That’s not spanking, that’s child abuse!

Because I picked on Ahamed a bit in the previous post, I want to make up for it by pointing out some excellent passages in his fine book.  Here he discusses the common misconception that money “goes into” markets:

There was the erroneous notion [in the 1920s] that a rising stock market “absorbs” money from the rest of the economy.  This is sheer nonsense, because for every buyer of stock there is a seller and whatever money flows into the stock market flow immediately out.

This issue has come up a lot in this blog, with some people claiming that expansionary monetary policy blows up bubbles, because the money “has to go somewhere.”

Update 7/20/09,  I misread the quotation.  In the comments below Jon points out that Ahamed ignores the increased demand for transactions balances that often accompanies a rising market.  (Although steeply falling markets also can see increases in transactions.)

An even better passage occurs on pages 276-77 when Ahamed discusses the dilemma faced by NY Fed Governor Strong:

But as an experienced Wall Street hand, he was quite aware of how difficult it was to identify a market bubble—to distinguish between an advance in stock prices warranted by higher profits and a rise driven purely by market psychology.  Almost by definition, there were always people who believed that the market had gone too high—the stock market depended on diversity of opinion and for every buyer dreaming of riches in 1925, there was a seller who thought the whole thing had gone too far.  Strong recognized his own highly fallible judgment about stocks was a very thin reed on which to conduct the country’s monetary policy.  Even though his initial reaction was that the market might have gone too far, he asked himself, “May it not be the case the world is now entering upon a period where business developments will follow the recovery of confidence, so long lost as a result of the war?  Nobody knows and I will not dare prophesy.”  Given so much uncertainty, he was convinced that the Federal Reserve should not try to make itself the arbiter of equity prices.

Moreover, even if he was sure that the market had entered a speculative bubble, he was conscious that the Fed had many other objectives to worry about apart from the level of the market.  He feared that if he added yet another goal—preventing stock market bubbles—to the list we would overload the system.  Drawing a rather stretched analogy between the Federal Reserve and its various and conflicting objectives for the economy and a family burdened by many children, he ruminated, “Must we accept parenthood for every economic development in the country?  That is a hard thing for us to do.  We would have a large family of children.  Every time one of them misbehaved, we might have to spank them all.”  He wanted the Fed to focus on stabilizing the overall economy and was reluctant to allow its policies to be dominated by the need to regulate the “affairs of gamblers” who thronged the tip of Manhattan.

After Strong died in late 1928 the Fed had no leadership, and drifted into a policy of trying to spank Wall Street.  Unfortunately, it also ended up spanking workers, farmers, banks, small businessmen, and most ominously, German voters.

From late-2006 to mid-2008 the markets were doing a very effective job of spanking those housing speculators who made a lot of foolish decisions.  Take a look at the graph in this link (you’ll have to scroll down to see the “W-shaped” graph.)  The first price drop is very appropriate punishment, but the second is cruel and unusual, a brutal whipping inflicted on an already badly bruised housing sector.  How could the Fed do something so cruel?  Because they stopped focusing on “stabilizing the overall economy,” which is roughly NGDP growth expectations, and started trying to spank the commodity markets which had soared in mid-2008.  The punishment didn’t look that bad, because the fed funds target rate wasn’t raised once during the summer.  But the overall economy was steadily weakening and desperately needed propping up before we were so far into a liquidity trap that conventional monetary tools were rendered impotent.  Instead they heeded warnings from economists who were panicked by headline inflation numbers and ignored the ominous downtrend in AD underway in August and September.

One of the most shameful aspects of Fed policy during the Great Depression was that when FDR finally took the US off gold in 1933 we still had by far the world’s largest gold stock.  All that ammunition, and never employed in exactly the sort of crisis for which it was held in reserve.  In early October 2008 US monetary policy lost all credibility, as critics like Paul Krugman pointed out that we were now effectively in a liquidity trap.  And this occurred with the fed funds target still at 2 percent!  Two hundred basis of ammunition unused as we entered a crisis that Bernanke said we needed to avoid at all costs—a deflationary liquidity trap.

All this happened because we stopped trying to target NGDP, and took time to spank the commodity markets.  Unfortunately, tens of millions of unemployed workers throughout the world had to share in the spanking.

PS.  I’m way behind on projects I need to complete this summer, so please don’t send me anything time consuming for the next few weeks.  I would appreciate if there were no ten foot long comments ending with the statement that I need to read Ludwig von Mises’ Human Action in order to understand anything in the comment.  Thanks.


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55 Responses to “That’s not spanking, that’s child abuse!”

  1. Gravatar of Jon Jon
    19. July 2009 at 19:28

    This issue has come up a lot in this blog, with some people claiming that expansionary monetary policy blows up bubbles, because the money “has to go somewhere.”

    1) Sure, it goes everywhere including to asset prices

    2) As the stock-market rises the transaction volume increases–volume (# of shares traded) trends at least flat but the price per-share traded goes up. Therefore, despite it being a ‘money-in-money-out’ process, the sequence is not instantaneous. More money does indeed get tied up in transaction accounts and thus drained from circulating elsewhere.

    The market ‘wealth’ expanded by many trillion dollars during the boom. Yet M2 expanded by only a few 100B per year during most of that period. The discrepancy is because the money is accounted for in the transactions not the bulk–and yes it went into some other markets too.

    So, Ahamed gets the story wrong. The notional transaction amount rises with the market therefore the market does absorb (some) of the new money and that new money does indeed cause asset prices to rise.

    The only sheer nonsense here is Ahamed’s straw-man rendition of the claim.

  2. Gravatar of bill woolsey bill woolsey
    20. July 2009 at 02:40

    Jon:

    You are getting close.

    The “money” doesn’t go into a market and get absorbed there.

    But increased nominal wealth almost certainly raises the demand for money. (The quantity of the medium of exchange people want to hold.)

    If we take the number of transactions in an asset market as given, then at higher prices, those transactions involve a higher demand for money.

    However, this is but one avenue by which higher asset prices might raise money demand. If the demand for money is positively related to total wealth, then higher asset prices raise money demand.

    If there is an excess supply of money, then people will spend. And they spend the money on something or other.

    Equilibrium will be reestablished, rapidly, by an increase in the demand for money. Lower interest rates/higher asset prices is a plausible rapid adjustment process.

    Other things being equal, this should raise the demand for consumer goods (because the greater wealth lowers the motivation to save and add even more to wealth, for example) or perhaps increase the demand for capital goods, (by borrowing to purchase capital goods or selling assets making up retained earnings to buy capital goods, or issuing new shares to buy capital goods.)

    Because of scarcity, only so many goods and services can be produced. But if there are shortages, their prices rise, reducing the real quantity of money.

    On the other hand, each individual only has limited wealth, and if they change their asset allocation, choosing to hold less of one stock and more of another, for example, there is a shift in demand. Less demand for one stock and more demand for another.

