Brad DeLong strays dangerously close to mentioning M*V
As most of you know, I have become obsessed with NGDP. A number of other bloggers such as Bill Woolsey, David Beckworth and Josh Hendrickson have also emphasized the role of falling NGDP in the current recession. But NGDP is a variable that you don’t see liberals discuss very often. David had a famous post last year that showed just how sharply NGDP had fallen below trend since mid-2008. Paul Krugman agreed that the graph was suggestive, but warned that talking about NGDP could lead people to consider some dangerous ideas, such as the quantity equation of exchange:
Here’s my problem. Underlying the focus on nominal demand or GDP is some notion that there’s a quantity equation:
MV = PY
where M is the money supply, V the velocity of money, P the price level, Y real GDP. And of course this always holds true, by definition. But the temptation is to take it as a causal relationship “” to say that real GDP fell because nominal GDP fell, and that this in turn was caused by either a fall in M or a fall in V; and furthermore that any such decline is a failure of monetary policy, because the central bank should have either prevented the fall in M or increased M enough to offset the fall in V.
Thus I was surprised to see not one but two liberal bloggers (Brad DeLong and Matt Yglesias) give big play to the same sort of graph that Beckworth and Woolsey often display on their blogs. Let’s hope Brad can avoid the temptation to start talking about M and V.
PS. Just so I am not misunderstood, there is no “point” to this post. I agree with the two posts, and don’t have any objections to anything they said. I’m glad to see more people paying attention to NGDP. If it becomes a more widely discussed variable then severe nominal shocks such as 2008-09 will be easier for people to identify. Right now these shocks are obscured by the focus on (flawed) inflation estimates. As I pointed out in my previous post, inflation is a variable that central banks hide behind when it suits their purposes. Yglesias also has a recent post on the ECB, which is presiding over an even more dreadful collapse in NGDP.
Tags: Equation of exchange
7. April 2010 at 20:01
Scott,
You wrote:
“Yglesias also has a recent post on the ECB, which is presiding over an even more dreadful collapse in NGDP.”
For the eurozone the decline in nominal GDP last year was 3.0% which is of course worse than the US (1.3%). However the eurozone was about 8% below NGDP trend last year, the same as the US.
Where the EU and the US differ is in the variability in the severity of the recession. To my knowledge no individual state has seen nominal GDP decline much more than a couple percent or so more than the US average. However there are individual countries in the EU that are suffering declines that are a magnitude greater than the EU average.
For example the EU as a whole has fallen about 10% below real GDP growth trend. However the countries most seriously affected are Ireland, Estonia, Latvia and Lithuania which are forecast to be about 27%, 33%, 40% and 33% below trend respectively in 2010.
7. April 2010 at 22:01
Brad DeLong talks about MV a lot. Whenever the subject of Say’s Law comes up, for example, I think he often talks about MV. Here’s one example: http://delong.typepad.com/sdj/2009/01/time-to-bang-my-head-against-the-wall-some-more-pre-elementary-monetary-economics-department.html?cid=6a00e551f080038834010536effaaa970b#comment-6a00e551f080038834010536effaaa970b
Sometimes, I even think he’s more monetarist than Keynesian.
8. April 2010 at 04:26
Mark, That’s a good point, but those are annual averages. The 4th quarter of 2009 was far worse in Europe than America. How do the numbers compare in a 2008:Q2 to 2009:Q4 comparison?
That’s also a good point about variability. I am surprised by the Irish figures. I wonder how sensitive they are to trend estimates. What’s the peak to trough drop in Ireland?
Nick, Yes, I have read posts where DeLong mentions MV, but only to criticize the monetarist assumption that V is stable. (Of course he’s right, V isn’t always stable.) Given that he had many posts last year saying that monetary policy is ineffective once rates hit zero, I wouldn’t consider him to be all that monetarist. Even new Keynesians are more optimistic about monetary policy at zero rates than DeLong was last year.
Of course my post was a sort of lame joke. I suppose I was implying “Don’t expect Krugman to criticize DeLong in the way he criticized Beckworth.” The serious point, if there was one, was that it is genuinely good news that NGDP is getting more attention.
8. April 2010 at 05:00
Scott,
In the eurozone-16 and the US NGDP dropped 3.1% and 0.3% respectively between Q2 2008 and Q4 2009. Differences in trend would account for half of that difference. So there’s a small but nevertheless significant difference in the decline in the rate of NGDP growth, as you expected.
Irish NGDP peaked in 4Q 2007. The absolute drop between then and 4Q 2009 has been 16.3% (so far). Yes, Irish GDP is something of a mystery as unlike the Baltic States it is actually on the euro. I think the conventional explanation is excessive growth in two sectors and not just one: housing and financial. But then why wouldn’t we see a similar phenomenon somewhere in the US?
