This is sort of a response to some Keynesian/fiscal theory/Post Keynesian/MMT theories I’ve seen floating around on the internet.  Theories that deny open market purchases are inflationary, because you are just exchanging one form of government debt for another.  But first a few qualifiers:

1.  If the new base money is interest-bearing reserves, I fully agree that OMOs may not be inflationary.  That’s exchanging one type of debt for another.  If it does raise inflation expectations (as QE2 did) it’s probably because it changed expectations of future monetary policy.

2.  If nominal rates are near zero, the situation is complex–I’ll return to that case later.

So let’s start with an economy that has “normal” (i.e. non-zero) interest rates, and non-interest-bearing base money.  How does the price level get determined in that case?  I’m told there are some theories of fiat money that suggest it must evolve from commodity money.  I don’t agree.  I think the quantity theory of money is all we need.  Suppose you dump 300,000 Europeans on an uninhabited island—call it Iceland.  The ship also drops off some crates of Monopoly money, and they’re told to use it as currency.  Assume no growth for simplicity.  Also assume no government and no banking system.  It’s likely that NGDP will end up being roughly 15 to 50 times the value of the stock of currency.  Once you pin down NGDP, then you figure out RGDP using real growth theories, and voila, you’ve got the price level.  At this point you might be thinking; “you consider ’15 to 50 times the currency stock’ to be a precise scientific solution?”  No, but it gets us in the ball park.  It tells us why prices are not 100 times higher than they are, or 1000 times higher.   BTW, prices in Japan are 100 times higher than in the US, and Korean prices are 1000 times higher.  I don’t see how other theories can even get us into the right ball park.

I’m going to illustrate the problem of non-QTM theories of the price level with a comparison of the US  Australia and Canada.  Here are some national debt figures from The Economist:

For simplicity assume Australia’s net debt was zero in 2007.  In Australia NGDP is about 30 times the currency stock.  Canada is similar.  (The US NGDP was only about 18 times the currency stock in 2007, because lots of our currency is hoarded overseas.)  This ratio is determined by the public.  The base also includes reserves, but in normal times like 2007 we can ignore those if we aren’t paying interest on reserves.  The opportunity cost of holding reserves is simply too large for banks to want to hold very much.  So the central bank determines the nominal base, and the public determines the ratio of NGDP to the base (aka velocity.)

Because Australia and Canada are fairly similar countries, I can get a reasonable estimate of each country’s price level as follows:

1.  Notice that their RGDP per capita is similar.

2.  Find the NGDP in one country (say Canada.)

3.   Find the currency stock in each country.

4.  Assume their NGDP/currency ratios are similar (roughly 30.)

Then all I need is Australia’s currency stock to estimate the price level in Australia.   Now suppose it was true that OMOs didn’t matter.  In that case the aggregates that would be important would be the entire stock of government liabilities, currency plus debt.  But as you can see, Canada’s was many times larger than Australia’s.  (Recall that in both countries currency is only about 3% to 4% of NGDP.)  If you looked at total government liabilities you’d get nonsense, you’d estimate Canada’s price level in 2007 to be between 5 and 10 times that of Australia, as its debt was 23.4% of GDP (so debt plus base was about 27% of GDP), vs. about 3% to 4% in Australia.   The base is “high-powered money” and interest-bearing debt isn’t.  Demand for Australian cash is very limited; you just need a little bit to smooth transactions in Australia.  Double it and the value of each note falls in half.  Double the amount of Australian T-bonds, and it’s just a drop in the bucket of a huge global market for interest-bearing debt.  The value of those bonds changes hardly at all.