    This is similar to people with limited income purchasing less of one good and more of another. Less demand for one thing, more of another. In reality, when this happens, there is more money flowing into the high demand sector and less money flowing into the low demand sector. This is because the point of these transactions is to obtain consumer goods or capital goods for use,

    With the asset markets, something exactly like this often happens, but be mindful that it is actually divergences in expectations that drive the transactions. If everyone shifts from one stock to another because of changed expectatins, the prices adjust without any transactions. So, the notion that more money flows into the asset with higher demand and less into the market with with less demand isn’t necessarily true.

    In the market with the higher demand, there was never a need for more money to be used to purchase more of them. The prices of the assets are higher. The nominal value of the assets are higher. But there is no extra money anywhere.

    But the demand to hold money is plausibly higher (other things being equal.) If the price of some other asset has fallen, that would offsent this effect.

    While the constraint on aggregate income is harder, because of scarcity, the constraint on aggregate wealth is soft. While the individual is limited, market prices for assets can rise without limit. As above, this requires no transactions to occur. If everyone thinks that all stocks are worth more, their prices rise, without anyone actually transacting any of them.

    If the demand for money rises because of the higher stock prices (or example,) and if the quantity of money doesn’t rise there will be a shortage of money. However, there is no reason to believe that this would keep the prices of the equitites from rising. Perhaps other assets or output prices would fall.

    Sumner’s point (and I strongly agree,) is that monetary institutions should focus on aggregate market clearing for currently produced output. (Well, actually, I think he is more focused on labor.) Because of scarcity, we can’t produce as much of these things as we would like. And so, microeconmics is all about redeployming resources from less valued to more valued fields of endevor. The best macroecnoomic environment for these shifts is for there to be shortages of goods where production should expand and surpluses where it should contract.

    Asset prices, on the other hand, do not reflect this sort of scarcity. They can be as high or as low as well like, unless or until they impinge on the actual production of goods and services. If asset prices are so high that the wealth results in demands for scarce goods beyond what can be produced, then they are too high for market clearing, but monetary institutions should focus on that–the market clearing for the products.

    It is a market failure if expecations of future profits drive higher asset prices, but the higher asset prices raise the demand for money. And the amount of money doesn’t rise, and so the result is reduced expenditures somewhere or other in the economy–at least if these lower expenditures generate surpluses on net of produced goods and services. That is, provide false signals that we should produce less of everything.

    If asset prices rise so high that there is a shortage of produced goods and services (say people save less and consume more and firms purchase money capital goods too,) then those asset prices are too high, but because they are consistent with market clearing, and that should be the focus of monetary institutions.

    Sumner (and I) reject the approach of having monetary institutions somehow determine that the asset prices don’t reflect future production correctly, and create or destroy money to get asset prices to better reflect actual future production.

    One final point. Aggregate wealth is a soft contraint. Suppose everyone espects more future profits, and asset prices all rise. Wealth is higher. If we thinking of saving as a flow, income less consumption, there was no need for any additional saving. If we instead using the consumption possibilities conception of income, then the capital gains reflect greater income, and people just save all the unrealized capital gains. They can do this.

    If monetary disequilibrium is created because of these process, it will be disruptive to what is important, the flow of income and output, the deployment of resources in producing what is most important.

    And, how could monetary institutions determine how much actual production will occur?

  3. Gravatar of bill woolsey bill woolsey
    20. July 2009 at 02:48

    Scott:

    “punishing commodities markets?”

    Commodities are produced. They require resources. If the demand for commodities rises relative to other things, so that more resources should be devoted to their production, then those resources should come from something else. And so, there should be offsetting surpluses.

    In view, trying to stablize equity markets is a categorical error. Trying to dampen moves in commodity markets is right, and the only problem would be that a backward looking policy is a mistake. (Even writing this short comment is pointing me to those difficult problems as to exactly which future quarter of nominal GDP should be targetted.)

  4. Gravatar of ssumner ssumner
    20. July 2009 at 04:08

    Jon and Bill, I misread the Ahamed quotation the first time through. I thought he was referring to the view that monetary injections by the Fed tend to push up asset prices because the money needs somewhere to go. That would have been a fallacy, as stock market volume also increases sharply when the stock market crashes, so more spending on stocks says nothing about which way stock prices would go. But I agree with Jon that Ahamed expressed a slightly different idea, and there is a problem there. Jon is right that if there was a rise in stock transactions volume during the 1920s, it would have raised the demand for transactions balances to buy those shares.

    I’ll add an update.

    I also agree with most of what Bill says, but don’t think his view really conflicts with the specific problem Jon raised.

    Bill#2, I strongly oppose targeting commodity price indices. I agree that commodity markets are important, but only to the extent that they signal excessive or deficient NGDP growth. In mid-2008 the commodity markets were booming, but expected NGDP growth was falling increasingly short of the policy goal. Commodities now less than 10% of GDP, if I’m not mistaken.
    I think we basically agree on the goal, but are thinking about the issue differently.

  5. Gravatar of azmyth azmyth
    20. July 2009 at 07:38

    Bill raises an interesting point that I have been thinking about lately: “…which future quarter of nominal GDP should be targetted”?

    Targeting further into the future improves credibility and puts the focus on long run policy at the expense of dealing with current problems. Also, the further out the Fed targets, the harder it is to predict what will happen, even for the market. Perhaps a weighted average would be useful. Do you have any papers that address this issue?

  6. Gravatar of 123 123
    20. July 2009 at 08:37

    “took time to spank the commodity markets”
    In a recent speech ECB’s Trichet used breakeven inflation rates derived from inflation protected securities market to argue that ECB was performing better than Fed during the crisis. The charts he gave indicate that last summer high prices in commodity markets have influenced 5 year market based inflation forecasts. So maybe they were right to spank the commodity markets. It was just that they were too slow to change direction.

  7. Gravatar of Current Current
    20. July 2009 at 10:05

    My short responses to this are:

    * Bill Woolsey is right about what he says about the relationship between stock markets and money.

    * In the long run MV=PT. So, unless there is a permanent change in V and permanent change in M will lead to price increases somewhere. However this is a long run effect, not a short run one.

  8. Gravatar of StatsGuy StatsGuy
    20. July 2009 at 11:51

    Bill:

    “But increased nominal wealth almost certainly raises the demand for money. (The quantity of the medium of exchange people want to hold.)”

    Why is this necessarily true?

    One would imagine there are at least two effects of assets increasing in nominal wealth. 1) Some type of transaction demand for money, to settle trades. This would increase demand for money. But 2) Money as a store of wealth…

    If my money-as-store-of-wealth demand curve (relative to assets) was constant elasticity, then an increase in asset values causes me to want to balance that with more liquid wealth. Demand for money goes up. That’s the traditional story.

    Indeed, this is the totally “rational” thing to do – rebalance your investment portfolio when asset prices go up. (in plain words: sell high, buy low)

    But I don’t think that’s what actually happened over the past year, perhaps due to risk perceptions or perhaps due to wrong assumptions about the shape of the money-as-store-of-wealth demand curve (which are probably related).

