Archive for September 2013


Banks maximize profits. Central banks maximize social utility. That’s why banks don’t matter.

This post was inspired by an excellent recent post by Nick Rowe.  Unfortunately he won’t entirely agree with this one.

Is it more useful to define money as the monetary base, or as M1 (cash plus checking account balances?) Nick would say M1. I prefer the base. So let’s think about what makes the base different from checking account balances.  The basic difference is that changes in the base are neutral; in the long run they affect all nominal variables proportionately. If the Fed wants to increase all nominal variables by 100 fold, it simply increases the base 100 fold. Because banks are profit-maximizing institutions, the DD/MB ratio is not affected (in the long run) by changes in the monetary base.  It’s a real variable.  In nominal terms the Fed is the dog and banks are the tail.

Banks can increase M1 by making it more attractive to hold demand deposits.  They can pay interest on checking accounts, for example, or offer free services. That changes a real variable; DD/MB. But they cannot make the Fed print more money. That’s the key difference. The Fed can get the banks to create more deposits, but the banks can’t get the Fed to print more.  The banks maximize profits while the Fed maximizes social welfare.

What about the fact that bank money is also a media of exchange?  Doesn’t that make banks special? Not really. Monetary theory is symmetrical. There is essentially no difference between an increase in the supply of money and a decrease in the demand for money. Any sector of the economy that has a major impact on the supply or the demand for money can influence nominal spending as long as there is no monetary offset. If drugs were legalized and less currency was used for drug smuggling then there would be a drop in the demand for base money.   Typically we don’t worry about this problem because of monetary offset.  But that’s equally true of a change in the supply of media of exchange originating in the banking system.  Banks don’t matter because the Fed won’t let them matter.

There are situations where a change in the private demand for base money does matter. The bank failures of the 1930s were important because we were on the gold standard and that limited the ability of the Fed to do monetary offset. If prohibition had increased the demand for currency during the early 1930s that would have also been deflationary. So banks did matter under the gold standard because of the difficulties in doing monetary offset.  So did prohibition.  Today, however, banks are not particularly special or important.

There is one possible exception to this claim. If the inflation rate is already relatively low, or more precisely if the nominal GDP growth rate is relatively low, then a major banking crisis could drive the nominal interest rate to zero. At that point monetary offset requires unconventional policies that central banks seem reluctant to engage in.

To summarize, Nick thinks banks are special because they create a significant fraction of transactions balances, a.k.a. M1. I don’t think banks are very important because of monetary offset. The Fed drives the nominal economy because it’s not a profit-maximizing institution. That gives it the ability to target nominal aggregates such as inflation or nominal GDP growth.

PS. This is my first post done with “Dragon dictate for Mac.” I find it difficult to get used to “writing” this way.  Hopefully I will get used to it over time.

PPS.   At least Nick and I agree that loans don’t matter.

Balance of payments issues are not macro issues

Recently I’ve seen a lot of misleading posts on international economics.  Here’s one by Paul Krugman. And this one by the normally reliable Ashok Rao repeats some of the misconceptions:

Dean Baker is concerned that America’s persistent trade deficit is a result of East Asian mercantilism, contradicting the textbook story on international capital flows. Baker’s argument is correct – demand for dollars originating from an Asian “savings glut” forced us to run a trade deficit. But where Baker worries about declining employment from an overvalued dollar, I see potential for America to provide yet another international service and profit in the process.

True, a shirt imported is a shirt an American could have made, so a trade deficit costs us jobs on the margin. On the other hand, you can think of that really cheap shirt you’re wearing as a free good: a gift to America in exchange for liquidity. You’re still getting all the utility of wearing the shirt and loosing nothing in the process (unless you drive with a “Buy American” bumper sticker in which case you were probably screwed to begin with).

A stronger point still: as an American, it’s your moral duty to consume. The odd way the international monetary structure is set up gives us the responsibility of issuing the reserve currency. If India wants to buy oil from Saudi Arabia, it has to sell us something first. This guarantees that we run a trade deficit.

