Noah Smith has a post that is rightly dismissive of the conservative obsession with QE’s inflationary potential.  He says this view is widely held in the finance community, and labels it the Finance Macro Canon (FMC.)  He attributes this belief to numerous factors, including:

2. The lingering influence of Milton Friedman and the monetarists. Friedman told us that easy monetary policy causes inflation. His insights form the core of the New Keynesian research program that has come to more-or-less dominate central bank thinking.

I do think the monetarists are partly to blame, but I would exonerate Friedman himself.  Unfortunately he did not live long enough to comment on the crisis, but here’s how (in 1998) he described a similar monetary policy in Japan:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

.   .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Also note that Friedman described monetary policy during the early 1930s as highly contractionary, despite low interest rates and lots of QE.  He was quite dismissive of the Austrian view in the Monetary History, and would probably be equally dismissive of those who claim that the Fed has had a easy money policy since 2008.  My hunch is that he’d focus on IOR (although I’m not at all sure that rescues the old monetarist model, which has other flaws.)

At the end of the post Noah Smith offers people suffering from FMC a few suggestions:

So how does one extract an individual human mind from this hive mind? That is always a tricky undertaking. But I’ve found two things that seem to have an effect:

Method 1: Introduce them to MMT. MMT is a great halfway house for recovering Austrians.

Method 2: Introduce them to the research of Steve Williamson. Williamson is an example of a guy who changed his mind about the most likely effect of QE, after observing its real effects.

So far, these are the only things I’ve found that work. If you have any other ideas, please share. Every mind we reclaim from the hive is another blow struck for rationalism, individuality, and optimal monetary policy (whatever that is).

As is often the case with Noah’s post, I have a hard time figuring out when he is joking.  The MMT explanation he links to suggests that the Great Inflation was caused by fiscal deficits, even though the deficits only became large in 1981-82, when the Great Inflation ended.  But much worse is this statement:

The monetarist Quantity Theory of Money (“QTOM”) is a fallacy, in part because it assumes that a country’s economy is always producing as many goods and services as it possibly can. Advocates of this theory also assume that no worker who doesn’t want to be is *ever* unemployed.

I guess the author has never read Friedman and Schwartz’s Monetary History of the US.  The rest of the long post is written at a similar level.  For instance, did you know that the money multiplier (the ratio of money to the base) is an “outright myth.”

The Williamson link is far better, which isn’t surprising as it’s written by Noah Smith himself.  It discusses the long debate over whether QE is inflationary or deflationary.  It also mentions that Noah has a relatively low opinion of the success of modern macro.  The fact that we still debate whether QE is inflationary or deflationary does tend to support Noah’s claim that modern macro has a lot to answer for. That’s because we already know the answer to the question.  QE is inflationary, but far less inflationary than the FMC worries.  And the reason we already know the answer is quite simple, we observe the response of markets to unexpected QE announcements.  The real question is not whether QE is inflationary, or whether it is inflationary but not highly inflationary, but why is it inflationary?  There are two good theories:

1.  QE is a signal of expected future policy, a form of forward guidance.

2.  Reserves and government securities are not perfect substitutes, even when rates are zero.

Both may be true; I actually have no idea which one is more important.  Indeed it’s very possible that one is more important at one time, and the other at another time.  But that’s what we should be trying to figure out.

Think about it, we are scientists trying to study the economy, and the debate of whether QE is inflationary suggests the economy (i.e. markets) actually know more than we do.  It’s as if gorillas knew more about primate brain function than the scientists studying gorillas. Very sad.

PS.  Good to see Noah starting to use Garett Jones’s “hive mind” metaphor.

HT:  Travis V.

[I wrote this yesterday but held off–as I often do for “spacing” reasons.  In the interim Nick Rowe did a post on the same paper.  I recommend you read his reaction if you only have time for one.  It’s much better.]