    Imagine that the typical household’s investment strategy is yield-maximizing, subject to a minimal value constraint.

    A very simple model works like this:

    – I need to keep a cushion of 60k in liquid assets
    – My bank account earns 2% interest (blech… I’m too smart for that)
    – I perceive a risk that the market will move 20% down or 30% up… (On average, it rises 5%) Other than my minimal value constraint, I believe myself to be risk neutral
    – I have 100k in assets…

    Under this strategy, I invest all 100k. (There is probably an intertemporal optimal ratio to put into stocks that you can arrive at by backsolving, but let’s keep this simple.)

    But if my wealth sees a sudden shock, and my investments drop more than expected (30%), I now have 70k left. Now, if the market falls 20% again, I am below my security constraint level. I therefore have no choice but to REMOVE money from the market even if I’d rather hold them. This could be viewed as a pure liquidity constraint… And there are other examples in the real world than households.

    -Margin calls (as asset values decline, I MUST SELL)
    -Bank Credit Agreements (I MUST raise money if my stock value declines below a threshhold – consider the shipping sector, which saw nearly every carrier in violation of bank collateral agreements as stock price and vessel resale price declined)
    -Capital/Asset requirements for banks (e.g. I am forced to build loan loss reserves as marked-to-market assets decline in value)

    The dynamic described above is both a) entirely rational and b) endogenously pro-cyclical. The decline in asset values independently INCREASES demand for holding money as a store of wealth (suppressing velocity). Thus, a negative wealth shock OF SUFFICIENT MAGNITUDE could by itself cause a recession or depression even without resorting to an explanation relying on the “mass psychology” story (which, btw, I partly agree with too – risk is partly psychological, partly derived from nonlinearities in the utility curve).

    In other words, an exogenous drop in asset values (if perceived as potentially longer duration than a few weeks), can trigger a self-reinforcing household balance sheet crisis. And that’s what happened in September/October…

    I’m sure that targeting market-clearing levels of labor/goods would fix this, but I’m not sure the Fed could have done this fast enough in September/October to prevent the asset crash. Fed policy lags the real economy by many weeks, partly due to data gathering and partly due to the Fed’s lazy meeting schedule. But I suppose if the Fed could _credibly_ commit to restoring lost NGDP, this would work even if the Fed operated at a lag vs. the real economy.

  9. Gravatar of StatsGuy StatsGuy
    20. July 2009 at 14:14

    DeLong writes this in the Economist’s Voice.

    “…the nominal interest rate on government securities
    is zero. Monetary policy cannot make safe
    wealth in the future any more valuable. And
    this is too bad, for if we could prevent a depression
    with monetary policy alone, we would do
    so, as it is the policy tool for macroeconomic
    stabilization that we know best and that carries
    the least risk of disruptive side effects.”

    Seems like that deserves a response, neh?

    (No disrespect to DeLong – his last re-post on the Fed, that central bank independence is a _political_ decision that favors lenders in setting monetary policy because it’s run by a cabal of… well, bankers… is 100% dead on. It seems like this is the real explanation why monetary policy is “ineffective” at the zero bound…)

  10. Gravatar of Nick Rowe Nick Rowe
    20. July 2009 at 16:16

    Isn’t it just shorthand for (or a sloppy way of writing) “…monetary injections by the Fed tend to push up asset prices because the money needs somewhere TO TRY to go.”?

    When there is an excess supply of money, people will TRY TO get rid of it by TRYING to spend it on assets, and the increased demand for (TRYING TO buy) assets pushes up their price.

  11. Gravatar of ssumner ssumner
    20. July 2009 at 18:13

    azmyth, The honest answer is that I have no idea. But with an NGDP trajectory (level targeting), I think it is less important. Thus I now favor a 106, 111, 116, 121, 126, etc NGDP target. If we use futures contracts I think we should pick one year, but I can’t give you a good reason why other than that shorter and longer choices both have problems, and it seem like a reasonable compromise. If someone said it should be 18 months, I’d say fine.

    123, I think you are right on both counts for 2008. The ECB was a bit better, and the real mistake may have been not reversing quickly. Of course I actually favor NGDP targeting, and NGDP has recently fallen sharply in Europe.

    Current, I also agree with Bill and you that it is a mistake to stabilize equity markets. You don’t want to use the MV=PY equation that way–it is a common mistake. Just say M causes P or PY to rise in the long run. The equation is now used as a tautology by most economists, and thus is true even in the short run.

    Stasguy, I think Bill should have said “ceteris parabis” more wealth leads to higher money demand. I agree that on many occasions the reverse is true. Indeed even though Ahamed’s logic was wrong, his facts were right for the 1920s. The huge stock boom which created a lot of wealth actually reduced the demand for money. Why? Because it raised interest rates, which are the opportunity cost of holding money. Thus real money demand was stable in the 1920s despite fast GDP growth, and money velocity declined. I also think per capita cash holdings declined.

    Statsguy, I’ll take a look at DeLong, but Zimbabwe found a way to create inflation in a depression. Perhaps we could send a fact-finding team of DeLong, Krugman, and Bernanke to investigate how they did it. Bring the BOJ prsident along as well. (Yes, I know it was also fiscal, but what if they had just bought US T-bonds with all those Zimbabwe dollars. Wouldn’t they still have gotten inflation?)

    Was the Fed run by a cabal of bankers from 1966-81 when they created massive inflation which transferred great wealth from lenders to borrowers?

    Nick, Good question, but I would say not always. A highly expansionary monetary policy will cause T-bond prices to fall, so it must be more than simply a question of the money needs some place to go. Think of a flexible price model for simplicity. You double the money supply and the price level doubles. So do stock prices.
    Now suppose you don’t change the money supply at all, but change the expected growth rate, you announce a switch from permanent 0% growth rate to a permanent 10% growth rate. Inflation expectations and nominal rates jump, and the price level and stock prices jump discontinuously. Now do the same except pull enough money out of circulation so that the price level doesn’t jump, but simply bends and shifts from a 0% growth rate to a 10% growth rate. There is no discontinuous change in the CPI, but it shifts from a 0% to a 10% growth rate. Stock prices will fall discontinuously, but not because you pulled money out of circulation, rather because taxation on capital is not indexed for inflation. After they fall, they will rise at 10%.

    What’s my point? I forgot. Oh yeah, my point is you can work all these things out by thinking in terms of a sort of finance model plus the QT of Money including violations of superneutrality when the opportunity cost of holding cash changes. The fact that cash may or may not be spent on stocks CHANGES NOTHING. Suppose for some weird reason people never spent money on stocks. They held other assets like T-bills, and it was traditional to exchange T-bills for stocks. In my view a monetary injection would still have exactly the same impact on the stock market. An expansionary monetary policy that is one-time (1933) will usually raise stock prices, whereas a rise in the money growth rate (late 1960s-1970s) will usually lower stock prices because of taxes. But whatever the effect, it has nothing to do with the fact that you can buy stocks with a wad of cash. You can buy safes with cash as well, but if the BOJ printed a lot of cash the demand for safes in Japan would fall, as people bought them to hold cash during deflation.

