Archive for February 2012


Ben Bernanke was a market monetarist (in 2003)

With apologies to Drudge:

Commenters dwb and Jim Glass sent me an amazing piece written by Bernanke in 2003:

The only aspect of Friedman’s 1970 framework that does not fit entirely with the current conventional wisdom is the monetarists’ use of money growth as the primary indicator or measure of the stance of monetary policy. Clearly, monetary policy works in the first instance by affecting the supply of bank reserves and the monetary base. However, in the financially complex world we live in, money growth rates can be substantially affected by a range of factors unrelated to monetary policy per se, including such things as mortgage refinancing activity (in the short run) and the pace of financial innovation (in the long run). Hence, it would not be safe to conclude (for example) that the recent decline in M2 is indicative of a tight-money policy by the Fed.

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

The absence of a clear and straightforward measure of monetary ease or tightness is a major problem in practice. How can we know, for example, whether policy is “neutral” or excessively “activist”? I will return to this issue shortly.

After reading that my heart started pounding so hard I thought I was going to have a heart attack.  I could hardly wait to find out what Bernanke thought was the right variable.  Surely it couldn’t be NGDP?  Recall all the times I’ve be ridiculed over the last three years for saying money has been incredibly tight since 2008.  Early on even some market monetarists didn’t like that characterization–preferring something less wacky sounding, like “not stimulative enough for on target NGDP growth.”  Almost no one agreed with my claim that money was as tight as it’s been since 1938.  Turns out it was even tighter than that.

Finally I reached the end of the article, where Bernanke returned to the question of how we tell whether money is easy or tight:

Do contemporary monetary policymakers provide the nominal stability recommended by Friedman? The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of financial innovation and institutional change, the rate of money growth does not seem to be an adequate measure of the stance of monetary policy, and hence a stable monetary background for the economy cannot necessarily be identified with stable money growth. Nor are there other instruments of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their instrument interest rates is not necessarily inconsistent with their providing a stable monetary background, as that manipulation might be necessary to offset shocks that would otherwise endanger nominal stability.

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.  (Emphasis added with pride.)

Yes !!!   Now all that remains is to ascertain the rate of NGDP growth since the second quarter of 2008:  6.1%.

That is not a 6.1% annual growth rate, that’s the total growth in NGDP since 2008:2.  And when was the last time NGDP grew that slowly over a 3 1/2 half year period?  Hint: Herbert Hoover was President at the time.

And then the concluding paragraph:

In summary, one can hardly overstate the influence of Friedman’s monetary framework on contemporary monetary theory and practice. He identified the key empirical facts and he provided us with broad policy recommendations, notably the emphasis on nominal stability, that have served us well. For these contributions, both policymakers and the public owe Milton Friedman an enormous debt.  (Emphasis added)

That’s why Ben Bernanke was my first choice for Fed chairman.  He gets it.  He understands that the job of the monetary policymaker is to focus like a laser on nominal stability.

PS.  Some killjoy may point out that Bernanke mentioned both NGDP and inflation as indicators of the stance of monetary policy.  OK, here’s the total inflation between July 2008 and January 2012:  3.8%

That’s not 3.8% CPI inflation at an annual rate over the past 3 and 1/2 years (which would still be lower that the rate Volcker produced in the mid-1980s) it’s a total increase of the CPI of 3.8% over 3 and 1/2 years, barely 1% per annum!  The Fed’s goal is 2%.

So can everyone now agree that Fed policy has been incredibly tight since 2008?

Interestingly, Bernanke is no longer a market monetarist, at least in public.  He now likes to emphasize at press conferences how extraordinarily accommodative Fed policy has been since 2008.  But that’s not what he really believes.  That’s what a man in his position is forced to say.  For what he really believes reread his powerful testimonial to Milton Friedman from 2008 2003, and especially this part:

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation.

That’s “only by looking” folks.  That means there is no other way. Money supply won’t work.  Interest rates won’t work.  Only NGDP or inflation can tell you the stance of monetary policy.  Every conservative who’s been complaining that Bernanke’s running an inflationary monetary regime needs to read this post, and verify the accuracy of my NGDP and CPI data.  And then admit they made a tragic mistake.  Now let’s see who’s got the guts to step up to the plate.

PS.  How did this amazing Bernanke piece slip through the cracks for 3 years?

