Archive for the Category Monetary Theory

 
 

Irving Fisher and George Warren

I am currently a bit over half way through an excellent book entitled “American Default“, by Sebastian Edwards. The primary focus of the book is the abrogation of the gold clause in debt contracts, which (I believe) is the only time the US federal government actually defaulted on its debt. But the book also provides a fascinating narrative of FDR’s decision to devalue the dollar in 1933-34.  I highly recommend this book, which I also discuss in a new Econlog post. Later I’ll do a post on the famous 1935 Court case on the gold clause.

Edwards has an interesting discussion of the difference between Irving Fisher and George Warren.  While both favored a monetary regime where gold prices would be adjusted to stabilize the price level, they envisioned somewhat different mechanisms.  Warren focused on the gold market, similar to my approach in my Great Depression book.  Changes in the supply and demand for gold would influence its value.  Raising the dollar price of gold was equivalent to raising the nominal value of the gold stock.  Money played little or no role in Warren’s thinking.

Fisher took a more conventional “quantity theoretic” approach, where changes in the gold price would influence the money supply, and ultimately the price level.  Edwards seems more sympathetic to Fisher’s approach, which he calls a “general equilibrium perspective”.  Fisher emphasized that devaluation would only be effective if the Federal Reserve cooperated by boosting the money supply.

I agree that Warren’s views were a bit too simplistic, and that Fisher was the far more sophisticated economist.  Nonetheless, I do think that Warren is underrated by most economists.

To some extent, the dispute reflects the differences between the closed economy perspective championed by Friedman and Schwartz (1963), and the open economy perspective advocated by people like Deirdre McCloskey and Richard Zecher in the 1980s.  Is the domestic price level determined by the domestic money supply?  Or by the way the global supply and demand for gold shape the global price level, which then influences domestic prices via PPP?  In my view, Fisher is somewhere in between these two figures, whereas Warren is close to McCloskey/Zecher.  I’m somewhere between Fisher and Warren, but a bit closer to Warren (and McCloskey/Zecher).

There’s a fundamental tension in Fisher’s monetary theory, which combines the quantity of money approach with the price of money approach.  Why does Fisher favor adjusting the price of gold to stabilize the price level (a highly controversial move), as opposed to simply adjusting the money supply (a less controversial move)?  Presumably because he understands that under a gold standard it might not be possible to stabilize the price level merely through changes in the domestic quantity of money.  If prices are determined globally (via PPP), then an expansionary monetary policy will lead to an outflow of gold, and might fail to boost the price level.  Thus Fisher’s preference for a “Compensated Dollar Plan” rather than money supply targeting is a tacit admission that Warren’s approach is in some sense more fundamental than Friedman and Schwartz’s approach.

Warren’s approach also links up with certain trends in modern monetary theory, particularly the role of expectations.  During the 1933-34 period of currency depreciation, both wholesale prices and industrial production soared much higher, despite almost no change in the monetary base.  Even the increase in M1 and M2 was quite modest; nothing that would be expected to lead to the dramatic surge in nominal spending.  That’s consistent with Warren’s gold mechanism being more important that Fisher’s quantity of money mechanism.  In fairness, the money supply did rise with a lag, but that’s also consistent with the Warren approach, which sees gold policy as the key policy lever and the money supply as being largely endogenous.  You might argue that the policy of dollar devaluation eventually forced the Fed to expand the money supply, via the mechanism of PPP.

A modern defender of Warren (like me) would point to models by people like Krugman and Woodford, where it’s the expected future path of policy that determines the current level of aggregate demand.  Dollar devaluation was a powerful way of impacting the expected future path of the money supply, even if the current money supply was held constant.

This isn’t to say that Warren’s approach cannot be criticized. The US was such a big country that changes in the money supply had global implications.  When viewed from a gold market perspective, you could think of monetary injections (OMPs) as reducing the demand for gold (lowering the gold/currency ratio), which would reduce the value of gold, i.e. raise the price level.  A big country doing this can raise the global price level.  So Warren was too dismissive of the role of money.  Nonetheless, Warren’s approach may well have been more fruitful than a domestically focused quantity theory of money approach.

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PS.  Because currency and gold were dual “media of account”, it’s not clear to me that the gold approach is less of a general equilibrium approach, at least under a gold standard.  When the price of gold is not fixed, then you could argue that currency is the only true medium of account, and hence is more fundamental.  During 1933-34, policy was all about shaping expectations of where gold would again be pegged in 1934 (it ended up being devalued from $20.67/oz. to $35/oz.)