    Here’s what I’d say. The attempt to get rid of cash bids up the price of goods and services in the long run. Whether that bids up the price of a given asset (T-bonds, stocks etc.) depends on how the real value of that asset is affected by both a change in the price level, and a change in the expected rate of inflation.

    Now that I am all done, I think you might be right for most real assets. But I think it is a bit more complicated than you suggested. I still want to insist it is the same reason that a big apple harvest makes the apple price of stocks rise. And I think you want a transaction mechanism. I should go to bed.

  12. Gravatar of David Pearson David Pearson
    20. July 2009 at 19:24

    Scott,

    In an earlier post, I argued that banks do not necessarily convert ER’s to RR’s by buying t-bills. I hope you don’t mind if I re-pose the question here.

    My contention is that purchases of existing t-bills may not reduce ER’s. The reason is that the sellers of near-zero yielding t-bills may be indifferent between holding cash and holding bills. They therefore may leave the proceeds of the sale of t-bills as cash deposits in the banking system. No expenditures yet. Now the banks need to decide whether to create credit with the cash deposits or leave them as ER’s. However, since they preferred ER’s before the t=bill purchases, they arguably would not elect to hold less ER’s after.

    For banking system t-bills purchases to hve to lead to more money in circulation, the banking system must create credit to the government, which in turn spends that credit. This is deficit spending, fiscal stimulus, deficit monetization — whatever you want to call it.

    So, my question is, how do you think the purchase of existing t-bills NECESSARILY leads to a reduction in aggregate ER’s?

  13. Gravatar of ssumner ssumner
    21. July 2009 at 03:37

    David, I agree that banks do not necessarily convert ERs into RRs by buying government debt. They might convert to cash. But one thing is certain, banks don’t have to hold a lot of ERs if they don’t want to. And with a penalty rate on ERs they won’t want to.

    Your mistake is to assume “since they preferred ERs before the t-bill purchases.” Actually, with a penalty rate they wouldn’t have preferred ERs before.

  14. Gravatar of David Pearson David Pearson
    21. July 2009 at 05:03

    Scott,

    You are making a rather important assumption without providing support.

    Is it your contention that banks would rather earn 15bp on ER’s than a spread of 500bp on loans? Do you think a change for +15bp to -25bp would really impact that trade-off?

    It is entirely plausible that banks prefer to hold ER’s because there is no incremental demand for credit at current underwriting standards. You assume that those standards can be influenced by the interest rate on ER’s. When I pointed out that the trade-off is not obvious, you stated that banks can just buy T-bills then. When I pointed out that T-bill purchases do not necessarily reduce ER’s, you went back to arguing banks would lend out the money.

    The reality is that the banks’ marginal propensity to lend is a complex function difficult to capture a priori. Much more difficult, at least, then you make it out to be. Why not just experiment? Charge a penalty on ER’s and just see what happens? I can’t disagree with that, however:

    If you believe that the Fed is now not being stimulative, and if you believe that the penalty rate may not work, then the clock is ticking — the probability of deflation is rising. The only policy we know for sure will fight that deflation is deficit monetization accompanied by an inflation target that implies inflation tail risk. This is a “messy” policy, one that may lead to overshooting. Such is the cost of trying to fine-tune the economy with monetary policy. This is a cost I would rather have avoided, but since we have embarked on fine-tuning since at least 1991, what choice do we have?

  15. Gravatar of David Pearson David Pearson
    21. July 2009 at 05:11

    BTW, Scott, I do also wonder why, necessarily, banks won’t pass the ER “tax” onto its customers. A negative deposit rate would do the trick, such that almost any penalty rate you come up with fails to reduce bank lending spreads.

    The ability of an industry to pass through a tax depends on the elasticity of demand and the competitiveness of the industry. The price elasticity of depositors depends on their attitudes towards risk. At a -4% deposit rate, would they go out and buy high-yield bonds? Maybe, or maybe they would just keep currency in vaults.

  16. Gravatar of StatsGuy StatsGuy
    21. July 2009 at 05:42

    If banks put a negative deposit rate on savings, consumers would withdraw physical cash (and/or switch to a different bank), effectively leading to a run on the bank that attempted it. No bank would risk a deposit run merely to cover 25 basis points – particularly in a liquidity crisis.

    The Federal Reserve, OTOH, _wants_ to initiative a deposit run on _itself_. Your better question is, would 25 basis points be enough? And where can the banks hide? It doesn’t seem likely that banks would be able to pass it on.

  17. Gravatar of David Pearson David Pearson
    21. July 2009 at 06:16

    StatsGuy,

    True enough — it would drive depositors into currency, which is the same thing as a run. So then the question becomes, could they pass it on to borrowers?

    Would 25bps be enough? I would be very surprised. Gross lending spreads are probably as high as they’ve ever been for banks. They have every incentive to lend and lend freely. The shift from +15 to -25bp implies a 40bp tax on ER’s. Assume that you can pass on half — 20bp. So you are increasing ROA’s by 20bp in the middle of a credit bust, and that is supposed to drive credit decisions? Not in the real world…

  18. Gravatar of Current Current
    21. July 2009 at 06:19

    With the crime rate in my area there is no way I would take my money out of the bank if they started charging me. I expect many others are in a similar situation. That’s not to say it won’t happen though.

  19. Gravatar of Nick Rowe Nick Rowe
    21. July 2009 at 08:00

    Scott: Yes. I basically agree with your reply to my comment.

    At a first order approximation, flows of output flow from hand to hand in exchange for the medium of exchange, and stocks of assets don’t; they are held.

    I had just wanted to make the more basic point, that sometimes when people say something silly, like “more money went into the stock market”, they can be re-interpreted to be saying something more sensible, like “people tried to put more money into the stock market”.

  20. Gravatar of Mattyoung Mattyoung
    21. July 2009 at 09:23

    Where did the notion come from that the Fed can time its actions appropriately? The Fed cannot be completely decorrelated from the real economy, so Fed timing is restricted, typically the Fed is six months late to the scene.

  21. Gravatar of Jon Jon
    21. July 2009 at 10:03

    David, I agree that banks do not necessarily convert ERs into RRs by buying government debt. They might convert to cash. But one thing is certain, banks don’t have to hold a lot of ERs if they don’t want to. And with a penalty rate on ERs they won’t want to.

    At current valuations of Treasuries, it would be impossible for Banks to drain all of their ER using only Treasury purchases. They’d have to buy out the entire market of treasury debt several times over. So I’m pretty sure that they aren’t interested. 8/900B in ER is an incredible amount.

  22. Gravatar of Bill Woolsey Bill Woolsey
    21. July 2009 at 10:56

    Pearson:

    Either you don’t understand how this works, or else, we are using the terms in a different way. But if you want to understand Sumner’s argument, you need to learn the way he is using the terms.

