Archive for March 2017


Think of money demand shocks as negative money supply shocks

Over at Econlog, I have a new post discussing Ricardo Reis’s proposal for a market-based price level target, which relies on shifts in money demand.  (In contrast, my NGDP futures targeting paper contemplates using markets to adjust the money supply until NGDP expectations are on target.)

When thinking about these two approaches, it might be useful to compare a money demand shock with a money supply shock.  We all know from EC101 that a shift in supply has the opposite impact (on value) from a shift in demand.  Money is no different.  Those who are used to taking a quantity theoretic approach to money might consider the following three examples:

1. Suppose there is a huge spike in the demand for US currency in foreign countries.  That will increase the demand for US base money and, other things equal, will reduce the US price level.  But you can also think of this sort of demand shock as reducing the supply of currency within the US.  With less currency circulating in the US, the price level falls for standard “quantity theory” reasons.

2. Now let’s consider an economy whose currency is of no interest to outsiders—say Canada.  If Canada imposes draconian taxes then the Canadian public might hoard currency as a way of hiding income from the government.  That would result in a huge spike in Canadian currency demand.  But you can also view that as a money supply shock.  The supply of currency actively being used as a medium exchange, aka Canadian “transactions balances”, would decline as hoarding balances increase. The quantity theory of money applies better to transactions balances than to all money balances.

3. With the advent of interest on reserves (IOR), and enormously bloated levels of excess reserves, the Fed has shifted somewhat away from a supply of money approach and towards a demand for money approach.  On the other hand, the original monetarist model treated “high-powered money” as being equivalent to the monetary base.  With IOR, the entire monetary base is no longer high-powered money.  Instead, the currency stock is the new high powered money.  So a change in IOR that impacts the demand for base money can also be thought of as impacting the supply of high-powered money.   Thus if the Fed suddenly cut IOR to zero, banks would try to get rid of some of their excess reserves, which would flow out into circulation, boosting the supply of currency, and hence the price level.

[Some people who understand accounting but not macroeconomics will tell you that banks as a whole cannot get rid of reserves—that reserves withdrawn from one bank will be deposited into another.  Don’t believe them.  A monopoly bank could easily get rid of unwanted ERs by buying assets, then making bank deposits unattractive enough so that all the base money doesn’t get redeposited into the banking system.  The entire banking system is no different.  People who treat macro as a branch of accounting will only confuse you—stay away from them.]

There’s nothing new in this post, even more than a quarter millennium ago David Hume knew that an increase in money demand is equivalent to a decrease in the money supply:

“If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” David Hume — Of Money

PS.  The thought experiments in this paper were merely to illustrate basic concepts. In the real world, the Fed would accommodate a shift in currency demand from overseas hoarding, or domestic tax evaders.  Hence there would be no significant macroeconomic impact.


Time to abolish interest on reserves

Patrick Sullivan directed me to a very interesting essay by Ben Bernanke.  As you’d expect, the article is well thought out and mostly accurate.  But there is one issue on which I strongly disagree:

Prior to the crisis, the Fed set short-term interest rates through open-market operations that varied the quantity of bank reserves in the system, a technique which involved on average low levels of reserves—perhaps $10 billion or so. Today, the level of bank reserves is much higher, which makes it impossible to manage interest rates through small changes in the supply of reserves. Instead, the Fed manages short-term interest rates by setting certain key administered interest rates, such as the rate it pays bank on reserves held with the Fed. This “floor system” (called that because rates like the interest rate on bank reserves set a floor for the policy rate) was adopted out of necessity but seems to be gaining favor with the FOMC as a better way to manage monetary policy.

