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?

Here’s Felix Salmon on a crazy idea that’s been making the rounds:

Tools like the 14th Amendment or even crazier loopholes like coin seignorage would be signs of the utter failure of the US political system and civil society. And that alone could mean the loss of America’s status as a safe haven and a reserve currency. The present value of such a loss? Much bigger than $2 trillion. (Coin seignorage, if you’re wondering, is the right that Treasury has to mint a couple of one-ounce, $1 trillion coins and deposit those coins in its account at the New York Fed. It could then withdraw cash from that Fed account to make all the payments it wanted.)

It seems that some of the MMT-types have been pushing this idea, for instance here’s Joe Firestone:

Throughout the next six months, a number of other posts appeared at various sites provided the authority, in legislation passed in 1996, for the US Mint to create platinum bullion or proof platinum coins with arbitrary fiat face value having no relationship to the value of the platinum used in these coins. These coins are legal tender. So, when the Mint deposits them in its Public Enterprise Fund account at the Fed, the Fed must credit that account with the face value of these coins. This difference between the Mint’s costs in producing the coins and the credit provided by the Fed is the US Mint’s profit. The US code also provides for the Treasury to periodically “sweep” the Mint’s account at the Federal Reserve Bank for profits earned from these coins. Coin seigniorage is just the profits from these coins, which are then booked as miscellaneous receipts (revenue) to the Treasury and go into the Treasury General Account (TGA), narrowing the revenue gap between spending and tax revenues. Platinum coins with huge face values e.g. $2 Trillion, could close the revenue gap entirely, and technically end deficit spending, while still retaining the gap between tax revenues and spending.

So is this a brilliant masterstroke that will solve all of Obama’s problems, or a loony idea that he should avoid touching with a ten foot pole.  Even though I only learned about this idea 30 minutes, ago, I can confidently answer “both.”

Let’s start with the easy part, the idea seems completely nuts.  The public would instinctively recoil from this idea, mainly because the public’s instincts are pretty good.  Roughly 99% of the time this sort of plan would produce hyperinflation.  It doesn’t really matter whether the idea is actually nutty, Presidents simply can’t be seen doing wild and crazy things with the currency.  FDR did something analogous (in a milder form) in 1933.  His policy led to the resignation in protest of a number of his top aides, including Secretary of the Treasury.  In the end FDR was forced to retreat.  And his political position was much stronger than Obama’s.  So if Obama’s political advisers are reading this, tell him to avoid the idea like the plague.

The harder part is whether it would work.  I don’t know if it’s legal, but Firestone seems to think so.  If it is legal it could not only solve Obama’s debt ceiling difficulties, it could also allow him to generate a fast economic recovery (in NGDP, or aggregate demand.)  In other words, he could do an end run around the Fed and run monetary policy right out of the White House, just as FDR did in 1933.  Or he could threaten the Fed to get his way, just as FDR did in 1933.  (FDR devalued the dollar, and basically told the Fed that if they tried to stop him he’d start printing fiat money, which was authorized by Congress in the devaluation bill.)  Of course either of these moves would delight Paul Krugman, and cause heart attacks amongst all the Very Serious People who run the country.  (You know, the ones who don’t understand the distinction between NGDP and RGDP.)  Just as FDR’s decision to torpedo the World Monetary Conference was called “magnificently right” by Keynes, but horrified all the Very Serious People of 1933.

I have to admit that as a contrarian, a quasi-monetarist, and a former coin collector, the idea of minting two $1,000,000,000,000 platinum coins as a way of solving our economic problems fills me with delight.  Remember, I’m the guy who once claimed the recession was caused by too few nickels.  Yes, I am slightly embarrassed to be in with the MMT people.  (Firestone seems to think we have 30% excess capacity, and that we could monetize the entire debt without creating hyperinflation.)  But not so embarrassed that I’m afraid to risk ridicule from the more respectable bloggers who dismiss this idea.