The Bank of England was kind enough to send me a new report explaining monetary policy.  Unfortunately I think the report is way off target. On the other hand if they knew anything about my blog they would have known that would be my reaction.  Let’s start here:

This article has discussed how money is created in the modern economy. Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. And in contrast to descriptions found in some textbooks, the Bank of England does not directly control the quantity of either base or broad money. The Bank of England is nevertheless still able to influence the amount of money in the economy. It does so in normal times by setting monetary policy “” through the interest rate that it pays on reserves held by commercial banks with the Bank of England. More recently, though, with Bank Rate constrained by the effective lower bound, the Bank of England’s asset purchase programme has sought to raise the quantity of broad money in circulation.

I hate the term ‘modern.’  The money directly produced or “printed” by the central bank is called base money. I don’t know about Britain, but in America the share of total money that is base money is actually higher than 100 years ago.  So there is nothing “modern” about our current system.  And the BoE does directly control the amount of base money, at least in the sense of “directly control” that the BoE uses when they describe direct control of short term interest rates.  Yes, if you set an interest rate target then the base becomes endogenous. But it’s equally true that if you set an inflation target then interest rates become endogenous.  However changes in the supply and demand for base money remain the lever of monetary policy.  And notice the BoE implies that once they stopped targeting interest rates they were no longer even doing monetary policy (or perhaps it’s just misleading language.) The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such as way as to produce 2% inflation.  And yet in that long chain interest rates are singled out as “monetary policy.”

Reserves are an IOU from the central bank to commercial banks. Those banks can use them to make payments to each other, but they cannot ‘lend’ them on to consumers in the economy, who do not hold reserves accounts.

Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’  Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.”  So it would have been more accurate to talk about central banks injecting coins into the system.  And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system.  Banks were not important for monetary policy, although of course they were a key part of the financial system.

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits “” the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

Another common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money “” the so-called ‘money multiplier’ approach. In that view, central banks implement monetary policy by choosing a quantity of reserves. And, because there is assumed to be a constant ratio of broad money to base money, these reserves are then ‘multiplied up’ to a much greater change in bank loans and deposits. For the theory to hold, the amount of reserves must be a binding constraint on lending, and the central bank must directly determine the amount of reserves.  While the money multiplier theory can be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality. Rather than controlling the quantity of reserves, central banks today typically implement monetary policy by setting the price of reserves “” that is, interest rates.

In reality, neither are reserves a binding constraint on lending, nor does the central bank fix the amount of reserves that are available. As with the relationship between deposits and loans, the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them “” which will, crucially, depend on the interest rate set by the Bank of England.

I’m not a fan of the money multiplier model, but it’s sometimes unfairly maligned. Textbooks don’t treat it as a constant, any more than they treat velocity or the fiscal multiplier as constants.  They may do an example where it is constant, but then they discuss reasons why it changes.

The real problem here is “binding constraint.”  In economics there are almost never binding constraints on anything.  If you at a binding constraint position then odds are you are not optimizing.  A reduction in the supply of apples will generally raise apple prices even if not at the binding constraint where one less apple would cause starvation.  By (permanently) adjusting the supply of “reserves” (again base money is what they actually mean) the central bank can affect the value of the medium of account (base money), and hence all nominal variables in the economy.  That includes the nominal size of the toilet paper industry, the nominal size of the steel industry, and the nominal size of bank balance sheets. Most importantly NGDP. If wages and prices are sticky they can also affect real GDP in the short to medium run.

Not sure why the Bank of England is so interested in the nominal size of the bank balance sheets, and not other industries.  Surely there are other nominal industry outputs that better correlate with the goals of monetary policy (NGDP) than the banking industry!  Why not focus on those industries?

The deeper problem here is the BoE mixes up microeconomics (the relative size of the banking industry) with macroeconomics (the determination of nominal aggregates), in a very confusing way.  You need to model the medium of account to have any sort of coherent explanation of monetary policy.  The interest rate approach combined with a banking sector and a “slack/overheating” model of inflation just won’t cut it.  Certainly the BoE report is not as bad as some of the things you see from MMTers, it nods to the old-style monetarists in its discussion the problems that might arise from of excessive growth of the aggregates.  But it nonetheless fails to come up with a model of the price level or NGDP. It can’t tell us why Britain has 20% inflation one year, and 2% another.  You need to explicitly model the supply and demand for base money to do macroeconomics.