The phrase “adopted out of necessity” caught my attention.  I think this is a very misleading way to describe what Ben Bernanke and I both think happened in October 2008. Presumably Bernanke means that given the Fed had decided to inject a large amount of reserves into the banking system in September 2008, and given the Fed had decided that it was unwise to reduce the interest rate target below 2% in September 2008, the IOR policy was necessary to keep the market fed funds rate close to the policy target.  But I think the average reader would not understand this very restrictive meaning of “necessity”.  The average reader might assume that Bernanke was saying something more like, “looking back on things, the imposition of IOR in October 2008 was necessary to meet the Fed’s policy mandate.”  In fact, it was just the opposite.  The decision to adopt IOR helped to prevent the Fed from achieving its policy goals, by making the Great Recession more severe than otherwise.  That’s not just my opinion; unless I am mistaken that’s the implicit message of Bernanke’s memoir, where he indicated that, in retrospect, the Fed did not move quickly enough to cut rates in the fall of 2008.

The world would be a better place today if the Fed had never instituted its policy of IOR in 2008.  I really don’t see how anyone can seriously dispute this claim.  If you want to dispute the claim, what specific way did IOR make the world a better place? When the policy was adopted in 2008, the New York Fed explained it to the public as a contractionary policy.  Can anyone seriously argue that the world would be worse off if monetary policy had been less contractionary in 2008-12?  Why?

Now of course its possible that in the future a policy of IOR could be helpful, and Bernanke provides several reasons:

As I noted here, there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis.

What Bernanke sees as an advantage, I see as a disadvantage.  In a technical sense, the Fed actually has more ability to add liquidity in a world without IOR, because the balance sheet will be smaller at the onset of a crisis, and hence have more room to grow to its effective maximum size.  Presumably Bernanke would respond that IOR allows the Fed almost unlimited ability to inject liquidity without sacrificing their other macroeconomic targets.  In other words (a cynic might say), IOR will allow the Fed to make the same mistake in future crises that they made in October 2008—trying to rescue Wall Street without rescuing Main Street.  OK, that’s probably too cynical, but I think it’s important for people to think about Bernanke’s argument in terms of what happened in the Great Recession.  Bernanke may be 100% correct with regard to future crises, but it’s clear that his rationale for IOR was 100% wrong for 2008.

In my view the Fed should refrain from IOR, and I hope that causes the Fed to focus like a laser on macroeconomic stability.  If the problem is solvency, then leave bailouts of banks to the Treasury or FDIC, or better yet, don’t bail out banks at all.  There are some very promising proposals being developed that would allow for bondholders to be “bailed in” via debt to equity conversions during a crisis.  If we move away from IOR, it’s more likely that the authorities will be forced to come up with an alternative method for dealing with large bank failures.  As long as the Fed is supplying enough liquidity to keep expected NGDP growth at about 4%, I’m not at all worried about bank failures—let them fail.

If the banking system has a problem of liquidity but not solvency, then the usual Bagehot rules apply. IOR is not needed, as the size of base injections appropriate for meeting a surge in demand for liquidity is the same as the size of base injections needed to keep NGDP on track.  If banks truly do “need” more liquidity, then injections of liquidity will not be inflationary.  Let base supply grow as base demand grows.

My second reason for opposing IOR is that it moves us even further away from a quantity theoretic approach to monetary policy.  The Fed already puts too much focus on nominal interest rates when considering the stance of monetary policy—IOR will make this problem even worse.  One of the causes of the Great Recession was that low interest rates led the Fed (and almost everyone else) to falsely assume that policy was “accommodative” in 2008 and 2009, when it fact it was highly contractionary.  With IOR, the quantity of money is even less informative. Let’s go back to the pre-2008 situation, where 98% of the base was currency.


I recently listened to David Beckworth’s interview with Tim Duy.  Tim is one of most talented Fed watchers, and had a number of astute observations about the way the Fed communicates.  At one point David was asking why the Fed seemed to be behind the curve in 2008.  Duy said something to the effect that the Fed hadn’t expected to encounter a situation like that, and wasn’t quite ready to deal with the need for policy alternatives at the zero bound.  (Not his exact words.)

I think that’s probably right, but it’s interesting to think about why the Fed was not better prepared for 2008.