Now suppose that in 2007 the US monetized the entire net debt, exchanging $6 trillion in non-interest bearing base money for T-securities.  And suppose this action is permanent.  The monetary base would have increased about 8-fold, and the QTM tells us the US NGDP (and price level) would also have increased 8-fold.  In that case our situation will be much like that of Australia; we’d have a monetary base, but no interest-bearing national debt.  So our price level would be determined in the same way Australia’s price level is determined.  NGDP would be some multiple of the base, depending on the public’s preference to hold currency (including foreign holdings of US currency.)   But since our base (and currency stock) went up 8-fold, if the ratio of NGDP to currency remained around 18, then the level of NGDP would also increase 8-fold.  That shows OMOs do matter, at least if I’m right about the public’s demand for currency usually being some fairly predictable share of NGDP.

Here’s my problem with all non-QTM models.  Suppose I’m right that only the QTM can explain the current price level.  Then it stands to reason that only the QTM can explain the price level in 2021.  Then it stands to reason that only the QTM can explain the inflation rate between 2011 and 2021.  Now it is true that a change in the money supply will have certain effects on nominal interest rates, economic slack, etc, depending on whether the monetary injections were expected or not.  And you can try to model the inflation rate using those changes in interest rates, economic slack, inflation expectations, etc.  But that’s really a roundabout way of getting at the problem.  If the QTM says that the price level in 2012 will be 47% higher due to changes in the monetary base, plus changes in the public’s desire to hold currency as a ratio or NGDP, then either the non-QTM approaches also give you the 47% answer, or they are wrong.

Here’s a nautical analogy.  You can estimate how fast a cigarette boat was going by looking at the size of the engine, the throttle setting, and so on.  That’s the direct approach, the engine drives the boat.  Or you can estimate its speed by how big its side effects were (the size of the wake, how loudly seagulls screeched as they got out of the way, etc.)  The engine approach is the QTM.  That’s what drives inflation.  (God I hope at least Nick gets this, otherwise I’ve totally failed.)  The Keynesian approach is to look at epiphenomena (like interest rates and slack) that may occur because wages and prices may be sticky to some unknown extent.  It’s like looking at the wake and trying to estimate what sort of boat went by.

OK, what about at the zero bound, aren’t cash and T-securities perfect substitutes?  Maybe, but if they aren’t expected to be perfect substitutes in 2021, then  a current OMO that is expected to be permanent will have the same impact on the expected long run price level as an OMO occurring when T-bill yields are 4%.

Of course central banks don’t target the base, they adjust the base until short term interest rates are at a level expected to produce the right inflation rate.  It’d be like adjusting the throttle until the wake looks about the right size to hit the target speed.    And in the future they might go even further away from money supply control, if they pay interest on reserves.  In that case they’ll be adjusting rates and the base in a more complicated pattern, both money supply and demand will change.  But the currency stock will still be non-interest bearing for a while, so that relationship will continue to hold.

What would cause a revival of monetarism?  That’s easy.  We just need to return to widely varying trend rates of inflation, as we saw in the 1960-1990 period.  In those decades countries might have 5%, 10%, 20%, 40% or even 80% trend inflation.  As that settles in, and people expect it, the various epiphenomena of unexpected money go away (liquidity effect, slack, etc.)  And everyone goes back to explaining inflation by looking at growth in the non-interest bearing monetary stock.  It’s the only way.  The best example was in the hyperinflationary early 1920s, when even Wicksell and Keynes, the two great proponents of the interest rate approach, became quasi-monetarists.  Needless to say I have very mixed feelings about the prospect of a revival of monetarism.

So here’s my question:  Are there any non-quantity theoretic models of the price level?  Theories that could explain the difference between Australian and Canadian and Japanese and Korean price levels?

Paul Krugman wrote an excellent essay on Keynesian economics for Vox.eu.  Krugman shares many of Keynes’s best characteristics; great intuition about the importance of aggregate demand, passionate belief that good policy can make the world a better place, and a witty writing style.  On the negative side he also has been known to take a few cheap shots at those with whom he disagrees.  Ironically, he comes close to absolving Keynes of the charge that he was unfair to “the classics,” even though Keynes most certainly was unfair:

I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way. But I’m inclined to believe that he was right. Why? Because you can see modern economists and economic commentators who don’t know their Keynes falling into the very same fallacies.