    If a bank buys a government bond from someone who is not a bank, the seller of the bond has more money in a checkable deposit. Perhaps you call this a “cash deposits?” Regardless, current reserve requirement is 10%, and so the amount of reserves the bond seller’s bank is required to hold increases by 10% of the values of the bonds purchased.

    The bank buying the bond gets rid of reserves, but the reserves shift to the bond seller’s bank, and the bond seller’s checkable deposit in that bank must be matched 10% by reserves, increasing the amount of required reserves.

    The increase in the amount of required reserves occurs at the bond seller’s bank.

    Checkable deposits expand by the value of the bonds purchased. And the amount of reserves required by the banking system increase by the increase in checkable deposits multiplied by the required reserve ratio.

    This doesn’t require that anyone spend, or that the government get the money and spend it, or anything else.

    Excess reserves in the banking system disappear as checkable deposits expand and the amount of reserves banks are required to hold expands to the amount that exist.

    Now, the most important real world complication is that bank will start counting checkable deposits under sweep agreements.

    I think there is no doubt that this process should reduce the interest rates banks pay on checkable deposits. And that is a good thing.

    Jon:

    Excess reserves are currently $751 billion. Treasury debt held by private investors is $6311 billion. Of that, about $1300 billion is already held by banks. And so, that leaves about $5,000 billion held by people other than banks. If banks purchased all of these, the checkable deposits created by the banks for the sellers would be an additional $5,000 billion. That would be leave about $250 billion in excess reserves.

    It isn’t “several times over,” but rather 50% over.

    Of course, these would be a variety of debt. Did you mean T-bills only? Or does the term “Treasuries” include notes and bonds, as well as bills.

  23. Gravatar of Bill Woolsey Bill Woolsey
    21. July 2009 at 11:04

    Statsguy:

    I am not claiming that the demand for money solely depends on nominal wealth, just that it is plausible that it is positively related.

    Of course people could choose to hold less money and more of some other asset if they wanted.

    If it isn’t, then that is one less reason to take seriously claims about money “going into” these asset markets.

  24. Gravatar of Bill Woolsey Bill Woolsey
    21. July 2009 at 11:06

    Pearson:

    You are assuming that Sumner advocates the penalty rate on excess reserves in order to get banks to make more loans. That isn’t the reason. It is rather to get the banks to stop holding so much base money. It is to increase the quantity of checkable deposits created by the banking system.

    Do you think that reserve requirements are proportional to bank loans? Perhap that is the source of the confusion. Reserve requirements are 10% (more or less) of transactions deposits. Basically, checkable deposits.

  25. Gravatar of Jon Jon
    21. July 2009 at 11:54

    Bill:

    The current reserve requirement is closer to 1%. The 10% reserve requirement has a fairly significant loophole: namely the “sweeping” of what would have historically been demand deposits into ‘time’ accounts.

    This has been the case for about fifteen years now; although banks have gradually become more efficient at sweeping. See a short description on page 12 of http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.pdf

  26. Gravatar of Rafael Rafael
    21. July 2009 at 12:33

    Hey Scott,

    A highly relevant article by Ben Bernanke:

    http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html

  27. Gravatar of StatsGuy StatsGuy
    21. July 2009 at 12:45

    Jon:

    This is precisely why the cap-asset ratio is a more critical regulatory focus than the reserve ratio. (Although, believe it or not, the recent crisis did actually cause some banks like E-trade to work harder to retain deposits.)

    Few people realize that the downgrading of “official” credit ratings on debt-backed securities (ratings issued from the sorrowfully innacurate ratings agencies) had an immediate effect on banks. Cap-asset ratios for secure assets are much more lenient (1/25) vs. risky assets (closer to 1/10), so by reclassifying assets from safe to risky, a bank may be forced to immediately raise capital depending on its leverage position (in a hostile liquidity environment) even if nothing else changes! Mark-To-Market accelerated this (and even if you believe in the EMH over the medium-to-long term, applying MtM instantaneously to massively leveraged financial instruments in a highly volatile environment where even good banks have only an 8% capital buffer against losses is just plain asking for trouble.)

    Having said that, prior to the current crisis, banks were already “innovating” ways around the cap/asset ratio requirements by buying “insurance” on assets to take them off the books (without regard for counterparty risk).

    In a sense, the old team (even, gulp, Evil Hank) had it right that the immediate liquidity crunch in September (which witnessed LIBOR skyrocketing) was caused by a cascade of forced-deleveraging due to arcane banking rules (and lax regulation/laws which had allowed traditionally conservative rules to be violated or repealed).

    One can argue that the wealth-shock in early October (and perhaps even later September) was not really real. It _became_ real when – week after painful week – the Fed refused to counteract it, as everyone expected…

    But the double crime was the failure to recognize when it stopped being a banking crisis, and became a debt/deflation trap. And that was sometime in October, but by November it was glaringly apparent even to a novice like myself when LIBOR dropped to below pre-crisis rates

    http://mortgage-x.com/general/indexes/wsj_libor_history.asp?y=2008

    After that, the Fed has no excuse. nothin’.

  28. Gravatar of StatsGuy StatsGuy
    21. July 2009 at 12:53

    On a separate topic:

    Could it be that the “Great Moderation” occurred because there were invisible changes to the banking system (sweeping is just one example) that effectively accelerated money and/or allowed greater leverage without this being visible to the bond markets? Hence, expectations of money supply growth were low in spite of significant M3 growth?

  29. Gravatar of David Landry David Landry
    21. July 2009 at 12:58

    So when will we get to hear your comments on Bernanke’s recent WSJ opinion piece, which talks a lot about paying interest on reserves? (http://online.wsj.com/article/SB10001424052970203946904574300050657897992.html#mod=rss_opinion_main)

  30. Gravatar of David Pearson David Pearson
    21. July 2009 at 13:25

    Woolsey,

    In your example, a $900b T-bill purchase by the banking system would result in a reduction of ER’s (assuming a 1% effective reserve ratio) of around $9b. Of course, checkable deposits would rise by $900b.

    You would say the money supply rises by $900b and that’s all we need to know.

    I would say all that’s happened is that private investors have shifted between T-bills and deposits, but that has not changed, necessarily, their time preference for spending. That is because ultra-low yielding T-bills and deposits are close to perfect substitutes.

    In other words, the T-bill purchase would increase M1, the multiplier on that would be zero, and ER’s would not meaningfully decline. Impact on AD: none.

    Correct?

  31. Gravatar of Bill Woolsey Bill Woolsey
    22. July 2009 at 02:43

    Jon:

    The required reserve ratio is 10%, not 1%.

    There is no effective required reserve ratio of 1%.

    The effective (actual) ratio of total bank liabilities to reserves was about 1% until last year. Now it is about 4%.

    If you want, you can try to make an argument that banks must expand their total liabilities in proportion to the increase in checkable deposits.

    Here is how it goes. As banks buy government bonds, checkable deposits expand and required reserves increase and excess reserves decrease. But as checkable deposits expand, people will shift from checkable deposits to savings accounts. _The banks will passively adjust to this._ Banks reduce checkable deposit balances and increase balances in savings accounts._ Required reserves decrease again, and excess reserves increase. And the same for CD’s. More savings and checking accounts. Depositors shift fund to C.D.s. The decrease in checkable deposits and expansion in CD’s decrease required reserves and increase excess reserves.