P.S. This might be easier to settle when the BEA comes out with the official Gross State Products for 2009.
8. April 2010 at 05:41
Mark, You said:
“So there’s a small but nevertheless significant difference in the decline in the rate of NGDP growth, as you expected.”
Good. That’s exactly how I would have characterized it. A 1% or 2% differential in GDP growth isn’t huge, but because GDP is the entire economy, 1% or 2% is more significant than it would be in a single sector like housing or autos.
The Irish decline shocks me. But I would add that the Baltic states are fixed to the Euro, so I’m not sure whether Ireland actually being on the euro is that different from the monetary situation in the Baltic states.
Yes, the states will be interesting. I wonder whether the biggest drop will be in a subprime area like Nevada, or a manufacturing area like Michigan.
8. April 2010 at 07:30
[…] think this goes back to what Scott Sumner keeps saying about Nominal GDP expectations. Probably nobody sits around thinking about their expectations about nominal GDP. But the fact of […]
8. April 2010 at 09:55
Scott,
You wrote:
“But I would add that the Baltic states are fixed to the Euro, so I’m not sure whether Ireland actually being on the euro is that different from the monetary situation in the Baltic states.”
My impression is that there should be a difference. With small nations pegged to a large currency area and large current account deficits there should be an increase in exchange rate uncertainty with a collapse in regional AD, and consequently a large capital outflow. So what’s happening to the Baltic States (and to a lesser extent, Bulgaria) makes sense to me. What’s happening in Ireland, despite the fact it had a large current account deficit going into this crisis, seems somewhat bizarre to me since there is essentially no exchange rate uncertainty, and so it must be the perfect storm of many factors.
9. April 2010 at 04:04
Dear Scott,
I was wondering about Japan and the “lost decade”. Why didn’t they come out of the crisis much earlier? Couldn’t you explain this in a post?
My question in particular is this: if the BOJ has some target of 0% inflation and say, 2% real growth, i.e. 2% NGDP growth, then the market could adopt to that and if the BOJ would ensure NGDP growing at 2% (did they?) then it shouldn’t be a problem to have a low inflation, or inflation of zero. If they did that, why didn’t it work?
I am just trying to bring your ideas and Japan together, but you are better at that.
Thanks,
S
9. April 2010 at 06:44
Mark, That’s a very good point. But I would add that although Ireland doesn’t have exchange rate uncertainty, there was uncertainy about its banking system and also its fiscal stability. So single currencies don’t remove all forms of risk.
Steve, NGDP has been fairly stable in Japan, with perhaps a tiny upward bias. The GDP deflator has fallen at about 1% a year for 16 years. I presume this is what the BOJ wants to happen. If they don’t, then they should not have let the yen appreciate. The BOJ has no long run impact on RGDP growth, so I presume the low trend in Japan is due to zero population growth and inefficient regulations that hamper the domestic sectors of the economy. (Their strength is obviously exports.)
9. April 2010 at 07:49
So what did the BOJ then do wrong?! Not stabilize NGDP growth at the beginning?
And the present low growth is unrelated to the policy of the BOJ?
9. April 2010 at 09:18
@Steve
I think Japan is a problem in demographics.
Birth rate – death rate – rate of increases in life expectancy in retired age cohorts is far too small.
10. April 2010 at 06:01
Steve, They let NGDP growth fall sharply, from the 5%-10% range of the 1980s to near zero after 1994. This greatly worsened their financial crisis, increased the budget deficit, and also created a recession, since wages are sticky. Indeed they made the same mistake that we just made.
But I want to be clear that BOJ policy is not Japan’s only problem, and doesn’t explain the low trend rate of RGDP grwoth.
Doc, That’s part of it.
11. April 2010 at 05:28
Here DeLong avoids talking about M and V and moves to fiscal theory of price level instead:
http://delong.typepad.com/sdj/2010/04/liveblogging-the-berkeley-finance-seminar-john-cochrane-2010-understanding-policy-in-the-great-recession-some-unpleasan.html
11. April 2010 at 08:54
Thanks 123, I’m not a fan of the fiscal theory of the price level. Cochrane views cash and government debt as close substitutes. I don’t agree. I don’t consider T-bills as something I’d want to put in my wallet when I go shopping. Banks might, but then just charge negative rates on reserves.
I think this also ignores the distinction between price level and inflation rate targeting. If you price level target you can always reduce real interest rates even if nominal rates are zero. Another option is to depreciate the currency in foreign exchange markets, or commodity markets. There are plenty of ways of creating inflation if you are determined to do so. And if you are determined to do so then you don’t get in liquidity traps in the first place. Liquidity traps don’t just happen, they reflect really tight money.
