Archive for February 2013


There’s no risk for the Fed . . . eral government

If you are a corporation is it risky to buy back your own debt?  Most people would say no.  How about if you are the Federal government?  Again, it doesn’t seem risky.

QE is not risky for the US government.  (Assuming the MBSs that are being purchased are already guaranteed by the Treasury.)

Is QE risky for the Fed?  Not really, although I suppose if a person really wanted to believe it was risky, they could think of some sort of convoluted theory to explain why.

The big “risk” that people worry about is that interest rates might rise sharply, and this could cause large capital losses if the Fed’s huge portfolio of bonds were sold.  I see several problems with that theory:

1.  First of all, the thing that would likely cause higher interest rates—increased NGDP growth, would actually improve the budget situation of the Federal government.  Since the Fed is part of the Federal government, that’s all that really matters.

2.  But let’s say you were really worried about the Fed’s balance sheet.  Some argue the Fed could simply hold the bonds to maturity.  But in that case if they wanted to avoid hyperinflation they’d have to sharply increase the interest rate paid on excess reserves, which could cause losses in the short run.  So holding bonds to maturity doesn’t avoid losses that would be incurred by selling bonds at a loss if nominal rates rise unexpectedly.  There’s no free lunch there.  Even so, why should we care if the Fed loses money?  It’s not a for-profit institution; it’s part of the Federal Government.

3.  One fear is that the Fed might become bankrupt, as its losses on bonds might exceed its capital.  It could lose its independence.  However their liabilities also include a trillion dollars of currency in circulation.  Or should I say “liabilities” as it’s debatable how we should regard currency.  If nominal rates rise to 5% then the Fed might have to go a few years without paying a dividend to the Federal government.  But is that so bad?  In the past few years they’ve been turning over massive profits to the Treasury, several times larger than normal.  If they went a few years without paying any money to the Treasury, it would merely offset the recent excess profits.  As the older low yielding T-bonds were replaced by newer bonds yielding 5%, the Fed would turn back into the government version of Apple Computer—a money machine churning out profits of $40 or $50 billion per year.

4.  Is there some tail risk I’ve missed?  Could the losses exceed the stock of currency?  Not really, but let’s say they did.  Suppose the US shifted to electronic money just as this bear market in bonds was occurring.  All currency was removed from circulation.  What then?  The Treasury could simply issue another trillion in T-bonds and give it to the Fed.  Now this might prove embarrassing for the Fed (although I can’t imagine why–it’s not their fault if the US suddenly shifted to all-electronic money.)  But is it a problem?  Clearly not.   And it’s not going to happen–there’ll still be a trillion in cash outstanding 10 years from now, when the Fed has adjusted to the higher interest rate.

Here’s what is risky; continued tight money, which worsens the fiscal situation so much that the Treasury eventually turns the Fed into its lapdog.  Tight money leading to fiscal dominance.  It happened once before (1930 to 1951), let’s not let it happen again.

BTW, I’d add that it’s very unlikely that 10 year T-bond yields will rise back to 5%.  But I didn’t want to rely on this argument.  Trust me—if the Fed were privatized and did an IPO, its market cap would greatly exceed Apple’s.

PS.  The Japanese case is far more interesting.  Suppose they adopt a 2% inflation target, and their NGDP growth rises to 3%.  This would be a huge boon to the Japanese government, even if the nominal interest rate on newer bonds rose by the full 3%.  That’s because the Japanese government, like all debtors, gains from unexpected inflation.  Its existing debt was sold under expectations of no inflation.  But even better for the Japanese, it’s quite possible the nominal interest rate on newer debt would not rise by the full 3%, as they are currently stuck at the zero bound.  Indeed rates might not rise at all.  In that case the Japanese have been walking right past 10,000 yen notes lying on the sidewalk, without bothering to pick them up.  I can’t see that situation lasting much longer.

HT:  Chris Beseda

The Money Confusion

I believe there’s a popular line in Hollywood that “nobody knows anything,” meaning that it’s really hard to predict which films will do well.

When I started blogging I felt the same way about monetary economics.  It seemed like almost everything I read was not just wrong, but nearly 180 degrees from the truth.