Toward the end of the essay Krugman gets more political, and less fair to those on the other side:

“When monetarism failed – fighting words, but you know, it really did “” it was replaced by the cult of the independent central bank. Put a bunch of bankerly men in charge of the monetary base, insulate them from political pressure, and let them deal with the business cycle; meanwhile, everything else can be conducted on free-market principles.”

OK, if monetarism is defined as the K% rule, then one can argue that it did fail.  But of course there is much more to monetarism.  Here’s a wonderful comment written by Nick Rowe:

The monetarist revolution was a revolution in the assignment of policy targets to policy instruments.

In the 1970’s Keynesianism:

1. AD (understood as unemployment) was assigned to fiscal policy.
2. The composition of AD, between consumption and investment, (or, in an open economy, between domestic absorption and net exports) was assigned to monetary policy, via its influence on interest rates and exchange rates.
3. That left inflation without an instrument. So they hunted around, and cobbled together a rag-bag of policies termed “industrial policy”, which meant controlling monopolies in both labour and output markets.

And Monetarism:
1. AD (understood as inflation) was assigned to monetary policy.
2. The composition of AD, between G vs C+I (or, in an open economy, between C+I+G vs NX) was assigned to fiscal policy.
3. That left unemployment without an instrument. So the industrial policy ragbag was assigned unemployment.

Canada, indeed most countries, look very monetarist from the perspective of a 1970’s Keynesian.

To argue that monetarism failed because no one talks about the K% rule today, is about like arguing that Keynesianism “failed” because people no longer talk about incomes policies.  By the 1990s Friedman was endorsing Robert Hetzel’s proposal to target inflation expectations directly (via the TIPS spread.)  And of course there are a few bloggers trying to keep the flame of monetarism alive.

Milton Friedman helped revive capitalism when he showed that the Great Depression didn’t show capitalism was unstable, but rather that monetary policy had been unstable.  Some critics argue he actually was a closet interventionist, as he thought capitalism required active stabilization policy.  Perhaps, but one could also argue that he was saying “as long as the government runs our monetary regime, they need to do it well.”  Sort of like a libertarian arguing that if governments build our bridges, they should build them so that they don’t collapse.

In any case, conservatives later started to drift away from the Friedman/Schwartz view of the Great Depression, and became increasingly disdainful of “demand shock” explanations of the business cycle.  This created a huge problem in 2008, as conservatives had great difficulty defending the free market, which seemed to have once again failed us.

To be sure, they did find some important policy failures; from the GSEs to deposit insurance to the regulation of the ratings agencies to the moral hazard created by “Too-Big-to-Fail.”  Nevertheless, given all the bad loans that were made without government pressure, by private banks, to middle class borrowers, it was pretty hard to completely absolve the private sector.

I believe that abandoning the Friedman/Schwartz view of the business cycle was a big mistake.  It’s not that this view would have magically absolved the private sector from any role in the sub-prime fiasco, I’m somewhere in the middle on this issue, believing both regulators and private actors made huge mistakes.  Rather the F/S view would have absolved the financial crash from being the primary cause of the Great Recession.  It would be much easier to live with the occasional financial fiasco if it didn’t lead to a Great Recession.  Remember 1987?

If RGDP hadn’t fallen sharply in 2009 then the banking crisis would have been resolved much more easily, with far less public money.  For that to have happened we would have needed to prevent NGDP growth from turning negative.  And that would have required that conservatives accept the F/S view of the Great Depression, instead of drifting toward “real” theories of business cycles.

Why focus on conservatives, weren’t liberals also clueless about monetary stimulus?  If people like Fisher, Plosser, and Hoenig had warned that aggressive monetary stimulus was needed to prevent a severe slump; does anyone really believe the doves at the Fed would have stood in the way?

