Archive for April 2015

 
 

Monetary policy is not about banking

When I advocate something like QE or negative interest on reserves, I often get people complaining that this will not boost bank lending, or that we shouldn’t even be trying to boost bank lending.  It almost makes me want to tear out my hair. What in the world does banking have to do with monetary policy?  Yes, it may or may not boost bank lending, but it doesn’t matter, as monetary policy is about the hot potato effect.  And yes, the Fed should not be trying to boost lending, any more than it should try to boost sales of microwave ovens.  NGDP is what matters.

Jim Glass directed me to a new study by the Bank of England, which confirms that monetary policy is about the hot potato effect (aka portfolio rebalancing channels) not bank lending.  Here is the abstract.

We test whether quantitative easing (QE) provided a boost to bank lending in the United Kingdom, in addition to the effects on asset prices, demand and inflation focused on in most other studies. Using a data set available to researchers at the Bank, we use two alternative approaches to identify the effects of variation in deposits on individual banks’ balance sheets and test whether this variation in deposits boosted lending. We find no evidence to suggest that QE operated via a traditional bank lending channel (BLC) in the spirit of the model due to Kashyap and Stein. We show in a simple BLC framework that if QE gives rise to deposits that are likely to be short-lived in a given bank (‘flighty’ deposits), then the traditional BLC is diminished. Our analysis suggests that QE operating through a portfolio rebalancing channel gave rise to such flighty deposits and that this is a potential reason that we find no evidence of a BLC. Our evidence is consistent with other studies which suggest that QE boosted aggregate demand and inflation via portfolio rebalancing channels.

PS.  I have a new post over at Econlog that is far more important than this post.  Read the whole thing.

Second thoughts on negative IOR

My very first blog post after the intro discussed negative IOR.  I also published a couple short articles discussing the option in early 2009.  Six years later, what can we say?

1.  I was wrong in assuming the zero lower bound was only 1 or 2 basis points negative.  I made that assumption because in the 1930s and early 1940s T-bill yields never went more than a couple basis points negative.

2.  Being wrong about the zero lower bound made me even righter than I anticipated about the effectiveness of negative IOR.  I argued that people and institutions didn’t particularly want to hold huge amounts of currency, and that assumption was much truer than even I expected.

3.  There was a period where some contrarians were suggesting that negative IOR is a contractionary policy.  I thought that was wrong, as it reduces the demand for the medium of account.  Now I think it’s pretty clear that the contrarian view is wrong.  Negative IOR weakens a currency in the forex market.

4.  Points 1, 2 and 3 seem to make negative IOR a more attractive policy, but if anything my views have evolved in the other direction.  I’d prefer to focus on monetary policy tools like QE and forward guidance, which allow you to exit the zero bound more quickly.  Ultra low rates mean policy has been too tight.

5.  When I originally proposed the idea it was seen as being slightly wacky (even by me.)  Now you have negative yields on 8-year German bonds and 10-year Swiss bonds.  Negative rates are an important part of the modern financial world. Lesson?  Never say never.  NGDP futures might look like a wacky idea today, but back in 2009 the idea of negative yields on 10-year government bonds seemed far, far wackier.  We always need to search for the best options, and let the conventional wisdom catch up when it’s ready.

PS.  Back in early 2009, MMs were the only people saying monetary policy was MUCH too tight.  Matt Yglesias points out that recent events suggest that we were right:

For the USA, the main implication [of negative interest rates] is that back in 2009 and 2010 the Federal Reserve made a mistake. All the objective economic metrics at the time said the “right” interest rate to curb unemployment would be negative. But negative interest rates are impossible! The Fed tried a few tricks to get around that problem, and also told Congress to try fiscal stimulus as a workaround.

The implication of the European experience, however, is that the Fed could have generated negative interest rates through a mix of Quantitative Easing and negative interest rates.

Creationism at the New York Times

The New York Times does not believe in creationism.  They believe in evolution. They look down their noses at people who do believe in creationism.  But when it comes to the social sciences, the Times believes in creationism, that is, they believe in theories that appeal to kindergarden-level intellects.