I’m afraid this is mostly wrong. Let’s start with the term “mercantilism.” What does it really mean?  Does it mean a policy of discouraging imports and encouraging exports? Well a 10% tariff on all imports and a 10% subsidy on all exports nets out to zero. Nada. At least according to standard trade theory.  Does it mean depreciating your nominal exchange rate? Yes, that may “work” in the short run (although it may not, as we saw when the US depreciated the dollar in 1933.)  But even if it works in the short run it doesn’t work in the long run. The effects are offset by inflation, and the real exchange rate doesn’t change.  Check out Latin America over the past 100 years if you don’t believe me.

Maybe is means a “pro-saving” policy, as the current account (CA) surplus is domestic saving minus domestic investment. OK, but I wouldn’t call that sort of policy “mercantilism.” I’d call it “smart” at least compared to the vast majority of countries that discourage saving. Contrary to Rao, Americans have a moral obligation to save more, not consume more. And it’s not even clear that the big East Asian surplus countries achieve those surpluses from government policies. In Japan the government spent enormous sums on wasteful infrastructure, which actually reduces the CA surplus. And they still has surpluses.  Northern European countries tend to have larger surpluses than East Asian countries, and they aren’t accused of mercantilism. Some claim Germany benefits from the euro, but they’d run large surpluses even if they were outside the euro. The CA surpluses of Sweden, Switzerland and Norway are larger than in Germany (in per capita terms) and they are outside the euro. CA surpluses reflect saving/investment imbalances, not (in most cases) “mercantilist” policies, whatever you wrongly think mercantilism might mean.

And no, India does not have to sell anything to us to buy oil from Saudi Arabia. Nor does anyone else, if “selling” means goods and services.  If we accept the odd claim that Treasury securities are somehow needed for the forex reserves of other countries (but why would that be true?) then those countries could get all the T-bonds they need by selling us assets of various sorts.  It doesn’t require the US to run a CA deficit.

Nor do imports cost us jobs “on the margin.”  If we import more than we export then we save less than we invest.  So every extra dollar of imports means an extra dollar of investment or consumption, as long as the Fed targets NGDP. And if the Fed doesn’t target NGDP, then it’s monetary policy, not imports, which are costing us jobs.  We had an even bigger CA deficit when our unemployment rate was 4.5%, and a few years earlier Germany’s unemployment rate was 10%.  Trade is not the issue, NGDP is.

Then Ashok makes some excellent points about the real problem being a soaring demand for dollars, and not enough money.  But then he gets off track again:

An excellent substitute for the United States dollar is a promise to pay a dollar later – known as Federal debt. Increasing the supply of the former requires us to print money and increasing the supply of the latter requires us to run budget deficits. Okay, I lied. It’s your moral duty to provide liquidity. The really sweet side effect of doing that is more stuff. Did someone say pre-school? Or solar power? In other words, the solution to the trade deficit “problem” is to allow for a larger budget deficit””U.S. government debt is one of our most important export goods.

The problem here is too little NGDP, and issuing more bonds won’t help. Otherwise Japan’s huge budget deficits would not have led to an astonishing decline in NGDP over the past 20 years.  A much better solution for Japan would have been a 3% NGDPLT.  Had they done so over the past 20 years their NGDP would now be almost double current levels, and the debt/GDP ratio would have been far smaller, for at least five reasons:

1.  More inflation.

2.  Slightly more RGDP growth.

3.  Less unemployment comp.

4.  Less discretionary stimulus on wasteful infrastructure projects.

5.  Lower real interest rates (due to the zero bound problem with falling NGDP.)

Their monetary base would also be smaller, as a share of GDP.

As Paul Krugman asks, if we don’t run a deficit who will? Some things are zero sum. Better the issuer of the world’s most in-demand currency run a deficit than the guy who prints Rupees, which nobody seems to want. We provide the public good of liquidity in return for the free good of imports.