In 1930-33 the policies advocated by Friedman and Schwartz would have been viewed as being highly progressive.  Later Friedman moved away from steady monetary growth toward policies that would offset velocity shocks—even more progressive.  It’s a pity that so few liberal and conservative economists picked up the torch when Friedman died in 2006.  What is “the torch?”

1.  Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

How many economists believed all three in October 2008?

My approach to macro has always been “nominal shocks have real effects.”  As a result, I’ve never cared for the Keynesian view that inflation was caused by an overheating economy, and disinflation was caused by economic “slack.”  If that were true, then it would be the case that “real shocks have nominal effects.”  I.e. changes in real GDP affect inflation.  And that just didn’t seem right.

Milton Friedman (and Irving Fisher) interpreted the Phillips curve in the same way I do—deflation causes unemployment, not the other way around.  As I got older I modified this view slightly, now I see nominal shocks as changes in NGDP growth.  But I still believe nominal shocks have real effects.  Only now an unexpected change in NGDP would simultaneously change both prices and output.  So how does this differ from the Keynesian view?

Mankiw and Reis (2006) identify “three key facts” of modern business cycle theory:

1. “The Acceleration Phenomenon . . . inflation tends to rise when the economy is booming and falls when economic activity is depressed.”
2. “The Smoothness of Real Wages . . . real wages do not fluctuate as much as labor productivity.”
3. “Gradual Response of Real Variables . . . The full impact of shocks is usually felt only after several quarters.”

None of these facts even comes close to fitting the economy of 1933, and the first is especially strongly rejected.  Inflation soared in 1933, when unemployment was at the highest level in history.  The monetarist model, however, can easily explain 1933.  After all, a powerful nominal shock (dollar devaluation) sharply raised output.  But I get tired of talking about 1933, unless there are other good examples then the distinction I’m trying to make might not be that important.  Fortunately, Paul Krugman has found some recent examples:

Via Mark Thoma, the Dallas Fed notes some acceleration even in its core inflation measures, although these remain below target. What should we make of this?  .  .  .

What this suggests to me, anyway, is that there’s a rate-of-change effect as well as a level effect: when the economy is growing, even from a low base, some firms gain pricing power, and some firms raise their wage offers a bit. So the acceleration of US growth and the fall in unemployment since last summer has produced an inflation uptick; if past experience is a good guide, however, this will be only temporary unless the economy continues to accelerate.

I’m sure if you add enough epicycles to the Keynesian model you can make it all work out.  For my part I’ll stick with Fisher and Friedman—nominal shocks have real effects.

PS.  Check out Krugman’s short post.  It’ll make more sense if you look at his graphs.  I don’t like to copy entire posts, if I can avoid it.

PPS.  Krugman refers to an “acceleration of US growth and the fall in unemployment since last summer”.  Did QE cause that acceleration?  Martin Feldstein says yes.  Wasn’t he one of those economists who said the Fed was out of ammo back in 2008-09?  Any help from commenters would be appreciated.

In this post Brad Delong treats me like a monetarist.  That ideology that died in 2006, when Milton Friedman passed away.  Friedman believed that the stance of monetary policy could be characterized by the growth rate of M2.  That the Fed should stabilize M2 growth, and that current monetary policy affects future aggregate demand.  That monetarism is dead.

Quasi-monetarists like me look at the world very differently.  Monetary aggregates are neither good indicators of the stance of monetary policy, nor good policy targets.  Rather than assume current changes in M affect future AD with long and variable lags, I assume current changes in the expected future path of M affect current AD, with almost no lag at all.  That is, I’m a Woodfordian on the role of policy expectations, and a Friedmanite in that I believe that changes in nominal aggregates are ultimately caused by changes in the supply and demand for the medium of account.  (Other quasi-monetarists like Nick Rowe would use the medium of exchange.)