12. April 2010 at 06:04
I certainly agree that there are plenty of ways to create inflation at any point in time, and I think Cochrane’s description of Japan’s price level as being fiscally determined is false. But no matter what model of price level you are using, you always have to look to what extent government debt is used as money and quasi-reserves by money market funds, shadow banks and large corporations. Money market funds that were backed by private sector liabilities experienced strong outflows, whereas money market funds that were backed by treasuries attracted new funds after September 15, 2008. Gary Gorton’s repo story is very important for understanding how broad money that was backed by mortgage securities started evaporating. So Cohrane is right in saying that on September 15 2008 people started running away from private sector liabilities and they started hoarding both money and government debt.
When both reserves and treasuries are hoarded, the main result of negative rates on reserves is the shift of activity from banks to treasury – backed money market funds. Total hoarding barely changes. That’s why I have to agree with Cochrane when he says this:
“As the Fed accommodated desires for M vs. B, I think we can understand a lot of the government’s policy response as accommodation for “more of both.” Many of the Fed’s new facilities basically took in private debt and gave out treasury bills. Debt guarantees effectively transform private debt to government debt. And of course, the government increased the supply of both M and B dramatically.
How do these actions raise aggregate demand?…”
You said:
“I don’t consider T-bills as something I’d want to put in my wallet when I go shopping. ”
In the thirties people didn’t consider gold bars as something they’d want to put in their wallets when shopping, but when they started hoarding gold bars, there was a problem.
13. April 2010 at 05:48
123, Cochrane doesn’t seem to realize that tight money causes deflationary expectations and deflationary expectations cause an increased demand for M and B.
We both agree that deflationary expectations cause an increase in the demand for M and B, but he thinks those expectations just happen, or happen because of a financial crisis. In contrast I believe the cause was the Fed’s failure to target NGDP growth at about 5%, level targeting, as they had done for several decades. So the Fed could have prevented this from happeneing, even w/o fiscal support.
As long as NGDP growth is on target (level targeting) nominal interest rates will be well above zero, and banks won’t be hoarding ERs unless the Fed pays them to hoard ERs.
14. April 2010 at 04:59
Losses at overleveraged financial institutions was the initial cause of the financial crisis. Financial panic has pushed the natural rate down and also has increased the volatility of the natural rate. Banks started hoarding M+B because they have undercapitalized balance sheets, not because of IOR subsidy. The only way Fed could have kept NGDP expectations at 5% was massive expansion of M+B. They did it to some extent (they have guaranteed money market mutual funds, they have expanded the monetary base), but a much larger expansion of M+B was needed.
14. April 2010 at 05:38
123, You said;
“The only way Fed could have kept NGDP expectations at 5% was massive expansion of M+B.”
I don’t agree. There is a much easier way of doing this, which doesn’t require a big increase in the MB. Set a 5% NGDP target path, level targeting. This would increase the demand for credit, and move interest rates above the zero lower bound. Once interest rates are positive then banks don’t want to hoard ERs, they hold T-bills instead.
But if they had to increase the base sharply, then so be it. There’s plenty of government debt out there to buy.
15. April 2010 at 03:27
Even with NGDP level targeting interest rate policy is a poor tool during the financial panic, as Libor-OIS spread has reached 350 bps in October 2010.
Scott, You said:
“But if they had to increase the base sharply, then so be it. There’s plenty of government debt out there to buy.”
Fortunately Bernanke thought the situation was more dangerous and he extended credit to private sector instead of buying government debt in late 2008.
15. April 2010 at 04:46
123, I agree, and indeed think the interest rate is always a poor tool, not just during crises.
16. April 2010 at 02:28
Fed understood that interest rate is a poor tool especially during crisis, so they started IOR program. IOR is an instrument that lets you to switch from a poor system of interest rate policy to a mix of interest rate and quantity of monetary base policy.
16. April 2010 at 05:04
123, Agreed, but the rate should have been negative.
16. April 2010 at 12:15
Why lower rate is better than larger monetary base?
28. April 2010 at 13:52
123, Sorry for the long delay. How about “more bang for the buck.” I’m not against a bigger base. It just seems silly to keep pumping up the base when it all goes into ERs. But with a robust NGDP target there would be more credit demand, and less ERs. So OMOs might work if combined with a NGDP target.
1. May 2010 at 03:35
Welcome back.
You said:
“It just seems silly to keep pumping up the base when it all goes into ERs.”
