I rarely use the term ‘risk’ in my macro posts.  It would barely show up in any word cloud.  I rarely use the term ‘power’ in my micro posts.  Those are my blind spots.  Today I’m going against conventional wisdom by arguing that the Fed’s ultra-tight monetary policy has dramatically increased risk in three areas: policy fragility, balance sheet risk, and financial system fragility.

Who says Fed policy is ultra-tight?  Actually, Ben Bernanke said so in 2003, when he argued that the money supply and interest rates were misleading, and that the “only” way to determine the stance of monetary policy is by looking at NGDP growth and inflation.  If you average those two variables, the past 46 months have been the tightest money since Herbert Hoover was President.  NGDP growth has averaged only 1.9%/year, inflation only 1.1%.

And what are the consequences of this policy?

1.  It’s obviously made the financial crisis much worse, as an unexpected slowdown in nominal income growth almost inevitably makes it harder to repay loans.  After all, income represents the resources that people, businesses and governments have to repay nominal debts.  Less nominal income leads to more defaults.  This is currently an even bigger problem is Europe.

2.  Less obvious is the fact that the ultra-tight monetary policy has lead to  a much bigger Fed balance sheet.  If you look  around the world you’ll see that countries with lower NGDP growth rates have lower nominal interest rates and much bigger monetary bases (as a share of GDP.)

Here is the data for the past 5 years, for three major economies:

Country         NGDP growth         5 year Gov bond yield          Base/GDP in 2011

Australia             41.3%                            3.69%                                 4.0%

America              12.8%                            0.90%                                 17.9%

Japan                  -8.3%                            0.31%                                 23.8%

(I took this from an old blog post, so the data’s slightly out of date.)

I actually worry less about this risk than the other two, as the Fed holds mostly T-securities and any losses it suffers are gains to the Treasury.  And the EMH says the expected gains or losses are roughly zero.  And it’s currently making vastly larger than normal profits.  But others who worry about this issue should favor much faster NGDP growth so we could shrink down closer to the RBA’s balance sheet (actually 6% of GDP is the “normal” level for the US.)

3.  The third big problem is policy risk.  When rates are above normal the Fed is able to use its preferred policy instrument (the fed funds target) combined with the Taylor Rule to deliver stable NGDP growth.  But ever since we’ve moved to the ultra-low tight money policy, interest rates have fallen to the zero rate bound.  There are other tools that would work, but the Fed isn’t comfortable using them.  This makes it less likely that they will hit their macro policy objectives.  This isn’t to say they’d stopped doing policy, they still try things like QE and interest rate guidance, rather it means they’ve introduced more macroeconomic risk.  That’s why volatility in the equity markets increased in the period after 2007, just as stock market volatility more than doubled in the 1930s.

The Fed has adopted an extremely reckless and risky policy.  But here’s the great irony; 99% of economists think that solving the problem, going back to faster NGDP growth, would be a risky decision for the Fed.   “Oh dear  . . . they might have to buy so much stuff.”   It’s all about fear of the unknown.  I’m here to tell you that 5% NGDP growth is the known.  What we have today is the unknown.  This applies doubly to Europe.  Remember those who said the euro would bring ‘stability,” that it would eliminate the instability of exchange rate fluctuations?  The Economist has a wonderful metaphor in their new issue:

Speaking recently in Brussels, the IMF’s Nemat Shafik compared such a process of internal devaluation to painting a house. “If you have an exchange rate you can move your brush back and forth. If you don’t have an exchange rate you have to move the whole house.”

The Europeans have picked up the whole country of Greece and are shaking it back and forth.  The result is an economic/social/political earthquake.  The real risk is not doing too much with monetary policy, it’s doing too little.

BTW.  Nick Rowe has a great new post–probably my favorite blog post of the year.  I’m sure that some of my future posts will be triggered by thinking about the implications of Nick’s metaphors.

PS.  I’ll be running behind this week on comment responses.

Update:  I forgot to mention that Yichaun Wang has an excellent post that discusses the risks associated with Switzerland’s tight money policy.  Because Switzerland prefers a low inflation/NGDP growth rate, it’s hard for the Swiss National Bank to cut interest rates enough to deter speculators.  Other options like currency pegs also carry risk.

Greg Ip has an excellent new post on Fed policy.  But I smiled when I read this paragraph:

This, however, will be fiddling at the edges. What critics say the Fed needs is a wholesale makeover of its goals and methods. Some want the Fed to raise its inflation target. Others would have it adopt a nominal GDP target. Both approaches are intended to induce easier monetary policy that would foster faster growth in employment.  At the opposite end of the spectrum, more conservative economists and Republican legislators want to take away the Fed’s responsibility for full employment and have it focus solely on inflation.

What do you notice?  The people who want NGDP targeting think the Fed needs an easier monetary policy.  But what about those who think the Fed should focus like a laser on hitting its 2% inflation target?  Well, inflation has averaged 1.1% over the past 46 months, and TIPS spreads suggest it will continue to average below 2% for the next few years.  So those on the “opposite end of the spectrum” should also favor easier money.  Of course Greg Ip’s right that they don’t, but the fact that even the most hawkish economists ought to be favoring more monetary stimulus tells you just how far off course the Fed has drifted.

