Archive for May 2013


Money multipliers: Nominal, real, and imaginary

Economics is full of “multipliers.”  One generally shouldn’t take them too seriously, as all sorts of economic forces will impact the relationship between any two variables, and hence multipliers will rarely be stable over time.  I’ve discussed the fiscal multiplier ad nauseum.  The crude quantity theory of money (assuming constant V) is a sort of multiplier model, where V is the multiplier linking the money supply and NGDP.  And then there are the monetary aggregate multipliers (deltaM/deltaMBase), which are almost never explained correctly.

1.  Let’s start with the nominal money multiplier.  Suppose the Fed decides to increase the base by 173% over the next 40 years, how will that affect various nominal aggregates?  The most likely answer is that NGDP, and all nominal components of NGDP, will be 173% larger in 40 years than if the Fed didn’t increase the base at all.  (Strictly speaking this is not exactly correct for large differences, because of hysteresis, but it’s close enough to get my point across.)

This means that in 40 years NGDP will be 173% larger than otherwise, and the size of the toaster, pedicure and banking industries will also be 173% larger than otherwise.  In that case there are “multipliers” for the toaster, pedicure and banking industries, although they aren’t very interesting.  This does NOT mean the three aforementioned industries will grow by 173%–far from it–rather that they will be 173% larger than otherwise.

2.  At the other extreme one can think of all sorts of real factors that influence the REAL size of the banking industry, which have nothing to do with monetary policy or NGDP.  Thus start with an economy that has no banking industry–perhaps due to usury laws.  Then a renaissance happens, and a banking industry springs up.  In that case the deposit base may grow enormously, even without any increase in NGDP or the monetary base.  The bankers would bid base money (cash) away from the public by offering higher interest rates, and once that cash got into the banking system it would provide the raw materials for a large quantity of deposits, loans, etc.  In this scenario it makes no sense to talk in terms of “money multipliers,” as there is no increase in the monetary base.

If these were the two relevant factors, the actual situation would be somewhat complex, but at least easy to talk about.  Both real and nominal shocks would be going on all of the time, and the actual outcome would reflect some combination of those shocks.

3.  Alas, the actual situation is far more complex, and this is where things get controversial.  Because prices are sticky, monetary injections have all sorts of short run real effects.  Most notably, a one-time increase in the base can reduce the short term nominal interest rate (liquidity effect.)  In that case you might get a short run “real multiplier” effect coming from a monetary shock.  For instance, suppose the base rose by 6%.  Let’s say that reduces short term rates from 5% to 3%.  At the lower rates the public is willing to hold 6% more non-interest bearing base money.  (Add in IOR and things get even trickier.)  Does that mean M1 and M2 rise by exactly 6%?  Probably not, because as interest rates fall the relative preference for currency and bank deposits will change, and in addition banks will want to hold slightly more excess reserves.  Nonetheless, the monetary aggregates might well increase, and if nominal interest rates are positive the aggregates will probably increase by more than the base.  So the “multiplier” might well exceed one.

There’s a lot of discussion about whether deposits cause loans or loans cause deposits.  So far as know all those discussions are basically useless, because they don’t distinguish between the three types of changes discussed above (monetary nominal, banking real, and monetary real.)  The actual outcome is incredibly complex, but it will help to start with a few basic principles:

1.  Loans and deposits are complements in production, like wool and mutton.  Thus there is at least some causation going in both directions, just as with wool and mutton.  But it’s certainly possible that most of the causation goes in one direction.

2.  Balance sheets are complex.  When loans increase you can increase deposits, or increase other forms of bank borrowing, or decrease bonds (on the asset side of the balance sheet.)  Ditto for an increase in deposits, it can lead to more loans, or more bonds, or less bank borrowing.  Capital requirements can impose some limits to this sort of substitution.

3.  Thinking about the process in a “mechanical” way is not helpful.  Thus it doesn’t matter whether the first round effect of a loan is to create an equal-sized deposit; what matters is the medium-term effect on the various aggregates within the financial system (after everyone has optimally adjusted their portfolio.)  Never, ever, ask a banker to explain the money supply process.

4.  When thinking about the effect of changes in one aspect of the banking system on another, one must first ascertain which of the three factors discussed above is causing these changes.  Are bank deposits (or loans) rising because monetary policy is inflating all nominal variables (long run), or because the real size of one component of the banking system is increasing or decreasing due to real factors, or because the injection of new base money has depressed interest rates and thus caused a temporary increase in the real demand for base money, as well as the monetary aggregates?

