguish between two different policy tools:

    1. By extending the period of expected zero interest rates, the Fed can provide more stimulus. The problem with this approach is that it increases current AD by promising to create above-normal AD in the future, so this approach runs into limits in a targeting regime.

    2. By doing QE, the Fed can reduce the term risk compensation the private sector requires for the activity of reflecting expectations about the Fed policy in the bond market. Lower term risk compensation is equal to higher AD, but when term risk premium goes down to zero, further QE does no good.

    So in the presence of zero interest rate bound, the power of monetary policy that is based on risk-free government securities runs into limits both in the expectations channel, and in the term risk premium channel.

  75. Gravatar of ssumner ssumner
    19. December 2010 at 12:22

    123, Neither of your comments addressed my point. You talk about the interest rate chaneel, which I think is totally unimportant, and you talk about the current impact of more QE, which I’ve also argued is unimportant. QE matters because it increases the expected future money supply relative to money demand, which raises NGDP. That’s the future excess cash balance channel. It doesn’t involve interest rates (which aren’t even affected in the long run by monetary policy), and it doesn’t involve any current effect of QE.

  76. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    21. December 2010 at 04:05

    Scott, both of my comments are relevant for the expected future money supply relative to money demand:
    1. Zero interest rates do not constrain AD in 2011, or any given separate time period. But they constrain the time path of AD. When the neutral interest rate is negative, if 5% NGDP growth is expected in 2011, this means that 7% NGDP is expected in 2012, and this is a problem.
    2. QE is just a mechanism that enhances the credibility of Fed’s plans about the future money supply relative to demand. However, the Fed’s plan gets 100% credible long before all the bonds are bought, and additional QE is not effective.

  77. Gravatar of ssumner ssumner
    22. December 2010 at 18:59

    123, I don’t know where the 7% NGDP number comes from, I am calling for 5% growth, level targeting.

    Whether more QE matter depends on how it affects expectations of future policy. And that depends on lots of things, including the signals sent by the Fed.

  78. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    27. December 2010 at 10:06

    Scott, we get the 7% NGDP number in the case where the neutral interest rates are negative. In this case, expected NGDP growth in 2012 is bigger than expected NGDP growth in 2011.

  79. Gravatar of Scott Sumner Scott Sumner
    28. December 2010 at 09:17

    123, I don’t understand your comment; the target growth rates for 2011 and 2012 are two separate issues. It would make more sense to target 7% NGDP growth in 2011 and 5% in 2012.

  80. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    29. December 2010 at 01:27

    The problem is the zero interest rate floor. If the natural nominal interest rate is negative, there will be an incentive to move consumption and investment from 2011 to 2012, and NGDP growth will be expected to be higher in 2012 than in 2011.

  81. Gravatar of Scott Sumner Scott Sumner
    30. December 2010 at 09:16

    Monetary policy determines NGDP growth, not interest rates. You set the base where expected NGDP for 2011 is on target (in the futures markets), and then a year later you set the base where expected 2012 NGDP growth is on target. Interest rates play no role.

  82. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    1. January 2011 at 04:13

    Scott, Happy New Year!

    While interest rates play no role in the monetary policy, the price ceiling created by the zero interest rate constraint sometimes makes monetary policy based on treasury OMOs ineffective. If the natural nominal interest rate is negative, the Fed will buy up all the treasuries available, and NGDP expectations for 2011 will still be below target. For example, NGDP growth expectations for 2011 will be 4%, for 2012 they will be 6%, and expectations will be exactly on target for all the years after 2012.

  83. Gravatar of Scott Sumner Scott Sumner
    1. January 2011 at 13:59

    123, Happy New Year to you as well.

    If NGDP is on target, I seriously doubt that the Fed would have to buy up all the T-bills. The demand for base money is typically quite low when future expected NGDP is on target.

    But if they did, then start in on the much more numerous T-notes.

  84. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    2. January 2011 at 05:17

    Scott, on one hand, it is possible and even very likely, that the natural nominal rate would never reach negative territory in Great Recession if NGDP level targeting regime was operating. On the other hand, we have to be ready for the crisis of 2018, 2028… If the natural nominal rate drops below zero, the Fed could buy all the government debt, and NGDP expectations will still be below target for one year, and above target for the next one.

  85. Gravatar of ssumner ssumner
    4. January 2011 at 10:40

    123, All the government debt in the world? I don’t think that’s likely. But if so, they should start in on AAA debt.

    As a practical matter we have other monetary policy issues that need much more urgent attention–the scenario you discuss is a one in a 100 event, in my view, especially if government debt is defined globally. Even if they aren’t doing NGDP targeting, I’d say it is less than 1 in 10.

  86. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    5. January 2011 at 05:21

    Scott, I was referring to domestic government debt only. When the natural nominal interest rate is negative, of course purchases of other assets are effective.

    My take on the practical relevance of negative nominal natural interest rates is completely different. Let’s take an example where the nominal negative interest rates are expected to persist for one year. Then after the Fed drives down the term risk premium to zero with QE (it happens long before it buys up all the national government debt), all the government debt becomes a perfect substitute for the reserves, and further purchases are not effective. Further purchases are not effective, as both the Fed and the markets expect them to be reversed after one year once the macroeconomic targets have been reached.