PPS.  There is a related post (with bonus coverage of Trump!) over at Econlog.

Two examples of low interest rate monetary policies

I’ve done a number of posts comparing New Keynesian and NeoFisherian views on the relationship between monetary policy and interest rates.  Here I’d like to illustrate the problem with a picture, as people often have trouble understanding this issue.  It’s really hard to not reason from a price change.  It’s hard to stop thinking of interest rate movements as a “policy” rather than an outcome.

These two graphs show the path of the exchange rate (E) over time, under two different monetary policies.  In both cases a higher exchange rate (E rising) reflects domestic currency appreciation.  Importantly, both of these examples are “low interest rate policies”, when the central bank reduces interest rates to a lower level than before.  But case #1 is an easy money policy, whereas case #2 is a tight money policy:

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To focus on the essentials, I’d like to assume that a policy change occurs at time = T’, and that the following movement in the exchange rate is anticipated, once policy has shifted.  (The policy move itself was unanticipated beforehand.)

Notice that in both cases, the exchange rate is expected to appreciate after time = T’.  Because of the interest parity theory, this expected appreciation means that interest rates will be lower than before the policy change, when the exchange rate was stable and interest rates were the same as in the other country.  So from the interest parity theory we know that these two cases are both shifts to a lower interest rate policy.

But now let’s look at the long run impact of the two policies on the level of the exchange rate.  In case #1, the exchange rate ends up lower (depreciated) in the long run, despite the near-term expectation of appreciation.  Because of PPP, that means the policy is expected to increase the price level in the long run.  In other words, it’s an expansionary monetary policy.

In case #2, the exchange rate appreciates in the long run, yielding a lower price level.  That’s a contractionary policy.

Because the first case looks so convoluted—a currency that is expected to appreciate over time but still end up lower than before—you might think it represents the “weird and controversial model”.  Just the opposite, the first case is the New Keynesian model of easy money, and more specifically the Dornbusch overshooting version.  The second more straightforward case reflects the weird and controversial NeoFisherian model.  Just looking at the second graph, it’s easy to see how the NeoFisherians are able to get their result from mainstream mathematical models of the economy.

Here’s another way of thinking about the two cases.  In case #1, there is a one-time increase in the money supply (and/or reduction in money demand).  It reduces interest rates (due to the liquidity effect.)  But it also leads to expectations of a higher price level in the long run, due to currency depreciation and PPP.  Because prices are sticky in the short run, the effect of easy money is to initially depreciate the currency, not raise the price level in proportion.

In case #2, there is a permanent decrease in the growth rate of the money supply (and/or increase in money demand growth).  Because of the quantity theory of money, that leads to a permanent decrease in the inflation rate.  And because of the Fisher effect, the lower inflation leads to lower nominal interest rates.  And because of interest parity, lower nominal interest rates lead to an expected appreciation in the currency.  But you don’t even need the interest parity relationship.  By itself, the lower expected inflation combined with PPP leads to the expected appreciation in the currency.

So how does this help us to better understand the New Keynesian/NeoFisherian dispute?  It may be helpful to contrast the “highly visible” with the “highly important”.  The New Keynesians are focused on the highly visible, while the NeoFisherians are focused on the highly important.

The vast majority of specific, short-term decisions by central banks are better viewed as one-time shifts in the money supply, rather than permanent changes in the growth rate of the money supply.  Thus “easy money” announcements often make short-term interest rates fall, even as inflation expectations rise.  At the same time, the truly major moves in interest rates over time largely reflect longer-term changes in the growth rate of the money supply (and money demand—in more recent years).  Thus the low nominal rates in Japan are primarily due to tight money, not easy money.

Both the New Keynesian and the NeoFisherian models are wrong, as both sides engage in reasoning from a price change.  The correct (market monetarist) model says that low rates can reflect easy or tight money, and that one should not draw any inferences about the current stance of monetary policy by looking at interest rates.

If one cannot draw any inferences about the current stance of policy by looking at rates, can one draw any inferences at all?  I see two:

1.  On any given day, a decision by a central bank to cut rates by more than the market expected is usually (not always) expansionary.  It reflects “expansionary intent” and may be viewed as a signal by the central bank of a desire to make policy more expansionary.  This is, of course, consistent with New Keynesianism.  But it does not mean the current stance of policy is expansionary.