I don’t recall ever seeing a blogger discuss the full complexity of the process, but instead see lots of catchy cliches that might apply to one situation, but not another.

Caveat emptor.

PS.  This is similar to the debate over forex policies, where one rarely see people distinguish between a real exchange rate policy (China) and a policy which affects real exchange rates in the short run, but is purely nominal in the long run (Japan.)  Indeed just as with the money multiplier, exchange rates involve three effects:

1.  Long run neutrality of M, i.e. QT of Money and PPP.

2.  Changes in the real exchange rate due to real policies affecting national saving, investment, etc.

3.  Monetary policy having short run real effects on exchange rates because prices are sticky.

So once again debates in this area often involve people screaming at each other that one of those three mechanisms is the “right way” to think about international economics, when in fact all three play a role.

The inflation hawks are so wrong that it’s not even funny anymore

I am constantly annoyed by reading inflation hawks warn that all this so-called “monetary stimulus” will hurt the Germans, or the elderly in Japan, or Americans that save.  Meanwhile, in the real world:

Over the past 12 months, inflation has risen just 0.7 percent, the smallest gain since October 2009 and pushing further below the Federal Reserve’s 2 percent target. The index had increased 1.0 percent in the period through March.

Core prices were up 1.1 percent, the smallest rise since March 2011 and slowing from 1.2 percent in March.

The fact of the matter is that if the Fed did actual monetary stimulus beyond my wildest imagination they’d still be unlikely to get the inflation rate up to their legal mandate for the period from 2008 to 2016.  That’s right, inflation will almost certain run under 2% during that 8 year period, even if the Fed does what I want them to do (and money is still too tight.)  Take a look at the PCE core rate, which is the one the Fed targets:

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Notice that it was above 2% before the recession, and has been consistently below 2% ever since.  And yet the Fed’s legal mandate calls for exactly the opposite pattern.  They are required to focus on both inflation and employment, which means higher than 2% during periods of high unemployment and vice verse.  As George Selgin points out in this video, the rate of inflation should be lower during periods of strong growth than otherwise. (Although George prefers a policy that would lead to a lower average rate of NGDP growth than I prefer.)

In Japan, prices continue to fall despite a massive depreciation of the yen.  That means that without Abenomics the rate of deflation would be even greater, as we know that (at a minimum) a sharp currency depreciation will boost import prices.

I really want to pull my hair out when I hear pundits warn of high inflation.  All they are doing is discrediting whatever macroeconomic philosophy they espouse.  Unfortunately for me, most of the inflation Cassandras (albeit not all) are on the right.  They share my views on many other issues. When the high inflation does not happen (and it won’t) their views will be even more discredited than they were after the failure of “austerity” to boost growth in Europe.

The good news is that inflation doesn’t matter, NGDP growth matters.  So as long as Abenomics boosts NGDP growth, it really doesn’t matter what happens to inflation.

Prediction:  At some point in the next 12 months the ECB will realize that the eurozone NGDP is not going to recover on its own, and they will launch a program of monetary stimulus.  The Germans will squeal, but inflation will continue to run BELOW the ECB’s legal mandate.  In other words, everyone will claim the Germans are being screwed, whereas the truth will be the exact opposite.

PS.  George missed a golden opportunity to point out that there has been a lot of “demand destruction” in both Japan and southern Europe.

PPS.  Not only do the Europeans pay no attention to NGDP, but they don’t even report the data.  I kid you not.  The first quarter NGDP for the eurozone is not yet available, and it’s the last day of May!  What are all those bureaucrats in Brussels doing?

PPPS.  And of course that means RGDP isn’t really available either; instead some bizarre proxy for RGDP is being reported, as you cannot compute RGDP w/o NGDP.

HT:  Lorenz

The continent that brought us the glories of the renaissance and the enlightenment . . .

. . . seems incapable of understanding that the following two statements cannot both be true:

1.  The eurozone needs to move away from austerity to boost growth.

2.  The ECB cannot do monetary stimulus because of its inflation mandate.

Statement 2 might be false, in which case the ECB should do monetary stimulus to boost growth.  Or it may be true, in which case ending austerity will not boost growth (due to monetary offset.)  But either way, the European consensus seems to be making an EC101-level error in logic. How a continent of 500 million highly educated people could make such a costly error without almost anyone noticing is beyond my comprehension.

PS.  I suspect inflation is running below 2% in the eurozone, and hence the ECB can ease.  So at a minimum 2 is false.  I don’t know enough about the ECB to comment on 1.