PS.  And why doesn’t the BoE subsidize and run a NGDP prediction market?

PPS.  Perhaps my report was too negative. I suppose it’s a fine explanation of monetary policy if you go for the interest rate approach to monetary economics, it’s just that I hate that approach.

In a recent post I argued that there is no answer to the question of whether money was too easy in 2004-06.  Or more precisely the answer depended on what the Fed had in mind for 2007-17.  This is actually not that strange a view—modern macro theory suggests that the conversation should not be about which policy is appropriate for a given period, but rather which monetary regime is optimal. Without a coherent regime, attempts to fine tune the economy will usually end badly.

Unfortunately, we don’t have a coherent policy regime. We don’t know what the Fed is trying to do to NGDP. More importantly, we don’t know what they’ll do if they fail. That is an important part of a regime. Will they act as they did in 2008-09? Or will they have learned something, and act more appropriately (with some catch-up.) I hope it’s the latter, but the honest truth is that we simply don’t know.

With this level of uncertainty is not obvious what sort of monetary policy is appropriate today, even for people who believe in something like 4.5% NGDPLT. And that’s because even if you decide to adopt that policy, you need to also decide where to start the trend line.  Right here?  Or after a bit of catch-up?  That’s discretionary.  Good policy is rules-based, but first you must use discretion to decide the optimal rule.  But we never actually do pick a rule, and hence the frustration of us rules proponents, we are always seeing the wrong debate take place.

We are inappropriately mixing a debate over day-to-day policy with a fight over what rule we should be on.  Imagine a cross-country road trip where there are constant disputes over which road to take because the two passengers aren’t sure exactly where they are, and also because one wants to go to LA and the other to San Francisco.  I’m saying we should at least agree on the destination, and then we can figure out which road is best (or better yet let the market figure it out.)

Evan Soltas has an excellent post explaining why current Fed policy is appropriate. Tyler Cowen agrees. Ryan Avent and Cardiff Garcia have excellent posts explaining why current policy is too tight. It’s not clear who’s right.  Policy in the US and the UK and Japan is defensible.  In contrast, policy a few years ago in those three countries was indefensible, and indeed policy in the eurozone continues to be indefensible to this day.

In the US, the optimal policy right now depends on what the Fed contemplates doing later.  Does the US plan to adopt a 4.5% NGDPLT regime in late 2015, when they exit the zero bound?  Then I’m with Soltas, I’m fine with current policy.  Does the Fed intend to continue its discretionary growth rate targeting after 2015?  Then I’d support a higher path of NGDP, for reasons explained by Avent—it makes the zero bound problem less likely.

Over at Econlog I have a new post arguing that the interest rate increase of late 2015 caused the Great Recession (a much more interesting post than this one, BTW.)  Given that assertion, it might seem odd that I think Soltas’s preferred policy is defensible.  The problem is that it was expectations of this 2015 policy that caused the Great Recession, and unfortunately that horse has already left the barn. Contrary to Krugman’s expectations trap argument, the problem wasn’t that the central bank couldn’t commit to being irresponsible, or that it wouldn’t be believed if it chose to commit, the problem is that the central bank simply didn’t want to. There’s no doubt in my mind that a Fed commitment to return 65% of the way back to the old trend line would have been believed. For the Fed, the costs of reneging on a promise would be an order of magnitude greater than the benefits. (BTW, contrary to what you read in the press, the Fed never reneged on its promise to not raise rates before unemployment fell to at least 6.5%, or inflation rose above 2.5%. Nor would they be reneging if they lowered the threshold to 6.0%)

The dispute between Soltas and the doves is certainly an interesting one, and both sides are making great arguments.  But as important as it is, the far more important debate is over what sort of monetary regime we should have.  Going forward, that should be the focus of our attention.  Solve that problem, and the day-to-day worries about the current stance of monetary policy will dissipate like the morning mist on a hot day.