And I’m afraid to say that things really aren’t much better today.  Here’s Matt Yglesias:

If you read a lot of economics coverage on the Internet, you’ll be struck by the amazing success of “dovish” monetary policy views. I’ve been pushing them here at Slate, Ryan Avent pushes them at the Economist, Matt O’Brien pushes them at The Atlantic, Tim Fernholz and Miles Kimball push them at Quartz, Josh Barro and the Stevenson/Wolfers team push them at Bloomberg, Ramesh Ponnuru pushes them at National Review, Ezra Klein pushes them on Wonkblog, Paul Krugman and Tyler Cowen have both pushed them in the New York Times, etc. It’s not like an overwhelming consensus or anything, but normally a political stance with this much representation in the media could find at least one significant politician to stand up for it. But while we have Obama’s former Council of Economic Advisors Chair and the chief economist at Goldman Sachs on our side, we seem to have zero members of congress.

It’s even worse.  There are people at the Fed who want to do more.  Indeed there are people at the most conservative part of the Fed (the regional banks) who want to do more.  But still no outside pressure.

When I started blogging in early 2009 almost no one realized that the Fed was running a tight money policy, that they could do much more, and that the recession would be much milder if they did much more.  And that’s still true today.

Yes, the list Yglesias provides looks impressive, but the real tragedy is that it’s damn near comprehensive.  In contrast, the list of people not on Yglesias’s list (over 7,000,000,000 people) is far more impressive.  Go on any political or financial news show and talk about how the recovery is slow because money’s too tight and they will look at you like you are a lunatic.

Things have changed since 2009, but only among the tiny number of people who pay attention to the monetary policy debate in the blogosphere.  And by the way, that excludes the economics profession.  Polls show they are just as clueless as the general public.  The percentage who say money’s too tight is close to zero.  (Memo to my conservative friends:  Not that hawkishness makes you clueless–but if there was general awareness of monetary economics out there then at least the liberals would support more stimulus.)

What’s interesting to me is just how influential the blogosphere is.  Even though Obama knows nothing about monetary policy, even though Congress knows nothing, even though most of the media know nothing, even though most economists know nothing, the tiny list identified by Yglesias (and perhaps market monetarists as well?) have succeeded in changing the debate where it really matters.  There is a sudden groundswell of talk about radical monetary initiatives everywhere from Japan to Britain.  The Fed is gradually changing its communication strategy.

Monetary policy is an issue unlike any other.  It’s an important issue where ideas matter.  And yet unlike virtually all other political issues there is no sizable bloc of political operatives on either side of the debate who understand the issue at all.  Even a tiny bit.  We might as well be debating the Copenhagen Interpretation vs. the Many Worlds Theory, for all Congress and the media know.

No wonder Krugman was inspired by Hari Seldon.

PS.  I’m falling way behind on stuff people send me.  Peter Laan sent me an article quoting the BoE’s Paul Tucker suggesting negative IOR.

Here’s another great Matt Yglesias post, pointing out that NGDP targeting is the best way to pressure countries to adopt sound pro-growth economic policies—including “economic reforms that promote competition and labor supply expansion” (aka the Nordic neoliberal model.)

Here I’ll disagree slightly with Matt:

Today Grillo ruled that out, meaning the only workable coalition would be a “grand coalition” between the Democrats and Silvio Berlusconi’s party.

That seems exceedingly unlikely, as the basic state of Italian politics is that the Democrats view Berlusconi as a criminal.

Meanwhile, Peer Steinbrueck, who leads Germany’s opposition Social Democrats, declared himself “appalled that two clowns have won” the election .  .  . “”referring to Berlusconi and Grillo.* That’s a reminder that though Italy is certainly still a democratic republic whose voters can elect whomever they want, the only choices actually acceptable to Germany are the left-wing-but-committed-to-austerity Democrats and Mario Monti.

I wouldn’t say the Democrats “view” him as a criminal, but rather they “are aware that” Berlusconi is a criminal.  And the interesting thing about the Steinbrueck comment is not what it says about Germany’s attitude toward Italy, but that it doesn’t involve any hyperbole at all.  Indeed it’s a slight at the clown community.  Obviously Italy (one of my favorite countries by the way–perhaps the best country in the world) has had a dysfunctional political system for years.  But one has to wonder if the structure of the EU, and especially the eurozone, are making it even more dysfunctional.  Responsibility without power breeds cynicism.  The fascist and communist parties in Greece are also polling quite well.