But the actions on the asset side of Fed’s balance sheet have softened the crisis. Without all extra reserves, there would be even less credit demand. A counterfactual -5% IOR and fixed size of Fed’s balance sheet would be much more contractionary – it’s hard to stop a financial panic by taxing hoarders, it’s much easier to do this by a direct intervention to a risky asset markets. I’d say the main mistake was underestimating the size of the needed expansion of the Fed’s balance sheet, Donald Kohn has said:
“However, the economic effects of purchasing large volumes of longer-term assets, and the accompanying expansion of the reserve base in the banking system, are much less well understood. So my second homework assignment for monetary policymakers and other interested economists is to study the effects of such balance sheet expansion; better understanding will help our successors if, unfortunately, they should find themselves in a similar position, and it will help us as we unwind the unusual actions we took.”
(more here: http://themoneydemand.blogspot.com/2010/03/really-great-links-textbook-models-and.html)
While you were on a holiday, I have found a blog with a good discussion of fed funds rate vs. IOR, and of T bills vs. reserves:
” As I discussed in an earlier post, as long as there are positive excess reserves in the banking system overnight, the relevant policy rate is the interest rate on reserves (IROR). Due to the fact that some important players in the system do not receive interest on reserves (principally Fannie and Freddie), and some lack of ability to arbitrage, fed funds currently trade at 10 or 12 basis points below IROR. There appears to be no reason to believe that this gap will not persist as IROR rises, and it should get smaller, as reserves will tend to shift to the banks that earn interest on reserves as IROR gets larger.
Now, inflation is not hard to control, even with a huge quantity of reserves in the system. As returns on other assets increase as we pull out of the recession, banks’ willingness to hold reserves will lessen. Given the quantity of assets on the Fed’s balance sheet, if IROR remains fixed at 0.25%, the quantity of reserves will fall, the quantity of currency will rise, and so will the price level. To prevent inflation from happening, the Fed will have to increase IROR, which will increase interest rates on all short maturity liquid assets.
Given that a positive quantity of excess reserves are held overnight, and fixing IROR, what would be the effect of an open market sale of assets (treasuries or mortgage backed securities – MBS) by the Fed? Given the current level of reserves, very little. Since the marginal liquidity value of reserves is essentially nil (the system is awash with the stuff) in daylight transactions, reserves are no better than T-bills, and arguably worse, since T-bills are useful both inside and outside the banking system as collateral. However, as the level of reserves falls, open market operations start to bite. With a fixed IROR, an open market sale of assets replaces an asset with a high marginal liquidity value (reserves) with an asset with a lower marginal liquidity value, and this should increase the T-bill rate, but would have no effect on IROR (obviously it’s fixed by the Fed) or the fed funds rate. Thus, with a low enough level of reserves, tightening can be achieved with two instruments – asset sales and increases in IROR. The more asset sales there are, the lower IROR needs to be to prevent serious inflation, and that will be important.”
(http://newmonetarism.blogspot.com/2010/04/inflation-control.html)
1. May 2010 at 10:37
123, Monetary theory is very simple; the price level is determined by the supply and demand for the medium of account (dollars). Normally the Fed has one tool–control of the supply of dollars. Increases in the supply are inflationary and decreases are deflationary. Now they have two tools, one affects the supply of dollars (OMOs) and the other affects the demand for dollars (IOR). If you increase the demand for dollars, or any other asset, the policy will increase the value of that asset. If the asset is dollars, an increase in its value is deflationary.
A decrease in the IOR, say to -5%, will reduce the demand for dollars. This will reduce the value of dollars, and hence is inflationary.
If you had both a -5% IOR and a small balance sheet, the effect is ambiguous, it depends which factor is more important. I still don’t see why one trillion dollars of ER was needed, I think a much smaller amount would have been adequate if combined with a negative IOR.
I agree with the material you quote from the new monetarist.
2. May 2010 at 12:37
Currently Fed has three tools, not two. They have IOR, they have the size of the monetary base, and they have the composition of the asset side of the balance sheet. During the banking panics the third tool is the most important.
IOR is deflationary only in the narrowest technical sense, in the way we could say that gasoline burns better than diesel. But it is a mistake to blame the “slow” diesel cars for the traffic jams in Europe, and it is a mistake to blame IOR for the deflationary pressures in the end of 2008.
There are two possible modes of central bank operations – tax on reserves approach used by Fed, and channel approach with IOR that was used by other central banks. Channel approach requires a bit larger balance sheet of the central bank. Channel approach with IOR is not inherently deflationary (see Canada). When Fed switched to IOR, they also increased their balance sheet more than enough to offset the effect of IOR. All the deflation needs to be attributed to the financial crisis that was not properly accommodated by the Fed’s QE/CE policy, not to the IOR.