One of those “theories” is the idea that California faces a severe water shortage because lots of people have moved to an area with a dry climate.  All thoughtful economists (on both the left and the right) view this theory as being preposterous. The California water shortage has almost nothing to do with population growth. Roughly 80% of the water is used by farmers, who squander vast quantities of water each year by employing extremely wasteful irrigation techniques in order to export crops like almonds.  And that occurs because the price at which water is sold to farmers is absurdly low.  Period. End of story.

This is EC101 economics, and I’ve never met an economist who did not understand this problem.  But the Times can’t be bothered to talk to economists, they rely on historians:

“Mother Nature didn’t intend for 40 million people to live here,” said Kevin Starr, a historian at the University of Southern California who has written extensively about this state. “This is literally a culture that since the 1880s has progressively invented, invented and reinvented itself. At what point does this invention begin to hit limits?”

California, Dr. Starr said, “is not going to go under, but we are going to have to go in a different way.”

That makes about as much sense as the Times asking a Christian fundamentalist preacher whether dinosaurs were warm-blooded.

The Times is a relatively good newspaper.  But to reach the elite level of papers like The Economist, they need to become familiar with good economic research.  And that means figuring out what economics is capable of telling us about the world, and what it cannot. Economists don’t know how to solve very many problems.  But one of the very few we do know how to solve is the California water shortage. Instead the Times is more likely to ask economists to explain complex problems like unemployment, financial instability and inequality, issues where we are not very strong.

The problem is simple to explain and (in a technical sense) simple to solve.  Of course the politics are complex, and thus far have prevented a solution. However, even dysfunctional California will eventually have to work out a political compromise.

PS.  The water used in irrigating just that portion of California’s almond crop that is exported is more than twice as much as the entire water consumption of San Francisco and Los Angeles combined.  The New York Times should be ashamed of itself.

Screen Shot 2015-04-08 at 12.18.23 PM

PPS.  Steven Johnson has an excellent reply to the above quote about “Mother Nature.”

First of all, Mother Nature didn’t intend for 2 million people to live on Manhattan Island either. Mother Nature would also be baffled by skyscrapers, the Delaware Aqueduct, and the Lincoln Tunnel. Anyone living anywhere in the United States”Š”””Šapart from the most radical of the off-the-gridders, most of whom are probably in northern California anyway”Š”””Šis dependent on a vast web of human engineering designed specifically to mess with Mother Nature’s intentions.

The question is whether that engineering is sustainable. What the Times piece explicitly suggests is that California has been living beyond its means environmentally. That’s the point of those extraordinary overhead photographs of lush estates, teeming with greenery, bordering arid desert. You see those images and it’s impossible not to feel that something shameful is happening here. And yet, picture a comparable view of Manhattan sometime in the depths of January, with a thermal imaging filter applied. The boundary between Man and Mother Nature would be just as stark: frigid air surrounding artificial islands of heat. It’s true that New York City distributes that artificial heat much more efficiently than the rest of the country, thanks largely to its density, but it’s still artificially engineering your environment, whether you want to make a dry place wet, or a cold place warm. And while the Northeast has an advantage over California in terms of rainwater, California has a decided advantage in terms of temperature and sunlight, particularly the coastal regions where almost all the people live. Coastal California enjoys one of the most temperate climates anywhere in the world, which allows its residents to consume far less energy heating or cooling their homes. California is dead last in the country in terms of per capita electricity use. Thanks to the state’s abundant sunshine (and pioneering environmentalism) there are more home solar panels installed in California than in all the other states combined. If you’re trying to find a sustainable place for 40 million people to live, there are plenty of environmental reasons to put them in California.

As expected, Ben is with Lars

Here’s Ben Bernanke on the idea of using monetary policy to address financial imbalances:

Let there be no mistake: In light of our recent experience, threats to financial stability must be taken extremely seriously. However, as a means of addressing those threats, monetary policy is far from ideal. First, it is a blunt tool. Because monetary policy has a broad impact on the economy and financial markets, attempts to use it to “pop” an asset price bubble, for example, would likely have many unintended side effects. Second, monetary policy can only do so much. To the extent that it is diverted to the task of reducing risks to financial stability, monetary policy is not available to help the Fed attain its near-term objectives of full employment and price stability.