PPS.  Has anyone ever done a sociological study explaining why there is almost no interest in classical liberal ideas in the Mediterranean countries (including France–which gave us the term “laissez-faire”?)  I understand they have traditionally had a powerful left wing party.  What interests me more is the complete lack of any party promoting small government ideas on either the left or the right.  Why?

PPPS.  I don’t know if Greece has a party that calls itself communist—so call it the “party far to the left of the socialists” if you prefer.

Bean on NGDPLT

Ben Southwood sent me an article discussing Charlie Bean’s views on NGDPLT.  Let me first apologize to regular readers; much of this will be going over ground I’ve already discussed dozens of times.  Unfortunately many of the leading economists now jumping into the NGDPLT debate do not keep up with the blogosphere, and hence are not aware that their arguments have been addressed numerous times.

Charlie Bean argues that the main difference between an inflation target and a nominal income growth target relates to communication – and he asks which framework would be a better way to describe policy. One argument in favour of a nominal income growth target is that there may be fewer divergences from the stated target for income growth than from an inflation target if there are a lot of costs shocks that are accommodated. But set against that, nominal GDP is more prone to revision than inflation which makes it harder to hold the MPC to account. And income growth targeting would be harder to explain to households and firms and so be less effective at anchoring inflation expectations.

NGDP targeting is actually far easier to explain to households than inflation targeting.  In 2010 Bernanke indicated that the Fed was determined to raise the cost of living of the average America.  People reacted with shock and outrage, and there was a firestorm of criticism.  Most people associate the term “higher cost of living” with “falling living standards”—i.e. supply-side inflation.  Thus they have no understanding of inflation targeting at all, which deals with stabilizing demand-side inflation.  Tell the average person about the need to be symmetrical when missing the target (i.e. low inflation is just as bad as high inflation) and you’ll see a blank look on their faces.  The press still reports below target inflation as “good news,” so they are no better than the man on the street.  In contrast, if Bernanke has announced in 2010 that he was trying to speed up growth in the average income of Americans to boost the recovery, QE2 would have been far more popular, and the public would have had a much better idea of what the Fed was actually trying to do.

And of course the BoE trying to boost inflation when it was already well above target created all sorts of confusion in Britain, and contributed to their sub-optimal fiscal policy decisions.

I’ve dealt with the data revisions issue before.  In this paragraph Bean was discussing NGDP growth rate targeting, not level targeting, hence all that needs to be said is that the central bank should target the forecast.  In that case revisions are not a problem.  In the case of NGDPLT, I’d refer you to this earlier post.  The article continues:

Charlie Bean argues that a nominal income levels target would involve rather different policy settings to an inflation target. Under such a regime the MPC would be tasked with returning nominal income to a continuation of its pre-crisis trend line in response to economic shocks. In theory, such a target may be a useful way to influence expectations, particularly when policy is constrained by the zero lower bound on interest rates. It acts to persuade people that if there is a large negative demand shock, interest rates will be “loose for longer” than under the present inflation targeting regime because they know the MPC will need to close the shortfall in the level of nominal income. Those lower expected future interest rates directly boost demand today.

This is true, but slides over the more important point—NGDPLT greatly moderates the initial move away from the trend line.

But the policy also generates higher inflation in the future, thus producing a second source of downward pressure on future real interest rates, which also raises demand today. Charlie Bean shows that in standard economic models this expectations channel can be powerful enough to deliver a substantial economic benefit when interest rates are at their zero floor. But he raises three real world caveats.

First he notes that in standard model simulations, a large negative demand shock generates deflation, which drives up real interest rates, further depressing demand. But in contrast, inflation in the UK has averaged well above target in recent years, suggesting there have been negative supply shocks as well as negative demand shocks. The advantage of a levels target for nominal income is less clear under those circumstances.

Not at all, if NGDP growth was well below target in Britain then a level targeting regime would have led to a smaller drop in AD, and hence a milder recession.

Second, a nominal income level target will mean tolerating periods of higher than normal inflation. Models don’t capture the risk of such a policy. Demand may be depressed as savers worry about the real value of their assets. Long term inflation expectations may get pushed up and it could be costly to bring them back under control.