Update:  The conventional wisdom, courtesy of Drudge:

Reply to Karl Smith

Karl Smith recently commented on my post about Hume and Woodford. I had argued that during “normal times” (when rates are positive) the future path of the base is a much better indicator of the future path of NGDP than is the future path of interest rates.  (I should have added that exactly the reverse is true at the zero bound.)  Karl responded:

Are you simply saying that we can’t solve for the interest rate path and therefore it is difficult to set up an effective communications strategy?

I think that’s true though we have to be aware the problem works both ways. The actual economy consists of millions of different economic agents all of whom face an interest rate that is based off of the Funds rate or the Interest on Reserves rate. However, each of their relationships to NGDP is less clear.

To know what this policy means they – or more realistically their banker – has to solve backwards.

For example, suppose I am expanding a hot new burrito chain in East Texas. Does a 30% higher NGDP for the US in 2017 mean I – and my banker – want to expand faster or slower?

Its not clear. The overall growth path of NGDP for the US is only loosely connected the actual revenue that I am going to receive. A booming national NGDP might mean I grow at 14% nominal rate rather than a 11% nominal rate. Though it could go the other way if my customers get lured away to work in West Texas.

However, the interest rate over this period is going to determine whether dumping a bunch of money into new restaurants is a good idea or not. Is that going to be higher or lower because of your target. Again, its not clear.

So, its not clear what I should do.

On the other hand if you said – interest rates will be zero through at least 2014, then it is at least certain that no one is getting any surprises over the construction loan period and that more than likely some decent loan is going to be available when my stores are done.

I have two problems with this.  Any macro signaling will seem to have a trivial effect if discussed at the micro level.  Let’s suppose the Fed did something now that caused the representative firm to boost output by 2% more than on the old Fed policy.  That’s a really big deal for the macroeconomy, but small potatoes for the representative firm within the economy (as 2% more business on average is swamped by local real shocks.)

But my bigger problem is Karl’s claim that interest rates are of more interest to the average business owner than the monetary base.  Suppose Karl and I both looked into a crystal ball and saw that the fed funds rate would be 12% in 2014.  From Karl’s post, I infer that he’d advise that small businessman to hold off on the investment project, as the cost of that floating rate business loan would soar in 2014.  I’d have the opposite reaction.  I’d beg, borrow, and steal every penny I could get my hands on, and pour all the money into REITs.  That’s because the 12% rate in the crystal ball would tell me I am wrong and Bob Murphy is right—that the inflated monetary base is going to drive inflation and NGDP dramatically higher in 2014, forcing the Fed to raise rates sharply in order to hold inflation down.  I see that as incredibly bullish for real estate.

To summarize, not only is the interest rate path not a good indicator of whether you want to invest more or not, it’s not even clear whether low rates are a good sign or a bad sign.  It’s hard to think of any other indicator that’s worse.  Most asset values at least have a monotonic relationship with NGDP growth, but not short term nominal interest rates.

BTW, there is an interesting discussion of exactly what the Fed’s low rates until 2014 promise (or prediction?) really means.  Romer and Romer have a good PP slide that correctly explains the flaw in the Fed’s policy.  But the art of signaling in a messy real world with a divided FOMC is about as subtle and complex issue as exists in all of macroeconomics.  So after reading Romer and Romer I’d recommend Ryan Avent, who I think strikes exactly the right balance.  The Romer’s are right that the policy is not what it might seem to be, or even close to what it should be, but as Ryan points out it’s probably something.

PS.  Ryan is also the only one who seems to understand what that “silly” OECD graph really means.  BTW, people who take medication tend to be sicker than those who don’t.

Never reason from an interest rate change

I recently caught Carmen Reinhart taking a short-cut, and ending up with erroneous conclusions:

Reinhart is the toast of economic circles these days for speaking out about the newest way Western governments are using financial repression to liquidate their debts, particularly after a financial crisis. They’re doing this on the backs of savers, including pension funds, according to economists. In practice, financial repression can lead to “the rape and plunder of pension funds,” Reinhart tells Institutional Investor. Financial repression consists of very low nominal interest rates combined with captive lending by large banks or pension funds to a government. The low, stable interest rate facilitates the servicing costs of large public debts. Sometimes modest inflation is added to the mix. This results in zero to negative real interest rates that reduce government debt. Hence, broadly defined, financial repression is a wealth transfer from savers to debtors using negative real interest rates “” with the government as one of the key debtors.

I’m sure my readers will immediately spot the error, but just in case here’s Milton Friedman in 1997:

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

.   .   .