I hope the Fed has a safe place to store those coins—wouldn’t want to “misplace” two trillion dollars.

PS.  I’ve done about 900 posts.  The “nickels” post that I link to above might be my favorite.

Here’s my latest.  [Update:  The first line of paragraph 3 should read  “A more sophisticated argument for fiscal stimulus . . .”

PS.  Jim Glass, (who sent me the household depression data) has his own blog.  This post has much more data, graphs, and is far superior to mine.

PPS.  When you wish Mankiw had a comment section.  (Read the final two paragraphs of the attached paper, the definitive refutation of the hypothesis that a large private sector promotes economic development.)

We all know about America’s sunbelt, that wide swath of states stretching from California to Florida.  This region has attracted droves of sun-seekers in recent decades.  Except it’s all a myth.  There is no sunbelt.  There are sun corners.  To prove this we’ll have to engage in a bit of detective work.

Let’s start with south central America, the huge region lying between Georgia on the east coast, and Arizona in the southwest.  South central America has 7 states, but initially I’d like to discuss just six of them: Alabama, Mississippi, Louisiana, Arkansas, Oklahoma, and New Mexico, which have a combined population of 21 million.  The recent census showed these six states grew by 6.6% since 2000.   That’s well below America’s 9.7% growth rate. If the term ‘belt’ means anything, it means a horizontal band.  And yet between Atlanta in the east and Phoenix in the west, we have a huge swath of the so-called sunbelt with net out-migration.  What gives?

My theory is that there are sun corners, and also one state that instituted such a pro-growth economic regime that it was able to overcome the disadvantage of lying in south central America.  What is that disadvantage?  I’m not entirely sure, but I’ll try to throw out some ideas.  My basic argument is that south central America is mostly hot, humid, flat, and boring.  Parts are also especially susceptible to temperature extremes, as the central US has a more “continental” climate than the corners.  It’s easier to make this argument vis-a-vis the southwest corner, which has a warm dry climate that many people like.  But the southeast can be hot and humid, so my theory doesn’t work as well there.  I’d like suggestions from my readers, but I still think the southeast is slightly more desirable than south central America.  Maybe it’s the thought that many of its metro areas are a short drive from either mountains or the ocean.  But I’m open to other suggestions.  Do you visualize it as being more desirable?  If so, why?

Now of course you’ve noticed one glaring flaw in my “no-sunbelt” hypothesis—Texas.  The 7 states of south central America contain four big boom towns (more than a million people), five if you consider Ft. Worth as a separate metro area.  All four are located on east Texas.  Is that a coincidence?  I doubt it.  Louisiana and Oklahoma are also oil rich, and New Orleans used to be an important headquarters for oil companies.  Oklahoma has two middle sized oil centers (Oklahoma City and Tulsa, which were once as big as Austin.  But the Texas boom towns have left all the others in the dust.  While the 6 states containing 21 million grew 6.6%, Texas (containing nearly 25 million, grew more than 20%.  BTW, although Texas is big, most is uninhabited desert—the big growth is in those 4 metro areas, a region no bigger than Alabama.

Paul Krugman and Ryan Avent point to the low cost of housing in Texas, and I’d never deny that’s a factor.  But housing is also dirt cheap in the other 6 south central states.  Again, don’t think sunbelt, think sun corners plus east Texas.  I think the main factor is that the Texas government has very pro-growth economic policies, such as the lack of an income tax.

The traditional argument against Texas being special is that there are other boom towns (Phoenix, Orlando, Atlanta, Raleigh, etc) that are in states that do have income taxes.  But notice they in are in the sun corners, not hot, humid, flat, boring south central America.