PPS.  Miles Kimbell and Yichuan Wang have a very good essay on the Rogoff and Reinhart study.  As always, I remain an agnostic on debt and growth.  (Glad to see those two guys working together at Michigan.)

PPPS.  David Beckworth has a very good new piece on low interest rates (in the National Review Online.)

PPPPS.  I was asked about this Paul Krugman post.  Even if you assume that tight money raises bond prices (income and expected inflation effects dominate), the qualitative result is the same—a strong recovery best matches the picture. But keep in mind that exchange rates are a “it takes two to tango” variable. Some of the dollar’s strength comes from the BOJ being more expansionary than the Fed. So I’d guess that the Fed’s shift toward easier money in late 2012 (or less contractionary if you prefer) plays some role in the picture Krugman describes.

John Carney on monetary offset

Here’s John Carney of CNBC:

Which is to say, the Fed would like to ease up on monetary accommodation but fears that Congress seems unlikely to implement fiscal policy that won’t restrain growth. To put it differently, if Congress were to “get its act together” and provide fiscal relief to the economy, the Fed likely would respond by tightening.

That means that the dominant narrative may have things backward. Instead of Fed policy enabling congressional bungling, it’s Congress that is enabling Fed policy. A Congress that was less divided along partisan lines and dedicated to stimulating the economy might trigger a tightening reaction by the Fed.

HT: David Gulley

PS.  Here’s Evan Soltas:

My view is that extending the payroll tax cut, replacing sequestration and investing in infrastructure would’ve led to a significantly stronger 2013 than we’ve had. But I’m less confident that those policies would’ve made a big difference, as opposed to a small difference, than I was six months ago.

And here Neil Irwin responds to me and several others making similar arguments:

There is good reason to think that monetary easing is doing quite a bit of the work offsetting tighter fiscal policy. The Fed’s policies, including buying $85 billion in bonds each month with newly created money, are directly aimed at housing; $40 billion of those purchases are of mortgage-backed securities, meaning the money is being funneled directly toward the sector. And sure enough, a solidifying housing market is an important part of the economy’s holding up. And a second important consequence of Fed easing is to boost the prices of other financial assets, including the stock market.

This isn’t rocket science: The Fed in September introduced a policy meant to boost housing and stock prices, and now, nine months later, housing prices and stock prices have risen quite a bit. Enough, indeed, to (so far) offset the impact of higher taxes that went into effect Jan. 1 and federal spending cuts that took effect March 1.

So far so good. The bad news, though, is that these channels through which monetary policy affects the economy tend to offer the most direct benefits to those who already have high incomes and high levels of wealth.

I have several problems with this.  First of all, income inequality tends to be pro-cyclical.  Stocks fall much more sharply than wages during recessions, and rise much faster during recoveries.  That’s nothing new.  Of course there is also a long term trend toward greater income inequality in America, but that has little or nothing to do with monetary policy.  If there are parts of the sequester that hurt the poor, those cuts should be re-evaluated on a cost/benefit basis, not based on whether they are perceived to promote recovery.

The Fed should focus on promoting a healthy macro environment.  To some extent they do, although in unusual circumstances such as 2008-09 they screw up.  It’s up to fiscal policymakers to adopt sound fiscal policies using cost/benefit calculations, not “stimulus estimates.”  In other words, let the Fed steer the car, and have Congress focus on setting the A/C controls, choosing the radio station, and adjusting the seating position.

Magnetic Hill, and the mystery of the jobless recoveries

Back in the 1970s I was driving near Moncton, New Brunswick when I came across Magnetic Hill.  Cars in neutral seem to roll uphill, perhaps due to an optical illusion.  I’m going to argue that this strange hill may provide an explanation for the mystery of the last three recoveries, which have been widely labeled “jobless recoveries.”

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The last three recoveries have been shaped like frying pans, not the V-shape that previously occurred.  Most of the explanations I see posit deep structural changes in the economy, and in particular the nature of labor markets.  But those theories actually fail on two different levels.  First, structural change is very gradual, and we suddenly went from V-shaped to pan-shaped recoveries.  More importantly, the real question is not why have robust recoveries in NGDP not led to rapid job growth, but rather why have we not had the usual rapid recoveries in NGDP.

In other words, monetary policy has been relatively tight during the past three recoveries, and hence NGDP growth has been slow.  Thus it’s no surprise that we’ve have very slow recoveries in the labor market.