For these reasons, I have argued that it’s better to rely on targeted measures to promote financial stability, such as financial regulation and supervision, rather than on monetary policy.

One of the “unintended side effects” of the Fed’s 1928-29 attempt to pop the stock market bubble was the Great Contraction of 1929-33.  Another was Hitler taking power in Germany.  And another was WWII.  So if anything, Bernanke is being too polite to those who favor using monetary policy to prevent financial imbalances.

Now of course they’d insist that they also favored macroeconomic stabilization, and merely wish to use monetary policy at the margin.  But even those more reasonable proposals are highly questionable.  Bernanke cites one study (links further down) that does find that monetary policy might play a role, but not a very large one:

Although, in principle, the authors’ framework could justify giving a substantial role to monetary policy in fostering financial stability, they generally find that, when costs and benefits are fully taken into account, there is little case for doing so. In their baseline analysis, they find that incorporating financial stability concerns might justify the Fed holding the short-term interest rate 3 basis points higher than it otherwise would be, a tiny amount (a basis point is one-hundredth of a percentage point). They show that a larger response would not meet the cost-benefit test in their estimated model. The intuition is that, based on historical relationships, higher rates do not much reduce the already low probability of a financial crisis in the future, but they have considerable costs in terms of higher unemployment and dangerously low inflation in the near- to intermediate terms.

And even this is doubtful, as it depends on the very dubious assumption that low interest rates imply easier money:

A new paper by Andrea Ajello, Thomas Laubach, David López-Salido, and Taisuke Nakata, recently presented at a conference at the San Francisco Fed, is among the first to evaluate this policy tradeoff quantitatively. The paper makes use of a model of the economy similar to those regularly employed for policy analysis at the Fed. In this model, monetary policy not only influences near-term job creation and inflation, but it also affects the probability of a future, job-destroying financial crisis. (Specifically, in the model, low interest rates are assumed to stimulate rapid credit growth, which makes a crisis more likely.)

Indeed a tighter monetary policy during the famous housing bubble of 2005-06 would have probably been associated with lower interest rates, not higher.  Thus in a counterfactual where in 2001-03 the Fed had cut rates to 3%, not 1%, the level of interest rates in the 2005-06 bubble would have had to be lower than the actual path of rates, as the economy would have been in depression.

What most caught my attention is that Bernanke comes down strongly in support of his former colleague Lars Svensson, who quit the Riksbank in disgust over its tightening of monetary policy around 2010-11:

Lars Svensson, who discussed the paper at the conference, explained, based on his own experience, why cost-benefit analysis of monetary policy decisions is important. Lars (who was also my colleague for a time at Princeton) served as a deputy governor of the Swedish central bank, the Sveriges Riksbank. In that role, Lars dissented against the Riksbank’s decisions to raise its policy rate in 2010 and 2011, from 25 basis points ultimately to 2 percent, even though inflation was forecast to remain below the Riksbank’s target and unemployment was forecast to remain well above the bank’s estimate of its long-run sustainable rate. Supporters justified the interest-rate increases as a response to financial stability concerns, particularly increased household borrowing and rising house prices. Lars argued at the time that the likely benefits of such actions were far less than the costs. (More recently, using estimates of the effects of monetary policy on the economy published by the Riksbank itself, he showed that the expected benefits of the increases were less than 1 percent of the expected costs). But Lars found little support for his position at the Riksbank and ultimately resigned. In the event, however, the rate increases were followed by declines in inflation and growth in Sweden, as well as continued high unemployment, which forced the Riksbank to bring rates back down. Recently, deflationary pressures have led the Swedish central bank to cut its policy rate to minus 0.25 percent and to begin purchasing small amounts of securities (quantitative easing). Ironically, the policies of the Swedish central bank did not even achieve the goal of reducing real household debt burdens.

When someone leaves an important policy position, where a person is not really free to speak their mind, to blogging, which is all about speaking one’s mind, you quickly learn a great deal about their views on controversial issues. Anyone want to wager with me on what Bernanke and Svensson think of the ECB’s decision to twice raise rates in 2011?