As long as NGDP growth is on target, higher inflation expectations will not feed into higher nominal interest rates or higher nominal wage rates.  Hence the higher inflation will not distort the capital and labor markets in the way that standard models suggest.  The problem here is that what is usually regarded as the welfare loss of inflation, is on closer inspection the welfare loss of excessively high and unstable NGDP growth.

Third, holding interest rates at very low levels for a long period, which would be required by a nominal income levels target, may generate credit / asset price booms and financial imbalances and so threaten financial stability. Overall one needs to be cautious about committing to loose monetary policy long after the economy has normalised.

Low nominal interest rates are a sign money has been tight.  That’s why the lowest interest rates in the world are in Japan, which has the lowest NGDP growth.  The developed country with the fastest NGDP growth is Australia, and it has the highest interest rates among the major developed economies.  So Bean has things exactly backwards.  In any case the central bank should not worry about bubbles.  As we saw in 1987, bubbles do not cause significant problems as long as the central bank keeps NGDP growing at a steady rate.  Problems with the financial system should be addressed through regulation, not driving all sectors of the economy into a recession in order to punish the one sector that is misbehaving.  The Fed tried that in 1929—to say it didn’t work out too well would be an understatement.

Charlie Bean concludes that it is sensible to review the monetary framework from time to time, but there is a danger in expecting too much from monetary policy.

I agree.  I think Britain has significant supply-side issues that need to be addressed.

“The Great Recession of 2008-9 was unlike earlier policy-induced downturns….it should not be surprising that the recovery since the middle of 2009 has been so muted”. Central bank policies “cannot – and should not seek to – prevent the necessary de-leveraging and rebalancing of production away from non-tradables towards tradables. That is a real process that takes time and means that the recovery is likely to remain somewhat subdued by historical standards.”

Yes, real adjustments need to occur, but they can occur most effectively against the backdrop of stable NGDP growth. The recovery process that Bean wishes to see is exactly what NGDP proponents favor, and yet is nearly the opposite of the policies that have actually been adopted.  In the US the huge drop in NGDP led to a big fall in the production of tradables (and other types of-non-residential construction output), making the adjustment far more difficult and prolonged.  I believe something similar occurred in Britain.

Why we’re in this mess

Everything you need to know about our current economic mess is contained in the recent Bernanke testimony before Congress.  Not his answers, which were mostly sensible, but the questions.  From the WSJ blog:

Sen. Tom Coburn (R., Okla.) asks whether all the major central banks easing might diminish the benefits and lead to trade protectionism.

“We don’t view monetary policy aimed at domestic goals a currency war,” [Bernanke] says. Easing policy can be “mutually beneficial” to other countries such as China, which depends on domestic demand in the U.S.

It’s a “positive-sum game, not a zero-sum game,” Bernanke says.

Exactly.  Not a zero-sum game.

What would be the effect on markets if the Fed were to liquidate a big part of its holdings?

Bernanke doesn’t have to answer that question as directly as Toomey may have hoped. “We could exit without ever selling by letting it run off,” he says.  In any case, the Fed has said it would sell its balance-sheet holdings “slowly, with lots of notice.”

Bernanke isn’t letting these barbs go easily. Maybe this is what you do in what could be your final year as Fed chairman.

Bernanke takes control to make a broader point about the economy: “There’s no risk-free approach to this situation. The risk of not doing anything is severe as well.”

Exactly.  Doing nothing is a highly risky policy.

Bernanke endorses the Bank of Japan’s new easy money approach. “I think they should try to get rid of deflation. I support their attempts to get rid of deflation.”

Thank God someone in the US government understands that Japan is being hurt by falling NGDP, and that the easier money required to end the deflation will likely lead to a lower nominal exchange rate.  Recall that the Very Serious People in Europe are outraged by Japan’s so-called “easy money” policy.

Bernanke gets hit with this question again: essentially, is the stock market getting bubbly?

“I don’t see much evidence of an equity bubble,” Bernanke says. Earnings are high and equity holders still are being somewhat risk-averse, he says.

Good, but I’d prefer he’d simply said that 1987 proved that massive stock market bubbles don’t matter, not even a tiny, tiny, tiny, tiny bit.