But why have the recent recoveries in NGDP been so slow?  Hasn’t monetary policy improved during the “Great Moderation?”  Isn’t the business cycle more stable?  (At least before 2008?)  Yes, monetary policy has improved, but it is still slightly flawed, and that flaw led to an asymmetric bias.  Policy was very good at preventing overheating–and hence the recoveries tended to be longer after the 1982 recession, but policy was not so good at promoting a brisk recovery.

So how does Magnetic Hill explain this mystery?  Suppose Magnetic Hill is caused by an optical illusion, which makes it seem like you are going uphill, when you are actually going downhill.  You’d then put too much pressure on the accelerator in one direction, and too little in the other.  Now suppose that since 1983 some sort of mysterious force caused monetary policy to be less expansionary that the Fed anticipated.  In that case they’d usually have a more contractionary policy than they wanted, which would extend booms (by preventing overheating) but also slow recoveries from recession.  That could explain why money was too tight during the last three recoveries, producing sub-optimal NGDP growth and suboptimal jobs growth.

Nice theory, but do I have any evidence for this mysterious “magnetic force” throwing off monetary policy since 1983.  Yes I do!!  Recall that NK policy works through adjusting the market interest rate relative to the unobserved Wicksellian equilibrium rate.  In practice, all we can do is look backward and estimate the Wicksellian rate by observing actual market rates in relation to the growth rate of prices and output. So in practice economists tend to assume the Wicksellian equilibrium real interest rate is fairly stable, at least averaged over the cycle.

So my theory of a mysterious force causing three consecutive jobless recoveries requires the economics profession to consistently overestimate the Wicksellian equilibrium real interest rates over a period of 30 years.  How likely is that?

Perhaps more likely than you’d think.  Suppose economists assumed the rate showed no long run secular trend, but in fact a major downward secular trend began in 1983.  In that case the Fed would almost always be overestimating the expansionary stance of its policy, producing a bias toward ever lower rates of inflation and NGDP growth.  This wouldn’t be much of a problem during booms, after all the Fed was usually too expansionary during booms in earlier decades.  But in recessions it would lead to slow recoveries, even if they seemed to be adopting highly expansionary policies.

Is there any evidence for a long downward secular trend in real interest rates since 1983?  Yes, there is, indeed this is probably the most notable stylized fact of recent American macro history:

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Real interest rates on 10-year T-bonds have fallen from 7% to less than zero percent over the past 30 years.   Yes, those are market rates, not Wicksellian equilibrium rates.  But since both inflation and NGDP growth have fallen sharply over that 30 year period, the decline in the Wicksellian equilibrium rate must have been even greater!!

It’s only in retrospect that the full importance of this earth-shaking trend has begun to sink in.  The Fed has now realized that low rates aren’t enough, and have moved toward more aggressive stimulus.  Ditto for the Japanese.  Stock investors now realize that low rates are not simply a cyclical pattern, but at least partially reflect a deep secular trend.  That means equity prices needed to be adjusted upward, and the process is well underway.  In fairness to my progressive friends, infrastructure projects that were not cost effective in 1983, suddenly are cost-effective in 2013, even if not used to stimulate the economy.

Low interest rates are the new normal, we all better learn to get used to it.

PS.  Bill Woolsey sent me a paper by an MIT economist named Ivan Werning, which starts out as follows:

The 2007-8 crisis in the U.S. led to a steep recession, followed by aggressive policy responses. Monetary policy went full tilt, cutting interest rates rapidly to zero, where they have remained since the end of 2008. With conventional monetary policy seemingly exhausted, fiscal stimulus worth $787 billion was enacted by early 2009 as part of the American Recovery and Reinvestment Act.

I don’t doubt that this is an excellent paper, but the intro annoyed me for several reasons.  Werning is expressing the conventional wisdom about interest rates in late 2008, but in fact the Fed was shamefully slow to ease policy.  A Svenssonian “target the forecast” approach would have forced the Fed to cut rates fast enough so that expected NGDP growth was always on target.  And yet rates didn’t hit zero until mid-December 2008, by which time it was obvious to everyone that we were in a severe recession.  The Fed did not even cut rates by a measely 1/4% in the meeting of mid-September 2008, 2 days after Lehman failed.  They weren’t targeting the forecast.

And in 2008 we were teaching our students that monetary policy is “highly effective” at the zero bound (in the number one money textbook, by Mishkin), so I can’t imagine why zero interest rates would imply a need for fiscal stimulus.

PPS.  Paul Krugman zeros in on a similar argument, from a slightly different direction.  All I’d add is that while a 4% inflation target would be better than a 2% inflation target, a 5% NGDP growth level target would be far better than either inflation target.