PS.  If you don’t understand why current eurozone policy is indefensible, go back to my road analogy.  Imagine there is a debate over whether the car should go to LA or SF, and they are currently closing in on Moose Jaw, Saskatchewan, from the south. That’s the eurozone.  In contrast, Soltas and Avant are in a car near Kansas City heading west.  That’s the US (and Britain and Japan.)

PPS.  I decided not to take a stand on the debate because I thought that doing so would distract from the purpose of this post.  I can do that elsewhere.

[Update:  Commenters “dlr” and Kevin Erdmann point out that I erred in assuming the low dividend ratios of modern times were also true in the past.  They were close to 5%. So there is a serious flaw in my post below, although I still believe that the rational view today is that stock returns going forward will be less than in the past.  However the excess returns over the past 100 years are harder to explain away than I assumed.  Also dlr cites data on bond yields that suggests I underestimated the expected return on NASDAQ in my previous post, which means the 2002 lows were probably more “accurate” than the peak of 2000.  I hope they’re right—I’m all in.]

In a previous post I argued that stock indices are not expected to grow faster than NGDP.  After all, the only index I know of that goes back 100 years (the Dow) has risen slower than NGDP over that period.  But that’s not why I made the claim, rather it seemed illogical that a sub-sample of stocks would out-perform NGDP, when the total value of all stocks would be expected to rise with NGDP in the very long run.  Now there are some possible weaknesses in my argument.  NASDAQ has a lower dividend yield, and hence a higher expected gain, but I doubt it dramatically affects my overall claim.

Then the argument got sidetracked on to a discussion of total returns, a different question.  That seemed to be where the real objection lay. Here’s Kevin Erdmann:

I, for one, am tickled by the irony that in the comment section of this excellent post about the pessimistic bias, Scott has been pulled into an argument where he is saying that a 4% equity risk premium that persisted for a century is the result of a lucky break – that a cumulative excess return of some 5000% over that time doesn’t reflect an expected return premium for equities. On average, less than every 20 years, equity portfolios have doubled government bond portfolios.

Sorry, but this is a misuse of statistical significance.  The 100 year time frame does not in any way prove that the returns were expected. Here’s a counterexample.  Take the 3 most successful stocks in the Dow over the past 100 years.  I have no idea what there are, let’s say IBM, GE and Exxon.  Now compute their total returns.  Since the overall market has done well, obviously the three best would have done amazingly well.  But no one would claim that their actual returns tell us anything about their expected returns.  And that’s because you had cherry picked some very impressive investments, ex post.  And that’s despite the fact that you would be working with 100 years of data.

In the case of the US stock market you are not just cherry picking, but double cherry picking.  You are selecting one of the most impressive economies in the world over the past 100 years.  A country that never adopted socialism, was never destroyed by war, revolution or hyperinflation.  Even many major economies like Germany, Japan, Russia and China suffered enormous problems at various stages of the past 100 years.  The commenter “dlr” shows that the US stock market has outperformed all of the other big economies.  And he compares the US to other countries that have done relatively well, leaving out places like Russia, China, Argentina, Venezuela, etc.  So by looking at the US you have cherry picked the most successful big economy in world history, during its golden age.  But that’s not enough to explain the entire equity premium, as dlr notes.  Other countries also have rather large returns.  

This leads to the second form of cherry picking, you are studying what has turned out (ex post) to be the Cadillac of investments—stocks. Today we think of stocks as a perfectly normal investment.  I’ve had all my 401k in stocks for almost my entire working life, and that’s not considered particularly weird.  But 100 years ago stocks did not have the prestige they have today.  Bonds and bank accounts would have been more typical investments.  I would have had railroad bonds in my 401k.  The stock market turned out to be the premier investment of the past century (for many complex and unexpected reasons), but no one knew that in 1914.