According to Lawrence Ball, Bernanke came to the Fed with pretty well formed ideas of how to deal with a liquidity trap.  Indeed that’s why I was so pleased when Bernanke was picked. But at an early meeting (in 2003), his views on policy options at the zero bound were dismissed or ignored by the Fed policy establishment.  According to Ball, after that meeting Bernanke mostly adopted the policy options of that establishment, not the options that Bernanke had previously recommended to the Japanese.

So why was the Fed so complacent?  I’m not sure the answer, but I do believe that this is a key question for the Fed going forward.  I’m convinced that there were alternative monetary policy options (such as NGDPLT) that would have led to a much milder recession.  But what does the Fed think?  Here are 4 options:

1.  By 2008, nothing could have prevented a severe recession, even with 20/20 hindsight.

2.  By 2008, a severe recession could only have been prevented by switching to a different regime, such as price level targeting or NGDP level targeting.  And the Fed is not willing to make that switch.

3.  By 2008, a severe recession could have been prevented by being much more aggressive with existing tools such as cutting rates sooner, doing QE sooner and more aggressively, and doing more aggressive forward guidance.  No regime change was needed.  But the Fed had no way of knowing (in 2008) that this sort of aggressive policy response was appropriate.

4.  By 2008, a severe recession could have been prevented being much more aggressive with existing tools such as cutting rates sooner, doing QE sooner and more aggressively, and doing more aggressive forward guidance.  No regime change was needed.  And the Fed could have seen the need for this if they had focused on NGDP forecasts rather than inflation, or perhaps if they had focused on TIPS spreads rather than past inflation rates.

I believe that #1 and #3 are false, and #2 and #4 are true.  But what does the Fed believe?  It would be nice if the Fed put together a report on what sort of policy would have been appropriate, in retrospect, during 2008.  The report should also discuss whether enough has been learned so that the same mistakes would not be made, should we ever face a similar situation.

PS.  While the Fed has been too complacent about the risks posed by the zero bound, the voters of LA have been exactly the opposite—rejecting complacency by an overwhelming margin:

Angelenos on Tuesday resoundingly voted down a ballot measure aimed at limiting the construction of big, tall buildings in the city of Los Angeles.

Measure S—an initiative supported by residents frustrated with large-scale development—took a beating at the polls, winning just 31.15 percent of votes, when it needed a majority to pass.

Launched and funded primarily by the nonprofit AIDS Healthcare Foundation, the measure would have placed a two-year moratorium on buildings that did not conform with the city’s outdated General Plan, which is like the bible for zoning and land-use.

So it seems the public actually opposes NIMBYism, it’s the special interest groups that support it.

Or more specifically one special interest group:

With city elections rapidly approaching, the AIDS Healthcare Foundation continues to pour money into Measure S, contributing nearly $3 million since the start of the year.

In the first three weeks of the year, the foundation poured $300,000 into the campaign, then it funneled $1.95 million to the campaign in the three weeks from January 22 to February 18. The latest filings show it has since given another $600,000.

The AIDS Healthcare Foundation has been the main backer of the March 7 ballot measure since its inception in November 2015. If passed by voters, Measure S would put a two-year moratorium on all development projects requiring zoning or height changes or adjustments to the city’s General Plan.

Numerous individual donors have also kicked in small contributions to the Measure S campaign—but more than 99 percent of the money raised during that three-week period came from the foundation.

99 percent?  Who knew?

After my Trump posts, I feel I’ve completely run out of sarcasm.  Let’s see what commenters can come up with here.


It’s nothing personal

I love Sean Spicer:

White House spokesman Sean Spicer tried to clarify Trump’s comments Monday, saying the president wasn’t using the word wiretapping literally, noting that Trump had put the term in quotation marks.

“The president used the word wiretap in quotes to mean broadly surveillance and other activities,” Spicer said. He also suggested Trump wasn’t accusing former President Barack Obama specifically, but instead referring to the actions of the Obama administration.