I was only disappointed by one aspect of the post—Bernanke continues to (implicitly) use a conventional measure for the stance of monetary policy.

Despite the substantial improvement in the economy, the Fed’s easy-money policies have been controversial. Initially, detractors focused on the supposed inflation risks of such policies. As time has passed with no sign of inflation, that critique now looks rather threadbare. More recently, opposition to accommodative monetary policy has mostly coalesced around the argument that persistently low nominal interest rates create risks to financial stability, for example, by promoting bubbles in asset prices or stimulating excessive credit creation.  (emphasis added)

In 2003, Bernanke correctly pointed out that conventional measures such as interest rates are highly flawed:

The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we don’t really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy, as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect, because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the value of specific policy indicators can be affected by the nature of the operating regime employed by the central bank, as shown for example in empirical work of mine with Ilian Mihov.

.  .  .

Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart.

Of course by that criterion (averaging inflation and NGDP growth), money was tighter in 2008-2013 than in any 5 year period since Herbert Hoover was president.

NGDP research bleg

There are basically three general arguments for NGDP targeting:

1.  It will reduce labor market instability.

2.  It will reduce credit market instability.

3.  It will lead to more pro-market public policies.

I am looking for links to previous empirical research in any of these three areas, but especially the last two.  The first is obviously important, perhaps the most important argument, but it’s also been researched fairly extensively.

Here I’ll sketch out what interests me about the second and third topic:

Financial instability:  It seems like financial crises are often associated with declines in NGDP.  Think about the US and Europe in 1931, Argentina in 2001, the US and Europe in the period after mid-2008.  But that’s just casual empiricism.  I’d like to see rigorous academic studies that look at many different financial crises.  How often are they associated with falling NGDP?  Does this correlation only show up in certain countries?  What about a slowdown in NGDP growth where it still remains positive?  (For instance, did the slowdown in NGDP growth during the 1980s and early 1990s contribute to the S&L crisis?)

Statist policies:  It seems like free market policies do fairly well when NGDP growth is fairly stable (1922-29, 1953-64, 1985-2007) and statist policies do better when NGDP growth is unstable (1913-21, 1930-52, 1965-81, 2008-10).  Obviously there are lots of issues here.  In the case of WWI and WWII, you may have reverse causality—government spending causes the NGDP instability.  But there’s also lots of plausible examples going the other way—the Great Depression leading to the NIRA, the Great Inflation leading to wage and price controls, the Great Recession leading to bailouts, etc.)

It would also be interesting to look at this question from an international perspective.  Out of curiosity, I took a look at the Heritage Economic Freedom scores for the US and Australia, before and after the crisis:

Country    Score(rank)2007     2015

Australia           82.7 (3)           81.4 (4)

USA                  82.0 (4)          76.2 (12)

Australia had much less NGDP instability, at least in a “level targeting” sense (this may not be easy to quantify.)  Is that why the economic freedom score for the US slipped much more than for Australia?  Perhaps, but Australia does slide behind New Zealand, which moved up to number 3, and which nonetheless had a worse recession than Australia.  Another problem is that smaller economies (and commodity exporters) “naturally” have a more unstable NGDP, indeed this is probably desirable.  So you’d need to control for a number of factors.

I seem to recall that the average Heritage Economic Freedom score was rising during the Great Moderation, and began falling after somewhere around 2008.  Is that correct?  I also wonder whether it depends on which regime (statist or market-oriented) is viewed as the plausible alternative.  In the US in 1930 the alternative was statism.  Today in Greece the alternative may be market-friendly policies.  That underlies the conservative fear that NGDP targeting might allow Greece to avoid the needed “tough choices.”

In any case, these are obvious three big issues that need looking at.  I’d guess there’s already some research on these topics, but mostly for labor market instability.  Again, I’d greatly appreciate links to any research on how NGDP instability is correlated with problems like unemployment, financial crises, and statist policies.

Update:  E. Harding sent me a graph showing the average Heritage ranking.  It rose to a peak at 60.2 in 2008, then fell to a trough of 59.4 in 2010, then rose again to an even higher peak of 60.4 in 2015.  Thus the US decline is not typical.