    Using ratios that developed when banks were seeking to minimizing required reserves hardly apply to a sitution where banks have what would be costly excess reserves.

    It is true, however, that banks will be motivated to shift existing funding from other liabilities to checkable deposits. As I have said many times, stopping any remaining sweep account activities would be a first step. All that means is honestly reporting checkable deposits as such, rather than reporting them as savings acounts. It has no impact on depositors at all, only what reports are sent to the Fed. Similarly, banks will be motivated to stop using any brokered funds.

    I think it is obvious the interest rates on FDIC insured deposits of all sorts would be dropped by the banks. And this is a good thing.

    Pearson:

    The argument is about how a penalty on exccess reserves will cause banks to get rid of the excess reserves by making them into required reserves. That is all.

    Because reserve requirements are based solely on checkabe deposits, the process is about an expansion of checkable deposits.

    Your remarks about bps and credit conditions the like were all beside the point.

    You are correct that an increase in the quantity of money will not result in greater spending if the demand for money rises with the increase in the quantity of money.

    This is called a liquidity trap. Welcome to the conversation. I hope that you will stop with the
    arguments about banks not getting rid of excess reserves.

    I think that it is obvious that the process will result in lower T-bill rates and lower interest rates on all sorts bank deposits. Other things being equal.

    As Sumner never ties of pointing out, however, other things are not equal, and the expansionary impact of these changes on aggregate demand will raise expected future output, which will raise credit demand, which will raise all of these interest rates.

    My view is that the Fed should “pay” interest on reserves and peg it rate at a bit lower than short T-bills. If T-bill yields go to zero, then the Fed would charge a penalty rate on reserves. Like now.

  32. Gravatar of Bill Woolsey Bill Woolsey
    22. July 2009 at 03:43

    Sumner:

    Reviewing your comments you say, “David, I agree that banks do not necessarily convert ERs into RRs by buying government debt. They might convert to cash”

    You need to be careful with your terminology. What do you mean by “cash?” I think the word you are looking for is “currency.”

  33. Gravatar of David Pearson David Pearson
    22. July 2009 at 04:29

    Woolsey,

    You seem to say,

    1) we might be in a liquidity trap and the multiplier might be zero.

    2) but don’t worry, Scott thinks the Fed will raise NGDP expectations.

    Sorry, but what’s the mechanism. If a penalty rate doesn’t lead to more spending, then why should actors expect more spending?

    My overall point — the point of most of my comments — is that if you want to raise inflation expectations, you have to stomach a rise in inflation. Monetizing government spending would certainly do it. So would, presumably, Scott’s NGDP futures scheme, although I strongly, strongly disagree that 2% is enough. What won’t do it is expecting that a small hit to banking system profits or increase in borrowing costs (the effect of a penalty) will all of a sudden erase the fear of deflation. It is an action (a penalty rate) without a promise (future inflation). It would fit very nicely with a Fed that wants to fight deflation with minimal risk of being blamed for inflation. It can’t be done, and they will realize it, probably this Fall when everyone wakes up to the reality that they are doing very little to stimulate AD.

  34. Gravatar of StatsGuy StatsGuy
    22. July 2009 at 05:10

    David/Bill –

    Pearson is reiterating the point made by Cochrane in his debate with ssumner. I still find myself somewhat confused by the transmission mechanism you describe – that is, how exactly a 0.25% penalty rate is going to have a large effect on AD, particularly if one of its primary effects is simply the relabeling of existing funds.

    Unless, of course, we are depending on some sort of psychological or signalling effect. Maybe, for example, if banks terminate the rate on checkable deposits this will have a disproportional impact on consumer psychology (before they were earning _something_, now they are earning _nothing_).

    In terms of accelerating money, is the penalty rate a minor point that we’ve all just focused on way too much, or is it really a major point? If it’s a major point, then maybe it should be de-emphasized and the focus should be on other mechanisms (NGDP futures targeting). Right now, making bones out of the 0.25% penalty rate seems to just give the opposition something easy to attack (and Cochrane latched onto it quickly) without any clear, easily explained, credible response.

  35. Gravatar of David Pearson David Pearson
    22. July 2009 at 05:18

    I also think its highly ironic that Scott wants the Fed to adopt a policy that will lead to ER’s being spent…

    …when Bernanke keeps promising, over and over, that the ER’s will be withdrawn before they are ever spent.

    Scott is putting the cart way before the horse. First, we need a Fed that believes we should stimulate AD. Then we can move on to HOW to stimulate AD.

  36. Gravatar of ssumner ssumner
    22. July 2009 at 05:22

    David, I would strongly recommend you look at my post “Reply to Mankiw” as it discusses many of the issues you raise. The tax on ERs need not hurt bank profits, and thus need not be passed on to depositors) as you can offset it with a subsidy on RRs. On the other hand, if it led to lower rates on deposits, why would we care?

    I did not say that buying T-bills might not reduce ERs. It will reduce ERs if the banks want it to. Again, if banks don’t want to hold ERs they don’t have to. This is basic money and banking, any textbook will say the same thing. A small interest rate spread is enough to make them hold T-bills instead, as T-bills are a very safe asset. If not, make the rate on ERs negative 5% or negative 15%. But it wouldn’t be necessary, as T-bills would be far better than ERs at even negative 1%.

    Statsguy, The question of whether there would be a run on banks depends on how the rate in RRs and ERs is structured. I doubt the Fed would allow a run on banks.

    Current, Crime is like a negative interest rate on cash. The Fed should use that fact if they are serious about reducing interest rates (which they obviously aren’t, or they wouldn’t pay interest on reserves.)
    Nick, I am OK with that as long as “putting money into the stock market” is not equated with “an increase in demand for stocks which drives up prices.” More transactions can occur in either a rising or a falling stock market.

    Mattyoung, Yes, they are often late because they use a backward looking approach. I favor targeting the forecast, in which case there is no lag, as forecasts can be observed in real time. This is why central banks can target gold prices or foreign exchange prices–these asset prices are observable in real time.

    Jon, Actually there are many trillions in T-debt outstanding. But I expect the Fed would pull some ERs out of the economy with an open market sale, as you are right that if they didn’t do that the demand for T-debt would be massive, and could cause hyperinflation.

    Jon#2, You may be right about the 1% figure, but it should be emphasized that that would make my proposal even more expansionary.

    Rafael, Thanks, I plan a post on that one.

    Statsguy, Maybe, but NGDP growth during the Great Moderation was fairly stable, which I think was the key. I’m not sure how the factor you cite would affect NGDP growth. (BTW, whoever thought up the stupid term “Great Moderation” jinxed the economy. It’s like stupid sports announcers that say what a good free throw shooter someone is as he steps the the line. Thanks a lot!)

    David, I will comment on Bernanke soon.