Only an unhinged Trump critic could have thought that Trump was specifically referring to President Obama:

Screen Shot 2017-03-13 at 9.09.07 PMClearly when he said “Obama” he was referring to the entire administration:

Screen Shot 2017-03-13 at 9.11.25 PMNotice he says “a sitting President” which could refer to anyone, including the President of the local chess club.

Screen Shot 2017-03-13 at 9.14.14 PMThe bad (or sick) guy might seem like an attack on Obama, but it you look closely it directly follows his reference to Nixon, who was indeed a bad or sick guy.  And in any case, Trump said “tapp my phones” which has a completely different meaning from “tap my phones”  Trump was sending a subtle signal of support for an organization that promotes online commerce in emerging markets.  People are reading way too much into these tweets.  Scott Adams showed that Trump’s tweets are actually a form of esoteric writing that only real Americans can understand.


In the news

1. There’s an interesting story in the WaPo showing the steep decline in the number of college students who favor free speech.  In 1976 (when I was in college), about 90% favored allowing communists to speak on campus, whereas today the figure is below 75%.  Even steeper drops occurred regarding free speech for racists.  Unfortunately, the academic study is gated.  I’d love to know what sort of overlap there was between those opposed to free speech for racists and those opposed to free speech for communists.  (And please don’t tell me that “it’s obvious”, as it most certainly is not.)

2.  When I waste time pointing to one of Trump’s many lies, his supporters will leave comments providing preposterous defenses for his statements—even libertarians who should know better.  Now we see that his press secretary thinks it’s so obvious to everyone that Trump is a pathological liar that he can freely joke about it with the press corps.

3.  Speaking of Trump lies, Max Boot thinks that Trump’s recent lies about Obama engaging in criminal acts are the sign of a desperate man who thinks the Feds are closing in on him. Interesting article.

4.  And McCain wonders why Trump doesn’t simply release the evidence:

“The president of the Unites States could clear this up in a minute,” McCain said. “All he has to do is pick up the phone, call the director of the CIA, director of National Intelligence and say, ‘OK, what happened?’ Because they certainly should know whether the former president of the United States was wiretapping Trump Tower.”

Indeed, if Trump had obtained wiretapping information from his own intelligence sources, he would have the authority to declassify the material and substantiate his claims.

“It looks as if the president just for a moment forgot that he was president,” former NSA and CIA Director Michael Hayden said last week on Fox News. “Why didn’t he simply use the powers of the presidency to ask the acting director of national intelligence, the head of the FBI, to confirm or deny the story he apparently read from Breitbart the evening before?”

So Trump knows not his own presidential superpowers.

5.  The FT has a very interesting article about the civil war within the White House over trade.  Trump seems to side with the protectionists like Bannon and Navarro, but the free traders like Cohn seem to have the upper hand.  This will be an interesting test of my claim that presidents are much less powerful than people assume.

And what does the Secretary of State think about this issue?  Last time I saw Tillerson his face was on the side of a milk carton.  (Oops, someone beat me to it.)

If you aren’t having fun watching the Trump show, then you really should consider psychiatric evaluation.

Update:  Miguel Madeira left this very informative comment on the poll results:

“I’d love to know what sort of overlap there was between those opposed to free speech for racists and those opposed to free speech for communists. ”

In the GSS it is possible to have an idea, because is a database with public access on-line.

Go there

In “Row” write SPKRAC; in “Column” write SPKCOM; run the table.

You will find that 68.6% of the respondents who say that communists should not be allowed to speak also say that racists should not be allowed to speak.

No, return to the main page and in “Control” write YEAR; run the table; now, you can see the evolution during the years; my impression is that the overlap is growing: in 1976, only 63% of the people who wanted to ban communist speech wanted also to ban racist speech; in 2014, 75% of the people who wanted to ban communist speech wanted also to ban racist speech.