Then things get even worse:

A testy exchange between Sen. Bob Corker (R-Tenn) and Bernanke. Corker says Bernanke has sparked a global currency war and created “faux” wealth. Bernanke says he’s not engaged in a currency war or targeting the currency. Corker says Bernanke is the biggest monetary ‘dove’ since World War II, proud of it and degrading society. Bernanke shoots back that he’s got the best inflation track record among Fed chairman since World War II. Corker says Bernanke is punishing savers with his low interest rate policies and throwing seniors under the bus.

I can forgive Corker for not having read Friedman; for not knowing that low interest rates usually mean money has been tight.  Even for knowing absolutely nothing about what’s happened to Japanese interest rates over the past 20 years, as they’ve followed the deflationary policy the GOP seems to prefer.  But how can Corker not know that Bernanke has presided over the lowest inflation of any Chairman since WWII?  That’s a pretty basic piece of knowledge.

Now consider Bernanke’s response.  A policy of ultra-low inflation during a period of very high unemployment is shameful, and indeed violates the Fed’s mandate to focus on both employment and price stability.  The Fed is supposed to run below average inflation during booms and above average inflation during recessions.  Indeed they are legally required to do so!

So we have Bernanke essentially bragging that he broke the law and helped create mass unemployment, because it’s his only way of defending himself against those Senators who want him to break the law even more egregiously—to create even lower than post-war record low inflation in order to create even higher unemployment.  Despite my sarcasm, I sympathize with Bernanke.  Indeed I probably would have said the same thing.

As I keep repeating, future generations will shake their heads in disbelief when they survey this train wreck.  I used to wonder how policymakers could have been so stupid in the early 1930s.  I will never again ask that question.

PS.  Did anyone demand more monetary stimulus?  Did even one senator show any understanding of what’s going on?  (I didn’t see the full transcript.)

PPS.  I look forward to Bernanke’s memoir, when we find out what he really thinks of our public servants.  Let’s just hope there’s nothing on what he really thinks of our snarky bloggers.

Excess demand (or supply) for money?

Nick Rowe has a new post that discusses the concept of an “excess demand for money.”  I’m not sure what that concept means, so I’ll address his post obliquely, by describing what I think is actually going on.  I’ll let readers decide how my monetary transmission process should be described.  Let’s look at a (permanent) 10% increase in the base, in 6 easy steps.  For those that don’t think the Fed controls the base, just assume an interest rate targeting change that forces the Fed to increase the base by 10% in order to hit their new interest rate target.

1.  Immediately after the money is injected there is an excess supply of money if we were to assume that there was no change in NGDP or any asset price.

2.  However asset prices and expected NGDP growth change immediately, so that Ms is again equal to Md.  There would be no excess supply or demand for money in that sense.  But the goods and labor markets don’t clear, so there may be an excess supply in some other sense.

3.  Time passes by . . .

4.  Output and semi-sticky prices adjust.  Semi-sticky prices include things like gasoline, food and real estate.

5.  More time passes by . . .

6.  Wages and sticky prices adjust.  Output and employment return to the natural rate, and NGDP rises by 10% relative to the level that would have occurred if there were no increase in the base.  Real asset prices are unchanged.  Nominal interest rates are unchanged.

That’s how I see things.  I prefer to call step two “monetary equilibrium,” but I don’t really have any substantive disagreement with those insist it should be called “monetary disequilibrium” because goods markets are not clearing.  That’s just semantics.  To me, disequilibrium is a psychological concept—frustration.  I want to buy tickets to see the Stones, but the concert is sold out.  I’m frustrated.  When the Fed increases or decreases the base I do not walk around weeks later frustrated that my wallet contains $260 in cash, rather than $240 or $280.  I’m holding exactly as much cash as I prefer to hold, given current asset prices.  Any increased frustration occurs in the goods and labor markets, where people can’t sell as much as they’d like, where they are forced to work overtime against their will.

Again, I’m not saying people who disagree with me on excess money demand are wrong, just that our disagreement is mere semantics, nothing more.

PS.  What causes the changes in step 4?  The increase in the money supply?  Yes.  Or the increases in asset prices and expected NGDP growth?  Yes.  Either/or questions are not supposed to be answered “yes” in both cases, but this is an exception.

PPS.  Those in the underground economy may feel frustration after a change in monetary policy, as it is costly to rapidly adjust cash balances via consumption, and they can’t adjust via asset purchases or sales without the IRS noticing.