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

Some might argue that it doesn’t matter whether the low rates were caused by tight money or easy money, they help debtors either way.  But this isn’t true.  That’s because the tight money policy of 2008 that led to the low interest rates today also drove NGDP more than 10% below trend.  Indeed it would be fair to say rates are low today precisely because NGDP fell so sharply.  And this fall in NGDP hurt debtors like the US government much more than the low rates helped them.  That’s why the debt to GDP ratio has risen sharply in the US, and most other developed countries.

In fact, very low interest rates (aka “tight money”) hurt both lenders and borrowers.  How can both be hurt?  Simple, it’s not a zero sum game.  The Fed’s policy reduced real income and real wealth, leaving America a poorer place.  Both lenders and borrowers have shared in that loss.

Admittedly the debt service costs are temporarily depressed.  But when the economy recovers rates will rise again.  But meanwhile the debt/GDP ratio will still be much higher than before the recession.  In the long run tight money (aka “low interest rates”) makes the government worse off.

PS.  I’m now so busy that I won’t be able to answer all comments.  I’ll continue answering comments from the most recent 5 posts.  Because this is a new policy, I’ll answer older comments one more time on Wednesday, to give commenters one more chance to respond to anything I said.  I’ve recently been getting comments from as many as 15 different posts on a given day–and this is just too much work with my teaching responsibilities and my attempt to revise my manuscript.  And I’m also doing new posts and keeping up with news in the blogosphere.  Plus I’ll be doing a lot of traveling and speaking in the next month.

From Hume to Woodford . . . and back to Hume?

David Hume developed most of monetary economics back around 1750, partly by just sitting in a room and thinking.  He discussed a thought experiment where everyone in England woke up one morning and discovered their purses contained twice as many gold coins as the night before.  Hume argued that England wouldn’t be any richer in real terms; rather the price level would double.  But he also noted that there would be a transition period where the extra money would be spent and trade would expand.  So he understood the Quantity Theory of Money (QTM) and the Phillips curve.  In the 1970s Friedman argued that in the past 200 years macroeconomics had merely gone “one derivative beyond Hume.”  I.e., Hume looked at changes in the price level (as did Irving Fisher) and Friedman looked at changes in the rate of inflation.

Hume also understood the impact of an increase in money demand (or reduction in velocity):

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume “” Of Money

Then people began to notice that when the supply of money increased there was a temporary decline in interest rates.  This occurred because wages and prices are sticky in the short run, and some variable needs to adjust to equate money supply and demand in the period before prices adjust.  Thus interest rates change until wages and prices adjust.  This led economics to take a momentous wrong turn.  Under the influence of Wicksell, and then later Keynes, macroeconomists began to see the change in interest rates as not some sort of epiphenomenon associated with an increase in the money supply, but rather as monetary policy itself.  This culminated in the work of Woodford, who developed monetary models without money, where interest rates were all that mattered.

But Woodford did more than that, he showed that aggregate demand depended much more on the future expected path of monetary policy than on the current stance of policy.  As we will see, that insight may have opened the door to a revival of Humean macroeconomics.

The QTM was based on the hot potato effect, the idea that if you double the supply of non-interest-bearing base money, people will try to get rid of excess cash balances.  But in aggregate they cannot do so, as the central bank controls the supply of base money.  Instead the attempt to get rid of excess cash balances drives up prices and NGDP until people are again willing to voluntarily hold the enlarged cash balances.  That occurs when prices and NGDP have doubled, so that real money demand and velocity return to their original level.

There is a flaw in Woodfordian macro.  No model lacking money can explain large changes in the money supply and price level.  That’s why the post-WWI hyperinflations caused even Wicksell and Keynes to briefly return to the quantity theory of money.  If you increase the monetary base by 87 times (and a number of middle income countries did this in the 1970s and 1980s) the monetary approach can give you a ballpark estimate of the price level (that it will rise by 87-fold), whereas the interest rate/economic slack approach to inflation is hopelessly lost.  So there’s not much doubt that in some sense the quantity of money is still driving the price level, at least in the long run.  But how can it be made relevant for our current situation, where inflation rates are quite low and velocity is quite unstable?

It seems to me that Woodford’s approach is capable of rescuing the QTM.  Think about it.  The QTM is criticized as only being able to explain price level changes in the long run.  And yet Woodford says that the current level of aggregate demand is mostly determined by the expected future course of monetary policy; i.e. the long run.  Keynes said in the long run we’re all dead, and now Keynes is dead and Woodford is saying in the short run AD is determined by (expected) long run changes.