Brad DeLong worries about what happens if an increase in the supply of money leads to lower interest rates, which produces an offsetting fall in the velocity of circulation.  He cites John Hicks as an inspiration.  But Hicks lived in a world where currencies were pegged to gold, or were expected to be pegged in the future.  I used to think the main problem with the gold standard was that it constrained the central bank from printing more dollars than they could back with gold.  In that sort of policy environment the danger Brad mentions is quite serious.  Now I think the bigger problem was the fact that the gold peg anchored the future expected price level.  To see why this is so important, we need to understand that modern policy is not really about either interest rates or (current changes in) the money supply.  It is about changes in the expected future path of prices and NGDP, which can be signaled by changes in interest rate targets or the money supply (as with QE.)

Yes, a doubling of the monetary base might have no impact on the price level.  Paul Krugman showed that in 1998 and I showed that in 1993.  But the reason it would fail (we both agree) is not because rates are stuck at zero, but rather because the money supply increase is expected to be temporary.  A money supply increase that is expected to be permanent will raise future expected NGDP, and Woodford showed that future expected AD is the most powerful determinant of current AD.  And this is true regardless of whether rates are zero or positive when the monetary injection first occurs.  A doubling of the money supply expected to be withdrawn 2 months later will have almost no effect, regardless of short term rates, and a permanent doubling of the money supply will have a huge effect, regardless of the level of short term rates.

We need to stop thinking of current changes in short term rates and/or the monetary base as causal factors, and start thinking of them as signaling devices.  Thus the question is not; (as DeLong often implies) “Just how much base money would it take to boost AD?”  The question is; “If the central bank promises to target 6% NGDP growth, how much base money do people want to hold?”

Because most economists wrongly assume that low rates and a bloated base mean easy money, they despair at how much easier money must be for significant stimulus to occur.  But this is looking at things backward.  Money has been extremely tight in the only metric that matters—relative to what is needed to produce on-target NGDP growth expectations.   That’s why rates are low and the base is bloated.  If the Fed promised to target a much higher future NGDP trajectory, and do level targeting (making up for undershoots), then the demand for base money would probably be far lower than today, and nominal rates might be higher.  As Friedman said about Japan, ultra-low rates aren’t a sign of easy money; they are a sign that money has been too tight.

A promise to raise the expected future growth of NGDP is equivalent to a promise to raise the expected future money supply. But it is not a promise to raise the current money supply, nor is it a promise to lower current rates, nor even (as Woodford asserts) to keep short term rates at the zero bound for a period longer than markets currently expect.  All those variables respond endogenously.

Friedmanite monetarism died because it wasn’t consistent with good right-wing economics.  The long and variable lags could not explain why markets often failed to respond to policy shocks that Friedman and Schwartz thought were important.  An X% money supply rule is clumsy central planning, clearly inferior to a policy of having markets determine the monetary base setting most likely to produce on-target inflation.  Don’t believe me?  Well then explain why late in his life Friedman endorsed Robert Hetzel’s 1989 proposal to have the Fed stabilize the TIPS spread.  I’m simply doing the sort of monetary economics Friedman would have done had he been born in 1955, and if his IQ had been 30 points lower, and if he had been able to stand on the shoulders of giants like Irving Fisher and . . . well, Milton Friedman.

Part 2.  Only Krugman understands the zero rate bound, and even he doesn’t really understand it.

Paul Krugman once had a post claiming he was the only person who understood liquidity traps.  I know the feeling of exasperation.  I often feel the same way. (Of course this isn’t actually true.  I’m only joking.)