This argument was more problematic in the sixties when economists like Robert Triffin argued that we’d be forced to run a deficit forever causing an inflationary spiral. But in the sixties neither the domestic nor global economy was anemic, and inflation was a real problem.

Triffin was of course wrong, he confused running budget deficits with printing money.  Reagan showed we could run big budget deficits and reduce inflation at the same time.  Foreign central banks want T-bonds, not dollar bills. The inflation of the late 1960s did not come from the modest budget deficits, but rather from the acceleration in the growth rate of the monetary base.  We printed too much money.

People should not mix up monetary and fiscal policy.  Nor should they mix up international economic issues with macro issues.  Yes, under fixed exchange rates they are linked, but that’s why we should have flexible exchange rates.  And if you have flexible rates there’s no need for such massive holdings of international reserves.

I believe in K.I.S.S.:

1.  Use monetary policy to do NGDPLT.

2.  Enact pro-saving policies (a la Singapore) to offset the other anti-saving policies.

3.  Let the market determine exchange rates and CA balances.

And for God’s sake let’s all stop acting like there is a qualitative difference between German workers building cars and exchanging them for Chinese built iPads versus Australian workers building condos and exchanging them for Chinese built iPads. Does geographical location of the German/Australian export really matter? Of course not.  Then why do most pundits act like Germany is a muscular success while Australia is a feeble weakling?

Apologies to Ashok, most of this tirade had nothing to do with what he actually wrote.  I actually agree with Ashok that we should not worry about the CA deficit. In contrast, I’d have to take some medication before addressing Krugman’s post.

Bill Woolsey on Bennett McCallum

Bennett McCallum has a new paper arguing that NGDP growth rate targeting is superior to NGDPLT. McCallum is right that NGDPLT doesn’t work well if it is used as a temporary expedient.  But I much prefer NGDPLT as a policy regime.

Bill Woolsey has an excellent reply.  I’ll just quote a few passages, but you should read the entire post:

It is great to see more new work from McCallum on nominal GDP level targeting.

He emphasizes discretionary and time invariant approaches to policy rules.    He also mentions a purported rule he calls strategically incoherent.   I am not sure I fully understand, but it looks to me that this is exactly the approach that Market Monetarists favor.   Right now, we have to decide where the initial growth path for nominal GDP will commence, and then we stick with it.   This is supposedly incoherent because why don’t we start it all up again every period?    Next year, why don’t we imagine we have no rule, and we will start it all up again.

Suppose we are considering the institution of  very strict gold standard.   In the future, the price of gold will be fixed.   The price next period will equal the price this period which equals the price last period.   Now, at what price do we set the price of gold?   Is it strategically incoherent to use anything other than last period’s market price of gold?   I don’t think so.   The relative price of gold can easily be impacted by using it as medium of account.   We are instituting a regime.   The logic for choosing a rule initially is not the same as the logic for sticking to the rule.

.  .  .

The studies McCallum refers to presumably use calculations of utility loss from inflation rather than a simple “loss” function.

But to what degree are these utility calculations based on the assumption of Calvo pricing?  That seem to me to put too much weight on an obviously unrealistic model whose only virtue is that it can be used to make calculations of utility in rational expectations models.

If instead, some prices are flexible and others are sticky, reversing the changes in the flexible ones so that the sticky ones don’t have to change is desirable.   This reasoning also applies when the sticky prices are those of labor–wages.   And that seems much more plausible.   Rather that keep the price level change and then make wages adjust, it makes much more sense to reverse the price level change so that labor markets clear at the sticky wage levels.

What about supply shocks?   While nominal GDP level targeting is the same as price level targeting when there are no aggregate supply shocks, one of the chief virtues of nominal GDP level targeting is that it does much better than price level targeting when there is a supply shock.

The model McCallum uses has an inflation shock.   It is just a random term at the end of the quasi-Phillips curve.   It seems to me that any such shock would push nominal GDP above target.   A growth rate target would just leave nominal GDP on a new, higher growth path.   In my view, that would be best.   (At least if these price level shocks are really just random and not regime dependent.)   Pushing the price level back down the next period would be pointless.   Nominal GDP level targeting would require a return of nominal GDP to target, and would likely push output below capacity.

However, what these random shocks in the model represent are real microeconomic events that impact both prices and capacity.   Negative covariance is very likely, and so just when the price level is shocked up, real output and capacity are both pushed down.   Any deviation of nominal GDP from target is likely to be small.

All I would add here is that if the price shocks were changes in VAT rates, it would make more sense to target NGDP net of indirect business taxes.

I happen to think that there is very little difference between NGDP growth rate targeting and NGDPLT when the central bank is competent, i.e. when it is targeting the forecast.  When central banks are incompetent (as the Fed was in 2008) then NGDPLT is a vastly superior policy—NGDP growth rate targeting doesn’t even come close.  NGDPLT almost forces central banks to “do the right thing.”

Summers and DeLong explain why Yellen is the better choice

[I did this a while back but never posted it.  I suddenly feel like I “shoulda hit Summers even harder.” So even though he has dropped out, I’ll take one more shot.]

I just read Summers and DeLong’s paper on fiscal stimulus.

The argument that normal-times policy-relevant fiscal multipliers should be presumed to be very small can be made more general. Optimizing central banks will be expected to offset shifts in discretionary fiscal policy””and thus lead to multiplier estimates near zero””under relatively unrestrictive conditions. Consider a government choosing monetary policy so as to achieve the best economic outcome from the set of outcomes attainable by policy P. A change in fiscal policy from baseline would change the relationship between monetary policy and the economic outcome. But unless the change in fiscal policy opens up access to an outcome not in the set P that is superior, or eliminates access to the best economic outcome in P, the government will shift its monetary policy so that it still picks the same economic outcome. It will thus engage in full monetary offset.

Note that for this point to hold, the choice of monetary policy m and the choice of fiscal policy g cannot themselves be part of the outcome the government values. A central bank that values a smooth path for interest rates (as did the pre-1979 Federal Reserve) or has preferences about the size of its balance sheet (as did the Federal Reserve under Paul Volcker) will not engage in full monetary offset. Monetary and fiscal policy must enter into the central bank’s objective only through their effects on economic outcomes for full monetary offset to hold.

So a sensible central bank will have a zero fiscal multiplier.  By “sensible,” I mean a central bank that focuses like a laser on inflation and employment, and does not put the stance of monetary policy into the objective function.  Bernanke and Yellen are a bit difficult to read.  They may have some reservations about a large balance sheet, but on the other hand monetary stimulus can be achieved without increasing the current size of the balance sheet—by forward guidance for instance.  So there’s no particular reason to believe the fiscal multiplier would not be zero, although of course it might be higher.

At the opposite extreme is someone like Larry Summers, who worries that low interest rates and a bloated balance sheet might lead to bubbles, and misallocation of investment.  In that case fiscal policy could be “effective.”  That sort of central banker would essentially be holding the economy hostage, much as the GOP radicals in the house are accused of doing.  A central banker with that objective function would intentionally hold NGDP below the optimal path, unless and until the Federal government would assure him or her that the extra NGDP growth would be in the public sector, where (unlike the private sector) the expenditures would not be wasted on foolish projects driven by a bubble mentality.  The Federal government spends money very wisely, especially when under pressure to quickly ramp up investment during temporary slumps in the economy.

PS.  Lars Christensen has a very good post on why the Japanese should not try to artificially push wages higher.

“Should’ve hit Yellen harder, say Summers’ friends”

That’s a headline that might raise some eyebrows.  Even more interesting is that the video suggests they should have attacked Yellen for favoring policy transparency.

Vote for Larry, he’ll keep the secrets well hidden within the temple.  When you need to know something, Mr Summers will tell you.