Why one trillion ER plus QE/CE was needed? -5% IOR is just a -0.1% weekly tax on hoarders that would do little to discourage a Diamond-Dybvig bank run. Whereas credit easing is a powerful tool to combat bank runs.
3. May 2010 at 06:00
123, I blame tight money for the problems of 2008, not simply IOR.
I agree that IOR can work if done correctly, as in Canada.
I would not deny that some balance sheet expansion might have been needed in 2008. I just think that with a negative IOR, it would have been far smaller.
I think most severe banking system problems are caused by tight money, and I don’t think the Fed realizes that. They seem to think bank runs just happen, and the Fed must ride to the rescue.
4. May 2010 at 05:20
With enormous leverage bank runs are inevitable even when NGDP expectations are appropriate (see Bear Stearns). And when banking system has experienced real losses, interest rate policy is powerless until there is enough additional supply of safe assets to satisfy precautionary demand, and until the spread of run on banks is limited by stabilizing the prices of risky assets.
4. May 2010 at 06:56
123, The Bear Stearns crisis was very minor compared to what happened in late 2008. I agree that problems in banking are inevitable, but I don’t agree that severe problems are inevitable with NGDP targeting. All the severe banking crises in developed economies (that I know of) seem associated with sharp falls in NGDP grwoth.
4. May 2010 at 07:49
Scott,
it will be your greatest achievement when we will get a severe banking crisis during a period of NGDP growth stability. Ah, the libertarian utopia and a nightmare of TBTF banking – stupid banks failing just like regular companies without dragging all the economy down.
The Bear Stearns crisis was minor only because of the bailout. The financial condition of other large banks was very similar to Bear Stearns in the beginning of 2008.
5. May 2010 at 05:24
123, That’s what they said about LTCM in 1998, but I’m not so sure. In any case, we would have been much better off if the crisis had occurred in February, when the world economy was strong, rather than September, when it was already weakening rapidly.
I distrust predictions of doom if we don’t “do something”. I recall Bush bailed out GM, arguing that no one would buy their cars if they went through bankruptcy. Then they went through bankruptcy anyway and nobody cared.
Then we were told that there would be a disaster if we didn’t buy up all sorts of bad debts. But correct me if I’m wrong, once the bad debt program was enacted, isn’t it true that most banks decided not to sell off their bad debts? I admit that my memory is a bit vague there, but I seem to recall that the program fizzled out. Then we loaned lots of money to the big banks, and they promptly turned around and repaid the loans. I’m not saying you are wrong about Bear Stearns, I’m just a bit suspicious.
Regarding my first paragraph, yes that is my dream.
6. May 2010 at 04:47
I’m not sure NGDP crash in February 2008 is preferable to NGDP crash in September 2008.
“I distrust predictions of doom if we don’t “do something”. I recall Bush bailed out GM, arguing that no one would buy their cars if they went through bankruptcy. Then they went through bankruptcy anyway and nobody cared.”
I oppose bailouts, and I support orderly bankruptcies.
“Then we were told that there would be a disaster if we didn’t buy up all sorts of bad debts. But correct me if I’m wrong, once the bad debt program was enacted, isn’t it true that most banks decided not to sell off their bad debts? I admit that my memory is a bit vague there, but I seem to recall that the program fizzled out. Then we loaned lots of money to the big banks, and they promptly turned around and repaid the loans. I’m not saying you are wrong about Bear Stearns, I’m just a bit suspicious.”
Initial plans to buy illiquid assets were replaced by the plans to recapitalize the banking sector. Recapitalization and stress test program has stopped the run on the financial system and has increased the AD.
“Regarding my first paragraph, yes that is my dream.”
Negative interest rates are not sufficient to achieve this dream.
6. May 2010 at 06:17
123, I’m still not convinced the bank bailouts were necessary. But I agree with you that we need a procedure for orderly liquidation in bankrupcies. Perhaps Mankiw’s idea of converting bank debt into equity might work.
You said;
“Negative interest rates are not sufficient to achieve this dream.”
I completely agree. The key reform is a NGDP target, level targeting.
Regardng February vs. September 2008, when the real economy is stronger it is easier to avoid a liquidity trap.
7. May 2010 at 06:03
Mankiw has got the right idea.
NGDP level targeting is also a good idea, but still there is a need for a credible tool to stabilize NGDP expectations during the financial panic. Even sharply negative overnight interest rates have little effect on the bank runs, so some other tools are needed.
The strength of the real economy in Feb. 2008 would not have saved us from the liquidity trap – financial panic is stronger.