Now let’s extend south central America one tier to the north, by adding Colorado, Kansas, Nebraska, Missouri, Tennessee and Kentucky.  These six states have two big boom towns, Denver and Nashville.  Colorado has an income tax, so that doesn’t fit my theory.  But is Denver really hot, flat, humid, and boring?  The only one of the states lacking an income tax is Tennessee, which contains Nashville.  In the northwest Washington has no income tax, and it’s most similar neighbor (Oregon) grows more slowly.  In New England New Hampshire is the only state without an income tax, and for many decades it has grown much faster than other New England states.  In north central America South Dakota is the state without an income tax, and it it sandwiched in between two slower growing Great Plains states.  Nevada lacks an income tax, and has been the fastest growing southwestern state for many decades–indeed the fastest in America.  Wyoming grew very fast, but so did other mountain states.   Alaska lacks a good comparison state.  The last state lacking an income tax is Florida, which has obviously grown very fast for a long time, although I’d concede it would have grown fast even with an income tax–climate matters a lot too.

PS.  I agree with Krugman and Avent that there is nothing special about Texas in this recession, nor would I have expected that.  It’s gained many more jobs than average, but has fairly normal unemployment.  It’s the long run trends that favor Texas.  I just wish more pleasant areas would institute more sensible economic policies (I’m looking at you California, where I intend to retire.)

PPS.  Yes, I know that New Mexico isn’t humid, but it’s also the only one of those states that grew slightly above average.  Consider it a transition state between true south central America, and booming Arizona.  And it has no big cities.

PPPS.  One thing that makes me think there really is something special about the Southeast is South Carolina.  For the other states I can imagine special factors (DC boosting Virginia, the Triangle Research Park, Atlanta–traditional capital of the South, etc.)  But even South Carolina is growing fast.

Matt Yglesias recently made this remark in a post criticizing Tyler Cowen’s assertion that the GSEs significantly worsened the US housing/banking crisis:

The part where unwise public policies to subsidize homeownership would seem to come into this is step (1), but we in fact see this happening in many markets (Spain, commercial real estate) where Fannie and Freddie weren’t players.

I’m not sure what Matt means by “many markets.”  According to the interactive housing price graph constructed by The Economist, only the US and Ireland experienced major housing bubbles.  Spain had a smaller one (although I suspect more accurate figures would show a more serious price decline in Spain.)  Japan and German also saw price declines after 2006, but they had had zero price run-up before 2006–so no bubbles there.  The vast majority of industrial countries saw big increases in real housing prices between 2001 and 2006, just like the US.  But unlike the US, prices tended to move sideways after 2006, even in real terms.  (Of course you can find some brief price dips in the severe 2008 recession, but nothing like the long collapse in the US, which pre-dated the recession.)

But let’s take a look at Spain.  It’s true that Spain does not have a single institution called “Fannie Mae.”  But do they have a similar problem of governments deeply involved in promoting real estate lending?  I’m no expert (and I welcome critiques) but my initial impression is that the answer is yes.  Here’s The Economist:

Another duality lies in the banking system. Observers fret that the Spanish state may have to pump a lot more money into the banks than the roughly €25 billion ($36 billion), or 2.5% of GDP, it currently reckons will be the total bill from Spain’s epic housing boom and bust (Ireland’s bank bail-out bill is over 40% of GDP).

The problem is concentrated in the cajas, local savings banks that make up around half the domestic banking system, rather than big Spanish banks like BBVA and Santander, which are protected by big international businesses. Not before time the government is overhauling the cajas. Their ranks are being slimmed””the number has fallen from 45 to 18″”and they are being reorganised as joint-stock companies that can raise equity capital. José Maria Roldan, director-general of banking regulation at the Bank of Spain, says that the reform is “a huge step forward, replacing the caja model with a standard banking template that is more secure and comprehensible to international investors.”

So I decided to further investigate the cajas, and this is what I found (also from The Economist):

IN THE end CajaSur trusted in God. On May 22nd the small savings bank (or caja), which is controlled by the Roman Catholic church in Córdoba, was seized by the Bank of Spain after failing to agree on a merger with Unicaja, a larger Andalusian rival. The move shocked investors and prompted other savings banks to hasten consolidation. But mergers between wobblier cajas, which are unlisted and make up close to half of Spain’s financial system by assets, are merely a first step in a longer process.