For the moment let’s set aside the question of interest on reserves, and focus on non-interest-bearing currency.  Before the recession (in 2007) currency was about 6% of U.S. NGDP.  And if interest rates are positive in 2017 it will again be about 6% of NGDP, give or take 1%.  That means the question of whether 2017 level of NGDP is 30% or 60% or 90% higher than in 2007, will mostly depend on where the Fed sets the currency stock in 2017.  Not precisely, but approximately.  Admittedly they don’t control the currency stock directly, they control the base.  But in normal times the base is more than 90% currency.  If the Fed wants that proportion to drop, they can increase IOR and inject enough extra base money to keep currency where they want it.  If they don’t want it to drop they can lower the IOR, to zero if necessary.

The rate of growth in NGDP between now and 2014 will be strongly influenced by where people think NGDP will be in 2017.  There is no interest rate path that the Fed can describe that would give people even a ballpark estimate of NGDP in 2017.  But if they say they will set the currency stock at $1.6 trillion in 2017, (twice the 2007 level) then people will know that 2017 NGDP is also likely to be roughly twice 2007 NGDP.   And if they do that, NGDP will grow very rapidly over the next two years.

Of course the Fed shouldn’t do that, for two reasons.  First, that would create faster NGDP growth than is desirable.  And second, it’s not as precise an instrument as targeting the forecast.  Better to say they’ll provide as much base money as necessary in 2017 to produce an NGDP that is 30% higher than in 2012.

That’s the sort of monetary policy Hume would understand, and approve of.

PS.  Why 30%?  It would allow for 7% growth between now and 2013, and 5% thereafter.  It’s a reasonable compromise that would dramatically speed up the recovery, but not create the politically unacceptable inflation likely to result from returning to the pre-2008 trend line.

PPS.  Commercial banks?  I don’t recall Hume having anything to say about them, so I never studied the subject.

I dedicate this post to MMTers everywhere.

Apart from iceberg collision episodes, the benefit from having lifeboats is likely to be modest

In a recent talk at the U.S. Monetary Policy Forum, Bank of Canada Governor Mark Carney argued that there wasn’t much to be gained from moving away from a low inflation target:

Finally, some have argued that an inflation target consistent with price stability is too low for a post-crisis world.

While the recovery is proceeding in crisis economies, it remains weak, particularly relative to the depth of the recession. This is consistent with the historical experience following financial crises. Indeed, it is only with justified comparisons to the Great Depression that the success of the U.S. policy response is apparent.

Read that last line several times, and just think about what he is actually saying.  Do you feel better now?

As Woodfordian logic would have it, a key appeal of NGDP-level targeting is that by compensating for past deviations from desired levels–i.e., by introducing more dependence on history–it would better harness the power of expectations to stabilize the economy.

In normal times, these greater stabilization benefits are not likely to be particularly important. As part of the work leading to the renewal of our inflation control agreement, the Bank of Canada analysed the benefits of price-level targeting (PLT) which, like nominal GDP targeting, is a way to introduce history dependence. Our research shows that, apart from lower bound episodes, the gains from better exploiting the expectations channel are likely to be modest.

Hence the title of this post.  Bill Woolsey pointed me to this gem:

In addition, under NGDP-level targeting, the central bank would seek to stabilize the GDP deflator in order to achieve price stability. But the GDP deflator measures the price level of domestically produced goods and services, which may not match up well with the cost of living that the CPI measures and that matters most for welfare, particularly in small, open economies where imports make up a substantial share of the consumption basket.

Looks like we need to modify our textbooks where they cover the “welfare costs of inflation.”  Now we need to add:  “Stuff costs more when people go shopping.”

Just so I don’t come across as too negative, let me congratulate the Canadians for avoiding the iceberg that we struck, and for successfully managing a flexible inflation targeting regime for several decades.  I still think NGDP targeting would be slightly better for Canada, but concede it’s a close call.  So there’s always the “if it ain’t broke don’t fix it” argument.   But for America it’s not even a close call.  We are doing significant fiscal stimulus that is highly costly (such as the payroll tax cut) precisely because our monetary policy regime is widely seen as producing inadequate nominal expenditure.  In America it is broke.  We are likely to hit many more zero bounds, as the Wicksellian equilibrium real rate seems to have shifted to a permanently lower level in this century.  And yet the Fed still doesn’t seem to understand that fact.