The rest of Greg Ip’s essay makes many of the same points I made in a recent post outlining a pragmatic stimulus policy that might be acceptable to the Fed.

Here’s Ip again:

Lost in this blizzard of outside advice is the fact that the Fed actually has a new framework of its own. In January it declared that henceforth its long-run target for inflation was 2%. Previously Fed members only stated their long-run preference, which ranged from 1.5% to 2%. It also said it considered its two statutory goals, low inflation and full employment, equally important. Previously, employment was, de facto, subordinate to inflation.

I pointed out that this framework gives the Fed quite a bit of room to ease.  Until I read Ip’s post, however, I didn’t quite realize that the equal weight on inflation and unemployment was something new.  I wonder if Bernanke sort of snuck this in, knowing that it would give the Fed a lot more leeway to allow slightly higher than 2% inflation when unemployment is higher than the estimated natural rate.

If the Fed were conducting policy based on this new framework, inflation would be centered around 2%. Indeed, if the Fed treated employment and inflation equally, it would likely tolerate inflation above 2% given that it is missing its full employment mandate more than its low inflation mandate.

What would such a policy look like? Fortunately, we don’t have to speculate. Janet Yellen, the Fed’s vice-chairman, described one in detail in speeches in April and in June. Ms Yellen uses a fairly conventional monetary policy rule in which the Fed seeks to minimize variations in inflation around its 2% target and in unemployment around its natural rate of 5.5%. In her simulation the Fed, by putting equal weight on its employment and inflation objectives, eases monetary policy more aggressively, keeping the federal funds rate at zero through the end of 2015 (instead of 2014 as currently projected). The result is a much more rapid decline in unemployment. Inflation briefly tops 2%, before returning to 2% over the long term.

That’s basically what I suggested, although I relied on a combination of QE and forecast targeting, whereas Yellen relies on interest rate guidance.  Still, it’s nice to see the Fed’s vice-chair taking their mandate seriously.  The first step in a long journey is figuring out where the hell you want to go.

Off topic, but many commenters keep asking me what’s wrong with using fiscal policy.  A few days ago Evan Soltas provided a very clear exposition of why monetary policy is better:

Government doesn’t tax and spend solely so that it can run surpluses or deficits. Sometimes, when economists talk about the need for discretionary stimulus, it’s easy forget that fiscal policy is far and away not the primary function of either government expenditures or tax policy. It is fundamental that you can’t target two variables at once — and this fact urges us to look for the trade-offs between static functions of government and the cyclical nature of fiscal policy.

.   .   .

These trade-offs between structural and cyclical policy don’t quite exist in monetary policy as they do in fiscal policy. While I find it pretty easy to see how large changes in spending or tax rates could inhibit private economic calculation at the firm level, monetary policy does not appear subject to the same trade-offs. Everything but the most extreme and irresponsible of monetary policies — read: hyper-inflationary monetization of debt due to lack of central bank independence — seems to me unlikely to affect in the slightest money’s structural function as the medium of exchange. (Ok, some of my Austrian friends beg to differ here, but I think everyone else can see my point.) In other words, monetary policy is a primary and independent function of the tool — money — in a way that fiscal policy can never be. There are negligible, if any, trade-offs between monetary policy and money’s structural purposes. It follows, then, from Ricardo’s basic principle of relative comparative advantage that monetary policy should do the stabilizing, whereas fiscal policy should be managed for the longer-term ends.

Evan Soltas also has an excellent post on the Swiss franc.

I’ve avoided making predictions about the endgame of eurozone crisis.  That’s partly because I don’t know a lot about Europe, and partly because even if I did those sorts of forecasts are extremely difficult to make.  But occasionally I recall events from the 1930s that others might find useful.

During 1931 Germany was the first domino and Britain was the second.  In modern terms Germany was Greece, and Britain was Spain.  Germany faced a more severe crisis than Britain, and it came to a head in July 1931, when Germany imposed exchange controls.  But they didn’t devalue, presumably due to memories of the 1923 hyperinflation.  In contrast, unemployment was the big fear in Britain, and they did devalue two months later.  So the second domino fell first.

I’ve always sort of assumed that Greece is the first domino, and if it fell then Spain and Portugal would also be forced to leave the eurozone.  And it’s very possible that will happen.  But it’s also possible that Greece will not leave first; that Spain might leave for macroeconomic reasons, not because speculators forced its hand.

Again, I don’t have much confidence in my predictions or even those of better informed experts.  I certainly agree with Krugman’s claim that the macro fundamentals of the eurozone periphery are unsustainable.  Beyond that, everything seems murky—even the question of which domino goes first.