8. May 2010 at 06:59
123, Financial panic is not an exogenous shock, it is a reflection of expected NGDP growth. If the economy is expected to grow at 5% over time, there will be enough income to service most debts and it is likely that any financial panic would be extremely mild. It is only when allowed to depress NGDP expectations that the panics become severe.
The Fed can print nearly an infinite amount of base money, so they clearly have the tools necessary to keep NGDP expectations on track, if they choose to use those tools.
If they are willing to use the “nuclear option,” NGDP expectations will stay on track, velocity will be well-behaved, and they will never actually have to use extreme measures.
The IMF scaled back estimated financial system losses from $4 trillion to 3.4 trillion. Then to 2.8 trillion. Just recently they were scaled back to 2.3 trillion. The change was attributed to the economic recovery around the world. Imagine how small the estimated losseds would have been had we never had NGDP downshift 8% below the previous trend line.
9. May 2010 at 16:48
“Financial panic is not an exogenous shock, it is a reflection of expected NGDP growth. If the economy is expected to grow at 5% over time, there will be enough income to service most debts and it is likely that any financial panic would be extremely mild. It is only when allowed to depress NGDP expectations that the panics become severe.”
With enormous leverage financial panics happen even when NGDP expectations are stable. And then when financial panic spreads it causes NGDP crash unless extraordinary measures are taken by central banks.
“If they are willing to use the “nuclear option,” NGDP expectations will stay on track, velocity will be well-behaved, and they will never actually have to use extreme measures.”
Hank Paulson said he needs a law so speculators will stop the attack on Freddie and Fannie, but he will never actually have to use it. After a month Paulson had to use the new extreme measures law to bail out Freddie and Fannie.
16. May 2010 at 17:58
123, I don’t see any evidence for your view that fiancial crises can become severe with stable NGDP expectations. And of course F&F got much worse because NGDP expectations fell sharply.
18. May 2010 at 04:13
Stable NGDP would not have prevented a dotcom bust. Why finance is different?
F&F were overleveraged just like Bear Stearns, and conservatorship was inevitable even if NGDP expectations were stable (because of real losses).
18. May 2010 at 08:08
123, I have been arguing for 20 years that F&F were time bombs waiting to go off, so I won’t argue with you there.
I can’t rule out a financial crisis with stable NGDP, I just doubt it would happen. If I see a real estate bust big enough to produce such a systemic crisis, even with stable NGDP, then I will change my mind. So far all I have seen is that the worst real estate bust in 100 years didn’t produce a crisis anywhere near big enough to bring down the banking system, until NGDP started falling.
19. May 2010 at 06:35
“I can’t rule out a financial crisis with stable NGDP, I just doubt it would happen. If I see a real estate bust big enough to produce such a systemic crisis, even with stable NGDP, then I will change my mind.”
You’ll have to wait until NGDP targeting is adopted. Since we don’t have NGDP targeting, there are no examples, so we have to use Diamond-Dybvig model. Negative short term interest rates have little impact on Diamond-Dybvig runs.
19. May 2010 at 07:41
123, I agree, but expectations of stable asset prices one and two years out would help a lot. As you know I think interest rates are not the right tool. I admit to being uninformed about the D-D model. Can that sort of run be addressed with the lender of last resort role of the Fed, or are they modelling solvency crises that require bill bailouts.
20. May 2010 at 05:04
Stability of asset prices is not the same as NGDP expectation stability.
D-D can be addressed with aggressive LOLR. In Summer 2007 ECB injected unlimited liquidity at 4% interest rates. Because of that, European economy outperformed USA in 2007-08. One small matter – aggressive LOLR requires central bank balance sheet flexibility. This means IOR is needed – fortunately ECB always had IOR.
21. May 2010 at 05:50
123, I don’t agree that you need IOR to do LOLR. If the reserves are truly needed for liquidity purposes, they won’t be lent out, and hence won’t be inflationary. They can be pulled back out when not needed. Of course getting the timing right is tricky—unless you have NGDP futures.
22. May 2010 at 01:10
No. If LOLR is credible, as it was in Europe from summer 2007 to summer 2008, natural short term interest rates can even increase.
22. May 2010 at 01:33
In other words – in summer 2007 should ECB have let interest rates drop because of aggressive LOLR, or was LOLR too large?
22. May 2010 at 07:34
123, You don’t see my argument (which may be wrong, BTW). I am arguing that if there is truly more demand for liquidity, then the extra liquidity injected will be held by banks, and won’t drive short rates lower. If short rates fall as a result, the liquidity was not needed. But there is another possibility–maybe short rates need to fall becasue the Wicksellian equilibrium natural rate is falling. In that case you don’t want to try to prevent short rates from falling.