If I am right that the zero bound is not a problem, why do central banks seem to flounder in that situation?  I’m not quite sure.  I’ve gradually become convinced that the BOJ actually likes zero to -1% inflation—they sure act that way.  Krugman doesn’t agree.  I still believe the US will eventually exit the liquidity trap, and not end up like Japan.  But I can’t be certain.  Nick Rowe has as good an explanation as any for the seeming paralysis of US policy at the zero bound.  He argues that nominal rates were the Fed’s way of signaling future policy intentions to the public.  It’s not that the fed funds rate actually matters all that much for long term investments.   And we know that when the Fed eases aggressively then long term rates often go in the opposite direction from short rates (January 2001, September 2007.)  No, the Fed is saying “by cutting our fed funds target, we signal that we will provide enough base money over time to raise the long run NGDP growth rate.”  That is, if they cut rates in order to change policy expectations.  Roughly 80% of rate adjustments are merely reflecting ongoing changes in the Walrasian equilibrium rate, and aren’t intended to move expectations.

Nick says that when the nominal rate hits zero, the Fed is (temporarily) mute.  They don’t know how to communicate policy intentions to the markets.  Eventually if things get bad enough they develop other languages; quantitative easing, inflation targeting, level targeting, exchange rate depreciation, lower IOR, etc.  As I pointed out earlier (and as Jim Hamilton also argued) QE2 did not do anything significant in a mechanical sense.  But it did convey to markets a renewed Fed determination to speed up NGDP growth.  And it worked; NGDP growth expectations rose significantly following each important Fed speech during September/October 2010, speeches hinting at QE2.

Once you start to look at things this way, everything makes much more sense.  Many of my commenters insist that monetizing deficits is the one surefire stimulus option.  Not so, as the Japanese have discovered over the past 17 years.  If the money supply increase is temporary, the future expected price level will not rise.  In that case all the deficit spending in the world won’t create inflation.   Yes, most examples throughout history of monetizing the debt have produced inflation, but that’s because no other central bank has been as obsessively masochistic as the BOJ.  They reduced the monetary base by 20% in 2006, even though the the price level had not increased in the previous 12 years!

This is not to say that monetizing deficits won’t “work” on most occasions.  I’m pretty sure if the Fed began dropping money out of helicopters most people would be able to quickly infer what they were trying to “communicate” about future policy.  But why bother, when all they need to do is say they want higher NGDP, or a higher price level?  So far the Fed refuses to set any sort of aggressive nominal target, thus it’s not surprising that we’ve been limping along.

The “new monetarism” of the 21st century can’t be found by reading the blogs of people who don’t think nominal shocks are important.  Rather, it will be based on a more sophisticated understanding of the role of expectations.  Eventually macro and finance will merge.  “Easy money” won’t be low interest rates, and it won’t be increases in the current money supply.  Easy money will be above-target NGDP futures prices, and tight money will be below target NGDP futures prices.  Then and only then will we be able to tear down the confusing Tower of Babel called 20th century macroeconomics, and all start speaking the same language.  Then and only then will we be able to focus on the real problems, which are the . . . “real” problems.

PS.  A commenter asked me to comment on this post by Mark Thoma, which he thought was directed at my views on QE2.  I’m not sure it was, as Mark never mentions my name.  But he does link to one of my posts.  All I can say is that his argument has no bearing on my claim that QE2 is working, because my argument was not based on how QE2 affected the economy, but rather how it affected market expectations.  Because expectations respond immediately to rumors of QE2, there is no policy lag to worry about, and no identification problem.  I did also discuss movements in the actual economy, but made it very clear that those changes would be of interest to others, not to me.  I had all the information I needed by November 3rd, 2010.

PPS.  I now realize that I never really answer Brad’s questions.  Financial assets play no role in my model.  In my view an increase in the expected future money supply (relative to demand) raises expected future NGDP.  That raises the current price of real assets and flexible price goods.  It also raises nominal spending, by boosting velocity.  With sticky wages, this raises current output.  Add interest rates if you wish, it adds nothing to the transmission mechanism in my view.  Interest rates aren’t causal factors; they reflect what’s going on with the economy.  Disinflation and low output produce low rates, and vice versa.

Yes, fiscal stimulus can “work” if the Fed wants it to work, by boosting V.  But if the Fed wants it to work, why not just do the job with monetary policy?