    David, Let’s say the 1% figure is right. Then the $900 billion in ERs would create $90 trillion in deposits—you don’t think that’s enough to boost AD? (Of course deposits wouldn’t really go up that much because there would be a currency drain, but they’d still rise a lot, as would cash in circulation. But this is all beside the point. An interest penalty on ERs would not do the job alone. It simply allows the Fed to engage in inflation targeting without having to buy up lots of risky assets. They still need a target.

    David, A few months ago lots or commenters said my negative interest was a loony idea. Then the world’s leading expert on interest on reserves (Robert Hall of Stanford) endorsed the idea. Then commenters said this was something only an academic would dream up, real world central banks wouldn’t do this. Then the Swedish Riksbank adopted it. Now the claim is that the Fed will never do this. Maybe, but I will keep pushing the idea.
    I do agree with you, however, that the key is to credibly change inflation expectations. They need an explicit CPI or NGDP path, but unfortunately they will not provide one. As far as I know not a single central bank targets the price level.

  37. Gravatar of Carl Lumma Carl Lumma
    9. August 2009 at 15:49

    Um, the stock market certainly can absorb money from elsewhere, and not just temporarily, in transaction accounts. How on Earth is it “money in, money out”? The seller may turn around and buy another stock. Corporations go public every day, absorbing more money when the market is higher. And higher market prices encourage more corporations to IPO than otherwise would have done. etc. Which brings me to this (from the FAQ):

    >15. Isn’t the CPI a bad measure of inflation,
    >because it ignores house prices and stock prices?
    >
    >Stocks prices should not be included.

    Why not?

  38. Gravatar of ssumner ssumner
    10. August 2009 at 06:06

    Carl, When you buy a stock someone else sells the stock. So the money you “put into” the market is immediately “taken out” by someone else.

    Obviously you can put stocks into the CPI if you want to, but it doesn’t belong there if you are trying to estimate the cost of living, or the cost of goods produced in the US. There may be a good argument for the CPI including stocks, but I have never seen it.

  39. Gravatar of Carl Lumma Carl Lumma
    10. August 2009 at 13:16

    Hi Scott,

    > immediately “taken out” by someone else.

    How do you know they don’t spend it on another stock (at an inflated price)? And as I point out, the supply of stocks increases in respond to the demand for them.

  40. Gravatar of ssumner ssumner
    11. August 2009 at 06:44

    Carl, Even if they do, then the money they spend is immediately taken out by another person. Obviously when the volume of transactions rises then more money is spent on stocks. But that is also true when the stock market market crashes. More money is put into the stock market during crashes, as more stocks are bought and sold.

  41. Gravatar of Carl Lumma Carl Lumma
    11. August 2009 at 09:31

    Scott: All transactions have this property, so of course no commodity can ‘take money out of the economy’. But if the value of a commodity (stocks or hair cuts or anything else) rises relative to GDP, we can say it has “absorbed money”. If the market crashes, dollars are not destroyed, but dollar-denominated assets are.

    If loose monetary policy enables me to get a loan, I may then have extra cash to buy stocks. If the stock market crashes and I default on the loan, the loan becomes inflationary, since my default indicates I don’t have assets sufficient to cover the dollars created to fund the loan. Through this mechanism, the stock market has temporarily absorbed the extra money (since I am paying off the loan and the bank thinks this will continue) and then released it to inflation.

  42. Gravatar of ssumner ssumner
    12. August 2009 at 10:20

    Carl, You said;

    “Scott: All transactions have this property, so of course no commodity can ‘take money out of the economy’. But if the value of a commodity (stocks or hair cuts or anything else) rises relative to GDP, we can say it has “absorbed money”. If the market crashes, dollars are not destroyed, but dollar-denominated assets are.

    If loose monetary policy enables me to get a loan, I may then have extra cash to buy stocks. If the stock market crashes and I default on the loan, the loan becomes inflationary, since my default indicates I don’t have assets sufficient to cover the dollars created to fund the loan. Through this mechanism, the stock market has temporarily absorbed the extra money (since I am paying off the loan and the bank thinks this will continue) and then released it to inflation.”

    You are obviously free to define rising commodity prices as markets that “absorbed money”, but any economist would see that as a bizarre definition. It has nothing to do with “money” as economists define the term. But what you are not free to do is then try to draw some sort of useful implication from that idea. Such as the view that if the Fed has an “easy money” policy (whatever that is) that somehow there is more money out there to be “absorbed by markets” and that this will make prices rise. Remember, if people take wads of money to the stock market to buy stocks, someone else is selling. Whether prices go up or down has nothing to do with the amount of money transacted, and everything to do with how investors value those assets. Money was tight during the great bull market of 1928-29, for instance

    And a loose monetary policy doesn’t “enable you to get a loan.” This confuses money and credit.

  43. Gravatar of Current Current
    12. August 2009 at 11:44

    Carl: “Through this mechanism, the stock market has temporarily absorbed the extra money (since I am paying off the loan and the bank thinks this will continue) and then released it to inflation”

    I wrote about this a while back, though I can’t find my post.

    You’re wrong, but it’s a not an easy point. The stock market doesn’t absorb money. All that matters is that as prices rise the amount of money that must hang around in accounts during the duration of clearing a payment may increase. The stock market only “soaks up money” due to this. This sort of thing is proportional to the delay involved in clearing and the number of trades as well as the stock market prices. I understand the number of trades is much more important in practice than the level of prices.

    In practice many trades are performed internally to stockbroking firms by cancellation. That is client A sells a stock at the same time client B is buying it. So the brokerage firm just updates it’s computers with the relevant info without any other transaction taking place.

  44. Gravatar of Carl Lumma Carl Lumma
    13. August 2009 at 10:27

    Current wrote:
    > You’re wrong,

    You haven’t convinced me (or even addressed my point).

  45. Gravatar of Current Current
    13. August 2009 at 10:45

    Carl Lumma: “or even addressed my point”

    I’m not sure I really understand your point.

    Carl Lumma: “if the value of a commodity (stocks or hair cuts or anything else) rises relative to GDP, we can say it has ‘absorbed money’.”

    In what sense has it “absorbed money”?

    Carl Lumma: “If the market crashes, dollars are not destroyed, but dollar-denominated assets are.”

    Yes.

    Carl Lumma: “If loose monetary policy enables me to get a loan, I may then have extra cash to buy stocks.”

    With you so far.

    Carl Lumma: “If the stock market crashes and I default on the loan, the loan becomes inflationary, since my default indicates I don’t have assets sufficient to cover the dollars created to fund the loan.”

    I don’t see how the loan “becomes inflationary”. Remember the real-bills doctrine is wrong. I will get back to arguing against Mike Sproul on that point soon.

    Carl Lumma: “Through this mechanism, the stock market has temporarily absorbed the extra money (since I am paying off the loan and the bank thinks this will continue) and then released it to inflation.”

    Now you’ve lost me.

  46. Gravatar of Current Current
    13. August 2009 at 10:46

    Please differentiate when you mean money and when you mean capital.