CajaSur is tiny, holding just 0.6% of Spain’s financial assets. Yet its seizure unsettled investors for two reasons. First, it was a reminder that politics often trumps rationality.

.   .   .

The politicians who control the cajas like this virtual structure because it allows the banks to keep their own brands, governing bodies and local retail operations while combining treasury and risk-management functions.

.   .   .

Encouragingly, both the government and the opposition have agreed to reform the law governing savings banks.Attracting private capital requires other changes, too, such as a reduction in the influence of politicians, something caja managers would relish. Greater openness about banks’ balance-sheets would also help: on May 26th the Bank of Spain moved in this direction by announcing plans for tougher provisioning rules.

“The politicians who control the cajas”?  I thought banks were supposed to be controlled by businessmen, not politicians.  I’m still no expert on Spanish banking.  But I’d wager that further investigation would turn up the same incestuous relationship between politicians and the cajas that we saw between politicians and the GSEs.

So we observed clear-cut housing bubbles and busts in just two countries with more than 5 million people; the US and Spain.  And both suffered from the same problem—politicized institutions that will require massive transfers from the public.  Both also had large private banks that made mistakes, but at least they didn’t impose huge burdens on the taxpayers.

Matt also mentioned commercial real estate in the US, but I don’t think that proves what he wants it to prove.  As you know, the profession has not accepted my argument that lack of AD, not the banking crisis is responsible for our macroeconomic problems.  But the one weakness in my argument is that the subprime bubble blew up well before the recession.  This leads Matt to draw a connection between the financial crisis and the recession.

Banking activities need to be regulated or else asset price fluctuations will lead to macroeconomic instability.

That’s why the stakes in this debate between progressives and libertarians are seen as being so high.  If it was just the TARP bailout, I’m not sure people would care that much.  The big banks are repaying the loans.  Indeed I’ve seem progressives praise the auto bailout, even though GM may never pay back all the money.  No, the reason this is so important is that it’s seen as a crisis that led to 9.2% unemployment three years later.  Fair enough.

But in that case Matt can’t use commercial real estate, as that was clearly a symptom of the recession.  Indeed commercial RE was still booming in mid-2008, and only turned south toward the end of the year.  Now in fairness to Yglesias, the fall in commercial RE did bring down lots of smaller regional banks, and this resulted in costly FDIC bailouts of depositors.  If we insist on having FDIC (a big mistake in my mind), and insist on not reforming it by placing $25,000 caps on insured deposits (and even bigger mistake), then yes, we need to regulate banking.  We tried to re-regulate after the 1990 S&L debacle, and it didn’t work.  We tried again with Dodd-Frank, and again failed to deliver an effective set of regulations (like, umm, banning subprime loans, for instance.)  But I would agree that in the presence of FDIC, a completely unregulated banking system will take far too many risks.  I don’t consider that the failure of “laissez-faire”, I view it as the failure of a banking system where much of the liabilities are essentially nationalized.

PS.  Interested readers may want to play around with the Economist’s interactive graph at this link:

It’s a bit hard to read the graph below, so a few comments.  The steady drop (orange line) is Japan.  The only other two countries down in real terms from 2001 are the US (grey) and Ireland (green, of course.)  Spain is a rather dark line that rises steadily to almost 180, then slips back to 140.  As I see the graph, most other countries had substantial real price run-ups, like the US, but then real prices trended sideways.  This shows that not everything that goes up must come down.  I see lots of commenters patting themselves on the back about how they predicted the bubble would burst.  Count yourself lucky that you live in America; otherwise you probably would have been wrong.  Germany is not listed because of incomplete data, but it had no bubble in the first place.

Also note that the default option is nominal prices, which is actually more supportive of my “very few bubbles” claim.  I converted to real for the graph below, which puts more of a downward bias on prices after 2007.