    I don’t agree that the Fed should in every case buy foreign government debt before starting domestic AAA bond purchases.

    On September 18, 2008, Krugman noticed that T-bill yields are negative, and said: “Professionally, I’m fascinated. As a citizen, I’m terrified.” Bernanke’s answer was to print $180 dollars by acquiring liabilities of foreign central banks. Now we know that Bernanke got the quantity of dollars wrong, but in my view he picked the right asset to acquire, whereas according to you he should have started purchasing T-bills.

    I think that selection of the assets to acquire should be driven by the risk/return considerations, and this is impossible if some mechanical rule is implemented.

  87. Gravatar of ssumner ssumner
    10. January 2011 at 19:38

    123, I meant they should purchase T-bills if they were targeting NGDP. If they were not targeting anything, and if they were using OMOs to send crude signals about future monetary policy intentions, then foreign bonds might have been better, because it would signal to the markets than the Fed could profit from inflation and currency depreciation.

  88. Gravatar of rob rob
    11. January 2011 at 11:15

    Scott, thanks for the replies, as always. Even though I tend to be wrong about every assertion I make on this site, at least I learn something from your response. I had never heard the “anxiety of influence” theory before, but it does seem compelling, particularly after I made that list of dates. When you mention 1970 as the general end-date for great commercial art, I can’t help but think how that corresponds with the end-date (unless I am wrong, as always) of rapid economic growth in the West. Coincidence?

  89. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    12. January 2011 at 06:57

    Scott, on a panic day like in September 17, 2008, people were buying T-bills as an insurance against Fed’s failure. If Fed buys T-bills, it increases the price of on an insurance against Fed’s failure, and this means that Fed is buying useless insurance, and is sending wrong price signals to the economy. NGDP targeting or not, T-bills are a wrong asset to buy on a days like September 17, 2008.

    BTW, have you noticed that the Treasury has sterilized the QE2?

  90. Gravatar of ssumner ssumner
    12. January 2011 at 14:26

    rob, Don’t put yourself down, your comment today about the 1970s is very astute. In any case, self-criticism already puts you far ahead of other people who spout nonsense but think they are always right.

    123, Yes, I have seen that. But I assumed the Fed was going to buy $600 billion, plus replace another $300 billion. Surely the Treasury won’t sterlize all $900 billion. Or will they? Time will tell.

    In any case, it only matters if the markets think it matters, and so far they don’t seem to.

    Wren’t T-bills already pretty low? I guess I don’t recall, but if they weren’t then we weren’t in a liquidity trap and the Fed could simply do routine fed funds targeting.

  91. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    14. January 2011 at 04:15

    Scott, sterilization is a good thing, as it provides a reduction in the effective IOR.

    On September 17, 2008 T-bills traded at negative yields as they offered protection against the collapse of the fed funds rate market. Any purchases of T-bills by the Fed would be counterproductive.

  92. Gravatar of ssumner ssumner
    14. January 2011 at 18:38

    123, It seems to me that one must separate monetary policy from lender of last resert. It’s a given the Fed should be the lender of last resort if the fed funds market collapses.

    But that shouldn’t interfere with monetary policy.

    BTW, the Fed could offer the public the option of zero rate deposits, which would make negative rates on T-bills impossible.

  93. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    17. January 2011 at 05:41

    Scott, You said:

    “BTW, the Fed could offer the public the option of zero rate deposits, which would make negative rates on T-bills impossible.”

    Bernanke has outsourced this business. He is paying 25bps IOR so the public can have risk free deposits at approximately zero rates.

    You said:
    “It seems to me that one must separate monetary policy from lender of last resert. It’s a given the Fed should be the lender of last resort if the fed funds market collapses.

    But that shouldn’t interfere with monetary policy.”

    The Fed did not do enough LOLR and after Lehman fed funds market was getting worse every day until mid-October. It seems all main central banks agree – floor system is the best when the risk of damage to the fed funds market is high.

    It is not clear what you mean by separation of monetary policy from LOLR activities, as there lots of different options. I like what Swiss National Bank is doing – they are targeting 3 month LIBOR, so the fed funds market cannot collapse by definition.

  94. Gravatar of ssumner ssumner
    18. January 2011 at 15:38

    123, The Fed doesn’t need to do any of those things to prevent the fed funds market from collapsing. LOLR is enough.

  95. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    19. January 2011 at 00:28

    Scott, the question is how much LOLR is enough? There is a trade-off between the extent of LOLR and the risk of fed funds market collapse. This trade-off is different in various institutional arrangements. Swiss and floor systems are two opposites. In the floor system you saturate the system with the LOLR operations, and what you get is the stability of the fed funds rate and smooth functioning of money markets. In the Swiss system the need for LOLR is much lower, as daily interest rates are volatile and absorb various shocks. The benefit is the lower need for LOLR, the second benefit is greater stability of three month interest rates – if the interval between the policy meetings is three months, three month rate may be the one you really need to stabilize.