2.  When nominal interest rates fall persistently over a long period of time, it is usually (not always) evidence that monetary policy has been contractionary.  (This is more consistent with NeoFisherism).  But it does not mean that the current stance of monetary policy is contractionary.  As usual, Milton Friedman was decades ahead of the rest of the profession:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.  .  .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In America, monetary policy in 2017 and 2018 became a bit more expansionary, despite higher rates.

Was NeoFisherism vindicated?

Rajat directed me to a new post by Stephen Williamson, which suggests that recent events provide support for the NeoFisherian view.  The Fed has been gradually raising their interest rate target since late 2015, and inflation has gradually risen from near zero up to roughly 2%.  In addition, nominal interest rates are positively correlated with inflation rates at the international level.

Here are three ways of interpreting that evidence:

1. Higher interest rates cause higher inflation.  (NeoFisherism)

2. Low unemployment led the Fed to fear inflation (Phillips Curve), and they tightened monetary policy to prevent inflation from overshooting. (Keynesian)

3. The Fed did not tighten at all.  Contra NeoFisherism, raising the interest rate target is usually contractionary, ceteris paribus.  But the Fed often raises rates during periods when the natural rate is rising, and in most cases they raise rates more slowly that the natural rate is rising.  This means that while it is true that raising rates is usually contractionary, ceteris paribus, in the majority of cases a period of rising interest rates is also a period of increasingly expansionary monetary policy. I would argue that 2017 was no different. So I also reject the Keynesian view.

I prefer the second and third explanation to the first because the NeoFisherian view is inconsistent with the response of asset prices to unexpected changes in the central bank’s nominal interest rate target.  And I prefer the third explanation to the second because the Phillips Curve is not a reliable way of forecasting inflation, and changes in the nominal interest rate are not a reliable indicator of changes in the stance of monetary policy.

Off topic, I just returned from a monetary conference at the Hoover Institution, which was attended by no fewer than 4 Fed presidents.  I was delighted to see both John Williams (who was recently appointed to the New York Fed), and Robert Kaplan (Dallas Fed) mention both price level and NGDP level targeting as promising options to think about.  While neither endorsed these policy options, I had the impression that if the Fed were not already committed to inflation targeting, these two Fed presidents would probably be favorably inclined to one of these two approaches.  Kaplan seemed especially interested in NGDP targeting.  However, I don’t expect the Fed to change its policy target as long as things are going well.  Instead, I’d expect some consideration of level targeting the next time we go into a recession, and hit the zero bound.

 

What is demand stimulus?

This is a sort of follow-up to my previous post.  One can think of demand stimulus as policies that boost NGDP.  (There are of course other policies that boost RGDP, such as supply side reforms, which work even if NGDP doesn’t rise.  But demand stimulus boosts NGDP.)

We know from long run money neutrality that the long run trend rate of growth doesn’t matter, except for second order effects like hysteresis and menu costs and taxation of capital income—and these second order effects might be positive or negative.  If someone argues that a certain policy may be able to significantly raise the trend line for RGDP, they may be right, but they are almost certainly NOT talking about demand-side stimulus.

The upshot of all of this is that there is only one coherent way to think about demand-side policies.  When should AD be more expansionary than average and when should it be less expansionary than average? It’s incoherent to say, “I think demand side polices should always be stimulative.”  That doesn’t even mean anything.  It’s like saying, “I believe all Americans should earn above average incomes.”  Any demand-side strategy should either call for stable AD growth, or else specify when aggregate demand should be more expansionary than average and when it should be more contractionary than average.

If you are advocating demand stimulus during a period of low unemployment, then (whether you know this or not) you are implicitly suggesting that demand-side policy should be more contractionary than average during a recession.  Not good.

A corollary of this is that terms like ‘hawks’ and ‘doves’ don’t have the meaning that almost everyone thinks they have.  If you have a 2% inflation target, exactly how do you implement a “dovish” policy?  A “hawkish” policy?

What if we turn to fiscal policy; does that change things?  Not at all.  The government’s national debt is constrained by the fact that the debt must be serviced in the long run.  This budget constraint means that budget deficits that are larger than average during certain periods must be offset by deficits that are smaller than average during other periods–to keep the debt manageable.  It makes no sense for someone to say, “I generally favor a more expansionary fiscal policy than what is favored by Sumner.”  It’s not even a coherent statement.  If you say that you favor a more expansionary fiscal policy that what I currently favor, you are implicitly saying, “and at some future date I prefer a more contractionary fiscal policy than what Sumner will favor at that point in time.”  I worry that the insights of Robert Lucas are being forgotten.