  47. Gravatar of Carl Lumma Carl Lumma
    13. August 2009 at 12:11

    Current: We’ve got to be careful since we haven’t agreed upon definitions. But you’re right I probably shouldn’t say “absorbed money”. Howabout “temporarily prevented inflation”?

    “Real bills doctrine” is another minefield. It sounds like we probably agree on everything except that. Briefly, loans estimate the value of future assets. If an estimate turns out to be low, the currency deflates; high, it inflates. If that’s what you call the real bills doctrine, I double-dog dare you to refute it.

  48. Gravatar of Current Current
    13. August 2009 at 15:56

    Carl Lumma: “But you’re right I probably shouldn’t say ‘absorbed money’;. Howabout ‘temporarily prevented inflation’?”

    How does it prevent inflation?

    Carl Lumma: “Briefly, loans estimate the value of future assets.”

    Yes.

    Carl Lumma: “If an estimate turns out to be low, the currency deflates; high, it inflates. If that’s what you call the real bills doctrine, I double-dog dare you to refute it.”

    Not necessarily. This is a complicated area since it involves much state legislation. I will give a more complete answer to Mike Sproul in the thread where I’m arguing with him.

    The short answer though is that that volume of currency in a modern economy depends on government policy. The Fed can change it. *What* they have to do to change it alters with time. They can never precisely determine the amount. However, it is principally under their control.

  49. Gravatar of Carl Lumma Carl Lumma
    13. August 2009 at 23:14

    Current: I’d be happy to read your refutation when and where you post it. Could you please send me a note when it’s up? clumma at gmail.

    In the example given, it temporarily prevents inflation by driving the value of stocks up. As the author of this blog points out, it is impossible to say that stock prices are inflated. So we won’t. Instead, when I default on my loan because my stock account has been smashed, it is the loan that was inflated. Any loan in default is an inflationary loan, by definition.

  50. Gravatar of Current Current
    14. August 2009 at 00:07

    Carl Lumma: “I’d be happy to read your refutation when and where you post it.”

    Just what am I refuting here?

    Carl Lumma: “In the example given, it temporarily prevents inflation by driving the value of stocks up.”

    How? Which example do you mean?

    I don’t think you understand how the market process works. The stock market doesn’t “hold” money, money flows through it. It’s rise can’t temporarily prevent inflation.

    Carl Lumma: “As the author of this blog points out, it is impossible to say that stock prices are inflated. So we won’t. Instead, when I default on my loan because my stock account has been smashed, it is the loan that was inflated. Any loan in default is an inflationary loan, by definition.”

    That seems to me just the same as saying that stock prices are inflated.

  51. Gravatar of ssumner ssumner
    14. August 2009 at 11:22

    Carl and Current, I lean toward Current’s view, but perhaps we are talking past each other so let me list a few points.

    1. The Fed controls the monetary base directly. Changes in the base can indirectly affect the nominal value of all sorts of other assets. Part of this is pure inflation. To the extent that more money raises the prices level, it will raise the nominal value of any real asset like equities. But if the price of an asset changes relative to the overall cost of living, if its real price changes, then there is some fundamental issue in that particular market.

    2. There are two separate issues involved when people spend more money on stocks. One is that the nominal value of transactions changes. And the other is that the price of the stocks may or may not change. When stocks rise or fall sharply, volume tends to increase. So more money is being transacted on stocks. That is the only sense in which one could say money might go into a market. But note that if that’s your definition of money going into a market, one can no longer say it will cause prices to rise. More money could be transacted on stocks even during a crash. If you have any other definition of money going into a market that is equated with rising stock prices, it is better to use the term “wealth” rather than “money.” During a stock boom wealth increases, but not necessarily money. During the famous 1928-29 boom the money supply didn’t change much.

  52. Gravatar of Carl Lumma Carl Lumma
    14. August 2009 at 11:38

    Current wrote:

    > Just what am I refuting here?

    The Real Bills Doctrine. You said it was wrong. I’m anxious to hear why you think so.

    > How? Which example do you mean?

    The example I gave: me defaulting on a loan.

    > I don’t think you understand how the market process works.

    I think I do.

    > It’s rise can’t temporarily prevent inflation.

    You keep saying this, but haven’t addressed my point.

    >That seems to me just the same as saying that stock prices are inflated.

    If you prefer. The question here is whether the stock market can ‘absorb money’ created by loose monetary policy. The answer is that yes, just like any other commodity, it can.

    -Carl

  53. Gravatar of Current Current
    14. August 2009 at 12:12

    Carl Lumma: “The Real Bills Doctrine. You said it was wrong. I’m anxious to hear why you think so.”

    Most economists consider the Real Bills Doctrine to be completely refuted. If I were to engage in a full refutation of it here it would take a long time. I’m slowly doing that in the discussion with Mike Sproul.

    It would be better if you told me why you think it is right. What is wrong in the standard refutation of the Real Bills Doctrine?

    Carl Lumma: “The example I gave: me defaulting on a loan.”

    If you default on a loan then your bank has lost an asset. However, there is no “organic connection” between that loss and any liability of bank account balances. The loss is, in fact, a loss of the banks owners, its shareholders. It is an asset *written off*. No person takes money out of their bank account because of your default. Nor can the bank make a person take money out of their bank account.

    Carl: “If you prefer. The question here is whether the stock market can ‘absorb money’ created by loose monetary policy. The answer is that yes, just like any other commodity, it can.”

    I think I see what you mean now.

    If there is loose monetary policy then prices somewhere will be bid up. Agent from that market will buy other things and bid other commodities up. This will continue and spread across the economy until eventually (probably after a considerable time) most prices have risen. This is the Cantillon Effect.

    A particular part can’t “absorb” money since it’s participants are constantly trading with other markets.

  54. Gravatar of Carl Lumma Carl Lumma
    15. August 2009 at 14:34

    Current: According to Wikipedia, “The Real Bills doctrine holds that issuing money in exchange for real bills is not inflationary.” I’m going to claim that’s true. You keep referring to a discussion with Mike Sproul, but I have no way to know where it is. This isn’t a discussion forum, it’s a blog commenting system, and I want to take a moment to thank Scott for being so open with it. We should take this somewhere else if possible. I have already given my e-mail address. I will be happy to lurk in your exchange with Mike Sproul if you tell its whereabouts.

    “If you default on a loan then your bank has lost an asset. However, there is no “organic connection” between that loss and any liability of bank account balances. The loss is, in fact, a loss of the banks owners, its shareholders. It is an asset *written off*.”

    That’s correct. Money was *created*, and this money now has no known value. Hence, it is inflationary. All inflation must be caused this way. Scott has argued, and I agree, that we can’t avoid conflating value and inflation when looking at prices. But we can isolate inflation in loan defaults. And potentially (as I mention elsewhere on this blog) in exchange rates.

  55. Gravatar of Current Current
    15. August 2009 at 19:34

    Regarding the Real Bills Doctrine discussion see….

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=1791

    I’ll reply to the rest soon.

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