23. May 2010 at 13:02
1. The extent of LOLR support is one of determinants of Wicksellian equilibrium natural rate
2. The size of financial shock is another determinant of natural rate
3. Depending on the relative size of initial financial shock and LOLR support provided, natural rate might decrease and increase.
4. In September 2008 financial shock was much stronger than botched LOLR, and natural rate fell. In summer 2007 LOLR in Europe was at least as strong as an initial financial shock.
5. There is no good method to determine the appropriate extent of LOLR. In order to minimize risks to macroeconomic stability, sometimes it is a good idea to provide unlimited liquidity at a fixed price, as ECB has done in summer of 2007. Such enormous LOLR might as well increase the natural rate (or natural rate might increase because of some other unrelated shock).
6. It follows that IOR removes the limitation on the size of LOLR operations
24. May 2010 at 06:24
123, I think there is a very good way of ascertaining the appropriate size of LOLR operations. Do them at a level that stabilizes NGDP futures prices. But first you much create the market. Anything else is guesswork.
24. May 2010 at 08:12
Lower interest rates and LOLR operations are substitutes. NGDP futures won’t help with the tradeoff between them.
25. May 2010 at 08:31
123, Use NGDP futures to set the monetary base, and use a fiscal facility to help problem banks with Treasury loans (if you must.) Don’t mix monetary and fiscal policy. Bernanke did that, and took his eye off monetary policy.
27. May 2010 at 07:37
Sorry for delay. I was thinking long and hard about what I could say to persuade you, but fortunately yesterday I found an excellent BOE presentation by Woodford, and it looks like I am on the Woodford’s side on the issues we are debating here:
Woodford supports IOR.
Woodford says there are three independent dimensions in monetary policy (quantity of reserves, IOR, asset side of CB balance sheet).
Woodford says credit easing is sometimes warranted even when interest rates are above zero.
My only disagreement with Woodford is that I think that QE has prevented an even greater contraction in Japan, whereas Woodford says QE had zero effect in Japan.
You can find a link to Woodford’s presentation here:
http://themoneydemand.blogspot.com/2010/05/michael-woodford-inflation-targeting.html
28. May 2010 at 06:18
123, Are you telling me that Woodford thinks interest rates should now be above zero? I’m not against IOR, so I don’t see the conflict. I just think the rate should be positive in normal times, and negaive right now. I wouldn’t be surprised in Woodford agrees.
29. May 2010 at 04:20
In his presentation Woodford says that zero rate bound constraint is largely mitigated by gap-adjusted price level targeting. So his policy advice is not negative rates, it is price level targeting.
You have said that switch to IOR was one of the key causes of the crash, Woodford says IOR is desirable.
Woodford takes Bernenke/Gertler seriously, you don’t. Woodford says credit easing is the answer for large credit shocks, you don’t.
Woodford also says decision to have credit easing is independent of the distance to zero rate bound (think ECB 2007).
29. May 2010 at 04:57
123, I also agree that price level targeting is far superior to negative IOR. But Bernanke refuses to do this.
I didn’t say IOR caused the problem, I said the rate applied to IOR was too high. I’d guess Woodford would agree. Woodford had good things to say about Hall’s IOR paper, and Hall agreed with me that the IOR rate was set to high, and perhaps should even be negativde.
30. May 2010 at 03:05
Hall is a pioneer of IOR analysis, but that doesn’t mean he gets the big picture right (for example he did not mention level targeting or credit frictions in 2008 and said the only monetary tool available was negative interest rates). On the other hand, Hall has said that net effect of switch to IOR and increase of quantity of reserves was not contractionary.
I think Woodford would say that fed funds rate was too high in second half of 2008. But he has said that switch to IOR was “desirable”.
30. May 2010 at 07:45
123, I agree, but Hall also said the IOR, considered in isolation, was contractionary. He called the Fed’s explanation a “confession,” a term not usually meant in a complementary way. Which is fine, but the Fed shouldn’t hide behind the argument that they did all they could in 2008. They could have had a more expansionary policy with a lower IOR, and made the recession milder, but chose not to. And admitted they chose not to.
30. May 2010 at 15:33
There is a huge disagreement between Hall and Woodford on this point. Hall said that the variable difference between IOR and fed funds rate is the potent new tool of monetary policy. Woodford has said that IOR should be equal to the fed funds rate, or alternatively, there should be a tiny constant spread between IOR and fed funds rate.
31. May 2010 at 06:08
123, Yes, but didn’t Woodford say he was intrigued by Hall’s idea of stabilizing the price level by adjusting that differential ex post? Or is that just my imagination? I agree though that this is Hall’s specific proposal, made in 1983, and then re-published around 2001 I believe.