How many punches should Chuck Norris be allowed to throw?

A number of market monetarist bloggers use the “Chuck Norris” metaphor for monetary policy credibility.  The basic idea is that if the central bank credibly promises to do whatever it takes to hit its target, then NGDP growth expectations won’t fall very far, nominal interest rates will stay above zero, and the central bank won’t have to actually take many “concrete steppes” to hit its target.  Exhibit A is the Reserve Bank of Australia, which never had to cut rates to zero or do QE during the global recession of 2008-09.  And yet the Aussie outcome was better than in other advanced economies.  The Chuck Norris metaphor refers to the fact that he can clear a room without throwing a punch, just due to his reputation.

Chuck Norris is a good metaphor, but (as far as I know) other bloggers have not fully fleshed out this line of reasoning.  The focus has been on what central banks need to do, but perhaps the real focus should be on what governments need to authorize.

Consider two countries with central bank balance sheets equal to 5% of GDP, both on the eve of the Great Recession.  In each case, the balance sheet balloons to 25% of GDP during the Great Recession.  In which case is policy more expansionary?

Case A:  The central bank is legally limited to a balance sheet of no more than 25% of GDP.

Case B:  There is no legal limit on the central bank balance sheet.

In case B, the expansionary impact of the QE will probably be much greater than in case A.  While the “concrete steppes” are identical, in case B there will probably be expectations of a more expansionary future policy than in case A.  Nick Rowe often points out that the current concrete steps taken by central banks are far less important than changes in the future path of policy.  That’s implicit in the Chuck Norris metaphor, and also an implication of state-of-the-art New Keynesian models developed by Michael Woodford and others.

At this point you might assume that the implication of my post is clear—don’t have legal limits on central bank balance sheets.  But a decade of reading deep thinkers like Tyler Cowen and Robin Hanson (or petty much any of the George Mason bloggers) has convinced me that when it comes to human institutions, things are always more complicated than they seem, certainly more complicated than they seemed to me a decade ago.  For instance, let’s add another case:

Case C:  The central bank’s balance sheet is legally limited to 250% of GDP.

Now let’s think about Fed policy during the recovery from the Great Recession.  We know that the Fed did three QE programs, and stopped when its balance sheet was just under 25% of GDP.  We know that Bernanke cited vague “costs and risks” of doing even more QE.  (Although we also now know from the FOMC transcripts that Bernanke himself was less concerned about these risks than other members of the committee.)  And we know that some in Congress were complaining about all the money printing, and almost no one on Congress were complaining that they did not print enough money.

To summarize, while the Fed was in Case B, with no legal limit on their balance sheet, the institution behaved as if there was a sort of implicit limit, probably much lower than 250% of GDP.  In that case, moving to case C might have actually been expansionary.  The Fed would have thought, “Congress has our back, they authorize us to do truly massive QE if necessary to achieve our mandate.”  Think of Russian highway speed limits changing from “no explicit limit but at the discretion of what the police officer views as unsafe” to “150 kilometers per hour”.  Do speeds rise or fall?

In a perfect world, I’d want Congress to tell Chuck Norris that he’s authorized to throw as many punches as required to clear the room.  Or perhaps to authorize a specific number that is clearly more than he would need (say 10,000 punches.)  But I’m not sure about the idea of actually having Congress set a limit.  If they had done so back in 2008, the limit on the central bank balance sheet would likely have been set too low.

Because Congress is so dysfunctional, and likely to remain so, one could argue that the Fed can pretty much do whatever they want.  Who will stop them?  The Fed is about 100 times more respected than Congress, and any Congressional attempt to control the Fed would almost certainly fail to get 51 votes in the Senate (which actually has a few grown-ups).  There are plenty of pragmatic GOP senators (say among people like Lindsey, McCain, Flake, Collins, etc.), some of which would not support a right wing attempt to rein in the Fed.  Heck I doubt even Trump would support it, as he knows he might need monetary stimulus if we again go into a recession.  So perhaps the Fed could simply put on its Superman costume (sorry for mixing metaphors) and unilaterally announce that it views itself as being authorized to lower IOR to as much as negative 0.75%, and boost the balance sheet to as much as 250% of GDP, and then dare Congress to stop them.

That won’t happen (Larry Summers was not picked to be chair), but it’s the sort of issue we should be thinking about.  Instead we think about question like “does QE work?”  Which is such a dumb question it makes my hair hurt every time someone asks it.

Update:  People keep asking me how I enjoy California: