Archive for March 2014


Reply to Frances Coppola

Here is Frances Coppola:

Scott Sumner argues thatwhen the monetary base is fixed, low interest rates are deflationary. I’ve emphasised the fixed monetary base because it is an important condition. If the monetary base is NOT fixed then the relationship between low interest rates and deflation is much less clear.

Logically, this makes sense. If the supply of base money is fixed, then falling interest rates indicate* rising demand for base money, increasing its value and therefore causing prices to fall. Aficionados of a classical gold standard will recognise this as “benign” deflation. Falling interest rates when the monetary base is fixed are an indicator of healthy growth.

I would argue the opposite.  Low interest rates are usually indicative of weak growth, as both real and nominal interest rates are procyclical.  Barsky and Summers showed that under the gold standard, when the economy slowed interest rates tended to fall.  This increased the demand for gold (the medium of account) and was deflationary.

The “good deflation” was a secular phenomenon.  It was associated with a rise in the demand for money from positive trend real GDP growth, not lower interest rates.

It’s misleading to say falling interest rates are only deflationary under a constant monetary base. They have a deflationary impact regardless of the base, it’s just that when the base is changing the deflationary impact from falling interest rates is often offset by the inflationary impact of a rising monetary base.

The Fed was not holding the monetary base fixed and allowing the interest rate to fall, which is what Sumner implies. It was actively supporting the Fed Funds rate.

The Fed Funds rate is not simply a market interest rate. At the time, it was the primary monetary policy tool, though these days – because of the presence of excess reserves in the system – it has been superseded by the interest on reserves (IOR) rate.

Interest rates fell becasue of a weakening economy, not because the Fed cut interest rates.  When the Fed announcement in December 2007 was less expansionary then expected, 3 month T-bill yields (which are market interest rates) fell on the news. Markets understand market monetarism. A few weeks later the Fed had a panicky emergency meeting and cut it’s fed funds target in an attempt to keep up with changing economic conditions.  The reduced demand for loanable funds was pushing rates lower, and because the Fed did not respond by increasing the base this led to a further slowdown in NGDP.

Sumner seems to think that the Fed should not have supported the rate by draining reserves. On he contrary, he explicitly blames the Fed’s failure to expand the monetary base at this time for the subsequent collapse of NGDP:

Between August 2007 and May 2008 there was no change in the monetary base, and yet interest rates fell sharply.  Not surprisingly NGDP growth slowed and we tipped into recession.

But the problem was inflation:

Expansionary monetary policy when inflation was already so far above target would have seemed like madness. Even since the crisis, it takes a brave central bank to hold its nerve and its expansionary policy when inflation is a long way above target, as the Bank of England has discovered.

Yes, at the time the market monetarist message would have seemed like madness—focus on NGDP growth and ignore inflation.  But we now know it is inflation targeting that is madness.  Even Bernanke now admits that actual policy was too tight during the crisis.

Nor would NGDP targeting necessarily have made much difference to Fed policy. We now know, with the benefit of hindsight, that NGDP was going to fall off a cliff in 2008. But at the time, NGDP didn’t show much sign of such a dramatic collapse:

It would have made a huge difference, because with NGDPLT monetary policy works with “long and variable leads.”  The expectation that the Fed would return to the 5% trend line in the long run would have stabilized asset markets in the short run, and Lehman might not have even failed.

Those in favour of a strict rule-based approach to monetary policy based on something like an NGDP target will no doubt be disappointed: but as I said above, an NGDP target would not necessarily have resulted in a markedly different policy stance in the crucial early part of the financial crisis.

Maybe not all that different, but then the initial part of the recession was exceedingly mild.  Most importantly NGDPLT would have created expectations of a very different policy in the latter half of 2008, which would have made the recession far milder.

PS.  The Coppola post refers to a money supply graph that I wasn’t able to find. Was it included? Another graph has a garbled horizontal axis, and another refers to potential NGDP which is a nonexistent concept.  “Potential” only has meaning for real variables.

Update:  I mistakenly linked to the wrong version of the post.  The correct version does have a money supply graph.

HT:  Travis V.


“Under NGDPLT, it becomes the job of Fiscal policy to control inflation.”

The title of this post was left in a recent comment by Morgan Warstler.  What he means is that NGDPLT takes nominal spending off the table, all that’s left is for the government to try to influence the split between P and Y.  And that means demand policies don’t work, all fiscal policy must be supply-side, aimed at more growth and hence less inflation.

If conservatives understood this then market monetarism would go from being a fringe movement eyed suspiciously by those on the right, to a position where we’d be headline speakers at CPAC.

While we’re at it, Morgan’s wage subsidy scheme makes the minimum wage and welfare obsolete.

PS.  I have a bubble post (with Shiller bleg) over at Econlog.

Now that Ben Bernanke is free to speak his mind . . .

What does Bernanke now say about the market monetarist claim that monetary policy was not expansionary enough during the 2008-09 crisis?  This:

(Reuters) – Former Federal Reserve Chairman Ben Bernanke said the U.S. central bank could have done more to fight the country’s financial crisis and that he struggled to find the right way to communicate with markets.

“We could have done some things on the margin to mitigate somewhat the crisis,” Bernanke, 60, said on Tuesday in his first public speaking engagement since he stepped down in January after eight years heading the Fed.

“Although we have been very aggressive, I think on the monetary policy front we could have been even more aggressive.”

Bernanke said he could now speak more freely about the crisis than he could while at the Fed – “I can say whatever I want” – and in remarks to over 1,000 bankers and financial professionals in the capital of the United Arab Emirates, he made clear that he had regrets.

Janet Yellen has only been in charge for a few weeks, and yet I think we are already discovering that Ben Bernanke was not the problem.

It’s the zeitgeist, stupid.

PS.  Marcus Nunes sent me a post by Philip Pilkington:

A revolution in how we understand economic policy is now visible – but the question remains as to whether the Bank will seize the moment. Monetarism, you see, has two components. The first is that the central bank should try to control the money supply. In light of the Bank’s report that part of the monetarist doctrine is now a dinosaur fit only to be displayed in the museum of failed economic ideas.

The second component, however, is alive and well. That is the idea that the central bank should use unemployment to control inflation. Although the central banks of the world rarely say it in public, since the monetarist era they have used interest rate hikes to generate recessions and increase unemployment any time they fear an uptick in inflation.

I’m not sure what the “second component” refers to, perhaps new Keynesianism (which is loosely related to monetarism.)  This quote provides a good opportunity to distinguish market monetarism from either the original or new Keynesian varieties.  We don’t favor controlling the money supply (he means aggregates), nor do we favor using unemployment to control inflation.  Indeed we don’t want the central bank to control inflation at all, but rather target NGDP growth.

PS.  His comment about the money supply after Thatcher took office is slightly misleading.

Inflation began to subside, not because the money supply stopped growing – it didn’t – but rather because wage growth was contained through high rates of unemployment and the demolition of trade unions.

Yes, it didn’t stop growing, but consider this data:  In 1969 the UK base was 3618 million pounds.   By 1979 it had soared to 10446 million pounds, up 189%.  Then the BoE stopped printing money at such a furious pace and growth slowed, so that the base reached 17621 million pounds in 1989, up 69%.  That’s certainly a significant slowdown, and largely explains why prices rose only 85% during the 1980s, after rising 222% during the 1970s.

Our monetary system is becoming increasingly primitive

David Glasner has a good post on the recent Bank of England essay on money, but I’d like to respond to one of his comments:

What the authors mean by a “modern economy” is unclear, but presumably when they speak about the money created in a modern economy they are referring to the fact that the money held by the non-bank public has increasingly been held in the form of deposits rather than currency or coins (either tokens or precious metals). Thus, Scott Sumner’s complaint that the authors’ usage of “modern” flies in the face of the huge increase in the ratio of base money to broad money is off-target. The relevant ratio is that between currency and the stock of some measure of broad money held by the public, which is not the same as the ratio of base money to the stock of broad money.

Actually my claim also applies to currency.  Here is the data for 1929 and today:

January 1929: Currency = $3.828b  M1 = $26.109b  M2 = $55.119b

Today:  Currency = $1239b    M1 = $2793b    M2 = $11137b

I realize that “everyone knows” that the modern economy relies more on bank deposits and less on cash than in the old days, but I’m afraid that’s just one of the many things “everyone knows” that is not true.  Note that the C/M1 ratio would have increased even if you had only looked at currency held within the US (believed to be as much as half of the total currency in circulation.)  It’s unclear what would have happened to the C/M2 ratio.

The definition of money doesn’t matter (and there are no “wrong” definitions)

In the comment section of a recent post lots of people objected to my definition of money, which is the “monetary base.”  Most did not seem to recall that Larry Summers once made the same argument (that falling interest rates are deflationary), in a paper explaining the Gibson paradox. And he used gold as the medium of account.  BTW, the fact that low interest rates being associated with low prices was considered a “paradox” shows that “reasoning from a price change” was a widespread problem until Larry solved the puzzle.  (credit also to his coauthor Robert Barsky (who probably did most of the work), and a slightly earlier paper by Chi-Wen Jevons Lee and Christopher Petruzzi.)

Of course we all know that monetary economics has regressed in the last 5 years, and based on recent comments I’ve received the Gibson paradox relationship is once again viewed as a “paradox,” not the natural implication (during periods where the supply of money was relatively stable) of the downward sloping demand for money as a function of nominal interest rates.

Another objection was that my monetary base definition of money is weird, and in some sense “wrong.”  If only I understood that demand deposits could also be used as money, I’d see how false my claims really are.  OK, just for today I’ll give you all your definition.  For today M2 is money, and the monetary base is called “SumNerdyProfessor’sObsession.”  Let’s shorten that to the base = SNPO. Now I want you to re-read all the posts I’ve written since February 2009, and replace “money” with “SNPO,” everywhere you see the term ‘money.’  Or at least pretend to.  OK, now all my posts are rewritten. Has anything changed?

Nope, all my arguments are equally valid for changes in the supply and demand for SNPO.

I’m begging everyone—no more complaints that I have the wrong definition for money.  A rose by any other name . . .

PS.  No one seems to research the demand for money anymore, but when I was young it was the most researched topic in all of economics.  There are 100s, maybe 1000s of old empirical studies that support my claim that falling interest rates are deflationary, holding the level of base money SNPO fixed.