1. June 2010 at 04:31
Maybe Woodford has changed his mind. His BoE presentation where he said IOR should be equal to fed funds rate was in May 2009. Interestingly, BoE was discussing negative deposit rates in summer 2009.
1. June 2010 at 06:17
123, Maybe he thinks the fed funds rate should be lower. I agree that it makes sense to equalize the two as long as the optimal fed funds rate is non-negative, but what does Woodford think should be done when the optimal rate is negative?
2. June 2010 at 04:03
When the optimal rate is negative Woodford says level targeting is the answer. But if we could imagine a country where there is no zero constraint, Woodford’s model would imply negative fed funds rate that is equal to IOR.
2. June 2010 at 05:37
123, Yes, and Woodford has pointed out that when we reach a cashless society (which I think might be sooner than people expect) the zero bound disappears.
So our debate will become academic.
3. June 2010 at 02:55
The more important part of our debate is Woodford’s strong support for credit easing.
3. June 2010 at 11:10
123, I am not ruling out the possibility that some credit easing might have helped. My view is that it probably wouldn’t have been needed with NGDP targeting, but if a bit was needed, so be it.
4. June 2010 at 07:09
With NGDP targeting level of leverage desired by people will increase up to the point where credit easing will be necessary. I think Great Moderation has encouraged such enormous levels of leverage where credit easing would be useful already in early 2008 even with NGDP level targeting.
5. June 2010 at 10:18
123, See my newest post on financial reform.
28. November 2011 at 08:01
I am a conservative who supported deregulation of the banking industry. Now I think deregulation was a huge mistake and the Glass-Steagall Act should be restored and hedge funds should be more regulated or even banned. Glass-Steagall prevented banks from owning securities firms and expanding to multiple states. While I once thought this law was anti-business and outdated, I now realize regulation is necessary to keep the banking industry safe by keeping banks from growing too big. Glass-Steagall is a proven law that protected the American financial industry well for 70 years and needs to be brought back immediately.
The financial crisis of 2008 and the current economic problems are partly due to the repeal of Glass-Steagall and the failure to regulate hedge funds. I am certain the world economy cannot risk another meltdown now. There is simply not enough money to bail out governments and banks of the world again.
The Dodd-Frank Act was enacted as replacement for Glass-Stegall, but I believe this new law is weak and doesn’t go far enough to prevent banks from owning investment companies, controlling banks from growing too big, and regulating derivatives enough. Bank of America, a bank, now owns Merrill Lynch, a brokerage firm, for example. Merrill Lynch recently moved $75 trillion of derivatives to the FDIC insured Bank of America side. If these derivatives fail, Bank of America will be affected, and how will the US government bail them out? The derivatives market is $600 trillion, but the economy of the ENTIRE world is only $74 trillion. One doesn’t need to be a rocket scientist to see the dangers of having government insured banks owning investment firms that buy risky hedge funds.
http://www.bloomberg.com/news/2011-10-18/bofa-said-to-split-regulators-over-moving-merrill-derivatives-to-bank-unit.html
http://articles.boston.com/2010-03-12/business/29329389_1_derivatives-gary-gensler-regulator
https://www.cia.gov/library/publications/the-world-factbook/geos/countrytemplate_xx.html
Billionaire Warren Buffet called derivatives “weapons of mass destruction” and Newt Gingrich thinks repealing Glass-Steagall was a big mistake.
http://www.economist.com/node/12274112
http://news.yahoo.com/newts-15-seconds-sun-094500280.html
Normally I am an optimist who doesn’t go around saying the sky is falling like a paranoid Chicken Little, but from my reading from trusted mainstream sources I have become quite worried about the economy. If I had understood the risks of derivatives and debt in 2007 and had said something then, no one would have believed me. Now I hope people will listen when experts say the government needs to better regulate the financial industry.
Businesses and banks may say that regulation slows the economy, but I think that if the Glass-Steagall Act is not restored and hedge funds are not more closely regulated, there will soon be no economy at all. While I realize restoring Glass-Steagall and regulating derivatives is complex and difficult, I believe making a law is easier than repealing one.
I suggest reading “The Big Short” by Michael Lewis for a readable introduction to the financial crisis and why the banking industry needs to be regulated.
Restoring Glass-Steagall and regulating derivatives is a urgent problem and is not a issue that can wait to be fixed. I cannot stress this enough. Write to your elected officials, talk with your friends, and contact the media urging the government to make Glass-Steagall a law again and ask legislators to better regulate hedge funds.
“Too big to fail” is simply too big.