Part 2.  Matt Yglesias (unintentionally) staged a sort of debate between Morgan Warstler and myself.  In this post Yglesias points out that the ECB acts as if it’s dual mandate is low inflation plus fanatical Warstlerian anti-statism.  For those who don’t read my comment section, Morgan Warstler is a colorful commenter who is totally obsessed with the idea that the Fed and ECB both should and will use this crisis to screw public employees everywhere and implement far-reaching market-oriented reforms.  Then Yglesias presents my counterargument to Morgan, which is that central banks should stick to stabilizing NGDP growth and leave public policy-making to democratically elected legislatures.

Lars Christensen has an excellent new post showing that the British government seems increasingly receptive to market monetarist ideas.  Lars quotes from a speech by Britain’s Business Minister Vince Cable.  I’ll quote from the same speech, and hence this post will partly (but not completely) overlaps Lars’ post:

Tight fiscal Policy; Loose Money

.   .   .

The right way to understand loose monetary policy is in terms of expectations: of whether future money demand will be growing fast enough to make borrowing to invest or spend worthwhile.  It is not enough just to look at the base rate.  Look at Japan: because of its persistent deflation, its zero-interest rates still do not reflect easy money conditions.  Anyone investing is facing the persistent pressure of falling prices and falling profits.

.   .   .

Aggressive monetary policy, enhanced by QE, has now been operating for four years. And the IMF has recently argued strongly for a reinforcement of supportive monetary policy through the liberal provision of liquidity to the banking system- as announced on Thursday -, QE (with a wider range of assets) and more aggressive interest rate policies.

I would supplement these useful moves with an observation about how monetary policy is communicated.  Quantitative Easing can sound like a powerful instrument – but if it does not succeed in making people expect rising money spending in the economy, it is likely to be far less effective than leaving gold proved in the 1930s.

.   .   .

[Our challenge] is the deficit, a record structural deficit for peace time that demanded a clear plan for its elimination in order to maintain the confidence of markets.  Our policy is far more flexible than our opponents claim – we have shown this by extending the period from 4 to 6 years for bring the budget to structural balance.  Automatic stabilizers still function.  But no-one within the Coalition doubts the need to get the deficit under control over a sensible time frame.

Innovative Policies

Given these constraints, what tools does the Government have? The first is continued use of monetary policy, and stronger communication of the policy aim it is meant to achieve – robust recovery in money spending and GDP. The Mansion House speeches signalled a clear intention to continue aggressive monetary policy.

I am sure that all the candidates to take over from Mervyn King are thinking very had about how best to do this.

Low rates aren’t easy money.  Britain needs tight fiscal policy and easier monetary policy.  The BoE needs to shape expectations—QE isn’t enough.  What sort of expectations?  Expectations of faster growth in NGDP.  And the new head of the BoE needs to understand all that.

Admittedly Mr. Cable in Business Minister, not Prime Minister.  So it’s unclear how much of this will actually get done.  But it’s nonetheless encouraging to see important policymakers who are aware of market monetarist ideas.

PS.  Mr. Cable also has some astute comments comparing between the interwar period and today.

Update:  Commenter 123 linked to a post by Giles Wilkes in 2010, which endorses market monetarist ideas (including this blog.)  Apparently Chris Giles Giles Wilkes is a key economic adviser to Vince Cable.

Tyler Cowen has a recent NYT column that includes this observation:

For instance, there is a good case to be made for monetary expansion, given the current low rate of inflation and high rate of unemployment. But if fear of inflation puts off the American public, such a policy will again underperform, relative to what we have learned in textbooks. There won’t be a credible commitment to see the monetary stimulus through, as people panic that resulting inflation will be used to redistribute wealth. (Although Sweden and Switzerland have had effective monetary policies recently, both of those countries have especially high rates of trust in government.)

I’ve made similar arguments, but I think this is too simple.  The deeper problem is that most American economists don’t agree with the claim that monetary stimulus could fix much of the problem, if only it was not constrained by popular skepticism.  Most macroeconomists in America think either that Bernanke is doing a good job, or that the Fed is too expansionary.  The Fed tends to do what a consensus of macroeconomists thinks they should do.  Fix the mistaken view of American macroeconomists, and you’ve gone 90% of the way toward fixing our AD problem.

In the short run we’ll lose.  But I’m heartened that the smartest young people in America (bloggers like Evan Soltas and Yichuan Wang) agree with market monetarism.  In the long run the AD-deniers will be dead, and market monetarism will win.

PS.  Yichuan has a good critique of my claim that growth was normal during the 1970s.  I accept his general argument, but I still think the 3.2% figure is pretty accurate.  Both 1970 and 1980 were similar phases of the business cycle (mild recession years) so I think 3.2% is close to trend growth for that decade.  If the higher inflation rate was raising RGDP in 1980 by 2%, then trend growth would have been 3% for the decade, and my qualitative judgment would still hold.  Recall that even market monetarists assume that money is neutral in the long run.  I believe that by 1980 workers had mostly adjusted to the higher NGDP growth.   Note that inflation rose by more that than NGDP growth between 1970 and 1980, mostly because 1980 saw a big oil price spike.  But Yichuan’s argument applies to increases in NGDP growth, not inflation.