I know that people will want to latch on to the 100 years of data—surely that is statistically significant?  I will admit that if stocks consistently earned large returns then you could say that investors should have caught on.  Suppose that the excess returns were always positive, but ranged from 1% to 9%, averaging 5%.  Then yes, 100 years would be enough.  But look at this data for the Dow:

March 11, 1914   Dow = 81.57,  CPI = 9.9  real Dow = 8.24

August 12, 1982,  Dow = 776.92   CPI = 97.7   real Dow = 7.95

In real terms the Dow went nowhere in 68 years.  Yes, the total real returns were positive because of dividends, and indeed probably larger than bonds (which were crushed by unexpected inflation after we left gold.)  But a real yield equal to slightly less than the dividend yield is not all that impressive for 68 1/2 years.  Now look at the next 18 years:

April 11, 2000  Dow = 11287   CPI = 171.3    real Dow = 65.9

The real Dow exploded more than 8-fold.  That’s an awesome return, which doesn’t even include dividends.  And then another 14 years of so-so, even given the extraordinary bull market of recent years:

March 11, 2014   Dow = 16351   CPI = 233.9   real Dow = 69.9

Yes, other indices like S&P 500 would probably have been different.  The early period would probably look better, weakening my argument.  But the 1982-2000 explosion would look even bigger, and the 2000-2014 slowdown even worse, both strengthening my argument.  The basic picture is that in 1982-2000 the market experienced something analogous to the “inflation” of the early universe, when values just exploded.

My pathetic attempt to explain that growth would involve many factors such as slowing inflation and lower taxes on capital gains.  But one factor might have been a growing awareness among investors that with modern investing techniques and longer lives and lots of people putting money away for 40 or 50 years in 401ks those massive excess returns that did occur were not “justified.” On this point theory is on my side.  The equity premium puzzle. They were not expected to occur, and when they did stocks rose to a level where they are not expected to repeat, from this point forward.  I think this may be why Robert Shiller seems to have never said “BUY,” at least since 1996. Perhaps his model doesn’t factor in the new normal of higher equity values due to a realization the equity premium (ex post) was too big in the past.

Don’t be lulled into thinking that 100 years of data is statistically significant.  Didn’t people in 2006 say “real housing prices in America never go down on a nationwide basis.”  How’d that work out?

PS. I’m not saying you should not own stocks.  I’m still fully invested, and still feel they are a bit better than bonds.  Just don’t count on those massive gains of the previous century, which were heavily concentrated in 18 years.  My claim is that going forward, returns will be (expected to be) similar to the other 82 years—basically the dividend yield in real terms, perhaps a bit more if the dividend yield has trended downward over time.  Somewhere between the US and Japanese performance since 1991.

PPS.  For non-American readers the phrase “Cadillac of investments” means roughly the “Mercedes of investments.”

PPPS.  Fat tails

PPPPS.  Transactions costs

Tyler Cowen has a post entitled “Is Abenomics Working?”  The first line of the post says:

Japan’s economy grew by 0.7% in 2013, down from an initial estimate of 1%.

That reflects the year over year figures, which makes the “in 2013” phrasing slightly misleading. The rate is quite low because Japanese RGDP was falling in 2012, before Abenomics was enacted.  A better test would be 4th quarter over 4th quarter figures, which show about 2.5% RGDP growth during calendar year 2013. That’s actually a decent number for a country with a falling population, and a working age population that is falling even faster than its overall population. Unemployment has fallen to 3.7%. Only once in the past 16 years was a lower unemployment rate reported.

Abenomics will not produce RGDP growth miracles due the the bad supply-side characteristics of the Japanese economy and the fact that unemployment is already fairly modest (even accounting for the bias in their data.) But it will boost growth modestly, and has the potential (if pushed more aggressively), to help reduce their debt burden.

PS.  The post title can be read in two ways, one of which is that “real” means ‘actual.’