  96. Gravatar of ssumner ssumner
    20. January 2011 at 14:33

    123, It seems to me you are making a mountain out of a mole hill here. Let’s start with the fact that a failed fed funds market will probably occur about once every 100 years, and that’s if the Fed is incompetent. For that brief period just have the Fed be lender of last resort. Problem solved. I don’t dispute that there are various ways to get at this issue, I just don’t see it’s importance. This problem had nothing to do with what went wrong in 2008, when the problem was the Fed’s refusal to do level targeting.

  97. Gravatar of 123 123
    24. January 2011 at 04:17

    Scott, yes, level targeting is the main solution to the problem of Depressions. But I think the composition of the asset side of Fed’s balance sheet is important, if we want to reduce the size of cyclical volatility, especially if bailouts are prohibited. Before Lehman, the solution was “let’s do a bailout, so we’ll know how much money to print”. After a large financial institution fails, the knowledge problem is much more severe, the market volatility is much larger, the potential for errors is greater (although level targeting will ensure that these errors leave no permanent damage).

    One problem is that easier money and larger LOLR operations are substitutes. Your proposals are silent on this trade-off. I don’t believe that you can hide behind the EMH, as the price of financial assets include a value of insurance against monetary policy errors. If the Fed purchases assets that have such insurance priced in, according to EMH it pays a fair price, but notice that the Fed has purchased a useless insurance – i.e. it has wasted money, it has consumed resources (tail-risk bearing capacity) at the moment when they are very scarce.

    Another problem is that events of September-October 2008 have demonstrated the danger of ad-hoc policy actions. Both the quantity of money and the extent of LORL operations should be based on rules. You say “and that’s if the Fed is incompetent”, but we shouldn’t bet on the competence of FOMC members, rather it is the rules-based policy framework that matters.

    Another problem is that now we know what is a failed fed funds market, and what is not, but if an automated market-based monetary policy is implemented, every day we would get just a quantity of money, and fed funds market indicators would be irrelevant. So we need to say something specific about LOLR if futures targeting is implemented.

    Finally, many central banks have expressed concern about solvency. Recently the ECB has increased the capital base, the Fed has changed the accounting rules. Solvency depends on the asset side of the central bank’s balance sheet, and my concern is that the silence on LOLR and asset side will reduce the influence of quasi-monetarism.

  98. Gravatar of ssumner ssumner
    24. January 2011 at 16:36

    123, You said;

    “Another problem is that events of September-October 2008 have demonstrated the danger of ad-hoc policy actions. Both the quantity of money and the extent of LORL operations should be based on rules. You say “and that’s if the Fed is incompetent”, but we shouldn’t bet on the competence of FOMC members, rather it is the rules-based policy framework that matters”

    Yes, a rules-based approach is exactly what I mean by “competence”.

    I don’t feel that I know enough about why the fed funds market failed to comment on that issue.

    If we had a automatic NGDP futures system, could fiscal authorities handle the LOLR role?

  99. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    29. January 2011 at 13:07

    Scott, commercial bond markets have a high market share in the US, so I think that LORL is never needed if instant reorganizations are available. Bond markets offer a non-discriminatory way out of the liquidity trap.

    The problem with automatic NGDP futures is with knowing which assets to buy. The price of T-bills includes insurance premium against the risk of deflationary failure by the Fed. In times of market stress, the Fed should reduce the price of the insurance against deflationary risks, so purchases of T-bills are a problem. Stocks are too risky, so I don’t agree with Nick Rowe when he says the Fed should buy stocks. Maybe instead of T-bills, the automatic NGDP futures system should buy LQD (an investment grade corporate bond ETF) if we want to avoid discretion.

    If the Fed is allowed to hold Treasuries only, and if LOLR MMLR (market-making of last resort) is the function of the Fed, there are two problems:
    1. If everything is OK, Treasury gets LOLR and MMLR profits, and the Fed gets losses because it bought Treasuries at high prices during the crisis. This could threaten Fed’s independence.
    2. If Treasury does a suboptimal quantity of LOLR and MMLR (see the failure to pass the TARP for the first time), Fed’s policy may lose effectiveness. For example, issuing monetary base with zero yield by purchasing T-bills at negative yields is clearly contractionary if automatic NGDP futures system is operating.

  100. Gravatar of ssumner ssumner
    30. January 2011 at 07:19

    123, Why not have the Fed buy foreign bonds in a crisis like October 2008, when the dollar was very strong? Then the Fed profits as their expansionary policy weakens the dollar.

  101. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    4. February 2011 at 10:52

    Scott, yes, foreign bonds are a good option in such cases. But I think Bernanke’s strategy of lending dollars to foreign central banks was a bit more powerful.

    The problem is discretion. There are times when foreign bonds are a bad investment, so I don’t see how discretion can be avoided.

  102. Gravatar of ssumner ssumner
    5. February 2011 at 09:16

    123, The bottom line is that we’ll never know how important all the issues you raise really are until we target 5% NGDP growth, and then see how unstable the Fed balance sheet is. I suspect it will be very stable, even during baning crises.

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